Accounting For Managerial Decisions Notes

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School Of Distance Education
SYLLABUS
MC1C3 ACCOUNTING FOR MANAGERIAL DECISIONS
Objective: Enable the students to know the applications of accounting tools, techniques and
concepts in managerial decision making process.
Module – 1 : Management Accounting: Nature, Scope and functions- Role of Management

Accountant- Cost Concepts and Classification- Variable Costing and Absorption Costing-
Emerging Costing Approaches – Life cycle costing- Quality costing- Kaizen costing- Throughput
costing- Back flush costing- Activity Based Costing- Introduction- Concepts- Cost drivers and cost
pools- steps to develop ABC System- ABC System and Corporate Strategy.
Module - 2 : Capital Investment Process- Investment Appraisal Methods- Payback period- ARR-
Time adjusted methods- Discounted payback period- Net Present Value method- IRR- PI- TV
method- Capital Rationing- Risk Analysis- Decision Tree approach- Sensitivity Analysis- Other
statistical methods.
Module – 3 : CVP Analysis and Decision Making: Managerial application of CVP analysis- Make
or Buy Decision- Alternative Methods of production- Buy or Lease decision- Shut down or
continue- Repair or replace- Accepting bulk orders for idle capacity utilization- Pricing under
different situation- Suitable product mix- Key factor etc.
Module – 4 : Cost of Capital : Concept- Relevance- Elements of cost of capital- Cost of Equity-
Cost of Debt- Cost of Retained Earnings- Calculation of Weighted Average Cost of Capital- Cost
control and cost reduction techniques- Value Engineering.
Module – 5 : Performance Measurement : Financial and Non-financial Measurement- Performance-

Return on Investment- Residual Income- EVA- Concept- Measurement- Balanced Score Card-
Concept- Objectives- Multiple Score Card measures- New horizons in Managerial Control-
Transfer Pricing- Responsibility Accounting- Performance Budgeting- ZBB- Social Cost Benefit
Analysis.
( Theory : 40% and Problems : 60% )

Books for reference:
1. Cost and Management Accounting- by SP Jain and KL Narang. (Kalyani)

2. Management Accounting and Financial control- by SN Maheswari. (Sulthanchand and Sons)
3. Advanced Management Accounting- by Ravi M Kishore. (Taxman)
Accounting for Managerial Decisions Page 3

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INDEX
UNIT Particulars Page No.
1. INTRODUCTION 5
2. COST CONCEPTS AND CLASSIFICATION 9
3. EMERGING COSTING APPROACHES 14
4. CAPITAL INVESTMENT PROCESS 19
5. RISK ANALYSIS IN CAPITAL BUDGETING 38
6. CVP ANALYSIS AND DECISION MAKING 42
7. COST VOLUME PROFIT ANALYSIS 49

(C.V. P ANALYSIS)
8. MANAGERIAL APPLICATION OF CVP 56

ANALYSIS
9. COST OF CAPITAL 65
10. COST CONTROL 74
11. PERFORMANCE MEASUREMENT 79
12. TRANSFER PRICING 86

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UNIT-1
INTRODUCTION
Evolution of Management Accounting
The evolution of Joint Stock Company from of organization has resulted in large scale
production and expansion of ownership. The increase in size and complexity of business and the
application of sophisticated modern technology have resulted in the separation of ownership and
management. The modern managers need meaningful and timely data for their primary function-
decision making. Though the financial accounting conveys meaningful information to the outsiders,
(eg., Shareholders, creditors etc.), it fails to communicate valuable and varied information to the
management. Financial accounting furnishes a good deal of factual information, but not of much
use in the current management perspective. Today management can no longer afford to wait up to
the end of a year to know the results of the day-to-day transactions. The effect of each business
transaction should be made available on a routine basis. The approach has changed the role of
accounting from a mere device of recording to a powerful tool of forecasting, budgeting, budgetary
control etc. This changing dimension of accounting has led to the development of the technique of
"Management Accounting".
Meaning:
Management Accounting can be referred to as "a system of accounting for management",
which provides necessary information to the management for discharge of its functions. These
functions include planning, organizing, directing, controlling and decision making. Management
accounting assists the management to carry out these functions more efficiently in a systematic
manner.
Definition:
Some of the important definitions of management accounting are:
The Institute of Chartered Accountants of England and Wales : "Any form of accounting which
enables a business to be conducted more efficiently can be regarded as management accounting."
Robert N. Anthony: “Management accounting is concerned with accounting information that is
useful to management.”
The Institute of Chartered Accountants of India: "Such of its techniques and procedures by which
accounting mainly seeks to aid the management collectively."
In short, management accounting can be defined in simple words as "accounting for
effective management."
Nature or Characteristics of Management Accounting:
1. Forecasting: It helps in planning for the future course of action.
2. Internal accounting: It is concerned with the provision of information to the management to
make better decisions.
3. Quantitative and qualitative information: It deals with both quantitative as well as
qualitative information.
4. Techniques and concepts: It uses special techniques and concepts to make the accounting
data more useful (eg: Marginal Costing, Cost-Volume-Profit Analysis etc.)
5. Multi-disciplinary: It is a combination of several disciplines such as financial accounting,
cost accounting, operations research, statistics, economics etc.
6. Cause and Effect Analysis: It attempts to test the "cause" and "effect” relationship of
different variables. For eg: if there is a loss, the reasons for the loss are looked in to.
7. No fixed norms: It has no fixed set of rules and formats like that of financial accounting.
The analysis of data depends upon the purpose and person using it.

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Scope of Management Accounting
The management accounting is a wide and broad-based subject, which includes a variety of
aspects of business operation. The following areas of specialization reveal its scope:
1. Financial Accounting: It is the basic accounting device which relates the recording of
transactions in the books, ledger postings, balancing and drafting of trial balance prior to the
preparation of Profit and Loss Account and Balance Sheet. A well designed financial
accounting is essential for the smooth operation of management accounting.
2. Cost Accounting: Costing is the technique and process of ascertaining costs. Cost
accounting system provides necessary tools such as standard costing, budgetary control,
marginal costing, inventory control etc. for carrying out the management accounting
functions efficiently.
3. Budgeting and Forecasting: Both budgeting and forecasting are useful for management
accountant in planning various activities.
4. Interim Reporting: This refers to reporting of financial results by means of weekly,
monthly, quarterly or half yearly statements to the management.
5. Statistical Methods: Statistical tools such as graphs, charts, diagrams, regression analysis,
time series etc., are used to make the information more impressive and intelligible.
6. Interpretation of Data: Analysis and interpretation of financial statements are important part
of management accounting.
7. Internal Audit: A system of internal control by establishing internal audit coverage for all
operating units. It also fixes responsibility of different individuals.
8. Tax Planning: Tax liabilities are calculated with the help of income statements.
Management accounting includes tax planning also.
9. Operations Research: Operation research techniques like Linear programming, Decision
Tree Analysis. Network Analysis etc also help the management in solving business
problems.
10. Break-Even Analysis: It helps the management to find out the no profit – no loss point and
also the probable amount of profit at different levels of activity.
Functions of Management Accounting
1. Planning and forecasting: Planning and forecasting are essential for achieving business
objectives. Management accounting provides necessary data for forecasting.
2. Modification of Data: It modifies the accounting data by rearranging in such a way that it
suits the requirements of the management.
3. Analysis and Interpretation: The accounting data is analyzed and interpreted meaningfully
for effective planning and decision making.
4. Serves as a Means of Communication: Management Accounting establishes communication
with in different levels of management and with the outside world.
5. Facilitates Managerial Control: It enables all accounting efforts to be directed towards the
attainment of goals efficiently by controlling the operations of the company. Standards of
various departments and individuals are fixed and actual performance is compared with it,
deviations are assessed and proper control exercised.
6. Use of Qualitative Information: Management accounting uses qualitative information also
to assist the management in decision making process Engineering records, case studies,
special surveys etc., are used in purpose.
7. Decision-making: Management accounting supplies analytical information regarding
various alternatives and selection is made easy.

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8. Co-ordination: It is the essence of managerial activity. The targets and performances of
different departments are co-ordinated and communicated to the management at proper
intervals.
Inter relationship with other subjects:
Management Accounting, Financial Accounting and Cost Accounting are complementary
and are necessary for running the concern efficiently. Now let us study the interrelationship
between these subjects by looking into the differences between them. The major points of
distinction between financial accounting and management accounting are:-
Items Financial Accounting Management Accounting
1. Object Records transactions, assess Assists management of
profitability by drafting final formulating policies and
accounts plans
2. Nature of data Historical nature Future plans & policies
3. Scope Ascertain profit or loss and financial Covers cost accounting,
position, Limited scope financial accounting,
budgetary control etc.
Broader scope.
4. Flexibility Rigid on rules and regulations Free and flexible, No hard
and fast rules.
5. Compulsion More or less compulsory for every Voluntary, not compulsory to
business install this accounting system.
6. Periodicity of reporting Accounts are prepared for a longer No specific period for which
period, say, one year. accounts are prepared
7. Precision Actual figures are recorded. Hence No emphasis given to actual
accuracy and precision maintained figures. Projections and
estimates are used.
8. Use Useful to outsiders like Internal use only for different
shareholders, investors, bankers etc. levels of management.
9. Coverage Covers the whole range of business Considers only parts of
activity business activity like
departments, cost centres etc.
10.Publication Profit & Loss A/c and Balance Accounts statements, reports
Sheet are published for the benefit etc., are for internal use only,
of the outsiders. hence not published.
11. Audit Audit is compulsory in certain Cannot be audited
cases.
12. Speed Slow and time consuming Reporting and follow up
activities are done very
quickly.
Relationship between Management Accounting and Cost Accounting:

Management accounting and Cost accounting are two important branches of accounting.
They are closely interrelated. Cost accounting is the process of accounting for costs. It is not a mere
tool for cost ascertainment and cost recording, it is also a good tool for cost control, ascertainment
of profitability and for management decision-making.

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The following table shows the main points of distinction between the two:
Sl.
Item Cost Accounting Management Accounting
No.
1. Object To record cost of To provide information to the
producing a product or management for planning and
rendering a service coordinating the activities.
2. Scope Narrow scope. Deals Wide scope. Includes financial
with cost ascertainment accounting, cost accounting,
budgeting, tax planning etc.
3. Principles Certain principles and No specific rules and procedures
procedures are followed. followed.
4. Nature Uses mainly past and Projections of figures for future.
present figures
5. Data used Only quantitative data Both quantitative and qualitative
(figures) are used information are used.
Role and Position of Management Accountant
Management accountant is a person responsible for the supply of accounting information to
the management. He may be known as financial controller, financial advisor, chief accounts officer
etc. The organizational status or position of a management accountant varies from concern to
concern. His position in the organization determines his function as line function of staff function.
If he participates in planning and execution of policies, he is equal to other functional managers and
his position will be a line function. But in most of the industries management accountant performs
only staff functions. That is supplies information and gives his views about the data and leaves the
final decision making to functional departmental heads. In America his position is more or less a
combination of line and staff functions. In any case, it can be concluded that he plays a significant
role in the decision making process and he is associated according to the needs and requirements of
the organization.
Functions of Management Accountant
The Financial Executives Institute, America has specified his function as follows:
1. Planning for control: Management accountant establishes co-ordinates and maintains an
integrated plan for the control of operation. Such a plan would provide cost standards,
expense budgets, sales forecasts, capital investment programs, profit planning etc.
2. Reporting: Management accountant measures performance against given plans, and
standards. The results of operations are interpreted and reported to all levels of management.
3. Evaluating: He should evaluate various policies and programs and check their effectiveness
to attain the objectives of the organization.
4. Administration of Tax: Management accountants are expected to report to Government
agencies as required under different laws and to supervise matters relating to taxes.
5. Protection of Assets: The protection of business assets is another function assigned to the
management accountants. It is performed through internal control, auditing and assuring
proper insurance coverage of assets.
6. Appraisal of External Effects: He has to continuously appraise economic and social forces
and government influences and interpret their effect upon business.
Try yourself:
1. “Management Accounting is accounting for effective management”. Explain the statement.
2. Explain Management Accounting. What are the functions of Management Accounting?
3. What are the differences between Management Accounting and Financial Accounting?
4. Distinguish between Management Accounting and Cost Accounting.
5. Explain the role of Management Accountant in an organization.

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UNIT-TWO
COST CONCEPTS AND CLASSIFICATION
CONCEPT OF COST
The term cost has a wide variety of meanings. Some use the word ‘price’ for cost, though cost is not
the same as price. In management terminology, cost refers to expenditures and not price. Some
important definitions of cost are given below to make the concept clear:
According to the British Institute of Cost and Works Accountants “Cost is the amount of
expenditure (actual or notional) incurred on or attributable to a given thing.”
W.M. Harper: “Cost is the value of economic resources used as a result of producing or doing the
thing costed.”
Raymond J. Chambers: The term cost is used in three different senses- 1) the expected cost of a
particular action, 2) the cost of something purchased, and 3) the cost of attaining some end, ie., the
sacrifices actually made to attain it.
The Institute of Cost and Management Accountants (ICMA), England: “Costing is the technique
and process of ascertaining costs.” Costing relates to the ascertainment of cost of a product
produced or service rendered.
ICMA, England defines cost accounting as “the process of accounting for cost from the point at
which expenditure is incurred or committed to the establishment of its ultimate relationship with
cost centres and cost units.” Thus cost accounting is a formal accounting procedure to ascertain cost
of production.
Cost accountancy is defined as “the application of costing and cost accounting principles, methods
and techniques to the science, art and practice of cost control and ascertainment of profitability. It
includes the presentation of information derived there from for the purpose of managerial decision-
making.”
Cost accountancy is thus a wide term which includes both costing and cost accounting. Its main
purposes are cost control and ascertainment of profitability. It is an important tool of managerial
decision-making.
CLASSIFICATION OF COST
Classification of cost is the process of grouping costs according to their common characteristics.
Classification is done on the following bases:
1. On the basis of elements of cost
2. On the basis of function
3. On the basis of behavior or variability
4. Classification for managerial decisions and control.
1. Classification by Nature or Elements of Cost
Under this head cost can be broadly classified as : a) Direct costs and b) Indirect Costs
a) Direct Costs: Direct Costs are the costs which can be easily identified with and allocated to a
particular product. Such costs are treated as the cost of the unit produced. For eg. Cost of raw
materials, labour and other direct expenses incurred for the production of a particular job,
product or process.
b) Direct costs can be further classified in to:
i) Direct Material: all those materials specifically consumed for the production of the unit,
including all primary packing materials.
ii) Direct Labour: Wages paid to workers directly engaged in the manufacturing process of
a product, a job or an operation can be stated as direct labour..

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iii) Direct Expenses: All expenses other than direct material and direct labour that are
specifically incurred for a particular job, product or process are called direct expenses or
chargeable expenses. Cost of special tools, patterns etc., made for a particular job,
product or process, hire charges of special equipment, excise duty, royalties, freight and
insurance on special materials etc. are other examples.
b) Indirect Costs: Indirect costs are those which cannot be assigned to any particular cost unit, ie., job,
product or process, but can be apportioned on a reasonable basis. These costs are of general
character and are incurred for the business as a whole or for several cost centres at a time. Such costs
are apportioned to those cost centres on the basis of benefits received by each. Indirect costs include:
i) Indirect Material such as fuel, lubricating oil, small tools, material consumed for
repairs and maintenance, miscellaneous stores used in the factory, etc.
ii) Indirect Labour which includes wages of general supervisors, inspectors, workshop
cleaners, store-keepers, time-keepers, etc.
iii) Indirect Expenses such as rent, lighting, insurance, canteen, hospital, welfare
expenses, etc.
Indirect costs are also called “Overheads” which can be further classified into:
a) Factory Overheads which include all indirect costs related with the manufacture
of a product such as lubricants, oil, consumable stores, works manager’s salary,
time keeper’s salary, factory rent, factory insurance, etc.
b) Office and Administration Overheads which include all indirect expenses
relating to administration and management of an office such as office rent, office
lighting, insurance, salaries of clerical and executive staff, etc.
c) Selling and Distribution Overheads which include all indirect costs connected
with marketing and sales such as advertising expenses, salaries of salesmen,
indirect packing materials, etc.
2. Functional Classification
On the basis of functions cost can be classified as follows:
a) Prime Cost: It consists of cost of direct materials, direct labour and direct expenses. It is
also known as direct cost or first cost.
b) Factory Cost: It is prime cost plus factory overhead or works overhead. Also known as
works cost, production cost or manufacturing cost.
c) Cost of Production: It is factory cost plus office and administration overheads. Also
known as office cost, administration cost or gross cost of production.
d) Total Cost or Cost of Sales: It comprises of cost of production plus selling and
distribution overheads.
Functional classification of cost can be summarized as below:
1. Prime Cost = Direct Material + Direct Labour + Direct Expenses
2. Factory Cost or Works Cost = Prime Cost + Works Expenses.
3. Office Cost or Cost of Production = Factory Cost + Office & Administrative
Overheads.
4. Total Cost or Cost of Sales = Cost of Production + Selling & Distribution
Overheads.

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3. Classification on the basis of Behavior
On the basis of behavior or variability, costs may be classified as:
a) Variable Cost: Costs that vary in direct proportion to the volume of production are called
variable costs. For eg. Direct material, direct labor and direct expenses. Variable costs vary in
total in relation to the units produced, but remain constant per unit at all levels, unless otherwise
stated. Variable cost is also known as product cost.
b) Fixed Cost: Costs which do not vary with the volume of production are called fixed costs. They
remain fixed in total irrespective of the level of production, but vary per unit for different levels
of activity. Fixed cost per unit decreases with increase in output and increases with decrease in
output. Fixed costs are normally based on time and hence also known as period cost. Eg. Rent
of building, office salary, insurance premium, etc.
c) Semi-variable costs: These costs are partly fixed and partly variable. These costs may vary with
the level of production but not in direct proportion to the output. Eg. Telephone charges, repairs
and maintenance, depreciation of machinery, etc.
4. Classification for Managerial Decisions and Control
a) Controllable and uncontrollable costs: Controllable costs are those costs which can be
controlled or influenced by a specified person or a level of management of an undertaking.
Costs which cannot be so controlled are known as uncontrollable costs.
b) Normal and abnormal cost: Costs which are normally incurred at a given level of output
are known as normal costs and it is charged to the cost of production. The costs which are
not normally incurred at a given level of output in the normal conditions are abnormal costs,
ie., any cost which is in excess of normal cost is treated as abnormal cost and is charged to
costing profit and loss account.
c) Avoidable and unavoidable costs: Avoidable costs are those costs which can be escaped if
some activity of the business is discontinued. Unavoidable costs are those which cannot be
escaped or eliminated.
d) Shut down and sunk costs: Those fixed costs which have to be incurred even if production
of an undertaking is discontinued temporarily due to some reasons such as strike, shortage
of raw material, etc., are called shut down costs. Costs which have been incurred and are
irrelevant in a particular situation are called sunk costs.
e) Out of pocket costs: It is a cost which involves actual cash payment to outsiders, like rent,
salary, interest, etc. Expenses like depreciation, goodwill written off, loss on sale of assets,
etc. do not involve cash payment and hence are not out of pocket costs.
f) Opportunity costs: It refers to the benefit forgone or sacrifice made in favor of an
alternative course of action. When one alternative is rejected in favor of another, the loss of
benefit from the rejected alternative is the opportunity cost. For e.g., if an owned building is
used for business, the rent that would have been received by letting it out is an opportunity
cost.
g) Conversion costs: It is the cost of converting or transforming raw materials into finished
products. It includes direct wages , direct expenses and factory overheads.
h) Replacement cost: Replacement cost is the cost of replacing an asset by purchasing it from
the market.

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i) Imputed cost or Notional cost: Imputed cost is a hypothetical cost which does not involve
actual cash expenditure. For e.g., rent of owned building, interest on owned capital, etc.
j) Differential cost, incremental cost and decremental cost: The difference in cost due to
change in the level of activity or method of production is known as differential cost. If the
change results in increase in total cost, it is called incremental cost. If the change results in
decrease in total cost, it is called decremental cost.
k) Marginal cost: Marginal cost is the cost of producing one additional unit. Marginal cost
concept is based on the distinction between fixed cost and variable cost. Marginal cost
includes variable costs only.
l) Budgeted costs and standard costs: Budgeted costs are estimated costs prior to a defined
period of time. Standard cost is a predetermined cost based on technical estimate for
materials, labour and overheads for a selected period of time and for a prescribed set of
working conditions.
m) Relevant cost: It is a cost which has a direct influence on managerial decision-making.
n) Postponable cost: Postponable cost is a cost which can be postponed to a future period
without any adverse effect on the efficiency of the present operations.
These are the important classifications of cost.
Now let us move on to the next module on Variable costing and Absorption costing.
VARIABLE AND ABSORPTION COSTING
VARIABLE COSTING
An analytical study of the behavior of overheads in relation to changes in volume of output reveals
that there are some items of cost which vary directly with volume of output whereas, there are some
other costs which remain unaffected by variations in the volume of output. Fixed and variable costs
behave differently with changes in the volume of output; variable costs tend to vary in total with
increase or decrease in the level of activity, but fixed costs tend to remain constant in total
irrespective of the level of activity.
The volume of production fluctuates from one period to another due to seasonal and other factors.
But fixed costs being same during each period, fluctuations occur in unit cost of production during
different periods. The total cost per unit may vary as a result of variation in the volume of output,
because of the incidence of fixed cost in it. To prevent this uneven incidence of fixed cost on units
produced, fixed costs are treated as period costs and excluded from product costs. The necessity for
separating fixed cost from product cost in order to eliminate the fluctuations in cost has given rise to
the concept of marginal costing. The essence of marginal costing lies in considering fixed costs as
distinct from variable cost and as such excluded from the product cost. Only variable cost is
considered as relevant to product cost and matched with revenues under different conditions of
production and sales, and hence marginal costing is also called as variable costing.
Definition: Marginal cost is the additional cost of producing an additional unit of a product. ICMA,
London defines Marginal cost as “the amount at any given volume of output by which aggregate
costs are changed if the volume of output is increased or decreased by one unit.” In practice, this
happens to be the total variable cost attributable to one unit.
Marginal cost may also be defined as the ‘aggregate of variable costs’ or “prime cost plus variable
overheads”.
For e.g.: Variable cost per unit Rs.6, fixed cost for the period Rs. 5,000, units produced during the
period: 500

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Cost of production = 500 x 6 = 3000 + 5000 = Rs. 8,000
If in another period, 501 units are produced, then cost of production will be:
Cost of production = 501 x 6= 3006 + 5000 = Rs. 8,006
Therefore, the change in aggregate cost per unit, ie., the marginal cost is Rs. 6, ( 8006-8000) which
is the same as the variable cost per unit.
A detailed discussion on marginal costing is done later in this text.
ABSORPTION COSTING AND MARGINAL COSTING
Let us compare and study the differences between these two concepts of costing:
1. Absorption costing, also known as total costing, conventional costing, traditional costing,
full costing etc., is the practice of charging all costs, both variable and fixed, to operations,
processes, or products. All costs whether variable or fixed, are treated as product costs under
absorption costing. It is a total cost technique.
In marginal costing only variable costs are treated as product cost and fixed costs are
treated as period cost and charged to profit and loss account for that period.
2. There are differences in the valuation of closing inventory. Under absorption costing, the
stock of finished goods and work-in-progress is valued at total cost, which includes both
fixed and variable cost. Under marginal costing, stocks are valued at marginal cost, i.e.,
variable cost only. Hence, it results in higher valuation of inventories in absorption costing
as compared to marginal costing.
3. Under absorption costing, there is apportionment of fixed cost over the products, which
may result in under or over absorption of such costs. While marginal costing excludes fixed
costs, the question of under or over absorption of fixed costs does not arise.
4. In absorption costing, managerial decision making is based upon ‘profit’, which is the
excess of sales value over total cost. While in marginal costing, the managerial decisions are
guided by ‘contribution’ which is the excess of sales value over variable cost.
5. Absorption costing is more suitable for long-term decision making where as marginal
costing is more suitable for short-term managerial decision making.

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UNIT- THREE
EMERGING COSTING APPROACHES
Some of the emerging costing approaches are discussed below:
Life Cycle Costing: The process of identifying and documenting all costs involved over the life of
an asset is known as life cycle costing. Consideration of costs over the life of an asset provides a
sound basis for decision making. It is possible to –
 Assess future resource requirements- cost wise projection of different items.
 Assess comparative costs of potential acquisitions- investment appraisal.
 Decide sources of supply- financing.
 Account for resources used now or in the past- reporting and auditing.
 Improve system design- manpower and utilities over the life cycle.
 Optimize operational and maintenance support.
 Assess when assets reach the end of their economic life and whether renewal is required.
Life cycle costing is an important economic analysis used in the selection of alternatives that impact
both pending and future costs. It compares initial investment options and identifies the least cost
alternatives to purchase, own, operate, maintain and finally dispose off. Life cycle costing takes into
account all user costs, agency costs related to future activities including future periodic maintenance
and rehabilitation. (e.g., Highway construction). All these costs are discounted to see the Net
Present Value of the project. In short, Life cycle costing is an analysis of cost of a system over its
entire life span which involves acquisition costs, operating costs, maintenance costs and disposal
costs.
QUALITY COSTING
There is a new awareness about quality in industry. The opening of Indian markets to multinationals
since 1990 has forced a sense of competition in Indian producers. The consumer started preferring
goods from foreign producers for the reason of lower price and better quality. It is at this stage that
Indian producers started thinking of product or service quality. The organizations that will maintain
productivity and quality on a continuous basis will be able to stay in the market for long. There is a
new competition in India for implementing total quality management and getting ISO 9000
certification.
The modern view of quality is that product should satisfy customers’ needs and expectations on a
continuous basis. This concept of quality calls for well designed products with functional
perfection, prompt satisfaction of customers’ expectations, excellence in service and absolute
empathy with customer.
Quality is the totality of features and characteristics of a product or service that bear on its ability to
satisfy stated or implied needs. Customer satisfaction will come when the product satisfies his
needs and aspirations from it. Total quality is the mobilization of the whole organization to achieve
quality continuously, economically and in entirety. Quality improvement is possible through an
improvement in purchasing, marketing, after sales service and many other factors.
CLASSIFICATION OF QUALITY COSTS
Quality costs can be classified under three heads:

a) Cost of conformance b) Cost of non-conformance c) Cost of lost opportunities.
a) Cost of conformance can be further grouped under the following two sub-heads:
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1) Cost of Prevention- It refers to the cost of those activities which prevent failure from
occurring, such as cost of training employees, cost of quality awareness and quality
maintenance programmes, cost of providing quality reports, quality circles, etc.
2) Cost of Appraisal- It is the cost incurred to determine conformance with quality standards
such as cost of inspection, testing, quality audit, etc.
b) Cost of Non-conformance: It includes:
Cost of internal failure, such as the cost incurred on correcting defects of products or services
which do not meet quality standards. Such defects are discovered prior to delivery of products
to the customers. Eg. Costs of scrap, spoilage, re-worked costs, etc.
Cost of External failure, such as the cost incurred on correcting products or services after
delivery to the customers. Eg. Warranty costs, installation costs, cost of replacement of
defectives, after sales service, etc.
c) Cost of Lost Opportunities: If the products or services are not delivered according to
required quality standards, it will result into loss of existing as well as potential customers.
This loss of revenue resulting from loss of customers is called cost of lost opportunities.
d) The quality costs constitute a significant percentage of total sales in the present days. Thus,
it is very important to reduce quality cost so as to increase the profitability of a concern.
KAIZEN COSTING
Kaizen means improvement, continuous improvement, involving everyone in the organization,

from top management to managers, supervisors, workers, etc. According to Imai “our way of life -
be it our working life, social life, or home life- deserves to be constantly improved.” Kaizen is a
Japanese philosophy for process improvement. ‘kai’ and ‘zen’ means ‘to break apart and
investigate’ and to ‘improve up on the existing situation’. The essence of kaizen is that the team
effort encourages innovation and change and by involving all layers of employees, the imaginary
organizational walls disappear to make room for productive improvements. Everyone in the
organization is a contributor. Kaizen could be an attitude for continuous improvement for every
individual.
According to James Womack “ the machine that changed the world(1991), with kaizen, the job of
improvement is never finished and the statuesque is always challenged. Toyota used Kaizen to rise
to world automotive leadership. Kaizen generates process oriented thinking, is people oriented and
is directed at people’s efforts.
Major differences between a conventional and kaizen approach:
Conventional Approach Process Oriented Approach ( Kaizen )
Employees are the problem Process is the problem
Doing my job Helping to get things done
Understanding my job Knowing how my job fits in the process
Measuring individuals Measuring performance
Change the person Change the process
Correct errors Reduce variation
Who made the error? What allowed the error to occur?

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Improvements through Kaizen: a process focus
The kaizen philosophy is: ‘not one single day should go in the firm without some type of
improvement being made in some process in the company’. Kaizen is everyone’s job; requires
sophisticated problem-solving expertise as well as professional and engineering knowledge and
involves people from different departments working together in teams to solve problems.
Steps in Kaizen
 Establish a plan to change whatever needs to be improved
 Carry out changes on a small scale
 Observe the results
 Evaluate the results and the process and determine what has been learned.
The three pillars of Kaizen, according to Imai are: 1) Housekeeping (managing the work
place) 2) Waste elimination 3) Standardization.
THROUGHPUT COSTING
Throughput costing or super variable costing is a method of costing a product, where only the unit
level direct costs are assigned to the product. It considers only direct materials as true variable cost
and other costs as period costs. Only direct material costs are charged to product. It is relevant only
for internal use of the management.
There is slight difference in the valuation of inventories under absorption costing, variable costing
and throughput costing. Consider the following example:
Production: 10,000 units; Sales: 9,000 units @ Rs 350 per unit. Variable manufacturing cost Rs 150
per unit; consisting of materials Rs 90, direct labour Rs 40 and variable manufacturing overhead
Rs20. Fixed overheads are: manufacturing: Rs 8,00,000 and administration: Rs 4,00,000. The cost
of inventory under each method of costing would be:
Cost statement for a production of 10,000 units
Cost elements Total Cost Cost Per unit
Direct Materials 9,00,000 90
Direct Labour 4,00,000 40
Variable manufacturing Overhead 2,00,000 20
Total variable cost or marginal cost 15,00,000 150
Fixed Overheads: Manufacturing cost 8,00,000 80
Administration overheads 4,00,000 40
Cost of Production 27,00,000 270
Under Absorption costing: 1000 units @ Rs 270 per unit = 2,70,000
Variable costing: 1000 units @ Rs 150 per unit = 1,50,000
Throughput costing: 1000 units @ Rs 90 per unit= 90,000
It can be observed that the closing inventory is valued differently under these three methods.
It is valued at cost of production under absorption costing, at marginal cost under variable costing
and at direct material cost under throughput costing.

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BACKFLUSH COSTING
Backflush costing is a product costing approach used in JIT (Just In Time) environment, in which
costing is delayed until goods are finished. Standard costs are then flushed backwards through the
system to assign costs to products. The detailed tracking of cost is thus eliminated. Backflush
costing transaction has two steps:
1. Product part which serves to increase the quantity on hand of the produced part, and
2. Which relieves the inventory of all component parts.
This represents huge savings over traditional method of :
a) Issuing component parts, one at a time
b) Receiving the finished parts in to inventory, and
c) Returning any unused components, one at a time, back to inventory.
Backflush costing simplifies costing since it ignores both labour variances and work-in- progress.
This method is employed where the overall business cycle time is relatively short and inventory
levels are low.
ACTIVITY BASED COSTING
Since liberalization policy in early nineties, Indian industry is facing intense competition
from multinationals of developed countries. These companies are offering products at low
prices when compared to Indian companies. In this context, every firm is trying to stay in
the market by offering goods and services at competitive prices. Since prices are dictated by
competitors, a firm can use price control measures for surviving in the market. Activity
Based Costing (ABC) is a method used to control costs.
Meaning: ABC is a new term used for finding out cost. It uses activities as the basis for
calculating the costs of goods and services. ABC attempts to absorb overheads into product
cost on a more realistic basis. In traditional costing direct costs are allocated to various
products on the basis of use and indirect costs are allocated through cost centres. The direct
costs will be in proportion to the volume of production and indirect costs ( like production,
administration, selling and distribution overheads etc.) are apportioned on some suitable
basis, say, based on machine hours, labour hours, direct costs, input, output, etc. ABC is
emphasizing more on indirect costs in the manufacturing operations as these costs far out-
weigh the direct processing costs in many a situations, where advanced manufacturing
technology is used. The idea behind ABC is that costs are grouped according to what drives
them to be incurred. The cost drivers are then used as an absorption base.
Kaplan and Cooper of Harvard Business school, have developed this new approach. The
ABC approach relates overhead costs to the forces behind them, known as cost drivers. A
cost driver can be defined as an activity which generates cost.
Steps in implementing ABC
Following steps are involved in implementing ABC:
1. Identifying of functional areas such as manufacturing, assembling etc., as well as
support activities like purchasing, packing and dispatching.
2. Identify the relative activities involved in each area.
3. Collect accurate data on labour, materials and overhead costs.

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4. Allocate the common expenditure to various activities in functional and support areas.
5. Identify the most suitable cost driver in each activity.
6. Absorb overhead expenses on the basis of rate/ cost driver.
ABC AND CORPORATE STRATEGY
In the present competitive environment, no organization can stay in the market without
using ABC, The accurate cost information is essential for taking important decisions. The
main benefits of ABC arise from quality managerial decisions based on accurate cost
information provided by ABC. This is the most promising aspect of ABC which is now
being called Activity Based Management (ABM). ABM views the activities in a dynamic
sense rather than just a step for cost allocation to the end products.
BENEFITS OF ABC
1. Determination of cost: ABC system allows allocation of expenses on the basis of activity
and cost drivers which facilitates accurate pricing of products. ABC also considers the
increasing non-manufacturing costs like marketing and servicing costs.
2. Helps improving performance: A better reporting of costs of activities and their performance
measures help in taking appropriate decisions and improving efficiency.
3. Helpful in strategic decision: ABC approach is helpful in taking important strategic
decisions, like cost cutting, downsizing, lay off, close downs etc. As ABC is focusing on the
activities, it is easy to spot out the non-value adding activity and discard it.
4. Make or buy decisions: Cost is a major factor in taking make or buy decisions. The analyses
of both direct and indirect costs are undertaken in ABC to arrive at such a decision.
5. Rationalizing product mix: ABC helps to take decision on discontinuing a product and
promoting another, looking in to its profitability.
6. Formulating budgets: ABC helps in establishing a relationship between activities and
indirect costs to facilitate formulation of proper budgets.
7. Helpful in target costing: Target costing is a tool used by Japanese manufacturers of
automobiles and electronic goods. It is believed that a product has a specific price based on
its usage and expectations of customers. The price of the product is fixed, sometimes, even
before it is designed. In that case, its cost is determined by deducting profit from its
predetermined price. This cost, known as target cost, is to be achieved through engineering,
design, cutting out of non-value adding activities and increasing efficiency. ABC helps in
identifying and eliminating the non-value adding activities.
***************

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UNIT - FOUR
CAPITAL INVESTMENT PROCESS
INTRODUCTION:
This unit gives a brief account of the important capital budgeting techniques or investment
appraisal methods. Capital budgeting is the process of making investment decisions in capital
expenditures. A capital expenditure may be defined as expenditure, the benefits of which are
expected to be received over a long period of time in future. Some of the examples of capital
expenditure are:
1) Cost of acquisition of permanent assets such as land and building, plant and machinery,
furniture and fixtures, goodwill, etc.
2) Cost of addition, expansion, improvement or alteration in the fixed assets.
3) Cost of replacement of permanent assets.
4) Research and development project cost, etc.
Capital expenditure decisions are also called as long-term investment decisions. It involves
planning and control of capital expenditure. It is the process of deciding whether or not to commit
resources to a particular long term project whose benefits are to be realized over a period of time,
longer than one year.
Definitions of Capital Budgeting
Charels T Horngreen: “Capital budgeting is long term planning for making and financing proposed
capital outlays.”
G.C. Philippatos: “Capital budgeting is concerned with the allocation of the firm’s scarce financial
resources among the available market opportunities”.
Richard and Greenlaw: “Capital budgeting is acquiring inputs with long-run return”.
Lynch: “Capital budgeting consists in planning and development of available capital for the
purpose of maximizing the long-term profitability of the concern.”
CAPITAL INVESTMENT PROCESS
The following procedure may be adopted in the capital investment process:
1) Identification of Investment Proposals: The capital investment process begins with the
identification of investment proposals. The idea or the proposal may originate from the top
management or middle level or bottom level management or even from floor level workers.
The proposal is to be submitted to the Capital Expenditure Planning Committee for
approval.
2) Screening the Proposals: The Expenditure Planning Committee screens the proposals from
different angles to ensure that these are in accordance with the corporate strategies.

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3) Evaluation of the Proposals: The next step in the capital investment process is to evaluate
the profitability of various proposals by using traditional as well as modern techniques.
(These techniques have been discussed later in this chapter).
4) Fixing Priorities: After evaluating various proposals, the profitable ones may be selected
and others rejected. It is essential to rank such proposals in order to accommodate with the
available resources, considering the risk and return of each.
5) Final Approval and Preparation of Capital Expenditure Budget: The capital expenditure
budget lays down the amount of estimated expenditure to be incurred on fixed assets during
the budget period.
6) Implementing the Proposal: The project has to be implemented in a time bound manner,
avoiding unnecessary delays and cost over runs.
7) Performance Review: Evaluation of performance is made through post completion audit by

comparing the actual expenditure on the project with the budgeted one. The actual revenue
from the project is also compared with the anticipated income from it. Unfavourable
variances, if any, should be looked into and the causes of the same be identified and
corrective measures to be taken.
INVESTMENT APPRAISAL METHODS
There are several methods for evaluating and ranking the capital investment proposals. There may
be a number of profitable projects available, but due to financial and other constraints, it may not be
possible to invest in all of them. The primary concern should be to allocate the available resources
to various proposals, considering the risk and return of each. The basic approach is to compare the
investment in the project with the benefits derived there from.
Some of the important methods of evaluating capital investment proposals are given below:
A) Traditional methods: These comprise of:
1) Pay-back Period Method or Pay out or Pay off Method.
2) Improvement of Pay-back Period Method.
3) Accounting Rate of Return or Average Rate of Return Method
B) Time Adjusted Method or Discounted Cash Flow Methods: These comprise of:
1) Net Present Value Method
2) Internal Rate of Return Method
3) Profitability Index Method
4) Net Terminal Value Method

A. TRADITIONAL METHODS
1) PAY-BACK PERIOD METHOD: Pay-back period is the period in which the total investment in the
project is recouped. It measures the period required to recover the original investment in a

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project through the earnings from it. Under this method, various investments are ranked on
the basis of their pay-back period and the project with the least pay-back period is selected.
The pay-back period can be calculated as follows:
a) Calculate annual net earnings(profit) before depreciation and after taxes; it is known as
annual cash inflows.
b) Divide the cost of the project by the annual cash inflow, where the project generates
constant annual cash inflow.
Thus, Pay- back period = Original cost of the project / Annual cash inflows
c) Where the annual cash inflows are unequal, the pay-back period can be ascertained by
adding up the cash inflows until the total is equal to the original cost of the project.
Eg. 1) A project costs Rs. 5,00,000 and yields an annual cash inflow of Rs.1,00,000 for 7 years.
Calculate its pay-back period.
Soln.: Pay-back period = Initial outlay of the project / Annual cash inflow
= 5,00,000 / 1,00,000 = 5 years.
Eg. 2) Initial investment Rs. 2,00,000 ; cash inflows over five years: 40,000, 80,000,60,000, and
40,000 in the first, second, third, and fourth year respectively. Calculate pay-back period.
Soln.:
Year Annual cash Cumulative

inflow cash inflows
1 40,000 40,000
2 80,000 1,20,000
3 60,000 1,80,000
4 40,000 2,20,000
The above table shows that in three years Rs 1,80,000 has been recovered and Rs 20,000 is yet to be
recovered towards the cost of the project. In the fourth year, the cash inflow is Rs. 40,000, which
means that the pay-back period is between third and fourth year. Assuming that the cash inflows
occur evenly throughout the year, the time required to recover Rs.20,000 will be:
= (20,000/40,000) 12 = 6 months.
Hence pay-back period = 3years and 6 months.
Eg. 3) A project costs Rs.5,00,000 and yields annually a profit of Rs.80,000 after depreciation@
12%p.a. but before tax of 50%. Calculate pay-back period of the project.

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Soln. Annual cash inflow is calculated as follows:
Particulars Amount (Rs)
Profit before tax 80,000
Less tax @ 50% 40,000
Profit after tax 40,000
Add back depreciation@12% on 5,00,000 60,000
Profit before depreciation but after tax 1,00,000
Or Annual Cash inflow
Pay-back period = Initial outlay of the project / Annual cash inflow
= 5,00,000 / 1,00,000 = 5 years.
Try yourself:
1. A project costs Rs.6,00,000 and yields annually a profit of Rs.90,000 after depreciation at
12.5% p.a. but before tax at 50%. Calculate pay-back period.
(Ans. 5yrs)
2. Calculate the pay-back periods of the following projects, each with a cash outlay of
Rs.1,00,000. Suggest which projects are acceptable if the standard pay-back period is 5
years
Cash inflows
Years Project A Project B Project C

1 30,000 30,000 10,000
2 30,000 40,000 20,000
3 30,000 20,000 30,000
4 30,000 10,000 40,000
5 30,000 5,000 ------
(Ans. Project A = 3.33yrs ; B = 4yrs ; C = 4yrs. All are acceptable as the pay-back periods
are below the standard fixed, ie. 5yrs)
Problem: X Ltd. is producing articles mostly by manual labour and is considering replacing
it by a machine. There are two alternative models available: M and N. Prepare a statement
of profitability showing the pay-back period of each machine from the following
information:

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Particulars Machine M Machine N
Estimated life 4 yrs 5 yrs
Cost (Rs) 90,000 1,80,000
Estimated savings in scrap 5,000 8,000
Estimated savings in direct wages 60,000 `80,000
Additional cost of maintenance 8,000 `10,000
Additional cost of supervision 12,000 18,000
Soln. Profitability Statement
Particulars Machine M Machine N

Estimated savings per annum:
Scrap 5,000 8,000
Direct wages 60,000 80,000
Total savings (a) 65,000 88,000
Additional cost per annum:
Maintenance 8,000 10,000
Supervision 12,000 18,000
Total additional cost (b) 20,000 28,000
Net savings or annual cash inflows 45,000 60,000
(a—b)
Pay-back period= 90,000/45,000 1,80,000/60,000
Initial Outlay/Annual cash inflow = 2 yrs = 3 yrs
Machine M is recommended as its pay-back period is less than that of Machine N.
Advantages of Pay-back Period Method
1. It is simple to understand and easy to calculate.

2. It takes less time and labour and hence saves cost.
3. It reduces the loss through obsolescence as it suggests the project with least pay-back
period.
4. It is particularly suited to firms whose liquidity position is not so good due to its short term
approach.

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Disadvantages of Pay-back Period Method
1. It does not take into account the cash inflows after the pay-back period, which is
inappropriate particularly when such amount is considerably high.
2. It ignores the time value of money as the cash inflows of different years are treated equally.
It is true that a rupee today is more valuable than a rupee received after a year.
3. It does not consider cost of capital which is an important factor in making sound investment
decision.
4. It does not take into account the profitability of the project throughout its life.
5. It may be difficult to determine the minimum acceptable pay-back period, which is usually a
subjective decision.
In spite of the above mentioned limitations, the pay-back period method can be used in
evaluating the viability of short and medium term capital investment proposals.
IMPROVEMENTS IN PAY-BACK PERIOD METHOD
a) Post Pay-back Profitability Method: A serious allegation against Pay-back period

method was that it does not consider cash inflows earned after pay-back period. Hence an
improvement over the traditional method can be made by taking into account the cash
flows beyond the pay-back period or post pay-back period profitability.
Post pay-back period profitability Index = (Post pay-back profit/ Investment) 100
Eg. For each of the following projects compute: a) Pay-back period c) Post Pay-back Profitability
b) Post pay-back profitability Index
1) Initial outlay Rs.50,000
Annual cash inflow(after tax but before depreciation) Rs.10,000
Estimated life 8 years
II) Initial outlay Rs.50,000
Annual cash inflow (after tax but before depreciation):
First three years Rs.15000

Next five years Rs.5000
Estimated life 8 years
Salvage Rs.8000
Soln.
I i) Pay-back period = Investment / Annual cash inflow = 50,000/10,000 = 5years

ii) Post Pay-back Profitability = Annual cash inflow (Estimated life-- Pay-back period)
= 10,000(8—5) = 30,000
iii) Post pay-back profitability Index = (30,000/50,000)100 = 60%

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II i) Cash inflows are not equal during the life of the asset.
Pay-back period = 3 yrs @ 15,000 + 4th year 5000 = 50,000 cost of investment.
Hence Pay-back period = 4 years
ii) Post Pay-back Profitability = Annual cash inflow X Remaining life after Pay-back period
= 5000 X 4 = 20000
iii). Post pay-back profitability Index = (20,000/50,000)100 = 40%
b). Pay-back Reciprocal Method: This method is employed to estimate the internal rate of
return generated by a project. It is calculated by reversing the pay-back formula:
Pay-back Reciprocal = Annual cash inflow/Total investment
The result can be presented in a percentage by multiplying it by 100.
c) Discounted Pay-back Method: To overcome the serious limitation that pay-back method
ignores time value of money, this improved method can be applied. Under this method the
present values of all cash inflows and outflows are computed at an appropriate discount
rate. The period at which the cumulative present value of cash inflows equals the present
value of cash outflows is known as discounted pay-back period. The project with the
shortest discounted pay-back period is accepted.
Eg. Calculate discounted pay-back period from the following data:
Cost of project Rs.6,00,000
Life of project 5 years
Annual cash inflow Rs.2,00,000 Cut off rate 10%
Soln. Calculation of Present Values of cash inflows
Years Inflows (Rs) PVF @ 10% Present Value Cumulative

discount factor (Rs) Present value
1 2,00,000 0.909 1,81,800 1,81,800
2 2,00,000 0.826 1,65,200 3,47,000
3 2,00,000 0.751 1,50,200 4,97,200
4 2,00,000 0.683 1,36,600 6,33,800
5 2,00,000 0.621 1,24,200 7,58,000
Cumulative present value of cash inflows at the end of third year is Rs.4,97,200 and it is
6,33,800 at the end of fourth year. Hence, discounted pay-back period falls in between 3 and 4
years. The exact discounted pay-back period will be = 3yrs + (1,02,800/1,36,600) = 3.75 yrs.
II. Rate of Return Method
This method takes into account the net profit after depreciation and tax over the life of the asset
rather than cash inflows to evaluate the project. Various projects are ranked in the order of their
rate of earnings or rate of return. The project with higher rate of return is selected as compared
to the one with lower rate of return. The return on investment can be computed in any of the
following ways:

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a). Average Rate of Return Method: Under this method average profit after tax and
depreciation is calculated and then it is divided by the total investment in the project.
Average Rate of Return = (Average Annual Profit/Net Investment in the Project) x 100
Eg. A project requires an investment of Rs.5,00,000 and has a scrap value of Rs.20,000 after
five years. It is expected to earn profits after depreciation and taxes during five years:
Rs.40,000, 60,000, 70,000, 50,000 and 20,000. Calculate the average rate of return on
investment.
Soln. Total profit = 40,000+60,000+70,000+50,000+20,000 = 2,40,000
Average profit = 2,40,000/5 = 48,000
Net investment in the project = 5,00,00 - 20,000 = 4,80,000
Average Rate Return = (Average annual profit/ Net investment) x 100
= (48,000/4,80,000) x 100 = 10%
b) Average Return on Average Investment Method;
Under this method, average profit is divided by average investment to ascertain ARR.
ARR = (Average Annual Profit after depreciation and taxes/ Average Investment) x 100
Average annual profit = Total profit over the life of the project/ Life of the project in years.
Average Investment = Net Investment/ 2
Eg. Calculate average rate of return for projects A and B from the following:
Particulars Project A Project B
Investment (Rs.) 2,00,000 3,00,000

Expected life (no salvage value) 4 years 5 years
Projected Net income: (after interest, depreciation
and taxes)
Year 1 20,000 30,000
2 15,000 30,000
3 15,000 20,000
4 10,000 10,000
5 ------ 10,000
If the required rate of return is 12% which project should be accepted?
Soln.
Particulars Project A (Rs.) Project B (Rs.)

Total Profit 60,000 1,00,000
Average Profit = Total profit/Life of the project 15,000 20,000
Net Investment in the Project
Average Rate of Return on Net investment: 2,00,000 3,00,000
= (Average profit/Net investment) x 100 (15,000/2,00,000) (20,000/3,00,000)

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If ARR is calculated on Average Investment: 0.075 or 7.5% 0.0666 or 6.67%
= (Average profit/Average investment) x 100 (15,000/1,00,000) (20,000/1,50,000)
Average Investment= Net Investment/2 0.15 or 15% 0.1333 or 13.33%
Both projects have ARR higher than the required rate of return, 12%. Project A is
recommended as its ARR is higher than that of Project B.
Problem: XLtd is considering the purchase of a machine. Two machines are available- E and F. The
cost of each machine is Rs 60,000 with an expected life of 5 years. Net profits before tax and after
depreciation during the expected life of the machines are given below:
Year Machine E Machine F
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000
Following the method of ARR on Average investment ascertain which of the alternatives will
be more profitable, assuming tax rate as 50%.
( Hint: Compute profit after tax @ 50%, then average profit p.a. divided by average investment, will be the ARR.
Machine E = 28.33% and Machine F = 30%, hence, Machine F is more profitable)
Advantages of ARR method:
1) It is simple to understand and easy to operate.

2) It gives a better of view of profitability as it uses the entire earnings of a project throughout
its life.
3) It is based on accounting concept of profits and can be readily calculated from financial
data.
Disadvantages of Average Rate of Return Method:
1) This method also ignores time value of money.
2) It does not deal with ‘cash flows’ which are more important than the accounting profits.
3) This method cannot be applied where investment is made in parts.

B. DISCOUNTED CASH FLOW METHODS OR TIME ADJUSTED TECHNIQUES
Discounted cash flow (DCF) methods are an improvement over the traditional techniques-
pay-back period and ARR methods. The time adjusted or discounted cash flow techniques
take into account the profitability throughout the life of the asset and also the time value of
money. The expected future cash inflows are discounted to the present to compare with the

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current cash outflow and check the financial viability of the project. These methods are also
called modern methods of capital budgeting.
1) NET PRESENT VALUE METHOD
Under this method the present values of cash inflows and outflows are calculated at the cut
off rate or cost of capital. Profit after tax but before depreciation represents cash inflows.
Cash outflows represent the investment and commitments of cash in the project at various
points of time. The Net Present Value (NPV) is the difference between the total present
value of future cash inflows and the total present value of cash outflows. The proposal will
be accepted if the NPV is positive, ie., the present value of total cash inflows are higher than
the present value of total cash outflows. It means that its yield is higher than the cost of
capital. The projects having negative NPV will be rejected as their yield will be less than the
cost of capital. When there are alternative projects, that with the highest positive NPV is to
be selected.
The mathematical formula for calculating present value factor is: PV= 1/(1+r)n
Where, PV = present value; r = rate of interest or discount rate; n = number of years.
The PV of cash flows for a number of years can be found as follows:
PV = A1/(1+r)1 + A2/(1+r)2 + A3/(1+r)3 +…………………+ An/(1+r)n
Where, A1, A2, A3……………..An = Future net cash flows; r = rate of interest or discount rate
1, 2, 3……………..n = number of years.
Alternatively, the present value of Re.1 at varying discount rates, due in any number of
years can be found with the help of ready-made present value tables.
Now, let us work out a problem to familiarize the computation of NPV.
Eg. 1. Calculate the NPV of the two projects and suggest which of the two projects should be
accepted assuming a discount rate of 10%.
Particulars Project X Project Y

(Rs) (Rs)
Initial Investment 2,00,000 3,00,000
Estimated life 5 years 5 years
Scrap value (Rs) 10,000 20,000
The cash inflows (profit before depreciation &
taxes) are:
Year 1 50,000 2,00,000
2 1,00,000 1,00,000
3 1,00,000 50,000
4
30,000 30,000
5
20,000 20,000

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Soln.1
The Net Present Value (NPV) of each project is calculated below by multiplying each cash flow by
the appropriate discount factor, assuming that the cost of capital is 10%.
Calculation of Net Present Value of Project X and Project Y
Project X Cash flows PVFactor Present Project Y Present

Year @10% Value of Cash value of
cash flows cash flows
(Using PV flows
tables) (PVCF) (PVCF)
1 50,000 0.909 45,450 2,00,000 1,81,800
2 1,00,000 0.826 82,600 1,00,000 82,600
3 1,00,000 0.751 75,100 50,000 37,550
4 30,000 0.683 20,490 30,000 20,490
5 20,000 0.621 12,420 20,000 12,420
5 (scrap) 10,000 0.621 6,210 20,000 12,420
Total PVCF 2,42,270 3,47,280
Less Investment 2,00,000 3,00,000
NPV 42,270 47,280
It is clear from the results that the net present value of Project Y is higher than the NPV of Project
X and hence, Project Y is recommended for acceptance.
Eg. 2. No project is acceptable unless the yield is 10%. Cash inflows of a certain project along with
cash outflows are as below:
Years cash outflows Cash inflows
0 1,50,000 ---------
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000
The salvage value at the end of the fifth year is Rs.40,000. Calculate NPV. PV factor at 10% are
0.909, 0.826, 0.751, 0.683, 0.621 respectively for one to five years.
Soln. 2:
In this problem, there are more than one cash outflow, unlike the conventional system of initial cash
outflow and a series of future cash inflows. In such cases, all cash out flows are also to be
discounted to the present to find the present value of total cash out flows. Then this will be
deducted from the total cash inflows to ascertain the net present value of the project. Now, see the
solution:

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Calculation of Present Value of Cash Outflows
Year Outflow (Rs.) PVFactor@10% PresentValue (Rs.)

discount factor
0 1,50,000 1.000 1,50,000
1 30,000 0.909 27,270
1,77,270
Calculation of Present Value of Cash Inflows and NPV
Year Inflows (Rs) PVFactor Present Value

@10% discount (Rs)
factor
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 60,000 0.751 45,060
4 80,000 0.683 54,640
5 30,000 0.621 18,630
5 Salvage 40,000 0.621 24,840
Total 1,86,130
Less PV of outflow 1,77,270
NPV 8,860
The project can be accepted as it has a positive NPV, which shows that its yield is more than 10%.
Problem.1
A project costing Rs. 10 lakhs has a life of 10 years at the end of which its scrap value is likely to
be Rs. 1 lakh. The firm’s cut off rate is 12%. The project is expected to yield an annual profit after
tax of Rs.1 lakh, depreciation being charged on straight line basis. At 12% per annum, the present
value of one rupee received annually for 10 years is Rs. 5.650 and the value of one rupee received
at end of 10 years is 0.322.
Ascertain the net value of the project and state whether we should go for the project.
(Hint: Annual cash inflow = Profit after tax + Depreciation;
Depreciation= 10 lakh---scrap 1 lakh/life of the asset = 9,00,000/10 = 90,000
Annual cash flow = 1 lakh+ 90,000= 1,90,000; PV of annual inflow and salvage=
190000 x 5.65= 10,73,500+ 32,200= 11,05,700; NPV=11,05,700—10lakh = 1,05,700. We should

go for the project.)
Problem 2.
A company is considering a proposal for investment of Rs.5 lakh on product development which is
expected to generate net cash inflows for 6 years as under:

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Years 1 2 3 4 5 6
Cash Inflows Nil 100 160 240 300 600
(Rs.’000)
PVFactor@15% 0.87 0.76 0.66 0.57 0.50 0.43
The company’s cost of capital is 15%. Advise the company on the desirability or otherwise of
accepting the proposal.
( Ans. NPV = Rs. 2,26,400; It is acceptable.)
Advantages of NPV method:
a) It considers the time value of money and is suitable to be applied in a situation with uniform
cash outflows and uneven cash inflows.
b) It takes into account the earnings over the entire life of the project.
c) It considers the objective of maximum profitability.
Disadvantages of NPV method:
a) It is difficult to understand and operate, when compared to traditional methods.

b) It may not give good results while comparing projects with unequal lives and unequal
investments.
c) It is no easy to determine an appropriate discount rate.
2 INTERNAL RATE OF RETURN OR TIME ADJUSTED RATE OF RETURN METHOD
Internal Rate of Return (IRR) is a modern technique of investment appraisal which considers both
time value of money and total profitability throughout the life of the project. IRR is the rate at
which the expected cash inflows are discounted to equate with the investment amount. At IRR, the
total discounted present value of cash inflows will be exactly equal to the total discounted cash out
flows, so that NPV at this rate will be zero.
The IRR may be found by ‘trial and error’ method. First, compute the present value of cash flows
from an investment, using an arbitrary interest rate, say, the cost of capital. Then compare the
present value so obtained with the amount of investment. If the present value is higher than the cost
figure, try a higher interest rate and go through the procedure again. Continue the process until the
present value of cash inflows from the project is approximately equal to its cost. The interest rate
that brings about this equality is defined as the IRR.
Alternatively, IRR can be calculated with the help of the interpolation formula. Somewhere
between a positive NPV and a negative NPV, there lies the IRR, which shows the NPV equals
zero.
Computation of IRR
a) When the annual net cash flows are equal or ‘even’ over the life of the asset: Find out the
present value factor by dividing initial outlay (cost of the investment) by annual cash flow,
ie,
PV Factor = Initial Outlay/Annual cash flow
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Then consult present value annuity tables with the number of years equal to the life of the
asset and find out the rate at which the calculated PV factor is equal to the present value
given in the table.
Eg. Initial outlay Rs. 80,000; annual cash inflow Rs.20,000; life of the asset 5 years.
Calculate IRR
Soln. Present Value Factor = Initial Outlay/Annual cash flow
= 80,000/20,000 = 4
Consulting PV Annuity tables for 5 years, at PV Factor of 4, IRR = 8% approx.
b) When the annual cash flows are unequal over the life of the asset:
The IRR is calculated by trial and error method. (This has been already discussed in the
beginning of this technique). Let us try a problem now:
Eg. 1. Initial investment Rs. 6,00,000
Life of the asset 4 years
Estimated net annual cash flows:
Year 1 2 3 4
Cash flows 1,50,000 2,00,000 3,00,000 2,00,000

Calculate the Internal Rate of Return.
Soln. 1 Cash flow at various discount rates of 12%, 14% and 15%
Year Annual PV Factor PVCF PV Factor PVCF PV Factor PVCF
cash flow @ 12% @ 14% @ 15%
1 1,50,000 0.892 1,33,800 0.877 1,31,550 0.869 1,30,350
2 2,00,000 0.797 1,59,400 0.769 1,53,800 0.756 1,51,200
3 3,00,000 0.711 2,13,300 0.674 2,02,200 0.657 1,97,100
4 2,00,000 0.635 1,27,000 0.592 1,18,400 0.571 1,14,200
Total 6,33,500 6,05,950 5,92,850
Less 6,00,000 6,00,000 6,00,000
Cost
33,500 5,950 (--7,150)
NPV
As the cash inflows are uneven during the life of the asset, trial and error method is followed to
find IRR. First an arbitrary rate of 12% is tried to calculate the present value of cash inflows. The
total present value comes to be Rs. 6,33,500 at 12%. To equate the present value to the investment
amount of Rs. 6,00,000, another higher rate is to be tried. Hence, 14% discount factor is tried which
still shows a higher present value of Rs. 6,05,950. This attempt is to be continued till we get the
present value more or less equal to the amount of investment. When the next higher rate is tried, ie.
15%, the present value came to Rs. 5,92,850, which is less than the capital outlay of Rs.6,00,000. It
means that the IRR lies in between 14% and 15% discount rates. The exact IRR can be worked out
by applying the formula for interpolation:

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IRR = Low rate + [NPV @ low rate ÷ (PVCF at low rate—PVCF at high rate)] x difference in rate
= 14% + [5950 ÷ (6,05,950—5,92,850)] x (15%---14%)
= 14% + (595 ÷ 1310) x 1% = 14.45%
Eg. 2. A ltd. is currently planning to invest in a project with the following returns over the life of
the project:
Years 1 2 3 4 5
Gross yield (Rs.) 80,000 80,000 90,000 90,000 80,000
PV factor @10% 0.91 0.83 0.75 0.68 0.62
PV factor @14% 0.88 0.77 0.67 0.59 0.52
Cost of machinery to be installed is Rs.2,00,000, depreciation to be charged at 20% p.a. on straight

line basis. Income tax rate is 50% and there is no salvage value. If the average cost of raising capital
is 11%, would you recommend the project under IRR method?
Soln. 2. In this problem, the gross yield is given. It has to be converted into cash flow after tax as
follows:
Year Gross Yield Depreciation EBT Tax@ 50% EAT CFAT (Rs.)
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (EAT+Depn).
1 80,000 40,000 40,000 20,000 20,000 60,000
2 80,000 40,000 40,000 20,000 20,000 60,000
3 90,000 40,000 50,000 25,000 25,000 65,000
4 90,000 40,000 50,000 25,000 25,000 65,000
5 80,000 40,000 40,000 20,000 20,000 60,000
Note: EBT= Earnings before tax; EAT= Earnings after tax; CFAT= Cash flow after tax
Now the cash flow after tax is ascertained. Let us calculate the IRR next.
Calculation of Present Value of Cash Inflows at 10% and 14%
Year Cash flows PV Factor at PVCF PV Factor at PVCF

10% 14%
1 60,000 0.91 54,600 0.88 52,800
2 60,000 0.83 49,800 0.77 46,200
3 65,000 0.75 48,750 0.67 43,550
4 65,000 0.68 44,200 0.59 38,350
5 60,000 0.62 37,200 0.52 31,200
2,34,550 2,12,100
Note : PVCF = Present value of cash flows.

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Both the present values of cash flows are higher than the amount of investment of Rs. 2 lakh. It
means that IRR of the project is above 14%. The project can be accepted as its IRR is more than the
cost of raising capital, 11%.
Advantages of IRR method:
 It takes into account the time value of money and profitability of the project throughout its
economic life.
 It is suitable to situations of even as well as uneven cash flows in different periods of time.
 Determination of cost of capital is not necessary for the use of this method.
 It provides for uniform ranking of various proposals due to the percentage rate of return.
 It is considered to be a more reliable method of investment appraisal.
Disadvantages of IRR method:
 It is difficult to understand the evaluation of investment proposals.

 The assumption that the earnings are reinvested at IRR for the remaining life of the project,
may not be a justified assumption always. NPV method seems to be better as it assumes that
the earnings are reinvested at the rate of cost of capital of the firm.
 The results of NPV method and IRR method may differ when the projects differ in their
size, life and timings of cash flows.
3. PROFITABILITY INDEX METHOD OR BENEFIT COST RATIO
Profitability Index (PI) method, like NPV and IRR methods, is also a time adjusted method
of investment appraisal. It shows the relationship between present value of cash inflows and the
present value of cash outflows.
Profitability Index (PI) = Present Value of Cash Inflows ÷ Present Value of Cash Outflows
The proposal will be accepted if the PI is more than one and will be rejected incase the PI is less
than one. When there are more projects, the one with the highest PI is to be selected.
Eg. The total present value of cash inflows from a project Rs. 2,34,550; Investment outlay Rs. 2
lakh. PI will be = PV of Cash Inflows ÷ PV of cash outflows
= 2,34,550 ÷ 2,00,000 = 1.17275
The project can be accepted as its PI is more than one.
Merits and Demerits of Profitability Index method
PI method is a slight modification of NPV method. NPV is the difference between present value of
cash inflows and present value of cash outflows, whereas, PI is the relation between present value
of cash inflows and present value of cash outflows. Under NPV method, it is not easy to rank
projects whose costs differ significantly. PI method will be more suitable in such cases. The other
merits and demerits of this method are the same as those of NPV method.
Problem. 1. Alpha company is considering the purchase of a new machine. Two alternatives , A and
B, are available, costing Rs.4,00,000 each. Earnings after taxation are expected to be as follows:

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Years 1 2 3 4 5
Cash inflows:
Machine-A 40,000 1,20,000 1,60,000 2,40,000 1,60,000
Machine-B 1,20,000 1,60,000 2,00,000 1,20,000 80,000
PVF @ 10% 0.91 0.83 0.75 0.68 0.62
The company has a target of return on capital of 10%. Compare the profitability of the machines
and state which alternative you consider financially preferable.
Soln.1. The profitability of machines can be compared on the basis of NPV and PI of the machines:
Year PV Machine A PVCF Machine B PVCF

Factor@10% Cash Inflow Cash inflow
1 0.91 40,000 36,400 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,000
3 0.75 1,60.000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,200 1,20,000 81,600
5 0.62 1,60,000 99,200 80,000 49,600
Total 5,18,400 5,23,200
Less Cost 4,00,000 4,00,000
NPV 1,18,400 1,23,200
PI 1.296 1.308
Profitability Index = PVCF ÷ Investment
Machine – A = 5,18,400 ÷ 4,00,000 = 1.296; B = 5,23,200 ÷ 4,00,000 = 1.308
Machine B is recommended as its NPV and PI are higher than that of machine A.
You may calculate the PI of all the previous problems dealing with NPV and IRR, so as to make
the concept clearer.
Problem without cash inflows, but only cash outflows: In such cases we have to compare the
profitability of the projects by looking into the annual equivalent present value of cash outflows
Annual equivalent present value of cash outflows = Total PV of Cash Outflows ÷ Annuity factor
Eg. Company X is forced to choose between two machines A and B with identical capacity.
Machine A costs Rs.3lakhs and will last for 3 years. It costs Rs.80,000 per year to run. Machine B
is an economy model costing only Rs. 2,00,000 but will last only for two years, and costs Rs.
1,20,000 per year to run. The costs are forecasted in rupees of constant purchasing power. Ignore
tax. Opportunity cost of capital is 10%. Which machine company X should buy?
The present value of annuity for 2 years and 3 years at 10% is 1.735 and 2.486 respectively.
Soln. Evaluation of Machines A and B
Machine A (Rs.) Machine B (Rs.)
Present Value of Cash Outflows:
Cost of Machine 3,00,000 2,00,000
PV of running cost:
A : for 3 years- 80,000 x 2.486 1,98,880 ----
B : for 2 years- 1,20,000 x 1.735 ------ 2,08,200
Total PV of cash outflows 4,98,880 4,08,200
Annual equivalent PV of cash outflow 4,98,880÷ 2.486 4,08,200÷ 1.735
2,00,676 2,35,274

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The company should buy Machine A as its annual equivalent present value of cash outflow is lower
than that of B. Hence Machine A is more profitable.
The inter relationship between Cost of Capital (COC), Net Present Value (NPV), Internal Rate of
Return (IRR), and Profitability Index (PI) can be studied from the following table:
If, IRR is more than COC, NPV will be positive, and PI will be more than 1
If IRR is equal to COC, NPV will be zero, and PI will be equal to 1
If IRR is less than COC, NPV will be negative, and PI will be less than 1
4. TERMINAL VALUE METHOD
Terminal Value (TV) Method is an improvement over the NPV method of making capital
investment decision. Under this method, it is assumed that each of the future cash flows is
immediately reinvested in another project at a certain rate of return, until the termination of the
project. The cash flows are compounded forward rather than discounting to the present, as in the
case of NPV method. The proposal will be accepted if the present value of the total of the
compounded reinvested cash inflows is more than the present value of the cash outlays. ie., when
there is positive Net Terminal Value (NTV). When there are more proposals to be selected from,
the project with higher NTV will be selected.
The following example will make the concept clear.
Initial outlay Rs.2,00,000
Life of the project 4 years
Cash inflows @ Rs. 1,00,000 for 4years; Cost of capital : 12%
Expected interest rates at which cash inflows will be reinvested:
End of the year 1 2 3 4
Interest rates (%) 7 7 9 9
Analyze the feasibility of the project using NTV method.
Soln. Calculation of Compounded Value of Cash inflows
Year Cash inflows Rate of Years for Compounding Compounded

(Rs.) Interest (%) Investment factor * value (Rs.)
1 1,00,000 7 3 1.225 1,22,500
2 1,00,000 7 2 1.145 1,14,500
3 1,00,000 9 1 1.090 1,09,000
4 1,00,000 9 0 1.000 1,00,000
Total 4,46,000
*Compounding factors are available in the Compound Factor Table given at the end.
Note: Rs. one lakh inflow at the end of first year can be reinvested for 3 years at 7% interest.
Similarly the second year inflow can be reinvested @ 7% for 2 years; and so on.

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Now, to find NTV, the total of compounded reinvested cash inflows is to be discounted at the cost
of capital, 12%, to ascertain its present value.
The PV Factor at 12% for 4 years is 0.636 (from present value table)
Hence, present value of compounded reinvested cash inflows = 4,46,000 x 0.636 = 2,83,656.
As the present value of the compounded reinvested cash inflows Rs.2,83,656 is greater than the
initial cash outlay of Rs.2,00,000, the NTV is positive, ie., Rs. 83,656, the project can be accepted.
CAPITAL RATIONING
Capital rationing refers to a situation where a firm is not in a position to invest in all profitable
projects due to the constraints on availability of funds. In other words, the funds available may not
be sufficient to take up and implement all the acceptable projects at a given time. In such a
situation, the emphasis should be to select a combination of investment proposals which provides
the highest NPV. Following are essential to achieve the objective of maximization of NPV:
a) All the projects must be ‘ranked’ according to their Profitability Index.
b) Projects must be selected as per the ranking until the available funds are exhausted.
Eg. Let us assume that a firm has only Rs.10 lakh to invest and more funds cannot be made
available. The various proposals along with their cost and profitability index (PI) are given below:
Proposal Cost involved (Rs) PI
1 3,00,000 1.46
2 1,00,000 0.098
3 5,00,000 2.31
4 2,00,000 1.32
5 1,50,000 1.25
It can be seen from the table that all proposals except No.2 give PI exceeding one and are profitable
investments. The total capital required to be invested in all the profitable projects is Rs. 11,50,000,
where as the total funds available is only Rs. 10 lakhs. Hence, the firm has to do capital rationing
and select the most profitable combination of projects within a total outlay of Rs. 10 lakhs. Project
numbers 1, 3, and 4 can be selected, which needs a total investment of Rs. 10 lakhs and project
number 5 need not be considered as its PI is the lowest among the profitable ones.
Try yourself:
A firm whose cost of capital is 10%, is considering two mutually exclusive projects X and Y, the
details of which are:
Year Project X (Rs) Project Y (Rs)
Investment 70,000 70,000
Cash flow year 1 10,000 50,000
“ 2 20,000 40,000
“ 3 30,000 20,000
“ 4 45,000 10,000
“ 5 60,000 10,000
1,65,000 1,30,000
Compute NPV, PI and IRR for the two projects.
(Ans. For Project X: NPV = 46,135 ; PI = 1.659 ; IRR = 27.326%
For Project Y: NPV = 36,550 ; PI = 1.522 ; IRR = 37.56%)

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UNIT – FIVE
RISK ANALYSIS IN CAPITAL BUDGETING
In the preceding pages we have examined the various techniques for evaluating capital investment
proposals. All these techniques require estimation of future cash inflows and cash outflows.
Decisions are taken on the basis of these forecasts which depend upon future events whose
occurrence cannot be anticipated with absolute certainty. It may be because of economic, social,
fiscal, political and other reasons. Thus, it is clear that risk is linked with business decisions. The
term risk in relation to capital budgeting decisions may be defined as “the variability likely to occur
in future between the estimated and the actual returns”. It seems to be a tough job to precisely
measure the extent of risk involved in accepting an investment proposal. Still some allowances for
the element of risk have to be provided in investment decisions.
The following methods are suggested for accounting for risk in capital budgeting:
1. Risk-Adjusted Discount Rate, Risk-Adjusted Cut-off Rate or Varying Discount Rate
Method.
2. Certainty Equivalent Method.
3. Sensitivity Technique.
4. Probability Technique.
5. Standard Deviation Method.
6. Co-efficient of Variation Method.
7. Decision Tree Analysis.
1. Risk-Adjusted Discount Rate: This method is based on the assumption that investors expect
a higher rate of return on risky projects as compared to less risky projects. The rate requires
determination of risk-free rate and risk premium rate. Risk-free rate is the rate at which future
cash inflows should be discounted if there is no risk. Risk premium rate is the extra return
expected by the investor over the normal rate (ie., the risk-free rate) on account of the project
being risky. For eg., if the risk-free rate of return is 9% and the risk premium rate is 3%, then
the risk adjusted rate of return will be: 9% + 3% = 12%.
2. Certainty Equivalent Method: Under this method, the forecasted cash inflows are reduced
to a more conservative level by applying a correction factor called ‘certainty equivalent
coefficient’. The correction factor is the ratio of riskless cash flows to risky cash flows.
Certainty Equivalent Coefficient = Riskless (or certain) cash flow ÷ Risky cash flow
Both these methods are simple to operate, and hence are more popular. The first method
discounts the cash flows at a higher rate, ie., risk adjusted rate and the second method brings
down the cash flows by multiplying the risky cash flows with a correction factor.
Eg. There are two projects X and Y. Each involves an investment of Rs. 40,000. The
expected cash inflows and the certainty equivalent coefficients (CEC) are as under:
Project X Project Y
Year Cash Inflow CEC Cash Inflow CEC
1 25,000 0.8 20,000 0.9
2 20,000 0.7 30,000 0.8
3 20,000 0.9 20,000 0.7
Risk-free cut off rate is 10%. Suggest which of the two should be preferred.

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Soln. Calculation of cash flows with certainty:
Project X Project Y
Years Cash inflow CEC Certain Cash inflow CEC Certain cash
cash inflow inflow
1 25,000 0.8 20,000 20,000 0.9 18,000
2 20,000 0.7 14,000 30,000 0.8 24,000
3 20,000 0.9 18,000 20,000 0.7 14,000
Present Value of cash flows
Year Discount Project X Present Project Y Present

factor @ 10% Cash Value of Cash inflows Value of
inflows cash flows cash inflows
1 0.909 20,000 18,180 18,000 16,362
2 0.826 14,000 11,564 24,000 19,824
3 0.751 18,000 13,518 14,000 10,514
Total 43,262 46,700
NPV : Project X = 43,262—40,000 = 3262 ; Project Y = 46,700—40,000= 6700
Project Y is preferred as its NPV is more than that of Project X
3. Sensitivity Technique: Generally, a single estimate of cash flow is made for future
period which may prove to be wrong. In sensitivity analysis cash flows are assumed to
be sensitive under different circumstances. So three kinds of cash flow forecasts are
made for each year- optimistic, most likely, and pessimistic. It explains how sensitive
the cash flows are under these three different situations. The larger is the difference
between the pessimistic and optimistic cash flows, the more risky is the project and vice
versa.
Eg. Mr. Risky is considering two mutually exclusive projects A and B. Advise him about the
acceptability of the projects from the following information:
Particulars Project A Project B

Investment outlay 50,000 50,000
Forecasted cash flows per annum for 5 years:
Optimistic 30,000 40,000
Most Likely 20,000 20,000
Pessimistic 15,000 5,000
Cost of capital to be assumed as 15%

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Soln. Calculation of NPV at a discount rate of 15% ( Annuity of Re.1 for 5 years)
Projt. A PVF PVCF NPV Projt.B PVF @ PVCF NPV

Cash @ Cash 15%
inflow 15% inflow
Optimistic 30,000 3.3522 1,00,566 50,566 40,000 3.3522 1,34,088 84,088

Most Likely 20,000 3.3522 67,014 17,044 20,000 3.3522 67,044 17,044
Pessimistic 15,000 3.3522 50,283 283 5,000 3.3522 16,761 (33,239)
The NPVs calculated above under the three situations differ widely in the case of Project B, which
indicates that it is more risky than Project A. The acceptability of the project will depend upon Mr.
Risky’s attitude towards risk.
4. Probability Technique: Probability is the relative frequency with which an event may occur
in future. It means the likelihood of happening of an event. ‘0’ probability means an event is
not at all likely to happen and ‘1’ probability shows that the event is certain to take place.
Between 0 and 1 different probability values can be assigned to events. The predicted cash
flows are multiplied by respective probability factors assigned. Then the usual method of
ascertaining present values can be followed. The project that gives higher NPV may be
accepted.
5. Standard Deviation Method: If two projects have the same cost and their NPVs are also the
same, standard deviations of the expected cash inflows of the two projects may be calculated
to judge the comparative risk of the projects. The project having higher standard deviation is
said to be more risky compared to the other. Standard deviation can be defined as “the square
root of squared deviations calculated from the mean”. It is a measure of dispersion.
Eg. From the following information, ascertain which project is more risky on the basis
of standard deviation:
Project A Project B
Cash inflow Probability Cash inflow Probability

2,000 0.2 2,000 0.1
4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4
8,000 0.2 8,000 0.1
Soln.
Calculation of standard Deviation
Project- A
Cash inflows Deviation Square of Probability Weighted
2)
from mean deviation (d sq.deviations
(d)
2,000 --3,000 90,00,000 0.2 18,00,000
4,000 -- 1,000 10,00,000 0.3 3,00,000
6,000 1,000 10,00,000 0.3 3,00,000
8,000 3,000 90,00,000 0.2 18,00,000
n=1 Ʃ(fd2) = 42,00,000
Mean = 20,000 ÷ 4 = 5,000
Standard Deviation = square root of Ʃfd 2 ÷ n = 2,050

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Project- B
Cash inflows Deviation Square of Probability Weighted

from mean deviation (d2) sq.deviations
(d)
2,000 --3,000 90,00,000 0.1 9,00,000
4,000 -- 1,000 10,00,000 0.4 4,00,000
6,000 1,000 10,00,000 0.4 4,00,000
8,000 3,000 90,00,000 0.1 9,00,000
n=1 Ʃ(fd2) = 26,00,000
Mean20,000 ÷ 4 = 5,000
Standard Deviation = square root of Ʃfd 2 ÷ n = 1,612
Project A is more risky as its standard deviation is more than that of Project B.
6. Coefficient of Variation Method: Coefficient of Variation is a relative measure of dispersion. If

the projects have the same cost but different NPVs, coefficient of variation should be computed
to judge the relative position of risk involved.
Coefficient of Variation = Standard Deviation ÷ Mean
Eg. Compute Coefficient of Variation using the same figures of the above problem.
Coefficient of Variation (CV) = Standard Deviation ÷ Mean
Project A, CV = 2050 ÷ 5000 = 0.41
Project B, CV = 1612 ÷ 5000 = 0.32
As the coefficient of variation of A is more than that of B, Project A is more risky.
7. Decision Tree Analysis: When a series of decisions are involved chronologically, decision tree
analysis is the appropriate technique. A decision tree is a graphic representation of the
relationship between a present decision and future events, future decisions and their
consequences. The sequence of events is mapped out over time in a format resembling branches
of a tree and hence the analysis is known as decision tree analysis.
Conclusion: Risk and uncertainty are inherent part of capital expenditure decision. However,
analyzing the causes of risk, the extent of risk and possible course of action to deal with
uncertainty are all necessary to minimize their impact on the investment decision. Specific
technique to be used for investment appraisal depends on the circumstances and the experience
of the analyst.
Try yourself:
1. Explain the risk incorporated techniques of capital budgeting.
2. Write short notes on the following:
a) Certainty Equivalent Coefficient
b) Sensitivity Analysis
c) Decision Tree Analysis
d) Probability Assignments
e) Capital Rationing
****************************

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UNIT - SIX
CVP ANALYSIS AND DECISION MAKING
PART A: MARGINAL COSTING:
Marginal costing is a technique of costing which shows the effect on profit, of changes in
the volume of output. There are some costs which vary in direct proportion to the volume of
production. Whereas there are some other costs which do not vary in relation to the output. The
first type of costs is known as variable costs and the second type is known as fixed costs. It is
essential to classify the costs in to fixed and variable in marginal costing.
Definition:-
Marginal cost is the cost of producing one additional unit. It is the increase or decrease in
total cost when there is an increase or decrease of one unit in production. The ICMA (Institute of
cost and Management Accountants)., England, defines marginal cost as "the amount at any given
volume of output by which the aggregate costs are changed if the volume of output is increased or
decreased by one unit. "The increase in cost due to an increase in output by one unit will be the
result of its variable cost. Hence marginal cost is also known as variable cost.
Marginal Cost:- ICMA defines it as "the ascertainment of marginal costs and of the effect on profit
of changes in volume of output by differentiating between fixed costs and variable costs".
Features of Marginal Costing
1. All costs can be classified into fixed and variable. Fixed cost remains fixed irrespective of
the volume of production. Eg. Salary, rent, depreciation etc. variable cost varies in relation
to the output eg. Direct material, direct labour, direct expenses etc.
2. Variable cost per unit remains fixed; total varies.
3. Fixed cost in total remains fixed; per unit varies.
4. Selling price per unit remains unchanged at all levels of activity.
5. The stock of work-in-progress and finished goods are valued at marginal cost.
Contribution:- Contribution is the difference between sales and marginal cost or variable cost.
Contribution includes fixed cost and profit. Contribution is also known as marginal income,
marginal revenue or contribution margin.
Marginal cost equation:
Sales – variable cost = Contribution
Sales – Variable cost = Fixed cost + profit (or less loss)
Ie. S-V=F+P (or F-loss)
When contribution is equal to fixed cost, neither profit is enjoyed, nor loss is incurred. That
is at this point of sales there will not be any profit or loss. Sales will exactly equal to total cost.
Such a point is known as Break. even Point (BEP). In other words BEP is the point of sales at
which the firm enjoys neither profit nor loss.
At BEP, Sales = Total cost. i.e. Sales = Variable cost + Fixed cost
The following simple problems will make the concept more clear.
Prob:1
Calculate contribution and profit:
Sales Rs. 8,00,000, Variable cost Rs. 4,00,000; Fixed cost Rs. 2,00,000.

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Sol-
Contribution = Sales – Variable Cost
= 800000–400000 = 400000
Profit = Contribution – Fixed cost
= 4,00,000–2,00,000 = 2,00,000
Prob:2
Calculate Fixed Cost:-
Sales: Rs. 20 lakhs, variable cost Rs. 9 lakhs, Profit Rs. 4 lakhs.
Sol-
Fixed Cost = Contribution–Profit
Contribution = S–V = 2000000–9,00,000 = 11,00,000
Fixed Cost = 11,00,000–4,00,000 = 7,00,000
Prob:3
Calculate Variable cost:-
Sales = 12,00,000, Fixed cost 2,00,000, Profit 1,20,000
Sol-
Variable cost = sales–contribution
= Sales–(Fixed cost + Profit) = 12,00,000–3,20,000
= 8,80,000.
Try yourself:-
1. Calculate contribution:
Sales Rs. 15,00,000 variable cost 60% of sales.
(Hint: Contribution 6,00,000)
Profit/Volume Ratio (P/V Ratio) or contribution Ratio or Marginal income Ratio:
contributi on
P/V ratio is the ratio of contribution to sales i.e. P/V ratio  x100 . A high P/V ratio
sales
indicates high profitability and vice versa. On the basis of this ratio, the following ratios can be
formed:
Contributi on
a) Sales =
P / V Ratio
b) Contribution = Sales x P/V Ratio
See the problem below:
1. Calculate P/V ratio:
Sales Rs.8,00,000, variable cost 4,80,000, fixed cost 1,50,000
Sol.
Contribution 8,00,000 - 4,80,000
P/V ratio = x 100  x 100
Sales 8,00,000
3,20,000
= x 100  40%
8,00,000
(Fixed cost need not be considered as S-V is )
If contribution is 40% variable cost will be 60% i.e.,

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i.e., variable cost = Sales (1 – P/V ratio)
= 8,00,000 (1 - 0.40) = 4,80,000
2. Contribution of a firm Rs.5,00,000; P/V ratio 50%; calculate sales.
Sol.
Contributi on 5,00,000
Sales =  x100  Rs.10,00,000
P / V ratio 50
Try yourself:-
1. Sales Rs. 6,00,000, P/V ratio 25%, Profit Rs. 50,000 calculate contribution and also
fixed cost.
(Ans: C=1,50,000, FC = 1,00,000)
P/V ratio can be improved by:
a) Increasing the selling price:
b) Reducing variable cost or
c) Concentrating on the most profitable product mix.
Prob: 3
Sales Rs. 2,00,000
Variable cost:-
Direct Material Rs. 60,000
Direct Labour Rs. 40,000
Variable overheads Rs. 20,000
Fixed cost Rs. 40,000
a) Calculate: P/V ratio
b) Sales to earn a profit of Rs. 80,000 and
c) Profit at a sale of Rs. 4,00,000
Sol-
Contribution = S–V
= 2,00,000–1,20,000 = 80,000
C 80,000
a) P/V ratio = x100  x100  40%
S 2,00,000
Fixed cos t  Desired profit
b) Sales to earn a profit of Rs. 80,000 =
P / V ratio
40,000  80,000
= x100  Rs.3,0,000
40
c) Profit at a sale of Rs. 4,00,000 =
40
Contribution at this sale=Sales X P/V ratio = 4,00,000 x  1,60,000
100
Profit = C–Fixed cost = 1,60,000 –40,000 = 1,20,000

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Prob:4
During a period 1000 units are produced and sold at Rs. 100. Variable cost per unit is Rs. 50 and
fixed cost Rs. 20,000 for the period.
Calculate:
1. P/V ratio
2. Profit at a sale of 2,000 units.
3. Number of units to be sold to earn a profit of Rs. 1,60,000.
4. What will be new P/V ratio if selling price is reduced by Rs. 20.
5. Calculate the number of units to be sold to earn a profit of Rs. 60,000 at reduced selling
price.
Sol-4
Contribution Statement
Total P.u
Sales: 1000x100 1,00,000 100
Less variable cost=1000x50 50,000 50
------------------------------------
Contribution 50,000 50
Less fixed cost 20,000 =========
-------------
Profit 30,000
========
C 50,000
1. P/V ratio = x100  x100  50%
S 1,00,000
2. Profit at a sale of 2,000 units:-
Contribution for 2000 units = 2000 x 50 = 1,00,000
Less fixed cost 20,000
----------------
Profit = 80,000
3. Units to be sold to earn a profit of Rs. 1,60,000
Fixed cos t  Desired profit 20,000  1,60,000
The formula for this is = 
Contribution per unit 50
= 3,600 units
Or
Sales amount to earn profit of Rs. 1,60,000 =
P / V ratio
20.000  1,60,000
= x100  Rs.3,60,000
50
Sales in Rupees 3,60,000
 No, of units to earn that profit = 
Selling price p.u 100

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4. New P/V ratio when the selling price is reduced by Rs. 20
New SP = 100 – 20 = 80
Contribution = S–V = 80 – 50 = 30
C 30
 P/V ratio = x100  x100  37.50%
S 80
5. Number of units t be sold to earn a profit of Rs.60,000/- at reduced selling price:
Fixed cos t  Desired profit 20,000  60,000
= 
New Contributionp.u 80  50
80,000
=  2,667 units
30
How to calculate P/V ratio when data for two periods are given:-
P/V ratio = (Change in Profit ÷ Change in sales) x100
Or (Change in Contribution ÷ Change in sales) x 100
Prob:
The data for two successive periods are given:-
2013 2014
Sales (Rs.) 40,00,000 5,00,000
Profit (Rs.) 50,000 1,00,000
Calculate:-
a) P/V ratio
b) Profit at a sale of Rs. 7,00,000
c) Sales to earn a profit of Rs. 75,000
Sol-
Change in profit 50,000
a) P/V ratio = x100 x100  50%
Change in sales 1,00,000
b) Profit at a sale of Rs, 7,00,000:
At any level of sales, contribution will be = Sales x P/V ratio. Contribution – Fixed cost will be
profit at that level.
 Fixed cost has to be computed i.e.
Contribution for Rs. 4,00,000 sales = 4,00,000x 50% = 2,00,000
i.e. Rs. 2,00,000 = Fixed cost + profit
2,00,000 = Fixed cost + 50,000
Fixed cost = 2,00,000 – 50,000 = 1,50,000
========
Fixed cost at all levels will be same. (If not stated other wise)
Hence profit at a sale of Rs. 7,00,000
50
Contribution = 7,00,000x  3,50,000
100

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Profit = 3,50,000 – fixed cost
= 3,50,000–1,50,000 = Rs. 2,00,000
c) Sales to earn a profit of Rs. 75,000 =
P / V ratio
= 1,50,000+75,000 ÷ 50% = 4,50,000
Try yourself:
1. Data for the two years are given as:-
Year Sales (Rs.) Total Cost (Rs)
2014 2,00,000 1,40,000 2015
3,00,000 1,90,000
Calculate:
a) P/V ratio
b) Fixed cost
c) Profit at a sale of Rs. 4,00,000
d) Sales to earn a profit of Rs. 1,20,000
(Ans) a) 50% b) Rs. 40,000 c) Rs. 1,60,000 d) Rs.3,20,000

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UNIT-SEVEN
PART B: COST VOLUME PROFIT ANALYSIS

(C.V. P ANALYSIS)
C.V.P analysis refers to the study of the relationship between cost, volume of sales and
profit. It is the analysis of relationship between variations in cost with variations in volume of
production as these are inter-related. It helps the management in profit planning, cost control and
decision making regarding:
1. Sales required to earn a desired amount of profit.
2. Sales to be made to break-even.
3. To make or buy a product or component.
4. Selection of most profitable product mix.
5. Exploration of foreign market at a lower rate etc.
Break-Even Analysis
You have already seen what a Break-Even-Point is. It is the volume of sale at which the
total sales equals the total cost, there is neither profit nor loss at this level ie. Sales–Variable cost =
Fixed cost. Break-Even Analysis is a method of C.V.P Analysis. It is used in two senses:-
1. Narrow sense:- It refers to the no profit no loss point i.e. B.E.P.
2. Broad sense: It refers to the study of relationship of cost, volume and profit at
different levels of activity.
The assumptions of marginal costing are applicable in B.E. Analysis too. Break even point
can be expressed in units or sales value. It can be calculated by:
a) Algebraic method or b) Graphic method.
A) Algebraic method of computing BEP:-
Fixed cos t Fixed cos t x sales
1. BEP in (Rs.) = or
P / V ratio Sales  var iable cos t
Fixed cos t
2. BEP in units = or
Contributi on per unit
F
= where
SV
F = Total fixed cost
S = Selling price p.u.
V = Variable cost p.u.
Prob:1
Selling price p.u. Rs. 25, variable cost p.u. Rs. 15 Fixed cost Rs. 50,000. Units produced
and sold 10,000. Calculate BEP in units and value.
Sol-
BEP (Units) = F ÷ C pu = 50,000 ÷ 10 = 5000units.
Contribution per unit = S—V = 25—15=10
FxS 50,000 x 25 50,000 x 25
BEP (Value) =    Rs.1,25,000
SV 25  15 10
or BEP (value) = BEP in units x selling price per unit = 5.000x25
= Rs. 1,25,000
==========
Fixed cos t Contributi on 25  15
or BEP (value) = , P / V ratio  x100 x100  40%
P / V ratio Sales 25

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50,000
= x100  Rs.1,25,00 0
40
========
(Try to understand the different ways to arrive the BEP, from the above)
Prob: 2
Fixed cost Rs. 50,000, variable cost p.u. Rs. 5, selling price per unit Rs. 10
1. Determine BEP
2. What is the sale price if BEP is 8,000 units
3. What is the BEP if sale price is reduced by 10%
4. What is the BEP if variable cost is 60%.
Sol-2
F 50,000
1. BEP =   10,000 x10  1,00,000 (Rs.)
C.pu 10  5
2. Sales price when BEP is 8000 units:
At BEP selling price = Variable cost + fixed cost
Variable cost p.u = 5
50,000
Fixed cost p.u =
8,000
50,000
= 5  5  6.25  11.25
8,000
 If BEP is 8,000 units, the selling price p.u will be Rs. 11.25
=====
3. BEP if sales price is reduced by 10%:-
New selling price = 10–10% of 10 = 10-1=9.00
Fixed cos t 50,000 50,000
 BEP =    12,500 units  BEP in Rs.
Contribution p.u 95 4
= 12,500xRs.9-Rs. 1,12,500
=========
4. BEP if variable cost is 60%:-
In this case variable cost is, 60% of sales price.
 VC = 60% of 10=Rs. 6.00 p.u
========
F 50,000
BEP =   12,500units
Cp.u 10  6
Prob:3
2
The fixed cost amounts to Rs. 50,000. Percentage of variable cost to sales = 66 %. If 100%
3
capacity sales are Rs. 3,00,000, find out the BEP and the percentage sales at BEP. Determine also
the profit at 80% capacity.
Sol-3
F
BEP =
P / V ratio
C
P/V ratio = x100;
S
C = S–V

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2 2
Here variable cost is 66 % of sales. Hence P/V ratio should be (i.e. 100-- 66 %. )
3 3
50,000
 BEP = x100  Rs.1,50,000
1
33
3
Percentage of BE sales = (1,50,000 ÷ 3,00,000)x100 = 50%
Profit at 80% capacity:-
80
Sales at 80% capacity = 3,00,000 x  2,40,000
100
1
33
 Contribution at 80% capacity = 240000 x 3  Rs.80,000
100
 Profit at 80% capacity = C-F = 80,000 – 50,000 = 30,000
Margin of safety
Margin of safety is the excess of sales over break even sales. It indicates the strength of a
business. A large margin of safety shows higher profitability of a concern. It is calculated as:
Margin of safety (M/S) = Sales – Break Even Sales.
or
F
Margin of safety =
P / V ratio
Prob: 4
Sales 10,000 units at Rs. 50 pu. Variable cost Rs. 25pu. Fixed cost Rs. 1,00,000.
A. Calculate 1) P/V ratio. 2) BEP. 3) Margin of safety & M/S ratio.
B. Calculate 1) New P/V ratio 2) New BEP 3) Margin of safety and M/S ratio
4) Sales to earn the same profit as before after reducing the selling price by 10%
5) Number of units to be sold to get a profit of Rs. 60,000 at the reduced price.
Sol-4
Sales: 10,000x50 = 5,00,000
Less Variable cost 10,000x25 = 2,50,000
Contribution = 2,50,000
Less fixed cost = 1,00,000
Profit = 1,50,000
C 2,50,000
A) 1. P/V ratio = x100  x100  50%
S 5,00,000
F 1,00,000
2. BEP =  x100  2,00,000
P / V ratio 50
3. Margin of safety = Sales—BES = 5,00,000--2,00,000 = 3,00,000
M / S Sales 3,00,000
Margin of safety ratio = x100  x100  60%
Sales 5,00,000

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B) 1. New P/V ratio= (New Contribution pu ÷ New Selling Price pu)x 100
New selling price = 50--5 = 45
New Contribution pu = 45—25 = 20; New P/V ratio = 20 ÷ 45 = 0.44 or 44.44%
F 1,00,000
2. New BEP =  x100  2,25,023,00
P / V ratio 44.44
3. Margin of safety = S--.BES = 10,000x45–2,25,023
= 4,50,000–2,25,023 = 2,24,977
2,24,977
M/S  x100  49.99%
4,50,000
4. Sales to earn a profit of Rs. 1,50,000 as before after reducing SP by 10%.
=
New P / V ratio
1,00,000  1,50,000
= x100  Rs.5.62.556
44.44
5. Number of units to be sold to earn a profit of Rs. 60,000 at the reduced price:
Fixed cos t  Desired profit 1,00,000  60,000 1,60,000
   8,000 unit s
New contribution per unit 45  25 20
Try yourself:
I. A. fixed cost Rs. 40,000: variable cost 60% on sales: Determine BEP
B. Find out new BEP if-
1. Fixed costs increases by Rs. 10,000.
2. Variable cost increase by 15% on sales.
3. Sales price increased by 20%.
4. Variable cost reduces by 10%.
(Ans: Assume sales price Rs. 100: A. BEP = 1,00,000 B. 1) 1,25,000 2) 1,60,000 3) 80,000
4) 80,000
II. Sales (5,000 units @ Rs. 20 each) = Rs. 1,00,000, variable cost Rs. 60,000 fixed
expenses Rs. 20,000.
Calculate a) P/V ratio. b) BEP c) Margin of safety d) If the selling price is reduced by 20% what
extra units should be sold to maintain the same profit as before?
FP 20,000  20,000
(Ans: a) 40% b) Rs.50,000 c) Rs. 50,000 d)  (Extra 5,000 units
New C.p.u 16  12
should be sold to maintain the profit = 10,000 units - present 5,000 units)
III. The ratio of variable cost is 60%. BEP occurs at 50% capacity sales. Find the capacity
sales (Total sales) when fixed costs are Rs. 2,00,000. Determine profit at 80%, and 100% sales.
[Ans: P/V ratio 40%. BEP = F ÷ P/V ratio = 2,00,000÷40% = 5,00,000; Capacity sales=
5lakh÷50%= Rs.10 lakhs; profit at 80% capacity = 1,20,000, profit at 100% capacity Rs. 2,00,000]

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B. Graphic method of Break Even Analysis or Break Even Chart: The BEP can be
computed with the help of a graph. Break Even chart (BEC) is graphical representation of marginal
costing. It shows the break-even point and the relationship between cost, volume and profit. The
break-even point in the graph will be the point when the total cost line and sales line intersect. At
this point the firm enjoys neither profit nor loss.
Construction of Break-Even Chart.
1. Draw 'X' axis to present sales in units or percentage capacity. Draw 'Y' axis to show costs and
revenue in rupees.
2. Draw fixed cost line parallel to the 'X',-axis. Fixed cost remains fixed at all levels of output.
3. Variable cost line is to be plotted over the fixed cost line at different levels, it becomes the total
cost line, when connected.
4. Sales to be plotted from zero level, splits the graph diagonally as the levels of activity
improves. A line joining these plotted points indicates sales line.
5. The point where sales line cuts the total cost line is the BEP.
6. A perpendicular may be drawn from the BEP to the x-axis to find the break- even units.
Similarly a perpendicular to the 'Y'-axis will show the break- even sales in rupees.
7. The area below the BEP is loss area and above it is profit area.
Prob: Draw a break-even chart.
Sales: 5000 units @ Rs. 60 p.u variable cost Rs. 30 p.u. fixed cost Rs. 60,000.
Sol-
Break Even Chart
Break-even chart shows the BEP at 2000 units on the 'X' axis and Rs. 1,20,000 on the 'Y' axis.
Margin of safety in units 3,000, M/S in Rs. 1,80,000. Variable cost, sales revenue, fixed cost, and
total cost at each level of activity are shown below:
Selling
Variable Total Total
Out put Fixed cost Total cost price
cost per Variable cost sales
units Rs. Rs. unit
unit Rs. Rs. Rs.
Rs.
0 - - 60,000 60,000 - -
1,000 30 30,000 60,000 90,000 60 60,000
2,000 30 60,000 60,000 1,20,000 60 1,20,000
3,000 30 90,000 60,000 1,50,000 60 1,80,000
4,000 30 1,20,000 60,000 1,80,000 60 2,40,000
5,000 30 1,50,000 60,000 2,10,000 60 3,00,000

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Note: It is better to follow same scaling for X-axis and Y-axis. For eg: 'X' axis: 1cm=1,000 units;
'Y' axis: 1 cm = sales revenue of 1,000 units, ie., Rs 60,000.
It can be seen from the table that at a production of 2000 units the total cost is Rs. 1,20,000.
At this level, the sales revenue is also Rs. 1,20,000. i.e., Sales = Total Cost. This is the BEP.
Angle of incidence: It is the angle between sales line and total cost line formed at the BEP.
It indicates the profit earning capacity of a firm. A large angle of incidence reflects a high rate of
profit and vice versa. A large angle with a high margin of safety shows the most favourable
position.
Types of Break Even chart
Apart from the simple break even charts, there are other forms of BEC, such as contribution
BEC, cash BEC, Control BEC, Analytical BEC etc.
Contribution BEC:- Under this method the variable cost line is drawn first. Fixed cost line is
drawn over and parallel to the variable cost line, then becoming the total cost line. Sales line is
drawn as usual and the difference between sales and variable cost line is seen together as
contribution.
Eg: The above example can be used to draw a contribution BEC as follows
Contribution BE Chart
Cash break chart: This chart shows the point at which the cash inflows from sales will be equal
to the costs requiring cash payments. It considers only the costs involving cash payments.
Depreciation, written off items etc. will not be included in the fixed cost.
Control BEC: It shows the actual figures as well as budgeted figures. It helps to compare and
study the deviations in cost, revenue etc. There will be two lines for each item in the graph for
which the actual and budget differs.
Analytical BEC: This chart analyses the elements of variable costs such as direct material, direct
labour, factory Overheads etc. Also shows the appropriation of profit.
Try yourself:
Draw a simple Break-even chart:
Plant capacity:1,60,000 units, fixed cost Rs. 4,00,000 variable cost Rs. 5 per unit, selling
prices Rs. 10 per unit.

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PROFIT VOLUME GRAPH (P/V Graph)
It is a simplified form of break even chart which shows the relationship of profit to volume of sales.
Profit or loss at different levels of sales can be seen directly from the profit graph (P/V graph)
Construction of a P/V Graph
1. Sales in volume or value are presented on the X-axis.
2. Profit-above the X-axis and fixed cost below X-axis, on Y-axis.
3. Profits and losses at different levels are plotted and the points joined and where this line
cuts the sales line is the BEP.
Eg:-
Draw a P/V graph from the following:
Units produced: 60,000 units, selling price p.u Rs. 15, variable cost pu Rs. 10; Fixed cost
Rs. 1,50,000.
Sol-
BEP = 30,000 units or Rs. 4,50,000 Note: Profit and fixed cost should be on a similar scaling.
Profit at any level can be located on the profit line by drawing a perpendicular from that level of
sales to the profit line.
Try yourself:-
Budgeted output 8,000 units, fixed cost Rs. 4,00,000 selling price Rs. 200 pu. variable cost Rs. 100
pu.
Draw a P/V graph and mark the BEP.
Show also the new BEP, if the selling price pu. is reduced to Rs. 180 pu.
***********************

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UNIT – EIGHT
MANAGERIAL APPLICATION OF CVP ANALYSIS
Marginal costing is an important tool for managerial decision-making. Some of the
problems for managerial solutions are:
a) Profit Planning: Marginal costing helps to plan the future operations with the help of
contribution, to maximize profit or maintain a desired level of profit. Change in sales price,
variable cost and product mix affects the profitability of a firm.
Prob:
KAMCO Ltd. Manufactures and sells 10,000 machines at a price of Rs. 500 each
The cost structure of a machine is as follows:-
Materials 100
Labour 50
Variable overheads 25
----------
Marginal cost 175
Fixed overheads 200
---------
Total cost 375
Profit 125
----------
Selling 500
======
Due to heavy competition, the price has to be reduced to Rs. 425 for the next year. Assuming no
change in costs, state the number of machines to be sold to maintain the total profit enjoyed now.
Sol-
Present total profit =10,000x125 = 12,50,000; Fixed Cost = 10,000x200=20,00,000
============ =======
New contribution per unit = New selling price – Variable cost = 425—175 = 250
 No. of units to be sold to
Maintain the present profit =
Contributi on Per unit
20,00,000  12,50,00
=  13,000 units
250
It shows that, by selling 13,000 units @ Rs. 425 p.u. the company can earn the present profit of Rs.
12,50,000.
b) Pricing Decisions: Under normal circumstances, the prices should be fixed at total cost
plus a desired margin of profit. Under special circumstances, products will have to be sold at a
price below the total cost, or at marginal cost or even below the marginal cost. Marginal costing
technique helps the management in fixing the selling price at different market situations.

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Prob:
A toy manufacturer produces 30,000 toys at 60% of the installed capacity and sells it @
Rs.30/- per toy, earning a profit of Rs. 6 per unit.
His cost structure is:-

Direct Material Rs. 8 per unit
Direct Labour Rs. 2 pu.
Works overhead Rs. 12 pu.(50% fixed)
Selling overhead Rs. 2 pu.(25% varying)
During the current year he desires to produce the same number but expects that:
a) His fixed charges will increase by 10%

b) Direct labour rates will increase by 20%
c) Rates of material will rise by 5%
d) Selling price will remain the same.
Under these circumstances he obtains an order for further 20% of the capacity. What
minimum price will you recommend for accepting the order to give the manufacturer an over all
profit of Rs. 1,80,000
Soln.
Marginal cost statement for current year
P.U. Rs. Total Rs.

Sales (30,000 Units 30.00 9,00,000
Less Marginal cost:-
Material: 8+5% increase 8.40
Labour 2+20% increase 2.40
Variable works: 50% of 12 6.00
Variable selling: 25% of 2 0.50
17.30 5,19,000
Contribution = (S-V) 12.70 3,81,000
Less fixed works overhead: 1,98,000.00
30,000x6=1,80,000+10% increase 18,000
Fixed selling overhead: 49,500.00
30,000x1.5= 45,000 2.47,500
+10% increase 4,500
Profit 1,33,500
========
The current year profit will be Rs. 1,33,500. Over all profit planned: 1,80,000
 Minimum price for the special order of 20% capacity:-

30,000
No. of units at 20% capacity = x 20  10,000 toys
60
Additional profit to be earned out of 10,000 toys
= 1,80,000–1,33,500 = 46,500
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======
Minimum price to be charged to earn this profit:-
Variable cost for 10,000 toys = 10,000x17.30 = 1,73,000
Profit to be earned = 46,500
Sales values of 10,000 toys = 2,19,500
2,19,500
 Minimum selling price per toy = = Rs.21.95
10,000
========
No additional fixed cost will be incurred for the production of this special order as it is within the
existing capacity of the plant. At present the plant is utilizing only 60% of its capacity.
Note:- A product may be sold at a price below the marginal cost in special cases such as:-
1. When a new product is launched in the market.
2. When new markets are explored in foreign countries.
3. To popularize a product.
4. To eliminate a weaker competitor from the market.
5. To dispose off perishable products and surplus stock.
6. To avoid retrenchment of labour and keep the plant in the running condition.
7. When the sale of one product will push up the sale of a joint product.
c) Make or buy decision: Marginal costing helps to determine whether a product or a
component should be produced in the factory or bought from outside. While deciding to ‘make or
buy’, the variable cost of manufacturing it should be compared with the price at which it is
available outside. It is advisable to produce it if the marginal cost is less than its purchase price.
Similarly it will be better to buy it if the purchase price is less than the variable cost of producing it.
Prob:
Ashok Ltd. finds that while the cost of making a component No. X5 in its own workshop is
Rs. 8 each, the same is available in the market at Rs. 6.50. Give your suggestions whether to make
or buy this component. Give also your views incase the supplier reduces the price from 6.50 to
5.50. The cost data are:
Materials 3.00
Direct Labour 2.00
Other variable exp. 1.00
Depreciation and other fixed exp. 2.00
-------
8.00
====
Sol-
To take a decision, the variable cost can be compared with the purchase price; (Fixed cost is not
considered as it will be incurred in any case)
Materials 3.00
Direct Labour 2.00
Other variable exp. 1.00
-------
6.00
====
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Decision:-
1.The marginal cost per unit when produced in the factory: Rs. 6,00, purchase price from the
market Rs. 6.50. As the marginal cost is less than the purchase price, it should be produced in the
factory.
2. If the supplier reduces the price from 6.50 to Rs. 5.50: It is better to buy the component as
there is a saving of 50 paise per unit.
d) Selection of a suitable sales mix: When a firm produces more than one product, the most
profitable product mix has to be selected. Marginal costing technique helps to select the most
profitable sales mix – ie., the mix that gives maximum contribution.
Prob: The cost records of Alcos Ltd. Shows the following:
Product X Product Y
Direct Material 25.00 30.00
Direct Wages 15.00 15.00
Selling price 75.00 125.00
Variable overheads: 100% of direct wages, fixed overheads Rs. 10,000 per annum.
Prepare a contribution statement and recommend which of the following sales mix should
be adopted.
1. 450 units of X and 300 units of Y
2. 900 units of X only
3. 600 units of Y only
4. 600 units of X and 200 unit of Y
Soln.
Product X Product Y
Selling price (Rs.) 75.00 125.00
Less Marginal Cost:-
Direct material 25.00 30.00
Direct wages 15.00 15.00
Variable O/H 15.00 55.00 15.00 60.00
Contribution per unit 20.00 65.00
===== =====
1. 450 units of X and 300 units of Y:
Contribution for 450 units of X 450x20 9,000.00
Contribution for 300 units of Y 300x65 19,500.00
28,500.00
Less fixed Expenses 10,000.00
Profit 18,500.00
========
2. 900 units of X only:-
Contribution for 900 units of X 900x20 18,000.00
Less fixed expenses 10,000.00
Profit 8,000.00
========
3. 600 units of Y only:-
Contribution from 600 units of Y 600x65 39,000.00
29,000,00
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========
4. 600 units of X and 200 units of Y:-
Contribution from 600 units of X 600x20 12,000.00
Contribution from 200 units of Y 200x65 13,000,00
Profit 10,000.00
15,000.00
========
The sales of 600 units of Y gives maximum profit and hence recommended.
e) Key factor or limiting factor, principal budget factor, critical factor or
governing factor:-
A key factor is one that limits the volume of production and profitability of a concern for eg:
shortage of material, labour, capital, plant capacity or market. Any one of these may act as limiting
factor. When limiting factor is in operation, contribution per unit of limiting factor should be the
criteria to assess the profitability of a product line.
Contributi on p.u
Profitability =
Limiting factor p.u
Prob:
Show which product is more profitable from the following data
Product A Cost Product B Cost
per unit per unit
Materials 5.00 5.00
Labour A 6 hrs @ Rs.0.50 3.00
B 3 hrs @ Rs.0.50 1.50
Overheads fixed-50% of labour 1.50 0.75
Variable O/H 1.50 1.50
Total cost 11.00 8.75
Profit 3.00 2.25
=========== =========
Total production for the month A = 600 units B = 600 units. Maximum capacity per month is 4,800
hrs.
Sol-
Here the limiting factor is the labour hours. Hence contribution per labour hour is to be calculated.
Product A per Unit (Rs.) Product B Per unit (Rs)
(Rs.)
Less variable
cost:-
Materials 5.00 5.00
Labour 3.00 1.50
Variable O/H 1.50 9.50 1.50 8.00
Contribution 4.50 3.00
per unit ======== ======
Labour hours required p.u 6 hrs 3 hrs.
4.50 3.00
 Contribution per hour  0.75  1.00
6 3

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 Product B is more profitable as it has more contribution per hour.
If the maximum capacity is used to produce A:-
Contribution: 4,800 hrs x 0.75 contribution per hour = Rs. 3,600
If used for producing B:-
Contribution = 4.800 hours x Re. 1 contribution per hours = Rs. 4,800
It shows that product B is more profitable.
f) Level of activity planning: Marginal costing technique helps the management to plan the
optimum level of activity- the level of activity, which gives the highest contribution, will be the
optimum level.
Prob:
Tip Top Ltd., manufacturing plastic buckets is working at 40% capacity and produces 10,000
buckets per annum
Cost break-up for one bucket
Materials Rs.100
Labour cost Rs. 30
Over heads Rs.50 (60% fixed)
-----------------------
Selling price Rs. 200
==============
If it is decided to work at 50%, the selling price falls by 3%. At 90% capacity, the selling price falls
by 5% accompanied by a similar fall in the price of material. You are required to calculate the profit
at 50% and 90% capacities and also calculate break even points for the capacity productions.
Sol-
Present capacity utilization = 40% = 10,000 buckets
10,000
 50% capacity production = x 50 = 12,500 buckets
40
10,000
 90% capacity production = x 90 = 22,500 buckets
40
BEP = Fixed cost ÷ Contribution per unit; F = 10,000 x 30 = Rs. 3,00,000
Contribution per unit = 200 –150 = 50

BEP = 3,00,000 ÷ 50 = 6000 units
BEP = at 50% capacity:
S P = 200—3% = 200—6 = 194; C = 194—150= 44
BEP = 3,00,000 ÷ 44 = 6818 buckets.
BEP at 90%capacity:
SP = 200—5% = 200—10= 190; C = 190—145= 45
BEP = 3,00,000 ÷ 45 = 6667 buckets

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Profitability Statement
At 50% Capacity 12,500 At 90% capacity 22,500
units units
Per unit Total Per Unit Total
Sales Price Rs. 194.00 24,25,000 190.00 42,75,000
Less variable costs:
Materials 100.00 12,50,000 95.00 21,37,500
Wages 30.00 3,75,000 30.00 6,75,000
Variable (40%of 50) 20.00 2,50,000 20.00 4,50,000
Total variable cost 150.00 18,75,000 145.00 32,62,500
Contribution 44.00 5,50,000 45.00 10,12,500
Fixed over heads
(30x10000) 3,00,000 3,00,000
Profit 2,50,000 7,12,500
g) Shut down decision:- Sometimes the management may be forced to shutdown the unit
because of low demand for the product. There are some fixed costs, which are unavoidable even if
the business is closed down. Such costs are known as shutdown cost. If operating losses are higher
than the shut down costs, the firm should not continue its operation. Where the operating losses are
equal to shut down costs, the point is known as shut down point.
h) Alternative Methods of Production:- Sometimes the management has to choose from among
alternative methods of production, eg., machine work or hand work, or machine A or B etc. In such
circumstances, marginal costing technique can be applied and the method which gives the highest
contribution can be adopted keeping in view the limiting factor.
Prob. Product ‘A’ can be manufactured either by Machine X or Machine Y. Machine X can
produce 50 units of ‘A’ per hour and Machine Y, 100 units per hour. Total machine hours available
are 2000 hours per annum. Taking into account following cost data, determine the profitable
method of manufacture:
Machine X Machine Y
(Rs) p.u. (Rs) p.u.
Direct material 8 10
Direct wages 12 12
Variable overheads 4 4
Fixed overheads 5 5
29 31
Selling Price 30 30
Soln. Profitability Statement
Machine X (Rs) Machine Y (Rs)

p.u. p.u.
Selling Price 30 30
Less: Direct Material 8 10
Direct wages 12 12
Variable overhead 4 24 4 26
Contribution per unit 6 4

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Output per hour 50 units 100 units
Contribution per hour Rs. 300 Rs. 400
Total Machine Hrs per annum 2000 2000
Total Contribution Rs. 6,00,000 Rs. 8,00,000
Machine Y is more profitable
i)Accepting Special orders, Bulk orders, Export orders and Exploring New Markets:- Bulk
orders, additional orders, export orders from foreign or new markets, may be accepted at a price
below the normal market price so as to utilize the idle capacity. Such orders are received usually
asking for a price below the market price and hence a decision is to be taken to accept or reject the
order. The order may be accepted at any price above the marginal cost because the fixed costs have
to be incurred even otherwise. Any contribution resulting from the additional sales would mean an
additional profit. But care must be taken to see that accepting an order below the market price does
not affect the normal selling price adversely.
Prob. A manufacturing company’s product cost Rs.17 per unit and sold at Rs.20 per unit. Its normal
production capacity is 50,000 units per annum and the budgeted costs at this level are:
Direct materials 3,00,000

Direct labour 2,00,000
Expenses: Fixed 2,50,000
Variable 1,00,000
Calculate the break-even sales volume.
There is a fall in the demand in local market and orders are expected for 35,000 units only. The
sales manager has stated that an export order for an additional 10,000 units could be negotiated at a
special price of Rs.14 per unit. He has also established that a second order of 4,000 modified units
could be obtained at a special price of Rs.13 per unit. The modifications would reduce the cost of
direct materials by Re.1 per unit but would increase the direct labour and variable expense by 25%.
Make necessary calculations and prepare a statement showing the effect of sales manager’s
proposals.
Soln.
Marginal cost and contribution statement for existing sale of 50,000 units
Particulars Perunit (Rs) Total (Rs) Perunit (Rs) Total (Rs)
Sales (50000X20) 20 10,00,000

Less Variable cost:
Direct Materials 6.00 3,00,000
Direct Labour 4.00 2,00,000
Variable expenses 2.00 1,00,000 12 6,00,000
Contribution 8 4,00,000
Less Fixed cost 2,50,000
Profit 1,50,000

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Calculation of Break-even Sales volume:
BEP (units) = Fixed cost ÷ contribution per unit = 2,50,000 ÷ 8 = 31,250 units
BEP (Rs) = 31,250 x 20 = Rs. 6,25,000
Statement showing marginal cost and contribution of alternative proposals
Particulars Estimated sales in domestic market

Sales 35,000units @ 20 = 7,00,000
--variable cost;
D.Materials 35000 x 6 = 2,10,000
D.Labour. 35000 x 4 = 1,40,000
V.Expenses 35000 x 2 = 70,000 4,20,000
Contribution 2,80,000
Contribution: Contribution: Export Total: Domestic
order-2 + Export 1 and 2
Export order-1
Sales:10000x14 = 1,40,000 4000x13= 52,000 8,92,000
Less:
D.mat. 10000x6= 60,000 4000x5= 20000
D.lab. 10000x4= 40,000 4000x5= 20000
V.exp.10000x2= 20,000 1,20,000 4000x2.5=10000 50,000 5,90,000
Contribution = 20,000 2,000 3,02,000
Less Fixed cost 2,50,000
Profit 52,000
Advantages of Marginal costing
1. Effective tool for cost control- by classifying the costs into fixed and variable.
2. It is simple to understand and easy to operate.
3. There is no chance of over absorption or under absorption of overheads.
4. Helpful to management to managerial decision-making.
5. It facilitates the study of cost-volume-profit relationship.
6. Relative profitability of various products can be studied.
7. It helps in fixing selling prices, level of activity planning, deciding on alternative
investment proposals, sales mixes etc.
8. Better presentation of information through graphs, charts etc.
Disadvantages of marginal costing
1. Difficulty in segregation of total costs in to fixed and variable.

