Financial &Cost

Accounting
(105A)
(As per the Maharaja Chhatrasal Bundelkhand University Syllabus)

By

Miss Sakshi Thakur (MBA)

Approved By,
Dr. Mohd. Ashfaq Siddiqui
HOD, Department of business management
INFINITY MANAGEMENT AND ENGINEERING COLLEGE, SAGAR
(M.P.)
 Distribution of Marks
S. Max.
No. Paper Title
Marks External Internal No. of
No. Max. Min. Max. Min. Lectur
Marks Marks Marks Marks es
Financial And Cost 80 32 20 8 60]
5. 105A Accounting 100

Essential & Suggested Readings :

 Anthony R N and Reece J S. Accounting Principles, 6th ed., Homewood, Illinois,
Richard D. Irwin, 1995.
MAX.
UNITS CONTEN HOURS
TS
UNIT – The basic accounting principles books of accounts, journals ledger 15 Hours
I etc. adjustment entries trial balance, preparation of trading account,
profit & Loss Account.
UNIT – Final Accounts, the Balance sheet, Responsibility Accounting 15 Hours
II

UNIT – Cost Accounting; Objectives of cost accounting, methods & 15 Hours

III techniques of costing, elements of cost, Cost Sheet-Output or Unit
costing.
UNIT – Contract costing, application & features, Costing procedure, Process 15 Hours
IV costing, Reconciliation of cost and financial statement, Cost Audit

 Bhattacharya S K and Dearden J. Accounting for Management. Text and Cases.

New Delhi, Vikas, 1996.
 Heitger, L E and Matulich, Serge. Financial Accounting. New York, McGraw
Hill, 1990.
 Hingorani, N L. and Ramanathan, A R. Management Accounting. 5th ed., New
Delhi, Sullan Chand, 1992.
 Horngren, Charles etc. Principles of Financial and Management Accounting.
Englewood Cliffs, New Jersey, Prentice Hall Inc., 1994.
 Needles, Belverd, etc. Financial and Managerial Accounting. Boston, Houghton
Miffin Company, 1994.
 Vij, Madhu. Financial and Management Accounting. New Delhi, Anmol
Publications, 1997.
 Notes
Unit 1

What is Accounting? - Meaning and Important Concepts

Accounting has been hailed by many as the “language of business”. There are many
quotations like “A pen is mightier than the sword but no match for the accountant” by
Jonathan Glancey which tell us about the power and importance of accounting.
The text book definition of accounting states that it includes recording,
summarizing, reporting and analyzing financial data. Let us try and understand the
components of accounting to understand what it really means:
1. Recording

The primary function of accounting is to make records of all the transactions that
the firm enters into. Recognizing what qualifies as a transaction and making a
record of the same is called bookkeeping.
Bookkeeping is narrower in scope than accounting and concerns only the
recording part. For the purpose of recording, accountants maintain a set of books.
Their procedures are very systematic. Nowadays, computers have been deployed
to automatically account for transactions as they happen.
2. Summarizing

Recording for transactions creates raw data. Pages and pages of raw data are of
little use to an organization for decision making. For this reason, accountants
classify data into categories. These categories are defined in the chart of accounts.
As and when transactions occur, two things happen, firstly an individual record is
made and secondly the summary record is updated.
For instance a sale to Mr. X for Rs 100 would appear as:

 Sale to Mr. X for Rs 100

 Increase the total sales (summary) from 500 to 600
3. Reporting
Management is answerable to the investors about the company’s state of affairs.
The owners need to be periodically updated about the operations that are being
financed with their money. For this reason, there are periodic reports which are
sent to them.
Usually the frequency of these reports is quarterly and there is one annual report
which summarizes the performance of all four quarters. Reporting is usually done
in the form of financial statements. These financial statements are regulated by
government bodies to ensure that there is no misleading financial reporting.
 4. Analyzing
Lastly, accounting entails conducting an analysis of the results. After results have
been summarized and reported, meaningful conclusions need to be drawn.
Management must find out its positive and negative points. Accounting helps in
doing so by means of comparison. It is common practice to compare profits, cash,
sales, assets, etc with each other to analyze the performance of the business.
Debits and Credits in Accounts
Debits and credits are the building blocks of the double entry accounting system. Many
accounting students find the usage of these words confusing. Many try to understand
them by trying to draw an analogy with something they already know like plus and
minus. However, debits and credits are distinctly different from plus and minus.
Sometimes a debit entry may make an account balance go up whereas other times it will
make an account balance go down. Let’s try and understand how this debit and credit
system works.
The debit credit system can be understood to be a two layered system. The steps
involved in deciding whether an account needs to be debited or credited are as follows:

1. Ascertain the type of account

2. Ascertain the type of transaction

Ascertaining the Type of Account

Accounts are of two types the debit and the credit types. Here is how they are
distinguished

 The 4 Classifications: There are four major classifications of accounts in

accounting. They are assets, liabilities, income and expenses. Any item can be
classified as exactly one of these classifications. However, the same item may be
split into two and be part asset and part expense and so on.
 Divide into Two Groups: We could consolidate these 4 categories into 2
categories. Expenses and assets denote outflow of resources from the firm. Income
and Liabilities denote inflow of resources to the firm. Thus accounts can be
classified as outflow and inflow
i. The outflow accounts i.e. expenses and assets have a by default debit
balance
ii. The inflow accounts i.e. income and sales have a by default credit balance

When you debit an account which has a default debit balance, you increase its value.
When you credit an account which has a default debit balance, you decrease its value.
The same is true for credit accounts as well.
Ascertain the Type of Transaction
Now you can decide whether to debit or credit an account. Let’s say you have to increase
the cash balance. Cash is an asset and therefore has a default debit balance. When you
debit it further, you increase its balance. Therefore, you will debit the cash account.
Similarly you can ascertain whether an item needs to be debited or credited. As a check,
you must ensure that the debits in every transaction are equal to the credits. This is like
the fundamental principle of accounting.
The Golden Rules of Accounting

1. Debit The Receiver, Credit The Giver

This principle is used in the case of personal accounts. When a person gives
something to the organization, it becomes an inflow and therefore the person must
be credit in the books of accounts. The converse of this is also true, which is why
the receiver needs to be debited.

2. Debit What Comes In, Credit What Goes Out

This principle is applied in case of real accounts. Real accounts involve

machinery, land and building etc. They have a debit balance by default. Thus
when you debit what comes in, you are adding to the existing account balance.
This is exactly what needs to be done. Similarly when you credit what goes out,
you are reducing the account balance when a tangible asset goes out of the
organization.

3. Debit All Expenses And Losses, Credit All Incomes And Gains

This rule is applied when the account in question is a nominal account. The capital
of the company is a liability. Therefore it has a default credit balance. When you
credit all incomes and gains, you increase the capital and by debiting expenses and
losses, you decrease the capital. This is exactly what needs to be done for the
system to stay in balance.
The golden rules of accounting allow anyone to be a bookkeeper. They only need to
understand the types of accounts and then diligently apply the rules.
What is Single Entry System ?

Single entry accounting systems record only one side of every transaction. This happens
because they use one entry to record every transaction. Therefore single entry system
does not use nominal and real accounts. The emphasis is on cash and accounts
receivable.
Single entry accounting system can be described as a system that businesses use to
get by rather than something that companies may find desirable.
Small Firms

Single entry system is used by small firms that have just started business. Such firms do
not have the resources that are required to put up a full-fledged accounting system in
place. Hence they begin with a single entry accounting system. However as and when
their business grows most firms are compelled to adopt the double entry system. This is
because the single entry system is highly inefficient and can be used only by sole
proprietors when the scale of business is very small and the transactions to be undertaken
are not very complicated.
Incomplete Records
The biggest problem with single entry bookkeeping system is that of incomplete records.
Single entry system records only transactions that the firm is undertaking with external
parties. There are numerous transactions within the firm that are of vital importance and
need a place in the financial statements. However, the single entry system ignores these
needs and gives incomplete information to the management.
No Reconciliation

Single entry accounting system does not have provisions for reconciliation of accounts.
This means that the system does not have inbuilt error detection. Therefore, if a clerk is
doing the task of making entries in the book, the system may be prone to clerical errors.
This could lead to management having insufficient information or no information when
they have to make decisions.
Possibility of Fraud

Single entry accounting system is highly prone to frauds and embezzlement. There is
only one book of account rather than an elaborate accounting system. Hence, the internal
checks are few. In fact they are non-existent. The person making the accounts could
single handedly manipulate the books of accounts and misappropriate the resources of
the firm.
To counter this problem, Luca Pacioli and other merchants of Venice created the double
entry accounting system. This system proved to be very effective and useful and soon
became the gold standard for the industry.
What Is Double Entry System ?

