Accounting For Managers

Accounting for Managers 1
Module-1: Introduction to Financial Accounting

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Module Objectives-
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The objective of this module is to introduce concepts of financial accounting such as
basics of accounting - rules of debit & credit, accounting cycle, journal entry & ledger
posting & trial balance etc. and knowledge of accounting principles.
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Learning Outcome:
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At the end of this module, learner will be able to-
1. Understand and apply the essential numerical skills required for accounting and
bookkeeping.
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2. Understand and describe the relationship between the accounting equation and
double-entry bookkeeping.
3. Record the transactions in appropriate ledger accounts employing the double-
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entry bookkeeping system.
4. Balance off ledger accounts at the end of an accounting period and prepare a trial
balance.
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“Accounting may be defined as the collection, compilation and systematic
recording of business transactions in terms of money, the preparation of
financial reports, the analysis and interpretation of these reports and the use
of these reports for the information and guidance of management”.
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According to A. W. Johnson-
Introduction
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Business is an economic activity conducted to earn profits and increase the wealth
of the owner. Business rules are based on general principles of trade social values and
the national or international boundaries legal framework. While these variables the vary
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for different companies and regions, the basic goal is to add value to the product or
service in order to satisfy customer demand.
Through reporting all transactions related to the development of monetary inflows

of sales revenue and monetary outflows of operating expenses, a business accounting
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system ensures an accountability. The accounting system provides the financial

information needed to assess the efficacy of both current and past activities. The
accounting system also provides the data required to file reports that show the status of
a business entity’s borrower liabilities, ownership equities and asset capital.
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1. Financial Accounting Meaning and Function

Accounting is a business language which elucidates the various kinds of
transactions during the given period of time. Accounting is broadly classified into three
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different functions viz. Recording , Classifying and Summarizing.
Amity Directorate of Distance & Online Education

Mod ul e- 1 : I ntrod uction to F inancial Accounting

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Mod ul e O b j ectiv es-
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The objective of this module is to introduce concepts of financial accounting such as
basics of accounting - rules of debit & credit, accounting cycle, journal entry & ledger
posting & trial balance etc. and knowledge of accounting principles.
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L earning O utcom e:
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At th e end of th is m od ul e, l earner w il l b e ab l e to-
1. Understand and apply the essential numerical skills required for accounting and
bookkeeping.
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2. Understand and describe the relationship between the accounting equation and
double-entry bookkeeping.
3. Record the transactions in appropriate ledger accounts employing the double-
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entry bookkeeping system.
4. Balance off ledger accounts at the end of an accounting period and prepare a trial
balance.
r
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“Accounting may be defined as the collection, compilation and systematic
recording of business transactions in terms of money, the preparation of
financial reports, the analysis and interpretation of these reports and the use
of these reports for the information and guidance of management”.
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According to A. W. Johnson-
I ntrod uction
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Business is an economic activity conducted to earn profits and increase the wealth
of the owner. Business rules are based on general principles of trade social values and
the national or international boundaries legal framework. While these variables the vary
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for different companies and regions, the basic goal is to add value to the product or
service in order to satisfy customer demand.
Through reporting all transactions related to the development of monetary inflows

of sales revenue and monetary outflows of operating expenses, a business accounting
m
system ensures an accountability. The accounting system provides the financial

information needed to assess the efficacy of both current and past activities. The
accounting system also provides the data required to file reports that show the status of
a business entity’s borrower liabilities, ownership equities and asset capital.
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1 . F inancial Accounting Meaning and F unction

Accounting is a business language which elucidates the various kinds of
transactions during the given period of time. Accounting is broadly classified into three
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different functions viz. Recording , Classifying and Summarizing.

2 Accounting for Managers
Accounting is treated as the language of business. It records all the transactions

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which can be measured in money and have occurred in a particular period. Accounts of
a business provide useful information to its users.
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Functions of Accounting
Accounting has a very broad scope and area of operation. Its use is not limited
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only to the business world but is distributed throughout all facets of society and all
occupations. Nowadays, financial transactions must take place in any social institution
or professional practice, whether that is income generating or not. Therefore the need
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to record and summarize these transactions as they occur emerges and there is a need
to figure out the net result of the same after the expiry of a certain fixed period.
●● To keep systematic records - Accounting is performed to keep a systematic

record of financial transactions. The primary objective of accounting is to help
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collect financial data and to record it systematically for the derivation of correct and
useful results of financial statements.
●● To ascertain profitability - With the help of accounting, the profits and losses
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incurred during a specific accounting period can be evaluated. With the help
of a Trading and Profit& Loss Account, the profit or loss of a firm can be easily
determined.
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To ascertain the financial position of the business - A balance sheet or a
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statement indicates the financial position of an Enterprise as on a particular date.
A properly drawn balance sheet gives us an indication of the value of assets, the
nature and value of a liability, and also the capital position of the firm. Thus, the
soundness of any business entity can be easily ascertained.
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●● To assist in decision-making - To take decisions for the future, there is a need

for accurate financial statements. One of the main objectives of accounting is to
take the right decisions at the right time. Thus, accounting gives the platform to
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plan for the future with the help of past records.

●● To fulfill Law compliance - Business entities like organizations, trusts, and
societies are being run and governed according to different legislative acts.
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Similarly, different taxation laws (direct-indirect tax) are also applicable to every
business house. It is requires to keep and maintain various types of accounts
and records as prescribed by corresponding laws of the land. Accounting helps in
running a business in compliance with the law.
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2. Role of Accounting in Business

Appropriate and appropriate accounting system plays a vital role in the successful
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operation of the enterprise. It also helps in determining production costs, controlling

the enterprise’s internal as well as external activities, forecasting profit, cost and sales,
etc. Accounting also helps to locate errors, to distribute dividends and bonuses to
shareholders. Thus, accounting is being used as a means to achieve the objective of
the business. The other advantages of the accounting are as follows:
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●● Helps in the determination of financial results and presentation of financial

position: Accounting is very useful in the determination of the profit and loss of a
business and demonstrating the financial position of the business.
●● Helpful to assess the tax liability: A business needs to pay the corporate tax,
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VAT and excise duty, etc. Therefore, it is necessary that proper accounts should
be maintained to compute the tax liability of the business.
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●● Helpful in the valuation of business: If the business is shut down and sold,
accounting helps in the determination of the value of business. It would be possible
only in the case when the accounts of the business are properly maintained.
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●● Helpful in the valuation of shares and goodwill: If accounts of the business
are properly maintained, it will be convenient to determine the value of goodwill.
Goodwill is very important for the determination of the value of shares of the
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Enterprise.
●● Accounting makes comparative statements possible: Proper and adequate
accounting helps in comparing the income, expenditure, purchase, sale of the
current year with that of the previous years. And then future plans, policies and
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forecasting may be possible.
●● Fund raising become easy: It helps in raising funds from investors or financial
institutions by promising investors a fixed claim (interest payments) on the cash
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flows generated by the assets, with a limited or no role in the day-to-day running of
the business.
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Human memory replacement: As the human’s memory is limited and short,
it is difficult to remember all the transactions of the business. Therefore, all the
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financial transactions of the business are recorded in the books. By this way
the businessmen cannot only see the records at the required time but can also
remember them for a long time. Thus, recording of the transactions is the
replacement of human’s memory.
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3. Branches of Accounting
Accounting is an old science that aims at keeping records of various transactions.
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Accounting is considered to be essential for record-keeping of all the receipts and

payments as well as the income and expenditures. Accounting can be broadly classified
into three categories:
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1. Financial Accounting - Financial accounting is aimed at identifying an accounting

year’s results in terms of profits or losses and assets and liabilities. To do this it
is important that numerous transactions are documented systematically. Financial
accounting is characterized as an art and science of systematically classifying,
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analyzing and reporting business transactions in order to prepare a report at the end
of the year to assess the details of the related year.
Financial Accounting Involves the Following Terms -

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●● Business transactions: A business transaction is any activity that creates

a kind of legal relationship. For example, the purchase and sale of goods,
appointing an employee and paying salary, payment of various expenses,
purchase of assets, etc.
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●● Classification of transactions: Before recording any transaction, it is

essential to classify it. A transaction can be classified as a cash and credit

transaction. Similarly, transactions of receiving income and expenditure

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payment can be segregated.
●● Recording of transactions: The essence of financial accounting is the
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recording of transactions. In accounting terms, recording of the transaction is
known as entry, and there are specific rules for recording various transactions
in books of accounts.
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2. Cost Accounting - Cost accounting is intended to capture an Enterprise’s production
costs by assessing the input costs for each production phase, as well as fixed costs
such as depreciation of an equipment. Cost accounting must analyze and record
these costs independently first, and then compare the results with expected or
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measurable outcomes to help the Enterprise assess financial performance. Cost
accounting is often used within an Enterprise to facilitate decision-making, and
financial management is typically seen by the investor’s external community. Cost
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accounting can also be useful in budgeting and setting up cost control systems as
a method for management, which can increase the Enterprise’s net profits in the
long run.
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3. Management Accounting - Management accounting is the application of
professional knowledge and skills for the preparation and presentation of accounting
information in such way that assists the management in the formulation of policies
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and also in planning and controlling the operations of the organization. The main
purpose of management accounting is to provide information to the management
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team at all levels within the organization for the following purposes:
(a) Formulating the policies––strategic planning
(b) Planning the activities of the organization––corporate planning
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(c) Controlling the activities of the organization

(d) Decision-making––long-term and tactical
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(e) Performance appraisals at strategic and operational level - A management

accounting/cost statement provides information to allow managers to plan,
control and organize the activities of the business.
The purpose of a costing/management accounting information system is:
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1. Provide information about the cost of the product to be used in financial

statements.
2. Provide information for planning, organizing and controlling.
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Difference between Management Accounting and Financial Accounting
S.no Management Accounting Financial Accounting

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1 Management Accounting is primarily Financial Accounting is based on the

based on the data available from monetary transactions of the enterprise.
Financial Accounting.
2 Reports prepared in Management Reports as per Financial Accounting are

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Accounting are meant for management meant for the management as well as for
and as per management requirement. shareholders and creditors of the concern.

3 It provides necessary information to Its main focus is on recording and classifying

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the management to assist them in monetary transactions in the books of
the process of planning, controlling, accounts and preparation of financial
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performance evaluation and decision statements at the end of every accounting
making. period.
4 Reports may contain both subjective Reports should always be supported by
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and objective figures. relevant figures and it emphasizes on the
objectivity of data.
5 Reports are not subject to statutory Reports are always subject to statutory audit.
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audit.
6 It evaluates the sectional as well as the It ascertains, evaluates and exhibits the
entire performance of the business. financial strength of the whole business
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4. Basic Accounting Terminology
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Accrual Basis: Accrual System means a cost incurred (i.e. accrued) is duly
accounted for irrespective of whether it is paid or not during that period. In addition, all
transaction are supposed to have dual aspect- debit aspect and a credit aspect.
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Liability: A liability is characterised as the future economic benefit sacrifices that
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the organisation is obligated to make as a result of past transactions or other past
events to other entities.
Double entry system: The double-entry accounting or bookkeeping scheme

means that sums must be reported in a minimum of two accounts for any business
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transaction. The double-entry system also specifies that the amounts entered as debits
must be equal to the amounts entered as credits for all the transactions.
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5. Capital Structure
Capital structure is the makeup of a firm’s capitalization. It represents the mix of
different sources of long term funds such as equity and preference shares, long term
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loans, retained earnings etc. In the total capitalization of an Enterprise. For example an
Enterprise has 1,00,000 equity shares, 1,00,000 preference shares, 50,000 debentures
and also 50,000 retained earnings, in this case the capitalization is of Rs. 3,00,000 as
the term capitalization is used for total long term funds. The term capital structure is
used for the mix of capitalization. In the given example it can be stated that the capital
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structure of an Enterprise consists of 1,00,000 equity shares, 1,00,000 preference

shares, 50,000 debentures and also 50,000 retained earnings.
The capital structure is the particular combination of an Enterprise’s debt and

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equity to finance its overall operations and growth. Debt comes in the form of bond
issues or loans, whereas equity may come in the form of common stock, preferred
stock, or retained earnings. Short-term debt such as provisions for working capital is
also considered a part of the capital structure.
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Understanding Capital Structure

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A reference to the capital structure is mostly to the debt-to-equity (D / E) ratio of
an Enterprise which provides insight into how risky the borrowing practices of an
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Enterprise are. A firm that is heavily financed by debt usually has a more aggressive
capital structure and thus poses greater risk to investors. However, this risk could be
the primary source of growth for the Enterprise.
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●● Debt is one of two main ways in which a business can raise money on capital
markets. Companies benefit from debt because of their tax benefits; interest
payments made as a result of borrowing funds can be deductible from taxes.
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Debt also allows a firm or business to retain ownership, as opposed to equity.
Furthermore, debt is ample and easy to access in periods of low interest rates.
●● Equity allows for part ownership in the Enterprise from outside investors.
Equity is costlier than debt, particularly when interest rates are low. Like debt,
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however, equity doesn’t need to be repaid. In the case of declining profits, this
is a gain to the Enterprise. By contrast, equity represents an owner’s claim on
the Enterprise’s future earnings.
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6. Capital & Revenue- Expenditures and Receipts
The profit and loss account and the balance sheet are, together popularly known
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as the final accounts. The profit and loss account is prepared to show the financial
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results of a business and the balance sheet is prepared to show the financial position.
To calculate the accurate amount of profit or loss, it is a must that there should be
recognition of the revenues and expenditures. If there is a wrong recognition of
expenses or revenues, results of the business will also be wrong. Thus, the distinction
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between the capital and revenue items is very important.
In business, there are thousands of items of expenditure. The following are some
of these expenditures which are generally incurred in all types of business:
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1. Purchase of goods
2. Purchase of fixed assets such as Building, Furniture, Machine, etc.
3. Carriage inwards
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4. Octroi
5. Purchase of Raw Material
6. Import duty
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7. Coal, gas, water, oil, grease, fuel, heating and lighting

8. Wages paid to workers for installation of machinery
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9. Salaries
10. Rent, rates and taxes
11. Stationery and printing
12. Postage and Telegrams
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13. Entertainment

14. Repairs and renewals

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15. Depreciation on fixed assets
16. Office expenses
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17. Bank charges
18. General expenses
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19. Travelling expenses
20. Overhauling of second hand machinery purchased
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21. Major repairs affected for reconditioning a machinery/the old assets
22. Increasing the seating capacity of a cinema hall
23. Constructing an additional room
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24. Carriage for bringing a fixed asset to place of business
25. Shifting business to convenient premises
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26. Advertisement on introducing a new product in market
27. Replacement of hand driven machine by automatic machine
28. Research and development
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There are two types of expenses and two types of incomes which are classified as:
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1. Revenue expenditure/Revenue receipts
2. Capital expenditure/Capital receipts
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a. Classification of Expenditures
Expenditures of a business are classified into following three categories:
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1. Capital expenditure: If expenditure is incurred in the business to get its

benefit for a long period, such expenditure is called capital expenditure. The
benefits of capital expenditures are generally availed in several accounting
years. Example: Expenditure to acquire a fixed asset as purchase of plant and
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machinery, land and buildings and furniture, Carriage paid in connection with
the purchase of fixed asset etc.
2. Revenue expenditure: When expenditure is done for a short period (less than
one year) and for the regular operation of business, it is termed as revenue
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expenditure. Their benefits are taken by the business in the current period
only. Example: Expenses incurred during the normal course of business – as
salaries of the staff, rent and taxes, fuel and electricity used for the running of
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machinery and cost of sales, Depreciation of fixed assets, expenditure incurred

for the upkeep of an asset etc.
3. Deferred revenue expenditure: There are certain revenue expenditures that
are incurred during one accounting year but are applicable wholly or in part in
future periods such as heavy expenditure on advertisement for introducing a
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new product in the market or for exploring new markets for the product. These
expenditures appear to be revenue expenditure. But it is not so because the
benefit from this is likely to the enjoyed over a number of years. When revenue
expenditure is done for the benefit of two or three years, it is termed as deferred
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revenue expenditure. Example: cost of heavy campaign of advertisement,
preliminary expenses, etc. The benefit of such type of expenditure is enjoyed
by the Enterprise for a number of years.
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b. Distinction Between Capital and Revenue Expenditure
1) An expenditure which increases the earning capacity of a fixed asset is a capital
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expenditure whereas an expenditure incurred for maintaining a fixed asset is
revenue expenditure.
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2) Cost of acquisition and installation of a fixed asset is a Capital expenditure
whereas purchase price of goods bought for resale is revenue expenditure.
3) An expenditure incurred for the acquisition of a source of income is a capital
expenditure whereas an expenditure incurred for the purpose of earning of an
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income is revenue expenditure.
4) An expenditure incurred by a person to free himself from a capital liability is
a capital expenditure. Whereas an expenditure incurred by a person to free
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himself from a revenue liability is a revenue expenditure.
5) An expenditure incurred in obtaining capital by issuing shares is a capital
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expenditure whereas expenditure incurred for raising loans or issuing
debentures is revenue expenditure.
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c. Classification of Receipts
Receipts of a business are classified into following categories:
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1. Capital Receipts: The receipts which do not arise out of normal course of
business are known as Capital Receipts. These do not affect profit/loss of
business. They either increase liability or reduce the asset. Capital receipts
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include the sale of fixed assets, long-term investments, and issue of share
capital, debentures and loan rose. Capital receipts are different from the capital
profits or loss. The entire amount from the sale of assets is called capital receipts
and the difference of sale proceeds and cost of assets is capital profit or loss.
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2. Revenue Receipts: The receipts which arise out of normal course of a

business are known as Revenue Receipts. These are shown on credit side
of P/L account. In other words, the receipts which are not capital receipts are
revenue receipts as sale of goods. These include income from sale of goods;
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dividend received from shares, rent received form letting out the business
property, Interest received from investment.
d. Differences between Capital and Revenue Receipts

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1. Sale proceeds of a fixed asset are a capital receipt. Whereas, the sale proceeds
of a trading asset is a revenue receipt.
2. A receipt in substitution of a source of income is a capital receipt. Whereas, a
receipt in substitution of income is a revenue receipt.
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3. Compensation received for loss of business is a capital receipt. Whereas,

compensation received for loss of profit is a revenue receipt.

4. Subsides or grants received from the government for any development scheme
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is a capital receipt. Whereas, subsidy or grants received from the government
for meeting foreign competition is a revenue receipt.
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5. Insurance money received for loss of a capital asset is a capital receipt.
Whereas, insurance money received for the loss of a trading asset is a revenue
receipt.
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7. Accounting Concepts and Conventions
Accounting principles are the basic guidelines which set standards for scientific
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accounting practices and procedures. They guide as to how to record and report the
transaction and also guarantee uniformity and understandability. The accounting
standards lay the foundations for the principles of accounting.
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Such principles ensure that financial facts are documented on solid foundations, and
rational criteria. Accounting Conventions are widely accepted approaches or procedures.
We follow the Conventions as transactions are registered or interpreted. The terms-
principles, definitions and conventions are however used interchangeably at times.
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A. Basic Assumptions
(a) Business Entity Concept - This concept explains how distinct the business is
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from its owner. Thus, business transactions are to be recorded in the business
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books only.
For example, a business should pay its debts and file its own income tax return.
The owner is required to file their income tax return that is separate from the business
return. The property or assets that a business owns must be recorded separately from
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the property that the owner of the business has.
Significance
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The significance of business entity concept is:
●● The concept helps in the ascertainment of the profit of business as only the
business expenses and revenues are recorded and all the other private and
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personal expenses are ignored.

●● The concept restraints the accountants from recording of the owner’s private
and personal transactions. Facilitates the recording and reporting of the
business transactions from the point of view of business.
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●● It is the very basis of accounting concepts, conventions, and principles.

(b) Going Concern Concept - When a business is started, the operations
are intended to last for some time or continue. It does not intend to go into
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bankruptcy or instantly dissolve. It expects to be able to meet its responsibilities

to its consumers or partners, to offer goods or services. The business often
continues, even when the ownership changes. The concept assumes that the
business has a perpetual succession or continued existence.
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For example, an Enterprise purchases a plant and machinery of Rs.2, 00,000

with a life span of 10 years. According to the concept every year some amount will be

shown as expenses and the balance amount as an asset. Thus, if an amount is spent
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on an item which will be used in business for many years, it will not be proper to charge
the amount from the revenues of the year in which the item is acquired. In the year of
purchase, only a part of the value is shown as expense and the remaining balance is
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shown as an asset.
Significance
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●● The significance of the going concern concept is;
●● The concept facilitates preparation of financial statements.
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●● On the basis of this concept, depreciation is charged on fixed asset.
●● It is of great help to the investors, as it assures, that there will be a continuous
income on their investments.
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●● The cost of a fixed asset will be treated as an expense in the year of its
purchase in the absence of the concept.
●● A business is accurately judged for its capacity to earn profits in future.
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(c) Money Measurement Concept – The concept assumes that all business
transactions must be in terms of money that is in the currency of a country.
In our country the transactions are in terms of rupees. Thus, according to this
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concept only those transactions which are expressed in money terms are to be
recorded in the books of accounts.
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For example, sale of goods worth Rs. 2,50,000, purchase of raw materials Rs.1,
00,000 Rent Paid is Rs.10,000 etc. are expressed in terms of money. Thus, they are
recorded in the books of accounts. But the transactions which cannot be expressed in
monetary terms are not recorded in the books of accounts.
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For example, loyalty, sincerity and the honesty of employees are not recorded in
books of accounts as they are immeasurable in terms of money, although they do affect
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the profits and losses of the business concern.
Significance
The following points highlight the significance of the money measurement concept :
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●● The concept guides accountants as to what to record and what not to record.
●● It helps in recording the business transactions uniformly.
●● If all the transactions are represented in monetary terms, the accounts
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prepared by the business enterprise will be easy to understand.

●● This enables the comparison of two different periods of business performance
of the same Enterprise or of the two different companies for the same
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duration.
(d) The Accounting Period Concept – According to the concept, all the
transactions are recorded in the books of accounts on the assumption that
profits on these transactions are to be ascertained for a specified period. Thus,
the concept requires that a balance sheet and profit and loss account should
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be prepared at regular intervals. This is relevant for various purposes such

as income calculation, financial position ascertainment, tax calculation etc.

Furthermore, the concept assumes that infinite business life is divided into
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parts. These sections are called as the Accounting Period. It may be of one
year, six months or three months etc., but usually one year is taken as one
accounting period which can be either a calendar year or a financial year.
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Significance
●● It helps in the prediction of future prospects of a business.
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●● It helps in the calculation of tax on the business income that is calculated for a
particular time period.
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●● It also helps the banks, financial institutions, creditors, etc. to assess and
analyze the performance of a business for a particular time period.
●● It also helps the business firms to distribute their income at regular intervals
as dividends.
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(e) The Accrual Concept – Accrual means something which becomes due,
especially an amount of money that is yet to be paid or received at the end of
an accounting period. This also means that revenues are recognized when they
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become receivable. The accrual concept is based on the recognition of both
cash and credit transactions. In case of a cash transaction, the owner’s equity
is instantly affected as cash either is received or paid. In a credit transaction, a
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mere obligation towards or by the business is created. When credit transactions
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exist, the revenues are not the same as cash receipts and expenses are not
same as cash paid during the period. Thus, the concept makes a distinction
between the accrual receipt of cash and the right to receive cash.
For example, a firm sells goods for Rest 50,000 on 20th March, 2008 and the
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payment is not received until 10th April 2008, the amount is due and payable to the firm
on the date of sale i.e., 20th March 2008. It must be included in the revenue for the year
ending 31st March 2008.
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Significance
●● Helps in the determination of actual expenses and actual income during a
particular time period.
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●● Helps in the calculation of the net profit of the business.
B. Basic Principles
(a) Realization Concept – The concept emphasizes on recording of only those
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transactions which are actually realized. For example, the sale or profit on
sales will be taken into account only when money is realized, i.e.. either cash is
received or legal ownership is transferred.
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Example – Mr. A sold goods for Rs.1,00,000 for cash in 2008 and the goods have
been delivered during the same year, Thus, The revenue for Mr. A for year 2007 is
Rs.1,00,000 as the goods have been delivered in the year 2007. Cash has also been
received in the same year.
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Significance
●● It makes the accounting information more objective.

●● Provides that, transactions must be recorded only when goods are delivered
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to the buyer.
(b) Matching Concept - It is referred to as matching of expenses against incomes.
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The concept states that all incomes and expenses relating to the financial period
to which the accounts relate should be taken in to account without regarding the
date of receipts or payment.
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Significance
●● Guides on how to balance expenditures with revenue to calculate exact profit
or loss for a given period.
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●● Helpful for the investors or the shareholders for determining the exact amount
of profit or loss of the business.
(c) Full Disclosure Concept - According to the concept, all significant information
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must be disclosed. For the purpose of presenting the financial statements
that are useful to accounting information users, accounting details should be
adequately described, summarized, aggregated, and explained. In practice,
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this concept underlines the materiality, objectivity and accuracy of accounting
data which should show a true and fair view of a firm’s state of affairs.
(d) Duality Concept - According to this concept each transaction has two aspects,
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i.e. the aspect of benefit receiving and the aspect of benefit giving. Such two
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factors are to be identified in the account books.
For example, goods purchased for cash has two aspects -
(i) Giving of cash

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(ii) Receiving of goods. These two aspects are to be recorded.

The duality concept is expressed in terms of fundamental accounting equation as –
Assets = Liabilities + Capital

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The above accounting equation states that the assets of a business are always
equal to the claims of the owner and the outsiders. The claim is also termed as capital
or owners’ equity and that of outsiders, as liabilities or creditors’ equity.
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(e) Verifiable Objective Concept – As per this concept, the accounting data
must be verified. It means the documentary proof of transactions that can be
checked by an independent respect must be given. Without such assurance,
the available data will neither be accurate nor correct, i.e. those details will be
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biased. Both verifiability and objectivity express dependability, reliability and the
trustworthiness, which is useful for the purpose of displaying accounting data
and information to the users.
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Significance
●● The concept requires assets to be shown at the price they have been
acquired, which can be verified from the supporting documents.
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●● Helps in the calculation of depreciation on fixed assets.

●● The effect of cost concept is that the item will not be shown in the account
books if the business entity does not pay anything for an asset
(f) Historical Cost Concept - Business transactions are always recorded at the
Notes
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actual cost at which they are undertaken. The main advantage is that, there
is an avoidance of the arbitrary value being attached to the transactions.
Whenever an asset is acquired, it is recorded at its actual cost, and the same
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is used as the basis for all subsequent accounting purposes, such as charging
depreciation on asset use.
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For example, if production equipment is bought for Rs.2 crores, the asset will be
shown at the same value in all future periods when disclosing the original cost. It will
be reduced by the amount of depreciation, which will be calculated with reference to
the actual cost. The actual value of the equipment may increase or decrease after
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the purchase but this is deemed irrelevant for accounting purposes according to the
concept. The limitation of this concept is that the balance sheet does not represent
the market value of the business-owned assets and therefore the owner’s equity will
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not reflect the real value. On an ongoing basis, however, the properties are seen as
reduced by depreciation at their historical prices.
C. Modifying Principles
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Accounting Convention refers to the customs and traditions followed by
Accountants as guidelines while preparing accounting statements. The important
accounting conventions are as follows:
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Accounting Conventions
Convention of Consistency Convention of Disclosure
Convention of Conservation Convention of Materiality

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(a) The Concept of Materiality or Full Disclosure - Materiality can be related to

information, amount, procedure and nature. According to the concept, all such
information having the chance to influence financial information including the
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owners is relevant and must be integrated into the accounting process. Error
in the description of an asset or a misclassification between capital and profits
may result in information materiality.
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For example, Where at the end of the accounting period postal stamps of 300
remain unused, the same may not be considered for acknowledgment as an inventory
on account of the materiality of the number. All accounting treatments rely on the
accounting standards defined procedures. All transactions are by nature of material
regardless of the amount involved, e.g. an audit fee, loan to directors.
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(b) Consistency Concept – According to this concept, the accounting practices

should not change or must remain unchanged over a period of several years.
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This means that the accounting principles, methods, practices, and procedures
adopted in accounting process shall be applied consistently. Frequent changes
in accounting methods is not desirable in accounting process, as it reduces
third party acceptability of financial statements.
(c) Conservatism Concept or Prudence - Conservatism concept states that when
(c
alternative valuations are possible then the alternative fairly representing the
economic substance of transactions should be selected. However, when such

choice is not clear then the alternative that is least likely to overstate net assets
Notes
e
and net income must be selected. The concept provides the best estimate for
all known expenditures and losses if the sum is not known with certainty but on
the basis of expectation it does not consider sales and profits.
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(d) Timeliness Concept – According to this concept, every transaction must be
recorded in proper time. It refers to the need for accounting information to be
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presented to the users in time to fulfill their decision making needs. In short,
transaction should be recorded date-wise in the books of accounts. A delay in
providing information makes it irrelevant and less useful to the decision making
needs of the users. Further, a delay in recording such transaction may lead to
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manipulation, misplacement of vouchers; misappropriation etc. of both cash
and assets.This concept is particularly followed during day-to-day cash balance
verification. It is also followed by banks i.e., each bank verifies the cash balance
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with their cash book and must complete the same within the day.
(e) Industry Practice - As there are different types of industries, each industry has
its own characteristics and features. There may be some seasonal industries
also. Every industry follows the accounting principles and standards for
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carrying out its own activities. Some of them follow to the values, definitions and
conventions in a modified manner. For example, the electric supply companies
or the insurance companies maintain their accounts in a specific manner.
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Insurance companies prepare a revenue account to ascertain the profit/loss
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of the Enterprise. Similarly, non-trading organizations prepare Income and
Expenditure Account to find out Surplus or Deficit.
8. Generally Accepted Accounting Principles

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A widely accepted set of rules, conventions, standards, and procedures for

reporting financial information, as established by the Financial Accounting Standards
Board are known as Generally Accepted Accounting Principles (GAAP). These are the
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common set of accounting principles, standards and procedures that companies use to
compile their financial statements.
GAAP is a mix of standards set by government bodies and essentially the

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commonly accepted methods of collecting and presenting information on accounting.