2. Assumptions like variable cost per unit remains fixed at all levels, fixed cost in total remains
fixed at all levels etc. are most of the time unrealistic.
3. Elimination of fixed cost from the valuation of stock and work-in progress is illogical.
4. Time factor is completely ignored.
5. It does not provide any standard for the evaluation of performance.

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Try yourself:
1. X co. Ltd has a P/V ratio of 40%. The marginal cost of product A is Rs. 30/- per unit.
Determine the selling price.
30
(Ans: Variable cost ratio = 1- P/V ratio = 60%; SP = x100  Rs.50)
60
2. Plant A produces a product which ccsts Rs. 3 p.u. when produced in quantities of 10,000
units and Rs. 2.50 p.u when produced in quantities of 20,000 units. Find our fixed cost.
Difference in Total cos t
(Ans:- VC. P.u =  Rs.2FC : 10,000
Difference in units
3. The P/V ratio of a company is 40% and its margin of safety is 50%. Work out the
net profit and the BEP if sales volume if Rs. 8,00,000.
(Ans: M/S 4,00,000; BEP = 4,00,000; Profit 1,60,000)
4. Company A & B, under the same management make and sell the same type of
product. There budgeted P/L A/c for the year ending 2002 are:-
Company A Company B
Sales (Rs.) 3,00,000 3,00,000
Less variable cost 2,40,000 2,00,000
Fixed cost 30,000 2,70,000 70,000 2,70,000
Profit 30,000 30,000
====== ======
a. Calculate the BEP for each company
b. Calculate the sales at which each will make a profit of Rs. 10,000.
c. State which company is likely to earn greater profits in conditions of
1. Heavy demand for the products.
2. Low demand for the products.
(Ans: a) BEP of Co.A: 1,50,000; Co. B = 2,10,000
b) Co.A = Rs. 2,00,000; Co. B = 2,40,000
c) M/S = Co.A = Rs. 1,50,000; Co. B Rs. 90,000
1. heavy demand = Co. B is better as its P/V ratio is high
2. Low demand = Co.A is better BEP earlier, M/S more)
5. Mr. X has Rs. 2,00,000 investment in his business firm. He wants a 15% return on his
money. His variable cost of operating is 60% of sales, fixed costs are Rs. 80,000 per year.
Answer the following questions:-
a) What sales volume must be obtained to Break even?

b) What sales volume will bring 15% return on investment?
c) He expects that even if he closes the business, he would incur Rs. 25,000 as expenses per
year. At what sales would be better off by closing his business up?
(Ans: P/V ratio = 40%, return expected = Rs. 30,000
FP
a) BEP = Rs. 2,00,000; b)  Rs.2,75,000
P / V ratio
c) Sales level at which it is better to lock up business, fixed cost when looked up 25,000.
25,000
Sales to recover such fixed cost x100  62,500
40
If sales fall below Rs. 62,500, it is better to lock up).
(Try to solve some more problems from texts).
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UNIT-NINE
COST OF CAPITAL
Introduction
The cost of funds used for financing a business can be termed as cost of capital. Cost of
capital depends on the mode of financing used – it refers to the cost of equity if the business is
financed solely through equity or to the cost of debt if it is financed solely through debt. Many
companies use a combination of debt and equity to finance their businesses, and for such
companies, their overall cost of capital is derived from a weighted average of all capital sources,
widely known as the weighted average cost of capital (WACC). Since the cost of capital represents
a hurdle rate that a company must overcome before it can generate value, it is extensively used in
the capital budgeting process to determine whether the company should proceed with a project or
not.
The cost of capital is very important in financial decision making. It is used as a measuring scale
for an investment proposal and in various methods of capital budgeting. It is the important in
formation of capital structure. It is used to evaluate the financial performance and the decision in
capital budgeting and the other alternative source of financing.
Definition
“The cost of capital is the minimum required rate of return, the hurdle or target rate or cut off or the
financial standard of performance of a project-“ G.C. Philippatos
“The cost of capital is the minimum required rate of earning or the cut off rate for capital
expenditures”- Solomon Ezra
“It is a cut off rate for the allocation of capital to investments or projects. It is the rate of return on a
project that will leave unchanged the market price of the stock”- James Van Horne
Concept of Cost of Capital
The cost of various capital sources varies from company to company, and depends on factors
such as its operating history, profitability, credit worthiness, etc. In general, newer enterprises with
limited operating histories will have higher costs of capital than established companies with a solid
track record, since lenders and investors will demand a higher risk premium for the former.
Importance of the concept
1. Design the corporate financial structure.
2. Allocation of capital.
3. Helpful in evaluation of expansion project based on Net present value, benefits cost ratio
and internal rate of return.
Every company has to chart out its game plan for financing the business at an early stage. The cost
of capital thus becomes a critical factor in deciding which financing track to follow – debt, equity or
a combination of the two. Early-stage companies seldom have sizable assets to pledge as collateral
for debt financing, so equity financing becomes the default mode of funding for most of them.
Specific Cost and Weighted Average Cost of Capital
The capital structure of a company comprises of various sources of funds such as debt
capital, preference share capital, equity share capital, retained earnings, etc. The cost of debt is
merely the interest rate paid by the company on such debt. Since interest expense is tax-deductible,
the after-tax cost of debt is calculated as: Interest offered on debt capital x (1 - T) where T is the
company’s marginal tax rate.
The cost of preference share capital is the rate of dividend offered on such shares. Like
interest on debt funds, there is no tax implication for dividend payment. The cost of equity is more

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complicated, since the rate of return demanded by equity investors is not as clearly defined as it is
by lenders.
The firm’s overall cost of capital is based on the weighted average of these costs. For
example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its
cost of equity is 10% and after-tax cost of debt is 6%. Therefore, its WACC would be (0.7 x 10%) +
(0.3 x 6%) = 8.8%. This is the cost of capital that would be used to discount future cash flows from
potential projects and other opportunities to estimate their Net Present Value (NPV) and ability to
generate value.
Companies strive to attain the optimal financing mix, based on the cost of capital for various
funding sources. Debt financing has the advantage of being more tax-efficient than equity
financing, since interest expenses are tax-deductible. However, too much debt can result in
dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher
default risk.
COMPUTATION OF COST OF EACH SPECIFIC SOURCE OF CAPITAL:

To calculate the overall cost of capital, we have to compute the specific cost of various sources
of finances employed by the company. Generally there may be four sources- debt funds, equity
share capital, preference share capital and retained earnings. We shall look into the computation
of cost of these individual sources of financing in the following pages.
a) Cost of debt
Debt funds include debentures, bonds, loans, borrowings and other creditorship securities. The
debenture may be redeemable or irredeemable, issued at par, premium or discount. The cost of
debenture is defined in terms of required rate of return that the debt financial investment must
yield to prevent damages to the stockholders position. This is the contractual interest rate
adjusted further for the tax liability of the firm. Normally the cost of debenture is denoted as Kd
Cost of debt issued at par
Kd = (1-T) R
Where, T= Tax rate
R = Contracted interest rate
Cost of debt issued at premium or discount

Kd = I/NP (1-T)
Where, I = Interest on debt, NP = Net proceeds, T = Company tax rate.
( )/
Before tax Kd = x 100
( )/
Where, I = Interest on debt, P= Par value of debentures, NP = Net proceeds of debentures,
n = number of years to maturity
After tax Kd = before tax Kd (1-tax)
Eg. A firm issues debentures of Rs. 1,00,000 and realizes Rs. 98,000 after allowing 2%
commission to brokers. The debentures carry an interest rate of 10% and due for maturity at the
end of the 10th year. Calculate the effective cost of debt before tax and after tax, if the tax rate is
40%.
( )/ , ( , , , )/
Kd (before tax) = ( )/
x 100 = ( , , , )/
x 100
,
= ,
x100 = 10.30%
Kd (after tax) = Kd (before tax)x (1-T) = 10.3(1--0.4) = 6.18%

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b) Cost of Preference Share capital:

The fixed percentage of dividend offered is assumed to be the cost of preference share
capital.
Kp = PD/NP, where PD = Preference dividend, NP = Net proceeds of preference shares. The
same formula can be applied to calculate cost of preference capital when issued at premium
or at discount.
Eg. A company raises preference share capital of Rs. 1,00,000 by issue of 10% preference
shares of Rs. 10 each. Calculate the cost of preference capital when they are issued at- a)
10% premium and b) 10% discount.
Sol. A) When preference shares are issued at 10% premium:
,
Kp = x100 = ,
x100 = 9.09%
B) When preference shares are issued at 10% discount:
,
Kp = 100 = 100 = 11.11%
,
Cost of Redeemable Preference shares: Incase of redeemable preference shares, the cost
of capital is the discount rate that equals the net proceeds of sale of preference shares with
the present value of future dividends and principal repayments. It is calculated almost like
cost of redeemable debentures, except for the tax adjustments..
( )/
Kp = ( )/
100
Where,
PD = Preference dividend, P = Par value of preference shares, NP = Net proceeds,
n= term of the share.
Eg. A firm issues 10% redeemable preference shares of Rs. 1,00,000 , redeemable at the end of the
10th year. The underwriting costs came to 2%. Calculate the effective cost of preference share
capital.
( )/ , ( , , , )/
Kp= x 100 = x 100
( )/ ( , , , )/
,
= ,
x100 = 10.30%
Before tax and after tax cost of preference share will be same as preference dividend is not a tax
deductible item like debenture interest.
c) Cost of Equity Share Capital :

It is the minimum rate of return a company should earn on its equity capital so as to keep
the equity shareholders satisfied. Cost of equity share capital may be defined as the
minimum rate of return that a firm must earn on the equity financed portion of an
investment project in order to leave unchanged the market price of such shares. The four
important approaches of calculating cost of equity are:
1. Dividend/Price approach: Under this approach, the investor arrives at the market price of
an equity share by capitalizing the set of expected dividend payments. Cost of equity capital
is “the discount rate that equates the present value of all expected future dividends per share
with the net proceeds of the sale or current market price of a share.” In other words, cost of
equity will be that rate of expected dividends which will maintain the present market price
of equity shares.

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Ke = D/MP, where Ke = Cost of equity, D= Dividend per equity share,
MP = Market Price per equity share. (for existing equity shares)
Or Ke = D/NP, NP = Net Proceeds per equity share (for fresh issue of equity shares)
Eg. A company offers for public subscription equity shares of Rs. 10 each at a premium of 10%.
The company pays 5% of the issue price as underwriting commission. The rate of dividend
expected by the equity shareholders is 20%. Calculate the cost of equity capital.
Will your cost of capital be different if it is to be calculated on the present market value of the
equity shares, which is Rs. 15 per share?
Soln. Cost of new equity, Ke = D/NP
D = 20% of Rs. 10 = Rs. 2, NP = 10 + 10% -- 5% = 11 –0.55 = 10.45
Ke = 2/10.45 = 0.19 or 19%
Cost of existing equity = D/MP
Ke = 2/15 = 0.133 or 13.3%
2. Dividend price plus growth approach: ( + Growth approach)

In this case the cost of equity is determined on the basis of the expected dividend rate plus the rate
of growth in dividend.
Ke = (D/MP) + g : for existing equity shares
Or (D/NP) + g : for fresh issue of equity shares.
Where, D = Dividend per share, MP = Market Price per share, NP = Net Proceeds per share,
g = Growth rate in expected dividend.
Eg. The current market price of an equity share is Rs. 90. The current dividend per share is Rs.
4.50. In case the dividends are expected to grow at the rate of 7%, calculate the cost of equity
capital.
Soln. Ke = (D/MP) + g = 4.50/90 +0.07 = 0.05 + 0.07 = 0.12 or 12%
Prob. Calculate the cost of equity capital:-
Details of XLtd. : Each share is of Rs. 150, Underwriting cost per share Rs. 2, The company has a
fixed dividend payout ratio. The expected dividend on the new shares amounts to Rs. 14.10 per
share.
Following are the dividend paid by the company for the last five years:
Year 2011 2012 2013 2014 2015
DPS 10.50 11.00 12.50 12.75 13.40
DPS = Dividend Per Share.

Soln. Growth rate of dividend is to be calculated. During the last four years (and not five years,
since dividends declared at the end of 2011 is compared with dividends at the end of 2015), the
dividend declared by the company has increased from Rs. 10.5 to 13.4, giving a compound factor of
1.276 (ie., 13.4/10.5). From compound value factor table it can be seen that Re. 1 would accumulate
to 1.276 in 4 years at 6% interest. This means that growth rate of dividend is 6%. Thus, cost of
equity will be calculated as:
Ke = (D/NP) + g = (14.10/147) + 6% = 9.6% + 6% = 15.6%
Net Proceeds = 150—underwriting cost per share @ 2% of 150 = 150—3 = 147
3.Earnings Price (E/P) Approach: Under this approach, it is the earnings per share (EPS) which
determines the market price of the share. This is based on the assumption that the shareholders
capitalize a stream of future earnings (as distinguished from dividends) in order to evaluate their
shareholdings.

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Ke = Earnings per share/Net Proceeds per share or EPS/NP
Eg. The capital employed by a company consists of 1,00,000 equity shares of Rs. 100 each. Its
current earnings are Rs. 10 lakhs per annum. The company wants to raise additional funds of Rs. 25
lakhs by issuing new shares. Calculate the cost of equity capital.
Soln. Ke = E/NP = 10/90 =0.11 or 11%
Where, E = EPS = Rs. 10,00,000/1,00,000 = Rs. 10
NP = Net Proceeds per share = Rs. 100—floatation cost @ 10% = 100 – 10 = Rs. 90
4. Realized Yield Approach: Under this method the cost of equity capital should be determined on
the basis of return actually realized by the investors on their equity shares. The past records of
dividend payment and actual capital appreciation in the value of the equity shares held by the
shareholders are to be taken to compute the cost of equity capital. This method fairly good results in
case of companies with stable dividends and growth records.
Eg. A purchased five shares in a company at a cost of Rs. 240 on January 1, 2011. He held them
for 5 years and finally sold them in January, 2015 for Rs. 300. The amount of dividend received by
him in each of these 5 years was as follows:
Years 2011 2012 2013 2014 2015
Dividend (Rs) 14.00 14.00 14.50 14.50 14.50
You are required to calculate the cost of equity capital.

Soln. In order to calculate cost of capital, it is necessary to calculate internal rate of return (IRR)
through” trial and error” method. (This method has been explained in unit four on investment
appraisal techniques). Let us see how it works:
Calculation of Present Value of Cash inflows in the form of Dividends and sale price
Year Dividend (Rs) Sale proceeds Discount Factor Present Value
(Rs) @ 10% (Rs)
2011 14.00 0.909 12.70
2012 14.00 0.826 11.60
2013 14.50 0.751 10.90
2014 14.50 0.683 9.90
2015 14.50 0.621 9.00
2015 300 0.621 186.30
240.40
The purchase price of the five shares on January 1, 2011 was Rs. 240. The present value of cash
inflows as on January, 2011 amounts to Rs.240.40. Thus, at 10%, the present value of cash inflows
over a period of 5 years is equal to the cash outflow in the year 2011. The cost of equity capital can,
therefore, be taken as 10%.
d) Cost of Retained Earnings
The companies do not generally distribute the entire earnings by way of dividend among their
shareholders. Some profits are retained by them for future expansion of the business. Many people
feel that such retained earnings are absolutely cost free. This is not true because the amount retained
by the company, if it had been distributed among the shareholders by way of dividend, would have
given them some earning. The company has deprived the shareholders of this earning by retaining a

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part of profit with it. Thus, the cost of retained earnings is the earning forgone by the shareholders.
In other words, the opportunity cost of retained earnings may be taken as the cost of retained
earnings.
The following adjustments are made for ascertaining the cost of retained earnings:
1) Income tax adjustment: The dividends receivable by the shareholders are subject to income
tax. Hence, the dividends actually received by them are the amount of net dividend, ie.,
gross dividend less income tax.
2) Brokerage cost adjustment: Usually the shareholders have to incur some brokerage cost for
investing the dividends received
Thus, Cost of Retained Earnings (Kr) = Ke (1-T) (1- B)

Where, Kr = Cost of retained earnings Ke = Cost of equity share capital
B = Brokerage cost. T = Shareholders’ marginal tax rate.
Eg. ABC Ltd. is earning a net profit of Rs. 50,000 per annum. The shareholders’ required rate of
return is 10%. It is expected that retained earnings, if distributed among the shareholders, can be
invested by them in securities of similar type, carrying return of 10% per annum. It is further
expected that the shareholders will have to incur 2% of the net dividends received by them as
brokerage cost for making new investments. The shareholders of the company are in 30% tax
bracket. Calculate the cost of retained earnings.
Soln. (Kr) = Ke (1-T) (1- B) = 10% (1-0.30) (1-0.02)
= 10% x 0.7 x 0.98 = 6.86%
Thus, the cost of retained earnings is 6.86%, which is less than cost of equity, 10%. It is because of
the personal tax and brokerage effect.
Weighted Average Cost of Capital (WACC)
After calculating the cost of each component of capital, the average cost of capital is generally
calculated on the basis of weighted average method. This is also known as overall cost of capital.
The computation of the weighted average cost of capital (WACC) involves the following steps:
1. Calculation of the cost of each specific source of funds: It involves the determination of the
cost of debt, equity capital, preference capital, retained earnings etc. as explained earlier.
2. Assigning weights to specific costs: This involves determination of the proportion of each
source of funds in the total capital structure of the company.
3. Adding of the weighted cost of all sources of funds to get an overall weighted average cost
of capital.
Eg. From the following capital structure of a company, calculate the overall cost of capital,
using- a) book value weights and b) market value weights.
Source Book value (Rs) Market value (Rs)
Equity share capital 45,000 90,000
(Rs. 10 shares)
Retained earnings 15,000
Preference share capital 10,000 10,000
Debentures 30,000 30,000

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The after tax cost of different sources of finance is as under:
Equity share capital: 14%; Retained earnings: 13%; Preference share capital: 10% and Debentures;
5%.
Soln. Let us compute the overall cost of capital (WACC), considering both book value and market
value as weights.
a) Computation of weighted average cost of capital (Book value Weights)
Source Amount (Rs) Proportion After tax Weighted cost
cost (in %) (in %)
Equity sh.capital 45,000 0.45 14 6.30
Retained Earnings 15,000 0.15 13 1.95
Pref.share capital 10,000 0.10 10 1.00
Debentures 30,000 0.30 5 1.50
b)Weighted Average cost of capital (Market value weights):

Sources Amount Proportion After Weighted cost
tax cost (in %)
Equity capital 90,000 0.692 14% 9.688
Pref. share capital 10,000 0.077 10% 0.770
Debentures 30,000 0.231 5% 1.155
11.613
Weighted Average Cost of Capital (Ko) = 11.613%
Problems:
1.XYZ Company has following capital structure on 31 December,
11% Debenture Rs. 5,00,000
10% Preference share Rs. 1,00,000
4000 Equity share of Rs 100 each Rs. 4,00,000
Total 10,00,000
Equity shares are quoted at Rs 102 and it is expected that the company will declare a dividend of Rs
10 per share at the end of current year. The dividend is expected to grow at 10% for the next 5
years. The company tax rate is 50 %.
(a) Calculate from the foregoing data the cost of equity capital and weighted average cost of
capital.
(b) Assuming the company can raise additional debenture of Rs 3 lakhs at 12%. Calculate
revised weighted cost of capital, if the resultant changes are
1. Increase in dividend rate from 10 to 12%
2. Reduction in growth rate from 10 to 8 %
3. Fall in market price of share from Rs 102 to Rs. 92.
Solution
a) Cost of equity= (D/MP)+g
Ke = (10/102) + 10%
.09+.10=.19 19%

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b) Revised Ke = (12/92) + 8%
.130+.8=.21 21%
c) Cost of Debt (Kd) = 11(1--0.5) = 5.5%
d) Kd of additional debt= 12(1—0.5)= 6%
a) Statement of Weighted Average Cost of Capital
Sources Amount Rs After Tax Weight Weighted

Cost
Equity share 4,00,000 .19 .400 .76
Preference share 1,00,000 .10 .100 .010
Debenture 5,00,000 .055 .500 .0275
10,00,000 .1135
Weighted Average cost of capital = 11.35%

b) Statement of Weighted Average Cost of Capital (Revised)
Sources Amount Rs After Tax Weight Weighted

Cost
Equity share 5,00,000 .21 .357 .0749
Preference share 1,00,000 .10 .71 .0071
Debenture (1) 5,00,000 .055 .357 .0196
Debenture (2) 3,00,000 0.60 .215 .0129
14,00,000 .1145
Weighted Average cost of capital = 11.45%

Try yourself:
1. Mendex Ltd. issued 10% irredeemable preference shares of Rs. 100 each. Calculate the cost
of preference share capital in each of the following cases:
a) When issued at 5% discount, b) When issued at 5% premium
(Ans. a) 10.53% b) 9.10%)
2. The current MP of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share.
Dividend per share amounts to Rs. 4.50 and is expected to grow at a rate of 7%. Calculate
the cost of equity share capital.
(Ans.: 12%)
3. Explain the concept of cost of capital as a device for establishing a cut off point of capital
investment proposals.
4. Focus Ltd. has the following capital structure:
Equity Share Capital (Expected dividend 12%): Rs. 10,00,000
10% Preference Share Capital : Rs. 5,00,000
8% Loan : Rs. 15,00,000
You are required to calculate the weighted average cost of capital, before and after tax,
assuming 50% as the rate of income tax.
(Ans.: before tax 9.66%, after tax 7.67%)

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5. Following are the details regarding the capital structure of Samurai Ltd.
Type of capital Book value Market value Specific
cost(%)
Debentures 40,000 38,000 5
Pref. capital 10,000 11,000 8
Equity capital 60,000 1,20,000 13
Retained earnings 20,000 9
1,30,000 1,69,000
Determine the WACC using – a) book value as weight, and b) market value as weights. Do
you think, there can be a situation where WACC would be the same irrespective of the
weights used ?
(Ans.: a) 9.54% b) 10.17%. WACC would be the same irrespective of the weights in case
the book value and the market value of the securities are the same)
Hint. Market value of equity shares and retained earnings is Rs. 1,20,000 against their book
value of Rs. 80,000. On this basis the market value of retained earnings is Rs. 30,000 (ie.,
20,000 x 120,000/80,000) and market value of equity capital is Rs. 90,000(ie., 60,000 x
1,20,000/80,000)

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UNIT-TEN
COST CONTROL
Introduction
Control of cost has become a major task of the management in the present day of competitive
environment. Entrepreneurs have to face stiff competition from within and outside the country.
Quality goods and services at minimum cost should be provided to survive and compete in the
market. This can be achieved by eliminating wastage and inefficiency in different areas of
operation. This needs proper planning and control of cost.
Definition
The Institute of Cost and Management Accountants, London defines cost control as “the regulation
by executive action of the cost of operating an undertaking particularly where such action is guided
by cost accounting”. The term ‘regulation’ and ‘executive action ‘indicate conscious attempt of
regulating the cost on the basis of predetermined ideas about what cost should be. It is only when
costs are predetermined i.e. a system of standard costing is in operation, that cost control measures
can give their best. Thus, cost control aims at reducing inefficiencies and wastages and setting up
predetermined costs and in achieving them.
Cost Control Techniques
Following are some of the techniques which have become popular for ensuring cost control:
a. Material control
b. Labour control
c. Overhead control
d. Budgetary control
e. Standard costing
f. Control of capital expenditure
g. Productivity ratio
Essentials for success of cost control

The following steps should be taken in an effective system of cost control:
(1) For an effective system of cost control, the firm should have a definite plan of organization.
Authority and responsibility of each executive should be clearly defined. Targets for
performance of work as well as the cost to be incurred for the purpose should be laid down
for each area of responsibility so that responsibility may be fixed for the deviation of actual
costs from the predetermined costs.
(2) Costs should be collected by each area of responsibility and reporting of efficiency or
inefficiency displayed by each section should be prompt. Information delayed is information
denied. If a considerable time elapses between happening of events and reporting,
opportunity for taking appropriate action may be lost or some wrong decisions may be taken
by management in the absence of information.
(3) The report draws management’s attention to exceptionally good or bad performance, so that
management by exception may be carried out effectively. The aim should be to bring to
light the factor leading to increase in cost rather than to punish people to take the remedial
action to improve the performance in future.
(4) Good performance should be handsomely rewarded, so that workers may be motivated
towards better performance.

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Cost Reduction
Definition
The Institute of Cost and Management Accountants, London defines cost reduction as follows:
“Cost reduction is to be understood as the achievement of real and permanent reduction in the unit
costs of goods manufactured or services without impairing their suitability for the use intended”.
The definition given above brings to light the following characteristics of cost reduction:
(1) The reduction must be a real one in the course of manufacture or service rendered. Real cost
reduction comes through greater productivity.
(2) The reduction must be permanent one. It is short lived if it comes through reduction in the
price of inputs such as material, labour etc. The reduction should be through improvement in
the method of production from research work.
(3) The reduction must not be at the cost of essential characteristics such as quality of the
products or service rendered.
Thus, cost reduction must be genuine one and should aim at the elimination of wasteful elements in
the methods of doing things. It should not be at the cost of quality.
Cost Control and Cost Reduction

Cost control and cost reduction are two efficient tools of management but their concepts and
procedures are widely different. The main points of difference between the two are the following
(1) Cost control aims at achieving the predetermined costs, whereas cost reduction aims at
reduction of costs.
(2) The process of cost control is to lay down a target, ascertain actual performance from the
target and take corrective action. On the other hand, cost reduction is not concerned with
maintenance of performance according to the predetermined standards.
(3) Cost control seeks adherence to standard, whereas cost reduction is a challenge to the
standard themselves; cost reduction assumes that there are chances of improvement in
predetermined standards.
(4) The aim of cost control is to see that actual cost do not exceed the predetermined cost, so it
is preventive function. On the other hand, cost reduction is a corrective function because it
challenges the predetermined cost and seek to improve the performance by reducing cost or
increasing production.
Areas of Cost Reduction

1. Product Design:
Cost reduction begins with the improvement in the design of the product. Product design is the first
step in the manufacturing of the product and the impact of cost reduction effected at this stage is felt
throughout the manufacturing life of the product. An investigation into the possibilities of cost
reduction should be made both when introducing new design and when making improvement in the
existing design.
2. Factory organization and production methods
All efforts should be constantly made to reduce the cost by the adoption of new methods of
organization and new product methods.
3. Factory layout
A cost reduction program should make a study of the factory layout to determine whether there is
any scope of cost reduction by elimination of wastage of time, unnecessary efforts and loss of
money due to useless movement and travel of work-in-progress.
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4. Administration
There is ample scope of cost reduction in this area because cost reduction is a top management
problem. Office should be recognized if there is scope of improvement in the efficiency of persons
engaged in the office. Use of unnecessary forms should be avoided to save the cost of stationary
and labour cost involved for compiling them. Efforts should be made to reduce the expenses on
telephone, lighting and travelling but not at the cost of efficiency.
5. Marketing
The various activities which can be brought under the cost reduction program include market
research, advertisement, packing, warehouse, distribution, after sales service etc.
6. Finance
With the increasing difficulty in procuring fiancé, management should eliminate useless
investment. To be able to do so, it must critically examine the amount of working capital and fixed
capital needed and the financial conveniences of reducing them. Wasteful use of capital is as bad as
inadequate capital. Over and under capitalization are both danger signals; what is needed is fair
capitalization. Capital should be procured at economical cost and it should be economically used so
as to give the maximum return. Fixed assets and inventories which cannot be economically used
should be sold and the money realized from their sale should be reinvested in more profitable
channels.
Tools and Techniques of Cost Reduction
The various tools and techniques used for achieving cost reduction are practically the same which
have been suggested for cost control. Some of these are
1. Budgetary control
2. Standard costing
3. Material control
4. Standardization of products and tools and equipments
5. Simplification and variety reduction
6. Improvement in design
7. Labour control
8. Overhead control
9. Production plan and control
10. Automation
11. Operation research
12. Market research
13. Planning and control of finance
14. Value analysis
Advantages of cost reduction

1. Cost reduction increases profit. It provided basis for more dividend to the shareholders,
more bonus to the staff and more retention of profit for expansion of the business
2. Cost reduction will provide more money for labour welfare schemes and thus improve men-
management relationship.
3. Cost reduction will help in making goods available to the consumers at cheaper cost.
4. Higher profit will provide more revenue to the government by way of taxation.

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Value Analysis or Value Engineering
It is one of the newer scientific aids to managerial decision making. It comprises a group of
techniques aimed at the systematic identification of unnecessary cost in a product or service and
efficiently eliminating them without impairing its quality and efficiency. It can also be defined as a
systematic analysis and evaluation of technique and functions in the various areas of a concerned
with a view to exploring channels of performance improvement so that value attached to the
particular product or service may be improved. It endeavors to achieve the maximum possible value
for a given cost by a continuous process of planned action and aims at cost of reduction from the
point of view of value.
Value analysis involves a creative approach for finding out unnecessary cost. Such costs are those
costs which though incurred in a product or service, are unnecessary and do not improve its quality
or efficiency, give it a better appearance, prolong its life nor provide any additional satisfaction to
the customer.
Value analysis is an effective tool for cost reduction. Cost reduction may be achieved by
economizing expenditure and increasing productivity. Whereas value analysis probes into economic
attributes of value. In value analysis, it is possible to improve performance, increase the value of a
product and thus reduce the cost by a continuous process of planned action.
Procedures of value analysis
1. Identification and defining the problem:
Ascertaining whether the customer is being given the full use value and esteem value for the
product he purchases and if not, what is required to be done.
2. The feasibility of alternatives and exploring the best method of performing the work at the
minimum cost.
3. The investment, if any required for the alternative.
4. Costs resulting indirectly out of a decision to change to alternative like costs of items
becoming obsolete, cost of training etc.
5. The benefits from alternatives like reduction in costs and increased revenue.
6. Percentage of return on new investment.
7. Recommendation of the final proposal for implementation.
Types of Industrial Product Value

1. Use value:
There are certain characteristics of a product which make it useful for certain purposes. For
example a book is written for the use of some category of students and it gives its full value if it
serves the purpose of that category of students. It measures the quality of performance of a product.
Use value may be primary use value, secondary use value and auxiliary use value. Primary use
value indicates the attributes of the products which are essential for its performance as engine,
steering wheel and axle in a motor car without which car cannot run. Secondary use value refers to
such devices as the bonnet or the mudguard or the windscreen without which motor car can be
driven but these are necessary for the protection of engine and other parts. Auxiliary use value is
essential for better control and operation as speedo meter, electric horn etc. in motor car.
2. Esteem value:
Certain properties of a product do not increase its utility value but they make it esteemable which
would induce customers to purchase the product. For example a watch with gold cover has an
esteem value. A rich customer may prefer a watch with a gold cover although a watch with a steel
cover may serve the same purpose of keeping time.

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3. Cost value:
This value is measured in terms of cost involved. In the case of a manufacturing concern, it refers to
the cost of production of the product produced and if some part of the product is purchased from
outside, it means cost of purchase of that part.
4. Exchange value:
Certain characteristic of product facilities its exchange for something else and which we get is the
exchange value of that product.
Relationship between Value, function and cost
The relationship between Value, Function and Cost can be expressed as follows:
Value = Function/Cost
Higher the ratio, higher is the value and lower ratio, lower is the value. Value can be improved:
(1) by improving functions, cost remaining constant, or
(2) by improving cost, function remaining constant, or
(3) by improving function and reduction cost.
Example 1: Cast iron components when purchased from a particular sole supplier and machined
showed certain cracks during machine operation. The percentage of such rejection was 5% and
considered normal but when alternative source of supply was tapped, at the same prize, the
rejections were reduced to 2%. Thus, it has improved the function without reducing the cost.
Example 2: In manufacturing a machine tool, two small parts where riveted together before
assembly of a product, frequently broke off during operation. In order to improve the function, the
two parts were redesigned and machined into one combined operation in order to eliminate the
necessity of riveting. This has also lowered the cost of operation.
Example 3: A spare part made of cast iron was being used in a machine. Its cost of manufacturing
increased. Experiments were carried out with plastic and rubber material to manufacture the spare
part which served for the purpose equally well. Besides improving the function, it reduced the cost
substantially.
Advantages of value analysis
1- It is a powerful tool for cost reduction because its basic objective is the identification of
unnecessary costs in a product or service and efficiently eliminating them without inspiring
its quality and efficiency.
2- It is the scientific tool for increasing productivity of a concern because it aims at exploring
various alternatives for efficient use of all types of resources in employment and making
available goods and services of the kind and quality most wanted by customer at lower cost.
In this way, the manufacturer of most suitable production is facilitated because value
analysis aims at giving highest use value and esteem value to customer.
3- It ensures the fullest possible use of resources because it aims at eliminating all unnecessary
costs.
4- It induces the creative ability of the staff because it involves a creative approach for finding
out unnecessary costs. Creativity develops new ideas which in turn make available the least
expensive alternative to do the same function.
5- It creates the proper atmosphere for increased efficiency because it aims at a continuing
search for improvement in efficiency.
6- It is helpful in any drive for import substitution because it explores new methods and
techniques of manufacturing indigenous goods which may serve the same purpose which
imported goods serve. Thus, it is helpful in saving precious foreign exchange.
7- It can be applied at all stages from the initial design stage of an item right up to the final
stage of its packing and dispatch because it aims at identifying unnecessary costs at all level
with a view to eliminating them systematically.

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UNIT-11
PERFORMANCE MEASUREMENT
MEANING AND CONCEPT

Performance measurement is the process of evaluating the efficiency of a business. It is the
basis of a management control system. Periodic comparisons of actual costs, revenues, profits and
investments with the budgeted costs, revenues, profits and investments help management in taking
decisions about future actions. The objective of performance measurement system should be to
implement the firm’s strategy. Performance measurement should be undertaken in respect of all the
responsibility centers.
MEASURES OF PERFORMANCE OR TECHNIQUES OF PERFORMANCE MEASUREMENT

There are many techniques or measures which may be used to evaluate the performance of a
business. These measures may be broadly classified into:
(a) Financial performance measures
(b) Non financial performance measures
(a)Financial performance measures

Financial performance measures include the following:
i. Responsibility accounting
ii. Budgetary control
iii. Variance analysis
iv. Contribution margin
v. Ratio Analysis
vi. Return on investment or return on capital employed(ROI)
vii. Residual income(RI)
viii. Economic Value Added(EVA)
ix. Balanced Score Card(BSC)
x. Transfer Pricing Policy
(b)Non financial performance measures

Financial measures of performance are important measures of evaluating the efficiency of a
business. However, these measures are not fully adequate and in fact can be dysfunctional for
several reasons. Financial performance measures generally lead to short term actions which may not
necessarily be in the firm’s long-term interests. The business/divisional managers may not
undertake long-term actions which may be useful in the long run but are risky to obtain short term
results which may not be beneficial to achieve the overall objectives of the firm in the long run.
Hence it is essential to use non-financial measures also along with the financial measures for
evaluating the performance of a business unit. The following are some non-financial measures that
may be employed for measuring the performance of a firm:
i. Market share for each product
ii. Product quality
iii. Productivity
iv. After sale service
v. Labor turnover
vi. Customer satisfaction
vii. Employee satisfaction
viii. Corporate governance

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ix. Social responsibilities
x. Business ethics
xi. Innovation and research
However, it may be emphasized that no single measure whether financial or non-financial is

sufficient to evaluate the performance. It is desirable to use multiple measures, both financial as
well as non-financial to measure the performance of a business unit.
RESPONSIBILITY ACCOUNTING
The system of costing like standard costing and budgetary control are useful to management for
controlling the costs. In those systems the emphasis is on the devices of control and not on those
who use such devices. Responsibility accounting is a system of control where responsibility is
assigned for the control of costs. The persons are made responsible for the control of costs. Proper
authority is given to the persons so that they are able to keep up their performance. In case the
performance is not according to the predetermined standards then the persons who are assigned this
duty will be personally responsible for it. In responsibility accounting the emphasis is on men rather
than on systems. For example, if Mr. A, the manager of a department, prepares the cost budget of
his department, then he will be made responsible for keeping the budgets under control. A will be
supplied with full information of costs incurred by his department. In case the costs are more than
the budgeted costs, then A will try to find out reasons and take necessary corrective measures. A
will be personally responsible for the performance of his department.
“Responsibility accounting is a system of accounting that recognizes various responsibility
centers throughout the organization and reflects the plans and actions of each of these centers by
assigning particular revenues and costs to the one having the pertinent responsibility. It is also
called profitability accounting and activity accounting”
According to this definition, the organization is divided into various responsibility centers and
each centre is responsible for its costs. The performance of each responsibility centre is regularly
measured.
Responsibility accounting focuses main attention on responsibility centers. The managers of
different activity centers are responsible for controlling the costs of their centers. Information about
costs incurred for different activities is supplied to the persons in charge of various centers. The
performance is constantly compared to the standard set and this process is very useful in exercising
cost controls. Responsibility accounting is different from cost accounting in the sense that the
former lays emphasis on cost control where as the later lays emphasis on cost ascertainment.
Steps involved in responsibility accounting
Responsibility accounting is used as a control device. The aim of Responsibility accounting is to

help management in achieving organizational goals. Steps are:
1. The organization is divided in to various responsibility centers. Each responsibility
center is put under the charge of responsibility manager. The managers are responsible
for the performance of their departments.
2. The targets of each responsibility centre are set in. The targets or goals are set in
consultation with the manger of the responsibility centre so that he may be able to give
full information about his department. The goals of the responsibility centers are
properly communicated to them.

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3. The actual performance of each responsibility centre is recorded and communicated to
the executive concerned and the actual performance is compared with goal set and it
helps in assessing the work of these centers
4. If the actual performance of a department is less than the standard set, then the
variances are conveyed to the top management. The names of those persons who were
responsible for that performance are also conveyed so that responsibility may be fixed.
5. Timely action is taken to take necessary corrective measures so that the work does not
suffer in future. The directions of the top level management are communicated to the
concerned responsibility centre so that corrective measures are initiated at the earliest.
The purpose of all these steps is to assign responsibility to different individuals so that the
performance is improved. In case the performance is not up to their targets set, then responsibility
may be fixed for it. Responsibility accounting will certainly act as control device and it will help in
improving the overall performance of the business.
RESPONSIBILITY CENTERS
“A responsibility centre is like an engine in that it has inputs, which are physical quantities of
material, hours of various types of labor, and a variety of services; it works with these resources
usually; working capital and fixed assets are also required. As a result of this work, it produces
output, which is classified either as goods, if they are tangible or as services, if they are intangible.
These goods or services go either to other responsibility centers within the company or to customers
in the outside world.
Responsibility accounting is used to measure both inputs and outputs. The inputs of materials
in quantity and labor in hours are expressed in monetary terms. The total of various inputs is called
‘cost’. The output can be expressed either in goods produced or services rendered. If the output is
meant for outsiders, then it is easy to measure the monetary value of the output, but if the output is
used for other departments of the center, then it will have to be valued objectively. The total
output is called ‘revenue’. So responsibility accounting is used in measuring costs and revenues.
The responsibility centers represent the sphere of authority or decision points in an
organization. For effective control, a large firm is usually divided into meaningful segments,
departments or divisions. These divisions of an organization unit are called responsibility centers.
In the words of Deakin and Maher, “a responsibility centre is a specific unit of an organization
assigned to a manager who is held responsible for its operations and resources.”
TYPES OF RESPONSIBILITY CENTERS

For the purpose of evaluating financial performance and control, the responsibility centers are
generally classified into following categories:
1. Cost or expenses centre
2. Profit centre
3. Revenue centre
4. Investment centre
1. COST OR EXPENSES CENTRE

“Cost centers are segments in which managers are responsible for costs incurred but have no
revenue responsibilities.” As observed earlier, responsibility accounting is used to measure both
inputs and outputs. However, when we can measure only expenses or costs incurred and not the
revenue earned from a responsibility centre, it is known as cost or expense centre.
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The contribution of accounting department to the company cannot be measured in monetary terms;
so will call it an expense centre. Generally, a company has production and service departments. The
output of production departments can be measured whereas, service departments incur only
expenses and their output is not measured. It may be either feasible or necessary to measure the
output of some service departments. Such centers are there for called expense cost centers.
The performance of cost centre is measured in terms of quantity of inputs producing a
given output. A comparison between actual input used and the pre determined budgeted inputs are
made to determine the variances which represent the efficiency of the cost centre.
Types of cost/expense centers
There can be two general types of expense centers
(a) Engineered expense centers
(b) Discretionary expense centers
The above classification of expense centers is based upon the two types of cost. i.e., engineered
and discretionary. Engineered costs are those costs which can be estimated with reasonable
reliability, for example, factory cots for direct material, direct labor and direct overheads. An
engineered cost has a definite physical relationship with output. Discretionary costs are those for
which no such engineered estimate is feasible. In discretionary expense centers, the costs incurred
depend upon the manager’s decisions. Discretionary expense centers include administrative and
support cost centers.
Cost centers can also be classified on functional basis as:
i. Production cost centre
ii. Service cost centre
iii. Ancillary cost centre
iv. Administrative and support centre
v. Research and development centre
vi. Marketing centre
2. PROFIT CENTRE
Responsibility centers may have both inputs and outputs. The inputs are taken as costs and
outputs are revenues. The difference between the revenue earned and costs incurred will be profit.
When a responsibility centre gets a profit from output, it will be called profit centre. The output of a
centre may be undertaken either for outside customers or for other centers in the same organization.
When the output is meant for outsiders, then the revenue will be measured from the price charged
from customers. If the output is meant for other responsibility centre then management takes a
decision whether to treat the centre as profit centre or not. For example, if a business has number of
processes and output of one process is transferred to the next process. When the transfer from one
process to another is only on cost, then these processes will not be profit centers. On the other hand,
if management decides to transfer the output from one process to the other as internal transfers at
profit, do not increase company’s assets whereas sales to outsiders will increase assets of the
company(in the shape of cash, debtors, bills receivables, etc.) The income statement of a profit
centre is used as a control device. The profits of a responsibility centre will enable in evaluating the
performance of the manager of that centre.
The performance of the manager of a profit centre may be evaluated by the following measures
of profitability.
i. Contribution margin
ii. Direct profit
iii. Controllable profit
iv. Profit/income before tax
v. Profit/income after tax/net income
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Suitability of profit centers
Establishment of profit centers may be suitable if the following conditions are satisfied:
(a) There exist a decentralized form of organization
(b) The divisional manager has access to all relevant information needed for decision making
(c) The divisional manager is sufficiently independent
(d) Internal transfers of output from one division/centre to another division are not significant
(e) A definite measure of performance is available
Advantages of profit centers
Establishing of profit centre offers the following advantages
i. It encourages initiative as a manager of a profit centre is subject to a lesser degree of control
of the top management
ii. It may improve the quality of decisions as these are made by managers responsible for their
execution.
iii. It may quicken the decision making process as these need not be referred to top
management
iv. It saves time of top management by allowing them management by exception
v. It enhances profit consciousness in the centre division/organization
vi. It promotes competition amongst managers of various profit centers and improves their
performance
vii. It helps in training divisional managers for top management responsibilities
Disadvantages of profit centers
Inspite of many advantages of establishing profit centers, there are many limitations or
disadvantages;
i. Loss of top management control over different divisions
ii. Faulty decisions at divisional level which might have been avoided at top management level
iii. Conflicts amongst individual interests of divisions and the organization as a whole.
iv. Too much emphasis on short term profitability
v. Increased cost due to multiple requirements of facilities and personnel at each profit centre
vi. Transfer pricing problems amongst profit centers
3. REVENUE CENTRE
A revenue center is a segment of the segment of the organization which is primarily responsible
for generating sales revenue. A revenue centre manager does not process control over cost,
investment in assets, but usually has control over some of expenses of the marketing department.
The performance of a revenue centre is evaluated by comparing the actual revenue with budgeted
revenue. The marketing managers of a product line or an individual sales representative are
example of revenue centers.
4. INVESTMENT CENTRE
“An investment centre is an entity segment in which a manager can control not only revenues and
costs but also investment.”
The manager of a responsibility centre is made responsible for properly utilizing the assets used in
his centre. He is expected to earn a fair return on the amount employed in assets in his centre.
Measurement of assets employed poses many problems. It becomes difficult to determine the
amount of assets employed in a particular responsibility centre. Some assets may be used in a
responsibility centre but their actual possession may be with some other department. Some assets
may be used by two or more responsibility centers and it becomes difficult to apportion the amount
of those assets to various centers. Investment centers may be used for big responsibility centers
where assets will be in exclusive possession of that centre.

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The performance of an investment centre can be measured by relating profit to investment base.
The two methods which are generally used to evaluate performance of an investment centre are:
1) Return on investment/capital employed(ROI)
2) Economic Value Added(EVA) or residual Income approach(RI)
RETURN ON INVESTMENT/CAPITAL EMPLOYED

Return on capital employed establishes the relationship between profits and the capital employed.
The term ‘capital employed’ refers to the total investment made in the investment centre/business.
However, net capital employed comprises the total assets used less its current liabilities. The profit
for the purpose of calculating return on capital employed should be computed according to the
concept of capital employed. i.e., gross capital employed or net capital employed. Further, net
profits should be taken before tax because tax is paid after profits have been earned and has no
relation to the earning capacity of a centre. Return on investment can be computed as follows:
Net Profit
Return on investment/capital Employed = x100
Capital employed
Net profit Sales
Or , ROI = x x100
Sales Capital Employed
Or, ROI = Net profit Ratio x Capital Turnover Ratio
Significance of Return on Capital Employed/ROI

The return on capital employed is the prime ratio which measures the efficiency of the business.
The study of this ratio is significant due to following reasons.
1. It is a prime test of the efficiency of business. It measures not only the overall efficiency of
business but also helps in evaluating the performance of various departments.
2. The owners are interested in knowing the probability of the business in relation to amounts
invested in it. A higher percentage of return on capital employed will satisfy the owners
that their money is profitably utilized.
3. The performance of the enterprise can be assessed in relation to ether concerns by making
inter-firm and intra-firm comparisons.
4. The borrowing policy of the enterprise may be properly formulated. The rate of interest on
borrowings should always be less than the return on capital employed.
5. The outsiders like bankers, creditors, financial institutions will be able to find whether the
concern is viable for giving credit or extending loans or not
6. Return on capital employed may help in devising future business policies for expansion or
diversification, etc
7. It helps in providing fair remuneration to various factors of production. Management aims
to make optimum use of various factors of production for increasing rate of return on
investment. The higher return on investment will enable better payments to workers and
other factors of production.
ECONOMIC VALUE ADDED/RESIDUAL INCOME APPROACH
Economic value added is a measure of performance evaluation that was originally
employed by Stern Stewart and Co. It is also referred to as residual income(RI) approach of

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performance evaluation. It is a very popular method used to measure the surplus value created
by an investment or a portfolio of investments. EVA has been considered as a better
measure of divisional performance as compared to the return on assets ROA or ROI. It
is also being used to determine whether an investment positively contributes to the
shareholders wealth. The economic value added of an investment is simply equal to the after
tax operating profits generated by the investment minus the cost of fund used to finance the
investment. EVA can be calculated as below:
EVA = (Net operating profit after tax) – (cost of capital x capital invested
Or, EVA = Capital employed (Return on investment – cost of capital)
Or, EVA = Capital employed (ROI – Cost of Capital)
According to this approach, an investment can be accepted only if the surplus (EVA) is
positive. It is the only positive EVA that adds value and enhances the wealth of stake holders.
However, to calculate the economic value added, we need to estimate the net operating profit
after tax and cost of funds invested. Suppose an investment generates net operating profit after
tax of Rs. 20 lakhs and the cost of financing investment is Rs. 16 lakhs. The economic value
added by the investment shall be Rs. 4 lakhs and it should be accepted.
BALANCED SCORE CARD (BSC)

The balanced score card is another technique of performance measurement. According to Robert S.
Kaplan and David P. Norton, the business units should be assigned goals and then measured from
the following four perspectives.
1. Financial, e.g., Profit margins, return on assets, cash flow
2. Customer, e.g., Market share, customer satisfaction
3. Internal business processes, e.g., capacity utilization, on time delivery, quality,
employee retention.
4. Innovation, e.g., development of new products
The BSC aims at achieving a balance among various strategic measures so as to achieve
integration of organizational and individual goals in the best interest of the organization.
The balanced score card is thus a tool that helps to achieve better communication and a focused
approach to implement the firm’s objectives and strategy. Balanced score card implies use of
multiple measures, both financial and non-financial, for the evaluation of performance of a business
unit. It also emphasizes the need to strike a balance between external measures such as customer
satisfaction and internal measures such as productivity. The balanced score card further emphasizes
the idea of cause and effect relationships among various performance measures. It is true to say that
balanced score card is a tool to translate firm’s strategy into action, although, some critics have said
that it is an old wine in a new bottle.
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UNIT-TWELVE
TRANSFER PRICING
Introduction
A transfer price is a price used to measure the price of goods or services furnished by a profit
centre to other responsibility centers within a company. As observed earlier, the evaluation of
managerial performance within the company through profit centers is impossible without
determining transfer prices in case various profit centers of the company exchange goods and
services. In such situations, there is a need to determine the monetary values, called transfer price,
at which the transfer should take place so that costs and revenues could be properly assigned. The
implication of transfer price is that for the transferring division it will be a source of revenue,
whereas for the division to which transfer is made it will be an element of cost. Thus, there is need
to determine proper transfer price for the successful implementation of responsibility accounting.
Methods of Transfer Pricing

There are various transfer pricing methods in use based on either (a) cost, (b) market price.
The following are the important types of intra-company transfer price.
1. Cost price
2. Cost plus a normal mark-up
3. Incremental cost
4. Shared profit relative to the cost
5. Market price
6. Standard price
7. Negotiated price
8. Dual or Two-way Price
1. Cost price: According to this method, goods and services are transferred from one segment of
the company to another on the basis of unit cost of production of the transferring division. The cost
could either be taken to be the actual cost of production or the standard cost of production. The
advantage of these methods of transfer pricing is that it is very simple and convenient to operate.
But, it distorts the profit of the various responsibility centers in the sense that the profit of the
transferring centre shall be underestimated and that of the centre to which transfer is made would be
over estimated. In fact, this method of transfer pricing is inappropriate for profit centre analysis.
2. Cost plus a normal mark-up: To overcome the short comings of the simple cost price method,
many companies add to the cost a margin of profit, say 15% of the cost, to determine the transfer
price. Thus, in this method, the buying division is charged the actual unit cost of production of the
transferring department. What so ever it may be, plus a mark up for the profit. The merit of this
method is again simplicity and convenience, but this methods is also not an appropriate method for
profit centre analysis as the inefficiencies of one department along with their costs are transferred to
another department.
3. Incremental cost: Another method of transfer pricing in use by certain companies is the
incremental cost of the transferring division. Incremental cost can be computed in two ways
depending upon the circumstances. In case entire production is transferred to another division
within the same company, the increment cost will be the total of variable cost of transferring centre
plus any fixed costs which are directly attributable to that centre/division. The incremental cost so
calculated suffers from the same defects as that of cost price method. The second approach may be
used when goods and services are sold to outside customers as well as transferred within the same
company. In such a case, incremental cost may be taken as the opportunity cost in the form of loss

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of revenue which the transferring division would have charged from the outside customers. The
second approach is similar to the market price basis and is more useful for profit-centre analysis.
4. Shared profit relative to the cost: According to this method no price is charged for the intra-
company transfers. Rather out of the total sales revenue of the company the aggregate cost of
various divisions is deducted to find out the profit for the company as a whole; and then the profit is
shared by the various profit centers relative to the cost basis of each centre, as below
Profit of the company x cost of particular profit centre
Share of the profit of a particular profit centre=
Total cost
Thus, in this method profit is shared according to the cost of each division. The drawback of this
method is that in efficiencies are not evaluated, and hence, it is not an appropriate method for profit
centre analysis.
5. Market price: In this method, the prices charged for intra-company transfers are determined on
the basis of market prices and not on the cost basis. There are three ways of computing the market
price. Firstly, the prevailing market price, after making adjustment for discounts and other selling
costs, may be taken as transfer price if there is a active market for goods and services transferred
between divisions of the same company. The main advantage of this method is that it protects the
profitability interest of both the divisions as the buying division is charged what it has to otherwise
pay to the outsiders, and the transferring division gets the price which, in any case, it would have
obtained from outsiders. Further, selling and distribution costs as well as costs of bad debts are
reduced and the transferring department gets an assured market, whereas, the buying division is
assured of regular and timely deliveries. Secondly where active market-does not exist or where
market price is not available, cost plus a normal profit may be taken as a reasonable market price.
But, then, inefficiencies of one division will be transferred to another division. Thirdly, the
company could invite bids from the market so as to determine the market price. The lowest bid may
be accepted as the market price for the transfer; however, the problem may arise because of false
bidding or no bidding at all.
6. Standard price: Transfer prices can also be fixed on predetermined standard price basis. The
standard price may be determined on the basis of cost production and the prevailing market
conditions. Thus, division working at less than the desired efficiency will show lesser profits as
compared to the efficient division. However, difficulties may arise in fixing the standard price
agreeable to the different divisions.
7. Negotiated price: The intra-company transfer price can also be determined on the basis of
negotiations between the buying and the transferring division. The price arrived at after negotiation
will be the mutually agreed price. Such as pricing method will be advantages to both the divisions
as well as the company as a whole. However, this method could be used only when both the buying
as well as transferring divisions has alternative choice available with them.
8. Dual or Two-way Price: According to this method, the transferring division is allowed to give
credit price, whereas, the buying division is charged at a different price. It enables better evaluation
of profit centers and avoids conflicts among them on account of transfer prices. However, the total
profits of the various segments would differ from the actual profit of the company as a whole. But,
it poses no problems for the company as transfer prices are meant for internal purposes of
performance evaluation only.

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SELECTION OF TRANSFER PRICING METHOD
The study of the various transfer pricing methods reveals that there is no particular method which
could be termed as the best method for all situations. The selection of a particular method will
depend upon the particular circumstances which may differ from case to case. However, the
following general criteria should be kept in mind while determining the transfer price.
a) The transfer price should be objectively determinable
b) The transfer price should be able to compensate the transferring division and charge the
buying division, commensurate with the value of the goods/services exchanged
c) It should contribute to congruence between the goal of the divisions and the goal of the
organization
d) It should provide for profit centre evaluation
e) It should maximize the efforts towards achievement of organizational goals
PERFORMANCE BUDGETING
Budgeting is the technique of expressing, largely in financial terms of management’s plans for
operating and financing the enterprise during specific periods of time. Performance budgets use
statement of mission, goals and objectives to explain why money is being spent. It is a way to
allocate resources to achieve specific objectives based on program goals and measured results. The
entire planning and budgeting frame work is result oriented.
Elements of Performance Budgeting: It comprises of three elements:
a) The result (final income or outcome)
b) The strategy (different ways to achieve the final outcome)
c) The activity/outputs ( what is actually done to achieve the final outcome)
Performance budgeting involves evaluation of the performance of the organization in the context of
both specific as well as overall objectives of the organization. It presupposes the crystal clarity of
organizational objectives and provides a definite direction to each employee and also a control
mechanism to higher management. Thus performance budgeting lays immediate stress on the
achievement of specific goals over a period of time. In the long run it aims at continuous growth of
the organization so that it continues to meet the dynamic needs of its growing clientele.
Performance budgeting requires preparation of periodic performance reports. Such reports compare
budget and actual data and show any existing variances. The responsibility for preparing the
performance budget of each department lies on the respective departmental head. Periodical reports
from various section of a department will be received by the departmental head who will in
summary form submit a report about his department to the budget committee. The report may be
daily, weekly or monthly depending on the size of business and the budget period. It facilitates
comparison between budgeted and actual figures and take corrective action, where ever necessary.
ZERO BASE BUDGETING
The purpose of management control is to ensure better performance and better utilization of scarce
resources. Traditional budgeting fails to achieve this objective of management effectively. “Zero
base budgeting” provides a solution towards this end.
Zero base budgeting is a comparatively new technique designed to revitalize budgeting. This
technique was first used by the US Department of Agriculture as long back as in 1961. Peter A.
Pyhrr designed its logical basic frame work in 1970 and successfully developed, implemented and
popularized its wider use in the private sectors. He defines ZBB as an “operating, planning and
budgeting process which requires each manager to justify his entire budget request in detail from
scratch (hence zero base) and shifts the burden of proof to each manager to justify why we should
spend any money at all”. The ZBB reviews a programme or project from scratch or zero.

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Process of ZBB
The following are the steps involved in ZBB:
1) Specification of decision units: The decision making centre may be a segment of an
organization or a project for which separate budgets are to be prepared and decisions are
made regarding the amount to be spent and quantum and quality of work to be done.
2) Development of decision packages: Formulation of decision packages is a set of documents
which identify and describe activities of the unit. A separate and different decision package
is require for each major activity to be started or continued.
3) Prioritization of activities: The next step in ZBB is the ranking of proposed alternatives
included in decision packages for various decision units.
4) Allotment of funds: The resources of the organization are allocated to various decision units
keeping in mind the alternatives selected and approved as a result by ranking process.
Advantages of ZBB
1) Optimum use of financial resources on the basis of priority of needs.
2) Weeding out of wastage: Inefficiency is being removed and wastage being reduced.
3) Participation by all concerned in decision making, management by objective is practiced.
4) Flexibility in Budget: The frequent review of performance results in adjustment of budgets
for shortfall of income’
5) Realistic targets: The budgets are prepared as per importance and essentiality of activity and
not on the basis of past occurrence. The budgets are prepared as per conditions prevailing
during the current period without considering the past as basis.
Limitations of ZBB
1) Time consuming: ZBB requires more time than traditional budgeting as there is no basis on
which estimates are to be made.
2) Lack of skilled Managerial Personnel.
3) Limited application: It cannot be directly applied to direct materials, direct wages and
overheads associated with production function.
SOCIAL COST BENEFIT ANALYSIS

The concept of social cost benefits is now increasingly applied to both the public and private
sector. Both these sectors use the resources of the society and, therefore, they have moral
responsibility to undertake only such projects which are socially desirable. Besides
commercial viability of the projects, the associated cost and benefits to the society should
also be considered. The Planning Commission has decided that the feasibility studies for the
public sector projects will include an analysis of the social rate of return. In the case of
private sector also, a socially beneficial project may be more easily acceptable to the
Government and hence the social cost benefit analysis will be relevant while granting
licenses, approvals etc.
MEASUREMENT OF SOCIAL COST BENEFIT
The United Nations Industrial Development Organization (UNIDO) and the Centre for
Organization of Economic Co-operation and Development (COECD) have come with useful
publications dealing with the problem of measuring social costs and social benefits. The actual cost
of or revenues from the goods or services to the organization may not reflect the monetary
measurement of the cost or benefit to the society. Following are some of the indicators or criteria
which can be used for measuring the social costs and benefits associated with the projects:

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1) Employment potential: A project having higher employment potentiality has to be preferred
over a project having a lower employment potential.
2) Capital output ratio: This ratio measures the expected output in relation to the capital
employed in the project. A project giving a higher output per unit of capital employed is to
be preferred over a project with a lower output.
3) Value added per unit of capital: This criterion is superior to the ‘capital output ratio’ since it
considers the net contribution of the firm to the nation’s economy. The term value added
refers to the cost incurred by an organization in converting materials into finished products.
Projects having high value added content are to be ranked high.
4) Savings in foreign exchange: The impact of the project on the foreign exchange reserves of
the country is also a good social criterion for accepting or rejecting a project. Projects
having greater potentiality in terms of foreign exchange benefits will have priority over
other projects.
5) Cost benefit ratio: The projects are evaluated on the basis of total social benefits and cost
associated with the projects. The projects are ranked according to their cost benefit ratio. A
project having the most favourable cost benefit ratio is given the highest preference.
Try yourself:
1. Explain the concept of social cost benefit analysis.
2. Discuss the different methods for measurement of social cost and benefits.
3. Write a short note on social cost benefit analysis
4. What is performance budgeting? What are the elements involved in it?
5. Explain the meaning and essential feature of ‘Responsibility accounting’
6. What is zero base budgeting? Explain the process of ZBB and its advantages.
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www.rejinpaul.com Accounting:
UNIT 1 ACCOUNTING: AN OVERVIEW An Overview
Structure
1.0 Objectives
1.1 Introduction
1.2 Need for Accounting
1.3 Definition of Accounting
1.4 Objectives of Accounting
1.5 Accounting as Part of the Information System
1.6 Branches of Accounting
1.6.1 Financial Accounting
1.6.2 Cost Accounting
1.6.3 Management Accounting
1.7 Role of Management Accountant
1.8 Financial Accounting Process
1.9 Accounting Equation
1.10 Accounting Concepts
1.10.1 Concepts to be Observed at the Recording Stage
1.10.2 Concepts to be Observed at the Reporting Stage
1.11 Accounting Standards
1.12 Accounting Assumptions and Policies as per Accounting Standards of India
1.13 Let Us Sum Up
1.14 Key Words
1.15 Answers to Check Your Progress
1.16 Terminal Questions
1.17 Some Useful Books
1.0 OBJECTIVES
After studying this unit you should be able to appreciate:
l the need for accounting;
l definition of accounting and its objectives;
l describe the advantages and limitations of branches of accounting;
l identify the parties interested in accounting information;
l activities of a management accountant;
l identify the stages involved in accounting process;
l explain the accounting concepts to be observed at the recording and reporting
stages; and
l understand and appreciate the Generally Accepted Accounting Principles.
1.1 INTRODUCTION
In business numerous transactions take place every day. It is humanly impossible to
remember all of them. With the help of accounting records the businessman is able to
ascertain the profit or loss and the financial position of the business at a given period
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Fundamentals of
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and communicate such information to all interested parties. In this unit you will learn
Accounting about an overview of accounting and the basic concepts which are to be observed at
the recording and reporting stage. You will also learn different stages involved in
accounting process and importance of accounting standards to maintain uniformity in
the practice of accounting.
1.2 NEED FOR ACCOUNTING

In early days the business organisations and transactions were small and easily
manageable by the owners of the business themselves. The businessmen used to
remember the transactions by memorizing them. In those days accounting developed
as a result of the needs of the business to keep relationship with the outsiders, listing
of their assets and liabilities. The advent of industrial revoluation and technological
changes have widened the market opportunities. Most of the business concerns in
these days are run by company type of organisation. The business concern has
constantly enter into transactions with outsiders. A transaction involves transfer of
money or money’s worth (goods or services) from one person to another. In addition
to the transactions with outsiders, there are also events requiring monetary record.
It is not possible for a human being to keep in memory all the transactions. Therefore,
it is necessary to record all these transactions properly to get required financial
information. With the help of accounting records the businessman would be able to
ascertain the profit or loss and the financial position of his business at the end of a
given period and would be able to communicate the results of business operations to
various interested parties. It is, therefore, necessary to record all the transactions
systematically from time to time irrespective of the form of business organisation.
The accounting information is useful both for the management and the outside
agencies. The management needs it for the purpose of planning , controlling and
decision making. The outsiders like banks, creditors etc. also require it for assessing
the financial solvency of the business and the tax authorities use it for determining the
amount of tax liability. Infact accounting is necessary not only for business
organisations but also for non-business organisations like schools, colleges, hospitals,
clubs etc.
1.3 DEFINITION OF ACCOUNTING

Accounting as said earlier, involves the collection, recording, classification and
presentation of financial data for the benefit of management and outside agencies such
as shareholder, creditors, investors, government and other interested parties.
Accounting has been defined in different ways by different authorities on the subject.
The following are some of the important definitions of accounting:
According to the Committee on Terminology of American Institute of Certified Public
Accountants (AICPA), “Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions and events
which are in part at least, of a financial character, and interpreting the results thereof”.
Eric L. Kohlen (A Dictionary for Accountants) defines accounting as “the procedure
of analysing, classifying and recording transactions in accordance with a pre-
conceived plan for the benefit of : (a) providing a means by which an enterprise can be
conducted in orderly fashion, and (b) establishing a basis for reporting the financial
condition of enterprise and the results of its operations.”
The former definition denotes that accounting is concerned with the recording of
transactions which are measurable in monetary terms in such a way that analysis and
6
interpretation of business activities is possible. According to the latter definition
accounting is concerned with the recording of business transactions for better
management of the concern and also reporting the true financial position of the An Overview
concern.
The American Accounting Association (AAA) defines accounting as “the process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by users of information.”
Smith and Ashburne define accounting as “the science of recording and classifying
business transactions and events, primarily of a financial character, and the art of
making significant summaries, analysis and interpretations of those transactions and
events and communicating the results to persons who must make decisions or form
judgments.” Thus this definition emphasises financial reporting and decision making
aspects of accounting.
From the above definitions it is clear that accounting is a science of recording
transactions of economic nature in a systematic manner and also an art of analysing
and interpreting the same.
Based on the above definitions, we can summarise the functions of accounting as:
i) Identifying financial transactions,
ii) Recording of transactions which are financial in character,
iii) Classification of transactions,
iv) Summarising the transactions which also includes preparation of trail balance,
income statements and balance sheet,
v) Interpretation of financial results, and
vi) Communicating the interpreted financial results in a proper form and manner to
the proper person.
Look at the following figure and note the functions of accounting which starts from
identifying financial transactions to be recorded in the books and ends with
communicating to the interested parties who use them for decision making.
Functions of Accounting
Identifying financial Recording of Classifying the

s
Transaction Financial Transaction Transaction

s
s
Communication Interpretation of Summarising
s
Make a Decision
s
Owner or Results the Transactions

Management
s
Interested Parties
Make Decision
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Fundamentals of
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Accounting 1.4 OBJECTIVES OF ACCOUNTING
The basic objectives of accounting is to provide necessary information to the persons
interested who will make relevant decisions and form judgement. The persons
interested in the business are classified into two types : i) Internal users, and
ii) External users. Internal users are those who manage the business. External users
are those other than the internal users such as investors, creditors, Government, etc.
Information required by the external users are provided through Profit and Loss
account and Balance sheet whereas the internal users get required information from
the records of the business. Thus the main objectives of accounting are as follows:
1) To keep systematic records of the business : Accounting keeps a systematic
record of all financial transactions like purchase and sale of goods, cash receipts
and cash payments etc. It is also used for recording all assets and liabilities of
the business. In the absence of accounting it is impossible to a human being to
keep in memory all business transactions.
2) To ascertain profit or loss of the business : By keeping a proper record of
revenues and expenses of business for a particular period, accounting helps in
ascertaining the profit or loss of the business through the preparation of profit
and loss account. Profit and Loss account helps the interested parties in
assessing the profit or loss made by the business during a particular period. It
also helps the management to take remedial action in case the business has not
proved remunerative or profitable. A proper record of all incomes and expenses
helps in preparing a profit and loss account and in ascertaining net operating
results of a business during a particular period.
3) To ascertain the financial position of business : The business man is also
interested to know the financial position of his business apart from operating
results of the business during a particular period. In other words, he wants to
know how much he owns and how much owes to others. He would also like to
know what happened to his capital, whether it has increased or decreased or
remained constant. A systematic record of assets and liabilities facilitates the
preparation of a position statement called Balance Sheet which provides
necessary information to the above questions. Balance Sheet serves as barometer
for ascertaining the financial solvency of the business.
4) To provide accounting information to interested parties : Apart from owners
there are various parties who are interested in the accounting information. These
are bankers, creditors, tax authorities, prospective investors etc. They need such
information to assess the profitability and the financial soundness of the
business. The accounting information is communicated to them in the form of an
annual report.
Parties Interested in Accounting Information
Many people are interested in examining the financial information provided in the
financial statements besides a owner or management of the concern. These financial
statements help them to know the following :
i) To study the present financial position of business,
ii) To compare its present performance with that of past years, and
iii) To compare its performance with similar enterprises.
The following are the various parties interested in the financial statements:
i) Owners/Shareholders : Shareholders are the real owners of the company
because they contribute the required capital and take the risk of business.
Obviously they are interested to know the result of operations and financial
position of the company. The shareholders are also interested to use the
accounting information to evaluate the performance of the managers because in
company type of organisation management of business is vested in the hands of
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paid managers.
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Prospective Investors : The persons who are interested in buying shares of a Accounting:
company or who want to advance money to the company, would like to know An Overview
how safe and rewarding the investments already made or proposed investments
would be.
iii) Lenders : Initially the required funds of the business are provided by the owners.
When business is going on, it requires more funds. These funds are usually
provided by banks and other money lenders. Before lending money they would
like to know about the solvency of the enterprise so as to satisfy themselves that
their money will be safe and repayments will be made on time.
iv) Creditors : The creditors are those who supply goods and services on credit.
These creditors like other money lenders are also interested to know the credit
worthiness of the business. The accounting information greatly helps them in
assessing the ability of the enterprise to what extent credit can be granted.
v) Managers : Accounting information is very much useful to managers. It helps
them to plan, control and evaluate all business activities. They also need such
information for making various decisions relating to the business.
vi) Government : The Government may be interested in accounting information of a
business on account of taxation, labour and corporate laws. The financial
statements are of great importance for assessing the tax liability of the enterprise.
vii) Employees : The employees of the enterprise are also interested in knowing the
state of affairs of the organisation in which they are working, so as to know how
safe their interests are in the organisation. The knowledge of accounting
information helps them in conducting negotiations with the management.
viii) Researchers : The accounting information is of immense value to the
researchers undertaking research in accounting theory and practices.
ix) Citizen : An ordinary citizen as a voter and tax payer may be interested to know
the accounting information to measure the performance of Government Company
or a public utility concern like banks, gas, transport, electricity companies etc.
1.5 ACCOUNTING AS PART OF THE INFORMATION

SYSTEM
Accounting is part of an organisation’s information system, which includes both
financial and non-financial data. Accounting is the process of identifying, measuring
and communicating economic information to permit judgment and decisions by users
of the information. The main objective of accounting is to provide information to the
users. Accounting is also required to serve some broad social obligations since the
accounting information is used by a large body of people such as customers,
employees, investors, creditors and government.
Accounting is commonly divided into (1) Financial Accounting, and (2) Managerial
Accounting. Financial accounting refers to the preparation of general purpose reports
for use by persons outside an organisation. Such users include shareholders,
creditors, financial analysts, labour unions, government regulations etc. External
users are interested primarily in reviewing and evaluating the operations and financial
status of the business as a whole.
Managerial accounting, on the other hand, refers to providing of information to
managers inside the organisation. For example a production manager may want a
report on the number of units of product manufactured by various workers in order to
evaluate their performance. A sales manager might want a report showing the
relative profitability of two products in order to pinpoint selling efforts. The financial
reports are available from the libraries or companies themselves where as managerial
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accounting reports are not widely distributed outside because they often contain
Accounting confidential information. The following figure shows that accounting is part of an
organisation system which includes both Financial and non financial data :
Accounting as part of the information system
Accounting and Non-accounting Information
Financial Accounting Managerial Accounting
Creditors Shareholders Tax Other Managerial Managerial Planning

Authorities External Decision making Performance Evaluation
Users
Uses of Accounting Information

Accounting provides information for the following three general uses :-
1) Managerial decision making : Management is continuously confronted with the
need to make decisions. Some of these decisions may have immediate effect
while the others have in the long run. Decisions regarding the price of the
product, make or buy the product or to dropt it, to expand its area of operations
etc., are some of the examples of decisions that face management and
accounting provides necessary information to arrive at right conclusions.
2) Managerial planning, control and internal performance evaluation :
Managerial accounting plays an important role in the planning and control. By
assisting management in the decision making process, information is provided for
establishing the standard. Accounting also provides actual results to compare
with projections.
Planning can be defined as the process of deciding how to use available
resources. The key word in this definition is deciding, because planning is
essentially a matter of choosing the set of alternatives which seem most likely to
enable the organisation to meet its objectives. Several different kinds of planning
processes can be identified, but most important is periodic planning for the
activities of the organisation as a whole.
Control is the complement of planning. It consists of management’s efforts to
prevent undesirable departures from planned results and to take corrective action
in response to it.
The planning and control process consist of the following steps :
i) Setting standards as to what actual performance should be.
ii) Measuring the actual performance.
iii) Evaluating actual performance by comparing actual performance with the
standards. This evaluation aids management in assessing actions already
taken and in deciding which course of action should be taken in future.
The main relationship between planning and control is the planning produces a
plan. This becomes a set of instructions to be executed. The results of the action
taken on the basis of the plan are then compared with the planned results. The
difference of the plan are interpreted to determine what kind of response is
appropriate. A corrective response requires a change in the way of plan is
carried out, while adaptive response requires replanning. Each of these leads
back to an earlier phase of the process and the loop is completed.
For example where a marketing manger is given a target of sales revenues of
Rs. 10 crores, the amount of Rs. 10 crores will serve as a standard for evaluating
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the performance of the marketing manager. If annual sales revenues vary Accounting:
significantly from Rs. 10 crores, steps will be taken to ascertain the causes for An Overview
the difference. When the factors leading to the variance are not under the control
of the marketing manager, then the marketing manager would not be held
responsible for it. On the other hand the cause for variance is under the control
of marketing manager then he will be held responsible in evaluating the
performance of marketing manager.
3) External Financial reporting and performance evaluation : Accounting has
always been used to supply information to those who are interested in the affairs
of the company. Various laws have been passed under which financial
statements should be prepared in such way that required information is supplied
to shareholders, creditors, government etc. For example, the investors may be
interested in the financial strength of the business, creditors may require
information about the liquidity position, government may be interested to collect
details about sales, profit, investment, liquidity, dividend policy, prices etc. in
deciding social and economic policies. Information is required in accordance
with generally accepted accounting principles so that it is useful in taking
important decisions.
1.6 BRANCHES OF ACCOUNTING

To meet the requirements of different people interested in accounting information,
accounting can be broadly classified into three categories :
1) Financial Accounting,
2) Cost Accounting, and
3) Management Accounting
1.6.1 Financial Accounting

The American Institute of Certified Public Accountants has defined Financial
Accounting as “the art of recording, classifying and summarizing in a significant
manner in terms of money transactions and events which are in part at least of a
financial character, and interpreting the results thereof”. Accounting is the language
effectively employed to communicate the financial information of a business unit of
various parities interested in its progress.
The object of financial accounting is to find out the profitability and to provide
information about the financial position of the concern. Two important statements of
financial accounting are Income and Expenditure Statement and Balance Sheet.
All revenue transactions relating to a particular period are recorded in this statement
to decide the profitability of the concern. The balance sheet is prepared at a particular
date to determine the financial position of the concern.
Functions of Financial Accounting

Financial accounting provides information regarding the status of the business and
results of its operations to management as well as to external parties. The following
are some of the important functions of financial accounting :
a) Recording of Information
In business, it is not possible to keep in memory all the transactions. These
transactions need to be systematically recorded and pass through the journals,
ledgers and worksheets before they could take the form of final accounts. Only
those transactions are recorded which are measurable in terms of money. The
transactions which cannot be expressed in monetary terms does not form part of
financial accounting even though such transactions have a significant bearing on
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the working of a business.
Fundamentals of b) Managerial Decision Making
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Accounting
Financial accounting is greatly helpful for managers in taking decisions.
Without accounting, the managerial functions and decision making programmes
may mislead. The performance of daily activities are to be compared with the
predetermined standards. The variations of actual operations and their analysis
are possible only with the help of financial accounting.
c) Interpreting Financial Information
Interpretation of financial information is very important for decision making.
The recorded financial data is interpreted in such a manner that the end users
such as creditors, investors, bankers etc., can make a meaningful judgment about
the financial position and profitability of the business operations.
d) Communicating Results
Financial accounting is not only concerned with the recording of facts and
figures but it is also connected with the communication of results. In fact
accounting is the source of business operation. Therefore, the information
accumulated and measured should be periodically communicated to the users.
The information is communicated through statements and reports. The financial
statements and reports should be reliable and accurate. A variety of reports are
needed for internal management depending upon its requirement. In
communicating reports to outsiders, standard criteria of full disclosure,
materiality, consistency and fairness should be adhered to.
Limitations of Financial Accounting

Financial accounting was able to cope up with the needs of business in the initial
stages when business was not so complex. This is because financial accounting is
mainly concerned with the preparation of final accounts, i.e., profit and loss account
and balance sheet. But the growth and complexities of modern business have made
financial accounting highly inadequate. The management needs information for
planning, controlling and coordinating business activities.
The limitations of financial accounting are as follows :
1) Historic nature : Financial accounting is the record of all those transactions
which have taken place in the business during a particular period. As
management’s decisions relates to future course of action, they are made on the
basis of estimates and projections. Financial accounting provides information
about the past data and not about the future. It does not suggest the measures
about what should be done to improve efficiency of the business. Past data are
needed for making future decisions but that does not alone sufficient.
2) It records only actual costs : Financial accounting has always been concerned
with figures treating them as single, simple and silent items because it records
only actual cost figures. The price of goods and assets changes frequently. The
current prices may be different from recorded costs. Financial accounts do not
record these price fluctuations. Therefore, the recorded information may not give
correct information.
3) It provides quantitative information : Financial accounting considers only
those factors which are quantitatively expressed. Anything which cannot be
measured quantitatively will not constitute a part of financial accounting. Today
business decisions are influenced by a number of social considerations.
Governments polices have a direct bearing on the working of business.
Therefore, in addition to social consideration the management has also to take
into account, the impact of government policies on the business. But these
factors cannot be measured quantitatively so their impact will not reflect in
1 2 financial statement.
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It provides information about the whole concern : Financial accounting Accounting:
provides information about the concern as a whole. It discloses only net results An Overview
of the collective activities of a business. Detailed information regarding product-
wise, process-wise, department wise, etc. is not recorded in financial accounts.
Thus, product wise or job wise cost of production cannot be determined. It is
essential to record the transactions activity wise for cost determination and cost
control purpose.
5) Difficulty in price fixation : The cost of the product can be obtained only when
all expenses have been incurred. It is not possible to determine the prices in
advance. Price fixation requires detailed information about variable and fixed
costs, direct and indirect costs. Financial accounting cannot supply such
information and therefore, it is difficult to quote the prices during the periods of
inflation or depression in trade.
6) Appraisal of policies is not possible : Financial accounting do not provide data
for evaluation of business policies and plans. There is no technique for
comparing actual performance with the budgeted targets. Financial accounting
do not provide any measure to judge the efficiency of a business. The only
criteria for determining efficiency is the profit at the end of financial period.
Therefore, the only yardstick for measuring the managerial performance is profit
and loss account which is not a reliable test for ascertaining efficiency of the
management.
7) It is not helpful in Decision Making : Financial accounting do not help the
management in taking strategic decisions because they do not provide adequate
information to compare the probable effect of alternative courses of action such
as replacement of labour by machinery, introduction of new product line,
expansion of capacity etc. The impact of these decisions and cost involved is to
be ascertained in advance. Due to historic nature of accounting data available
from financial accounts, it is not of much helpful to the management.
8) Lack of uniformity in accounting principles : Accounting policies differ on
the use of accounting principles. There is lack of unanimity on the use of
accounting principles and procedures. The financial statements prepared by two
different persons of the same concern gives different results due to varying
personal judgment in applying a particular convention. The methods of valuing
inventory, methods of depreciation, allocation of expenses between revenue and
capital etc. are the most controversial issues on which unanimity is not possible.
The use of different accounting methods reduces the usefulness and reliability of
financial accounting.
9) It is not possible to control costs : Another limitation of financial accounting is
that the cost figures are known only at the end of financial period. When the cost
has already been incurred then nothing can be done to control the cost. A
constant review of actual costs from time to time is required for cost control and
this is not possible in financial accounting.
10) Possibility of manipulation of accounts : The over and under valuation of
inventory may affect the profit figures. The profit may be shown more or less to
get more remuneration, to pay more dividend or to raise the share prices, or to
save taxes or not to pay bonus to workers, etc. The possibility of manipulating
financial accounts reduces their reliability.
11) Technological revolution : With the advancement in science and technology very
minute and detailed break-up of all types of data relating to various parts of a
business unit have become a must for the management of its day to day
functioning. It is clear that financial accounting with its simple structure is not
in a position to cater the needs of the management because it supplies only
elementary information. 1 3
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The limitations of financial accounting have given scope for the development of
Accounting Costing and Management accounting.
1.6.2 Cost Accounting

Cost accounting is one of the important elements of accounting information about the
problems of internal managerial control. Financial accounts are unable to meet
information needs about the cost structure of a product. The need for cost
determination and controls necessitated new set of principles of accounting and thus
emerged ‘Cost accounting’ as a specialised branch of accounting. Cost accounting is
the process of accounting for costs. It includes the accounting procedures relating to
recording of all income and expenditure and preparation of periodical statements and
report with the object of ascertaining and controlling costs. Such cost accounting is a
good technique for ascertaining profitability and for decision making. The Institute of
Cost and Management, London defines cost accounting as “the application of costing
and costing principles, methods and techniques to the science, art and practice of cost
control and ascertainment of profitability. It includes presentation of information
derived therefrom for the purpose of managerial decision making.”
Functions of Cost Accounting

The main functions of cost accounting can be briefed as follows :
a) Cost accounting enables the management to ascertain the cost of product, job,
contract, service or unit of production.
b) It helps in price fixation or quotation.
c) It provides information for the preparation of estimates and tenders.
d) It helps in minimizing the cost of manufacture.
e) It helps in determining profitability of each product, process, department etc.
f) It is a useful tool for managerial control and helps in cost reduction and cost
control.
g) It increases efficiency and reduces wastages and costs.
h) It provides cost data for comparison in different periods.
Limitations of Cost Accounting

Cost accounting lacks a uniform procedure. It is developed through theories and
accounting practices based on reasoning and common sense. There is no common
system of cost accounting applicable to all industries. A limitation of cost accounting
is its emphasis on cost data and largely based on estimates. Hence, it is considered
very narrow in its perspective as it fails to consider the revenue aspect in detail.
Moreover, cost accounting can be used only in big organisations.
1.6.3 Management Accounting

Cost accounting helps the internal management by directing their attention on
inefficient operations and assisting in a day-to-day control of business activities.
The costing data needs to be arranged, re-analysed and processed further for effective
role in managerial process. In addition to costing and accounting data, managerial
functions need the use of socio-economic and statistical data (e.g., population
break-ups, income structure, etc.). Cost and financial accounting do not provide such
information and this limitation pave the way for the emergence of management
accounting. Management accounting is a systematic approach to planning and control
functions of management. It generates information for establishing plans and
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controls. It provides for a system of setting standards, plans, or targets and reporting Accounting:
variances between planned and actual performances for corrective actions. Thus, An Overview
Management accounting consists of cost accounting, budgetory control, inventory
control, statistical methods, internal auditing and reporting. It also covers financial
accounting.
Management accounting is the process of identification, measurement, accumulation,
analysis, preparation, interpretation and accumulation of financial information used
by management to plan, evaluate, and control within an organisation and to assure
appropriate use of and accountability for its resources. Management accounting also
comprises the preparation of financial reports for management groups such as
shareholders, creditors, regulator agencies and tax authorities.Thus it is the
application of professional information to assist the management in the formation of
policies and in planning and control of the operations of the business enterprise.
Thus Management accounting helps an organisation to accomplish its goals in the
following ways :
1) It provides a way to communicate expectations to managers throughout the
organisation.
2) It provides feedback which enables a manager to monitor the day to day
operations of the company for which he is responsible. If actuals differ
significantly from targeted results, the manager is alerted, can look for causes for
deviation and can take corrective actions.
3) It provides a set of prescribed tools and techniques for use in decision making.
Limitations of Management Accounting

Though Management Accounting is a useful tool for planning, directing and
controlling functions still it suffers from the following limitations :
1) Based on Cost and Financial Information: Management accounting derives
information from financial and cost accounting and other records. The
accounting statements and records suffer from certain limitations as they are
prepared on the basis of certain accounting concepts and conventions. The
correctness and effectiveness of managerial decisions will depend upon the
quality of data on which these decisions are based. If financial data is not
reliable then management accounting will not provide correct analysis. The
limitations of financial statements and records may be transmitted to the
management accounting system. This may limit its effectiveness and make the
information a substandard one.
2) Persistence of Intuitive Decision Making: Management accounting provides
facts and figures of various situations and assists management in taking
decisions scientifically. It includes decision tools such as marginal costing,
differential costing and OR techniques like linear programming, decision theory,
etc. Despite the facilities provided, the management mostly resorts to simple
methods of decision making by intuition. Intuitive decisions limit the usefulness
of management accounting.
3) It has a very Wide Scope: For taking decision, management requires
information from both accounting as well as non-accounting sources and also
quantitative as well as qualitative information. This creates many problems and
brings a degree of inexactness and subjectivity in the conclusions obtained
through it .
4) Lack of Knowledge: The use of Management accounting requires the
knowledge of a number of related subjects. Lack of knowledge in the related
subjects limits the use of management accounting 1 5
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It is very Costly System: The installation of Management accounting system
Accounting needs a very elaborate organisational system. A large number of rules and
regulations are also required to make this system workable and effective. This
results in heavy investment which only big concerns can afford.
6) Scope for Personal Bias: The interpretation of financial information depends
upon the capability of interpreter as one has to make a personal judgment. There
is every possibility of personal bias in analysis and interpretation. Personal bias
will affect the quality of decision making.
7) It invites Resistance within the Organisation: The installation of management
accounting needs a radical change in the accounting organisation. New rules and
regulations are also to be framed. It demands rearrangement of personnel and
their activities. This will affect a number of personnel and therefore, there is a
possibility of resistance by some of the people of the organisation concerned.
Check Your Progress A

1. What is Accounting ?
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2. List out various Accounting activities in an organisation.
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3. What are the limitations of Accounting ?
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4. Name the parties interested in accounting information.
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5. What is the main purpose of Financial Accounting and Management Accounting ?
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6. State whether each of the following statements is True or False :
i) Accounting is concerned only with the recording of transactions.
ii) Accounting is the language of the business.
iii) Accounting records both financial and non financial transactions.
iv) Management accounting provide necessary information to outsiders only.
v) Cost accounting helps in ascertaining and controlling costs.
vi) The main objective of financial accounting is to ascertain the operating
results and financial position of a concern.
vii) Management accounting provides decision to the management.
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1.7 ROLE OF MANAGEMENT ACCOUNTANT An Overview
The term Management Accountant has been applied to any one who performs
accounting work within a firm and it encompasses persons performing activities which
range from :
i) Posting customers’ receivable accounts,
ii) Doing financial analysis for decision making, and
iii) Making high-level decisions in a large scale organisation.
There is no particular academic or professional accomplishments have been associated
with the term. He plays a significant role in the decision making process of an
organisation. The positional status of management accountant in an organisation
varies from concern to concern depending upon the pattern of management system in
the concern. He plays a significant role in the decision making process of the
organisation heading the accounting department. In large organizations he is known
as Financial Controller, Financial Advisor, Chief Accounts officer etc. He is
responsible for installation, development and efficient functioning of the management
accounting system. He plays an important role in collecting, compiling, reporting and
interpreting internal accounting information. He prepares the financial and cost
control reports to satisfy the requirements of different levels of management. He
computes variances by comparing the actuals with the standards and interprets the
results of operations to different levels of the organisation and to the owners of the
business.
Thus, the management accountant occupies an important position in the organization.
He performs a staff function and also has line authority over the accountants. If he
participates in planning and execution of policies, he is equal to other functional
managers. In most of the organisations, management accountant performs staff
functions. He supplies information and gives his views about the data and leaves the
final decision making to functional heads. If management accountant provides the
facts accurately and are presented in a manner which allows proper analysis and
interpretation then he cannot be held responsible for any wrong judgment by the
management. On the other hand, if the information provided by the management
accountant is biased, inaccurate and is not presented properly then he is responsible to
the management for wrong decision making.
Functions of Management Accountant

The functions of the Management Accountant depends upon the position he occupies
in the organisation and requirements of the organisation. The functions of the
controller, by whatever name he is called, have been laid down by the controllers’
Institute of America which are as follows :
1) Planning and Control : Management accountant establishes, coordinates and
maintains an integrated plan for the control of operations. Such a plan would
provide, to the extent required in the business cost standards, profit planning,
programmes for capital investing and for financing, sales forecast and the
expense budgets, together with necessary procedures to effectuate the plan.
2) Reporting and Interpreting : Management accountant measures the
performance against given plans and standards. The results of the operations are
interpreted to all levels of management and to the owners of the business. This
also includes installation of accounting and costing system and recording of
actual performance to find out deviation, if any.
3) Evaluation of Policies and Programmes : He is responsible to evaluate various
policies and programmes. The effectiveness of policies, programmes and
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organisation structure to attain the objectives of the organisation to a large extent
Accounting depends upon the caliber of the management accountant.
4) Tax administration : It is also the function of management accountant to report
to the government as required under different laws in force and to establish and
administer tax policies and procedures. He has also to supervise and coordinate
preparation of reports to government agencies.
5) Protection of assets : The management accountant has to assure fiscal
protection for the assets of the business through adequate internal control and
proper insurance coverage.
6) Appraisal of External Effects : He has to assess continuously the effect of
various economic and social forces and government policies and interpret their
effect upon the business towards the attainment of common goals.
The functions as stated above can also prove to be useful under the Indian
context. Some of the above functions, in India are performed by Company
Secretary, top level management, statistical department etc.
1.8 FINANCIAL ACCOUNTING PROCESS

Accounting may be defined as the process of recording, classifying, summarizing,
analysing, and interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.
Thus the accounting process consists of the following five stages :
1) Recording the Transactions,
2) Classifying the Transactions,
3) Summarizing the Transactions, and
4) Interpreting the Tesults.
Let us discuss briefly these stages:
1) Recording the Transactions : The accounting process begins with the basic
function of recording all the transactions in the book of original entry. This book
is called ‘Journal’. The journal is a daily record of business transactions. All
business transactions of financial character are recorded in the journal in a
chronological order (date wise) with the help of various vouchers such as cash
memos, cash receipts, invoices, etc. The process of recording a transaction in
the journal is called journalising. The journal may be further sub-divided into
various subsidiary books such as cash journal for recording cash transactions,
Purchase Journal for recording purchase of goods, Sales Journal for recoding
sale of goods, etc. The number of subsidiary books to be maintained will depend
upon the nature and size of the business.
2) Classifying the Transactions : The journal is just a chronological record of all
business transactions and it does not provide all information regarding a
particular item at one place. To overcome this difficulty we maintain another
book called ‘Ledger’. It consists of systematic analysis of the recorded data with
a view to group the transactions of similar nature and posting them to the
concerned accounts. It contains different pages of individual account heads
under which all financial transactions of similar nature are collected. For
example, all transactions related to cash are posted to cash account and
transactions related to different persons are entered separately in the account of
each person. The objective of classifying the transaction in this manner is to
ascertain the combined effect of all transactions of a given period in respect of
1 8 each account. For this purpose all accounts are balanced periodically.
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Summarising the Transactions : The third step is presenting the classified data Accounting:
in a manner which is understandable and useful to the internal as well as external An Overview
end users of accounting information. This can be done through the preparation
of a year end summary known as ‘Final Accounts’. Before proceeding to final
accounts one has to prepare a statement called ‘Trial Balance’ in order to check
the arithmetical accuracy of the books of accounts. If the Trial Balance tallies,
more or less it means that the transactions have been accurately recorded and
posted into the ledgers. Then with the help of the Trial Balance and some other
additional information, final accounts are prepared. The objective of preparing
final accounts are :
i) To know the net operating results of the business, and
ii) To ascertain the financial position of the business at a particular date.
The operating results of the business can be ascertained by preparing an income
statement called Trading and Profit and Loss Account and financial position of
the business can be known by preparing a position statement called ‘Balance
Sheet’. The Trading and Profit and Loss account gives information about the
profit or loss made during the year and the Balance Sheet shows the position of
assets and liabilities of the business at a particular time.
4) Interpreting the Results : The final stage of accounting is analysing and
interpreting the results shown by the final accounts. The recorded financial data
is analysed and interpreted in a manner that the end users can make a
meaningful judgement about the financial position and profitability of the
business operations. This involves computation of various accounting ratios to
assess the liquidity, solvency and profitability of the business. The balance on
various accounts appearing in the Balance Sheet will then be transferred to the
new books of account for the next year. Thereafter the process of recording
transactions for the next year starts again.
The accounting information after being meaningfully analysed and interpreted has to
be communicated in the proper form and manner to the proper person. This is done
through preparation and distribution of accounting reports which includes besides the
final accounts, in the form of ratios, graphs, diagrams, funds flow statements, etc.
1.9 ACCOUNTING EQUATION

The recording of transactions in the books of accounts is based on accounting
equation. Each transaction has double effect on the financial profit of a concern.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. Thus, the total claims will equal to the total assets of the firm.
The total claims may be to outsiders and the proprietor. In the beginning the owner of
the firm provides funds to the business in the form of ‘capital’ which is also known as
‘owners equity’. Initially the capital contributed by the owner to the business will be
in the form of cash and this cash is treated as an asset of the firm. At the same time a
liability will be created in the form of owners’ equity according to business entity
concept (i.e., business and the owner are two separate entities). Thus, the asset is
(cash) balanced against liability (capital).
The accounting equation can thus be expressed as follows :
Cash (Asset) = Capital (Liabilities)
Total Assets = Total Liabilities (Capital + Liabilities)
OR
Fixed Assets + Current Assets = Internal Liabilities + External Liabilities
Capital = Assets – Liabilities
OR
Liabilities = Assets – Capital 1 9
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Thus the above relationship is known as accounting equation and it is also called as
Accounting Balance Sheet equation. Each transaction will affect the above equation but the
relationship will remain the same on account of dual aspect of the transaction. An
increase in asset side leads to increase in the liabilities side and vice versa. Thus dual
effect will take place either on the same side or on both the sides of accounting
equation. Let us take a few transactions and see how accounting equation is always
maintained.
1. Mr. X started business with Rs. 1,00,000 cash : The business received a cash of
Rs. 1,00,000 which is an asset to business. The capital contributed by Mr. X is
a liability to the business because from the business point of view owner and
business are separate legal entity.
The equation now stands as follows:
Equation : Assets = Capital + Liabilities
Rs. 1,00,000 (Cash) = Rs. 1,00,000 + Nil
2. The business purchased furniture worth Rs. 15000 and paid cash : The effect of
this transaction is that on one hand it increases one asset (furniture) and on other
hand it decreases another asset (cash). The equation now will appear as follows;
Assets
Cash + Furniture = Capital + Liabilities

Old equation 1,00,000 + – = 1,00,000 + –
New Transaction –15,000 + 15,000 = – + –
New Equation 85,000 + 15,000 = 1,00,000 + –
3. The business purchased goods on credit from Mr. Z for Rs. 10,000: The effect of
this transaction is that it increases an asset (stock of good) and creates a liability
(creditor). The equation now will be as follows :
Assets
Cash + Furniture + Stock = Capital + Liabilities

Old equation 85,000 + 15,000 + – = 1,00,000 + –
New Transaction – + – + 10,000 = – + 10,000
(Creditor)
New Equation 85,000 + 15000 + 10,000 = 1,00,000 + 10,000
4. The business sold goods for Rs. 7,000 on credit : In this transaction, assets will
be decreased by Rs. 7,000 in the form of stock and assets will be increased by
Rs. 7,000 in the form of sundry debtors.
Assets Liabilities
Cash + Furniture + Stock + Sundry Debtors = Capital + Creditors

Old equation 85,000 + 15,000 + 10,000 + – = 1,00,000 + 10,000
New – + – + (–7000) + 7,000 = – + –
Transaction
New 85,000 + 15000 + 3000 + 7000 = 1,00,000 + 10,000

Equation
2 0
5.
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Mr. X withdrew Rs. 10,000 for his private expenses : Withdrawing of cash from Accounting:
the business for private expenses, reduces business assets in the form of cash as An Overview
well as his capital by Rs. 10,000.
Assets Liabilities
Cash + Furniture + Stock + Sundry = Capital + Creditors

Debtors
Old 85,000 + 15000 + 3000 + 7000 = 1,00,000 + 10,000
equation
New –10,000 + – + – + – = –10,000 + –
Transaction
New 75,000 + 15000 + 3000 + 7000 = 90,000 + 10,000
Equation
Thus, the sum of assets will be equal to the sum of Capital and Liabilities irrespective
of the number of transactions. The equation can also be presented in the form of
statement of assets and liabilities called Balance Sheet which is always prepared at a
particular date. The last equation stated above if presented in the form of Balance
Sheet, it will be as follows :
Balance Sheet of Mr. X as at ………….
Capital and Liabilities Rs. Assets Rs.
Capital 90,000 Cash 75,000
Creditors 10,000 Stock 3,000
Sundry debtors 7,000
Furniture 15,000
1,00,000 1,00,000
It should be noted that the total of both the sides of Balance Sheet should be equal
irrespective of the number of transactions and the items affected thereby. It is due to
the dual effect of business transactions on the assets and liabilities of the business.
1.10 ACCOUNTING CONCEPTS

Accounting is the language of business. Business firms communicate their affairs and
financial position to the outsiders through accounting in the form of financial
statements. To make the language to convey the same meaning to all interested parties
it is necessary that it should be based on certain uniform scientifically laid down
standards. The accountants in general, have agreed on certain principles to be
followed strictly by them to maintain uniformity and also for comparison purpose.
These principles are termed as ‘Generally Accepted Accounting Principles’.
Accounting principles may be defined as “those rules of action or conduct which are
adopted by the accountants universally while recording accounting transactions. They
are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practice and as a guide for selection
of conventions or procedures where alternatives exist.” To explain these principles,
the writers have used a variety of terms such as concepts, postulates, conventions,
underlying principles, basic assumptions, etc. The same rule may be described by one
author as a concept, by another as a postulate and still by another as convention.
Hence, it is better to call all rules and conventions which guide accounting activity and
practice as ‘Basic Accounting Concepts. These are the fundamental ideas or basic
assumptions underlying the theory and practice of financial accounting and are broad 2 1
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working rules for all accounting activities developed and accepted by the accounting
Accounting profession. It brings about uniformity in the practice of accounting.
These concepts can be classified into two broad groups which are as follows :
1) Concepts to be observed at the recording stage i.e., while recording the
transactions, and
2) Concepts to be observed at the reporting stage i.e., at the time of preparing final
accounts.
It must however be remembered that some of them are overlapping and even
contradictory.
1.10.1 Concepts to be Observed at the Recording Stage

The concept which guide us in identifying, measuring and recording the transactions
are :
1) Business Entity Concept
2) Money Measurement Concept
3) Objective Evidence Concept
4) Historical Record Concept
5) Cost Concept
6) Dual Aspect Concept
Let us explain them one by one and learn the accounting implications of each
concept.
1) Business Entity Concept

According to this concept business is treated as a separate entity from its owners. All
transactions of the business are recorded in the books of the firm. Business
transactions and business property are different from personal transactions and
personal property. If business affairs are mixed with private affairs, the true picture
of the business is not available. The owner of the firm is treated as a creditor to the
extent of his capital. From the accounting point of view the owner is different and the
business is different. Therefore, under this concept the capital contributed by the
owner of the firm is the liability to the firm and the owner is regarded as the creditor
of the firm. However, personal expenditure of the owner is met from business funds it
shall be recorded in the business books as drawings by the owner and not as business
expenditure.
The business entity concept is applicable to all form of business organisation. This
distinction can be easily maintained in the case of a limited company because the
company has a separate legal entity of its own. But such distinction becomes difficult
in case of a sole proprietorship or partnership, because in the eyes of law sole
proprietor or partners are not considered separate entities. They are personally liable
for all business transactions. But for accounting purpose they are treated as separate
entities. This enables them to ascertain the profit or loss of the business more
conveniently and accurately.
2) Money Measurement Concept
Usually business deals in a variety of items having different physical units such as
kilograms, quintals, tons, metres, liters, etc. If the sales and purchase of different
items are recorded in the physical terms, it will pose problems. But if these are
recorded in common denomination their total become homogeneous and meaningful.
Therefore, we need a common unit of measurement. Money does this function. It is
2 2 adopted a common measuring unit for the purpose of accounting. All recording,
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therefore, is done in terms of the standard currency of the country where business is Accounting:
set up. For example, in India, it is done in terms of Rupees. In USA it is done in An Overview
terms of US dollars and so on.
Another implication of money measurement concept is that only those transactions
and events are recorded in the books of accounts which can be expressed in terms of
money such as purchases, sales, salaries etc. Other happenings (non-monetary) like
labour management relations, sales policy, labour unrest, effectiveness of competition,
a team of dedicated and trusted employees etc., which are vital importance to the
business concern do not find place in accounting. This is because their effect is not
measurable and quantifiable in terms of money.
Another limitation of this concept is that it is based on the assumption that the money
value is constant which is not true. The value of money changes over a period of
time. The value of rupee today is much less than what it was in 1971. This is due to
a fall in money value. Thus this concept ignores the qualitative aspect of things and
the impact of inflationary changes is not adjustable in this principle. That is why
accounting data does not reflect the true and fair view of the affairs of business.
Now-a-days it is considered desirable to provide additional data showing the effect of
changes in the price level on the reported income and the assets and liabilities of the
business.
3) Objective Evidence Concept

The term objectivity refers to being free from bias or free from subjectivity.
Accounting measurements are to be unbiased and verifiable independently. For this
purpose all accounting transactions should be evidenced and supported by documents
such as invoices, receipts, cash memos etc. These supporting documents (Vouchers)
form the basis for making entries in the books of account and for their verification by
auditors. As per the items like depreciation and the provision for doubtful debts
where no documentary evidence is available, the policy statements made by the
management are treated as the necessary evidence.
4) Historical Record Concept

Recording the transactions in the books of account will be done only after identifying
the transactions and measuring them in terms of money. According to the historic
record concept we record only those transactions which have actually taken place in
the business during a particular period of time and not those transactions which may
take place in future. It is because accounting record presupposes that the transactions
are to be identified and objectively evidenced. This is possible only in the case of past
(actually happened) transactions. The future transactions can hardly be identified and
measured accurately. You also know that all transactions are to be recorded in
chronological (date wise) order. This leads to the preparation of a historical record of
all transactions. It also implies that we simply record the facts and nothing else.
One limitation of this concept is that the impact of future uncertainties has no place in
accounting. Management needs information for future planning not only of the past
but also for future. You know that we will also make a provision for some expected
losses such as doubtful debts at the time of ascertaining profit or loss of the business
which is contrary to the historic record concept. But it is not a routine item. This is
done in accordance with another concept called conservation concept which you will
study later.
5) Cost Concept
The price paid (or agreed to be paid in case of a credit transaction) at the time of
purchase is called cost. Under this concept fixed assets are recorded in the books of 2 3
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account at the price at which they are acquired. This cost is the basis for all
Accounting subsequent accounting for the asset. For example, when an asset is acquired for
Rs. 1,00,000, it is recorded in the books of account at Rs. 1,00,000 even though the
market value may be different later. But the asset is shown in the books at cost price.
You know that with passage of time the value of an asset decreases. Hence, it may
systematically be reduced from year to year by charging depreciation and the assets be
shown in the balance sheet at the depreciated value. The depreciation is usually
charged at a fixed percentage on cost. It bears no relationship with the changes in its
market value. This makes it difficult to assess the true financial position of the
concern and it is, therefore, considered an important limitation of the cost concept.
Another limitation of the cost concept is that if the business pays nothing for an item it
acquired, then this will not appear in the accounting records as an asset. Thus, all
such events are ignored which affect the business but have no cost. Examples are : a
favourable location, a good reputation with its customers, market standing etc. The
value of an asset may change but the cost remains the same in the books of account.
As such the book value of an asset as recorded do not reflect their real value.
It should, however, be noted that the cost concept is applicable to the fixed assets and
not to the current assets.
In spite of the above limitations the cost concept is preferred because firstly, it is
difficult and time consuming to ascertain the market values and secondly, there will be
too much of subjectivity in assessing current values. However, this limitation can be
overcome with the help of inflation accounting.
6) Dual Aspect Concept

This is a basic concept of accounting. According to this concept every business
transaction has a two-fold effect. In commercial context it is a famous dictum that
“every receiver is also a giver and every giver is also a receiver”. For example, if you
purchase a machine for Rs. 8,000, you receive machine on the one hand and give
Rs. 8,000 on the other. Thus, this transaction has a two-fold effect i.e.,(i) increase in
one asset, and (ii) decrease in another asset. Similarly, if you buy goods worth
Rs. 500 on credit, it will increase an asset (stock of goods) on the one hand and
increase a liability(creditors) on the other. Thus, every business transaction involves
two aspects (i) the receiving aspect, and (ii) the giving aspect. In case of the first
example you find that the receiving aspect is machinery and the giving aspect is cash.
In the second example the receiving aspect is goods and the giving aspect is the
creditor. If complete record of transactions is to be made, it would be necessary to
record both the aspects in books of account. This principle is the core of double entry
book-keeping and if this is strictly followed, it is called “Double Entry System of
Book-keeping’.
Let us understand another accounting implication of the dual aspect concept. To start
with, the initial funds (capital) required by the business are contributed by the owner.
If necessary, additional funds are provided by the outsiders (creditors). As per the
dual aspect concept all these receipts create corresponding obligations for their
repayment, In other words, a contribution to the business, either in cash or kind, not
only increases its resources (assets), but also its obligations (liabilities/equities)
correspondingly. Thus, at any given point of time, the total assets and the total
liabilities must be equal.
This equality is called ‘balance sheet equation’ or ‘accounting equation’. It is stated
as under :
Liabilities (Equities) = Assets
Capital +Outside Liabilities = Assets
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The term ‘assets’ denotes the resources (property) owned by the business while the Accounting:
term ‘equities’ denotes the claims of various parties against the business assets. An Overview
Equities are of two types : (i) Owners’ equity, and (ii) outsiders’ equity. Owners’
equity called capital is the claim of owners against the assets of the business
outsiders’ equity called liabilities is the claim of outside parties like creditors, bank,
etc. against the assets of the business. Thus, all assets of the business are claimed
either by the owners or by the outsiders. Hence, the total assets of a business will
always be equal to its liabilities.
When various business transactions take place, they effect the assets and liabilities in
such a way that this equity is maintained. You will study later in detail under ‘1.9
Accounting Equation’ of this unit how the equity is maintained.
1.10.2 Concept to be Observed at the Reporting Stage

The following concepts have to be kept in mind while preparing the final accounts:
1. Going concern concept
2. Accounting period concept
3. Matching concept
4. Conservatism concept
5. Consistency concept
6. Full disclosure concept
7. Materiality concept
Let us discuss the above concepts one by one.
1) Going Concern Concept

According to this concept it is assumed that every business would continue for a long
period. Keeping this in view, the investors lend money and the creditors supply goods
and services to the concern. For all practical purpose the business is normally treated
as a going concern unless there is a strong evidence to the contrary. The current
disposal value is irrelevant for a continuing business. Recording of transactions in
accounting is judged whether the benefits from expenses are immediate (short period,
say less than one year) or a long term. If the benefits from expenses are immediate it
is treated as a revenue or if the benefits are for long term, it is to be treated as capital
depending upon the nature of expenses. Short term benefits expenses like rent, repairs
etc. are limited to one year therefore such expenses are fully debited to profit and loss
account of that year. On the other hand, if the benefit of expenditure is available for a
longer period, it must be spread over a number of years. Therefore, only a portion of
such expenditure will be debited to profit and loss account. The balance of
expenditure is shown as an asset in the Balance Sheet. Similarly fixed assets are
recorded at original cost and are depreciated in a proper manner and while preparing
the balance sheet, market price of fixed asset are not considered. For example, a firm
purchased a delivery van for Rs. 1,00,000 and its expected life is 10 years. The
accountant has to spread the cost of the van for 10 years and charges Rs. 10,000
being 1/10th of its cost to the profit and loss account every year in the form of
depreciation and show the balance in the balance sheet as an asset. While preparing
final accounts, a record will also be made for outstanding expenses and prepaid
expenses on the assumption that the business will continue for an indefinite period and
the assets will be used for its expected life.
This concept will not apply in case of a concern when it has gone into liquidation or it
has become insolvent. In such as case the assets are valued at their current values and
the liabilities at the value at which they are to be met. 2 5
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Accounting
You know that the going concern concept assumes that life of the business is indefinite
and the preparation of income and positional statements after a long period would not
be helpful in taking appropriate steps at the right time. Therefore, it is necessary to
prepare the financial statements periodically to find out the profit or loss and financial
position of the business. It also helps the interested parties to make periodical
assessment of its performance. Therefore, accountants choose some shorter period to
measure the results and one year has been generally accepted as the accounting period.
However, accounts can also be prepared even for a shorter period for internal
management purposes. But one year accounting period is recognised by law and
taxation is assessed annually. Acconting period may be a calender year i.e., January 1
to December 31 or any other period of twelve months, say April 1 to March 31 or
Diwali to Diwali or Dasara to Dasara. The final accounts are prepared at the end of
each accounting period and the financial reports thus, prepared facilitate to make good
decision, corrective measures, business expansion etc. and also enable the end users to
make an assessment of the progress of the enterprise.
3) Matching Concept
Matching concept is based on the accounting period concept. The matching concept is
also called Matching of costs against revenue concepts. To ascertain the profit made
by the business during a particular period, the expenses incurred in an accounting year
should be matched with the revenue earned during that year. The term ‘matching’
means appropriate association of related revenues and expenses. For this purpose,
first we have to recognize the revenues during an accounting period and the costs
incurred in securing those revenues. Then the sum of costs should be deducted from
the sum of revenues to get the net result of that period. The question when the
payment was received or made is irrelevant. In other words, all revenues earned
during an accounting period, whether received or not and all costs incurred, whether
paid or not have to be taken into account while preparing the final accounts.
Similarly, any amount received or paid during the accounting period which actually
relates to the previous accounting period or the following accounting period must be
eliminated from the current accounting period’s revenues and costs. Therefore,
adjustments are to be made for all outstanding expenses, accrued incomes, prepared
expenses and unearned incomes, etc., while preparing the final accounts at the end of
the accounting period. By application of this concept, the owner of the business easily
know about the operating results of his business and can make effort to increase
earning capacity.
4) Conservation Concept
This concept is also known as Prudent Concept. It ensures that uncertainties and risks
inherent in business transactions should be given a proper consideration.
Conservatism refers to the policy of choosing the procedure that leads to
understatement of assets or revenues, and over statement of liabilities or costs. The
consequence of an error of understatement is likely to be less serious than that of an
error of over statement. On account of this reason, accountants generally follow the
rule ‘anticipate no profit but provide for all possible losses. In other words, profits
are taken into account only when they are actually realized but in case of losses, even
the losses which may arise due to a remote possibility should also be taken into
account. That is the reason why the closing stock is valued at cost price or market
price whichever is less. Similarly, provision for doubtful debts and provision for
discounts on debtors are also made. This reflects a generally pessimistic attitude of
the accountant, but it is regarded as the best way of dealing with uncertainty and
protecting creditors against an unwarranted distribution of the firm’s assets as
2 6 dividends.
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This concept is subject to criticism that it is against the convention of full disclosure. Accounting:
It encourages creation of secret reserves and financial statements do not reflect a true An Overview
and fair view of the affairs of the business.
5) Consistency Concept
The principle of consistency means that the same accounting principles should be used
for preparing financial statement for different periods. It means that there should not
be a change in accounting methods from year to year. Comparisons are possible only
when a consistent policy of accounting is followed. If there are frequent changes in
the accounting treatment there is little scope for reliability. For example, if stock is
valued at ‘cost or market price whichever is less, this principle should be followed
year to year. Similarly if deprecation on fixed assets is provided on straight line basis,
it should be followed consistently year after year. Consistency eliminates personal
bias and helps in achieving comparable results. If this principle of consisting is not
followed, the accounting information about an enterprise cannot be usefully compared
with similar information about other enterprises and so also within the same enterprise
for some other period. Consistency principle enhances the utility of the financial
statements.
However, consistency does not prohibit change. When a change is desirable, the
change and its affect should be clearly stated in financial accounts.
6) Full Disclosure Concept

This concept states that the financial statements are to be prepared honestly and all
significant information should be incorporated there in because these statements are
the basic means of communicating financial information to all interested parties.
Therefore, these statements should be prepared in such a way that all material
information is clearly disclosed to the persons interested in its affairs . The purpose of
this concept is that any body who wants to study the financial statements should not
be prejudiced by concealing any facts. It is, therefore, necessary that the disclosure
should be fair and adequate to make impartial judgement.
This concept assumes greater importance in respect of Joint Stock Company type of
organisations where ownership is divorced from management. The Joint Stock
Companies Act, 1956 requires that Profit and Loss Account and Balance Sheet of a
company must give a true and fair view of the state of affairs of the company and also
provided prescribed form in which these statements are to be prepared so that
significant information may not be left out.
7) Materiality Concept
This concept is closely related to the full disclosure concept. Full disclosure does not
mean that everything should be disclosed. It only means that relevant and material
information must be disclosed. American Accounting Association defines the term
materiality as “An item should be regarded as material if there is reason to believe that
knowledge of it would influence the decisions of informed investor”. Materiality
primarily relates to the relevance and reliability of information. All material
information should be disclosed through the financial statements accompanied by
necessary notes. For example commission paid to sole selling agents, and a change in
the method of rate of depreciation, if any, must be duly reported in the financial
statements.
Further strict adherence to accounting principles is not required for items of little
importance or non-material nature. For example, erasers, pencils, stapler, pins, scales
etc., are used for a long period, but they are not treated as assets. They are treated as
expenses. This does not affect the amounts of profit or loss materially. Similarly,
while showing the amounts of various items in financial statements, they can be 2 7
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rounded off to the nearest rupee or hundreds. There may not be any material effect.
Accounting For example if an amount of Rs. 145,923.28 is shown as Rs. 1,45,923 or
Rs. 1,45,900 it does not make much difference for assessment of the performance of
the enterprise.
The materiality and immateriality convention varies according to the company, the
circumstances of the transaction and economic significance. An item considered to be
material for one business, may be immaterial for another. Similarly, an item of
material in one year may not be material in the subsequent years. However, there are
no specific rules for ascertaining material or non-material items. They are rather in
the category of conventions or rules developed from experience to fulfil the essential
and useful needs and purposes in establishing reliable financial and operating
information control for business entities. What is required is just a matter of personal
judgment.
Check Your Progress B