In a double entry bookkeeping system there are two sides to every transaction. The
sides are equal in magnitude i.e. the debits must always equal the credits.
Large Firms

When a firm grows beyond a certain size it has to use double entry system of accounting.
This is both because it is mandated by law as well as because it is the most efficient
system.
Complete Records

Double entry accounting system keeps a record of all major accounting transactions.
These could be transactions outside the firm with third parties. Or they could be intra
firm transactions where raw material has now been converted to Work In Progress
(WIP). By making sure every record about credit as well as intra firm transactions is
being accounted for, double entry system provides the most accurate record.
Automatic Reconciliation

As the scale of a business grows, it becomes more prone to clerical errors. A clerk
accounting for a large number of transactions all day is bound to make some mistakes.
However, the double entry system does not allow these mistakes to have a cascading
effect. This is because the system is constantly checking whether total debits equal total
credits. When they are not, accountants know they are dealing with an error. They can
then find out the error, correct it and then move forward. This saves a lot of time and
builds incredible accuracy in the system.
However the double entry accounting system is not 100% error proof. There is a
possibility that an entry may have been completely omitted or that there may have
been compensating errors done while passing the entry.
Fraud is Difficult

Just like reconciliation, when a business grows, more and more responsibilities need to
be entrusted to workers. Many times this leads to frauds by the workers as they embezzle
cash and make use of resources for personal benefits. However, the double entry
accounting system, when used correctly prevents such situations from arising. The
system has strong inbuilt controls to avoid misuse of any resources.
1. The basic accounting principles:

The basic accounting concepts are referred to as the fundamental ideas or basic
assumptions underlying the theory and practice of financial accounting and are broad
working rules for all accounting activities and developed by the accounting profession.
The important concepts have been listed as below:
• Business entity;
• Money measurement;
• Going concern;
• Accounting period;
• Cost
• Dual aspect (or Duality);
• Revenue recognition (Realisation);
• Matching;
• Full disclosure;
• Consistency;
• Conservatism (Prudence);
• Materiality;
• Objectivity.

i. Business Entity Concept

The concept of business entity assumes that business has a distinct and separate entity
from its owners. It means that for the purposes of accounting, the business and its
owners are to be treated as two separate entities. Keeping this in view, when a person
brings in some money as capital into his business, in accounting records, it is treated as
liability of the business to the owner. Here, one separate entity (owner) is assumed to be
giving money to another distinct entity (business unit). Similarly, when the owner
withdraws any money from the business for his personal expenses(drawings), it is
treated as reduction of the owner’s capital and consequently a reduction in the liabilities
of the business. The accounting records are made in the book of accounts from the point
of view of the business unit and not that of the owner. The personal assets and liabilities
of the owner are, therefore, not considered while recording and reporting the assets and
liabilities of the business. Similarly, personal transactions of the owner are not recorded
in the books of the business, unless it involves inflow or outflow of business funds.
 ii. Money Measurement Concept

The concept of money measurement states that only those transactions and happenings in
an organisation which can be expressed in terms of money such as sale of goods or
payment of expenses or receipt of income, etc., are to be recorded in the book of accounts.
All such transactions or happenings which can not be expressed in monetary terms, for
example, the appointment of a manager, capabilities of its human resources or creativity
of its research department or image of the organisation among people in general do not
find a place in the accounting records of a firm. Another important aspect of the concept
of money measurement is that the records of the transactions are to be kept not in the
physical units but in the monetary unit. For example, an organisation may, on a particular
day, have a factory on a piece of land measuring 2 acres, office building containing 10
rooms,30 personal computers, 30 office chairs and tables, a bank balance of `5 lakh, raw
material weighing 20-tons, and 100 cartons of finished goods. These assets are expressed
in different units, so can not be added to give any meaningful information about the total
worth of business. For accounting purposes, therefore, these are shown in money terms
and recorded in rupees and paise. In this case, the cost of factory land may be say ` 2 crore;
office building ` 1 crore; computers `15 lakh; office chairs and tables ` 2 lakh; raw material
` 33 lakh and finished goods ` 4 lakh. Thus, the total assets of the enterprise are valued at
` 3 crore and 59 lakh. Similarly, all transactions are recorded in rupees and paise as and
when they take place. The money measurement assumption is not free from limitations.
Due to the changes in prices, the value of money does not remain the same over a period
of time. The value of rupee today on account of rise in prices is much less than what it
was, say ten years back. Therefore, in the balance sheet, when we add different assets
bought at different points of time, say building purchased in 1995 for ` 2 crore, and plant
purchased in 2005 for ` 1 crore, we are in fact
adding heterogeneous values, which can not be clubbed together. As the change in the
value of money is not reflected in the book of accounts, the accounting data does not reflect
the true and fair view of the affairs of an enterprise.

iii. Going Concern Concept

The concept of going concern assumes that a business firm would continue to carry out its
operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in
the foreseeable future. This is an important assumption of accounting as it provides the
very basis for showing the value of assets in the balance sheet. An asset may be defined
as a bundle of services. When we purchase an asset, for example, a personal computer, for
a sum of ` 50,000, what we are
buying really is the services of the computer that we shall be getting over its estimated life
span, say 5 years. It will not be fair to charge the whole amount of ` 50,000, from the
revenue of the year in which the asset is purchased. Instead, that part of the asset which
has been consumed or used during a period should be charged from the revenue of that
period. The assumption regarding continuity of business allows us to charge from the
revenues of a period only that part of the asset which has been consumed or used to earn
that revenue in that period and carry forward the remaining amount to the next years, over
the estimated life of the asset. Thus, we may charge ` 10,000 every year for 5 years from
the profit and loss account. In case the continuity assumption is not there, the whole cost
(` 50,000 in the present example) will need to be charged from the revenue of the year in
which the asset was purchased.

iv. Accounting Period Concept

Accounting period refers to the span of time at the end of which the financial statements
of an enterprise are prepared, to know whether it has earned profits or incurred losses
during that period and what exactly is the position of its assets and liabilities at the end of
that period. Such information is required by different users at regular interval for various
purposes, as no firm can wait for long to know its financial results as various decisions are
to be taken at regular intervals on the basis of such information. The financial statements
are, therefore, prepared at regular interval, normally after a period of one year, so that
timely information is made available to the users. This interval of time is called accounting
period. The Companies Act 2013 and the Income Tax Act require that the income
statements should be prepared annually. However, in case of certain situations, preparation
of interim financial statements become necessary. For example, at the time of retirement
of a partner, the accounting period can be different from twelve months period. Apart from
these companies whose shares are listed on the stock exchange, are required to publish
quarterly results to ascertain the profitability and financial position at the end of every
three months period.

v. Cost Concept

The cost concept requires that all assets are recorded in the book of accounts at their
purchase price, which includes cost of acquisition, transportation, installation and
making the asset ready to use. To illustrate, on June 2005, an old plant was purchased for
` 50 lakh by Shiva Enterprise, which is into the business of manufacturing detergent
powder. An amount of ` 10,000 was spent on transporting the plant to the factory site. In
addition, ` 15,000 was spent on repairs for bringing the plant into running position and `
25,000 on its installation. The total amount at which the plant will be recorded in the
books of account would be the sum of all these, i.e.
` 50,50,000. The concept of cost is historical in nature as it is something, which has been
paid on the date of acquisition and does not change year after year. For example, if a
building has been purchased by a firm for ` 2.5 crore, the purchase price will remain the
same for all years to come, though its market value may change. Adoption of historical
cost brings in objectivity in recording as the cost of acquisition is easily verifiable from
the purchase documents. The market value basis, on the other hand, is not reliable as the
value of an asset may change from time to time, making the comparisons between one
period to another rather difficult. However, an important limitation of the historical cost
basis is that it does not show the true worth of the business and may lead to hidden
profits. Duringthe period of rising prices, the market value or the cost at (which the
assets can be replaced are higher than the value at which these are shown in the book of
accounts) leading to hidden profits.