Organizations are to follow GAAP so that investors have an optimal level of consistency
in the financial statements they use when evaluating firms for investment purposes.
GAAP covers the aspects like revenue recognition, balance sheet items classification
and outstanding share measurements.
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a. International Financial Reporting Standards

International Financial Reporting Standards (IFRSs) are set by the International
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Accounting Standards Board (IASB) that was established in 2001 to replace the
International Accounting Standards Committee (IASC). International Financial Reporting
Standards (IFRS), formerly known as International Accounting Standards (IAS) are the
standards, interpretations and the framework preparing and presenting the Financial
(c
Statements adopted by the International Accounting Standards Board (IASB).

What is International Accounting Standards Board (IASB)?

Notes
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The IASB is the independent standard setting body of the IFRS to approve
the interpretations of IFRS as developed by the IFRS Interpretations Committee.
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The IASB engages closely with the stakeholders globally including the investors,
analysts, regulators, accounting standard setters and more. The formulation if ISB is
necessary as –
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●● There is a recognized and growing need for the common international
standards
●● No individual setter has a monopoly over a best solution to the accounting
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standards.
●● No national standard setter is in a position to set accounting standard that
gain acceptance around the world.
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Steps taken by IASB for Global Convergence
Issued a conceptual framework - It had adopted the framework issued by IASC in
1989. The framework saves as guide to IASB for developing Accounting Standards.
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Issue of IAS – Till now IASC had Issued 41 International Accounting Standards
IAS List Particulars

IAS 1 r
Presentation of Financial Statements
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IAS 2 Inventories
IAS 7 Statement of Cash Flows
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
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IAS 10 Events After the Balance Sheet Date

IAS 11 Construction Contracts
IAS 12 Income Taxes
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IAS 16 Property, Plant and Equipment

IAS 17 Leases
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IAS 18 Revenue
IAS 19 Employee Benefits
IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance
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IAS 21 The Effects of Changes in Foreign Exchange Rates

IAS 23 Borrowing Costs
IAS 24 Related Party Disclosures
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IAS 26 Accounting and Reporting by Retirement Benefit Plans

IAS 27 Consolidated and Separate Financial Statements
IAS 28 Investments in Associates
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IAS 29 Financial Reporting in Hyperinflationary Economies

IAS 31 Interests in Joint Ventures

IAS 32 Financial Instruments: Presentation

Notes
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IAS 33 Earnings Per share (EPS)
IAS 34 Interim Financial Reporting
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IAS 36 Impairment of Assets
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
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IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement
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IAS 40 Investment Property
IAS 41 Agriculture
Issue of International Financial Reporting Standards (IFRS)
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IFRS 1 First-time Adoption of IFRS
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IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4
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Insurance Contracts
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IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 6 Exploration for and evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures
IFRS 8 Operating Segments
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IFRS 9 Financial Instruments

IFRS 10 Consolidated Financial Statements
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IFRS 11 Joint Arrangements

IFRS 12 Disclosure of Interests in Other Entities
IFRS 13 Fair Value Measurement
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b. IFRS Foundation
On 24 May 2000, IASC members approved the first constitution of the IASC
foundation, and on 5 March 2002, IASC foundation trustees amended those articles,
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effective that date. These amendments were necessary to implement some elements of
the IASB’s Standing Interpretation Committee preface to IFRS.
The IFRS foundation is an independent and not for profit private sector organization
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that works in public interest. The principal objectives of the organization are –
●● The main objective of the IFRS Foundation is to establish a common set of

high quality, comprehensible, enforceable and internationally agreed financial
reporting standards based on clearly articulated principles for the public
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interest.
●● Development of a single set of high quality, understandable and a globally
accepted IFRS through its standard setting body ISB.
●● Promote the use and a regular application of the principles.

Notes
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●● Take into account the financial reporting needs of the emerging economies
and the small and medium sized entities (SME’s)
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9. Accounting Cycle
When a complete sequence of accounting procedure is done which happens
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frequently and repeated in same directions during an accounting period, the same is
called an accounting cycle.
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Phases of the accounting Cycle
Collect and Analyze

Cash and every Transactions
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Take action for
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investment, credit and Posting into
similar decisions Journals
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Interpretation Posting Transactions
to ledger accounts
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Prepare financial Prepare

statements Trial Balance
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Steps in the Accounting Cycle

●● Recording of Transaction: As soon as a transaction happens it is at first
recorded in subsidiary book.
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●● Journal: The transactions are recorded in Journal chronologically.

●● Ledger: All journals are posted into ledger chronologically and in a classified
manner.
●● Trial Balance: After taking all the ledger account closing balances, a Trial
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Balance is prepared at the end of the period for the preparations of financial
statements.
●● Adjustment Entries: All the adjustments entries are to be recorded properly
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and adjusted accordingly before preparing financial statements.

●● Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.
●● Closing Entries: All the nominal accounts are to be closed by the transferring
to Trading Account and Profit and Loss Account.
(c
●● Financial Statements: Financial statement can now be easily prepared which

will exhibit the true financial position and operating results.

10. Accounting Equation

Notes
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The recording of business transaction in books of accounts is based on a
fundamental equation called accounting equation. Whatever business possesses in the
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form of assets is financed by proprietor or by outsiders. This equation expresses the
equality of assets on one side and the claims of outsiders (liabilities) and owners or
proprietors on the other side.
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In Mathematical form = Assets = Liabilities + Capital
Or A = L + P or
P=A–L
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Or L = A – P
Where A = Assets, L = Liabilities, P = Capital
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For example –
Mr. A has started business by contributing INR2, 00,000 as Capital. It can be said
that asset in the form of Cash has been created for the business concern.
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Hence, Cash = Rs. 2,00,000 Capital = Rs. 2,00,000
Mr. A later on purchased furniture for INR.20, 000 and machinery for 60,000. Now
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the position of the assets is a follows
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Capital = Cash + Machinery + Furniture
2,00,000 1,20,000 20,000 60,000
( 2,00,000 – 80,000)
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From the above business transactions, we find that Capital = Assets or Assets
= Capital Increase or decrease in capital will result in the corresponding increase or
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decrease in assets.
For example, Mr. A introduces INR50, 000 as additional capital
Capital = Cash + Machinery + Furniture

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2,00,000 + 50,000 1,20,000 + 50,000 20,000 60,000

2,50,000 1,70,000 20,000 60,000
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In general, any business concern borrows money by outsiders to carry out its
operations. To put it another way, through business concern owes money to outsiders.
Such assets are financed by the funds provided by both proprietors and outsiders.
Money borrowed from outsiders is called a liability.
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Example – XYZ Ltd. is a company incorporated to carry on the business of selling

juices. XYZ Ltd.’s transactions for the month of January were as follows:
Jan. 1 Issued equity shares of 20,00,000 (cash received in full).

(c
Jan. 5 Purchased land for 5,75,000.

Jan. 8 Purchased a building for 4,40,000, paying 1,40,000 in cash and the balance
payable in three monthly installments.

(c
(Figures are in `)
Assests Liabilities +Capital
Solution –
Cash Inventory Land Building Machinery Creditors Bills
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Payable
Accounting for Managers
Jan. 1 (+) 20,00,000 +20.00.000

Jan. 5
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(-) 5,075,000 +5,75,000
Balance 14,25,000 5,75,000
Jan. 8 (-) 1,40,000 ________ + 4,40,000 = +3,00,000
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Balance 12,85,000 5,75,000 4,40,000 =3,00,000 20,000,00
Jan. 15 (-)2,20,000 U_______ +2,20,000 =_______
Balance 10,65,000 5,75,000 4,40,000 2,20,000 =3,00,000 20,00,000
Jan. 15 Purchased machinery worth 2,20,000.
Jan. 20 (-)1,75,000 +5,75,00 +4,00,000

Balance 80,90,000 5,75,000 5,75,000 4,40,000 2,20,000 =3,00,000 4,00,000 20,00,000
Jan. 25 Purchased further machinery worth 50,000.
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Jan. 25 (-)50,000 _______ _______ _______ +50,000 _______ _______
Balance 8,40,000 5,75,000 5,75,000 4,40,000 2,70,000 =3,00,000 4,00,000 20,00,000
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Jan. 31 +50,000 (-)30,000 _______ +20,000
effects of the above transactions upon the accounting equation.
(50,000-
r 30,000)
Balance 8,90,000 5,45,000 5,75,000 4,40,000 2,70,000 =3,00,000 4,00,000 20,20,000
1,75,000 in cash and accepting a bill drawn by the supplier for the balance.
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Jan. 31 Sold cold drinks worth 50,000 (consuming 30,000 of syrup). Show the
Jan. 20 Purchased syrup (raw material) for making soft drinks worth 5,75,000, paying
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Notes

19
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11. Recording of Transactions

Notes
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Accounting is the analysis & interpretation of book keeping records. It includes
not only the maintenance of accounting records but also the preparation of financial &
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economic information which involves the measurement of transactions & other events
relating to entry.
The main object of keeping the books of accounts is to ascertain the profit or loss
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of business and to assess the financial position of the business at the end of the year.
The object is better served if the businessman first satisfies himself that the accounts
written up during the year are correct or at least arithmetically accurate. When the
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transactions are recorded under double entry system, there is a credit for every debit,
when on a/c is debited; another a/c is credited with equal amount.
In the Journal the business transactions of the financial nature are recorded on
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the basis of debit and credit. The accounts are debited and credited on the basis of
following rules. These rules are based on the English classification of accounts.
The accounts are classified as -
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1. Personal Account: If in a transaction, individual receives something in cash
or goods, it is debited and if he gives, it is credited. Debit account is denoted by
‘Dr.’ while credit account is denoted by ‘Cr.’ In brief, the rule of personal account is
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Receiver is debited (Dr.) Giver is credited (Cr.)
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2. Real Account: If in a transaction, the assets are coming into business, they are
debited and if those are going outside from business, they are credited. Thus these
rules are as below: ‘What comes in’ is debited ‘What goes out’ is credited
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3. Nominal Account: The rules of debiting and crediting of nominal account are –
the expenses and losses of the business are debited and the gains and profit of
the business are credited. In brief the rules are: Expenses and Losses are debited
Incomes and Gains are credited
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At the time of Journalising of the transactions, when an account is debited it is

denoted by ‘Dr.’ and crediting of an account by ‘To’. When a transaction is recorded first
of all its two aspects (accounts) are identified, those may of the same group (same type
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of account) or different groups (different types of accounts). Then the rules of debiting
and crediting are applied. On the completion of a page of the Journal it is totaled and
the balance is carried forward to the next page.
Since ‘Source’ and ‘Uses’ are relatively longer words, as in Chemistry, they can
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be replaced by short symbols. The accepted symbol for sources is Cr. and that for
uses is Dr. These symbols are purely incidental and could well have been switched or
entirely changed without any loss in generality whatsoever. However, the symbol Cr. is
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commonly pronounced as ‘CREDIT’ and the symbol Dr as ‘DEBIT’.
In accounting, the terms CREDIT and DEBIT are merely two different sounds and
do not have the same implications as they have in English Language. Thus increase in
liabilities, revenue or profits being sources of funds are all called ‘Cr’ items. Similarly,
increase in assets, expenses and losses being uses of funds are called ‘Dr’ items. This
(c
may be expressed by the following matrix.

Increase Decrease
Notes
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Liability, revenue and Profit CR=Source DR=Use
Asset, Expense and Loss DR=Use CR=Source
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Modern Approach to Accounting
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Under the Modern Approach, the accounts are not debited and credited. Hence,
the Accounting Equation is used to debit or credit an account. Thus, it is also known as
the Accounting Equation Approach.
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Modern Classification of Accounts
Types of accountq Normal Account to be Account to be

balance of debited when credited when
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account there is; there is:
Asset account Debit Increase Decrease
Liabilities account Credit Decrease Increase
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Capital account Credit Decrease Increase
Revenue account Credit Decrease Increase
Expenditure account Debit

r Increase Decrease
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Drawing account Debit Increase Decrease
●● Debit Amount (Debit): The debit amount is recorded in the debit amount column
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opposite to the title of the account that is being debited.

●● Credit Amount (Credit): The credit amount is recorded in the credit amount
column opposite to the title of the account that is being credited.
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The Basic Accounting Equation is: Assets = Liabilities + Capital (Owner’s Equity)
Furthermore, it can be expanded as Assets = Liabilities + Capital + Revenues –
Expenses
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Also, Profit = Revenues – Expenses

a. Assets Accounts: Assets are a business’s properties, possessions or economic
resources. They assist in company activities and help to raise money. It is possible to
calculate them in terms of revenue. Resources may be either intangible or tangible.
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You may also identify assets as fixed assets and current assets. For the long-term,
fixed assets are retained.
b. Liabilities Accounts: Liabilities are the amounts that an entity owes to the outsiders.
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These are the obligations or the debts payable by the business. Liabilities can also
be classified as Long-term and Current.
Long-term Liabilities are payable after a period of one year. For example, debentures,
bank loans, etc. Current liabilities are payable within one year. For example, creditors,
(c
bills payable, rent outstanding, bank overdraft, etc.

c. Capital Accounts: The cash brought by the investor into the corporation is called
Notes
e
Capital or Owner’s Equity. The capital may be transported by the owner in cash or
properties. Capital is a corporation responsibility that needs to be paid back to the
owner. Therefore, capital is shown on the liabilities side of the Balance Sheet. The
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capital account is shown after deducting the Drawings by the owner. Drawings are
the amount of cash, goods or assets taken by the owner for personal use from the
business.
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d. Revenue Accounts: Revenue is the amount earned by an enterprise by selling
goods or rendering of services. Also, it includes other incomes such as rent and
commission received, interest received, dividend earned, etc. All items of revenue
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are also clubbed together under the Modern Approach.
e. Expenses Accounts: All costs incurred or money invested by a corporation in
order to raise income are called costs. It is interesting here that it is considered an
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expenditure when the advantages of the money invested are exhausted within a
span of one year. If the advantage lasts for more than a year, it is called investment.
Therefore, the purchase of goods is expenditure while the cost of goods sold is an
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expense. For example, rent paid, salary paid, electricity charges, interest paid, etc.
are expenses. While the purchase of assets, purchase of short-term investments,
etc. fall under the category of expenditure.
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The Concepts Of ‘Account’, ‘Debit’ And ‘Credit’
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The concept of Account
An account is defined as a summarized record of transactions related to a person

or a thing, for example when the business deals with customers and suppliers, each of
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the customers and supplier will be a separate account.
The account is also related to things – both tangible and intangible. E.g. land,
building, equipment, brand value, trademarks etc. are some of the things. When a
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business transaction happens, one has to identify the ‘account’ that will be affected by it
and then apply the rules to decide the accounting treatment
Typically, an account has two sides. The left hand side is called as “Debit’ side and
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the right hand side is called as “Credit’ side. The debit is denoted as ‘Dr’ and the credit
by ‘Cr’. The convention is to write the Dr and Cr labels on both sides as shown below.
Dr. Cash Account Cr.

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Debit Side Credit Side
12. Journal
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Journal is a book listing an Enterprise’s financial transactions other than cash,

before adding them to ledgers. Currently, the journal is only used to a limited extent
to cover topics outside the scope of other books of accounting. Let us understand the
mechanism of recording business transaction in a journal.
Journal is a book listing an Enterprise’s financial transactions other than cash,

(c
before adding them to ledgers. Currently, the journal is only used to a limited extent

to cover topics outside the scope of other books of accounting. Let us understand the
Notes
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mechanism of recording business transaction in a journal
A Journal, as originally used, is a book of primary entry in which transactions are
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copied in the order of date from a memorandum or waste book. The entries are then
copied and classified into debts and credits, so far to facilitate their being correctly
posted afterwards in the ledger”. The proforma of a Journal is given here under:
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Pro forma of a Journal
Date Particulars L.F. Amount Dr. (`) Amount Cr. (`)
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As per the above pro forma of Journal the first column is kept for date means date
of transaction is recorded, second wide column for particulars of business transactions
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in which the related accounts are showed along with their narrations. Third column is
for ledger folio number where the journal entry is posted in ledger. The fourth and fifth
columns are kept for debit amount and credit amount.
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Business transactions of Mr.A for the month of Jan.1997.
1st January, 1997 A started business with cash Rs.20,000/-

3rd January, 1997 r
Goods purchased for cash Rs.6,000/-
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5th January, 1997 Goods purchased from S Rs.4,000/-
7th January,1997 Goods sold for cash Rs.2,000/-
10th January, 1997 Goods sold to B Rs.6,000/-
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12th January, 1997 Cash paid to S Rs.2,000/-
Journal Entries
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Dr. Amount Cr. Amount

Date Particulars
(`) (`)
1997 Cash A/c Dr. 20,000/-
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Jan. 1 To Capital A/c (Being cash introduced by A) 20,000/-

Jan. 3 Purchase A/c Dr. 6,000/-
To Cash A/c (Being cash purchases) 6,000/-
Jan. 5 Purchase A/c Dr. 4,000/-
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To S/s A/c (Being credit purchase from S) 4,000/-

Jan. 7 Cash A/c Dr. 2,000/-
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To sales A/c (Being Cash sales) 2,000/-

Jan. 10 B’s A/c Dr. 6,000/-
To Sales A/c (Being the amount of credit sales) 6,000/-
Jan. 12 S/ A/c Dr. 2,000/-
(c
To Cash A/c (Being the amount of credit sales) 2,000/-

a. Functions of Journal
Notes
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●● Analytical Function: The debit aspect and the credit aspect of each
transaction are evaluated. It helps to determine how each transaction will
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affect the business financially.
●● Recording Function: Accountancy is a business language that helps to
record the transactions based on various principles. Each of the recording
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entry is supported by a narration that explains the transaction in a simple
language. Narration means to narrate – i.e. to explain and it starts with the
word – Being.
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●● Historical Function: It contains a chronological record of all the transactions
for future references.
b. Advantages of a Journal
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●● Chronological Record: It records transactions as and when it happens. Hence,
it is possible to get detailed day to day information.
●● Minimizing the possibility of errors: The nature of transaction and its effect on
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the financial position of the business is determined by recording and analyzing
into debit and credit aspect.
●● Narration: It refers to the explanation of the recorded transactions.
●● r
Helps to finalize the accounts: Journal is the basis of ledger posting and the
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ultimate Trial Balance.
13. Principal Book: Ledger

A ledger is a list of records. Most of us probably saw a bound book printed on the
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cover, with the word ‘ledger. All an industry’s accounts may be entered in a summarized
and classified form in a ledger in the accounts concerned.
From the journal a trader cannot know his total cash, purchases, and the amount
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spent under each head of expense and also the amount earned under each head of
the income. Further, the journal does not tell as to what the trader owes to his creditors
and what his customers owe to him. Such classified information can be received only by
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opening ledger accounts for every kind of transaction.
Each ledger has two sides which are debit and credit. The left side is debit and the
right side is credit. Each side of the ledger has columns on date, particulars, journal
folio and amount. The name of the account from which benefit is earned is reported in
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the particulars column of the debit side, and on the credit side is recorded the name of
the account to which benefit is received.
The book which contains accounts is known as the ledger. Since, finding
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information pertaining to the financial position of a business emerges only from the
accounts, the ledger is also called the Principal Book. As a result, all the necessary
information relating to any account is available from the ledger. This is the most
important book of the business and hence is rightly called the “King of All Books”. It is
also known as the Book of Final Entry.
(c
The specimen of a typical ledger account is given below:

(Dr.) Particulars J.F Amount Particulars J.F Amount

Notes
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Date (Cr.)
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Ledger Posting: It is known as posting to transfer entries from the journal or
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a subordinate book to the ledger. Posting the journal ledger is simple as the journal
transactions are already marked as debit and credit. The following points should,
however, be noted before publishing the ledger.
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●● For the same person or expense only one account must be opened.
●● Cash and credit sales should be posted to the sales account and cash and
credit purchases to the purchase Account.
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●● The word Debit as Dr. and Credit as Cr. should not be omitted.
●● Date and folio columns should not be left blank.
Balancing of Ledger Accounts: The debit and credit sides of individual ledger
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accounts are tallied at periodic intervals, and the balance of each account is shown.
If any account’s total debit side is more than the credit side, then there will be a debit
balance, and if the credit side is more than the debit side, there will be credit balance.
A debit denotes:
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(a) In the case of a person has received some value from which he has already
rendered some service or in the future will render service. When a person is
responsible for doing something for the business, the fact is reported by debiting
the account of that individual, this relates to Personal Account
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(b) In case of goods or a property, the value and the stock of such goods or
properties has increased, this relates to Real Accounts
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(c) In case of other accounts like the losses or expenses, which the firm has
incurred certain expenses or has lost money, this relates to a Nominal Account
A credit denotes:
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(a) In the case of a person, he has earned some benefit, entitling him to claim a
return profit from the firm in the form of cash or products or service. When for
some reason a person is entitled to income or property. The fact is recorded by
crediting him, this relates to a Personal Account.
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(b) In the case of the goods or a property, that the stock and value of such goods
or properties has decreased, this relates to the Real Accounts.
(c) In case of other accounts like the interest or a dividend or the commission
)A
received, or discount received, that the firm has made a gain, this relates to a
Nominal Account
Example 1.
(c
Example – On 1st August 2015 goods are sold for cash Rs. 12,000

Solution:
Notes
e
Journal Entry
Date Particulars L.F Dr. (`) Cr. (`)
in
2015 Aug. 1 Cash A.c Dr. 12,000
to Sales A/c 12,000
nl
(For each sales)
Cash A/C
O
Dr. Cr.
Date Particulars J.F (`) Date Particulars J.F (`)
2015
ty
Aug. 1 To Sales A/c 12,000
Sales A/c
si
Dr. Cr.
Date Particulars J.F (`) Date Particulars J.F (`)
r 2015
ve
Aug. 1 By Cash A/c 12,000

c. Difference between Journal and Ledger

ni
Basis Journal Ledger

Nature of book It is the first/original book of entry. It is the book of final entry.
Record Book for chronological record. Book of analytical record.
U
Weight in legal Book of source entry and has a It has lesser weight as legal
evidence greater weight as legal evidence. evidence is based on journal.
Unit of classification of Unit of classification of data within Unit of classification of data
data the journal is transaction. within the ledger is an account.
ity
Process of recording Process of recording in journal is Process of recording in ledger is

called journaling. called posting.
Place More than one transaction More than one transaction
regarding one account are written regarding one account is written
m
at places date wise. at one place.
14. Illustration/Numerical on Journal entry & ledger posting

)A
Enter the following transactions in the journal and Post them in Ledger.
January 2 Furniture purchased for cash ` 20,000

2014 5 Rahul owed ` 1,500. He sent a cheque which was paid into bank the
same day for ` 1,450 in full settlement.
(c
10 Goods purchased for ` 15,000

15 Sold goods for ` 20,000

Journal
Notes
e
Date Particulars Debit Credit
in
2014 January 2 Furniture A/c 20,000
To Cash A/c 20,000
(Being furniture purchased for cash)
nl
2014 January 5 Bank Account 1,450
Discount Account 50
To Rahul’s Account 1,500
O
Being amount received in full
settlement from Rahul)
2014 January 10 Purchases Account 15,000
ty
To Cash Account 15,000
(Being purchased goods for cash)
2014 January 15 Cash Account 20,000
si
To Sales Account 20,000
55,000 55,000
Ledger Accounts
r
ve
Cash A/c
(Dr.) Date Particulars J.F Amount Date Particulars J.F Amount

(Cr.)
ni
2014 To Sales 25,000 Jan 2 By furniture A/c 20,000

January 15
U
31 To balance c/d 10,000 Jan 10 By purchases 15,000

A/c
35,000 35,000
ity
Feb 1 By Balance b/d
Furniture A/c
m

(Cr.)
Jan 2 To Cash A/c 20,000 Jan 31 By balance c/d 20,000
)A
Feb 1 To balance b/d 20,000

(c

Bank A/c
Notes
e
(Cr.)
in
Jan 5 To Rahul’s A/c 1,450 Jan 31 By balance c/d 1,450
Feb 1 To By balance 1,450
nl
c/d
Discount A/c
O
(Cr.)
Jan 5 To Rahul’s A/c 50 Jan 31 By balance c/d 50
ty
Feb 1 To balance b/d 50
Purchases A/c
si
(Dr.) Particulars J.F Amount Date Particulars J.F Amount
Date (Cr.)
Jan10 To cash A.c r 15,000 Jan 31 By balance c/d 15,000
ve
Feb 1 To By balance b/d 15,000
15. Subsidiary Books

ni
All business transactions, at the first stage, are recorded in the book of original
entry, which is the Journal and then is posted into the ledger under the double entry
system of book-keeping. This procedure is both easy and practicable in small business
U
houses where the number of business transactions is less and where a single person
can also handle the business transactions.
But it is practically very difficult, rather impossible, to record all the business
ity
transactions of a day in the Journal of a large business house where the number of
business transactions are varied and enormous because of the following reasons:
(i) The system of recording all transactions in a journal requires -

Writing down the name of the account involved as many times as the
m
transactions occur; and

An individual posting of each account debited and credited and thus,
involves the repetitive journalising.
)A
(ii) The information is not provided on a prompt basis.

(iii) The journal becomes bulky and voluminous.
(iv) The system does not facilitate the installation of an internal check system, as
(c
the journal can be handled by only one person.

Therefore, to overcome the shortcomings of the use of the journal as the only book
of original entry, the journal is subdivided into special journals. It is divided in such a
way that a separate book is used for each category of business transactions which are
Notes
e
repetitive in nature, similar and are sufficiently large in number. Special journals refer to
the journals meant for recording specific business transactions of similar nature.
in
●● Cash Book: It records all those transactions which are in cash or by cheques.
●● Purchases Book: It records all transactions relating to goods purchased on
credit.
nl
●● Sales Book: It records all transactions relating to goods sold on credit.
●● Purchases Return Book: It records return of goods to suppliers.
●● Sales Return Book: It records return of goods by the customers.
O
●● Bills Receivable Book: It records entries regarding bills receivables. The
details of bills are given in this book.
●● Bills Payable Book: All bills which are accepted and payable by a business
ty
house are recorded in this book.
●● Journal Proper: Those transactions which are not recorded in any of the
above mentioned books are recorded in the Journal Proper
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16. Trial Balance
The trial balance is simply a list of names of the accounts, and the balances in
r
each account at a given period of time, with debit balances in one column and credit
ve
balances in another column. The preparation of trial balance serves two principal
purposes -
●● It shows whether the equality of debits and credits has been maintained and
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●● Provides a convenient transcription of the ledger record as a basis for making

revisions and closing entries for final accounts preparations.
When the total debits equal total credits, it does not always represent that there
U
has been no error in recording the transactions. Entries may have been omitted entirely,
or they may have been posted to the wrong accounts, there can be off-setting errors
that may have been made, or the transactions may have been analyzed incorrectly.
For example when a debit for purchase of a tractor is made incorrectly to an

ity
expense account, rather than correctly to a fixed assets account, the total of the trial
balance is not affected.
Nevertheless, errors that result in unequal debits and credits are common, and
the existence of such errors is revealed when the trial balance does not balance. This
m
is when the debit column does not add to the same total as the credit column. A trial
balance may be prepared at any time. A pre-adjustment trial balance is one prepared
following the posting of the original entries for the year, but prior to the adjustment and
)A
closing process. Following the closing process a post closure trial balance is set.
a. Features of a Trial Balance

The features of trial balance include -
(c
●● It is a list of debit and credit balances which are extracted from various ledger
accounts.

●● It is a statement of debit and credit balances.