1) What do you understand by money measurement concept ?
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
2) Explain dual aspect concept.
............……………………….....………………………………………………..
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............……………………….....………………………………………………..
3) List the concepts to be observed at the reporting stage.
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
4) What are the stages in accounting process ?
............……………………….....………………………………………………..
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............……………………….....………………………………………………..
6) State whether each of the following statements is True or False :
i) In accounting all business transactions are recorded which are having a
dual effect.
ii) It is the basis of a going concern concept that the assets are always valued
at cost price.
iii) Accounting principles are the rules which are adopted by accountants
universally while recording transactions.
iv) A controller is entrusted with the responsibilities of raising funds.
v) Money measurement concept ignores qualitative aspect of things.
2 8
1.11 ACCOUNTING STANDARDS An Overview
Accounting standards are generally accepted accounting principles which provides the
basis for accounting policies and for preparation of financial statements.
The object of these standards is to provide a uniformity in financial reporting and to
ensure consistency and comparability of the information provided by the business
firms. Therefore, the standards set for must be easily understandable as well as
acceptable by all and significantly reduce manipulation of information in the
books of accounts.
Thus, accounting standards provide useful information to the users to interpret
published reports. It provides information about the basis on which accounts have
been provided and the rules followed while preparing financial statements.
Importance of Accounting Standards

1) It helps the investors in assessing the return and possible risk involved in
evaluating the various investment proposals in different enterprises.
2) It raises the standards of audit while reporting the financial statements to the
management.
3) It helps the government and other interested parties in formulating economic
policies, tax planning, market analysis, investment decisions etc.
4) It helps the Chartered Accountants to deal with their client, in preparing financial
statements on a true and fair basis. They can refuse the reports of their clients
which are found to be incorrect or misleading.
5) It helps the interested parities to understand the information properly and make
meaningful comparisons and interpretations for decision-making purposes.
6) It facilitates inter firm comparison of the financial position and operating results
of similar enterprises.
7) It will reduce the scope of manipulation of accounts to suit the requirement of
management.
8) It would facilitate the development of international trade and commerce as
financial statements are clearly understandable.
Compliance with the accounting standards has been made mandatory. Section 211(3A)
of the Companies Act, 1956 requires that every financial statement i.e., profit and loss
account and balance sheet shall comply with the accounting standards. For the
purpose of this section the accounting standards issued by the Institute of Chartered
Accountants of India (ICAI) shall be deemed to be the accounting standards.
According section 211 (2B), If the financial statements of any company do not
comply with requirements of the accounting standards, it should state the reasons for
such deviations from the accounting standards together its financial effect, if any,
arising due to such deviation. Therefore, it is advisable for the companies as far as
possible to comply with the accounting standards in view of its mandatory nature. In
case the mandatory accounting standards are not complied with, it is in contravention
of provisions of the Companies Act and the financial statements prepared and
presented will not reflect a true and fair view of the state of affairs of the company.
These accounting standards also apply in respect of financial statements audited for
tax purpose under section 44 AB of Income Tax Act 1961.
These accounting standards are applicable to all commercial, industrial or business
activities of any enterprise but not to those enterprises which are not commercial,
industrial or business in nature.
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Accounting 1.12 ACCOUNTING ASSUMPTIONS AND POLICIES AS
PER ACCOUNTING STANDARDS OF INDIA
Accounting measurements are not always uniform. Some financial quantities can be
measured in two or more different ways. The management with the help of company’s
accountant decides which measurement alternatives are to be used. These choices are
known as ‘accounting policies’. These accounting polices differ from company to
company. Therefore, it is advisable to each company to state in the notes of its
financial statements which accounting policy it has followed. The company should
not change its policy frequently and when there is a change in the policy, the
company should justify the reason for such a change.
The management is not completely free in choosing any accounting policies because
selection of policy must fit within the limits set by the measurement guidelines known
as ‘generally accepted accounting principles’ as well as to comply statutory
requirements. For example, The Central Board of Direct Taxes requires the following
information to be disclosed in respect of change in accounting polices :
1) A change in accounting policy shall be made only if the adoption of different
accounting policy is required by statute or if it is considered that the change
would result in more appropriate in preparation or presentation of the financial
statements of an assessee.
2) Any change in accounting policy which has material effect shall be disclosed in
the financial statements of the period in which such change is made. Where the
effect of such change is not ascertainable or such change has no material effect
on the financial statements for the previous year but has material effect in years
subsequent to the previous year, the fact shall be stated in the previous year in
which such change is adopted.
Materiality of an item depends on its amount and nature. An item should also be
considered material if the knowledge of it would influence the decisions of the
investors. Materiality varies from one business to another business. Similarly, an item
which is material in one year may not be material in the next year. While preparing
financial statements it is, therefore, necessary to give emphasis only on those matters
which are significant and thereby ignoring insignificant matters.
In order to bring uniformity for the presentation of accounting results, the Institute of
Chartered Accountants of India, established an Accounting Standard Board (ASB) in
April, 1977. The Board consists of representatives from industry and government.
The main function of ASB is to formulate accounting standards to be followed while
preparing and interpreting the financial results. While framing the accounting
standards, the ASB will pay due attention to the International Accounting Standards
and try to integrate them to the possible extent. It also takes into account the
prevailing laws, customs and business environment prevailing in India. To improve
quality and bring parity with the presentation of financial statements in India, the
ASB has formulated the following accounting standards:
No. Title
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events occurring after Balance Sheet Date
AS 5 Net Profit or Loss, Prior Period Items and Changes in Accounting Policies
AS 6 Depreciation Accounting
3 0 AS 7 Accounting for Construction Contracts
AS 8 Accounting for Research and Development
An Overview
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 Accounting for the Effect of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Accounting for Retirements Benefits in the Financial Statements of Employers
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Consolidated Financial Statement
AS 21 Earnings per Share
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in Consolidated Financial Statements
AS 24 Discounting Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interest in Joint Ventures
Check Your Progress C

1) Why accounting practices should be standardised ?
..........……….......………………………………………………………………..
..........……….......………………………………………………………………..
..........……….......………………………………………………………………..
.........……….......………………………………………………………………...
2) State whether each of the following statements is True or False:
i) A management accountant is not the custodian of properties and financial
interests of a business enterprise.
ii) ‘Statement of Standard Accounting Practice’ were formulated by an
Accounting Standard Board in India.
iii) The generally accepted accounting principles prescribe a uniform
accounting practice.
iv) The materiality concept refers to the state of ignoring small items and
values from accounts.
vi) The avoidance of insignificant things will not affect accounting results.
1.13 LET US SUM UP

In business a number of transactions take place every day. It is not possible to
remember all of them. Hence there is a need to record them. The recording of
business transactions in a systematic manner is the main function of accounting. It
enables to ascertain the profit and loss and the financial position of the business. It
also provides necessary financial information to all interested parties.
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Accounting is the process of identifying, measuring, recording, classifying and
Accounting summarizing the transactions and analysing, interpreting and communicating the
results thereof. Accounting provides information for three general uses such as
i) managerial decision-making, ii) managerial planning control, and internal
performance evaluation, and iii) financial reporting and external performance
evaluation. To meet the requirements of different people interested in accounting
information, accounting is classified as financial accounting, cost accounting and
management accounting. Financial accounting refers to the preparation of reports for
general purpose whereas management accounting provides information to inside the
organisation. Cost accounting provides information about the problems of internal
managerial control.
Management accountant plays a significant role in the decision making process and it
depends upon his position and requirements of the organisation. The accounting
process is divided into four stages: (i) recording the transactions, (ii) classifying the
transactions, (iii) summarizing the transactions, and (iv) interpreting the results. The
recording of transactions in the books of accounts is based on accounting equation.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. The relationship will remain the same on account of dual aspect
of the transaction.
The accountants over a period of time, have developed certain guidelines for all
accounting work. These are called basic concepts of accounting. Certain concepts
are to be observed at the time of recording the transactions, while others are relevant
at the summarizing and reporting stages. The concepts to be observed at the recording
stage are : business entity, money measurement, objective evidence, historical record,
cost and the dual aspect concept. Concepts to be observed at the reporting stage are :
going concern concept, accounting period concept, matching concept, conservatism
concept, consistency concept, full disclosure concept and materiality concept. Lack of
uniformity in accounting practice makes it difficult to compare the financial reports of
different companies. The multiplicity of accounting practices makes it possible for
management to conceal material information. To avoid this problem accounting
standards are developed by various professional bodies. The object of accounting
standards is to provide uniformity in financial reporting and to ensure consistency and
comparability of the information provided by the business firms. The management is
not absolutely free in choosing any accounting policy. The accounting policy selected
must fit within the limits set by generally accepted accounting principles and also
comply to the statutory requirements. The Accounting Standard Board (ASB) of
India, has developed so far 27 standards to improve quality and parity with the
preparation of financial statements.
1.14 KEY WORDS

Accounting Period : A period of twelve months for which the accounts are usually
kept.
Balance Sheet : A statement of assets and liabilities as at the end of an accounting
period.
Books of Accounts : Books in the form of bound registers or loose sheets wherein
transactions are recorded.
Business Unit : A unit formed for the purpose of carrying on some kind of business
activity.
Financial Position : Position of assets and liabilities of a business at a given point of
time.
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Financial Statement : Summary of accounting information such as profit and loss Accounting:
account and Balance Sheet prepared at the end of accounting period. An Overview
Profit and Loss Account: An account showing profit or loss of the business during
an accounting period.
Transaction : Transfer of money or money’s worth between the two business units.
Management Accountant : A staff-functionary who uses accounting information for
management planning and control.
Staff Function : It is performed in an advisory capacity without line or decision-
making.
Accounting Conventions : Methods or procedures used in accounting
Accounting Equation : Assets = Owners’ equity + Liabilities
Accounting Principles : The methods or procedures used in accounting for events
reported in the financial statements.
Accounting Standards : Accounting Principles.
Cost Accounting : Classifying, Summarizing, recording, reporting and allocating
current or predicted costs.
Double Entry : The system of recording transactions that maintains the equality of
the accounting equation.
Generally Accepted Accounting Principles (GAAP) : The conventions, rules and
procedures necessary to define accepted accounting practice at a particular time;
includes both broad guidelines and relatively detailed practices and procedures.
Internal Reporting : Reporting for management’s use in planning and control.
Materiality : The concept that accounting should disclose separately only
those events that are relatively important for the business or for understanding its
statement.
External Reporting : Production of financial statements for the use of external
interest groups like shareholders, investors, creditors, government etc.
1.15 ANSWERS TO CHECK YOUR PROGRESS

A) 6 (i) False (ii) True (iii) False (iv) False (v) True (vi) True (vii) True
B) 5 (i) True (ii) True (iii) True (iv) False (v) True
C) 2 (i) False (ii) True (iii) True (iv) False (v) True
1.16 TERMINAL QUESTIONS

1) What are the objectives of Accounting ? Name the different parties interested in
accounting information and state why they want it.
2) Briefly explain the accounting concepts which guide the accountant at the
recording stage.
3) What do you understand by Dual Aspect Concept ? Explain the accounting
implications.
4) Explain the role of Management Accountant in a modern business organisation.
5) What are the accounting concepts to be observed at the reporting stage ?
Explain any two in detail.
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Discuss in brief the basic accounting concepts and fundamental accounting
Accounting assumptions.
7) Why do accounting practices be standardized ? What progress has been made in
India regarding standardization of accounting ?
8) Is it possible to give a true and fair view of a company’s position using account-
ing information ? Explain.
9) Explain the following :
i) Accounting equation
ii) Convention of materiality
iii) Accounting standards
iv) Accounting process
v) Branches of accounting
vi) Accounting a source of financial information.
1.17 SOME USEFUL BOOKS

Harold Bierman Jr. and Allan R. Drebin, 1978. Financial Accounting : An
Introduction, W. B. Sounders Company, Philadelphion, London (Chapter 1-3).
Maheswari, S. N., 2002, An Introduction to Accounting, Vikas Publishing House :
New Delhi (Chapter 1 and 2)
Patil, V.A.,and J. S. Korlahalli, 1986. Principles and Practice of Accounting,
R. Chand and Co., New Delhi (Chapter 1-3)
Gupta, R. L. and M. Radhaswamy, 1986. Advanced Accountancy, Sultan Chand and
Sons : New Delhi (Chapter I and II)
Anthony, Robert, N. and James Reece, 1987. Accounting Principles, All India
Traveler Book Seller, New Delhi (Chapter 1-3)
Meigs, Walter, B. and Robert F. Meirgs, 1987. Accounting : The Basis for Business
Decisions, MC Graw Hill : New York (Chapter I)
Sidney Davidson, Michael W. Maher, Clyde P. Stickney, Roman L Weil, 1985.
Managerial Accounting, An Introduction to Concepts, Methods, and Uses, Holt-
Saunders International Editors, Japan. (Chapter I)
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Basic Cost Concepts
UNIT 2 BASIC COST CONCEPTS
Structure
2.0 Objectives
2.1 Introduction
2.2 Need for Cost Data
2.3 Cost Concept
2.4 Classification of Costs
2.4.1 Functional Classification
2.4.2 On the Basis of Identifiability with Products
2.4.3 On the Basis of Variability
2.4.4 On the Basis of Product or Period
2.4.5 On the Basis of Controllable and Non-Controllable Costs
2.4.6 On the Basis of Relevance to Decision-Making
2.5 Concepts of Cost Unit and Cost Centre
2.5.1 Cost Unit
2.5.2 Cost Centre
2.6 Elements of Cost
2.6.1 Materials
2.6.2 Labour
2.6.3 Expenses
2.7 Total Cost Build-Up
2.8 Cost Sheet
2.9 Calculation of Recovery Rates
2.10 Statement of Quotation
2.11 Methods of Costing
2.11.1 Job Costing
2.11.2 Contract Costing
2.11.3 Batch Costing
2.11.4 Unit Costing
2.11.5 Bocess Costing
2.11.6 Operating Costing
2.11.7 Multiple Costing
2.11.8 Uniform Costing
2.12 Types of Costing
2.12.1 Marginal Costing
2.12.2 Absorption Costing
2.12.3 Historical Costing
2.12.4 Standard Costing
2.13 Let Us Sum Up
2.14 Key Words
2.17 Some Useful Books
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Accounting 2.0 OBJECTIVES
After studying this unit, you should be able to :
l describe the need for cost data;
l meaning and classification of costs;
l explain the concept of cost unit and cost centre;
l describe the elements of cost;
l prepare a Proforma of Cost Sheet and identify the components of total cost;
l prepare a statement of quotation and ascertain the price of a tender; and
l describe different methods of costing and identify the industries to which each
method is applicable.
2.1 INTRODUCTION
In this unit you will learn about certain basic cost concepts like cost, cost unit, cost
centre, classification of costs, elements of costs and components of total cost.
Apart from these aspects, the unit also covers preparation of cost sheet showing
details of various components of total cost. You will also study about the
preparation of statement of quotation. The unit also discusses various methods and
types of costing.
2.2 NEED FOR COST DATA

Enterprises may be either profit making or non-profit making organisations. If they
are profit making organisations, one of their primary objectives is to operate at a
profit. Non profit organisations are generally providers of service. Cost data is
required to know how much profit the enterprise is earned. To properly set their
prices at a level to ensure a profit for the entity as a whole, the enterprise must know
what their costs are. Similarly, decisions regarding adding new products or dropping
old products, etc., knowledge of cost data is essential to know how profit changes with
various alternatives. In case of non-profit institution, cost data helps to know what
level of funding is needed to provide the services. It also helps the management to
decide what kind of activities can engage in most efficiently. Thus the management
of an organisation requires cost data for the following purposes :
1) To ascertain profit or loss periodically,
2) To plan the operations and performance evaluation,
3) For cost control,
4) To price the products or services,
5) To value inventory and measure the expenses in external financial reports, and
6) In day to day operations of plans and policies,
2.3 COST CONCEPT

In principle, a cost is a sacrifice of resources. According to the terminology of British
Institute of Cost and Works Accountants, ‘‘Cost is the amount of expenditure (actual
or notional) incurred on or attributable to a given thing’’. In other words, cost
indicates, (i) an actual or estimated expenditure (ii) a direct or indirect expenditure,
and (iii) it relates to a job, process, product or service. Examples of such costs are :
Material, labour, factory overheads, administrative overheads, selling and distribution
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Cost is a very broad and flexible term. It does not give an exact meaning unless it is Basic Cost Concepts
used in some particular context. It varies with time, volume, firm, method or purpose.
The meaning of cost may change according to its interpretation and the manner in
which it is ascertained. It does not mean the same thing under all circumstances.
Therefore, cost must indicate its purpose and the conditions under which it is
computed.
Costs and Expenses

Cost information is necessary both for managerial accounting and financial
accounting. When costs are used inside the organisation to evaluate its performance
we say that costs are used for managerial accounting purposes. On the other hand
when costs are used by outsiders (interested parties) to evaluate the performance of
management and make investment decisions in the organisation, then costs are used
for financial accounting purpose.
It is also important to distinguish between cost as used in managerial accounting, from
expense, as used in financial accounting. A cost is a sacrifice of resource to achieve
specific objective which has been deferred or not yet utilized for the realisation of
revenues. The price paid for the acquisition of fixed assets, materials, etc. are the
examples of such deferred costs.
An expense is a cost that is charged against revenue in an accounting period
and hence expenses are deduced from revenue in that accounting period.
Examples are : Salaries, rent rates, etc. Generally Accepted Accounting
Principles and Regulations specify when costs are treated as expenses to be
charged to revenues.
In accounting for managerial decisions the focus is on costs, and not on expenses. For
external reporting, the term expense is used as defined by Generally Accepted
Accounting Principles. But in practice, the terms cost and expenses are sometimes
used synonymously.
Cost and Loss : There is difference between ‘cost’ and ‘loss’. You know that cost
signifies an expenditure incurred for recurring some benefit to the enterprise. If no
benefit is derived from a particular expenditure, it is treated as a loss. Cost of
material destroyed by fire, salary paid to a foreman during the period of strike etc.,
are the examples of loss to the business.
2.4 CLASSIFICATION OF COSTS

Costs may be classified into different categories depending upon the purpose.
The following are the various bases according to which costs have been classified :
1) According to functions to which they relate,
2) According to their identifiability with jobs, products, or services,
3) According to their variability with changes in output,
4) According to the association with product or period,
5) According to their controllability, and
6) According to their relevance to decision-making
Let us discuss all the above in detail.
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2.4.1 Functional Classification
Accounting
The most common classification of costs in a manufacturing establishment is on the
basis of functions to which they relate because costs have to be ascertained for each of
these functions. On the basis of functions, costs are classified into four categories.
They are :
i) Manufacturing Costs
ii) Administrative Costs
iii) Selling Costs
iv) Distribution Costs
Manufacturing Costs : Manufacturing costs are those costs related to factory
operations which are essential to the completion of the product. It includes direct
material costs, direct labour costs and manufacturing overheads. Direct materials are
the major components of the finished product and can be easily identified with the
product. Direct labour is the labour which is used in actually producing the product.
Manufacturing overheads consist of all other costs related to the manufacturing
process. These are also termed as ‘production costs’.
Administrative Costs: Administrative costs includes all those costs incurred on the
general administration and control of the firm. Examples of such costs are : salaries
of the office staff, rent of the office building, depreciation and repairs of the office
furniture etc. Infact any expenditure which is not related directly to production,
selling, distribution, research and development forms part of the administrative costs.
Selling Costs: Selling costs are those costs which are incurred in connection with the
sale of goods. Some examples of such costs are : Cost of warehousing, advertising,
salesmen salaries etc.
Distribution Costs: Distribution costs are those costs which are incurred on despatch
of finished products to customer including transportation. Examples of such costs are:
packing, carriage, insurance, freight outwards, etc.
2.4.2 On the Basis of Identifiability with Products

On this basis costs are divided into (i) Direct Costs, and (ii) Indirect Costs:
Direct Costs : Direct costs are those costs which are the major components of the
finished products and can be clearly identified with the product being produced. The
examples of direct costs are : raw materials, labour and other direct expenses which
are exclusively incurred for a particular job, product or process.
Indirect Costs : indirect costs are those costs which cannot be assigned to any
particular product, job or process. These costs are usually incurred for the business as
a whole and therefore, are to be allocated to various products manufactured in the
factory on some reasonable basis. Examples of indirect costs are : factory lighting,
rent of factory building, salaries of foreman, etc, Indirect costs are also called as
‘overheads’ or ‘on costs’. These overheads can be further subdivided into factory
overheads, administrative overheads, selling and distribution overheads.
2.4.3 On the Basis of Variability

Another classification is based on the cost behaviour. On this basis costs are
classified into (i) Fixed Costs, (ii) Variable Costs, and (iii) Semi-variable
(or semi-fixed) Costs, (iv) Step Costs.
Fixed Costs: These costs remain fixed irrespective of a change in the volume of
output. But fixed cost varies when it is expressed on per unit basis. In other words
fixed cost per unit decreases when the volume of production increases and vice versa.
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Rent and lease, salary of production manager, salaries of staff, etc., are the examples Basic Cost Concepts
of fixed cost. It should also be noted that fixed costs do not remain fixed always.
They remain fixed only upto a certain level of production activity. If there is a change
in the production capacity which require additional building and equipment, staff, etc.,
such cost will also change. Therefore, fixed costs are fixed within a relevant range of
production. For example, if we produce 1000 units or 10,000 units of a particular
product during a particular period, the rent of the factory building or the salary of the
production manager will remain the same.
Variable Costs: Variable costs are those costs which vary directly or almost
proportionately with the level of output. When volume of output increases, total
variable cost also increases and when volume of output decreases the variable cost
also decreases. But the variable cost per unit will remain unaffected. The examples
of variable costs are : direct material, direct wages, power, commission of salesmen
etc. Let us see the following example how the variable cost varies with the change in
the level of output.
Variable Cost Level of Output (Units)

3,000 4,000 5,000
Unit Costs: Rs. Rs. Rs.
Direct Material 3,000 4,000 5,000
(Rs. 1 per unit)
Direct Labour 6,000 8,000 10,000
(Rs. 2 per unit)
Direct Expenses 3,000 4,000 5,000
(Rs. 1 per unit)
Total Variable Cost 12,000 16,000 20,000
Cost per unit Rs. 4 Rs. 4 Rs. 4
(Total VC ÷ No. of Units)
In the above example the variable cost varies in direct proportion to the activity level
but the variable cost per unit is fixed.
The following are the characteristics of variable costs :
i) The variable cost varies direct proportion to the volume of output.
ii) The cost per unit will remain the same irrespective of level of activity.
iii) It is easy to accurate allocation and apportionment to different cost centres.
iv) Variable costs can be controlled by functional managers as they incur only when
production takes place.
Semi-variable Costs (or semi-fixed costs): These costs are partly fixed and partly
variable. These are the costs which do vary but not in direct proportion to output.
A part of semi variable costs comprising of fixed cost component , is not expected to
change in response to the changes in the level of activity. Thus, semi-variable
costs vary in the same direction but not direct proportion to the changes in the
volume of output. Telephone bills, power consumption, depreciation, repairs, etc.,
are the examples of semi-variable costs. In case of telephone bills, there is a
minimum rent and after specified number of calls, the charges are according to the
number of calls made. Similarly, power costs include a fixed portion of
minimum charge will be charged even if the power is not consumed and
variable charge is based on the consumption of power. Thus, telephone
and power charges increase with an increase in the usage level but not in the same
direction.
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Step Costs: Fixed cost in general remain fixed over a range of activity and then jump
Accounting to a new level as activity changes. For example, a foreman can supervise a given
number of workers in a particular shift. The introduction of anther shift will require
additional foreman and certain costs will increase in lumps. Such costs are known as
‘step costs’ or ‘stair step costs’.
The graphical representation of fixed costs, variable costs semi-variable costs and
step costs is shown below:
Fixed Cost-Behaviour Variable Cost-Behaviour
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3 3
2 Fixed Cost Line 2
ƒs
Fixed Cost Line
1 1
0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)
Semi-Variable Cost Behaviour Fixed Costs Rising in Steps
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Semi-variable cost line 3
3
ƒs
ƒs
2 2 Fixed cost rising line
1 1
0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)
Identification of costs according to their behaviour into fixed and variable elements is
essential for profit planning, cost control, fixation of prices, preparation of budgets
and also in various managerial decisions like make or buy or drop out decisions,
selection of a product mix, level of activity decisions, etc.
2.4.4 On the Basis of Product or Period

Product costs are those costs which are easily attributable to products. These costs
are necessary for the production and will not be incurred if there is no production.
Product costs consist of direct material, direct labour and a reasonable share of
factory overhead. These costs are also called inventoriable costs because these are
included the cost of product as work-in-progress, finished goods or cost of sales.
Generally all manufacturing costs are treated as product costs.
Costs which are easily attributable to time interval are known as period costs. These
costs do not attach to products. These costs incurred for a time period and generally
non-manufacturing costs are treated as period costs. These costs are charged to profit
and loss account. The examples of period costs are rent of office building, salary of
company executives, etc.
Period costs affect profit as they are charged to profit and loss account after they are
incurred whereas product costs will affect profit only when they goods are realized.
Thus, classification of costs on the basis of product and period is significant from
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2.4.5 On the Basis of Controllable and Non-Controllable Costs
Controllable costs are those costs which can be controlled by a specified person or a
level of management. Variable costs are generally controllable by the lower level of
management like departmental heads. For example cost of raw materials can be
controlled by purchasing them in bulk quantities. Uncontrollable costs are those costs
which cannot be controlled or influenced by a specified person of an enterprise. For
example costs like factory rent, managerial salaries etc. It should be noted that the
costs which are not controllable in the short run likely to become controllable in the
long run at some level in the organisation. Similarly, when one moves to the higher
levels of management in the organisation more and more costs become controllable.
Sometimes classification of costs as controllable or non controllable will be a
discretionary matter of the management. The classification of costs on the basis of
controllability is important for the evaluation of performance of the executives and
assigning the responsibility in the organisation.
2.4.6 On the Basis of Relevance to Decision-Making

The following are some important cost concepts which help the management in
decision making process.
Differential Costs: The difference in total costs among the various alternatives is
termed as differential cost. In other words, differential cost is the result of change in
the total cost from an alternative course of action. If the change increases the cost it is
called incremental cost and the change decreases the cost it is called decrimental cost.
The difference in the total cost may be due to change in the methods of production,
change in sales volume, product mix, make or buy or drop out decisions, etc. While
assessing the profitability of a proposed change, the incremental costs should be
matched with the incremental revenues. Look at the following example :
A company is selling 1500 units @ Rs. 15 per unit. The variable cost per unit is
Rs. 7 and the total fixed costs is Rs. 6000. The company receives an export order for
the supply of 300 units @ Rs. 12 per unit. If this order is accepted, fixed cost will be
increased by Rs. 300.
Solution
The cost and sales before and after accepting the export order is worked out as follows:
Particulars Before the Export After the Export Incremental

Order Order
Cost Revenue Cost Revenue Cost Revenue
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 22,500 26,100 3,600
Less Variable Costs 10,500 12,000
Fixed Costs 6,000 16,500 6,300 18,900 2,400
Profit 6,000 7,200 1,200
The proposed export order will result a profit of Rs. 1200. If the proposal is
implemented it results an incremental revenue of Rs. 3600 against the incremental cost
of Rs. 2400. Thus the differential concept is important for managerial decision making.
Sunk Costs: Sunk costs results from past expenditure. Sunk costs cannot be changed
now and management has no control over such costs. The examples of Sunk costs are :
past cost of inventory, past costs of long term assets etc. It should be noted that past
information is totally irrelevant but can be used to predict differential costs in future
course of actions. Further the management uses the past expenditure information in
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Imputed Costs : These costs are also called hypothetical costs or notional costs.
Accounting These costs are included in cost accounts only for the purpose of taking managerial
decisions. For example, interest on capital, rent of own building should be taken into
account while evaluating the relative profitability of the projects.
Opportunity Costs : Opportunity cost refers to the benefit foregone as a result of
accepting one course of action. The manager, while taking a decision should not only
take into account the costs and benefits of the proposed alternative but also the profit
scarified by making the decision. For example, if an owned building is proposed to be
utilized for housing a new project plant, the likely revenue which the building could
fetch, if it is let out, is the opportunity cost which should be taken into account while
evaluating the profitability of the project.
2.5 CONCEPTS OF COST UNIT AND COST CENTRE
2.5.1 Cost Unit

The main function of costing is to ascertain cost per unit of output. Each economic
activity has to be measured in identifiable units which may serve as the basis of
accounting. Such units for the purpose of costing may be as follows :
1) Unit of product, or a group of products (e.g., pair of shoes or one batch of shoes
say one dozen)
2) Unit of operating service (e.g., cost of running a bus per one kilometer)
3) Unit of time (e.g., cost of generating electricity per hour)
4) Unit of weight (e.g., cost per one tonne of steel)
5) Unit of measurement (e.g., cost per meter of cloth or one litre of petrol)
Thus a cost unit is ‘a unit of product, service or time in relation to which costs may be
ascertained or expressed’. In other words cost unit is unit of measurement of cost. It
will be normally the quantity of product for which price is quoted to the consumers.
The selection of cost unit must be appropriate, natural to the business, easily
understandable and acceptable to all concerned. Firstly, it should offer convenience in
cost ascertainment. Secondly, it should be easier to associate expenses with cost units.
Thirdly, it should be according to the nature and prevailing practice of the business.
Some examples of cost unit for different products and services are given below:
Product/Activity Cost Unit
Cement Per-tonne/per bag
Iron Per-tonne/quintal
Chemicals Per-tonne/kilogram/litre, etc
Power Per-kilowatt hour
Coal Per tonne/kilogram
Bricks Per thousand
Printing press Per thousand copies
Paper Per ream/per kilogram
Transport Per passenger per kilometer/per
kilogram per kilometer
Telephone Per call
Timber Per cubic foot/square foot
Pencils Per dozen or gross
4 2
Petrol Per litre
Television Per set
Gold Per gram
Hotel Per room per day
Nursing Homes Per bed per day
Cars Per car
2.5.2 Cost Centre

A cost centre is ‘location, person, or item of equipment (or group of these) for which
costs may be ascertained and used for the purpose of control’. Thus a cost centre
refers to a section of business to which costs can be charged. It may consist of either
or a combination of the following :
Location : Factory, Department, Office, Warehouse, Stores, Sales Depot, etc.
Person : Salesman, a machine operator, customer, etc.
Equipment : Machine, Car, Truck, etc.
Types of Cost Centres : Cost centres may be divided into the following four types :
1) Process Cost Centre (Based on sequence of operations)
2) Production Cost centre (for regular production in a factory)
3) Operation Cost Centre (where various operations are involved in the production
process)
4) Service Cost Centre (for activities supporting the main production)
Thus identification or selection of cost centres depends on the nature and types of
industry. The identification of cost centres helps us in :
i) ascertaining the centre-wise costs,
ii) comparing the centre-wise costs periodically,
iii) finding out the major trends of variance, and
iv) applying the techniques of control to check undue, undesirable or unexpected
movements in cost.
A cost centre segregates operations, democrats activities, and distributes expenses.
This also helps in fixing responsibilities for every cost centre.

1. What is the concept of Cost ?
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2. Distinguish between direct and indirect costs.
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3. Give four examples of indirect expenses.
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4 3
Fundamentals of 4. Distinguish between cost and loss.
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Accounting
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5. Give two examples of semi-variable costs.
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6. State whether each of the following statements is True or False
i) Variable cost remains fixed per unit but varies direct proportion to the
volume of output.
ii) Variable costs are controllable.
iii) Operating costing is used in transport industry.
iv) Semi-variable costs vary in the same direction to the volume of output but
not direct proportion to the changes in the volume of output.
v) Fixed costs are also known as period costs.
vi) Direct Material + Direct wages + Direct expenses = Works cost.
vii) Works cost + Office overheads = Cost of production.
2.6 ELEMENTS OF COST

In order to understand and interpret the term ‘cost’, it will be necessary to
understand about the elements of cost. The following are the three elements
of costs: (1) Materials, (2) Labour, (3) Expenses
These can be further sub-dividend into as direct or indirect as follows :
Direct Indirect
Material Material
Labour Labour
Expenses Expenses
2.6.1 Materials
The term ‘materials’ refers to those commodities which are used as raw materials,
components, or consumables for manufacturing a product. In other words, the
substance from which the product is made is known as ‘materials’. Materials can be
direct or indirect.
Direct Materials: All materials which become an integral part of the finished product
and which can be conveniently assigned to specific physical units is termed as ‘Direct
Materials’. Direct material generally becomes a part of the finished product. The
following are some examples of direct material :
i) All materials or components specifically purchased, produced or requisitioned
from stores (e.g., sugar can for sugar, cloth for ready-made garments, cotton for
cloth, tyres for car, etc.)
ii) Primary packing material (e.g., wrapping, cardboard, boxes etc.)
iii) Partly produced or purchased components
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Indirect Materials: All materials which are used for purposes ancillary to the Basic Cost Concepts
business and which cannot conveniently be assigned to specific physical units is
termed as ‘indirect materials’. These materials cannot be conveniently identified with
individual cost units. Their cost is insignificant in the finished product. Pins, screws,
nuts, bolts etc., are some examples. There are some other items which do not
physically become part of the finished product. Examples are : Consumable stores,
lubricating oil, Greece, printing and stationery etc., These items do not form part of
the finished product.
2.6.2 Labour
The workers employed for converting material into finished product or doing various
odd jobs in the business are known as ‘Labour’. Labour can be direct as well as
indirect.
Direct Labour: The workers who are directly involved, in the production of goods
are known as ‘direct labour’. They may be labourers producing manually or workers
operating machinery. Direct labour costs can be conveniently identified with a
particular product, job or process. For example, the wages paid to a machine
operator engaged in the manufacture of goods. The wages paid to such workers are
known as ‘manufacturing wages’.
Indirect labour : The workers employed for carrying out tasks incidental to
production of goods or those engaged for office work and selling and distribution
activities are known as indirect labourí. The wages paid to such workers are known
as ‘indirect wages’. Indirect labour is of general character in nature and cannot be
conveniently identified with a particular unit of output. The examples of indirect
labour costs are : wages of storekeepers, foremen, directors’ fees, salaries of
salesman, etc.
2.6.3 Expenses
All expenses other than material and labour are termed as ‘expenses’. Expenses may
be direct or indirect.
Direct Expenses : Expenses which can be identified with and allocated to cost
centres or units are called direct expenses. These are the expenses which are
specifically incurred in connection with a particular cost unit. Direct expenses are
also called as ‘chargeable expenses’. The examples of such expenses are : Carriage
inwards, production royalty, hire charges of special equipment, cost of special
drawings, designs and layouts, experimental costs, etc.
Indirect Expenses : These are expenses which cannot be directly or wholly allocated
to cost centres or cost units. In other words, all expenses other than indirect material
and labour which cannot be directly attribute to a particular product, job or service
are called indirect expenses. Examples of such expenses are : Rent and Rates,
lighting and heating, advertising, insurance, repairs, carriage, etc.
The above elements of cost may be shown in the form of a chart as shown below:
Elements of Cost
Cost
s s s
Materials Labour Expenses
s s s s s s
Direct Indirect Direct Indirect Direct Indirect
Overheads
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All materials, Labour, expenses which cannot be identified as direct costs are termed
Accounting as ‘indirect costs’. The three elements of indirect costs viz., indirect materials, indirect
labour and indirect expenses are collectively known as ‘overheads’ or ‘on costs’.
Overheads are grouped into three categories:
1) Factory (or manufacturing) overheads,
2) Office (or administrative) overheads, and
3) Selling and distribution overheads.
1) Factory Overheads
All indirect manufacturing costs which cannot be identified with specific unit of
output are called factory overheads. It includes:
i) Indirect material such as lubricants, oil, consumable stores etc.,
ii) Indirect labour a such as gate-keepers’ salary, works manager’s salary etc., and
iii) Indirect expenses such as factory rent, depreciation on factory building and
equipment, factory insurance, factory lighting etc.,
iv) Factory overheads are also known as manufacturing overheads, indirect
production costs, factory on cost, overhead expenses etc.
2) Office Overheads
Indirect expenses incurred in connection with the general administration like
formulating policies, planning and controlling of a firm for attainment of its goal, are
included in these overheads. They include (i) indirect material used in office such as
printing and stationary material, brooms and dusters etc. (ii) Indirect labour such as
salaries payable to office manager, clerks, etc. and (iii) indirect expenses such as rent,
insurance, lighting of the office etc.,
3) Selling and Distribution Overheads

Selling and distribution overheads include all those costs which are incurred for
promoting and marketing the products. These include :
(i) Indirect material used such as packing material, printing and stationary
material etc, (ii) Indirect labour such as salaries of salesmen, sales manager, etc. and
(iii) Indirect expenses such as rent, insurance, advertising expenses etc.
The above classification of overheads can be shown with the help of the following
Figure:
Classification of Overheads
Overheads (Indirect Costs)

s s s
Factory Overheads Office Overheads Selling and Distribution Overheads
s s s s s s
s s s
Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect
Materials Labour Expenses Materials Labour Expenses Materials Labour Expenses
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2.7 TOTAL COST BUILD-UP
Components of Total Cost
Total cost of a product is the combination of direct costs and indirect costs. Direct
Costs, as you know, consist of direct materials, direct labour and direct expenses and
it is also known as prime cost. Indirect Costs known as overheads consists of factory
overheads, office overheads and selling and distribution overheads. Thus, the two
main components of total cost are: 1) Prime cost, and (2) Overheads.
If we add various costs one by one, we get the framework of total cost build up as
follows :
1) Prime Cost: It consists of cost of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost. Thus,
Prime cost = Direct material + Direct Labour + Other direct expenses
2) Factory Cost : It includes Prime Cost and factory overheads which consists of
indirect material, indirect labour and indirect factory expenses. The factory cost
is also known as works cost, production or manufacturing costs. Thus,
Factory Cost = Prime Cost + Factory Overheads
3) Cost of Production: It comprises factory cost and office and administrative
overheads. It is also known as office cost. Thus,
Cost of Production = Factory Cost + Office and Administrative Overheads
4) Total Cost: It comprises cost of production and selling and distribution
overheads. It is also called as cost of sales.
Total Cost = Cost of Production + Selling and Distribution overheads
The above framework of total cost building-up is shown in the following Figure :
Total Cost Build Up
Materials
Labour Prime Cost
Direct Expenses +
Factory Factory Cost
Overheads s+ Cost of
Office Production Cost of
Overheads + Sales
Selling and
Distribution
Overheads
Thus, the components of total cost are :

Prime Cost, (2) Works Cost, (3) Cost of Production, and (4) Cost of Sales.
2.8 COST SHEET

The elements of cost can be presented in the form of a statement called ‘Cost Sheet’.
A cost sheet is a statement showing the various components of total cost of output for
a certain period which acts as a guide to pricing decisions and cost control. It has
been defined as ‘‘a document which provides for the assembly of the detailed cost of a
cost centre or cost unit’’. The cost sheet should be prepared properly and at frequent
intervals, i.e., weekly, monthly, quarterly, yearly etc. Cost sheet may be prepared
separately for each cost centre. Additional columns can also be provided for the
purpose of comparison of current data with the previous data. 4 7
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Cost Sheet, generally serves the following purposes :
Accounting
i) It provides total cost and cost per unit of production,
ii) It gives the details regarding various elements of total cost, i.e., material, labour,
overheads, etc.,
iii) It gives scope for a comparative study of cost of production of the current period
with that of the previous period.
iv) It helps the management in taking managerial decisions relating to pricing
decisions, quotation of tenders, cost control etc.
The information to be shown in the cost sheet will depend upon the nature and
requirement of the enterprise. Generally, following information may be incorporated
into a cost sheet :
1) Name of the product, cost centre or cost unit
2) Period to which the statement relates
3) Output of the period
4) Details of various components of total cost
5) Item-wise cost per unit
6) Changes in stock position
7) Cost of goods sold
8) Profit or loss position
The Proforma of Cost sheet is given below :
Proforma of Cost Sheet

COST SHEET OF..................................................
For the month ending..................................................
Output..................nits
Total Per Unit

Rs. Rs.
Raw Materials consumed :
Opening Stock of Raw of materials .....................
Add : Purchases of Raw Materials .....................
Less : Closing stock of raw materials ....................
Direct Labour
Direct Expenses
PRIME COST
Factory Overheads :
Rent
Depreciation on premises
Power and light
Indirect material
Indirect wages
Telephone Charges
Insurance etc.
WORKS COST
4 8
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Basic Cost Concepts
Office and Administrative Overheads:
Office salaries
Office rent
Office expenses, etc
COST OF PRODUCTION
(.................units)
Add Opening Stock of Finished goods
(.................units)
Less Closing Stock of Finished Goods
(.................units)
COST OF GOODS SOLD
(.................units)
Selling and Distribution Overheads :
Salaries and commission
Advertising
Packing expenses
Travelling expenses
Warehouse charges
Carriage outwards, etc.
COST OF SALES
(.................units)
PROFIT (LOSS)
SALES/SELLING PRICE
Look at the following illustration and see how a Cost Sheet is prepared with the
following information:
Illustration 1
From the following particulars of a manufacturing firm prepare a cost sheet showing
different components of total cost for the year ending 31st March, 2003.
Particulars Amount (Rs.)
Stock of material (April 1, 2002) 80,000
Purchase of Raw materials 12,00,000
Stock of finished goods on 1,00,000
1-4-2002 (10,000 units)
Direct wages 8,00,000
Direct chargeable expenses 8,000
Finished goods sold (1,80,000 units) 25,40,000
Factory rent rates and power 20,000
Indirect wages 5,000
Depreciation on Plant and Machinery 2,000
Carriage Outwards 20,000
Carriage Inwards 2,000
Office rent and taxes 1,500
Telephone charges 3,000
Travelling expenses 60,000
Advertising 10,000
Depreciation on office premises 1,500
Stock of materials on 31.3.2003 1,60,000
Stock of finished goods on 31.3.2003 (12,000 units) 1,20,000 4 9
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Accounting
Firstly, we have to find out the number of units produced during the year, before
preparing the cost sheet.
No. of Units
Closing Stock (31.3.2003) 12,000
Add: Number of Units sold 1,80,000
1,92,000
Less : Opening Stock (1.4.2002) 10,000
Number of units produced during the year 1,82,000
COST SHEET
for the year ending 31.3.2003
Output: 1,82,000 Units
Particulars Total Per Unit

Rs. Rs.
Raw Materials Consumed:
Opening Stock (1.4.2002) 80,000
Add: Purchase of Raw material 14,21,000
Add : Carriage inwards 2,000
__________
15,03,000
Less : Closing stock of raw material 1,60,000
(as on 31.3.2003) __________ 13,43,000
Other direct chargeable expenses 8,000
_________
Prime Cost 21,51,000
Works Overheads:
Indirect wages 5,000
Factory rent, rates and power 20,000
Depreciation on plant and machinery 2,000
______ 27,000
_________
Works Cost 21,78,000
Office and Administrative Overheads:
Office rent and taxes 1,500
Telephone charges 3,000
Depreciation on office premises 1,500
_______ 6,000
_________
Cost of Goods Sold 21,84,000 12.00
(1,82,000 units @ Rs.12 per unit)
Add : Opening stock of Finished goods
(10,000 units @ Rs.12 per unit) 1,20,000 12.00
––––––––
2,30,000
Less : Closing stock of Finished goods 1,44,000 12.00
(12,000 units @ Rs.12 per unit) ––––––––
5 0 21,60,000
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Basic Cost Concepts
Cost of Goods Sold
(180,000 units)
Selling and Distribution Overheads:
Travelling expenses 60,000
Carriage outwards 20,000 90,000 0.50
Advertising Cost of Sales 10,000 _______ _______
Profit 22,50,000 12.50
6,30,000 3.50
SALES 28,80,000 16.00
2.9 CALCULATION OF RECOVERY RATES

Sometimes, you are required to calculate overheads recovery rates based on the cost
sheet prepared by you. Such rates are usually in respect of factory overheads and
administration overheads. Factory overhead rate is usually calculated as a percentage
of direct wages as follows:
Factory Overheads
Factory Overhead Rate = —————————— × 100
Direct wages
Administration overhead rate is usually calculated as a percentage of works cost as follows:
Office Administration Overheads

Administration Overhead Rate = —————————————––––— × 100
Factory or Works Cost
Selling and distribution overheads rate may be computed either as a percentage of Works
cost or as a percentage of sales as follows :
Selling and Distribution Overheads
Selling and Distribution Overhead Rate = ————————————————— × 100
Works Cost or Sales
Let us see the following illustration how the recovery rates are calculated :
Illustration 2
The following is the cost data relating to a manufacturing company for the period ending
December 31, 2002 :
Rs.
Raw material purchased 1,20,000
Stock of raw material on 1-1-2002 25,000
Factory overheads 60,000
Carriage inwards 1,00,000
Selling and distribution overheads 72,800
Administration overheads 67,200
Stock of raw material on 31.12.2002 35,000
Sales during the year 6,12,000
Find out a) Cost of Production
b) Cost of Sales
c) The Net Profit for the year
d) The percentage of factory overheads on direct wages
e) The percentage of administration overheads on works cost
f) The percentage of selling and distribution overheads on works cost and
g) The percentage of profit to cost of sales.
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Accounting
Cost Sheet for the period ending December 31, 2002
Cost of Raw material consumed : Rs. Rs.

Stock of Raw Material (as on 1-1-2002) 25,000
Add : Raw material purchased 1,20,000
Add : Carriage inwards 1,00,000
––––––––
2,45,000
Less : Stock of Raw Material (as on 31-12-2002) 35,000
–––––––– 2,10,000
Direct Wages 1,00,000
––––––––
PRIME COST 3,10,000
Factory Overheads 60,000
––––––––
WORKS COST 3,70,000
Administration Overheads 67,200
––––––––
(a) COST OF PRODUCTION 4,37,200
Selling and Distribution Expenses 72,800
—————
(b) COST OF SALES 5,10,000
(c) PROFIT 1,02,000
—————
SALES 6,12,000
—————
(d) Percentage of Factory Overheads to Direct Wages

Factory Overheads
= ————————— × 100
Direct Wages
60,000
= ————— × 100
1,00,000
= 60%
(e) Percentage of Administration Overheads to Works Cost
Administration Overheads
= ————————————— × 100
Works Cost
67,200
= ————— × 100
3,70,000
= 18.16%
(f) Percentage of Selling and Distribution Expenses on Works Cost
Selling and Distribution Expenses

= ———————————————— × 100
Works Cost
5 2
72,800
= ———— × 100
3,70,000
= 19.68%
(g) Percentage of Profit to Cost of Sales
Profit
= ——————— × 100
Cost of Sales
1,02,000
= ————— × 100
5,10,000
= 20%
2.10 STATEMENT OF QUOTATION

A manufacturer, sometimes, may be asked to quote a price for supply a particular
article with certain specifications. The term ‘Quotation’ refers to quoting the
minimum price for obtaining a specific order. Such a price is quoted before the
commencement of actual production in anticipation of obtaining a particular order.
While quoting the price the manufacturer has to keep in view the likely impact of
inflationary trends on the input. Before submitting a tender or fixing price he must
have full information regarding cost of inputs like raw materials, wages, different
overheads and a reasonable amount of profit. On the basis of past records, he can
prepare a cost sheet incorporating inflationary trends in price levels of various
components of production. While quoting the price for such specific order, he has to
be cautious that the price is neither too high nor too low. In case the price is too high,
the tender will be rejected outright. On the other hand, if the price is too low, it will
result in either lower profit or loss. Therefore, it is important to estimate the cost as
accurately as possible.
Statement of quotation is prepared in the same manner as Cost Sheet as shown in
illustration 3
Illustration 3
A manufacturing company receives a quotation for the supply of 10,000 units of its
products. The costs are estimated as follows :
Raw material 80,000 kgs. @ Rs. 4 per kg.
Direct wages 10,000 hours @ Rs. 2 per hour
Variable overheads :
Factory @ Rs. 2.50 per labour hour
Selling and Distribution Rs. 30,000
Fixed Overheads :
Factory Rs. 10,000
Office and Administration Rs. 75,000
Selling and Distribution Rs. 20,000
The company adds 10% to its cost as its margin of profit. Prepare a Statement of
Quotation showing the price to be quoted.
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Accounting
Statement of Quotation showing the price to be quoted for 10,000 units
Total Per Unit

Rs. Rs.
Estimated cost of Direct Materials 3,20,000 32.00
(80,000 kgs X Rs. 4 per kg)
Estimated Cost of Direct Labour 20,000 2.00
(10,000 hours X Rs. 2 per hour)
Estimated Prime Cost 3,40,000 34.000
Add : Estimated Factory Overheads :
Variable (10,000 hours X Rs. 2.50) 25,000
Fixed 10,000 35,000 35.00
Estimated Factory Cost 3,75,000 37.50
Add:Estimated Office and Administrative 75,000 45.00
Overheads
Estimated Cost of Production 4,50,000 45.00
Add: Estimated Selling and Distribution Overheads
Variable Rs. 30,000
Fixed Rs. 20,000 50,000 5.00
Estimated Cost of Sales 5,00,000 50.00
Add: Deserved Profit @ 10% on cost price 50,000 5.00
Estimated Selling Price 5,50,000 55.00
Sometimes, cost records for a particular period are given and the estimated cost of
material and labour of a work order are provided for the purpose of ascertaining its
selling price to be quoted. In such a situation, you should prepare the cost sheet first
and ascertain the recovery rates for factory overheads as a percentage to direct wages,
for administrative overheads as a percentage of works costs, and for selling and
distribution overheads as percentage of cost of goods sold or as suggested in the given
question. These rates must be duly adjusted with the anticipated changes, if any,
before preparing the statement of quotation. Look at the following illustration and
how the statement of quotation for a work order is prepared with the help of a give
cost data.
Illustration 4
The following figures have been obtained from the cost records of a manufacturing
company for the year 2002 :
Cost of Materials 1,20,000
Wages for Direct labour 1,00,000
Factory overheads 60,000
Distribution expenses 28,000
Administration expenses 67,200
Selling expenses 44,800
Profit 84,000
A work order was executed in 2003 and the following expenses were incurred :
Cost of Materials 16,000
Wages for labour 10,000
Assuming that in 2003 the rate for factory overheads went up 20%, distribution
charges went down by 10% and selling and administration charges went up by 12 1 2 ,
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at what price should the product be quoted so as to earn the same rate of profit on the Basic Cost Concepts
selling price as in 2002. Show the full workings.
Factory overheads are based on direct wages while administration, selling and
distribution expenses are based on factory cost.
Solution
Statement of Cost for the year 2002
Rs.
Cost of Direct Materials 1,20,000
PRIME COST 2,20,000
Factory Overheads 60,000
WORK COST 2,80,000
Administration Overheads 67,200
COST OF PRODUCTION 3,47,200
Selling Overheads 44,800
Distribution Overheads 28,000
COST OF SALES 4,20,000
Profit 84,000
SALES 5,04,000
Factory Overheads
Factory Overhead Rate = ————————— × 100
Direct Wages
60,000
= ———— × 100
1,00,000
= 60%
Administration Overheads
Administrative Overheads Rate = ——————————— × 100
Works Cost
67,200
= ———— × 100
2,80,000
= 24%
Selling Overheads
Selling Overheads Rate = ———————— × 100
Works Cost
44,800
= ————— × 100
2,80,000
= 16%
Distribution Overheads
Distribution Overhead Rate = —————————— × 100
Works Cost
28,000
= ————— × 100
2,80,000
= 10% 5 5
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Accounting Profit
Rate of Profit = —————— × 100
Cost of Sales
84,000
= ———— × 100
4,20,000
= 20% cost of sales
Statement of Quotation showing the price to be quoted for a work order

Rs.
Cost of Direct Materials 16,000
Direct wages 10,000
PRIME COST 26,000
Factory Overheads : 60% of wages 6,000
Add 20% increase 1,200 7,200
WORK COST 33,200
Administration Overheads: 24% of works cost 7968
1 996 8,964
Add : 12 increase
2
COST OF PRODUCTION 42,164
Selling Overheads : 16% of works cost 5312
1
Add : 12 increase 664 5,976
2
Distribution Overheads : 15% of works cost 3320
Less : 10% decrease 332 2,988
COST OF SALES 51,128.00
Profit (20% of Cost of Sales) 10,225.50
SALES 61,353.50

1) What is a cost Sheet ?
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2) Name the basic methods of costing

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3) Name different types of costing.
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4) What do you mean by quotation? Why is it necessary ?
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5) State whether each of the following statement is True or False
i) Selling and distribution overheads are recovered on the basis of
percentage to cost of production.
ii) Office and administrative overheads are recovered usually on the basis of
percentage to factory cost.
iii) Factory overheads rate is usually calculated as a percentage of direct
wages.
iv) Cost of sales = Factory cost + Selling and Distribution overheads.
v) Selling price = Cost of sales + Profit.
2.11 METHODS OF COSTING

Business enterprises are not alike. They are different from another in some way or
other. The basic principles and procedures of costing remains the same in all
industries but the method of analysis and presentation of cost of their products and
services vary from industry to industry. Therefore, the choice of a particular method
of costing depends upon the nature and types of the product or service provided by a
business unit. The various methods of costing can be summarized as follows :
2.11.1 Job Costing

Under this method, costs are ascertained for each job or work order separately. The
job may consist of a single unit or it may consist of identical or similar products under
a single work order. This method applies where work is undertaken against
customers’ requirements. Job costing is suitable to industries like printing, repairs,
foundries, interior decorators, building construction etc. Non profit organisations like
rehabilitation or street repair programmes also use job costing to ascertain cost of
individual projects. It can also be used in industries where different product lines are
manufactured. For example, a furniture manufacturer may produce a batch of similar
chairs, a batch of tables and so on. Each batch can be treated as a job for accounting
purposes. Job costing also found in service organisations like engineering,
consultancy and accounting firms. Job costing procedure is the same both in
manufacturing and service organisations, except that service units use no direct
material.
The purpose of job costing is to ascertain the cost of production of each job for fixing
selling prices, bidding, controlling costs and evaluating performance. It also provides
information for negotiating price increase with the customers.
2.11.2 Contract Costing

This method is used in case of big jobs and therefore, the principles of job costing are
applied to contract costing The contract work usually involves heavy expenditure,
spreads over a long period and is usually undertaken at different sites. Hence, each
contract is treated as a separate unit for the purpose of cost ascertainment and control.
Contract costing is also termed as terminal costing as the cost can be terminated at
some point and related to a particular job. Contract costing is employed in business
undertakings engaged in construction of buildings, roads, bridges, ship building and
other civil and mechanical engineering works. 5 7
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2.11.3 Batch Costing
Accounting
This method of costing is used in industries where the production is carried on in
batches. Each batch consist of identical products which maintains its identity
throughout one or more stages of production. Each batch cost is used to determine the
unit of cost of products. On completion of the batch the cost per unit can be
calculated by dividing the ‘total batch cost’ by the number of units produced. This
method of costing is suitable to industries where production consists of repetitive
production in nature and specified number of products are produced in one batch. It
is generally used in industries like engineering component industry, pharmaceuticals,
footwear, bakery, readymade garments, toy manufacturing, bicycle parts etc.
2.11.4 Unit Costing

Unit Costing is a method of cost accounting where costs are determined per unit of a
single product. This method is also called single or output costing. This method is
suitable to industries where production is continuous and uniform and engaging in the
production of a single product in two or three varieties. The cost per unit is found by
dividing the total cost by the total number of units produced. Where the product is
produced in different grades, costs are ascertained grad wise. It is suitable for
industries like collieries, quarries, brick works, flour mills, paper mills, cement, textile
mills, diaries etc.
2.11.5 Process Costing

Where a product passes through different processes and each process is distinct and
well defined the method employed for ascertaining the cost at each stage of production
is called process costing. Process costing is used in those industries where the
production is continuous and the final product is the result of sequence of operations
or processes. The finished product of one process will become the raw material of the
next process and the output of the last process will be the finished stock. The cost per
unit at each process will be calculated by dividing the total cost by the number of units
produced at each stage and the cost per unit of the final product is the average cost of
all the processes. During the course of processing of raw material, loss of some raw
material is unavoidable or it may give rise to the production of several products called
joint products or by products. Process costing is used in case of chemicals, paints,
textiles, bakeries, oil refining, food products, etc. Standardization of processes helps
the management to submit quotations in time without any delay. As actual and
budgeted costs are available in each process it facilitates managerial control by
evaluating the performance at each process level.
2.11.6 Operating Costing

Operating Costing is also called as ‘service costing’ because this method is used in
those undertakings which provide services and are not engaging in manufacturing
tangible products. It is used for ascertaining the cost of operating a service such as
railways, roadways, airways, hotels, nursing homes, power supply, water supply etc.
In these undertakings the cost unit is a service unit which is as follows:
Undertaking Cost Unit
Canteen per cup of tea
Cinema per seat
Electricity per kilo watt
Hospital per bed
School/College per student
Transport per passenger kilometer/per tonne kilometer
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A large amount of capital is invested in fixed assets and comparatively less Basic Cost Concepts
working capital is required in these industries. Operating costing is different from
operation costing. Operating costing is used to determine the cost of providing a
service whereas operation costing is used to find out cost of each operation
in those of industries which produce goods consisting of a number of
operations.
2.11.7 Multiple Costing

It is an application of more than one method of costing in respect of the same
product. This method is suitable in industries where a number of components are
manufactured separately and then assembled into a finished product. In cases of
motor car, type writer, television, refrigerators, etc., costs are to be ascertained for
each component as well as for finished product. This involves use of different
methods of costing for different components and so it is known as ‘multiple’ or
‘composite costingí.
2.11.8 Uniform Costing

The practice of using a common method of costing by a number of firms in the same
industry is known as ‘uniform costing’. Thus it is not a separate method of costing. It
simply refers to a common system using agreed concepts, principles and standard
accounting practices. This helps in making inter-firm comparisons and fixation of
prices.
It should be noted that there are two basic methods of costing. They are : (i) Job
costing, and (ii) Process costing. The other methods discussed above are simply
variants of these two methods.
2.12 TYPES OF COSTING
2.12.1 Marginal Costing

It is also known as Variable Costing. It may be defined which methods of costing
rebers to the process and practice of ascertaining costs of products and serrices, the
types of costing rebers to the techniqu of analysing and presenting costs for the
purpose of control and managerial decisions. The hypes of costing (also known as
techniques of costing) generally used are as follows:
as ‘‘the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs.’’ It
is a technique of costing which emphasizes the distinction between product costs and
period costs. Only variable costs (direct material, direct labour, other direct expenses
and variable overheads) are allocated to products without taking into account fixed
costs. Fixed costs are treated as period costs and are charged to costing profit and
loss account of the period in which they are incurred. The profitability of the product
is based on the amount of contribution made by each product. Contribution is the
difference between selling price and marginal cost of sales. The price of a product
will be determined on the basis of marginal cost plus contribution. The difference
between the total contribution and total fixed cost represents the profit (Profit =
Contribution – Fixed cost).
The technique of marginal costing is a valuable tool to management in making
managerial decisions like fixation of selling price, selection of suitable product mix,
selection of alternative methods of production, make or buy decisions, and also for
cost control.
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2.12.2 Absorption Costing
Accounting
Absorption costing is a principle whereby fixed as well as variable costs are allotted
to cost units. It is a technique of charging all costs, both fixed and variable costs, to
production of a product. Absorption costing does not require a break-down of costs
into fixed and variable costs. As such fixed costs are treated as product costs under
absorption costing. The reports prepared under absorption costing can be used for
external use.
2.12.3 Historical Costing

It refers to a system of cost accounting under which costs are ascertained only after
they have been incurred. In other words, accounting is done in terms of actual costs
and not in terms of predetermined and standard costs. In the initial stages of
development of cost accounting, historical costing is the only system available for
ascertaining costs. This system is not useful for cost control and measuring the
performance efficiency of the concern. Moreover, it is not useful in price quotations
and production planning.
2.12.4 Standard Costing

It refers to the system of cost accounting under which costs are determined in advance
on certain predetermined standards. These are known as standards which indicate the
level of costs that should be attained under a given set of operating conditions. The
standard costs are compared periodically with the actual costs and underlying causes
for variances are analysed so that corrective action may be taken in time wherever
necessary. The Standard Costing is helpful to the management for cost control,
production planning, formulation of policies, measuring efficiencies, eliminating
inefficiencies, etc.
2.13 LET US SUM UP

Cost data is required by an organisation for the purpose of ascertaining profit or loss
periodically, to plan its future operations as well as to evaluate its performance and
cost control. It also requires to price its products or services, to value its inventory and
day to day operations of plans and policies. Costs indicates (i) an actual or estimated
expenditure (ii) a direct or indirect expenditure and (iii) it relates to a job, process,
product or services. Cost is a flexible concept. It varies with time, volume, firm,
method or purpose. There is difference between ‘cost’ and ‘loss’. Cost signifies an
expenditure incurred for recurring some benefit and if no benefit is desired from a
particular expenditure, it is treated as loss.
Cost can be classified in various ways. On the basis of functions to which they relate,
costs are classified into manufacturing costs, administrative costs, selling and
distribution costs. On the basis of Identifiability with products costs can be classified
into direct costs and indirect costs. On the basis variability costs can be classified into
fixed costs, variable costs and semi variable costs. Costs can also be classified on the
basis of product or period. Product costs are those costs which are easily attributable
to products where as costs which are easily attribute to time interval are known as
period costs. Costs can also be classified on the basis of controllable and non-
controllable costs.
A cost unit is a unit of product, service or time in relation to which costs may be
ascertained or expressed. A cost centre is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for the purpose of
control. There are three elements of costs : (i) Materials (ii) Labour and (iii)
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Expenses. These costs can be further sub-dividend into as direct or indirect costs. Basic Cost Concepts
Indirect costs are : indirect material, indirect labour, and indirect expenses. Indirect
costs are known as ‘overheads’. Overheads can be classified into factory overheads,
office overheads, selling and distribution overheads.
The main components of total cost are prime cost, works cost, cost of production and
cost of sales. The elements of cost can be presented in the form of a statement called
‘cost sheet’ A cost sheet is a statement showing the various components of total cost
of output for a certain period which acts as a guide to pricing decisions and cost
control. Overhead recovery rates are based on the cost sheet. Sometimes, a statement
of quotations is required to be prepared in order to find out the price to be quoted to
the prospective buyer for obtaining a specific order. Such a price is quoted before the
commencement of actual production after taking into consideration the inflationary
trends in the price levels of various components of production.
There are various methods of costing. These are: (i) Job costing (ii) Contract costing
(iii) Batch costing (iv) Unit costing (v) Process costing (vi) Operating costing (vii)
Multiple costing (viii) Uniform costing. The types of costing refers to the techniques
of analysing and presenting costs for the purpose of control and managerial decisions.
The types of costing generally used are: (i) Marginal costing (ii) Absorption costing
(iii) Historical costing, and (iv) Standard costing.
2.14 KEY WORDS

Allocation: Distribution of expenditure among various cost centres.
Costing: The technique and process of ascertaining costs.
Cost Sheet: A statement showing different elements of cost relating to a particular
product or a job for a particular period.
Cost Centre: A location, person, equipment or department for which costs may be
ascertained and used for purpose of control.
Direct Expenses: Expenses or decrease in the same proportion on the increase or
decrease in the output.
Cost of Sales: Total cost of a product including selling and distribution expenses.
Prime Cost: Cost of direct expenses including direct materials and wages.
Semi-variable costs: Expenses which change with changes in output, but not in the
same proportion.
Works cost: Prime cost plus factory overheads.
Chargeable expenses: Other direct expenses.
By-product: A product of relatively small value produced incidentally from
processing the raw material for the main product.
Joint Product: Two or more products resulting from processing a particular raw
material.
Process Costing: A method of ascertaining the cost of a product at each stage or
process of manufacturing.
Contract Costing: A special form of job costing applicable to big projects which
involves huge cost to complete and is usually site-based.
Job Costing: Specific order costing involving accumulation of costs relating to a
single cost unit - the job - when each order is of comparatively short duration.
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Accounting 2.15 ANSWERS TO CHECK YOUR PROGRESS
A) 6 i) True (ii) False iii) True (iv) True (v) True (vi) False (vii)True
B) 4 i) False (ii) True iii) True iv) False v) True

1) Distinguish among variable, fixed and semi-variable costs. Why is this distinc-
tion important?
2) ‘‘fixed Costs are really variable. The more you produced the less they become’’.
Comment the statement.
3) Describe briefly the different methods of costing and state the particular indus-
tries to which they can be applied.
4) Distinguish between the following :
i) Product cost and period cost
ii) Controllable and uncontrollable cost
iii) Variable and fixed costs
iv) Direct and indirect costs
5) Costs may be classified according to their nature and characteristics’ Explain.
6) Cooling Ltd manufactured and sold 1,000 refrigerators in the year ending 31st
March, 2002. The summarized Trading and Profit & Loss Account is set out
below :
Rs. Rs.
To Cost of Sales 8,00,000 By Sales 40,00,000
To Direct Wages 12,00,000
To Other Manufacturing Cost 5,00,000
To Gross Profit c/d 15,00,000
40,00,000 40,00,000
To Management and Staff Salaries 6,00,000 By Gross Profit b/d 15,00,000
To Rent, Rates and Insurance 1,00,000
To Selling Expenses 3,00,000
To General Expenses 2,00,000
To Net Profit 3,00,000
15,00,000 15,00,000
For the year ending 31st March, 2003, it is estimated that

a) Output and sales will be 1,200 refrigerators.
b) Prices of Material will go up by 20% on the level of previous year.
c) Wages will rise by 5%
d) Manufacturing costs will rise in proportion to the combined cost of Material and
wages.
e) Selling cost per unit will remain unaffected
f) Other expenses will also remain constant
You are required to submit a statement to the Board of Directors showing the price at
which the refrigerators should be marketed so as to show profit of 10% on selling
price.
6 2 (Answer : Estimated selling price Rs. 51,00,000 Profit Rs. 5,10,000)
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The following particulars have been made available from the Cost Ledger of a Basic Cost Concepts
Company :
Rs.
Stock of Raw materials on 31.12.2000 25,600
Stock of finished Goods on 31.12.2000 56,000
Purchase of Raw materials 5,84,000
Sales 11,84,000
Stock of Raw Materials on 31.12.2001 27,200
Stock of Finished goods on 31.12.2001 60,000
Works Overheads 88,072
Office and general Charges 71,048
The company is required to submit a tender for a large machine. The Cost
Department estimates that the materials will cost Rs. 40,000 and wages to fabricate
the machine Rs. 24,000. The tender is to be made at a net profit of 20% on selling
price.
Prepare a statement showing a) Cost of materials used, b) total cost, c) percentage of
factory overheads to direct wages, and d) percentage of office overheads to works
cost.
Also prepare a statement of quotation showing the price at which the tender of the
machine can be submitted.
(Answer : Cost of materials used Rs. 5,82,400; Total Cost Rs. 11,38,520;
Percentage of Factory overheads to Direct Wages 22%; Percentage of Office
Overheads to Works Cost 6.65%; Price to be quoted in tender : Rs. 92,360)
Note : These questions will help you to understand the unit better.
Try to write answers for them. But do not submit your
answers to the University. These are for your practice only.
2.17 SOME USEFUL BOOKS

Arora, M. N. 2000, A Text Book of Cost Accountancy. Vikas Publishing House Pvt.
Ltd., New Delhi (Chapter 1-2).
Bhar, B. K. 1990. Cost Accounting : Methods and Problems. Academic Publishers,
Calcutta (Chapter 1-2)
Maheswari, S. N. and Mittal, S. N. 1990. Cost Accounting : Theory and Problems.
Shree Mahavir Book Dept, Delhi (Chapter I)
Nigam B. M. L. and Sharma G. L. 1990. Theory and Techniques of Cost Accounting.
Himalaya Publishing House, Bombay (Chapter 1-3)
Owler. L. W. J. and J. L. Brown 1984. Wheldon’s Cost Accounting. ELBS, London
(Chapter 1-2)
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Accounting UNIT 3 FINANCIAL STATEMENTS
Structure
3.0 Objectives
3.1 Introduction
3.2 Natural of Financial Statements
3.3 Contents of Financial Statements
3.3.1 Manufacturing Account
3.3.2 Trading Account
3.3.3 Profit and Loss Account
3.3.4 Profit and Loss Appropriation Account
3.3.5 Balance Sheet
3.4 Concept of Capital and Revenue
3.5 Revenue Recognition
3.5.1 Revenue Recognition in Case of Sale of Goods
3.5.2 Revenue Recognition in Case of Rendering of Services
3.6 Format of Financial Statements – Non-corporate Entities
3.6.1 Conventional Format
3.6.2 Vertical Format
3.7 Corporate Financial Statements
3.7.1 Items Peculiar to Corporate Balance Sheet
3.7.2 Items Peculiar to Corporate Income Statement
3.8 Requirements for Corporate Financial Statements as per Schedule VI
3.9 Basic Principles Governing the Preparation of Financial Statements
3.10 Preparation of Corporate Financial Statements
3.11 Let Us Sum Up
3.12 Key Words
3.0 OBJECTIVES
After studying this unit you should be able to:
l state the nature and contents of financial statements;
l know the differences between capital and revenue;
l know the prepration of non-corporate financial statements;
l be acquainted with the items peculiar to corporate financial statements; and
l prepare the profit and loss account and the balance sheet of a company as per the
requirements of the Companies Act.
3.1 INTRODUCTION
Accounting involves the collection, recording, classification and presentation of
financial data for the benefit of management and external agencies. For this purpose,
the transactions recorded in the books of accounts are periodically summarised and
presented in the form of two financial statements. One is the Balance Sheet or
64 Positional Statement and the other is Profit and Loss Account or Income Statement.
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These are periodical reports which reflect the financial position and operating results Financial Statements
of the entire business for an accounting period, generally one year. These financial
statements are the basis for decision making by the management as well as outsiders.
However, the information presented in these statements must be analysed and
interpreted carefully before drawing conlcusions. In this unit we shall study the
preparation of financial statements both corporate and non-corporate entities as well
as the salient points involved in the preparation of these statements in the light of
Sections 210 to 223 and Part I and II of Schedule VI of the Companies Act, 1956.
3.2 NATURE OF FINANCIAL STATEMENTS

Financial Statements are prepared by all forms of business organizations to ascertain
the result of operating, financial and investment activities and to know the financial
position on the date of closing of books of accounts. In case of sole trade or a
partnership firm, maintenance and preparation of financial statements is not
mandatory but desirable. However, in case of Joint Stock Company, Sections 209 and
210 of the Companies’ Act 1956 make it obligatory and compulsory to maintain and
prepare financial statements by the end of each accounting period. Thus, main
objective of financial statements is to serve the information needs of users of
accounting information. These financial statements are the basis for decision making
by the management as well as to the outsiders like investors and share holders,
creditors and Financiers, government authorities, etc.
Objectives of Financial Statements

The primary objective of financial statement is to assist in decision making.
These statements enable the users:
i) To make rational investment, credit and similar other financial decisions.
ii) To estimate future cash flow and bankruptcy risk assessment.
iii) To ascertain NAV (Net Assets Value) or Net worth of the enterprise after
evaluating the value of assets, resources owned and the claims thereon
(liabilities) in order to make share purchase and sale decisions, takeovers and
merger decisions.
iv) Collective bargaining decision relating to wages, working conditions and job security.
v) To make assessment of economic and financial decisions.
(vi) To form appropriate taxation and subsidy policy, regulatory policy and
employment policy.
Besides, the financial statements are tools of judging earning capacity and managerial
efficiency to facilitate comparison and help evaluate its own performance. Thus, these
provide necessary inputs for forecasting and other relevant decision-making purposes.
According to American Institute of Certified Public Accountants “Financial
statements are prepared for the purpose of presenting periodical review or report on
progress by management and deal with the status of the investment in the business and
the results achieved during the period under review. Financial statements reflect a
combination of recorded facts, accounting-conventions and the personal judgment
and the judgments and conventions applied affect them materially. The soundness of
the judgments necessarily depends on the competence and integrity of those who make
them and on their adherence to generally accepted accounting principles and
conventions.
Hence, these financial statements must give sufficient analysis of the figures, without
unnecessary details to enable the users to understand its financial implications. This
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which affect the decisions of the users of financial statements. It also demands that
Accounting any departure from previous year’s practice should clearly be indicated. In other
words the “convention of consistency” should strictly be adhered to. An enterprise has
to be consistent with reference to depreciation policy, inventory valuation policy and
other policy to facilitate horizonal and vertical comparison. Financial statements are
based on fundamental accounting assumptions of “going concern”, “consistency” and
accrual and are guided by major considerations governing the selection and
application of accounting policies.
3.3 CONTENTS OF FINANCIAL STATEMENTS
3.3.1 Manufacturing Account

Business concerns engaged in the activities of manufacturing or production of goods
which involves purchase of raw materials and in incurring of other manufacturing
expenses, prepare Manufacturing Account which shows the cost of raw materials
consumed, cost of conversion of raw materials into finished product and the cost of
goods produced. The cost of goods produced charged to Trading Account. The cost of
conversion includes–Direct Expenses, Frieght or Carriage Inward, direct labour.
Productive wages/Factory wages and factory expenses, such as factory rent, fuel,
power and gas, etc.
Cost of goods produced = Raw materials consumed + Cost of conversion
If, however, there is opening and closing work in progress due adjustment is made
accordingly. Similarly, value of material residue, which is sold as scrap, is credited to
Manufacturing Account.
Thus, we can say
Cost of goods produced = opening work-in-progress = cost of raw materials
consumed + cost of conversion – closing work in
progress – sale of scrap
Points to note regarding Manufacturing Account

1) Work in progress: It refers to the value of incomplete or semi-finished goods
which includes cost of raw materials, and proportionate wages and direct ex-
pense incurred till this stage of semi completion. Opening and closing balances of
the same are shown to the debit and credit side respectively.
2) Raw materials consumed: This shows the cost of materials used in the produc-
tion process. This is arrived at by Adding the net purchases to the opening
balance of raw materials and deducting the closing balance of raw materials at
hand by the end of accounting period.
3) Direct expenses: These expenses are incurred either on procurement or pur-
chases of raw materials and on conversion thereof into finished product. It
includes productive wages, freight inward, cartage or carriage inward, etc. That
is, it includes direct labour and direct expenses (factory).
4) Factory overheads or indirect expenses: Factory overheads refer to indirect
material, indirect labour and indirect expenses. These include cotton waste,
lubricating of machine oil, works manager, supervisor or foreman’s salary, fuel
and power, repairs and maintenance of factory machine, depreciation of factory
assets, rent, rates and taxes of the factory building, factory insurance, etc.
5) Scrap: It denotes the value of material residue coming out of certain types of
processes. It is sold as scrap and credited to Manufacturing Account to arrive at
66 the correct cost of production.
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Cost of production: Manufacturing Account ascertains the cost of goods Financial Statements
manufactured during any accounting period as shown in the format of Manufac-
turing Account. The cost of production of goods produced is transferred to
Trading Account.
3.3.2 Trading Account

Trading Account is prepared to know the result of trading operations. It shows the
gross profit or gross loss arising from buying and selling of goods in which the
business enterprise deals in. Gross profit or gross loss is the difference between ‘sales’
and ‘cost of goods sold’.
Cost of goods sold = opening stock + purchases (less returns) + direct
expenses – closing stock
It is to be noted that Trading Account shows the result of trading operations under
normal conditions only. Abnormal losses (items) if any – such as loss of stock due to
fire, theft or accident are credited to Trading Account, at cost.
Analysis of Items Appearing to the Debit Side of Trading Account
1) Opening Stock: It refers to the value of goods at hand at the end of last
accounting year. It becomes the opening stock for the current accounting year. It
represents the value of goods in which business deals in.
2) Purchases: It denotes the value of goods (in which the concern deals in) purchased
either for cost or on credit for the purpose of resale. However, if the goods so
purchased are returned or used by proprietor for self consumption, or distributed as
free samples or taken up by the employer for their use, or given as charity, or to be
sent on consignment, or used for any other purpose, except for resale, such amounts
shall be deducted from the total purchases.
3) Director Expenses: These expenses are incurred in connection with purchase,

procurement or production of goods. It also includes expenses which bring the goods
up to the point of sale. Examples of direct expenses are:
a) Carriage Inwards (carriage paid on purchases)
b) Freight – Railways, Airways and Shipping
c) Transit – Insurance
d) Loading charges
e) Packing
f) Import duty
g) Export duty
h) Custom duty
i) Dock dues
j) Octroi
k) Warehousing wages
However, for a manufacturer in addition to above direct expenses include –
l) Wages and salaries
m) Fuel, coal, power, gas and water
n) Factory heating*
o) Factory insurance*
p) Factory lighting* 67
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Foreman’s and Supervisor’s salary*
Accounting
r) Other factory expenses*
s) Royalty on production*
t) Depreciation on Factory Building and machine*
* These are also known as Factory overheads or Factory indirect expenses from cost
accounting point of view but for financial accounting purposes these are treated as
direct expenses.
It is to be noted that a manufacturer prepares a Manufacturing Account

where all the above mentioned direct expenses are debited. However, if in
any case Manufacturing Account is not prepared, then all such expenses
will be charged to Trading Account.
Analysis of Items Appearing to the Credit Side of Trading Account
1) Sale: It refers to the sale of goods in which business deals and includes both cash
and credit sales. It does not include sale of old, obsolete or depreciated assets which
were acquired for use in business. Similarly, goods returned by customers or goods
sent to customers on approval basis or sales tax, if any, included in sales price should
be excluded.
2) Abnormal Loss: It refers to abnormal loss of stock due to fire, theft or accident.
Since Training Account is prepared under normal conditions of the business, abnormal
loss, if any, is credited fully to the Trading Account.
3) Closing Stock: It refers to the value of goods lying unsold at the end of any
accounting year. The stock at the end is valued either at cost or market price,
whichever is less. Since Trial Balance generally does not include closing stock, the
following entry is recorded to incorporate the effect of closing stock in the Trading
Account.
Closing Stock A/c Dr
To Trading A/c
However, if closing stock forms the part of Trial Balance it will not be
transferred to Trading Account but taken to Balance Sheet only.
In case goods have been sent to customer on approval (Sale/Return) basis, such goods
should be included in the value of closing stock if no approval has been received from
them.
Constituents of closing stock are:

i) Stock of Raw materials
ii) Work-in-progress or semi-finished goods
iii) Finished goods – remaining unsold at the end of the year,
– lying unsold at different branches, if any,
– lying unsold with the consignee
iv) Stores supplies = goods, materials required for converting the raw materials
into finished product, such as machine oil, cotton waste,
chemicals and machine spares (as per As-2)
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Points to Remember
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l It is to be noted that Income Statement + (viz. Manufacturing/

Trading/Profit and Loss Account) is parepared on Accrual)
(Mercantile) basis (Accrual concept) covering an accounting period
(accounting period concept) during which expenses are matched with
revenue (Matching Concept) to ascertain the profit or loss of an
enterprise. That is why unpaid expenses are added as outstanding in
the Income Statement and shown as liability in the Balance Sheet.
Similarly income accrued but not received are credited to Income
Statement and shown as asset in the Balance Sheet.
l It is important to remember that “Outstanding” Accrued or “Prepaid”,

if forming part of Trial Balance, then such items will be shown in the
Balance Sheet only and no treatment required in the Income
Statement.
l Conversely, “prepaid expenses” are shown by way of deduction in

the Income Statement and treated as an asset in the Balance Sheet,
whereas income received in advance are subtracted from the income
received and shown as a liability in the Balance Sheet.
3.3.3 Profit and Loss Account

This account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. It starts with gross profit or gross loss
as disclosed by the Trading Account. It takes into account all the remaining direct
(normal and abnormal) expenses and losses related to or incidental to business. These
operating and non-operating expenses are charged to Profit and Loss Account and
shown to the debit side of the Profit and Loss Account.
The operating expenses include:
i) All office or Administrative overheads such as rent, rates and taxes, office staff
salaries, printing and stationary, postage, telephone, office lighting, depreciation
on office equipment, etc.
ii) Selling and Distribution overheads such as Salesmen’s salaries, commission on
sales, travelling expenses, advertisement and publicity, trade expenses, carriage
outward, bad debts, warehouse expenses, delivery van expenses, packing ex-
penses and rebate to customers.
Non-operating expenses include financial expenses such as interest, bank
charges, discount on bill, abnormal losses (loss of goods due to fire, theft or
accident) and loss on sale of fixed assets, etc.
Whereas Non-operating incomes include income from investment and financing
activities, such as Interest Received, Rent Received, Dividend Received, Profit
on Sale of Investment, and Insurance Claims and other Miscellaneous Receipts,
like duty drawback and subsidy and apprenticeship premiums, etc. These
incomes are credited to Profit and Loss Account.
It is to be noted that if an enterprise prepares a Manufacturing Account, the factory
expenses (both direct and indirect) are charged to Manufacturing Account. If a
Manufacturing Account is not prepared, then direct factory expenses are charged to
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Trading Account and indirect factory expenses to Profit and Loss Account. Royallties
Accounting paid on production should be treated as direct expenses and royalties based on sales
as indirected expenses.
Some Important Points

1) Salaries: Salaries paid/payable to employees including Directors’ salaries,
Managers’ salaries (except Work Managers salaries) should be debited to
Manufacturing Account. In case a concern does not prepare Manufacturing
Account, the same should be charged to Trading Account. Similarly, salaries and
wages should also be charged to Profit and Loss Account. But wages and
salaries be charged to Trading Account.
2) Brokerge: This refers to brokerage paid on the items in which the business
trades in. Such as brokerage on buying and selling of goods in which the enter-
prise deals in is shown to the debit of Profit and Loss Account. However, any
brokerage paid on sale or purchase of assets is treated as of capital nature and
hence it is deducted from sale proceeds of the asset sold or added to the cost of
the asset required.
3) Trade Expenses: These expenses are of miscellaneous nature and of
small amount and sometimes termed as Sundry expenses or Miscellaneous
expenses or even Petty expenses. These are debited to Profit and
Loss Account.
4) Advertisement: Expenses on advertisement which are of revenue and recurring
nature are charged to Profit and Loss Account. Whereas cost of heavy advertise-
ment the benefit of which is likely to cover more than one accounting year is
treated as deferred revenue expenditure. For example, a company incurs
Rs. 1,00,000 on advertisement and it is estimated that the benefit of this
advertisement expenditure is likely to extend over a period of four years. In this
case Rs. 25,000, i.e. one-fourth of total cost of advertisement will be charged to
current year’s Profit and Loss Account whereas three-fourths, i.e. Rs. 75,000,
will be taken to Balance Sheet to be treated as ‘Deferred Revenue Expenditure’.
However, advertisement expenses incurred for purchase of goods should be
charged to Trading Account. Advertisement expenses paid for acquiring a capital
asset are capitalised. Again, cost of advertisement in respect of sale of any
capital asset is deducted from the sale proceeds of the asset concerned and hence
not charged to profit and loss account.
5) Rebate to Customers: It is an allowance given to a customer when his
purchases from the concern exceeds the certain limits say Rs. 200. In such cases
all those customers who make purchases from the company exceeding Rs. 200
will be entitled to rebate of 1% or 2% depending upon the policy declared
by the company. The amount of rebate so allowed is charged to Profit and Loss
Account.
6) Duty drawback and subsidy: It is a refund of duties levied on purchases made
by exporter. It serves as an incentive to exporter. The duty drawback and cash
subsidy should be deducted from the purchases. But in practice it is treated as
‘income’.
7) Apprenticeship Premium: It is the fee charged by the business enterprise to train
persons in various trades. It is treated as revenue receipts and credited to Profit
and Loss Account.
8) Factory Expenses: Factory expenses are of two types, viz. direct and indirect,
and both are shown in the Manufacturing Account. If a concern does not prepare
Manufacturing Account, then direct expenses are charged to Trading Account
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Royalties: Royalties are paid by the business concerns to the landlord, author of Financial Statements
a patentee for the right to use their land, copyrights or patents right. Payment of
such royalty sum based on sales is debited to Profit and Loss Account.
However, if royalty is paid on the basis of production, it is charged to Trading
Account.
10) Free Samples and Publicity Expenses: These expenses are incurred to attract
cumtomers for increasing the volume of sale and as such are charged to Profit
and Loss Account. Similarly, money spent on prizes given to customers under the
scheme of ‘sales promotion’ such as ‘Bumper sales’, ‘Dhamaka sales’ are treated
as selling and distribution expenses. If a large sum is incurred on heavy
advertisement under a contract or whose benefits may accrue over a period of
more than one year, say four years, such expenses are spread over the period of
its benefits and a proportionate part is charged to Profit and Loss Account and
remaining is taken to Balance Sheet as deferred revenue expenditure.
11) Abnornal Losses and Insurance Claims: As a rule, the entire amount of
abnormal losses either arising from accident, fire or tgheft are credited to
Trading Account and debited to profit and loss account irrespective of the
insurance claims. The amount so received/settled/receivable from the insurance
company is credited to Profit and Loss Account.
Alternatively, Trading Account may be credited with the net abnormal loss
(abnormal loss insurance claim, if any) and insuracne claims and Profit and Loss
Account may be debited by net abnormal loss only.
3.3.4 Profit and Loss Appropriation Account

This account shows the distribution or appropriation of profit after the same has been
earned and computed. In case of sole proprietor, since entire amount of profit belongs
to him, no Profit and Loss Appropriation is prepared. However, this account is
prepared by partnership firms and Joint Stock Companies where there are several
claimants in the net profit. A partner shares earnings of the firm in the form of salary,
commission, interest and profit and credited to Profit and Loss Appropriation
Account.
However, a company’s Profit and Loss Appropriation account shows the transfer from
Profit and Loss Account an amount equivalent to “currnet year’s profit after tax”.
This account is further credited by the reserves and provisions made last year, now no
longer required, such as Development Rebate Reserve and Provision for Tax, etc. The
following items are debited to Profit and Loss Appropriation Account:
– Transfer to General Reserve
– Transfer to Capital Reserve
– Dividend Paid
– Proposed Dividends
– Bonus to Shareholders
– Excess of actual tax liability over the provisions made last year
– Corporate Dividend Tax, if any.
However, a detailed explanation of Profit and Loss Appropriation Account is to be

made under Corporate Financial Statements under 3.7 of this unit.
3.3.5 Balance Sheet

Balance sheet is a statement of assets and liabilities which helps us to ascertain the
financial position of a concern on a particular date, i.e. on a date when financial
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statements or final accounts are prepared or books of accounts are closed. In fact, it
Accounting treats the balances of all those ledger accounts standing to the debit or credit column
of the Trial Balance and which have not been squared up. These accounts relate to
assets owned, expensed incurred but not paid or not due, expenses due but not paid,
incomes accrued but not received or certain receipts which are not due or accrued. In
fact it deals with all those “real” and “personal accounts” which have not been
accounted for in the Manufacturing, Trading and Profit and Loss Accounts. Besides,
the balance sheet also treats all those items in the adjustments, whch affect Real or
Personal Accounts. The Nominal Accounts are treated in the Income Statement
(P&L A/c). A Balance Sheet aims to ascertain nature and amount of different assets
and liabilities so that the financial position could clearly be known to all those
concerned. Thus, the main function of the Balance Sheet is to depict the true picture of
the concern on a particular date.
Preparation and Presentation of Balance Sheet

The process of preparation and presentation of balance sheet involves two steps:
(i) Grouping and (ii) Marshalling. The first step refers to proper grouping of the
various items, which are of similar nature. For example, amount due from persons
who were sold goods on credit basis must be shown under the heading ‘Trade
Debtors’ and must be distringuished from money owing other than due to credit sales
of goods. The second step involves ‘marhsalling’ of assets and liabilities. It means
orderly arrangement in which assets and liabilities are presented or shown in the
Balance Sheet. There are two methods of presentation: (i) In order of “Liquidity, and
(ii) In order of “permanence”.
Under the “Liquidity Order”, assets are shown on the basis of liquidity or realisability.
These are arranged in order of “most liquid”, more liquid”, “liquid”, “least liquid” and
“not liquid” (fixed) assets. Similarly, liabilities are arranged in the order in which
these are to be paid or discharged. The liquility form is suiable for banking and other
financial companies.
Under the ‘‘Order of Permanence”, the assets are arranged on the basis of their useful
life. The assets which are to serve business for the longest period of time are shown
first, i.e. Fixed Assets, Semi Fixed, Current, Liquid and Most Liquid. Similarly, in
case of liabilities, after Capital, the liabilities are arranged as long term, medium term,
short term and current liabilites. The Companies Act has adapted permanency form
preparing balance sheet.
Some Important Items
1) Fixed Assets: Fixed assets are those assets, which are reuired for the purposes of
producing goods or rendering services. These are not held for resale in normal
course of business. Fixed assets are used for the purpose of earning revenue and
these are held for a longer period of time. These are also treated as ‘Gross Block’
(Fixed assets after depreciation) and ‘Net Block’ (Fixed assets after deprecia-
tion). Investment in these assets is known as ‘Sunk Cost’. Examples of fixed
assets are Land and Building, Plant and Machinery, Furniture and Fixtures,
Tools and Equipments, Motor Vehicles, etc. All fixed assets are ‘tangible’ by
nature.
2) Intangible Assets: Intangible assets are those capital assets which do not have
any physical existence. Though cannot be touched or seen yet they have long life
and help to generate income. Such assets have value by virtue of the rights
conferred upon the owner by mere possession. Goodwill, trademarks, copyrights
and patents are the examples of intengible assets.
3) Current Assets: Current assets include cash and other assets which are con-
verted or realized into cash within a normal operating cycle or say within a year.
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These are acquired either for the purpose of resale, or assisting and helping Financial Statements
process of production or rendering of service or supplying of goods. These assets
constantly keep on changing their form and contribute to routine transactions and
operations of business. Examples are, Cash in Bank, Bills Receivables, Debtors,
Stock, Prepaid Expenses, etc. Current assets are also known as floating assets or
circulating assets.
4) Liquid or Quick Assets: Those current assets whch can be converted into cash
at a very short notice or immediately without incurring much loss or exposing to
high risk. Quick assets can be worked out by deducting Stock (Raw materials,
work in progress or finished goods) and prepaid expenses out of total current assets.
5) Fictitious Assets: These are the non-existent worthless items which represent
unwritten off losses or cost incurred in the past which cannot be recovered in
future or realized in cash. Examples of such assets are preliminary expenses
(formation expense), Advertisement suspense, Underwriting - commission,
discount on issue of shares and debentures, Loss on issue of debentures and debit
balance of Profit and Loss Account. These fictitious assets are written off or
wiped out by debiting to Profit and Loss Account.
6) Wasting Assets: Assets with limited useful life by nature deplete over a limited
period of time are called wasting assets. These assets become worthless once its
utility is over or exhaust fully. Such assets are natural resources like, timer, coal
oil, mineral deposits, etc.
7) Contingent Assets: Contingent assets are probable assets which may or may not
become assets as it depends upon occurrence or non-occurrence of a specified
event or performance of a specified act. For example, a suit is pending in the
court of law against ownership title of any dispsuted property and if the suit is
decided in favour of the business concern it becomes the asset of the concern. On
the other hand, if the decision goes against the concern, the company cannot
claim to enjoy ownership rights. Thus, it remains a contingent asset as long as
the judgment is not pronounced by court. Such assets are shown by means of
footnote and hence do not form part of assets shown in the Balance Sheet. Beside
this hire purchase contract, uncalled share capital etc. are the other examples of
contingent assets.
8) Classification of Liabilities
Long Term Liabilities: These are the obligations which are to be met by the business
enterprise after a relatively long period of time. Such liabilities do not become due for
payment in the ordinary course of business operation or within normal operating
cycle. Debentgures, long term loans from Bank or financial institutions are the
examples of long-term liabilities.
Current Liabilities: Current liabilities are those liabilities which are payable within
normal operating cycle, i.e. within an accounting year. These may arise either out of
realization from current assets or by creating fresh current liability (obligation). Trade
creditors, Bill payable, Bank overdraft, Outstanding expenses, Short-term loan
(payable within twelve months or within accounting year) are examples of current
liabilities.
Contingent Liability: It is not an actual liability but an anticipated (probable liability
which may or may not become payable). It depends upon happending of certain events
or performance of certain acts. An element of uncertainty is always attached. A
contingent liability, thus, may or may not become a sure liability. Examples are,
liability for bills discounted, liability for acting as surety, liability arising on a suit for
damages pending in the court of law, liability for calls on partly paid shares, etc.
Contingent liabilities are shown as footnote under the Balance Sheet.
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Accounting 3.4 CONCEPTS OF CAPITAL AND REVENUE
You know that a firm prepares Profit and Loss Account for ascertaining the net result
of business operations and the Balance sheet for determining the financial position of
the business. These are prepared with the help of Trial Balance which shows the final
position of all ledger accounts. All items appearing in the Trial Balance are transferrd
either to the Profit and Loss Account or to the Balance Sheet. As per rules, the items
of revenue nature are taken to the Profit and Loss Account and the items of capital
nature are shown in the Balance Sheet. In other words whether an item appearing in
the Trial Balance is to be taken to the Profit and Loss Account or the Balance Sheet
depends upon the capital and revenue nature of the item. If any item is wrongly
classified i.e., if an item of revenue nature is treated as a capital item or vice versa, the
Profit and Loss Account will not reveal the correct amount of profit and the Balance
Sheet will not reflect the true and fair view of the affairs of the business. It is therefore
necessary to determine correctly whether an item is of capital nature or of a revenue
nature and record it in the books accordingly. There are certain rules governing the
allocation of expenditures and receipts between capital and revenue which should be
clearly understood.
Capital and Revenue Expenditures
You incur expenditure on various items every day. You buy food items, stationery,
cosmetics, utensils, furniture, etc. Some of them are consumables and some are
durables. The benefit of expenditure on consumables like stationery, cosmetics, etc. is
derived over a short period. But in case of durables like furniture, utensils, etc., the
benefit spreads over a number of years. Same is true of business also. In business you
incur expenditure on two types of items: (i) routine items like stationery, and (ii) fixed
assets like machinery, builing, furniture, etc., whose benefit is available over a number
of years. In accounting terminology the first category of expenditure is called revenue
expenditure and the second one is called capital expenditure. Let us now study the
exact nature of capital and revenue expenditures.
Capital Expenditure: As stated above, when the benefit of an expenditure is not
exhausted in the year in which it is incurred but is available over a number of years it
is considered as capital expenditure. The following expenditures are usually treated as
capital expenditures:
1) Any expenditure which results in the acquisition of fixed assets such as land,
buildings, plant and machinery, furniture and fixures, office equipment,
copyright etc. you should note that such capital expenditure includes not only the
purchase price of the fixed asset but also the expenses incurred in connection
with their acquisition. Thus, the brokerage or commission paid in connection
with the acquisition of an asset, the freight and cartage paid for transportation of
machinery, the expenses incurred on its installation, the legal fees and
registration charges incurred in connection with purchase of land and buildings
are also treated as capital expenditure.
2) Any expenditure incurred on a fixed asset which results in (a) its expansion,
(b) substantial increase in its life, or (c) improvement in its revenue earning
capacity. Improvement in the revenue earning capacity can be in the form of
(i) increased production capacity, (ii) reduced cost of production, or
(iii) increased sales of the firm. Thus, cost of making additions to buildings and
the amount spent on renovation of the old machinery are also regarded as capital
expenditures. If you buy a second hand machinery and incur heavy expenditure
on reconditioning it, such expenditure is also to be treated as capital expenditure.
Similarly, expenditure on structural improvements or alterations to existing fixed
assets whereby their revenue earning capacity is increased, is also treated as
capital expenditure.
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Expenditure incurred, during the early years, on development of mines and land Financial Statements
for plantations till they become operational.
4) Cost of experiments which ultimately result in the acquisition of a patent. The
cost of experiments which are not successful is not to be treated as capital
expenditure. It is treated as a deferred revenue expenditure which is written off
within two to three years.
5. Legal charges incurred in connection with acquiring or defending suits for
protecting fixed assets, rights, etc.
Revenue Expenditure: When the benefit of an expenditure is not likely to be
available for more than one year, it is treated as revenue expenditure. So all expenses
which are incurred during the regular course of business are regarded as revenue
expenditures. The examples of such expenses are:
1) Expenses incurred in day-to-day conduct of the business such as wages, salaries,
rent, postage, stationery, insurance, electricity, etc.
2) Expenditure incurred for buying goods for resale or raw materials for
manufacturing.
3) Expenditure incurred for maintaining the fixed assets such as repairs and
renewals of building, machinery, etc.
4) Depreciation on fixed assets. This can also be termed as revenue loss.
5) Interest on loans borrowed for running the business. You should note that
any interest of loan paid during the initial period before production
commences, is not treated as revenue expenditure. It is treated as capital
expenditure.
6) Legal charges incurred during the regular course of business such as legal
expenses incurred on collection from debtors, legal charges incurred on
defending a suit for damages, etc.
Deferred Revenue Expenditure

Sometimes, certain expenditure which is normally treated as revenue may be
unusually heavy and its benefit is likely to be available for more than one year. In such
a situation, it is considered appropriate to spread the cost of the expenditure over a
number of accounting years. Hence, it is capitalised and only a portion of the total
amount spent is charged to the Profit and Loss Account of the current year. The
balance is shown as an asset which wil be written off during the subsequent
accounting years. Such expenditure is called a Deferred Revenue Expenditure because
its charge to Profit and Loss Account has been deferred to future years. Some example
of such expenditure are:
1) Expenditure incurred on advertising campaign to introduce a new product in the
market.
2) Expenditure incurred on formation of a new company (preliminary expenses)
3) Brokerage charges, underwriting commission paid and other expenses incurred in
connection with the issue of shares and debentures.
4) Cost of shifting the plant and machinery to a new site which may involve
dismantling, removing and re-erection of the plant and machinery.
Let us take the case of expenditure on advertising campaign. It is not a routine
advertisement and the amount involved is unusually heavy. Its benefit will not
completely exhaust in one accounting year but will contunue over two to three years.
Hence, it is not proper to charge such expenditure to the Profit and Loss Account of
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one year. It is better to distribute it carefully over three years. So, in the first year we
Accounting may charge one-third of the amount spent to the Profit and Loss Account and show
the balance in the Balance Sheet as an asset. In the second year again we may charge
a similar amount to the Profit and Loss Account and show the balance as an asset. In
the third year. we may charge this balance to the Profit and Loss Account. Every
expenditure which is regarded as deferred revenue is treated in this way in the final
accounts.
Look at Illustration 1 and note how each expenditure has been treated and why.
Illustration 1
State whether the following items of expenditure would be treated as (a) capital
expenditure, (b) revenue expenditure, or (c) deferred revenue expenditure:
i) Carriage on goods purchased Rs. 25.
ii) Rs. 2,000 spent on repairs of machinery.
iii) Rs. 5,000 spent on white washing.
iv) Rs. 8,000 paid for import duty and cartage on the purchase of machinery from
west Germany.
v) Rs. 25,000 spent on issue of equity shares.
vi) Rs. 14,000 spent on spreading new tiles on factory floors.
vii) Rs. 4,000 spent on dismantling, transportation and reinstalling plant and
machinery to new site.
viii) Rs. 60,000 spent on construction of railway siding.
ix) Rs. 20,000 spent on some major alterations to a theatre which made it more
comfortable and attractive.
x) A second hand maching was bought for Rs. 10,000 and an amount of Rs. 6,000
was spent on its overhauling.
Solution
i) It is a revenue expenditure as it relates to the goods for resale.
ii) It is a revenue expenditure as it relates to the maintenance of a fixed asset.
iii) Same as no. (ii).
iv) It is a capital expenditure as it is spent in connection with the purchase of a fixed
assets.
v) It would be treated as deferred revenue expenditure. It is a heavy amount in-
curred in connection with reising of capital for the company and so capitalised.
Even under the Indian Companies Act and the Indian Income Tax Act this
expenditure is allowed to be written off over a number of years.
vi) It is a revenue expenditure so it is treated as a sort of repairs not leading to any
increase in the earning capacity of a fixed asset.
vii) Normall expenditure on transportation etc. is revenue in nature. But this expendi-
ture has been incurred on shifting to new site which is non-recurring in nature
and involves a heavy amount. Hence it shall be treated as a deferred revenue
expenditure.
viii) It is a capital expenditure as it is incurred on the construction of railway siding, a
fixed asset.
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ix) It is a capital expenditure as the alterations made the theatre more comfortable Financial Statements
and attractive which is likely to increase its collections.
x) It is a capital expenditure as it is incurred on making the newly bought second
hand machinery operational.
Capital and Revenue Receipts

Receipts refer to amounts received by a business i.e., cash inflows. Receipts may be
classified as Capital Receipts and Revenue Receipts. It is necessary to note this
distinction clearly because only the revenue receipts are taken to the Profit and Loss
Account and not the capital receipts.
Capital Receipts: Capital receipts are the amounts received in the form of (a)
additional capital introduced in the business, (b) loans received, and (c) sale proceeds
of fixed assets. You are aware that a loan taken by the business is repayable sooner or
later. Similarly, additional capital received represents an increase in the proprietor’s
claim over the business assets. Thus these two items represent increase in liabilities of
the business and obviously are not incomes or revenues. These are capital receipts and
should be treated as such. The sale proceeds of a fixed asset are also treated as a
capital receipt because the amount received is not revenue earned in the normal course
of business. The capital receipts increase the liabilities or reduce the assets. They do
not affect the profit or loss.
Revenue Recipts: Revenue receipts are the amounts recived in the normal and regualr
course of business. They take the form of (a) sale proceeds of goods, and (b) incomes
such as interest earned, commission earned, rent received, etc. These receipts are on
account of goods sold or some services rendered by the business and as such they are
not repayable. All revenue receipts are treated as incomes and shown on the credit side
of the Profit and Loss Account.
3.5 REVENUE RECOGNITION

Revenue arises in the ordinary course of business activities of an enterprise from:
– sales of goods,
– rendering of services, and
– use by others of enterprise resources yielding interest, royalties and dividends.
Revenue recognition is mainly concerned with the timing of recognition revenue in the
statement of profit and loss. According to AS-9, “revenue is the gross in flow of cash,
receivables, or other consideration arising in the course of ordinary activities of an
enterprise.”
The basic problem of revenue recognition lies in identifying of the “accounting
period” during which revenues are earned. There are several stages or activities in a
business before the revenues are earned and realized. Hence the problem arises –
should revenue be recognized at the point of production, sale, delivery or receipt of
cash. According to “Realisation Concept” revenues are recognized at the point of
sale or services are rendered. However, there is no single uniform practice to
recognize various types of revenues according to one common principle. There are
guidelines, which help us in recognizing operating revenues and non-operating
revenues. Non-operating revenues include interest, dividend and rent and other
incomes which are not related to normal course of operation of the enterprise.
It is advisable to show operating and non-operating revenues separately in the
Profit and Loss Account.
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Following are some of the established practices to recognize revenue as per AS-9.
Accounting
3.5.1 Revenue Recognition in Sale of Goods
Trading and Manufacturing organizations, in general, recognize revenue when sale is
effected. However, the following conditions should be satisfied:
i) The “property in goods” is transferred for a price.
ii) All significant risks and rewards have been transferred and no effective control is
retained by the seller.
iii) No significant uncertainty exists regarding the collection of amount of consider-
ation.
Special Cases of “Sale of Goods” and applicability of AS-9

a) Delivery of goods delayed at buyer’s request and buyer takes title and
accepts billing: Revenue should be recognized and the “goods to be delivered” at
any subsequent date should not be included in the inventory.
b) Goods delivered subject to installation and inspection: Revenue should be
recognized only after the installation and inspection is completed.
c) Sale on Approval: In case of sale on approval or return basis, revenue should be
recognized only when acceptance is received from buyer.
d) Sale subject to warranty: If sales are subject to a warranty, revenue recognition
should not be deferred but a provision should be made to cover the liability
which may arise under the terms and period of warranty.
e) Guaranteed Sales: Sometimes goods are sold and delivery is made giving the
buyer the unlimited right to return. This is under “Money back guarantee”, if not
completely satisfied. Under this situation it is apparent to recognize the ‘revenue’
at the point of sale and to make provisions for returns as well.
f) Consignment Sales: Revenues are recognized when the goods are sold to
customers by the consignee and at the time of dispatch of goods of consignor.
g) Cash on delivery Sales: If a sale has been effected under the terms of
“Cash-on-delivery”, revenue should be recognized only when cash is
received by seller.
h) Installment Sales: Revenues are recognized on delivery to the extent of normal
cash down price. However, interest on deferred payment should be recognized in
the ratio of amount outstanding.
I) Special Order: Where payment is received against the specific order of goods,
which are not in stock. Revenue from such sale should be recognized only when
goods are purchased or manufactured and are ready for delivery.
j) Sale/Repurchase Agreement: Where seller concurrently agrees to repurchase
the same goods at some late date, the flow of cash under such a situation will not
be recognized as revenue.
k) Sales to Distributors to Dealers for Resale: Revenues are recognized only if
significant risks of ownership have passed on distributors/dealers.
3.5.2 Revenue Recognition in Case of Rendering of Services

Revenue recognition in case of rendering services care based on the following
conditions:
i) Revenue recognized either on completed service method or ‘proportionate
completion’ method.
ii) No significant uncertainty exists regarding amount of consideration.
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Under completed service method revenue are recognized only on completion of Financial Statements
service. In cases there are more than one act involved, revenue are recognized on
execution of all these acts.
Proportionate completion method recognized revenue proportionate with the degree
of completion of services. If there are more than one act involved revenue are
recognized on execution of certain acts. Some examples of recognition of service
revenue are –
1) Installation Fee: In cases where installation fees are other than incidental to
sales, the revenue should be recognized only when the equipment is installed and
accepted by the customer.
2) Advertising and Insurance Agency Commission: Revenue should be recog-
nized when service is completed. For advertising agencies, media commission
will normally be recognized when the related advertisement or commercial
appears before the public, and the necessary intimation is received by the agency.
Insurance agency commission should be recognized on the effective
commencement renewal dates of the related policies.
3) Financial Service Commissions: A financial service may be rendered as a single
act or may be provided over a period of time. Similarly, charge for such services
may be made as a single amount or in stages over the period of the service or the
life of the transaction to which it relates. Such charges may be settled in full
when made or added to a loan or other account and settled in stages.
The recognition of revenue should therefore have regard to:
a) Whether the service has been provided one and for all or in an continuing
basis.
b) The incidence of cost relating to service.
c) Commission charged for arranging and granting of loan or other facilities,
should be recognized when a binding obligation has been entered into.
Commitment, facility or loan management fees which relate to
continuing obligations or service should normally be recognized over the
life of the loan or facility having regard to the amount of the obligation
outstanding, the nature of the service provided and timing of the costs
relating thereto.
Admission Fees: Revenue from artistic performance, banquets and other
special events should be recognized when the event takes place. When fees to a
number of events, it should be allocated to each event on a systematic and
rational basis.
Tution Fees: Revenue should be recognized over the period of instruction.