vi. Dual Aspect Concept

Dual aspect is the foundation or basic principle of accounting. It provides the very basis
for recording business transactions into the book of accounts. This concept states that
every transaction has a dual or two-fold effect and should therefore be recorded at two
places. In other words, at least two accounts will be involved in recording a transaction.
This can be explained with the help of an example. Ram started business by investing in
a sum of ` 50,00,000. The amount of money brought in by Ram will result in an increase
in the assets (cash) of business by ` 50,00,000. At the same time, the owner’s equity or
capital will also increase by an equal amount. It may be seen that the two items that got
affected by this transaction are cash and capital account. Let us take another example to
understand this point further. Suppose the firm purchase goods worth ` 10,00,000 on
cash. This will increase an asset (stock of goods) on the one hand and reduce another
asset (cash) on the other. Similarly, if the firm purchases a machine worth ` 30,00,000 on
credit from Reliable Industries. This will increase an asset (machinery) on the one hand
and a liability (creditor) on the other. This type of dual effect takes place in case of all
business transactions and is also known as duality principle. The duality principle is
commonly expressed in terms of fundamental Accounting Equation, which is as follows
:
Assets = Liabilities + Capital
In other words, the equation states that the assets of a business are always equal to the
claims of owners and the outsiders. The claims also called equity of owners is termed as
Capital(owners’ equity) and that of outsiders, as Liabilities(creditors equity). The two-
fold effect of each transaction affects in such a manner that the equality of both sides of
equation is maintained.
The two-fold effect in respect of all transactions must be duly recorded in the book of
accounts of the business. In fact, this concept forms the core of Double Entry System of
accounting, which

vii. Revenue Recognition (Realisation) Concept

The concept of revenue recognition requires that the revenue for a business transaction
should be included in the accounting records only when it is realised. Here arises two
questions in mind. First, is termed as revenue and the other, when the revenue is realised.
Let us take the first one first. Revenue is the gross inflow of cash arising from (i) the sale
of goods and services by an enterprise; and (ii) use by others of the enterprise’s
resources yielding interest, royalties and dividends. Secondly, revenue is assumed to be
realised when a legal right to receive it arises, i.e. the point of time when goods have
been sold or service has been rendered. Thus, credit sales are treated as revenue on the
day sales are made and not when money is received from the buyer. As for the income
such as rent, commission, interest, etc. these are recongnised on a time basis. For
example, rent for the month of March 2017, even if received in April 2017, will be taken
into the profit and loss account of the financial year ending March 31, 2017 and not into
financial year beginning with April 2017.

Similarly, if interest for April 2017 is received in advance in March 2017, it will be
taken to the profit and loss account of the financial year ending March 2018. There are
some exceptions to this general rule of revenue recognition. In case of contracts like
construction work, which take long time, say 2-3 years to complete, proportionate
amount of revenue, based on the part of contract completed by the end of the period is
treated as realised. Similarly, when goods
are sold on hire purchase, the amount collected in installments is treated as realised.

viii. Matching Concept

The process of ascertaining the amount of profit earned or the loss incurred during a
particular period involves deduction of related expenses from the revenue earned during
that period. The matching concept emphasises exactly on this aspect. It states that
expenses incurred in an accounting period should be matched with revenues during that
period. It follows from this that the revenue and expenses incurred to earn these revenues
must belong to the same accounting period. As already stated, revenue is recognised
when a sale is complete or service is rendered rather when cash is received. Similarly, an
expense is recognized not when cash is paid but when an asset or service has been used
to generate revenue. For example, expenses such as salaries, rent, insurance are
recognized on the basis of period to which they relate and not when these are paid.
Similarly, costs like depreciation of fixed asset is divided over the periods during which
the asset is used. Let us also understand how cost of goods are matched with their sales
revenue. While ascertaining the profit or loss of an accounting year, we should not take
the cost of all the goods produced or purchased during that period but consider only the
cost of goods that have been sold during that year. For this purpose, the cost of unsold
goods should be deducted from the cost of the goods produced or purchased. You will
learn about this aspect in detail in the
chapter on financial statement. The matching concept, thus, implies that all revenues
earned during an accounting year, whether received during that year, or not and all costs
incurred, whether paid during the year, or not should be taken into account while
ascertaining profit or loss for that year.

ix. Full Disclosure Concept

Information provided by financial statements are used by different groups of people such
as investors, lenders, suppliers and others in taking various financial decisions. In the
corporate form of organisation, there is a distinction between those managing the affairs
of the enterprise and those owning it. Financial statements, however, are the only or
basic means of communicating financial information to all interested parties. It becomes
all the more important,
therefore, that the financial statements makes a full, fair and adequate disclosure of all
information which is relevant for taking financial decisions. The principle of full
disclosure requires that all material and relevant facts concerning financial performance
of an enterprise must be fully and completely disclosed in the financial statements and
their accompanying footnotes. This is to enable the users to make correct assessment
about the profitability and
financial soundness of the enterprise and help them to take informed decisions. To
ensure proper disclosure of material accounting information, the Indian Companies Act
1956 has provided a format for the preparation of profit and loss account and balance
sheet of a company, which needs to be compulsorily adhered to, for the preparation of
these statements. The regulatory bodies like SEBI, also mandates complete disclosures
to be made by the companies, to give a true and fair view of profitability and the state of
affairs.

x. Consistency Concept

The accounting information provided by the financial statements would be useful in

drawing conclusions regarding the working of an enterprise only when it allows
comparisons over a period of time as well as with the working of other enterprises. Thus,
both inter-firm and inter-period comparisons are required to be made. This can be
possible only when accounting policies and practices followed by enterprises are
uniform and are consistent over the period of time. To illustrate, an investor wants to
know the financial performance of an enterprise in the current year as compared to that
in the previous year. He may compare this year’s net profit with that in the last year. But,
if the accounting policies adopted, say with respect to depreciation in the two years are
different, the profit figures will not be comparable. Because the method adopted for the
valuation of stock in the past two years is inconsistent. It is, therefore, important that the
concept of consistency is followed in preparation of financial statements so that the
results of two accounting periods are comparable. Consistency eliminates personal bias
and helps in achieving results that are comparable. Also the comparison between the
financial results of two enterprises would be meaningful only if same kind of accounting
methods and policies are adopted in the preparation of financial statements. However,
consistency does not prohibit change in accounting policies. Necessary required changes
are fully disclosed by presenting them in the financial statements indicating their
probable effects on the financial results of business.

xi. Conservatism Concept

The concept of conservatism (also called ‘prudence’) provides guidance for recording
transactions in the book of accounts and is based on the policy of playing safe. The
concept states that a conscious approach should be adopted in ascertaining income so
that profits of the enterprise are not overstated. If the profits ascertained are more than
the actual, it may lead to distribution of dividend out of capital, which is not fair as it
will lead to reduction in the capital of the enterprise. The concept of conservatism
requires that profits should not to be recorded
until realised but all losses, even those which may have a remote possibility, are to be
provided for in the books of account. To illustrate, valuing closing stock at cost or
market value whichever is lower; creating provision for doubtful debts, discount on
debtors; writing of intangible assets like goodwill, patents, etc. from the book of
accounts are some of the examples of the application of the principle of conservatism.
Thus, if market value of the goods purchased has fallen down, the stock will be shown at
cost price in the books but if the market value has gone up, the gain is not to be recorded
until the stock is sold. This approach of providing for the losses but not recognising the
gains until realised is called conservatism approach. This may be reflecting a generally
pessimist attitude adopted by the accountants but is an important way of dealing with
uncertainty and protecting the interests of creditors against an unwanted distribution of
firm’s assets. However, deliberate attempt to underestimate the value of assets should be
discouraged as it will lead to hidden profits, called secret reserves.

xii. Materiality Concept

The concept of materiality requires that accounting should focus on material facts.
Efforts should not be wasted in recording and presenting facts, which are immaterial in
the determination of income. The question that arises here is what is a material fact. The
materiality of a fact depends on its nature and the amount involved. Any fact would be
considered as material if it is reasonably believed that its knowledge would influence the
decision of informed user of financial statements. For example, money spent on creation
of additional capacity of a theatre would be a material fact as it is going to increase the
future earning capacity of the enterprise. Similarly, information about any change in the
method of depreciation adopted or any liability which is likely to arise in the near future
would be significant information. All such information
about material facts should be disclosed through the financial statements and the
accompanying notes so that users can take informed decisions. In certain cases, when the
amount involved is very small, strict adherence to accounting principles is not required.
For example, stock of erasers, pencils, scales, etc. are not shown as assets, whatever
amount of stationery is bought in an accounting period is treated as the expense of that
period, whether consumed or not. The amount spent is treated as revenue expenditure
and taken to the profit and loss account of the year in which the expenditure is incurred.

xiii. Objectivity Concept

The concept of objectivity requires that accounting transaction should be recorded in an

objective manner, free from the bias of accountants and others. This can be possible
when each of the transaction is supported by verifiable documents or vouchers. For
example, the transaction for the purchase of materials may be supported by the cash
receipt for the money paid, if the same is purchased on cash or copy of invoice and
delivery challan, if the same is purchased on credit. Similarly, receipt for the amount
paid for purchase of a machine becomes the documentary evidence for the cost of
machine and provides an objective basis for verifying this transaction. One of the
reasons for the adoption of ‘Historical Cost’ as the basis of recording accounting
transaction is that adherence to the principle of objectivity is made possible by it. As
stated above, the cost actually paid for an asset can be verified from the documents but it
is very difficult to ascertain the market value of an asset until it is actually sold. Not only
that, the market value may vary from person to person and from place to place, and so
‘objectivity’ cannot be maintained if such value is adopted for accounting purposes.
3 Golden rules of accounting

1. Debit the receiver and credit the giver

2. Debit what comes in and credit what goes out
3. Debit expenses and losses, credit income and gains

What Is a Journal?
A journal is a running record of all of a business's financial transactions. It is used to
reconcile accounts and is transferred to other accounting records, such as the general
ledger.

The journal states the date of a transaction, which accounts were affected, and the dollar
amounts, usually in a double-entry bookkeeping method.