Notes
e
●● The purpose is to establish arithmetical accuracy of the transactions recorded
in the Books of Accounts.
in
●● It is usually prepared at the end of the accounting year but it can also be
prepared anytime as and when required like weekly, monthly, quarterly or half-
yearly.
nl
●● It is a link between books of accounts and the Profit and Loss Account and
Balance sheet.
b. Purpose of a Trial Balance
O
It serves the following purposes:
●● To check the arithmetical accuracy of the recorded transactions.
ty
●● To ascertaining the balance of any of the ledger accounts.
●● To serve as an evidence of fact that the double entry has been completed in
respect of every transaction.
si
●● To facilitate the preparation of final accounts promptly
17. Preparation of Trial Balance

r
A trial balance is prepared in accordance to the following steps -
ve
1. It may be prepared on a loose sheet of paper.
2. The ledger accounts are balanced at first. They will have either “debit-balance”
or “credit balance” or “nil balance”.
ni
3. The accounts having debit-balance is written on the debit column and those
having credit-balance are written on the credit column.
The sum total of both the balances must be equal, for “Every debit has its
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corresponding and equal credit”.
Example:
ity
From the following ledger account balances, prepare a Trial Balance of Mr. Tom for
the year ended 31st March, 2016.
Capital `80,000; Sales `10,00,000; Adjusted Purchase `8,00,000; Current A/c(cr)

`10,000; Petty Cash `10,000; Sales Ledger Balance `1,20,000; Purchase Ledger
m
Balance `60,000; Salaries `24,000; Carriage Inwards `4,000; Carriage Outward

`6,000; Discount Allowed `10,000; Building `80,000; Outstanding Expenses `10,000;
Prepaid Insurance `2,000; Depreciation `4,000; Cash at Bank `80,000; Loan A/c
(cr) `66,000; Profit & Loss A/c(cr) `20,000; Bad Debts Recovered `2,000; Stock at
)A
31.03.2016 `1,20,000; Interest Received `10,000; Accrued Interest `4,000; Investment

`20,000; Provision for Bad Debts (01.04.2015) `6,000; General Reserve `20,000.
(c

Solution –
Notes
e
Head of Accounts Amount Head of Account Amount
in
Adjusted Purchase 8,00,000 Capital 80,000
Petty Cash 10,000 Sales 10,00,000
Sales Ledger Balance 1,20,000 Current A/c 10,000
nl
Salaries 24,000 Purchase Ledger Balance 60,000
Carriage Inward 4,000 Outstanding Expenses 10,000
O
Discount Allowed 10,000 Loan A/c 66,000
Building 80,000 Profit & Loss A/c 20,000
Prepaid Insurance 2,000 Bad Debts Recovered 2,000
ty
Depreciation 4,000 Interest Received 10,000
Cash at Bank 80,000 Provision for Bad Debts 6,000
Stock ( 31.03.2016) 1,20,000 General Reserve 20,000
si
Accrued Interest 4,000
Investment 20,000
Carriage Outward 6,000
r
ve
Total 12,84,000 Total 12,84,000
Note: Closing Stock will appear in Trial Balance since there is adjusted purchase.
Adjusted purchase = Opening Stock + Purchase - Closing Stock.
ni
c. Limitations of a Trial Balance

A trial balance is not a conclusive proof of the books of accounts being absolutely
U
accurate. If the trial balance agrees, this doesn’t mean that books now have absolutely
no mistakes. Even if the trial balance agrees, certain errors will remain undetected, and
the trial balance will not disclose them. The errors which are not disclosed by a trial
balance are as under:
ity
●● Errors of Omission: - If an entry has not been recorded in the original or

subsidiary book at all, then both the aspects of the transaction will be omitted
and the trial balance will not be affected.
●● Errors of Commission: This refers to the posting an item on the correct side
m
but to the wrong account.

●● Error of subsidiary books: This refers to the wrong amount being entered in
the subsidiary book.
)A
●● Compensating errors: These are errors arising from the excess-debits on

under debits of accounts being neutralized by excess credit or under credit to
the same extent of some other accounts.
●● Error of principle: Whenever any amount is not properly allocated between
(c
capital and revenue or some double entry principles are violated the error so
made is known as error of principle.

●● Compensatory Errors: These are the errors on one side of the ledger
Notes
e
account, and are compensated by errors of the same amounts on the other
side or on the same side
in
d. Suspense Account
When the Trial Balance does not tally, efforts are made to make the trail balance
tally. However, if the efforts fail, then temporarily the difference of Trail Balance is
nl
transferred to an account known as the “Suspense Account”.
Suspense Account is shown in the balance sheet on asset aside in case of a

debit balance and on the liabilities side in case of a credit balance. During the course
O
of preparation of final accounts if errors are located, they are corrected through the
suspense A/c.
●● Effect on Profit and Losses Account - All such rectifying entries which are
ty
related to normal account, affect profit or loss, hence after making rectifications,
all nominal account which are affected should be taken into consideration and their
amounts be considered for assessing the exact amount of loss or profit.
si
●● Effects on Balance Sheet - All such rectifying entries which are related with
personal and real accounts affect the Balance Sheet. Rectifying entries related
with nominal account affect profit or loss and this profit or loss is taken to Balance
r
Sheet. Hence, these entries also affect Balance Sheet.
ve
Enter the following transactions in the Journal of Mr. Harry.
March
1 Harry started business with cash ` 1,50,000
ni
3 Goods purchased for cash ` 50,000

4 Sold goods for cash ` 30,000 Notes
U
5 Goods purchased from Anush ` 20,000

7 Sold goods to Ramesh ` 15,000
8 Purchased furniture for cash ` 5,000
ity
10 Paid cash to Anush ` 15,000

11 Bought goods from Raj for cash ` 27,000
13 Sold goods to Ashok on credit ` 12,000
m
16 Paid wages to Chandra ` 800

18 Interest received ` 250
22 Paid Rent ` 5,000
)A
27 Received cash from Rajesh ` 13,000

29 Sold goods to Rajib for cash ` 6,00.
31 Paid salary to Mohanthy ` 2,300
(c

Solution:
Notes
e
In the books of Harry Journal Entries
Date Particulars LF Debit Credit
in
Mar.1 Cash Account Dr. 1,50,000
2004 To Capital Account 1,50,000
(Being Mr. Harry commenced business)
nl
3 Purchases Account Dr. 50,000
(Being purchased goods for cash)
O
4 Cash Account Dr. 30,000
(Being sold goods for cash)
5 Purchases Account Dr. 20,000
ty
To Anush’s Account 20,000
(Being purchased goods from Anush on credit)
7 Ramesh’s Account Dr. 15,000
si
(Being sold goods on credit to Ramesh)
8 Furniture Account Dr. 5,000
To Cash Account r 5,000
ve
(Being bought furniture for cash)
10 Anush’s Account Dr. 15,000 15,000
To Cash Account
(Being cash paid)
ni
11 Purchases Account Dr. 27,000 27,000

To Cash Account
(Being goods purchased from Raj for cash)
U
13 Ashok’s Account Dr. 12,000 12,000

To Sales Account
(Being goods sold on credit)
16 Wages Account Dr. 800 800
ity
To Cash Account
(Being wages paid
18 Cash Account Dr. 250 250
To Interest Account
m
(Being received interest)

22 Rent Account Dr. 5,000 5,000
To Cash Account
(Being rent paid)
)A
27 Cash Account Dr. 13,000 13,000

To Rajesh’s Account
(Being cash received from Rajesh)
29 Cash Account Dr. 6,000 6,000
(c
To Sales Account
(Being sales for cash)

31 Salary Account Dr. 2,300

Notes
e
(Being salary paid to Mohanthy)
in
3,51,350 3,51,350
Example 2:
nl
From the following transactions prepare in the Personal Account of Mr. Anand and
balance the amount at the end of each month.
O
2010 April
1 Sold goods to Mr. Anand ` 30,000
3 Received from Mr. Anand ` 24,550 and discount allowed him ` 50.
ty
12 Mr. Anand bought goods ` 7,000
16 Received cash from Mr. Anand ` 5,400
May -1 Balance from last month ` 6,000
si
2 Sold goods to Mr. Anand ` 7,000
20 Received cash from Mr. Anand ` 5,540 and discount allowed ` 60
30
r
Received Cash ` 12,950 in full settlement of account ` 13,000
ve
Solution:
ni
Mr. Anand’s Account
Date Particulars JF Amount Date Particulars JF Amount

U
2010 2010
Apr. 1 To Sales A/c 30,000 Apr. 3 By Cash Account 24,550
12 To Sales A/c 7,000 3 By Discount A/c 50
ity
16 By Cash Account 5,400

31 By Balance c/d 7,000
37,000 37,000
May. 1 To Balance b/d 7,000 May. 20 By Cash Account 5,540
m
2 To Sales Account 7,000 20 By Discount A/c 60

30 To Balance c/d 4,600 30 By Cash Account 12,950
)A
30 By Discount A/c 50
18,600 18,600
Example 3:
(c
Re-write the following trial balances to correct same Trial Balance as on 31 March
2010

Particulars ` Particulars `
Notes
e
Wages 2,680 Capital 10,000
Purchase 12,490 Sales 31,080
in
Salaries 520 Rent paid 500
Carriage 50 Discount received 120
nl
Buildings 12,010 Light charges 160
Bank overdraft 470 Suppliers 800
Cash in hand 60 Opening stock 9,260
O
Customers 1,490 Furniture 3,250
29,770 55,170
ty
Solution:
Trial Balance
Ledger Accounts LF Debit Credit
si
Wages 2,680
Purchases 12,490
Salaries
Carriage
r 520
50
ve
Building 12,010
Cash in hnd 60
Bank overdraft 470
ni
Customers 1,490
Capital 10,000
Sales 31,080
U
Rent paid 500

Discount received 120
Light charges 160
ity
Suppliers 800
Stock 9,260
Furniture 3,250
42,470 42,470
m
Key Takeaways
)A
●● Accounting: Accounting is treated as the language of business. It records all the

transactions which can be measured in money and have occurred in a particular
period.
●● Cost accounting: It is intended to capture an Enterprise’s production costs by
assessing the input costs for each production phase, as well as fixed costs such
(c
as depreciation of an equipment.

●● Management accounting: It is the application of professional knowledge and

Notes
e
skills for the preparation and presentation of accounting information.
●● Account: An account is a record used to properly classify the activity recorded in
in
the General Ledger.
●● Accrual Basis - Method of accounting that recognizes revenue when earned,
rather than when collected and expenses when incurred rather than when paid.
nl
The college uses the accrual basis for its accounting.
●● Asset - Anything of use to future operations of business and belonging of an
enterprise. An asset is what the college owns. For example- land, property,
O
buildings, equipment, cash in bank accounts, other investments and accounts
receivable.
●● Credit - A credit is an entry on the right side of a double-entry accounting system
ty
that represents the reduction of an asset or expense or the addition to a liability or
revenue.
●● Debit - A debit is an entry on the left side of a double-entry accounting system
si
that represents the addition of an asset or expense or the reduction to a liability or
revenue.
●● Double-Entry Accounting - Method of recording financial transactions in which
r
each transaction is entered in two or more accounts and involves two-way, self-
ve
balancing posting.
●● Expense/Costs - It is the expenditure incurred by enterprise to earn revenue.
An expense is funds paid by the college. For example-paychecks to employees,
reimbursements to employees, payments to vendors for goods or services.
ni
●● Equity- It refers to total claims against enterprise. It is further dividers into Owner’s
Claim (Capital) and Outside’s Claim (Liability).
●● GAAP - GAAP stands for Generally Accepted Accounting Principles which are
U
conventions, rules, and procedures necessary to define accepted accounting

practice at a particular time.
●● General Ledger - The general ledger is the collection of all asset, liability, fund
ity
balance (net assets), revenue and expense accounts.

●● Journal Entry - A journal entry is a group of debit and credit transactions that are
posted to the general ledger. All journal entries must net to zero so debits must
equal credits.
m
●● Liability - A liability is what the colleg.e owes. For example-loans, taxes, payables,
long term debt from a bond issue, funds held by the college for a third party such
as a student group.
)A
●● Subsidiary Ledger - A subsidiary ledger is a group of accounts containing the

detail of debit and credit entries. For example detail information contained in
Accounts Payable.
●● Revenue - Revenue is funds collected by the college; it can also be called income.
(c
It is monetary value of products/services sold to customers during the period. For

example-tuition, fees, rentals, income from investment.

●● Cash Book - Cash book was used to record all cash and bank related
Notes
e
transactions. Some records only the cash related transactions while other use the
cash book for both type of transactions.
in
●● General Ledger - The General Ledger contains all the accounts of an enterprise.
●● Trial Balance - In accounts every amount that is placed on the debit side of
an account must have a corresponding entry on the credit side of some other
nl
account.
●● Profit and Loss Account – The account is prepared to see the profit earned or
loss incurred by an enterprise within specific period. The account is usually made
O
on a yearly basis.
●● Balance Sheet - The Balance Sheet is the statement summarizing the financial
position of a business on a given date. It summaries on the right hand side the
ty
assets of the business and on the left hand side the liabilities of the business.
Check your progress
si
1. Accounting based on the monetary transactions of the enterprise is
a) Management Accounting
b) Cost Accounting
c) Financial Accounting
r
ve
d) Absorption Accounting
2. Accounting aimed at identifying an accounting year’s results in terms of profits or
losses and assets and liabilities.
ni
a) Management Accounting
b) Cost Accounting
U
c) Financial Accounting
d) Absorption Accounting
3. ________________ is the language of business.
ity
a) Accounting
b) Business Transaction
c) Profits
m
d) Financial Management
4. The makeup of a firm’s capitalization is
)A
a) Capital Accounting
b) Capital structure
c) Capital Expenditure
d) Capital Receipt
(c
5. The concept explaining the distinction of business is from its owner is?
a) Going Concern Concept

b) Money Measurement Concept

Notes
e
c) Business Entity Concept
d) Prudence Concept
in
Questions & Exercises
1. Define Accounting. How it is different from Accountancy and Book-keeping?
nl
2. Explain various steps in the process of Accounting.
3. What do you understand by Accounting Principles? Explain some of them.
O
4. Explain the usefulness of accounting process and its limitations.
5. Explain in brief about various branches of accounting.
ty
Check your progress:
1. c) Financial Accounting
2. c) Financial Accounting
si
3. a) Accounting
4. b) Capital structure
5. c) r
Business Entity Concept
ve
Further Readings
1. Accounting for Managers. Maheshwari and Maheshwari. Vikas publication.
2. Financial Accounting. Meigs and Meigs. Mcgraw Hills Inc.
ni
3. Introduction to Accountancy. T S Grewal. S Chamd & Co Ltd

4. Advanced Accounting, Sehgal Ashok, Sehgal Deepak .Taxman Allied Services
U
(P) Ltd., New Delhi

5. Advanced Accountancy, Jain S.P., Narang K.L..Kalyani Publishers, Ludhiana.
6. Advanced Accounts, Shukla M.C., Grewal T.S.: S. Chand & Company Ltd.,
ity
New Delhi.
7. Advanced Accountancy, Gupta R.L., M. Radhaswamy: Sultan Chand & Sons,
New Delhi.
8. Financial Accounting, Tulsian. Tata McGraw-Hill, New Delhi.
m
)A
(c

Module-2: Preparation of Financial Statements

Notes
e
Module Objective-
in
This Module is intended to introduce the concepts and practice of preparation of
Financial Statements and to enable learner to understand information contained in the
published financial statements of companies. It includes the preparation of accounting
nl
statements and their uses.
Learning Outcome:
O
●● Prepare the financial statements with ease.
ty
●● Analyze and draw conclusion from unstructured numerical problems & financial
statements.
●● Describe the impact of journal entries on financial statement.
si
●● Understand the concept of depreciation and various methods of depriciation.
“Accounting is the art of recording, classifying and summarizing in a

r
significant manner and in terms of money, transactions and events, which are,
ve
in part at least, of a financial character and interpreting the result thereof”.
According to Smith and Ashburne-

ni
Introduction
Financial Analysis is defined as being the process of identifying financial strength
and weakness of a business by establishing relationship between the elements of
U
balance sheet and income statement. The information pertaining to the financial
statements is of great importance through which interpretation and analysis is made.
It is through the process of financial analysis that the key performance indicators, such
as, liquidity solvency, profitability as well as the efficiency of operations of a business
ity
entity may be ascertained, while short term and long term prospects of a business may
be evaluated. Thus, identifying the weakness, the intent is to arrive at recommendations
as well as forecasts for the future of a business entity.
m
1. Meaning of Financial Statements

Financial statements are the essential documents of business. They are the
outputs of financial accounting. They are the final products of the accounting process.
)A
They are statements containing financial information of a business enterprise. They

convey certain message to feel financial pulse of an organization. The basic purpose
of preparing financial statements is to convey information about financial position of the
enterprise to owners, creditors and the investors.
(c

Nature of Financial Statements

Notes
e
The following characteristics of financial statements indicate their nature:
1. Recorded Facts - The term recorded facts refers to the data drawn from
in
accounting records. Only those facts which have been recorded in the books
are shown in the financial statements.
2. Accounting Principles - In the preparation of financial statements, certain
nl
accounting principles, concepts and conventions are followed. For example:
The principle of cost price or market price whichever is less is followed for
valuation of stock.
O
3. Assumptions - Business transactions are recorded on certain assumptions.
For example: In preparing financial statements, the accountants make many
assumptions like that the value of money remains constant, going concern
ty
concept etc.
4. Personal Judgment - The financial statements are affected by the personal
judgment of accountants. For example: The method of stock valuation, method
si
of depreciation etc. depend on the personal judgment of the accountant.
The accountant can select one of the available methods of stock valuation,
depreciation etc.
r
Essentials of Financial Statements
ve
The financial statements should possess the following essential qualities:
1. Understandability - Financial statements should be easily understandable by

users. For this, the information contained in these statements should be clear
ni
and simple.
2. Relevance - The financial statements must contain only relevant information.
Then only the users can evaluate past, present and future events and can take
U
wise decisions.
3. Reliability and Accuracy - Financial statement should disclose information in
such a way that the users can compare the current year’s progress with that of
ity
previous year. Users must also be able to compare the financial performance of
reporting Enterprise with that of other companies.
4. Comparability - Financial statements should disclose information in such a
way that the users can compare the current year’s progress with that of previous
m
year. Users must also be able to compare the financial performance of reporting
Enterprise with that of other companies.
5 Completeness - The information contained in the financial statements should
)A
be complete in all respects. This means all information should be shown in

these statements. It further means that the information shown in the financial
statements should not mislead creditors, investors and other users.
6. Timeliness - The financial statements should be prepared within a reasonable
time after the accounting period is over. If the statements are not prepared
(c
and presented in time, they cannot be properly used. Besides, the firm cannot
formulate plans for future.

2. Importance of Financial Statements or Users of Financial

Notes
e
Statements
The chief function of financial statements is providing valuable information about
in
financial position and operating strength or weakness of the enterprise to various
parties interested in the enterprise. The various interested parties are management,
investors, creditors, banks, employees, government, customers, public, trade
nl
associations, stock exchanges etc. They are the users of the financial statements
and financial statement analysis is actually the vehicles through which the financial
information is transported to users of financial information. The following are the uses of
financial statements to different parties are:
O
1. Importance for Management (Owners) - Financial statements supply valuable
information to owners or management. They make use of financial statements for
ascertaining the earning capacity, financial position, growth etc. Management can
ty
take decisions and manage the business efficiently on the basis of information
provided by financial statement.
2. Importance for Investors - In the case of Joint Stock Enterprise, shareholders and
si
long term leaders (debenture holders) are the investors. Shareholders are the real
owner of joint stock companies. Shareholders need information to decide whether
to buy, hold or sell shares of the Enterprise. They also need information regarding
financial position, earning of the firm. Debenture holders need information to know
r
whether the Enterprise has ability to repay the debt and to pay the interest. The
ve
information required by investors is provided by financial statements.
3. Importance for Trade Creditors or Suppliers - Trade creditors or suppliers need
information to determine whether amounts owing to them will be paid when due.
Financial statements help them to know whether the Enterprise has the capacity to
ni
pay the amount due to them in time.

4. Importance for Banks - Banks will ensure that their loans along with interest will
be paid on due dates while granting loans. For this, they want to know about the
U
financial position and profit earning capacity of the borrowing Enterprise. Banks will
get the required information from the financial statements.
5. Importance for Customers - Customers needs information to know whether the
ity
Enterprise will be able to continue supply of goods and services to them. For knowing
this, financial statements come to their help.
6. Importance for Employees - Employees requires information to assess the
profitability and stability of the enterprise. The profitability of the Enterprise affects the
remuneration, bonus, retirement benefits, working conditions etc. of the employees.
m
Therefore, the employees are also interested in the financial statements.

7. Importance for Government and Agencies - Governments need information about
the affairs of an Enterprise to formulate tax policies, export-import policies, annual
)A
budget etc. Controlling agency like SEBI is interested in the financial statements of
businesses to exercise control over them better. Similarly, tax authorities are also
interested in income statements of the taxpaying companies. The income statement
provides the basis for assessing the taxable income.
(c
8. Importance for Public - Public also interested in financial statements of business

enterprises. Financial statements provide information to public to judge whether the
enterprise has fulfilled its social responsibility or not.

9. Importance for Trade Unions - Trade unions requires information to initiate

Notes
e
wage negotiations. This information is provided by financial statements. Financial
statements are also important for stock exchanges, research scholars etc. Thus,
financial statements are able to satisfy the needs of all the parties interested in the
in
business.
3. Income Statement
nl
The income statements are also called as the profit loss statements. This
statement gives information on the result of various operations of the Enterprise over
a term period. An income statement is a type of summary flow report that lists and
O
categorizes the various revenues and expenses that result from operations during
a given period - a year, a quarter or a month. The difference between revenues and
expenses represents an Enterprise’s net income or net loss. The amounts shown
ty
in the income statement are the amounts recorded for the given period – a year,
a quarter or a month. The next period’s income statement will start over with all
amounts reset to zero.
si
4. Income Statement – Recording COGS
When income is increased by the sale value of goods or services sold, it is also
r
decreased by the cost of these goods or services. The cost of goods or services sold
is called the cost of sales. In manufacturing firms and retailing business it is often
ve
called the cost of goods sold. The complexity of calculation of cost of goods sold varies
depending upon the nature of the business. In the case of a trading concern which
deals in commodities it is very simple to calculate the cost of goods sold and it is done
as follows:
ni
Opening stock xxx

Add: purchase xxx
U
freight xxx
Goods available for sale xxx
Less: closing stock xxx
Cost of goods sold xxx
ity
Example –
Profit and Loss Account for the Year Ended 31st March 2018
Particulars Amount Particulars Amount

m
Cost of goods sold 78,680 Sales 89,740

Expenses 33,804 Other Income 39,947
)A
Director’s fee 11
Depreciation 2094
Interest 2902
Provision for Taxation 6565
(c
Net profit 5625

1,29,687 1,29,687

In the “t” shaped profit and loss account, expenses are shown on the left hand
Notes
e
side i.e., the debit side and revenues are shown on the right hand side i.e., the credit
side. Net profit or loss is the balancing figure. The profit and loss account can also be
presented in the form of a statement when it is called as income statement. There are
in
two widely used forms of income statement: single step form and multiple-step form.
The single-step form of income statement derives its name from the fact that the total of
all expenses is deducted from the total of all revenues.
nl
Income Statement for The Year Ending 31 March, 2018
Revenues Amount Amount
O
Net Sales 89,740
Other Income 39,947
Expenses: COGS 78,680
ty
Expenses 33,804
Director’s fee 11
Depreciation 2094
si
Interest 2902
Provision for Taxation 6565 1,24,062
r 5,625
ve
5. Income Statement Recording Operating Expenses
Expenses which are incurred for running the business and which are not directly
related to the Enterprise’s production or trading are collectively called as operating
expenses. Usually operating expenses include administration expenses, finance
ni
expenses, depreciation and selling and distribution expenses. Administration expenses

generally include personnel expenses also. However, sometimes personnel expenses
may be shown separately under the heading establishment expenses.
U
Example:
Prepare the Profit and Loss Account from the following particulars relating to the
year ending 30th April 2011
ity
Particular `
Office Salaries 40,000
Postage and Telegrams 20,000
m
Office Rent 7,000

Sundry Office expenses 10,000
Selling expenses 8,000
)A
Gross Profit 2,00,000

Advertisement 12,000
Commission paid 9,000
Commission received 8,000
(c
Prepaid Rent 1,000

Outstanding Salaries 15,000

Profit and Loss Account for the year ended 30th April 2011
Notes
e
Dr. Cr.
in
To Office Salaries 40,000 By Gross Profit 2,00,000
To Postage and Telegrams 20,000 By Commision received 8,000
nl
To Sundry Office Expenses 10,000
To Selling Expenses 8,000
To Advertisement 12,000
O
To Commission Paid 9,000
To Office Rent 7,000
Net Profit 1,02,000
ty
(transfer to Capital A/c)
2,08,000 2,08,000
si
7. Dividends and Earning Per Share
Dividend per Share

r
The DPS ratio is very similar to the EPS: EPS shows what shareholders earned
ve
by way of profit for a period whereas DPS shows how much the shareholders were
actually paid by way of dividends. The DPS formula is:
Dividend per share = Dividend paid to equity shareholders/ Average number of

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issued equity shares
Earning per share

U
This is the ratio between the net profit after tax and the distribution of dividend to
preference shareholders and the number of equity share holders. In other words, it is
the ratio between earnings available to equity shareholder and number of shareholders
in an organization.
ity
Earning per share = Earnings available to equity shareholders / Number of

shareholders
Earning’s available to equity shareholder’s means net profit after tax and
distribution of dividend to preference share holder’s
m
Number of equity share = Total equity capital / Face value per share
)A
8. Balance Sheet - Recording Long Term Liabilities

Balance sheet is a statement reflecting true position of assets and liabilities in a
particular period. It is also known as the financial statement of a business.
Balance sheet is prepared from the Trial balance, after all the balances on nominal
(c
account are transferred to the trading and profit and loss account and corresponding
account in the ledger are closed. The balances now left in the trial balance and

remaining one in the ledger represent either personal or real account. All assets and
Notes
e
liabilities are setout in the balance sheet in a systematic manner. In the right side are
shown the assets and on the left-hand side are shown the various liabilities.
in
Finally, Balance Sheet shows the true financial position of the business on a
specific date i.e., at the end of an accounting period the total assets and total liabilities
must be equal.
nl
Definitions
According to T.R. Batliboi, “A Balance Sheet is a statement prepared with a view
O
to measure the exact financial position of a business on a certain fixed date”.
In the words of ‘Free man,’ A Balance sheet is an itemwise lists of assets, liabilities
and proprietorship of a business at a certain data.
ty
According to Palmer, “The Balance sheet is a statement at a particular date
showing on one side the trader’s property and possessions and on the other side the
liabilities.
si
Preparation of balance sheet
In a balance sheet, the liabilities are on the left hand side and assets are on the
r
right hand side. There is no debit or credit side. The structure of a balance sheet is
ve
described as:
Structure of a Balance Sheet as on…
Liabilities Amount Assets Amount

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Current Liabilities: Current Assets:

Bank Overdraft xxx Cash in hand xxx
U
Bills Payable xxx Cash in Bank xxx

Outstanding expenses xxx Bills Receivable xxx
Income received in advance xxx Prepaid expenses xxx
ity
Sundry Creditors xxx Accrued Income xxx

Short term loans xxx Investment xxx
Fixed Liabilities: Sundry Debtors xxx
Long term loan xxx Stock (closing) xxx
m
Reserves xxx Loose Tools xxx

Capital xxx Fixed Assets: xxx
Add: Net profit xxx Goodwill xxx
)A
Add: Interest on Capital xxx Furniture & Fixture xxx

xxx Plant & Machinery xxx
Less: Drawings xxx Long term Investment xxx
(c
Less: Interest on Drawings xxx xxx

xxx xxx

Alternative Structure of a Balance Sheet as on …

Notes
e
Capital xxx Fixed Assets:
in
xxx
Add: Net profit xxx Goodwill xxx
Add: Interest on capital xxx Furniture & Fixture xxx
nl
xxx Plant & Machinery xxx
Less: Drawing xxx Long term Investment xxx
O
Less: Interest on Drawings xxx xxx Current Assets:
Fixed Liabilities: Cash in hand xxx
Long term loan xxx Cash at Bank xxx
ty
Reserves xxx Bills Receivable xxx
Current Liabilities: Prepaid expenses xxx
Bank Overdraft xxx Accrued Income xxx
si
Bills payable xxx Investment xxx
Outstanding expenses xxx Sundry Debtors xxx
Income received in advance r xxx Stock (closing) xxx
ve
Sundry Creditors xxx Loose Tools xxx
Loan x xxx
xxxx xxxx
ni
Example:
From the following particulars prepare a Balance Sheet for the year ended 3rd
U
May, 2011.
Particulars `
Land and Building 80,000
ity
Capital 1,90,000
Plant and Machinery 1,20,000
Net Profit 20,000
m
Sundry Creditors 48,000

Cash at Bank 10,000
Bills Payable 9,000
)A
Sundry Debtors 20,000

Bills Receivable 7,000
Cash in hand 30,000
(c

Solution:
Notes
e
Balance Sheet for the year ended 31st May, 2011
in
Capital 1,90,000 Land & Building 80,000
Add: Net Profit 20,000 2,10,000 Plant & Machinery 1,20,000
nl
Sundry Creditors 48,000 Bills Receivable 7,000
Bills Payable 9,000 Cash at Bank 10,000
O
Cash in hand 30,000
Sundry Debtors 20,000
2,67,000 2,67,000
ty
9. Introduction to Depreciation
Depreciation means the fall or decrease in the value of assets by using them in
si
the operation of business. In the depreciable assets land, goodwill, forest, livestock,
R&D are not included. Depreciation is not evident like other business expenses which
are transparent and regarded when measuring the Enterprise’s profit or loss. But in the
r
case of asset depreciation this is not so. Its amount is not fixed, either. This is rooted in
past experience. Some businesses do not have asset depreciation, and do not subtract
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the net income from the gross profit.
In the AS-6 the depreciation is defined as, “Depreciation is a measure of

wearing out, consumption or other loss of value of a depreciable asset, arising from
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use, afflation of time or obsolescence through technology and market changes.