Entrance and Membership Fees: AS.9 recommends capitalization of entrance fees.
If membership fee permits only membership and all other services of products are paid
for separately or if there is a separate annual subscription, the fee should be
recognized as revenue when received. If the membersyhip fee entitles the member to
services or publications to be provided during the year, it should be recognized on a
systematic and rational basis having regard to the timing and nature of all services
provided.
Subscription for Publications: Revenue received or billed should be deferred and
recognized either on straight-line basis over time or where the items delivered
vary in value from period to period revenue should be based on the sales value
of the items delivered in relation to total sales value of all items covered by
the subscription.
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Exceptions to General Rule
Accounting
1) Revenue recognition at the point of production (Completed Production
Method): Under this method revenue are recognozid at the point of production.
It applies to case of agriculture. Extractive industries like gold, silver, uranium,
other metals and oil (crude) etc. revenue are recognized just after completion of
production even before the sales take place.
2) Cash Basis: Under this, revenue are not recognized at the point of sale but when
cash is realized including outstanding, if any. This basis is applicable in case of
hire-purchase system where revenue are recognized on the basis of cash received
and installments due during the year.
3) Revenue Recognition during the production period on percentage of
completion method: Under this method revenue are recognized on the basis of
contract value, associated costs, number of acts or other susitable basis. It is
applicable in case of long-term construction contracts where revenue are
recognized on the basis of degree of completion or what work certified bears to
cash received by the contractor.
4) Time Basis: In many cases revenue are realized on the basis of time or period.
For example, interest on fixed deposits is credited to Profit and Loss Account on
time proportion basis, i.e. interest accrued yet not payable.
It is to be noted that revenue in case of “Royalties” are recognized on an accrual basis

in according with terms of agreement and, Dividends are recognized when the right to
receive payment is established.
3.6 FORMAT OF FINANCIAL STATEMENTS

(NON-CORPORATE ENTITIES)
The financial statements may be prepared and presented either in conventional (also
known as ‘T’ form) or Vertical form. The basic purpose is to serve the information
needs of the users of accounting information. The idea is to present these accounting
figures in such a way that provides maximum input for decision-making purposes.
The income statement gives the clear picture operating efficiency of the enterprises by
disclosing the amount of gross profit or loss through Trading Account. At the same
time Profit and Loss Account reveals the overall ‘net’ result – the “net profit” or “net
loss”. The Balance Sheet, which is also known as “position statement” is required to
depict the true and fair view of state of affairs of business enterprise. Sole traders and
partnership firms are not requqired to comply any legal provisions as far as
presentation and formats of financial statements are concerned. However, these
income statements, meant basically for self consumption, must be prepared in
conformity with the accounting concepts, conventions and applicable accounting
standards.
The financial statements of non-corporate entities may be presented either of the
following ways:
1) Conventional Format, and
2) Vertical Format
3.6.1 Conventional Format

Following are the conventional formats of ‘Income’ and ‘Position statements’:
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Format of a Manufacturing Account
www.rejinpaul.comFinancial Statements
For the year ended 31st March....
Dr. Cr
Rs. Rs.
To Opening Work-in progress ----- By Closing Work-in- Progress -----
To Raw materials consumed ----- By Sale of Scrap -----
Operating stock of Raw material By Cost of goods
Add: Purchases produced-transferred
Less: Closing stock of ----- to Trading Account -----
Raw material
To Direct Expense
Productive Wages -----
Freight Inward Raw material -----
Cartage/Carriage Inward -----
To Factory overheads
Salary of Works Manager -----
Gas, Fuel and Power -----
Factory Light -----
Rent, Rates and Taxes -----
Insurance of factory assets -----
Repairs of factory assets -----
Depreciation of factory assets
Other Factory Expenses -----
*** ***
Trading Account (A format)

For the year ended 31st March ....
Dr. Cr
Rs. Rs.
To Opening Stock (Finished Goods) ----- By Sales less Returns -----
To Transfer from Manufacturing A/c ----- By Abnormal Loss:
or/and Purchases less returns (Transferred to
To Direct Expense Profit and Loss A/c)
Carriage/cartage Inward Loss by Fire
Freight Loss by Accident
Insurance-in-transit ----- Loss by Theft -----
Wages ----- By Closing Stock -----
* Fuel and Power ----- By Gross Loss A/c
* Coal, Gas and Water ----- (Balancing figure)
Packing (essential) -----
Octroi -----
Import duty
* Consumable Stores -----
Royalty (based on output) -----
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Fundamentals of * Manufacturing Expenses
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-----
Accounting * Excise Duty -----
Dock dues
To Gross Profit A/c
(Balance fiture)** -----
*** ***
* Concerns not preparing Manufacturing Account separately

** Balancing figure will be either gross profit or gross loss.
Profit and Loss Account (A format)

Dr. Cr
Rs. Rs.
To Gross Loss* b/d ------- By Gross Profit b/d* ------
To Office & Administration Expenses: By Interest Received ------
Salaries of Office Staff By Dividend Received ------
Office Rent, Rates and Taxes By Rent Received ------
Printing and Stationery ------- By Discount Received ------
Postage and Telephone ------- By Profit on sale of fixed assets ------
Fire Insurance Premium ------- By Profit on sale of Investment ------
Audit Fees ------- By Insurance Claims ------
Repairs and Maintenance ------- By Duty–Draw Backs ------
Legal Expenses ------- By Apprenticeship Premium ------
Office Lighting ------- By Miscellanceous Receipts ------
Depreciation-office assets ------- By Bad debts Recovered ------
Other Office Expenses ------- By Net loss transferred ------
To Selling and Distribution Expenses: to Capital account
Salesmen’s Salaries (Balancing figure)** ------
Commission on Sales
Travelling Expenses
Brokerage
Trade Expenses
Advertisement and Publicity
Sales Promotion Expenses
Carriage Outward
Bad Debts
Provision for Bad Debts
Repairs of Vehicles
Depreciation on Vehicles
Warehouse Expenses
Warehouse Insurance
Warehouse Rent
Delivery Van Expenses
Packing Expenses
Rebate to Customers
Royalty on Sales
To Financing Expenses:
Discount Allowed
Interest on Capital
Discount of Bills
Bank Charges
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To Abnormal Losses:
Transferred from Trading Account –
(loss by – Fire
– Accident
– Theft)
To Loss on sale of Fixed Assets
To Miscellaneous Expenses
To Net Profit Transferred to
Capital A/c (Bal. Figure)**
*** ***
* Balancing b/d may be either Gross Profit or Gross Loss
** The Balancing figure may be either Net Profit or Net Loss
Profit and Loss Appropriation Account (A format)
Dr. Cr
Rs. Rs.
To Profit and Loss A/c (Net Loss)* —— By Profit and Loss A/c (Net Profit)* ——
To Interest on Partner’s Capitals —— By Interest on Drawings ——
To Salary to Partners —— By Balance (transferred to
To Commission to Partners Partner’s Capital Account) ——
To Balance (Transferred to
Partner’s Capital Accounts)**
*** ***
* There will either be Profit or Loss
** Represent balancing fiture – a residual profit or loss to be shared by partners in
the profit sharing ratio.
Balance Sheet of ......... (A format)
as on 31st March .......
Liabilities Rs. Assets
Capital ----- Fixed Assets: -------
Add Profit or less Loss ----- Goodwill -------
Less Drawings ----- ----- Land and Building -------
Plant and Machinery -------
Long Term Liabilities
Tools and Equipments -------
Mortgaged Loan -----
Motor Vehicles -------
Loan from Bank -----
Furniture and Fixtures -------
Current Liabilities Patents and Trademarks -------
Sundry Creditors -----
Investment (Long Term) -------
Bills Payable -----
Current Assets: -------
Income Received in Advance -----
Stock -------
Outstanding Expenses -----
Accrued Income -------
Bank Overdraft -----
Prepared Expenses -------
Sundry Debtors -------
Bills Receivable -------
Short Term Investment -------
Marketable Securities -------
Cash and Bank Balance -------
Fictitious Assets: -------
Advertisement -------
Profit and Loss Account -------
Miscellaneous Expenditure -------
*** ***
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*The items in the above format have been shown in order of permanence.
Alternatively, this can be presented in order of liquidity as explained earlier.
Fundamentals of 2.
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From the following Trial Balance of Trader, you are required to prepare Trading
Accounting and Profit Account for the year ended 31st March 2001 and a Balancing Sheet as
on that date.
Trial Balance as on 31st March 2001

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
Drawing Account 7,500 Capital 1,50,000
Plant and Machinery (1.4.2000) 1,25,000 Returns Outward 1,250
Plant and Machinery 6,250 Sundry Creditors 22,500
(1.4.2000) 19,250 Sales 2,00,000
Stock (1.4.2000) 1,02,500 Porivision for Bad
Purchases 2,500 and Doubtful debts 500
Returns Inward 25,750 Discount Received 1,000
Sundry Debtors 6,200 Rent (up to 30.9.2002) 1,500
Furniture 12,500
Freight 625
Carriage Outward 5,750
Rent, Rates and Taxes 1,000
Printing and Stationary 500
Trade Expenses 875
Insurance Charges 26,625
Salaries and Wages 25,675
Cash in Bank 7,250
Cash in Hand 1,000
Postage and Telegram
3,76,750 3,76,750
Adjustments:
1) Stock on 31st March 2001 was valued at Rs. 15,000
2) Write off Rs. 750 as bad debts.
3) Provision for Bad and doubtful debt is to be maintained at 5% on sundry debtors.
4) Create a provision for discount on debtors and also reserve for discount on
creditors @ 2%.
5) Charge depreciation @ 2% p.a. on Plant and machinery and @ 5% on furniture.
6) Insurance prepaid was Rs. 125.
7) Goods worth Rs. 6,250 were totally demaged in an accident. The insurance
company admitted claim of Rs. 5,000 on 28.3.2001.
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Solution
Trading Account
For the year ended 31st March 2001
Dr. Cr.
Rs. Rs.
To Opening Stock 19,250 By Sales 2,00,000
To Purchases 1,02,500 Less Returns 2,500 1,97,500
Less Returns 1,250 1,01,250 By Closing Stock 15,000
To Freight 12,500 By Insurance Claims 5,000
To Gross profit transterred By Profit & Loss A/c 1,250
to Profit & Loss A/c 85,750 (Abnornal Loss)
2,18,750 2,18,750
Profit and Loss Account

Dr. Cr.
Rs. Rs.
To Rent, Rates & Taxes 5,750 By Gross Profit b/d 85,750
To Printing and Stationary 1,000 By Discount Received 1,000
To Trade Expenses 500 By Rent Received 1,500
To Insurance 875 Less Prepaid 750 750
Less Prepaid 125 750
To Salaries & Wages 26,625 By Reserve for discount 450
To Postage & Telegram 1,000 on creditors
To Bad debts 750
To Provision for Bad and doubtful debts 750
(New reserve Rs. 1250-Old
reserve Rs. 500)
To Provision for discount on debtors 475
To Carriage outward 625
To Abnormal loss (Accident) 1,250
To Depreciation on:
Furniture 310
Plant & Machinery 25,625 25,935
(Rs. 25000 + Rs. 625)
To Net profit transfered A/c540
to capital 87,950 87,950
Balance Sheet As on 31st March 2001

Dr. Cr.
Liabilities Amount Assets Amount
Rs. Rs.
Add. Capital 1,50,000 Plant & Machinery 1,25,000

Net Profit 22,540 Additions 6,250
1,72,540 1,31,250
Less Drawings 7,500 1,65,040 Less Dereciation 25,625 1,05,62
Sundry Creditors 22,500 Furniture 6,200
Less Provision 450 22,050 Less Depreciation 310 5,89
Advance Rent 750 Closing Stock 15,00
Sundry Debtors 25,750
Less Bad Debts 750
25,000
Less Provision @ 5% 1,250
23,750 85
Fundamentals of
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Less Provision for discount 475 23,27
Accounting Cash at Bank 25,67
Cash in hand 7,25
Insurance Claims 5,00
Prepaid Insurace 12
1,87,840 1,87,84
Illustration 3
The following is the Trial Balance of Mr. Mahesh as 31st December 2003. Prepare a
Trading and Profit & Loss Account for the year ended 2003 and Balance Sheet as on
31st December 2003.
Dr. Cr
Rs. Rs.
Purchases 1,80,000 Sales 2,05,000

Opening Stock 10,000 Loan (10% interest) 10,000
Salaries Less Provident Fund 5,400 Creditors 15,000
Drawinges 5,000 Capital 55,000
Provident fund remittances including
Proprietor’s contribution 50% 1,200
Rent Rs. 250 per month 2,750
Machinery 29,000
Wages 3,000
Furniture & Fittings 5,000
Electricity 550
Trade Expenses 1,500
Debtors 10,500
Interest on Loan 900
Commission 200
Building 30,000
2,85,000 2,85,000
Wages include Rs. 1,000 Paid for machinery erection charges. Purchases include cost
of moped scooter for Rs. 5,000 Proprietor has taken goods costing Rs. 1,000 for
which no entry has been made, Electricity outstanding Rs. 50. Goods costing Rs.
5,000 were destoyed by fire and insurance claim was receied for Rs. 4,000 Provide
depreciation at 10% on machinery, furniture & moped. Provide depreciation 5% on
Bulding. Closing stock is Rs. 12,000
Solution
Trading And Profit and Loss Account
For the year ended 31st December 2003
Dr. Cr

Rs. Rs.
To Opening Stock 10,000 By Sales 205,000
To Purchases 180,000 By Loss by fire transferred
Less Purchase of Scooter 5,000 to P&L A/c 5,000
Less Drawings (goods used) 1,000 174,000 By Closing Stock 12,000
To Wages 3,000
Less Erection charges 1,000 2,000
To Gross Profit c/d 36,000
222,000 222,000
To Salaries 5,400 By Gross Profit b/d 36,000
Add Subscription 600 By Insurance claims 4,000
86 Contribution 600 6,600
To Rent 2,750
Add Outstanding 250 3,000
To Electricity 550
Add Outstanding 50 600
To Commission 200
To Trade Expenses 1,500
To Bad debts 500
To Interest 900
Add Outstanding 100 1,000
To Provision for Bad debts 1,000
To Loss by fire (Trading A/c) 5,000
To Depreciation on:
Building 1,500
Machinery 3,000
Furniture 500
Scooter 500
To Net Profit 15,100
40,000 40,000
Balance Sheet
As on 31st December 2003
Dr. Cr
Rs. Rs.
Capital 55,000 Building 30,000
Add Net Profit 15,100 Less Depreciation 1,500 28,500
Less Drawings (5000 + 1000) 6,000 64,100 Machinery 29,000
Add Erection Charge 1,000
30,000
10% Loan 10,000 Less Depreciation (10%) (3,000) 27,000
Creditors 15,000 Furniture 5,000
Rent outstanding 250 Less Depreciation 500 4,500
Interest outstanding 100 Scooter 5,000
Electricity Changes O/s 50 Less Depreciation 500 4,500
Closing Stock 12,000
Debtors 10,500
Less Bad debts 500
Less Provision @ 10% 1,000 9,000
Insurance claims 4,000
89,500 89,500
3.6.2 Vertical Format

Under vertical form various items of incomes and expenses, assets and liabilities are
arranged vertically to get some additional information about the operating efficiency
and financial position of the business enterprise. The vertical form of Income
Statement shows the gross profit, operating profit, net profit. The impact of non-
operating incomes and expenses cannot be ascertained if the Trading & Profit and
Loss Account is not prepared under vertical form. Similarly the Balance Sheet
discloses owner’s capital, borrowed capital, net working capital, etc. It is to be noted
that sole traders and partnership firms hardly adopt vertical form of financial
statements. Following formats will bring about a clarity of understanding of vertical
form of financial statements.
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Fundamentals of
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Income Statement (A format)
Accounting For the year ending 31st March .....
Particulars Figures at the end of
Previous Year Current Year
Rs. Rs.
Sales/Turnover -------- --------
Less Cost of Goods Sold* -------- --------
Gross Profit **** ****
Less Administrative Expenses* -------- --------
Less Selling and Distribution Expenses* -------- --------
Operating Profit **** ****
Add Other Incomes* (Non-operating Incomes) -------- --------
Less Financial Expenses (Non-operating Expenses) -------- --------
Net Profit **** ****
Less Transfer to General Reserve and/or capital -------- --------
account/accounts (in the form of profit, -------- --------
salary, commission, etc.)
* Explained earlier under conventional form.
Operating vs Non-operating
Operating Profit/Loss
The excess of operating incomes over operating expenses represents operating
profit, whereas when operating expenses exceed operating income it results in
operating loss.
Operating incomes are those incomes which arise from operating activities in which
the enterprise deals in. For a trading concern, revenue arising from sale of goods in
which the enterprise deals in is treated as operating income. In fact, operating
activities are the principal revenue-producing activities of the entertprise. Operating
income measures the efficiency of a business enterprise, because these activities make-
up the main business of the enterprise and are of recurring in nature. The operating
activities may be:
l Purchasing and selling of goods.
l Services and even securities by a Trading concern.
l Exploration of natural resources by Extracting & Trading entity.
l Granting of loans and advances by a ‘Financial Institution’.
l Construction and development of colonies by construction enterprise.
Operating expenses are those expenses which are incurred in connection with main
revenue producing activities. These operating expenses may be classified under
various heads, such as office and administrative expenses and selling and
distribution expenses. A detailed list of these expenses has already been given under
conventional format of Profit and Loss Account under 3.6.1 of this unit. These
expenses are necessary to run the business enterprise but which are not directly related
to trading or manufacturing activities. These directly related expenses are termed as
direct expenses, which are charged to Manufacturing/Trading/Account. Hence
Operating Profit = Gross Profit – Operating Expenses (Office and Selling
Distribution).
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Non-operating Incomes
Such incomes arise from other than major or principal revenue earning activities.
These are in the form of, in case of a manufacturing and trading concern, rent
received, interest received, dividend received, which are credited to Profit and Loss
Account. Profit on sale of fixed assets and the revenue arising from activities which
are incidental to main business, are treated as non-operating incomes. Such types of
incomes arise when unused portion of building used for business purposes is let-out or
idle funds of business invested either in shares, debentures, government securities or
deposited in a fixed deposit account. Since such incomes have nothing to do with the
business operation of the enterprise, these incomes are treated as non-operating
incomes.
It is to be noted that “Interest” and “Dividend” received by a “Financial

Institution” is treated as operating income because these incomes arise
from main/principal revenue earning activity.
Non-operating Expenses
These expenses are incurred on activities other than main or principal revenue earning
activities. These may be in the form of non-operating losses. Interest paid on
borrowings (financial overheads), loss on sale of fixed assets, loss on sale of
investment (held as an asset) are some of the examples of non-operating
expenses. Such expenses are also charged to Income Statement to ascertain the
overall net profit.
Balance Sheet of ........................ (A format)

As on 31st March ..........
Assets Figures at the end of

Previous Year Current Year
Fixed Assets -------- --------
Less Depreciation -------- --------
Net Fixed Assets (a) -------- --------
**** ****
Stock-in Trade -------- --------
Sundry Debtors -------- --------
Bills Receivables -------- --------
Cash and Bank balance -------- --------
Total Current Assets* (b) **** ****

TOTAL ASSETS (a+b) -------- --------
Liabilities and Capital
Capital -------- --------
Add Profit (Retained Earnings) -------- --------
Less Drawings -------- --------
Owner’s Equity (c) -------- --------
Sundry Creditors -------- --------

Bills Payable -------- --------
outstanding Expenses -------- --------
Total Current Liabilities (d) -------- --------
TOTAL (c + d) -------- --------

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* The list is not exhaustive
Fundamentals of Activity
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Accounting
1) What are operating and non-operating profits?
2) What do you understand by “Grouping” and “Marshalling” of assets and liabili-
ties?
3) Write short notes on the following:
a) Outstanding of Expenses
b) Accrued Incomes
c) Intangible Assets
d) Fictitious Assets
e) Cost of Conversion
f) Cost of Goods Sold
g) Direct vs Indirect Expenses
4) Draw an imaginary Balance Sheet.
3.7 CORPORATE FINANCIAL STATEMENTS

The process of preparation of financial statements of companies is similar to that of
non-corporate entities except for certain peculiar items and legal requirements. The
corporate reporting has assumed great importance in recent years. The Company Law
Board, the Institute of Chartered Accountants of India and whole corporate world are
trying to bring about a total transparency in the matter of reporting. The fundamental
objective of corporate reporting is to communicate economic information about the
resources and performance of the reporting entity to the users of financial statements.
The professional bodies have also developed several (till date – 28) accounting
standards for the purpose of preparing and disclosing accounting information in order:
1) To serve the varied needs of users for decision-making purposes.
2) To harmonise the diverse accounting practices.
3) To ensure transparency, consistency, comparability, adequacy and
reliability of information-contents.
4) To make accounting information more meaningful and useful.
5) And to improve overall quality of presentation and reporting.
Since every interested party has a right to information which is merely not the
outcome of statue but is based on the principle of public accountability. The financial
statements which are prepared on the basis of various accounting postulates, concepts
and conventions, are supposed to endowed with many qualitative characteristics, viz.
understandability, relevance, materiality, reliability, faithful representation, substance
over form, neutrality, prudence, completeness and comparability.
General and Legal Requirements

Section 209 to 223 of the Companies Act, 1956 deal with provision governing
maintenance and preparation of financial statements.
Section 209 deals with the maintenance of proper books of accounts in respect of
1) Receipts and disbursements of money,
2) Sales and purchases of raw materials/goods,
3) Description peratining to usage of raw material and labout, etc., and
4) All assets and liabilities.
90
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Section 209 also requires that books of accounts must show the “True and fair” view Financial Statements
of state of affairs of the company. Section 211 requires that the Balance Sheet must
give true and fair view of the results of operations. It simply implies that financial
statements should disclose every material information without any concealment of
facts and figures and in such a manner that working results and financial position of
the reporting enterprise, may correctly be interpreted in true spirits. It should be free
from personal biases and mis-statements. It will be possible only if financial
statements are prepared in accordance with generally accepted accounting principles
and in conformity with the various accounting standards as applicable to the reporting
enterprise. Companies (Amendment) Act 1999 has made it mandatory for companies
to comply with accounting standards set by ICAI. In case company fails to comply
with any of generally accepted accounting assumptions or standards, the fact should
be disclosed.
Section 210 requires that financial statements should be presented to shareholders at
every Annual General Meeting along with the Auditor’s and Directors’ Reports. Every
Balance Sheet and Profit and Loss Account must be duly authenticated. These
statements must be signed by Manager or Secretary and by two directors, at least one
of whom must be managing director (Section 215).
3.7.1 Items Peculiar to Corporate Balance Sheet

Share Capital: Under this head following details are required to be disclosed:
1) Details of Authorised, Issued and Subscribed Capital along with number and
nominal value of the shares with respect to preference and equity shares.
2) Calls-in-Arrears must be deducted from Called-up Capital. However, Calls-in-
arrears on shares held by directors are to be shown separately. Similarly, Calls-
in-Advance should be treated as a separate items and shown accordingly.
3) Forfeited Shares Account, if any, should be added to paid-up Capital which
forms the part of total of Balance Sheet. It is to be noted that the Authorised,
Issued and Subscribed capitals are not considered for the purpose of total of
Balance Sheet.
4) Shares issued for consideration other than cash must be disclosed. Such as
shares allotted to transferor company under the agreement of takeover/merger,
Issue of bonus shares and the source thereof.
5) If preference shares have been issued, the terms of redemption or conversion
along with the earliest date of redemption/conversion must be specified.
6) Excess application money on account of over-subscription not requiring any
adjustment, should be refunded. If not, the money refundable must be shown as
part of current liabilities.
3.7.2 Reserves and Surplus

This may be in the following forms:
i) Capital Reserves: It refers to those profits which are not earned from normal
business operations. Such profits are not available for the purpose of distribution
as dividend. It is created out of profit on sale of-fixed assets or investments held
as asset, profit on reissue of forfeited shares, pre-incorporation profit, profit on
revaluation of fixed assets, profit on purchase/acquisition of assets or profit on
purchase of business (excess of net assets over purchase price).
ii) Capital Redemption Reserve: It is created when fully paid preference shares
are redeemed out of divisible profits of the company. This reserve may be
utilized for the purpose of issuing fully paid bonus shares to the members of the
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company.
Fundamentals of
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iii) Securities Premium: When a company issues shares or debentures at a price
Accounting which is more than its face value, it is said to have issued shares/debentures at a
premium. The premium so received is transferred to “Securities Premium
Account”.
According to Section 78 of Companies Act, the premium may be utilized for –
issuing fully paid bonus shares, writing off preliminary expenses, discount on
issue of shares or debentures, and providing premium on redemption of
preference shares or debentures.
iv) Revenue Reserves: These may be in the form of specific reserves or free
reserves and are created out of revenue profits of the company. Usually such
reserves are formed from annual appropriation. Specific Reserves are created
for specific purpose. For example, Dividend Equalisation Reserve is created to
meet the shortfall in the divisible profits of the company intends to follow a
stable dividend policy. Or to redeem the debentures, a sinking fund or a deben-
ture redemption reserve may be created. Other specific reserves are Development
Rebate Reserve, Investment Allowance Reserve, Export Incentive Reserve, etc.
The term ‘Fund’ is used when the money earmarked for any specific purpose is
invested in ourside securities. For example, if money appropriated for the
purpose of redemption of debentures is invested outside and business is termed as
Debenture Redemption Fund, if not invested outside but retained or ploughed
back in the business, it is called Debenture Redemption Reserve.
Surplus
The Credit balance of Profit and Loss Account or P&L Appropriation Account (i.e.
after making necessary transfer to reserves and appropriating for proposed interim or
final dividend including bonus, if any) is shown under the heading as surplus. If a
company has a debit balance of Profit & Loss Account, the same should be adjusted
under this head.
3) Secured Loans: This refers to mortgaged loan or other loans, which are fully
secured either by a fixed or floating charge on the assets of the Company. It
includes loans from bank, financial institutions or from other companies pro-
vided these are secured against the specific or all assets of the company. Deben-
tures are assumed to have first floating charge on the assets of the company. It is
to be noted that interest accrued and due on secured loans is to be treated as and
shown under Secured Loans. Loan from or guaranteed by directors should be
disclosed and shown separately. In case of debentures, the terms of redemption/
conversion and its earliest date of redemption/conversion be stated.
4) Unsecured Loans: These are the loans against which no security stands a
pledged or mortgaged. It also includes amount not covered by the value of
security provided in respect of partly secured loans. It covers all loans which are
not at all secured such as –
– Fixed Deposits from public
– Loans and Advances from Subsidiaries
– Short-term loans and Advances from Banks and others
– Other Loans and Advances
– It may include creditors for purchase of an asset.
5) Current Liabilities and Provisions: This heading is split in two sub-headings :
current liabilities and prosvisions.
Current Liabilities: It refers to those liabilities which are to be paid or payable within
a period of twelve months. It includes, Sundry Creditors, Bills Payable, Outstanding
92 Expenses, Income Received in Advance, Amount payable to Subsidiaries.
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It is to be noted that short-term loans and interest outstanding thereon are to be shown Financial Statements
under “Secured” or “Unsecured Loan” as the case may be and not under Current
Liabilities.
Provisions: Provisions such as Proposed dividend, Provision for Depreciation,
Repairs and Renewals, Provision for Doubtful Debts, Investment Fluctuation Reserve,
Provident Fund, Pension Fund etc. are shown separately under this head.
* Provision for Depreciation and Provision for Doubtful Debts may be

shown on the “Assets side” as a deduction from the asset concerned.
Contingent liabilities: As explained earlier, these liabilities are shown as a footnote

and include the following:
l Liability for bills discounted
l Claims against the company not acknowledged as debt
l Uncalled liability on partly paid shares
l Arrears of fixed cumulative preference dividends
l Guarantee given by the Company on behalf of directors or other officers of the
Company
l Estimated amount of contracts remaining to be executed on capital account not
provided for, and
l Other money for which company is contingently liable.
It is to be noted that if any provision is made against any contingent

liability, the same is to be shown under the head provisions.
Fixed Assets
Under this head there are eleven types of “fixed assets” starting from goodwill to
vehicles. According to AS-10 a fixed asset is an “asset held with the intention of being
used for the purpose of producing or providing goods or services and is not held for
sale in the normal course of business.” Even assets which are not legally owned but
held for the purpose of production are treated and shown under this head. These
include assets acquired under hire-purchase agreement and assets taken on lease, after
considering the addition and disposal, if any. Valuation of fixed assets is made at cost
less depreciation after considering the addition and disposal, if any.
It is worth remembering that “goodwill” should be shown in the books only when it is
acquired for some consideration. According to AS–26 internally generated goodwill
should not be recognized as an asset.
*As per Schedule VI the fixed assets are classified as follows:
1) Goodwill
2) Land
3) Building
4) Leasehold
5) Railway Slidings
6) Plant and Machinery
7) Furniture and Fittings
8) Development of Property
9) Patents, Trade Marks and Designs
10) Live Stock
11) Vehicles 93
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In case of revaluation of fixed assets, every balance sheet subsequent to such
Accounting revaluation must show the revised figures with the date of increase or decrease in
place of original cost. In ascertaining the cost of an asset all expenditures incurred in
bringing the asset to its working condition should be included. This includes cost of
transportation, expenditure on trial runs. In case of land and building, stamp duty,
registration fee and architects fees should be capitalised.
Investments
As per AS-13 (Accounting for Investments), “Investments are assets held by an
enterprise for earning income by way of dividends, interest and rentals, for capital
appreciation or for other benefits to the investing enterprise”. Assets held as stock-in-
trade are not investments. Money invested outside business is termed as investments
which may be long term, current investment or an investment property.
According to AS-13, a “current investment ” by its nature as readily realizable is

intended to be held for not more than one year, whereas an “investment propery” is an
investment in land or building that are not intended to be occupied substantially for
use by the enterprises.
Schedule VI requires investments to be shown as follows:
i) Investments in Government or Trust Securities.
ii) Investments in shares, debentures or bonds, fully paid up and partly paid
up and also different classes of shares.
iii) Immovable properties
iv) Investments in the Capital of partnership firms.
The following details about the investments must be given:
a) Nature of investment.
b) Mode of valuation of Investments.
c) Aggregate amount of company’s quoted investments and its market value.
d) Aggregate amount of company’s unquoted investments.
e) Amount of fully paid and partly paid shares.
f) Investment in subsidiary companies.
Current Assets, Loans and Advances
This is subdivided in two sub-headings:
A) Current Assets: As per the Guidance note issued by ICAI, “current assets means
cash and other assets that are expected to be converted into cash or consumed in the
production of goods or rendering or services in the normal course of business and
include:
i) Stock-in-trade (inventories of raw materials, work-in-progress finished
goods, stores and spare parts to be shown separately) including mode of
valuation.
ii) Debtors should show the age-wise and security-wise classification such as
Debts outstanding for a period of more than six months and other debts.
Debtors considered good in respect of which company holds no security
other than the debtor’s personal security.
Debts considered doubtful or bad.
Debts due by directors on other officers
Debts due from other companies (subsidiaries)
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Maximum amount due by directors or other officers of the company Financial Statements
(footnote through)
Provision for doubtful debts is required to be deducted from sundry debtors
Provision should not exceed the amount considered from sundry debtors.
Provision should not exceed the amount considered doubtful or bad. Any
excess provision be shown under “Reserve and Surplus”.
iii) Cash and Bank balances should be shown separately. Bank balances
should be classified into balances with scheduled banks and other banks
along with details of current account, saving bank and fixed deposits. Bank
overdraft, if any, should be shown under Sundry Creditors. This informa-
tion of inclusion be disclosed in a footnote that the Sundry Creditors
include bank overdraft amounting to Rs....
B) Loans and Advances

The disclosure rules which are applicable to sundry debtors, the same should be
applied to “Loans and Advances”, i.e. these should be shown in age-wise, security-
wise and reliability-wise classification. In addition the following should be shown:
i) Advances and loans to subsidiaries
ii) Advances and loans to partnership firms in which the company or subsid-
iary is a partner
iii) Bills of Exchange
iv) Advances recoverable in cash or kind or for value (Rent, Rates and Insur-
ance)
v) Balance with customers, port trust, etc. which are payable on demand
Miscellaneous Expenditure
These are the expenses incurred in earlier years but not written off. These include:
i) Preliminary expenses (Formation expenses incurred on preparation of Memoran-
dum and Articles of Association, legal fees, registration fee, etc.)
ii) Share and Debentures issue expenses, such as brokerage, underwriting commis-
sion, discount on issue of share and debentures.
iii) Interest paid out of Capital during construction.
Such miscellaneous expenditure is written off over a period for which benefit is
available.
Profit and Loss Account (Debit balance)
This represents past unwritten-off losses. These are adjusted and written off against
the free reserves (divisible profits/revenue profits) to the available extent. Unabsorbed
amount is shown under this head.
3.7.2 Items Peculiar to Corporate Income Statement

Salient Features
Though the procedure and the process of preparation of “Income Statement” of a
Company and that of non-corporate entities are similar in principles, there are some
differences in the method of presentation and some additional items which form the
part of a corporate income statement. These differences are as under:
1) Heading: Non-corporate entities name income statement as “Trading and Profit
and Loss Account”, while companies call it “Income Statement” or Profit and
Loss Account only. The items of Trading Account become the part of “Income
Statement”. No separate Trading Account is prepared. 95
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Appropriation: Sole trader does not prepare any appropriation account, while
Accounting partnership firms and companies do. A company’s Profit and Loss Account is
split up in to two parts – “above the line” and “below the line”. All items of
appropriations are shown “below the line” and the remaining balance is trans-
ferred to the liabilities side of the balance sheet. A partnership firm prepares a
separate Profit and Loss Appropriation Account.
3) As per AS–5 extraordinary items (abnormal nature), prior period items are
shown separately whereas in case of non-corporate entities, such items are stated
along with the normal and routine items.
4) Requirement: The Profit and Loss Account of a company should conform to the
requirements of Schedule VI of Companies Act 1956 and adhere to AS–1; AS–4
and AS–5 recommendations, whereas non-corporate enterprises are not required
to do so.
5) Income Tax: It is treated as an expense for the companies while for firms and
sole trade enterprise, it is treated as drawings.
6) Companies’ Profit and Loss Account should disclose the figures for the previous
year along with the current year’s whereas non-company enterprises are not
required to show figures relating to previous year.
Treatment of Special Items of Profit and Loss Account

1) Interest on Debenture and Loans: This item includes interest paid and payable
for the financial period for which accounts are prepared and shown to the debit
side of Profit and Loss Account. Likewise, interest due but remaining outstand-
ing is taken to the liability side of the Balance Sheet. Interest on Debentures and
interest on secured loan outstanding, if any, is shown under the heading “Secured
Loans” whereas interest outstanding on unsecured loan is shown under “unse-
cured loans”.
It is to be noted that interest on loan for the construction period should be

capitalized and added to the cost of the asset concerned.
2) Tax on Interest on Debentures: As per Income Tax Act 1961, every company
must deduct tax at source (TDS) while paying interest to the debenture holders. The
amount so deducted shall be deposited with the Government treasury. The current
rates for TDS are as follows:
Debentures (listed) 10.5% including surcharge
Debentures (unlisted) 21% including surcharge
If A ltd. has to pay interest on its 9% debentures (listed) of the face value of Rs.
5,00,000, then gross interest will be Rs. 45,000 and tax deducted at source Rs. 4,725
balance shall be paid to the Debenture holders Rs. 40,275. The following entry is
recorded –
Interest on Debentures A/c Dr 45,000
To Debenture Holders A/c 40,275
To Income Tax Payable A/c 4,725
Income Tax deducted but not deposited with the Government is to be shown in the
Balance Sheet under the heading “Current Liabilities”.
It should be remembered that Profit and Loss Account will always be

debited with the gross amount of interest.
96
3)
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Discount on Debentures/Loss on Issue/Debenture Issue Expenses: Discount Financial Statements
on issue of debentures, debenture issue expenses such as commission, brokerage,
etc. are premium payable on redemption (treated as loss on issue which may
include discount also) are to be written off as early as possible, or over the life
span of the debentures, depending upon the policy of the company in the absence
of any specific instructions in the question, such amount should be written off on
the basis of debentures outstanding. The unwritten off balance is to be shown on
the assets side of the Balance Sheet under the heading of ‘Miscellaneous Expen-
diture’.
It should be remember that only written off amount is charged to Profit and Loss
Account.
4) Prelimiary Expenses: As already explained under Balance Sheet items, it
appears on the assets side of the Balance Sheet under the heading ‘Miscellaneous
Expenditure’ as long as it is not written off. The amount written off is charged to
Profit and Loss Account. If there is no specific instructions relating to the
amount to be written off, then the entire amount should be shown in the
Balance Sheet.
5) Corporate Income Tax: This is shown under three stages.
i) Advance Income Tax: As per Income Act 1961, the companies are required
to pay income tax on the profits earned. They have to deposit advance tax
under PAYE (Pay As You Earn) scheme on specific dates during the finan-
cial year. The advance tax so paid is adjusted against income tax liability.
The unadjusted amount of advance income tax is shown as an asset under
the heading Current Assets, Loans and Advances.
ii) Provision for Taxation: While preparing Profit and Loss Account, a
provision for income tax is created on the basis of current year’s profit to
meet the actual tax liability. The amount so provided depends on the prevail-
ing tax rate. The current rate of corporate tax is 35% plus 5% surcharge for
domestic companies and 40% plus 5% surcharge for foreign companies. The
following entry is recorded.
Profit and Loss Account Dr.
To Provision for Taxation A/c
AS–22 “Accounting for Taxes on Income” recommends that the net balance, i.e.
excess of “Advance Tax” may be shown on the assets side or liabilities side of the
Balance Sheet as the case may be, till the final assessment is made and actual tax
liability is determined by the tax authorities.
iii) Determination of Actual Tax Liability: As per Income Tax rules, income
(profits) for the previous year is assessed and taxed in the assessment year.
When the assessment is completed the provision for taxation so created
may either fall short of actual tax liability or may exceed the tax liability.
Such a shortfall or excess is treated as prior period item (AS–5) and
therefore its adjustment is made in the Profit and Loss Account but
“below the line”, either to the debit side (for shortfall) or to the credit
side (for excess).
On the other hand, the actual tax liability is compared with advance income
tax paid. In case actual tax liability is more than the amount of advance
tax paid the same may be paid or shown as a current liability in the
Balance Sheet and if advance tax paid exceeds, the difference being
refund should be stated under Current Assets Loans and Advances in the
Balance Sheet.
97
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Illustration 4
Accounting
Extracts from a Trial Balance of a Company
As on 31st March, 2003.
Dr. Cr.
(Rs.) (Rs.)
Provision for Taxation (2001-02) 2,50,000
Advance Income Tax (for 2001-02) 2,60,000
Advance income Tax (for 2002-03) 3,00,000
Additional Information
i) The actual tax liability for the year 2001-2002 amounted to Rs. 2,75,000
ii) provision for Taxation for the year 2002-03 of Rs. 2,85,000 is required to be
made.
Show the relevant information in the relevant ledgers.
Solution
Profit and Loss Account (Extracts)

for the year ended 31st March 2003
Rs.
To Provision on for Taxation
(2002-03)
285,000
–––––– ––––––
} above the
line
–––––– ––––––
To provision for Taxation (2001-02)
(Rs 2,75000-2,50000)
Tax Liability-Provision
25,000
} below the
line
Balance Sheet (Extracts)

As on 31st March 2003
Liabilities Rs. Assets Rs. Rs.
Loans & Advances
Advance Tax 3,00,000
Current Liabilities (Current Year)
Less Provision for
Income Tax payable (2001-02) 15,000 Taxation 2,85,000 15,000
(Tax liability–Advance Tax)
Rs. 2,75,000 – Rs. 2,60,000)
Provision for Taxation (2001-02)

Rs. Rs.
To Income Tax (Tax liability) 275,000 By Balance b/d 250,000
By Profit & Loss A/c 25,000
(below the line)
275,000 275,000
98
Provision for Taxation (2002-03)
Rs. Rs.
To Balance C/d By Profit and Loss A/c
2,85,000 (above the line) 2,85,000
2,85,000 2,85,000
Illustration 5: From the following extract of a Trial Balance and the additional
information, show the treatment of taxation, in the relevant ledger accounts:
Trial Balance (Extracts)

Dr. (Rs.) Cr (Rs.)
Provision for Taxation 1,20,000
Income Tax 1,10,000
Additional information: Provide Rs. 1,50,000 for provision for taxation.
Solution
Provision for Taxation A/c (old)
To Income Tax 1,10,000 By balance b/d 1,20,000
To Profit and Loss A/c. 10,000
(below the line)
1,20,000 1,20,000
Provision for Taxation A/c (New)

Rs. Rs.
To balance c/d 150,000 By Profit and Loss A/c. 150,000
(To be taken to liabilities) (above the line)
side of B/S
150,000 150,000
Profit and Loss Account (Extracts)

Rs. Rs.
To provision for Taxation 150,000 -Above
(New)
––––––
} the
line
––––––
By Provision
for Taxation
––––––
10,000
––––––
} - below
the
line
99
Fundamentals of
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Balance Sheet (Extracts)
Accounting As on 31st March 2002
liabilities Assets Rs.

Current liabilities and Provision
B. Provisions:
provision for Taxation 15,000
Illustration 6
From the following particulars prepare necessary accounts for the year ending
31st March 2003:
Trial Balance (Extracts)

Dr. Cr.
Rs. Rs.
Provision for Taxation (1.4.2002) 4,59,000
Advanced Tax Paid (1.4.2002) 4,20,000
Tax Deducted at Source (1.4.2002) 3,500
On 1.1.2003, the assessment was completed and tax liability of Rs. 5,30,000 was
determined Advance payment of tax for the year 2002-03 amounted to Rs. 5,10,000.
A provision for taxation is to be made for Rs. 5,75,000 for the year ended 31st March
2003.
Solution
Provision for Taxation Account
Rs. Rs.
To Income Tax A/c (Tax liability) 5,30,000 By Balance b/d 4,50,000
By profit & Loss A/c
(below the line) 80,000
5,30,000 5,30,000
To Balance C/d 5,75,000 By Profit & Loss A/c 5,75,000
Advance Income Tax account

Rs. Rs.
To Balance b/d 4,20,000 By income Tax A/c 4,20,000
4,20,000 4,20,000
Income Tax Account (Tax liability)

Rs. Rs.
To Advance Income Tax A/c 4,20,000 By Provision for 5,30,000
To Tax Deducted at source A/c 3,500 Taxation A/c
To Bank A/c. (Balance Paid) 1,06,500
5,30,000 5,30,000
100
Rs. Rs.
To Provision for Taxation
(2002-03) 5,75,000 } Above the line
To Provision for Taxation 80,000 } below the line

(2001-02)
6) Managerial Remuneration
The payment of managerial remuneration is governed by the provisions of
sections 198 and 309 either by the Articles or by a ordinary/special resolution
passed by the company in general meeting. Managerial personnel refers to
managing director, whole-time director, part-time director and manager. The
provisions of Companies Act shall apply to a public company and private
company and a private company which is a subsidiary of a public company but to no
other private company.
The over all managerial remuneration payable by a public company or a private
company which is a subsidiary of a public company to it’s managerial personnel shall
not exceed 11% of the net profits for that financial year. Remuneration limit does not
include fees. Within the maximum limit of 11% a company may pay a monthly
remuneration to its managing or whole-time director in accordance with the provisions
of Section 309 or to its manager in accordance wit the provisions of Section 386 of
the Companies Act. In case there is no profit or inadequate profit for any year, the
company may pay remuneration as per the provisions of Schedule XIII of the
Company Act.
7) Contribution/donation to a Political party

Any contribution or donation to any political party must be disclosed separately
in the Profit and Loss Account. According to section 293, Government
companies and companies with less than three years are not allowed to make any
political contribution or donation. Those allowed can make such contribution up to
5% of it’s average profit. The average net profit for this purpose are to be
determined on the basis of the three immediately preceding financial years’
profit as determined in accordance with the provision of Section 349 of the
Company Act.
8) Prior Period Items

The nature and amount of prior period items should be separately disclosed in the
Profit and Loss Account in a manner that there impact on the current profit or
loss can be perceived. In case, accounts are adopted in the annual general
meeting and if some adjustments relating to previous year are to be made, these
should be stated below the line, i.e. in the Profit net Loss Appropriation account as
per AS-5.
9) Extra-Ordinary items
Extraordinary items are incomes or expenses that arise from events or transactions
which are clearly distinct from the ordinary activities of the enterprise and therefore,
are not expected to recur frequently or regularly, these items should be disclosed in the
statement of profit and loss as a part of profit or loss for the period (AS-5). “Fixed
assets destroyed in an earthquake” is an example of “Extraordinary items”.
101
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10) Contingencies and Events occurring after balance Sheet Date
Accounting
As per AS-4, the amount of a contingent loss should the be provided for by a charge
in the statement of Profit and loss if:
i) it is possible that future events will confirm that an asset has been impaired or a
liability has been incurred as at the Balance Sheet date and
ii) A reasonable estimate of the amount of the resulting loss can be made.
The existence of a contingent loss should be disclosed in the financial statements if
either of the above condition is not met, unless the possibility of loss is remote.
Contingent gains should not be disclosed in the financial statements. Only virtually
certain gains should be recognized.
11) Appropriation and Disposition of Profits

Once the profits have been ascertained as per the statement of profit and loss, the next
step is the appropriation and disposition of the available profit. It includes:
i) Transfer to general reserve and other reserves such as capital redemption reserve.
Development rebate reserve etc.
ii) Transfer to sinking fund.
iii) Transfer to Dividend Equalization fund.
iv) Providing for interim or final dividend, and
v) Paying bonus to share holders.
All these items are treated “below the line” or a separate “Profit and loss
Appropriation Account” is prepared.
12) Dividends
Dividends refers to that amount of divisible profits which is distributed among the
share holders of the company. A member (shareholder) is entitled to receive dividend
when it is declared by the Board of directors as per the provisions of the Article. The
Board has absolute right to recommend the rate of dividend to the declared subject to
the approval of shareholders and provisions of Articles of Association. However, the
shareholders cannot compel the Board recommend & declare dividend. It is to be
noted that dividend is always declared for the working of one financial year at the
annual general meeting. In case the dividend could not be declared at the annual
general meeting the same can be declared at the Extraordinary meeting. The power to
declare dividend is implied and does not require express authority either in the Articles
or Memorandum of Association. It should be remembered that, where a dividend has
been declared at Annual General Meeting, neither he company nor the directors can
declare a further dividend for the same year at the subsequent general meeting. It is
known as Final Dividend.
No devidend should be paid out of capital. Dividends should be paid in proportion to
the amount paid up on each share. No dividend shall be payable on calls in advance
unless authorised by the Articles. Dividend should be payable in cash except when it
is adjusted towards unpaid amount on shares or where bonus shares are issued.
According to Section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits from that year unless certain percentage of profit as
prescribed by Central Government not exceeding 10% has been transferred to reserve.
However, the company may voluntarily transfer higher percentage of the profit to its
revenue subject to the rules laid down under the Companies (Transfer of Profits to
Revenue) Rules 1975 as amended in 1976. A newly incorporated company is
prohibited to transfer more than 10% of its profits to revenue for the initial
102 three years.
i) Preference Dividend: The preference dividend is paid to Preference
shareholders at a pre-determined fixed rate on priority basis. These holders are
entitled dividend in preference to equity shareholders. However the preference
shareholders can claim dividend only out of profits and if it is declared at the
annual general meeting. If preference shares are of cumulative nature, the
arrears of preference dividend if any, shall be payable to preference
shareholders before any equity dividend. It should be noted that preference
shareholders cannot force the company to pay all the dividends including
arrears. If equity shareholders are not paid any dividend, preference
shareholders cannot claim any dividend from the company. It is to be noted
that the arrears of preference dividend are treated as a contingent liability
which appears as a foot note under the Balance Sheet.
Not–cumulative preference shares are not entitled to any arrears resulting from
non-payment of dividend due to losses or inadequate profits. If a company has issued
participating preference shares with a right to participate in the balance of profits, left
after paying fixed preference dividend and a certain percentage of equity dividend,
then the participating preference shareholders are entitled against a certain percentage
out of the balance (residua) profit as per the items of issue. For example 9%
preference shares may be issued with a further right to 40% of the excess dividend
over 20% paid to equity shareholders. If a company declares 25% dividend to equity
to equity shareholders, the preference shareholders will get 11% dividend. (9% plus
40% of (25%-20%) i.e., 2%).
ii) Unclaimed Dividend: According to Section 205 A of the companies Act 1956
dividends remaining unpaid must be deposited in the “unpaid unclaimed Dividend
account within 42 days of declaration of dividend. Any claim thereafter, must be met
out of the unclaimed dividend account. Money so transferred to the aforesaid account
which remains unpaid or unclaimed for a period of seven years from the date of such
transfer, shall be transferred to “Investor Education and Protection Fund” maintained
u/s 205 of Companies (Amendment) Act 1999.
Unclaimed dividend appears on the liabilities side of Balance Sheet under the head
“Current liabilities & Provisions”.
iii) Proposed Dividend: Dividend recommended by the directors to be paid to
shareholders for any accounting period on or after the close of books of accounts but
before the Annual General Meeting, is known as proposed dividend. Once it is
approved by the shareholders in the General meeting, it becomes final dividend. It is to
be noted that rate of dividend declared cannot exceed the proposed dividend. Proposed
dividend is an appropriation of profit, hence it is shown to the debit side of profit and
loss Appropriation Account and on the liabilities side of balance sheet under the
heading “Current liabilities and Provisions”.
iv) Final Dividend: It is a dividend which is declared at the annual general meeting of
the shareholders. Such dividend is declared only after the close of books of accounts;
the share holders may reduce the rate of final dividend but cannot increase it. Once the
final dividend is declared it becomes the liability of the company. It should be noted
that when a final dividend is declared then interim dividend is not adjusted unless there
is any specific resolution for such adjustment. Final dividend is paid on paid up
Capital for the whole year as against the interim dividend, which is usually paid only
for six months. For example N Ltd. has 5,00,000 shares of 10 each Rs. 8 paid,
declares 5% p.a. interim dividend and final dividend @ 10% p.a., then the total
dividend will be Rs. 5,00,000 i.e. (Rs. 1,00,000 interim dividend + Rs. 4,00,000 final
dividend)
I.D. = (4, 00,000 5/100 × 6/12 = 1,00,000) + F.D. = (4,00,000 × 10/100) 103
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v) Interim Dividend: A dividend declared by the Directors between two annual
Accounting general meetings of the company is known as interim dividend, where the directors
believe that the company will have sufficient profits available for dividends at the end
of the year, they may distribute a part of the profit as a part payment on account.
Payment so made in anticipation and on account of total dividend to be paid for the
year is treated as interim dividend. However, such payment must be authorised by the
Articles. Interim dividend should be declared only when the company has even a better
prospects for the second half as well. Regulation 86 of Table–A provides that “Board
may from time to time pay to the members such interim dividend as it appears to be
justified by the profits of the company.” Thus, there is no limit on the number of
interim dividend the company may pay in a year. The payment of interim dividend
does not require approval of general meeting.
Companies (Amendment) Act 2000 has granted statutory recognition to the right of
directors to declare interim dividend. The term dividend now includes interim dividend
also. All provisions the Companies Act which apply to dividends have now become
applicable to interim dividends also. A company cannot declare any interim dividend
unless it has made:
i) necessary provision for depreciation for the whole year.
ii) prior adjustment of accumulated losses, if any
iii) and transfer to general reserve as required u/s 205 (2A)
Once an interim dividend is declared it becomes legally enforceable debt
against the Company. Prior to the Amendment Act 2000 the interim dividend
was not an enforceable debt Board had right to rescind the resolution
already passed.
The period, for which an interim divided is paid, is usually six months. However,
students should note that whether the rate of dividend includes the words “per
annum” or not. For example the directors of a company declare an interim dividend @
12% per annum, the interim dividend shall be calculated only for six months. If the
rate declared by directors is 12% and the words “per annum” are not mentioned, then
the dividend shall be calculated @ 12% without reference to time. i.e. 12% x amount
of paid up Capital. If the Capital of the company is Rs. 10,00,000 then
in the first case interim dividend will amount to Rs. 60,00 and in the second
case Rs. 1,20,000.
vi) Corporate Dividend Tax

Finance Act 1997 had exempted the dividend in the hands of shareholders and
introduced corporate dividend tax to be paid by the dividend paying company.
Thereafter, the corporate dividend tax was withdrawn by the Finance Act 2002
and the burden of tax was shifted on the shareholders and hence company was not
liable to pay any tax on dividend declared, distributed or paid between 1.4.2002. to
31.3.2003.
The Finance Act 2003 has again shifted the liability of such tax on the domestic
companies who shall be liable to pay additional tax on the amount declared,
distributed or paid by way of dividends on or after 1.4.2003. The rate of tax being
12.5% plus surcharge @ 2.5% which is equal to 12.8125%* This rate is applicable
for the financial year 2003-04.
Note: Students should verify the rate applicable because this rate may be changed by
the Finance Act 2004 or by the subsequent Finance Act. It is further to be noted that
dividends from domestic companies in the hands of shareholders are totally exempt
again. As per guidance not it is be treated as appropriation.
104
13) Transfer to General Reserve
According to section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits for that unless a certain percentage of profits as
prescribed by the Central government not exceeding 10%, has been transferred to
reserve. As per the Central Government rules transfer to revenue should be made as
follows:
The Central Government has prescribed the following rules under the companies
(Transfer of profits to reserve) Rules 1975 as amended in 1976.
Rate of Dividend Percentage of profits* to

be transferred to reserve
(i) If the rate of 10% but not 12.5% 2.5%
dividend exceeds
(ii) “ 12.5% to 15% 5%
(iii) “ 15% to 20% 7.5%
(iv) If the rate of 20% 10%
dividend exceeds
Accounting Treatment of Dividend

Illustration 7
X Ltd. has a paid up capital of Rs. 30,00,000 dividend into 2,00,000 equity shares of
Rs. 10 each and 10% 1,00,000 preference shares of Rs. 10 each. Other particulars
were as under.
Rs.
Opening balance of Profits and loss Appropriation Account 57,500
Net profit earned during the year (after Tax) 7,50,000
Dividend Declared for the year 22%
Prepare Profit and Loss Appropriation Account. Comply with necessary statutory
provisions.
Solution
Profit and Loss Appropriation Account
Rs. Rs.
To General Reserve (1) 75,000 By Balance b/d 57,500
To Preference Dividend (2) 1,00,000 By Net Profit 7,50,000
To Equity Dividend 4,40,000
To Corporate Dividend (3) 67,500
Tax 1,25,000
To Balance c/d
8,07,500 8,07,500
Working notes
(1) As per the provisions of the section 205 on a dividend of 22% a statutory
transfer of 10% on the net profit to be made.
(2) Declaration of equity dividend will automatically make the company liable to pay
preference dividend. No equity dividend can be paid without paying preference
dividend.
(3) A corporate dividend Tax (C.D.T.) @ 12.5% has been provided. A surcharge of
2.5% has been ignored for the sake of simplicity. However, the effective rate of
C.D.T. is 12.8123% including surcharge. 105
Fundamentals of Illustration 8
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Accounting
Victor Ltd. disclosed the following particulars:
Rs.
9% 80,000 Preference shares of Rs. 10 each fully paid 8,00,000
50,000 Equity shares of Rs. 10 each fully paid 5,00,000
30,000 Equity shares of Rs. 10 each Rs. 8 paid up 2,40,000
20,000 Equity shares of Rs. 10 6 paid up 1,20,000
The directors proposed a dividend of 15% or equity shares and resolved to make the
following appropriations:
– Transfer to general reserve as per the provisions of the section 205
– Transfer to dividend equalisation fund Rs. 1,75,000
– Transfer to debenture Redemption Fund Rs. 1,00,000
– Transfer to Investment Allowance Reserve Rs. 1,25,000
The net–profit (before tax) for the year amounted to Rs. 12,50,000 you are required to
prepare Profit and Loss Appropriation Account. Provide for income tax @ 50% and
Corporate Dividend Tax @ 12.5%
Solution
Rs. Rs.
To General Reserve1 31,250 By Net Profit (After tax) 6,25,000
To Dividend Equalisation fund 75,000
To Debenture Redemption Fund 1,00,000
To Investment Allowance Reserve 1,20,000
To Proposed Dividend
– Preference Dividend 72,000
– Equity Dividend 1,29,000
To Corporate Dividend Tax2
On Rs. (72000 + 1,29,000) 25,125
To Balance c/d 67,625
6,25,000 6,25,000
Working
1. As per the statutory requirement, a transfer of 5% of the net profit after tax” has
been made to General Reserve
2. Corporate dividend tax has beesn provided on the total dividend.
3.8 REQUIREMENTS FOR CORPORATE FINANCIAL

STATEMENTS AS PER SCHEDULE VI
The Balance Sheet of a company like any other business organisation is a statement of
assets and liabilities. However, in the case of a company, the nature of the details to be
shown and the order of the arrangement of the items must conform to the requirements
prescribed in Schedule VI, Part I of the Companies Act. There items are already
discussed under 3.7.1 of this Unit.
The requirements as to Profit and Loss Account are as follows:

i) The Profit and Loss Account shall be so made out as clearly to disclose the result
of the working of the company during the period covered by the P&L account
and shall disclose every material feature, including credits or receipts and debits
or expenses in respect of non-recurring transaction or transactions of an
106 exceptional nature.
ii)
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The Income Statement is not required to be split in the parts, such as Financial Statements
Trading Account, profit earned and appropriated. Schedule VI only
recommends to disclose gross profit, net profit and it’s appropriation there of.
This may be shown under one head of Income Statement or Profit and Loss
Account. Chargeable items are shown “above the line” whereas appropriations
“below the line”.
iii) Figures relating to previous year should also be shown along with the current
year’s figures in a separate column.
iv) As far as possible information given in the statement must be complete in all
respects. Such as the details of “turnover” made by the company should disclose
sales in respect of each class of goods & their quantities separately. Likewise
commission paid to sole selling agents and to other agents should be shown along
with the brokerage.
v) The Account should disclose quantities and values of various types of raw-
material purchased and quantities and values of various products produced/
purchased including opening and closing balances there of and that of work-in-
progress.
vi) The amount provided for depreciation, renewals or diminution in value of fixed
assets and the method adopted for making such provisions.
If no such provision has been made- the fact should be disclosed by way of note
including arrears of depreciation.
vii) The amount of interest on company’s debentures and on other fixed period loans
be stated separately, including interest paid or payable to directors.
viii) The amount of Income Tax on profits as per Income Tax Act 1961 at the pre-
scribed rate including other taxes if any, should be shown separately.
ix) Expenditure incurred on each of the following items be disclosed separately–
a) Consumption of stores and spare parts
b) Power and fuel
c) Rent
d) Repairs to Building
e) Repairs to Machinery
f) i) Salaries, Wages and bonus
ii) Contribution to provident and other funds
iii) Workmen and staff welfare expenses
g) Insurance
h) Rates and Taxes (excluding income tax)
i) Miscellaneous expenses provided any item exceeds 1% of revenue of
Rs. 5,000
Whichever is higher be shown separately.
j) Payment to Auditor
a) as auditor
b) as advisor in respect of
i) Taxation matter
ii) Company law matters
iii) Management services
k) Remuneration received by managing directors or managers either from the
company or it’s subsidiaries should be indicated separately including it’s
computation. 107
Fundamentals of x)
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The Profit and Loss Account should disclose the various items of incomes
Accounting arranged under appropriate heads.
a) Turnover giving details in respect of each class of goods indicating
quantities of such sales for each class separately.
b) Amount of income from interest specifying the nature of the income
c) Income from investment stating from trade investments & other investments
d) Profit or losses or investments
e) Dividends including dividends from subsidiary companies
f) Miscellaneous incomes such as royalty, fees etc.
g) Foreign exchange earnings, if any
The Profit and Loss Account must be made out in such a manner that discloses “true
and fair” view of the profit or loss of the company for the current accounting year.
This means that items of extraordinary nature or those unrelated to company’s
business or items relating to previous years (Prior Period items) should be separately
stated, if these are material.
Similarly amount drawn from reserves, profits from revaluation of assets or profits
arising due to change in method of accounting or major policy change in the method of
valuation higher the operating efficiency or position much better that it actually is
would be contraray to the spirit of law.
3.9 BASIC PRINCIPLES GOVERNING THE

PREPARATION OF FINANCIAL STATEMENTS
1) Materiality: It is a relative term. What is material for one company may be
immaterial for other. According to American Accounting Association (AAA) an item
should be regarded as material if there is reason to believe that knowledge of it would
influence the decision of informed investors, banks, creditors & other interested
parties. AS-5 sates that all material information and items should be disclosed which
are necessary and vital to make the financial statements more clear and
understandable – operating efficiency — wise and financial-position-wise. Treatment
of certain expenditure as capital by one company and revenue by the other is a clear
example of it. Hence materiality is purely matter of personal judgment which is guided
by size and nature of enterprise.
2) Prior Period Items: (AS-5)
As a matter of fact the Profit and Loss Account should disclose the profit or loss for
the period for which accounts are prepared, that is for the reported (current) period. If,
however, some items were omitted to be accounted for in the preparation of financial
statements then it is not possible to reopen the accounts for the previous year after it
has been adopted by the shareholders in the annual general meeting. The ICAI defines
“Prior Period Items” as incomes or expenses which arise in the current period as a
result of errors or omissions in the preparation financial statements of one or more
periods”. The errors may occur as a result of mathematical mistakes, oversight
(omissions), misinterpretation of facts and wrong application of accounting policies or
a wrong or inaccurate estimate. Hence these items should be shown “below the line”
i.e. in the Profit and Loss Appropriation Account. However, prior period adjustments
do not cover–
– Minor omissions of accruals and prepayments
– Prior period’s revenue which was not accounted for on the ground of
prudential practice.
– Recovery of bad debts written off earlier
– Adjustments to the useful life of the depreciable assets
108
3) Extra Ordinary Items: (AS–5)
Extraordinary items are income or expenses that arise from events or transactions that
are clearly distinct from the ordinary activities of the enterprise and, therefore, are not
expected to recur frequently and regularly (AS-5). These items are shown in the Profit
and Loss Account for the period but the nature of such items should be disclosed
separately. These include
– Write down of inventories to “net realizable value”
– Profit or loss on sale of fixed assets or long-term investments.
– Reversals of provisions
– Reversals of writing off of the fixed assets
– Losses sustained on account of an earthquake.
4) Change in Accounting Policies: (AS-5)
Accounting policies are the specific accounting principles and the methods of applying
these principles adopted by an enterprise in the preparation and presentation of
financial statements. A change in accounting policy is required by statue or by the
accounting standard setting body or if it is considered that the change will result in a
more appropriate presentation of the financial statements of the enterprise. Any
material effect of such a change in the current or subsequent periods should be
quantified and disclosed together with the reasons for the change. Following are the
change in policy:
– A change in the method of charging depreciation from written down value
(WDV) to straight line method (SLM) and vice versa.
– A change in the method of valuation of inventories.
However, a change in the estimated life of a machine is not a change in policy
but a change in estimate.
3.10 PREPARATION OF CORPORATE FINANCIAL

STATEMENTS
As already stated, the Board of Directors of the company shall present a Balance
Sheet as at the end of the period; and a Profit and Loss Account for that period at the
annual general meeting. In case of company not carrying on business for profit, an
Income and Expenditure Account shall be laid at the annual general meeting instead of
Profit and Loss Account. Every Profit and Loss Account shall also give a “true and
fair” view of profit or loss of the company for the financial year and shall comply with
the requirements of schedule VI. Every Insurance or Banking company or any
company engaged in the generation of electricity or any other class of company for
which the Profit and Loss Account has been specified under the Act governing such
class of company need not follow the Form given in Schedule VI to this Act. Similarly
every Balance Sheet shall give a “true & fair” view of the state of affairs of the
company as per Schedule VI. Any Insurance or Banking company or any company
engaged in generation or supply of electricity or any other class of company for which
a form of Balance Sheet has been prescribed under the Act governing such class of
company need not to follow such form.
Recently the Companies (Amendment) Act 1999 has made the compliance of
accounting standards mandatory. Accordingly every Profit and Loss Account and
Balance Sheet of the Company shall comply with the “Accounting Standards”.
However, in case of non-compliance the company must disclose the ‘deviation’ from
the accounting standards. It should also state “reasons” for such deviation; and
“financial effect” if any, due to such deviation.
On the basis of requirements of Schedule VI and accounting standards following is the
format of Profit and Loss Account of a Company. 109
Fundamentals of
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Profit and Loss Account of ....
Accounting
Figure Figures Figure Figures

for the for the for the for the
previous current Previous current
year year year year
Rs. Rs. Rs. Rs.
... To Opening Stock ... By Sales Less Returns ...

... Raw Material ... ... By Income from Services ...
... Finished Goods ... ... By Closing Stock ...
... To Purchases (Raw materials) ... ... Raw Materials ...
... Less Returns ... ... Work-in-progress ...
... To Stores & Spares (consumed) ... ... Finished Goods ...
... To Power and Fuel ...
... To Wages (Productive) ...
... To Manufacturing Expenses ...
... To Gross Profit c/d
xxx xxx
... ... ... By Gross Profit b/d ...
... To Rent ... ... By Income from
Investments ...
... To Repairs to Building ... By Profit on Sale of
Investment ...
... To Repairs to Machinery ... By Dividend Income ...
... To Salaries & Bonus ... By Miscellaneous
Incomes ...
... To Contribution to Provident
Fund ...
... To Staff Welfare Expenses ...
... To Contribution to
Pension/Gratuity Fund ...
... To Insurance ...
... To Rates & Taxes ...
... To Printing & Stationery ...
... To Postage, Telegrams, Fax &
Telephone ...
... To Commission, Brokerage
and Discount ...
... To Bank Charges & Interest ...
... To Depreciation ...
... To Loss on sale of Investments ...
... To Remuneration payable to ...
... Directors & other ...
... Managerial Personnel ...
... To Auditor’s Fee ...
... To Provision for Taxation ...
... To Net Profit (transferred to ...
Profit & Loss Account) ...
xxx xxx xxx xxx
110
Schedule VI
(Part I - Form of Balance Sheet)
(Conventional Format)
Balance Sheet of...............
As on 31st March..............
Figure Figures Figure Figures

for the for the for the for the
previous Liabilities current Previous Assets current
year year year year
Rs. Rs. Rs. Rs.
Share Capital Fixed Assets
Authorised*.... shares of Goodwill
Rs. ...... each. Land
Issued..... shares of Rs. Each Building
(*Various classes of shares and Leasehold
their called up amount including Railway sidings
details of Plant and machinery
- Shares issued for consideration Furniture and Fittings
other than Cash Development of Property
- Bonus Issue made, if any Patents, Trade Marks and
Less Call Unpaid Designs
(i) By Directors Live Stock and Vehicles etc.
(ii) By Other Investments
Add. Forfeited shares Showing nature of Investment
(amount actually paid) and mode of valuation-cost
Reserves & Surplus Or market value, and
(1) Capital Reserve distinguishing between
(2) Capital Redemption Reserves (1) Investments in Government
(3) Securities Premium or Trust Securities
(4) Others Reserves & specifying (2) Investments is Shares,
the nature of each reserve and Debentures or bonds
amount in respect there of (Giving details of classes
Loss Debit balance of P&L A/c of shares along with their
(5) Surplus-Balance in paid up value)
Profit and Loss Account after (5) Immovable Properties
providing for proposed (4) Investments in Capital of
allocation namely Partnership firms.
Dividend-Bonus, or Reserves Current Assets, Loans and
(6) Proposed Additions to Reserves Advances
(7) Sinking Fund (A) Current Assets
Secured Loans (1) Interest Accrued on
(1) Debentures Investments
(2) Loans & Advances from Banks (2) Stores and Spare parts*
(3) Loans & Advances from subsidiaries (3) Loose Tools
(4) Other loans & Advances (4) Stock in Trade*
* Interest accrued and due should be (5) Work-in Progress*
Included in the respective sub-head) * Mode of valuation and
* Nature of security to be specified in Amount in case of raw
each case) materials
* Terms of redemption or conversion of Sundry Debtors
debentures to be stated together with (a) Debts outstanding for a
earliest date of conversion/redemption. period exceeding six
months
Unsecured Loans (b) Other debts
(1) Fixed Deposits (Less Provision)
(2) Loans & Advances from subsidiaries In regard to sundry debtors,
(3) Short-term loans & advances particulars to be given
(a) From Banks separately
(b) From Others (i) Debts considered good
(4) Other loans and advances and In respect of which
(a) From Banks company is fully secured
(b) From Others (ii) Debts considered good
111
Fundamentals of Current Liabilities & Provisions
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Accounting A. Current Liabilities no security other than the
(i) Acceptances debtor’s personal security.
(ii) Sundry Creditors (iii) Debts considered doubtful
(iii) Subsidiary Companies doubtful or bad.
(iv) Advance payments and (iv) Debts due by directors
Unexpired discounts for the portion or Other officers or any
for which value has still to be give of them either severally
e.g. in the following classes of companies or jointly with any other
Newspaper, Fire-Insurance, Theaters, person or debts due by
Clubs, Banking & Steamship Companies firms or private
(5) Unclaimed Dividends companies respectively
(6) other Liabilities, if any in which any director or
(7) Interest accrued but not due on loans a member–to be
separately stated.
B. Provision (7a) Cash Balance at hand
(8) Provision for taxation (7b) Bank Balances
(9) Proposed dividends (i) With Scheduled banks &
(10) For Contingencies (ii) With Others
(11) For Provident Fund Scheme (B) Loans and Advances
(12) For Insurance, Pension and (8) (a) Advances loans to
Similar Staff Benefit schemes Subsidiaries.
(13) Other provisions (b) Advances and loans to
Partnership firms in which
company or any of it’s
subsidiaries is a partner.
(9) Bills of Exchange
(10) Advance receivable in cash
or in kind or for value to be
received e.g. rate, taxes
Insurance etc.
(11) Balances on Current
Accounts with managing
Agents, secretaries and
Treasures.
(12) Balances with customs
Port trust (where payable
on Demand)
Misc. Expenditure
(1) Preliminary Expenses
(2) Expenses including
commission, or brokerage on
underwriting or subscription
of shares or debentures.
(3) Discount on issue of Shares
or debentures
(4) Interest paid out of capital
during construction period
(5) Development Expenditure
not adjusted
(6) Other items (specifying nature)
(Debit balance of P&L A/c
Carried forward after
adjusting uncommitted
(free) reserves, is any.)
xxx xxx xxx xxx
112
Footnote: to be shown separately such as:
1) Claims against the Company not acknowledged as debts.

2) Uncalled liability on shares partly paid
3) Arrears of cumulative dividends
4) Estimated amount of contracts remaining to be executed on capital
account and not provided for.
5) Other money for which company is contingently liable.
Preparation of Financial Statements–Conventional Format
Illustration 9
From the following Trial Balance of A Ltd., prepare a Profit and Loss Account of the
company for the year ended 31st March 2003 and a Balance Sheet as on that date.
Rs. Rs.
5,00,000 Equity shares of Rs. 10 each fully called 50,00,000
9% Debentures (Rs. 100 each) 20,00,000
Freehold Building 40,50,000
Plant and Machinery 28,00,000
Profit and Loss Account 2,75,000
Stock (1.4.2002) 7,50,000
S. Debtors and Creditors 9,50,000 4,25,000
Bills Payable 3,75,000
Purchases and Sales 19,75,000 45,25,000
Provision for Bad Debts 45,000
Bad Debts 25,000
General Reserves 3,50,000
Calls in Arrears 75,000
Goodwill 3,00,000
Interim Dividend Paid (1.11.2002) 4,92,500
Cash at Bank 1,60,000
Wages and Salaries 6,95,500
Office Expenses 77,000
Salaries of office and marketing staff 5,15,000
Interest on Debentures 90,000
Discount on Issue of Debentures 40,000
1,29,95,000 1,29,95,000
Adjustments:
i) Stock on 31st March 2003 was Rs. 8,75,000
ii) Depreciate Plant & Machinery by 10% and write off 1/8th of the discount con
issue of debentures
iii) Maintain 5% provision for doubtful debts on debtors.
iv) Interest on debentures has been paid only for the first half
v) Income tax @ 50% is to be provided. Corporate dividend tax is 12.5%
vi) There is a claim for Rs. 50,000 for workmen’s compensation, which has been
disputed by the company. The case is pending in the country of law. 113
Fundamentals of
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Solution
Accounting
Rs. Rs.
To Stock (1.4.2002) 7,50,000 By Sales 45,25,000
To Purchases 19,75,000 By Closing Stock 8,75,000
To Wages and Salaries 6,95,500
54,00,000 54,00,000
To Salaries 5,15,000 By Gross Profit b/d 19,79,500
To Office Expenses 77,000
To Bad Debts 25,000
To Provisions for bad debts
(Rs. 47,500 – Rs. 45,000) 2,500
To Depreciation 2,80,000
To Interest on Debentures
Rs. 90,000
Add outstanding interest Rs. 90,000
1,80,000
interest on Debentures
To Discount on issue of Deb. 5,000
To Provision for Tax 4,47,500
To Net Profit c/d 4,47,500
19,79,500 19,79,500
To Interim Dividend 4,92,500 By Balance b/d 2,75,000
To Corporate Dividend Tax 61,563 By Profits and Loss A/c
(Interim dividend (Net Profit) 4,47,500
Rs. 4,92,500 x 12.5%)
To Balance c/d 1,68,437
72,22,500 7,22,500
Balance Sheet of A Ltd.

Liabilities Rs. Assets Rs.
Called up & paid up Capital Fixed Assets
5,00,00 shares of Rs. 10 each Goodwill 3,00,000
Rs. 50,00,000 Freehold Building 40,50,000
Less Calls-in-Arrears Rs. 75,000 49,25,000 Plant & Machinery
Reserve & Surplus (Rs. 28,00,000–Rs. 2,80,000) 25,20,000
General Reserve 3,50,000 Current Assets, Loans
Profit and Loss Account 1,68,437 Advances
Secured Loan Current Assets
9% Debentures Rs. 20,00,000 Stock 8,75,000
Interest outstanding Rs. 90,000 20,90,000 Debtors (Rs. 9,50,000–Rs. 47,500) 9,02,500
Current Liabilities and Provisions Cash at Bank 1,60,000
Current Liabilities Miscellaneous Expenditure
Sundry Creditors 4,25,000 Discount on Issue 35,000
Bills Payable 3,75,000 of Debentures
Provisions: (Rs 40,000–written off Rs 5000)
Provision for Tax 4,47,500
Corporate Dividend Tax 61,563
114 88,42,500 88,42,500

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Note: There is a contingent liability of Rs. 50,000 for workmen’s compensation Financial Statements
l No statutory transfer to general reserve is made, as the dividend paid does not
exceed 10% of paid up capital.
For the sake of simplicity surcharge on corporate dividend tax not taken into
account.
Illustration 10
Following in the Thial Balance of a limited Company as at 31st December, 2004.
Particulars Debit
Credit
Share Capital 4,00,000
Cash in Hand 6,200
Rent 5,300
Prepaid Expenses 4,600
Repairs & Maintenance 8,600
Advances from Customers 50,000
General Reserve 3,00,000
Raw Materials at Cost 2,67,000
Sundry Creditors 3,40,000
Power 8,800
Travelling and Conveyance 4,100
Auditors’ Fees 1,500
Cash at Bank 8,000
Land 30,000
Furniture 12,200
Staff advances 5,300
Sundry Debtors 1,40,000
Misc. Income 54,600
Finished Goods at cost 3,10,000
Income-tax Advances 3,00,000
Misc. Expenses 61,400
Raw Materials consumption 28,60,000
Sales 42,30,000
Development Rebate Reserve 1,00,000
Building 74,100
Salaries, Wages & Bonus 11,60,000
Cash Credit from Bank 12,500
Total 56,97,100 56,97,100
The following additional information is also available:

i) The authorised capital of the company is 80,000 equity shares of Rs. 10 each of
which 50% has been issued and has been recommended by the directors.
ii) A dividend of 15% on the paid up capital has been recommended by the
directors.
iii) The closing stock of finished goods at cost is Rs. 5,60,000.
iv) The development rebate reserve is no langer required.
v) Depreciation on plant and machinery amounting to Rs. 43,000 on furniture
amounting to Rs. 1,300 and on building amounting to Rs. 3,800 has been debited
to miscellanceous expenses.
vi) Surplus in profit and loss account after proposed dividends, is to be transferred
to general reserve. 115
Fundamentals of
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vii) Income-tax assessment for a prior year has been completed, fixing the income
Accounting tax liability at Rs. 1,55,000 (against which a provision of Rs. 80,000 and
advances of income tax of Rs. 70,000 exists in the books).
You are required to prepare:
i) profit and loss account for the year ended 31st December, 2004; and
ii) Balance sheet in the prescribed form as on that date.
Solution
A Company Limited
for the year ended 31st December, 2004
Particulars Rs Particulars Rs
To Open. Stock of finished goods 3,10,000 By Sales 42,30,000
To Raw Materials consumed 28,60,000 By Clos. Stock of Finished 5,60,000
To Gross Profit c/d 16,20,000 Goods
47,90,000 47,90,000
To Salaries, Wages and Bonus 11,60,000 By Gross Profit b/d 16,20,000
To Power 8,800 By Miscellaneous Income 54,600
To Rent 5,300
To Repairs and Maintenance 8,600
To Aduditors’ Fees 1,500
To Travelling and Conveyance 4,100
To Depreciation on:
Plant and Machinery 43,000
Furniture 1,3000
Building 3,800
To Miscellanceous Expenses 13,300
To Provision for Taxation 169960
To Net Profit for the year 254940
16,74,600 16,74,600
To Provision for Taxation By Net Profit for the year 2,54,940
(for a prior year) 75,000 By Development Rebate Reserve
To Statutory Reserve 12747 written Back 1,00,000
To Proposed Dividend 60,000
To General Reserve (transfer) 2,07,193
354940 354940
Note: Provision for taxation for the year is assumed to be 40% of the profit.
A Limited Company
Balance Sheet
as on 31st December, 2004
Particulars Rs Particulars Rs
Share Capital: Fixed Assets:
Authorised: Land at cost Rs. 30,000
80,000 Equity shares of Rs. 10 each 8,00,000 Building 77,900
Issued: Subscribed and Paid up: Less: Depreciation 3,800 74,100
40,000 Equity shares of Rs 10 each Plant and Machinery 4,73,000
fully paid up 4,00,000 Less: Depreciation 43,000 4,30,000
Reserves and Surplus: Furniture 13,500
General Reserve: Rs. Less: Depreciation 1300 12,200
Brought forward 3,00,000 Investments –
116 Add: ransfer from Current Assets, Loans and
Profit and Loss A/c 207193 5,07,193 Advances:
Satutory Reserve 12,747 A. Current Assets:
Development Raw Materials at cost 2,67,000
Rebate Reserve: 1,00,000 Finished Goods at cost 5,60,000
Less: Transferred to Sundry Debtrors 1,40,000
Profit and Loss A/c 1,00,000 – Cosh in Hand 6,200
Secured Loans: Cash at Bank 8,000
Cash Credit from Bank 12,500 B. Loans and Advances:
Unsecured Loans: – Staff Advances 5,300
Current Provisions: Prepaid Expenses 4,600
A. Current Liabilities: Income Tax Advance 2,30,000
Income Tax Payable 85,000
Advances from Customers 50,000
B. Provisions:
Provisions for Taxation 2,99,960
Proposed Dividend 60,000
Total 17,67,400 17,67,400
Working Notes:
(i) Provision for Taxation: Rs

As per Trial Balance 2,10,000
Less: Adjustment for prior year provision 80,000
1,30,000
Add. Provision for current year taxation 169,960
Provision taken to Balance Sheet 2,99,960
(ii) Prior year tax Adjustments:
Income Tax Liability for Prior Year 1,55,000
Less: Prior Provision 80,000
Additional Provision to be made in current year 75,000
Total Tax Liability 1,55,000
Less: Advance Tax 70,000
Tax Payable 85,000
(iii) Advances Income Tax 3,00,000
Less: Adjustment against prior year completed assessment 70,000
Balance in Advance Income tax 2,30,000
(iv) A sum equal to 5% to the net profits is required to be transferred to statutory
reserve as the rate of dividend is 15%.
117
Fundamentals of Illustration 11
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Accounting
The Bangalore Manufacturing Co. Ltd., was registened with a nominal capital of
Rs. 15,00,000 divided into equity shares of Rs. 100 each. On 31st March 2004 the
follwing ledger balances were extracted from the company’s books.
Rs. Rs.
Equity Share Capial Called Preliminary Expenses 12,500
up and paid up 11,50,000 Freight and Duty 32,750
Calls-in-arrears 18,750 Goodwill 62,500
Plant and Machinery 9,00,000 Wages 2,12,000
Stock (1-4-2003) 1,87,500 Cash in hand 5,875
Fixtures 18,000 Cash at Bank 95,750
Sundery Debtors 2,17,500 Directors’ Fees 14,350
Buildings 7,50,000 Bad Debts 5,275
Purchases 4,62,500 Commission paid 18,000
Interim Dividend Paid 18,750 Salaries 36,250
Rent 12,000 6% Debentures 7,50,500
General Expenses 12,250 Sales 10,37,500
Debenture Interest 12,250 4% Government Securities 1,50,500
Bills Payable 95,000 Provision for Doubtful Debts 8,750
General Reserve 62,500 Sundry Creditors 1,15,000
Profit and Loss A/c 36,250
(Cr.) 1-4-2003
The stock on 31st March, 2004 was estimated at Rs. 2,52,000

The following adjustments© were to be made:
1) Final Dividend at 5% to be provided.

2) Depreciation on Plant and Machinery at 10% and on Fixtures at 5%.
3) Preliminary expenses to be written off by 20%.
4) Rs. 25,000 were to be transferred to General Reserve.
5) The provision for bad debts to be maintained at 5% on sundry debtors.
You are required to prepare the Trading and Profit and Loss Account and Profit and
Loss Appropriation Account for the year ended 31st March 2004 and the Balance
Sheet as on that date.
118
Solution
Trading and Profit and Loss Account of the Bengal Manufacturing Co. Ltd.
for the year ending 31st March, 2004
Rs. Rs.
To Opening Stock (1-4-2004) 1,87,500 By Sales 10,37,500
” Purchases 4,62,500 ” Closing Stock (31-3-2004) 2,52,000
” Freight and Duty 32,750 2,52,000
” Wages 2,12,000
” Gross Profit c/d 3,94,750
12,89,500 12,89,500
ToSalaries 36,250 By Gross Profit b/d 3,94,750
” Commission 18,000
” Rent 12,000
” General Expenses 12,250
” Directors’ Fees Rs. 14,350
” Debenture Interest 12,500
Add. Outstanding
Interest 32,500
To Bad Debts 5,275
Add: Provision for
Bad Debts
Required @ 5%
on Debtors
Rs. 2,17,500 10,875
16,150
Less: Old Provision
for Doubtful
Dets 8,750
7,400
” Depreciation on:
Plant & Machinery
@ 10% 90,000
Fixtures @ 5% 900
90,9000
“ Preliminary Expenses (20%) 2,500
” Provision for Taxation 62,500
” Net Profit transferred to
Profit and Loss Appro-
priation A/c 93,000
3,94,750 3,94,750
Calculation of Outstanding Interest

Rs.
Interest on Rs. 7,50,000 debentures @ 6% for one year 45,000
Less: Debenture interest paid 12,500
Outstanding interest 32,500
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Accounting for the ending 31st March, 2004
Rs. Rs.
To Interim Dividend 18,750 By Balance b/d (1-4-2003) 36,250
” Proposed Final Dividend ” Net Profit for the year 93,600
@ 5% on Rs. 11,31,250
(i.e. Rs. 11,50,000 called) up
capital—Rs. 18,750 calls-in-arrears) 56,562
” General Reserve 25,000
Balance c/d 29,538
1,29,850 1,29,850
Balance Sheet of the Bangalore Manufacturing Co. Ltd.

as at 31st March, 2004

Share Capital: Rs. Fixed Assets:
Authorsed Capital: 15,000 Goodwill 62,500
equity shares of Rs. 100 each 15,00,000 Buildings Rs. 7,50,000
Plant & Machinery 9,00,000
Called up and Paid up Capital: Less: Depreciation 90,000
11,500 shares of Rs. 100 each 8,10,000
fully calld up 11,50,000 Fixtures 18,000
Less: Calls-in-arrears 18,750 Less: Depreciation 900
11,31,250 17,100
Reserves and Surplus: Investments:
General Reserve 62,500 4% Government Securities 1,50,000
Add: Transferred during Current Assets, Loans and
the year 25,000 Advances:
87,500 A. Current Assets:
Profit and Loss Account 29,538 Stock 2,52,000
Secured Loans Sundry Debtors 2,17,500
6% Debentures 7,50,000 Less: Provision for
Debenture Interest Outsanding 32,500 Bad Debts @ 5% 10,875
Unsecured Loans Nil 2,06,625
Current Liabilities & Provisions: Cash in hand 5,875
A. Current Liabilities: Cash at Bank 95,750
Bills Payable 95,000 B. Loans and Advances Nil
Sundry Creditors 1,15,000 Miscellanceous Expenditure:
B. Provisions: (to the extent not written
Provision for Taxation 62,500 off or adjusted)
Proposed Dividends 56,562 Preliminary Expenses 10,000
23,59,850 23,59,850
Illustration 12
Spik and Span Ltd. was registered with an authorised capial or Rs. 3 lakh divided into
30,000 equity shares of Rs. 10 each. The company offered 15,000 shares for public
subscription of which Rs. 7.50 pen share was called up.
The following trral balance was drawn from the book of accounts as on March 31,
2004. You are required to prepare a Profit & Loss Appropriation Account for the year
120 ending on March 31, 2004 and Balance Sheet as on that date.
Debit Credit
Rs. Rs.
Land 23,800
Buildings 52,900
Calls in Arrear 5,000
Brokerage on Shares 8000
Stores and Spare parts 18,000
Preliminary Expenses 7,600
Unexpired Insurance 640
Live Stock 900
Plant & Machinery 1,03,600
Loose Tools 24,000
Stock in trade at cost 50,000
Cash at Office 12,480
Cash Bank 25,000
Sundry Debtors 26,000
Capital Reserve 30,800
Wages Outstanding 1,820
Godown Rent due 700
General Reserve 16,800
Employee’s Benefit Fund 3,000
Salaries Outstanding 1,000
Reserve for Doubtful Debts 1,300
Unpaid Dividends 700
Profit & Loss Accoaunt 57,500
Total 3,50,720 3,50,720
Out of the creditors of, Rs. 1,24,600 Rs. 84,600 were due to bank for a loan secured
by mortage on buildings and machinery, and Rs. 22,000 were due on account of loan
from subsidiary company.
The company earned a profit of Rs. 61,200 during the year. The balance
of profit brought forward from the previous year was Rs. 38,600 out of which it
was decided that Rs. 15,000 be paid as final dividend, Rs. 16,800 the carried to
General Reserve, Rs. 3,000 to Employees Benefit Fund. It was further resolved
that Rs. 7,500 be paid by way of interim dividend for the first half of the
current year.
Solution
Spik and Span Ltd.
Profit and Loss Appropriation A/c for the year ended March 31, 2004
Rs. Rs.
To Interim Dividend 7,500 Balance as per P & L A/c for the
To Balance of Profit 57,500 year ending March 31, 2003 38,600
To Dividend 15,000
To General Reserve 16,800
To Employee’s Benefit Fund 3,00 Profit as per P & L A/c 61,200
99,800 99,800
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Spik & Span Ltd.
Accounting Balance Sheet as on March 31, 2004

Share Capital: Fixed Assets:
Authorised (Net Block) Rs.
30,000 Equity Shares of Land 23,800
Rs. 10 each 3,00,000 Buildings 52,900
Issued & Subscribed Capital:
15,000 Equity Shares of Plant &
Rs. 10 each Rs. 750 per Machinery 103,600
Share called up Rs. 1,12,500 Live Stock 900 1,81,200
Less Calls in Arrear Rs. 5,000 Current Assets:
1,07,500 Stock in trade at cost 50,000
Stores & Spares 18,000
Reserves and Surplus:
Capital Reserve 30,800 Loose Tools 24,000
General Reserve 16,800 Sundry Debtors 26,000
Less Reserve
Profit & Loss Account 57,500 for D’ful Debts 1,300 24,700
Empioyees Benefit Fund 3,000 Cash & Bank Balances 37,480
Secured Loans: Loans and Advances:
From Bank (Secured by Unexpired Insurance 640
mortgage on buildings machinery) 84,600
Unsecured Loans: Miscellanceous Expenditure
From Subsidiary 22,000 & Losses:
Current Liabilities and Preliminary Expenses 7,600
Provisions: Brokerage on Shares 800
Sundry Creditors 18,000
Unpaid Dividends 700
Outstanding Wages 1,820
Outstanding Salary 1,000
Godown Rent due 700
3,44,420 3,44,420
Adjustment: (1) Stock on 31st March 2003 was valued at Rs. 3,42,000
(2) Depreciate:
Plant and Machinery 15%
Computers 10%
patents & Trade Marks 5%
(3) Provision for Bad & doubtful debts is required at Rs. 2,040
(4) Provide for–
Rent o/s Rs. 3,200
Salaries o/s Rs. 3,600
Proposed Dividend 15%
Provision for Income Tax 50% & Corporate Dividend tax 12.5%
Ans: Net Profit after Tax Rs. 1,03,900
Corporate dividend Rs. 12,000
Balance Sheet Total Rs. 8,32,800
Corporate Tax = Rs. 6000 + Rs. 3600 = Rs. 9600
122 Rs. 96000 × 12.5% = Rs. 12000
2. The following balances appeared in the books of ABC Co. Ltd. as on
December 31, 2004.
Particulars Rs. Rs.
Paid up Capital 6,00,000
60,000 Equity Shares of Rs. 10 each 2,50,000
Unclaimed Dividend 36,858
Trade Creditors
Buildings at Cost 1,50,000
Purchases 5,00,903
Sales 10,83,947
Manufacturing Expenses 3,59,000
Establishment Charges 26,814
General Charges 31,078
Machinery at Cost 2,00,000
Motor Vehicle at Cost 30,000
Furniture at Cost 5,000
Opening stock 1,72,058
Book Debts 2,23,380
Investments 2,88,950
Depreciation Reserve 71,000
Advance Payment of Income Tax 50,000
Cash Balnce 72,240
Directors Fees 1,800
Investment’s Interest 8,544
Profit and Loos Account
(January 1,2004) 16,848
Staff Providend Fund 37,500
21,11,223 21,11,223
From these balances and the following information prepare the Company’s Balance
Sheet as on December 31, December 31, 2004 and its Profit and Loss Accout for the
year ended on that date.
a) The stock on December 31, 2004 was Rs. 1,48,680.

b) Provide Rs. 10,000 for depreciation on fixed assets, Rs. 6,500 for Managing
Director’s Commission and Rs. 1,500 for the Company’s contribution to the
Staff Providend Fund.
c) Interest accrued on Investment amounted to Rs. 2,750.
d) A Provision of Rs. 60,000 for taxes in respect of the profit for 2004 is
considered necessary.
e) The directors propose a final dividend at 4% after transfering Rs. 50,000 to
general Reserve.
f) A claim of Rs. 2,500 for workmen’s compensation is being disputed by the company.
g) The Market value of investment as on 31.12 2004 amounts to Rs. 3,02,500.
(Ans: Net Profit after tax Rs. 74,268, P and L Appn. A/c Rs. 17,116, Balancer Sheet
Rs. 10,90,000).
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3) An inexperienced accountant has prepared the balance sheet of ABC Ltd. as follows:
Accounting
Balance Sheet of A B C Limited
Liabilities Rs Assets Rs
Trade Creditors 80,900 Stock:
Advances from Customers 42,260 In hand 3,60,480
Share Capital 8,00,000 With Agents 24,300
Profit & Loss A/c 45,630 Cash in hand 23,540
Provision for Taxes 95,000 Investments 20,000
Proposed Dividend 59,000 Fixed Assets:
Loan to Managing Director 5,000 Land 1,80,000
General Reserve 75,000 Plant & Machinery
Dev. Rebate Reserve 30,000 (W.D.V.) 4,10,000
Provision for Contingencies 23,000 Debtors 2,15,450
Share Premium A/c 22,000 Less: Provision
Forfeited Shares 3,000 For B/D 9,300
2,06,150
Bills Receiveable 5,000
Amount due from Agents 51,320
12,80,790 12,80,790
Redraft the above Balance Sheet in the form prescribed by Indian Companies Act,
1956 giving necessary details yourself.
4) The following balances have been extracted from AB Ltd. as on
September 30, 2004:
Rs. Rs.
Share Capital (Authorised and issued):
Equity (1,50,000 shares) 15,00,000
8% Redeemable Preference (400 shares) 40,000
Share Premiium 25,000
Preference share Redemption 48,000
Land (Cost) 3,00,000
Buildings (Cost less Depreciation) 7,00,000
Furniture (Cost Less Depreciation) 20,000
Motor Vehicle (Cost less Dep.) 35,000
Trading Account–gross Profit 9,00,000
Establishment Charges 2,50,000
Rates, Taxes and Insurance 12,000
Commission 4,000
Commission 5,000
Discount received 8,000
Directors’ Fees 2,000
Depreciation 60,000
Sundry Office Expenses 60,000
Payment to Auditors 4,000
Sundry Debtors and Creditors 1,06,600 25,600
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Financial Statements
(as on 30.9.2003) 10,000
Unpaid Dividend 2,000
Cash in hand 12,000
Cash at Bank in Current Account 1,95,000
Security Deposit 10,000
Outstanding Expenses 6,000
Investment in G.P. Notes 2,00,000
Stock-in-trade (at or below cost) 3,53,000
Provision for taxation (y/e 30.9.03) 70,000
Income tax paid under dispute (y/e 30.9.03) 1,00,000
Advanced payment of income-tax 2,20,000
Total 26,91,600 26,91,600
The following further details are available:

1) The Preference shares were redeemed on 1st October, 2003 at a premium of 20%
but no entries were passed for giving effect thereto, except payment standing to
the debit of Preference Share Redemption A/c.
2) Depreciation provided up to 30th September, 2004 is as follows:
a) Buildings 2,10,000
b) Furniture 20,000
c) Moter Vehicles 60,000
3) Establishment charges include Rs. 18,000 paid to Managing Director as mini-
mum remuneration in terms of agreement which provides for a remuneration of
5% of annual net profits subject to the above minimum in the case of absence or
inadequacy of profitsw in the year.
4) Payment to Auditors includes Rs. 1,000 for taxation work in addition to audit
fees.
5) Market value of investments on 30th September 2004 Rs. 1,80,000
6) Sundry Debtors include Rs. 40,000 due for a period exceeding six months.
7) All receivables and deposits are considered good for realisation.
8) Income-tax demand for the year ended 30.9.2003 Rs. 1,00,000 has not been
provided for against which an appeal is pending.
9) Income-tax to be provided@ 55%.
10) Directors decide to transfer Rs. 25,000 to the General Reserve and to recommend
payment of dividend on equity shares at the rate of 5%.
11) Ignore previous year’s figures.
You are required to prepare the Profit and Loss Account for the year ended
30th September, 2004 and the Balance Sheet as at that date.
(Ans: Net profit after tax and commission Rs. 2,30,422,
Balance of P/L Appn. A/c Rs. 1,40,422
Balance Sheet Total Rs. 22,51,600).
Hint: 5% Remeneration Rs. 26950
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5) The following balances have ben extracted for the books of XYZ Company Ltd.
Accounting as on March 31, 2004.
Rs. Rs.
Freehold Land 23,000 Income from Investments 1,200
Building 7,500 Provisions for doubtful debt
Furniture 2,000 (1st April 2003) 200
Debtors 5,000 Creditors 2,000
Stock (31 March 2004) 4,000 Provision for Depreciation
Cash at Bank 500 (1st April, 2003) 500
Cash in hand 100 Buildings
Cost of Goods sold 30,000 Furniture
Salaries and Wages 1,500 Suspense A/c
Misc. Expenses 800 Equity Share Capital 36,750
Investment in Shares 18,000 6% Cumulative Pref.
Interest 300 Share Capital 8,000
Bad Debts 100 Share Premium 1,000
Repairs and Maintenance 150 Bank Overdraft 5,000
Advance payment of Sales 38,000
Income-tax 600 Profit and Loss A/c
(1st April, 2003) 250
93,550 93,550
The following further particulars are available:

1) The land was revalued on 1st january, 2004 at Rs. 30,000 by an expert valuer
but no effect has been given in the books although the Directors have decided to
adjust the relavant amount.
2) Provision for doubtful debt is to be adjusted to 5% on the amount of debtors.
3) Equity Share Capital is composed of Rs. 10 Shares, 3640 shares were fully paid
and 50 on which a call of Rs. 3 remains unpaid.
4) Suspense A/c represents money received from the new allottee for re-issue of
50 shares shares forfeited during the year for non-payment of the final call, but
no entry for adjustment thereof has been passed.
5) Provision for taxation is to be made at 45%
6) Market value of investments was Rs. 18,500 on 31st March 2004
7) The company is managed by the Directors who are entitled to a remuneration of
3% on the annual net profits.
8) Depreciation is to be charged on written down value of:
Building at 2%
Furniture at 10%
9) The land and buildings of the company are mortgaged in favour of the bank as
security for overdraft sanctioned up to a limit of Rs. 25,000.
10) Dividend on Cumulative preference shares were in arrears for 5 years upto
March 31, 2004. The Directors have recommended payment of dividend for two
years.
Prepare Profit and Loss Account for the year ended March 31, 2004 and Balance
Sheet on that date.
126
(Answer: Profit Rs. 5,999, Balance Sheet total Rs. 60,491)
6) Ajax Co. Ltd. had an authorised capital of 5,000 equity shares of Rs. 100 each.
As on December 31, 2003, 3000 shares were fully called up, and the following
balances were extracted from the company’s ledger accounts.
Rs. Rs.
Salary 4,85,000 Printing and Stationery 2,300
Purchases 3,20,000 Advertishing Expenses 7,300
Stock 75,000 Sundry Debtors 52,700
Manufacturing wages 70,000 Sundry Creditors 34,200
Insurance upto 31-3-2004 6,720 Plant & Machinery 83,500
Rent 6,000 General Reserve 60,700

Salaries 18,500 Furniture 27,100
Discount Allowed 1,050 Building 84,580
General Expenses 9,050 Cash at Bank 1,24,000
Calls in Arrear 4,800 Loans from Managing Director 3,700
Profit and Loss A/c (Cr.) 21600 Bad Debts 12,600
The following further information is given: (i) Depreciation to be charged on

Machinery and Furniture at 15% and 10% respectively; (ii) Provision for Taxation to
be made Rs. 19,000; (iii) Closing Stock Rs. 1,21,000; (iv) Outstanding liabilities:
Wages, Rs. 7,000; Salaries Rs. 8,200; Rent, Rs. 1,600; (v) Dividend at 5%
on paid-up capital to be provided; (vi) Rs. 10,000 to be transferred to
General Reserve.
Prepare Profit and loss Account for the year ended December 31, 2003 and Balance
Sheet (in proper form) as on that date.
(Answer: Profit for the year Rs. 28125, total of Balance Sheet Rs. 4,79,325).
7) The following balances are extracted from the books of ABC Ltd., as on
31 March, 2003.
Cash in hand 62,000
Repairs and Maintenance 86,000
Raw Materials at cost 26,70,000
Furniture 1,22,000
Directors’ Fees 4,000
Miscellaneous Expenses 6.10,000
Land 3,00,000
Finished Goods at cost 31,00,000
Sales 4,33,00,000
Buildings 7,41,000
Cash at Bank 80,000
Sundry Debtors 14,00,000
Raw Materials Consumption 2,86,00,000 127
Fundamentals of Staff Advance
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53,000
Accounting
Advance from customers 5,00,000
Salaries, Wages and Bonus 1,16,00,000
Cash credit from Bank 1,25,000
Power 88,000
Prepaid expenses 46,000
Rent 53,000
Travelling and Conveyance 41,000
Auditors’ Fees 15,000
Miscellaneous Income 5,46,000
Income Tax Advance 30,00,000
The following further information is also given:

1) The authorised share capital of the company is 80,000. Equity Shares of Rs. 100
each which has been issued and subscribed to the extent of 50%.
2) Tax provision @ 6% is to be made on current year’s profits.
3) 15% dividend on the paid-up share capial is recommended by the Directors.
4) The closing stock of finished goods at cost is Rs. 56,00,000.
5) Depreciation on assets amounting to Rs. 4,30,000 on Furiture and Rs. 33,000 on
Building has been debited to miscellanceous expenditure.
6) The surplus in profit and loss account is to be transferred to General Reserve
Account.
Prepare Profit and Loss Account and Balance Sheet as on 31.3.2003.
(Answer: Net Profit before tax Rs. 25,79,000
Total of Balance Sheet Rs. 1,57,04,000)
8) An inexperienced accountant has prepared the balance sheet ABC Ltd. as follows:
Balance Sheet of A B C Limited

Liabilities Rs Assets Rs
Trade Creditors 80,900 Stock:
Adances from Customers 42,260 In hand 3,60,480
Profit and Loss A/c 45,630 Cash in hand 23,540
General Reserve 75,000 Plant and Machinery
Dev. Rebate Reserve 30,000 (W.D.V.) 4,10,000
Forfeited Shares 3,000 For B/D 9,300
2,06,150
Bills Receiveable 5,000
Amount Due from Agents 51,320
12,80,790 12,80,790
128
3.11 LET US SUM UP
Financial statements are prepared by all forms of business organisations to ascertain
the operating results of the business and to know the financial position on a particular
date. Before preparing financial statements one must gain clarity about the nature of
certain items and their treatment in the final accounts. It is obligatory on the part of
companies to maintain and prepare financial statements by the end of each accounting
period. Manufacturing account is prepared to know the cost of goods produced while
Trading account is prepared to know the results of trading operations. Profit and loss
account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. The operating and non-operating
expenses are charged to profit and loss account. The distribution or appropriation of
profit is shown under Profit and Loss Appropriation Account, which is also called
‘Below the Line’.
Balance Sheet is a statement of assets and liabilities to ascertain the financial position
of a concern at a particular date. The assets and liabilities are presented either on the
basis of liquidity or performance. Under ‘liquidity order’ assets are shown on the
basis of ‘most liquid’, ‘liquid’ and ‘least liquid’ assets. Liabilities are shown in the
order of payment. Under ‘order of performance’ the assets are arranged on the basis
of their useful life whereas liabilities are shown on the besis of long term, medium
term, short term and current liabilities.
It is important to distinguish between capital and revenue to ascertain correct profit or
loss amount and fair view of the affairs of the business. There are certain rules which
guide us to determine whether a particular expenditure or receipt is of a capital nature
or of a revenue nature.
Revenue recognition is concerned with the timing of recognition revenue in the
statement of profit and loss. ‘Realisation Concept’ recognises the revenue at the point
of sale or service rendered. Operating and non-operating revenues should be shown
separately while preparing Profit and Loss Account. There are some established
practices as per the Accounting Standards to recognise certain items as revenues. The
Accounting Standards have some established practices to recognise revenue in cases
of sale of goods, rendering services and financial services. But there are also certain
exception to this general rule.
The financial statements of non-corporate entities may be presented either in
conventional format or vertical format. Under vertical form various items of incomes
and expenses, assets and liabilities arranged vertically to get some additional
information about the operating efficiency and financial position of the business
enterprise. The sole traders and partnership forms hardly adopt vertical form of
financial statements. As regards preparation of Balance Sheet of a company, the
nature of details shown with respect to the liabilities and assets and the order of
arrangement of the items are prescribed in Schedule VI, Part I of the Companies Act.
There are two alternate proformas given in Schedule VI for the preparation of
Company Balance Sheets: (i) horizonal and (ii) vertical. Any of these forms may be
adopted for the Balance Sheet of a Company. Both the prescribed forms may require
that the figures of the previous year should be shown in a separate column along side
the figures of the current year.
3.12 KEY WORDS

Capital Expenditure: An expenditure which results in the acquisition of fixed asset
or addition to fixed asset, or an improvement in the earning capacity of the business.
Capital Receipt: Receipt in the form of additions to capital, liabilities or sale
proceeds of a fixed asset. 129
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Revenue Expenditure: An expenditure the benefit of which is limited to one year.
Accounting
Revenue Receipt: Receipts on account of goods sold or services provided.
Deferred Revenue Expenditure: A revenue expenditure which involves a heavy
amount and the benefit of which is likely to spread over the years.
Appropriation: Distribution of profits.
Balance Sheet: Statement of assets and liabilities depicting the financial position at
the end of the financial year.
Below the line: Part of the Profit and Loss Account which shows the appropriation of
profits.
Above the line: Profit and loss account which shows the profit or loss before
appropriation of profits.
Contingent Liability: Liability which depends upon the happening of a certain event
Preliminary Exenses: Expenses incurred in connection with the formation and
registration of a company.
Profit and Loss Account: Income statement disclosing the results of operation (profit
or loss) for the financial year.
Dividend: Part of profits distributed to the equity shareholders.
Final Dividend: Dividend declared in the annual general meeting.
Provision for Taxation: The amount appropriated from profit for the liability arising
on account of payment of taxes.
Financial Statements: Annual statements of assets and liabilities (Balance Sheet) and
of income and expenditure (Profit and Loss Account).

1) Following is the Trial Balance of V.N. Ltd. as on 31st March 2003. Prepare
Trading and Profit and Loss Account and Balance Sheet after taking into account
the adjustments.
Rs. Rs.
Opening Stock 3,00,000
Purchases/Sales 9,80,000 13,60,000
Bills Receivable/Bills Payable 20,000 28,000
Patents and Trade Marks 19,200
Cash at Bank 1,84,800
Debtors and Creditors 1,10,000 70,000
Dividend paid for 2001-2002 36,000
Profit and Loss A/c (1.4.2002) 94200
Sundry Expenses 28,200
Rent 16,000
Salaries 30,000
Computers 68,000
Carriage–Inward 38,000
Discount Received 12,000
Wages 1,20,000
Return outwards 40,000
130 20,66,200 20,66,200

www.rejinpaul.com Understanding
UNIT 4 UNDERSTANDING FINANCIAL Financial Statements
STATEMENTS
Structure
4.0 Objectives
4.1 Introduction
4.2 Vertical Format of Corporate Financial Statements
4.2.1 Vertical Format of Balance Sheet
4.2.2 Vertical Format of Profit and Loss Account
4.3 Revenues and Provisions
4.3.1 Reserves
4.3.2 Provisions
4.3.3 Distinction between Provision and Reserve
4.4 Concepts of Profits
4.4.1 Gross Profit
4.4.2 Operating Profit
4.4.3 PBIT, PBT, PAT
4.4.4 Cash Profit
4.4.5 Profit Available to Equity Shareholders (Residual Profit)
4.5 Concept of Capital
4.5.1 Capital Employed
4.5.2 Shareholders Funds
4.5.3 Shareholders Equity
4.5.4 Debt Fund
4.5.5 Net Working Capital Employed
4.6 Uses of Financial Statements
4.7 Limitations of Financial Statements
4.8 Let Us Sum Up
4.9 Key Words
4.12 Suggested Readings
4.0 OBJECTIVES
After studying this unit you should be able to:
l prepare company financial statements in vertical form;
l acquaint with the concepts of revenues and provisions, profit and capital; and
l appreciate the uses and limitations of financial statements.
4.1 INTRODUCTION
According to Section 210 of the Companies Act, a company is required to prepare a
balance sheet at the end of each trading period. Section 211 requires the balance sheet
is to be prepared in the prescribed form. Schedule VI Part I permits presentation of
Balance Sheet either in horizontal or vertical forms. The present trend of the whole
corporate world is to present their annual accounts in vertical form which has now 131
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become a modern practice. The purpose of this unit is to provide knowledge of
Accounting working model of annual financial statements prepared in accordance with Schedule
VI of Companies Act 1956, Accounting Standards applicable to reporting enterprise
and the basic concepts of reserves and provisions, profit and capital. It also deals with
the uses and limitations of financial statements.
4.2 VERTICAL FORMAT OF CORPORATE FINANCIAL

STATEMENTS
The Profit and Loss Account and Balance Sheet may also be presented in vertical
form. In the vertical form, a summarised profit and loss account is prepared and
details of the items are shown separately in the form of annexures. In the case of
balance sheet, the liabilities are shown under the heading ‘Sources of Funds’ and the
assets are shown under the heading ‘Application of Funds’. Both the prescribed forms
of profit and loss account and balance sheet require that figures of the previous year
should be shown in separate column along with the figures of the current year with
respect to each of the items. The current trend of the whole corporate world is to
present their annual accounts in vertical form. Part I of Schedule VI permits
preparation of financial statements in vertical form which has now become a modern
practice.
4.2.1 Vertical format of Balance Sheet

Under vertical form, a Balance Sheet is prepared under single column divided in two
sections. First section shows the “Sources of Funds” which includes Share Capital,
Reserves and Surplus, Secured and Unsecured Loans. The second section is
represented by “Application of Funds” in the form of Fixed Assets, Investments, Net
Current Assets (Current Assets-Current Liabilities) and Miscellaneous Expenditure.
A format is given below.
Balance sheet of ............
As on ......
I Sources of Funds Schedule Figures for the Figures for the
No. current year previous year
1. Shareholders’ Funds
(a) Share Capital 1 ............... ...............
(b) Reserves and Surplus 2 ............... ...............
2. Loan Funds 3
(a) Secured Loans ............... ...............
(b) Unsecured Loans ............... ...............
Total ............... ...............
II Application of Funds:
1. Fixed Assets 4
(a) Gross Block ............... ...............
(b) Less Depreciation ............... ...............
(c) Net Block ............... ...............
(d) Capital Work-in-progress ............... ...............
2. Investments 5 ............... ...............
3. Current Assets, Loans and 6 ............... ...............
132 Advances
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less: Current Liabilities and 7
Provisions
(a) Liabilities
(b) Loans and Advances
Net Current Assets
4. (a) Miscellaneous Expenditure
(Amount not written off)
(b) Profit and Loss Account
(Less) Balance in General Reserve
As per contra
Total
Significant Accounting Policies & 15
notes on accounts
Various schedules as mentioned above, will provide necessary details of items and
information as required to be given as per schedule VI of Companies Act 1956. The
figures in the amount column may be rounded off to the nearest thousand (000) as
may be decided by the management. These schedules, significant accounting
policies and explanatory notes form an integral part of the Balance schedules,
significant accounting policies and explanatory notes form an integral part of the
Balance Sheet as required by applicable Accounting regarding disclosure of
accounting policies. Contingent liabilities are shown by means of footnote to the
Balance Sheet.
4.2.2 Vertical Format of Profit and Loss Account

Almost all the companies prepare and present their Income Statement (Profit and Loss
Account) in vertical form. In fact the information relating to activities (operating ,
investing, financing) of the companies are arranged in vertical order rather than
conventional (horizontal ‘T’ form). A format of Profit and Loss in vertical form is
given below:
Particulars Schedule Figures at the Figures at the
No. end of current end of previous
year year
I Income
Sales
Services
Dividend
Interest
Other Income 8
TOTAL
II Expenditure
Cost of goods sold/raw 9
material consumed
Selling and other expenses 10
Depreciation 11
Financial Expenses 12
TOTAL 133
Fundamentals of
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Profit before Taxation, Extraordinary
Accounting and Prior Period Items
Provision of Taxation
Net Profit before Extraordinary and 12
Prior Period Items
Extra Ordinary Items (Net of Tax) 13
Prior Period Items (Net of Tax) 14
Net Profit
Balance brought forward from
Previous year profits available for appropriation
Appropriation
Interim Dividend
Dividend on Preference Shares
Proposed Final dividend
Corporate Dividend Tax
Transfer to Debenture
Redemption Reserve
Transfer to Capital Redemption
Reserve
Transfer to General Reserve
Balance taken to Balance Sheet
Significant Accounting Policies and notes on accounts 15
(For details of schedules learners are advised to refer to Horizontal (conventional)
form of Balance Sheet)
A list of significant accounting policies and notes is as follows:
1. Basis of Accounting
2. Revenue Recognition
3. Fixed Assets
4. Depreciation and Amortisation
5. Investments
6. Inventories
7. Foreign Currency Transactions
8. Retirement Benefits
9. Deferred Revenue Expenditure
10. Hire Purchase-Lease rental income
11. Product warranty expenses
12. Provision for contingencies
13. Research and Development
14. Taxation
15. Investment in debt and equity shares
16. Long term contracts and property development activity
17. Government grants
18. Amortisation of License fees
19. Changes in accounting policies
20. Amortisation of License fees
21. Provision for re-inventing the company
22. Employees stock option scheme.
134 23. Amalgamation
24. Changes in provisions of retirement benefits of employees.
25. Investment in sick units
26. Contingencies
27. Approval of managerial remuneration
28. Extraordinary items.
Illustration 1
The following is the trail balance of ABC Ltd. as on 31st March 2003 (Rs. In ‘000’)
Debit Balances Rs. Credit Balances Rs.
Freehold Building 2750 Equity Share Capital 3750
(Shares of Rs. 10 each)
Plant and Machinery at Cost 9500 10% Debenture 2500
Debtors 1200 General Reserve 1625
Stock (31.03.2003) 1075 Profit and Loss Account 900
Bank 250 Securities premium 500
Adjusted Purchases 4000 Sales 8750
Factory Expenses 750 Creditors 650
Administration Expenses 375 Provision for Depreciation 2050
Selling Expenses 375 Other Income 25
Debenture Interest 250
Interim Dividend 225
20750 20750
Additional Information:
i) The authorised share capital of the company is Rs. 75,00,000.
ii) Freehold premises have been valued at Rs. 45,00,000.
iii) Proposed final dividend is 10% & corporate dividend tax 12.5%.
iv) Depreciation on Plant & Machinery is to be provided at 10% on cost.
v) Provided for income tax @ 40%.
You are required to prepare Profit and loss account for the year ended 31st March
2003 and a Balance Sheet as on that date in vertical form as per the provisions of
Schedule VI of the Companies Act 1956.
Solution ABC Ltd.

Profit and Loss Account for the year ended 31st March 2003
Particulars Schedule No. Rs. (in ‘000’)
Income:
Sales 8750
Other Income 25
8775
Expenditure:
Purchases (Adjusted) 4000
Factory Expenses 750
Administration Expenses 375
Selling Expenses 375
Depreciation 950
Interest on debentures 250
6700 135
Fundamentals of Profit before tax
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Accounting Less: Provision for taxation @ 40% on Rs. 2075 830
Net Profit after tax 1245
Less: Dividend: Interim 225
Final (Rs.3750 × 10%) 375
Dividend tax 75 675
1
(225+375 = 700 × 12 /2%) 570
Balance Sheet as on 31st March 2003
Schedule No. Rs. (in ‘000’)
I Sources of Funds
Shareholders Funds
(a) Share Capital 1 3750
(b) Reserves and Surplus 2 5345
9095
Loan Funds: a) Secured
10% Debentures 2500
Total 11595
II Application of Funds
Fixed Assets 3
(a) Gross Block 1400
(b) Depreciation 3000
(c) Net Block 11000
Current Assets:
(a) Stock 1075
(b) Debtors 1200
(c) Bank 250 2525
Less: Current Liabilities

Creditors 650
Provision for Taxation 830
Proposed Dividend 375
Corporate Dividend Tax 75 1930
595
Net Current Assets 11595
Schedule 1: Share Capital:
Authorised
75,000 shares of Rs. 10 each Rs. 75,00,000
Issued, Subscribed & paid up
37500 shares of Rs. 10 each
fully paid Rs. 37,50,000
Schedule 2: Reserves and Surplus Rs.
Securities Premium 5,00,000
Revaluation Reserve 17,50,000
Profit & Loss Account*
(9,00,000 + 5,70,000) 14,70,000
* (Opening Bal. +Bal. of Current year’s P&L A/c) 53,45,000
136
Schedule 3: Fixed Assets
Opening Additions Revaluation Disposal Provision Closing
Balance Reserve for Dep. Balance
1 Freehold 27,50,000 – 17,50,000 – – 45,00,000
Premises (4500000–2750000)
2 Plants & 95,00,000 – – – 30,00,000 65,00,000
Machinery
1,22,50,000 17,50,000 30,00,000 1,10,00,000
Illustration 2
From the following information, prepare a Balance Sheet in a vertical form as on 31st
March 2003 as per the provisions of Schedule VI of Companies
Act 1956.
Debit Balances Rs. (000) Credit Balances Rs. (000)
Fixed Assets 14,300 Equity Share Capital 4,000
Finished Goods 1,500 10% Pref. Share Capital 1,600
Stores 800 Profits for the year 1,810
(Before interest & tax)
Preliminary Expenses 206 12% Debenture 3,000
Advance Tax 400 P & L Account (1.04.2002) 100
Capital Work-in-progress 640 Security deposits from dealers 240
Interest on debentures (net) 324 Securities Premium 1,000
Interest on Loans (other) 160 Investment Allowances Reserves 300
Cas at Bank 550 Creditors 2,300
Loose Tools 100 Provision for doubtful debts 50
Short term investment at cost 450 Provision for Depreciation 3,000
(Market value Rs. 440)
Advance to staff 120 Loan from Customers 400
Debtors 2,450 General Reserve 4,200
22,000 22,000
(i) Dividend is proposed on equity shares @ 0%.
(ii) Provide TDS:
Interest on debentures @ 10%
Corporate dividend tax @ 12.5%
Corporate Income tax @ 40%
Solution
Balance sheet of...
Schedule No. Rs. (in ‘000’)
I Sources of Funds
1 Shareholders funds
a. Share Capital 1 5,600
b. Reserves & Surplus 2 5,738
11,338
2 Loan Funds
a. Secured Loans 3,000
b. Unsecured Loans 3 640
TOTAL 14,978 137
Fundamentals of II Application of Funds:
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Accounting 1. Fixed Assets 4
a. Gross Block 14,300
b. Less Depreciation (3000)
c. Net Block 11,300
d. Capital work-in-progress 640
11,940
2. Short term Investments (at realisable value) 440
3. Current Assets, Loans and Advances
a. Inventories 2400 5
b. Debtors less provision 2400
c. Cash at Bank 550
d. Loan & Advances 120
(Advance to staff)
5470
Less: Liabilities and Provision
a. Liabilities (2336) 6
b. Provisions (742) 7
Net Current Assets (Working Capital) 2,392
4. Miscellaneous Expenditure 206
(Prelim. Exp.)
TOTAL 14, 978
Schedule 1
Share Capital
Equity Share Capital 4000
10% Pref. Share Capital 1600
5600
Schedule 2
Reserves and Surplus:
Securities Premium 1000
Investment allowance Reserve 300
General Reserve 4200
Profit & Loss Account 238
5738
Schedule 3
Unsecured Loans:
Security deposits from Dealers 240
Loans from Customers 400
640
Schedule 4
Fixed Assets 14300
Less Depreciation 3000
11300
Capital work-in-progress 640
11940
138
Schedule 5
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Understanding
a. Inventories
Loose tools 100
Stores 800
Finished Goods 1500
2400
Schedule 6
Current Liabilities Rs.
Creditors 2300
TDS on interest on debentures 36
2336
Schedule 7
Provisions: Rs.
Provision for Income Tax 512
Less Advance Tax 400 112
proposed Dividend:
Equity 400
Preference 160
Corporate Dividend Tax 70
742
Working:
Rs. Rs.
To Interest on debentures 360 By Profit 1810
To Interest on Loan 160
To Loss on Investment 10
To Provision for Income Tax 512
{1810 – (360+160+10) x 40/100}
To Balance c/d 768
1810 1810
To Proposed Dividend: By Balance b/d 768
Equiity 400
Preference 160 By profit 100
To Corporate Tax 70 (1.4.02)
To Balance (Carried to Balance Sheet) 238
868 868
1) Under what headings will you classify the following items:
a) Securities Premium
b) Preliminary Expenses
c) Live-Stock
d) Unclaimed Dividend 139
Fundamentals of e)
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Interim dividend declared but not paid
Accounting
f) Arrears of fixed cumulative preference dividend
g) Share forfeited account
h) Loose tools
i) Advance income tax paid
j) Sinking fund
2. State briefly the items that are included under the following heads:
a) Contingent Liabilities (b) Unsecured Loans (c) Secured Loans
d) Reserve & Surplus (e) Current Liabilities & Provisions
f) Current Assets, Loans & Advances
l Students are advised to see the annual reports of various companies to develop
a better understanding of financial statements through notes attached thereto.
4.3 RESERVES AND PROVISIONS

The reliability, and accuracy of income statement (profit & loss account) and financial
position statement (balance sheet) depends to a greater extent, upon the estimates,
which govern the amount of various provisions to be made. And similarly transfers to
various reserves including statutory transfer, determine the financial soundness,
creditworthiness and depict strong fundamentals which send clear signal to stock
market and other interested parties. Hence, the concepts of ‘reserves’ and ‘provisions’
are of utmost importance while preparing, analysing and understanding the financial
statements.
4.3.1 Reserves
The portion of earning, receipts or other surplus of an enterprise (whether capital or
revenue) appropriated by management for a general or specific purpose is known as
reserve. These reserves are primarily of two types: Revenue and Capital reserves
which may be classified and treated as follows:
1) Revenue Reserves: are also know as free reserves. These are created to meet a
contingent liability not specifically mentioned. These contingencies reserves
indicate management’s belief that funds may be required for an usual purpose or
to meet a possible obligation that does not yet have the status of a liability such
as settlement of a pending law suit or to meet any trading loss. These reserves
are also created for any other general purposes such as for expansion or
modernisation. For accounting purposes the transfer of amount to such ‘general
reserve’ or ‘contingency reserve’ is treated as appropriation and not a charge.
2) Specific Reserve: When a reserve is created for a specific purpose it is known as
‘specific reserve’. It may be created to maintain a stable rate of dividend or to
meet redemption of debentures after a stipulated period of time. Such reserves
may take form of “Dividend Equalisation Reserve”, “Debenture Redemption
Reserve” etc. None of these reserves represent maney or anything tangible. From
accounting point of view it is simply a transfer of divisible profit to other head.
However, when these Revenue Reserves (General/Specific) are not retained
within the business but invested outside business are termed as “reserve Funds”.
3) Capital Reserve: A reserve which is created not out of divisible profits is called
capital reserves. Such reserve is not available for distribution among sharehold-
ers as dividend. It is generally created out of capital profits such as profits prior
to incorporation, securities premium, profit on re-issue of forfeited shares, profit
140
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on redemption of debentures, profit on sale of fixed assets, profit on revaluation Understanding
of fixed assets and capital redemption reserve crated as per the provisions of Financial Statements
Companies Act on redemption of preference shares.
As stated above, such profits are not available for distribution as dividend.
However, some of the capital profits (profit on sale of fixed assets) can be
distributed as dividend if the same are realised in cash. But the companies act
expressly prohibits the following to be used for payment of dividend:
Premium on issue of shares.
Profit on re-issue of forfeited shares and
Capital redemption reserve
Revaluation reserve
According to section 7 of Companies Act 1956, Securities Premium can be utilized
only for the following purposes:
1) Issue of fully paid bonus shares.
2) Writing off the preliminary expenses, discount on issue of shares or debentures
or other fictitious assets.
3) Providing for the premium payable on redemption of debentures or preference
shares.
U/s80, Capital Redemption Reserve can be utilised only for the purpose of issuing
fully paid bonus shares.
4) Secret Reserve: A reserve which is not disclosed in the Balance Sheet is known
as secret reserve. The companies Act 1956 prohibits creation of secret reserve
because it conceals the actual financial position. However, the financial position
of the company is definitely better what it appears from the balance sheet. Such
reserve is created in any of the following manner by:
1) Writing of excessive depreciation
2) Understating the value of assets.
3) Overstating liabilities.
4) Treating capital expenditure as revenue.
5) Creating excessive provision for bad debts.
6) Creating provisions which are not required.
7) Treating contingent liability as an actual liability
8) Treating revenue receipt as capital
Secret reserve may arise on account of a permanent appreciation in the value of assets
or a permanent diminution in the value of a liability. Such changes usually are not
accounted for in the books of accounts.
The policy of secret reserve is adopted by the management to achieve the following
objectives:
l To meet the exceptional losses
l To bring down the market value of shares within the trading range.
l To enhance the availability of working capital
l To maintain dividend rate
l To elude competition by concealing large profits
l To minimize tax liability
l To keep strong financial position
l To lessen the dependence on external finances
All these reserves are shown on the liabilities side of the balance sheet. 141
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4.3.2 Provisions
Accounting
The companies Act 1956 states that, “Provision means amount written off or retained
by way of providing depreciation, renewals of diminution in the value of assets or
retained by way of providing for any known liability the amount of which can not be
determined with substantial accuracy”.
Thus the above definition clearly mentions that a provision may be created either for
depreciation or for a known liability, the amount which cannot be ascertained with
substantial accuracy such as:
– Provision for bad & doubtful debts
– Provision for Repairs and renewals.
– Provision for discount on debtors
– Provision for fluctuation in investments
Therefore, it can be summed up that a provision is created either against the loss (fall)
in the value of assets in the normal course of business operation or against a known
liability the amount of which cannot be determined accurately but in estimated only.
4.3.3 Distinction between Provision and Reserve

1) A provision is a charge against the profits which reserve is simply an appropria-
tion of profits.
2) A provision is created to meet a known liability whose amount is uncertain while
reserve is created to strengthen the financial position and the meet contingency, if
any.
3) A provision is shown as a deduction out of the assets concerned whereas reserve
is shown separately on the liabilities side.
4) The sum so set aside as provision is never invested outside business whereas
reserves may be invested outside business.
5) Provision is part of divisible profits but the same cannot be made available for
the purpose of distributing dividend while reserves (revenue) are always avail-
able to be distributed as dividends.
6) Provisions have to be created whether there is profit or loss while reserve is
created only when there is profit.