Understanding a Journal
For accounting purposes, a journal may be a physical record or a digital document
stored as a book, a spreadsheet, or data entered into accounting software. When a
transaction is made, a bookkeeper records it as a journal entry. If the expense or income
affects one or more business accounts, the journal entry will detail that as well.

Journaling is an essential part of objective record-keeping. Journals are straightforward

to review and easily transferred later in the accounting process. Journals, in addition to
the general ledger, are often reviewed as part of a trade or audit process.

Information that is recorded in a journal may include sales, expenses, movements of

cash, inventory, and debt. The information is best recorded immediately for the sake of
accuracy.

An accurate journal is critical to business planning, budgeting, and tax preparation.

Using Double-Entry Bookkeeping in Journals

Double-entry bookkeeping is the most common system of accounting.

Every business transaction is made up of an exchange between two accounts. Thus,

every journal entry is recorded with two columns.

For example, if a business owner purchases $1,000 worth of inventory using cash, the
bookkeeper records two transactions in a journal entry. The cash account will show a
credit of $1,000, and the inventory account, which is a current asset, will show a debit of
$1,000.

Using Single-Entry Bookkeeping in Journals

Single-entry bookkeeping is rarely used in accounting and business. It is the most basic
form of accounting and is set up like a checkbook, in that only a single account is used
for each journal entry. It is a simple running total of cash inflows and cash outflows.
If, for example, a business owner purchases $1,000 worth of inventory with cash, the
single-entry system records a $1,000 reduction in cash, with the total ending balance
below it. Separately, another line indicates that $1,000 has been deducted from the cash
account.

It is possible to separate income and expenses into two columns so a business can track
total income and total expenses, and not just the aggregate ending balance.

The Journal in Investing and Trading

A journal is also used by those in the investment finance sector. For an individual
investor or professional money manager, a journal is a comprehensive and detailed
record of trades in the investor's accounts and can be used for tax, evaluation,
and auditing purposes.

Traders use journals to keep a chronicle of their trading activities and to learn from past
successes and failures. Over time, a trader can sometimes spot the errors, emotional
decisions, or divergence from investing strategy that caused a loss.

The investor's journal typically has a record of profitable trades, unprofitable trades,
watch lists, pre- and post-market records, and notes on why an investment was
purchased or sold.

What Information Must Be Recorded in a Business Journal?

Every entry in a business journal must contain all critical information about a
transaction. In double-entry accounting, this means the date of the transaction, the
amount to be credited and debited, a brief description of the transaction, and the business
accounts that are affected by it.

Depending on the business, the journal may make room for other entries, such as the tax
implications or the impact on a subsidiary.1

What Are the Types of Journals?

The word journal has a number of meanings, but all of them refer to a running record of
events:

A personal journal is to record and reflect on events in a person's life over time.

A published journal is devoted to reporting news and events. Some are specialized
publications devoted to scientific, medical, professional, or trade interests.

A business journal is used to record business transactions as they occur.

Types of Journals
In double-entry bookkeeping, companies usually keep 7 different types of accounting
journals. This is done in order to further organize the kind of transactions into the
specific journal type where it fits.

This way, it will be easier to analyze the effects of the transactions than if they were
recorded in one journal.
The seven types of accounting journals are:

Purchase Journal
The purchase journal is where all credit purchases of merchandise or inventory are
recorded. Thus, this kind of journal must not contain transactions such as the purchase
of assets on credit because this should only be exclusively for merchandise or inventory.

Also, merchandise or inventory purchases paid by cash should not be recorded in this
journal as it is exclusively for credit purchases.

Purchase Returns Journal

This type of journal houses all returns of inventory that were originally purchased on
credit. Take note that inventory returns that were originally purchased in cash cannot be
entered into this journal.

Cash Receipts Journal

The cash receipts journal is where all cash receipts, which could be payments from
customers for the service or product that you sell, are recorded.

Sources of cash could also include, but are not limited to, debtors, income, or loans
received. This is where one would record items such as customer payments and bank
deposits.

Cash Disbursements Journal

The cash disbursements journal is where all payments to creditors using cash are noted
down. This includes payments for a variety of expenses such as payroll, suppliers’ bills,
interest paid on a loan, or mortgage payment.

The cash disbursements journal is also otherwise known as the “cash payments journal.”
Note that some companies may have specific journals for each type of expense category
they have in order to track costs more effectively.

Sales Journal
This journal records all sales of goods on credit. Sales to customers who pay in cash
should not be recorded here, but instead entered in the Cash Receipts Journal.

Sales Returns Journal

This journal is where all credit returns of merchandise or inventory are recorded. Also, if
the items were originally purchased in cash and returned in credit, they should not be
entered here but instead entered in the Purchase Returns Journal.

General Journal
The general journal is where one will record all the journal entries that do not fit into
any of the six types mentioned above. An example of a financial transaction that could
be recorded here is the purchase of an asset on credit.
This is also where we list information about credits and debits so as to form a complete
accounting system for recording transactions in double-entry bookkeeping.

A simple journal entry in a general journal will look like this:

Question 1: Prepare a journal of Manohar Lal & sons from the following transactions:-
2018 Amount

March 1 Manohar Lal & Sons started a business with cash 60,000

March 2 Purchased furniture for cash 10,000

March 4 Purchased goods for cash 25,000

March 5 Bought goods from Kamlesh 15,000

March 10 Paid cash to Kamlesh 15,000

March 16 Purchased goods from Sohan 6,000

March 18 Purchased goods from Sohan for cash 8,000

March 20 Paid rent for the of몭 ce 1,000

Solution 1
Question 2: Prepare Journal of M/s Tripathi Bros from the following
transactions:-
2018 Amount
Jan. 6 Sold goods for Cash 36,000
Jan. 8 Sold goods to Hari 30,000
Jan. 14 Received cash from Hari 18,000
Jan. 26 Received Commission 750
Jan. 27 Paid Salary to Gopal 1200
Jan. 28 Received cash from Hari 12,000
Jan. 29 Withdrew cash from of몭 ce personal use 4,000
Jan. 30 Wages paid 7,200
Jan. 30 Bought Machinery for cash 8,000

Solution 2:
Question 3: Prepare Journal of Sahil Bros. from the following transactions:-

2017 Amount

March 3 Sold goods to Dev 1,00,000

March 5 Received from Dev in full settlement of his account 98,000

March 6 Sold goods to Manmohan 80,000

March 8 Manmohan returned goods 1,000

March 15 Received from Manmohan in full settlement of his account 78,200

March16
Received cash from Ramdiscount allowed 19,500500
March20
Paid cash to Pawan and discount received from him 4,700
March25 Sold goods to Varun of the list price of Rs. 25,000 at
20% tradediscount
Journal vs Ledger\

Both journals and ledgers are useful tools in bookkeeping but each of these serves
different purposes and uses. As has been already mentioned, a journal is where a
financial transaction is first recorded.

A ledger, on the other hand, is where the results of the transactions are kept
permanently. During preparation, all financial transactions will have to be recorded
first in the journal before they are translated into the ledger.

The five types of adjusting entries

If making adjusting entries is beginning to sound intimidating, don’t worry—there

are only five types of adjusting entries, and the differences between them are clear
cut. Here are descriptions of each type, plus example scenarios and how to make
the entries.

1. Accrued revenues

When you generate revenue in one accounting period, but don’t recognize it until a
later period, you need to make an accrued revenue adjustment.

Example scenario

Your business makes custom tote bags. In February, you make $1,200 worth for a
client, then invoice them. The client pays the invoice on March 7.

You incurred expenses making the bags—cost of materials and labor, workshop
rent, utilities—in February. To accurately reflect your income for the month, you
need to show the revenue you generated. (Remember: Revenue minus expenses
equals income.)

First, you make an adjusting entry, moving the revenue from a “holding account”
(accrued receivables) to a revenue account (revenue.) Then, on March 7, when you
get paid and deposit the money in the bank, you move the money from revenue to
cash.

Example adjusting entry

In your general ledger, the adjustment looks like this. First, during February, when
you produce the bags and invoice the client, you record the anticipated income.

For the sake of balancing the books, you record that money coming out of revenue.
Then, when you get paid in March, you move the money from accrued receivables
to cash.

2. Accrued expenses

Once you’ve wrapped your head around accrued revenue, accrued expense
adjustments are fairly straightforward. They account for expenses you generated in
one period, but paid for later.

Example scenario

Suppose in February you hire a contract worker to help you out with your tote
bags. You agree in advance to pay them $400 for a weekend’s work. However,
they don’t invoice you until early March. In March, when you pay the invoice, you
move the money from accrued expenses to cash, as a withdrawal from your bank
account.

Example adjusting entry

In February, you record the money you’ll need to pay the contractor as an accrued
expense, debiting your labor expenses account.