Depreciation is allocated so as to change a fair proportion of the depreciable amount
in each accounting period during the expected useful life of the asset. Depreciation
U
includes amortization of assets whose useful life is predetermined.” As per International

Accounting Standards Committees, “Depreciation is the allocation of the depreciable
amount of an asset over its estimated useful life. Depreciation for the accounting period
is charged to income either directly or indirectly”
ity
10. Depreciation - Straight Line Method

It is also known as the fixed installment. In this method, depreciation is ascertained
by a fixed percentage on the original expense, taking into account the scrap value of
m
the properties. Under this method the depreciation amount remains uniform or fixed and
the value of the asset at the end of its life becomes close to zero. It is calculated as –
Depreciation = Original Cost – Scrap Value / Life of assets in years

)A
Merits
Following are the merits of this method:
1. The method is simple and easy to use.

(c

2. The value of the asset becomes zero at the end of the life of the assets as total
Notes
e
value is divided by the life of the assets.
3. This method is suitable for the type of assets taking place in physical deterioration
in
as buildings, leasehold properties, etc.
Demerits
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This method has following demerits:
1. The amount of depreciation remains unaffected and does not change while the
amount of repairs and renewal increases with the time passage.
O
2. The amount of depreciation is not invested outside the firm and thus it is a loss
of interest.
3. If any other asset is purchased during the year, then depreciation is calculated
ty
separately.
4. This method is not recognized in the rules of income tax.
si
Example-
Mr. A purchased a second hand machine for 24,000 on 1st April, 2006. He spends
10,000 on its overhaul and installation. Depreciation is written off 10% p.a. on the
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original cost. On 30th June, 2008 machine was found to be unsuitable and sold for
ve
19,000. Prepare the machine account from 2006 to 2008 assuming that accounts are
closed on 31st December, every year
Solution:
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In the books of Mr. A Machine Account
Date Particulars (`) Date Paritulars (`)

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2006 2006
April 1 To Cash A/c 34,000 Dec. 31 By Depreciation (for 9 2,550
(24,000=10,000) months)
Dec. 31 By Balance c/d 31,450
ity
34,000 34,000
2007 2007
Jan.1 To Balance b/d 31,450 Dec. 31 By depreciation A/c (for 3,400
m
12 months)
Dec. 31 By Balance c/d 28.050
31,450 31,450
)A
2008 2008
Jan. 1 To Balance b/d 28,050 June 30 b y D e p re ci a ti o n ( 6 1,700
months)
By Cash A/c (Sale) 19,000
(c
By P&L A/c (Less) 7,350

28,050 28,050

Working Note:
Notes
e
1. Cost of Machine =24,000=10,000= `34,000
in
34,000 x 10 9
2. Depreciation for 2006 = x = 2,550
100 12
34,000 x 10
3. Depreciation for 2007 = = 3,400
nl
100
34,000 x 10 6
4. Depreciation for 2008 (for 6 months) = x = ` 1,700
100 12
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11. Depreciation - Annuity and Units of Production Method
In this method, the asset depreciation is measured taking into account both the
value of the assets and the interest on them. The annuity method is a compounded
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interest method which calculates the depreciation based on the assumption that the
depreciation plus the normal capital cost to finance the assets is constant over the
assets’ life.
si
Interest along with the cost of asset is also taken into account while calculating
the depreciation amount. Every year, the amount of interest is debited to the account
of the properties and then the amount of depreciation is credited to the account.
r
Interest calculation is dependent upon an asset’s opening balance. Therefore, interest
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decreases each year but the volume of depreciation stays constant, which is taken from
the depreciation annuity tables. This amount of depreciation is considerable by which
the value of asset becomes zero.
Example : A Rubber Manufacturing Firm takes a lease costing 4,00,000 for 4 years.
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It decides to write off this lease by annuity method. You are given from the annuity table
that in order to write off the lease on Annuity Method at 5 per cent interest per annum,
the amount to be written off annually as depreciation amounts to 1,12,804. Show lease
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account for all the four years
Solution:
ity

1 year
st
To Bank A/c 40,00,000 1 year
st
To Depreciation A/c 1,12,804
To Interest A/c 20,000 To Balance c/d 3,070196
4,20,000 4,20,000
m
2 year To Balance b/d

nd
3,07,196 2 year
nd
To Interest A/c 15,360 To Balance c/d 2,09,752
3,22,556 3,22,556
)A
3 year
rd
To Balance b/d 2,09,752 3 year
rd
To Interest A/c 10,488 To Balance c/d 1,07,436
2,20,240 2,20,240
4th year To Balance b/d 1,07,436 4th year To Depreciation A/c 1,12,804
(c
To Interest A/c 5,368

1,12,804 1,12,804

12. Depreciation- Sinking Fund and Depletion Method

Notes
e
Sinking fund method is a method of calculating depreciation for an asset in which
apart from calculating depreciation, it also keeps aside a fund for replacing the asset at
in
the end of its useful life.
This method is used when the assets that need to be replaced are of high cost.
To avoid paying for the replacement of assets at a time, companies maintain a sinking
nl
fund that will help them recover the cost of the asset while also accounting for its
depreciation.
The formula for sinking fund is as follows.
O
(1+r/m) nxm –1
A= xP
r/m
Where
ty
A = Money Accumulated
P = Periodic Contribution to the sinking fund
r = Rate of Interest
si
n = number of years
m = number of payments per year
r
Depletion method is also known as production method. This method is useful for
ve
natural assets as coal mines, oil wells, etc. These are taken for excavation for a definite
period on the contact basis. In this case the depreciation is computed on the basis
of production. First the total production of the contract period is estimated, then total
depreciable cost is divided by the total production and multiplied by annual output to
ni
determine the annual amount of depreciation.
In the form of formula: Annual Depreciation = Annual Output /Total Estimated

Output
U
Q. On 1st April 2015, ABC enterprises purchased a lease property for `2000000. The
lease will expire on 31st March 2018. It was decided to provide depreciation on lease
using the Sinking Fund Method. Following transactions took place during the period.
ity
Prepare the required accounts.

i. On 31 March 2016: Depreciation was `640000 and this sum was invested.
ii. On 15 November 2016: Investments costing `100000 was sold for `120000
and the proceeds were re-invested.
m
iii. On 31 March 2017: Depreciation was `640000 and the interest on investments
was `32000. These sums were re-invested.
)A
iv. On 31 August 2017: Investments costing `200000 was sold for `225000 and
the proceeds were re-invested.
v. On 31 March 2018: All investments were sold for 950000. Interest earned was
64000. Depreciation was `640000.
(c

Solution:
Notes
e
Lease A/c
in
2015-16 2015-16
1 Apr To Bank A/C 2000000 31 Mar By Balance c/d 2000000
nl
2000000 2000000
2016-17 2016-17
O
2000000 2000000
2017-18 2017-18
ty
2000000 2000000
Sinking Fund A/c
si
2015-16 2015-16
31 Mar To Bank A/C 640000 31 Marr By Balance c/d 640000
ve
640000 640000
2016-17 2016-17
31 Mar To Bank A/C 1332000 31 Apr By Balance c/d 640000
15 Nov B y S i n k i n g F u n d 20000
ni
Investment A/c
31 Mar By Interest on Sinking 32000
Fund Investment A/c
U
31 Mar By depreciation A/c 640000

1332000 1332000
2017-18 2017-18
ity
31 Mar To Sinking Fund 407000 1 Apr By Balance c/d 1332000

Investment A/c
31 Mar To Less A/c 2000000 31 Aug B y S i n k i n g f u n d 25000
Investment A/c
m
31 Mar By Interest on Sinking 64000

fund Investment A/c
31 Mar By Depreciation A/c 346000
)A
(Deficit)
2407000 2407000
(c

Sinking Fund Investment A/c

Notes
e
2015-16 2015-16
in
31 Mar To Bank A/C 640000 31 Mar By Balance c/d 640000
640000 640000
nl
2016-17 2016-17
1 Apr To Balance b/d 640000 15 Nov By Bank A/c (sale) 120000
15 Nov To Sinking Fund A/c 20000 31 Mar By Balance c/d 1332000
O
(Profit on sale)
15 Nov To Bank A/c 120000
(sale proceeds reinvested)
ty
31 Mar To Bank A/c 672000
(Depreciation and interest
amt. reinvested)
si
1452000 1452000
2017-18 2017-18
1 Apr To Balance b/d r 1332000 31 Aug By Bank A/c (sale) 225000
ve
31 Aug To Sinking Fund A/c 25000 31 Mar By Bank A/c (sale) 950000
(Profit on sale) 31 Mar By Sinking Fund A/c 407000
31 Aug To Bank A/c 225000 (loss on sale)
(sale proceeds reinvested)
ni
1582000 1582000
U
13. Depreciation - Change in Rate and Useful Life

Depreciation expense measurement includes calculating the elements that may
alter or require revision during asset life due to internal or external factors. As a result of
ity
any reform in either of these bodies, the reform will have to be adopted in a prospective
way, i.e. change must be introduced from and beyond the date of the revision. Previous
time periods are not modified for calculation adjustment.
Prospectively, useful life adjustment is accounted for: the estimation shift is

m
stated in both the present and prospective periods. In other words, previously stated
statements and opening balances need not be changed to reflect the shift in the
expected useful life.
)A
The reasons prior periods do not need to be restated are as follows:

●● Hang in the useful life estimate does not represent a possible accounting error.
●● Estimate changes are inherent and a continual part of the estimation process.
(c
When a change in the useful life estimate occurs, then there is no need to record a
journal entry. New depreciation rate is recorded at the end of the accounting period.

Example:
Notes
e
ABC Ltd. bought an asset for 20,000 three years back with a total useful life of 10
years. At the time of acquisition entity estimated the salvage value to be 2,000. Entity
in
depreciates the asset using straight-line method. Survey of same asset in during fourth
year mentioned the salvage value of asset to be nill.
nl
Solution:
Step 1: Calculating the net book value of asset:
Cost of the asset 20,000
O
Depreciable value 20,000 – 2,000 = 18,000
Accumulated depreciation [18,000 x 3/10] (5,400)
ty
Net book value 14,600
Step 2: Calculating depreciation charge using revised estimates.
As salvage value is nill therefore, the whole amount of remaining carrying amount
si
is now depreciable value over the remaining useful life of 7 years.
= 14,600 / 7
r
= 2,086 will be the depreciation charge for the fourth year.
ve
Numericals for understanding
Example:
From the following information of Chandrashekar, prepare Final Accounts for the
ni
year 31st March 2006.
U
Drawings 4,500 Trade expenses 300

Purchases 20,000 Printing 150
Returns Inwards 1,500 Furniture 2,000
ity
Stock (1-4-2005) 8,000 Machinery 5,000

Salaries 4,200 Bad debts 400
Wages 1,200 Discounts 700
Rent 350 Sundry Debtors 14,000
m
Cash in hand 260 Insurance 400

Cash at Bank 5,940 Sales 30,500
Capital 24,000 Discounts 1,900
)A
Sundry Creditors 10,000 Bills payable 2,500
Adjustment:
a) Closing stock ` 7,000
(c
b) Insurance prepaid ` 60
c) Outstanding liabilities: salaries ` 200, wages ` 200

d) Make provision for doubtful debts at 5% on debtors

Notes
e
e) Calculate interest on capital at 5% p.a.
f) Depreciate Machinery at 5% and Furniture at 10%
in
g) Reserve for discount on creditors at 1%.
Solution:
nl
Trading and Profit & Loss Account of Chandrashekar
for the year ended 31st Mar. 2006
O
To Opening Stock 8,000 By Sales 30,500
To Purchases 20,000 Less: RIW 1,500 29,000
ty
To Wages 1,2000 By Closing stock 7,000
Add: O/s wages 200 1,400
To Gross profit c/d 6,600
si
36,000 36,000
To Salaries 4,200 By Gross profit b/d 6,600
Add: O/s salaries
To Rent
r
200 4,400 By Discount
350 By Reserve for Dist. on creditors
1,900
100
ve
To Insurance 400 By Net loss (transferred to capital) 390
Less: Prepaid 60 340
To Trade expenses 300
ni
To Printing 150
To Discount 700
To Interest on capital 1,200
U
To Depreciation on
a) Machinery 250
b) Furniture 200
ity
To Bad debts 400

Add: Provision for DD 700 1,100
8,990 8,990
m
Chandrashekar’s Balance Sheet as on 31st March 2006
)A
Sundry creditors 10,000 Land & Building 260

Less Reserve for Dist. 100 9,900 Cash at bank 5,940
Bills payable 2,500 Sundry debtors 14,000
O/s expenses: Less: Provision for DD 700 13,300
(c
Salary 200
Wages 200 400 Closing stock 7,000

Capital 24,000 Prepaid insurance 60

Notes
e
Add: Int. on capital 1,200 Machinery 5,000
25,200 Less: Dept. 250 4,750
in
Less: Net loss 390 Furniture 2,000
24,810 Less: Dept. 200 1,800
nl
Less: Drawings 4,500 20,310
33,110 33,110
Example:
O
From the following Balances, prepare final accounts of Rajeev, on 31st Dec 2009 after
considering the adjustments given below:
ty
Particulars Amount Particulars Amount
Capital 35,000 Taxes & Insurance 2,000
Drawings 6,000 General expenses 4,000
si
Furniture 2,600 Salaries 12,000
Bank loan 4,200 Commission (Dr.) 1,600
Creditors 13,800 Carriage outwards 2,000
Buildings r
24,000 Discount (Dr.) 2,000
ve
Stock on (1-1-2009) 20,000 Discount (Cr.) 2,000
Debtors 15,000 Bad debts 800
Rent received 1,000 Sales Returns 2,000
ni
Purchases 1,12,000 Sales 1,50,000
Adjustments:
U
a) Stock on hand on 31-12-2009 ` 20,000

b) Write off depreciation: Buildings ` 1,000, Furniture ` 600
c) Make Reserve of 5% on Debtors for Bad debts.
ity
d) Carry forward ` 200 for unexpired insurance.
Solution:
Trading and Profit & Loss Account of Rajeev Dr. as on 31st Dec, 2009 Cr.
m
To Opening stock 20,000 By Sales 1,50,000
)A
To Purchases 1,12,000 Less: Returns 2,000 1,48,000

To Gross Profit c/d 36,000 By Closing stock 20,000
1,68,000 1,68,000
To Salaries 12,000 By Gross Profit b/d 36,000
(c
To Commission 1,600 By Discount (Cr.) 2,000

To Taxes & Insurance 2,000 By Rent received 1,000

Less: Prepaid 200 1,800

Notes
e
To General Exps 4,000
To Carriage outwards 2,000
in
To Discount(Dr.) 2,000
To Bad debts 800
nl
Add: New reserve 750 1,550
To Depreciation
Building 1,000
O
Furniture 600 1,600
To Net Profit 12,450
39,000 39,000
ty
Balance Sheet for the year ended 31-12-2009
si
Capital 35,000 Furniture 2,600
Add: Net Profit 12,450 Less: Depreciation 600 2,000
Less: Drawings
r
47,450
6,000
Buildings
41,450 Less: Depreciation
24,000
1,000 23,000
ve
Bank loan 4,200 Debtors 1 5,000
Creditors 13,800 Less: Reserve 750 14,250
Stock 20,000
ni
Prepaid Insurance 200

59,450 59,450
U
Key Takeaways:
●● Financial statements: The essential documents of business. They are the
outputs of financial accounting.
ity
●● Income statement: Summary flow report that lists and categorizes the various
revenues and expenses that result from operations during a given period - a year,
a quarter or a month.
●● Dividend per share: DPS shows how much the shareholders were actually paid
m
by way of dividends.
●● Earning per share: ratio between the net profit after tax and the distribution of
dividend to preference shareholders and the number of equity share holders.
)A
●● Balance Sheet: It is a statement of assets and liabilities of an NPF at any

particular date.
●● Depreciation: It means the fall or decrease in the value of assets by using them
in the operation of business.
(c
●● Straight line method: Ascertainment of depreciation by a fixed percentage on the

original expense, taking into account the scrap value of the properties.

●● Annuity Method: Measurement of asset depreciation taking into account both the
Notes
e
value of the assets and the interest on them.
Check your progress
in
1. Ratio between the net profit after tax and the distribution of dividend to preference
shareholders and the number of equity share holders.
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a) Dividend per Share
b) Return on Capital
c) Return on Investment
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d) Earning per share
2. DPS ratio is calculated as -
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a) Dividend paid to equity shareholders/ Average number of issued equity shares
b) Dividend paid to preferance shareholders/ Average number of issued equity
shares
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c) Dividend paid to equity shareholders/ Average number of issued preferance
shares
d) Dividend paid to preferance shareholders/ Average number of issued
preferance shares r
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3. The essential documents of business are -
a) Accounting principles
b) Business Transactions
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c) Financial Statements
d) Financial Management
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4. The fall or a decrease in the value of assets is?

b) Depreciation
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d) Liability
5. The asset depreciation is measured taking into account both the value of the assets
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and the interest on them

a) Going Concern Method
b) Annuity Method
)A
c) Sinking Fund Method

d) Straight Line Method

(c
1. What do you understand by Financial Statements? Explain the nature and essentials.
2. Explain the importance of financial statements

3. What do you understand by DPS and EPS?

Notes
e
4. What is depreciation? Explain the straight line method.
5. Explain the annuity and sinking fund method.
in
1. a) Dividend per Share
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2. a) Dividend paid to equity shareholders/ Average number of issued equity shares
3. c) Financial Statements
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4. b) Depreciation
5. b) Annuity Method
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Further Readings
1. Accounting for Managers. Maheshwari and Maheshwari. Vikas publication.
2. Financial Accounting. Meigs and Meigs. Mcgraw Hills Inc.
si
3. Introduction to Accountancy. T S Grewal. S Chamd & Co Ltd
4. Advanced Accounting, Sehgal Ashok, Sehgal Deepak. Taxman Allied Services
(P) Ltd., New Delhi
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5. Advanced Accountancy, Jain S.P., Narang K.L..Kalyani Publishers, Ludhiana.
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6. Advanced Accounts, Shukla M.C., Grewal T.S.: S. Chand & Company Ltd.,
New Delhi.
7. Advanced Accountancy, Gupta R.L., M. Radhaswamy: Sultan Chand & Sons,
New Delhi.
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8. Financial Accounting, Tulsian. Tata McGraw-Hill, New Delhi.

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ity
m
)A
(c

Module-3: Analysis of Financial Statements

Notes
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Module Objective-
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This module is designed to explain how financial measures of corporate
performance are calculated and used to assess credit worthiness of a business with
the help of techniques of financial statement analysis. The module covers the basics
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of financial statement analysis and enables participants to confidently use financial
terminology.
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Learning Outcome:
At the end of this module, learner will be able to understand-
●● The basic techniques of financial statement analysis.
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●● How a company’s business and financing activities are reflected in its financial
statements.
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●● The components of financial statements: Balance sheet, profit and loss and cash
flow and key notes to the accounts.
●● The distinction between cash flow and profits & How to measure operating,
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investing and financial performance using appropriate ratios and cash flow tools.
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“Accountancy is the science which deals with recording of monetary trans-
actions of every description”.
According to F.W. Pixley-

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1. Overview of Financial Statement Analysis

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Financial statement analysis is defined as the process of identifying financial

strengths and weaknesses of the firm by properly establishing relationship between the
items of the balance sheet and the profit and loss account. There are various methods
or techniques that are used in analyzing financial statements, such as comparative
ity
statements, schedule of changes in working capital, common size percentages, funds

analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also
for decision making purposes. They play a dominant role in setting the framework of
m
managerial decisions. But the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these statements alone.
However, the information provided in the financial statements is of immense use in
)A
making decisions through analysis and interpretation of financial statements.
Tools And Techniques of Financial Statement Analysis:

Following are the most important tools and techniques of financial statement
(c
analysis:

●● Horizontal and Vertical Analysis

Notes
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Horizontal Analysis or Trend Analysis: Comparison of two or more year’s financial
data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated
in
by showing changes between years in both dollar and percentage form.
●● Trend Percentage
Horizontal analysis of financial statements can also be carried out by computing
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trend percentages. Trend percentage states several years’ financial data in terms of a
base year. The base year equals 100%, with all other years stated in some percentage
of this base.
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●● Vertical Analysis
Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing on it in
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percentage form as well as in dollar form. Each item is stated as a percentage of some
total of which that item is a part. Key financial changes and trends can be highlighted by
the use of common size statements.
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2. Ratio Analysis - Part 1 (Profitability Ratios)
Profitability ratios are a class of financial metrics used over time to measure the
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ability of a corporation to produce profits compared to its sales, operating expenses,
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balance sheet assets, or equity of shareholders, using data from a particular point in time.
Profitability Ratios
These ratios are measurement of the firm’s profitability in three dimensions namely
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the sales, investments and on capital employed.
a. Gross Profit Ratio

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The ratio elucidates the relationship in between the gross profit and the sales
volume. It determines the profit earning capacity of the firm out of the manufacturing or
trading operations.
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Gross Profit Ratio = Gross Profit/ Sales × 100
Remember: Turnover = Sales Gross Profit = Net Sales - Cost of Sales Cost of
Sales = Opening Stock + Net Purchases + Other Direct Expenses – Closing Stock
The gross profit margin ratio tells us the profit a business makes on its cost of
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sales, or cost of goods sold. It is a very simple idea and it tells us how much gross profit
per Rs1 of turnover our business is earning. Gross profit is the profit we earn before we
take off any administration costs, selling costs and so on. So we should have a much
)A
higher gross profit margin than net profit margin.
Example – ABC enterprises has earned a gross profit of Rs. 4,00,000 in the first
quarter. Calculate the gross profit ratio if the corresponding sales amounted to a value
of Rs. 20,00,000. What does it imply?
(c
Gross Profit Ratio = Gross Profit/ Sales × 100

Gross Profit Ratio = 4,00,000/ 20,00,000 × 100

Notes
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= 20:1 to 20%
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b. Net Profit Ratio
The ratio expresses the relation between the net profit and the amount of the sales.
It facilitates the representation of the Enterprise’s overall operational effectiveness.
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The net profit ratio is an indicator of the firm’s overall earning capacity in terms of sales
volume return.
Net Profit Ratio = Net Profit/ Sales × 100
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Example – ABC enterprises has earned a gross profit of Rs. 4,00,000 in the first
quarter. Calculate the gross profit ratio if the corresponding sales amounted to a value
of Rs. 40,00,000. What does it imply?
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Net Profit Ratio = Net Profit/ Sales × 100
Net Profit Ratio = 4,00,000/ 40,00,000 × 100
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= 1:1 to 10%
c. Operating Profit Ratio

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The operating ratio is establishing the relationship in between the cost of goods
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sold and operating expenses with the total sales volume.
Operating Ratio = Cost of Goods Sold + Operating expenses/ Net Sales × 100
d. Return on Assets Ratio

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This ratio demonstrates the relationship between the profits and the total assets
employed in the business. The ratio also highlights the firm’s successful use of assets
by assessing the return on total assets hired.
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Return on Assets = Net profit after taxes/ Average total assets × 100
Example: If Enterprise XYZ has an income of `1 crore and total assets of

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`10,00,000, what will be the return on assets if net profi t after taxes is ` 500000?
Return on Assets = Net profit after taxes/ Average total assets × 100
= 5,00,000/1,00,0000 × 100
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= 50%
e. Return on Capital Employed

)A
The ratio indicates how much return is received out of the total capital employed
in the form of Net profit after taxes. The capital employed is nothing but a blend of
the non-current liabilities and the equity of the shareholders. The ratio expresses the
relation between the total after-tax earnings and the total capital employed
Return on total capital employed = Net profit after taxes/ Total capital employed ×
(c
100

3. Ratio Analysis- Part 2 ( Liquidity Ratios)

Notes
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To study the short-term solvency or liquidity of the firm, there are two ratios:
1. Current Assets Ratio
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2. Acid Test Ratio or Quick Assets Ratio
1. Current Assets Ratio
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The current ratio is also known as the working capital ratio and is normally
presented as a real ratio. In order to survive, firms must be able to meet their short-
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term obligations—pay their creditors and repay their short-term debts. Thus, the liquidity
of the firm is one measure of a firm’s financial health. This is the ratio establishes the
relationship in between the current assets and current liabilities.
Current Ratio = Current Assets/ Current Liabilities
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Current Assets includes Cash + Bank balances + Marketable Securities + Stock
+ Accrued/Outstanding Incomes + Prepaid Expenses while Current Liabilities include
Creditors + Short term debt + outstanding expenses and unearned income etc.
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A big limitation of current ratio is that the current assets are equally weighed
against each other to match the current liabilities.
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Example: Enterprise ABC has current assets worth Rs. 5 lac, while the liabilities
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amounting to Rs. 2 lac. What is the current ratio of the firm?
Current Ratio = Current Assets/ Current Liabilities
Current Ratio = 5/2

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= 2.5
2. Acid test ratio

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The acid test ratio is also known as the liquid or the quick ratio. The ratio expresses
the relation between the quick assets and the current liabilities. The ratio is used to
replace the related bottleneck with the current ratio. It considers the liquid assets that
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can quickly be converted into cash to satisfy the financial obligations.
Acid Test Ratio = Liquid Assets/ Current Liabilities
Example: Enterprise XYZ has a closing stock of `30,000 while its prepaid
expenses are `5000. What will be its quick assets ratio if the current assets are worth
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`55000 while current liabilities are worth `15000?
Solution:
)A
Liquid Asset = Current Assets – (Closing Stock + Prepaid Expenses)

= 55000 – (30000 + 10000)
= 15000
Acid Test Ratio = Liquid Assets/ Current Liabilities

(c
= 15000/15000
= 1:1

4. Ratio Analysis- Part 3 (Solvency Ratio)

Notes
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Solvency ratios indicate the ability of the Enterprise to fulfill its long term
obligations. Those ratios are therefore also known as long-term solvency ratios. A
in
Enterprise’s long-term debt covers debentures, long-term loans, unpaid hire-purchase
installments and long-term creditors.
Example:
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The long-term debt of company ABC is 3 crores and the networth of the company
is 5 crores. If the company has a short-term debt of 1 crore, what is the total debt equity
ratio of ABC?
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Short-term Debt + Long-term Debt 1+3
Total Debt-equity Ratio = = = 4.5
Equity (Shareholders Fund) 5
a. Debt Equity Ratio
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It is the ratio that expresses the relationship between the ownership funds and the
outsiders’ funds. The debt-equity ratio is understood into two different forms:
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1. Long-term debt-equity ratio
2. Total debt-equity ratio
1. Long term Debt equity ratio r

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It is a ratio that expresses the relationship between the contribution of the outsiders
through debt financial resource and the contribution of the shareholders through equity
capital, preference share capital and past accumulated profits. It reveals the cover or
cushion that the firm has enjoyed because of the contribution of the owners over the
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contribution of the outsiders.
Debt equity ratio = Debt ( Long term Debt ) / Net worth ( Equity or Shareholder’s
funds)
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2. Total Debt equity ratio

The purpose of the ratio is to express the relationship of the total volume of debt
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irrespective of its nature and the shareholders’ funds. If the contribution of owner is
lesser in volume in general, it leads to a worse situation in recovering the contribution
amount of outsider during liquidation.
Total Debt equity ratio = Short Term Debt + Long term Debt / Equity (Shareholder’s
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funds)
b. Proprietary Ratio
)A
The ratio expresses the relationship in between the owners’ contribution and the
total volume of assets. It shows as to how much funds are contributed by the owners
in financing the assets of the firm. A greater ratio means greater contribution by the
owners’ to finance the assets.
Proprietary Ratio = Owner’s Funds / Total Assets

(c

Example:
Notes
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The net worth of company XYZ is 30 crores and the total assets are worth 10
crores. What is the proprietary ratio of the firm?
in
Owners’ Funds or Equity or Shareholders’ Funds 30
Proprietary Ratio = = = 3:1
Total Assets 10
The ratio shows that the firm is in quite a good financial position.
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c. Coverage Ratios
These ratios are calculated to determine the solvency of the firm during the
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periodical payments of interest and preference dividends. The interest and preference
dividends are to be paid irrespective of the earnings available with the firm. These are
known as fixed commitment charge of the firm.
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●● Interest Coverage Ratio
The firms are expected to make unfailing interest payments on the sum of
borrowings. This ratio makes it easier for prospective lenders to study the strength of
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the enterprise in making regular interest payments out of the total income.
To study the capacity in making the payment of interest is known as interest

coverage ratio or debt service coverage ratio. The ability or capacity is analysed only
r
on the basis of Earnings Before Interest and Taxes (EBIT) available in the hands of the
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firms. Greater the ratio means that better the capacity of the firm in making the payment
of interest as well as greater the safety and vice versa.
Interest coverage ratio = Earnings before Interest and Taxes/ Interest
Example: Mr Rahul had an earning of Rs 4,00,000 before he paid the interests and
ni
taxes. What will be the interest coverage ratio if he pays Rs. 40,000 as an interest?
What will it mean?
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Interest coverage ratio = Earnings before Interest and Taxes/ Interest