I.
1. ................... is created to meet a known liability. (Provision)
2. ................... is built to meet a contingency. (Revenue reserves)
3. ................... is treated as a charge against profits. (Provision)
4. Transfer to ................... is an appropriation. (General reserve)
5. ................... is not affected by profit or loss of the enterprise. (Secret reserve)
6. ................... is made only when there are profits. (Reserve)
II. Write a short note on usage of “Securities Premium”, U/s 78
III. Prepare a list of possible capital profits.
IV.. What are managerial objectives for creating secret reserves, and how is it
created?
V. Distinguish between: Reserve and Reserve Fund
General Reserve Vs Specific Reserve.
142
4.4 CONCEPTS OF PROFITS Financial Statements
The main objective of this topic is to make students familiar with the various concepts
of profits which are used by the management as the basis for taking appropriate
decisions. A clear line of demakation between these terms will help to understand their
application for decision-making purposes.
4.4.1 Gross Profit

It is also known as gross margin. As per the provisions of Companies Act 1956,
Gross profit is ‘the excess of the proceeds of goods sold and services rendered during
a period over their cost, before taking into account administration, selling and
distribution and financing expenses”.
So the difference between the revenue (Sales) and cost of goods sold is the gross
profit. Normally, the profit and loss account is prepared in two parts– (1) Trading
Account and (2) Profit and Loss Account. Trading Account shows the “result” of
trading operation under normal conditions which represents “Gross Profit” or “Gross
Loss”. Revenue means the inflow from main business activity in which the enterprise
deals in whereas the cost of goods sold, in case of trading concerns, comprises
purchases (of goods in which concern deals in) and direct expenses incurred (such as
freight, octroi, duty etc) on or before purchases. However, in case of a manufacturing
concern, the cost of goods sold will include cost of materials consumed, wages and
other manufacturing expenses.
Modern practice of the whole corporate world is to present the information in a
summarized statement (called abridged profit and loss account) giving the details in
various schedules forming part of income statement.
Illustration 3
From the following details of ABC manufacturing company find the gross profit:
Rs.
Raw Material Purchased 12,00,000
Stock of raw material in the beginning 2,50,000
Productive wages 3,50,000
Carriage Inward 20,000
Freight and Octroi 60,000
Other manufacturing expenses 1,20,000
Stock of raw material at the end 2,40,000
Sales 18,75,000
Solution
ABC Company
For the year ended ....................
Income:
Sales 1 1875
Other Income* (not related business) –
1875
Expenditure
Cost of goods sold 2 1760
Gross Profit 115
* Not to be considered for gross profit purposes. 143
Fundamentals of
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Schedule 1: Provides the details of sales: product-wise, segment-wise (Business
Accounting segment/Geographical segments) etc in India and outside India less returns inwards &
sales or trade discount.
Schedule 2:
Cost of goods sold: Rs.
Opening stock of raw material 2,50,000
Add: Purchases 12,00,000
14,50,000
Less: Closing Stock 2,40,000
Raw Material Consumed 12,10,000
Add: Direct expenses
Carriage Inward 20,000
Freight & Octroi 60,000
Productive wages 3,50,000
Other manufacturing expenses 1,20,000
Cost of goods produced (sold) 17,60,000
l Because there is no closing balance
l When there is opening and closing work in progress (semi-finished goods), then
along with the opening and closing stock of raw material, the work-in-progress
(semi-finished goods) will also be added and subtracted accordingly.
l However, if there is opening and closing stock of finished goods, this will also
form the part of inventory.
Illustration 4
In the above illustration, if the following balances also appear, findout the cost of
goods sold:
Rs.
Opening balance of work-in-progress 35,000
Opening balance of finished goods 1,25,000
Closing balance of work-in-progress 55,000
Closing balance of Finished goods 1,75,000
Solution
The following changes will be made in the Schedule 2:
Schedule 2: Cost of goods sold will be as follows
Inventory on 1st April...........
Raw Material 2,50,000
Semi-finished goods 35,000
Finished goods 1,25,000 4,10,000
Add: Purchases 12,00,000
Direct Expenses 5,50,000
21,60,000
Less: Inventory on 31st March
Raw Material 2,40,000
Semi-finished goods 55,000
Finished goods 1,75,000 4,70,000
Cost of Goods Sold 16,90,000
144
4.4.2 Operating Profit
It refers to net profit arising from the main revenue producing activities of an
enterprise after accounting for operating expenses but before taking into account
expenses of financial nature and non-operating income. Operating expenses include
over and above the cost goods sold, such as:
l Factory overheads
l Administration Overheads (Office Over-Heads) and
l Selling and Distribution over-heads
In other words, when above mentioned operating expenses are subtracted from the
gross profit, the resultant figure is “operating profit” and if total operating expenses
exceed gross profit, the difference is treated as operating loss. Operating profit is the
measure of operating efficiency of the enterprise and it is referred as OPBIT
(Operating Profit before and Tax). When non-operating items are also considered, the
resultant figure is Profit Before Tax (PBT). Let us consider the following illustration:
Illustration 5
From the following information, calculate gross profit and OPBIT
Rs. (in ‘000’)
Sales (Gross) 2,075
Return Inwards 15
Return Inwards 60
Rent Received 25
Interest & Dividend on investments 35
Direct Expenses (Manufacturing) 375
Selling and Distribution expenses 75
Office and Administration Expenses 150
Purchases Less returns 850
Inventories (1.4.2002) 145
Inventories (31.03.2003) 165
Solution
Sales 1 2,060
Less Cost of goods sold 2 1,205
Gross Profit 855
Operating Expenses:
Office and Administration expenses 150
Selling and Distribution expenses 75
225
Operating Profit (OPBIT) 630
Schedule 1: Rs. (000)

Gross Sales 2,075
Less Returns 15
2,060
145
Fundamentals of Schedule 2:
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Accounting
Add: Purchases Less Returns 850
995
Add: Direct Expenses 375
1,370
Less: Inventories (31.03.2203) 165
Cost of goods sold 1,205
4.4.3 PBIT (Profit Before Interest and Tax)

It refers to net profit before deducting any amount of financing expenses and income
tax. other words when interest expense and tax liability are not accounted for while
calculating profit or loss of an enterprise, it is treated as PBIT. Interest expense includes:
Interest on debentures
Interest paid or public deposits accepted by a trading or manufacturing organisation
Interest on Loan from public
Interest on Loan from Banks, financial institution or from Government.
Cas packaging or credit from Banks.
PBIT = Operating Profit + Other Income
* PBT (Profit Before Tax)

PBT = PBIT – Interest
When interest expense is subtracted from ‘Profit Before Interest & Tax’ (PBIT) (or
total net earnings) before providing for any income tax thereon, it is called ‘Profit
before Tax’. This shows overall performance of an enterprise resulting from
operating, investing and financing activities. This is also termed as EBT (Earnings
before tax). Thus,
PBT = PBIT – Interest.
* Pat (Profit After Tax)

This refers to net profit after taxes, but before making nay appropriation during the
year. The net profit before tax (PBT) is adjusted for tax liability calculated at the
current rate of taxation. For various sources of incomes there are different rates. Such
as income from business is taxed at a flat rate of 35%, income from long-term capital
gains @ 20%. The tax so calculated will be enhanced by a surcharge of 5% for
assessment year 2003-2004 and 2.5% for 2004-2005 However, for foreign companies
the tax rate is 40%.
PAT = PBT – Provision for Taxation

It should be noted that income tax purposes the profits are recomputed for determining
tax liability by income tax authorities. The actual tax liability is determined only after
the assessment is completed. That’s why in the profit and loss account the amount of
tax so determined on the basis of net profit as disclosed by Profit and Loss Account is
transferred to ‘Provision for Taxation’. This provision is adjusted against the actual
tax liability. You might have already learnt more about provision for taxation under
Unit 3.
Illustration 6
From the above Illustration 5, calculate Gross Profit, Operation Profit, PBIT, PBT
146 and PAT
Solution
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Understanding
Particulars Schedule No. Rs. (in ‘000)
Sales 1 2,060
Less cost of goods sold 2 1,205
Gross Profit 855
Operating Expenses:
Office and Administation expenses 150
Selling Distribution expenses 75
225
Operating Profit (OPBIT) 630
Add: Non Operating Incomes 60
Net profit before interest and tax (PBIT) 690
Less: Financial expenses (Non-operating) 60
Net profit before tax (PBT) 630
Less: Provision for Taxation 220.5
(630000 × 35%) 220.5
Profit After Tax (PAT)
409.5
Schedule 1:
Rs. (000)
Gross Sales 2,075
Less: Returns 15
2,060
Schedule 2:
Add: Purchases Less Returns 850
995
Add: Direct Expenses 375
1,370
Less: Inventories (31.3.2003) 165
Cost of goods sold 1,205
Schedule 3:
Other Income (Non-operating):
Rent Received
Interest and Dividend 25
35
60
147
Fundamentals of
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4.4.4 Cash Profit
Accounting
When all the non-cash charges which have been debited to Profit and Loss Account
are added back to net profit, the amount so arrived at is termed as cash profit. Non-
cash charges are those expenses in respect of which no payment is to be made to
outside parties. It includes
– Depreciation
– Discount on issue of shares & debentures written off
– Preliminary Expenses written off, etc.
It should be noted that ‘outstanding expenses’ are not treated as non-cash charges
because in respect of such expenses, the payment has to be made in the next
accounting year. Whereas cash does not flow-out in respect of depreciation and
discount on issue of shares or debentures. Preliminary expenses are the formation
expenses which have already been incurred in yester years, hence question of making
payment of such expenses does not arise. That’s why while calculating cash profit
such non-cas charges are added back to net profit. Suppose net profit of an enterprise
amounts to Rs. 15,30,000 after changing depreciation of Rs. 3,70,000 and writing off
of Rs. 15,000 preliminary expenses. The cash profit will be taken at Rs. 19,15,000.
(Rs. 15,30,000 + 3,70,000 + 15,000).
The concepts of Gross Profit, Operating Profit before interest and Tax, Operating
Profit before Tax and Operating Profit after Tax can be found out with the help of the
following format:
Operating Income Statement for the period ........
Gross Sales xxx
Less: Returns xxx
Net Sales xxx
Less: Cost of sales:
Material consumed xxx
Direct wages xxx
Manufacturing expenses xxx
Finished goods, etc. xxx xxx
Less: Closing stock xxx
Gross Profit xxx
Less: Operating expenses:
Office & Administrative expenses xxx
Selling ad Distribution expenses xxx xxx
Net Operating Profit (Opit) xxx
Add: Non-operating Incomes
Interest Received xxx
Dividend Received xxx
Rent Received, etc. xxx
Less: Non-operating expenses: xxx
Discousnt Allowed xxx
Interest on Debentures xxx
Interest on Borrowings, etc. xxx xxx
Net Profit Before Tax (PBT) xxx
Less: Provision for Income Tax xxx
148 Net Propfit After Tax (PAT) xxx
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Understanding
4.4.5 Profits Available to Equity Shareholders (Residual Profit)
Residual profit is that portion of profit which is available for equity share holders. It
means the profit which the directors consider, should be distributed among equity
shareholders after making necessary adjustments as per the provisions of companies
Act. In normal course, profits are distributed as dividend only after meeting all
expenses, losses, depreciation (current & unabsorbed), fall in the amount of current
assets, taxation, past losses, preference dividend and transfer to sinking fund,
debenture redemption fund and to general reserve U/s 205 (2A). However, profit
arising out of revaluation of fixed assets and other profits of extra ordinary nature
(capital profits) are not included in the profits available for equity shareholders ads
dividend. It should be noted that the depreciation must be calculated as per the
provisions of the section 205 of the Companies Act 1956.
Illustration 7
You are given the following information:
Rs. (000)
PBIT 5,782
Depreciation charged as per Books 182
Depreciation as per Section 205 360
10% Preference Share Capital 1,500
Past Accumulated Losses 1,500
Transfer to Debenture Redemption Fund 1,200
Unabsorbed Depreciation as per section 205 560
Interest on Loans & Advances 252
Transfer to General Reserves 600
Calculate profit available for equity shareholders, presuming tax rate of 40%.
Solution
Rs. (000)
PBIT (as given) 5782
Less Interest 252
5530
Less provision for transfer @ 40% 2212
3318
Add Depreciation as per books 182
3500
Less Depreciation as per section 205 360
3140
Less Unabsorbed Depreciation 560
2580
Less Accumulated Past Losses 1200
1380
Less Transfers-Debenture Redemption Fund150 150
General Reserve 600 750
630
Less Preference Dividend 150
Profits available to equity shareholders 480

1. Gross Profit is the result of two variables
(i) Turnover & (ii) ..................................
2. Turnover is the total of:
(i) Gross Profit & (ii) .................................. 149
Fundamentals of 3. Operating profit is equal to
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Accounting (i) ..................... (ii) Operating expenses
5. Operating expenses include:
(i) .....................
(ii) .....................
(iii) .....................
6. Financial expenses are treated as .....................
7. When non-cash charges are added back to net profit the resultant is ....................
8. Non-cash charges include:
(i) ................................
(ii) ................................
(iii) ................................
4.5 CONCEPTS OF CAPITAL

There are certain key terms which are used in the process of analysis of financial
statements, to draw certain conclusions after judging the company’s networth,
liquidity, solvency and credit worthiness etc.
4.5.1 Capital Employed

The term capital employed has been defined as the finances deployed by an enterprise
in it’s fixed assets, investments and working capital. However, if the investments are
non-business or non-trading, the same may be excluded from the capital employed.
The capital employed can be worked out by two methods:
First Method: Capital Employed = Fixed assets (Less Depreciation)
+ Net working capital (Current Assets – Current Liabilities)
Since spare funds are used to buy government, semi-govt, or commercial securities the
same are treated as non-trading assets. Hence, such funds are not used for business
purposes. However, if such assets have to be acquired, these should be treated as trade
investments and should form part of capital employed.
Second Method: Capital employed can also be worked out and expressed as the total
sum of share capital (Preference & Equity both), reserves (accumulated till date) and
long-term liabilities (loans & debentures) as reduced by fictitious assets such as Debit
balance of profit and loss account, preliminary expenses, discount on issue of shares
and debentures and non-business assets.
It should be noted that certain intangible assets which have been generated over the
years and no payment has been made to acquire them, are not considered for the
purpose of determining capital employed. These intangible assets include goodwill,
patents, copyrights, trade marks etc.
Thus capital employed = Paid-up share capital (Preference & Equity) + Reserves +
Accumulated profits + Revaluation – Revaluation Loss-
Fictitious assets–intangibles (generated.)
Average Capital Employed

It is calculated by adding the capital employed in the beginning and at the end divided
by two. Alternatively, half of the current year’s profits may be added to the capital
employed in the beginning or subtracted from the capital employed at the end to arrive
at the figure of average capital employed which fairly represents capital employed
throughout the year.
Capital Employed at the beginning + Capital Employed at the end
150 Average capital employed =
2
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It should be remembered that when capital employed is calculated for the Understanding
purpose of determining the rate of net profit on capital employed then, Financial Statements
debentures and loans are excluded for the purpose of computing the capital
employed because net profit does not include interest on loans and debentures.
Illustration 8
From the following Balance Sheet, calculate capital employed under both the methods:
9% 2500 preference shares of 2,50,000 Goodwill 50,000
Rs. 100 each
50,000 equity shares of Rs. 10 5,00,000 Fixed Assets 9,00,000
each
Reserve Fund 4,50,000 Investment in Govt. 1,00,000
Securities
10% Debentures 2,50,000 Current Assets 5,00,000
Provision for Taxation 50,000 Preliminary Expenses 50,000
Creditors 1,25,000 Discount on issue of 25,000
debentures
16,25,000 16,25,000
Fixed assets are valued at Rs. 9,25,000.
Solution
Computation of capital employed: (First Method)
Rs.
Fixed Assets (after revaluation) 9,25000
Current Assets 5,00,000
14,25,000
Less: Creditors 50,000
Provision for taxation 1,25,000 1,75,000
12,50,000
Alternatively: (Second Method)
Rs.
9% Preference Share Capital 2,50,000
Equity Share Capital 5,00,000
Reserve Fund 4,50,000
10% Debentures 2,50,000
14,50,000
Add: Revaluation Profit 25,000
14,75,000
Less: Goodwill 50,000
Investment 1,00,000
Preliminary Expense 50,000
Discount on issue of 25,000 2,25,000
shares & debentures
Capital Employed 12,50,000
4.5.2 Shareholders Funds

Shareholders funds are also referred as networth which is equal to the excess of total
assets (excluding fictitious) over the liabilities. This represents the amount belonging
to shareholders i.e. what amount the shareholders will be paid, had there been 151
liquidation of the company.
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Hence, shareholders funds = All assets (excluding fictitious) less liabilities (short-term
Accounting and long-term both)
or
Shareholders funds = Preference share capital + Equity share capital + Reserves +
Accumulated Profits (Capital/Revenue)–Fictitious assets– Assets which are worth less
+ revaluation profit - Revaluation loss.
Illustration 9
From the following information compute shareholders’ funds
11% Preference Share Capital 3,00,000 Goodwill 2,50,000
Equity Share Capital 7,00,000 Fixed Assets 10,00,000
Reserves (Revenue) 1,50,000 Investments 2,50,000
Capital Reserves 75,000 Current Assets 3,75,000
Securities Premium 1,25,000 Preliminary Expenses 80,000
9% Debentures 5,00,000 Discount on debentures 45,000
Current Liabilities 1,50,000
20,00,000 20,00,000
Fixed assets include Rs. 40000 for patents which are considered useless and freehold
premises which is valued Rs. 75000 more than its bookvalue. Goodwill is to be valued
at Rs. 2,20,000.
Solution
Computation of Shareholders’ Funds
First Method
Rs.
Goodwill 2,50,000
Fixed Assets 10,00,000
Investments 2,50,000
Current Assets 3,75,000
18,75,000
Less: 9% Debentures 5,00,000
Revaluation Loss:
Patents 40,000
Goodwill 30,000 7,20,000
11,55,000
Add: Revaluation Profit (Freehold premises) 75,000
Shareholders’ Funds 12,30,000
Second Method: Shareholders’ Funds may also be computed as follows:

Rs.
Pref. Share Capital 3,00,000
Revenue Reserve 1,50,000
Capital Reserve 75,000
Securities Premium 1,25,000
13,50,000
Less: Preliminary Expenses 80,000
Disc. On debentures 45,000
Revaluation Loss (Patent Rs. 40,000 + 70,000 1,95,000
Goodwill Rs. 30,000) 11,55,000
Add: Revaluation Profit (Freehold premises) 75,000
152 Shareholders’ Funds 12,30,000
4.5.3 Shareholders
It is the interest of equity shareholders in the net assets of the company. However, in
case of liquidation it is represented by the residual assets meeting prior claims. If the
claims of the preference shareholders are subtracted from the shareholders’ funds the
remaining balance is termed as equity shareholders’ equity.
Shareholders’ Equity = Shareholders’ Funds – Preference Shareholders claim
In the above example, equity shareholders’ equity will be Rs. 9,30,000
(Rs. 12,30,000-3,00,000). That is shareholders funds less preferences share capital,
if the preference shares are participating i.e. they are entitled to share surplus assets
after meting the claims, then such share of preference shareholders will also be
subtracted from the shareholders’ funds.
It is to be noted that “Shareholders’ Equity” includes preference share capital
also as against the “Equity Shareholders’ equity” which expressly excludes
preference share capital and other claim thereof.
4.5.4 Debt Funds

Debt Funds are represented by outside liabilities. It is also known as “external
equities”. It consists of short-term as well as long-term liabilities. Debt funds are in
the form of debentures, loans and borrowings, and current liabilities such as creditors,
bills payable, bank overdraft and short term bank credit. By and large these current
liabilities are always available year after year on a permanent basis, thus become a
part of debt funds.
However, there is no unanimity or consensus on this point. Some authors do not treat
current liabilities as a part of debt funds, especially for the purpose of calculating
debt-equity ratio because of the following reasons:
i) Currnet liabilities are of a short-term nature and the liquidity ratios are
calculated to judge the ability of the firm to honour current obligations.
ii) Current liabilities vary from time to time within a year and interest thereon has
no relationship with the book value of current liabilities.
The reasons for taking both short-term and long-term debts are as follows:
i) When a firm has an obligation, no matter whether it is of short-term or long-term
nature, it should be taken into account to evaluate the risk of the firm.
ii) Just as long-term loans have a cost, short-term loans do also have a cost.
iii) As a matter of fact, the pressure from the short-term creditors is often greater
than that of long-term loans.
4.5.5 Net-working Capital Employed

Net working capital implies to the “funds available for conducting day-to-day
operations of an enterprise”. It can also be referred as excess of current assets over
current liabilities. Hence working capital is the results of two variables viz current
assets and current liabilities. A change in the amount of either of two variables brings
about a change in the amount of working capital employed.
Net working capital employed = current assets–current liabilities.
Current assets refer to “cash and other assets which are expected to be converted into
cash or consumed in the production of goods or rendering of services in the normal
course of business. This includes stock, debtors, bill receivable, short-term trade
investment or marketable securities & pre-paid expenses etc.
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Current Liabilities are those liabilities which have to be paid within a normal course
Accounting of business (within a year). It includes creditors, bills payable, Bank-overdraft, short-
term loans, outstanding expenses of other liabilities which fall due for payment in a
relatively short period, not more than twelve months.
An enterprise should employ enough working capital so that it can meet its current
obligations to keep the enterprise on the margin of safety. However, tis margin of
safety should not be big enough that the most of the funds remain idle. Otherwise the
company cannot make optimum use of the funds employed. The ideal amount of net
working capital to be employed, according to traditional belief, should be equal to
current liabilities i.e. current assets should be double of the amount of current
liabilities so that company enjoys better liquidity position and does not become
technical insolvent.
4.6 USES OF FINANCIAL STATEMENTS

The financial statements are useful in many ways in the process of decision making.
They are the basis of decision making for its users, namely management, investors,
creditors, government authorities, etc. Let us now discuss the usefulness of financial
statements.
1) Economic Decision-making
Sound economic decisions (of external users) require assessment of impact of current
business activities and development on the earning power of the company. Information
about economic resources and obligations of a business enterprise is needed to form
judgement about the ability of the enterprise to survive, to adopt, to grow, to prosper
amid changing economic conditions. In this process, the financial statements provide
information that is important in evaluating the strength and weaknesses of the
enterprise and its ability to meet it’s commitments.
2) Investors Decisions
Adequate disclosure in the financial statements in expected to have favourable effect
on security process of the company. An informed investor is always in a position to
take appropriate and timely decision on investment or disinvestment. Financial
statements and annual reports provide necessary information regarding profitability,
dividend policy, net worth, intrinsic value of shares. Earnings per share (EPS) to
assess future prospects to substantiate their investment decisions. The group is not
only interested in present health of the enterprise but the future fitness as well.
Bankers & financial institutions and foreign institutional investors are always worried
about the future solvency of the invested firms.
3). Employees’ Decisions

Employees’ decisions are usually based on perceptions of a company’s economic
status acquired through financial statements. Employees and their trade unions use the
financial statements to assess risk and growth potential of a company, which helps
settle industrial disputes, avert lockout & strike or likewise situation arise form
demand for wage hike, bonus, higher compensation, more fringe benefits, better
working conditions and so on. Labour unions and individual employees use financial
statements as the basis for collective bargaining and settlement. Tis develops sense of
belongingness among the workers for they know that their interest is not being
jeopardised.
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4) Creditors and Financiers
Short-term creditors make use of the financial statements mainly to ascertain the
ability of the firm to pay its current liabilities one time and the value of stock
and other asset which can be accepted as security against credits granted.
Long-term creditors and financiers are more concerned about the firm’s
ability to repay the principal amount as and when due. From the financial data
provided by the periodic statements, it is possible to make projections about the
generation of funds and cash flows, which may assure the safety of investment in
debentures and loans.
5) Customers’ Public and Competitiors’ Decisions

Customers and the public in general may use financial statements to predict and
forecast future prospect of the company. This information may be important in
estimating the value of warranty or in predicting the availability of supporting services
or continuing supplies of goods over an extended period of time. Likewise,
competitors may analyse financial statements (from competition point of view) to
judge the ability of competitor to withstand competition and it’s absorbing capacity.
6) Managerial Decisions
Published account and reports forming part of financial statements may have
economic effects through it’s impact on the behaviour of the managers of corporate
enterprises. Financial statements provide necessary information base for taking all
managerial decisions. In the absence of accounting information neither the objectives
of the enterprise can be laid down nor measurement and evaluation of performance is
possible nor corrective measures can be taken. Managerial tools such as production
budget, sales budget, cash budget, capital budget, and master budget etc. are all the
offspring of financial statements. Similarly, wage policy, price policy, credit policy,
recruitment policy and other policy matters are decided after careful analysis of
financial statements.
7) Government and it’s Agencies

Government Agencies include taxation authorities and regulatory bodies such as
Ministry of Trade & Commerce, Company Law Board, Registrar of Joint Stock
Companies, Securities Exchange Board of India (SEBI). These agencies require
information for policy decisions purposes. It may be a fiscal policy of Central Board
of Direct Taxes (CBDT) or a regulatory policy of company law board and so on, they
all require financial statements for policy formulation purposes.
8) Others
The financial statements are also useful to stock exchange, brokers, underwriters,
press and the public in general. Though Their interest and goals being altogether
different in nature, yet they require accounting information in the form of financial
statements to serve their own ends. For example researchers may provide some
startling facts and findings which may be used by Government to set its economic
policy, by regulatory agencies to take regulatory measures and by management to
review its own policies and by the public (NGO’s) for social reporting purposes.
Social reporting aims at measuring adverse and beneficial effects of an enterprise
activities both on the company and those affected by the firm; it measures social costs
and the related benefits thereof.
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Accounting 4.7 LIMITATION OF FINANCIAL STATEMENTS
Despite the fact that financial statements are the back-bones of the decision-making
process for different levels of executives in an organisation, financial analysts and
advisors and other interested persons, these suffer from certain limitations because the
facts and figures which are reported may not be precise, exact and final. Again some
aspects which may be crucial for decision-making purposes may go unreported.
1) Periodic nature of statements: The profit or loss arrived at in the Profit and Loss
Account is for a specified period. It does not give any idea about the earning capacity
over time. Similarly, the financial position as at the date of Balance Seet is true of that
point of time. The likely change in position on a future date is not depicted. Liabilities
which were dependent on future events (contingent liabilities) are estimated and shown
in the Balance Sheet. They are not accurate figures. Similarly, revenue expenditure is
sometimes partly charged to Profit and Loss Account and partly deferred or carried
forward. The proportion which is deferred and shown on the asset side of Balance
Sheet is based on convenience and depends on the level of earnings relatively to the
expenditure. In all these respects the annual statements do not reveal the exact earning
capacity or financial state of affairs.
2) The statements are not realistic: Financial statements are prepared on the basis
of certain accounting concepts and conventions. As a result, the financial position
depicted in the statements cannot be considered realistic. For example, fixed assets are
required to be shown on the basis of their value to the business as represented by their
acquisition price less depreciation, not as per the estimated resale price. Also, the
Profit and Loss Account invariably includes probable losses but does not include
probable income. This is according to the accounting convention of conservation.
3) Lack of objectivity due to personal judgement: Values assigned to many items
are determined on the basis of the personal judgement of accountants. Hence, relevant
amounts shown in the financial statements have no objectivity and they are not
varifiable. For instance, estimates of the life of fixed assets and the method of
depreciation to be used are based on the personal judgement of accountants. So is the
case with valuation of inventories (stock) of materials, work in progress, stores and
spare parts, etc. The method of valuation to be adopted depends on the poilicy at the
discretion of management based on their judgement.
4) Only financial matters are reported: The financial statements present
information in terms of monetary units. There is no information relating to the non-
monetary aspects of business operations. Facts which cannot be depicted in money
terms are excluded from the statements. Thus, information relating to the development
of skill and efficiency of employees, the reputation of management, public image of
the firm, and such matters do not find a place in the financial statements. Yet these are
very relevant for investors to consider while forming any opinion about the future
prospects of the firm.
5) No Suggestive Approach: Financial Statements disclose information about the

past (historical) i.e. what has happened? But it does not disclose why and how it
happened. If a company makes profits or incurs losses, the financial statements will
show only the amount of profits or losses made but fails to divulge any details as to
why there is an increase or decrease in profits or losses.
6) Subjective Approach of the Management: Financial performance (profitability)

cannot be taken as the only indicator of managerial performance. The profit figures, to
a greater extent, are affected by managerial policy of charging depreciation, writing
off fictitious assets, amortisation of intangible assets, allocation of advertisement cost,
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valuation of stock etc. Likewise, objectivity factor is lost while preparing financial Understanding
statements to depict the financial position of the concern. Further application of Financial Statements
certain concepts and conventions does not allow to show the assets at the true current
values (cost concept). The assets shown in the Balance Sheet reflect unexpired cost
(W.D.V.) However, liabilities are shown at the same figures thereby distrorting the
solvency position of the enterprise. Likewise, the accounting year may be chosen after
due thought so that financial statements can send the desired signals to outside
interested parties.
7) Conflicting Principles: According to Principle of conservatism stock may be

valued at cost or market price whichever is less. This implies that current assets are
shown at cost in one year and at marker price the other year. It shows clear violation
of principle of consistency. Similarly the change of method of charging depreciation
from straight line method to written down value method and vice versa highlights
contradiction in application of accounting principles. Again, because of flexibility of
accounting principles, certain liabilities are not provided for, such as no provision for
gratuity payment is made. This is bound to give distorted picture of the financial
statements.
8) Figures are not-self explanatory: How far the financial statements are useful
depends upon the ability of the users to analyse and interpret accounting data for their
decision making purposes. Truly accounting is the language of the business but
financial statements do not speak themselves, you need certain expertise and tools to
make them speak. Every user is not competent to draw conclusions from these
statements. Even audited financial statements do not provide a complete and total
guarantee of accuracy.
Check Your Progress D

1. Fill in the blanks:
(a) Final accounts of a company are prepared according to ............. Companies
Act ...........
(b) Excess of current assets over current liabilities is called .................
(c) Shareholders’ funds comprise of ................ and .................
(d) Liquidity is the ability of the company to meet ................
(e) Net worth of the company is equal to ................
(f) ................ are show by means of footnote under the Balance Sheet.
4.8 LET US SUM UP

The financial statements are presented either in horizontal or vertical form. The
present practice of the corporate enterprises is to present their annual accounts in
vertical form which has now become a modern practice. Under vertical form, in case
of Balance Sheet, the liabilities are shown under the heading “Sources of Funds” and
the assets are shown under the heading “Application of Funds”. A summarised profit
and loss account is prepared to know the profit or loss and the details of the items are
shown separately in the form of annexures.
The concepts of “Reserves” and “Provisions” have its own significance in the
preparation of financial statements. The portion of earning whether capital or revenue
appropriated by management for a general or specific purpose is known as reserve. A
reserve may be a revenue reserve or capital reserve. A revenue reserve may be either a
general reserve or specific reserve. General reserve is created to meet a contingent
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liability. A specific reserve is created for a specific purpose. It may be created to
Accounting maintain a stable rate of dividend or to meet redumption of debentures, etc. A reserve
which is not created out of ‘divisible profits’ is called ‘capital reserve’ and is generally
created out of capital profits. Capital profits are not available for distribution as
dividends. A reserve which is not disclosed in the Balance Sheet is called as ‘secret
reserve’. Secret reserves may arise on account of permanent appreciation in the value
of assets or permanent diminution in the value of a liability which is not
accounted for in the books of accounts. A provision may be created either
against the loss (fall) in the value of assets in the normal course of business
operation or against a known liability the amount of which cannot be determined
accurately but is estimated only.
Gross profit is the difference between the revenue (sales) and cost of goods sold. If we
deduct operating expenses from the gross profit, the resultant figure is ‘operating
profit’. When interest expense and tax liability are not accounted for while calculating
profit or loss, of an enterprise, it is treated as ‘Profit before Interest and Tax’ (PBIT).
When interest expense is subtracted from PBIT before providing any income tax, the
resultant figure refers to PBT. PAT refers to net profit after taxes. When all non-cash
charges which have been debited to Profit and Loss account are added back to net
profit, the amount so arrived at is termed as ‘cash profit. There are certain key
concepts which are used in the process of analysing financial statements. These
concepts are: capital employed, shareholders’ funds, equity shareholders’ equity, debt
fund and net working capital.
The financial decisions are useful in many ways in the process of decision-making.
These statements are the basis for decision making for its users, e.g. management,
investors, creditors, government authorities, etc. They help us in evaluating the
strength and weaknesses of the enterprise and investment decisions. Inpsite of its uses,
these statements are subject to certain limitations because the facts and figures which
are reported may not be precise, exact and final. Further, some aspects which are
crucial for decision making may go unreported.
4.9 KEY WORDS

Vertical form of Balance Sheet: A statement prepared under single column divided in
two sections, viz. ‘Sources of Funds’ and ‘Application of Funds’.
Vertical form of Profit and Loss Account: A summarised profit and loss account
prepared in vertical form and details of the items are shown separately in the form of
annexures.
Residual Profit: Net profit available for equity shareholders.
Secret Reserve: A reserve which is not disclosed in the Balance Sheet which may
arise on account of a permanent appreciation in the value of assets or a permanent
diminuation in the value of a liability.
Gross Profit: The difference between net sales and cost of goods sold.
Operating Profit: Gross profit minus operating expenses.
Cash Profit: The amount which is arrived at by adding back to net profits those non-
cash charges which have been debited to the profit and loss account.
Capital Employed: Long-term funds including owners’ capital and borrowed capital.
Net Working Capital: Excess of current assets over current liabilities.
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4.10 ANSWERS TO CHECK YOUR PROGRESS Financial Statements
A. 1 (a) Reserves and surplus, (b) Miscellaneous expenditure, (c) Fixed assets,
(d) Current liabilities and provisions, (e) Current liabilities and provisions,
(f) Contingent liability, (g) Reserves and surplus, (h) Current assets,
(i) Loans and advances or a deduction from liability for tax, (j) Reserves and
surplus.
B. 1. Provision, 2. Revenue reserves, 3. Provision, 4. General reserve, 5. Secret
reserve, 6. Reserve.
C. 1. Cost of goods sold, 2. Cost of goods sold.
4. Gross profit, 5(i) Factory overheads, (ii) Office and administrative
overheads, (iii) Selling and distribution overheads, 6. Non-operating
expenses, 7. Cash profit, 8(i) Depreciation, (ii) Discount on issue of shares
and debentures written off, (iii) Preliminary expenses written off.
D. 1 (a) Schedule VI, 1956, (b) Net working capital, (c) Share capital, reserves
and surplus, (d) Debts, (e) Excess of total assets over the liabilities,
(f) Contingent liabilities.

1) Write notes on:
a) Horizontal presentation of Balance Sheet, and
b) Vertical presentation of Balance Sheet.
2) “Balance Sheet is a statement of assets and liabilities or sources and uses of
capital or both”. Comment.
3) What are the financial statements? How far are they useful for decision-making
purposes?
4) Write a note on nature and limitations of financial statements.
5) Z Ltd. made a loss of Rs. 50,000 after providing depreciation of Rs. 1,00,000 in
2002. In 2003 the company earned a profit of Rs. 3,00,000 before charging
depreciation of Rs. 75,000.
b) Also find out cash profit for the year 2002 and 2003.
(Ans: (a) Rs. 1,25,000 (b) Rs. 50,000 and Rs. 3,00,000)
6) From the following calculate Gross Profit, operating profit, Profit before tax
(PBT) and Profit after Tax (PAT). The balance of profit standing to the credit of
Profit and Loss Account after making following adjustments Rs. 61,000.
Rs.
Depreciation 85000
Proposed Dividend 1,50,000
General Reserves 45,000
Dividend Received 10,000
Loss on sale of fixed assets 23,000
Indirect Business Expenses 3,05,000
However, Income tax @ 50% has not been provided for.
(Ans: Gross Profit : Rs. 6,53,000
Net Profit : Rs. 2,50,000 (PBT) & Rs. 1,25,000 (PAT)
Operating Profit : Rs. 2,40,000)
159
Fundamentals of 7)
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Explain the purpose and procedure of calculating the following:
Accounting
1) Gross Profit
ii) Operating Profit
iii) PBIT
iv) PAT
8) An inexperienced accountant has prepared the balance sheet of ABC Ltd. as
follows:
Balance Sheet of ABC Limited
Trade Creditors 80900 Stock:
Advances from Customers 42,260 In hand 3,60,480
Profit & Loss A/c 45,630 Cash in hand 23,540
General Reserve 75,000 Plant and Machinery
Development Rebate Reserve 30,000 (W.D.V.) 4,10,000
Forfeited Shares 3,000 for B/D 9,300
2,06,150
Bills Receivable 5,000
Amount due from Agents 51,320
12,80,790 12,80,790
Redraft the above Balance Sheet in the vertical form prescribed by Indian Companies
Act, 1956 giving necessary details yourself.
9) From the following prepare a Balance Sheet in vertical form as on 31st
March 2003
Sundry Debtors 612500
Profit & Loss A/c (Dr.) Current year 150000
Miscellaneous Expenses 29000
Investments 112600
Loose Tools 25000
Advances to staff 27500
Cash & Bank Balances 137500
Advances 186000
S. Creditors 572500
Term Loan 500000
Capital work-in-progress 100000
General Reserve 1025000
Finished Goods 375000
160
Gross Block (NDR)
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2575000 Understanding
Stores 200000
Provision for doubtful debts 10100
Loans from Customers 100000
Share Capital: Equity Shares 150000
10% Preference Shares 500000
(1) Terms Loans are secured (2) Depreciation on fixed assets Rs. 2,50,000
10) From the following particulars prepare profit and loss account for the year ended
31st March 2003 and a Balance Sheet as on that data in vertical form. The
company has a authorised capital of Rs. 50,00,000 divided in to 2,50,000 equity
of Rs. 10 each and 2,50,000 10% preference shares of Rs. 10 each.
Debit Balances Rs. (000) Credit Balances Rs. (000)

Materials Purchased 1233 4% debentures 500
Furniture & Fittings 150 Equity Share Capital 1500
Stock (1.4.2002) 665 10% Preference Share Capital 500
Discounts & Rebates 30 Bank overdraft 757
Patents 375 S. Creditors 240
Carriage Inwards 57 Sales 3617
Rent, Rates & Insurance 55 Transfer Fees 7
Wages 1305 Rent Received 30
Coal & Coke 63 Profit & Loss A/c (1.4.02) 67
Bank Balance 20
Cash in Hand 8
Debenture Interest (for 6 month) 10
Bank Interest 91
Preliminary Expenses 10
Calls-in-Arrears 10
Freehold Premises 1250
Plant & Machinery 750
Tools & Equipment 150
Goodwill 375
S. Debtors 266
Bills Receivable 134
Advertisement 15
Commission & Brokerage 68
Business Expenses 56
Repairs 47
Bad Debts 25
7218 7218
The closing stock was valued at Rs. 712000. Outstanding liabilities for wages Rs.
25,000 and for business expenses Rs. 25,000 Charge depreciation on:
Plant and Machinery @ 5%
Tools and Equipments @ 20%
Patents @ 10%
Furniture & Fixtures @ 10%
161
Fundamentals of
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Provide 2% on debtors for doubtful debts after writing off Rs. 16,000 as bed debts.
Accounting Write off preliminary expenses Rs. 5000. Transfer Rs. 50,000 to debenture
Redemption Fund. A dividend of 10% was declared. Corporate Income tax @ 5-% is
to be provided. Ignore dividend tax.
Hints
1. Provision for Bad debts (Debtors-Additional Bad debts) 2% on (Rs. 2,66,000-
16000) = 5000
2. Dividend @ 10 % on paid up capital:
Preference : 50000
& on Equity Capital @ 10% :
(Rs. 150000-1000) 149000
199000
3. Add amount of Outstanding expenses to their respective heads
4. Balance of profit and loss account after appropriation: Rs. 38,000
5. Outstanding debenture interest for six months: Rs. 10,000
(Ans: Net Profit Rs. 2,20,000 (after tax))
4.12 SUGGESTED READINGS

1. Report of the study group on the “Objectives of Financial Statements” AICPA,
1973
2. ‘Accounting for Financial Statements Presentation’ by Smith & Keith.
3. Financial Accounting “A Simplified Approach” by Dr. Naseem Ahmed–Atlantic
Publishers & Distributors 2002, Darya Ganj, New Delhi.
162
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UNIT 5 TECHNIQUES OF
FINANCIAL ANALYSIS
Structure
5.0 Objectives
5.1 Introduction
5.2 Techniques of Financial Analysis
5.3 Common Size Statements
5.4 Comparative Statements
5.5 Trend Analysis
5.6 Ratio Analysis

5.6.1 Liquidity Analysis Ratios
5.6.2 Profitability Analysis Ratios
5.6.3 Profitability in Relation to Capital Employed (Investment)
5.6.4 Activity Analysis Ratios
5.6.5 Long-Term Solvency Ratios
5.6.6 Coverage Ratios
5.7 Dupont Model of Financial Analysis
5.8 Uses of Ratio Analysis
5.9 Limitations of Ratio Analysis
5.10 Let Us Sum Up
5.11 Key Words
5.13 Further Readings
5.0 OBJECTIVES
The objectives of this unit are to:
! explain the need for analysing financial statements;
! know different methods of analysing the financial statements;
! understand how investors and others examine the performance of the

company through ratio analysis;
! explain a few advanced financial analysis models with the help of ratio
analysis; and
! caution the users of financial statements for some of the limitations of

financial statement analysis.
1
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Analysis
An Overview
of Financial
Statements 5.1 INTRODUCTION
In the previous units you would have been familiarised by many terms like what is a
firm, an entity, profit, loss, balance sheet, profit and loss account etc. You would
have seen that any business unit contains three major activities – namely; operating,
financing, and investing. All the three activities transactions are contained in three
major financial statements namely, the Balance Sheet, the Profit and Loss Account,
and the Cash Flow Statement. While the Balance Sheet reveals the statement of
wealth at any given point of time, Profit and Loss Account reveals the income
earned and expenses incurred during the financial year. Cash Flow Statement
reflects the cash inflow or outflow of the above three major activities mentioned.
Most small investors like you invest in shares of varied companies with minimum
knowledge on the company itself. However, in most cases it so happens that the
small investors who do not understand much about the financial reports take the help
of the mutual funds. You would be reading more about mutual funds in some other
course. To familiarise you with the term, mutual funds are trusts or entities
managed by investment trusts and registered under the Trust Act. They pool the
money of the small investor and do the investment in shares and debentures or
bonds on behalf of them. Most often than not, the mutual funds give better returns to
the individual and small investors in comparison to the returns they would have
earned had they invested by themselves. This is because the mutual funds are
specialists in investing and gain significant experience and expertise in investing as
against the naive investors. The main reason being investors often do not find the
time to analyse and evaluate the financial credence of the company. This requires a
basic understanding of the financial statements disclosed by the company. Hence, a
layman who wishes to invest in companies or prefer to have any sort of dealings
with the company has to perform an analysis of the financial statements. This holds
good for any stakeholder of the company, be it the employee, or the shareholder, or
the supplier, the Government, the Tax authorities, the bankers and lenders etc.
The lending institutions need to analyse the financial statements to make sure the
company would be able to repay the loans. Similarly, the shareholder would like to
analyse the financial statements to find out the prospects of the company and
whether it would pay sufficient returns for the money invested. The Government
would also be interested in analyzing the financial statements of the company to
check whether the company is performing well like the other companies in the same
industry or whether it is functioning as a sick company. Hence the details taken out
of the financial statement analysis differs based on who analyse the financial
statements. Given the various objective of financial statement analysis lets move on
to find out how exactly financial statement analysis is performed.
1) Who and why would any one perform financial statement analysis?
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2) Being an employee of your company, would you be interested in the analysis of
the financial statements of your company? If yes, why and what would be
analysing?
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2 ...........................................................................................................................
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Techniques of Financial
5.2 TECHNIQUES OF FINANCIAL ANALYSIS Analysis
Investors buy shares based on all kinds of information about a company. For
example, it may be that a particular firm has invented a new drug, or is a takeover
candidate, or has started exports to a boom region of the world or has discovered
new seams of gold. Any of these factors may be sufficient to give the shares a big
short-term boost.
But, despite all this, it is important to realise that profits are the key to a company’s
long-term performance. Without profits a company cannot invest in growth, cannot
repay loans and cannot pay dividends. Eventually, its very survival may be in doubt.
And so most analysis is directed towards understanding the company’s profits.
Financial analysis is done to try and predict the future performance of a company.
This of course has some limits. This is because your analysis will essentially be of
historical figures; yet you are trying to forecast the future. However, there are
experts who use technical analysis to predict the future stock prices using historical
data, where mostly the reality is not predicted. Also, you would have noticed that
analysis by some of the world’s top economists was unable to predict the recent
Asian economic implosion. So you should be aware of the fact that there are some
pretty important limitations to what you can expect from financial analysis.
Apart from this, its highly important to check whether the company is operating
efficiently. In the sense that it does not suffice by investing in the growth. It is
equally important that the company operates efficiently in comparison to its
competitors.
It is also necessary to be analyse the debt levels and how these may affect the
company’s performance. When interest rates are low it can make good strategic
sense for a company to borrow heavily in order to invest for growth. But once
interest rates start heading up again it may be that the company’s profits come
under threat, and it is important to gauge its ability to repay its loans.
So mostly financial analysis would be directed towards three major areas—

Profitability, Productivity and Risk (determined by leverage or debt equity mix).
In order to perform the analysis, we need to do some sort of comparison. Generally

the comparison done could be of the following types : 1) Comparing the
performance of the interested company with the competitors, 2) Comparison
with the benchmark (either the competitor or some other benchmark company,
3) Comparison with the industry averages, and 4) Comparing the performance of
the company over the years. Second and third type of comparison is called cross
section analysis and fourth type of comparison is called time series analysis.
Hence this sort of analysis requires some organized techniques such as:
1) Common size statement analysis
2) Ratio analysis
3) Comparative Statement Analysis (Cross Section analysis)
4) Trend Analysis (Time Series analysis)
5) Du Pont Analysis (Structured Ratio Analysis).
All the above are widely used techniques by experts across the world. You will
be learning the above techniques in detail in the coming sections. 3
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Analysis
An Overview
of Financial Check Your Progress B
Statements
1) List out the different techniques of performing financial analysis?
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2) List out the major components that you would concentrate while analysing the
financial statements.
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3) Suppose if you are interested in investing in any of the software company.
How would you decide which company to invest in the software industry.
List some of the factors that you would analyse and the procedure of analysis.
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5.3 COMMON SIZE STATEMENTS

When comparing your company with industry figures, make sure that the financial
data for each company reflect comparable price levels, and that it was developed
using comparable accounting methods, classification procedures, and valuation
bases.
Such comparisons should be limited to companies engaged in similar business
activities. When the financial policies of two companies differ, these differences
should be recognized in the evaluation of comparative reports. For example, one
company leases its properties while the other purchases such items; one company
finances its operations using long-term borrowing while the other relies primarily on
funds supplied by shareholders and by ploughing back the earnings. Financial
statements for two companies under these circumstances are not wholly
comparable.
Hence, you require some comparable basis to overcome this problem. Hence we use
common size statement. Common Size Statement represents a financial statement
that displays all items as a percentage of a common base figure. Such a statement
may be useful for noting changes in the relative size of the various elements.
In other words, it is a statement in which all items are expressed as a percentage of
a Base figure, which is used for analyzing trends and changing relationship among
Financial statement items. For example, all items in each year’s income statement
could be presented as a percentage of Net sales. This technique is quite useful
when you are comparing your business to other businesses or to averages from an
entire industry, because differences in size are neutralized by reducing all figures to
common-size ratios. Industry statistics are frequently published in common-size
4 form.
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When performing a ratio analysis (you would be learning in detail about this in the Techniques of Financial
next section) of financial statements, it is often helpful to adjust the figures to Analysis
common-size numbers. To do this, one has to change each line item on a statement
to a percentage of the total. For example, on a balance sheet, each figure is shown
as a percentage of total assets, and on an income statement, each item is expressed
as a percentage of sales.
Hypothetical Common-Size Income Statement
2003 2002 2001
Sales 100% 100% 100%
Cost of Sales 65% 68% 70%
Gross Profit 35% 32% 30%
Expenses 27% 27% 26%
Taxes 2% 1% 1%
Profit 6% 4% 3%
The following gives the common size financial statements of ABC Industries Ltd.
Common Size balance Sheet Ratios of ABC Industries Ltd.
Year 2003-04 2002-03 2001-02 2000-01 1999-2000
SOURCES OF FUNDS :
Share Capital 2.78 2.27 4.23 5.28 5.15
Reserves and Surplus 57.80 56.99 55.07 49.55 48.51
Total Shareholders Funds 60.59 59.26 59.30 54.83 53.65
Secured Loans 23.49 30.54 16.34 23.48 23.76
Unsecured Loans 15.92 10.20 24.37 21.69 22.59
Total Debt 39.41 40.74 40.70 45.17 46.35
Total Liabilities 100.00 100.00 100.00 100.00 100.00
APPLICATION OF FUNDS :
Gross Block 100.84 100.57 101.83 95.40 80.90
Less: Accum. Depreciation 36.82 32.45 47.55 36.13 29.03
Net Block 64.01 68.12 54.27 59.27 51.87
Capital Work in Progress 3.98 3.30 2.06 1.30 14.91
Investments 13.41 8.29 27.01 23.79 18.63
CURRENT ASSETS, LOANS AND ADVANCES :
Inventories 14.98 10.71 9.24 7.15 6.11
Sundry Debtors 5.94 5.86 4.55 3.30 1.98
Cash and Bank Balance 0.29 3.79 0.40 4.24 21.24
Loans and Advances 25.07 22.00 22.44 16.10 7.38
Less: Current Liab. and Prov.
Current Liabilities 24.83 19.60 16.51 12.61 19.77
Provisions 2.94 2.61 3.47 2.55 2.36
Net Current Assets 18.50 20.16 16.66 15.64 14.59
Miscellaneous Expenses not w/o 0.09 0.14 0.00 0.00 0.00
Total Assets 100.00 100.00 100.00 100.00 100.00
Note : All items under the ‘Use of Funds’ side have been presented as a percentage
of Total Assets and all items under the ‘Sources of Funds’ are presented as
a percentage of Total liabilities.
5
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Analysis
An Overview
of Financial Common Size Ratios of Income Statement of ABC Industries Ltd.
Statements
Year 2003-04 2002-03 2001-02 2000-01 1999-2000
Income :
Sales Turnover 100.00 100.00 100.00 100.00 100.00
Other Income 2.37 2.64 4.27 6.16 5.92
Stock Adjustments 4.86 ---- 2.00 1.38 2.17 ---- 1.43
Total Income 107.23 100.64 105.65 108.33 104.49
Expenditure :
Raw Materials 68.42 62.08 53.71 44.98 32.01

Excise Duty 8.77 7.23 11.21 15.47 18.16
Power and Fuel Cost 1.44 1.63 4.29 2.77 2.54
Other Manufacturing Expenses 2.97 3.22 4.54 6.85 9.73
Employee Cost 1.23 1.18 1.80 2.26 3.32
Selling and Administration
Expenses 4.99 4.19 5.10 4.72 5.90
Miscellaneous Expenses 0.72 1.15 0.86 1.34 1.70
Less: Preoperative Expenditure
Capitalised 0.01 0.00 0.01 0.02 0.11
Profit before Interest,
Depreciation and Tax 18.70 19.98 24.16 29.95 31.23
Interest and Financial Charges 3.10 4.02 5.28 6.36 6.86
Profit before Depreciation
and Tax 15.59 15.96 18.87 23.59 24.37
Depreciation 5.66 6.20 6.80 8.07 8.05
Profit Before Tax 9.93 9.75 12.08 15.52 16.32
Tax 1.74 2.61 0.59 0.36 0.28
Profit After Tax 8.19 7.14 11.49 15.17 16.04
Adjustment below Net Profit 0.00 0.01 0.00 0.00 0.00
P & L Balance brought forward 5.44 4.76 7.56 7.15 9.86
Appropriations 6.96 5.91 9.66 11.34 15.24
P & L Bal. carried down 6.67 6.00 9.38 10.98 10.66
Equity Dividend 1.39 1.46 1.95 2.43 3.30
Preference Dividend 0.04 0.00 0.02 0.22 0.22
Corporate Dividend Tax 0.18 0.00 0.20 0.29 0.38
Equity Dividend (%) 0.10 0.10 0.18 0.25 0.35
Earning Per Share (Rs.) 0.06 0.07 0.11 0.14 0.17
Book Value 0.40 0.52 0.49 0.65 0.94
Extraordinary Items 0.01 0.70 0.05 0.32 0.06
6 Note : All figures are expressed as a percentage of sales.
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Vertical and Horizontal Analysis Techniques of Financial
Analysis
Vertical analysis is the computation of percentages, ratios, turnovers, and other
measures of financial position and operating results for one fiscal period. When
these figures are compared with those from other periods, it becomes horizontal
analysis. For instance if you would have done the above conversion into
percentages for ABC industries for only year 2003 then it would have been Vertical
analysis. But what has been presented to you is the Horizontal Analysis of the
common size financial statements.
Activity 3
1) Visit any company’s website and download the annual report. Prepare
common size statement for two year period and write down your
understanding.
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2) What do you think is the purpose for the Common Size Financial Statement?
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3) Take any software firm and a manufacturing firm and perform common size
financial statement. Examine the difference and explain why they are
different.
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5.4 COMPARATIVE STATEMENTS

When you first look at a company’s current financial figures it can be quite
overwhelming and, more often than not, a little confusing. But, if you were to
compare that data to that of the business’s historical performance, it becomes
significantly more meaningful. Hence it would make more sense to compare the
company’s current financial numbers with monthly, quarterly, or annual data from
previous fiscal years. In this process you should notice some trends that will help
you map out the future of your business.
This is done the same way common size financial statement is done but a little
differently. A hypothetical example would help you understand the importance of
the same. The following example gives the comparative financial statements of a
hypothetical XYZ company. Despite calculating the percentage for each of the
year that is the vertical analysis, the horizontal analysis has also been performed in
the sense that the conversion is done over the years. This facilitates in comparing
the performance over the year but also with the industry average. The industry
average has also been given for the XYZ Company. 7
8
XYZ Company An
Comparative Income Statement
Analysis
for Fiscal Years Ended December ......

Statements
Overview
( Rs. in Thousands)
Audited Audited Audited Audited Audited Industry

of Financial
1999 2000 2001 2002 2003 Average

Rs. % Rs. % Rs. % Rs. % Rs. % %
Sales 33,013.0 100.0 33,395.0 100.0 37,021.0 100.0 40,733.0 100.0 43,412.0 100.0 100.0
Cost of Sales 19,305.0 58.5 19,891.0 59.6 21,836.0 59.0 23,779.0 58.4 27,142.0 62.5 65.7
Gross Profit 13,708.0 41.5 13,504.0 40.4 15,185.0 41.0 16,954.0 41.6 16,270.0 37.5 34.3
Operating Expenses 12,875.0 39.0 12,516.0 37.5 13,728.0 37.1 15,657.0 38.4 15,862.0 36.5
Operating Profit 833.0 2.5 2.9 1,457.0 3.9 1,297.0 3.2 408.0 1.0
Interest Expense 726.0 2.2 647.0 1.9 522.0 1.4 526.0 1.3 566.0 1.3
Other Income 83.0 0.3 373.0 1.1 33.0 0.1 30.0 0.1 189.0 0.4
Pre-Tax Profit 190.0 0.6 714.0 2.1 968.0 2.6 801.0 2.0 31.0 0.1
Taxes 151.0 0.5 226.0 0.7 27.0 0.1 21.0 0.1 2.0 0.0
Net Profit 39.0 0.1 1.4 941.0 2.5 780.0 1.9 29.0 0.1 1.8
Depreciation 769.0 2.3 2.1 612.0 1.7 540.0 1.3 520.0 1.2
Sales to Assets 2.4 3.0 3.2 3.3 3.2

% Return on Assets
(Before Tax) 1.4 6.5 8.3 6.5 0.2 3.4
% Return on Equity
(Before Tax) 12.1 38.5 39.8 24.7 1.2 13.7
Pre-Tax Interest Cover 1.3 2.1 2.9 2.5 1.1
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XYZ Company
Comparative Balance Sheet
for Fiscal Years Ended December.......
( Rs. in Thousands)
Audited Audited Audited Audited Audited Industry
1999 2000 2001 2002 2003 Average
Assets Rs. % Rs. % Rs. % Rs. % Rs. % %
Cash 733.0 6.4 600.0 6.6 494.0 5.1 180.0 1.7 232.0 2.0 6.8
Other Current 727.0 6.3 499.0 5.5 712.0 7.3 724.0 7.0 888.0 7.8 2.5
Accounts Receivable 2,789.0 24.2 2,186.0 24.1 2,137.0 22.0 2,155.0 20.9 2,220.0 19.4 17.2
Inventories 4,949.0 42.9 4,027.0 44.4 4,778.0 49.1 5,795.0 56.2 5,909.0 51.7 40.3
Total Current Assets 9,198.0 79.8 7,312.0 80.6 8,121.0 83.5 8,854.0 85.8 9,249.0 80.9 66.8
Net Fixed Assets 1,875.0 16.3 1,401.0 15.4 1,319.0 13.6 1,280.0 12.4 2,070.0 18.1 25.9
Other Assets 0.0 0.0 0.0 0.0 97.0 1.0 74.0 0.7 0.0 0.0 7.0
Notes Receivable 90.0 0.8 82.0 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.9
Intangibles 363.0 3.1 278.0 3.1 193.0 2.0 107.0 1.0 116.0 1.0
Total Assets 11,526.0 100.0 9,073.0 100.1 9,730.0 100.1 10,315.0 99.8 11,435.0 99.9 100.0
Total Liabilities and Equity
Other Current Liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Notes Payable 2,500.0 21.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 7.4
Current Maturities 999.0 8.7 294.0 3.2 304.0 3.1 265.0 2.6 99.0 0.9 2.0
Accounts Payable 1,313.0 11.4 992.0 10.9 1,182.0 12.1 1,751.0 17.0 922.0 8.1 15.8
Accrued Expenses 1,300.0 11.3 1,179.0 13.0 1,221.0 12.5 1,158.0 11.2 1,646.0 14.4
Taxes Payable 410.0 3.6 594.0 6.5 377.0 3.9 507.0 4.9 0.0 0.0
Notes Payable-Officer 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total Current Liabilities 6,522.0 56.7 3,059.0 33.6 3,084.0 31.6 3,681.0 35.7 2,667.0 23.4 35.5
Long-Term Debt 3,174.0 27.5 3,902.0 43.0 4,082.0 42.0 3,392.0 32.9 6,261.0 54.8 20.2
Subord. Long-Term Debt 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Deferred Taxes 257.0 2.2 257.0 2.8 129.0 1.3 0.0 0.0 0.0 0.0
Total Liabilities 9,953.0 86.4 7,218.0 79.4 7,295.0 74.9 7,073.0 68.6 8,928.0 78.2 55.7
Equity 1,573.0 13.6 1,855.0 20.4 2,435.0 25.0 3,242.0 31.4 2,507.0 21.9 39.5
Total Liab. & Equity 11,526.0 100.0 9,073.0 99.8 9,730.0 99.9 10,315.0 99.9 11,435.0 100.0 100.0
Working Capital 2,676.0 23.2 4,253.0 46.9 5,037.0 51.8 5,173.0 50.2 6,582.0 57.6
Retained Earnings 39.0 0.3 488.0 39.0 941.0 9.7 780.0 7.6 (764.0) (6.7)
Current Ratio 1.4 2.4 2.6 2.4 3.5 2.0
Quick Ratio 0.7 1.1 1.1 0.8 1.3 0.7
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Debt to Worth 6.3 3.9 3.0 2.2 3.6 1.6
9
Analysis
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Analysis
An Overview
of Financial Activity 1
Statements
1) Carefully read the comparative income statement of XYZ and write down
how the company has performed over the 5 year period and also its
performance in comparison to the industry.
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2) Visit any company’s website and download their income statement for 5 year
period. Perform horizontal analysis. Collect the industry average for the
company and list down the performance of the company with respect to the
industry average.
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3) List down the usefulness of the comparative financial statements.
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5.5 TREND ANALYSIS

The earlier sections had exposed you to analyzing statements using horizontal and
vertical form as well as using the common size financial statements in the
comparative form. The horizontal analysis performed there, comparing the
performance of the XYZ company over the five year period indicates the time
series analysis or rather trend analysis. This is called as trend analysis because we
are trying to see if there is a pattern in the performance of the company over the
year which could help us forecast the performance of the company for the future.
Why this is useful? Its utmost useful because we are not only interested in the past
performance whereas our utmost interest lies in finding whether the company will
continue to perform the same way or in a better way in the coming years. Similar
analysis is done for investing in stocks. There are experts in Technical Analysis
who perform similar analysis of analyzing the trend of the prince movement of the
stock and predicting the future stock price. Similar analysis is done here as well.
But how and where can we use the trend analysis of the financial statements?
Trend analysis is a key to recognizing potential problems of a borrower. This is
important during the initial review of a loan application, as well as part of on-going
monitoring of a loan that has already been disbursed. Sound companies and weak
ones may have displayed some of the same trends, however, it is a pattern of many
negative trends that indicates a potential problem that needs to evaluated further.
Trend analysis involves spreading the financial statements and comparing similar
operating periods (i.e. year to year). This comparative analysis allows the reviewer
to identify both positive and negative trends. Once a pattern of negative trends are
identified further action should be taken. For a potential loan, additional information
or a detailed explanation should be obtained. The trends should be weighed
10 carefully in making or rejecting the loan. For loans that have already been made, a
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pattern of negative trends requires fast action. Current financial information may Techniques of Financial
indicate a problem that will enable the reviewer time to react. The following is a Analysis
general discussion of some trends to look for in the review of financial statements:
1) Decreasing cash position: This could be a lower level of cash or cash as a
percentage of total assets. Look for changes in deposit activity, draws on
uncollected funds, declining average monthly balances, etc.
2) Slowdown in receivables collection: Could be an indication of distractions
in the business, neglect, changes in collection policies, etc.
3) Significant increases in accounts receivable: This could be in the dollar
amount, percentage of assets or in accounts receivable to a single customer
(need aging of accounts receivable to determine).
4) Rising inventories: Either in the dollar amount or as a percentage of total
assets. This may be an indication of a need to liquidate excessive or obsolete
inventory, lack of attention to purchasing, slowing of sales, etc.
5) Slowdown in inventory turnover: This could indicate a slowdown in sales,
overbuying, production problems, and/or problems in the purchasing policies
of the business.
6) Changes in sales terms/sales policies: Look for changes from cash sales
to instalment sales, leasing instead of selling, and other similar changes.
7) A decline in liquid assets: This could be a dollar decline or a decline in
current assets (cash, accounts receivable, etc.) to total assets. As current
assets decline or become less liquid, a business may experience difficulties
meeting current liabilities.
8) Changes in the concentration of fixed assets: Both declining and rising
concentrations of fixed assets should be reviewed. A decline could indicate
that funds needed to purchase fixed assets are being used for other purposes.
This can be a significant problem if a business is not replacing, renovating or
rehabilitating fixed assets as needed. A rise in fixed assets could be a
problem when done at the expense of other assets/operational need. Levels
of fixed assets should be compared to both historical financial statements and
industry averages.
9) Revaluation of assets: A revaluation of assets on the financial statements
needs to be justified. If not justified, it impacts the financial picture of the
company.
10) Changes in liens of assets: Evidence of new subordinated debt should be
a concern. It could indicate a deteriorating financial situation.
11) A high or increasing concentration of assets in intangibles: The value
of intangible assets is difficult to establish. Typically, intangible assets are
eliminated from the financial review.
12) Increases in current debt: A rise that is tied to a concentration in trade
debt or no corresponding increase in assets should be viewed as a risk factor.
Increases in long-term debt: Increases in long term debt must be reviewed
carefully. If repayment is dependent on higher than historical or reasonable
projected sales, a concern should be raised.
13) An increase or major gap between gross and net sales: result or lower
quality, production problems, out-of-date product lines and other related
production and/or market factors.
11
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Analysis
An Overview
of Financial 14) An increase in debt to capital: This is of particular concern when the
Statements current ratio is low. Undercapitalized firms will typically exhibit poor working
capital conditions.
15) Increase in cost of goods sold: An increase may indicated problems in the
operation or other expense areas.
16) Decline in profits compared to sales: The decline may be a result of poor
cost controls, management problems, failure to pass on increases in costs, etc.
17) Increases in bad debt: An increase as a percentage of sales usually
indicates poor collection procedures, management problems and/or
deterioration of the quality of the customer.
18) Assets rising faster than sales: This is an indication that increased assets
are not creating increases in sales.
19) Assets rising faster than profits: Assets are investments designed to create
profits. Concerns should be raised when increased assets are not resulting in
higher profits.
20) Significant variations in other areas of the financial statements: Marked
changes should always be examined!
21) An increase or major gap between gross and net sales: Result or lower
quality, production problems, out-of-date product lines and other related
production and/or market factors.
22) An increase in debt to capital: This is of particular concern when the
current ratio is low. Undercapitalized firms will typically exhibit poor working
capital conditions.
23) Increase in cost of goods sold: An increase may indicate problems in the
operation or other expense areas.
24) Decline in profits compared to sales: The decline may be a result of poor
cost controls, management problems, failure to pass on increase in costs, etc.
25) Increases in bad debt: An increase as a percentage of sales usually
indicates poor collection procedures, management problems and/or
deterioration of the quality of the customer.
26) Assets rising faster than sales: This is an indication that increased assets
are not creating increases in sales.
27) Assets rising faster than profits: Assets are investments designed to create
profits. Concerns should be raised when increased assets are not resulting in
higher profits.
28) Significant variations in other areas of the financial statements: Marked
changes should always be examined!
Apart from the above analysis one could adopt a simpler form of performing trend
analysis. This is done by performing what is called as the Index Number Trend
analysis.
Index-Number Trend Series

If you are trying to analyze financial data that span a long period of time,
mechanically trying to compare financial statements can turn into quite a
cumbersome task. If you find yourself in this boat, try to create an index-number
12 trend series to alleviate some of your confusion.
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First, choose a base year to which all other financial data will be compared. Techniques of Financial
Usually, the base year is the earliest year in the group being analyzed, or it can be Analysis
another year you consider particularly appropriate.
Next, express all base year amounts as 100 percent. Then state corresponding
figures from following years as a percentage of the base year amounts. Keep in
mind that index-numbers can be computed only when amounts are positive.
Hypothetical Example
2001 2002 2003
Sales 100,000 150,000 175,000
Index-Number Trend 100% 150% 175%
The index-number trend series technique is a type of horizontal analysis that can
provide you with a long range view of your firm’s financial position, earnings, and
cash flow. It is important to remember, however, that long-range trend series are
particularly sensitive to changing price levels. For instance, the price level could
increase to greater extent for some years. A horizontal analysis that ignored such a
significant change might suggest that your sales or net income increased
dramatically during the period when, in fact, little or no real growth occurred.
Data expressed in terms of a base year can be very useful when comparing
your company’s figures to those from government agencies and sources within
your industry or the business world in general, because they will often use an
index-number trend series as well. When making comparisons, be sure the
samples you use are in the same base period. If they aren’t, simply change one
so they match.
5.6 RATIO ANALYSIS

We have seen that most of us are interested in the bottom line of the company. Or
in other words analysing the profitability of a company. While the profit figure is
important, it however, does not give the complete picture of the performance of the
company. So one should not use the bottom line figure alone as a barometer for
some sort of an indicator. That would have severe repercussions. Take for instance
two companies A and B of the same industry. A has earned a profit of Rs. 100
Crs. And B has earned Rs. 1000 Crs. for the financial year 2003. Now one would
on the face of it say that Company B is better than company A. However, if it
should be wise enough to compare the profit earned with the level of investment
made to earn the profit. For instance, company A had spent about 500 Crs to
earn Rs 100 Cr. Profit and Company B had spent about Rs. 1000 Cr. to earn
Rs. 1000 Cr. profit. So its clear that profitability of company A is higher than
company B. In that the profit earned to the investment ratio is higher for company
A (100/500 = 20%) compared to company B (1000/10000 = 10%). Hence one
should look at profitability and not just profit figures. So the key point is that one
has to look into appropriate ratios not just absolute figures for comparison. Hence
ratio analysis would help understand the financial results better.
This often means working out a range of ratios. By doing so, a large amount of
complex information can be condensed into easily digestible and standardized form,
and numerous comparisons between different years for a single company, between
companies of varying sizes or between industries can be made. (Note that a ratio
in isolation generally has little meaning).
And it is important to note that ratios are just signals, or clues, rather than the
answers to complex questions about a company. Some might direct you to a 13
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Analysis
An Overview
of Financial specific problem within the company, but many tell you no more than that something
Statements needs further investigation.
A ratio can be expressed in various ways, including as a percentage, a fraction, a

“times” figure, a number of days, a rate or as a simple number.
The various ratios that are generally used have been summarized below.
5.6.1 Liquidity Analysis Ratios
A firm needs liquid assets to meet day to day payments. Therefore, liquidity ratios
highlight the ability of the firms to convert its assets into cash. If the ratios are low
then it means that money is tied up in stocks and debtors. Thus, money is not
available to make payments. This may cause considerable problems for firms in the
short run. It is often viewed that a value less than 1.5 implies that the company may
run out of money as its cash is tied up in unproductive assets.
Liquidity ratio helps in assessing the firm’s ability to meet its current obligations.
The following ratios come under this category:
i) Current ratio;
ii) Quick ratio; and
iii) Net Working Capital Ratio.
i) Current Ratio
The current ratio shows the relationship between the current assets and the current
liabilities. Current assets include cash in hand, cash at bank and all other assets
which can be converted into cash in the ordinary course of business, for instance,
bills receivable, sundry debtors (good debts only), short-term investments, stock etc.
Current liabilities consists of all the obligations of payments that have to be met
within a year. They comprise sundry creditors, bills payable, income received in
advance, outstanding expenses, bank overdraft, short-term borrowings, provision for
taxation, dividends payable, long term liabilities to be discharged within a year. The
following formula is used to compute this ratio:
Current Assets
Current Ratio =
Current Liabilities
ii) Quick Ratio

The acid test ratio is similar to the current ratio as it highlights the liquidity of the
company. A ratio of 1:1 (i.e., a value of approximately 1) is satisfactory. However, if
the value is significantly less than 1 it implies that the company has a large amount
of its cash tied up in unproductive assets, so the company may struggle to raise
money in the short term.
Quick Assets
Quick Ratio =
Current Liabilities
Quick Assets = Current Assets---Inventories
iii) Net Working Capital Ratio

The working capital ratio can give an indication of the ability of your business to pay
its bills.
14
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Generally a working capital ratio of 2:1 is regarded as desirable. However, the Techniques of Financial
circumstances of every business vary and you should consider how your business Analysis
operates and set an appropriate benchmark ratio. A stronger ratio indicates a better
ability to meet ongoing and unexpected bills therefore taking the pressure off your
cash flow. Being in a liquid position can also have advantages such as being able to
negotiate cash discounts with your suppliers. A weaker ratio may indicate that your
business is having greater difficulties meeting its short-term commitments and that
additional working capital support is required. Having to pay bills before payments
are received may be the issue in which case an overdraft could assist. Alternatively
building up a reserve of cash investments may create a sound working capital
buffer. Ratios should be considered over a period of time (say three years), in order
to identify trends in the performance of the business.
The calculation used to obtain the ratio is:
Net Working Capital
Net Working Capital Ratio =
Total Assets
Net Working Capital = Current Assets -- Current Liabilities
Illustration 1
The Balance Sheet of X Company Ltd. as on March 31, 2005 is given below. You
are required to calculate the following ratios:
i) Current ratio,
ii) Quick ratio,
iii) Net Working capital ratio.
Balance Sheet of X Company Ltd., as on 31.3.2005
Rs. Rs.
Share Capital 20,000 Buildings 20,000

Reserves and Surplus 16,000 Plant and Mechinery 10,000
Debentures 10,000 Stock 8,000
Sundry Creditors 11,000 Sundry Debtors 7,000
Bank Overdraft 1,000 Prepaid expenses 2,000
Bills Payable 2,000 Securities 12,000
Provision for Taxation 1,000 Bank 2,000
Outstanding Expenses 1,000 Cash 1,000
62,000 62,000
Solution
Current Assets
i) Current ratio =
Current Liabilities
Current Assets = Cash Rs. 1000 + Bank Rs. 2000 + Securities Rs. 12000
+ Prepaid expenses Rs. 2000 + Sundry Debtors Rs. 7000
+ Stock Rs. 8000
= Rs. 32,000. 15
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Analysis
An Overview
of Financial Current Liabilities = Outstanding expenses Rs. 1000 + Provision for taxation
Statements Rs. 1000 + Bills payable Rs. 2000 + Bank overdraft
Rs. 1000 + Sundry creditors Rs. 11,000
= Rs. 16,000.
Current Assets 32,000
∴ Current ratio = = = 2 :1
Current Liabilities 16,000
Quick Assets
ii) Quick ratio =
Current Liabilities
Quick Assets = Cash Rs. 1000 + Bank Rs. 2000 + Securities Rs. 12,000
+ Sundry Debtors Rs. 7,000
= Rs. 22,000.
Current Liabilities = Sundry creditors Rs. 11,000 + Bills payable Rs. 2000 +
Outstanding expenses Rs. 1000 + Provision for Taxation
Rs. 1000 + Bank overdraft Rs. 1000
= Rs. 16,000
Quick Assets
Quick ratio =
Current Liabilities
22,000
=
16,000
= 1.37 : 1
Net Working Capital
iii) Net Working capital ratio =
Total Assets
Net Working Capital = Current Assets -- Current Liabilities
= Rs. 32,000 -- Rs. 16,000
= Rs. 16,000
16,000
Net Working capital ratio =
32,000
= 1 : 2.
5.6.2 Profitability Analysis Ratios
Profitability ratios are the most significant - and telling - of financial ratios. Similar
to income ratios, profitability ratios provide a definitive evaluation of the overall
effectiveness of management based on the returns generated on sales and
investment.
Profitability in relation to Sales
Profits earned in relation to sales give the indication that the firm is able to meet all
operating expenses and also produce a surplus. In order to judge the efficiency of
management with respect to production and sales, profitability ratios are calculated
in relation to sales.
There are :
i) Gross Profit Margin
ii) Net Profit Margin
iii) Operating Profit Margin
16 iv) Operating Ratio.
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i) Gross Profit Margin Techniques of Financial
Analysis
This is also known as gross profit ratio or gross profit to sales ratio. This ratio may
indicate to what extent the selling prices of goods per unit may be reduced without
incurring losses on operations. This ratio is useful particularly in the case of
wholesale and ratail trading firms. It establishes the relationship between gross
profit and net sales. Its purpose is to show the amount of gross profit generated for
each rupees of sales. Gross profit margin is computed as follows:
Gross profit
Gross profit = × 100
Net Sales
The amount of gross profit is the difference between net sales income and the cost
of goods sold which includes direct expenses. A high margin enables all operating
expenses to be covered and provides a reasonable return to the shareholders. If
gross profit rate is continuously lower than the average margin, something is wrong.
To keep the ratio high, management has to minimise cost of goods sold and improve
sales performance. Higher the ratio, the greater would be the margin to cover
operating expenses and vice versa.
Note : This percentage rate can --- and will --- vary greatly from business to
business, even those within the same industry. Sales location, size of operations and
intensity of competition etc., are the factors that can affect the gross profit rate.
Illustration 2
From the following particulars, calculate gross profit margin.
Trading Acount of ABC Company for the year ended March 31, 2005
Rs. Rs.
To Opening stock 6,000 By Net sales 96,000
To Net purchases 63,000 By Closing stock 6,000
To Direct expenses 9,000
To Gross profit 24,000
1,02,000 1,02,000
Solution
Gross Profit
Gross Profit Margin = × 100
Net Sales
24,000
= × 100
96,000
= 25%
ii) Net Profit Margin
This ratio is called net profit to sales ratio and explains the relationship between net
profit after taxes and net sales. The purpose of this ratio is to reveal the amount of
sales income left for shareholders after meeting all costs and expenses of the
business. It measures the overall profitability of the firm. The higher the ratio, the
greater would be the return to the shareholders and vice versa. A net profit margin
of 10% is considered normal. This ratio is very useful to control costs and to
increase the sales. It is calculated as follows:
Net Profit after taxes
Net Profit Margin = × 100
Net Sales 17
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Analysis
An Overview
of Financial Illustration 3
Statements
The Gross Profit Margin of a company is Rs. 12,00,000 and the operating expenses
are Rs. 4,50,000. The taxes to be paid are Rs. 4,80,000. The sales for the year are
Rs. 27,00,000. Calculate Net Profit Margin.
Solution
Net Profit after taxes
Net Sales
Net Profit after taxes = Gross Profit --- Expenses --- Taxes
= Rs. 12,00,000 --- Rs. 4,50,000 --- Rs. 4,80,000
= Rs. 2,70,000
2,70,000
27,00,000
= 0.10 or 10%
iii) Operating Profit Margin
This ratio is a modified version of Net Profit Margin. It studies the relationship
between operating profit (also known as PBIT — Before Interest and Taxes)
and sales. The purpose of computing this ratio is to find out the amount of
operating profit for each rupee of sale. While calculating operating profit, non-
operating expenses such as interest, (loss on sale of assets etc.) and non-operating
income (such as profit on sale of assets, income on investment etc.) have to be
ignored. The formula for this ratio is as follows:
Operating Profit
Operating Profit Margin = × 100
Sales
Illustration 4
From the following particulars of Nanda and Co., calculate Operating Profit
Margin.
Profit and Loss Account of Nanda and Co. Ltd.

as on March 31, 2005
Rs. Rs.
To Opening Stock 3,000 By Sales 36,000
To Purchases 22,000 By Closing Stock 10,000
To Manufacturing Expenses 9,000
46,000 46,000
To Operating Expenses 4,000 By Gross Profit b/d 12,000
To Administrative Expenses 2,000
To Interest on Debentures 1,000
To Net Profit 5,000
12,000 12,000
18
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Solution Techniques of Financial
Analysis
Operating Profits
Operating Profit Margin = × 100
Sales
Operating Profits = Net Profit + Interest on Debenture (non-operating
expenses)
= Rs. 5000 + Rs. 1000 = Rs. 6,000
Rs. 6,000
Operating Profit Maring = × 100 = 0.167 or 16.7 %
Rs. 36,000
A high ratio is an indicator of the operational efficiency and a low ratio stands for
operational inefficiency of the firm.
iv) Operating Ratio
This ratio established the relationship between total costs incurred and sales. It may
be calculated as follows :
Cost of goods sold + Operating expenses
Operating Ratio = × 100
Sales
Illustration 5
From the following particulars, calculate the Operating Ratio :
Rs.
Sales 5,00,000
Opening Stock 1,00,000
Purchases 2,00,000
Manufacturing Expenses 25,000
Selling Expenses 5,000
Office Expenses 20,000
Solution
Cost of goods sold + Operating expenses
Operating Ratio = × 100
Sales
Cost of Goods sold = Opening Stock + Purchases +
Manufacturing expenses ---- Closing Stock.
= Rs. 1,00,000 + Rs. 2,00,000 + Rs. 25,000 -- Rs. 30,000
= Rs. 2,95,000.
Operating Expenses = Selling Expenses + Offices Expenses

= Rs. 5000 + Rs. 20,000 = Rs. 25,000
Rs. 2,95,000 + Rs. 25,000
Operating Ratio = = 0.64 or 64 %
Rs. 5,00,000
High operating ratio is undesirable as it leaves a small portion of income to meet
other non-operating expenses like interest on loans. A low ratio is better and
reflects the efficiency of management. Lower the ratio, higher would be the 19
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Analysis
An Overview
of Financial profitability. If operating ratio is 64%, it indicates that 64% of sales income has gone
Statements to meet cost of goods sold and operating expenses and 36% is left for other
expenses and dividend.
The operating ratio shows the overall operating efficiency of the business. In order
to know how individual items of operating expenses are related to sales, individual
expenses ratios can also be calculated. These are calculated by taking operational
expenses like cost of goods sold, administrative expenses, selling and distribution,
individually in relation to sales (net).
5.6.3 Profitability in Relation to Capital Employed (Investment)

Profitability ratio, as stated earlier, can also be computed by relating profits to
capital or investment. This ratio is popularly known as Rate of Return on
Investment (ROI). The term investment may be used in the sense of capital
employed or owners’ equity. Two ratios are generally calculated:
i) Return on Capital Employed (ROCE), and
ii) Return on Shareholders’ Equity.
i) Return on Capital Employed (ROCE)
The ratio establishes the relationship between total capital and net operating profit
of the business. The purpose of this ratio is to find out whether capital employed is
effectively utilised or not. The formula for calculating Return on Capital Employed is:
Net Operating Profit
Return on Capital Employed = × 100
Capital Employed
The term ‘Net Operating Profit’ means ‘Profit before Interest and Tax’. The term
‘Interest’ means ‘Interest on Long-term borrowings’. Interest on short-term
borrowings will be deducted for computing operating profit. Similarly, non-trading
incomes such as income from investments made outside the business etc. or non-
trading losses or expenses will also be excluded while calculating profit. The term
‘capital employed’ has been given different meanings by different accountants.
Three widely accepted terms are as follows:
1) Gross Capital Employed = Fixed Assets + Investments + Current Assets
2) Net Capital Employed = Fixed Assets + Investments + Net Working

Capital (Current Assets --- Current
Liabilities).
3) Sum total of long term funds = Share capital + Reserves and Surpluses +
Long Term Loans --- Fictitious Assets ---
Non business Assets.
In managerial decisions the term capital employed is generally used in the meaning
given in the third point above.
Return on capital employed ratio is very significant as it reflects the overall

efficiency of the firm. The higher the ratio, the greater is the return on long-term
funds invested in the firm. It is also an indication of the effective utilisation of
capital employed. However, it is very difficult to set a standard ratio of return on
capital employed as a number of factors such as business risk, the nature of the
industry, economic conditions etc., may influence such rate. This ratio could be
supplemented with a number of ratios depending upon the purpose for which it is
20 computed.
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Illustration 5 Techniques of Financial
Analysis
From the following financial statements, calculate return on capital employed.
Profit and Loss Account for the year ended 31.3.2005
Rs. Rs.
To Cost of goods sold 3,00,000 By Sales 5,00,000
To Interest on Debentures 10,000 By Income from
Investment 10,000
To Provision for Taxation 1,00,000
5,10,000 5,10,000
Balance Sheet as on 31.3.2005

Share Capital 3,00,000 Fixed Assets 4,50,000
Reserves 1,00,000 Investments in Govt. Bonds 1,00,000
10% Debentures 1,00,000 Current Assets 1,50,000
Profit and Loss a/c 1,00,000
7,00,000 7,00,000
Solution
Net Operating Profit
Capital Employed
Net Operating Profit = Net Profit before Tax and Interest --- Income from
Investment
= Rs. 1,00,000 + 100,000 + 10,000 ---10,000
= Rs. 2,00,000
Capital Employed = Fixed Assets + Current Assets --- Current Liability
= Rs. 4,50,000 + Rs. 1,50,000 --- Rs. 1,00,000
= Rs. 5,00,000
OR
= Share Capital + Reserves + Debentures + Profit and
Loss account --- Investments in Govt. Bonds
= Rs. 3,00,000 + Rs. 1,00,000 + Rs.1,00,000 +
Rs. 1,00,000 ---Rs. 1,00,000
= Rs. 5,00,000
2,00,000
500,000
= 40 %
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Analysis
An Overview
of Financial Return on Investment (ROI)
Statements
When you are asked to find out the profitability of the Company from the share
holders’ point of view, Return on Investment should be Computed as follows:
Net Profit after Interest and Tax
Return on Investment = × 100
Shareholders’ Funds
The term ‘Net Profit’ means ‘Net Income after Interest and Tax’. This is because
the shareholders are interested in Total Income after Tax including Net non-
operating income.
From illustration 5, Net profit after interest and tax will be Rs. 1,00,000 and Return
1,00,000
on Investment will be 20% i.e.( × 100 )
5,00,000
ii) Return on Shareholders’ Equity
This ratio shows the relationship between net profit after taxes and Shareholders’
equity. It reveals the rate of return on owners’/shareholders’ funds. The term
shareholders’ equity is also known as ‘net worth’ and includes Equity Capital,
Share Premium and Reserves and Surplus. The formula of this ratio is as follows:
Net Profit after Tax and Preference Dividend

Return on Shareholder’s Equity =
Shareholders’ Equity
Illustration 6
From the following Balance Sheet find Return on Shareholders’ Equity.
Balance Sheet of ABC Company Ltd. as on 31.3.2005
Equity Share Capital 1,00,000 Fixed Assets 2,25,000
10% Preference Capital 50,000 Current Assets 1,25,000
Reserves 50,000
10% Debentures 50,000
Profit and Loss a/c 50,000
Provision for Taxation 50,000
3,50,000 3,50,000
Solution
Net Profit After Tax and Prefence Dividend
Return on Shareholders’ equity = × 100
Shareholders’ Equity
Net profit after, tax and prefence Dividend
10
= Rs. 50,000 ---- Preference dividend 5000 (Pref. capital 50,000 × )
100
= Rs. 45,000
Shareholders’ equity = Equity capital + Reserves + Profit and Loss account
= Rs. 1,00,000 + 50,000 + 45,000
= Rs. 1,95,000
45,000
Return on Shareholders’ Equity = × 100
1,95,000
22 = 23 %
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The higher the ratio, the greater is the efficiency of the firm in generating profits on Techniques of Financial
shareholders’ equity and vice versa. The ratio is very important for the investors to Analysis
judge whether their investment in the firm generates a reasonable return or not.
This ratio is important to the management as it proves their efficiency in employing
the funds profitably.
Earnings Per Share
Earnings per Share (EPS) is an important ratio from equity shareholders’ point of
view as this ratio affects the market price of share and the amount of dividend to
be given to the equity shareholders. The earnings per share is calculated as follows:
Net profit after Tax ---- Preference Dividend
Earnings Per Share (EPS) =
Number of Equity Shares
Illustration 7
From the following information calculate Earnings per Share of X Company Ltd. :
Balance Sheet of X Company Ltd.
Equity Share Capital 2,50,000 Plant and Machinery 8,00,000
(25,000 Share) Current Assets 2,50,000
Reserves and Surpluses 3,00,000
8% Long term Loans 3,00,000
10,50,000 10,50,000
The net profit before interest and after Tax was Rs. 78,000.
Solution
Net Profit after Tax ---- Preference Dividend
Earnings per share =
Number of Equity Shares
Rs. 78000 ---- 9000 (9% of Rs.1,00,000)
=
25,000
Rs. 69,000
= = Rs. 2.76
25,000
The Earnings Per Share is useful in determining the market price of equity share
and capacity of the company to pay dividend. A comparison of earning per share
with another company helps to know whether the equity capital is effectively used
in the business or not.
5.6.4 Activity Analysis Ratios
Activity Analysis Ratio may be studied under the following three heads:
i) Assets Turnover Ratio,
ii) Accounts Receivable Turnover Ratio, and
iii) Inventory Turnover Ratio.
Assets Turnover Ratio
The asset turnover ratio simply compares the turnover with the assets that the
business has used to generate that turnover. In its simplest terms, we are just saying
that for every Re. 1 of assets, the turnover is Rs. x. The formula for total asset
turnover is: 23
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Analysis
An Overview
of Financial Sales
Statements Assets Turnover Ratio = —————————
Average Total Assets
Beginning Total Assets + Ending Total Assets

Average Total Assets =
2
Asset turnover is meant to measure a company’s efficiency in using its assets.
The higher a company’s asset turnover, the lower its profit margin tends to be
and visa versa .
Accounts Receivable Turnover Ratio
The debtor turnover ratio indicates the average time it takes your business to
collect its debts. It’s worth looking at this ratio over a number of financial years to
monitor performance trends.
Use information from your annual Profit and Loss Statement along with the trade
debtors figure from your Balance Sheet for that financial year to calculate this
ratio.
A ratio that is lengthening can be the result of some debtors slowing down in their
payments. Economic factors, such as a recession, can also influence the ratio.
Tightening your business’ credit control procedures may be required in these
circumstances.
The debtor ageing ratio has a strong impact on business operations particularly
working capital. Maintaining a running total of your debtors by ageing (e.g.
current, 30 days, 60 days, 90 days) is a good idea, not just in terms of making sure
you are getting paid for the work or goods you are supplying but also in managing
your working capital.
No. of days (365) or months (12) in a year

Debtor Ageing Ratio (in days) =
Accounts receivables turnover ratio
Sales
Accounts Receivable Turnover Ratio =
Average Accounts Receivable
Average Accounts Receivable = (Beginning Accounts Receivable + Ending
Accounts Receivable) ÷ 2
Inventory Turnover Ratio
The inventory turnover ratio indicates how quickly your business is turning over
stock.
A high ratio may indicate positive factors such as good stock demand and
management. A low ratio may indicate that either stock is naturally slow moving or
problems such as the presence of obsolete stock or good presentation. A low ratio
can also be indicative of potential stock valuation issues. It is a good idea to monitor
the ratio over consecutive financial years to determine if a trend is developing.
It can be useful to compare this financial ratio with the working capital ratio. For
example, business operations with low stock turnover tend to require higher working
capital.
Cost of Goods Sold
Inventory Turnover Ratio = —————————
Average Inventories
24 Average Inventories = (Beginning Inventories + Ending Inventories) ÷ 2

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5.6.5 Long-term Solvency Ratios Techniques of Financial
Analysis
The long-term solvency ratios are calculated to assess the long-term financial
position of the business. These ratios are also called leverage, or capital
structure ratios, or capital gearing ratios. The following ratios generally come
under this category :
i) Debt-Equity Ratio/Total Debt Equity Ratio,
ii) Proprietory ratio, and
iii) Capital Gearing ratio.
i) Debt-Equity Ratio/Total Debt Equity Ratio
It shows the relationship between borrowed funds and owner’s funds, or external
funds (debt) and internal funds (equity). The purpose of this ratio is to show
the extent of the firm’s dependence on external liabilities or external
sources of funds.
In order to calculate this ratio, the required components are external liabilities and
owner’s equity or networth. ‘External liabilities, include both long-term as well as
short-term borrowings. The term ‘owners equity’ includes past accumulated
losses and deferred expenditure. Since there are two approaches to work out
this ratio, there are two formulas as shown below :
Long-Term Debt
_____________
i) Debt -Equity Ratio =
Owner's Equity
Total Debt
_____________
ii) Total Debt-Equity Ratio =
Owner's Equity
In the first formula, the numerator consists of only long-term debts, it does
not include short-term obligations or current liabilities for the following
reasons :
1) Current liabilities are of a short-term nature and the liquidity ratios

are calculated to judge the ability of the firm to honour current
obligations.
2) Current liabilities vary from time to time within a year and interest thereon
has no relationship with the book value of current liabilities.
In the second formula, both short-term and long-term debts are counted in the
numerator. The reasons are as follows :
1) When a firm has an obligation, no matter whether it is of short-term or

long-term nature, it should be taken into account to evaluate the risk of the
firm.
2) Just as long-term loans have a cost, short-term loans do also have a cost.
3) As a matter of fact, the pressure from the short-term creditors is often

greater than that of long-term loans.
25
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Analysis
An Overview
Statements
From the following Balance Sheet of Kavitha Ltd., Calculate Debt Equity Ratio :
Balance Sheet of Kavitha Ltd.
Rs. Rs.
Equity Capital 1,50,000 Land and Buildings 2,00,000
9% Preference Capital 60,000 Plant and Machinery 2,00,000
Reserves and Surpluses 40,000 Sundry Debtors 1,10,000
8% Debentures 80,000 Cash at Bank 35,000
Long-term loans 1,20,000
Creditors 30,000
Bills payable 65,000
5,45,000 5,45,000
Solution
Long-term Liabilities/Debt
_______________________
i) Debt-Equity Ratio =
Owner’s Equity
Long-term liabilities = Long-term Loan + 8% Debentures
= Rs. 1,20,000 + Rs. 80,000
= Rs. 2,00,000
Onwer’s equity (Networth) = Equity Capital + Preference Capital +
Reserves and Surplus
= Rs. 1,50,000 + Rs. 60,000 + Rs. 40,000
= Rs. 2,50,000
Rs. 2,00,000
Debt -equity ratio = = 0.8:1
Rs. 2,50,000
Total Debt
ii) Total Debt-Equity Ratio =
Owners’ Equity
Total Debt= Long-term Loan + 8% Debentures + Bills Payable + Creditors
= Rs. 1,20,000 + Rs. 80,000 + Rs. 30,000 + Rs. 45,000
= Rs. 2,75,000
Rs. 2,75,000
Total Debt to Equity Ratio = = 1.1: 1
Rs. 2,50,000
For analysing the capital structure, debt-equity ratio gives an idea about the relative
share of funds of outsiders and owners invested in the business. The ratio of long-
term debt to equity is generally regarded as safe if it is 2:1. A higher ratio
may put the firm in difficulty in meeting the obligation to outsiders. The higher the
ratio, the greater would be the risk as the firm has to pay interest irrespective of
profits. On the other hand, a smaller, ratio is less risky and creditors will have
greater margin or safety.
What ratio is ideal will depend on the nature of the enterprise and the economic
conditions prevailing at that time. During business prosperity a high ratio may be
favourable and in a reverse situation a low ratio is preferred. The Controller of
26 Capital Issues in India suggests 2:1 as the norm for this ratio.
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ii) Proprietory Ratio Techniques of Financial
Analysis
This ratio is also known as Equity Ratio or Networth to Total Assets Ratio. It
is a variant of Debt-Equity Ratio, and shows the relationship between owners’
equity and total assets of the firm. The purpose of this ratio is to indicate the
extent of owners’ contribution towards the total value of assets. In other
words, it gives an idea about the extent to which the owners own the firm.
The components required to compute this ratio are proprietors’ funds and total
assets. Proprietors’ funds include equity capital, preference capital, reserves and
undistributed profits. If there are accumulated losses they are deducted from the
owners’ funds. ‘Total assets’ include both fixed and current assets but exclude
fictitious assets, such as preliminary expenses; debit balance of profit and loss
account etc. Intangible assets, if any, like goodwill, patents and copy rights are taken
at the amount at which they can be realised . The formula of this ratio is as follows :
Proprietors’ Funds
Proprietory Ratio =
Total Assets
Taking the information from Illustration 3, the Proprietory Ratio can be calculated
as follows :
Proprietory Funds Rs. Total Assets Rs.
Equity Capital 1,50,000 Land and Building 1,20,000
8% Preference Capital 60,000 Plant and Machinery 2,00,000
Reserves and Surpluses 40,000 Debtors 1,10,000
Cash and Bank 35,000
2,50,000 4,65,000
Proprietors’ Funds
Proprietory Ratio =
Total Assets
2,50,000
= = 53.76 %
4,65,000
There is no definite norm for this ratio. Some financial experts hold the view that
proprietors’ funds should be from 67% to 75% and outsiders’ funds should be from
25% to 33% of the total assets. The higher the ratio, the lesser would be the
reliance on outsiders’ funds. A high ratio implies that the firm is not using
outsiders’ funds as much as would maximise the rate of return on the proprietors’
funds. For instnace, if a firm earns 20% return on borrowed funds and the rate of
interest on such fund is 10% the proprietors would be able to gain to the extent of
10% on the oustiders’ funds. This increases the earning of the shareholders.
iii) Capital Gearing Ratio
This ratio establishes the relationship between equity share capital on one hand and
fixed interest and fixed dividend bearing funds on the other. It does not take current
liabilities into account. The purpose of this ratio is to arrive at a proper mix
of equity capital and the source of funds bearing fixed interest and fixed
dividend.
For the calculation of this ratio, we require the value of (i) equity share capital
including reserve and surpluses, and (ii) preference share capital and the sources
bearing fixed rate of interest like debentures, public deposits, long-term loans, etc.
The following formula is used to compute this ratio :
Equity Capital including Reserves and Surplus
Capital Gearing Ratio =
Fixed Dividend and Interest bearing securities 27
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Analysis
An Overview
Statements
The following are the particulars extracted from the Balance Sheet of XYZ Ltd. as on
31.03.2005. Calculate Capital Gearing Ratio.
Rs.
9% Preference Share Capital 60,000
Reserves and Surpluses 20,000
Long-term Loans 1,20,000
Solutio
Equity Capital
Capital Gearing Ratio =
Fixed dividend and interest bearing securities
Equity Share Capital + Reserves and Surpluses

=
9% Preference Share Capital + Long-term loans.
Rs. 1,00,000 + Rs. 20,000 Rs. 1,20,000

= =
Rs. 60,000 + Rs. 1,20,000 Rs. 1,80,000
= 0.67 : 1
A firm is said to be highly geared when the sum of preference capital and all other
fixed interest bearing securities is proportionately more than the equity capital. On the
other hand, a firm is said to be lowly geared when the equity capital is relatively more
than the sum of preference capital and all other fixed interest bearing securities.
The norm suggested for this ratio is 2:1. However, the significance of this ratio largely
depends on the nature of business, return on investment and interest payable to outsiders.
Illustration 10
From the following particulars compute leverage ratios :
Balance Sheet of Raja Ltd.
Liabilities Assets
Rs. Rs.
Equity Share Capital 40,000 Land 22,000
8% Preference Share Capital 20,000 Building 24,000
Reserves 10,000 Plant and Machinery 38,000
Profit and Loss Account 5,000 Furniture 5,000
10% Debentures 45,000 Sundry Debtors 22,000
Trade Creditors 9,000 Stock 13,000
Outstanding Expenses 2,000 Cash 14,000
Provision for Taxation 3,000 Prepaid expenses 2,000
Proposed Dividend 6,000
1,40,000 1,40,000
Solution
Leverage Ratios
Long-term Debt
1) Debt Equity Ratio =
Owners’ Equity
Long-term Debt = 10% Debentures
28 = Rs. 45,000
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Owners’ Equity = Equity Share Capital + 8% Preference Share Techniques of Financial
Capital + Reserves + Profit and Loss Account Analysis
= 40,000 + 20,000 + 10,000 + 5,000

= Rs. 75,000
45,000
Debt Equity Ratio = = 0.6 : 1
75,000
2) Total Debt Equity Ratio
Total Debt = 10% Debentures + Trade Creditors
+ Proposed Dividend
= 45,000 + 9,000 + 2,000 + 3,000 + 6,000
= Rs. 65,000
Equity is Rs. 75,000 as calculated in Debt Equity Ratio. Total Debt to Equity
65,000
Ratio = = 0.87 : 1
75,000
Proprietor’s Funds
3) Proprietory Ratio =
Total assets
Proprietor’s Funds is same as Owner’s equity i.e., Rs. 75,000 as calculated in
Debt Equity Ratio.
Total Assets = Land + Building + Plant and Machinery
+ Furniture + Current Assets
= 22,000 + 24,000 + 38,000 + 5,000 + 51,000
= Rs. 1,40,000
75,000
Proprietory Ratio = = 1:1.87
1,40,000
Equity Capital
4) Capital Gearing Ratio =
Fixed Interest Bearing Securities
Equity Capital = Equity Share Capital + Reserves + Profit and
Loss Account
= 40,000 + 10,000 + 5,000
= Rs. 55,000
Fixed Interest bearing
secuities = 10% Debentures + 8% Preference Share Capital
= 45,000 + 20,000
= Rs. 65,000
55,000
Capital Gearing Ratio = = 0.85 :1
65,000
5.6.6 Coverage Ratios
As mentioned earlier, leverage ratios are computed both from Balance Sheet and
Income Statement (Profit and Loss Account). Under Section 5.6.5 of this Unit
Long term Solvency Ratio you have studied the ratios computed from Balance
Sheet. Let us now discuss the second category of leverage ratios to be calculated
from Income Statement. These ratios are called ‘Coverage Ratios’.
29
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Analysis
An Overview
of Financial In order to judge the solvency of the firm, creditors assess the firm’s ability to
Statements service their claims. In the same manner, preference shareholders evaluate the
firm’s ability to pay the dividend. Theses aspects are revealed by the coverage
ratios. Hence, these ratios may be defined as the ratios which measure the
ability of the firm to service fixed interest bearing loans and other fixed
charge securities. These ratios are:
i) Interest Coverage Ratio,
ii) Dividend Coverage Ratio, and
iii) Total Coverage Ratio.
i) Interest Coverage Ratio
This ratio is also known as ‘times interest earned’ ratios. It is used to assess the
firm’s debt servicing capacity. It establishes the relationship between Net Profit or
Earnings before interest and Taxes (EBIT). The purpose of this ratio is to reveal
the number of times that the Interest charges are covered by the Net Profit before
Interest and Taxes. The formula for this ratio is as follows:
Net Profit before Interest and Taxes
Interest Coverage Ratio =
Interest Charges
Illustration 11
The Net Profit after Interest and Taxes of a firm is Rs. 98,000. The interest and
taxes paid during the year were Rs. 16,000 and Rs. 30,000 respectively. Calculate
Interest Covereage Ratio.
Solution
Net Profit before Interest and Taxes (EBIT)
__________________________________
Interest Coverage Ratio =
Interest Charges
EBIT = Net Profit after Interest and Taxes + Taxes +Interest
= Rs. 98,000 + Rs. 30,000 + Rs. 16,000 = Rs. 1,44,000
Rs. 1,44,000
__________
Interest Coverage Ratio = = 9 times or 9
Rs. 16,000
In the above illustration, the interest coverage ratio is 9. It implies that even if the
firm’s profit falls to 1/9th, the firm will be able to meet its interest charges. Hence, a
high ratio is an index of assurance to creditors by the firm. But too high a ratio
reflects the conservation attitude of the firm in using debt. On the other hand, a low
ratio reflects excessive use of debt. Therefore, a firm should have comfortable
coverage ratio to have credit worthiness in the market.
ii) Dividend Coverage Ratio
This ratio indicates the relationship between Net Profit and Preference dividend.
Net profit means Net Profit, after Interest and Taxes but before dividend on
preference capital is paid. The purpose of this ratio is to show the number of times
preference dividend is covered by Net Profit after Interest and Taxes. To compute
this ratio. The following formula is used:
Net Profit after Interest and Taxes
__________________________
Dividend Coverage Ratio =
Preference Dividend
30
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Illustration 12 Techniques of Financial
Analysis
The Net Profit before Interest and Taxes of a Company was Rs. 2,30,000. The
Interest and taxes to be paid are Rs. 15,000 and Rs. 35,000 respectively. The preference
dividend declared was 20 per cent on the preference capital of Rs. 2,25,000. Caclulate
Dividend Coverage Ratio.
Solution
Net Profit after Interest and Taxes
__________________________
Dividend Coverage Ratio =
Preference Dividend
Net Profit after Interest and Taxes = EBIT --- Interest --- Taxes
= Rs. 2,30,000 ---Rs. 15,000 --- Rs. 35,000 = Rs. 1,80,000
Preference Dividend = 20% on Rs. 2,25,000
20
___
= Rs. 2,25,000 × = Rs. 45,000
100
Rs. 1,80,000
_________
Dividend Coverage Ratio = = 4.5 times
Rs. 45,000
This ratio reveals the safety margin available to the prefereence shareholders. The
higher the ratio, the greater would be the financial strength of the firm and vice versa.
iii) Total Coverage Ratio
Also known as ‘Fixed Charge Coverage Ratio’. This ratio examines the relationship
between Net Profit Before Interest and Taxes (EBIT) and Total Fixed Charges. The
purpose of this ratio is to show the number of times the total fixed charges are covered
by Net Profit before Interest and Taxes.
The components of this ratio are Net Profit Before Interest and Taxes (EBIT) and
Total Fixed Charges. The Fixed Charges include interest on loans and debentures,
repayment of principle, and preference dividend. It is calculated as follows:
Total Coverage Ratio =
Total Fixed Charges
Illustration 13
The Net Profit Before Interest and Taxes of a firm is Rs. 84,000. The interest to be
paid on loans is Rs. 14,000 and preference dividend to be paid is Rs. 7,000. Calculate
Total Coverage Ratio.
Solution
Total Coverage Ratio =
Total Fixed Charges
Total Fixed Charges = Interest + Preference dividend
= Rs. 14,000 + Rs. 7,000 = Rs. 21,000
Rs. 84,000
Total Coverage Ratio = = 4 times or 4 to 1.
Rs. 21,000

1) What is leverage ratio? Are leverage ratios and gearing ratios different?
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Analysis
An Overview
of Financial
Statements 5.7 DUPONT MODEL OF FINANCIAL ANALYSIS
While ratio analysis helps to a great extent in performing the financial statement
analysis, most of the time, one would be left in confusion with umpteen ratio
calculation in hand. Hence one has to have a guided and structured form of ratio
analysis to get a complete picture of the overall performance and risk of the
company in a nut shell. This was made possible by the company DuPont. This
company had given a structured form of doing financial statement analysis for the
first time and from here on most analysts started using the technique.
The DuPont System of Analysis merges the income statement and balance sheet
into two summary measures of profitability: Return on Assets (ROA) and Return
on Equity (ROE). The system uses three financial ratios to express the ROA and
ROE: Operating Profit Margin Ratio (OPM), Asset Turnover Ratio (ATR), and
Equity Multiplier (EM).
The DuPont chart analysis has been explained with an example below.
To understand the Dupont analysis better, it’s better to condense the income
statement and balance sheet data in a required format as given below. The
following table gives the balance sheet and income statement of Asian Paints for
the year ending March 2001 and March 2002.
Asian Paints
Income Statement 2001 2002
Sales 1215 1331
Raw Material 696 749
Operating Expenses 320 331
Profit Before Interest and Tax (PBIT) 199 251
Interest 22 14
Profit Before Tax (PBT) 177 237
Tax 50 66
Profit After Tax (PAT) 127 171
Balance sheet 2001 2002
Net Worth 411 410
Debt 227 111
Total Liabilities 638 521
Net Fixed Assets 376 384
Inventory 199 156
Receivables 122 119
Investments 44 63
Other current assets 129 87
Cash 12 22
Less: Current Liabilities and Provision 244 310
Miscellaneous expenditure 4 6
Total Assets 638 521
Current assets 462 384
32 Cost of debt 9.69 12.61

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DuPont Chart Financial Statement Analysis (Template) Techniques of Financial
Analysis
Return on Networth
PBT/Networth
Impact of Leverage Leverage or Financial Risk

(ROI - Kd)* Debt/Equity Debt to Networth
Return on
Investment
PBIT/Total Assets
Asset Turnover Ratio (ATO)

Sales /Total Assets Profit Margin
Profit /Sales
Fixed Asset To Current Asset To

Sales /Fixed Sales /Current Raw Material to Sales
Assets Assets Raw Material/Sales
Current Ratio
Current Assets/ Conversion Cost to
Current Liabilities Inventorry To Sales
Sales/Inventory Operating Expenses/
Sales
Debtors To
Interest on Sales
Sales /Debtors
Interest /Sales
Collection Period
365 or 12 /Debtors To
Where ROI implies Return on Investment; Kd represents Cost of Debt Capital;

PBT implies Profit Before Tax; PBIT implies Profit Before Interest and Tax;
Networth implies Equity Capital + Reserves and Surplus.
The above analysis is a good example of time series analysis. It implies comparing the
financial statements of the same company over the years. The results indicate that
Asian paints had done well during the year 2002. We need to find out the reasons that
had contributed to the good performance of the company. The ROA or ROI has
increased from 31% to 48%. This has been made possible due to the combined positive
effect of profit margin and the asset turnover ratios. The company was able to increase
its profit margin from 16% to 18% in 2002. This was made possible by cutting down on
raw material costs, conversion costs and interest expenses. Further to this, the company
was also able to maintain better efficiency in terms of productivity of assets. This
included improvement in overall asset turnover ratio, increase in current and fixed asset
turnover ratio and also inventory turnover ratio. 33
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Analysis
An Overview
of Financial DuPont Chart Financial Statement Analysis of Asian Paints
Statements
2001 2002
Retrun on Networth
43.07 57.80
Impact of leverage Leverage of Financial risk

11.87 9.63 0.55 0.27
Return on Investment
31.19 48.18
Assest Turnover ration (ATO) Profit Margin

1.90 2.55 16.38 18.86
Fixed Asset To Current Asset To Raw Material to Sales

3.23 3.47 2.63 3.47 57.28 56.27
Current Ratio Inventory To

Conversion Cost of Sales
1.8934 1.24 6.11 8.53
26.34 24.87
Debtors To
9.96 8.53 Interest on Sales
Collection Period 1.81 1.05
(Months)
1.20 1.07
The debtors turnover ratio has also improved indicating that the company is turning on
its receivables more frequently. This is also indicated in the low credit period that is
given to its customers. The credit period has reduced from 1.2 to 1.07 during 2002.
Besides this, the company also had a positive impact of the leverage impact. The debt
equity mix has come down for the period 2002, but still gave a positive impact and
hence boosted the returns to the shareholders by 9%. Hence the ROE moved to 57%
as against 43% in the year 2001. When one would compare the performance of
Asian paints with the industry average, the results would seem more interesting. It’s
very difficult to see such alarming increasing returns and highly good performance.
This company should be performing well above the industry average.
Inter-Firm Comparison (Cross Section Analysis)
While the above analysis enabled you to compare the performance of the firm over
the years, most often this may not be alone helpful. You would be also interested in
seeing how the firm has performed over its counterparts. In the sense that, you might
want to see if Asian paints has performed well over the industry average or whether
34
Asian paints has performed well in comparison with the firms in the same industry.
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This sort of analysis becomes most useful when you are doing the industry analysis Techniques of Financial
and when the company you are analysing is not the monopoly in the industry. This Analysis
would make sense to see why the company has either underperformed or over
performed in comparison to the other firms. This sort of analysis helps the analysts
forecasts the future market share, profitability and the sustainable growth rate of
the company in the presence of competition.
Check Your Progress D
1) What is the basic benefit of using the DuPont form of financial statement
analysis?
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2) Take any other manufacturing company’s annual report and perform similar
analysis to get a practice of DuPont analysis.
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3) What are the different ways in which this chart analysis can be used?
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5.8 USES OF RATIO ANALYSIS

Ratio analysis is used as a device to analyse and interpret the financial strength of
the enterprise. With the help of these ratios Financial statements can be analysed
and interpreted more clearly and conclusions can be drawn about the performance
of the business. The importance of a ratio analysis is widely recognised on account
of its usefulness as outlined below:
1) It conveys inter-relationship between different items of the financial
statements: Since the ratios convey the inter-relationship between different
items of the Balance Sheet and Profit and Loss account, they reflect the
financial state of affairs and efficiency of operations more clearly than the
absolute accounting figures. For example, the net profit earned by a firm may
appear to be quite satisfactory if the amount of profit is large, say Rs. 5 Lakh.
But, the profit earned can not be regarded good unless it is ralated to the total
investment. If the capital invested is say Rs. 2 crore, the amount of profit
expressed as a percentage of investment comes to be only 2.5%. This cannot
be said to be satifactory performance. However, if the capital invested was
Rs. 50 Lakh, profit earned would be 10% of the capital investment which may
be considered reasonably good.
2) Helps to judge the performance of the business: Efficiency of
performance of management and the overall financial position are revealed by
means of financial ratios which may not be otherwise apparent from a set of
accounting figures. The index of efficiency reflected in the ratios can be used
as the basis of management control. The trend of ratios over a period of time
can also be used for planning and forecasting purposes. 35
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Analysis
An Overview
of Financial 3) Facilitates inter-firm and intra-firm comparison: Ratio analysis provides
Statements data for inter and intra firm comparison. With the help of these data
comparison of the performance of different firms within the industry as well as
the performance of different divisions within the firm can be made and
meaningful conclusion can be drawn out of it as to whether the performance
of the firm is improving or deteriorating so as to make appropriate investment
decisions.
4) To determine credit worthiness of the business: The credit worthiness of
the firm, its earning power, ability to pay interest and debt, prospects of growth,
and similar information are revealed by ratio analysis.These are required by
creditors, financiers, investors as well as shareholders. They make use of ratio
analysis to measure the financial condition and performance of the firm.
5) Helpful to Government: The financial statement published by the industrial
units are used by the government to calculate ratios for determining short-term
long-term and overall financial position of the firms.These financial ratios of
industrial units may be used by the Government as indicators of overall
financial strength of industrial sector.
5.9 LIMITATIONS OF RATIO ANALYSIS

By now you should have mastered the techniques of ratio analysis and its
application at the various situations. However, before you start applying the ratios you
should be careful enough to be aware of some of its limitations while being used.
1) You should be aware that many companies operate in more than one industry
take for instance companies like LandT, HLL, PandG etc. which does not
operate in only one business segment but in diversified businesses. So care
should be taken to ensure that segment level ratios are compared.
2) Inflation has distorted balance sheets, in the sense that, the financial
statements do not account for inflation which implies that they do not represent
the real picture of the scenario. However, given not so high inflation it would
not affect the analysis much.
3) Seasonal factors can greatly influence ratios. Hence, you should make sure
that you control for the seasonal differences. Better would be to perform the
ratio analysis on a quarterly basis to get the complete picture for the whole
year.
4) With the kind of accounting scams breaking every other day, its not unusual to
find that Window-dressing could have been done. Though small investors have
no control on this and very little chance to get to know about the creative
accounting that is taking place one should not however loose sight into any sort
of discrepancies in the accounting.
5) Its quite possible that different companies within an industry may use different
accounting practices which would make it difficult to compare the two
companies. In that situation it should be made sure that the changes are
accounted for and made sure that it would not affect the analysis.
6) It could also be possible that different companies may use different fiscal
years. Say for instance one company may use the calendar year as its account
closing year while some others may use the fiscal year. In that process care
should be taken to compare the respective months or years adjusting for the
differences in the accounting year.
7) The age of the company may distort ratios. So it should be take into account
36 that the companies you are comparing have some basic similarities. The longer
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the company had stayed in business the ratios would be quite different from Techniques of Financial
Analysis
the new entrants in the same industry. Such factors have to be accounted for.
8) However, there is also possibility that innovation and aggressiveness may lead
to “bad” ratios. So one should not blindly depend on the numeric ratio figures
but try and understand why the company has bad ratios in any particular year
before jumping into wrong conclusions.
9) There could also be possibility that the benchmark used for analyzing the ratios
may not be appropriate. The industry average may not be an appropriate or
desirable target ratio. One has to carefully pick the industry averages or the
benchmark ratios. As industry averages can be very rough approximations.
10) The other downside of the ratio analysis is that ratios should not be interpreted
“one-way,” e.g. a higher ratio may only be better up to a point. So one should
not assume that this will hold good in future. A company having a Profit
margin of 10% in 2003 does not necessarily indicate that it would have atleast
10% profit margin in the year 2004.
5.10 LET US SUM UP

Financial statements represent a summary of the financial information prepared in
the required manner for the purpose of use by managers and external stakeholders.
Financial reports are prepared basically to communicate to the external
shareholders about the financial position of the company that they own.
Different groups of users of financial statements are interested in different aspects
of a company’s financial activities. Short-term creditors are interested primarily in
the company’s ability to make cash payments in the short term; they focus their
attention on operating cash flows and current assets and liabilities. Long-term
creditors, on the other hand, are more interested in the company’s long-term ability
to pay interest and principal and would not limit their analysis to the company’s
ability to make cash payments in the immediate future. The focus of common
stockholders can vary from one investor to another, but generally stockholders are
interested in the company’s ability to pay dividends and increase the market value
of the stock of the company. Each group may focus on different information in the
financial statements to meet its unique objectives
An important aspect of financial statement analysis is determining relevant
relationships among specific items of information. Companies typically present
financial information for more than one time period, which permits users of the
information to make comparisons that help them understand changes over time.
Financial statements based on absolute value and percentage changes and trend
percentages are tools for comparing information from successive time periods.
Component percentages and ratios, on the other hand, are tools for establishing
relationships and making comparisons within an accounting period. Both types of
comparisons are important in understanding an enterprise’s financial position, results
of operations, and cash flows.
Assessing the quality of information is an important aspect of financial statement
analysis. Enterprises have significant latitude in the selection of financial reporting
methods within generally accepted accounting principles. Assessing the quality of a
company’s earnings, assets, and working capital is done by evaluating the
accounting methods selected for use in preparing financial statements.
Management’s choice of accounting principles and methods that are in the best
long-term interests of the company, even though they may currently result in lower
net income or lower total assets or working capital, leads to a conclusion of high
quality in reported accounting information.
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Analysis
An Overview
of Financial Financial accounting information is most useful if viewed in comparison with other
Statements
relevant information. Net income is an important measure of the financial success of
an enterprise. To make the amount of net income even more useful than if it were
viewed simply in isolation, it is often compared with the sales from which net income
results, the assets used to generate the income, and the amount of stockholders’
equity invested by owners to earn the net income. Hence Ratio analysis is used as a
major tool.
Ratios are mathematical calculations that compare one financial statement item with
another financial statement item. The two items may come from the same financial
statement, such as the current ratio, which compares the amount of current assets with
the amount of current liabilities, both of which appear in the statement of financial
position (balance sheet). On the other hand, the items may come from two different
financial statements, such as the return on stockholders’ equity, which compares net
income from the income statement with the amount of stockholders’ equity from the
statement of financial position (balance sheet). Accountants and financial analysts have
developed many ratios that place information from a company’s financial statements in
a context to permit better understanding to support decision making.
Often ratio analysis is performed in a more structured form called the Dupont model of
analysis. This helps the investors a better picture of the analysis and also more
meaningful and holistic picture of the financial position of the companies.
5.11 KEY WORDS

Accounting Ratio : Ratio of accounting figures presented in financial statements.
Common Size Balance Sheet : Statement of assets and liabilities showing each item
as a ratio (percentage) of the aggregate value of assets/1iabilities.
Common Size Income Statement : Statement of income and expenditure showing
each item as a ratio (percentage) of net sales.
Comparative Balance Sheet : Statement presenting changes in the value of assets,
liabilities and capital investment between two Balance Sheet dates.
Comparative Income Statement : Statement presenting changes in income and
expenditure over successive years.
Capital Employed : Long-term funds including owners’ capital and borrowed capital.
Capital Structure : Financial mix plan of debt and equity.
Financial Analysis : Process of examining the financial position and operating
performance with the help of information provided by the financial statement.
Financial Reporting : Communicating information based on financial data in the form
of reports.
Financial Ratios : Ratios indicating financial soundness of the firm. It is also called
leverage ratio.
Financial Statements : Annual statements of assets and liabilities (Balance sheet) of
income and expenditure (Profit and Loss account).
Intra-firm Comparison : Comparing financial data of one firm with the corresponding
data of comparable firm(s).
Intra-firm Comparison : Comparison of the financial data relating to one period with
those of previous periods in respect of the same firm.
Owners’ Equity : Shareholders funds including share capital (both preference and
equity) P & L A/c balance, reserves minus fictitious assets. It is also called net
38 worth.
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Ratio : Measure of one value or number in relation to another. Techniques of Financial
Analysis
Ratio Analysis : Computing, determining and explaining the relationship between
the component items of financial statements in terms of ratios.
Leverage Ratios : Ratios that evaluate the long-term solvency of a firm. These
are also called solvency ratios.
Liquidity Ratios : Ratios that assess the capacity of a firm to meet its short-term
liabilities.