3. Deferred revenues

If you’re paid in advance by a client, it’s deferred revenue. Even though you’re
paid now, you need to make sure the revenue is recorded in the month you perform
the service and actually incur the prepaid expenses.

Example scenario

Over the years, you’ve become well-respected in the tote bag community. You’re
invited to speak at the annual Tote Symposium, in Lodi, California.

The conference showrunners will pay you $2,000 to deliver a talk on the changing
face of the tote bag industry. They pay you in January, after you confirm you’ll be
attending. You’ll speak at the conference in March.
Example adjusting entry

First, record the income on the books for January as deferred revenue. You’ll credit
it to your deferred revenue account for now. Then, in March, when you deliver
your talk and actually earn the fee, move the money from deferred revenue to
consulting revenue.

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4. Prepaid expenses

Prepaid Expenses work a lot like deferred revenue. Except, in this case, you’re
paying for something up front—then recording the expense for the period it applies
to.

Example scenario

You rent a new space for your tote manufacturing business, and decide to pre-pay a
year’s worth of rent in December.

In December, you record it as prepaid rent expense, debited from an expense

account. Then, come January, you want to record your rent expense for the month.
You’ll move January’s portion of the prepaid rent from an asset to an expense.

5. Depreciation expenses

When you depreciate an asset, you make a single payment for it, but disperse the
expense over multiple accounting periods. This is usually done with large
purchases, like equipment, vehicles, or buildings.

At the end of an accounting period during which an asset is depreciated, the

total accumulated depreciation amount changes on your balance sheet. And each
time you pay depreciation, it shows up as an expense on your income statement.
The way you record depreciation on the books depends heavily on which
depreciation method you use. It’s a pretty complex operation involving large sums.
Considering the amount of cash and tax liability on the line, it’s smart to consult
with your accountant before recording any depreciation on the books. To get
started, though, check out our guide to small business depreciation.

Trial balance

A trial balance is a report that lists the balances of all general ledger accounts of a
company at a certain point in time. The accounts reflected on a trial balance are
related to all major accounting items, including assets, liabilities, equity,
revenues, expenses, gains, and losses. It is primarily used to identify the balance of
debits and credits entries from the transactions recorded in the general ledger at a
certain point in time.

What Does a Trial Balance Include?

A trial balance includes a list of all general ledger account totals. Each account
should include an account number, description of the account, and its final
debit/credit balance. In addition, it should state the final date of the accounting
period for which the report is created. The main difference from the general ledger
is that the general ledger shows all of the transactions by account, whereas the trial
balance only shows the account totals, not each separate transaction.

Finally, if some adjusting entries were entered, it must be reflected on a trial

balance. In this case, it should show the figures before the adjustment, the
adjusting entry, and the balances after the adjustment.

Undetectable Errors in a Trial Balance

A trial balance can trace the mathematical inaccuracy of the general ledger.
However, there are a number of errors that cannot be detected by this report:

 Error of omission: The transaction was not entered into the system.
 Error of original entry: The double-entry transaction includes the wrong
amounts on both sides.
  Error of reversal: When a double-entry transaction was entered with the
correct amounts, but the account to be debited is credited and the account to
be credited is debited.
 Principle error: The entered transaction violates the fundamental principles
of accounting. For example, the amount entered was correct and the
appropriate side was chosen, but the type of an account was wrong (e.g.,
expense account instead of liability account).
 Commission error: The transaction amount is correct, but the account
debited or credited is wrong. It is similar to the principle error described
above, but commission error is usually a result of oversight, while principle
error is a consequence of a lack of knowledge of accounting principles. You
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Preparation of Trial Balance:

The statement for trial balance can be prepared at any time in the business like at
the end of a financial year, for half yearly, at the end of a quarter, or at the end of
every month. But most often trial balance is prepared at the end of the financial
year so that it can be ensured that books of accounts are maintained with
complete accuracy. The statement for trial balance is not prepared as such for a
particular period rather it is prepared on a set date. Following are the three
methods for preparing the statement for trial balance:

1. Balance Method:

While preparing the statement of trial balance under this method, all the ledger
accounts with the debit balances are carried forward to the debit side of the trial
balance and all the ledger accounts with the credit balances are carried forward to
the credit side of the trial balance. As the name suggests, it is a method related to
the balances, so the balances are available in the ledger account at the end after
all the adjustments are carried forward to the trial balance. Also, if any of the
ledger accounts do not show any balance i.e. the total on both the debit and the
credit side is the same, then there is no need to carry it to the trial balance. So, in
the end, if the debit and credit side of the trial balance matches, it can be said that
the trial balance has been well prepared.

2. Total Amount Method:

While preparing the statement of trial balance under this method, unlike the
balance method, not only balances rather the total amount on the debit side of the
ledger account is transferred to the debit side of the trial balance and the total
amount on the credit side of the ledger account is transferred to the credit side of
the trial balance. Under this method, the statement for trial balance can be
prepared promptly after posting all the entries to ledger accounts before any
adjustments are made to them.

3. Total-cum-Balances method:

Under this method, two methods – ‘Balance Method’ and ‘Total Amount
Method’ are combined to prepare the statement of trial balance. It implies that in
total, four columns are prepared, two columns are for recording the debit and
credit balances of ledger accounts and two columns are for recording the debit
and credit totals of various ledger accounts. This method is rarely used and not so
frequently used while making the statement for the trial balance.

Format of Trial Balance according to the Balance Method:

Example of Trial Balance:

Following are the ledger balances of Ram Das Pvt. Ltd. as on the date 31 March,
2022. Prepare the Trial Balance using the following balances.
Preparation of Trading Account
At the end of the financial year or at the end of the financial accounting period, an
entity prepares the financial accounting statements to know the profit and loss and
also the financial position of the business. These statements help users of financial
accounting, information in decision making. In this article, we will see the steps of
preparation of trading account.

Trading account is the first step in the process of preparing final accounts. It helps in
finding out the gross profit or gross loss during an accounting year, which is an
important indicator of business efficiency.

It is normally prepared by a merchandising concern which purchases and sells the

goods during a particular period.

The trading account shows the gross profit or gross loss during the accounting period.
Trading account is based on matching the selling price of goods and services with the
cost of goods sold and services rendered.
Features of Trading Account

1. It is the first stage in the preparation of financial accounting statement of a

trading concern.
2. It records only the net sales and direct cost of goods sold.
3. The balance of this account discloses the gross profit and gross loss.
4. We transfer the balance of the trading account to the profit and loss account.

Contents of a Trading Account

Trading Account Statement include

 Opening Stock
 Purchases
 Direct expenses
 Gross profit

Opening Stock

In the case of trading concern, the opening stock means the finished goods only. We
take the amount of opening stock from Trial Balance.

Purchases

The amount of purchases during the year includes cash as well as credit purchases.
The deductions from purchases are purchase return, drawings of goods by the
proprietor, distribution of goods as free samples, etc.

Direct expenses

It means all those expenses which are incurred from the time of purchases to making
the goods in suitable condition. This expense includes freight inward,
octroi, wages etc.

Gross profit
If the credit side of Trading A/c is greater than the debit side of Trading A/c gross
profit will arise.

The following are the items appearing in the credit side of Trading Account

 Sales Revenue
 Closing Stock
 Gross Loss

Sales Revenue

The sales revenue i.e. the income earned from the main business activity or activities.
When goods or services are sold to customers then the income is earned.

If there is any return, it should be deducted from the sales value. As per the accrual
concept, income should be recognized as soon as it is accrued and not necessarily
only when the cash is paid for.

The Accounting standard 7 (in case of contracting business) and Accounting standard
9 (in other cases) define the guidelines for revenue recognition.

The essence of the provisions of both standards is that revenue should be recognized
only when significant risks and rewards (vaguely referred to as ownership in goods)
are transferred to the customer.

Example, if an invoice is made for the sale of goods and the term of sale is door
delivery, and then recognition of sale can be done only on getting proof of delivery of
goods at the door of the customer. And if such proof is pending at the end of the
accounting period, then we can not treat this transaction as sales but will have to treat
it as unearned income.

Closing Stock

In the case of trading business, there will be closing stocks of finished goods only.
According to the convention of conservatism, the stock is valued at cost or net
realizable value whichever is lower.
Gross Loss

When the debit side of Trading A/c is greater than the credit side of Trading A/c, the
gross loss will appear.
Example
From the following ledger balances extracted from the books of Mr. Bharath,
prepare a profit and loss account as on March 31, 2019.

Solution
Profit and Loss Account for Mr. Bharath for the Year Ended 31st March
2019
 Unit-2

Final Accounts

Final Accounts are the accounts, which are prepared at the end of a fiscal year. It
gives a precise idea of the financial position of the business/organization to the
owners, management, or other interested parties. Financial statements are primarily
recorded in a journal; then transferred to a ledger; and thereafter, the final account
is prepared.