= 4,00,000/40,000
= 10:1
ity
Since the interest coverage ratio is substantially high, it means that Mr. Rahul has a
good capacity in making the payment of interest and has a high safety.
●● Dividend Coverage Ratio

It defines the ability of the firm to make payment of preference dividend out of the
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earnings available to the firm after the tax payments. Greater the size of profits after
taxation, greater is the area for the payment of preference dividend and vice versa. The
preference dividends are to be paid without fail irrespective of the available profits after
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the taxation.
Dividend coverage ratio = Earnings after Taxation/ Preferance Dividend
Example: ABL Manufacturers have to make a preference dividend of ` 60,000. The

earnings after taxation is ` 3,00,000. What will be the Dividend coverage ratio? What
(c
does it mean?
Interest coverage ratio = Earnings after Taxation/ Preferance Dividend

Interest coverage ratio = 3,00,000/ 60,000

Notes
e
= 5:1
As the value of the dividend coverage ratio is quite high, the business has a strong
in
base for the payment of preference dividend.
5. Ratio Analysis - Part 4 (Turnover ratios)
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Turnover ratios highlight the relationship between the sales and various assets. It
indicates the speed which is taken by the firm to convert their assets into sales.
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●● Stock Turnover Ratio
The ratio expresses the speed of converting the stock into sales. It determines as
to how fast the stock is being converted into sales in a year. The greater the ratio of
conversion leads to lesser the number of days, weeks or the months required to convert
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the stock into sales.
Stock Turnover Ratio = COGS/ Average Stock or Sales/ Closing Stock
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Example:
The cost of goods sold is 500,000. The opening stock is 40,000 and the closing
stock is 60,000 (at cost). Calculate inventory turnover ratio
Solution:
r
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Opening Stock = Closing Stock 40,000 = 60,000
Average Stock = = = 50,000
2 2
Cost of Goods Sold 5,00,000
Stock Turnover Ratio = = = 10:1
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Average stock 50,000
●● Debtors Turnover Ratio

The ratio exhibits the speed of the collection process of the firm. Represents the
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collected amount of the over dues from the debtors and against the bills receivables.
The speediness is being computed through debtors velocity from the ratio of Debtors
Turnover Ratio.
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Debtor Turnover Ratio = Net Credit Sales/ Average Debtors
Example:
Sam & Co. Sells goods on cash as well as credit basis. The following particulars
are extracted from the books of accounts for the calendar 2010:
m
Particulars `
Total Gross sales 2,00,000
)A
Cash Sales (included in above) 40,000

Sales Returns 14,000
Total Debtors 18,000
Bills Receivable 4,000
(c
Provision for Doubtful Debts 2,000

total Creditors 20,000

Solution:
Notes
e
To find out the average collection period, first debtors turnover ratio has to
computed
in
Net Credit Sales
Debtors Turnover Ratio =
Bills Receivable + Debtors
Net Credit Sales = Gross Sales – Cash Sales – Sales Return
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= 2,00,000–40,000û14,000=1,46,000
1,46,000
Debtor Turnover Ratio = = 6.64 times
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4,000 + 18,000
365 days 365 days

Debtors Velocity = = = 55 days
Debtors Turnover Ratio 6.64 times
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●● Creditors Turnover Ratio
It shows effectiveness of the firm in deploying the credit period allowed by the
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creditors during the moment of a credit purchase.
Credit Turnover Ratio = Credit Purchase/ Average Creditors
Example:
r
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Find out the value of creditors from the following:
Sales `1,00,000 Opening Stock `10,000

Gross profit on sales 10% Closing stock `20,000
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Creditors velocity 73 days Bills payable `16,000
Note: All purchases are credit purchases

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Solution:
Cost of goods sold = Opening Stock + Purchases – Closing Stock
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= 10,000 + Purchases – 20,000
Cost of goods sold = Sales – Gross Profit
= 1,00,000 – 10% on 1,00,000 = 90,000

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The next step is to apply the found value in the early equation
Purchases = 90,000 – 10,000 + 20,000 = 1,00,000

)A
To find out the value creditors, the creditor velocity and creditors turnover ratio
Notes:
365 days
Creditors Velocity =
Creditors Turnover Ratio
(c
Credit Purchases
Creditors turnover Ratio =
Bills Payable + Sundry Creditors

1,00,000
Notes
e
=
16,000 + Sundry Creditors
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The next step is to find out the sundry creditors, the reversal process to be adopted
365 days
73 days =
Creditors Turnover Ratio
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365 days
Creditors Turnover Ratio = = 5 times
73 days
The next step is to substitute the found value in the equation of creditors turnover ratio
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`1,00,000
16,000 + Sundry creditors =
5
Sundry Creditors = 20,000 – 16,000 = 4,000
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6. Ratio Analysis - Part 5 (Earning ratios)
●● Dividends and Earning Per Share
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The DPS ratio is very similar to the EPS: EPS shows what shareholders earned
by way of profit for a period whereas DPS shows how much the shareholders were
actually paid by way of dividends. The DPS formula is:
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Dividend per share = Dividend paid to equity shareholders/ Average number of
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issued equity shares
●● Earning per share

This is the ratio between the net profit after tax and the distribution of dividend to
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preference shareholders and the number of equity share holders. In other words, it is
the ratio between earnings available to equity shareholder and number of shareholders
in an organization.
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Earning per share = Earnings available to equity shareholders / Number of

shareholders
Earning’s available to equity shareholder’s means net profit after tax and
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distribution of dividend to preference share holder’s
Number of equity share = Total equity capital / Face value per share
Example:
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The following is the balance sheet of a company as on 31-3-06
Liabilities ` Assets `
)A
Equity Shares 40,00,000 Land & building 40,00,000

Reserves & Surplus 20,00,000 Plant & Machinery 40,00,000
Debuntures 30,00,000 Investments 30,00,000
LOng term loans 50,00,000 Stock 25,00,000
Creditors 8,00,000 Debtors 15,00,000
(c
Other current liablities 12,00,000 Other current assets 10,00,000

1,60,00000 1,60,00000

Notes
e
Calculate:
a. Current ratio
in
b. Stock to working capital rato
c. Debt-Equity ratio
d. Net-worth ratio/properetor/ratio
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e. Fixed assets to net worth ratio
f. Current assets to net worth ratio
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g. Solvency ratio
a. Current ratio = Current Assets/Current Liabilities = 50,00,000/20,00,000 =2.5
b. Stock to working capital ratio =Stock/ Inventory/ Working capital x 100
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Working capital = Current Assets – Current uabilitics
= 50,00,000 = 20,00,000 - 30,00,000
si
= 25,00,000/30,00,000 X 100 = 83.33%
c. Debt - Equity ratio = Debt/ Equity
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Debt = Long-term loans 30,00,000 + 50,()(M)00 = 8(M)(),000
ve
Equity = Share capital + Reserves + Surplus
= 40,00,000 + 20,00,000 = 60,00,000
= 80,00,000/60,00,000 =1.33
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d. Net worth or proprietary ratio = Net worth (euity}/Total assets

(Net worth) = Share capital + Reserves & Surplus
= 60,00,000/1,60,00,000 = 0.375
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e. fixed assets to net worth ratio = Net fixed assets

=80,00,000/60,00,000=1.33
ity
f. Current assets to net worth ratio = Current assets/Net worth

= 50,00,000/60,00,000 = 0.833
g. Solvency ratio = total assets/Total liabilities
m
Total assets = Total of asset side of balance sheet.

total liabilities = Both long-term and current liablities.
= 1,60,00,000/1,00,00,000 = 1.6
)A
7. DuPont Decomposition Analysis

The DuPont analysis (also known as the DuPont identity or DuPont model) is a
fundamental Performance Measurement Method. DuPont analysis is a useful technique
(c
for decomposing the various return on equity (ROE) engines. The ROE decomposition
helps investors to concentrate separately on the main metrics of financial success to
define strengths and weaknesses.
There are three financial metrics driving equity return (ROE): operating
Notes
e
performance, asset usage efficiency and financial leverage. Operating output is a net
profit margin or a net income separated by overall revenue or profits. The performance
of asset usage is determined by the turnover ratio of the assets. Leverage is calculated
in
by equity multiplier equivalent to average assets divided by average equity.
DuPoint Analysis = Net Profit Margin x AT x EM
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Where,
Net profit Margin = Net Income/ Revenue
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AT = Asset Turnover
Asset Turnover = Sales/ Average total assets
EM = Equity Multiplier
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Equity Multiplier = Average Total Assets / Average Shareholder’s equity
8. Cash flow Statement - Overview & Benefits (as per IND AS 3)
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The cash flow statement provides details about a firm’s cash flow operations.
This statement explicitly includes the Enterprise‘s acquisition, operation, and financing
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activities. The cash flow statement displays all sources and uses of cash by a
Enterprise over the accounting period. Sources of cash listed on the statement include
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the revenues, long-term financing, sales of noncurrent assets, and an increase in any
current liability or the decrease in any current asset account. Uses of cash include the
operating losses, debt repayments, equipment purchases and increases in current
asset accounts.
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The cash flow statement is intended to -
1. Provide information on a firm’s liquidity and solvency and its ability to change
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cash flows in future circumstances.

2. Provide additional information for evaluating changes in assets, liabilities and
equity.
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3. Improve the comparability of different firms’ operating performance by

eliminating the effects of different accounting methods.
4. Indicate the amount, timing and probability of future cash flows.
m
Benefits –
The uses of financial statements vary from entity to entity and for different users,
they have different uses. Presented under is a brief list of benefits they give to their
)A
users –
1. For equity investors and lenders: Existing equity investors and lenders
to a Enterprise need to track their investments and evaluate management
performance. In this end, they have no other help than a Enterprise’s financial
(c
statements. Prospective investors and lenders make use of financial statements

to determine whether to invest in an entity or not.

2. For finance specialists: Investment analysts, money managers, and

Notes
e
stockbrokers, use financial cash flow statements to make buy, sell and hold the
recommendations to their clients.
in
3. For credit rating agencies: Many rating agencies also assign their credit
ratings on the basis of the financial statements of an Enterprise.
4. For customers and suppliers: Major customers and suppliers to an entity
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measure the financial strength and the Enterprise’s staying power as a reliable
tool for their sector. In that end, the most possible supports are those in the
organization’s financial statements.
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5. For Labour unions: Labour unions use financial statements of a Enterprise to
gauge how much of a pay increase a Enterprise is able to afford in upcoming
labour negotiations.
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9. Classification of Activities for the Preparation of Cash Flow
Statement
The cash flow statement is partitioned into three segments, namely: cash flow
si
resulting from operating activities, cash flow resulting from investing activities, and cash
flow resulting from financing activities. The money coming into the business is called
cash inflow, and money going out from the business is called cash outflow.
●●
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Operating activities
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Operating activities include the production, sales and delivery of the Enterprise’s
product as well as collecting payment from its customers. This could include purchasing
raw materials, building inventory, advertising, and shipping the product. Operating cash
flows include:
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●● Receipts from the sale of goods or services

●● Receipts for the sale of loans, debt or equity instruments in a trading portfolio
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●● Interest received on loans

●● Dividends received on equity securities
●● Payments to suppliers for goods and services
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●● Payments to employees or on behalf of employees

●● Interest payments
Items which are added back to [or subtracted from, as appropriate] the net income
figure (which is found on the Income Statement) to arrive at cash flows from operations
m
generally include:
●● Depreciation (loss of tangible asset value over time)

●● Deferred tax
)A
●● Amortization (loss of intangible asset value over time)

Any gains or losses associated with the sale of a non-current asset, because
associated cash flows do not belong in the operating section.(unrealized gains or losses
are also added back from the income statement)
(c
●● Investing Activities
An enterprise’s investment practices include the acquisition of fixed assets (such

as plants and equipment, land and buildings, furniture and fixtures) with a view to
Notes
e
producing potential revenues. Owing to being a significant operation, the cash flows
from these operations are reported separately. Examples of cash flows arising from
investing activities are in AS-3 (revised) as follows:
in
(a) Cash payments of acquired fixed assets including the intangibles. These
payments include those relating to capitalized research and development costs
nl
and self-constructed fixed assets;
(b) Cash receipts from disposal of fixed assets including the intangibles.
(c) Cash payments to acquire shares, warrants or the debt instruments of other
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enterprises and interests in joint ventures (other than the payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
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(d) Cash receipts from the disposition of shares , bonds or debt instruments of
other undertakings and joint venture interests (other than receipts from such
instruments deemed to be cash equivalents and retained for the purposes of
trading or dealing);
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(e) cash advances and loans that are made to third parties. This excludes the
advances and loans made by a financial enterprise);
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(f) cash receipts from the repayment of advances and loans made to third parties
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(other than advances and loans of a financial enterprise);
(g) cash payments for future contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and
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(h) cash receipts from future contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.
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●● Financing Activities
All activities related to the size and composition of the capital (equity and
preferences) and borrowing or loans are listed under fiancial activities. According to
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the AS-3 (revised), separate disclosure of cash flows resulting from funding activities
is relevant as it is useful in predicting potential cash flow statements by fund providers
(both capital and borrowings) to the Business.
(a) Cash proceeds from issuing of shares or other similar instruments;

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(b) Cash proceeds from issuing debentures, loans, notes, bonds and other short or
long-term borrowings; and
)A
(c) Cash repayments of the borrowed amounts.
10. Preparation of Cash Flow Statement

The direct method of preparing a cash flow statement results in a more easily
understood report. The indirect method is almost universally used, because most of the
(c
accounting standards requires a supplementary report similar to the indirect method if a

Enterprise chooses to use the direct method.

Direct method
Notes
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The cash receipts from operating income and cash payments for operating
expenses are organized and reported in the cash flow statement by direct process.
in
Gross cash flow due from business activities is the difference between cash receipts
and cash payments. It is in essence a profit & loss account on a cash basis.
Another way to determine cash flows under the direct method is to prepare
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a worksheet for each major line item, and eliminate the effects of accrual basis
accounting in order to arrive at the net cash effect for that particular line item for the
period. Some examples for the operating activities section include:
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Cash receipts from customers:
●● Net sales per the income statement.
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●● Plus beginning balance in accounts receivable.
●● Minus ending balance in accounts receivable.
●● Equals cash receipts from customers.
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Cash payments for inventory:
●● Ending inventory.
●● r
Minus beginning inventory.
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●● Plus beginning balance in accounts payable to vendors.
●● Minus ending balance in accounts payable to vendors.
●● Equals cash payments for inventory.
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Cash paid to employees:

●● Salaries and wages per the income statement.
●● Plus beginning balance in salaries and wages payable.
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●● Minus ending balance in salaries and wages payable.

●● Equals cash paid to employees.
Cash paid for operating expenses:
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●● Operating expenses per the income statement.

●● Minus depreciation expenses.
●● Plus increase or minus decrease in prepaid expenses.
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●● Plus decrease or minus increase in accrued expenses.
Equals
)A
●● Cash paid for operating expenses Taxes paid:

●● Tax expense per the income statement.
●● Plus beginning balance in taxes payable.
●● Minus ending balance in taxes payable.
(c
Equals taxes paid

●● Interest expense per the income statement.
●● Plus beginning balance in interest payable.

Notes
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●● Minus ending balance in interest payable.
Equals interest paid
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Under the direct method, for this example, you would then report the following in
the cash flows from operating activities section of the cash flow statement:
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●● Cash receipts from customers.
●● Cash payments for inventory.
●● Cash paid to employees l Cash paid for operating expenses.
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●● Taxes paid.
●● Interest paid Equals net cash provided by (used in) operating activities.
Sample cash flow using direct method
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Cash flows from (used in) operating activities
Cash receipts from customers 27,00
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Cash paid to suppliers and employees (20,000)
Cash generated from operations (sum0 7,500
Interest paid (2,000)
Income taxes paid
r (4,000)
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Net cash llows from operating activities 1,500
Cash flows from (used in) investing activities
Proceeds from the sale of eqipment 7,500
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Proceeds from sale of investiment 3,00

Net cash flows from investing activities 10,500
Cash flows from (used in) Financing activities
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Dividends paid (2,500)

Net cash flows used in financing activities (2,500)
Net increase in cash and cash equivalents 9,500
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Cash and cash equivalents, begiknning of year 1,00

Cash and cash equivalents, end of year `10,500
Indirect Method
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The net income (loss) is used as the basis in this process and is translated to net
cash generated by operating activities. The indirect approach changes net income for
things which have had an effect on net income but have not affected cash. Non-cash
)A
and non-operating costs on the profit & loss account are applied back to net income,
while non-cash and non-operating credits are excluded to measure operating profit
before working capital changes.
Rules of Converting Profit to Cash flow under Indirect Method

(c
The following rules are used to make adjustments for changes in current assets
and liabilities, operating items not providing or using cash and non-operating items. The

following is an example of how the indirect method would be presented on the cash flow
Notes
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statement:
●● Net income per the income statement
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●● Minus entries to income accounts that do not represent cash flows
●● Plus entries to expense accounts that do not represent cash flows
●● Equals cash flows before movements in working capital
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●● Plus or minus the change in working capital, as follows:
An increase in current assets (excluding cash and cash equivalents) would
be shown as a negative figure because cash was spent or converted into
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other current assets, thereby reducing the cash balance.
A decrease in current assets would be shown as a positive figure, because
other current assets were converted into cash.
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An increase in current liabilities (excluding the short-term debt which
would be reported in the financing activities section) would be shown as a
positive figure since more liabilities mean that less cash was spent.
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A decrease in current liabilities would be shown as a negative figure,
because cash was spent in order to reduce liabilities.
Example 1:
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From the following, calculate cash from Operations:
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Particulars `
Total Sales 6,00,000
Total Purchases 4,50,000
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Debtors at the beginning of the year 80,000

Debtors at the end of the year 2,00,000
Creditors for supplies at the beginning of the year 50,000
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Creditors for supplies at the end of the year 1,20,000

Operating Expenses 80,000
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Solution:
Statement showing Cash From Operations Notes
Particulars ` `
Cash Sales
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Total Sales 6,00,000

Less: Increase in Debtors (Credit sales)
(2,00,000 - 80,000) 1,20,000 4,80,000
)A
Less: Cash Purchases

Total Purchases 4,50,000
Less: Increase in Creditors (Credit purchase)
(1,20,000 - 50,000) 70,000 3,80,000
1,00,000
(c
Less: Operating Expenses (paid in cash) 80,000

Cash from Operations 20,000

Following is the Trading and Profit and Loss Account for the year ended 31st
Notes
e
March, 2015
Dr. Cr.
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To Purchases 1,27,600 By Sales 1,91,000
To Wages 31,900
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To Gross Profit c/d 31,500
1,91,000 1,91,000
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To Salaries 6,600 By Gross Profit b/d 31,500
To Rent 3,190 By Profit on Sale of Building
To Depreciation 9,570 (Book Value 40,000) 25,000
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To Loss on sale of Investments 3,200
To Goodwill written off 3,940
To Net Profit 30,000
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56,500 56,500
Calculate Cash from Operations.
Solution: r
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Statement showing Cash from Operations
Particulars ` `
Net Profit as per P&L A/c 30,000
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Add: Non Cash and Non Operations

expenses
Depreciation 9,570
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Loss on sale of Investment 3,200

Goodwill written off 3,940 16,710
46,710
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Less: Non Cash and Non Operating Income

Profit on sale Buildings 25,000
Cash from Operations 21,710
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Example:
Given below are the balance sheets of RK Ltd., as on 31-03-2013 and 31-03-2014
)A
2013 2014
Liabilities
Equity share capital 2,00,000 3,00,000
Long term loan 1,00,000 1,00,000
(c
Creditors 1,50,000 2,00,000

Bills payable 2,00,000 3,00,000

Retained earnings 1,80,000 2,00,000

Notes
e
Assets 8,30,000 11,00,000
Cash 60,000 30,000
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Stock 1,20,000 1,90,000
Debtors 80,000 1,20,000
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Goodwill 2,00,000 1,50,000
Plant and machinery 1,00,000 2,00,000
Land and building 2,00,000 4,00,000
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Furniture 70,000 10,000
8,30,000 11,00,000
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Additional Information:
a) Operating expenses include depreciation ` 80,000 and a mortization of Goodwill
` 50,000.
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b) A machine has been sold for ` 15,000. The cost reduce of the machine was `
40,000 and ` 20,000 depreciation is charged on the same in 2014.
c) Plant and machinery was purchased for cash ` 1,40,000 and land and buildings
for ` 2,60,000. r
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d) Furniture was sold for cash ` 60,000.
e) Equity shares were issued for cash ` 1,00,000.
f) ` 80,000 dividend was paid in cash.
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g) Net profit for the year ending 31-03-2014 was ` 1,00,000.

Prepare statement of cash flow as per As-3 indirect method for the year ending 31-
03-2014.
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Solution:
Plant and Machinery Account

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` `
To Balance b/d 1,00,000 By Cash (Sale) 15,000
To Purchase of Machine (B/F) 1,40,000 By Loss on Sale 5,000
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By Depreciation 20,000
By Balance c/d 2,00,000
2,40,000 2,40,000
)A
Land and Building A/c

` `
To Balance b/d 2,00,000 By Depreciation (b/f) 60,000
To Purchase A/c 2,60,000 By Balance c/d 4,00,000
(c
4,60,000 4,60,000

Furniture A/c
Notes
e
` `
To Balance b/d 70,000 By Cash 60,000
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By Balance c/d 10,000
70,000 70,000
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Cash flow Statement for the year ending 31-03-2014
` `
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1) Cash flow from operating activities:
Net profit for the year after dividend and tax 1,00,000
Add:
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Depreciation (Plant+Building) 80,000
Loss on sale of plant 5,000
Goodwill written off 50,000
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Increase in creditors 50,000
Increase in Bills payable 1,00,000 2,85,000
3,85,000
Increase in Stock r (70,000)
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Increase in Debtors (40,000) 1,10,000
Net Cash inflows from operations activities 2,75,000
2) Cash flow from investing activities:
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Purchase of plant and Machinery (1,40,000)

Purchase of Land Building (2,60,000)
Sale of Machinery 15,000
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Sale of Furniture 60,000

Net Cash outflow from investing activities (3,25,000)
(50,000)
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3) Cash flow from financial activities

Issue of equity capital 1,00,000
Dividend payment (80,000)
Net cash flow from financial activities 20,000
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Net Decrease in cash (30,000)

Cash Balance in the beginning 60,000
)A
Cash Balance at the end 30,000
Example 4:
Following is the Balance sheet of J.K Ltd as on 31-3-2011 and 31-3-2012. You are
required to prepare the comparative statement and comment on the financial position of
(c
the concern.

Notes
31/03/2012
31/03/2012
31/03/2011
31/03/2011
Liabilities
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Assets
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Share capital 1,00,000 1,25,000 Fixed Assets
Reserves and Surplus 20,000 25,000 Building 75,000 1,50,000
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8% Debentures 45,000 30,000 Furniture 2,00,000 2,40,000
Longterm Borrowings 2,00,000 2,50,000 Current Assets
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Creditors 1,25,000 1,50,000 Stock 1,00,000 35,000
Bills Payable 45,000 50,000 Debtors 40,000 1,00,000
Bank Overdraft 12,500 15,000 Cash 1,32,500 1,20,000
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5,47,500 6,45,000 5,47,500 6,45,000
Solution:
Comparative Statement as on 31-3-2011 and 31-3-2012
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Particulars 31/3/2011 31/03/2012 ↑ or ↓ in ↑ or ↓
` ` Amount ` in %
Liabilities:
a) Share capital
r 1,00,000 1,25,000 +25,000 +25
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Total (a) 1,00,000 1,25,000 +25,000 +25
b) Reserves & Surplus 20,000 25,000 +5,000 +25
Total (b) 20,000 25,000 +5,000 +25
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c) Long term Liabilities

8% Debentures 45,000 30,000 –15,000 -33.333
Long term borrowings 2,00,000 2,50,000 +50,000 +25
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Total (c) 2,45,000 2,80,000 +35,000 +14.285

d) Current Liabilites
Creditors 1,25,000 1,50,000 +25,000 +20
Bills payable 45,000 50,000 –5,000 +11.11
ity
Bank overdraft 12,500 15,000 +2,500 +20

Total (d) 1,82,500 2,15,000 +32,500 +17.80
Total Liabilities (a + b + c + d) 5,47,500 6,45,000 +97,500 +17.80
Assets:
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a) Fixed Assets
Building 75,000 1,50,000 75,000 100
Furniture 2,00,000 2,40,000 40,000 20
)A
b) Current Assets Total (a) 2,75,000 3,90,000 1,25,000 45.45

Stock 1,00,000 35,000 –65,000 –65
Debtors 40,000 1,00,000 60,000 150
Cash 1,32,500 1,20,000 –12,500 –9.433
(c
Total (b) 2,72,500 2,55,000 –17,500 –6.422

Total (a + b) 5,47,500 6,45,000 97,500 +17.80

Conclusions or Interpretation of the financial statement:

Notes
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a) There has been overall increase in the Fixed Asset of ` 1,10,000, which is
financed by the further equity issue and long-term borrowings. It indicates the
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sound financial policy of the concern.
b) There has been overall decrease in the Current Asset of ` 17,500, and increase
in Current Liabilities of ` 32,500. That means the companies Short-term
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solvency position is not favorable. It is always ideal to have current ratio of
2:1 i.e., for every rupee of Current liabilities there must be at least two rupee
of current asset with the company so that it can meet its immediate financial
O
obligation satisfactory.
c) The reserves and surplus has increased by ` 5,000 which indicates good
profitability of the concern. Overall, the financial position and profitibility of the
company is satisfactory.
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The Balance sheets of Karthik Company and Subash Company as on 31.12.2015
are as follows. Compare the financial position of both the firms with the help of common
size balance sheets and interpret the results.
si
Liabilities Karthik Subash Assets Karthik Subash
Co. Co. Co. Co.
Preference Land & Bld r 80,000 1,23,000
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share capital 1,20,000 1,80,000 Plant & M 3,34,000 6,00,000
Equity share Temporary
capital 1,50,000 4,00,000 Investment 1,000 40,000
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Reserves & Surplus 14,000 18,0000 Stock 10,000 25,000

Long term loans 1,15,000 1,30,000 Book Debts 4,000 8,000
Bills Payable 2,000 - Prepaid exp. 1,000 2,000
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Sundry Creditors 12,000 4,000 Cash at Bank

O/S Expenses 22,000 10,000 Balance 8,000 30,000
Proposed Dividend 10,000 90,000 Preliminary exp. 7,000 4,000
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4,45,000 8,32,000 4,45,000 8,32,000
Solution:
Common Size Balance Sheet
m
Particulars Karthik Co. % Subash Co. %

A. Current Assets:
Temporary Investment 1,000 0.22 40,000 4.81
)A
Stock 10,000 2.25 25,000 3.00

Book Debts 4,000 0.90 8,000 0.96
Prepaid Expenses 1,000 0.22 2,000 0.24
Cash and Bank Balance 8,000 1.80 30,000 3.62
(c
Total (A) 24,000 5.39 1,05,000 12.63

B. Fixed Assets:

Land & Building 80,000 17.98 1,23,000 14.78

Notes
e
Plant & Machinery 3,34,000 75.06 6,00,000 72.11
Preliminary Expenses 7,000 1.57 4,000 0.48
in
Total (B) 4,21,000 94.61 7,27,000 87.37
Total Assets (A + B) 4,45,000 100 8,32,000 100
A. Current Liabilities
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Bills Payable 2,000 0.45 - -
Sundry Creditors 12,000 2.70 4,000 0.48
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O/S Expenses 22,000 4.94 10,000 1.20
Proposed Dividend 10,000 2.25 90,000 10.82
Total (A) 46,000 10.34 1,04,000 12.50
B. Long Term Debt 1,15,000 25.84 1,30,000 15.63
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C. Shareholder Funds:
Preference Share Capital 1,20,000 26.97 1,80,000 21.63
Equity Share Capital 1,50,000 33.71 4,00,000 48.08
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Reserves and Surplus 14,000 3.14 18,000 2.61
Total (C) 2,84,000 63.82 5,98,000 71.87
Total liabilities (A + B + C)
r 4,45,000 100 8,32,000 100
ve
Key Takeaways:
●● Financial statement analysis: It is defined as the process of identifying financial
strengths and weaknesses of the firm by properly establishing relationship
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between the items of the balance sheet and the profit and loss account
●● Profitability Ratios: Measurement of the firm’s profitability in three dimensions
namely the sales, investments and on capital employed
U
●● Solvency ratios: They indicate the ability of the Enterprise to fulfill its long term
obligations
●● Proprietary Ratio: Expresses the relationship in between the owners’ contribution
ity
and the total volume of assets.

●● Coverage ratios: These ratios are calculated to determine the solvency of the firm
during the periodical payments of interest and preference dividends.
●● Turnover ratios: Turnover ratios highlight the relationship between the sales and
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various assets. It indicates the speed which is taken by the firm to convert their
assets into sales.
●● DuPont analysis: A fundamental Performance Measurement Method
)A
●● Cash flow statement: Statement providing details about a firm’s cash flow
operations.