1) From the following balance sheet of XYZ Co. Ltd. calculate Return on
Capital employed.
Balance sheet as on 31.03.2005
Share Capital 6,00,000 Fixed assets 9,00,000
Reserves 2,00,000 Current assets 3,00,000
10% Debentures 2,00,000 Investment in
Provision for Taxation 2,00,000 Govt. securities 2,00,000
Profit and Loss A/c 2,00,000
14,00,000 14,00,000
Profit and loss for the period ended 31.03.2005

Rs. Rs.
To Cost of goods sold 6,00,000 By Sales 10,00,000
To Interest on Debentures 20,000 By Income from investment 20,000
To Provision for Taxation 2,00,000
To Net profit after Tax 2,00,000
10,20,000 10,20,000
(Ans.: Operating profit : Rs. 4,00,000 Capital employed : Rs. 10,00,000 ROC = 40%).
2) Following is the Profit and Loss Account of Shriram Company Ltd., for the
year ending March 31, 2005 and the Balance Sheet as on that date. You are
required to compute liquidity, long-term solvency, turnover ratios, and
profitability ratios both in relation to capital and sales.
Profit and Loss Account of Shriram Company Ltd.
for the year ending March 31, 2005
Rs. Rs.
To Direct Expenses 20,000
14,10,000 14,10,000
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Analysis
An Overview
of Financial
Statements To Operating Expenses: By GrossProfit b/d 4,00,000
Administrative
Expenses 40,000
Selling & Distribution
Expenses 60,000 1,00,000
To Non-operating
Expenses:
Loss on the sale 10,000
of shares
Interest 30,000 40,000
To Provision for Taxation 40,000
4,00,000 4,00,000
Balance Sheet of Shriram Company Ltd. as on March 31, 2005

Equity Share Capital Land & Buildings 4,00,000
(60,000 shares of Rs. 10 each) 6,00,000 Plant & Machinery 3,20,000
Reserves & Surplus 50,000 Stock 1,50,000
Profit & Loss Account 1,60,000 Cash at bank 1,20,000
10% Debentures 3,00,000 Debtors 3,00,000
Creditors 1,80,000
12,90,000 12,90,000
(Ans.: Current ratio = 3.17 : 1, Quick ratio = 2.33:1

Gross profit ratio = 31.75%, Net profit ratio = 17.46%
Operating profit ratio = 23.89%
Operating ratio =76.19%
Return on capital employed = 27%
Return on Investment = 19.82%
Return on shareholder’s equity = 27.16%
Earning per share =3.67)
3) The following is the Balance Sheet of X Co. Ltd. as on March 31, 2005.
Calculate the liquidity ratios.
Share Capital 50,000 Plant and Machinery 60,000
Profit and Loss A/c 10,000 Stock 20,000
10% Debentures 30,000 Debtors 14,000
Sundry Creditors 14,000 Bills Receivables 5,000
Outstanding Expenses 6,000 Short-term Securities 8,000
Provision for Taxation 3,000 Cash 6,000
1,13,000 1,13,000
40 (Answer: Current Ratio = 2.304, Quick Ratio = 1.43)

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4) From the following details, calculate leverage ratios. Techniques of Financial
Analysis
Balance Sheet of ABC Ltd. as on March 31, 2005
Equity Share Capital 1,00,000 Land 60,000
8% Preference Share Capital 40,000 Plant and
Reserves & Surpluses 30,000 Machinery 1,50,000
9% Long-term Loan 50,000 Less:
10% Debentures 60,000 Accumulated
depreciation 30,000 1,20,000
Creditors 20,000
Stock 40,000
Bills Payable 15,000
Debtors 70,000
Accrued Expenses 5,000
Prepaid Expenses 5,000
Marketable Securities 20,000
Cash 5,000
3,20,000 3,20,000
Answer: Debt Equity Ratio = 0.647 : 1

Proprietory Ratio = 0.531 : 1
Total Debt Ratio = 0.469 : 1
5) From the following details you are required to compute:

i) Current Ratio
ii) Operating Ratio
iii) Stock Turnover Ratio
iv) Total Assets Turnover Ratio
v) Return on Shareholders Equity, and
vi) Net Profit Ratio
Profit and Loss Account for the year
ended March 31, 2005
Rs. Rs.
To Purchases 3,40,000 By Closing Stock 30,000
To Incidental Expenses 20,000
5,30,000 5,30,000
To Operating Expenses : By Gross Profit b/d 1,20,000
By Non-operating Income:
Selling and
Distribution 20,000 Interest 2,000
Administrative 30,000 50,000 Profit on sale of
shares 3,000 5,000
To Non-operating Expenses:
Loss on Sale of assets 2,500
1,25,000 1,25,000
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Analysis
An Overview
of Financial Balance Sheet as on March 31, 2005
Statements
Share Capital : Land and Building 50,000
10,000 ordinary shares of 1,00,000 Plant and Machinery 1,00,000
Rs. 10 each
Debtors 35,000
Reserves 22,500 Stock 30,000
Current Liabilities 45,000 Bank 2,500
2,17,500 2,17,500
Answer : i) Current Ratio = 1.5:1, ii) Operating Ratio = 0.86:1,

iii) Stock Turnover Ratio = 9.5 times, iv) Net Assets Turnover
Ratio = 2.9 times,
v) Return on Shareholders vi) Net Profit Ratio = 14.5%)
Equity = 42%,
6) The following is the Balance Sheet of Dev Ltd. for the year ended March 31,
2005.
Equity Capital 2,50,000 Fixed Assets 9,00,000
(2,500 share of Rs. 100 each) Less: Depreciation 2,50,000
7% Preference Capital 50,000 6,50,000
Reserve & Surpluses 2,00,000 Current Assets
6% Debentures 3,50,000 Cash 25,000
Current Liabilities 10% Investments 75,000
Creditors 30,000 Debtors 1,00,000
Bills Payable 50,000 Stock 1,50,000 3,50,000
Accured Expenses 5,000
Provision for Taxation 65,000
10,00,000 10,00,000
Additional Information : Rs.

Net Sales 15,00,000
Purchases 13,00,000
Cost of Goods Sold 12,90,000
Profit before Tax 1,46,500
Profit after Tax 50,000
Operating Expenses 50,000
Market Value per Share 150
Calculate activity ratios and profitability ratios.

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[ Answer : Activity Ratios: Total Assets Turnover =1.5 times,
Stock Turnover =8.89 times.
Analysis
Debtors Turnover = 15 times

Creditors Turnover = 10 times. Net Assets Turnover = 1.765 : 1
Profitability Ratio : Gross Operating Margin = 14%, Net Profit
Margin = 3.33% Gross Operating Margin = 10.67%,
Operating Ratio = 89.33%
ROCE = 18.82%, Return on Shareholders’ Equity = 10%
EPS = Rs. 18-60 ]
7) During the year 2005, Satyam Co. made sales of Rs. 4,00,000. Its gross
profit ratio is 25% and net profit ratio is 10% . The stock turnover ratio was
10 times. Calculate (i) Gross Profit, (ii) Net Profit , (iii) Cost of Goods Sold,
(iv) Operating Expenses.
Answer : i) Gross Profit : Rs. 1,00,000
ii) Net Profit : Rs. 40,000
iii) Cost of goods sold : Rs. 3,00,000
iv) Operating Expenses : Rs. 60,000)
8) Following is the Profit and Loss Account and Balance Sheet of a company :
Profit & Loss Account for the year ended 31st March, 2005
Particulars Rs. Particulars Rs.
To Opening Stock 3,00,000 By Sales 20,00,000
To Direct Wages 4,00,000 By Profit on Sale of Shares 1,00,000
To Manufacturing Expenses 2,00,000
To Administrative Expenses 1,00,000
To Selling and Distribution
Expenses 1,00,000
To Loss on Sale of Plant 1,10,000
To Interest on Debentures 20,000
26,00,000 26,00,000
Balance Sheet as on 31st March, 2005
Equity share Capital 2,00,000 Fixed Assets 5,00,000

Preference Share Capital 2,00,000 Stock 5,00,000
Reserves 2,00,000 Sundry Debtors 2,00,000
Debentures 4,00,000 Bank 1,00,000
Bills Payable 1,00,000
13,00,000 13,00,000
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Analysis
An Overview
of Financial Examine the Profit & Loss A/c and Balance Sheet given above and calculate the
Statements following ratios:
i) Gross Profit Ratio
ii) Current Ratio
iii) Debt Equity Ratio
iv) Liquidity Ratio
v) Operating Ratio
vi) Propreitory Ratio
vii) Total Assets to Debt Ratio 50%
(Answer : i) Gross profit Ratio 50%
ii) Current Ratio : 2. 67:1
iii) Debt Equity Ratio : 0.67:1
iv) Liquidity Ratio : 1:1
v) Operating Ratio : 60%
vi) Proprietory Ratio : 0.46:1
vii) Total assets to Debt Ratio : 3.25:1)
9) With the help of the given information calculate following ratios:

(i) Operating Ratio, (ii) Current Ratio, (iii) Stock Turnover Ratio,
(iv) Debt Equity Ratio
Rs.
12% Debentures 1,20,000
Sales 4,00,000
Opening Stock 24,000
Purchases 2,50,000
Wages 15,000
Selling and Distribution Expenses 3,000
Other Current Assets 1,00,000
Current Liabilities 75,000
(Answer : i) Operating Ratio : 66.5

ii) Current Ratio : 1.68:1
iii) Stock turnover ratio : 10.52 times
iv) Debt equity ratio : 33.05%)
10) Prepare a horizontal analysis of the balance sheet for Grant, Inc., by
computing the percentage change from 2004 to 2005 for each of the amounts
listed below. Comment on the results. (Figures in Rs.)
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Balance Sheet of CC Ltd. 2005 2004 Analysis
Cash 50,000 40,000

Accounts receivable 100,000 60,000
Inventory 150,000 100,000
Equipment, net 1,200,000 800,000
Total assets 1,500,000 1,000,000
Accounts payable 150,000 100,000
Bonds payable (long-term debt) 400,000 400,000
Common stock 600,000 300,000
Retained earnings 350,000 200,000
Total Liabilities & Shareholder Equity 1,500,000 1,000,000
11) Given below are the financial statements of Aventis Pharma for the year
ending March 2004 and 2005. Analyse and answer the questions
following the data.
Company Name Aventis Pharma

2005 2004
Sales 609.92 675.81
Raw material consumed 185.93 207.84
Operating expenses 327.49 376.88
PBIT 96.5 91.09
Interest 1.48 0.41
PBT 95.02 90.68
TAX 47.09 32.7
PAT (NNRT) 47.93 57.98
2003 2002
Net worth 212.24 239
Borrowings 33.88 20.01
TL 246.12 259.01
Net fixed assets 158.44 149.95
Inventories 66.92 78.36
Sundry debtors 48.24 34.28
Cash and marketable securities 57.32 120.64
Less Current liabilities & provision 118.08 129.81
Other CA 33.28 5.59
TA 246.12 259.01
Current assets 205.76 238.87
Cost of debt 4.37 2.05
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Analysis
An Overview
of Financial i) Discuss the quality of a company’s earnings, assets, and working capital.
Statements
ii) Put the company’s net income into perspective by relating it to sales,
assets, and stockholders’ equity.
iii) Compute the ratios widely used in financial statement analysis and explain
the significance of each.
iv) Analyze financial statements from the viewpoints of common stockholders,

creditors, and other stakeholders if any.
v) Perform a Dupont analysis for the two years and list down your
observations and conclusions.
12) Given below is the Balance sheet of CC Company Ltd.
a) Compute the following ratios for December 2004 and December 2003:
Current Ratio, Acid-test Ratio, and the Debt Ratio. Comment the
results.
b) The income statement for 2002 reported: Net sales Rs. 1,600,000; Cost of
goods sold Rs. 600,000; and Net income Rs. 150,000. Compute the
following ratios for 2002: Inventory Turnover, Return on Sales, and Return
on Equity. Comment the results.
c) Identify the ratios of most concern to Creditors. Explain why Creditors are
most interested in these ratios.
d) Identify the ratios of most concern to Shareholders. Explain why

Shareholders are most interested in these ratios.
Balance Sheets 31.12.2004 31.12.2003
Rs. Rs.
Cash 50,000 40,000
Accounts receivable 100,000 60,000
Inventory 150,000 100,000
Equipment, net 1,200,000 800,000
Total assets 15,00,000 10,00,000
Accounts payable 150,000 100,000
Bonds payable (long-term debt) 400,000 400,000
Common stock 600,000 300,000
Retained earnings 350,000 200,000
Total Liabilities 15,00,000 10,00,000
Note : These questions will help you to understand the unit better. Try to write answers
for them. But do not submit your answers to the University. These are for your
practice only.
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5.13 FURTHER READINGS Analysis
Daniel L. Jensen, “Advanced Accounting” (McGraw-Hill College Publishing, 1997).

Eric Press, “Analyzing Financial Statements” (Lebahar-Friedman, 1999).
Foster (2002), “Financial Statement Analysis”.
Gerald I. White, “The Analysis and Use of Financial Statements” (John Wiley &
Sons, 1997).
Horngren et al. (2002), Financial Accounting Pearson’s Ed.
Howard M. Schilit (1993) Financial Shenanigans: How to Detect Accounting
Gimmicks & Fraud in Financial Reports by McGrahill.
Leopold Bernstein and John Wild, “Analysis of Financial Statements” (McGraw-Hill,
2000) .
Martin Mellman et. al, “Accounting for Effective Decision Making”
(Irwin Professional Press, 1994).
Mulford and Comiskey (2002), The Financial Numbers Game: Detecting Creative
Accounting Practices, John Wiley & Sons.
Peter Atrill and Eddie McLaney, “Accounting and Finance for Non-Specialists”
(Prentice Hall, 1997).
Pinson, Linda (2001), Keeping the Books: Basic Record keeping and Accounting
for the Successful Small Business (5th Ed), Dearbon Publishing.
Wild, Bernstein and Subramanyam (7th Ed.), Financial Statement Analysis, Irwin
McGrawhill.
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An Overview
Analysis of Financial
Statements UNIT 6 STATEMENT OF CHANGES IN
FINANCIAL POSITION
Structure
6.0 Objectives
6.1 Introduction
6.2 Need for Changes in Financial Position
6.3 Statement of Changes in Financial Position---Meaning
6.4 Concept of Funds
6.5 Flow of Funds
6.6 Sources and Uses of Funds
6.7 Statement of Changes in Financial Position---Cash Basis
6.8 Statement of Changes in Financial Positions---Working Capital Basis
6.9 Funds Flow Statement

6.9.1 Schedule of Changes in Working Capital
6.9.2 Statement of Funds from Operations
6.9.3 Preparation of Funds Flow Statement
6.9.4 Steps in Preparation of Funds Flow Statements
6.10 Funds Flow Statement vs. Other Financial Statements
6.11 Importance of Funds Flow Statement
6.12 Let Us Sum Up
6.13 Key Words

6.0 OBJECTIVES
! explain need for funds flow statement for investors and other stockholders in
addition to balance sheet and profit and loss account;
! compare the differences between funds flow statement with other financial
statements;
! familiar with the concept of funds;
! explain the methodology for preparation of funds flow statement under
different methods; and
! explain how funds flow statement can be used in real life for different decision
making.
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Statement of Changes
6.1 INTRODUCTION in Financial Position
As a student of accounting, you are aware of basic difference between Profit

and Loss Account and Balance Sheet on time scale. While Profit and Loss
Account is prepared for a period, Balance Sheet presents financial position at a
particular point of time. Is there any way for users to convert the Balance Sheet
into a flow statement? If the answer is yes, what is the use of such conversion?
Let us take the second issue to understand the concept. Balance Sheet shows
the sources of capital or funds for the assets that the firm holds or how the firm
spent its capital or funds on various assets. This is an important useful
information to the users of financial statements but it fails to tell how much of
assets have been added during the period and how such additional investments
are funded. In other words, the users would like to know whether the firm is
growing or not and if it is growing, what is the source of capital or funds. Users
would also like to know whether there is any change in the pattern of funding
over the years. Therefore, there is a need for converting the point statement into
flow statement. So, the next question is how to convert the Balance Sheet into
Funds Flow Statement. There are different levels at which one can achieve the
translation and the easiest and crude way is to find the differences in the values
of each Balance Sheet item.
To illustrate the idea of funds flow statement and also to get a quick idea on the
concept, let us have a look on the summary of Balance Sheet items of Ranbaxy
Laboratories Ltd., which is one of the largest players in the pharmaceutical
industry in India. The details are as follows:
Summary of Balance Sheet values of Ranbaxy Laboratories Ltd.

(Rs. in Crores)
Year 2002 2001 2000 1999 1998
Share Capital 185.45 115.90 115.90 115.90 115.90
Reserves & Surplus 1686.06 1486.30 1466.76 1382.04 1284.94
Loans 6.90 125.98 255.81 322.88 424.93
Current Liabilities and Provision 935.37 586.67 417.98 308.71 307.49
Total 2813.78 2314.85 2256.45 2129.53 2133.26
Fixed Assets 675.39 613.05 644.37 631.90 613.56
Investments 337.50 342.52 290.03 282.77 332.47
Current Assets, Loans

& Advances 1800.89 1359.28 1322.05 1214.86 1187.23
Total 2813.78 2314.85 2256.45 2129.53 2133.26
The above Balance Sheet values show how the values have changed
(increased or decreased) over the years. It also tells how the assets are funded
over the years. The following table shows the Balance Sheets values in
percentage format.
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An Overview
Analysis of Financial Summary of Balance Sheet values of Ranbaxy Laboratories Ltd. (in %)
Statements
(Rs. in Crores)
Year 2002 2001 2000 1999 1998
Share Capital 7% 5% 5% 5% 5%
Reserves & Surplus 60% 64% 65% 65% 60%
Loans 0% 5% 11% 15% 20%
Current Liabilities and Provision 33% 25% 19% 14% 14%
Total 100% 100% 100% 100% 100%
Fixed Assets 24% 26% 29% 30% 29%
Investments 12% 15% 13% 13% 16%
Current Assets, Loans &
Advances 64% 59% 59% 57% 56%
Total 100% 100% 100% 100% 100%
The picture is somewhat clear now but not complete. Ranbaxy, which used to have
about 20% of total funds through loans is now not raising any debt to fund its
assets. The company has turned almost zero-debt company over the period of
5 years. This decline is suitably compensated through an increase in current
liabilities. There is also an increase in current assets values over the years. While
these details are useful, the percentage analysis fails to show any movement of
funds in absolute value. Let us now simply take the difference of the values and
see how the picture looks over the years.
Summary of Changes in Balance Sheet values of Ranbaxy Laboratories Ltd.
(Rs. in Crores)
Year 2002 2001 2000 1999
Share Capital 69.55 0.00 0.00 0.00
Reserves & Surplus 199.76 19.54 84.72 97.10
Loans ---119.08 ---129.83 ---67.07 ---102.05
Current Liabilities and Provision 348.70 168.69 109.27 1.22
Total 498.93 58.40 126.92 -3.73
Fixed Assets 62.34 --- 31.32 12.47 18.34
Investments --5.02 52.49 7.26 --- 49.70
Current Assets, Loans & Advances 441.61 37.23 107.19 27.63
Total 498.93 58.40 126.92 --- 3.73
The above table gives better picture. Over the years, Ranbaxy invested heavily on
current assets, loans and advances. The source of funds to meet this huge increase
in investments is primarily current liabilities and also from funds from operation.
The company reduced its loans value over a period of time by repaying loans. Once
you have this information, it is possible for you to examine how Ranbaxy is
comparable with other companies in the industries. For instance, if you find some of
the pharmaceutical companies are expanding faster than Ranbaxy, then as an
investor, you will worry about the future of the company. It is possible to perform
such analysis using funds flow statement. The funds flow statement, which we
have prepared above is bit crude and we need to make some adjustments to
54 prepare a good funds flow statement. This will dealt with in subsequent sections.
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Activity 1 Statement of Changes
in Financial Position
1) Refer Ranbaxy Laboratories Ltd. Balance Sheet. Prepare a statement to
show how the funds have moved from the year 1998 to 2002. Ignore the
funds flow of in between years i.e., assume Ranbaxy has not prepared any
balance sheet for in between years.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
2) List down major sources and uses of funds in descending order.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
3) Draw a broad conclusions on the flow of funds during this period.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
6.2 NEED FOR CHANGES IN FINANCIAL

POSITION
Accounting Standard (Revised) - 3 has made funds flow statement redundant and
prescribed cash flow statement. Despite that why do we feel funds flow statement
is useful to users of accounts? Funds flow statement provides some further insight
into the Balance Sheet and particularly shows how the firm is able to get money to
take up several activities. It is possible to know what is the kind of funds mix that
the firm is using particularly a comparison of internal and external funds. For
instance, Ranbaxy heavily uses internal funds and depend little on external funds.
In contrast, Aurobindo Pharma Ltd. another major player in the pharmaceutical
industry uses debt substantially for the funding its activities.
Summary of Changes in Balance Sheet values of Aurobindo Pharma Ltd.
(Rs. in Crore)
2002-03 2001-03 2000-03 1999-03
Share Capital 0.67 1.00 0.55 13.23
Reserves & Surplus 84.27 55.71 94.43 41.45
Debt 110.10 84.99 29.95 40.10
Total 195.04 141.70 124.93 94.78
Funds flow statement can also be used to know how the resources raised are used.
For instance, we observed Ranbaxy spends most of the resources for increasing
current assets. Aurobindo Pharma also uses substantial part of the funds for
increasing current assets and it looks like that there is something which is driving
for the industry to build up more current assets. A further analysis shows that a
significant part of the currents assets are funding of receivables without
corresponding increase in sales. Though balance sheet also highlights an increase in
receivables values, it is not apparent that substantial part of the funds raised during
the period go for funding of such receivables. 55
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An Overview
Analysis of Financial It is possible to examine how healthy the financial policies of firms. For instance,
Statements
many firms would like to avoid using short-term capital for long-term purposes. It is
possible to identify whether firms in which you are interested use funds in a sub-
optimal way.
Activity 2
1) Pick up annual report of two or three companies belonging to software or any
other industry. Compare the changes in balance sheet values for two years
and write down the values here.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
2) Write a brief on the sources of funds and where they are used. Also, compare
these figures between the companies and write down your views.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
3) Do you find all the companies are behaving in a same way? Mostly it will not
be and if so, why do you feel companies follow different strategies in raising
funds and using the same in different assets?
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6.3 STATEMENT OF CHANGES IN FINANCIAL

POSITION ----MEANING
Statement of changes in financial position is a statement which outlines the causes
of a change in the financial position of a company during an accounting period.
These causes are reflected in the movement of funds viz., inflows and outflows of
funds during the period. Therefore, it is called Funds Flow Statement in which the
inflows are shown as sources of funds and the out flows are shown as application
or uses of funds. The difference between the two (inflows and outflows) indicates
the net changes (increase or decrease) in the position of funds during the
accounting period.
6.4 CONCEPT OF FUNDS

The Balance Sheet gives a ‘snapshot’ view at a point in time for the sources from
which a firm has acquired its funds and the uses, which the firm has made of these
funds. The flow statement explains the changes that took place in the Balance
Sheet account. Firms get funds from various sources. Broadly, we classify the
sources of funds into two categories namely, long-term funds and short-term funds,
Sources of long-term funds include equity share capital, funds provided by
operation, term loan, etc. Source of short-term funds consists of supplier credit and
any short-term borrowing. The term fund is broader compared to the term cash.
For instance, when a firm sells goods on credit, there is no cash flow and cash flow
statement ignores such transactions. On the other hand, funds flow statement treats
this source of funds from operating activities and treat the increased accounts
receivables as application of funds for working capital purpose. On the other hand,
if the firm collects receivables of last year, it appears in cash flow statement,
56 whereas it has no impact in funds flow statement because there is no change in
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working capital. That is, while receivables decline its value, cash increases to that Statement of Changes
extent and flow of funds is restricted within the working capital group. The concept in Financial Position
of funds simply denotes whether there is any change in Balance Sheet item at
aggregate level and such changes lead to an increase in fund or decrease in fund.
The following are certain activities, which will not affect fund flow statement and
any effect that arises out of these activities will be restricted to working capital
statement.
a) Collection of bills receivable.
b) Payment of bills payable.
c) Purchase of Materials for cash or on credit basis.
d) Sale of goods on cash or credit basis (except for the profit or loss component).
The above items normally affect cash flow statement [cash part of item (c) and (d)].
There are several items, which affects funds flow and not cash flow statement.
A few of them are:
a) Sale or purchase of goods on credit basis --- it affects funds from operation and
to a minor extent working capital statement.
b) Purchase of fixed assets on credit basis.
c) Expenses incurred but not paid.
d) Income accured but not received.
e) Changes in value of closing stock.
There are several items, which affect both funds flow and cash flow statement.
A few of them are:
a) Fresh Equity
b) Fresh loan or repayment of loan
c) Purchase of fixed assets by paying cash
d) Cash sales and purchases
e) Cash Expenses
From the above discussion, it is clear that ‘funds’ in funds flow statement means
changes in equity, liability or working capital. It includes both cash and non-cash
items. In this unit, for the purpose of funds flow statement, we use the net working
capital concept which refers to excess of current assets over current liabilities.
Activity 4
1) A machine costing Rs. 70,000 (book value Rs. 40,000) was sold for
Rs. 25,000. What is the impact of this transaction on funds flow statement?
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2) The book value of Inventory was Rs. 8 lakhs and market value is Rs. 6.50
lakhs. What is the effect of change in market value on funds flow statement?
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An Overview
Analysis of Financial 3) Finished goods worth of Rs. 3 lakhs was sold for Rs. 3.50 lakhs on cash. What
Statements is the impact of this transaction on funds flow statement? Suppose if the above
sale is on credit basis, will it have different impact? Explain.
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4) What do you understand the term ‘fund’ in the context of funds flow
statement?
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5) Categorise the following items under current and non-current assets and
liabilities.
i) Bank Balance ............................................................................................
ii) Goodwill .....................................................................................................
iii) Income received in advance ......................................................................
iv) Share premium ..........................................................................................
6.5 FLOW OF FUNDS

Flow of funds means ‘change in fund position’ or ‘change in net working capital’.
Whenever there is a change in the funds, it is presumed that flow of funds has
taken place. The flow of funds can be in the form of a inflow or an outflow. An
inflow of funds increases the working capital and an outflow of funds decreases the
working capital.
Flow of funds will takes place if a transaction involves a change in a current item
and change in a non-current item. A non-current item means either a non-current
asset (Fixed asset) or a non-current liability (long-term liability). There will be no
change in net working capital (flow of funds) if a transaction involves : (i) only the
current items or (ii) only the non-current items. In other words, a transaction,
involving a fixed asset/fixed liability on the one hand and a current asset/current
liability on the other, will alone result in flow of funds. Let us understand these rules
by taking up some examples.
1) Transactions involving items from both current and non-current
categories which result in flow of funds:
i) Purchased machinery for Rs. 30,000 : This transaction increases
machinery (a non-current asset) and reduces cash (a current assets).
The reduction in cash reduces current assets without any corresponding
reduction in current liabilities. As a results, the net working capital gets
reduced.
ii) Shares issued for Rs. 2,00,000 : In this case, a non-current liability
(i.e., share capital) has increased and a current asset (i.e., cash) has
increased. Thus the current asset has increased without any
corresponding change in current liabilities. As a result, net working capital
58 gets increased.
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2) Transactions affecting items in the current category only which do not Statement of Changes
result in flow of funds: in Financial Position
i) Cash collected from debtors Rs. 4000 : This transaction results in an

increase in cash (a current asset) and a decrease in debtors (a current
asset, again) by the same amount. Thus the total current assets remain the
same and there will be no change in the net working capital.
ii) Acceptance given to creditors Rs. 3,000 : Both creditors and bills
payable are current liabilities. By giving acceptance to creditors, the amount
of creditors decreases and that of bills payable increases by the same
amount. Since this transaction does not affect the total amount of current
assets as also the total amount of current liabilities, the difference between
current assets and current liabilities remains unchanged. Thus, there is no
flow of funds and no change in the net working capital.
iii) Paid creditors Rs. 1,000 : By paying the creditors cash (a current asset)
is reduced and the amount of creditors (a current liability) is also reduced
by the same amount. Therefore, the difference between the current assets
and current liabilities will be the same as it was before. So there will be no
flow of funds, which means no change in the net working capital.
3) Transactions affecting items in the non-current category only which do

not result in flow of funds:
i) Land exchanged for machinery Rs. 10,00,000 : Both land and

machinery are non-current assets. By exchanging land for machinery, the
book value of land is reduced and that of machinery is increased, but the
total of non- current assets remains unaffected. Further, it does not effect
any change in the current assets or the current liabilities. Hence, there will
be no change in the net working capital position.
ii) Preference shares are converted into equity shares Rs. 10,00,000 :
Both preference share capital and equity share capital are non-current
items. As a result of conversion, the equity share capital stands increased
and the preference share capital gets reduced by the same amount. As no
current item is affected, there will be no change in net working capital.
iii) Purchased land worth Rs. 50,000 and issued shares in consideration
thereof : This transaction increases the debit balance of the land account
and credit balance of share capital account Both land and share capital are
non- current items. Since no current items is involved, the net working
capital remains unaffected.
We can summarise the above analysis as follows :
1) There will be flow of funds if transaction involves:
i) Current assets and non-current liabilities:
ii) Current assets and non-current assets.
iii) Current liabilities and non-current assets.
2) There will be no flow of funds if a transaction involves :
i) Non-current assets and non-current liabilities.
ii) Current assets and current liabilities.

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An Overview
Statements For easy reference, the list of non-current and current items is given below :
Non Current Liabilities Non-Current Assets
Equity Share capital Goodwill
Preference Share Capital Plant and Machinery
Debentures Furniture
Share Premium Trade Marks, Patnets, Copyrights
Forfeited Shares Land and Buildings
Current Liabilities Current Assets

Bank Overdraft Stock
Bills Payable Debtors
Creditors Bills Receivable
Outstanding Expenses Income Outstanding
Incomes received in advance Cash at bank
Cash in hand
In order to know whether a transaction brings a change in working capital, it is

better to journalise the transaction and then classify the accounts of the
transaction to which account it belongs. If both the accounts of the transaction
belong to current category or non-current category, there will be no change in
working capital. On the otherhand if one account of transaction belongs to
current item and the other to non-current item, then there will be a change in
working capital.
6.6 SOURCES AND USES OF FUNDS

You have learnt that, funds represent that portion of current assets which is not
financed by current liabilities but is financed from the long-term/non-current
sources. You have also learnt that as and when a change takes place in current
items resulting from a change in non-current items the net working capital will be
affected. The increase and decrease in only non-current (long-term) assets and
liabilities alone will act as a source or an application (use) of funds. For the
preparation of funds flow statement it is necessary to find out the sources and
application of funds. Let us now identify the sources and application of funds.
Sources of Funds : The sources of funds can be classified as external sources
and internal sources. External sources of funds refer to sources of funds from
outside the business. These are : (a) raising additional capital, (b) increasing long-
term borrowings, and (c) sale of fixed assets and long term investments. Internal
sources consist of funds that are generated internally by the organisation. Every
profitable sale brings in funds to the extent of the excess of sales revenue over cost
of goods sold. Such profits, called funds from operation, are also an important
internal sources of funds.
Application of funds : It may be noted that all funds raised through long term
source are not necessarily applied for financing the increase in net working capital.
A substantial part of this amount may be utilized for purchasing the fixed assets,
redemption of debentures or preference shares, payment of dividends and meeting
losses from operations, if any. In fact whatever is left the application of funds for
these purposes, will be the amount used for financing the increase in working
capital. Uses of funds thus are: (i) purchase of fixed assets or long term invest-
ments, (ii) redemption of debentures and preference shares, (iii) repayment of long
term loans, (iv) payment of dividends (v) meeting losses from operations (net loss),
60 and (vi) financing the increase in working capital.
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6.7 STATEMENT OF CHANGES IN FINANCIAL in Financial Position
POSITIONS --- CASH BASIS

There are two versions of the statement of changes in financial position. The
first version is called cash basis and the second one is called working-capital
basis. The cash basis of changes in financial position is to an extent close to
cash flow statement though it is presented in a different manner. This statement
first takes revenue and then removes all non-cash revenues and all cash related
revenues which are not recognised in computing revenues. In other words, at
this stage, we are interested to find out how much of cash is generated under
revenue head without bothering whether such revenue pertains to current year,
previous year or next year. Similarly, we consider expenses and then remove
all non-cash expenses and consider all cash expenses of previous period as well
as next period but not considered under the expenses value. For example, if
there is a payment for outstanding liability of previous year, it is also considered.
The difference of these two is funds or cash from operating activities. Next,
cash received from other sources are considered. In the last step, uses of
cash for capital transactions are considered to find out the net difference
between the sources and uses. The net difference shall be equal to net changes
in cash.
The main limitation or shortcoming of this method is its failure to segregate current
year income/expenses with other period income/expenses. Our next statement
overcomes this issue.
6.8 STATEMENT OF CHANGES IN FINANCIAL

POSITIONS---WORKING CAPITAL BASIS
As stated earlier, our main funds flow statement excludes all past and future
items and follows accrual and matching principle. Any such outstanding
expenses or prepaid expenses or income received in advance, etc. are adjusted
in a separate statement called working capital statement. Funds flow statement
under this method is prepared in two stages. The following diagram illustrates
the concept.
Assets Liabilities + Equity
Permanent Capital
Fixed Assets Share Capital + Reserves
Long-Term Loan
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
Current Assets Current Liabilities
Funds derived from permanent capital are reduced by funds used for fixed
assets acquisition. The balance is the amount available for working capital purpose.
The working capital statement shows the difference between the current assets and
current liabilities. Thus the above format clearly brings out how much of long-term
funds are used for working capital or how much of short-term working capital is
used for long-term purpose.
In this unit our funds flow analysis is based on working capital concept which you
will study in detail under 6.9 Funds Flow Statement of present unit. 61
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An Overview
Analysis of Financial Activity 5
Statements
1) Refer the two sets of Changes in Financial Positions statements. Briefly write
important differences between the two statements.
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2. Briefly write your understanding under each of the two formats which one you
feel is useful in your analysis.
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3. List down atleast three financial transactions that leads to differences in funds
flow from operations.
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6.9 FUNDS FLOW STATEMENT

Fund flow statement is intended to explain the magnitude, direction and the causes
of changes in the position of funds (net working capital) that took place during the
two balance sheets dates. Thus, it highlights the basic changes in the financial
structure, asset structure and the liquidity position of a business between two
balance sheet dates. But primarily, it reveals changes in the financial position of the
company by identifying the sources and application of funds resulting from financing
and investing decisions that took place during a particular period.
The preparation of fund flow statement involves essentially the following three steps:
1) Schedule of Changes in Working Capital.

2) Statement of Funds from Operations.
3) Preparation of the Funds Flow Statement (on working capital basis).
6.9.1 Schedule of Changes in Working Capital

As explained earlier, the first step in the preparation of fund flow statement is to
prepare the schedule of changes in working capital. For this purpose, all non-current
items are to be ignored as the net working capital is simply the difference between
current assets and current liabilities.
In order to ascertain the amount of increase or decrease in the net working capital,
it could be noted that :
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i) an increase in any current asset, between the two balance sheet dates, results Statement of Changes
in an increase in net capital and a decrease in any current asset result in a in Financial Position
decrease in net working capital; and
ii) an increase in any current liability, between the balance sheet dates, decreases
the net working capital whereas a decrease a in any current liability increases
the net working capital.
The schedule of changes in working capital may be prepared with the help of the
following specimen statement:
Proforma of Schedule of Changes in Working Capital
Changes in Working
Capital
Particulars Previous Year Current Year Increase Decrease
Rs. Rs. (Debit) (Credit)
Rs. Rs.
Current Assets:
Cash in hand
Cash at Bank
Marketable Securities
Bills Receivable
Debtors
Stock
Prepaid Expenses
Current Liabilities:
Creditors
Bills Payable
Outstanding Expenses
Working Capital:
Increase/Decrease
in Working Capital
Illustration 1
From the following summarised Balance Sheets of ABC Ltd. as on 31st March,
2004 and 2005, prepare a schedule of changes in working capital:
Liabilities 2004 2005 Assets 2004 2005
Rs. Rs. Rs. Rs.
Equity share capital 1,20,000 1,20,000 Fixed assets 90,000 75,000
Preference share capital ---- 30,000 Sundry debtors 1,20,000 72,000
General Reserve 6,000 6,000 Closing stock 30,000 1,05,000
Profit and Loss a/c 12,000 16,200 Prepaid expenses 3,900 1,500
Debentures 33,000 38,400 Bank 600 10,500
Conditors 36,000 39,000
Bank Overdraft 37,500 14,400
2,44,500 2,64,000 2,44,500 2,64,000
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An Overview
Analysis of Financial Solution
Statements
Schedule of Changes in Working Capital
2004 2005 Changes in working capital

Rs. Rs. Increase (+) Decrease (--- )
Rs. Rs.
Current Assets:
Sundry Debtors 1,20,000 72,000 --- 48,000
Closing Stock 30,000 1,05,000 75,000 ---
Prepaid Expenses 3,900 1,500 --- 2,400
Bank 600 10,500 9,900
1,54,500 1,89,000
Current Liabilities:
Creditors 36,000 39,000 3,000
Bank Overdraft 37,500 14,400 23,100
73,500 53,400
Working Capital 81,000 1,35,600
Net increase in working 54,600
capital 54,600
1,35,600 1,35,600 1,08,000 1,08,000
6.9.2 Statement of Funds from Operations

You know that profit is an important source of funds. Profit is the result of revenue
over expenses. When a business earns profit the net working capital gets increased
to the extent of the profit earned. Therefore, the profit earned constitutes an
important element of the funds provided by operations. Certain items charged and
revenues earned actually do not involve any flow of funds during the current period.
Similarly, certain deferred revenue expenses written off like preliminary expenses,
discount on issue of shares etc. do not involve any outflow of funds. Hence, these
items are added back to the net profit in order to arrive at the amount of funds from
operations. Also there are certain non- operating incomes and expenses like profit
or loss on the sale of fixed assets, dividend from investment, etc. are taken into
account to arrive at net operating results of the business. The profit or loss arising
out of these transactions are not regular operations of business. Hence, the effect
of these items must not be taken into account while preparing funds from
operations, i.e., the profit on such items are to be excluded from the net profit and
loss must be added back to the net profit to ascertain the amount of funds from
operations. There are many items which are charged and credited to profit and loss
account but do not affect working capital. Hence, all such items need adjustment to
calculate funds from operations.
There are two methods to calculate ‘Funds from Operations’ :
1) Statement of Funds from Operations Method.
64 2) Adjusted Profit and Loss Account Method.

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Statement of Funds from Operations Method Statement of Changes
Under statement form, all non-funds or non-trading charges which were already
debited to Profit and Loss Account are added back to net profit and all non-trading
incomes which were already credited to profit and loss account are to be subtracted
from the net profit. Funds from operations may be calculated with the help of the
following proforma:
Proforma of Statement of Funds from Operations
Rs. Rs.
Net Profit (Current year) xxx
Add: Non-fund and non-trading charges : ...
(Already debited to P& L a/c)
Depreciation Preliminary expenses ...
Transfer to General Revenue ...
Transfer to Sinking Fund ...
Provision for Taxation
Proposed dividend ...
Loss on Sale of Fixed assets ... xxxx
Total xxxx
Less: Non-fund items and non-trading Incomes:
(Already credited to P&L a/c)
Profit on sale of fixed assets ...
Profit on revaluation of fixed assets ...
Non-operating incomes: ...
Dividend received/accrued ...
Refund of Income tax ...
Rent received/accrued, etc. ... ... xxx
Funds from Operations xxxx
Note: In case Profit and Loss Account shows ‘‘Net Loss’’, it should be taken as
an item which decreases funds and therefore, all the items shown under
‘Add’ head above should be subtracted and those shown under ‘less’ head
should be added to the ‘Net loss’.
Adjusted Profit and Loss Account Method
‘Funds from Operations’ may also be computed in an ‘Account Form’ which is as
follows:
Proforma of Adjusted Profit and Loss Account
To Depreciation xx By Net Profit xxx
To Preliminary expenses xx (previous year)
(written off ) By Dividend Received xxx
To General Reserve xx By Refund of Tax xxx
(Transfer)
By Rent Received xxx
To Sinking fund (Transfer) xx By Profit on Sale of xxx
To Provision for Taxation xx Fixed assets
To Proposed Dividend xx By Profit on revaluation
of fixed assets xxx
To Loss on sale of fixed assets xx
By Funds from operation xxx
To Net Profit xx (Balancing figure)
(current year) xx
xxxx xxxx
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An Overview
Analysis of Financial Illustration 2
Statements
From the following Profit and Loss Account, calculate funds from operations under
both the methods as stated above.
Rs. Rs.
To Purchases 1,60,000 Less:Returns 10,000 4,00,000
Less : Returns 32,000 1,28,000 By Closing Stock 3,20,000
To Wages paid 80,000
Add : Outstanding 40,000 1,20,000
7,20,000 7,20,000
To Rent paid 40,000 By Gross Profit b/d 3,44,000
To Salary 1,00,000 By Interest on Investments 10,000
To Depreciation 12,000
To Discount on issue of shares 50,000
To Preliminary expenses 20,000
(written off)
To Goodwill (written off) 24,000
To Net Profit c/d 1,08,000
3,54,000 3,54,000
Solution
Method I
Statement of Funds from Operations
Rs. Rs.
Net Profit as per Profit and Loss account 1,08,000
Add: Depreciation 12,000
Discount on issue of shares 50,000
Preliminary expenses 20,000
Goodwill written off 24,000 1,06,000
2,14,000
Less: Interest on investments 10,000 10,000
Funds from operations 2,04,000
Method II
Adjusted Profit and Loss Account
Rs. Rs.
To Depreciation 12,000 By Net Profit ----
(Previous year)
To Discount on issue By Interest on investments 10,000
of shares 50,000 By Funds from operations 2,04,000
To Preliminary expenses 20,000 (Balancing figure)
To Goodwill written off 24,000
(Current year)
2,14,000 2,14,000
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When all the information is available, it is relatively easy to calculate the amount of Statement of Changes
funds from operations. Some times, full information is not available and it becomes
necessary to dig out the hidden information on the basis of clues available. Let us
now study a few situations involving such items and learn how will these be
ascertained and adjusted for determining the amount of funds from operations.
1) Depreciation
It is a practice in every business to write off dipreciation on fixed assets which is
debited to Profit and loss account and a corresponding credit to Fixed asset
account. Since, both profit and loss account and the Fixed asset account are non-
current accounts, depreciation is a non-fund item. It is neither a source nor an
application of funds. It is added back to operating profit to find out Funds
from operations.
When the profit and loss account is given, whether in full or as a summary thereof, the
amount charged as depreciation can be easily ascertaind. But when any details
regarding the income statement are not given, the depreciation amount is to be
ascertained from the data given in the balance sheet and from the other available
information. If the figures given in two Balance Sheets show the opening and
closing balances of the asset concerned at their depreciated value (cost less
depreciation till date) and there is no mention of purchase and sale of the asset
during that year, the difference between the opening and closing balance may be
considered as the depreciation charged during the years. Sometime, the fixed
assets are shown at cost on the assets side and the depreciation or, as a provision
for depreciation or as accumulated depreciation, is either shown as a deduction
from the fixed asset concerned or appears on the liabilities side. In such a situation,
the increase in the amount of accumulated depreciation during the year (assuming
that there were no purchases and sales of fixed assets) must be taken as the
amount of depreciation charged during that year. Study Illustrations 3 given below
and learn how will the amount of depreciation is to be ascertained.
Illustration 3
From the following, ascertain the amount of machinery for the year 2005:
Balance Sheet (asset-side only)
As on 31.12.2004 As on 31.12.2005
Furniture at Cost - less Rs. Rs.
depreciation 80,000 1,00,000
Other information : Depreciation Charged during the year on Machinery Rs. 8000
Solution
Machinery Account
Rs. Rs.
To Balance B/d 80,000 By Depreciation 8,000
To Bank (Purchases) By Balanace c/d 1,00,000
(Balancing figure) 28,000
1,08,000 1,08,000
Though the difference between the figures of the asset on two balance sheet dates
is Rs. 20,000, the value of machinery bought during the year is Rs. 28,000 and not
Rs. 20,000. This has been worked out after taking into account the amount of
Rs. 8000 as depreciation.
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An Overview
Analysis of Financial 2) Profit or Loss on Sale of Fixed Assets
Statements
When a fixed asset is sold at a price which is higher than its book value, the profit
on its sale is credited to profit and loss account. Hence, this amount will have to be
deducted from the net profit in order to ascertain the amount of funds from
operations. Similarly, when a fixed asset is sold at a loss (price is less than its book
value), the loss is charged to profit and loss account and it becomes necessary to
add back this amount to the net profit so as to show the correct amount of funds
from operations. The purpose of adjusting the amounts of profit or loss on sale of
fixed assets in the net profit is to avoid double counting of such profit or loss as the
same is already included/excluded in the amounts from the sale of the fixed assets
which would be shown separately as a source of fund. Thus, the actual sale of
fixed assets are shown as a source of funds, and, if there is a profit on sale it must
be subtracted from the net profit, and, if there is a loss the same must be added
back to the net profit. This adjustment is necessary for ascertaining the correct
amount of funds provided by operations.
If complete information is available with regard to purchase and sale of fixed assets
it will not be a problem to ascertain the amount of depreciation, value of assets
purchased, sale proceeds, gain/loss on such a sale and depreciation charged till the
date of sale of the assets sold. When detailed information is not available, then you
have to ascertain the hidden information. Look at the following illustration 4:
Illustration 4
Extracts of Balance Sheet
Liabilities As on As on Assets As on As on
31-12-04 31-12-05 31-12-04 31-12-05
Rs. Rs. Rs. Rs.
Accumulated
Depreciation 50,000 75,000 Machinery 37,500 90,000
Net profit for the year was Rs.75,000. Machinery with an original cost of
Rs. 12,500 was sold (accumulated depreciation on it being Rs. 5,000) for
Rs.10,000. Ascertain the amounts of depreciation, funds from operations, and
asset purchased.
Solution
Accumulated Depreciation Account
Rs. Rs.
To Depreciation on By Balance b/d 50,000
Machinery sold 5,000 By P& L A/c- 30,000
To Balance c/d 75,000 Depreciation charged
80,000 (Balancing figure) 80,000
Machinery Account
Rs. Rs.
To Balance b/d 37500 By Accumulated
To P & L A/c 2,500 Depreciation 5,000
(gain on sale)
By Cash (sale) 10,000
To Cash --- purchase 65,000 By Balance c/d 90,000
(balancing figure)
1,05,000 1,05,000
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Gain on Machinery Sold Statement of Changes
Book Value 12,500
Less: Depreciation 5,000
Depreciated value 7,500
Sale price 10,000
Gain on sale 2,500
Funds from Operations:

Net profit as reported 75,000
Add : Depreciation charged 30,000
1,05,000
Less : Gain on Sale 2,500
Funds from Operations 1,02,500
Note : The total sale proceeds of Rs. 10,000 will be shown as a source of fund in
the fund flow statement.
If we had merely compared the opening and closing balances of the accumulated
depreciation account, we would have wrongly concluded that depreciation charged
during the year was only Rs. 25,000. The sale of an old asset required that the
accumulated depreciation in respect there of should be transferred from
accumulated depreciation account to the concerned asset account, and it is only
after incorporating this entry that the actual depreciation charged during the year
can be correctly ascertained Thus, the depreciation charged during the year works
out to Rs. 30,000 and not Rs. 25,000. This amount of depreciation charged during
the year has been added back to the net profit, in order to ascertain funds from
operations as the same must have been debited to profit and loss account earlier.
3) Profit or Loss on sale of Long term Investments
If a company made long term investment in other company, such investment must
be considered as non-current item like a fixed asset. If there is any profit or loss on
their sale, it would be dealt in the same manner as the profit or loss on the sale of
fixed assets. On the other hand, if the investments made are only for a short period,
in such a case the investments must be treated as an item of current asset. Any
changes in short term investments will appear in the schedule of changes in working
capital, otherwise it would appear directly in funds flow statement.
4) Amortisation of Expenses and Writing Off of Intangible Assets
Sometimes, a firm decides to write off a portion of its intangible assets like goodwill,
patents, copy rights, etc., by charging it to the profit and loss account. Similarly, it
may decide to write off deferred revenue expenses, like preliminary expenses,
discount on issue of shares, etc., by charging some amount to the profit and loss
account. These write off amounts, like depreciation, are non-cash costs and reduce
the amount of profit. But they do not affect flow of funds. For this reason, such
amounts must be added back to the net profit to determine the amount of funds
provided by operations.
5) Provision for Taxation
Provision for taxation represents the amount likely to be paid as tax after the
assessment is complete during the next accounting period. Thus, provision for taxes
is shown as a current liability in the balance sheet, and if for purposes of preparing
fund flow statement it is treated as such, this would appear in the schedule of
changes in working capital, and the amount of tax paid during the year will not be 69
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An Overview
Analysis of Financial shown as an application in the fund flow statement. However, as per practice, tax on
Statements
profits is normally treated as a non-current item for preparing the fund flow statement.
Hence, this will not be taken to the statement of changes in working capital. In fact,
the provision made during the current year will have to be added back to net profit to
find out the amount of funds from operations, as the same must have been debited to
profit and loss account earlier. As for the amount of tax paid, it must be shown as an
application of fund in the fund flow statement. It may be noted that if no additional
information is available, the provision for tax shown in the previous year’s balance
sheet shall be taken as the tax paid during the year, and the provision for tax shown in
current years’ balance sheet be treated as the amount of tax provided during the
current by debiting it to the current year’s profit and loss account. Of course, this
amount will have to be added back to net profit for ascertaining funds from
operations. This treatment of taxation is in strict conformity with the requirements of
the Accounting Standard on State of Changes in Position of Funds (AS-3).
6) Proposed Dividends
Proposed dividend, as in the case of provision of taxation, can be treated either a
current liability or as a non-current liability and its treatment will differ accordingly. In
case it is treated as a current liability, it will appear as one of the items in the schedule
of changes in working capital and the amount of dividend paid will not be shown as an
application of funds in fund flow statement. But, as per the requirement of AS-3, the
proposed dividends are also to be treated as a non-current item for purposes of fund
flow statement. As such proposed dividends will not find a place in the schedule of
changes in working capital. The amount of proposed dividends relating to current year
if already deducted from profits, shall be added back for ascertaining the amount of
funds from operations, and the dividends actually paid during the year will be shown
as an application of funds. It may be noted that, just like provision for tax, if no details
are available, the proposed dividends shown in the previous year’s balance sheet shall
be taken as dividends paid during the year and the proposed dividends shown in
current year’s balance sheet shall be treated as the amount of dividends provided
during the current year by debiting it to the current year’s profit and loss appropriation
account.
7) Provision for Doubtful Debts

Provision for doubtful debts is treated as a current item as it relates to an item of
current asset (debtors) and therefore it should appear in the schedule of changes in
working capital.
6.9.3 Preparation of Funds Flow Statement (on working capital

basis)
Funds flow statement is a statement which explains about the movement of funds
where from working capital originates and where into the same goes during the
accounting period. While preparing funds flow statement, current assets and current
liabilities are to be ignored and only changes in non-current assets and non-current
liabilities are taken into account. In otherwords, funds flow statement is prepared on
the basis of the changes in fixed assets, long term liabilities and share capital shown in
the Balance Sheet after taking into account the additional information given, if any.
This statement has two parts, Sources of funds and Application of funds. The
difference between sources and application of funds shows the net changes in the
working capital during a specified period. The transactions which increase working
capital are sources of funds and the transactions which decrease working capital are
application of funds. Therefore, funds flow statement is also called as a Statement of
Sources and Application of Funds, Inflow-outflow of Funds Statement etc.
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This can be prepared either in a (1) Statement Form, or (2) Account Format as Statement of Changes
given below: in Financial Position
1) Statement Form :
Proforma of Fund Flow Statement
Fund Flow Statement for the year ending ................................
A) Sources of Funds : Rs. Rs.
1) Funds from operations ---------------
2) Issue of share capital ---------------
3) Issue of debentures ---------------
4) Long-term loans raised ---------------
5) Sale of fixed assets ---------------
--------------- xxxx
B) Uses of funds
1) Operating loss, if any ---------------
2) Redemption of preference share capital ---------------
3) Redemption of debentures ---------------
4) Repayment of long- term liabilities ---------------
5) Purchase of fixed assets ---------------
6) Payment of dividends (final and interim) ---------------
7) Payment of taxes ---------------
--------------- xxxx
Increase/Decrease in Working Capital (A-B) xxxx

2) Account Format
Proforma of Fund Flow Statement

Fund Flow Statement for the year ending..............
Sources Rs. Uses Rs.
Funds from operations ................. Operating loss, if any ................

Issue of Share capital ................. Redemption of preference share capital .............
Issue of debentures ................. Redemption of debentures ................
Long term loans raised ................. Repayment of long term loans ................
Sale of fixed assets ................. Purchases of fixed assets ................
Decrease of Net ................. Payment of dividends (final and interim) ............
Working Capital ................. Payment of tax
(Balanicing figure) ................. Increase of Net Working Capital ................
(Balanicing figure)
Total Total
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An Overview
Analysis of Financial 6.9.4 Steps in Preparation of Funds Flow Statement
Statements
To prepare funds flow statement, sources and application of funds have to be
ascertained. The usual sources of funds and uses of funds are as follows:
1) Funds From Operation: Identify profit after tax but before any appropriation.
With that value, add the following values:
l Depreciation on fixed assets
l Any expenses written off during the year
l Loss on sale of fixed assets and investments
Deduct the following:
l Profit on sale of fixed assets and investments
l Profit on revaluation of fixed assets
l Non-operating incomes
2) Fresh issue of Equity shares, issue of debentures, fresh loan from financial
institutions, etc. are next major sources of funds.
3) Sale proceeds of fixed assets and investments are next source of funds.
4) Non-operating income, which was deducted earlier to compute funds from
operation has to be added at this stage since it is also source of funds.
5) The above four sources of funds give your gross value of funds generated
during the year. From this value deduct the following uses of funds of long-
term nature.
6) Purchase of fixed assets and investments has to be deducted.
7) Repayment of loan, debentures, share repurchase are to be deducted.
8) Payment of dividend, income-tax, etc., are to be reduced.
9) The difference between the sources and uses of funds calculated above is
sources of funds from long-term operations.
10) Find out changes in current assets and current liabilities values of two periods
and compute how much net change on working capital. The net changes in
working capital will be equal to net changes in long-term sources and uses.
6.10 FUNDS FLOW VS. OTHER FINANCIAL

STATEMENTS
Funds flow statement is unique compared to other statement since it converts a
stock statement (balance sheet) into a flow statement. As such, there is not much
of comparison or relationship between funds flow and other financial statements.
When compared to cash flow statements, which will be discussed in the next
section, funds flow gives a broader view of financial flow. While cash flow shows
how cash balance changed from one period to another period, funds flow statement
typically shows the changes in the balances of working capital, which includes cash
balance. Normally, funds flow statement is used to understand long-term stability of
business whereas cash flow statement is used to find out short-term stability. Cash
flow statement can be used to assess the quality of reported profit, whereas it
would be difficult to do such exercise with funds flow statement.
There are significant differences between funds flow statement and profit and loss
account. Though both of them are flow or period statement, profit and loss account
72 excludes all capital-related transactions like capital expenditure or capital receipts.
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Funds flow statement considers both revenue and capital items. The only Statement of Changes
relationship between the two statements is both are concerned with funds raised in Financial Position
through operating activities. To get funds from operating activities, we use profit
and loss statement and perform some adjustments.
As discussed earlier, funds flow statement is a kind of extension of Balance Sheet.
There are number of similarities between the two statements. Many accounting
heads of both statements are common and the only difference is the valuation.
While Balance Sheet shows the figure as on a particular date, Funds Flow
Statement shows the period value. While Balance Sheets values are normally
positive, funds flow statement may show negative values on some of the items. For
instance, consider secured loan item of Balance Sheet. It might show a value of
Rs. 200 lakhs last year and Rs. 150 lakhs at the end of current year. Both are
positive values. In Funds Flow Statement, the secured loan account will have
negative value of Rs. 20 lakhs, since this much of amount is repaid and hence it is
application of funds. While Balance Sheet is a single statement, funds flow is
normally prepared in two stages and includes working capital statement.
Activity 3
1) Visit some of the web sites of large Indian companies, which have also issued
American Depository Receipts (ADR). From the web sites, download the
P&L account as per Indian Accounting Standards and also P&L account
drawn under US accounting standards (called US GAAP). Compare the two
statements and then briefly write your overall observations.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
2) Why do feel that the two figures are different? List down some of the
dominant reasons.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
3) Now, you check the cash flow statement reported under two systems and list
down your observations.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
6.11 IMPORTANCE OF FUNDS FLOW

STATEMENT
An important contribution of funds flow statement is to know how funds have
moved between long-term and short-term needs of the organisation. It is generally
believed that organisation needs to match assets and liabilities on time scale though
assets are always equal to liabilities. For instance, if a firm raises funds through 364
days commercial paper and uses the money to buy a plant. There is a asset-liability
mismatch between the sources and uses of funds. Suppose, the interest rate is
10% and expected return from the project is 12%. Today, the project looks 73
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An Overview
Analysis of Financial profitable. But what will happen when the interest rate increases to 13% from 10%
Statements at the end one year. If the commercial paper is renewed or new commercial paper
is substituted for the same, the project profitability turns negative. Further, what is
the assurance that the company would be in a position to roll-over the commercial
paper or substitute a new paper. If there is delay or difficulty in doing it, it will put
lot of pressure on the part of organisation. Thus, prudential norms require use of
long-term funds for long-term purpose and short-term funds for short-term needs,
which is mainly working capital. Since it is difficult to exactly match this way,
normally, if the flow is from long-term sources to short-term uses, then it is
considered to be a good funds management. Here again, too much of excessive use
of long-term funds for short-terms is not good. Funds flow statement shows how
efficient the firm is in managing two sources of funds.
Funds flow statement is also useful to ascertain whether the firm is liquid or not and
whether the firm is in a position to raise funds from operation to sustain its
activities. If the firm has set some budgets, which show the funding pattern of
future expansion, funds flow statement will be useful to compare whether we are
able to achieve the budget terms. If the funds flow statement is prepared for the
future years, then it is possible for the management to plan in advance how to
manage the funds and what steps need to be taken today to raise different sources
of funds.
An analysis of working capital statements will be useful to know where the need
for working capital arises. Other things being equal, it is desirable to reduce the
working capital since investments in working capital yield very low return or zero
return. It is also possible to compare this statement with budgets to control the
growth of working capital. Let us consider the Funds Flow Statement of BHEL to
understand this point.
Bharat Heavy Electricals Ltd.
Funds Flow Statement
(Rs. in Crores)
Year 2001-02 2000-01 1999-2000 1998-99 1997-98
Sources of Funds
Funds From Operation 881.15 443.53 715.52 667.64 827.08
Funds from Fresh Loans 0.00 784.90 70.58 0.00 0.00
Sale of Investments 0.00 0.00 4.76 9.00 110.96
Miscellaneous Sources 0.00 12.35 0.00 10.73 17.96
Total 881.15 1240.78 790.86 687.37 956.00
Application of funds
Decrease in Loan funds 381.10 0.00 0.00 219.43 508.48
Investments in Fixed Assets 173.44 181.98 152.60 243.53 315.64
Dividend 97.91 73.43 73.42 61.19 61.19
Miscellaneous Uses 20.69 0.00 238.63 0.00 0.00
Total 673.14 255.41 464.65 524.15 885.31
Net Funds from long-term sources 208.01 985.37 326.21 163.22 70.69
Increase in Working Capital 208.01 985.37 326.21 163.22 70.69
BHEL working capital is showing steady increase over the years. However, in all
the five years, BHEL was able to generate adequate long-term funds to meet the
increasing short-term needs.
Let us consider one more large Indian company to understand the issue. Sterlite
Industries funds flow statement given below shows wide variation in the flow of
74 funds. Of the five years, funds from long-term sources turned negative and it
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means, short-term sources are used to fund the long-term needs. As we know, Statement of Changes
Sterlite made a number of acquisition and in that process, there are some in Financial Position
deviations in resources planning. As you see, the company is setting right the
situation in 2001. by bringing down the gap and hopefully, it will come to normal in
year 2002.
Sterlite Industries (India) Ltd.

Funds Flow Statement
(Rs. in Crores)
Year 2001-02 2000-01 1999-2000 1998-99 1997-98
Sources of Funds
Funds From Operation ----166.03 130.48 512.77 235.78 191.02
Funds from Fresh Loans 11.34 0.00 110.27 0.00 188.17
Sale of Investments 2.34 0.00 4.86 0.00 0.00
Miscellaneous Sources 2.53 1.20 35.85 10.88 0.52
Total ----149.82 131.68 663.75 246.66 379.71
Decrease in Loan funds 0 169.08 0 73.14 0
Investments in Fixed Assets 44.57 4.75 85.14 93.05 419.97
Purchase of Investments 0 737.52 0 2.25 10.35
Dividend 1.81 33.64 57.51 45.32 38.53
Miscellaneous Uses 5 20 0 0 0
Total 51.38 964.99 142.65 213.76 468.85
Net Funds from long-term sources ----201.20 ----833.31 521.10 32.90 ----89.14
Increase in Working Capital ----201.20 ----833.31 521.10 32.90 ----89.14
6.12 LET US SUM UP

The statement of changes of financial position explains the differences in various
assets and liabilities items of balance sheet between the beginning of the year and
end of the year. It converts balance sheet into a flow statement. An increase in
liability side means the organisation has generated funds during the period. There
are broadly three sources of funds - funds from operation, funds from other long-
term sources like equity, loan, etc. and funds generated from working capital (e.g.
increase in payables). There are broadly two uses of funds namely, funds required
to buy assets and other long-term need and funds required for current assets
(purchase of inventory, funding receivables, etc.). Funds flow statement can be
prepared on cash basis or working capital basis. Funds flow on cash basis is similar
to cash flow statement and hence there is limited use since all companies are asked
to give cash flow statement under AS-3. Funds flow statement on working capital
basis throws some insight further on the flow of funds between long-term and
short-term needs of organisation.
Funds flow statement is not required under the current Accounting Standards
and hence very few companies provide such statement. Further, funds flow
statement is not free from window dressing since uses only the two principal
financial statements. Many organisations prepare funds flow statement for
internal purpose and normally it is compared with budgets to set right deviation
from budgets.
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An Overview
Statements 6.13 KEY WORDS
Funds: Cash or net working capital.
Flow of funds: Movement or change in the net working capital.
Current Assets : Cash and other assets that are converted into cash or consumed
in the production of goods in the normal course of business.
Fund Flow Statement: Statement which shows the sources (inflows) and uses
(outflows) of funds between two balance sheet dates.
Funds from Operations: The amount of net profit that acts as a source of fund
i.e., profit before charging certain non-cash costs and before crediting items like
profit on sale of fixed assets.
Current - liabilities : Liabilities payable within one year.
Gross Working Capital : Total of current assets.
Net Working Capital: Excess of current assets over current liabilities.
Non-Current Items: Long term asset and long-term liabilities.
Schedule of Changes in Working Capital: Statement which reveals the effect

of item wise change in current asset and current liabilities on the net working
capital between two balance sheet dates.
Working Capital: That part of the capital which is required for recoming operations
of a business as distinguished from capital invested in fixed assets.

1) Compared to two principal financial statements namely, Profit and Loss
Account and Balance Sheet, what is additional insight you get from funds flow
statement?
2) “Funds flow statement is only supplementary to P&L Account and Balance

Sheet; it can’t be substitute to P&L Account and Balance Sheet” - Do you
agree to this statement? Explain your views.
3) Discuss a few basic differences between “cash” concept of funds flow

statement and “working capital” concept of funds flow statement.
4) A firm is found to have negative changes in working capital. What does it

mean? Is it good for the firm in the long-run if the negative change in working
capital continues for a long period?
5) “Funds Flow Statement also suffers from window dressing of accounts and
hence fails to give true view of funds movement; for instance, funds from
operation can be increased by recording a few dummy sales” - Do you agree
to this criticism? Give your views.
6) From the following figures, prepare Funds Flow Statement under both methods
and then give your comments and observations.
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Year 1 Year 2 in Financial Position
Assets
Fixed Assets (Net Block) 510000 620000
Investments 30000 80000
Current Assets 240000 375000
Discount on Issue of Debentures 10000 5000
Total 790000 1080000
Liabilities
Equity Share Capital 300000 350000
14% Preference Share Capital 200000 100000
14% Debentures 100000 200000
Reserves 110000 270000
Provision for Doubtful Debts 10000 15000
Current Liabilities 70000 145000
Total 790000 1080000
Additional Details
a) Provision for Depreciation stood at 150000 at the end of Year 1
and Rs. 190000 at the end of Year 2.
b) During the year, a machine costing Rs. 70000 (book value Rs. 40000)
was disposed of for Rs. 25000.
c) Preference shares redemption was carried out at a premium of 5%.
d) Dividend @ 15% was paid on equity shares for the year 1 during the
year 2.
7) Following is the summarised Balance Sheet of Bombay Industries Ltd. as on
December 31, 2004 and 2005 :
Balance Sheet
Rs. Rs. Rs. Rs.
Sundry Creditors 40,400 43,200 Cash and Bank 44,600 47,800
Bills Payable 10,800 12,200 Debtors 10,800 17,000
Outstanding Rent 2,600 1,000 Stock-in-trade 44,000 67,200
Mortgage Loan 22,000 21,000 Temporary Investments 30,200 8,000
Share Capital 2,80,000 3,20,000 Plant & Machinery 2,54,600 3,35,800
Reserves 1,12,600 1,31,600 Land 50,000 50,000
Proposed Dividend 28,000 32,000 Long-term investment 62,200 35,200
4,96,400 5,61,000 4,96,400 5,61,000
You are required to prepare schedule of changes in working capital. 77

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An Overview
Analysis of Financial 8) Funds Flow Statements of two large Indian textile companies are given below.
Statements Analyse and give your views on the performance of the companies.
Bombay Dyeing & Manufacturing Company Ltd
Funds Flow Statement (Rs in Cr.)
Year 2002-03 2001-02 2000-01 1999-2000 1998-99
Sources of Funds
Funds From Operation 68.18 -286.50 38.16 79.74 1122.22
Funds from Fresh Loans 88.45 - - - 667.58
Sale of Investments - 193.33 115.38 - -
Miscellaneous Sources - 46.09 - - -
Total 156.63 ---47.09 153.54 79.74 1789.8
Decrease in Loan funds 0.00 305.42 4.48 65.23 0.00
Investments in Fixed Assets -5.49 -21.08 31.76 17.49 847.61
Purchase of Investments 156.94 0.00 0.00 16.35 421.94
Dividend 11.54 7.83 8.20 12.30 12.30
Miscellaneous Uses 0.00 0.00 9.30 7.01 29.78
Total 162.99 292.17 53.74 118.38 1311.63
Net Funds from long-term sources ---6.36 ---339.3 99.8 ---38.64 478.17
Increase in Working Capital ---6.36 ---339.3 99.8 ---38.64 478.17
Raymond Ltd.
Funds Flow Statement (Rs. in Crore)
Year 2002-03 2001-02 2000-01 1999-2000 1998-99
Sources of Funds
Funds From Operation 130.40 98.52 165.53 129.21 165.74
Funds from Fresh Loans 0 4.36 0 0 0
Sale of Investments 0 19.78 0 0 15.92
Miscellaneous Sources 1.10 0.90 0 3.09 0
Total 131.50 123.56 165.53 132.30 181.66
Decrease in Loan funds 49.69 0 237.51 140.79 71.51
Investments in Fixed Assets 75.41 53.05 ---401.60 17.43 86.85
Purchase of Investments 24.66 0 421.61 89 0
Dividend 27.62 27.62 18.41 11.26 15.02
Miscellaneous Uses 0 0 0.21 0 2.75
Total 177.38 80.67 276.18 258.48 176.13

Net Funds from long-term sources ---45.88 42.89 ---110.70 ---126.20 5.53
Increase in Working Capital --- 45.88 42.89 ---110.70 ---126.20 5.53

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9) Calculate the Funds from Operations from the following Profit and Loss Statement of Changes
Appropriation Account.
Rs. Rs.
Salaries 25,000 Gross profit 1,50,000
Rent 9,000
Profit on sale of
Depreciation on plant 15,000 buildings:
Preliminary expenses Book value Rs. 45,000
Written off 6,000 Sold for Rs. 30,000
Printing and stationery 9,000 15,000
Goodwill written off 9,000
Provision for tax 12,000
Proposed dividends 8,000
Net Profit 72,000
1,65,000 1,65,000
(Answer: Rs. 1,07,000)

Note: Provision for tax is treated as a non-current item.
10) Calculate fund/loss from operations from the fol1owing data:
Rs.
P & L Alc (credit balance) as on April 01, 2004 70,600
P & L Ale (credit balance) as on March 31, 2005 30,000
Loss on issue of debentures 12,000
Operating expenses 28,000
Premium of expenses written Off 13,000
Transfer to general reserve 15,000
(Answer: Operating Loss: Rs.600 No adjustment is needed for operating
expenses.)
11) From the following Balance Sheets, prepare Statement of Changes in
Working Capital and Adjusted Profit and Loss A/c for ascertaining Funds
from Operations.
Liabilities 31.3.2004 31.3.2005 Assets 31.3.2004 31.3.2005
Rs. Rs. Rs. Rs.
Share Capital 1,50,000 2,00,000 Goodwill 57,500 45,000

8% Redeemable Buildings 1,00,000 85,000
Preference Share Plant 40,000 1,00,000
Capital 75,000 50,000 Debtors 80,000 1,00,000
General Reserve 20,000 35,000 Stock 38,500 54,500
Profit & Loss A/c 15,000 24.000 Bills Receivable 10,000 15,000
Proposed Dividend 21,000 25,000 Cash 7,500 5,000
Creditors 27,500 41,500 Bank 5,000 4,000
Bills Payable 10,000 8,000
Provision for Tax 20,000 25,000
3,38,500 4,08,500 3,38,500 4,08,500

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An Overview
Analysis of Financial Additional Information
Statements
a) Depreciation of Rs. 10,000 and Rs. 15,000 has been charged on Plant and
Buildings respectively.
b) lncome tax of Rs. 17,500 has been paid during the year.
(Answer : Increase in Working Capital : Rs. 25,500; Funds from Operation
Rs. 1,09,000)
12) Prepare a statement of funds from operations and the schedule for changes in
working capital
Rs. Rs. Rs. Rs.
Share Capital 25,00,000 20,00,000 Fixed Assets 15,50,000 15,00,000
Surplus 7,50,000 2,50,000 Investments 75,000 -----

Proposed Dividend 5,00,000 6,00,000 Stock 37,50,000 39,37,500
Debtors 20,00,000 17,50,000
Secured loans 12,50,000 14,00,000 Cash & bank 1,25,000 62,500
Current liabilities 25,00,000 30,00,000
75,00,000 72,50,000 75,00,000 72,50,000
Additional Information
a) Dividend paid during 2004-05 Rs. 2,50,000.
b) Depreciation on fixed assets for the year Rs. 1.5 lakh.
(Answer : Decrease in Working Capital: Rs. 6,25,000; Funds from operations
Rs. 8,00,000).
13) From the following Balance Sheets of ABC company Ltd., prepare:
i) Statement of Changes in Working Capital.
ii) Funds Flow Statement.
Rs. Rs. Rs. Rs.
Creditors 45,000 20,000 Goodwill 5,000 12,000
Bills Payable 35,000 23,000 Cash 70,000 25,000
12% Debentures 80,000 ----- Debtors 90,000 98.000
Share Capital 1,25,000 1,50,000 Stock 1,20,000 87,000
Profit & Loss a/c 42,000 62,000 Investments 10,000 15,000
Land (Cost) 27,000 15,000
Preliminary Expenses 5,000 3,000
3,27,000 2,55,000 3,27,000 2,55,000
Additional lnformation
i) Land sold for Rs. 24,000
ii) Dividend paid Rs. 30,000
iii) Debentures redeemed at a premium of 10%.
80
(Ans : Net decrease in working capital Rs. 33,000 Funds operations : Rs. 41,000)
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14) From the following Balance sheets of a Company as on 31st March, 2004 and Statement of Changes
31st March 2005 you are required to prepare Schedule of Changes in the
Working Capital and a Funds Flow Statement
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,50,000 Non-current Assets 1,00,000 2,00,000

Profit & Loss Account 40,000 60,000 Current Assets 1,30,000 1,40,000
Provision for Taxes 20,000 30,000 Discount on Issue
Proposed Dividend 10,000 15,000 of Shares --- 5,000
Creditors 25,000 37,000
Outstanding Expenses 20,000 30,500
2,30,000 3,45,000 2,30,000 3,45,000
Additional Information is given below:

(i) Tax paid during 2004-05 Rs. 25,000; (ii) Dividend paid during 2004-05 Rs. 10,000.
(Answer : Net decrease in working capital : Rs. 20,000, Funds From operations :
Rs. 70,000)
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.
6.15 FURTHER READINGS

Robert N Anthony and James S Reece, Management Accounting: Text and Cases,
Richard D. Irwins Inc, Homewood, Illinois.
M C Shukla, T S Grewal and S C Gupta, Advanced Accounts (Volume II),
S.Chand & Company Ltd. New Delhi.
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Statements UNIT 7 CASH FLOW ANALYSIS
Structure
7.0 Objectives
7.1 Introduction
7.2 Need for Cash Flow Statement
7.3 Cash Flow Statements vs. Other Financial Statements
7.4 Preparation of Cash Flow Statement
7.4.1 Sources and Uses of Cash
7.4.2 Ascertaining Cash from Operations
7.5 Preparation of Cash Flow Statement

7.6 Regulations Relating to Cash Flow Statement
7.7 Cash Flow Statement Formats
7.8 Cash Flow from Operating Activities
7.9 Cash Flow From Investing and Financing Activities
7.10 Uses of Cash Flow Analysis
7.11 Distinctions between Funds Flow and Cash Flow Analysis
7.12 Let Us Sum Up
7.13 Key Words
7.0 OBJECTIVES
! explain importance of cash flow statement for investors and other
stockholders;
! compare the differences between cash flow statement with other financial
statements;
! explain regulations relating to preparation of cash flows;
! familiar with the methodology for preparation of cash flow statement and
different components of cash flow statement; and
! comprehend how cash flow statement can be used in real life for different
decision making.
7.1 INTRODUCTION
The statement of cash flows, required by the Accounting Standard-3, is a major
development in accounting measurement and disclosure because of its relevance
to financial statement users. Cash Flow Statement is reasonably simple and easy
to understand. It is also difficult to fudge or manipulate the cash flow numbers
and hence often used as a way to test the real profitability of the firm. For
instance, if your company approaches a bank for a loan, your company will
82 normally highlight the profitability of your business as your strength. But the bank
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manager may not be sure how you arrived at the profit, particularly when we read Cash Flow
Analysis
lot of accounting related scams. Hence, the bank manager would like to examine
whether you have actually earned the profit or not. Cash Flow Statement will be
useful to examine whether the profits are realised and if so, to what percentage of
profit a firm has realised. In other words, a company that shows high level of
profit need not be liquid in cash. Suppliers of goods will also be interested to
examine the cash flow position of the company before supplying goods on credit.
Investor, who have no control on management, will also be interested in examining
the cash flow to supplement her/his analysis on profitability of the business.
Activity 1
1) Before you read further, can you think about why profit reported in P&L
account might be misleading? Can you think about some examples of how
profit can be overstated?
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2) If you have identified some examples, can you think about why companies
resort to do such things and also how you can find out if you are an outsider?
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7.2 NEED FOR CASH FLOW STATEMENT

The primary objective of the statement of cash flows is to provide information
about an entity’s cash receipts and cash payments during a period. The net effect
of cash flow is provided under different heads namely cash flow from operating,
investing and financing activities. It helps users to find answers to the following
important questions:
a) Where did the cash come from during the period?
b) What was the cash used for during the period?
c) What was the change in the cash balance during the period?
The AS-3 identifies two important uses of cash flow statement as follows:
a) A cash flow statement, when used in conjunction with the other financial
statements, provides information that enables users to evaluate the changes in
net assets of an enterprise, its financial structure (including its liquidity and
solvency) and its ability to affect the amounts and timing of cash flows in
order to adapt to changing circumstances and opportunities. Cash flow
information is useful in assessing the ability of the enterprise to generate cash 83
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Analysis of Financial and cash equivalents and enables users to develop models to assess and
Statements
compare the present value of the future cash flows of different enterprises. It
also enhances the comparability of the reporting of operating performance by
different enterprises because it eliminates the effects of using different
accounting treatments for the same transactions and events.
b) Historical cash flow information is often used as an indicator of the amount,

timing and certainty of future cash flows. It is also useful in checking the
accuracy of past assessments of future cash flows and in examining the
relationship between profitability and net cash flow and the impact of changing
prices.
A Statement issued by Securities and Exchange Board of India in 1995 when it

made the cash flow statement mandatory also lists the above are primary objective
of requiring the listed companies to provide cash flow statement to the investors.
The importance of cash flow as a measure of corporate performance and as a

critical variable to appraise loan decisions has been supported by several influential
persons or organisations. The importance of cash flow statements is clear from the
following excerpts:
1) Harold Williams (the then chairman of the SEC) made the following comments
in a speech to the Financial Executives Research Foundation:
Corporate earnings reports communicate, at best, only part of the story.

And, their most critical omission - in recognition that insufficient cash
resources are a major cause of corporate problems particularly in
inflationary times - is their failure to speak to a corporation’s cash
position. Indeed, in my view, cash flow from operations is a better
measure of performance than earnings-per-share. What should be
considered is more revealing analytical concepts of cash flow or cash-
flow-per-share, which reflect the total cash earnings available to
management - that is earnings before expenses such as depreciation and
amortization are deducted. An even more sophisticated - and, in my
opinion, more informative - analytical tool is free cash flow, which
considers cash flow after deducting such spiralling corporate costs as
capital expenditures. This technique allows (evaluation of ) the costs of
maintaining the corporation’s present capital and market position - cost
which are, in essence, expenses and cash flow obligations that should be
considered in determining the corporation’s financial position. Arthur
Young Views (January 1981).
2) Robert Morris Associates, a national association of bank loan and credit

officers, advocates the use of cash flow analysis as a tool necessary to
evaluate, understand, and accurately determine a borrower’s ability to repay
loans:
Banks lend cash to their clients, collect interest in cash, and require debt
repayment in cash. Nothing less, just cash. Financial statements,
however, usually are prepared on an accrual basis, not on a cash basis.
And projections? Same thing. Projected net income, not projected cash
income. Yet, cash repays loans. Therefore, we are compelled to shift our
focus if we truly wish to assess our client’s ability to pay interest and
repay debt. We must turn our attention to cash, working through the
roadblocks thrown up by accrual accounting, to properly evaluate the
creditworthiness of our client. (RMA Uniform Credit Analysis,
Philadelphia, Robert Morris Associates, 1982).
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Activity 2 Cash Flow
Analysis
1) Pick up annual report of a company and show the Balance Sheet and Profit
and Loss account to your non-accounting friends. Ask them how comfortable
in reading the two statements and record their observation here.
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2) Now, show the Cash Flow statements to them and ask them whether they are
able to understand anything better about the company. Record their statements
here.
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3) Examine the above two and record your overall assessment whether there is
any improvement in their understanding.
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7.3 CASH FLOW STATEMENT VS. OTHER

FINANCIAL STATEMENTS
The cash flow statement is different from other principal financial statements in
many different ways. Financial statements like P&L account and Balance Sheet
are prepared using accrual accounting principle. For instance, when a firm sells
its products, it is assumed that profit is realised. It is assumed as a going concern,
the firm will eventually realise its profits. Similarly, the expenses incurred against
the sale are assumed to have incurred or paid irrespective of the fact whether
cash is paid or not. Interest expenses are charged against profit though it is an
outcome of financing decision. Several non-cash expenses like depreciation are
also charged against profit. On the other hand, cash flow statement is prepared
on the principle for cash accounting concept. It is simply a summary of cash
book classified under three headings namely cash flow from operating, investing
and financing activities. In a broad context, the cash flow from operating activities
culls out all Profit and Loss Account entries of cash book (like sales, material,
wages, etc.,) and summarise the same. The cash flow from investing activities
summarises all the assets side entries like purchase of fixed assets, sale of fixed
assets, etc., of cash book. Finally, the cash flow from financing activities
summarises all the liability side entries like borrowing, repayment, fresh equity,
etc. of cash book. The following table shows the Cash Flow Statement of a
company, which simply summarises the cash book entries under different
headings, which are easily readable.
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Analysis of Financial Cash Flow Statement Under Direct Method
Statements
(A) Operating Activities
Cash Collection from Sales 115716
Less: Cash Paid for:
Raw Materials (18478)
Direct Labour (13452)
Overhead (8758) (40688)
Less: Cash Paid for Non-factory Costs:
Salaries and Wages (14625)
Other Sales and Administration (413) (15038)
Cash Generated from Operation 59990
Add: Interest Earned 390
Net Cash from Operating Activities (X) 60380
(B) Investment Activities
Purchase of Plant Assets (23000)
Short-term investments (12000)
Net Cash Flow from Investing Activities (Y) (35000)
(C) Financing Activities
Dividends paid (25000)
Net Cash Flow from Financing Activities (Z) (25000)
(D) Net Change in Cash (X ----- Y+Z) 380
Cash at the Beginning of the year 6000
Cash at the End of the Year 6380
Profit and Loss account is also equally readable but the problem is it may be
confusing too. For example, many companies as a part of expenditure, put an
additional entry titled “changes in stocks” or “increase/decrease in stocks” and
sometime add and sometime deduct the value from sales. For example, see the next
table, where we have reproduced Birla 3M Ltd. Profit and Loss Account for the
year ended 31st December, 2001. As an accounting student, you will know that this
is nothing but changes in opening and closing stock but a non-accounting reader will
get confused. Many readers are not aware of the meaning of depreciation and also
“Balance in Profit and Loss Account Brought Forward”. Starting from the year
2001-02, the P&L account has one more confusion for ordinary readers namely
“Deferred Tax”. To add further confusion, in the Balance Sheet, it has both
Deferred Tax Asset and Deferred Tax Liability. The mismatch between the
depreciation value and deferred tax value shown in P&L account and Balance
Sheet is further confusion to ordinary readers. As an accounting, you are familiar
with all these jargons but it is really a maze for ordinary readers. They will give up
after reading couple of pages.
The Balance Sheet is also equally puzzle to investors. Many students and even
executives ask us if the company has huge reserves and surplus, does it mean the
company has such amount of cash? Many of you after having some much
accounting background would still have the doubt. In fact, when we answer such
questions that Reserves will not be in the form of cash, then the next question is
where is it or where it has gone or when it is not in the form of cash, why is it called
‘Reserves”? These are really genuine doubts to ordinary readers of financial
86 statements. To a great extent, cash flow statement is free of this kind of confusion.
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Profit and Loss Account for the Year Ended 31 December, 2001 Cash Flow
Analysis
Schedule For the year For the year
Number ended ended
31.12.2001 31.12.2000
Income:
Sales 2,297,840,701 2,078,920,263
Other Income 13 18,576,299 10,484,038
2,316,417,000 2,089,404,301
Expenditure:
Finished Goods Purchased (traded) 1,065,927,769 1,054,428,027
Manufacturing, Administrative 827,610,543 747,207,666
and Selling Expenses
Execise Duty Paid 107,210,150 99,240,285
Depreciation 60,747,768 47,550,244
(Increase)/decrease in inventories 22,942,022 (59,994,012)
Public issue expenses amortized 125,130 500,517
2,084,563,382 1,888,932,727
Profit from Operations 231,853,618 200,471,574
Profit before tax 231,853,618 200,471,574
Provision for Income Tax 93,900,000 92,938,485
Net Profit 137,953,618 107,533,089
Balance in Profit & Loss
(Account brought forward) 347,096,664 239,563,575
Balance Carried to Balance Sheet 485,050,282 347,096,664
Notes to Accounts 16
Activity 3
1) Visit some of the web sites of large Indian companies, which have also issued
American Depository Receipts (ADR). From the web sites, download the
P&L account as per Indian Accounting Standards and also P&L account
drawn under US accounting standards (called US GAAP). Compare the two
statements and then briefly write your overall observations.
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2) Why do you feel that the two figures are different? List down some of the
dominant reasons.
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Analysis of Financial 3) Now, you check the cash flow statement reported under two systems and list.
Statements
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7.4 CASH FLOW STATEMENTS

In the previous unit you have learnt that flow of funds means change in working
capital. An inflow of funds increases the working capital. Under cash flow
analysis, all movements of cash, rather than the inflow and outflow of working
capital would be considered. In other words, cash flow analysis, focuses attention
on cash instead of working capital. When the movements of cash (i.e., cash inflow
and cash outflow) is depicted in a statement, it is called Cash Flow Statement. Thus,
a cash flow statement summarises the causes of changes in cash position of a
business between two balance sheet dates. The flow of cash may be inflow or
outflow. When cash inflows are more than the cash outflows, there would be an
increase in cash balance. On the other hand, if cash outflows are more than the
cash inflows, there would be decrease in cash balance. The term cash includes both
cash and bank balances.
Availability cash, generally, determines the ability to meet the maturing obligations.
If cash is not available and current obligations cannot be met, it may result in
technical insolvency. Therefore, it is very essential for a business to maintain
adequate cash balance. A proper planning of the cash resources will enable the
management to have cash available whenever needed and employes surplus cash, if
any, to the most profitable or productive use. For this purpose, we prepare cash
flow statement which shows the sources and application during a year and the
resultant effect on cash balance.
7.4.1 Sources and Uses of Cash

The change in the cash position is computed by considering ‘Sources’ and
‘Applications’ of cash which are as follows:
Sources of cash
The sources of cash includes:
1) Cash from Operations
2) Issue of Shares
3) Issue of Debentures
4) Long term Loans Raised
5) Sale of Fixed Assets
Application (uses) of cash
Application of cash includes the following:
1) Redumption of Preference Shares
2) Redumption of Debentures
3) Repayment of Loans
4) Purchase of Fixed Assets
5) Payment of Dividends
6) Payment of Taxes
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Cash Flow
7.4.2 Ascertaining Cash from Operations Analysis
You have learnt that the main purpose of preparing a cash flow statement is to
explain the increase/decrease in the cash balance between the two balance sheet
dates and that it is prepared on the same pattern as the fund flow statement. Just
as the net profit is adjusted to ascertain the amount of funds from operations, the
funds from operations are now adjusted to ascertain the cash from operations. For
this purpose, you have to look at the changes in current assets and current liabilities
that have taken place during the year.
Conversion of ‘Funds from Operations’ to ‘Cash from Operations’ is necessary
because, under the working capital concept, funds from operations are based on
accrual concept of accounting, and total sales (whether credit or cash) and total
purchases (whether credit or cash) are recognised as sources and uses of working
capital respectively. But under a cash concept of funds only cash sales and
receipts from debtors are treated as sources of cash, while cash purchases and
payment to creditors are regarded as uses of cash. The same holds good for the
other incomes and expenses. Therefore, funds from operations (based on the
accrual concept) require conversion into cash from operations (based on cash
accounting). For example, assume that a business was started on 1-1-2003 and the
sales during the year were Rs. 3,00,000. Also assume that there were no closing
debtors. As there are no opening and closing debtors, it must be assumed that the
entire amount of Rs. 3,00,000 was realised by way of cash. Now assume that the
closing debtors on 31-12-2003 were Rs. 40,000. This would mean that the entire
amount of sales were not collected during the year. Since Rs. 40,000 (closing
debtors) was still to be realised, the cash from sales would be Rs. 2,60,000
(Rs. 3,00,000 ---Rs. 40,000).
The closing debtors on 31-12-2003 would become opening debtors on 1-1-2004.
Assume further that sales during 2004 were Rs. 4,00,000 and the closing debtors on
31-12-2004 were Rs. 50,000. In that case, the cash received from sales during the
year 2004 be ascertained as follows:
Rs.
Opening Debtors as on 1-1-2004 40,000
Add : Sales during the year 4,00,000
4,40,000
Less: Closing Debtors as on 31-12-2004 50,000
Cash from Sales during the year 3,90,000
The same result can also be obtained by subtracting the increase in debtors from
the sales during the year as shown hereunder.
Sales during the year (2004) 4,00,000
Less: Increase in Debtors during the year
(Closing debtors Rs. 50,000 ---- Opening debtors Rs. 40,000) 10,000
Cash from sales during the year 3,90,000
Cash from Operations can be calculated on the basis of the following equation:
Cash from Operations = Net profit + Opening Debtors at the beginning of the
year ---- Closing Debtors at the year end
or
= Net Profit + Decrease in Debtors
or
---- Increase in Debtors
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Analysis of Financial Similarly, in the case of credit purchases decrease in the creditors from one year to
Statements another year will result in decrease of cash from operations because more cash
payments have been made to the creditors which will result in outflow of cash. On
the other hand, increase in creditors from one period to another will result in
increase of cash from operations as less amount has been paid to the creditors
which result in increase of cash balance in the business.
The effect of cash purchases in computing cash from operations can be calculated
as follows:
Cash from operations = Net profit + Increase in Creditors

or
--- Decrease in Creditors
Similar is the case of Opening and Closing Stock. When opening stock is charged to
Profit and Loss account it reduces the net profit and when closing stock is credited
to Profit and Loss account it increases the net profit without corresponding change
in cash from operations. Therefore, the net profit needs for adjustments to arrive at
cash from operations as follows:
Cash from Operations = Net Profit + Opening Stock ---- Closing Stock
or
= Net Profit + Decrease in Stock
or
---- Increase in Stock
The effect of outstanding expenses, Incomes received in advance on cash from
operations is similar to the effect of Creditors i.e., any increase in these expenses
will result in increase in cash from operations and any decrease results in decrease
in cash from operations. This is on account of profit from operations calculated
after charging all expenses whether paid or outstanding. In case of income received
in advance, it is not be taken into account while preparing profit from operations as
it relates to the next year. Therefore, the cash from operations will be higher than
the actual net profit shown by the Profit and Loss Account. Therefore, it should be
added to net profit while calculating cash from operations. Prepaid expenses do not
have effect on the net profit for the year but it decreases cash from operations.
Prepaid expenses of the current year should be taken as an outflow of cash in the
cash flow statement, but the expenses paid in the previous year do not involve
outflow cash in the current year but they are charged to the Profit and Loss
Account. Therefore, prepaid expenses of the previous year which are related to
current year should be added back while calculating cash from operations. Similarly,
accrued income will increase the net profit for the year without corresponding
increase in cash from operations.
Therefore, the effect of prepaid expenses and accrued income on cash from
operations will be shown as follows:
Cash from operations = Net profit + Decrease in Prepaid Expenses and
Accrued Incomes
---- Increase in Prepaid Expenses and
Accrued Incomes
From the above discussion it may be summed up as increase in current assets and
decrease in current liability will have the effect of decrease in cash from
operations and decrease in current asset and increase in current liability will
90 have the effect of increase in cash from operations.
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Cash Flow
Illustration 1
Analysis
Calculate Cash from Operations from the following information :
Profit and loss account for the year ended 31st March, 2005
To Purchases 40,000 By Sales 60,000
To Wages 10,000
60,000 60,000
To Salaries 2,000 By Gross Profit b/d 10,000
To Rent 2,000 By Profit on Sale of Building 10,000
To Depreciation on Plant 2,000
To Loss on Sale of Furniture 1,000
20,000 20,000
Additional information:
Balance as on
31st March, 2004 31st March, 2005
Stock 20,000 24,000
Debtors 30,000 40,000
Creditors 10,000 15,000
Bills receivable 10,000 16,000
Outstanding expenses 6,000 10,000
Bills payable 8,000 4,000
Prepaid expenses 2,000 1,000
Calculate Cash from Operations.

Solution
Calculation of Cash from operations
Rs.
Net Profit as per Profit and Loss account 11,000
Add : Non-cash items: (i.e., Items which
do not result in outflow of cash) Rs.
Depreciation on Plant 2,000
Loss on sale of Furniture 1,000
Goodwill written off 2,000
Increase in Creditors 5,000
Increase in Outstanding expenses 4,000
Decrease in Prepaid Expenses 1,000 15,000
26,000
Less: Non-cash items (i.e., items which
do not result in inflow of cash):
Profit on Sale of Building 10,000
Increase in Stock 4,000
Increase in Debtors 10,000
Increase in Bills receivable 6,000
Decrease in Bills payable 4,000 34,000
Outflow of Cash from Operations (----) 8,000
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Statements 7.5 PREPARATION OF CASH FLOW
STATEMENT
The cash flow statement is similar to fund flow statement. You have learnt in
Section 7.4 that, apart from cash from operations, the source and uses of cash are
the same as those shown in the fund flow statement. Usually, cash flow statement
starts with the opening cash balance followed by the details of sources and uses of
cash. The opening balance plus the sources of cash minus the uses of cash should
be exactly to the closing balance of cash which is shown as the last item in the cash
flow statement. A cash flow statement can be prepared either in Vertical form or an
Account form as shown below:
Vertical Form of
Cash Flow Statement
for the year ending . . . . . . . . . . . .
Rs. Rs.
Cash Balance on 1.1.20 .............. ..................
Add : Sources of Cash
Cash from Operations ..................
Issues of shares ..................
Raising of long-term loans ..................
Sale of fixed assets ..................
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Less: Uses of Cash

Redemption of redeemable preference shares ..................
Redemption of debentures ..................
Repayment of long-term loans ..................
Purchase of fixed assets ..................
Payment of tax ..................
Payment of Dividends ..................
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Cash Balance as on 31-12-20...........
Account Format
The cash flow statement can also be prepared in an account form starting with an
opening balance of cash on its debit side and ending with the closing balance of
cash on its credit side as shown below:
Account Form of
Cash Flow Account for the year ending.........
Rs. Rs.
To Opening Cash Balance ...... By Redumption of Preference Shares...
To Cash from Operations ...... By Redumption of Debentures ......
To Issue of Shares ...... By Repayment of Long term Loans......
To Long term Loans ...... By Purchase of Fixed Assets ......
To Sale of Fixed Assets ...... By Payment of Tax ......
By Payment of Dividends ......
By Cash Balance (closing) ......
(Balancing figure)
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Cash Flow
7.6 REGULATIONS RELATING TO CASH FLOW Analysis
STATEMENT
Accounting standards in India are formulated by the Accounting Standards Board
(ASB) of the Institute of Chartered Accountants of India (ICAI). Though
International Accounting Standard Committee has revised the International
Accounting Standard-7 (IAS-7) in 1992 and switched over to cash flow statement,
Accounting Standard-3 (AS-3) of ASB, which is equivalent to earlier IAS-7, was not
revised till 1997. In 1997, ASB of ICAI revised the AS-3 in line with revised IAS-7
and issued an accounting standard on reporting cash flow information (see AS-3 full
text given in http://www.icai.org.). However, this standard was not been made
mandatory immediately in 1997. However, AS-3 was made mandatory for the
accounting period starting on or after 1st April 2001 for the following enterprises:
i) Enterprises whose equity or debt securities are listed on a recognised stock

exchange in India, and enterprises that are in the process of issuing equity or
debt securities that will be listed on a recognised stock exchange in India as
evidenced by the board of directors’ resolution in this regard.
ii) All other commercial, industrial and business reporting enterprises, whose
turnover for the accounting period exceeds Rs. 50 crore.
Since ASB of ICAI took a long time for the introduction of cash flow statement,
the SEBI had formed a group consisting of representatives of SEBI, the Stock
Exchanges, ICAI to frame the norms for incorporating Cash Flow Statement in the
Annual Reports of listed companies. The group has recommended cash flow
statement to be supplied by listed companies. SEBI, following the recommendation
of the group, has instructed the Governing Board of all the Stock Exchanges to
amend the Clause 32 of the Listing Agreement as follows:
“The company will supply a copy of the complete and full Balance Sheet, Profit
and Loss Account and the Directors Report to each shareholder and upon
application to any member of the exchange. The company will also give a Cash
Flow Statement along with Balance Sheet and Profit and Loss Account. The
Cash Flow Statement will be prepared in accordance with the Annexure
attached hereto”.
Cash Flow Statement, as a requirement in the Listing Agreement, has been made
effective for the accounts prepared by the companies and listed entities from the
financial year 1994-95. Cash Flow Statement, as a requirement of the Listing
Agreement, has been made effective for the accounts prepared by the companies
listed in stock exchanges from the financial year 1994-95.
Activity 4
1) Read carefully the AS-3 given in http.//www.icai.org. Write in your own words,
the objectives, scope and benefit of the Cash Flow Information.
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Analysis of Financial 2) Download the cash flow statement of a company (visit the web site) for two
Statements years and read the statement carefully. Write your observation whether the
benefits stated in the AS-3 is actually true.
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3) List down your difficulties in understanding cash flow statement given in the
annual reports.
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7.7 CASH FLOW STATEMENT FORMATS

The statement of cash flow requires restating of the information presented on
a Balance Sheet but in flow format. The Balance Sheet is prepared by
measuring the assets and liabilities at a point of time, usually as on March 31st
of the year. In flow statements, whether it is funds flow or cash flow, we
measure the changes in assets and liabilities during the period. For example,
the liability side of the Balance Sheets contains so many items, which are
essentially brought funds for the company. How much of cash is received
under each item or how much cash was given back on each item constitute
one part of the cash flow statement. Similarly, cash flows on the assets sides
are also computed. The changes in retain earning part of the Balance Sheet
actually reflect Profit and Loss Account. Cash Flow statement separately
computes cash generated and paid for various operating activities. Cash Flow
Statement can be prepared in two ways. They are called direct and indirect
method. Actually, these two methods differ on the part in which we compute
cash from operating activities. It may be noted that AS-3, IAS-7 and also
FASB Statement No. 95 all recommend presentation of the direct method in
the primary statement though firms are allowed to use either method.
However, companies normally provide the statement in indirect format and you
will shortly realise some of the reasons behind such practice. While direct
method logically summarises cash flow movement under broad operating
heads, indirect method works backward from Net profit and remove all non-
cash income and expenses to get cash from operating activities. The format
94 used under these two methods are given below:
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Table 1 Cash Flow
Analysis
Cash Flow Statement Under Listing Agreement and IAS-7
IAS-7 (Indirect Method) /SEBI Format IAS-7 (Direct Method)
A. Cash flow from operating activities A. Cash flow from operating activities
Net profit before tax & extraordinary items Cash receipt from customers
Adjustments for:
Depreciation Less: Cash paid to suppliers & other
Foreign Exchange operating expenses
Investments
Operating Profit before working
capital changes
Adjustments for:
Trade and other receivables
Inventories
Trade Payables
Cash generated from operations Cash generated from operation
Less: Interest paid Less: Interest paid
Direct tax paid Income tax paid
Cash flow before extraordinary items Cash flow before Extraordinary items
Extraordinary items Less: Extraordinary items
Net Cash from / (used in) operating Net Cash from / (used in)
activities operating activities
B. Cash flow from investing activities B. Cash flow from investment activities
Purchase of fixed assets Purchase of fixed assets
Sale of fixed assets Proceeds from sale of fixed assets
Acquisition of companies Investment in subsidiaries
Purchase of investments Investment in trade investment
Sale of investments Loans and Advances Taken/(returned)
Interest Received Current investments made
Dividend Received Interest/Dividend Received
Net cash used in investing activities Net cash used in investing activities
C. Cash flows from financing activity C. Cash flows from financing activity
Proceeds from issue of share capital Proceeds from issue of share capital
Proceeds from long-term borrowings(net) Proceeds from long-term borrowings
Repayment of financial lease liabilities Repayment of Loans
Dividend paid Dividend paid
Net Cash used in financing activities Net Cash used in financing activities
Net Increase in cash & cash equivalents Net Increase in cash & cash equivalents
Direct Method
Under Direct method, the difference between cash receipts from customers and
cash paid to suppliers and other operating expenses represents ‘‘cash generated
from operations’’. Both cash receipts from customers and cash paid to suppliers
and operating expenses can be calculated as follows:
Cash receipts from customers :
Cash sales during the year xxx
Credit sales during the year xxx
Add : Sundry debtors at the beginning ... xxx
" Bills receivable at the beginning ... xxx 95
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Analysis of Financial Less : Sundry debtors at the end xxx
Statements
" Bills receivable at the end ... xxx xxx
Cash receipts from the Customers xxx
Cash paid to Suppliers and employees
Cost of goods sold xxx
Operating expenses xxx xxx
Add : Sundry creditors at the beginning ...
Bills Payable at the beginning ...
Outstanding expenses at the beginning ...
Stock at the end ...
Prepaid expenses at the end ... xxx
xxx
Less: Sundry Creditors at the end ...
Bills Payable at the end ...
Stock at the beginning ...
Prepaid expenses at the beginning ... xxx
Cash paid to Suppliers and employees xxx
Under direct method all non-cash transactions such as depreciation, goodwill,

preliminary expenses, discount on shares and/or debentures etc. and loss or profit
on sale of assets and investments are to be ignored as these are non-cash
transactions. Similarly, non-operating income such as income from interest and
dividends are not to be considered.
The cash flows associated with extraordinary items like bad debts recovered,
insurance claim received, loss of stock by fire, earthquake etc., cash flows from
interest and dividends received and paid should be disclosed separately.
Cash flow from operating activities is computed under the following heads using a
set of equation listed against each.
Cash Flow Item Methodology

Cash collection from Sales
customers -- Increase in Accounts Receivables
+ Decrease in AccountsReceivables
Cash Paid to suppliers Cost of Goods Sold
-- Decrease in Inventory
+ Increase in Inventory
Cash Paid to Employees Salary Expenses
-- Increase in accrued/outstanding Salaries payable
+ Decrease in accrued/outstanding Salaries
payable
Cash Paid for Other Other Operating Expenses
operating expenses -- Depreciation and other non-cash expenses
-- Decrease in prepaid expenses
-- Increase in outstanding operating expenses
+ Increase in prepaid expenses
+ Decrease in outstanding operating expenses
Cash paid/received for Net Interest Expenses (expense-income)
interest -- Increase in outstanding interest
+ Decrease in outstanding interest
-- Increase in interest receivable
+ Decrease in interest receivable
96
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Cash Flow
Cash from dividend or Dividend or Other Income Analysis
other sources + Decrease in other income receivable
-- Increase in other income receivable
Cash Paid for Taxes Tax Expense
-- Increase in deferred tax liability
+ Decrease in deferred tax liability
-- Decrease in deferred tax asset
+ Increase in deferred tax asset
-- Increase in taxes payable
+ Decrease in taxes payable
-- Decrease in prepaid taxes
+ Increase in prepaid taxes.
For some of you the above table may be confusing but it is relatively easier to
understand. The first item of the equation is actually the figure you get from P&L
account. We know the figure that has given in the P&L account is mostly based on
accrual concept and hence include ‘non cash’ part. The second and subsequent
lines of the equation are actually for weeding out the ‘non cash’ part to get the
‘cash’ part of the expenses. Take a simple item of the above table namely ‘cash
paid to employees’. The figure Salary and Wages given in the P&L account need
not be equal to actual salary and wages that the company has paid. For instance,
the company may not have paid March month salary on 31st March as many
companies pay their work on 7th of every month. We know this item will appear
under salary outstanding. To get the cash amount of salaries and wages, we need
to deduct, salary outstanding. Suppose, there is a salary outstanding at the beginning
of the year, which means that the company has not paid some salary last year.
Assume this value be Rs. 15 lakhs. At the end of the year, the company has not
paid March salary and assume this value be Rs. 25 lakhs. If the outstanding salary
account at the end of the year shows Rs. 25 lakhs, it means the company would
have paid Rs. 15 lakhs of the previous year salary during the current year. Though
this Rs. 15 lakhs will not be included in salary expense shown in P&L account
(there is no need to show this value as it relates to previous year expenses), we
need to consider the same for computing cash paid for salary, where we are not
bothered whether the expenses is related to last year or current year. Suppose, if
the salary expenses shown in the P&L account is Rs. 300 lakhs, we deduct from
Rs. 300 lakhs, a value equal to Rs. 10 lakhs (Rs.25 lakhs --- Rs. 15 lakhs) and state
that cash paid for salary is equal to Rs. 290 lakhs. This value represents Rs. 275
lakhs salary of this year and Rs. 15 lakhs salary of the previous year and both paid
during the year. Try to develop such logic for each of the equation to understand
the concept better.
A comprehensive illustration is provided in the next section.
Indirect Method
Under this method net profit or loss is adjusted for the non-cash items as well as
the items for non-operating incomes. The net profit or loss as shown by the profit
and loss account cannot be treated as cash from operations. As you are aware that
there are certain items like depreciation, goodwill, preliminary expenses etc., which
appear or the debit side of profit and loss account but do not affect cash. Such
items are added back to net profit. Similarly, items of non-trading incomes like profit
on sale of fixed assets, interest and dividend received on investments, refund of
taxes, provision for discount on creditors etc., which appear on credit side of profit
and loss account, should be deducted from net profit to find out cash from
operation. 97
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Analysis of Financial In addition to the above, there are also certain items which do not appear in the
Statements profit and loss account, but have effect on cash. Such items represent changes in
current assets and current liabilities. All these adjustments must be made to the net
profit or loss as shown by the profit and loss account to ascertain actual amount of
cash flow from operations. The proforma for computing the actual cash flow from
operations is given below:
Proforma for
Computation of Cash Flow from Operating Activities
Rs.
Net Profit (Before tax and Extraordinary items) Rs. ..........
Add : Adjustments for : Depreciation ..........
Misc. Expenses written off ..........
Foreign Exchange ..........
Loss on sale of fixed assets ..........
Interest expenses ..........
(----) Profit on sale of Fixed asset ..........
(----) Dividend received .......... ..........
Operating Profit before Working Capital Changes ..........
Add : Adjustment for (working capital changes) :
Decrease in current assets (Excluding cash and equivalents) ........
Increase in current liabilities .......... ..........
Less :Increase in current Assets ..........
Decrease in current Liabilities ..........
Cash generated from operating activities ..........
Less :Income tax paid ..........
Cash flow before extraordinary items ..........
Add : Income from extraordinary items: ..........
Bad debts recovered ..........
Insurance claim received ..........
Income from lottery
Gain from exchange operations etc. .......... ..........
Less :Loss from extraordinary items :
Loss of stock from fire, floods etc. ..........
Loss from earthquake ..........
Loss from exchange operations .......... ..........
Net Cash from Operating activities xxxx
Here under indirect method, you will be seeing a lot of adjustments. These
adjustments are mainly to remove non-cash items. For example, if a firm sells
Rs. 3000 worth of goods but received only Rs. 2000 and the balance is not received
at the end of the period, the receipt of Rs. 2000 can be found out using P&L and
Balance sheet values. Assume the company has an opening receivables balance of
Rs. 2000. Immediately after the sale, it should have gone up to Rs. 5000 and when
it collects Rs. 2000, the closing balance should be Rs. 3000. So, we have the
following figures in our P&L and Balance Sheet.
Receivables (opening balance) Rs. 2000
Receivables (closing balance) Rs. 3000
Sales Rs. 3000
Thus, the cash collected from customers is equal to Opening Receivables Balance
plus Sales less Closing Receivables Balance i.e. Rs. 2000+3000 ---- 3000 = Rs. 2000.
Alternatively, we can deduct Rs. 1000 (which is the changes in opening and closing
98 receivable balance) as adjustment to see the impact of the credit sales on the cash.
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We will discuss more on these issues in the next section. At this stage, you note Cash Flow
Analysis
down that cash flow statement shows three important values: Net Cash Generated
through Operating Activities, Net Cash spent for Investing Activities and finally, net
cash generated through financing activities.
In the part one of the table, we have removed non-cash items and in the second
part, we removed the impact of changes in inventory. While removal non-cash
expenses or income included in the net income is obvious, when changes in current
assets and liabilities are adjusted. A firm invests in current assets (raw materials,
receivables, etc.) and acquire current liabilities mainly operating purpose. An
increase in current assets means spending some money to buy fresh current assets
during the period but not necessarily the firm incurs that amount fully. Since part of
the amount is received through current liabilities (creditors), we also look into the
changes in current liabilities. For instance, if inventory increases by Rs. 50 lakhs
and creditors also increases by Rs. 20 lakhs, it means the company has spent
Rs. 30 lakhs cash and hence it has negative impact on the cash value.
7.8 CASH FLOW FROM OPERATING

ACTIVITIES
We use an illustration to explain the three important items of cash flow statement.
Before you proceed further, read the Cash Flow Statement of Infosys Technologies
Ltd. given below:
Infosys Technologies Ltd .
Cash Flow Summary 2001-02 2000-01 1999-00
Cash and Cash Equivalents at Beginning of the year 577.74 508.37 416.66
Net Cash from Operating Activities 834.22 560.49 259.41
Net Cash Used In Investing Activities --280.23 --451.3 --146.2
Net Cash Used In Financing Activities --104.77 --39.82 --21.54
Net Inc/(Dec) In Cash And Cash 449.22 69.37 91.71
Cash And Cash Equivalents At End of the year 1,026.96 577.74 508.37
Cash Flow From Operating Activities 2002-03 2001-02 2000-01
Net Profit Before tax & Extraordinary Items 943.39 696.03 325.65
Adjustment For Depreciation 160.65 112.89 53.23
Interest(Net) --51.23 --38.47 0
Dividend Received 0 0 0
P/L on Sales of Assets --0.09 --0.09 0
P/L on Sales of Invests 0 0 0
Prov. & W/O(NET) 0 15.29 0
P/L In Forex --13.26 --20.17 0
Others --139.96 --85.18 --36.71
Op. Profit Before Working Capital Changes 899.5 680.3 342.17
Adjustment For
Trade & other Receivables --34.36 --166.2 --58.3
Inventories 0 0 0
Trade Payables --5.16 60.93 42.65
Loan & Advances --39.02 --34.72 --41.5
Direct Taxes Paid 0 0 --35.54
Cash Flow Before Extraordinary Items 820.96 540.32 249.48
Extraordinary Items
Gain on Forex Exchange Transaction 13.26 20.17 9.93
Net Cash Flow From Operating Activities 834.22 560.49 259.41 99
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Analysis of Financial The first part of the table shows the summary of Cash Flows of Infosys
Statements Technologies Ltd. and the second part lists detail working of Net Cash
Flow Operating Activities. Infosys has generated Rs. 834.22 cr. during the year
2001-02 through its operation against Rs. 560.49 cr. during the previous year.
How this is comparable with the net profit figure? It is comparable for this
company since during the year 2001-02, the company reported a net profit value
of Rs. 807.96 cr. But it need not be true for other companies where the net profit
and cash from operating activities may show substantial difference. For instance,
Pentamedia Graphics Ltd. has reported a net profit of Rs. 98.75 cr. for the year
ending March 2002 whereas for the same period, its cash flow from operating
activities is a negative value of Rs. 360.88 cr. There could be several reasons for
such wide difference between the reported book profit and cash flow from
operating activities.
In the Infosys Cash Flow Statement, the first part of the adjustment is related to
removing non-cash expenses and income and the second part of adjustment is
related to impact of changes in current assets and liabilities. In the third part, cash
arising out of extraordinary items is shown separately since the profit figure of the
first line excludes such extraordinary items. In terms of relative importance, the part
one adjustments are high value. While this may be true for companies like software
where working capital is not high, the second component may be large for
manufacturing companies. For instance, the cash flow statements of Cipla Ltd. for
the year ending 2002 shows an adjustment factor of Rs. 1.25 cr. (negative) for non-
cash items against Rs. 183.13 cr. (negative) for working capital items. The
adjustments relating to extra-ordinary items is not a regular feature and in the
Cipla’s case, it has not shown any value in the last three years. An analysis of
component of the three operating items shows further insight on where the cash is
drained. A year-to-year comparison also shows how much of additional amount is
being pumped in each of these items. While such an analysis is possible with
balance sheets figures alone, an analysis on cash basis is much simpler and straight
forward without any accounting principles and policies related issues. Increasingly,
users of financial statement rely on cash flow statement for this reason.
Activity 5
1) Collect Cash Flow from Operations of few companies and examine how is
related to Profit reported in P&L account?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
2) Compare the each components of cash flow from operating activity over the
period and record your observations here.
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..........................................................................................................................
..........................................................................................................................
100 ..........................................................................................................................
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Cash Flow
7.9 CASH FLOW FROM INVESTING AND Analysis
FINANCING ACTIVITIES
Measuring cash flow from investing and financing activities is simple and
straightforward. Any amount spent in purchase of fixed assets forms part of
investing activities. For instance if a firm spends Rs. 20 lakhs to buy new assets
and also sold Rs. 3 lakhs worth of assets for Rs. 8 lakhs, the net cash flow on
investing activities is Rs. 12 lakhs (Cash outflow of Rs.20 lakhs less Cash inflow
Rs. 8 lakhs). Similarly, it is easier to compute cash flow from financing activities.
Here we will try to find out the fresh equity and loan that the company has raised
during the period and from that we deduct loan amount repaid. In addition to this,
we also deduct dividend since dividend is outcome of financing activities. However,
you may wonder why interest is not deducted here since it is also related to
financing activity. There is no straight answer to this but accounting standards
require interest to be shown as an cash outflow item in operating activities.
The cash flow from investing and financing activities of Infosys is given below.
Infosys is spending a lot on fixed asset acquisition during the last three years. At
the same time, it is not raising any fresh capital and hence its cash flow financing
activities is also negative due to high dividend payment.
Cash Flow From Investing and Financing Activities of Infosys
Technologies Ltd.
Cash Flow From Investing Activities 2002-03 2001-02 2000-01
Investment In Assets :
Purchased of Fixed Assets ----322.74 ----463.4 ----159.9
Sale of Fixed Assets 1.6 0.23 0.1
Financial/Capital Investment:
Purchase of Investments ----10.32 ----26.65 ----13.08
Sale of Investments 0 0 0
Investment Income 0 0 26.69
Interest Received 51.23 38.47 0
Dividend Received 0 0 0
Invest. in Subsidiaries 0 0 0
Net Cash Used in Investing Activities ----280.23 ----451.3 ----146.2
Cash Flow From Financing Activities 2002-03 2001-02 2000-01
Proceeds:
Proceeds from Issue of share capital 0 0 1.76
Dividend Paid ----109.37 ----42.2 ----19.93
Others 4.6 2.38 ----3.37
Net Cash Used in Financing Activities ----104.77 ----39.82 ----21.54
Illustration 2 Using the P and L account and Balance Sheet given below, prepare
Cash Flow Statement both under direct and indirect method.
Profit and Loss Account for the year ended 31st March, 2005
(Rs. in thousands)
Year 2004-05 Year 2003-04
Sales 111780 98050
Other Income 390 220
Cost of Goods Sold 41954 39010
Selling and Administrative Expenses 16178 12500
Profit Before Tax 54038 46760
Less: Income Tax 21615 18704
Profit After Tax 32423 28056 101
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Analysis of Financial (b) Balance Sheet as on 31st March, 2005
Statements
(Rs. in thousands)
Liabilities and Shareholder Equity As on 31-3-05 As on 31-3-04
Equity Share Capital 180000 180000
Retained Earnings 134045 101622
Current Liabilities
Accounts Payable 3526 4330
Income Tax Payable 21615 ----
Dividend Payable ---- 25000
Total Liabilities 339186 310952
Assets
Fixed Assets 393000 (370000)
Less: Depreciation 92400 (90000) 300600 280000
Current Assets
Cash 6380 6000
Accounts Receivable: 20064
Less: Provision -- (972) 19092 23568
Inventory : Raw Materials 516 636
Finished Good 598 748
Investments 12000 ----
Total Assets 339186 310952
Solution
Cash Flow Statement Under Direct Method (Rs. in thousands)
Cash Collection from Sales 115716
Less: Cash Paid for:
Raw Materials (18478)
Direct Labour (13452)
Overhead (8758) (40688)
Less: Cash Paid for Non-factory Costs:
Salaries and Wages (14625)
Other Sales and Administration (413) (15038)
Cash Generated from Operation 59990
Add: Interest Earned 390
Net Cash from Operating Activities 60380
Net Cash Flow from Investing Activities (35000)
Net Cash Flow from Financing Activities (25000)
(D) Net Change in Cash 380
102 Cash at the End of the Year 6380
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Cash Flow Statement Under Indirect Method/as per Listing Agreement Cash Flow
Analysis
Profit After Tax or Net Income 32423
Adjustments for:
Depreciation 2400
Trade Receivables 4476
Inventories 270
Income Tax 21615
Accounts Payable (804) 27957
Net Cash from Operating Activities 60380
Net Cash Flow from Investing Activities (35000)
Net Cash Flow from Financing Activities (25000)
(D) Net Change in Cash 380
Cash at the End of the Year 6380
Illustration 3
Prepare a Cash Flow Statement from the following information under both Direct
method and Indirect method:
Balance Sheet as on 31.12.2005
(Rs. in 000)
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 3,000 2,500 Cash and Bank balances 400 50
Reserves 6,820 2,760 Short-term investments 1,340 270
Long term debt 2,220 2,080 Sundry debtors 3,400 2,400
Sundry creditors 300 3,780 Interest receivable 200 ----
Interest Payable 460 200 Inventories 1,800 3,900
Income Tax Payable 800 2,000 Long term investments 5,000 5,000
Accumulated depreciation 2,900 2,120 Fixed assets (cost) 4,360 3,820
16,500 15,440 16,500 15,440
Profit and loss account for the period ending Dec. 31, 2005
(Rs. in 000)
Rs. Rs.
To Cost of Sales 52,000 By Sales 61,300
To Gross Profit 9,300
61,300 61,300
103
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Analysis of Financial To Administrative and By Gross Profit b/d 9,300
Statements
selling expenses 1820
To Interest expense 800 By Dividend income 400
To Foreign exchange loss 80 By Interest income 600
To Depreciation 900
To Net Profit (Before taxation 6700
and Extraordinary item)
10,300 10,300
To Income Tax 600 By Net profit b/d 6,700

To Net Profit c/d 6460 By Insurance proceeds from 360
earthquake settlement
7,060 7,060
Additional information : (Figures are in Rs. 000)

1) An amount of Rs. 500 was raised from the issue of share capital and a further
Rs. 500 was raised from long term borrowings.
2) Interest expense was Rs. 800 of which Rs. 340 was paid during the period.
Rs. 200 relates to interest expense of the prior period was also paid during the
period.
3) Dividends paid were Rs. 2,400.
4) Tax deducted at source on dividends received (which was included in the tax
paid of Rs. 600 for the year) amounted to Rs. 80.
5) During the period, the enterprise acquired fixed assets paying Rs. 700.
6) Plant which costs Rs. 160 and accumulated depreciation of Rs. 120 was sold
for Rs. 40.
7) Foreign exchange loss is due to change in exchange rates of short term
investments.
Solution
Cash Flow Statement (Direct Method)
(Rs. in 000)
A) Cash Flow from Operating activities 2005 year
Cash receipts from customers (1) 60,300
Less : Cash paid to suppliers and employees (2) 55,200
Cash generated from operations 5,100
Less : Income Tax Paid (3) 1,720
Cash Flow before extraordinary item 3,380
Add : Proceeds from earthquake settlement 360
Net cash from operating activities 3,740
B) Cash Flows from Investing activities
Sale of Plant 40
Interest received (Rs. 600 -- Rs. 200 Accrued interest) 400
Dividend received (Rs. 400 -- Tax deducted at source Rs. 80) 320
760
Less :
Purchase of fixed assets 700
104 Net cash from Investing activities 60
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C) Cash Flows from financing activities Cash Flow
Analysis
Issue of share capital 500
Long term borrowing 500
1000
Less : Repayment of long term debt (4) 360
Interest paid (5) 540
Dividend paid 2,400
3,300
Net cash used in financing activities (----) 2300
Net increase in cash and cash equivalents 1,500
Add : Cash and cash equivalent at the beginning 320
(Rs. 50 + Rs. 270 Short term Investments)
Cash and cash equivalent at the end 1,820*
* [Rs. 400 + (Short term investments Rs. 1340 +
Loss in exchange rate Rs. 80)]
Working Notes:
1) Cash receipts form customers (Rs. in 000)
Sales 61,300
Add : Sundry debtors at the beginning 2,400
63,700
Less : Sundry debtors at the end 3,400
60,300
2) Cash paid to suppliers and employees (Rs. in 000)
Cash of Sales 52,000
Administrative and selling expenses 1,820
53,820
Add : Opening creditors 3,780
" Inventories at the end 1,800 5,580
59,400
Less : Creditors at the end 300
" Opening inventories 3,900 4,200
55,200
3) Income tax paid (Rs. in 000)
Tax paid (Including Tax deducted at source from 600
dividends received)
Add : Tax liability at the beginning 2,000
2600
Less : Tax liability at the end 800
1,800
Out of Rs.1800, tax deducted at source on dividends received (Rs.80), is
shown in ‘Cash Flows from Investing Activities’ and balance of Rs. 1720 is to
be shown under ‘cash flows from operating activities’.
4) Repayment of long term borrowings (Rs. in 000)
Long term debt at the beginning 2,080
Add : Long term debt made during the year 500
2,580
Less : Long term debt at the end 2,220
360
105
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Analysis of Financial 5) Interest Paid (Rs. in 000)
Statements
Interest expense for the year 800
Add : Interest Payable at the beginning 200
1,000
Less : Interest payable at the end 460
540
Cash Flow Statement (Indirect Method)

(Rs. in 000)
Cash flows from operating activities 2005 year
Net Profit before taxation and extraordinary item 6,700
Adjustments for:
+ Depreciation 900
+ Foreign exchange loss 80
+ Interest expense 800
--- Interest income (---) 600
--- Dividend income (---) 400 780
Operating Profit before Working Capital Changes 7480
(---) Increase in sundry debtors (---) 1,000
(+) Decrease in inventories 2,100
(---) Decrease in sundry creditors (---) 3,480 (---) 2,380
Cash Generated from Operations 5,100
(---) Income tax paid (Rs. 1800 --- Tax deducted at source Rs. 80) 1,720
Cash flow before extraordinary item 3,380
Proceeds from earthquake settlement 360
Net Cash from Operating Activities 3,740
Cash flows from investing activities
(---) Fixed assets purchased (---) 700
(+) Proceeds from sale of plant 40
(+) Interest received 400
(Interest income Rs. 600 --- Accrued interest Rs. 200)
(+) Dividend received
(Rs. 400 --- Tax deducted at source Rs. 80) 320
Net Cash from Investing Activities 60
Cash flows from financing activities
(+) Issue of additional capital 500
(+) Proceeds from long term borrowings 500
(---) Repayment of long term borrowings (Opening balance (---) 600
Rs. 2,080 + Borrowings during the year Rs. 500 --- Balance at
the end Rs. 2,220)
(---) Interest paid (---) 540
(---) Dividend paid (---) 2,400 (---) 2,300
Net Cash Used in Financing Activities 1,500
Cash & Cash equialent at the beginning (Rs. 50 + Rs. 270) 320
106 Cash and cash equivalent at the end 1,820

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Cash Flow
7.10 USES OF CASH FLOW STATEMENT Analysis
Cash flow statement is very useful to the financial management. It is used as a tool for
financial analysis for short term planning.
The preparation of cash flow statement has several uses. The more important uses
are as follows:
1) Changes in cash balance between two points of time and the contributing factors
for such change are clearly revealed.
2) The cash flow statement explains the reasons for:
i) the presence of very low cash balance inspite of huge operating profits: or
ii) the presence of a higher cash balance inspite of a very low level of profits
3) Projected cash fow statements help the management in short-term planning and
several other ways like:
i) Determination of additional cash requirements during a given period and
making timely arrangements
ii) Identification of the size of surplus and the time for which such surplus
funds are likely to be available
iii) Judging the ability of the firm to repay/redeem debentures/preferences
shares.
iv) Examining the possibility of maintaining/increasing dividends
v) Assessing the capability of finance, replacement of fixed assets
vi) Assessing the capacity of the firm to finace expansion.
vii) More efficient and effective management of cash flows.
7.11 DISTINCTION BETWEEN CASH FLOW

ANALYSIS AND FUND FLOW ANALYSIS
Following are the major points of difference between cash flow analysis and fund flow
analysis:
1) Fund flow analysis deals with the change in working capital position between two
balance sheet dates, whereas the cash flow analysis is concerned with the
change in cash position.
2) Cash flow analysis is more useful as a tool in short-term financial planning,
whereas fund flow analysis is more useful in long-term financial planning.
3) An increase in current liability or decrease in current asset (other than cash)
results in an increase in cash whereas such changes result in decrease in the net
working capital. Similarly, a decrease in any current liability or an increase in
current asset (other than cash) results in a decrease in cash, whereas such
changes increase the net working capital.
4) Cash flow statement recognises 'cash basis of accounting' where as funds flow
statement is based on accrual basis of accounting.
5) Cash flow analysis explains only the causes of cash variations, wheresas funds
flow analysis discloses the causes of overall working capital variations. 107
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Analysis of Financial Activity 6
Statements
1) Compute the changes in cash flow from operating activities of Infosys
between Year 2001 & 2000 and 2002 & 2001.
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2) Compute the changes in profit before taxes and depreciation of Infosys
between Year 2001 & 2000 and 2002 & 2001.
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3) Compare whether the profit changes are in line with the changes in cash flow
from operating activities.
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4) Repeat the above two steps for few companies and write your findings.
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7.12 LET US SUM UP

Cash Flow Statement and cash flow analysis have assumed importance
particularly when many companies have started adopting creative accounting
and earnings management. Realising the needs of new users as well as others,
regulating agencies have made reporting of cash flow statements mandatory.
Cash flow statement is easy to understand and difficult to manipulate. It
provides three important pieces of information on cash flow movements of the
firm --- how much cash is generated through operation, financing and how much
cash is spent for investment? It gives a clear and real picture about the internal
activities of the firm. There are two methods of preparation of cash flow
statements, namely direct and indirect method. While direct method gives more
details on cash flow from operating activities and also reader-friendly, indirect
method is more accounting oriented and fails to provide any additional
information. Unfortunately, many companies use indirect method though the
accounting standards allow both methods. This indirectly shows the eagerness
of management to withhold information unless it is required by the regulation.
Fortunately, the final figure is adequate to get good insight though additional
information will always be useful. Cash flow analysis are typically done by
108 comparing the changes in cash flow from operating activities from period to
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period with the changes in profit levels of the firm. Such comparison is useful to Cash Flow
Analysis
understand the quality of reported profit. Also, the cash flow from operating
activities are used to compare whether they are sufficient to meet the liabilities of
lenders and also contribute for further investments.
7.13 KEY WORDS

Cash Flow: Movement of cash i.e., cash in flow and cash outflow
Cash Flow Statement: Statement prepared to show the sources and uses of cash
between the two balance sheets dates.
Cash from Operations: Net profit adjusted for changes in the current items in
additional to the adjustments already made while ascertaining funds from
operations.