Usually, a final account includes the following components −

 Trading Account
 Manufacturing Account
 Profit and Loss Account
 Balance Sheet

Now, let us discuss each of them in detail −

Trading Account

Trading accounts represents the Gross Profit/Gross Loss of the concern out of sale
and purchase for the particular accounting period.

Study of Debit side of Trading Account

 Opening Stock − Unsold closing stock of the last financial year is appeared
in debit side of the Trading Account as “To Opening Stock“ of the
current financial year.
 Purchases − Total purchases (net of purchase return) including cash
purchase and credit purchase of traded goods during the current financial
year appeared as “To Purchases― in the debit side of Trading Account.
 Direct Expenses − Expenses incurred to bring traded goods at business
premises/warehouse called direct expenses. Freight charges, cartage or
carriage charges, custom and import duty in case of import, gas, electricity
fuel, water, packing material, wages, and any other expenses incurred in this
regards comes under the debit side of Trading Account and appeared as
“To Particular Name of the Expenses―.
 Sales Account − Total Sale of the traded goods including cash and credit
sales will appear at outer column of the credit side of Trading Account as
 “By Sales.― Sales should be on net releasable value excluding Central
Sales Tax, Vat, Custom, and Excise Duty.
 Closing Stock − Total Value of unsold stock of the current financial year is
called as closing stock and will appear at the credit side of Trading Account.
closing Stock = Opening Stock + Net Purchases - Net Sale
 Gross Profit − Gross profit is the difference of revenue and the cost of
providing services or making products. However, it is
calculated before deducting payroll, taxation, overhead, and other interest
payments. Gross Margin is used in the US English and carries same meaning
as the Gross Profit.
Gross Profit = Sales - Cost of Goods Sold
 Operating Profit − Operating profit is the difference of revenue and the
costs generated by ordinary operations. However, it is
calculated before deducting taxes, interest payments, investment
gains/losses, and many other non-recurring items.
Operating Profit = Gross Profit - Total Operating Expenses
 Net Profit − Net profit is the difference of total revenue and the total
expenses of the company. It is also known as net income or net earnings.
Net Profit = Operating Profit - (Taxes + Interest)

Format of Trading Account

Trading Account of M/s ABC Limited

(For the period ending 31-03-2014)

Particulars Amount Particulars Amount

To Opening Stock XX By Sales XX

To Purchases XX By Closing Stock XX

To Direct Expenses XX By Gross Loss c/d XXX

To Gross Profit c/d XXX

Total XXXX Total XXXX

Manufacturing Account

Manufacturing account prepared in a case where goods are manufactured by the

firm itself. Manufacturing accounts represent cost of production. Cost of
production then transferred to Trading account where other traded goods also
treated in a same manner as Trading account.

Important Point Related to Manufacturing Account

Apart from the points discussed under the section of Trading account, there are a
few additional important points that need to be discuss here −

 Raw Material − Raw material is used to produce products and there may be
opening stock, purchases, and closing stock of Raw material. Raw material
is the main and basic material to produce items.
 Work-in-Progress − Work-in-progress means the products, which are still
partially finished, but they are important parts of the opening and closing
stock. To know the correct value of the cost of production, it is necessary to
calculate the correct cost of it.
 Finished Product − Finished product is the final product, which is
manufactured by the concerned business and transferred to trading account
for sale.
 Raw Material Consumed (RMC) − It is calculated as.
RMC = Opening Stock of Raw Material + Purchases - Closing Stock
 Cost of Production − Cost of production is the balancing figure of
Manufacturing account as per the format given below.
Manufacturing Account
(For the year ending……….)

Particulars Amount Particulars Amount

To Opening Stock of By Closing Stock of
XX XX
Work-in-Progress Work-in-Progress

To Raw Material
XX By Scrap Sale XX
Consumed

To Wages XXX By Cost of Production XXX

To Factory overheadxx (Balancing figure)

 Power or fuelxx

Dep. Of Plantxx

Rent- Factoryxx

Other Factory Exp.xx xxx

Total XXXX Total XXXX

Profit and Loss Account

Profit & Loss account represents the Gross profit as transferred from Trading
Account on the credit side of it along with any other income received by the firm
like interest, Commission, etc.

Debit side of profit and loss account is a summary of all the indirect expenses as
incurred by the firm during that particular accounting year. For example,
Administrative Expenses, Personal Expenses, Financial Expenses, Selling, and
Distribution Expenses, Depreciation, Bad Debts, Interest, Discount, etc. Balancing
figure of profit and loss accounts represents the true and net profit as earned at the
end of the accounting period and transferred to the Balance Sheet.

Profit & Loss Account of M/s ………

(For the period ending ………..)

Particulars Amount Particulars Amount

To Salaries XX By Gross Profit b/d XX

To Rent XX

By Bank Interest
To Office Expenses XX XX
received

To Bank charges XX By Discount XX

By Commission
To Bank Interest XX XX
Income

By Net Loss transfer

To Electricity Expenses XX XX
to
 To Staff Welfare Expenses XX

To Audit Fees XX

To Repair & Renewal XX

To Commission XX

To Sundry Expenses XX

To Depreciation XX

To Net Profit transfer to

XX
Balance sheet

Total XXXX Total XXXX

Balance Sheet

A balance sheet reflects the financial position of a business for the specific period
of time. The balance sheet is prepared by tabulating the assets (fixed assets +
current assets) and the liabilities (long term liability + current liability) on a
specific date.

Assets

Assets are the economic resources for the businesses. It can be categorized as −

 Fixed Assets − Fixed assets are the purchased/constructed assets, used to

earn profit not only in current year, but also in next coming years. However,
it also depends upon the life and utility of the assets. Fixed assets may be
tangible or intangible. Plant & machinery, land & building, furniture, and
fixture are the examples of a few Fixed Assets.
 Current Assets − The assets, which are easily available to discharge current
liabilities of the firm called as Current Assets. Cash at bank, stock, and
sundry debtors are the examples of current assets.
 Fictitious Assets − Accumulated losses and expenses, which are not
actually any virtual assets called as Fictitious Assets. Discount on issue of
shares, Profit & Loss account, and capitalized expenditure for time being are
the main examples of fictitious assets.
  Cash & Cash Equivalents − Cash balance, cash at bank, and securities
which are redeemable in next three months are called as Cash & Cash
equivalents.
 Wasting Assets − The assets, which are reduce or exhausted in value
because of their use are called as Wasting Assets. For example, mines,
queries, etc.
 Tangible Assets − The assets, which can be touched, seen, and have volume
such as cash, stock, building, etc. are called as Tangible Assets.

 Intangible Assets − The assets, which are valuable in nature, but cannot be
seen, touched, and not have any volume such as patents, goodwill, and
trademarks are the important examples of intangible assets.
 Accounts Receivables − The bills receivables and sundry debtors come
under the category of Accounts Receivables.
 Working Capital − Difference between the Current Assets and the Current
Liabilities are called as Working Capital.

Liability

A liability is the obligation of a business/firm/company arises because of the past

transactions/events. Its settlement/repayments is expected to result in an outflow
from the resources of respective firm.

There are two major types of Liability −

 Current Liabilities − The liabilities which are expected to be liquidated by

the end of current year are called as Current Liabilities. For example, taxes,
accounts payable, wages, partial payments of long term loans, etc.
  Long-term Liabilities − The liabilities which are expected to be liquidated
in more than a year are called as Long-term Liabilities. For example,
mortgages, long-term loan, long-term bonds, pension obligations, etc.
Grouping of Assets and Liabilities

There may be two types of Marshalling and grouping of the assets and liabilities −

 In order of Liquidity − In this case, assets and liabilities are arranged

according to their liquidity.
 In order of Permanence − In this case, order of the arrangement of assets
and liabilities are reversed as followed in order of liquidity.
Liabilities

Understanding what a company owes is the starting point of balance sheet analysis.
All outstanding financial obligations of a company are its liabilities. Long-term
liabilities mostly include debt that the company has raised for more than five years.
It can be in the form of money borrowed from a bank or funds raised through the
sale of bonds (i.e. debentures).

Current liabilities include the following:

Short-term debt and current portion of long-term debt, i.e. funds borrowed for less
than one year and the portion of long-term borrowings that is to be repaid within
one year.

Accounts payable,e. the amount yet to be paid to suppliers for materials supplied
by them.
Accrued liabilities,e. the service that a company is yet to render, but for which it
has already been paid

Shareholders’ equity
Equity or stocks provide their holders ownership interest in the company. Equity
capital is initially brought in by the company’s promoters. As the business grows,
it requires more funds.
Promoters sell some shares to investors or the general public to raise these funds.
These shares are sold at a higher price or a premium on the original. The equity
value you see on the balance sheet of a company is based on the original price. It is
known as the book value of equity.