(c
1. Process of identifying financial strengths and weaknesses of the firm is?

a) Accounting Fundamentals

b) Financial ratio analysis

Notes
e
c) Computation of balance sheet
d) Financial Statement Analysis
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2. Ratio between the net profit after tax and the distribution of dividend to preference
share holders and the number of equity share holders.
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b) Return on Capital
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d) Earning per share
3. DPS ratio is calculated as -
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a) Dividend paid to equity shareholders/ Average number of issued equity shares
b) Dividend paid to preferance shareholders/ Average number of issued equity
shares
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c) Dividend paid to equity shareholders/ Average number of issued preferance
shares
d) Dividend paid to preferance shareholders/ Average number of issued
preferance shares r
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4. Ratios that highlight relationship between the sales and various assets.
a) Profitability Ratios
b) Turnover Ratios
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c) Coverage Ratios
d) Solvency Ratio
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5. Which ratio is also known as the Quick ratio?

a) Current Ratio
b) Debt Turnover Ratio
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c) Acid test Ratio

d) Equity Ratio

m
1. What are financial statements? Explain the tools and techniques?

2. Explain the various solvency ratios?
)A
3. What do you understand by DPS and EPS?

4. What is meant by cash flow statement?
5. Classify the activities for the Preparation of Cash Flow Statement
(c
Check your progress

1. d) Financial Statement Analysis

2. d) Earning per share

Notes
e
3. a) Dividend paid to equity shareholders/ Average number of issued equity shares
4. a) Profitability Ratios
in
5. c) Acid test Ratios
Further Readings
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1. Horngren.C.T., Accounting For Management Control - An Introduction,
Englewood Cliffs, Prentice Hall, 1965.
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2. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.
3. Hingorani, Ramanathan & Grewal, Management Accounting.
4. Jain S.P. And Narang, K.L., Cost Accounting.8. Financial Accounting, Tulsian.
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Tata McGraw-Hill, New Delhi.
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ity
m
)A
(c

Module-IV: Introduction to Cost & Management

Notes
e
Accounting
in
Module Objective-
This module is designed to discuss the theoretical foundation of cost accounting,
nl
the basic issues related to cost measurement and control, costing systems and acquire
knowledge of application of cost & management accounting.
O
Learning Outcomes-
At the end of this module, learner will be able to understand-
●● The fundamental purposes of cost and management accounting. As part of this
ty
learning, learner will be able to appreciate the use of different costs for different
purposes.
●● How to prepare cost sheet and the concept of Marginal Costing and Cost Volume
si
Profit Analysis
●● The Use of standard costing to prepare budgets for planning and control purposes.
r
“Nearly every business enterprise has accounting system. It is a means of
ve
collecting, summarizing, analyzing and reporting in monetary terms, infor-
mation’s about business”.
According to R.N Anthony-

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1. Cost & Management Accounting - Introduction

Cost Accounting Is the accounting branch which deals with documentation,
U
classification, distribution, and recording of current and potential costs. The aim of cost
accounting is to ascertain the cost of products generated or services provided by a
business. This also helps the Enterprise monitor costs by displaying avoidable losses
and waste.
ity
The purpose of management accounting is to provide the management with

relevant information to enable it to take control of decision and effect at the appropriate
time. Managerial accounting is the accounting division intended to provide information
to the different levels of management in the hospitality operation for the purpose of
m
strengthening controls.
Objectives of Cost Accounting

)A
There is a relationship among information needs of management, cost accounting

objectives, and techniques and tools used for analysis in cost accounting. Cost
accounting has the following main objectives to serve:
1. Determining the selling price - The objective of determining the cost of products
(c
is of main importance in cost accounting. The total product cost and cost per unit of
product are important in deciding selling price of product. Cost accounting provides

information regarding the cost to make and sell product or services. Other factors
Notes
e
such as the quality of product, the condition of the market, the area of distribution,
the quantity which can be supplied etc., are also to be given consideration by the
management before deciding the selling price, but the cost of product plays a
in
major role.
2. Controlling cost - Cost accounting helps in attaining aim of controlling cost by using
nl
various techniques such as Budgetary Control, Standard costing, and inventory
control. Each item of cost [viz. material, labour, and expense] is budgeted at the
beginning of the period and actual expenses incurred are compared with the budget.
This increases the efficiency of the enterprise.
O
3. Decision-making - Cost accounting helps the management in providing information
for managerial decisions for formulating operative policies. These policies relate to
the following matters:
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(a) Determination of the cost-volume-profit relationship.
(b) Making or buying a component.
si
(c) Shutting down or continuing operation at a loss.
(d) Continuing with the existing machinery or replacing it by improved and
economical machines.
r
4. Ascertaining costing profit - Cost accounting helps in ascertaining the costing
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profit or loss of any activity on an objective basis by matching cost with the revenue
of the activity.
5. Facilitating preparation of financial statements - Cost accounting helps to
produce statements at short intervals as the management may require. The financial
ni
statements are prepared generally once a year or half year to meet the needs of the
management.
In order to operate the business at high efficiency, it is essential for management
U
to have a review of production, sales and operating results. Cost accounting provides
daily, weekly or monthly statements of units produced, accumulated cost with analysis.
Cost accounting system provides immediate information regarding stock of raw material
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and types of goods, which helps in the preparation of financial statements.
2. Cost Classifications
Cost is the money spent which represents the production of a product or to
m
provide a service. Costs are the economic expenditure (the payment of wages,
the procurement of products, the manufacture of a product, the raising of funds to
support the management of the business, etc.) to be made in order to achieve the
)A
operational goal. Failure to achieve the desired target, an organization is said to have
had losses.
The term cost is used in many different ways. The reason is that there are many
types of costs, and these costs are classified differently according to the immediate
need of management. For example, managers may want cost data to prepare external
(c
financial reports, to prepare planning budgets, or to make decisions. Each different use
of cost data demands a different classification and definition of cost. For example, the

preparations of external financial reports require historical cost data, whereas decision
Notes
e
making may require predictions about future costs. In the following paragraphs it has
been discussed many of possible use of cost data and how costs are defined and
classified for each use.
in
Manufacturing and Non-manufacturing Costs
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Manufacturing Costs
These are those costs that are directly involved in manufacturing of products and
services. Examples of manufacturing costs are raw material costs and salary of labour
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workers. Manufacturing cost is divided into three broad categories by most companies.
(a) Direct materials cost
ty
Direct materials cost the cost of direct materials which can be easily identified with
the unit of production. The components must be readily recognisable with the resulting
product (otherwise they are assumed to be joint costs). The direct material cost is one
of the few variable costs involved in the manufacturing process; as such, it is used in
si
the derivation of throughput from production processes.
Direct material is Opening stock + Purchases – Closing stock
Example:
r
ve
a. Wood is a basic raw material for the wooden furniture. The cost of the wood
procured for the furniture is known direct material cost.
B. Cotton is a basic raw material for the production of yarn. The cost of procuring
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the cotton is known as direct material for the manufacturing of yarn.
(b) Direct labour cost

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The term direct labour is reserved for those labour costs that can be essentially
traced to individual units of products. Direct labour is sometime called touch labour,
since direct labour workers typically touch the product while it is being made. The
labour cost of assembly line workers, for example, is a direct labour cost, as would the
ity
labour cost of carpenter, bricklayer and machine operator.
Labour costs that cannot be physically traced to the creation of products, or that
can be traced only at a great cost and inconvenience, are termed indirect labour and
treated as part of manufacturing overhead, along with indirect materials.
m
Indirect labour includes the labour costs of supervisors, materials handlers, and the
night security guards. Although the efforts of these workers are essential to production,
it would be either impractical or impossible to accurately trace their costs to specific
)A
units of product. Hence, such labour costs are treated as indirect labour.
In some industries, major shifts are taking place in the labour cost structure.
Sophisticated automated equipment, run and maintained by skilled workers, is
increasingly replacing the direct labour. In few enterprises, direct labour has become
(c
such a minor element of cost that it has disappeared altogether as a separate

cost category. However the vast majority of manufacturing and service enterprises
throughout the world continue to recognize direct labour as a separate cost category.
Direct Materials cost combined with direct labour cost is called prime cost. In
Notes
e
equation form:
Prime Cost = Direct Materials Cost + Direct Labour Cost.
in
For example total direct materials cost incurred by the Enterprise is ` 4,500 and
direct labour cost is ` 3,000 then prime cost is ` 7,500 (` 4,500 + ` 3,000).
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Manufacturing overhead
It includes all costs of manufacturing except direct material and direct labour.
Examples of manufacturing overhead include items such as indirect material, indirect
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labour, maintenance and repairs on production equipment and heat and light, property
taxes, depreciation, and insurance on manufacturing facilities.
Indirect materials are minor items such as solder and glue in manufacturing
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industries. These are not included in direct materials costs. Indirect labour is a labour
cost that cannot be trace to the creation of products or that can be traced only at great
cost and inconvenience.
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Costs incurred for heat and light, property taxes, insurance, depreciation and
so forth associated with selling and administrative functions are not included in
manufacturing overhead. Manufacturing overhead is known by various names, such as
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indirect manufacturing cost, factory overhead, and factory burden. All of these terms are
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synonymous with manufacturing overhead.
Manufacturing overhead cost combined with direct labour is called conversion cost.
In equation form:
Conversion Cost = Direct Labour Cost + Manufacturing Overhead Cost

ni
For example if total direct labour cost is `3,000 and total manufacturing overhead
cost is `2,000 then conversion cost is `5,000 (`3,000 + `2,000).
U
Non-manufacturing Costs
Non-manufacturing costs are those costs that are not incurred to manufacture a
product. Examples of such costs are salary of sales person and advertising expenses.
ity
Generally non-manufacturing costs are further classified into two categories.
(a) Marketing or Selling Costs: Includes the marketing or selling costs necessary
to secure customer orders and get the finished product into the hands of the
customers. These costs are often called order getting or order filling costs.
m
Examples include the advertising costs, shipping costs, sales commission and
sales salary.
(b) Administrative Costs: Includes all executive, organizational, and clerical
)A
costs associated with general management of an organization rather than

with manufacturing, marketing, or selling. Examples of include the executive
compensation, general accounting, secretarial, public relations, and similar costs
involved in the overall, general administration of the organization as a whole.
(c
Product Costs Vs Period Costs

Product costs include all the costs that are involved in acquiring or making product.
In the case of manufactured goods, these costs consist of direct materials, direct labour,
Notes
e
and manufacturing overhead. Period costs are all the costs that are not included in
product costs. Therefore, Non-manufacturing costs are period costs.
in
Cost Classifications for Predicting Cost Behavior (Variable and Fixed cost):
It is necessary to predict how a certain cost will behave in response to a change in
nl
activity. Cost behavior refers to how a cost will react or respond to changes in the level
of business activity. As the level of activity rises and falls, a particular cost may rise and
fall as well—or it may remain constant. For planning purposes, a manager must be able
to anticipate which of these will happen; and if a cost can be expected to change, the
O
manager must know by how much it will change. To help make such distinctions, costs
are often characterized as variable or fixed.
1. A variable cost is a cost that varies, in total, in direct proportion to changes in
ty
the level of activity. The activity can be expressed in many ways, Such as units
produced, units sold, miles driven, beds occupied, hours worked and so forth.
Direct material is a good example of variable cost.
si
2. A fixed cost is a cost that remains constant, regardless of the changes in the
level of activity. Consequently, as the activity level rises and falls, the fixed costs
remain constant in total amount unless influenced by some outside forces, such
r
as price changes. Fixed cost can create confusion if they are expressed on per
ve
unit basis. This is because average fixed cost per unit increases and decreases
inversely with changes in activity. Examples of fixed cost include straight line
depreciation, insurance property taxes, rent, supervisory salary etc.
3. Mixed cost is also known as the semi-variable costs. A mixed cost consists of
ni
both variable and fixed cost elements. The relationship between mixed cost and
level of activity can be expressed by the equation y = a + bX.
Cost classification for Assigning Costs to Cost Objects (Direct and Indirect
U
Cost):
1. A direct cost is a cost that can be quickly and efficiently tracked to the source
of the particular cost in question. The object of cost is any item that needs
ity
cost data like goods, consumer employment and organizational sub-units. For
example, if an Enterprise is assigning costs to its various regional and national
sales offices, then the salary of the sales manager in Chennai office will be a
direct cost of that office.
m
2. An indirect cost is a cost that cannot be easily and conveniently traced to the
particular cost object under consideration. For example, a soup factory may
produce dozens of varieties of canned soups. The wage of the factory manager
)A
will be an indirect expense of a given reality such as chicken noodle soup. The
explanation is that no particular type of soup determines the income of the
factory manager. To be traced to a cost object such as a specific product, the
cost object has to be responsible for the cost. This manger pay is called rising
cost of manufacturing the factory’s different goods.
(c
A common cost is a cost that is incurred to support a number of costing objects but
cannot be traced to them individually. A common cost is a particular type of indirect cost.

Decision making costs—cost classification for decision making:

Notes
e
Costs can be classified for decision making purposes. Costs are important feature
of many business decisions. For decision making purposes cost is usually classified as
in
differential cost, opportunity cost, and sunk cost. It is essential to have a firm grasp of
these cost concepts.
1. Differential Cost. Decisions involve choosing between alternatives. In business,
nl
each alternative will have certain costs and benefits that must be compared to
the costs and benefits of the other available alternatives. A difference in cost
between any two alternatives is known as differential cost.
O
A difference in revenue between any two alternatives is known as differential
revenues. Differential cost includes both cost increase (incremental cost) and
cost decrease (decremental cost). In general the difference (cost and revenue)
between alternatives are relevant in decision making. Those items that are the
ty
same under all alternatives can be ignored.
2. Quality Costs: Quality cost can be defined as a cost incurred to avoid defaults
before the products are shipped to the customers or to satisfy the customers
si
by removing the faults if defaulted products have been shipped to customers to
secure the good will of the Enterprise. Quality costs can be broken down into
four broad groups namely the prevention costs and appraisal costs. These are
r
incurred in an effort to keep defective products from falling into the hands of
ve
customers. The other two groups of costs are known as internal failure costs
and external failure costs. These are incurred because defects are produced
despite efforts to prevent them. These are also known as costs of poor quality.
3. Opportunity cost - It is the potential benefit that is provided when one alternative
ni
is selected over another. For Example: Lily has a part-time job that pays her Rs
400 per week while attending college. She would like to spend a week at the
beach during spring break, and her employer has agreed to give her the time
U
off, but without pay. Thus, Rs 400 in lost wages would be an opportunity cost
of taking week off to be at the beach.
4. Sunk cost – It is the cost which has already been incurred and that cannot
be changed by any decision made now or in future. Example: An enterprise
ity
paid Rs 60,000 several years ago for a special purpose machine. The machine
was used to make a product that is now obsolete and is no longer being sold.
Even though in hindsight the purchase of the machine may have been unwise,
no amount of regret can undo that decision. And it would be folly to continue
m
making the obsolete product to recover the original cost of the machine. In
short, the Rs 60,000 originally paid for the machine has already been incurred
and cannot be differential cost in any future decision. For this reason, such
)A
costs are said to be sunk costs and should be ignored in decision making.
3. Cost Sheet - Part 1 - Explaining the Sheet

Cost sheet is a statement of cost. In other words, when costing information is set
out in the form of a statement, it is called cost sheet. It is usually adopted when there is
(c
only one product is produced and all costs are incurred for that product only. Cost sheet
may be prepared for a week, monthly, quarterly or yearly indicating various components

of cost as prime cost, works cost, cost of production, cost of goods sold, total cost and
Notes
e
also profitability on a production. The preparation of cost sheet depends on the cost
data provided by cost accounting.
in
Due to differences in the nature of cost data there are three different cost sheets, a
Performa may be used.
1. Cost sheet with break up cost: These types of cost sheet contains two columns
nl
as total cost, cost per unit of output.
2. Cost Sheet with treatment of Stock: This type of cost sheet is maintained in
case of manufacturing concern.
O
Generally there are three types of stock as
(a) Stock of Raw material,
ty
(b) Stock of work in progress and
(c) Stock of finished goods. The treatment of stock in cost sheet has been given in
a separate Performa.
si
3. Estimated cost sheet or price quotation: Quotation means quoting the minimum
Price for obtaining a specific order. The quotation is sent in the form or estimated
cost sheet having one column. In estimated cost sheet all elements of cost and
r
overhead expenses are calculated in the following manner.
ve
Estimated direct material
Estimated labour cost
Estimated overheads.
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4. Cost Sheet - Part II - Showing a Numerical Example

Particulars Amount Amount
U
Opening Stock of Raw Material

Add: Purchase of Raw materials
Add: Purchase Expenses
ity
Less: Closing stock of Raw Materials

Raw Materials Consumed
Direct Wages (Labour)
Direct Charges
m
Prime cost (1)

Add: Factory Over Heads:
Factory Rent
Factory Power
)A
Indirect Material
Indirect Wages
Suervisor Salary
Drawing Office Salary
(c
Factory Insurance
Factory Asset Depreciation

Works Cost Incurred

Notes
e
Add: Opening Stock of WIP
Less: Glosing Stock of WIP
in
Works Cost (2)
Add: Administration Over Heqads:
Office Rent
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Asset Depreciation
General Charges
Audit Fees
O
Bank Chanrges
Counting house Salary
Other Office Expenses
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Cost of Production (3)
Add: Opening stock of Finished Goods
Less: Closing stock of Finished Goods
si
Cost of Goods Sold
Add: Selling and Distribution OH:
Salesman commission
Salesman salary r
ve
Traveling Expenses
Advertisement
Delivery man expenses
Sales Tax
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Cost of Sales (5)

Profit (Balancing Figure)
Sales
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Example -
The following data has been from the records of Centre corporation for the period
from January 1 to January 30, 2010.
ity
2005 1st Jan 2005 31st Jan

Cost of raw materials 60,000 50,000
Cost of work in progress 24,000 30,000
m
Cost of finished good 1,12,000 1,10,000

Transaction during the month
)A
Purchase of raw materials 9,00,000

Wages paid 4,60,000
Factory overheads 1,84,000
Administration overheads 60,000
(c
selling overheads 40,000

Sales 18,00,000

Solution:
Notes
e
Particulars (`) (`)
Opening stock of raw materials 1st Jan 60,000
in
(+) Purchase of raw materials 9,00,000
(-) Closing stock of raw materials 31st Jan 50,000
nl
Raw materials consumed during the year 9,10,000
(+) Wages paid 4,60,000
Prime cost 13,70,000
O
(+) Opening stock of semi goods 24,000
(-) Closing stock of semi goods 30,000
ty
Factory or Works cost 15,48,000
si
(+) Administration overheads 60,000
Cost of Production 16,08,000
(+) Opening stock of finished goods 1,20,000
(+) Closing stock of finished goods r 1,10,000
ve
Cost of goods sold 16,18,000
(+) selling overheads 40,000
Cost of sales 16,58,000
ni
Net Profit 1,42,000

Sales 18,00,000
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5. Marginal Costing - Meaning and Purpose

Marginal cost is the cost nothing but a change occurred in the total cost due to
changes taken place on the level of production i.e., either an increase or decrease by
ity
one unit of product.
According to ICMA, London, “Marginal cost is the amount at any given volume of
output, by which aggregate costs are charged, if the volume of output is increased or
decreased by one unit.”
m
●● The marginal cost of production includes all costs which vary with the
production level. For instance, if a firm wants to build a brand new factory to
manufacture more products, the cost of constructing the factory is a marginal
)A
cost. The sum of the marginal cost will vary depending on the volume of the
good being made.
●● The purpose of the marginal cost analysis is to evaluate the point at which
an enterprise can achieve economies of scale in order to maximize output
(c
and overall operations. When the marginal cost of generating one additional
unit is smaller than the price per product, the manufacturer has the ability to
make a profit.

6. CVP Analysis - Contribution, P/V ratio, etc

Notes
e
Cost volume profit analysis (CVP analysis) is one of the most powerful tools that
managers have at their command. It helps them understand the interrelationship
in
between cost, volume, and profit in an organization by focusing on interactions among
the following five elements:
1. Prices of products
nl
2. Volume or level of activity
3. Per unit variable cost
O
4. Total fixed cost
5. Mix of product sold
Because cost-volume-profit (CVP) analysis helps managers understand the
ty
interrelationships among cost, volume, and profit it is a vital tool in many business
decisions. These decisions include, for example, what products to manufacture or
sell, what pricing policy to follow, what marketing strategy to employ, and what type of
si
productive facilities to acquire.
Contribution Margin and Basics of CVP Analysis: Contribution margin is the amount
remaining from sales revenue after variable expenses have been deducted. Thus
r
it is the amount available to cover fixed expenses and then to provide profits for the
ve
period. Contribution margin is first used to cover the fixed expenses and then whatever
remains go towards profits. If the contribution margin is not sufficient to cover the fixed
expenses, then a loss occurs for the period. This concept is explained in the following
equations:
ni
[ Sales revenue “ Variable cost* = Contribution Margin ]
*Both Manufacturing and Non Manufacturing

U
[ Contribution margin “ Fixed cost* = Net operating Income or Loss ]
Profit-Volume (P/V) Ratio

The ratio or percentage of contribution margin to sales is known as P/V ratio. This
ity
ratio is known as marginal income ratio, contribution to sales ratio or variable profit
ratio. P/V ratio, usually expressed as a percentage, is the rate at which profits increase
with the increase in volume. The formulae for P/V ratio are:
P/V ratio = Marginal contribution/Sales Or

m
Sales value – Variable cost/Sales value Or
1 – Variable cost/Sales value Or

)A
Fixed cost + Profit/Sales value Or
Change in Profits/Contributions/Changes
A comparison for P/V ratios of different products can be made to find out which
(c
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.

Notes
e
2. Reducing direct and variable costs by effectively utilising men, machines and
materials.
in
3. Switching the product to more profitable terms by showing a higher P/V ratio
Illustration-2
nl
Sales ` 8,00,000
Variable Cost ` 3,00,000
O
Fixed Cost ` 2,00,000
Caculate P/V Ratio?
Solution:
ty
Sales – Variable cost
Method-1 P/V Ratio = x 100
Sales
si
8,00,000–3,00,000 5,00,000 x 100
= x 100 = = 62.5%
8,00,000 8,00,000
Fixed cost + Profit

Method-2 P/V Ratio =
Sales r
x 100
ve
Profit = Sales – Variable cost – Fixed cost)
= 8,00,000 – 3,00,000 – 2,00,000
= 8,00,000 – 5,00,000 = 3,00,000
ni
2,00,000+3,00,000
P/V Ratio = x 100
8,00,000
U
5,00,000 x 100
= = 62.5%
8,00,000
ity
7. CVP Analysis - Break Even Analysis

Break-even analyzes the relationship between the firm’s overall sales, total
expenses, and total income at different production rates. This is used to calculate the
m
amount of revenue required for the business to break even and the overall gains and
losses at all sales point.
BEP = Fixed Costs / Selling Price – Variable cost per unit

)A
Example:
Sales price per unit = `250

Variable cost per unit = `150
(c
Total fixed expenses = `35,000

Calculate the break even point

Solution:
Notes
e
BEP = Fixed Costs / Selling Price – Variable cost per unit
BEP = 35,000 / 250 – 150
in
BEP = 35,000/100
BEP = 350 Units
nl
The break even point in sales Rs can be computed by multiplying the break even
level of unit sales by the selling price per unit. 350 Units × Rs250 Per unit = Rs 87,500
O
Assumptions of Break-even Analysis
The break-even analysis is based on certain assumptions, namely:
1. Over the entire production period, all costs are either perfectly variable or
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absolutely fixed.
2. The volume of production and the volume of sales are equal; but in reality they
do differ.
si
3. All revenue is perfectly variable with the physical volume of production and this
assumption is not valid.
4. The assumption of a stable product mix is unrealistic.
r
ve
Advantages of Break-even Analysis
The main advantages of using break-even analysis in managerial decision making
can be the following:
ni
1. Determines the optimum level of output below which it is not profitable for the
firm to produce.
2. Determines the target capacity for a firm to get the benefi t of minimum unit cost
U
of production.
3. Determines minimum cost for a given level of output.
4. Helps in deciding which products are to be produced and which are to be bought
ity
by the firm.
5. Facilitates plant expansion or contraction decisions.
6. Analysis of price changes and profit costs of the firm
m
7. Facilitates decisions regarding dropping or adding a product to the product line.

8. Evaluates the percentage financial yield from a project and thereby helps in the
choice between various alternative projects.
)A
9. Finds the selling price which would prove most profitable for the firm.
10. The break-even point, helps in establishing the point wherefrom the firm can
start payment of dividend to its shareholders.
From the follwing particulars calculate BEP.
(c
Fixed Expenses `60,000
Variable cost per unit `5

Selling price per unit `8

Notes
e
Solution:
Fixed Cost
in
Part-1 BEP (in unit)=
contribution
Fixed Cost
nl
=
Selling Price per unit – Variable cost per unit
60,000 60,000
= = = 20,000 units
O
8–5 3
Fixed Cost
Part-1 BEP (in sales)=
P/V ratio
ty
Sales – Variable Cost
P/V Ratio = x 100
Sales
si
8–5 3x100
= x 100 = = 37.5%
8 8
60,000 60,000x100
r
ve
Because BEP = = = `1.60.000
37.5% 37.5
Hence, BEP in output is 20,000 units and BEP in volume or sales is `1,60,000.
ni
8. CVP Analysis - Margin of Safety

Margin of safety is the difference between the actual sales and sales at break-even
U
point. Sales beyond break-even volume brings in profits. Such sales represent a margin
of safety.
Margin of safety = Actual sales – Break-even Sales = Profit P/V ratio

ity
Every business must have a safety margin of at least 50% to meet long-term
financial obligations. If the ratio exceeds the criteria, the Enterprise’s interest will be
destroyed by the outsiders at a period when they are unable to make the payment of
interest on period in compliance with the terms of the previous agreement.
m
Example:
Margin of safety can improve by taking any or more of the following steps:
)A
a. Increasing the selling price

b. Increasing the production
c. Changing the product mix
(c
d. Reducing variable cost

e. Reducing Fixed cost.