1) How cash flow statement is different from income statement? What are the
additional benefits to different users of accounting information from cash flow
statement?
2) List down any four important accounting transactions that increase the profit
but has no impact on cash flow statement.
3) How does cash flow statement differ from funds flow statement? What are
the uses of cash flow statement?
4) How does cash flow analysis help the management in decision making?
5) What is a ‘Cash Flow Statement’? Explain the techniques of preparing a cash
flow statement.
6) A summary of Cash Flow Statement of Shaheed Industries Ltd. for the last
few years is given below. The details of profit are also stated. Suppose you
are an analyst working for a leading mutual fund in India prepare a small
report on the performance of the company using these two pieces of
information.
Summary of Cash Flow Statement of Shaheed Industries Ltd.
Year 2003 2002 2001 2000
Cash and Cash Equivalents at

Beginning of the year 1,760.71 143.27 1,081.55 4,897.60
Cash from Operating Activities 6,642.31 7,523.00 4,748.08 1,630.55
Cash Used In Investing Activities -- 6,575.53 -- 3,928.34 -- 2,423.89 -- 5,000.06
Cash Used In Financing Activities -- 1,680.28 -- 1,977.22 -- 3,305.11 -- 446.54
Net Inc/(Dec) In Cash And Cash -- 1,613.50 1,617.44 -- 980.92 -- 3,816.05
Cash and Cash Equivalents at end 147.21 1,760.71 100.63 1,081.55

of the Year
Net Profit Before tax & 4,974.21 4,428.70 2,645.62 2,403.25

Extraordinary Items
Depreciation 3,452.79 3,435.82 2,636.73 2,533.59

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Analysis of Financial 7) The following are the Balance Sheet of M/s. Rao Brother Private Ltd. as on
Statements March 2004 and 2005
Rs. Rs. Rs. Rs.
Equity Shares 4,000 4,000 Fixed assets 4,100 4,000

12% Redeenable Less : Depreciation 1,100 1,500
Preference shares ---- 1,000 3,000 2,500
Profit and loss a/c 100 120 Sundry Debtors 2,000 2,400
General reserve 200 200 Stock 3,000 3,500
Debentures 600 700 Prepaid expenses 30 50
Creditors 1,200 1,100 Cash 120 350
Provision for taxation 800 1,000
Bank overdraft 1,250 680
8,150 8,800 8,150 8,800
Your are required to prepare a Cash Flow Statement.

(Ans. Cash from Operation Rs. 400, Sources Rs.1,600, Applications Rs. 800)
8) ABC company supplies you the following Balance Sheets on 31 December:

Rs. Rs. Rs. Rs.
Share capital 14,0000 148,000 Bank balance 18,000 15,600

Bonds 24,000 12,000 Receivable 29,800 35,400
Accounts Bills payable 20,720 23,680 Inventories 98,400 85,400
Provision for Doubtful debts 1,400 1,600 Land 40,000 60,000
Goodwill 20,000 10,000
Reserves & surplus 20,080 21,120
206,200 206,400 206,200 206,400
Following additional information has also been supplied to you :
i)Dividends amounting to Rs. 7000 were paid during the year 2004.
ii) Land was purchased for Rs. 20,000.
iii) Rs. 10,000 were written off for Goodwill during the year.
iv) Bonds of Rs. 12,000 were paid during the course of the year. You are required to
prepare a Cash Flow Statement.
(Ans. Cash from Operations Rs. 28600, Sources Rs. 36,600,

Applications 39,000)
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Cash Flow
9) From the following Balance Sheets of Alfa Ltd., prepare Cash Flow Statement Analysis
under both the methods:
Equity Share Capital 150,000 2,00,000 Fixed Assets 2,00,000 275,000

Profit & Loss A/c 42,500 55,000 Stock 1,00,000 112,500
Bank Loan 50,000 37,500 Debtors 1,05,000 95,000
Accumulated Depreciation 40,000 67,500 Bill Receivable 40,000 55,000
Creditors 155,000 147,500 Bank 15,000 ---
Proposed dividend 22,500 30,000
4,60,000 5,37,500 4,60,000 5,37,500
Additional information A piece of machinery costing Rs. 30,000 on which accumu-

lated depreciation was Rs. 7500 was sold for Rs. 15,000.
(Ans. Net Decrease in Cash Rs. 15,000)
10) The Profit and Loss Account of an enterprise for the year ended 31st March,
2004 stood as follows :
Rs. Rs.
To Opening Stock of Materials 1,00,000 By Sales 13,80,000
To Purchase of Materials 9,30,000 By Dividend Received 30,000
To Wages 200,000 Bt Commission Accrued 10,000
Add : Outstanding Wages 50,000 2,50,000 By Profit on Sale of Building:
To Salaries 80,000 Book value 5,00,000
Add Outstanding Salaries 40,000 Selling Price 6,20,000 1,20,000
1,20,000 By Closing Stock 1,30,000
Less : Prepaid Salaries 5,000 1,15,000
To Selling & Distribution Expenses 40,000
To Depreciation 55,000
To Preliminary Expenses (written off) 12,000
To Goodwill (written off) 20,000
16,70,000 16,70,000
Calculate the amount of Cash generated from Operating activities under both the
methods as per AS-3 (Ans: Rs. 70,000 )
11) From the following information , you are required to compute Cash Flow from
Operating Activities under (i) Direct Method and (ii) Indirect Method.
Profit & Loss Account
for the year ended 31st March, 2005
To Cost of Goods Sold 2,00,000 By Sales (including cash 2,50,000
To Office Expenses 10,000 sales Rs. 50,000)
To Selling and Distribution Exp. 3,000 By Profit on Sales of Land 10,000
To Depreciation 4,000 By Interest Received 12,000
To Loss on Sale of Plant 2,000
To Income Tax paid 9,000
2,72,000 2,72,000 111
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Analysis of Financial The following is the position of Current Assets and Current Liabilities :
Statements
Particulars As on 31st As on 31st
March, 2004 March, 2005
Stock 20,000 18,000
Debtors 13,000 10,000
Bills Receivable 8,000 9,000
Creditors 9,000 15,000
Outstanding Office Expenses 3,000 5,000
(Ans: Cash flow from operating activities: Rs. 39,000

Cash Receipt from customers : Rs. 252,000
Cash paid to suppliers and Employees : Rs. 2,04,000)
12) From the following balance sheets prepare a cash flow statement.
Share Capital 2,00,000 250,000 Fixed Assets:
Reserves 100,000 120,000 Land 300,000 350,000
Profit & Loss A/c 1,20,000 1,50,000 Machinery 2,00,000 2,40,000
Debentures 90,000 1,00,000 Current Assets:
Accumulated Inventory 1,00,000 1,30,000
Depreciation 60,000 80,000 Debtors 70,000 50,000
Current Liabilities: Cash 40,000 60,000
Creditors 40,000 45,000
Expenses Outstanding 35,000 45,000
7,10,000 8,30,000 7,10,000 8,30,000
Note: Machinery costing Rs. 40,000 (accunulated depreciation Rs. 10,000) was sold
for Rs. 35,000
(Ans. : Cash from Operation Rs. 55,000)
13) Extracts of Balance Sheets of Messers Beta Company Ltd. are given below:
Rs. Rs. Rs. Rs.
Share Capital 50,000 60,000 Fixed Assets: 1,50,000 2,44,000
Stock in Hand 3,800 6,600
Creditors 54,000 70,000 Debtors 76,000 67,000
Cash 36,000 13,750
Bills Receivable 17,500 19,000
Additional information
The profits for the year ended 31.12.2004 amounted to Rs. 48,000 before charging
depreciation & taxation. During the year 500 share were issued at Rs. 20 each. Interim
dividend paid during the year Rs. 6,950. Prepare cash flow statement.
112 (Answer : Cash flow from operation Rs. 68,700)

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14) The following are the summarised Balance Sheets of Wye Ltd. as on 31st March, Cash Flow
2002 and 2003. Analysis

Rs. Rs. Rs. Rs.
Share Capital: Fixed Assets 4,10,000 4,00,000
Preference Capital - 1,00,000 Less: Depreciation 1,10,000 1,50,000
Equity Capital 4,00,000 4,00,000 3,00,000 2,50,000
General Reserve 20,000 20,000 Debtors 2,00,000 2,40,000
Profit & Loss A/c `10,000 12,000 Stock `3,00,000 3,50,000
14% Debentures 60,000 70,000 Prepaid Expenses 3,000 5,000
Creditors 1,20,000 1,10,000 Cash 12,000 35,000
Provision for Taxation 30,000 42,000
Proposed Dividends 50,000 58,000
Bank Overdraft 1,25,000 68,000
8,15,000 8,80,000 8,15,000 8,80,000
You are required to prepare a Statement of Cash Flow.

[Cash from Operation Rs. 40,000; Cash Inflow Rs. 1,60,000
Cash Outflow Rs. 1,37,000]
[Note. Provision for Tax and Proposed Dividend are treated as Non-Current Liability.]
15) From the following Balance Sheets of Exe Ltd., you are required to prepare a Cash
Flow Statement:
Rs. Rs. Rs. Rs.
Equity Share Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000

10% Preference Buiding 2,00,000 1,70,000
Share Capital 1,50,000 1,00,000 Plant 80,000 2,00,000
General Reserve 40,000 70,000 Debtors 170,000 2,00,000
Profit & Loss A/c 30,000 48,000 stock 77,000 1,09,000
Proposed Dividend 42,000 50,000 Bills Receivable 20,000 30,000
Creditors 55,000 83,000 Cash in hand 15,000 18,000
Provision for Taxation 40,000 50,000
6,77,000 8,17,000 6,77,000 8,17,000
i) Depreciation on Plant Rs.10,000
ii) Gain on Sale of Building Rs. 20,000
[Fund from Operation , Rs. 1,63,000, Cash from Operation Rs. 1,15,000 Cash
Inflow Rs. 2,80,000; Cash Outflow Rs. 2,62,000]
16) You are given the following Balance Sheets of International company Ltd., for the
years ending 31st December, 2002 and 2003.You are required to prepare a Cash
Flow Statement under i) Direct Method and ii) Indirect Method for the year
ended 31st December, 2003.
Liabilities 2002 2003 Assest 2002 2003
Rs. Rs. Rs. Rs.
Equity Share Capital 30,000 30,000 Land 12,000 10,800
General Reserve 5,200 5,400 Building 11,100 10,800
Profit & Loss A/c 3,800 3,900 Short Term Investments 3,000 3,300
Accounts Payable 2,400 1,620 Inventories 9,000 7,020
Short Term Loan 360 240 Account Receivable 6,000 6,660
Provision for Taxation 4,800 5,400 Bank Balance 1,980 5,160
Provision for Bad Debts 120 180 Dicount on Issue of share 3,600 3,000
46,680 46,740 46,680 46,740
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Analysis of Financial Following additional information has also been supplied to you:
Statements
i) A piece of land has been sold for Rs. 2,400 at a profit of 100%
ii) Depreciation of Rs. 2,100 has been charged on Building.
iii) Dividend paid during the year Rs. 4,500.
[Ans : Net increase in cash Rs. 3480 , cash balance as on 31-12-2003, Rs 8460]
17) Following are the comparative Balance Sheets of ABC Company Ltd. for the
years ended 31st December , 2002 and 31st December, 2003:
Liabilities 2002 2003 Assest 2002 2003
Rs. Rs. Rs. Rs.
Equity Share Capital 4,00,000 6,00,000 Machinery (at cost) 2,00,000 2,60,000
Profit & Loss A/c 47,000 1,04,000 Computer _ 2,00,000
Securities Premium _ 10,000 Land 20,000 20,000
Debentures 80,000 70,000 Cash at Bank 86,000 1,26,000
Provision for Doubtful 4,000 6,000 Prepaid Expenses 4,000 4,000
Accumulated Depreciation 30,000 51,000 Debtors 1,60,000 1,80,000
Creditors 66,000 80,000 Stock 64,000 80,000
Outstanding Expenses 7,000 9,000 Investments 1,00,000 60,000
6,34,000 9,30,000 6,34,000 9,30,000
Additional Information :
i) Dividend paid @ 8% on share capital during 2003.
ii) Investments costing Rs. 40,000 were sold in 2003 for Rs. 50,000.
iii) Machinery costing Rs. 18,000 on which Rs. 2,000 depreciation has been accumu-
lated , was sold for Rs. 12,000 in the year 2003.
Prepare Cash Flow Statement for the year 2003 as per AS -3
[ Ans. Net Increase in Cash and Cash Equivalent : Rs. 40,000]
18) On the basis of the information given in the Balance Sheet of ABC Ltd. prepare
a Cash Flow Statement
Equity Share Capital 1,50,000 2,00,000 Goodwill 35,000 10,000
12% Debentures 50,000 75,000 Land and Buiding 1,20,000 1,75,000
10% Preference Share Capital 40,000 25,000 Machinery 75,000 1,00,000
General Reserve 30,000 37,500 Debtors 50,000 70,000
Creditors 47,500 42,500 Stock 37,500 25,000
3,27,500 4,00,000 327,500 4,00,000
114 [Ans: Net increase in cash : Rs. 10,000]

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19) From the following Balance Sheet of M/s Electronics Ltd. as on 31.12.2003 and Cash Flow
Analysis
2004, prepare a Cash Flow Statement’

Rs. Rs. Rs. Rs.
Equity Share Capital 1,00,000 1,50,000 Goodwill 10,000 5,000
9% Redeemable Preference Building 1,50,000 2,20,000
Share Capital 50,000 40,000 Plant 80,000 1,00,000
12% Debentures 51,000 69,000 Stock 60,000 75,000
General Reserve 30,000 20,000 Debtors 20,000 17,000
P & L A/c 50,000 70,000 Bills Receivable 8,000 9,000
12% Public Deposits 80,000 1,20,000 Accrued Income 10,000 6,000
Creditors 8,000 10,000 Prepaid Expenses ----- 2,000
Outstanding Expenses 3,000 1,000
3,78,000 4,84,000 3,78,000 4,84,000
[Ans: Net increase in cash : Rs. 10,000]
AS-3 statement issued by ICAI has also contains an exhaustive illustration on

Cash Flow Statements. Students may visit the following link to see the
illustration. http://www.icai.org/common/index.html
answers for them. But do not submit your answers to the University. These
are for your practice only.
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UNIT 8 BASIC CONCEPTS OF
BUDGETING
Structure
8.0 Objectives
8.1 Introduction
8.2 Meaning of Budgeting
8.3 Definition of Budget and Budgetary Control
8.4 Objectives of Budgeting
8.5 Advantages of Budgeting
8.6 Limitations of Budgeting
8.7 Essentials of Effective Budgeting
8.8 Establishing a Budgeting System
8.9 Classification of Budgets
8.10 Let Us Sum Up
8.11 Key Words
8.0 OBJECTIVES
The main objectives of this unit are to acquaint you with:
l the concepts of budgeting and budgetary control;
l the establishment of effective budgeting system; and
l classification of various types of budget.
8.1 INTRODUCTION
The efficiency of a management depends upon the attainment of the objectives of the
enterprise. It is effective when it achieves the objectives with minimum effort and
cost. This requires proper planning and therefore, management must chart out its
course of action in advance. One systematic approach for attaining effective
management performance is profit planning and control or budgeting. Profit planning
or budgeting is an integral part of management. Budgeting is an important control
technique of cost control. This is the process of pre-estimation of cost, revenue, profit
and other figures for the next year or period and on that basis, actual expenses
incurred, revenue generated/earned. Afterwards budget is used as a standard for
measuring actual performance. The deviations are found out and responsibility fixed
for deviations. Thus, this is indirectly management control process, which involves
planning, control, coordination, communication, etc. In this unit you will study about the
basic concept of budgeting, establishment of a system of budgeting and classification
of budgets. 1
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Budgeting and
Budgetary Control 8.2 MEANING OF BUDGETING
In our daily life, we use to prepare budgets for matching the expenses with
income; and available funds can be invested in a profitable manner. Similarly in
business, budgets are prepared on the basis of future estimated production and
sales in order to find out the profit in a specified period. A budget is in the nature
of an estimate and is a quantified plan for future activities to coordinate and
control the use of resources for a specified period. Thus budget is a quantitative
statement of management plans and policies for a given period and is used as a
guide for the purpose of attaining the given objectives. It is also used as standard
with which actual performance is measured. Budgets must be prepared with full
knowledge and acceptance by the executives whose performance is to be
measured against the budget. Different types of budgets are prepared for
different purposes.
Budgeting may be defined as the process of preparing plans for future activities of
a business enterprise after considering and involving the objectives of the said
organization. This also provides process/steps of collection and comparison of
data, by which deviations from the plan, either favourable or adverse, can be
measured. This analysis is helpful in performance analysis, cost estimation,
minimizing wastage and better utilisation of resources of the organisation.
8.3 DEFINITION OF BUDGET AND BUDGETARY

CONTROL
Budgeting is a process, which includes two important functions: Budget and
Budgetary control. Budget is a planning function and budgetary control is a
controlling system or technique. A manager looks to the future, searches for
alternative courses of action and predetermines a course of action to be taken in
relation to known events and the possibilities of future problems. Thus, the budget
will do this work for the activities of a business enterprise. I.C.M.A., London
defines the budget as “Budget is financial and/or quantitative statement, prepared
prior to a defined period of time, of the policy to be pursued during that period for
the purpose of attaining a given object”.
At the same time, controlling is the process of measuring current performances

and guiding them towards some predetermined goals. The essence of control lies in
checking existing actions against some desired results determined in the planning
process. Thus, the budgetary control is a tool of control to achieve the budgeted
goals. I.C.M.A., London defines budgetary control as, “Budgetary control is the
establishment of budgets relating to the responsibilities of executives to the
requirement of a policy and the continuous comparison of actual with budgeted
results either to secure by individual action the objectives of that policy or to
provide a basis for its revision.”
In nutshell, Budgetary control is a system and a technique which uses budgets

as a means of controlling all aspects of the business and is designed to assist
management in the allocation of responsibility and authority, in the measurement
of actual performance, in the analysis of variations between budgeted and
actual results and to develop basis of measurement, in the light of experience
gained and results achieved, with which to evaluate performance and efficiency
of the operations. Thus, a budget is a means and budgetary control is the end
result.
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Basic Concepts of
8.4 OBJECTIVES OF BUDGETING Budgeting
It is a well known fact that a planned activity has better chances of success than an
unplanned one. The budgeting is a forward planning and effective control tool. Thus,
the objectives of the budgeting are:
a) To control the cost and increase revenue and thereby maximise profit, so as to
know profit at different level of production and best production level.
b) To run production activities in efficient manner by lay behind the chances of
interruption in production process due to lack of material, labour etc.
c) To bring about coordination between different functions of an enterprise, which is
essential for the success of any enterprise.
d) To incorporate measures of calculation of deviations from budgeted results and
analysis of the same, whereby responsibility can be fixed and controlling
measures/action can be taken.
e) To ensure that actions taken are in accordance with the targets and if required, to
take suitable corrective action.
f) To predict short-term and long-term financial positions for better financial position
and management of working capital in better manner.
8.5 ADVANTAGES OF BUDGETING

The following are the advantages of budgeting:
a) Budgeting leads to maximum utilisation of resources with a view to ensuring
maximum return.
b) Budgeting increases the awareness about business enterprise at all levels of
management in the process of fulfillment of targets.
c) Budgeting is helpful in better co-ordination between different functions/activities
of business/organisation and hence, better understanding between different
functions.
d) Budgeting is a process of self-examination and self-criticism which is essential
for the success of any organisation.
e) Budgeting makes a path for active participation and support of top management
f) Budgeting enables the organisation to prefix its goals and push up the forces
towards their achievements.
g) Budgeting stimulates the effective use of resources and creates an attitude of
cost consciousness throughout the organisation.
h) It creates the bases for measuring performances of different departments as well
as different functions of the production activities.
8.6 LIMITATIONS OF BUDGETING

Inspite of the above advantages, budgeting has the following limitations:
a) Forecasting, planning or budgeting is not an exact science and a certain amount
of judgement is present in any budgeting plan.
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Budgeting and b) The basic requirement for the success of budgeting is the absolute support and
Budgetary Control enthusian provided by the top management. If it is lacking at any time, the whole
system will collapse.
c) Budgeting should be followed up by effective control action, this is often lacking

in many organisations, which defeats the very purpose of budgeting.
d) The installation of budgeting system is an elaborate process and it takes time.
e) It is only a source and not a target and hence, can not take the place of
management, while it is only a tool of management. Thus, the budget should be
regarded not as a master, but as a servant.
f) It requires the experienced man-power, technical staff, analysis, control etc,

hence, it is costly affair.
8.7 ESSENTIALS OF EFFECTIVE BUDGETING

A good budgeting system requires good organisational system with lines of authority
and responsibility clearly mentioned. There must be perfect co-ordination among
different functions as well as participation of responsible managers / supervisors in the
decision making process. Thus, the main essentials of effective budgeting may be as
follows:
a) There should be well-planned organisational set-up, authority and responsibility
clearly defined, budget committee should be formed consisting of all top
executives.
b) There should be a good accounting system which provides accurate and timely
information.
c) Variations should be reported promptly and clearly to the appropriate levels of

management.
d) Budgets have no meaning unless they lead to control action as a consequence of

feedback provided.
e) The whole system should enjoy the support and co-operation of top management.
f) Staff should be strongly and properly motivated towards the systems.
g) Budgets should be prepared on the basis of clearly defined business policies after
discussion held with the head of individual department so that they may provide
their suggestions in this regard.
8.8 ESTABLISHING A BUDGETING SYSTEM

For preparing an efficient budget, there is an urgent need of well-versed system for
preparing the budget. This process is required an efficient system of implementation
within the organisation. The main essentials of establishment of system of budgeting
are:
1) Budget Centres
2) Budget Committee
3) Budget Officer
4 4) Budget Manual
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5) Budget Period Basic Concepts of
Budgeting
6) Budget Key Factor or Determining Principal Budget Factor
7) Forecasting
8) Determining Level of Activity
9) Preparation of Budget
Let us study each one of the above in detail.
1) Budget Centres: Budget centre are defined as different sections of an

undertaking or an organisation, where budgetary control measures are to be applied
and for the purpose, separate budgets are to be prepared with the help of head of
these centres so that these may be implemented more efficiently.
2) Budget Committee: The budget committee is a group of representatives of

various functions in an organisation, e.g. Sales Manager, Production Manager, R&D
Manager, Materials Manager, etc. As all functions are interrelated and any change in
one’s target will have its impact on that of the others. Therefore, it is necessary to
discuss the targets so that a mutually agreed programme can be determined. This is
really the co-ordination in budget making. It is powerful force in knitting together the
various activities of the business and enforcing real control over operations. The
principle functions of a Budget Committee are:
a) To provide departmental managers past data regarding performance, costs etc.

thus, helping them to prepare their respective budgets.
b) To co-ordinate, receive, review the functional budgets in the light of general

policies and objective of the organisation.
c) To approve the functional budgets after making necessary changes.
d) To prepare and present the Master Budget on the basis of functional budgets, so
developed and approved for final considerations and approval of the Board of
Directors.
e) To recommend action to be taken on the basis of variance analysis.
3) Budget Officer: To link up or co-ordinate the various functions, to bring them

together and to co-ordinate their efforts in the matter of preparation of target figures,
there should be a person called Budget Officer or Budget Controller. He is enable to
provide ready data relating to all the functions. He is more or less the Secretary to the
Budget Committee. His duties will comprise mainly:
a) Helping in preparation of the various budgets and their co-ordinations and

compilation into the master budget.
b) Compiling information about actual performance on a continuous basis,

comparing it against the budget figures, ascertaining causes of deviation and
preparing reports based thereon and sending them to the appropriate executives.
c) Bringing to the notice of the management the need for revision of budgets and
assisting them in the task, and
d) Compiling information of all types for the purpose of efficient preparation of

budgets and proper reporting. 5
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Budgeting and 4) Budget Manual: Budget manual is defined as a document which sets
Budgetary Control
outstanding instructions, the responsibility of the persons engaged in, and the
procedures, forms and records relating to the preparation and use of budgets. Thus
budget manual is a booklet of budget policies which lays down the details of the
organisational set up with duties and responsibilities of executives including the
budget committee and budget officer and procedures to be followed for developing
budget in respect of various activities.
The following are some of the important matters dealt with in the budget manual:
a) The dates by which preliminary forecasts and plans are to be submitted.
b) The forms in which these are to be submitted and the person to whom these
are to be forwarded.
c) The important factors that must be considered for each forecast or plan
d) The categorisation of expenses, e.g., variable and fixed, and the manner in
which each category is to be estimated and dealt with.
e) The manner of scrutiny and the personnel to carry it out.
f) The matter which must be settled only with the consent of the managing
director, departmental manager, etc.
g) The finalisation of the functional budgets and their compilation into the Master
Budget.
h) The form in which the various reports are to be made out, their periodicity and
dates, the persons to whom these and their copies are to be sent.
i) The reporting of the remedial actions.
j) The manner in which budgets, after acceptance and issuance, are to be
revised or amended, and
k) The matters to be included in budgets, on which action may be taken only with
the approval of top management.
5) Budget Period: This is the period for which forecasts can reasonably be
made and budgets can be formulated. Budget periods vary between short-term and
long-term and no specific period can be laid down for all budgets. Normally, a
detailed budget for each responsibility centre is prepared for one year. In fact, the
length of the budget period depends on the type of the business, the length of the
manufacturing cycle from raw material to finished products, the ease or difficulty
of forecasting future market conditions and other factors. It should be kept in mind
that the budget period should be long enough to allow for the financing of
production well in advance of actual needs and also coincide with the financial
accounting period to compare actual results with budgeted estimates.
6) Budget Key Factor or Determining Principal Budget Factor: The key

factor is also known as limiting factor, governing factor, etc. and may be defined as
the factor which at a particular time or over a period will limit the activities of an
undertaking. The limiting factor is, usually, the level of demand for the products or
services of the undertaking, but it could be a shortage of one of the productive
resources, e.g. skilled labour, raw material, or machine capacity etc.. In order to
ensure that the functional budgets are reasonably capable of fulfillment, the extent
of the influence of this factor must be assessed.
The key factor is normally temporary in nature and is a constraint at a particular
point of time. In the long run, they can be overcome by proper planning and
6 management action.
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The principal budget factor which will influence the targets may be : (i) customer Basic Concepts of
demand, (ii) plant capacity, (iii) availability of raw materials, (iv) availability of skilled Budgeting
labour, (v) availability of adequate capital, (vi) storage capacity of raw material and
finished goods, (vii) space for plant installation, and (viii) governmental restrictions etc.
7) Forecasting: Forecasting is the statement of events likely to occur. It connotes
a degree of looseness, so that it is usually the practice to judge the accuracy of
forecasts on the basis of actual performance, taking the latter to be correct. The
forecast of a function need not necessarily be well coordinated. The desired co-
ordination could be obtained before the budget is finalised. A forecast forms the basis
for the budget. A budget indicates a target and it is a statement of planned events,
generally evolved from the forecast.
8) Determining Level of Activity: The level of activities are determined on the
basis of information and estimates provided regarding / about future conditions and
activities of market and position of product in the market by departmental heads or
concerned managers. For this purpose, detailed discussions, analysis, preparation of
reports are to be done and then written report to be formed and submitted to budget
committee for their decision making.
9) Preparation of Budget: After discussing all the factors, which may affect the
process of budgeting, the budget should be prepared. The manager who is responsible
for meeting the budgeted performance should prepare the budget for those areas for
which they are responsible. The preparation of the budget should be a bottom-up
process. This means, the budget should originate at the lowest levels of management
and be refined and co-ordinated at higher levels. This will enable managers to
participate in the preparation of their budgets and increases the probability that they will
accept the budget and strive to achieve the budgeted targets.
When all the budgets prepared by respective managers, then, they should be co-
ordinated with each other and corrected in respect of organisational goal and then,
summarized into a Master Budget consisting of a Budgeted Profit and Loss Account,
a Balance Sheet and a Cash Flow Statement. After the Master Budget has been
approved, the budgets are to be passed down through the organisation to the appropriate
responsibility centre. The approval of the master budget gives the authority for the
manager of each responsibility centre to carry out the plans contained in each budget.
8.9 CLASSIFICATION OF BUDGETS

Budgets can be classified into different categories on the basis of time, functions or
flexibility. The different budgets covered under each category are shown in the
following chart :
Classification of Budgets
↓ ↓ ↓
Time Function Flexibility
l Long-term l Sales l Fixed
l Short-term l Production l Flexible
l Current l Cost of Production
l Purchase
l Personnel
l Research
l Capital Expenditure
l Cash
l Master
Let us study all the above budgets briefly. You will study these budgets in detail in Unit 9. 7
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Budgeting and 1) Classification According to Time
Budgetary Control
The budget, on the basis of time, may be classified as :
a) Long-term budget,
b) Short-term budget, and
c) Current budget.
Long-Term Budget : A budget designed for a long period is termed as a Long-term

budget. The period generally is of 5 to 10 years. These budgets are concerned with
planning of the operations of a firm over a considerably long period of time. They are
generally prepared in terms of physical quantities.
Short-Term Budget : The budget prepared for a period of less than 5 years is a
short-term budget. Generally short-term budgets are prepared for a period of one to
two years. They are generally prepared in terms of physical as well as in monetary
units.
Current Budget : The budget prepared for a period of a week, a month, or a quarter
is termed as a current budget. They are essentially short-term budgets adjusted to
current conditions or prevailing circumstances.
2) Classification According to Function

Budgets can be classified on the basis of functions, they are meant to perform.
Different types of budgets under this head are as follows:
Sales Budget : This is the most important budget on which all other budgets are
based. The sales manager is responsible for preparation and execution of the budget.
The budget forecasts total sales in terms of quantity, value, items, periods, areas etc.
Production Budget :The budget is basically based on sales budget. It forecasts

quantity of production in terms of items, periods, areas, etc. The works manger is
responsible for the preparation of overall production budget and departmental works
manager is responsible for departmental production budgets.
Cost of Production Budget : It forecasts the cost of production. Separate budgets

are prepared for different elements of costs such as direct materials budget, direct
labour budget, factory overheads budget, office overheads budget, selling and
distribution overhead budget, etc.
Purchase Budget : The budget forecasts the quantity and value of purchases
required for production. It gives quantity-wise and period-wise information about the
materials to be purchased. It correlates with sales forecast and production planning.
Personnel Budget : The budget anticipates the quantity of personnel required during
a period for production activity. This may be further split up between direct and
indirect personnel budgets.
Research Budget : The budget relates to the research work to be done for
improvement in quality of the products or research for new products.
Capital Expenditure Budget : The budget provides a guidance regarding the

amount of capital that may be required for procurement of capital assets during the
budget period.
Cash Budgets : The budget is a forecast of the cash position, for a specific duration
of time for different time periods. It states the estimated amount of cash receipts and
8 cash payments and the likely balance of cash in hand at the end of different periods.
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Master Budget : It is a summary budget incorporating all functional budgets in a Basic Concepts of
capsule form. It interprets different functional budgets and covers within its range the Budgeting
preparation of projected income statement and projected balance sheet.
3) Classification According to Flexibility
Budget can also be classified in the following categories:
Fixed Budget : A budget prepared on the basis of a standard or a fixed level of

activity is called a fixed budget. It does not change with the change in the level of
activity. If the output and sales do not fluctuate from year to year or if an accurate
prediction of the same can be made, a fixed budget can be prepared.
Flexible Budget : A budget designed in a manner so as to give the budgeted cost of

any level of activity is termed as a flexible budget. Such a budget is prepared after
considering the fixed and variable elements of cost and the changes that may be
expected for each item at various levels of operation.
Check Your Progress
1) What do you mean by Budgeting ?
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
2) What is Budgetary Control ?
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
3) List out the essentials of a sound system of Budgeting.
1 ………………….. 4 ………………………………
2 …………………. 5 ……………………………..
3 ………………… 6 ……………………………..
4) Differentiate between a Forecast and a Budget.
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................ 9
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Budgeting and 5) Fill in the blanks :
Budgetary Control
a) The process of preparing and using budgets to achieve the objectives of
management is called ....................................... .
b) ............................ is a tool of control to achieve the budgeted goals.
c) .................................... is a group of representatives of various functions

of an organisation for preparing budgets and exercising overall control.
d) A book let of budget policies which lays down duties and responsibilities of
executives and procedures to be followed for preparation and
implementation of budget programme is called ..................................... .
e) .......................... is the basis for preparation of the budget.
f) The most important budget on which all other budgets are based is
................... .
g) A summary of budget which contains all functional budgets in a capsule

form is called ............... .
h) In the preparation of budgets ..................... limits the volume of budget activity.
i) A budget may be defined as a ............... expression of a business plan for

a specified future period.
6) State whether each of the following statements is True or False.
a) A budget is a means and budgetary control is the end result. ( )
b) Budget should be regarded as a master but not as a servant. ( )
c) Key factor can be overcome in the long-run by proper planning. ( )
d) Research budget relates to the improvement in quality and

development of the new products. ( )
e) Flexible budget gives details of budgeted cost at any level of activity. ( )
f) A budget is both a plan as well as a control tool. ( )
g) A budget is a base while the forecast is the structure built on the base( )
h) A fixed budget is concerned with budgeting of fixed assets. ( )
i) A budget manual contains a summary of all functional budgets. ( )
j) A budget is a plan of the management for a future period expressed in

quantitative terms. ( )
8.10 LET US SUM UP

A budget is in the nature of an estimate and is quantified plan for future activities
to coordinate and control the use of resources for a specified period. Budget is
used as a standard with which actual performance is measured. Budgeting is a
process which includes both budget and budgetory control. Budget is a planning
10 function and budgetory control is a system and technique which uses budgets as a
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means of controlling all aspects of the business and is designed to assist Basic Concepts of
management in the measurement of actual performance, in the analysis of Budgeting
deviations from the budgeted targets and to evaluate performance and efficiency
of the operations. A good budgeting system requires good organisational system
with the lines of authority and responsibility clearly mentioned. The important
essentials required for the establishment of a sound system of budgeting includes
budget centres, budget committee, budget officer, budget manual, budget period,
budget key factor, forecasting, determining level of activity and preparation of
budget.
Budget may be classified on the basis of time, function and flexibility. On the
basis of time, budget may be classified as long term budget, short-term budget and
current budget. The classification of budget according to functions generally
include : Sales budget, production budget, cost of production budget, purchase
budget, personnel budget, research budget, capital expenditure budget, cash budget
and master budget. Budget can also be classified according to flexibility as fixed
and flexible budget.
8.11 KEY WORDS

Budget : A comprehensive and coordinated plan, expressed in financial terms, for
the operations and resources of an enterprise for some specific period in the future.
Budgeting : The process of preparing plans for future activities of a business
enterprise for attaining the objectives of an organisation.
Budgetory Control : The establishment of budgets relating to the responsibilities of
executives to the requirement of a policy and the continuous comparison of actual with
budgeted results either to secure by individual action the objectives of that policy or to
provide a basis for its revision.
Budget Centres : Different sections of an undertaking or an organisation, where
budgetory control measures to be applied and for the purpose, separate budgets are to
be prepared.
Budget Committee : A group of representatives of various functions in an
organisation
Budget Officer : A person who links up or coordinates the various functions, to
bring them together and coordinate their efforts in the matter of preparation of target
figures.
Budget Manual : A document which sets out standing instructions, the responsibility
of the persons engaged in, and the procedures, forms and records relating to the
preparation and use of budgets.
Budget Period : The period for which forecasts can reasonably be made and
budgets can be formulated.
Budget Key Factor : The factor which at a particular time or over a period will limit
the activities of an undertaking.
Forecasting : A statement of events likely to occur
Fixed Budget : A budget prepared on the basis of a standard or a fixed level of
activity
Flexible Budget : A budget designed in a manner so as to give the budgeted cost at
any level of activity.
Master Budget : A summary budget incorporating all functional budgets which is
finally approved, adopted and employed. 11
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Budgeting and
Budgetary Control 8.12 ANSWERS TO CHECK YOUR PROGRESS
5) a) Budgeting b) Budgetary control c) Budget Committee
d) Budget Manual e) A forecast f) Sales budget
g) Master budget h) The key factor i) Quantitative
6) a) True, b) False, c) True, d) True, e) False, f) True, g) True, h) False,
i) False, j) True

1) Define budgeting and budgetory control. State the objective of Budgeting.
2) What is budgeting ? What are the advantages and limitations of Budgeting ?
3) What are the essentials of an effective system of Budgeting ? Explain
4) What is a Budget Manual ? State briefly the contents of a budget manual.
5) What do you mean by Budgeting ? Mention different types of budgets that a big
industrial concern would normally prepare.
6) What are the essentials of establishment of sound system of Budgeting ?
7) Explain the following :
i) Budget Committee
ii) Budget Officer
iii) Budget Key Factor
iv) Budget Period
8) Explain in brief different types of budgets.
9) “A budget is a means and budgetory control is the end result”. Explain.

Edward B. Deakin and Michael W. Maher, Cost Accounting, Richard D. Erwin, inc.,
Homewood, Illinois.
Lal Nigam B.M. and Sharma G.L., Advanced Cost Accounting, Himalaya
Publishing House, Bombay-4.
Indira Gandhi National Open University, Study Material MS-4 and MS-43.
Maheswari, S.N. 1987, Management Accounting and Financial Control, Sultan
Chand : New Delhi.
12
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Preparation and
UNIT 9 PREPARATION AND Review of Budgets
REVIEW OF BUDGETS
Structure
9.0 Objectives
9.1 Introduction
9.2 Sales Budget
9.3 Production Budget
9.4 Production Cost Budget
9.5 Materials Budget
9.6 Purchase Budget
9.7 Direct Labour Budget
9.8 Overheads Budget
9.9 Capital Expenditure Budget
9.10 Cash Budget
9.11 Master Budget
9.12 Revision of Budgets
9.13 Budget Report
9.14 Let Us Sum Up
9.15 Key Words
9.0 OBJECTIVES
The main objectives of this unit are to make you familiar with :
l the preparation of different types of budgets;
l the preparation of Master budget; and
l review of different budgets.
9.1 INTRODUCTION
In the previous unit you have learnt about the basic concept of budgeting,
establishment of a sound system of budgeting and classification of budgets. You
have also learnt that budgeting is the principal instrument for projecting the future
costs and revenues which is an essential aspect of management accounting and
financial control. Budgeting helps in monitoring the present as well as past.
Preparation of budgets involves a number of forecast or projections. It starts with
sales forecasting and ends with the compilation of the master budget. In this unit you
will study about the construction of functional budgets.
9.2 SALES BUDGET

The sales budget is usually the keystone in planning and control of operation of a
business. Sales forecast serves as a base for the sales budget. The sales budget is
prepared in quantitative terms of units expected to be sold and the value expected to 17
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Budgeting and be realised. The Sales Manager should be made directly responsible for the
Budgetary Control preparation and execution of sales budget. This is prepared according to the
requirements of the business while preparing sales budget. The useful classification
may be-products, territories, customers, salesmen, etc. More than one classification
may be employed. However, at the time of preparing sales budget the following
factors should be kept in mind:
(a) salesmen’s estimates (b) orders in hand (c) Past behaviour (d) Management
policies for future (e) seasonal fluctuations (f) availability of materials (g) plant
capacity (h) availability of finance (i) potential market (j) level of competition
(k) position of competitors, etc. Look at the following illustration how a sales budget is
to be prepared.
Illustration 1
Shri Ramu manufactures two types of toys, Raja and Rani and sell them in Agra and
Mumbai markets. The following information is made available for the current year
2003-2004:
Places/ Markets Type of Toys Budgeted Sales Actual Sales

2002-2003 2002-2003
Agra Raja 400 at Rs. 9 each 500 at Rs. 9 each
Rani 300 at Rs. 21 each 200 at Rs. 21 each
Mumbai Raja 600 at Rs. 9 each 700 at Rs. 9 each
Rani 500 at Rs. 21 each 400 at Rs. 21 each
Market studies reveal that toy Raja is popular as it is under priced. It is observed that
if its price is increased by Rs.1 it will find a ready market. On the other hand, Rani is
over-priced and market could absorb more sales if its selling price is reduced to Rs.
20. The management has agreed to give effect to the above price changes.
On the above basis, the following estimates have been prepared by Sales Manager:
Product % increase in Sales Over Current Budget
Agra Mumbai
Raja +10% +5%
Rani +20% +10%
With the help of an intensive advertisement campaign, the following additional sales
above the estimated sale are possible:
Product Agra Mumbai
Raja 60 units 60 units
Rani 40 units 50 units
You are required to prepare a budget for sales incorporating the above estimates.
18
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Solution Preparation and
Review of Budgets
Sales Budget Period 2003-2004
Budget for the year 2002-2003 Actual Sales Budget for the future
2002-2003
Place Product Units Price Value Units Price Value Units Price Value
Raja 400 9 3600 500 9 4500 500 10 5000
Agra Rani 300 21 6300 200 21 4200 400 20 8000
Total 700 - 9900 700 - 8700 900 - 13000
Raja 600 9 5400 700 9 6300 700 10 7000
Mumbai Rani 500 21 10500 400 21 8400 600 20 12000
Total 11 0 0 15900 11 0 0 - 14700 1300 - 19000
Raja 1000 9 9000 1200 9 10800 1200 10 12000
Total Rani 800 21 16800 600 21 12600 1000 20 20000
Total 1800 - 25800 1800 - 73400 2200 - 32000
Working Note:
1) Calculation of Budget Estimates
Agra Mumbai
Raja-Budgeted 400 600
Increase 40 (+10%) 30 (+5%)
440 630
Advertisement effect 60 70
500 700
Rani-Budgeted 300 500
Increase 60 (+20%) 50 (+10%)
360 550
Advertisement effect 40 50
400 600
Thus a preliminary sales budget is prepared product wise, territory-wise and also
customer-wise and then a detailed budget is also prepared on the basis of salesman’s
estimates. Both the budgets are to be compared and necessary adjustments are to
made to the final sales budget after taking into account the policy of the management.
Then the sales budget will be submitted to the budget committee for approval and
incorporation in the master budget.
9.3 PRODUCTION BUDGET

The Production Budget is a forecast of the production for the budget period. It
provides an estimate of the total volume of production product-wise with the
scheduling of operations by days, weeks and month and also a forecast of the
closing finished product inventory. It is based on sales budget. The Factory
Manager is the person generally made responsible for its preparation,
19
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Budgeting and administration and execution. This budget can also be prepared department-wise.
Budgetary Control This budget is prepared in quantity terms only. The main factors, which are useful
in preparing production budgets are:
(a) Inventory Policies (b) Sales Requirements (c) Uniformity of Production (d) Plant
Capacity (e) Availability of inputs (f) Duration of Production.
Production may be computed as follows :
Units to be produced = Budgeted Sales + Desired Closing Stock of finished goods –

Opening Stock of finished goods.
Illustration 2
A manufacturing company submits the following figures for the first quarter of 2002 :
Particulars Product X Product Y Product Z
Sales (units) January 50,000 60,000 20,000

February 40,000 50,000 20,000
March 60,000 70,000 20,000
Selling price per unit (Rs.) 10 20 40
Targets for Ist quarter 2003:

Increase in sales quantity 20% 10% 10%
Increase in sales price Nil 10% 25%
Opening stock on Jan. 1, 2003
(Percentage of sales) 50% 50% 50%
Stock position on 31st March, 2003 40,000 50,000 10,000
Closing stock for January and February
(Percentage of subsequent months sales) 50% 50% 50%
You are required to prepare the Sales and Production Budgets for the 1st quarter of
2003.
Solution
Sales Budget
January, 03 February, 03 March, 03 Total
Units Rate Value Units Rate Value Units Rate Value Units Value
(Rs.) ( Rs.) ( Rs.) ( Rs.) ( Rs.) ( Rs.) ( Rs.)
Product X 60,000 10 6,00,000 48,000 10 4,80,000 72,000 10 7,20,000 1,80,000 18,00,000
Product Y 66,000 22 14,52,000 55,000 22 12,10,000 77,000 22 16,94,000 1,98,000 43,56,000
Product Z 22,000 50 11,00,000 22,000 50 11,00,000 22,000 50 11,00,000 66,000 33,00,000
Total 1,48,000 — 31,52,000 1,25,000 — 27,90,000 1,71,000 — 35,14,000 4,44,000 94,56,000
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Working Note : Preparation and
Review of Budgets
1) Calculation of Budget estimates
January February March
Product X : Budgeted 50,000 40,000 60,000

Increase (20%) 10,000 8,000 12,000
60,000 48,000 72,000
Product Y : Budgeted 60,000 50,000 70,000
Increase (10%) 6,000 5,000 7,000
66,000 55,000 77,000
Product Z : Budgeted 20,000 20,000 20,000
Increase (10%) 2,000 2,000 2,000
22,000 22,000 22,000
Production Budget for the 1st Quarter 2003 (Units)
Particulars January February March Total

Product X : Sales Budget 60,000 48,000 72,000 1,80,000
Add : Closing Stock
(50% of subsequent month sales) 24,000 36,000 40,000 40,000
84,000 84,000 1,12,000 2,20,000
Less : Opening Stock
(50% of sales) 30,000 24,000 36,000 30,000
PRODUCTION BUDGET 54,000 60,000 76,000 1,90,000
Product Y : Sales Budget 66,000 55,000 77,000 1,98,000
Add : Closing Stock
93,500 93,500 1,27,000 2,48,000
(50% of sales) 33,000 27,500 38,500 33,000
PRODUCTION BUDGET 60,500 66,000 88,500 2,15,000

Product Z : Sales Budget
22,000 22,000 22,000 66,000
Add : Closing Stock
33,000 33,000 33,000 76,000
(50% of sales) 11,000 11,000 10,000 11,000
PRODUCTION BUDGET 22,000 22,000 23,000 65,000
Note : Closing stock as on 31st March, 2003 is given in the problem. Opening and
closing stock for January and February months have been calculated as per
the percentages given in the problem. Students should be noted that the
previous months closing stock will become opening stock of subsequent
month. 21
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Budgeting and
Budgetary Control 9.4 PRODUCTION COST BUDGET
This budget is a forecast of the cost of production which has been planned in the
production budget. The production budget is prepared in terms of quantity to be
produced. The amount is shown in this budget. The total cost of production is
arrived at by adding the cost of materials, labour and manufacturing overheads.
The quantity of material, the time taken by labour and the estimated costs of
material, labour and expenses- all can be shown as part of production cost budget
also.
Illustration 3
The following information is abstracted from the books of a ABC Co. Ltd., for the six
months of 2005 in respect of product X :
The following units are to be sold in different months of the year 2005:
January 2,200
February 2,200
March 3,400
April 3,800
May 5,000
June 4,600
July 4,000
There will be work in progress at the end of the month. Finished units are equal to
half the sales of the next month’s stock at the end of every month (including
December, 2004). Budgeted production and production cost for the half-year ending
30th June, 2005 are as follows :
Production (units) 40,000
Direct material per unit Rs. 5
Direct wages per unit Rs. 2
Factory Overheads apportioned to production Rs.1,60,000
You are required to prepared Product Budget and Production Cost Budget for the six
months of year 2005.
Solution
Production Budget (in Units)
January February March April May June Total
Estimated Sales 2200 2200 3400 3800 5000 4600
Add : Closing Stock 1100 1700 1900 2500 2300 2000
3300 3900 5300 6300 7300 6600
Less : Opening Stock 1100 1100 1700 1900 2500 2300
Production 2200 2800 3600 4400 4800 4300 22,100
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Production Cost Budget Preparation and
Review of Budgets
(Production : 22, 100 units)
Rs.
Direct materials @ Rs. 5 for 22,100 units 1,10,500
Direct wages @ Rs. 2 for 22100 units 44,200
Factory Overheads @ Rs. 4 for 22100 units 88,400
(Rs. 1,60,000/40,000 units)
————
Total Production Cost 2,43,100
————
9.5 MATERIALS BUDGET

Materials are either direct or indirect. The Material budget generally deals only
with the direct materials. Indirect materials are generally included in overhead
budget. The material requirements are estimated on the basis of quantity of each
class of products to be produced by multiplying the exact material requirement
for each class of product by the number of units of that class. Material budget
can be prepared on the basis of standards or, historical data regarding
percentage of raw materials to total cost, adjusted for current price and normal
wastage of material.
The factors to be considered while preparing the Material Budget are : the
quantity of material required for the production budget, tentative dates by which
required material must be available, the availability of storage facilities as well as
credit facilities, price trends in the market, nature of the materials required etc.
Only direct materials are to be taken into account and indirect materials are not
taken into account as they are considered under overheads budget. The material
budget helps the management for proper planning of purchases. The object of the
budget is to ensure the availability of adequate quantities of materials as and when
required. It will be included in the Master Budget after the approval of Budget
Committee.
Illustration 4
The following information relates to a manufacturing company :
Targeted sales of product X 1,00,000 units. Each unit of product X requires 3 units of
material A and 4 units of material B.
Estimated opening balances at the commencement of the next year :
Finished product : 20,000 units
Material A : 24,000 units
Material B : 30,000 units
The desirable closing balances at the end of the next year are :
Finished Products : 28,000 units
Material A : 26,000 units
Material B : 32,000 units
From the above information prepare a Material Budget.
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Budgeting and Solution
Budgetary Control
Firstly, we have to find out the number of units to be produced. We know that,
Opening Stock + Production = Sales + Closing Stock
Units to be produced = Sales + Closing Stock – Opening Stock
= 1,00,000 + 28,000 – 20,000
= 1,08,000 units
Material required :
Material A = 1,08,000 × 3 = 3,24,000 units
Material B = 1,08,000 × 4 = 4,32,000 units
Material Purchase Budget ( Units)
Particulars Finished Product Material required
A B
Budgeted Production 1,08,000 3,24,000 4,32,000
Add : Opening Stock (+) 20,000 ( --) 24,000 ( --) 30,000
————— ————
1,28,000 3,00,000 4,02,000
Less : Closing Stock ( -- ) 28,000 ( +) 26,000 (+) 32,000

————— ———— ————
Estimated product for sales 1,00,000
—————
Estimated Material required : 3, 26, 000 4, 34, 000
9.6 PURCHASE BUDGET

Purchase Budget gives the details of material purchases to be made in the budget
period. It correlates with sales forecast and production planning. It deals with
purchases that are required for planned production. Purchases would include both
direct and indirect materials and goods. While placing the purchase orders material
manager has to see the orders on hand and unfulfilled orders at the beginning of the
budget period and adjust the purchases accordingly. Purchase budget enables the
budget officer to provide funds in the cash budget according to delivery schedules,
terms of payment and credit period. While preparing purchase budget the factors like
the opening and closing stock to be maintained, maximum and minimum stock
quantities to be maintained, economic order quantity level, the resources available, the
policy of management etc., should also be taken into account.
Budgeted Purchase Quantity = Budgeted Consumption Quantity +
Required Closing Stock – Opening Stock.
9.7 DIRECT LABOUR BUDGET

The direct labour budget tells about the estimates of direct labour requirements
essential for carrying out the budgeted output. The quantity of labour, e.g. skilled,
unskilled, semi-skilled etc are estimated first. The time taken by them can be measured
in terms of man hours. Thereafter, the total cost of labour is estimated by multiplying
the rates of pay with the labour hours. The purpose of this budget is to ensure
24 optimum utilization of labour force.
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Preparation and
9.8 OVERHEADS BUDGET Review of Budgets
The overheads budget should be prepared in three parts as follows :

1) Manufacturing Overhead Budget
2) Administration Overhead Budget, and
3) Selling and Distribution Overhead Budget.
Manufacturing Overhead Budget
The budget is an estimate of the manufacturing overhead costs to be incurred in the
budget period to achieve the targeted production. Manufacturing overheads include
indirect material, indirect labour, and indirect expenses related to the factory. The cost
of each and every item of these three components of manufacturing overhead is
separately estimated as per the requirements of production.
Administration Overhead Budget
Administration overhead includes the costs of framing policies, directing the
organisation and controlling the business operations. Most of the administration
expenses are normally unconnected with the volume of activity, therefore,
experience and anticipated changes in conditions are the guides for the preparation of
this budget.
Selling and Distribution Overhead Budget
The budget includes all expenses relating to selling, advertising, delivery of goods to
customers, etc. The overheads may be determined on the basis of sales targets being
allocated to different territories or salesman etc. Those expenses which generally vary
with the sales quantity are estimated on sales basis, others which are of a fixed nature,
are estimated on the basis of past experience and anticipated changes. The
responsibility for the preparation of this budget lies with the executives of the sales
departments. Let us prepare a sales overheads budget from the following illustration.
Illustration 5
Prepare a Sales Overheads Budget for the quarter ending 31st March, 2005 from the
estimates given below:
Rs.
Advertisement 12,500
Salaries of sales department 25,000
Expenses of sales department 7,500
Counter salesmen salaries and allowances 30,000
Commission to counter salesmen is payable at 1% of sales executed by them.

Travelling salesman are entitled to a commission at 10% on sales effected through
them and a further 5% towards expenses. ( Rs. )
Sales Territories Sales at Sales by Total estimated
Counters Travelling sales
salesmen
A 4,00,000 50,000 4,50,000

B 6,00,000 75,000 6,75,000
C 7,00,000 1,00,000 8,00,000
25
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Budgetary Control
Sales Overheads Budget
For the period ended March 31, 2005
Estimated Sales in Territories

A B C
Rs. Rs. Rs.
4,50,000 6,75,000 8,00,000
Fixed Overheads:
Advertisement 12,500 12,500 12,500
Salaries of Sales Department 25,000 25,000 25,000
Expenses of Sales Department 7,500 7,500 7,500
Counter Salesmen's Salaries
and allowances 30,000 30,000 30,000
(a) 75,000 75,000 75,000
Variable Overheads:
Counter salesmen commission 4,000 6,000 7,000
@ 1% on sales
Traveling salesmen commission 5,000 7,500 10,000
@ 10%
Expenses @ 5% on Sales by
Travelling Salesmen 2,500 3,750 5,000
(b) 11,500 17,250 22,000
Total Sales Overheads (a) + (b) 86,500 92,250 97,000
9.9 CAPITAL EXPENDITURE BUDGET

The budget is the plan of the proposed outlay on fixed assets such as land, buildings,
plant and machinery. The budget is prepared after taking into account the available
productive capacities, probable reallocation of existing assets and possible improvement
in production techniques. etc.
Capital expenditure budget serves the following purposes :
i) It facilitates long-term planning and policy-making.
ii) It facilitates of replacing the old machinery by latest machinery or to change the
methods of production for reducing costs.
iii) It helps in the estimates of capital requirement after taking into account the
disposable value of old assets.
iv) It helps in the preparation of cash budget and also assessing the capital cost of
improving working conditions or adopting safety measures, etc.
9.10 CASH BUDGET

A Cash Budget is a summary statement of the firms’ expected cash inflows and
outflows over a projected time period. In other words, cash budget involves a
26 projection of future cash receipts and cash disbursements over various time intervals.
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While preparing cash budget seasonal factors must be taken into account and in Preparation and
practice cash budget is prepared on a monthly basis. The availability of other budgets Review of Budgets
is tested in terms of cash availability. Cash budget is also called as cash flow
statement which indicates cash inflow and cash outflows. It is generally prepared for
a maximum period of one year.
A cash budget helps the management in (i) determining the future cash needs of the
firm, (ii) planning for financing of the needs; (iii) exercising control over cash and
liquidity of the firm.
The overall objective of a cash budget is to enable the firm to meet all its commitments in
time and at the same time prevent accumulations of unnecessary large balance with it.
Methods of Preparing Cash Budgets
There are basically three methods for preparing cash budgets.
1) Receipts and Payments Method
2) Adjusted Profit and Loss Account Method
3) Balance Sheet Method
Let us study about these methods in brief.
1) Receipts and Payments Method
Under this method, all receipts are added and out of the total, the sum of all payments
is deducted to arrive at the balance in hand. The closing balance in hand say, for a
particular month is the opening balance of the next month and is added to the total of
receipts so as to know the total availability of cash during the month. The receipts and
payments during the budget period are found out from various functional budgets
prepared. The credit allowed to debtors, the credit allowed to us by suppliers, the delay
in payment of wages and other expenses etc. are the factors, which are taken into
account to determine the timing of receipts and payments. Advance payments and
receipts are to be included but the payment in abeyance and income accrued on
outstanding are excluded from cash budget. Revenue as well as capital receipts and
payments are recorded in cash budget.
Illustration 6
A company newly starting manufacturing operations on 1st January 2003 has made
adequate arrangement for funds required for fixed assets. It wants you to prepare an
estimate of funds required as working capital. It is to be remembered that:
a) In the first month there will be no sale, in the subsequent month sale will be 25%
cash and 75% credit. Customer will be allowed one month credit.
b) Payments for purchase of raw materials will be made on one month credit basis.
c) Wages will be paid fortnightly on the 22nd and 7th of each month.
d) Other expenses will be paid one month in arrear except that 5% of selling
expenses are to be paid immediately on sale being effected.
The estimated sales and expenses for the first six months, spread evenly over the
period subject to (a) above are as under:
Rs. Rs.
Sales 3,60,000 Administrative Expenses 54,000
Material Consumed 1,50,000 Selling Expenses 42,000
Wages 60,000 Depreciation on fixed assets 50,000
Manufacturing Exp. 48,000 27
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Budgeting and The article produced is subject to excise duty equal to 10% of the selling price. The
Budgetary Control duty is payable on March 31, June 30, September 30, and December 31 for sales upto
February 28, May 31, August 31 and November 30 respectively.
Prepare Cash Budget for each of the six months indicating the requirement of working
capital.
Solution
Cash Budget
for the six months ended on June 30, 2003
Particulars January February March April May June
Receipts:
Opening Balance - (--) 7,500 (--) 45,000 (--) 39,200 (--) 26,200 (--) 13,200
Cash Sales - 18,000 18,000 18,000 18,000 18,000
Receipts from customers - - 54,000 54,000 54,000 54,000
Cash Available (A) - 10,500 27,000 32,800 45,800 58,800
Payments:
Wages 7,500 10,000 10,000 10,000 10,000 10,000
Materials - 25,000 25,000 25,000 25,000 25,000
Manufacturing Exp. - 8,000 8,000 8,000 8,000 8,000
Administrative Exp. - 9,000 9,000 9,000 9,000 9,000
Selling Exp. - 3,500 7,000 7,000 7,000 7,000
Excise Duty - - 7,200 - - 21,600
Total Payments (B) 7,500 55,500 66,200 59,000 59,000 80,600
Closing Balance (A--B) (--) 7,500 (--) 45,000 (--) 39,200 (--) 26,200 (--) 13,200 (--) 21,800
Note : The Company needs overdraft facility to the extend indicated above for every
month.
2) Adjusted Profit and Loss Account Method
The budgeting done by Adjusted Profit and Loss account method is known as cash
flow statement and is more suitable for long-term forecasting. Under this method
profit is taken as equivalent to cash and necessary adjustments are done in respect of
non-cash transactions. The net estimated profit is taken as the base and non-cash
items like depreciation, outstanding expenses, provisions etc. already deducted to arrive
at the net profit are added back. The capital receipts, reduction in debtors, stocks,
increase in liabilities, issue of share capital and debentures are other items which are
added to compute the total cash receipts. The payments of dividends, prepayments,
capital payments, increase in debtors, increase in stock and decrease in liabilities are
deducted out of the total cash receipts. The profit adjusted this way denotes the
estimated cash available. The cash available during budget period is calculated in the
following form:
28
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Cash Budget Preparation and
For the period ending 31st March……………. Review of Budgets
Rs.
Opening balance of Cash xxx
Add :
Net profit for the year xxx
Funds from operations :
Depreciation xxx
Provision and write off xxx
Loss on sale of assets xxx
xxx
Less : Profit on sale of assets xxx xxx
“ Decrease in debtors xxx
“ Decrease in Stocks xxx
“ Decrease in other assets xxx
“ Decrease in prepaid exps. xxx
“ Increase in Capital xxx
“ Increase in liabilities xxx
“ Increase in debentures xxx xxx
xxx
Less :
Dividends xxx
Capital payments xxx
Repayment of loans xxx
Increase in Debtors xxx
Increase in Stock xxx
Decrease in liabilities xxx xxx
Closing balance of Cash xxx
Illustration 7
The following data are available to you. You are required to prepare a cash budget
according to Adjusted Profit and Loss method.
Balance Sheet as on 31st December, 2005

Rs. Rs.
Share Capital 1,00,000 Premises 50,000
General Reserve 20,000 Machinery 25,000
Profit and Loss A/c 10,000 Debtors 40,000
Creditors 50,000 Closing Stock 20,000
Bills Payable 10,000 Bills Receivable 5,000
Outstanding Rent 2,000 Prepaid Commission 1,000
Bank 51,000
1,92,000 1,92,000
29
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Budgeting and Projected Trading And Profit and Loss Account
Budgetary Control
for the year ending 31st December, 2005
Rs. Rs.
To Purchases 1,50,000 By Closing Stock 15,000
To Octori 2,000
2,15,000 2,15,000
To Interest 3,000 By Gross Profit b/d 43,000
To Salaries 6,000 By Sundry Receipts 5,000
To Depreciation (10% on
Premises and Machinery) 7,500
To Rent 6,000
Less: Outstanding
(Previous Year) 2,000
4,000
Add-Outstanding
(Current Year) 1,000 5,000
To Commission 3,000
Add-Prepaid (Previous Year) 1,000 4,000
To Advertisement Expenses 1,000
To Net Profit c/d 19,500
48,000 48,000
To Dividends 8,000 By Balance of Profit
(from last year) 10,000
To Addition to Reserves 4,000 By Net Profit b/d 19,500
To Balance c/d 17,500
29,500 29,500
Closing Balance of certain items:

Share Capital Rs. 1,20,000, 10% Debentures Rs. 30,000, Creditors Rs. 40,000, Debtors
Rs. 60,000, Bills Payable Rs. 12,000, Bill Receivable Rs. 4,000, Furniture Rs. 15,000
and Plant Rs. 50,000 (both these assets are purchased at the end of the year).
Solution
Cash Budget
For the period ending 31st December, 2005
Rs. Rs.
Opening Balance as on 1st January, 2005 51,000
Add: Net Profit for the year 19,500
Depreciation 7,500
Decrease in Bills Receivable 1,000
Increase in Bills Payable 2,000
Issue of Share Capital 20,000
Issue of Debentures 30,000
Decrease in Prepaid commission 1,000
Decrease of Stock 5,000 86,000
30 1,37,000
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Less: Purchase of Plant 50,000 Preparation and
Review of Budgets
Purchase of Furniture 15,000
Increase of Debtors 20,000
Decrease of Creditors 10,000
Decrease in Outstanding Rent 1,000
Dividends Paid 8,000 1,04,000
Closing Balance as on 31st December, 2005 Rs. 33,000
3) Balance Sheet Method
Under this method, at the end of budget period a projected balance sheet is drawn up
setting out the various assets and liabilities, except cash and bank balances. The
balancing figure would be the estimated closing cash/bank balance. Thus, under this
method, closing balances other than cash/bank will have to be found out first to be put
in the budgeted balance sheet. This can be done by adjusting the anticipated
transaction of the year in the opening balances. If the liabilities are more than assets,
this reveals a balance of cash/bank and if assets exceed liabilities, it reveals a bank
overdraft. Thus, under Adjusted Profit and Loss method, the amount of cash is
computed by preparing a Cash Flow Statement and the same amount is computed as a
balancing figure under Balance Sheet method.
Illustration 8
Prepare the Cash Budget using Balance Sheet method on the basis of figures given in
illustration 7.
Solution
Budgeted Balance Sheet
as on 31st December, 2005
Liabilities Amount Assets Rs. Amount
Rs. Rs.
Share Capital 1,20,000 Premises 50,000

10% Debentures 30,000 Less : Depreciation 5,000 45,000
General Reserve 24,000 Machinery 25,000
(Rs. 20,000 +Rs. 4000)
Less: Depreciation 2,500 22,500
Creditors 40,000 Furniture 15,000
Bills payable 12,000 Debtors 60,000
Outstanding Rent 1,000 Bills Receivable 4,000
Plant 50,000
Bank (Balancing Figures) 33,000
2,44,500 2,44,500
31
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Budgeting and
Budgetary Control 9.11 MASTER BUDGET
Master Budget is a combination of all other budgets prepared for a specific period.
It shows the overall budget plan. All the budgets are coordinated into one
harmonious unit.
According to Rowland and William H. Harr, “Master Budget is a summary of the

budget schedules in capsule form made for the purpose of presenting in one report
the highlights of the budget forecast.” Thus, Master Budget sets out the plan of
operations for all departments in considerable detail for the budget period. The
budget may take the form of a Profit and Loss Account and a Balance Sheet as at
the end of the budget period.
The budget generally contains details regarding sales (net), production costs, cash
position, and key account balances like debtors, fixed assets, bills payable, etc. It
also shows the gross and the net profits and the important accounting ratios. It is
prepared by the Budget Officer and it requires the approval of the Budget
Committee before it is put into operation. If approved, it is submitted to the Board
of Directors for final approval. The Board may make certain alterations if
necessary before it is finally approved.
Illustration 9
A Glass Manufacturing Company requires you to calculate and present the budget for
the next year from the following information.
Sales:
Toughened glass Rs. 3,00,000
Bent toughened glass Rs. 5,00,000
Direct Material Cost 60% of Sales
Direct Wages 20 Workers @ Rs. 150 per month
Stores and spares 2½ % on Sales
Depreciation on Machinery Rs. 12,600
Light and Power Rs. 5,000
Factory Overhead:
Indirect Labour:
Works Manager Rs. 500 per month
Foreman Rs. 400 per month

Repairs and maintenance 10% on direct wages
Administration, selling and distribution expenses Rs. 14,000 per year.
32
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Preparation and
Solution
Review of Budgets
Master Budget
for the period ending on ..................
Sales (as per Sales Budget) Rs. Rs. Rs.
Toughened Glass....... units @ Rs 3,00,000
Bent toughened glass ....... units @ Rs 5,00,000 8,00,000
Less- Cost of Production (as per Cost of Production Budget) :
Direct Materials (.... units @ Rs......) 4,80,000

Direct Wages 36,000
Prime Cost 5,16,000
Factory Overhead:
Variable: Stores and Spares (2½% of Sales) 20,000
Light and Power 5,000
Repairs and Maintenance 8,000 33,000
Fixed : Works Manager’s Salary 6,000
Foreman’s Salary 4,800
Depreciation 12,600
Sundries 3,600 27,000
Works Cost 5,76,000
Gross Profit 2,24,000

Less : Administration, Selling and Distribution Overheads 14,000
Net Profit 2,10,000
9.12 REVISION OF BUDGETS

Once a budget is fixed it should not be revised too frequently, as it loses its
importance. On the other hand, under changing conditions, a fixed or static budget
will lead to serious inaccuracies and will fail to serve as a control document and a
measuring tool. Normally, budgets are prepared well before the period of
commencement and naturally all the factors can not be foreseen with minute
accuracies. It is a recognised fact that business is dynamic and factors are ever
changing. Budget, in order to play its proper role changes must be incorporated if
they are significant. The revision of budgets may be necessitated on account of the
following reasons:
i) Budgeting errors, detected at a later stage.
ii) Change in external factors like material price-spiral, inflation in the prices of
fixed assets, increased wage rates, change in government policy, etc.
33
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Budgeting and iii) Additional expenditure to meet contingencies of an unforeseen nature, e.g.
Budgetary Control sudden loss on account of fire, strikes, lockouts, flood, tycoons, etc. If such
contingencies are of a temporary nature, the budgets are again reshaped in their
original form.
Illustration 10
A Company produces two products A and B and budgets at 70% level of activity for
the year 2003. It gives the following information :
Products A B
(Rs.) (Rs.)
Raw material cost per unit 15 7
Direct wages per unit 8 6
Variable overhead per unit 4 3
Fixed overhead per unit 12 9
Selling price per unit 38 27
Production and sales (Units) 12000 18000
The managing director proposed to decrease sales to 8000 units and 12000 units of
Product A and B respectively and increasing the selling price to Rs. 40 in the case of
Product A and Rs. 30 in the case of Product B.
You are required to present the overall profitability under the original budget and
revised budget after taking the above proposal into consideration.
Solution
Budget
For the year 2004
Revised Budget Original Budget
Particulars
A B Total A B Total
Sales Units 8,000 12,000 12000 18000
Sales (Value in Rs.)(A) 3,20,000 3,60,000 6,80,000 456,000 4,86,000 9,42,000
Costs : Rs. Rs. Rs. Rs Rs Rs
Raw Material 1,20,000 84,000 2,04,000 1,80,000 1,26,000 3,06,000
Labour 64,000 72,000 1,36,000 96,000 1,08,000 2,04,000
Variable O.H 32,000 36,000 68,000 48,000 54,000 99,000
Fixed O. H. 96,000 1,08,000 2,04,000 1,44,000 1,62,000 3,06,000
Total Cost (B) 3,12,000 3,00,000 6,12,000 4,68,000 4,50,000 9,18,000
Profit (A-B) 8,000 60,000 68,000 (--) 12,000 36,000 24,000
The managing director’s proposal is to be implemented as the profit is

34 increasing from Rs. 24,000 to Rs. 68,000 keeping in view other factors also.
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Preparation and
9.13 BUDGET REPORT Review of Budgets
Proper reporting is an essential element in budgetary control. The management must

be regularly informed about the results of various functions so that follow up actions
can be taken up without loss of time. The periodicity of reports depends on the nature
of operations involved. The budgetary control reports are prepared on the basis of the
budget reports. The comparison of budgeted and actual figures is made and deviations
taken out- all the relevant figures are presented in the control reports. On the basis of
the principle of management by exception, remedial and corrective action is taken.
The report may indicate the necessity of revision of the budget also.
The budget report should be prompt and factual and should have the requisite degree of
accuracy. The report should be prepared in such a manner that it reveals the
responsibility of a department or an executive and give full reasons for the variances
so that proper corrective action can be taken.
Check Your Progress
1) State the factors that should be kept in mind while preparing Sales Budget.
a) ……………………….. d) …………………………….
b) ………………………… e) …………………………….
c) ………………………… f) …………………………….
2) What are the components of functional budgets ?
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
3) Specify the objectives of preparing capital expenditure budget.
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
4) Why does revision of budget necessary ?
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
5) Fill in the blanks :
a) .................. is responsible for the preparation and execution of sales budget.
b) Production budget is based on ...................................... budget.
c) Purchase budget must correlate .......................... budget and ....................

budget. 35
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Budgeting and d) .............................. budget is the combination of all other budgets.
Budgetary Control
e) The preparation of cash budget by the method of adjusted profit and loss
account is also known as............................... .
f) Master budget is the summary of all components of .............................. .
6) State whether each of the following statement is true or false.
a) The cost of materials, labor and manufacturing overheads constitutes total

cost of sales [ ]
b) The purpose of Direct labour budget is to ensure optimum utilisation of

labour force. [ ]
c) Direct materials are generally included in overhead budget. [ ]
d) Once a budget is fixed there is no need to incorporate the changes in the

budget however significant they are. [ ]
e) Cash budget indicates the amount of loan required as well as the time when
it is needed. [ ]
f) A Master Budget is the master plan drawn up by the organisation for the
budget period. [ ]
9.14 LET US SUM UP

Budgeting is the main instrument for projecting the future costs and revenues and for
financial control of the organisation. Preparation of budgets involves a number of
forecasts or projections. It starts with sales forecasting and ends with the compilation
of the master budget. The sales budget is the keystone in planning and control of
operations of a business. Sales forecast serves as a base for the sales budget. The
Sales Manager is responsible for the preparation and execution of sales budget. In
addition to sales budget, other functional budgets are also prepared. The other
functional budgets are : i) Production Budget, ii) Cost of Production Budget,
iii) Material Budget, iv) Purchase Budget, v) Direct Labour Budget,
vi) Manufacturing Overhead Budget, vii) Administration Overhead Budget,
viii) Selling and Distribution Overhead Budget, and ix) Capital Expenditure Budget.
A cash budget is a summary statement of the firms expected cash inflows and
outflows over a projected time period. It is generally prepared for a maximum
period of one year. There are three methods of preparing cash budgets. They are :
i) Receipts and Payment Method, ii) Adjusted Profit and Loss Account Method, and
iii) Balance Sheet Method.
A master budget is a combination of all other budgets prepared for a specific

period. It shows the overall budget plan. The budget generally contains details
regarding sales, production costs, cash position and the key account balances. It
also shows profit and important accounting ratios. Revision of budgets is
necessary to incorporate the changing conditions for effective control. Revision of
budget may be necessitated due to budgeting errors, change in external factors and
additional expenditure to meet unforeseen contingencies. Proper reporting is an
essential element in budgetory control. The management must be regularly
informed about the results of various functions so that remedial and corrective
action may be taken well in time. The report may also indicate the necessity of
36 revision of budget also.
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Preparation and
9.15 KEY WORDS Review of Budgets
Cash Budget : A summary statement of future cash receipts and payments over a
projected time period.
Production Budget : A forecast of production expressed quantitatively for the budget
period.
Sales Budget : A budget expressed in quantitative terms of units expected to be sold
and the value expected to be realised for the budget period.

5) a) Sales Manager b) Sales c) Sales, production d) Master Budget
d) Cash flow statement f) Functional budget
6) a) False b) True c) False d) False e) True f) True

1) What is a Sales Budget ? How is it prepared ?
2) Write short notes on the following :
i) Sales Budget
ii) Material Budget
iii) Production Cost Budget
iv) Overhead Budget
3) What is a Cash Budget ? How is it prepared ?
4) What is a Master Budget ? What are its Components ?
5) From the following particulars, prepare a production budget of a manufacturing
company for the year ended 31st March, 2003.
Product Sales Budget Estimated Stock (Units)

(Units) 1-4-2002 31-3-2003
A 75,000 7,000 7,500
B 50,000 2,500 7,250
C 35,000 4,000 4,000
(Ans. A : 75,500 Units, B : 54, 750 Units, C : 35,000 Units)

6) Prepare a material procurement budget (in units) from the following information :
Estimated sales of a product 40,000 units. Each unit of the product requires 3
units of Material A and 4 units of Material B. Estimated opening balance at the
beginning of the next year:
Units
Finished Products 5,000
Material A 19,000
Material B 31,000
The desired level of closing balances at the end of the next year :
Finished Products 7,000 37
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Budgeting and Material A 23,000
Budgetary Control
Material B 35,000
(Ans. Production 42,000 units, Material required : Material A : 1,30,000
units, Material B : 1,72,000 units)
7) The budgeted expenses for production of 10,000 units in a manufacturing
company are given below. From the information prepare a budget for the
production of (a) 8000 units and (b) 6000 units. Assume that the administration
expenses are fixed for all levels of production:
Rs. Per unit

Materials 70
Labour 25
Variable Overheads 20
Fixed Overheads (Rs. 1,00,000) 10
Variable Overheads(Direct) 5
Selling expenses (10% fixed) 13
Administration expenses (Rs. 50,000) 5
Distribution expenses (20% Fixed) 7
Rs.155
( Ans. (a) Rs. 12,75,400 (b) Rs. 10,00,800 )
8) A Company produces and sells three products : Product A, Product B and

Product C. The Company has divided its market into two areas as North zone
and South zone. The actual sales for the year 2003 were as follows :
North Zone South Zone

Products
Price per No. of Units Price per No. of Units
Unit (Rs.) Unit (Rs.)
A 12 8,00,000 12 5,00,000
B 15 5,00,000 15 7,00,000
C 16 6,00,000 16 6,00,000
For the current year i.e, 2002, it is estimated that the sales of product A will go up
by 10% in South zone and of Product C by 50,000 units in North zone. The company
plans to launch an intensive advertisement campaign through which budgeted figures
for product B are to be increased by 20% in both the zones.
There will be no change in the pries of the product A and C but the price of Product B
will be reduced by Rs. 1.
38 You are required to prepare a sales budget for the year 2003.
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Ans. : Preparation and
Review of Budgets
North South Total Budget
(Units) (Units) (Rs.)
Product A 8,00,000 5,50,000 162,00,000

Product B 6,00,000 8,40,000 201,60,000
Product C 6,50,000 6,00,000 200,00,000)
9) Andhra Ltd has three sales division at Chennai, Bangalore and Hyderabad.
It sells two products – I and II. The budgeted sales for the year ending
31st December, 2002 at each place are given below:
Chennai Product I 50,000 units @ Rs. 16 each

Product II 35,000 units @ Rs. 10 each
Bangalore Product II 55,000 units @ Rs. 10 each
Hyderabad Product I 75,000 units @ Rs. 16 each
The actual sales during the same period were :
Chennai Product I 62,500 units @ Rs. 16 each

Product II 37,500 units @ Rs. 10 each
Bangalore Product II 62,500 units @ Rs. 10 each
Hyderabad Product I 77,500 units @ Rs. 16 each
From the reports of the sales department it was estimated that the sales budget for the
year ending 31st December, 2003 would be higher than 2002 budget in the following
respects :
Chennai Product I 4000 units

Product II 2,500 units
Bangalore Product II 6,500 units
Hyderabad Product I 5,000 units
Intensive sales campaign in Bangalore and Hyderabad is likely to result in additional

sales of 12, 500 units of Product I in Bangalore and 9,000 units of Product II in
Hyderabad. Let us prepare a sales Budget for the period ending 31st December,
2003.
(Ans. : Chennai : Product I 54000 Units

Product II 37,500 Units
Bangalore : Product I – 12500 units

Product II 61,500 units
Hyderabad : Product I 80,000 units

Product II 9000 units)
10) Draw a Material Procurement Budget (Quantitative) from the following

information:
Estimated sale of a product is 20,000 units. Each units of the product requires
3 units of material X and 5 units of Material Y. 39
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Budgeting and Estimated opening balance at the commencement of the next year :
Budgetary Control
Finished product 2,500 kgs.
Material X 6,000 units
Material Y 10,000 units
Materials on Order :
The desirable closing balances at the end of the next year :
Finished Product 3,500 units
Material on order :
11) The Sales Director of Asian Company expects to sell 25,000 units of a particular
product next year. The Production Director consulted the storekeeper who gave
the necessary details as follows :
Two kinds of raw material, P and Q are required for manufacturing the product.
Each unit of the product requires 2 units of P and 3 units of Q. The estimated
opening balance at the commencement of the next year are :
Finished product : 5,000 units
Raw Material P : 6,000 units
Raw Material Q : 7,500 units
The desirable closing balance at the end of the next year are :
Finished Products : 7,000 units
Raw Material P : 6500 units
Raw Material Q : 8000 units
Prepare a statement showing Material Purchase Budget for the next year.
(Ans. : Material required for 25,500 units : P - 54,500 units, Q - 81,500 units)
12) A company is expecting to have Rs. 50,000 cash in hand on 1st April, 2005
and it requires you to prepare an estimate of cash position during the three
months, April to June 2005. The following information is supplied to you :
Sales Purchases Wages Expenses

(Rs.) (Rs.) (Rs.) (Rs.)
February 1,40,000 80,000 16,000 12,000

March 1,60,000 1,00,000 16,000 14,000
April 1,84,000 1,04,000 18,000 14,000
May 2,00,000 1,20,000 20,000 16,000
June 2,40,000 110,000 24,000 18,000
40
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Additional Information : Preparation and
Review of Budgets
a) The credit period allowed by supplies is two months.
b) 25% of sales is for cash and credit period allowed to customers is one month.
c) Delay in payment of wages and expenses is one month.
d) Income tax Rs. 50,000 is to be paid in June 2005.
(Ans. : April Rs. 1,06,000, May Rs. 1,62,000, June Rs. 1,82,000)
13) A Company is expected to have Rs. 12,500 cash in hand on 1st July, 2005 and it
requires you to prepare a cash budget for the period July, 2005 to September,
2005 from the following particulars :
Sales Purchases Wages
(Rs.) (Rs.) (Rs.)
May 90,000 62,400 6,000
June 96,000 72,000 7,000
July 54,000 1,21,500 5,500
August 87,000 1,23,000 5,000
September 63,000 1,34,000 7,500
Creditors are paid in the month following the month of purchase. 50% of credit sales
are realised in the month following the credit sales and the remaining 50% in the
second month following. Delay in the payment of wages is one month.
(Ans. Cash balance : July Rs. 26,500 (+), August Rs. 25,500 (--), September
Rs. 83,000(--) )
14) A company expects to have Rs. 37,500 cash in hand on 1st April, and requires
you to prepare an estimate of cash position during the three months, April, May
and June. The following information is supplied to you :
Sales Purchases Wages Factory Office Selling
( Rs.) ( Rs.) ( Rs.) Expenses Expenses Expenses
( Rs.) ( Rs.) ( Rs.)
February 75,000 45,000 9,000 7,500 6,000 4,500

March 84,000 48,000 9,750 8.250 6,000 4,500
April 90,000 52,500 10,500 9,000 6,000 5,250
May 1,20,000 60,000 13,500 11,250 6,000 6,570
June 1,35,000 60,000 14,250 14,000 7,000 7,000
1) Period of credit allowed by suppliers 2 months
2) 20% of sales is for cash and period of credit allowed to customers for credit is one
month
3) Delay in payment of all expenses – 1 month
4) Income tax of Rs. 57,500 is due to be paid on June 15th.
5) The company is to pay dividends to shareholders and bonus to workers of
Rs. 15,000 and Rs. 22,500 respectively in the month of April. 41
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Budgeting and 6) Plant has been ordered to be received and paid in May. It will cost
Budgetary Control Rs. 1,20,000.
(Ans. : Cash balance : April (+) Rs. 11,700, May (--) Rs. 91,050,
June (--) Rs. 1,15,370 )
15) From the following information, you are required to prepare cash budget
according to Adjusted Profit and Loss method as well as Balance Sheet method.
Balance Sheet as on 1-1-2005
Share Capital 5,00,000 Debtors 5,00,000
Reserves 10,00,000 Stock and Stores 3,00,000
Debentures 3,00,000 Fixed assets 13,00,000
Public deposits 2,00,000 Cash balance 1,00,000
Current liability 2,00,000
22,00,000 22,00,000
Projected Trading and Profit and Loss A/c for the year ending 31-12-2005

To Direct Cost of Production 12,00,000 By Closing Stock 6,00,000
To Depreciation 1,00,000
To Variable selling and

distribution costs 2,00,000
To Net profit c/d 3,00,000
21,00,000 21,00,000
To Dividends 50,000 By Net Profit b/d 3,00,000
To Balance c/d 2,50,000
3,00,000 3,00,000
Collection of debtors and sales proceeds during the year Rs. 17,00,000, refund of
public deposits Rs. 1,00,000, increase in current liability Rs. 50,000
(Ans. : Cash balance as on 31.12.2005 : Rs. 3,00,000, Debtors as on 31.12.2005 :

Rs. 3,00,000 (Opening debtors Rs. 5,00,000 + Sales Rs. 15,00,000 – Collection
from debtors Rs. 17,00,000)
16) From the following information prepare a cash budget under the Adjusted Profit
42 and Loss Account Method and Balance Sheet Method.
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Balance Sheet as on 1-1-2005 Preparation and
Review of Budgets
Share capital 50,000 Land and buildings 30,000
Capital reserve 5,000 Plant and Machinery 20,000
Profit and loss a/c 9,000 Furniture and fixtures 5,000
Debentures 10,000 Closing stock 4,000
Creditors 28,800 Debtors 26,000
Accrued expenses 200 Bank 18,000
1,03,000 1,03,000
Forecast Trading, and Profit and Loss Account

For the Year ending 31-12-2005
Opening Stock 4,000 Sales 80,000
Purchases 60,000 Closing Stock 10,000
Gross Profit c/d 26,000
90,000 90,000
Salary and wages 2500 Gross profit b/d 26,000
Add Outstanding 500 3000 Interest received 100
Depreciation :
Plant and Machinery 2,000
Furniture and fixture 1,000
Administrative expenses 3,500
Selling expenses 2,500
Net Profit c/d 14,100
26,100 26,100
Dividend paid 10,000 Balance b/d 9,000
Balance c/d 13,100 Net profit b/d 14,100
23,100 23,100
The following are the additional information for the year 2005 : shares were
issued for Rs. 10,000, and debentures were issued for Rs. 2,000.
On 31-12-2005, the accrued expenses were Rs. 500, Debtors Rs. 20,000, Creditors
Rs. 30,000, and Land and buildings, Rs. 40,000.
(Ans : Cash balance as on 31.12.2005 : Rs. 28,600, Balance Sheet total : Rs.1,20,600)

Edward B. Deakin and Michael W. Maher, Cost Accounting, Richard D. Erwin, inc.,
Homewood, Illinois.
Lal Nigam B.M. and Sharma G.L., Advanced Cost Accounting, Himalaya Publishing
House, Bombay-4. 43
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UNIT 10 APPROACHES TO
BUDGETING
Structure
10.0 Objectives
10.1 Introduction
10.2 Fixed Budgeting
10.3 Flexible Budgeting
10.4 Difference between Fixed and Flexible Budgeting
10.5 Appropriation Budgeting
10.6 Zero Based Budgeting (ZBB)
10.7 Performance Budgeting
10.8 Budgetary Control Ratios
10.9 Behavioural Consideration
10.10 Let Us Sum Up
10.11 Key Words
10.0 OBJECTIVES
After studying this unit you will be able to know:
l different approaches for the preparation of budgets;
l the process of adjusting the budget to reflect actual conditions; and
l the differences between planned activity and actual activity.
10.1 INTRODUCTION
In the previous Unit you have learnt the preparation and review of various types
of budgets. You have also learnt about the development of the master budget
for planning and control of costs. In this unit, you will study about different
approaches to budgeting and further to examine the use of the budget as a tool
for performance evaluation and control. The actual performance is compared
with the budgeted programme and the variances are analysed and investigated
so that corrective action may be taken well in time to ensure the success of the
business.
10.2 FIXED BUDGETING

According to C.I.M.A., London, “a fixed budget is a budget which is designed to
remain unchanged irrespective of the level of activity actually attained.” Thus, a budget
prepared on the basis of a standard or fixed level of activity is known as a fixed
44 budget. It does not change with the change in the level of activity. Therefore, it
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becomes an unrealistic yardstick in case the level of activity actually attained does not Approaches to
confirm to the one assumed for budgeting purposes. The management will not be in a Budgeting
position to assess the performance of different heads on the basis of budgets prepared
by them because they can serve as yardsticks only when the actual level of activity
corresponds to the budgeted level of activity. Fixed budget is useful when there is no
significant variation between the budgeted output and the actual output. It does not
consider variances due to changes in the volume. In the industries where the pattern
of demand is stable a fixed budget may be adequate, especially where the budget
period is comparatively short. In such concerns it is possible to forecast sales with a
considerable degree of accuracy.
10.3 FLEXIBLE BUDGETING

Flexible budget, also known as variable or sliding sale budget, is a budget which is
designed to furnish budgeted costs for any level of activity actually attained. Flexible
budgeting technique may be employed to adjust other budgets according to current
conditions arising out of seasonal variations or changes in the length of the working
period etc.
According to C.I.M.A., London, “a flexible budget is a budget designed to change in

accordance with the level of activity actually attained.” Thus, a budget prepared in a
manner so as to give the budgeted cost for any level of activity is known as a flexible
budget. Such a budget is prepared after considering the fixed and variable elements of
cost and the changes that may be expected for each item at various levels of
operations.
Under this method, a series of budgets would be prepared at different levels of activity.
Variable items are shown in the budget as per the level of output. Fixed costs are
shown at the same amount irrespective of level of output. Sales value is computed and
entered into the flexible budget. The position of profit or loss will be revealed at the
various levels of activity. Management will take a decision to operate at a particular
level of activity where the profit is maximum taking into account all other factors.
A flexible budget is more realistic, useful and practical. The likely changes in the actual
circumstances are taken into account while preparing a flexible budget. The technique
is highly useful for control purposes. Actual performance of an executive may be
compared with what he should have achieved in the actual circumstances and not with
what he should have achieved under quite different circumstances.
Illustration 1
A Company producing electronic watches, estimates the following factory overhead

costs for producing 5,000 units:
Rs.
Indirect Materials 16,000
Indirect Labour 30,000
Inspection Costs 16,000
Heat, Light and Power 8,000
Expendable tools 8,000
Supervision costs 8,000
Equipment depreciation 4,000
Factory rent 4,000
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Budgeting and Indirect labour, indirect material and expendable tools are entirely variable. Heat,
Budgetary Control light and power and inspection costs are variable to the extent of 50%, 40%
respectively. Other costs are fixed costs a month.
Prepare a flexible budget for production of 4,000 and 6,000 units per month. Also
find out the average factory overheads per unit for these two production levels.
Solution
Flexible Budget
for the production of 4,000 and 6,000 units per month
5000 Units 4000 Units 6000 Units
Rs. Rs. Rs.
Overheads:
Indirect Material 16,000 12,800 19,200
Indirect Labour 30,000 24,000 36,000
Inspection Costs 16,000 14,720 17,280
Heat, Light and Power 8,000 7,200 8,800
Expendable tools 8,000 6,400 9,600
Supervision Costs 8,000 8,000 8,000
Equipment depreciation 4,000 4,000 4,000
Factory rent 4,000 4,000 4,000
94,000 81,120 1,06,880
Average factory overheads
per unit 18.80 20.28 17.81
Illustration 2
A manufacturing company is presently working at 50% capacity and produces
1000 units at a cost of Rs. 360 per unit. The details of cost are given below :
Rs.
Material 200
Labour 60
Factory Overhead 60 (Rs. 24 fixed)
Administrative overheads 40 (Rs. 20 fixed)
Rs. 360
The current selling price of the product per unit is Rs. 400. At 60% of its capacity,
material cost per unit increases by 2% and selling price per unit falls by 2%.
At 80% of its capacity, material cost per unit increases by 5% and selling price per
unit falls by 5%. Estimate profits at 60% and 80% level of output and offer your
suggestions.
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Solution Approaches to
Budgeting
Flexible Budget
(Showing the forecast of Profit at different levels)
Elements of Cost Level of Output
50% 60% 80%
(1000 Units) (1200 Units) (1600 Units)
Rs. Rs. Rs.
Material 200 204 210
Labour 60 60 60
Factory Overhead (Variable) 36 36 36
Administrative O.H. (Variable) 20 20 20
Marginal Cost per Unit 316 320 326
Sales Per unit 400 392 380
Contribution per Unit 84 72 54
(Sales – Marginal Cost)
Total contribution 84,000 86,400 86,400
Fixed Overhead 44,000 44,000 44,000
(Rs. 24 + Rs. 20)
Profit 40,000 42,400 42,400
(Contribution – Fixed OH)
Suggestion : It is advisable to operate at 60% level of capacity as the profit at 80%

capacity is the same. More risk is involved at 80% capacity as more production, more
working capacity, more efforts still profit remains the same.
Illustration 3
The following data belongs to a manufacturing company for the year ending
31st March, 2005. You are required to prepare a flexible budget for the year 31-3-2005
and forecast the profit at 60%, 75%, 90% and 100% of capacity.
Fixed Expenses : Rs.
(Lakhs)
Wages and salaries 4.2
Rent, rates and taxes 2.8
Depreciation 3.5
Administrative expenses 4.5
Total 15.0
Semi-Variable expense : @ 50% of capacity
Maintenance and repairs 1.5
Indirect Labour 4.7
Sundry administrative expenses 2.7
Total 8.9
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Budgeting and Variable expenses : @ 50% of capacity
Budgetary Control
Material 12.0
Labour 12.8
Other direct expenses 2.0
26.8
It is estimated that fixed expenses remain constant for all levels of production; semi-
variable expenses remain constant between 45% and 65% of capacity, increasing
by10% between 65% and 80% of capacity and 20% between 80% and 100% of
capacity.
Sales at various levels are :
50% capacity Rs. 45 lakh
Solution
Flexible Budget for the year ended 31st March, 2005
(Rs. in lakh)
Elements of Cost Level of Output
50% 60% 75% 90% 100%
Fixed expenses :
Wages and salaries 4.2 4.2 4.2 4.2 4.2
Rent, Rates and taxes 2.8 2.8 2.8 2.8 2.8
Depreciation 3.5 3.5 3.5 3.5 3.5
Administrative expense 4.5 4.5 4.5 4.5 4.5
15.0 15.0 15.0 15.0 15.0
Semi-Variable Expenses :
Maintenance and repairs 1.5 1.5 1.65 1.80 1.80
Indirect labour 4.7 4.7 5.17 5.64 5.64
Sundry admn. Expenses 2.7 2.7 2.97 3.24 3.24
8.9 8.9 9.79 10.68 10.68
Variable expenses :
Material 12.0 14.4 18.0 21.60 24.0
Labour 12.8 15.36 19.2 23.04 25.6
Other direct expenses 2.0 2.40 3.0 3.60 4.0
26.8 32.16 40.2 48.24 53.6
Total cost of Production 50.7 56.06 64.99 73.92 79.28
Profit/Loss (--) 5.7 (--) 6.06 (--) 4.99 (+) 1.08 (+)5.72
48 Sales 45.00 50.00 60.00 75.00 85.00

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Approaches to
10.4 DIFFERENCE BETWEEN FIXED AND Budgeting
FLEXIBLE BUDGETING
The differences can be outlined as follows:
1) Fixed budgeting is inflexible and remains the same irrespective of the volume of
business activity, whereas flexible budgeting can be suitably recast quickly to suit
changed conditions.
2) Fixed budgeting assumes that conditions would remain static, whereas, flexible
budgeting is designed to change according to a change in the level of activity.
3) Under fixed budgeting, costs are not classified according to fixed, variable and
semi-variable, while, under flexible budgeting, costs are classified according to
nature of their variability.
4) Under fixed budgeting, actual and budgeted performances can’t be correctly
compared if the volume of output differs, while under flexible budgeting,
comparisons are realistic since the changed plan figures are placed against actual
ones.
5) Under fixed budgeting, cost cannot be ascertained if there is a change in the
circumstances, while, under flexible budgeting, costs can easily be ascertained at
different levels of activity. The task of fixing prices becomes smooth.
10.5 APPROPRIATION BUDGETING

Generally budgets are prepared for the regular business activities and they cover the
operational activities of an organisation. However, it is not true that budgets are only
useful for operational activities, these may also prepare for any particular purpose, like
for constructing any particular building, development activities, where revenue is not
concerned, only expenditures are there. When budgets are prepared only for a
particular activity/work, that is called Appropriation Budget. These budgets are related
to only one activity /work and on completion of that particular activity the purpose of
this budget ends. Hence, this type of budget are always relate /cover different activities
in an organisation.
10.6 ZERO BASED BUDGETING (ZBB)

The technique of zero based budgeting suggests that an organisation should not only
make decisions about the proposed new programmes but it should also, from time to
time, review the appropriateness of the existing programmes. Such review should
particularly done of such responsibility centres where there is relatively high proportion
of discretionary costs.
Zero based budgeting, as the term suggests, examines a programme or function or
responsibility from “ scratch.” The reviewer proceeds on the assumption that nothing
is to be allowed. The manger proposing the activity has, therefore, to prove that the
activity is essential and the various amounts asked for are reasonable taking into
account the volume of activity. Nothing is allowed simply because it was being done or
allowed in the past. Thus, it means writing on a clean slate.
Peter A. Pyhrr defined the zero based budgeting as “an operating planning and
budgeting process which requires each manager to justify his entire budget requests in
detail from scratch (hence zero basis). Each manager states why he should spend any
money at all. This approach requires that all activities be identified as decision
packages which would be evaluated by systematic analysis ranked in order of
importance.”
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Budgeting and Thus, a cost-benefit analysis is done in respect of every function or process. It has to
Budgetary Control be justified while framing budgets. The assumption underlying zero base budgeting is
that the budget for the previous period was zero, therefore whatever costs are likely to
be incurred or spending programmes are chalked out, justification or the full amount is
to be given. Under conventional system of budgeting, however, the justification is to be
submitted by the manager only in respect of the increase in the demand for allotment
of funds in excess over the budget for the previous period. Thus, instead of
functionally-oriented spending approach, programme-oriented and decision-oriented
approach is followed under zero based budgeting.
Advantages of ZBB
1) This system is decision oriented.
2) The technique is relatively elastic, because budgets are prepared every year as
zero base.
3) It reduces wastage, eliminates inefficiency and reduces the overall cost of
production because every budget proposal is on the basis of cost-benefit ratio
after careful evaluation of different alternatives and the one which is ‘best’ is
approved.
4) It provides for a greater possibility of goal congruence.
5) It takes into consideration inflationary trends, competitor games and consumer
behaviour.
6) It vastly improves financial planning and management information system in view
of its revolutionary approach.
Disadvantages of ZBB
1) It is possible to quantify and evaluate budget proposals involving financial matters
but computation of cost-benefit analysis is not possible in respect of non-financial
matters.
2) The cost of administration of zero based budgeting is high.
3) It may be difficult to search out various alternatives for the same activity.
4) Some decision packages are inter-related which may be difficult to rank.
5) Ranking the decision is a scientific technique. Every manager can not be
expected to have the necessary technical expertise in this matter.
6) Zero based budgeting dismisses that the past is irrelevant and thereby challenges
the fundamental theory of continuity. Budgeting is a continuous process of
estimating and forecasting about the future and is based on past happenings.
10.7 PERFORMANCE BUDGETING

Performance budgets are framed in such a manner that items of expenditure and
receipts for a budget period related to a specific responsibility centre are linked with
the physical performance of that centre. The main issue involved in the preparation of
performance budgets is the development of work programmes and performance
expectation by assignment of responsibility. It is essential for the attainment of the
objectives.
In this approach, there is not only a financial plan but also a work plan in terms of
work done or end-products produced. Thus, it gives a broader view to the budget as a
plan and programme of action rather than only as an instrument for obtaining funds. In
50 fact, it makes the integration of inputs with the outputs of a development programme.
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According to National Institute of Bank Management, performance budgeting Approaches to
technique is, “ the process of analysing, identifying, simplifying and crystallising specific Budgeting
performance objectives of a job to be achieved over a period, in the framework of the
organisational objectives, the purpose and objectives of the job. The technique is
characterised by its specific direction towards the business objectives of the
organisation.”
The main objectives of performance budgeting are :
i) to coordinate the physical and financial aspects,
ii) to improve the budget formulation, review and decision making at all levels of
management,
iii) to facilitate better appreciation and review by controlling authorities as the
presentation is more purposeful and intelligible,
iv) to make more effective performance audit possible, and
v) to measure progress towards long term objectives which are envisaged in a
development plan.
Performance budgeting requires preparation of periodic performance reports.
Such reports compare budget and actual data, and show variances. Their
preparation is greatly facilitated if the authority and responsibility for the
incurence of each cost element is clearly defined within the firm’s
organisational structure. The responsibility for preparing the performance
budget of each department lies on the respective department head. Periodic
reports from various sections of a department will be required by the
departmental head who will submit a summary report about his department to
the budget committee. The report will be in the form of comparison of budgeted
and actual figures both periodic and cumulative. The purpose of preparing these
reports is to promptly inform about the deviations in actual and budgeted activity
to the person who has the necessary authority and responsibility to take
necessary action to correct the deviations from the budget.
Thus, performance budgeting lays immediate stress on the achievement of
specific goals over a period of time. However, in the long-run it aims at
continuous growth of the organisation so that it continues to meet the dynamic
needs of its growing clientele. It enables the organisation to be sensitive and
adaptive, preventing it from developing rigidities which may retard the process of
growth.
A comparison of the master budget with the flexible budget and with actual
results forms the basis for analyzing difference between plans and actual
performance. The difference between operating profits in the master budget
and operating profits in the flexible budget is called an activity variance. When
the change from the master budget to the flexible budget is due to changes in
sales volume, the activity variance is known as the sales volume variance. The
variance may be favourable or unfavourable variance. Let us take the following
illustration.
Illustration 4
Z Ltd had a profit plan approved for selling 5,000 units per month at an average price
of Rs. 10 per unit. The budgeted variable cost of production was Rs. 4 per unit and
the fixed costs were budgeted at Rs 20,000, the planned income being Rs. 10,000
per month. Due to shortage of raw materials, only 4,000 units could be produced and
the cost of production increased by 50 paisa per unit. The selling price was raised by
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Budgeting and Rs. 1.00 per unit. In order to improve the producti1on process, an expenditure of
Budgetary Control Rs. 1,000 was incurred for research and development activities.
You are required to prepare a Performance Budget and find out the variance.
Solution
Z Ltd
Performance Budget
Original Plan Adjusted Plan Actual Position Variance
(5000 units) (4000 units) (4000 units) (Rs.)
Rs. Rs. Rs.
Sales Revenue 50,000 40,000 44,000 4000 (F)
Variable Costs 20,000 16,000 18,000 2000 (U)
Contribution 30,000 24,000 26,000 2000 (F)
Fixed Costs 20,000 20,000 21,000 1000 (U)
Net Income 10,000 4,000 5,000 1000 (F)
Flexible budget variance = Rs. 5000 – Rs. 4000 = Rs. 1000 (F)
Illustration 5
From the following information prepare the performance budget of ABC Company Ltd
for the month of December, 2005.
Variables Actual (Based on Flexible Budget Master budget

actual activity of (based on actual (based on a
10,000 units sold) activity of 10,000 prediction of
units sold) 8,000 units sold)
Rs. Rs. Rs.
Sales Revenue 2,10,000 2,00,000 1,60,000
Manufacturing costs 1,05,440 1,00,000 80,000
Marketing and 11,000 10,000 8,000
administrative costs
Fixed costs 65,000 60,000 60,000
Solution
Performance Budget of ABC Co. Ltd for the month of December 2005
Variables Actuals Variance Flexible Variance Master
(based on Budget Budget
actual activity (Based on (based on a
of 10,000 actual activity prediction
units sold of 10,000 of 8000
units sold) units sold)
Rs. Rs. Rs. Rs. Rs.
Sales Revenue 2,10,000 10,000 (F) 2,00,000 40,000 (U) 1,60,000
Less: Mafg. Costs
and Administrative 1,16,440 6,440 (U) 1,10,000 22,000 (U) 88,000
costs
93,560 3,560 (F) 90,000 66,000 (U) 72,000
Less : Fixed Cost 65,000 5,000 (F) 60,000 — 60,000
Profit 28,560 1440 (U) 30,000 18,000 (F) 12,000
Total Variance from Flexible Budget = Rs. 1440 (U)

52 Total Variance from Master Budget = Rs. 18,000 – Rs. 1440 = Rs. 16,560 (F)
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Approaches to
10.8 BUDGETARY CONTROL RATIOS Budgeting
Three important ratios are commonly used by the management to find out whether the
deviations of actuals from budgeted results are favourable or otherwise. These ratios
are expressed in terms of percentages. If the ratio is 100% or more, the trend is taken
as favourable. The indication is taken as unfavourable if the ratio is less than 100.
These ratios are:
1) Activity Ratio
2) Capacity Ratio
3) Efficiency Ratio
Let us study these ratios in brief.
1) Activity Ratio
It is the measure of the level of activity attained over a period. It is obtained when the
number of standard hours equivalent to the work produced are expressed as a
percentage of the budgeted hours.
Standard hours for actual production

Activity Ratio = × 100
Budgeted hours
2) Capacity Ratio
This ratio indicates whether and to what extent budgeted hours of activity are actually
utilised. It is the relationship between the actual number of working hours and
maximum possible number of working hours in budget period.
Actual hours worked

Capacity Ratio = × 100
Budgeted hours
3) Efficiency Ratio
The ratio indicates the degree of efficiency attained in production. It is obtained when
the standard hours equivalent to the work produced are expressed as a percentage of
the actual hours spent in producing that work.