The premium is also mentioned in the shareholders’ equity section of the balance
sheet. Some other important components of equity are:

 Retained earnings or the proportion of a company’s net income that hasn’t

been distributed to shareholders.
 Capital reserve, i.e. the part of their retained earnings set aside to invest in
fixed assets in future.
 Reserves and surplus, i.e. funds set aside to meet other future requirements

Assets
Assets are the heart of a business. This is where you should spend most of your
time when doing a balance sheet analysis. Anything a company owns, tangible or
intangible, that can generate revenue in the future, is its asset.
Accounting standards require that a possession be recognised as an asset only if its
value can be measured reliably and if it can be sold separately.
In addition to tangible or ‘hard’ assets, like land and machinery, companies own
several intangibles that qualify as an asset. These include patents, copyrights, and
trademarks. These cannot be touched or felt, but they can generate revenue, be
valued reliably, and be sold separately.

Companies record assets as ‘current’ and ‘fixed’ on the balance sheet. Fixed assets
include plant & machinery, land, and building etc. All fixed assets, apart from
land, lose value over time. This loss in value is called depreciation.
It is reported as an expense on the income statement each year. The value at which
a fixed asset is recorded on the balance sheet is the differences between its
purchase price and the total depreciation charged till the balance sheet date.
For intangible assets, the annual loss in value is called amortization. It is treated
identically to depreciation.

Current assets include the following:

 Cash
 Short-term investments in financial products, such as commercial papers, t-
bills and certificates of deposit (CDs).
 Inventory of unsold goods, raw material, and unfinished goods
 Accounts receivable, i.e. the amount the company is yet to receive for the
goods it has sold on credit

None of these assets is depreciated.

Responsibility Accounting:
Responsibility Accounting is management accounting where all the company’s
management, budgeting, and internal accounting are held responsible. The primary
objective of responsibility accounting is to hold responsible all the concerned
departments of any particular function.

In this type of accounting system, responsibility is assigned on the basis of the

knowledge and skills of the individuals. The basic motive of responsibility
accounting is to decrease the overall cost and increase the overall profit. If the
motives do not get fulfilled, the concerned people are held accountable and
answerable. Accountability is clearly defined under responsibility accounting, so
concerned people work more carefully as they are made answerable to their
seniors, management, and board of directors.
Responsibility accounting often entails the creation of monthly and annual budgets
for each responsibility centre. It also keeps track of a company’s costs and
revenues, with reports compiled monthly or annually and sent to the appropriate
manager for review. The focus of responsibility accounting is mostly on
Responsibility Center
Types of Responsibility Centers
1. Cost Center
A cost center is responsible for cost control. The main objective of the cost center
is to minimize cost. The cost center’s prime work is to check the cost of an
organisation and to limit the unwanted expenditure that the company may acquire.
Costs, in this respect, are basically classified as controllable costs and non-
controllable costs. Controllable costs are the costs that can be controlled by the
organization. Uncontrollable costs are the cost that the organization can not
control. The concerned center is made responsible and accountable for only
controllable expenses. So, it is important to distinguish between controllable costs
and non-controllable costs. The performance evaluation is done on the basis of the
actual cost that occurred and the targeted cost.

Some types of costs centers are:

Production Cost Center

Personal Cost Center
Service Cost Center
Impersonal Cost Center
Process Cost Center
Operation Cost Center
2. Revenue Center
This center is basically inclined towards the generation of leads and subsequently
increasing the overall revenue of the firm. Company’s sales team is mainly held
responsible for this. A revenue center is judged solely on its ability to generate
sales; it is not judged on the amount of costs incurred. Revenue centers are
employed in organisations that are heavily sales focused. Sales team are trained to
generate more leads and convert them. Trainings are set up for them and evaluation
of the personnel is made on the basis of the conversion rates.

3. Profit Center
A profit center refers to a center whose performance is measured in cost and
revenue both. It contributes to both revenue and expenses, resulting in profit and
loss. Profit occurs when revenues are more than costs and loss occurs when costs
are more than profits. The profit center is accountable for all the actions associated
with the sale of goods and production. The principle objective of a profit center is
to generate and maximize profit by minimising the cost incurred and increasing
sales. The accomplishment of a profit center is estimated in terms of profit growth
during a definite period.

4. Investment Center
This center is held responsible for using the company’s assets in the most efficient
way and investing them in the best opportunities in order to increase returns.
Companies evaluate the performance of an investment center according to the
revenues it brings in through investments in capital assets. An investment center is
sometimes called an investment division. Investment centers are increasingly
important for firms as financialization leads companies to seek profits from
investment and lending activities in addition to core production.

Features of Responsibility Accounting

1. Inputs and Outputs: Responsibility accounting majorly covers two most
important aspects of business i.e. costs and revenue. Costs can be identified as
inputs and revenue can be identified as outputs. Cost and revenue are the essence
of the business and need a close watch.

2. Use of Budgeting: Budgeting involves planning and controlling inputs and

outputs. Costs can be identified as inputs and revenue can be identified as outputs.
Under budgeting process, planned stats of cost and revenue are set up and then
compare with the actual cost and revenue and offset the deviations.

3. Performance Reporting: Performance reports of all the responsibility centers are

made properly and reported to seniors for evaluation. Corrective measures are
taken in case of deviations.

4. Identification of Responsibility Centers: Under responsibility accounting,

various types of responsibility centers are identified and operated to ensure the
smooth running of various functions of the organisation.

Objectives of Responsibility Accounting

1. Accountability: Responsibility Accounting makes concerned people accountable
for the results. Division needs to prepare the reports and send them to the manager.
In this way, personnel takes care of all the necessary things, as they know they
have to give proper reports to the managing authorities.
2. More Responsible Personnel: Responsibility Accounting makes the company’s
personnel more responsible for the organisation’s performance. Responsibility
accounting ensures better results, growth, proper documentation, effective and
efficient personnel, and more accountable and responsible employees.

3. Minimisation of Costs: Responsibility Accounting ensures the minimisation of

costs at various levels in order to avoid wastage of resources. A cost center ensures
a cut in costs and makes the overall cost system effective.

4. Maximisation of Profits: Under Responsibility Accounting, the main goal of the

profit center is to increase the profits of the organization over different periods of
time, which improves the overall financial position of the company.

5. Decentralisation: Responsibility Accounting decentralises power so that

personnel will have a sense of responsibility and belongingness to the organisation.

Advantages of Responsibility Accounting

1. System of Control: Responsibility Accounting sets up a system of control in a
way that concerned people are held responsible for their work and they are
accountable to their seniors and management regarding their performances.

2. Awareness: Responsibility accounting creates awareness in the workplace as the

personnel has to explain the deviation of their assigned responsibility center.

3. Better Results: As actual numbers are compared with the target numbers over
the years, management will know the reasons for the constant deviation and they
can take corrective measures carefully according to the needs of the organization.

4. Efficiency: Responsibility Accounting creates a sense of efficiency within

individual employees as their work and achievements will be reviewed.

5. Effective communication: Individual and company goals are established and

communicated in the best way.

Steps in Responsibility Accounting Process

Responsibility Accounting involves the following steps:

 Identification of responsibility sectors correctly.

  Setting goals and assigning responsibilities to the various responsibility
centers.
 Keeping an eye on their actual performance.
 Comparison of actual performance to the target.
 Finding the reasons for deviations, if any.
 Taking corrective measures.

UNIT-3

CONCEPTS OF COST- Cost is the amount of resource given up in exchange for

some goods or services. The resources given up are money or money’s equivalent
expressed in monetary units.
Cost Accounting- Cost accounting may be regarded as ``a specialised branch of
accounting which involves classification, accumulation, assignment and control of
costs.
The Costing terminology of C.I.M.A. London defines cost accounting as ``The
establishment of budgets, standard costs and actual costs of operations, processes,
activities or products, and the analysis of variances, profitability or the social use
of funds”.
`Wheldon defines cost accounting as “classifying, recording and appropriate
allocation of expenditure for determination of costs of products or services and for
the presentation of suitably arranged data for purposes of control and guidance of
management”. It is thus, a formal mechanism by means of which costs of products
or services are ascertained and controlled. Cost accounting is different from
costing in the sense that the former provides only the basis and information for
ascertainment of costs. Once the information is made available, costing can be
carried out arithmetically
by means of memorandum statements or by method of integral accounting.