Fixed cost `1,50,000

Notes
e
Profit `90,000
Sales
in
`5,00,000
Calculate Margin of safety.
Profit
nl
Margin of Safety =
P/V ratio
Profit + Fixed Cost
O
P/v Ratio = x 100
Sales
90,000 + 1,50,000 2,40,000 x 100

= x 100 = = 48%
ty
5,00,000 5,00,000
90,000 90,000 x 100

\ Margin Safety = = = 1,87,5000
48% 48
si
Again/or
Margin of Safety = Sales – Break Even Sales
BEP (in sales) =

r
Fixed Cost
ve
P/V ratio
1,50,000 1,50,000 x 100

= = = ` 3,12,500
48% 48
ni
\ Margin of Safety = 5,00,000 – 3,12,5000 = `1,87,5000

U
9. CVP Analysis - Decision Making, Examples

The break-even analysis uses the cost data to make decisions. The following are
the key methods used for break-even analysis:
ity
1. Break-even Charts
2. Algebraic Method
●● Break even chart

m
The difference between Price and Average Variable Cost (P – AVC) is defined as
profit contribution.
That is, revenue on the selling of an production product is compensated after

)A
variable costs is a contribution to profit. At low sales rates the Enterprise may lose
money because the income contribution has not yet exceeded fixed costs. Therefore,
income allocation is used to cover fixed costs at such low production levels. Once fixed
expenses have been paid the business should make a profit.
(c
The break-even chart indicates the magnitude of the firm’s income or loss at
different operation rates. A break-even chart may be described as an overview of the
output and sales to benefit relationship in graphical form.
A manager may want to know the output rate necessary to cover all fixed costs
Notes
e
and to earn a “required” profit of R. Assume that both price and variable cost per unit of
output (AVC) are constant. Profit is equal to total revenue (P.Q.) less the sum of Total
Variable Costs (Q.TVC) and fixed costs. Thus
in
pR = PQ – [(Q.AVC) + FC]
pR = TR – TC
nl
The break even chart shows the extent of profit or loss to the firm at different
levels of activity. A break even chart may be defined as an analysis in graphic form of
the relationship of production and sales to profit. The Break even analysis utilises a
O
break even chart in which the Total Revenue (TR) and the Total Cost (TC) curves are
represented by straight lines, as shown –
ty
D Profit
Break-even point TR
TC
si
Loss
Variable cost
Cost,
Revenue TFC
Price (`)
r
ve
Fixed cost
O Qi Quantity (Q)
ni
In the figure total revenues and total costs are plotted on the vertical axis whereas
output or sales per time period are plotted on the horizontal axis. The slope of the TR
curve refers to the constant price at which the firm can sell its output. The TC curve
U
indicates Total Fixed Costs (TFC) (The vertical intercept) and a constant average
variable cost (the slope of the TC curve). This is often the case for many firms for small
changes in output or sales.
ity
The firm breaks even (with TR=TC) at Q1 and incurs losses at smaller outputs
while earnings profits at higher levels of output. Both the Total Cost (TC) and Total
Revenue (TR) curves are shown as linear. TR curve is linear as it is assumed that the
price is given, irrespective of the output level. Linearity of TC curve results from the
m
assumption of constant variable costs
Example:
)A
From the following information relating to quick standards Ltd., you are required to
find out (i) PV ratio (ii) break even point (iii) margin of safety (iv) calculate the volume of
sales to earn profit of 6,000/-
Total Fixed Costs ` 4,500

(c
Total Variable Cost ` 7,500
Total Sales ` 15,000

Solution:
Notes
e
First step to find out the contribution volume
Sales ` 15,000
in
Variable Cost ` 7,500
Contribution ` 7,500
nl
Fixed Cost ` 4,500
Profit ` 3,00
O
1. Second step to determine the PV ratio
Contribution 7,500
Pv ratio = x 100 = x 100 = 50%
Sales 15,000
ty
Third step to find out the Break even sales
Fixed cost 4,500

2. Break even sales = = x 9,000
si
PV ratio 50%
3. Margin of safety can be found out in two ways
r
(a) Margin of Safety = Actual sales – Break even sales
= ` 15,000 – ` 9,000 = ` 6,000
ve
Profit ` 3,000
(b) Margin of Safety = = x ` 6,000
PV ratio 50%
ni
4. Sales required to earn profit = ` 6,000/-

To determine the sales volume to earn desired level of profit
Fixed Cost + Desired Profite

U
=
PV ratio
` 4,500 + ` 6,000
= = ` 21,000
ity
50%
●● Algebraic Method
Break-even analysis can also be performed algebraically, as follows.
Total revenue is equal to the selling price (P) per unit times the quantity of output
m
or sales (Q). That is TR = (P) . (Q)
Total costs equal total fi xed costs plus Total Variable Costs (TVC).
)A
Since TVC is equal to the Average (per unit) Variable Cost (AVC) times the quantity
of output or sales, we have
TC = TFC + TVC or,
TC = TFC + (AVC). (Q)

(c
Setting total revenue equal to total costs and substituting QB the break-even output
for Q, then -
TR = TC
Notes
e
(P). (QB) = TFC + (AVC). (QB) Or,
TFC = P. (QB) – (AVC) (QB)
in
TFC = QB. (P – AVC)
10. Inventory Valuation - Introduction, Periodic, Perpetual & FIFO
nl
Inventory is defined as assets that are intended for sale, are in process of being
produced for sale or are to be used in producing goods. Inventory is also referred as
Stock.
O
Inventory Valuation Methods
Periodic Inventory Valuation - Periodic inventory is a method of valuing
ty
accounting stocks that is carried out at defined intervals. At the end of the day,
companies physically count their goods and use the data to balance their general
ledger. The balance is then applied to businesses at the start of the new period.
si
Perpetual Inventory valuation - To display the amount of inventory on hand at
all times, the perpetual inventory system includes accounting records. For any good
in stock, it maintains a separate account in the subsidiary ledger, and the account is
r
changed each time a quantity is added or taken out. A business makes no attempt to
maintain accurate inventory records of items on hand within this system; instead, sales
ve
of goods are reported as a debit to the inventory ledger. Effectively, such components
as direct labour and inventory costs and direct factory operating costs are included in
the cost of goods sold.
ni
The accounting method that a Enterprise decides to use to determine the costs
of inventory can directly impact the balance sheet, income statement and statement
of cash flow. There are three inventory-costing methods that are widely used by both
U
public and private companies:
1. First-In, First-Out (FIFO) - This method assumes that the first unit making its way
into inventory is the first sold. For example, let’s say that a bakery produces 200
loaves of bread on Monday at a cost of `1 each, and 200 more on Tuesday at `1.25
ity
each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is `1
per loaf (recorded on the income statement) because that was the cost of each of
the first loaves in inventory. The `1.25 loaves would be allocated to ending inventory
(appears on the balance sheet)
m
Illustration-1
Prepare the stores ledger under first in first out method. 1st january 2014 Opening
)A
balalnce 200 units at `25 per unit.
Receipts:
4th Jan 2014 200 Units at `24 per units

(c

22nd Jan 2014 100 Units at `23.50 per units

Notes
e
Issues:
5th Jan 2014 250 Units
in
nl
Solution:
Stores Ledger Accounts Under FIFo Method
O
Receipts Balance
Amount (`)
Amount (`)
Particulars
Issue Rate
Amount
Rate (`)
ty
Rate (`)
Units
Units
Units
Date
si
1/1/14 To Bal b/d 200 25 5,000
4/1/14 To GRN No. 200 24 4,800 200 25 5,000
200 24 4,800
5/1/14 By MRN No. r 200 25 8,000
ve
(250 Units)
50 24 1,200 150 24 3,600
10/1/14 To GRN No. 150 23 3,450 150 24 3,600
150 23 3,450
ni
12/1/14 By MRN No. 150 24 3,600

(200 units)
50 23 1,150 100 23 2,300
U
18/1/14 To GRN No. 100 23 2,000 100 23 2,300

100 20 2,000
22/1/14 To GRN NO. 100 23.50 2,350 100 23 2,300
ity
100 20 2,000
100 23.50 2,350
25/1/14 By MRN No. 100 23 2,300 - - -
(250 Units)
m
100 20 2,000 - - -
50 23.50 1.175 50 23.50 1.175
31/1/14 To Bal C/d 20 23.50 1.175
)A
Therefore, Value of closing stock on 31st Dec. 2014 - 50 units @ `23.50 = `1.175
2. Last-In, First-Out (LIFO) - This method assumes that the last unit making its way
into inventory is sold first. The older inventory, therefore, is left over at the end of the
accounting period. For the 200 items sold on Wednesday, the same bakery would
(c
assign `1.25 per loaf to COGS while the remaining `1 loaves would be used to
calculate the value of inventory at the end of the period.

Poplive Co., uses a raw material called ‘pop’ for its production purposes. The
Notes
e
details are as below:
2016 July
in
1 Opening balalnce 300 liters at `25 per litre
3 Purchased 500 liters @ `26.60 per litre
nl
4 Issued 220 liters
10 Issue 400 liters
20 Purchased 490 liters @ ` 23 per litre
O
25 Issued 300 liters
26 Surplus 20 liters returned to stores out of issues on 4th July
ty
Solution:
Receipts Issues Balance
si
Amount (`)
Amount (`)
Particulars
Issue Rate
Amount
Rate (`)
Rate (`)
Date
Qty.
Qty.
Qty.
r
ve
July Opening bal. 300 25 7,500
3 Purchased 500 26.6 13,300 300 25 7,500
300 26.6 13,300
4 Issue (220 units) 220 26.6 5,852 300 25 7,500
ni
280 25.6 7,448

10 Issue (400 units) 280 26.6 7,448
U
120 25 3,000 180 25 4,500

20 Purchase 490 23 11,270 180 25 4,500
490 23 11,270
25 Issue (300 units) 300 23 6,900 180 25 4,500
ity
190 23 4,370
26 Surplus 20 26.6 532 180 25 4,500
(Material returned) 190 23 4,370
(closing stock 20 26.6 532
m
remaining same)
Example:
)A
Krishna and Sons have purchased the material as under:
Jan. 3, 2006 500 Kg. of crude oil @ `2 per kg.

Jan. 18, 2006 350 Kg. of crude oil @ `3 per kg.
(c
Jan. 25, 2006 600 Kg. of crude oil @ `2.5 per kg.
Feb. 4, 2006 500 Kg. of crude oil @ `2.75 per kg.

Issue there from are as under:

Notes
e
Jan. 19, 2006 600 Kg. of crude oil
Jan. 27, 2006 450 Kg. of crude oil
in
Feb. 5, 2006 500 Kg. of crude oil
Feb. 7, 2006 150 Kg. of crude oil
nl
Prepare the Stores Ledger Account using the following methods of Pricing
materials issue
O
a. First-in First-out emthod, and
b. Last-in-First-out method.
Solution
ty
a. FIFO Method
Stores Ledger Account
si
Date & year
Date & year

Amount (`)
Amount (`)
Particulars
Particulars
Qty. Kg.
Qty. Kg.
Rate (`)
Rate (`)
r
ve
2006 2006
Jan.3 To Purchase 500 2.00 1000 Jan.19 By Issue 500 2.00 1000
Jan.18 To Purchase 350 2.00 1050 By Issue 100 3.00 300
600
ni
By Issue 200 2.50 50
450
U
Feb.4 To Purchase 500 2.75 1375 Feb.5 By Issue 400 2.50 1000
By Issue 100 2.75 275
500
ity
Feb.7 By Issue 150 2.75 412.50

To Balance b/d 250 2.75 687.50
1950 4925 1950 4925
m
b. LIFO Method
Stores Ledger Account
)A
Amount (`)
Amount (`)
Particulars
Particulars
Qty. Kg.
Qty. Kg.
Rate (`)
Rate (`)
Date &
Date &
year
year
2006 2006
(c
By Issue 250 2.00 500

600
Notes
e
Jan.25 To Purchase 600 2.50 1500 Feb.5 By Issue 500 2.75 1375
in
Feb.4 To Purchase 500 2.75 1375 Feb.7 By Issue 150 2.50 375
To Balance b/d 250 2.00 500
nl
1950 4925 1950 4925
3. Average Cost - This method is quite straightforward; it takes the weighted average
of all units available for sale during the accounting period and then uses that average
O
cost to determine the value of COGS and ending inventory. In the bakery example,
the average cost for inventory would be Rs1.125 per unit, calculated as [(200 x Rs1)
+ (200 x Rs1.25)]/400.
ty
4. Specific Identification Method - A less commonly used, but important method to
valuation is called specific identification. This method is used for high-end items that
are more easily tracked. In some cases, this method can be used for more common
items, but less value is realized from this accounting method is such cases. This
si
is because powerful and detailed tracking software is required to employ specific
identification on large numbers of goods. The cost of such software often outweighs
the financial benefits that might be gained.
r
ve
11. Standard Costing & Variance Analysis – Introduction
Standard Cost
Standard costs are predetermined cost which may be used as a yardstick
ni
to measure the efficiency with which actual costs has been incurred under given
circumstance. To illustrate, the amount of raw material required to produce a unit of
product can be determined and the cost of that raw material estimated. This becomes
U
the standard material input.
Standard Costing
Standard costing is a cost accounting methodology that compares, as predicted,
ity
the results of actual production with the specific cost model to evaluate the reasons for
discrepancies between the estimated and actual costs.
Salient Features of Standard Costing

m
The salient features of standard costing are as follows:
●● Ascertainment of the standard costs under each element of cost, i.e., material,
labour and expenses,
)A
●● Comparison of actual cost with standard cost and finding out the variance of
actual from standard,
●● Recording of the standard cost for various elements of total cost,
●● Simultaneously recording the actual cost,
(c
●● Locating the factors responsible for such variances, and

●● Reporting to management for taking proper action to maximise the efficiency.

Objectives of Standard Costing

Notes
e
1. Cost Control: The most important objective of standard cost is to help the
management in cost control. It can be used as a yardstick against which actual costs
in
can be compared to measure efficiency. The management can make comparison of
actual costs with the standard costs at periodic intervals and take corrective action
to maintain control over costs.
nl
2. Management by Exception: The second objective of standard cost is to help the
management in exercising control over the costs through the principle of exception.
Standard cost helps to prescribe standards and the attention of the management is
O
drawn only when the actual performance is deviated from the prescribed standards.
It concentrates its attention on variations only.
3. Develops Cost Conscious Attitude: Another objective of standard cost is to make
the entire organisation cost conscious. It makes the employees to recognise the
ty
importance of efficient operations so that costs can be reduced by joint efforts.
4. Price Fixation: To help the management in formulating production policy and helps
in fixing the price quotations as well as in submitting tenders of various products.
si
This can be done with accuracy with standard cost than the actual costs. It also
helps in formulating production policies. Standard costs removes the reflection of
abnormal price fluctuations in production planning.
r
5. Fixing Prices and Formulating Policies: Another object of standard costs is to help
ve
the management in determining prices and formulating production policies. It also
helps the management in the areas of profit planning, product-pricing and inventory
pricing etc.
6. Management Planning: In order to optimize benefit through various product
ni
combinations, management undertakes budget preparation at different rates at

periodic intervals. It is more efficient to use standard costing for this purpose than
real costs, since it is performed in a logical and reasonable way, taking into account
U
all technical aspects.
Variance
ity
When a distinction is made between the real and the normative, there is usually
some difference. The disparity between norm and real is called variance. Whether
the actual cost is greater than the standard cost or the actual result is better than the
standard result, it is known as a desirable variance. At the other hand, if the actual
costs surpass standard costs or if the actual results are not standard, it is known as
m
unfavourable or adverse variance.
Principles of Analysis of Variance

)A
A number of principles must be borne in mind at the time of calculation of standard

cost variances. These are as follows:
(a) Variances should be stated in monetary terms, i.e., it should be expressed in

currency form.
(c
(b) Variances should be analysed product-wise, i.e., it must be calculated for each
product,

(c) Variances can be favourable or unfavourable (adverse), and

Notes
e
(d) Total cost variance represents the difference between the standard cost of
actual output and the actual cost incurred.
in
12. Variance Analysis - Material
The classification and computation of variances are the objectives of standard
nl
costing. Variances can be found out with respect to all the elements of cost, i.e., direct
material, direct labour and overheads.
In case of materials, the following may be the variances: (i) Material Cost Variance,
O
(ii) Material Price Variance, (iii) Material Usage or Quantity Variance
1. Material Cost Variance
ty
Material cost variance represents the difference between the actual material value
and standard material value for a given output. The formula for the measurement of
material cost variance (MCV) will be:
si
MCV = (SP x SQ) - ( AP x AQ)
Where: SP-Standard price, SQ-Standard quantity, AP-Actual price, AQ-Actual
quantity.
r
ve
2. Material Price And Usage Variances
Direct material Variance
Material
ni
Cost Variance (MCV)

U
Material Material
Price Variance (MPV) Usage Variance (MPV)
ity
Material price variance captures that part of cost variance which is due to
the difference in price per unit of materials. The variation in the material price is the
disparity between the standard price and actual purchase price for each unit of material
multiplied by total amount of purchased material. It is better to base the price variance
m
on the total amount of material purchased and not on the actual quantity used so that
price variances can be identified as soon as possible for control purposes
The formula for the measurement of material price variance (MPV) will be:
)A
MPV = (SP - AP) x AQ.
Material usage variance is that part of cost variance which is due to the difference
in the utilization of material quantity. It indicates the deviation from the standard
caused by the difference in quantity used. Due to the difference between the standard
(c
quantity of materials specified for the expected production and the expected quantity of
materials used, it is the portion of the material cost variance.

The formula for the measurement of material usage variance (MUV) will be:
Notes
e
MUV = (SQ - AQ) x SP.
Where: SP-Standard price, SQ-Standard quantity, AP-Actual price, AQ-Actual
in
quantity.
3. Material Mix variance
nl
This is the portion of the material usage variance that is due to the difference
between normal and real mixture composition. In other words, this difference occurs
when the ratio of the products from the standard ratio range is modified. It is measured
O
as the difference between standard mix price and actual mix price.
Material Mix Variance = Standard rate (Standard quantity – Actual quantity)
ty
13. Variance Analysis - Labour
The labour variances can be computed and analysed in the same way as material
variances have been carried out.
si
1. Labour Variance
Labour cost variance represents the difference between the actual labour cost paid
r
and standard labour cost for a given output.The formula for the measurement of labour
ve
cost variance (LCV) will be:
LCV = (SR x SH) - ( AR x AH)
Where: SR-Standard rate, SH-Standard hours, AR-Actual rate, AH-Actual hours.

ni
If the actual labour cost is lower than the standard labour cost, then the variance is
favourable. Whereas, if the actual labour cost is higher than the standard labour cost,
the variance will be adverse.
U
2. Labour Rate And Efficiency Variances
Direct laour Variance

ity
Labour
Cost Variance (LCV)
m
Labour Labour
Rate Variance (LRV) Efficiency Variance (LEV)
)A
Labour rate variance captures that part of cost variance which is due to the
difference in wage rate of labour. This is the difference between the standard and the
direct actual for the total hours worked, labour cost per hour. “This variance is similar to
variance in material price and the formula for the measurement of labour rate variance
(c
(LRV) will be:
LRV = (SR - AR) x AH.

Labour efficiency variance measures that part of cost variance which is due to
Notes
e
the difference in the efficient performance of labour. The variance in labour-efficiency
is the difference between the actual hours taken to produce the actual output and the
standard hours this output would have taken, multiplied by the standard hourly rate.The
in
formula for the measurement of labour efficiency variance (LEV) will be:
LEV = (SH - AH) x SR.
nl
Where: SR-Standard rate, SH-Standard hours, AR-Actual rate, AH-Actual hours.
Labour Variance
O
3. Labour Mix variance
This variance is similar to the variance of the material mix, and it develops
Whenever the degree of labour employed deviates from the normal mix of labour.
ty
That means this variation occurs when the actual composition of labour-power is not in
accordance with the regular mix. It is calculated as below:
Labour Mix Variance = Standard rate × (Revised standard time – Actual time)
si
Or LMV = SR (RST – AT)
Revised Standard time = Total actual time / Total standard time × Standard time
Example: r
ve
A reputed firm gives the detail of grade A & B worker the standard direct labour cost
of which is `100 per unit. The details are given below:
Grade of workers Hours Rate (`) Amount (`)

ni
A 25 2.5 62.50
B 20 2 40.00
45 102.50
U
During a period 80 unit of the product were produced, the actual labour cost of
which are as follows.
ity
Grade of workers Hours Rate (`) Amount (`)

A 3,000 2 6,000
B 1,600 3 4,800
m
4,600 10,800
Calculate Labour Mix Variance.

)A
Solution:
Labour Mix Variance = Standard Rae x (Revised Standard Hours – Actual
Hours)
Standard hours of the grade
Revised Standard Hours = x Total Actual Hours
(c
Total Standard hours
Standard hours of the Grade A = 25 x 80 = 2,000

B = 20 x 80 = 1,600
Notes
e
Total = 3,600
2000
Revised Standard hours: Grade A = x 4600 = 2,556 hrs.
in
3600
1600
Grade B = x 4600 = 2,044 hrs.
3600
Labour Mix Variance
nl
Grade A = 2.5 (2,556–3,000) = 1110 (Adverse)
B = 2,(2,044–1600) = 888 (Favourable)
O
Total Labour Mix Variance = `222 (Adverse)
14. Budget & Budgeting - Introduction & types of Budgets
ty
Budget
A budget is a plan and blueprint for planned action by management. It expresses
itself in monetary terms. It is a financial or quantitative analysis of the strategy to be
si
followed during that period for the purpose of attaining a given objective, prepared prior
to a fixed period of time.
Objectives of Budget
r
ve
The main objectives of budget are:
(i) It directs the attention of all concerned to the attainment of a common objective
or goal.
ni
(ii) It contributes to coordinated efforts of all departments in order to achieve an

integrated goal.
(iii) It aims at careful control over the performance and cost of every function.
U
(iv) Budgets grow from bottom and are controlled from top-level, and
(v) Budgets are to be compared with actual performance.
ity
Budgeting
Budgeting represents the process of budget planning. In other words, budgeting
applies to the budget-formulating management practice. Budget preparation includes
analyzing business conditions and understanding management priorities, as well as
organizational capacity.
m
Objectives of Budgeting
The main objectives of budgeting are:
)A
●● To obtain more economical use of capital.

●● To bring about coordination between the different organization functions.
●● To plan and control organization’s earnings and expenditure.
(c
●● To create a good business practice by planning for future.

●● To ensure the matching of sales with production.

●● To fix departmental responsibilities on different department managers.

Notes
e
●● To prevent wastages or losses and reduce the expenditures,
●● To ensure the availability of working capital in the organisation.
in
Budgeting Process
The Planning/ Budgeting process involves four stages. They are:
nl
1. Objective Determination Stage. The first stage is setting the ‘Objectives’
which are defined as the ‘broad and long- range desired state or position in
the future’. They are motivational or directional in nature and are expressed in
O
Qualitative terms.
2. Goal Determination Stage. The second stage is specifying the goals. The
term goal represents targets, specific in quantitative terms to be achieved in a
ty
specific
3. Strategy Formulation Stage. The next step involves laying down the
strategies. Strategies denote specific methods or courses of action to achieve
si
the goals, for instance, promotion of sales through price reduction or aggressive
advertisement and so on.
4. Budget Preparation Stage. At this stage the budgets are prepared.
15. Types of Budgets Part-1

r
ve
Budgets may be classified into a number of categories. Classification of budgets
is based on some features, connected with the operational activities of a business.
Various budgets may be classified on following basis:
ni
(a) On the Basis of Time,

(b) On the Basis of Functions
U
●● On the basis of time

On the basis of time, budgets may be classified into three categories:
(a) Long-term Budgets: When the budgets are prepared for a period of 5 to 10
ity
years, they are called long-term budgets. These budgets help in business
forecasting and future planning.
(b) Short-term Budgets: These are budgets for a short period of a year or two.
These are prepared in the form of production plan in monetary term.
m
(c) Current Budgets: A current budget can be defined as a budget which is related
to the current conditions and is prepared for use over a short period of time.
This budget is more useful than a basis budget, as a target it lays down will be
)A
corrected to current conditions.

The budget can be understood as a quantitative plan that acts as an estimate of
future operation. Fixed Budget is a budget that remains constant, irrespective of the
levels of activity, i.e. the budget is created for a standard volume of production. Flexible
(c
Budget is the budget created for different production levels or capacity utilization, i.e. it
changes in accordance with the activity level.

Basis Fixed Budget Flexible Budget

Notes
e
Meaning The budget designed to remain constant, The budget designed to change
regardless of the activity level reached is with the change in the activity
in
Fixed Budget. levels is Flexible Budget.
Activity Level Only one Multiple
nl
P e r f o r m a n c e Comparison between actual and budgeted It provides a good base for
Evaluation levels cannot be done accurately, if there making a comparison between
is a distinction in their activity levels. the actual and budgeted levels.
O
Nature Static Dynamic
Estimates Based on assumption Realistic and Practical
Rigidity Fixed Budget cannot be modified as per Flexible budget can be easily
the actual volume. modified in accordance with the
ty
activity level attained.
si
16. Types of Budgets Part-2
On the Basis of Functions

r
On the basis of functions, budgets may be classified into following categories:
ve
(a) Functional Budgets, and
(b) Master Budget.
ni
1. Functional Budgets: Functional budgets are:

●● Sales Budget
The sales budget is a forecast of the total sales which may be expressed in
U
monetary and quantitative terms. In practice, quantitative budget is prepared first, and
is then translated into monetary terms. The preparation of sales budget is generally
the starting point in the operation of budgetary control because sales become, more
often than not, the principal budget factor. However, sales budget is very difficult to
ity
prepare as many of the factors affecting this budget are beyond the scope of control by
business. A sales budget may be prepared under the following classifications:
●● Products or Groups of products,

m
●● Areas or Towns,
●● Salesmen or Agents,
●● Types of customers, and
)A
●● Periods, such as month, quarter, year, etc
●● Selling and Distribution Cost Budget

The selling and distribution cost budget is a forecast of the cost of selling and
distributing the goods during the budget period. This budget is generally based upon
(c
the sales volume as per sales budget. However, certain other related information should
also be taken into consideration in the preparation of selling and distribution cost budget.

●● Production Budget
Notes
e
Production budget is prepared by the production manager, showing the forecast of
output. The objective is to determine the quantity of production for a budgeted period.
in
It is in quantity of units to be produced during the budget period. Production budget is
based on the sales budget. Production budget is divided into two parts, i.e., one part
contains the volume of production and the other part shows the cost of production.
Apart from the sales budget, optimum utilisation of plant, availability of raw materials,
nl
labour, etc., are to be considered. It must avoid overwork in rush reasons. It must
maintain a minimum stock of finished goods.
O
●● Purchase Budget
This budget represents the purchases to be made during the budget period. This
will include direct and indirect materials and services. Where, however, finished goods
are purchased for resale, the purchasing budget should take into consideration the
ty
requirements of finished goods for resale. The purchasing budget may be expressed in
terms of quantity or money. Purchase budget is generally based upon:
(a) Sales and production budgets,
si
(b) Capital expenditure budget,
(c) Research and development cost budget,
(d) Purchase orders already placed, r
ve
●● Administration Cost Budget
Administration cost budget will show the total estimated cost of formulating the
policy, directing the organisation and controlling the operations of an undertaking which
is not related directly to research, development, selling, distribution and production
ni
activity or function. Most of the expenditures relating to administration will be of fixed

nature within defined limits, and, therefore, the preparation of this budget is relatively
easy as compared to other functional budgets
U
●● Capital Expenditure Budget

A business with a manufacturing operation, spending on fixed assets such as
plants and equipment is needed. It is influenced by the materialization of its goal of
ity
earning revenue through the selling of products generated according to the budget of
production. Such fixed-asset investment is known as capital investment. The budget
that discloses the estimate of such expenditures of a business organisation of unit for
future period is called the capital expenditure budget. The capital expenditure budget
will be prepared taking the following further points into consideration:
m
(a) Proposal for purchase of new plants to add to the existing capacity,
(b) Proposal for replacement of the existing plants as required,
)A
(c) Requirement of installing an improved machinery for reducing cost of production,

(d) Overloading on the production facilities, as detailed in the plant utilisation
budget, and
(e) Meeting the requests for machinery and other assets, as the case may be, from
(c
the managers of production, service, transport departments and the accountant.

Cash Budget
Notes
e
Cash budget is another important budget. Its object is to indicate the flow of
funds and their requirements. It takes into account the amount received from Sales
in
– cash sales and payments made by credit customers and the expenditure to be
incurred in cash – both capital and revenue. The budget shows up whether and when
arrangements should be made for overdraft, loans, etc.
nl
Master Budget
It is defined as a budget which is prepared from and summarises, the functional
O
budgets. The term summary budget is synonymous. In short, when all the functional
budgets are prepared, they can be summarised to produce:
(a) Budgeted profit and loss account (including appropriations), and
ty
(b) Budgeted balance sheet.
A master budget commonly takes the form of a budgeted profit and loss account
and budgeted balance sheet. Budgeted funds flow may also form part of a master
si
budget. Therefore, a master budget is an overall business plan and is akin to familiar
financial statements, the major technical difference is that here one is dealing with
expected future data rather than with historical data. The budget committee will prepare
r
the master budget on the basis of coordinated functional budgets. When it is approved
by the committee, it becomes the target for the Enterprise during the budget period.
ve
17. Numericals - CVP Analysis
From the following details find out:
ni
Sales ` 1,00,000 Total cost ` 75,000 Fixed cost ` 20,000 Net profit ` 25,000
(i) P/V Ratio,

U
(ii) Break-even Point, and

(iii) Margin of safety.
Answer:
ity
P/V Ratio = Contribution x 100/Sales
= 45,000 x 100/ 1,00,000
= 45%
m
(ii) Break-even Point (in`)

= Fixedcost P/Vratio
)A
= 20,000 x 100/45
= ` 44,444
Margin of Safety = Profit x P/Vratio

(c
= 25,000 x 100/45
= ` 55,556 OR

Margin of Safety = Actual sales – Break-even point sales

Notes
e
= 1,00,000 – 44,444
= ` 55,556
in
19. Numericals - Variance Analysis
nl
The standard material required to manufacture 1 unit of product ‘X’ is 10 kgs and
the standard price per Kg of material is ` 25. The cost accounts records however reveal
that 11,500 kgs materials costing ` 2,75,000 were used for manufacturing 1,000 units of
O
product ‘X’. Calculate Material variances.
Solution:
Standard wages = 1,000 units x 10 kgs = 10,000 kgs
ty
2,76,000
Actual Rate = = ` 24
11,500
1) Material Cost Variance = Standard Cost – Actual Cost
si
= (SQ x SR) – (AQ x AR)
= (10,000 x 25) – (11,500 x 24) = 2,50,000 – 2,76,000
= 26,000 (Adverse)
r
ve
2) Material Price Variance = Actual Quantity x (Std Rate – Actual Rate)
= 11,500 (25 – 24) = 11,500 x 1 = 11,500 (Favourable)
= 11,500 (Favourable)
ni
3) Material usage Variance = Standard Price x (Standard Quantity – Actual Quantity)

= 25(10,000 – 11,500)
U
= 25 x (–1,500)
= 37,500 (Adverse)
Numericals for practice

ity
Example:
A product Z requires 25 units of standard materials at the rate of ` 5 per unit. The
actual consumption of material for the manufacturing of product Z came to 20 units of
m
material at the rate of ` 4 per unit Calculate Material Price Variance.
Solution:
)A
Material Price Variance = Actual Quantity x (Standard Price – Actual Price)
= AQ x (SP – AP)
Material Price Variance for Z
= 20 (5 – 4) = 20 (Favourable).
(c

Example:
Notes
e
Calculate the material mix variance from the following data:
in
Particulars Standard Actual
Material A 50 Kgs @ ` 5 40 Kgs @ ` 6
Material B 30 Kgs @ ` 6 40 Kgs @ ` 5
nl
80 Kgs 80 Kgs
Solution:
O
The material mix variance can be determined by computing the material usage
variances for each of the ingredients at standard rates and adding them up. Thus:
Material A – ` 5 (50 – 40) = ` 50 (Favourable).
ty
Material B – ` 6 (30 – 40) = ` 60 (Adverse)
Material Mix Variance = ` 10 (Adverse)
si
Example:
100 workers are working in a factory at a standard wage rate of ` 4.80 per
r
hour. The standard performance is set at 360 units per hour. The actual production
ve
was 56,000 units. There was a power failure which stopped production for 2 hours.
Calculate idle time variance.
Solution:
ni
Idle time variance = Idle hours x Standard Rate per hour
Idle hours = 100 workers @ 2 hrs = 200 hrs

U
Idle time variance = 200 hrs x 4.80 = ` 960 Adverse
Example:
A reputed firm gives the detail of grade A & B worker the standard direct labour cost
ity
of which is ` 100 per unit. The details are given below:
Grade of workers Hours Rate (`) A mount (`)

A 25 2.5 62.50
m
B 20 2 40.00
45 102.50
During a period 80 unit of the product were produced, the actual labour cost of
)A
which are as follows.
Grade of workers Hours Rate (`) Amount (`) mount (`)

A 3,000 2 6,000
B 1,600 3 4,800
(c
4,600 10,800

Calculate Labour Mix Variance.