Efficiency Ratio = × 100
Actual hours worked
Illustration 6
A factory manufactures two types of articles namely X and Y. Article X takes 10 hours
to make and article Y requires 20 hours. In a month (25 days of 8 hours each) 500
units of X and 300 units of Y are produced. The budget hours are 8500 per month. The
factory employs 60 men in the department concerned. Compute Activity Ratio,
Capacity Ratio and Efficiency Ratio. 53
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Budgetary Control
Standard hours for actual production Hrs.
X : 500 units × 10 5,000
Y : 300 units × 20 6,000
11,000
Budgeted Hours 8,500
Actual Hours worked (60 × 8 × 25 ) 12,000

Activity Ratio = × 100
Budgeted hours
11000
= × 100 = 129%
8500
Actual hours worked

Capacity Ratio = × 100
Budgeted Ratio
12000
= × 100 = 141%
8500

Efficiency Ratio = × 100
Actual hours worked
11,000
= × 100 = 92%
12,000
10.9 BEHAVIOURAL CONSIDERATION

Basically budgets are prepared on the basis of past data available after considering the
changes in future conditions. However, it must be kept in mind that human behaviour is
volatile in nature. So, the preferences will change in future if there are changes in level
of living, earning capacity, awareness about the new product, health consciousness,
etc. Therefore, at the time of preparing the budget, the factors which affect the
behaviour of human being, must be considered, because, these factors make drastic
changes in the demand position of any product and budget estimates will not find near
to actual data/ results.
Check Your Progress
1) State the differences between fixed and flexible budgeting.
a) ......................................................................................................................
b) ......................................................................................................................
c) ......................................................................................................................
d) ......................................................................................................................
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2) What is meant by Appropriation Budgeting ? Approaches to
Budgeting
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
3) What are the budgetory control ratios ?
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
4) Fill in the blanks :
a) A budget which is designed to remain unchanged irrespective of the level

of activity is called ..........................
b) A budget which is prepared to change according to the level of activity is

called ..........................
c) When a budget is prepared only for a particular activity such budgeting is

called ..........................
d) A system of establishing financial plans beginning with an assumption of

no activity is called ..........................
e) The difference between operating profits in the master budget and flexible
budget is called .......................... variance.
5) State whether each of the following statement is true or false.
a) Fixed budgeting is useful when there is no significant variations [ ]

in the budgeted output and actual output
b) Incase of industries where the demand for goods is stable and [ ]

budget period is short flexible budgeting is suitable for them
c) Flexible budgeting is also called sliding scale budget. [ ]
d) Budgets are prepared only for operational activities of an [ ]

organisation
e) A zero-base budgeting is prepared on the assumption that the [ ]

budget for previous period is nil
f) Performance budgeting lays immediate stress in the achievement [ ]

of specific goals over a period of time.
g) Fixed budget is suitable for fixed expenses [ ]
h) Every item of budget has to be justified when a zero based [ ]

budgeting is prepared.
i) Fixed budget is more useful than a flexible budget. [ ]

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Budgeting and
Budgetary Control 10.10 LET US SUM UP
A budget prepared on the basis of a standard level of activity is known as fixed budget.
It does not change with the change in the level of activity. It is useful when there is no
significant changes between the budgeted output and actual output. Flexible budget is
a budget prepared in a manner so as to give the budgeted cost for any level of activity.
The likely changes in the actual circumstances are taken into account while preparing
the flexible budget. A series of budgets would be prepared at different levels of
activity. Budgets are prepared not only for regular business activities but also for any
particular purpose. When budgets are prepared for only a particular activity it is called
appropriation budget. This type of budget cover different activities in an organisation.
Zero based budgeting suggests that an organisation should not only make decisions
about the proposed new programmes but it should also, from time to time, review the
appropriateness of the existing programmes. The underlying assumption of zero base
budgeting is that the budget for the previous period is zero, therefore whatever costs
are likely to be incurred are chalked out and full amount is to be given.
Performance budgeting requires preparation of periodic performance reports. Such
reports compare budget and actual data, and show variances. There are three
important ratios commonly used by the management to find out whether the deviations
of actuals from budgeted results are favoruable or otherwise. These ratios are :
Activity ratio, capacity ratio and efficient ratio.
10.11 KEY WORDS

Appropriation Budgeting : A budget which is prepared only for a particular
activity/work
Flexible Budget : A budget which is designed to change in accordance with the
level of activity attained.
Fixed Budget : A budget which remains unchanged whatever the actual level of
activity.
Zero-Based Budgeting : A system of establishing financial plans beginning with an
assumption of no activity and justifying each programme or activity level.

4) (a) Fixed budgeting (b) flexible budgeting (c) Appropriation budgeting
(d) Zero based budgeting (e) Activity
5) a) True b) False c) True d) False e) True
f) True g) True h) True i) False

1) What are fixed and flexible budgets? Differentiate between these two.
2) What do you understand by zero base budgeting? How is it different from
traditional budgeting?
3) Why do accountants prepare a budget for a period that is already over when we
know the actual results by then? Explain.
4) Why is a variable costing format useful for performance evaluation?
5) What are the three important control ratios? Explain them in brief.
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6) “Performance budgeting requires preparation of periodic performance reports’’ Approaches to
Explain. Budgeting
7) A single product manufacturing company is currently producing 12,000 units (at

60% capacity). The following particulars relating to its cost structure are
available :
Per Unit (Rs.)
Direct materials 5
Direct Labour (Variable) 2
Manufacturing overheads (60% fixed) 5
Administrative overheads (fixed) 2
Selling and distribution overheads (40% variable) 3
Cost of sales 17
Profit 3
Selling price 20
You are required to prepare a flexible budget for 60%, 80% and 100% activity
levels taking into account the following additional information :
1) if activity exceeds 60%, a 5% quantity discount on raw materials on account
of increase in the total quantity will be received
2) The present fixed cost structure will remain constant upto 90% capacity,
beyond which a 20% increase in cost is expected.
3) The present unit selling price will remain constant upto 70% activity level,
beyond which a 2 ½ % reduction in original price for increase in activity by
every 5% is contemplated.
(Ans. At 60% : Rs. 36,000, at 80% : Rs. 71,200, at 100 : Rs. 53,080)
8) The following data are available in a manufacturing company for the period of a
year.
Rs. ( ’000)
Fixed expenses :
Wages and salaries 950
Rent, rates and taxes 660
Depreciation 740
Sundry administrative expenses 650
Semi-variable expenses : (at 30% of capacity)
Maintenance and repairs 350
Indirect labour 790
Sales department salaries etc. 380
Sundry administrative expenses 280
Variable expense : (at 50% of capacity)
Materials 2,170
Labour 2,040
Other expenses 790
9800
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Budgeting and Assume that the fixed expense remain constant for all levels of production; semi-
Budgetary Control variable expenses remain constant between 45% and 65% of capacity, increasing
by 10% between 65% and 80% capacity, and by20% between 80% and 100%
capacity.
Sales at various levels are :
Rs. (Lakhs)
50% capacity 100
60% capacity 120
75% capacity 150
90% capacity 180
100% capacity 200
Prepare the flexible budget for the year and forecast the profits at 60%, 75%
90% and 100% of capacity.
(Ans. : 60% Rs. 12 lakhs, 75% Rs. 25.2 lakh, 90% Rs. 38.4 lakhs, 100%
Rs. 47.4 lakhs)
9) A manufacturing Co. Ltd operates a system of flexible budgetary control.

A flexible budget is required to show levels of activity of 80%, 90% and 100%.
The following information is available :
1) Sales, based on normal level of activity of 80% are 8,00,000 units at Rs. 10
each. If output is increased to 90%, it is thought that the selling price should
be reduced by 2 ½% , and if output reached is 100%, it would be necessary
to reduce the original price by 5% in order to reach a wider market.
2) Prime costs are :

Direct material Rs. 3.50
Direct labour Rs. 1.25
Direct expense Rs. 0.25
Rs. 5.00
If output reaches at 90% level of activity as above, the purchase price of

raw material will be reduced by 5%.
3) Variable overheads, salesmen’s commission is 5% on sales value.
4) Semi-variable overheads at normal level of activity are :
Rs.
Supervision 80,000
Power 70,000
Heat and light 40,000
Maintenance 50,000
Indirect labour 1,00,000
Salesmen’s expenses 60,000
Transport 2,00,000
Semi-variable overheads are expected to increase by 5% if output reaches a
level of activity of 90%, and by a further 10% if it reaches the 100% level.
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5) Fixed overheads are : Rs. Approaches to
Budgeting
Rent and rates 1,00,000
Depreciation 4,00,000
Administration 7,50,000
Sales department 2,00,000
Advertising 5,00,000
General 50,000
(Ans : 80% Rs. 10 lakhs, 90% Rs. 1363750, 100% Rs. 1507000)
10) A department of a Company X attains sales of Rs. 3,00,00 at 80% of its normal
capacity and its expenses are given below :
Administration Costs:
Salaries : Rs. 45,000, General expenses 2% of sales,

Depreciation Rs. 3,750, Rates and taxes Rs. 4,375
Selling Costs :
Salaries 8% of sales, Travelling expenses 2% of sales,
Sales expenses 1% of sales, general expenses 1% of sales.
Distribution Costs :
Wages Rs. 7,500, Rent 1% of sales, other expenses 4% of sales.
Prepare a flexible administration, selling and distribution costs budget, operating at
90% and 100% of normal capacity.
90% 100%
(Ans. : Administration costs Rs. 59,875 Rs. 60,625
Selling Costs Rs. 40,500 Rs. 45,000
Distribution Costs Rs.14,375 Rs. 26,250
Total Rs. 1,14,750 Rs. 1,31,875
11) From the following particulars relating to XYZ company for the month of
November, 2003 prepare a report comprising actual results with the flexible and
master budget.
Units produced and sold : 50,000 (Budgeted sales 45,000 units)
Selling price per unit : Rs. 10 (Budgeted Rs. 11 per unit)
Actual variable cost per unit : Rs. 5 (Budgeted Rs. 4 per unit )
Actual fixed overhead : Rs. 83, 000 (Budgeted Rs. 80,000)
Actual fixed administration cost : Rs. 96,000 (Budgeted Rs.1,00,000)
Actual Variable administration Cost : Rs. 62,500 (Budgeted Rs. 1 per unit)
(50,000 units @ 1.25 per unit)
[Ans. : Total variance from flexible budget : Rs. 1,27,500 (Unfavourable)]

Total variance from Master budget : Rs. 2,39,000
(Unfavourable) ]
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Budgeting and 12) From the following controllable and non-controllable costs relating a
Budgetary Control manufacturing company for 31st March, 2003, prepare a performance budget by
comparing actual results with the flexible and master budget :
Standard budget based on 20,000 units :
Controllable Costs : Non Controllable Costs :
Rs. Rs.
Indirect Labour 70,000 Supervision 34,000
Indirect material 20,000 Rates and taxes 12,000
Fuel and power 56,000 Insurance 2,000
Maintenance 12,000 Depreciation 15,000
1,58,000 63,000
The actual production during the year was as follows :
Controllable costs : Actual Costs Budget based on
18,000 units actuals
Rs. Rs.
Indirect labour 63,000 65,000
Indirect material 21,000 18,000
Fuel and power 56,000 51,400
Maintenance 12,000 11,600
1,52,000 1,46,000
Non-controllable costs :
Supervision 32,980 31,600
Rates and taxes 12,000 12,000
Insurance 2,000 2,000
Depreciation 15,000 15,000
61,980 61,600
[Ans. Total Variance from flexible budget : Controllable costs Rs. 6000 (U),
Non Controllable Costs : Rs. 1380 (U), Total variance from Master budget :
Controllable costs : Rs. 6000 (F) Uncontrollable costs : Rs. 1020 (F) ]
Note : These questions will help you to understand the unit better. Try to write answers
for them. But do not submit your answers to the University. These are for your
practice only.

Prem Chand, 1969, Performance Budgeting, Academic Books : New Delhi.
Pyhrr, Peter, A. 1973, Zero Base Budgeting, John Wiley and, Sons ; New York.`
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____________________________________________________________
UNIT 11: STANDARD COSTING

_____________________________________________________________
Introduction
One of the prime functions of management accounting is to facilitate managerial control

and the important aspect of managerial control is cost control. The efficiency of
management depends upon the effective control of costs. Therefore, it is very important
to plan and control cost. Standard costing is one of the most important tools, which helps
the management to plan and control cost of business operations. Under standard costing,
all costs are pre-determined and pre determined costs are then compared with the actual
costs. The difference between pre-determined costs and the actual costs is known as
variance which is analysed and investigated to the reasons. The variances are then
reported to management for taking remedial steps so that the actuals costs adhere to pre-
determined costs. In historical costing actual costs are ascertained only when they have
been incurred. They are useful only when they are compared with predetermined costs.
Such costs are not useful to management in decision-making and cost control. Therefore,
the technique of standard costing is used as a tool for planning, decision-making and
control of business operations. In this unit you will study the basic concepts of standard
costing.
Meaning of Standard Cost
Standard costs are predetermined cost which may be used as a yardstick 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 the standard
material input. If actual raw material usage or costs differ from the standards, the
difference which is called ‘variance’ is reported to manager concerned. When size of the
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variance is significant, a detailed investigation will be made to determine the causes of

variance
According to the chartered Institute of Management Accountants (C.I.M.A) London,

“Standard cost is the predetermined cost based on technical estimates for materials,
labour and overhead for a selected period of time for a prescribed set of working
conditions.”
The Institute of Cost and Works Accountants defines standard costs as “Standard costs
are prepared and used to clarify the final results of a business, particularly by
measurement of variations of actual costs from standard costs and the analysis of the
causes of variations for the purpose of maintaining efficiency of executive action.”
Thus standard costs is a predetermined which determines what each product or service
‘should be’ under given circumstances. From the above definitions we may note that
standard costs are:
i) Pre-determined cost: Standard cost is always determined in advance and

ahead of actual point of time of incurring of costs.
ii) Based on technical estimated: Standard cost is determined only on the basis of
a technical estimate and on a rational basis.
iii) For the purpose of Comparison: The very purpose of standard cost is to aid
the comparison with actual costs.
iv) Based for price fixing: The prices are fixed in advance and hence the only
variation basis is the standard cost.
Standard Cost and Estimated Costs
Estimates are predetermined costs which are based on historical data and is often not very
scientifically determined. They usually compiled from loosely gathered information and
therefore, they are unsafe to use them as a tool for measuring performance. Standard
costs are predetermined costs which aims at what the cost should be rather then what it
will be. Both the standard costs and estimated costs are used to determine price in
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advance and their purpose is to control cost. But, there are certain differences between
these two costs as stated below:
Differences between Standard costs and Estimated Costs:
The following are some of the important differences between standard cost and estimated
cost:
Standard Cost Estimated Cost

Standard cost emphasizes as what the cost Estimated cost emphasizes on what the cost
‘should be’ in a given set of situations. ‘will be’.
Standard costs are planned costs which are Estimated costs are determined by taking
determined by technical experts after into consideration the historical data as the
considering levels of efficiency and basis and adjusting it to future trends.
production
It is used as a devise for measuring It cannot be used as a devise to determine
efficiency efficiency. It only determines expected
costs.
Standard costs serve the purpose of cost Estimated costs do not serve the purpose of
control cost control.
Standard costing is part of cost accounting Estimated costs are statistical in nature and
process may not become a part of accounting.
It is a technique developed and recognised It is just an estimate and not a technique
by management and academecians
It can be used where standard costing is in It may be used in any concern operating on
operation a historical cost system.
Concept of Standard Costing
Standard costing is a technique used for the purpose of determining standard cost and
their comparison with the actual costs to find out the causes of difference between the
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two so that remedial action may be taken immediately. The Charted Institute of
Management Accountants, London, defines standard costing as “the preparation of
standard costs and applying them to measure the variations from actual costs and
analysing the causes of variations with a view to maintain maximum efficiency in
production”.
Thus, standard costing is a technique of cost accounting which compares the ‘standard
cost’ of each product or service, with the actual cost, to determine the efficiency of the
operation. When actual costs differ from standards the difference is called variance and
when the size of the variance is significant a detailed investigation will be made to
determine the causes of variance, so that remedial action will be taken immediately.
Thus, standard costing involves the following steps:

1. Setting standard costs for different elements of costs
2. Recording of actual costs
3. Comparing between standard costs and actual costs to determine the variances
4. Analysing the variances to know the causes thereof, and
5. Reporting the analysis of variances to management for taking appropriate
actions wherever necessary.
The system of standard costing can be used effectively to those industries which are
producing standardised products and are repetitive in nature. Examples are cement
industry, steel industry, sugar industry etc. The standard costing may not be suitable to
jobbing industries because every job has different specifications and it will be difficult
and expensive to set standard costs for every job. Thus, standard costing is not suitable in
situations where a variety of different kinds of tasks are being done.
Objectives of Standard Costing:
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 can
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be compared to measure efficiency. The management can make comparison of actgual

costs with the standard costs at periodic intervals and take corrective action to maintain
control over costs.
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 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
importance of efficient operations so that costs can be reduced by joint efforts.
4. Fixation of Prices: To help the management in formulating production policy

and helps in fixing the price quotations as well as in submitting tenders of various
products. 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.
5. Fixing Prices and Formulating Policies: Another object of standard cost is to

help 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: Budget planning is undertaken by the management

at different levels at periodic intervals to maximise the profit through different product
mixes. For this purpose it is more convenient using standard costing than actual costs
because it is done on scientific and rational manner by taking into account all technical
aspects.
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Check your progress A
1. Standard costing involves in determining

i) Standard Costs
ii) Actual Costs
iii) Estimated Costs
2. The difference between actual costs and standard cost is known as
i) Profit
ii) Variance
iii) Historical Cost
3. The purpose of standard costing is to
i) Reduce Costs
ii) Measure Efficiency
iii) Control Prices
4. Distinguish between standard cost and estimated cost
5. What do you understand about standard cost and standard costing.
True or False Statements

a. Standard costing is suitable to job industries where different kinds of tasks are
being done. (False)
b. Standard costing is used effectively in those industries which are producing
standardized products and are repetitive in nature. (True)
c. Budgeting is the process of preparing plans for future activities of an
enterprise. (True)
d. Standard costing is suitable for small business. (False)
e. The figure based on the average performance of the past after taking into
account the seasonal/cyclical changes is called expected standards. (False)
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f. The success of a standard costing depends upon the reliability and accuracy of
the standards. (True)
Standard Costing and Budgeting
the business enterprise after considering and involving the objectives of the said
organisation. This also provides process/steps of collection and preparation of data, by
which deviations from the plan can be measured. This analysis helps to measure
performance, cost estimation, minimizing wastage and better utilisation of resources of
the organisation. Thus, budgets are prepared on the basis of future estimated production
and sales in order to find out the profit in a specified period. In other words Budget is an
estimate and a quantified plan for future activities to coordinate and control the uses of
resources for a specified period. According to Institute of Cost and Works Accountants,
“A budget is a financial and / or quantitative statement prepared prior to a defined period
of time, of the Policy to be pursued during that period for the purpose of attaining a given
objective.” Budgeting is a process which includes both the functions of budget and
budgetory control. Budget is a planning function and budgetory control is a controlling
system or a technique. You might have already studied the budgeting in detail in Block
3, under Unit-8: Basic Concepts of Budgeting.
The objective of the standard costing and budgeting is to achieve maximum

efficiency and cost control. Under both the systems actual performance is compared with
predetermined standards, deviations, if any, are analysed and reported. Budgeting is
essential to determine standard costs while standard costing is necessary for planning
budgets. Both are complimentary in nature and in determining the results. Besides
similarities there are certain differences between standard costing and budgeting which
are as follows:
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Standard costing Budgeting

1. Standard costing is based on 1. It is based on standard cost, historical costs
technical information and is fixed and estimates.
scientifically.
2. Standard costs are used mainly for 2. Budgets are prepared for different
the manufacturing function and functional departments such as sales,
also for marketing and purchase, production, finance, personnel
administration functions. department. Therefore, it requires
Therefore, it does not require functional coordination.
functional coordination.
3. Standard costs emphasises the 3. Budgets emphasises cost levels which
cost levels which should be should not be exceeded.
reduced
4. In standard costing variances are 4. In Budgeting, variances are not revealed
usually revealed through through accounts and control in exercised
accounts. by putting budgeted figures and actuals
side by side.
5. In standard costing, a detailed 5. No further analysis is required if costs are
analysis is needed in case of within the budget.
variances.
6. Standard costing sets realistic 6. Budgets generally set maximum limits of
yardsticks and therefore, it is expenditure without considering the
more useful for controlling and effectiveness of expenditure.
reducing costs.
7. Standard cost is revised only 7. Budgeting is done before the beginning of
when there is a change in the each accounting period.
basic assumptions and basis.
8. Standard costs are based on the 8. Budgets are set on the basis of present
basis of standards set by level of efficiency.
management.
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9. Standard costing cannot be used 9. Budgeting can be done either wholly or

partially. Standards will have to partly.
be set for all elements of cost.
10. Standard cost is a projection of 10. Budgeting is a projection of financial
cost accounts. accounts.
Advantages of Standard Costing
The introduction of Standard Costing system may offer many advantages. It varies from
one business to another. The following advantages may be derived from standard costing
in the light of the various objectives of the system:
1. To measure efficiency: Standard Costs provide a yardstick against which

actual costs can be measured. The comparison of actual costs with the standard cost
enables the management to evaluate the performance of various cost centres. In the
absence of standard costing, efficiency is measured by comparing actual costs of different
periods which is very difficult to measure because the conditions prevailing in both the
periods may differ.
2. To fix prices and formulate policies: Standard costing is helpful in

determining prices and formulating production policies. The standards are set by
studying all the existing conditions. It also helps to find out the prices of various
products. It helps the management in the formulation of production and price policies in
advance and also in the areas of profit planning product pricing, quoting prices of tenders.
It also helps to furnish cost estimates while planning production of new products.
3. For Effective cost control: One of the most advantages of standard

costing is that it helps in cost control. By comparing actual costs with the standard costs,
variances are determined. These variances facilitate management to locate inefficiencies
and to take remedial action against those inefficiencies at the earliest.
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4. Management by exception: Management by exception means that each

individual is fixed targets and every one is expected to achieve these given targets.
Management need not supervise each and everything and need not bother if everything is
going as per the targets. Management interferes only when there is deviation. Variances
beyond a predetermined limit may be considered by the management for corrective
action. The standard costing enables the management in determining responsibilities and
facilitates the principle of management by exception.
5. Valuation of stocks: Under standard costing, stock is valued at standard cost and
any difference between standard cost and actual cost is transferred to variance account.
Therefore, it simplifies valuation of stock and reduces lot of clerical work to the
minimum level.
6. Cost consciousness: The emphasis under standard costing is more on cost

variations which makes the entire organisation cost conscious. It makes the employees to
recognise the importance of efficient operations so that efforts will be taken to reduce the
costs to the minimum by collective efforts.
7. Provides incentives: Under standard costing system, men, material and

machines can be used effectively and economies can be effected in addition to enhanced
productivity. Schemes may be formulated to reward those who achieve targets. It
increases efficiency, productivity and morale of the employees.
Limitations of Standard Costing
In spite of the above advantages, standard costing suffers from the following
disadvantages:
1. Difficulty in setting standards: Setting standards is a very difficult task as it

requires a lot of scientific analysis such as time study, motion study etc. When standards
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are set at high it may create frustration in the minds of workers. Therefore, setting of a
correct standards is very difficult.
2. Not suitable to small business: The system of standard costing is not

suitable to small business as it requires lot of scientific study which involves cost.
Therefore, Small firms may find it very difficult to operate the system.
3. Not suitable to all industries: The standard costing is not suitable to those
industries which produces non-standardised products and also not suitable to job or
contract costing. Similarly, the application of standard costing is very difficult to those
industries where production process takes place more than one accounting period.
4. Difficult to fix responsibility: Fixing responsibility is not an easy task.

Variances are to be classified into controllable and uncontrollable variances because
responsibility can be fixed only in the case of controllable variances. It is difficult to
classify controllable and uncontrollable variances for the variance controllable at one
situation may become uncontrollable at another time. Therefore, fixing responsibility is
very difficult under standard costing.
5. Technological changes: Standard costing may not be suitable to those

industries which are subject to frequent technological changes. When there is a change in
the technology, production process will require a revision of standard. Frequent revision
of standards is a costly affair and therefore, the system is not suitable for industries where
methods and techniques of production are subject to fast changes.
In spite of the above limitations, standard costing is a very useful technique in

cost control and performance evaluation. It is very useful tool to the industries producing
standardised products which are repetitive in nature.
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Pre-requisites for success
In establishing a system of the standard costing, there are a number of

preliminaries which are to be considered. These include:
1. Establishment of Cost Centres
2. Classification of Accounts
3. Types of Standards
4. Setting Standard Costs
Let us study the above in detail
1. Establishment of Cost Centres: A cost centre is a location, person or an item

of equipment (or group of these) in respect of which costs may be ascertained and related
to cost units. A centre which relates to persons is referred to as a personal cost centre and
a centre which relates to location or to equipment as an impersonal cost centre. Cost
centres are set up for cost ascertainment and cost control. While establishing cost centres
it should be noted that who is responsible for which cost centre. In many cases each
department or function will form a natural cost centre but there may also have a number
of cost centres in each department or function. For example, there may be six machines
in a manufacturing department, each machine may be classified as a cost centre. Cost
centres are essential for establishing standards and analysing the variances.
2. Classification of Accounts: Accounts are classified to meet a required purpose.

Classification may be by function, revenue item or asset and liabilities item. Codes and
symbols are used to facilitate speedy collection and analysis of accounts.
3. Types of Standards: The standard is the level of attainment accepted by

management as the basis upon which standard costs are determined. The standards are
classified mainly into four types. They are:
i) Ideal Standard: The ideal standard is one which is set up under ideal
conditions. The ideal conditions may be maximum output and sales, best possible prices
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for materials, most satisfactory rates for labour and overhead costs. As these conditions
do not continue to remain ideal, this standard is of little practical value. It does provide a
target or incentive for employees, but is usually unattainable in practice.
ii) Expected Standard: This is the standard which is actually expected to be
achieved in the budget period, based on current conditions. The standards are set on
expected performance after allowing a reasonable allowance for unavoidable losses and
lapses from perfect efficiency. Standards are normally set on short term basis and
requires frequent revision. This standard is more realistic than ideal standard.
iii) Normal Standard: This represents an average figure based on the
average performance of the past after taking into account the fluctuations caused by
seasonal and cyclical changes. It should be attainable and provides a challenge to the
staff.
iv) Basic Standard: This is the level fixed in relation to a base year.
The principle used in setting the basic standard is similar to that used in statistics when
calculating an index number. The basic standard is established for a long period and is
not adjusted to the present conditions. It is just like an index number against which
subsequent price changes can be measured. Basic standard enables to measure the
changes in cost. It serves as a tool for cost control purpose because the standard is not
revised for a long period. But it cannot be used as a yard stick for measuring efficiency.
4. Setting Standard Costs: The success of a standard costing system depends

upon the reliability and accuracy of the standards. Therefore, every case should be taken
into account while establishing standards. The number of people involved with the
setting of standards will depend on the size and nature of the business. The responsibility
for setting standards should be entrusted to a specific person. In a big concern a Standard
Costing Committee is formed for this purpose. The committee consists of Production
Manager, Personnel Manager, Production Engineer, Sales Manager, Cost Accountant and
other functional heads. The cost accountant is an important person, who has to supply
the necessary cost figures and coordinate the activities of budget committee. He must
ensure that the standards set are accurate and present the statements of standard cost in
most satisfactory manner.
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Standard costs are set for each element of cost i.e., direct materials, direct labour
and overheads. The standards should be set up in a systematic manner so that they can be
used as a tool for cost control. Briefly, standard costs will be set as shown below:
i) Standard Cost for Direct Materials:

If material is used for manufacturing a product it is known as direct
material. Direct material cost involves two things (a) Quantity of materials and (b) Price
of materials. Firstly, while setting standard for quantity of material, the quality and size
of the material should be determined. The standard quantity of material required for
producing a product is decided by the technical experts in the production department.
While fixing standard for material quantity, a proper allowance should be given to normal
loss of materials. Normal loss will be determined after careful analysis of various factors.
Secondly, standard price for the material is to be determined. Setting standard price for
material is difficult because the prices are regulated more by the external factors than the
company management. Before fixing the standard, factors like prices of materials in
stock, price quoted by suppliers, forecast of price trends, the price of materials already
contracted, provision for discounts, packing and delivery charges etc., should be
considered.
ii) Setting Standards for Direct material:

The labour involved in manufacture of a product is known as direct
labour. The wage paid to such workers is known as direct wages. The time required for
producing a product should be ascertained and labour should be properly graded. Setting
of standard cost of direct labour involves fixation of standard time and fixation of
standard rate. Standard time is fixed by time or motion study or past records or
estimates. While fixing standard time normal ideal time is to be allowed for normal
delays, idle time, other contingencies etc. The labour rate standard refers the wage rate
applicable to different categories of workers. Fixation of standard rate will depend upon
various factors take demand for labour, policy of the organisation, influence of unions,
method of wage payment etc. If any incentive scheme is in operation then anticipated
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extra payment to the workers should also be included in determining standard rate. The
Accountant will determine the standard rate with the help of the Personnel Manager,.
The object of fixing standard time and labour rate is to get maximum efficiency in the use
of labour.
iii) Setting Standards for Direct Expenses

Direct expenses are those expenses which are specifically incurred in
connection with a particular job or cost unit. These expenses are also known as
chargeable expenses. Standards for these expenses must also be determined. Standards
for these may be based on past performance records subject to anticipatory changes
therein.
iv) Setting Standards for Overheads

Indirect costs are called overheads. These costs are those which cannot be
assigned to any particular cost unit and are incurred for the business as a whole. The
overheads are classified into fixed, variable and semi-variable overheads. Standard
overhead rate is determined for these on the basis of past records and future trend of
prices. It will be calculated per unit or per hour. Setting standard for overhead cost
involves the following two steps:
a) Determination of the standard overhead costs, and
b) Determination of the estimates of production
Standard overhead absorption rate is computed with the help of the following
formula:
Standard overhead for the period
Standard overhead rate = ---------------------------------------------
(per hour) Standard hours for the period
or
Standard overhead rate = -------------------------------------------------------
(per hour) Standard production (in units) for the period
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The purpose of setting standard overhead rate is to minimise overhead costs.

Overhead rates are more useful to the management if they are divided into fixed and
variable components. When overheads are divided into fixed and variable, separate
overhead absorption rates are to be calculated with the help of the following formulae:
Standard Variable Overhead for the Period

Standard Variable Overhead Rate = --------------------------------------------------------
Standard Production (in Units or Hours) for the Period
Standard Fixed Overhead for the Period

Standard Fixed Overhead Rate = --------------------------------------------------------
Standard Hour
Production may be expressed in different units of measurement such as kilos,

tones, litres, numbers etc. When a concern produces different types of products, the
production will be expressed in different units. It is difficult to aggregate the production
which is expressed in different units. To over come this difficulty, the production is to be
expressed in a common measure known as ‘Standard Hour’. The standard hour is the
quantity of output which should be produced in one hour. A standard hour may be as “A
hypothetical hour which represents the amounts of work which should be performed in
one hour under stated conditions.” A measure of standard hour is useful for the purpose
of comparison of performance of one department to another. It is also useful to compute
efficiency and activity ratios. For example if 20 units of product A are produced in 2
hour, and 40 units of product B are produced in 5 hours, the standard hours represent 10
20 Units 40 Units
units of product A (-----------)and 8 units of product B (-------------). Therefore, standard
2 hrs 5 hrs
hour is the quantity of production of a given product for one clock hour.
Revision of Standards
Standard cost is based on a number of factors. These factors some may be

internal or external may vary from time to time depending upon different situations.
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Standard cost may become unrealistic if it is not revised according to the changed
circumstances. Then a question arises what would be the period in which standards
should be set? If the standard is set for a shorter period it is expensive and frequent
revision of standards will impair the utility and purpose of the standard cost. If the
standard is set for a longer period it may not be useful particularly during periods of high
inflation and rapidly changing technological environment. Therefore, standards are
normally set for a fixed period of one year and revised annually at the beginning of
accounting period. If there are major changes, a revision may also be required within the
accounting period. If there are minor changes, the causes of difference between actual
and standards may be explained without being revised the standards. There are certain
conditions which necessitate the revision of standard costs. These conditions are:
i) Changes in price levels of materials, labour and overheads

ii) Technological changes
iii) Changes in production methods or product mixes
iv) Changes in plant capacity utilization
v) Errors discovered in setting standards
vi) Changes in designs or specification
vii) Changes in the policy of organisation
viii) Changes in government policy affecting the product or organisation, etc.
Check your progress B
1. State some of the conditions under which a revision of stand cost takes place
2. Explain the concept of standard hour.
a) Standard hour is a hypothetical hour which represents the amount of work

to be done in one hour under given circumstances (True)
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b) To control cost either standard costing or budgetory control should be

used but not both the techniques. (False)
c) Standard cost is used as a yardstick to measure the efficiency with which

actual cost has been incurred. (True)
d) Standard cost is a projection of costs accounts whereas budgeting is a

projection of financial accounts. (True)
e) Standards are normally set for a longer period and revised annually.
(False)
Terminal Questions
1. What is Estimating Costing and how does it differ from Standard Costing?
2. What do you understand by standard costing. Give a suitable definition to explain

your answer.
3. What is Standard Costing? State the objectives of standard costing.
4. Give a comparative account of standard costing and budgeting.
5. Write a detailed note explaining the advantages and limitations of standard

costing.
6. How do you ensure the success of a standard costing method in your organisation
7. Write notes on the following:

a) Ideal standard
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b) Expected standard
c) Normal standard
d) Basic standard
8. Explain the meaning of Standard Hour.
9. Write a note on Revision of Standards.
10. How are standards fixed? Explain.
11. A company has decided to introduce a system of standard costing. What are the
preliminaries to be considered before developing such a system? Explain.
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____________________________________________________________
UNIT 11: STANDARD COSTING

_____________________________________________________________
Introduction
One of the prime functions of management accounting is to facilitate managerial control

and the important aspect of managerial control is cost control. The efficiency of
management depends upon the effective control of costs. Therefore, it is very important
to plan and control cost. Standard costing is one of the most important tools, which helps
the management to plan and control cost of business operations. Under standard costing,
all costs are pre-determined and pre determined costs are then compared with the actual
costs. The difference between pre-determined costs and the actual costs is known as
variance which is analysed and investigated to the reasons. The variances are then
reported to management for taking remedial steps so that the actuals costs adhere to pre-
determined costs. In historical costing actual costs are ascertained only when they have
been incurred. They are useful only when they are compared with predetermined costs.
Such costs are not useful to management in decision-making and cost control. Therefore,
the technique of standard costing is used as a tool for planning, decision-making and
control of business operations. In this unit you will study the basic concepts of standard
costing.
Meaning of Standard Cost
Standard costs are predetermined cost which may be used as a yardstick 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 the standard
material input. If actual raw material usage or costs differ from the standards, the
difference which is called ‘variance’ is reported to manager concerned. When size of the
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variance is significant, a detailed investigation will be made to determine the causes of

variance
According to the chartered Institute of Management Accountants (C.I.M.A) London,

“Standard cost is the predetermined cost based on technical estimates for materials,
labour and overhead for a selected period of time for a prescribed set of working
conditions.”
The Institute of Cost and Works Accountants defines standard costs as “Standard costs
are prepared and used to clarify the final results of a business, particularly by
measurement of variations of actual costs from standard costs and the analysis of the
causes of variations for the purpose of maintaining efficiency of executive action.”
Thus standard costs is a predetermined which determines what each product or service
‘should be’ under given circumstances. From the above definitions we may note that
standard costs are:
i) Pre-determined cost: Standard cost is always determined in advance and

ahead of actual point of time of incurring of costs.
ii) Based on technical estimated: Standard cost is determined only on the basis of
a technical estimate and on a rational basis.
iii) For the purpose of Comparison: The very purpose of standard cost is to aid
the comparison with actual costs.
iv) Based for price fixing: The prices are fixed in advance and hence the only
variation basis is the standard cost.
Standard Cost and Estimated Costs
Estimates are predetermined costs which are based on historical data and is often not very
scientifically determined. They usually compiled from loosely gathered information and
therefore, they are unsafe to use them as a tool for measuring performance. Standard
costs are predetermined costs which aims at what the cost should be rather then what it
will be. Both the standard costs and estimated costs are used to determine price in
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advance and their purpose is to control cost. But, there are certain differences between
these two costs as stated below:
Differences between Standard costs and Estimated Costs:
The following are some of the important differences between standard cost and estimated
cost:
Standard Cost Estimated Cost

Standard cost emphasizes as what the cost Estimated cost emphasizes on what the cost
‘should be’ in a given set of situations. ‘will be’.
Standard costs are planned costs which are Estimated costs are determined by taking
determined by technical experts after into consideration the historical data as the
considering levels of efficiency and basis and adjusting it to future trends.
production
It is used as a devise for measuring It cannot be used as a devise to determine
efficiency efficiency. It only determines expected
costs.
Standard costs serve the purpose of cost Estimated costs do not serve the purpose of
control cost control.
Standard costing is part of cost accounting Estimated costs are statistical in nature and
process may not become a part of accounting.
It is a technique developed and recognised It is just an estimate and not a technique
by management and academecians
It can be used where standard costing is in It may be used in any concern operating on
operation a historical cost system.
Concept of Standard Costing
Standard costing is a technique used for the purpose of determining standard cost and
their comparison with the actual costs to find out the causes of difference between the
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two so that remedial action may be taken immediately. The Charted Institute of
Management Accountants, London, defines standard costing as “the preparation of
standard costs and applying them to measure the variations from actual costs and
analysing the causes of variations with a view to maintain maximum efficiency in
production”.
Thus, standard costing is a technique of cost accounting which compares the ‘standard
cost’ of each product or service, with the actual cost, to determine the efficiency of the
operation. When actual costs differ from standards the difference is called variance and
when the size of the variance is significant a detailed investigation will be made to
determine the causes of variance, so that remedial action will be taken immediately.
Thus, standard costing involves the following steps:

1. Setting standard costs for different elements of costs
2. Recording of actual costs
3. Comparing between standard costs and actual costs to determine the variances
4. Analysing the variances to know the causes thereof, and
5. Reporting the analysis of variances to management for taking appropriate
actions wherever necessary.
The system of standard costing can be used effectively to those industries which are
producing standardised products and are repetitive in nature. Examples are cement
industry, steel industry, sugar industry etc. The standard costing may not be suitable to
jobbing industries because every job has different specifications and it will be difficult
and expensive to set standard costs for every job. Thus, standard costing is not suitable in
situations where a variety of different kinds of tasks are being done.
Objectives of Standard Costing:
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 can
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be compared to measure efficiency. The management can make comparison of actgual

costs with the standard costs at periodic intervals and take corrective action to maintain
control over costs.
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 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
importance of efficient operations so that costs can be reduced by joint efforts.
4. Fixation of Prices: To help the management in formulating production policy

and helps in fixing the price quotations as well as in submitting tenders of various
products. 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.
5. Fixing Prices and Formulating Policies: Another object of standard cost is to

help 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: Budget planning is undertaken by the management

at different levels at periodic intervals to maximise the profit through different product
mixes. For this purpose it is more convenient using standard costing than actual costs
because it is done on scientific and rational manner by taking into account all technical
aspects.
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Check your progress A
1. Standard costing involves in determining

i) Standard Costs
ii) Actual Costs
iii) Estimated Costs
2. The difference between actual costs and standard cost is known as
i) Profit
ii) Variance
iii) Historical Cost
3. The purpose of standard costing is to
i) Reduce Costs
ii) Measure Efficiency
iii) Control Prices
4. Distinguish between standard cost and estimated cost
5. What do you understand about standard cost and standard costing.
True or False Statements

a. Standard costing is suitable to job industries where different kinds of tasks are
being done. (False)
b. Standard costing is used effectively in those industries which are producing
standardized products and are repetitive in nature. (True)
c. Budgeting is the process of preparing plans for future activities of an
enterprise. (True)
d. Standard costing is suitable for small business. (False)
e. The figure based on the average performance of the past after taking into
account the seasonal/cyclical changes is called expected standards. (False)
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f. The success of a standard costing depends upon the reliability and accuracy of
the standards. (True)
Standard Costing and Budgeting
the business enterprise after considering and involving the objectives of the said
organisation. This also provides process/steps of collection and preparation of data, by
which deviations from the plan can be measured. This analysis helps to measure
performance, cost estimation, minimizing wastage and better utilisation of resources of
the organisation. Thus, budgets are prepared on the basis of future estimated production
and sales in order to find out the profit in a specified period. In other words Budget is an
estimate and a quantified plan for future activities to coordinate and control the uses of
resources for a specified period. According to Institute of Cost and Works Accountants,
“A budget is a financial and / or quantitative statement prepared prior to a defined period
of time, of the Policy to be pursued during that period for the purpose of attaining a given
objective.” Budgeting is a process which includes both the functions of budget and
budgetory control. Budget is a planning function and budgetory control is a controlling
system or a technique. You might have already studied the budgeting in detail in Block
3, under Unit-8: Basic Concepts of Budgeting.
The objective of the standard costing and budgeting is to achieve maximum

efficiency and cost control. Under both the systems actual performance is compared with
predetermined standards, deviations, if any, are analysed and reported. Budgeting is
essential to determine standard costs while standard costing is necessary for planning
budgets. Both are complimentary in nature and in determining the results. Besides
similarities there are certain differences between standard costing and budgeting which
are as follows:
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Standard costing Budgeting

1. Standard costing is based on 1. It is based on standard cost, historical costs
technical information and is fixed and estimates.
scientifically.
2. Standard costs are used mainly for 2. Budgets are prepared for different
the manufacturing function and functional departments such as sales,
also for marketing and purchase, production, finance, personnel
administration functions. department. Therefore, it requires
Therefore, it does not require functional coordination.
functional coordination.
3. Standard costs emphasises the 3. Budgets emphasises cost levels which
cost levels which should be should not be exceeded.
reduced
4. In standard costing variances are 4. In Budgeting, variances are not revealed
usually revealed through through accounts and control in exercised
accounts. by putting budgeted figures and actuals
side by side.
5. In standard costing, a detailed 5. No further analysis is required if costs are
analysis is needed in case of within the budget.
variances.
6. Standard costing sets realistic 6. Budgets generally set maximum limits of
yardsticks and therefore, it is expenditure without considering the
more useful for controlling and effectiveness of expenditure.
reducing costs.
7. Standard cost is revised only 7. Budgeting is done before the beginning of
when there is a change in the each accounting period.
basic assumptions and basis.
8. Standard costs are based on the 8. Budgets are set on the basis of present
basis of standards set by level of efficiency.
management.
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9. Standard costing cannot be used 9. Budgeting can be done either wholly or

partially. Standards will have to partly.
be set for all elements of cost.
10. Standard cost is a projection of 10. Budgeting is a projection of financial
cost accounts. accounts.
Advantages of Standard Costing
The introduction of Standard Costing system may offer many advantages. It varies from
one business to another. The following advantages may be derived from standard costing
in the light of the various objectives of the system:
1. To measure efficiency: Standard Costs provide a yardstick against which

actual costs can be measured. The comparison of actual costs with the standard cost
enables the management to evaluate the performance of various cost centres. In the
absence of standard costing, efficiency is measured by comparing actual costs of different
periods which is very difficult to measure because the conditions prevailing in both the
periods may differ.
2. To fix prices and formulate policies: Standard costing is helpful in

determining prices and formulating production policies. The standards are set by
studying all the existing conditions. It also helps to find out the prices of various
products. It helps the management in the formulation of production and price policies in
advance and also in the areas of profit planning product pricing, quoting prices of tenders.
It also helps to furnish cost estimates while planning production of new products.
3. For Effective cost control: One of the most advantages of standard

costing is that it helps in cost control. By comparing actual costs with the standard costs,
variances are determined. These variances facilitate management to locate inefficiencies
and to take remedial action against those inefficiencies at the earliest.
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4. Management by exception: Management by exception means that each

individual is fixed targets and every one is expected to achieve these given targets.
Management need not supervise each and everything and need not bother if everything is
going as per the targets. Management interferes only when there is deviation. Variances
beyond a predetermined limit may be considered by the management for corrective
action. The standard costing enables the management in determining responsibilities and
facilitates the principle of management by exception.
5. Valuation of stocks: Under standard costing, stock is valued at standard cost and
any difference between standard cost and actual cost is transferred to variance account.
Therefore, it simplifies valuation of stock and reduces lot of clerical work to the
minimum level.
6. Cost consciousness: The emphasis under standard costing is more on cost

variations which makes the entire organisation cost conscious. It makes the employees to
recognise the importance of efficient operations so that efforts will be taken to reduce the
costs to the minimum by collective efforts.
7. Provides incentives: Under standard costing system, men, material and

machines can be used effectively and economies can be effected in addition to enhanced
productivity. Schemes may be formulated to reward those who achieve targets. It
increases efficiency, productivity and morale of the employees.
Limitations of Standard Costing
In spite of the above advantages, standard costing suffers from the following
disadvantages:
1. Difficulty in setting standards: Setting standards is a very difficult task as it

requires a lot of scientific analysis such as time study, motion study etc. When standards
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are set at high it may create frustration in the minds of workers. Therefore, setting of a
correct standards is very difficult.
2. Not suitable to small business: The system of standard costing is not

suitable to small business as it requires lot of scientific study which involves cost.
Therefore, Small firms may find it very difficult to operate the system.
3. Not suitable to all industries: The standard costing is not suitable to those
industries which produces non-standardised products and also not suitable to job or
contract costing. Similarly, the application of standard costing is very difficult to those
industries where production process takes place more than one accounting period.
4. Difficult to fix responsibility: Fixing responsibility is not an easy task.

Variances are to be classified into controllable and uncontrollable variances because
responsibility can be fixed only in the case of controllable variances. It is difficult to
classify controllable and uncontrollable variances for the variance controllable at one
situation may become uncontrollable at another time. Therefore, fixing responsibility is
very difficult under standard costing.
5. Technological changes: Standard costing may not be suitable to those

industries which are subject to frequent technological changes. When there is a change in
the technology, production process will require a revision of standard. Frequent revision
of standards is a costly affair and therefore, the system is not suitable for industries where
methods and techniques of production are subject to fast changes.
In spite of the above limitations, standard costing is a very useful technique in

cost control and performance evaluation. It is very useful tool to the industries producing
standardised products which are repetitive in nature.
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Pre-requisites for success
In establishing a system of the standard costing, there are a number of

preliminaries which are to be considered. These include:
1. Establishment of Cost Centres
2. Classification of Accounts
3. Types of Standards
4. Setting Standard Costs
Let us study the above in detail
1. Establishment of Cost Centres: A cost centre is a location, person or an item

of equipment (or group of these) in respect of which costs may be ascertained and related
to cost units. A centre which relates to persons is referred to as a personal cost centre and
a centre which relates to location or to equipment as an impersonal cost centre. Cost
centres are set up for cost ascertainment and cost control. While establishing cost centres
it should be noted that who is responsible for which cost centre. In many cases each
department or function will form a natural cost centre but there may also have a number
of cost centres in each department or function. For example, there may be six machines
in a manufacturing department, each machine may be classified as a cost centre. Cost
centres are essential for establishing standards and analysing the variances.
2. Classification of Accounts: Accounts are classified to meet a required purpose.

Classification may be by function, revenue item or asset and liabilities item. Codes and
symbols are used to facilitate speedy collection and analysis of accounts.
3. Types of Standards: The standard is the level of attainment accepted by

management as the basis upon which standard costs are determined. The standards are
classified mainly into four types. They are:
i) Ideal Standard: The ideal standard is one which is set up under ideal
conditions. The ideal conditions may be maximum output and sales, best possible prices
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for materials, most satisfactory rates for labour and overhead costs. As these conditions
do not continue to remain ideal, this standard is of little practical value. It does provide a
target or incentive for employees, but is usually unattainable in practice.
ii) Expected Standard: This is the standard which is actually expected to be
achieved in the budget period, based on current conditions. The standards are set on
expected performance after allowing a reasonable allowance for unavoidable losses and
lapses from perfect efficiency. Standards are normally set on short term basis and
requires frequent revision. This standard is more realistic than ideal standard.
iii) Normal Standard: This represents an average figure based on the
average performance of the past after taking into account the fluctuations caused by
seasonal and cyclical changes. It should be attainable and provides a challenge to the
staff.
iv) Basic Standard: This is the level fixed in relation to a base year.
The principle used in setting the basic standard is similar to that used in statistics when
calculating an index number. The basic standard is established for a long period and is
not adjusted to the present conditions. It is just like an index number against which
subsequent price changes can be measured. Basic standard enables to measure the
changes in cost. It serves as a tool for cost control purpose because the standard is not
revised for a long period. But it cannot be used as a yard stick for measuring efficiency.
4. Setting Standard Costs: The success of a standard costing system depends

upon the reliability and accuracy of the standards. Therefore, every case should be taken
into account while establishing standards. The number of people involved with the
setting of standards will depend on the size and nature of the business. The responsibility
for setting standards should be entrusted to a specific person. In a big concern a Standard
Costing Committee is formed for this purpose. The committee consists of Production
Manager, Personnel Manager, Production Engineer, Sales Manager, Cost Accountant and
other functional heads. The cost accountant is an important person, who has to supply
the necessary cost figures and coordinate the activities of budget committee. He must
ensure that the standards set are accurate and present the statements of standard cost in
most satisfactory manner.
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Standard costs are set for each element of cost i.e., direct materials, direct labour
and overheads. The standards should be set up in a systematic manner so that they can be
used as a tool for cost control. Briefly, standard costs will be set as shown below:
i) Standard Cost for Direct Materials:

If material is used for manufacturing a product it is known as direct
material. Direct material cost involves two things (a) Quantity of materials and (b) Price
of materials. Firstly, while setting standard for quantity of material, the quality and size
of the material should be determined. The standard quantity of material required for
producing a product is decided by the technical experts in the production department.
While fixing standard for material quantity, a proper allowance should be given to normal
loss of materials. Normal loss will be determined after careful analysis of various factors.
Secondly, standard price for the material is to be determined. Setting standard price for
material is difficult because the prices are regulated more by the external factors than the
company management. Before fixing the standard, factors like prices of materials in
stock, price quoted by suppliers, forecast of price trends, the price of materials already
contracted, provision for discounts, packing and delivery charges etc., should be
considered.
ii) Setting Standards for Direct material:

The labour involved in manufacture of a product is known as direct
labour. The wage paid to such workers is known as direct wages. The time required for
producing a product should be ascertained and labour should be properly graded. Setting
of standard cost of direct labour involves fixation of standard time and fixation of
standard rate. Standard time is fixed by time or motion study or past records or
estimates. While fixing standard time normal ideal time is to be allowed for normal
delays, idle time, other contingencies etc. The labour rate standard refers the wage rate
applicable to different categories of workers. Fixation of standard rate will depend upon
various factors take demand for labour, policy of the organisation, influence of unions,
method of wage payment etc. If any incentive scheme is in operation then anticipated
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extra payment to the workers should also be included in determining standard rate. The
Accountant will determine the standard rate with the help of the Personnel Manager,.
The object of fixing standard time and labour rate is to get maximum efficiency in the use
of labour.
iii) Setting Standards for Direct Expenses

Direct expenses are those expenses which are specifically incurred in
connection with a particular job or cost unit. These expenses are also known as
chargeable expenses. Standards for these expenses must also be determined. Standards
for these may be based on past performance records subject to anticipatory changes
therein.
iv) Setting Standards for Overheads

Indirect costs are called overheads. These costs are those which cannot be
assigned to any particular cost unit and are incurred for the business as a whole. The
overheads are classified into fixed, variable and semi-variable overheads. Standard
overhead rate is determined for these on the basis of past records and future trend of
prices. It will be calculated per unit or per hour. Setting standard for overhead cost
involves the following two steps:
a) Determination of the standard overhead costs, and
b) Determination of the estimates of production
Standard overhead absorption rate is computed with the help of the following
formula:
Standard overhead rate = ---------------------------------------------
(per hour) Standard hours for the period
or
Standard overhead rate = -------------------------------------------------------
(per hour) Standard production (in units) for the period
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The purpose of setting standard overhead rate is to minimise overhead costs.

Overhead rates are more useful to the management if they are divided into fixed and
variable components. When overheads are divided into fixed and variable, separate
overhead absorption rates are to be calculated with the help of the following formulae:
Standard Variable Overhead for the Period

Standard Variable Overhead Rate = --------------------------------------------------------
Standard Fixed Overhead for the Period

Standard Fixed Overhead Rate = --------------------------------------------------------
Standard Hour
Production may be expressed in different units of measurement such as kilos,

tones, litres, numbers etc. When a concern produces different types of products, the
production will be expressed in different units. It is difficult to aggregate the production
which is expressed in different units. To over come this difficulty, the production is to be
expressed in a common measure known as ‘Standard Hour’. The standard hour is the
quantity of output which should be produced in one hour. A standard hour may be as “A
hypothetical hour which represents the amounts of work which should be performed in
one hour under stated conditions.” A measure of standard hour is useful for the purpose
of comparison of performance of one department to another. It is also useful to compute
efficiency and activity ratios. For example if 20 units of product A are produced in 2
hour, and 40 units of product B are produced in 5 hours, the standard hours represent 10
20 Units 40 Units
units of product A (-----------)and 8 units of product B (-------------). Therefore, standard
2 hrs 5 hrs
hour is the quantity of production of a given product for one clock hour.
Revision of Standards
Standard cost is based on a number of factors. These factors some may be

internal or external may vary from time to time depending upon different situations.
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Standard cost may become unrealistic if it is not revised according to the changed
circumstances. Then a question arises what would be the period in which standards
should be set? If the standard is set for a shorter period it is expensive and frequent
revision of standards will impair the utility and purpose of the standard cost. If the
standard is set for a longer period it may not be useful particularly during periods of high
inflation and rapidly changing technological environment. Therefore, standards are
normally set for a fixed period of one year and revised annually at the beginning of
accounting period. If there are major changes, a revision may also be required within the
accounting period. If there are minor changes, the causes of difference between actual
and standards may be explained without being revised the standards. There are certain
conditions which necessitate the revision of standard costs. These conditions are:
i) Changes in price levels of materials, labour and overheads

ii) Technological changes
iii) Changes in production methods or product mixes
iv) Changes in plant capacity utilization
v) Errors discovered in setting standards
vi) Changes in designs or specification
vii) Changes in the policy of organisation
viii) Changes in government policy affecting the product or organisation, etc.
Check your progress B
1. State some of the conditions under which a revision of stand cost takes place
2. Explain the concept of standard hour.
a) Standard hour is a hypothetical hour which represents the amount of work

to be done in one hour under given circumstances (True)
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b) To control cost either standard costing or budgetory control should be

used but not both the techniques. (False)
c) Standard cost is used as a yardstick to measure the efficiency with which

actual cost has been incurred. (True)
d) Standard cost is a projection of costs accounts whereas budgeting is a

projection of financial accounts. (True)
e) Standards are normally set for a longer period and revised annually.
(False)
Terminal Questions
1. What is Estimating Costing and how does it differ from Standard Costing?
2. What do you understand by standard costing. Give a suitable definition to explain

your answer.
3. What is Standard Costing? State the objectives of standard costing.
4. Give a comparative account of standard costing and budgeting.
5. Write a detailed note explaining the advantages and limitations of standard

costing.
6. How do you ensure the success of a standard costing method in your organisation
7. Write notes on the following:

a) Ideal standard
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b) Expected standard
c) Normal standard
d) Basic standard
8. Explain the meaning of Standard Hour.
9. Write a note on Revision of Standards.
10. How are standards fixed? Explain.
11. A company has decided to introduce a system of standard costing. What are the
preliminaries to be considered before developing such a system? Explain.
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UNIT 17 RELEVANT COSTS FOR
DECISION MAKING
Structure
17.0 Objectives
17.1 Introduction
17.2 Relevant Costs for Decision Making
17.2.1 Concept of Relevant Costs
17.2.2 Concept of Differential Costs
17.2.3 Decision-Making Process
17.2.4 Selling Price Decisions
17.2.5 Exploring New Markets
17.2.6 Make or Buy Decisions
17.2.7 Expand and Contract
17.2.8 Sales Mix Decisions
17.2.9 Alternative Methods of Production
17.2.10 Plant Shut Down Decisions
17.2.11 Acceptance of Special Order
17.2.12 Adding or Dropping a Product Line
17.2.13 Replacement of Machinery
17.3 Let Us Sum Up

17.4 Key Words
17.0 OBJECTIVES
After studying this unit, you should be able to:
! distinguish between the different types of costs;
! distinguish between the nature of costs;
! present different alternatives before the decision making; and
! selection out of different alternatives.
17.1 INTRODUCTION
The analysis of costs plays a vital role in selecting the alternatives available before the
management. Costs could shape alternative opportunities and therefore, it influences
and shapes future profits. Management is not only interested in the historical cost
analysis but it is also interested to study those costs, which are influencing the future 69
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Cost Volume Profit operations. After analyzing different types of costs according to their nature, one can
Analysis be able to select one out of the various optimal alternatives. When costs are future
oriented then only they remain important for the decision maker. In this unit you will
study the importance of relevant costs for decision making.
17.2 RELEVANT COSTS FOR DECISION MAKING

With different objectives the different costs concept is always there. It is pertinent to
use the word relevant while providing the information about costs. When the costs are
not changing with the different alternatives and remain fixed in nature then they
become irrelevant or sunk costs. When management wants to select any of the
alternatives available before them and take decision then the relevant costs become
very important.
17.2.1 Concept of Relevant Costs

Relevant cost is a cost of decision. You may call it decision cost, as it is always
relevant with the selection of one out of different alternatives. If decision is being
taken and any cost is increased because of the change in decision, that particular cost
becomes relevant cost. Relevant cost is always for future and not for the analysis of
the past decisions. These costs are ‘Future Costs’ and they differ to different
alternatives. We focus on the future whether it may be 10 seconds after or it may be
10 years later.
Relevant costs are also known as differential costs. Relevant costs differ among the
different alternatives. For example, if an engineering graduate wants to start his own
work shop and he has a choice to complete his post–graduation. Relevant costs to
continue his studies are fees and books. Irrelevant costs are clothes and his residential
arrangements, which will incur under both the circumstances.
17.2.2 Concept of Differential Costs

Differential cost is the difference between the costs of alternatives. Difference in total
cost between the two alternatives available. It is also known as net relevant cost.
Differential cost is not calculated per unit. It is calculated as total cost and then the
difference is being calculated between the two levels of production or is being
calculated between the two alternatives. Both variable costs and fixed costs may be
differential cost when there is a change in both these costs in response to alternative
course of action. When a decision does not affect either the variable or fixed costs
then there is no differential costs. It is a technique of costing and not a method. Only
relevant costs of the option are being considered. It is normally calculated on sales
basis, which gives revenue. Decision cannot be taken only on the basis of differential
cost analysis as other factors like government policies, social and financial causes,
investment and the behaviour of the workers are also the influential part of the
decision-making process. Conditions and costs of different alternatives always differ,
so the differential costs once calculated cannot be used without adjustments for the
other decisions. As differential costs are relevant costs for future, so irrelevant costs
should be known. The costs which do not change as a result of decision are irrelevant
costs. Fixed costs are irrelevant costs as they do not change if production is expanded
upto certain level.
17.2.3 Decision-Making Process

Decision-making is a process of selecting any of the alternatives available after
evaluation of all the options. Selection of one alternative out of two or more should
maximize the profits of the concern. Decision-making is very much related with
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future planning with a particular goal. In this process, available information Relevant Costs for
regarding the options should be analyzed properly to make a beneficial decision for Decision Making
the benefit of the organization. Before taking decision firstly one should recognise
the problem, secondly identify the various alternatives, thirdly evaluate different
alternatives with helps of cost benefit analysis and finally adopt the most profitable
course of action.
Differential cost analysis is a very useful technique to the management in formulating

policies and making the following decisions:
1) Selling Price Decisions
2) Exploring New Markets
3) Make or Buy Decisions
4) Expand and Contract
5) Sales Mix Decisions
6) Alternative Methods of Production
7) Plant Shut Down Decisions
8) Acceptance of Special Order
9) Adding or Dropping a Product Line
10. Replacement of Machinery
Let us study each one of these in detail.
17.2.4 Selling Price Decisions
Pricing process is different in different industries. It differs according to the nature,

cost and demand of the product. Every producer accepts the different criterion for
pricing his product. Effect of changes in selling price can easily be understood with the
help of the following illustration.
Illustration 1
X Ltd. produces and markets ballpoint pens. Due to competition, the company
proposes to reduce the selling price. From the following information, examine the
effects of reduction in selling price by (a) 5%, (b) 10% and (c) 15%
Rs. Rs.
Present Sales 3,000 units ----- 3,00,000
Variable Costs 1,80,000
Fixed Costs 70,000 2,50,000
Net Profit 50,000
Indicate the number of units to be sold if the company wants to maintain the same
profits in each of the above cases. 71
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Cost Volume Profit Solution
Analysis Statement of Cost and Profit
Particulars Present Price Price Price
price Reduction Reduction Reduction
by 5% by 10% by 15%
Selling price per unit (Rs.) 100 95 90 85

Less: Variable cost (Rs.) 60 60 60 60
Contrubution (Rs.) 40 35 30 25
Contribution for 3,000 units (Rs.) 1,20,000 — — —
Contribution required to maintain
same profit (Rs.) — 1,20,000 1,20,000 1,20,000
Required units to be sold — 3,429 4,000 4,800

Less: Units sold at present price — 3,000 3,000 3,000
Additional Units required to be sold
to earn the same amount of Profit — 429 1,000 1,800
Decision: If company reduces the selling price by 5% then it requires 429 pens more
to sell to earn the same amount of profit. If it accepts the second option to reduce the
price by 10% then it requires 1,000 pens more to sell to earn the same amount, and if it
accepts the third alternate to reduce the price by 15% then it require 1,800 pens more
to sell to earn the same amount.
Working Notes:
1) It has been assumed that in all the options, fixed costs remain unchanged and to
earn the same amount of profit the contribution should remain the same.
2) Calculation of Required Units to be sold to earn the same amount has been
mentioned with the use of the following formulae:
Required Contribution Rs. 1,20,000

Required Sales = = = 3,429 units required to
Contribution per Unit Rs. 35
be sold if selling price
is being reduced by 5%
17.2.5 Exploring New Markets
Decisions regarding new market can be taken if the home market is not affected. If
we sell the commodity to the foreign market at lower price and they re-export to our
existing customers at lesser price what we charge to our customers, then there
cannot be a decision in favour of new market even if profit or contribution is
increased. It is advisable only when other things being remain same in the home or
present market. To make use of the existing capacity, export and new market is the
best alternate. With the following illustration, one can understand about the new
market decision.
Illustration 2
X Ltd. manufactures 1,000 units p.a. at a cost of Rs. 40 per unit and there is a
demand of the whole production at a price of Rs. 42.5 per unit in the home market.
There is a fall in the demand in the home market in the year 2003 and the whole
production can be sold in the home market at a selling price of Rs. 37.2 per unit.
72 The cost analysis for 1,000 units is as follows:
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Rs. Relevant Costs for
Decision Making
Materials 15,000
Wages 11,000
Variable Expenses 6,000
Fixed Expenses 10,000
2,000 Units can be sold in the foreign market at a explored price of Rs. 35.5 per unit.
It is also estimated that for additional 1,000 units of the product the fixed cost will
increase by 10%. Advise the management.
Solution
Statement showing the Effects of Selling Goods in the Foreign Market
Particulars Year 2002 Year 2003
Home market Home market Foreign market Total

1,000 units 1,000 units 2,000 units 3,000 units
Rs. Rs. Rs. Rs.
Materials 15,000 15,000 30,000 45,000

Wages 11,000 11,000 22,000 33,000
Variable expenses 6,000 6,000 12,000 18,000
Marginal cost 32,000 32,000 64,000 96,000
Sales 42,500 37,200 71,000 1,08,200
Contribution
(Sales – Marginal Cost) 10,500 5,200 7,000 12,200
Less : Fixed cost 10,000 10,000 2,000 12,000
Profit / (Loss) 500 (4,800) Loss 5,000 200
It is advisable to accept the proposal for sale in the foreign market as it converts loss
of Rs. 4,800 of home market into a net profit of Rs. 200.
17.2.6 Make or Buy Decisions

Decisions about, whether a manufacturer of goods or services should produce goods
or services within the factory or purchase them from the market. This type of
decision is needed when the concern organization is producing the item, which is also
available in the market at cheaper rate. If, purchased from the open market,
retrenchment of workers becomes inevitable or may not be able to reduce the fixed
costs of the factory. During the processing of the alternatives available other than
cost factor should also be considered. Some of these are quality of the product
available in the market, regularity of the supply, expected fluctuations in the demand
and reliability of the supplier. The processing and designing of the item of a product
should be kept as a secret, then this cannot be purchased from the market and it
should be produced at the floor of the factory. The following example makes this
concept easy to understand:
Illustration 3
With the help of the following data, a manufacturer seeks your advice whether to buy an
item from the market or to produce it at the floor of the factory: 73
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Cost Volume Profit Present Proposed
Analysis Particulars
(Buy) (Make)
Rs. Rs.
Sales 16,00,000 16,00,000
Costs: Variable 11,20,000 10,24,000
Fixed 3,60,000 4,00,000
Capital required 8,00,000 9,00,000
Advise the management.

Solution
Statement of Cost and Profitability
Particulars Buy Make
Rs. Rs.
Sales ( S ) 16,00,000 16,00,000

Less : Variable Costs 11,20,000 10,24,000
Contribution ( C ) 4,80,000 5,76,000
Less : Fixed Costs 3,60,000 4,00,000
Profit ( P ) 1,20,000 1,76,000
P/V Ratio (C/ S multiplied by 100) 30% 36%
Percentage of profit on sales (P/S multiplied by 100) 7.5% 11%
Return on capital employed (P/Capital multiplied by 100) 15% 19.6%
Decision: By describing the above statement making of the item at the floor is
better than to buy.
Working Note: Total costs would be reduced by Rs. 56,000 and by the same
amount the profit would also increase. P/V Ratio and profit on sale increase by
6 % and 3.5% respectively. Return on capital employed will also increase by
4.6 %.
17.2.7 Expand and Contract
In any factory, if there is scope of expansion and there is a possibility to purchase

the same item on contract basis from the market then we would look at the total
cost of both the alternate. It can be understood easily with the following example:
Illustration 4
X Ltd. has two factories – A and B. A is running at 70% of installed capacity

(Installed capacity is 12,000 units) and B Factory supplies its requirements by
working at 80% of its installed capacity. The cost structure of the B factory is
given below:
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Relevant Costs for
Materials Rs. 16,800 Decision Making
Labour Rs. 6,000
Apportioned Fixed Overheads Rs. 7,500
Variable Overheads Rs. 4,200
Total Rs. 34,500
The production of A factory is to be increased to 80% capacity. The component

produced in B factory can be purchased from the market at Rs. 4.00 per unit. As the
cost of B factory exceeds Rs. 4 per unit, it is proposed to obtain the additional
requirement from the market instead of getting it from B factory. Advise the
management.
Solution
A factory can produce 12,000 units at 100% capacity and is working at 70%
capacity means it is producing 8,400 units. B factory is working at 80% capacity to
fulfill the needs of A factory. B factory when working at 100% capacity can
produce 84,000 / 80% = 10,500 units, so if A factory is working at 100% capacity
B factory cannot fulfill the requirement of A factory. If A factory is working at 80%
capacity that is 9,600 units (80%of 12,000). B factory will be required to produce
1,200 units more (9,600 – 8,400). For this analysis, the following statement is
required:
Statement showing costs of buying and manufacturing for 1200 units

Cost of Manufacturing Cost of Buying
Component 1,200 units 1,200 units
Rs. Rs.
Material (16,800 / 8,400) 1,200 2,400 ---

Labour (1,200 multiplied by 0.50) 600 ---
Variable overhead (4,200 / 8,400) 1,200 600 ---
Costs of buying @ Rs. 4.00 per unit --- 4,800
Total Costs (Rs.) 3600 4,800
Decision: B factory will continue supply to A factory as manufacturing cost of

Rs. 1,200 (Rs. 4800 -- Rs. 3600) less than the cost of buying. So it is advisable to
expand B factory. It is presumed that fixed cost will not change after the expansion.
17.2.8 Sales Mix Decisions

The relative contribution of quantities of products or services constitutes total
revenues. It becomes difficult to analyze the profitability of the product when more
than one product is produced. To establish most profitable sales mix it becomes
necessary to get the most profitable sales mix by considering all the alternatives. Look
at following example.
Illustration 5
X Ltd. produces and sells four products A, B, C and D. The analysis of income from
each product has been shown in the following statement. Which of these product lines
would you like to continue and which would you like to drop? 75
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Cost Volume Profit
Analysis
Income Statement
Particulars Products
A B C D Total
Rs. Rs. Rs. Rs. Rs.
Sales 6,80,000 29,20,000 8,00,000 6,00,000 50,00,000
Less Variable Cost 4,00,000 5,70,000 5,50,000 5,80,000 21,00,000
Gross Contribution 2,80,000 23,50,000 2,50,000 20,000 29,00,000
Less : Variable Selling Costs:
Salesmen 50,000 7,00,000 70,000 20,000 8,40,000
Warehouse 40,000 7,00,000 60,000 10,000 8,10,000
Packing 30,000 2,00,000 50,000 2,000 2,82,000
Delivery 30,000 3,00,000 40,000 8,000 3,78,000
Total Variable Selling Costs: 1,50,000 19,00,000 2,20,000 40,000 23,10,000
Net Contribution 1,30,000 4,50,000 30,000 − 20,000 5,90,000
Less: Fixed Selling Cost − − − − 1,10,000
Contribution for Fixed

Administrative Cost
& Profit 4,80,000
Less: Fixed Administration

Costs 1,88,000
Net Profit 2,92,000
Solution
By looking at the above statement it is concluded that selling price of the product D is
not able to recover its variable costs even, so, the production of product D should be
stopped immediately. It shows the loss of Rs. 20,000 in net contribution.
Gross contribution of product Y is also not satisfactory so management can reconsider

about the use of resources engaged in the production of Y.
17.2.9 Alternative Methods of Production

The decision to be taken is of the nature of selecting one machine out of one or more
available in the market for production or to purchase the ready goods for further
processing from the market. In these cases, cost is considered and the decision is
taken in favour of the lowest cost occurring sector. Look at illustration 6 and see how
a decision will be taken out of alternative methods of production.
Illustraton 6
X Ltd. has to install a machine for the production of a part of a new product to be
launched by them. Two machines B and C are being considered. Their details are
given below:
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Details Machine B Machine C Relevant Costs for
Decision Making
Cost in Rs. 2,00,000 4,40,000
Annual Capacity in units 4,000 10,000
Life in Years 10 10
Salvage value in Rs. Nil 40,000
Material per unit in Rs. 30.00 30.00
Production cost per unit (other than depreciation) 45.00 45.00
Apportioned overheads 2,000 2,000
Interest is @ 10% per annum. The part is available in the market @ Rs. 90 per unit
and can be sold at a net price of Rs. 85 per unit. The company requires 6,000 units per
annum. Advise the management.
Solution
Statement of cost of Depreciation and Interest per annum
Particulars Cost of Cost of

Machine B Machine C
Rs. Rs.
Initial Investment needed 2,00,000 4,40,000
Less Salvage Value Nil 40,000
Net Value of Machine to be depreciated 2,00,000 4,00,000
Depreciation p.a.for 10 years 20,000 40,000
Interest on initial investment @10% p.a. 20,000 44,000
Statement showing Comparative Costs in Different Alternatives

Cost, if Cost of Cost of
Particulars
purchased Machine B Machine C
Rs. Rs. Rs.
Units purchased 6,000 2,000 --
Units produced -- 4,000 10,000
Surplus units to be sold in the open market -- -- 4,000
Annual requirement (units) 6,000 6,000 6,000
Rs. Rs. Rs.
Cost of material @ Rs. 30 per unit -- 1,20,000 3,00,000
Production cost @ Rs. 45 per unit -- 1,80,000 4,50,000
Cost of Depreciation p.a. 20,000 40,000
Cost of interest @ 10% per annum -- 20,000 44,000
Total Cost of production 3,40,000 8,34,000
Add : Cost of purchases @
Rs. 90 per unit 5,40,000 1,80,000 --
Less : Sale proceeds of surplus
production @ Rs. 85 per unit -- 3,40,000
Net Cost of 6,000 units Rs. 5,40,000 Rs. 5,20,000 Rs. 4,94,000
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Cost Volume Profit Decision: In all the above three alternatives the last alternate that is to purchase machine
Analysis
C is the cheapest and so company should purchase in the machine C and install it.
17.2.10 Plant Shut Down Decisions

This type of decision is being taken when the nature of business is seasonal, cut-throat
competition and other un-favourable conditions of the market are there. While taking
the decision of ‘Shut Down’ of the going concern the behaviour of costs should be
considered.
When one shuts down his plant, there are some avoidable, traceable or escapable fixed
costs such as salaries of temporary workers and salary of sales man, which can be
stopped by this decision. Some unavoidable or un-escapable cost are : depreciation on
fixed assets, rent of office and factory, insurance, interest and salaries of permanent
staff. These can not be stopped by shutting down the plant temporarily.
Some additional cost of Shut Down or Reopening Costs should be considered as the part
of the unavoidable costs. Normal decisions are for maximizing the profits; but Shut Down
decision is for reducing the loss as it always considers the savings under loss. Calculation
of net avoidable costs can be made through the following formulae:
Net Avoidable FC = Total FC – (Un-avoidable FC + Re-opening Costs)
If the loss by taking the decision of ‘Shut Down’ is less than the continuity of the
business then the decision of ‘Shut Down’ may be considered as favourable in short
term. Some aspects other than costs should also be considered, such as utility of the
goods by the consumers, benefits of the employees, obsolescence of machinery,
goodwill of the concern, objection by the labour unions and the government
interference. ‘Shut Down Point’ can be calculated by marginal cost method by the
following formulae:
Net Avoidable Fixed Cost

Shut Down Point (in Units) =
Contribution per Unit
Net Avoidable Fixed Cost

Shut Down Point (in Value) =
P/V Ratio
There is a great difference between the ‘Shut Down’ of a business and stopping the
production of one type of product. If production of any type of product is stopped then
the fixed cost of that product can be allocated to the remaining products; but when the
plant is being ‘Shut Down’, the remaining fixed costs are the loss for the concern. You
may have already learnt it in Unit 15 under the head 15.7. Managerial uses of Marginal
cost.
17.2.11 Acceptance of Special Order

If any producer is not utilizing plant’s full installed capacity and he receives special
order for the product and that will not make any adverse impact on our present sale
then the offer will be accepted if it increases contribution. This can be illustrated by
the following illustration:
Illustration 7
Y Ltd. is working on 80% capacity and its Flexible Budget is as follows:
Output 60,000 units, sales value Rs. 12,00,000, material cost Rs. 30,000, wages
Rs. 2,10,000, variable expenses Rs. 1,20,000, Semi-variable expenses Rs. 70,000
and fixed costs Rs. 2,00,000.
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A proposal for additional sale of 7,500 units is available, if it is accepted and supplied at Relevant Costs for
Rs. 14.00 each. The semi-variable overheads increases by Rs. 2,500 for the additional Decision Making
production. Advise the management.
Solution
Statement of Marginal Cost and Profitability
Particulars Production of Production of Total Units:
60,000 units Additional 7,500 67,500
units
Rs. Rs. Rs.
Material @ Rs. 0.50 30,000 3,750 33,750
Wages @ Rs. 3.5 2,10,000 26,250 2,36,250
Variable Expenses @ Rs. 2 1,20,000 15,000 1,35,000
Semi-variable expenses 70,000 2,500 72,500
Marginal cost 4,30,000 47,500 4,77,500
Sales 12,00,000 1,05,000 13,05,000
Contribution = (S-V) 7,70,000 57,500 8,27,500
Less Fixed Costs 70,000 --- 70,000
Profit 7,00,000 57,500 7,57,500
Decision: If the proposal for additional supply of 7,500 units is accepted then contribution
increases by Rs. 57,500 and profit also increases by the same amount. So it is advisable
to accept the offer for additional supply. It is assumed that this supply will not affect the
present market for its product.
17.2.12 Adding or Dropping a Product Line

It is obvious to add or drop a product line to increase the profitability of the business. For
this purpose it is needed to analyze all the details available. Profitability should be assessed
in the existing framework and then the profitability of all the alternatives should be compared
and then the decision should be taken.
Look at the following illustration :
Illustration 8
A factory manager seeks your advice whether he should drop one item from his product
line and replace it with another. Present cost and production data per unit are as follows:
Product Price Variable Costs % Sales in

(Rs.) (Rs.) Total Sales
Tables 60 40 50
Chairs 100 60 10
Book Stands 200 120 40
Total Fixed cost per annum Rs. 7,500
Current Sales of the year Rs. 25,000
The change under consideration consists in dropping the line of chairs and replacing it
with a line of Sofa. If this drop and add change is made the manager forecasts the
following data regarding cost and output: 79
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Cost Volume Profit
Product Price Variable Costs % Sales in
Analysis
(Rs.) (Rs.) Total Sales
Tables 60 40 30
Sofa 160 60 20
Book Stands 200 120 50
Total Fixed cost per annum Rs. 7,500
Projected Sales of the year Rs. 26,500
Is this proposal feasible? Advise the management.

Solution
Statement of profitability for current production
Particulars Tables Chairs Book Stands Total
Rs. Rs. Rs. Rs.
Selling Price 60 100 200 -----
Less Variable Cost % 40 60 120 -----
Contribution 20 40 80 -----
P/V Ratio 33.33% 40% 40% -----
Sales of Rs. 25,000 in the
ratio of 50%, 10% & 40% 12,500 2,500 10,000 25,000
Contribution (P/V
multiplied by Sales) 4,167 1,000 4,000 9,167
Less Fixed Costs --- --- --- 7,500
Profit ---- --- --- 1,667
Statement of profitability for projected production

Particulars Tables Sofa Book Stands Total
Rs. Rs. Rs. Rs.
Selling Price 60 160 200 -----
Less Variable Cost 40 60 120 -----
Contribution 20 100 80 -----
P/V Ratio 33.33% or 1/3 62 ½% 40 % -----
Sales of Rs. 26,500 in the
ratio of 30%, 20% & 50% 7950 5300 13250 26,500
Contribution (P/V
multiplied by Sales) 2650 3313 5300 11,263
Less Fixed Costs ----- ----- ----- 7,500
Profit ----- ----- ----- 3,763
Decision: After analyzing the above statements it is observed that if the proposal is
accepted then the profit will increase by Rs. 2,096 (i.e., Rs. 3,763 – Rs. 1,667). It is
presumed that the demand of the proposed products will remain in the market.
80 Therefore the proposed is to be accepted.
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Relevant Costs for
17.2.13 Replacement of Machinery Decision Making
It becomes necessary to replace the old machinery by a new because of the
obsolescence of the old one or the renovation of the old one. Objective of replacing the
old machinery by a new machine is to reduce the cost of production and to increase
the revenue. While deciding the replacement of machinery factors like operating cost,
technological development, return on capital, demand for the product, opportunity cost
of the capital, availability of raw material, labour etc, should be taken into
consideration. The replacement of machinery is assessed either by marginal cost
analysis or differential cost analysis but the later is more appropriate and is much in
use. Let us study in brief the factors to be considered for the replacement of
machinery
i) Operating Cost: Comparative study of the operating cost of the old and the new
machinery should be done. Per unit cost of production by old machinery and the
new one can be analyzed by the comparative statement.
ii) Technological Development: New inventions are taking place every day. The
chances of new inventions should be taken into consideration before the decision
of replacement.
iii) Return On Capital: Return on capital on the new investment should be feasible.
What will be the amount of loss while selling the old?
Demand for the Product: Production will be increased by the use of the new
machine and the demand for the increased production should be estimated. If the
production at full capacity cannot be sold, then what percentage of the capacity
can be sold and at this point of utilization of the capacity would it be possible to
keep the price competitive. Market trend of the product should also be analyzed.
If the nature of the product is not going to last for a greater period then the
decision regarding change of machinery is not required.
v) Assessment of the Opportunity Cost of the Capital: If the capital needed for
the replacement is being used for any other alternative would the capital yield
more. If it is so then the decision of replacement should be dropped.
vi) Availability of Raw Material and Skilled Labour: Availability of raw material
and skilled labour to run the machinery should be studied before replacing the
machine.
Illustration 9
The following facts relate to two machines:
Existing Machine New Machine
Capital cost (Rs.) 10,00,000 40,00,000

Marginal cost per unit (Rs.) 60 52
Selling price per unit (Rs.) 120 120
Fixed expenses (Rs.) 1,00,000 4,00,000
Annual output (units) 20,000 40,000
Life of machines (years) 10 10
The existing machine has worked for 5 years. Its present resale value is Rs. 4,00,000.
The scrap value of the machine may be taken as nil, Advise whether new machine
should be installed if rate of interest is 10 %.
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Cost Volume Profit Solution
Analysis
Statement of Differential Cost And Incremental Revenue
Particulars Existing Machine New Machine Incremental
Cost Revenue Cost Revenue Cost Revenue

Sales 24,00,000 48,00,000 24,00,000
Total Marginal Cost 12,00,000 20,80,000
Total Fixed Cost 1,00,000 4,00,000
Interest on additional
capital outlay on
36,00,000 @ 10 %
(Rs. 40,00,000 —
Rs. 4,00,000) 3,60,000
Depreciation on
original cost 1,00,000 4,00,000
Loss on sale of
machinery 14,00,000 1,00,000 33,40,000 19,40,000
Profit 10,00,000 14,60,000 4,60,000
Decision: It is clear from the above statement that installation of new machinery is
beneficial as incremental revenue is Rs 24,00,000 where as the differential cost is
Rs. 19,40,000. After installing the new machine the total increase in the revenue will
be Rs. 4,60,000.
Working Note:
1) Total cost of the machine is Rs. 10,00,000 and life is for 10 years and it has
been used for 5 years. The present book value of existing machine is Rs.
5,00,000. So, the loss on sale of old machine is = Rs. 1,00,000. (Rs. 5,00,000-
4,00,000)
2) The net amount required to install new machine is Rs. 3,60,000 i.e., after
deducting the amount of Rs. 4,00,000 received on sale of existing machinery.
3) Loss on sale of existing machinery is to be included in the total cost of new

machinery for evaluation of new proposal.
4) Opportunity cost of the capital has not been considered.
Check Your Progress
1) What do you understand about relevant cost and irrelevant costs ? Give one
example.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
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2) Explain the concept of differential cost. Relevant Costs for
Decision Making
................................................................................................................................
................................................................................................................................
................................................................................................................................
................................................................................................................................
3) What is decision making process ?
................................................................................................................................
................................................................................................................................
................................................................................................................................
................................................................................................................................
4) List out four managerial applications of differential cost analysis .
1 ................................................................ 3. …………………………………….
2. ............................................................... 4. …………………………………….
5) State whether the following statements are True or False:
i) Relevant cost analysis is used for future decision making and not for past
decisions
ii) Relevant costs are also known as differential costs
iii) Differential cost is always calculated per unit and not on total cost of two
alternatives
iv) Differential costs and marginal costs are the same
v) Fixed costs are not taken into account for differential cost analysis.
6) X Ltd. produces 1,000 articles at the following costs:
Components Rs. Rs.

Materials — 4,00,000
Wages — 3,60,000
Factory Overheads: Fixed 1,20,000
Variable 2,00,000 3,20,000
Fixed Administrative Overhead — 1,80,000
Selling Overheads: Fixed 1,00,000
Variable 1,60,000 2,60,000
Total — 15,20,000
1,000 units @ Rs. 1,550 can be consumed in home market. Foreign market can
consume 4,000 articles of this product if rate can be reduced to Rs. 1,250 per article.
Is the foreign market worth trying?
7) The present volume of sales in a factory is 30,000units and the management has
installed modern machinery to increase the production to 6 times. The present
selling price is Rs. 24 per unit. Six successive levels with equal increments
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Cost Volume Profit reaching up to 1,80,000 units are contemplated sales. The reduction in selling
Analysis
price is expected to be Rs. 2 at each higher level of sales. Fixed cost of
Rs. 1,32,000 will not change Other costs at different levels are given below:
Production (units in’000) 30 60 90 120 150 180

Variable cost (in Rs. ‘000) 4.18 8.18 12.78 15.78 17.78 19.02
Semi Variable Cost (in Rs. ‘000) 1.50 1.50 1.70 1.70 2.00 2.00
Prepare a statement of differential cost and incremental revenue and give your advice
as to which level of production should be adopted to gain maximum
17.3 LET US SUM UP

Before taking a decision, one must analyze the alternatives available before him and
then one should take a decision, which is beneficial to the management. The decision
should be in such a way that it increases the profit of the company. When we take a
decision for a short period, normally we look at the contribution we receive in all the
available alternatives and compare them and one should accept the alternate, which
provides more contribution, as in shorter period it is presumed that fixed costs will not
change. If a decision is to be taken for a long period when the fixed costs will also
change then one should take the decision through differential cost system. So, costs
become relevant when decisions are being taken. In long-run variable and fixed costs
normally change. Total differential cost and incremental revenue is considered in this
method of analyzing for longer period.
17.4 KEY WORDS

Alternative: Options
Administrative Cost : A cost which relates to the enterprise as a whole
Book Value : The amount shown in books of account for an asset
Contribution Margin : Excess of sales revenue over all variable expenses
Differential analysis : Process of estimating the consequence of alternative actions
while taking a decision by decision-makers
Differential cost : The costs which will change in response to a particular course of
action.
Interest : The cost for using money.
Make or buy decision : A managerial decision about whether the firm should
produce internally or purchase it from outside
Opportunity Cost : The present value of income/costs that could be earned from
using an asset in its best alternative uses.
Residual value : The estimated realisable value of an asset after use.
Relevant costs : Costs that are different under different alternatives
Short run : Period of time over which capacity will not be changed.
Decision: Deciding one out of the many options
Differential Cost: Change in the cost
Incremental revenue: Increase in the revenue
Semi variable costs: A cost, which has both variable and fixed elements.
84 Sunk Costs: Past costs which are unavoidable because they cannot be changed
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Relevant Costs for
17.5 ANSWERS TO CHECK YOUR PROGRESS Decision Making
5) i) True ii) true iii) False iv ) False v ) False

6) Statement Showing Differential Cost And Incremental Revenue
Components Rs. Rs.
Sales of 4,000 units @ Rs.1250 (incremental revenue) — 50,00,000
Differential costs:
Materials (4,00,000/1,000)4,000 16,00,000 —
Labour (3,60,000/1,000)4,000 14,40,000 —
Factory O.H. (2,00,000/1,000)4,000 8,00,000 —
Selling O.H. (1,60,000/1,000)4,000 6,40,000 44,80,000
Net profit or incremental profit 5,20,000
Decision: It is better to accept the foreign proposal, as it will increase the profit by
Rs. 5,20,000. It is assumed that this acceptance will not affect the home market and
the fixed cost will remain same.
7) Statement of Differential Cost And Incremental Revenue
Production Selling Sales Variable Semi- Fixed Total Differential Incremental

in Units Price per Revenue Cost Variable Cost Cost Cost Revenue
(’000) Unit (Rs. (Rs. Cost (Rs. (Rs. (Rs. (Rs. ’000) (Rs. ’000)
’000) ’000) ’000) ’000) ’000)
30 24 720 4.18 1.50 132 137.68 — —

60 22 1320 8.18 1.50 132 141.68 4.00 600
90 20 1800 12.78 1.70 132 146.48 4.80 480
120 18 2160 15.78 1.70 132 149.48 3.00 360
150 16 2400 17.78 2.00 132 151.78 2.30 240
180 14 2520 19.02 2.00 132 153.02 1.24 120
Decision: Production level can be increased up to the equalization of incremental

revenue and the differential cost. In this case both of these are equal at the level of
90,000 units but the incremental revenue increases till the production level is achieved
at 1,50,000 units. After this level incremental revenue is decreases so the production
fixed at 1,50,000 units will provide the optimum level of profit.

Questions
1) What do you understand by differential costing ? How does it differ from
managerial costing?
2) Explain the practical applications of differential costing.
3) X Company Ltd. manufactures a product. You are required to prepare a
statement showing differential cost and incremental revenue. At what volume
the company should set its level of production ?
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Cost Volume Profit
Output Selling price Total semi-fixed Total variable Total fixed cost
Analysis
(in ’000 units) Per unit cost per unit Cost per unit per unit
30 24 1.50 4.18 1.32

60 22 1.50 8.18 1.32
90 20 1.70 12.78 1.32
120 18 1.70 15.78 1.32
150 16 2.00 17.78 1.32
180 14 2.00 19.02 1.32
(Ans : Production at 1,50,000 units will provide optimum level of profit)

4) What considerations are involved in taking decision of the following :
i) Make or buy decisions
ii) Dropping a product or adding a new product
iii) Shut-down of plant
5) Golden company Ltd produces a product which is yielding a profit of
Rs. 14,00,000 after charging fixed costs of Rs. 10,00,000 per annum. The selling
price of the product is Rs. 50 per unit and has a variable cost of Rs. 20 per unit.
The management wants to make changes in the selling price of the product. The
following options are open to the management.
Alternatives Reduction in Selling Price Increase in quantity to be sold
1 5% 10%
2 7% 20%
3 10% 25%
Evaluate the above alternatives and advise the management which alternative yields
maximum profit ?
(Ans : Contribution : 1. Rs. 2 4 , 2 0 , 0 0 0 2. Rs. 25,44,000 and
3. Rs. 2 5 , 0 0 , 0 0 0
Decision : Alternative 2 gives maximum profit.
6) X Company Ltd is producing 10,000 articles and its cost data is given below :
Variable Cost per unit : Rs. 26
Fixed overheads : Rs. 10
Total Cost : Rs. 36
A manufacturer offers the same commodity for Rs. 32 per unit. The analysis of
the cost data shows that Rs. 60,000 of fixed overheads will be incurred
regardless of production.
You are requested to suggest that should company X make or buy the article ?
(Ans : Cost of making product Rs. 30, Difference of Rs. 2. is in favour of
making the product)
7) The total fixed cost of a company for producing a product price is Rs. 15 lakhs,
the selling price per unit is Rs. 50 and the variable cost per unit is Rs. 40. The
company is incurring losses for the past several years due to lack of demand.
86 The company wants to shut down the plant till the demand picks up. The
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avoidable costs are estimated at Rs. 4,00,000. Should the company discontinue Relevant Costs for
production till the demand picks up ? Advise the management. Decision Making
(Ans. If the company’s sales are at least Rs. 55,00,000, it should not be
shut down )
[ Fixed Cost – Avoidable cost

Hint : Shut down sales = ———————————
P/V ratio
]
8) A firm manufactures and sells three products – X, Y and Z. Their cost data is
given below:
Product : A B C
Production (Units) : 5,000 12,500 17,500
Selling Price (Rs.) 9 5 15
Variable Cost (Rs.) 8 3 11
Fixed Cost Rs. 1,05,000
There is no under utilisation of production capacity. Fixed costs are allocated on
the basis of units produced. There is no difference in the manufacturing time of
each product. The management proposes to drop product A as it contributes a
loss of Rs. 2 per unit as calculated below :
Selling price Rs. 9
Variable cost Rs. 8
Fixed cost Rs. 3
(Rs. 105000 ÷ 35000 units) Rs. 11
Loss per unit Rs. 2
The management proposes to add product S in place of product A as more units
of product S can be produced and sold in the market whose selling price and
variable cost per units is Rs. 8 and Rs. 7.75 respectively. It is estimated that
12,000 units of product S can be sold if product A is dropped. You are
requested to advise the management.
(Ans : Contribution : Product A : Rs. 1. Profit would decrease by
Rs. 5000 if the product A is dropped.
Product S : Rs. 0.25 p. If product S is added in place of
product A profit will decrease by Rs. 2000)
answers for them but do not submit your answers to the University. These
are for your practice.
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UNIT 18 REPORTING TO
MANAGEMENT
Structure
18.0 Objectives
18.1 Introduction
18.2 Concept of Management Reporting
18.3 Objectives of Reporting
18.4 Reporting Needs at Different Managerial Levels
18.5 Types of Reports
18.6 Modes of Reporting
18.7 Essentials of Successful Reporting (Guiding Principles)
18.8 Let Us Sum Up
18.9 Key Words
18.0 OBJECTIVES
After studying this unit, you should be able to :
! understand the report for the specific purpose;
! follow the pattern of reports and apply these to your decisions;
! prepare good reports;
! know the needs of the reports; and
! use the reports for data base.
18.1 INTRODUCTION
The purpose of reporting is to provide the information needed by the concerned party.
The value of information is determined by how the information meets the needs of the
users. This information creates an atmosphere for internal decision makers. The
communication of the information between two or more parties through reports is
known as reporting. Report is the essence of the management information system.
Report is a statement containing facts and if they contain accounting information and
data they are called accounting reports. So, report may be known as process of
providing accounting information to those who needs to make decisions. Report may
be for the past, present and for the future developments. In this unit you will study
about the objectives of reporting, need of reporting at different managerial levels, types
and modes of reporting and essentials of a successful reporting.
18.2 CONCEPT OF MANAGEMENT REPORTING

Reporting can be defined as communication of statements with related information
between the two parties. The process of providing information to the management is
88 known as management reporting. These reports are provided to the various levels of
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management on regular basis to keep the management abreast about the effectiveness Reporting to
of their respective responsibility. Reporting is an important function of the management Management
accountant as the efficient and smooth working of the business depends upon the good
reporting. The effectiveness of reporting to management to a large extent depends
upon the form and timing of its presentation. The process of reporting to management
is concerned with proper selection of financial and operating data, arranging
information in a proper form, analysing and interpreting the data and then reporting it to
the management through an appropriate method.
18.3 OBJECTIVES OF REPORTING

Main objectives of reporting can be divided under the following heads:
Accounting reports consist of financial statistics. Management cannot analyse all

significant facts regarding its business especially in case of large scale production
where the business operations are more complex in nature. Accounting reports helps
to get full information about the its entire operative activity of the firm.
i) Providing accounting information: Accounting reports consist of financial

statistics. Management may not analyse all significant facts regarding its business
operations especially in case of large scale production where the business
operations are more complex in nature. Accounting reports help to get full
information about its entire operative activity of the firm. Thus important
objective of the reporting is to provide accounting information to operating and top
level management in accurate form in understandable brief manner.
ii) To take right decision: To help the management in taking the right decisions
with suitable statements provided by the management accountant.
iii) Acceptability of the decision by all: Reporting leads to motivate people,

increases efficiency and boosting the morale of the people engaged in the various
aspects of the work of the enterprise.
iv) Maximizing the profits: To achieve this ultimate goal of any business reporting
at the right time, at right place to the right person in right manner becomes an
essential feature.
v) For better control: Abnormal events can be checked in time by obtaining the
necessary information in respect of each operating activity. Control through
reports become effective as compared to personal investigations.
18.4 REPORTING NEEDS AT DIFFERENT

MANAGERIAL LEVELS
Reporting is the lifeline of the organization. It helps in planning and control and works
as a media of communication and stimulates corrective action. Accounting system
becomes useless, if the business has no system of reporting because all decisions are
normally based on reporting system.
Need of reporting differs at different management levels. This also differs to the user
community also. There are three levels of management and the reports can be
classified according to the needs as follows:
1) Top-Level Management Reports
2) Middle Level Management Reports
3) Lower Level Management Reports 89

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Cost Volume Profit 1) Top Management Reports
Analysis
At this level reports are concerned with the following matters:
l For determining the aims of the enterprise;
l For formulation of policies and plans;
l For delegation of responsibility in successful manner to executives for the best
utlization of resources; and
l For formulating special significant plans.
It can be assumed that top brass of the business only needs reports for cost and
operational control. The report submitted to the level should be brief or we can call
it a summarized statement, which provides an overall view on the subject. Previously
these reports used to be submitted within the time framework. The time framework
may be monthly, quarterly or yearly. With the use of information technology and the
real time accounting, the whole time framework has been changed and now these
can be made available online.
Reports to top level management consist of the following:
a) Reports to the Board of Directors
b) Reports to the Chief Finance Officer
c) Reports to the Chief Production officer, and
d) Reports to the Chief Executive Marketing and Sales .
Let us study these reports in brief.
a) Reports to the Board of Directors : Generally, following reports are to be
submitted to the Board of Directors and the Chief Executive Officer (C.E.O.):
i) Different budgets,
ii) Machine utilization statement
iii) Work force utilization statement
iv) Cost analysis statement
v) Fund flow statement
vi) Cash flow statement, and
vii) Balance sheet and income statement
b) Reports to the Chief Finance Officer : Following reports are to be
submitted to the Chief Finance Officer (C.F.O.) :
i) Cash flow statement,
ii) Funds flow statement,
iii) Abstract of receipts and payments and
iv) Report regarding any special problem such as make or buy,
replacement of old assets or any other.
c) Reports to the Chief Production Officer: Following reports are to be
submitted to the Chief Production Officer (C.P.O.) :
i) Cost analysis statement
ii) Machine utilization report
iii) Work force utilization statement
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iv) Materials statement, Reporting to
Management
v) Production statement showing budgeted and actual with variance and
vi) Overheads cost statement
d) Report to the Chief Executive Marketing and Sales : Following reports
are to be submitted to the Chief Executive Marketing and Sales:
i) Sales summary
ii) Reports on credit collection
iii) Reports of orders received and executed and outstanding orders
iv) Report on stock of finished goods
2) Middle Level Management Reports
The middle level management consists of the heads of various departments. The
reports at this level should show the efficiency and cost data relating to different
departments. At this level execution of plans formulated by the top management
is worked out and all the managers in each department are concerned with this.
It is also the function of middle level management to coordinate different
activities of different departments. The reports at middle level management
consists of the following:
a) Report to the General Manager : The following Reports are to be submitted
to the General Manager :
i) Administration budget,
ii) Cash and capital budget,
iii) Salaries statement of staff and
iv) Research and development budget
b) Report to the Finance Manager : The reports to be submitted to the Finance
Manager are:
i) Funds flow statement
ii) Cash flow statement
iii) Cash and bank reports
iv) Debtor’s collection period reports
v) Average payment period reports
c) Reports to the Purchase Manager : The following reports are to be
submitted to the Purchase Manager:
i) Stock level of raw material,
ii) Use of raw material,
iii) Raw material budget and actual purchases, and
iv) Budgeted cost and actual cost of purchases
d) Reports to the Works Manager : The reports submitted to the Works
Manager are:
i) Production cost report
ii) Raw material budget and actual consumption
iii) Production budget and actual production
iv) Idle time report
v) Idle capacity report
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Cost Volume Profit e) Reports to the Sales and Marketing Managers : The following reports
Analysis are to be submitted to the Sales and Marketing Manager:
i) Report of budgeted and actual sales,
ii) Report of orders booked and executed,
iii) Statement of sales ,
iv) Finished goods stock position and
v) Position of collections and debtors.
With modernization and adoption of computers in the business house, the
reporting period has been reduced tremendously and the data are ready at
hand and these can be used to prepare reports instantly. Middle level
management is connected on line with the computers within the organization,
so preparation of reports has become easy.
3) Lower Level Management Reports
At this level foremen and supervisors are concerned at the floor and they
prepare their reports physically without any expert opinion. They are
concerned with the daily work and they infuse a certain amount of
competitive spirit among the workers by comparing the output per man per
hour in a similar job. These reports include the following factors:
i) Workers efficiency report,
ii) Daily production report,
iii) Workers utilization report and
iv) Scrap report
v) Over-time report
vi) Material spoilage report
vii) Accident report etc.
18.5 TYPES OF REPORTS

Reports can be classified in various ways in which the different reports are presented
to the management such as :
1) Users Reports
2) Reports Based on Information
3) Reports Based on Nature
4) Functional Classification of Reports
Let us study each of them in brief.
1) Users Reports
Depending upon users, reports can be classified as follows :
i) Internal Users Report
ii) Special Reports
iii) Routine Reports
iv) Management Level Reports
v) External Users Reports
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Reports can be prepared according to the users. They can be: Reporting to
Management
i) Internal Users: Reports, which are prepared for the use of different levels
of management and for the use of the employees are known as the reports for
internal users. These are not public documents. These reports are aimed to
different levels of management.
ii) Special Reports: These reports play a vital part in decision-making. They
are prepared for specific reasons. While preparing this type of report the problem
under study should be clearly be defined and understood and effect of cost and
income should be considered. Comparison of cost of study and estimation of
cost and income relating to the problem should also be considered. These
reports can be prepared for any of the problems relating to : i) market analysis
ii) Make or buy decisions iii) Problems of raw material iv) Technological
changes v) labour problems vi) Cost reduction schemes or any other problems
as discussed in Unit 18 of this course.
iii) Routine Reports: These are only control reports and they are required only
when a control system exists. These are prepared daily as per scheduled time
regarding activities. Production operation reports, cost reports, research and
development reports, various budget reports, utilization of man, machine and
material reports, report regarding customer default, sales and distribution report,
administration reports, income statement and balance sheet and cash flow
statement are included in this classification.
iv) Management Level Reports: Main classification of these reports have
been provided while describing the reporting needs at different management
levels at 18.3.3.
v) Reports for External Users: These reports are prepared for the external
users who have interest in the enterprise. They are the shareholders,
debenture holders, creditors, bankers, other financial institutions, stock
exchange and the Government. They may be interested in knowing the
financial position, progress made, future-plans and growth of the company.
While preparing these reports, the information regarding the interest of all
the external users should be taken into consideration. For example, the
profit and loss account and balance sheet are prepared every year and these
statements are to be filed with the Registrar of Companies and also stock
exchange authorities.
2) Reports Based on Information
There are two types of information reports. They are : i) Operating Reports,
and ii) Financial Reports.
i) Operating Reports: These reports convey the information regarding the
operations of the business at different functional levels. These reports are
used to review and control the total production and to improve the inter-
departmental efficiency. Operating reports can further be classified as
information reports and the control reports.
l Information Reports: The reports prepared for this purpose should be
simple and clear in respect of various operating activities. These reports
are of three types, viz., trend reports, analytical reports and activity report.
In trend reports, comparative information is provided over a period
regarding the direction or trend of different activities. Analytical reports
are based on the horizontal comparison of results. This provides information
in an analytical manner about comparison of different activities for a
particular period. When reports are prepared for any particular activity
of the business then they are known as activity reports. Segment reports
are also information reports. 93
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Cost Volume Profit l Control Reports : These reports are prepared to help the managers
Analysis in controlling the operations of the business. Various responsibility
centers are established in every business to have an effective control.
To know the performance of each responsibility center reports are
prepared for them. First important aspect regarding the performance
of the center manager and the other is concerned with the economic
performance of the center towards the goal or the business, are the
main features of these reports. These reports can be current control
reports or they can be summary control reports. Summary control
reports can be master summary control reports or these can be
subsidiary summary control reports.
ii) Financial Reports : Financial reports differ from control or information
reports. They are necessary to know the success or failure of the
management’s responsibility to shareholders through the accounting. These
reports can be of two types viz., dynamic financial reports and static
financial reports. Dynamic financial reports show the changes took place
during the year in the financial position of the business. These reports
include report of financial change, financial control reports and effective use
of funds reports. Static financial reports provide the information regarding
the position of assets and liabilities. They include balance sheet and certain
additional statements for individual items of the balance sheet.
3) Reports Based on Nature
There are three types of reports based on nature:
i) Enterprise Reports : These are the reports, which give a detailed
description of the various operating activities and financial position of the
business. They are generally meant for the external users i.e. bankers,
financial institutions, shareholders and government authorities. They are
generally regular and include annual accounts, directors’ reports, auditors
report. It is obligatory under Companies Act to furnish these reports.
ii) Control Reports : These reports have already been discussed under the
head reports based on information.
iii) Investigative Reports : These reports are specially prepared only when
to investigate a particular problem. These types of reports contain findings
and suggestions to solve the problem. These reports are helpful in taking a
decision on a particular problem.
4) Functional Classification of Reports
These reports are normally for the particular function or for a particular department
or for joint activity. They are also of two types:
i) Individual Activity Report : Report is prepared for the individual activity
of a single department working under the supervision of one executive is
known as individual activity report.
ii) Joint Activity Report : This report is prepared when joint efforts are
made in performing the activity. When the details are necessary then they
should be included in appendix. Then the results of all the joint activities are
considered under the supervision of the main supervisor.
18.6 MODES OF REPORTING

There are three modes of reporting:, 1) Written 2) Graphic, and 3) Oral. These
reports are further divided as follows :
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Modes of Reporting Reporting to
Management
Written Graphic Oral
1. Financial Statements 1. Charts 1. Group meetings

2. Tabulated Information 2. Diagram and Pictures 2. Conferences and
Conferences and Individual talks
3. Graphs
Individual Talks
3. Accounting Ratios
1) Written Reports : Written reports are prepared in the different forms to provide
information. These are as follows:
l Financial Statements: These statements provide the information regarding

the data of actual performance with budgeted figures and comparative
statements containing information over a period.
l Tabulated Information: Information related with expenditure, production,

sales and distribution is furnished in the form of tables so that the data can
easily be analyzed.
l Accounting Ratios: Accounting ratios play a vital role for the

interpretation of accounting and financial statements. Different liquidity
ratios, profitability ratios, efficiency ratios and capital structure ratios may be
used for this purpose
2) Graphic Reporting: Graphic reporting is very common in these days to present

information to the management. These reports can be submitted in the form of
graphs, diagram, pictures and charts. They are prepared when quick action is
needed.
The common charts and diagrams usually included in a report are :
i) Line Graphs : To show, for example, cumulative actual sales against

budget and/or against previous year’s actuals;
ii) Bar Charts : Generally used for showing comparison of month-wise sales
and expenses – budgeted and actuals;
iii) Pie Charts : Commonly used to show in a circular diagram the distribution
of the total sales revenue among costs, profits as also the total costs among
the different constituent elements.
3) Oral Reporting : Oral reporting may take place in the form of (1) Group
meeting, (2) Conferences, and (3) Individual talks. These oral meetings cannot be
part of important decisions, but they furnish a common platform to discuss the
problems genuinely. For decision- making the written reports have a upper hand
over all types of reports.
18.7 ESSENTIALS OF SUCCESSFUL REPORTING

(GUIDING PRINCIPLES)
Business report is a media of communication that contains factual, correct and clear
information and it should be able to add to the knowledge of the recipient. It should be
easy to understand the problem of the event reported to him. Accounting reports
become ideal if they follow the following guidelines: 95
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Cost Volume Profit 1) Content and the shape : While making a draft of the report the following heads
Analysis should be kept in mind:
1.1 Suitable title : Title should be short and suitable to the content.
1.2 Time : It should give time and the person for whom it is prepared.
1.3 Facts : Report should contain facts and not the opinions.
1.4 Totals : Where statistics are required, only relevant data should be provided
and details may be given in appendix.
1.5 Objectives : Contents should serve the purpose for which it is prepared.
1.6 Synchronize : The contents should be in logical sequence.
2) Precise : Report should not be lengthy. It should be precise, specific and concise.
It should not contain irrelevant matter. If details are necessary then they should
be included in appendix.
3) Accuracy : The information provided in the reports should be accurate.
4) Comparable : It should be prepared in such a manner that comparison with past
and predetermined standards can be made.
5) Simple : Report should be simple and should not contain any ambiguity.
6) Timeliness : Reports should be prepared and presented in time, so that decisions
can be taken promptly and further deviations checked.
7) Consistency : For comparison consistency is necessary. Uniform system of
collection, classification and presentation of the information should be followed.
8) Attractiveness : The report should be eye-catching in the sense that it does not
go unheeded by the users.
9) Jargon : All technical jargon should be avoided as for possible since the reader
may not understand these and, therefore, may become hostile to even the spirit of
the report.
10) Highlighting Deviations : Report should highlight the variations and trouble
spots which are significant to the organisation.
11) Assumptions : Assumptions used in the preparation of reports should be stated
neatly, precisely and separately.
12) Effective Communication : Report that communicates effectively to all levels
of management stimulates action and influence decisions. Detailed planning,
codification and timely processing of data are the essential requisites for effective
reporting.
13) Figures and data : These should be presented is a tabular form preferably in
annexure at the end of the report.
Check Your Progress
1) Define reporting to management.
................................................................................................................................
................................................................................................................................
96 ................................................................................................................................
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2) Explain any two objectives of reporting. Reporting to
Management
................................................................................................................................
................................................................................................................................
................................................................................................................................
3) What is control report?
................................................................................................................................
................................................................................................................................
................................................................................................................................
4) What are the types of reports, which are required by the middle level of
management? Name any five.
1. ................................................... 3 ................................... 5 ...............................
2. ................................................... 4 ...................................
5) What are the different modes of reporting?
................................................................................................................................
................................................................................................................................
................................................................................................................................
18.8 LET US SUM UP

One should be very clear about the objective of the report before preparing it. He
should be able to clearly define and understand the problem for which the report is
going to be presented. Needs of report differs at different management levels. So this
should be decided that which level of management will use the particular report. Mode
of reporting is also important regarding the presentation. Report will be a users report
or information report or any other type of report. Certain guiding principles such as
brief, sequencing, consistency, comparability, timeliness, accuracy, attractiveness,
simplicity, shape and contents are very important and these should be taken into mind
while preparing a report.
18.9 KEY WORDS

Static Financial Report : Providing information about the position of assets and
liabilities of the concern.
Graphic Reports : Information supplied in the form of Charts, Diagrams, Pictures
etc.
Reporting : Providing information to the person concerned.
Dynamic Financial Report : The information regarding the change that took place in
the position of assets and liabilities of a firm
Operating Reports : Information regarding the operating of a business at different
functional levels
Accuracy: correct, right
Consistency: Uniformity
Synchronize: Clear sequence
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Cost Volume Profit
Analysis 18.10 ANSWERS TO CHECK YOUR PROGRESS
4) Names of five reports:
1. Administrative Budget
2. Funds Flow Statement
3. Cash Flow Statement
4. Stock Level of Raw Material
5. Production Cost Report
5) Modes of Reporting:
1. Written: Financial Statements
Tabulated Information
Accounting Ratios
2. Graphic: Charts
Diagram and Pictures
Graphs
3. Oral: Group Meetings
Conferences and Individual Talks

1) What do you mean by accounting reports? What are the different types of
reports for internal use? Discuss each of them.
2) What are the special reports? What matters may be covered by the special
reports?
3) Describe the reporting needs of different levels of management and how a
system of reporting can satisfy it?
4) What are the essentials of a good report? Describe.
5) Explain the different types of the reports that are used in an enterprise
6) “Accounting Reports are a matter of necessity for the management and not a
matter of convenience” Discuss.
Note: These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.
98

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MC1C3 ACCOUNTING FOR MANAGERIAL DECISIONS

Module – 1 : Management Accounting: Nature, Scope and functions- Role of Management

Module – 5 : Performance Measurement : Financial and Non-financial Measurement- Performance-

( Theory : 40% and Problems : 60% )

1. Cost and Management Accounting- by SP Jain and KL Narang. (Kalyani)

Accounting for Managerial Decisions Page 3

UNIT Particulars Page No.

2. COST CONCEPTS AND CLASSIFICATION 9

3. EMERGING COSTING APPROACHES 14

4. CAPITAL INVESTMENT PROCESS 19

5. RISK ANALYSIS IN CAPITAL BUDGETING 38

6. CVP ANALYSIS AND DECISION MAKING 42

7. COST VOLUME PROFIT ANALYSIS 49

8. MANAGERIAL APPLICATION OF CVP 56

10. COST CONTROL 74

11. PERFORMANCE MEASUREMENT 79

12. TRANSFER PRICING 86

Accounting for Managerial Decisions Page 4

Accounting for Managerial Decisions Page 5

Accounting for Managerial Decisions Page 6

Relationship between Management Accounting and Cost Accounting:

Accounting for Managerial Decisions Page 7

Accounting for Managerial Decisions Page 8

Accounting for Managerial Decisions Page 9

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Accounting for Managerial Decisions Page 13

CLASSIFICATION OF QUALITY COSTS

Quality costs can be classified under three heads:

Kaizen means improvement, continuous improvement, involving everyone in the organization,

Accounting for Managerial Decisions Page 15

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Accounting for Managerial Decisions Page 17

Accounting for Managerial Decisions Page 18

2) Cost of addition, expansion, improvement or alteration in the fixed assets.

3) Cost of replacement of permanent assets.

4) Research and development project cost, etc.

Definitions of Capital Budgeting

The following procedure may be adopted in the capital investment process:

Accounting for Managerial Decisions Page 19

7) Performance Review: Evaluation of performance is made through post completion audit by

A) Traditional methods: These comprise of:

1) Pay-back Period Method or Pay out or Pay off Method.

2) Improvement of Pay-back Period Method.

3) Accounting Rate of Return or Average Rate of Return Method

1) Net Present Value Method

2) Internal Rate of Return Method

3) Profitability Index Method

4) Net Terminal Value Method

Accounting for Managerial Decisions Page 20

The pay-back period can be calculated as follows:

= 5,00,000 / 1,00,000 = 5 years.

Year Annual cash Cumulative

Hence pay-back period = 3years and 6 months.

Accounting for Managerial Decisions Page 21

Particulars Amount (Rs)

Profit before tax 80,000

Less tax @ 50% 40,000

Profit after tax 40,000

Add back depreciation@12% on 5,00,000 60,000

Profit before depreciation but after tax 1,00,000