Notes
e
Solution:
in
Labour Mix Variance = Standard Rate x (Revised Standard Hours – Actual Hours)
Standard hours of the grade

Revised Standard Hours = x Total Actual Hours
Total Standard hours
nl
Standard hours of the Grade
A = 25 x 80 = 2,000
O
B = 20 x 80 = 1,600
Total = 3,600
2000
Revised Standard hours: Grade A = × 4600 = 2,556 hrs.
ty
3600
1600
Grade B = × 4600 = 2,044 hrs.
si
3600
Labour Mix Variance
Grade A = 2.5 (2,556 – 3,000) = 1110 (Adverse)
B = 2 (2,044 – 1,600) = 888 (Favourable) r

ve
Total Labour Mix Variance = ` 222 (Adverse)
Example:
ni
Sale of product amounts to 200 units per month at ` 10 per unit. Fixed overhead is
` 400 per month and variable cost is ` 6 per unit.
There is proposal to reduce prices by 10%. Calculate present and future P/V ratio.
U
How many units must be sold to earn the present total profit?
Solution:
ity
Sales (200 x 10) 2,000

Less: Variable cost (200 x 6) 1,200
Contribution 800
Less: Fixed cost 400
m
Profit 400
Contribution
Present P/V ratio = x 100
Sales
)A
800
= × 100 = 40%
2,000
Fixed cost 400
B.E.P = = = 1,000
P/V ratio 40%
(c
When price is reduced by 10%

Selling price 9
Notes
e
Less: Variable cost 6
Contribution per unit 3
in
3
P/V ratio = × 100 = 33.33%
9
F.C. + Desired Profit 400 + 400
nl
Required sales = = = ` 2,400
P/V ratio 33.33
Example:
O
An Analysis of cost of X Manufacturing Ltd. from the following information -
Cost element Variable cost %of sales Fixed cost

Direct material 32.8 -
ty
Direct labour 28.4 -
Factory overhead 12.6 1,89,900
Distribution expenditure 4.1 58,400
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General expenditure 1.1 66,700
Budget sales for the next year ` 18,50,000. We are require to determine -
i) Break even sales volume r

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ii) The profit in budget sales volume
iii) The profit and actual sales
a) Drop by 10%
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b) Increase 5% by budget.
Solution:
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Total % of variable cost to sales -
Direct material 32.8%

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Direct labour 28.4%
Factory over head 12.6%
Distribution Exp. 4.1%

m
General Expenditure 1.1%
Total = 79%
)A
Now total fixed cost = 1,89,900 + 58,400 + 66,700 = 3,15,000
Contribution = Sales - Variable cost
= (100 - 79)% = 21%
Fixed Cost
(c
i) Break even sales volume =

P/v ratio

315000 315000 x 100

= – × = 15,00,000 ` Notes
e
21% 21
ii) Profit, when budget of Sales ` 18,50,000
in
Profit = Sales x P/V ratio - Fixed cost
= 18,50,000 x 21% - 3,51,000
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= 18,50,000 x 21100 - 3,15,000
= 18,500 x 21 - 3,15,000
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= 3,88,500 - 3,15,000 = 73,500
iii) a) Profit, when sales drop by 10%

Sales 18,50,000
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Less: 10% 1,85,000
Sales 16,65,000
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Profit = Sales × P/V ratio - Fixed cost
= 16,65,000 × 21% - 3,15,000 = 34,650
b) Profit, when sales Increase by 5% r

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Sales 18,50,000
Add: 5% 92,500
Sales 19,42,500
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Profit = Sales × P/V ratio - Fixed cost
= 19,42,500 × 21% - 3,15,000

U
= 4,07,925 - 3,15,000 = 92,925
Example:
ity
The sales and profit figures of two years are given below:
Year Sales Profit

31/3/2014 1,50,000 20,000
m
31/3/2015 1,70,000 25,000
You are required to calculate (a) P/V ratio (b) Break even point (c) The sales
)A
required to earn profit of ` 40,000 (d) Margin of safety at a profit of ` 50,000 (e) The
profit made when sales are ` 2,50,000.
Solution:
Change in profit
(a) P/V Ratio = × 100
Change in Sales
(c
25,000 – 20,000 5,000

= x 100 = x 100 = 25%
1,70,000 –1,50,000 20,000

Fixed Cost
Notes (b) Break even point =
e
P/v ratio
17,500 17,500 x 100
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= = = 70,000
25% 25
Note: Fixed Cost = Sales x P/V ratio – Profit
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25
= 1,50,000 × – 20,000 = 37,500 – 20,000 = ` 17,500
100
(c) The sales when profit earn of ` 40,000
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Fixed Cost + Desired Profit
Sales =
P/V ratio
17,500 + 40,000 57,500 x 100
= = = ` 2,30,000
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25% 25
(d) Margin of Safety at a profit of ` 50,000
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Profit
Margin of Safety =
P/v ratio

= r50,000
25%
=
50,000 x 100
25
x 2,00,000
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(e) Profit, when sales are ` 2,50,000
Profit = Sales × P/V ratio – Fixed cost
ni
25
= 2,50,000 × – 17,500
100
= 62,500 – 17,500 = ` 45,000.

U
Example:
A retail dealer in a garment is currently selling 24,000 shirts annually. He supplies
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the following details for the year ended 31 December 2014.
Selling price per shirt ` 400

Variable cost per shirt ` 250
m
Fixed Cost:
a) Salaries for the year ` 12,00,000
b) General office costs for the year ` 8,00,000
)A
c) Advertising cost for the year ` 4,00,000

From the above details:
a) Calculate break-even point and margin of safety in sales revenue and number
(c
of shirts sold.
b) Assume that 20,000 shirts were sold in a year and findout the net profit of the
firm.
c) If it is decided to introduce selling commission of ` 30 per shirt, how many shirts

Notes
e
would require to be sold in a year to earn a net income of ` 1,50,000?
d) Assuming that for the year 2015, an additional staff cost of ` 3,30,000 is
in
anticipated and price of a shirt is likely to be increased by 15%, what should be
break-even point in number of shirts and sales volume?
Solution:
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a) Breakeven point and margin of safety in sales revenue and number of shirts sold:
Fixed cost 25,00,000
O
(i) BEP (in units) = = 16,000 Shirts
Contribution/Unit 150
Fixed cost = 1,20,000 + 8,00,000 + 4,00,000 = 24,00,000
ty
Contribution/unit = SP/unit – VC/unit = 400 – 250 = 150
(ii) Breakeven sales (value) = 16,000 shirts x 400 = ` 64,00,000 or
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Fixed cost 24,00,000
BEP (Value) = = = 64,00,000
37.5% 37.5%
Contribution 150
PV ratio = x 100 = x 100 = 37.5%
Sales 400 r
ve
(iii) Margin of safety (in units) = Actual – Breakeven Sales
= 24,000 shirts – 16,000 shirts = 8,000 Shirts
(iv) Margin of safety (value) = 8,000 shirts x 400 = ` 32,00,000
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b) Net profit when 20,000 shirts were sold:
Fixed cost + Desired Profit

Sales =
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P/V Ratio
24,00,000 + Desired Profit
(20,000 shirts x 400) =
37.5%
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80,00,000 x 37.5% = 24,00,000 + Desired profit

30,00,000 = 24,00,000 + Desired profit
Desired profit = 30,00,000 – 24,00,000 = 6,00,000
c) Sales when profit is ` 1,50,000 and increase in variable cost (selling commission)
m
Fixed cost + Profit

Sales =
New P/v ratio
)A
Sales – New Variable Cost

New PV Ratio = × 100
Sales
400 – 280
= × 100 = 30%
400
(c
24,00,000 + 1,50,000 25,50,000

Sales = = = 85,00,000
30% 30%

85,00,000
Notes No. of shirts sold = = 21,250 shirts
e
400
d) Breakeven point in number of shirts and sales volume when fixed cost is increased
in
by ` 3,30,000 and selling price by 15%
New selling price = 400 + 15% = ` 460
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New fixed cost = 24,00,000 + 3,30,000 = ` 27,30,000
New contribution/Unit = New SP – VC = 460 – 250 = 210
New Fixed Cost
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BEP (in units) =
New Contribution/unit
27,30,000
= = 13,000 shirts
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210
Key Takeaways:
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●● Cost: It is the money spent which represents the production of a product or to
provide a service
●● Cost Accounting: It Is the accounting branch which deals with documentation,
r
classification, distribution, and recording of current and potential costs
ve
●● Manufacturing costs: These are those costs that are directly involved in
manufacturing of products and services.
●● Cost sheet: It is a statement of cost.
●● Marginal cost: It is the cost nothing but a change occurred in the total cost due to
ni
changes taken place on the level of production

●● CVP Analysis: It helps them understand the interrelationship between cost,
U
volume, and profit in an organization by focusing on interactions among the

following five elements:
●● Margin of safety: It is the difference between the actual sales and sales at break-
even point.
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●● Standard costs: The predetermined cost which may be used as a yardstick to

measure the efficiency with which actual costs has been incurred under given
circumstance
m
●● Standard costing: It is a cost accounting methodology that compares, as

predicted, the results of actual production with the specific cost model
●● Budget: It is a plan and blueprint for planned action by management. It expresses
)A
itself in monetary terms.

●● Budgeting: It represents the process of budget planning. In other words,
budgeting applies to the budget-formulating management practice
Check your progress

(c
1. Method assuming the first unit making its way into inventory is the first sold
a) FIFO
b) LIFO
Notes
e
c) Budgeting
d) Average Cost
in
2. P/v ratio is described as -
a) Current Assets/Current Liabilities
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b) Sales/ Contribution
c) Marginal contribution/Sales
O
d) Assets/ Contribution
3. ____ is the difference between the actual sales and sales at break-even point
a) Margin of Safety
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b) LIFO
c) CVP analysis
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d) Average Cost
4. Budget which is prepared from and summarises, the functional budgets is known
as -
a) Cash Budget r
ve
b) Master Budget
c) Capital Expenditure Budget
d) Administration cost budget.
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5. Labour Mix Variance is described as -

a) Standard rate × (Revised standard time – Actual time)
U
b) Standard time × (Revised actual time – Standard time)

c) Standard rate (Standard quantity – Actual quantity)
d) Standard time (Standard quantity – Actual quantity)
ity

1. Explain CPV analysis and its techniques.
2. What is break even analysis? What are its objectives
m
3. What is Standard Costing? What are its objectives?

4. Explain Budgeting and its process.
)A
5. What do you understand by budget? Describe various types of budget.

1. a) FIFO
(c
2. c) Marginal contribution/Sales
3. a) Margin of Safety

4. b) Master Budget
Notes
e
5. a) Standard rate × (Revised standard time – Actual time)
in
Further Readings
1. Horngren.C.T., Accounting For Management Control - An Introduction,
Englewood Cliffs, Prentice Hall, 1965.
nl
O
ty
r si
ve
ni
U
ity
m
)A
(c

Module - 5: Latest Development Trends & Practices

Notes
e
Module Objective-
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This Module is intended to introduce the latest developments in accounting
concepts like, Human Resource Accounting, Inflation Accounting etc. and introduction
nl
of software packages MS excel and prowess for analysis of accounting data.
Learning Outcomes-
O
●● Describe the concept of Human Resource Accounting, Inflation Accounting and

IFRS.
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●● Demonstrate useful spreadsheet techniques and tools in a Financial Analysis
context.
●● Understand the Prowess database of the financial performance of enterprises and
si
its use for analysis.
“Financial statements are the principal means through which financial

r
information is communicated to those outside an enterprise”.
ve
According to Donald E. Kieso-
1. Preparation of Integrated Financial Statement Framework in

Excel
ni
Financial statements are an important part of corporate financial management.

Through analysis of corporate financial statements, management can timely identify the
U
strengths and weaknesses of the company and make appropriate financial adjustments
in a timely manner. Excel is a powerful tabular analysis tool that sorts, filters, and
aggregates large amounts of data, simultaneously.
Microsoft Excel has met the various requirements of financial management for
ity
financial employees with its intuitive gui, efficient data processing feature and easy
operating skills. In daily financial work, it is the most commonly used data analysis
method for modern financial personnel. Its specific instruments, roles and so on are
important in the gradual accounting and financial work of the organisation.
m
It can calculate the data automatically and easily sort, philtre, and summarise a
large volume of data automatically, completing relatively complex data analysis. It can
be used to construct a bar chart, line chart, scatter chart, and other charts at the same
)A
time. Excel incorporates common calculation of the table, ample display of charts and
convenient analysis of results. It has a simple mode of operation, a strong feature and a
great reporting system and is generally used in the operation of financial management.
2. Using Software for Financial Analysis

(c
While we are building the income statement, and want to keep a couple of general
principles in mind. Principle one says that we want to make Excel do as much of the

work as possible. Any time a value can be calculated, we should use Excel to do so.
Notes
e
The reasoning behind this principle is that we want to avoid mistakes and increase
productivity. A little thought before beginning the design of a worksheet can help
minimize data entry errors and increase productivity by reducing the amount of data
in
that needs to be entered. Principle 2 says the worksheet must be formatted in such
a way as to make it easy to comprehend. There are many times that you will create a
worksheet for others to use or for your own use at a later date.
nl
The sheets can be easily created following various rules such as –
●● Properly organizing the data and the judicious use of colour and fonts can
O
make the worksheet easier to use and modify.
●● Worksheets that are disorganized and sloppily formatted waste the time of the
audience and do not engender faith in their results. It is usually helpful when
working with multiple worksheets in a workbook for each sheet to be given a
ty
name other than the default.
●● Worksheets can be renamed using the Format button on the Home tab or
by right-clicking the sheet tab. Right-click “Sheet 1,” choose Rename, and
si
then type Income Statement over the existing name. This step is important
because when later we begin to reference data on the same sheet, the
references will require the name of the sheet in addition to the cell reference.
●● r
In general, Merge and Center icon must not be used. From this point we can
ve
move line by line through the income statement, entering a label followed
by the value. An alternative is to enter all of the labels and then all of the
numbers.
●● When entering large numbers, it is often preferable to display them in
ni
thousands or millions of dollars, instead of the full amount. For example, for
calculating EPI, the numbers are entered in full precision and later apply a
custom number format.
U
●● The SUM function can also be used to easily build the financial statements.
There are two advantages of using the SUM function in this case: (1) It is
faster and more compact and (2) The range will automatically expand if we
insert a new row. The second advantage is the most important.
ity
3. Using Prowess
ProwessIQ is an interactive querying system to find companies from the Prowess
database. It consists of a client software that provides an interface to construct and
m
submit queries over the internet to the Prowess database and receive answers to the
queries from the database.
●● Prowess is a database of firms ‘ financial results. The principal sources of data are
)A
the annual reports of corporations, stock exchanges and regulators. Prowessdx

is a distribution of the Prowess database explicitly tailored for the academic
community. Prowessdx makes it easy to import data in a plain text format with
ease.
(c
●● Based on these, the database includes the profit and loss statement, balance
sheet, and ratios. Cash flow statements, quarterly financial statements, share

prices, executive behaviour, and daily total returns are included in the case of
Notes
e
listed firms.
●● There are available financial statements based on a combined and standalone
in
basis. There is standardisation in financial statements. The database does not
suffer from any intentional bias in survival.
The statement of cash flows is organized into three sections according to how the
nl
cash flows were generated:
1. Cash Flows from Operations – cash flows that are generated by the firm in the
ordinary course of conducting its business.
O
2. Cash Flows from Investing – cash flows that result from buying and/or selling
long-term assets such as land, buildings, machinery, and long-term securities.
3. Cash Flows from Financing – cash flows resulting from obtaining or repaying
ty
long-term capital. This includes changes in long-term debt, common equity (but
not retained earnings), and the payment of dividends
si
4. Human Resource Accounting
Human Resource Accounting (HRA) is the method of defining and recording
an organization’s human resources assets which are currently unaccounted for in
r
traditional accounting practice. This is an extension of the traditional accounting
ve
standards.
Objectives
(1) HRA facilitates the management of people as one of the resources of the organization.
ni
(2) Helps the management to make decision regarding acquiring, allocating, developing
and maintaining the human resources so as to keep control on human resource cost
as one of the organizational objective.
U
(3) Providing information to the management regarding human resources cost and
value.
(4) Determining whether the human resources are effectively utilized or not
ity
(5) Determination, if the human resources are producing a return on investment of the
people interested in the organization.
(6) Provide human resources accounting details to financers such as the bankers,
m
financial institutions and creditors
Methods of HR Accounting
)A
1. Historical Cost Approach:

It is based on the concept that there are various human resources expenses borne
by the organisation. Cost is an element of cost incurred in obtaining any advantages
or services anticipated. In this strategy, the real expenses incurred by the company in
(c
recruiting, choosing, hiring, training and improving human resources are retained and
a proportion is written off to the profit of the next and expected useful life of human
resources.

The approach of the cost of human resources is very similar to the book value of
Notes
e
the other physical assets. The method is based on traditional accounting concept of
matching cost with revenue, is simple to understand and easy to work out.
in
2. Replacement Cost Approach:
Human resources of an organisation must be the values on the assumption that
a new similar organisation has to be created from cut down. What will be the cost to
nl
the firm if the existing resources were required to be replaced with other persons of
equivalent talents and experience is also to be determined.
O
According to this model the employee’s worth is calculated as the replacement
expense with a new employee with equal ability and performance. There are two
costs, the cost of replacing individually and the cost of replacing positionally. Costs for
recruiting, selection, training and development, and familiarization are accounted for
ty
in individual cost of replacement. When an employee changes the present position to
another or leave the organisation then the cost of moving, vacancy, carrying and other
relevant costs reflect in the individual replacement cost. Positional replacement cost
si
refers to the cost of filling different position in an organisation.
3. Opportunity Cost Approach
r
This approach analyzes alternative sources of earnings from human resource
productive capacity by putting in some alternative use. Opportunity cost is the value of
ve
an asset (HR) where it is used alternately. Opportunity expense opportunities for those
workers who are not limited are diminishing.
Here, the importance of human capital can be composed only of the scarce
ni
citizens. Nonetheless, the alternative use of HR within the company is restricted and at
the same time the use of HR with figuring out the alternative costs might not be properly
implemented.
U
4. Standard Cost Approach

This approach is based on the line and staff as well as the functional relationship
of employees in an organisation. The employees of an organisation are categorised
ity
and divided into different groups with respect to their hierarchical levels or positions.
Standard cost is fixed for each category of employees and their worthwhile role may be
calculated. Due to some of the static position of employees on account of their status
and position, it does not take any differences of them put in the same group.
m
5. Inflation Accounting
Inflation accounting is a special method used to weigh on the published statistics of
)A
multinational firms in the effects of soaring or plummeting prices of products in certain

regions of the world. Financial statements are calculated according to price indices to
paint a better image of a firm’s financial position in inflationary conditions, rather than
relying solely on cost accounting. It is also known as price level accounting.
(c
Types and Components of Inflation Accounting

There are various kinds of techniques that are involved in the inflation accounting
and there are various methods attached to it.
●● Current Purchasing Power Method

Notes
e
This technique involves the adjustment of the financial statements to the current
price changes. It also involves the recalculation of the historical financial figures of the
in
company at the current purchasing power which is done by the application of certain
conversion factors.
●● Current Cost Accounting
nl
Under this method, the cost categories and the various cost items and the items in
the balance sheet are shown at the current cost rather than the historical cost and the
profit is determined on the actual cost period and not on the basis of the sales.
O
●● Current Value
Under this method, all the assets and liabilities are measured and are reinstated at
their current cost structure.
ty
●● Replacement Cost Accounting
Under this method, the cost of replacing is the parameter under which all the
assets and the liabilities on the balance sheet are recorded
si
6. IFRS
r
International Financial Reporting Standards (IFRSs) are set by the International
Accounting Standards Board (IASB) that was established in 2001 to replace the
ve
International Accounting Standards Committee (IASC). International Financial Reporting
Standards (IFRS), formerly known as International Accounting Standards (IAS) are the
standards, interpretations and the framework preparing and presenting the Financial
Statements adopted by the International Accounting Standards Board (IASB).
ni
7. IFRS Framework
What is International Accounting Standards Board (IASB),
U
The IASB is the independent standard setting body of the IFRS to approve
the interpretations of IFRS as developed by the IFRS Interpretations Committee.
The IASB engages closely with the stakeholders globally including the investors,
analysts, regulators, accounting standard setters and more. The formulation if ISB is
ity
necessary as –
●● There is a recognized and growing need for the common international

standards
m
●● No individual setter has a monopoly over a best solution to the accounting

standards.
●● No national standard setter is in a position to set accounting standard that
)A
gain acceptance around the world.
Steps taken by IASB for Global Convergence

Issued a conceptual framework - It had adopted the framework issued by IASC in
1989. The framework saves as guide to IASB for developing Accounting Standards.
(c
Issue of IAS – Till now IASC had Issued 41 International Accounting Standards


Notes
e
IAS 1 Presentation of Financial Statements
IAS 2 Inventories
in
IAS 7 Statement of Cash Flows
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
nl
IAS 10 Events After the Balance Sheet Date
IAS 11 Construction Contracts
IAS 12 Income Taxes
O
IAS 16 Property, Plant and Equipment
IAS 17 Leases
IAS 18 Revenue
ty
IAS 19 Employee Benefits
IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance
si
IAS 21 The Effects of Changes in Foreign Exchange Rates
IAS 23 Borrowing Costs
IAS 24 r
Related Party Disclosures
ve
IAS 26 Accounting and Reporting by Retirement Benefit Plans
IAS 27 Consolidated and Separate Financial Statements
IAS 28 Investments in Associates
IAS 29 Financial Reporting in Hyperinflationary Economies
ni
IAS 31 Interests in Joint Ventures

IAS 32 Financial Instruments: Presentation
U
IAS 33 Earnings Per share (EPS)

IAS 34 Interim Financial Reporting
IAS 36 Impairment of Assets
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IAS 37 Provisions, Contingent Liabilities and Contingent Assets

IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement
IAS 40 Investment Property
m
IAS 41 Agriculture
)A
Issue of International Financial Reporting Standards (IFRS)

IFRS 1 First-time Adoption of IFRS
IFRS 2 Share-based Payment

(c
IFRS 3 Business Combinations

IFRS 4 Insurance Contracts

Notes
e
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
in
IFRS 6 Exploration for and evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures
IFRS 8 Operating Segments
nl
IFRS 9 Financial Instruments
IFRS 10 Consolidated Financial Statements
O
IFRS 11 Joint Arrangements
IFRS 12 Disclosure of Interests in Other Entities
IFRS 13 Fair Value Measurement
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IFRS Foundation
si
On 24 May 2000, IASC members approved the first constitution of the IASC
foundation, and on 5 March 2002, IASC foundation trustees amended those articles,
effective that date. These amendments were necessary to implement some elements of
r
the IASB’s Standing Interpretation Committee preface to IFRS.
ve
The IFRS foundation is an independent and not for profit private sector organization
that works in public interest. The principal objectives of the organization are:
●● The main objective of the IFRS Foundation is to establish a common set of high
quality, comprehensible, enforceable and internationally agreed financial reporting
ni
standards based on clearly articulated principles for the public interest.

●● Development of a single set of high quality, understandable and a globally
accepted IFRS through its standard setting body ISB.
U
●● Promote the use and a regular application of the principles.

●● Take into account the financial reporting needs of the emerging economies and the
small and medium sized entities (SME’s)
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Key Takeaways:
●● Financial statement analysis: It is defined as the process of identifying financial
strengths and weaknesses of the firm by properly establishing relationship
m
between the items of the balance sheet and the profit and loss account
●● Human Resource Accounting: It is the method of defining and recording an
organization’s human resources assets which are currently unaccounted for in
)A
traditional accounting practice

●● Inflation accounting: It is a special method used to weigh on the published
statistics of multinational firms in the effects of soaring or plummeting prices of
products in certain regions of the world
(c
●● International Financial Reporting Standards (IFRSs): Standards set by the

International Accounting Standards Board (IASB)

●● IASB: An independent standard setting body of the IFRS to approve the

Notes
e
interpretations of IFRS as developed by the IFRS Interpretations Committee.
Check your progress
in
1. Principle 1 of preparation states -
a) Excel should be employed at last stage
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b) Excel must do as much of the work as possible
c) Worksheet must be formatted in such a way as to make it easy to comprehend
d) Multiple worksheets must be created.
O
2. Principle 2 of preparation states -
a) Excel should be employed at last stage
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b) Excel must do as much of the work as possible
c) Worksheet must be formatted in a way as to make it easy to comprehend
d) Multiple worksheets must be created.
si
3. The advantage of using sum Function is
a) It is compact
b) It is faster r
ve
c) The range automatically expands
d) All of these
4. The concept that human resources expenses borne by the organization is
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a) Replacement Cost Approach

b) Historical Cost Approach
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c) Opportunity Cost Approach

d) Standard Cost Approach
5. _________________ is a method used to weigh on the published statistics of
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multinational firms in the effects of plummeting prices of products in certain regions

a) Cost Accounting
b) Inflation Accounting
c) Standard Costing
m
d) Marginal Costing

)A
1. Explain the preparation of Integrated Financial Statement Framework in Excel

2. Explain the Use of MS Excel in Financial statements analysis- Ratio Analysis
3. Describe cash flow statements using Excel
(c
4. What is meant by Human resource accounting? What are methods of HR Accounting

5. Explain Inflation accounting


Notes
e
1. b) Excel must do as much of the work as possible.
2. c) Worksheet must be formatted in a way as to make it easy to comprehend
in
3. d) All of these
4. b) Historical Cost Approach
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5. b) Inflation Accounting
Further Readings
O
ty
r si
ve
ni
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ity
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)A
(c

Accounting For Managers

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Accounting For Managers

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Accounting for Managers 1

Module-1: Introduction to Financial Accounting

Through reporting all transactions related to the development of monetary inflows

system ensures an accountability. The accounting system provides the financial

1. Financial Accounting Meaning and Function

different functions viz. Recording , Classifying and Summarizing.

Amity Directorate of Distance & Online Education

Mod ul e- 1 : I ntrod uction to F inancial Accounting

Through reporting all transactions related to the development of monetary inflows

system ensures an accountability. The accounting system provides the financial

1 . F inancial Accounting Meaning and F unction

different functions viz. Recording , Classifying and Summarizing.

Amity Directorate of Distance & Online Education

Accounting is treated as the language of business. It records all the transactions

●● To keep systematic records - Accounting is performed to keep a systematic

●● To assist in decision-making - To take decisions for the future, there is a need

plan for the future with the help of past records.

2. Role of Accounting in Business

operation of the enterprise. It also helps in determining production costs, controlling

●● Helps in the determination of financial results and presentation of financial

Accounting is considered to be essential for record-keeping of all the receipts and

1. Financial Accounting - Financial accounting is aimed at identifying an accounting

Financial Accounting Involves the Following Terms -

●● Business transactions: A business transaction is any activity that creates

●● Classification of transactions: Before recording any transaction, it is

Amity Directorate of Distance & Online Education

transaction. Similarly, transactions of receiving income and expenditure

(c) Controlling the activities of the organization

(e) Performance appraisals at strategic and operational level - A management

1. Provide information about the cost of the product to be used in financial

Difference between Management Accounting and Financial Accounting

S.no Management Accounting Financial Accounting

1 Management Accounting is primarily Financial Accounting is based on the

2 Reports prepared in Management Reports as per Financial Accounting are

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3 It provides necessary information to Its main focus is on recording and classifying

4 Reports may contain both subjective Reports should always be supported by

Double entry system: The double-entry accounting or bookkeeping scheme

structure of an Enterprise consists of 1,00,000 equity shares, 1,00,000 preference

The capital structure is the particular combination of an Enterprise’s debt and

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Understanding Capital Structure

between the capital and revenue items is very important.

7. Coal, gas, water, oil, grease, fuel, heating and lighting

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14. Repairs and renewals

1. Capital expenditure: If expenditure is incurred in the business to get its

machinery and cost of sales, Depreciation of fixed assets, expenditure incurred

2. Revenue Receipts: The receipts which arise out of normal course of a

d. Differences between Capital and Revenue Receipts

3. Compensation received for loss of business is a capital receipt. Whereas,

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the property that the owner of the business has.

The significance of business entity concept is:

personal expenses are ignored.

●● It is the very basis of accounting concepts, conventions, and principles.

bankruptcy or instantly dissolve. It expects to be able to meet its responsibilities

For example, an Enterprise purchases a plant and machinery of Rs.2, 00,000

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the profits and losses of the business concern.

prepared by the business enterprise will be easy to understand.

be prepared at regular intervals. This is relevant for various purposes such

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