Objectives of Cost Accounting

Cost accounting aims at systematic recording of expenses and analysis of the same
so as to ascertain the cost of each product manufactured or service rendered by an
organisation. Information regarding cost of each product or service would enable
the management to know where to economise on costs, how to fix prices, how to
maximise profits and so on. Thus, the main objects of cost accounting are the
following:
(1) To analyse and classify all expenditures with reference to the cost of products
and operations.
(2) To arrive at the cost of production of every unit, job, operation, process,
department or service and to develop cost standard.
(3) To indicate to the management any inefficiencies and the extent of various
forms of waste, whether of materials, time, expenses or in the use of machinery,
equipment and tools. Analysis of the causes of unsatisfactory results may indicate
remedial measures.
(4) To provide data for periodical profit and loss accounts and balance sheets at
such intervals, e.g., weekly, monthly or quarterly, as may be desired by the
management during the financial year, not only for the whole business but also by
departments or individual products. Also, to explain in detail the exact reasons for
profit or loss revealed in total, in the profit and loss account.
(5) To reveal sources of economies in production having regard to methods, types
of equipment, design, output and layout. Daily, weekly, monthly or quarterly
information may be necessary to ensure prompt and constructive action.
(6) To provide actual figures of cost for comparison with estimates and to serve as
a guide for future estimates or quotations and to assist the management in their
price-fixing policy.
(7) To show, where standard costs are prepared, what the cost of production ought
to be and with which the actual costs which are eventually recorded may be
compared.
(8) To present comparative cost data for different periods and various volumes of
output.
(9) To provide a perpetual inventory of stores and other materials so that interim
profit and loss account and balance sheet can be prepared without stock taking and
checks on stores and adjustments are made at frequent intervals. Also to provide
the basis for production planning and for avoiding unnecessary wastages or losses
of materials and stores.
(10) To provide information to enable management to make short-term decisions
of various types, such as quotation of price to special customers or during a slump,
make or buy decision, assigning priorities to various products, etc.

IMPORTANCE OF COST ACCOUNTING

Importance Of Cost Accounting:
The limitations of financial accounting have made the management to realise the
importance of cost accounting. Whatever may be the type of business, it involves
expenditure on labour, materials and other items required for manufacturing and
disposing of the product. The management has to avoid the possibility of waste at
each stage. It has to ensure that no machine remains idle, efficient labour gets due
incentive, byproducts are properly utilised and costs are properly ascertained.
Besides the management, the creditors and employees are also benefited in
numerous ways by installation of a good costing system. Cost accounting increases
the overall productivity of an organisation and serves as an important tool, in
bringing prosperity to the nation. Thus, the importance of cost accounting can be
discussed under the following headings:
(a) Costing as an Aid to Management
Cost accounting provides invaluable aid to management. It provides detailed
costing information to the management to enable them to maintain effective
control over stores and inventory, to increase efficiency of the organisation and to
check wastage and losses. It facilitates delegation of responsibility for important
tasks and rating of employees. For all these, the management should be capable of
using the information
provided by cost accounts in a proper way. The various advantages derived by the
management from a good system of costing are as follows:
1. Cost accounting helps in periods of trade depression and trade competition -
In periods of trade depression, the organisation cannot afford to have losses which
pass unchecked. The management must know the areas where economies may be
sought, waste eliminated and efficiency increased. The organisation has to wage a
war not only for its survival but also continued growth. The management should
know the actual cost of their products before embarking on any scheme of price
reduction. Adequate system of costing facilitates this.
2. Cost accounting aids price fixation - Although the law of supply and demand to
a great extent determines the price of the article, cost to the producer does play an
important role. The producer can take necessary guidance from his costing records
in case he is in a position to fix or change the price charged.
3. Cost accounting helps in making estimates - Adequate costing records provide
a reliable basis for making estimates and quoting tenders.
4. Cost accounting helps in channelising production on right lines - Proper
costing information makes it possible for the management to distinguish between
profitable and non-profitable activities. Profits can be maximised by concentrating
on profitable operations and eliminating non-profitable ones.
5. Cost accounting eliminates wastages - As cost accounting is concerned with
detailed break-up of costs, it is possible to check various forms of wastages or
losses.
6. Cost accounting makes comparisons possible - Proper maintenance of costing
records provides various costing data for comparisons which in turn helps the
management in formulation of future lines of action.
7. Cost accounting provides data for periodical profit and loss account -
Adequate costing records provide the management with such data as may be
necessary for preparation of profit and loss account and balance sheet at such
intervals as may be desired by the management.
8. Cost accounting helps in determining and enhancing efficiency - Losses due to
wastage of materials, idle time of workers, poor supervision, etc., will be disclosed
if the various operations involved in the production are studied carefully.
Efficiency can be measured, costs controlled and various steps can be taken to
increase the efficiency.
9. Cost accounting helps in inventory control - Cost accounting furnishes control
which management requires in respect of stock of materials, work-in-progress and
finished goods.
(b) Costing as an Aid to Creditors
Investors, banks and other money lending institutions have a stake in the success of
the business concern and are, therefore, benefited immensely by the installation of
an efficient system of costing. They can base their judgment about the profitability
and future prospects of the enterprise on the costing records.
(c) Costing as an Aid to Employees
Employees have a vital interest in their employer’s enterprise in which they are
employed. They are benefited by a number of ways by the installation of an
efficient system of costing. They are benefited, through continuous employment
and higher remuneration by way of incentives, bonus plans, etc.
(d) Costing as an Aid to National Economy
An efficient system of costing brings prosperity to the business enterprise which in
turn results in stepping up of the government revenue. The overall economic
development of a country takes place as a consequence increase in efficiency of
production. Control of costs, elimination of wastages and inefficiencies led to the
progress of the industry and, in consequence of the nation as a whole.

Methods of Costing:
The general fundamental principles of ascertaining costs are the same in every
system of cost accounting, but the methods of analysis and presenting the costs
vary from industry to industry. Different methods are used because business
enterprises vary in their nature and in the type of products or services they produce
or render.
Job Costing
It refers to a system of costing in which costs are ascertained in terms of specific
jobs or orders which are not comparable with each other. Industries where this
method of costing is generally applied are printing press, automobile garage, repair
shop, ship-building, house building, engine and machine construction, etc.
Contract Costing
Although contract costing does not differ in principle from job costing, it is
convenient to treat contract cost accounts separately. The term is usually applied to
the costing method adopted where large scale contracts at different sites are carried
out, as in the case of building construction.
Batch Costing
This method is also a type of job costing. A batch of similar products is regarded as
one job and the cost of this complete batch is ascertained. It is then used to
determine the unit cost of the articles produced. It should, however, be noted that
the articles produced should not lose their identity in manufacturing operations.
Terminal Costing
This method is also a type of job costing. This method emphasises the essential
nature of job costing, i.e. the cost can be properly terminated at some point and
related to a particular job.
Operation Costing
This method is adopted when it is desired to ascertain the cost of carrying out an
operation in a department, for example, welding. For large undertakings, it is
frequently necessary to ascertain the cost of various operations.
Process Costing
Where a product passes through distinct stages or processes, the output of one
process being the input of the subsequent process, it is frequently desired to
ascertain the cost of each stage or process of production. This is known as process
costing. This method is used where it is difficult to trade the item of prime cost to a
particular order because its identity is lost in volume of continuous production.
Process costing is generally adopted in textile industries, chemical industries, oil
refineries, soap manufacturing, paper manufacturing, tanneries, etc.
Unit or Single or Output or Single-output Costing
This method is used where a single article is produced or service is rendered by
continuous manufacturing activity. The cost of whole production-cycle is
ascertained as a process or series of processes and the cost per unit is arrived at by
dividing the total cost by the number of units produced. The unit of costing is
chosen according to the nature of the product. Cost statements or cost sheets are
prepared under which various items of expenses are classified and the total
expenditure is divided by total quantity produced in order to arrive at unit cost of
production. This method is suitable in industries like brick-making, collieries, flour
mills, cement manufacturing, etc. This method is useful for the assembly
department in a factory producing a mechanical article e.g., bicycle.
Operating Costing
This method is applicable where services are rendered rather than goods produced.
The procedure is same as in the case of single output costing. The total expenses of
the operation are divided by the units and cost per unit of service is arrived at. This
method is employed in railways, road transport, water supply undertakings,
telephone services, electricity companies, hospital services, municipal services, etc.
Multiple or Composite Costing
Some products are so complex that no single system of costing is applicable. It is
used where there are a variety of components separately produced and
subsequently assembled in a complex production. Total cost is ascertained by
computing component costs which are collected by job or process costing and then
aggregating the costs through use of the single or output costing system. This
method is applicable to manufacturing concerns producing motor cars, aeroplanes,
machine tools, type-writers, radios, cycles, sewing machines, etc.
Departmental Costing
When costs are ascertained department by department, the method is called
“Departmental Costing”. Usually, for ascertaining the cost of various goods or
services produced by the department, the total costs will have to be analysed, say,
by the use of job costing or unit costing.

Techniques of Costing:
The following techniques of costing are used by the management for controlling
costs and making managerial decisions:
Historical (or Conventional) Costing
It refers to the determination of costs after they have been actually incurred. It
means that cost of a product can be calculated only after its production. This
system is useful only for determining costs, but not useful for exercising any
control over costs. It can serve as a guidance for future production only when
conditions continue to be the same in future.
Standard Costing
It refers to the preparation of standard costs and applying them to measure the
variations from standard costs and analysing the variations with a view to maintain
maximum efficiency in production. What is done in this case is that costs of each
article are determined before-hand under current and anticipated conditions, but
sometimes they are determined before-hand under normal or ideal conditions. Then
actual costs are compared with the pre-determined costs and deviations known as
variances are noted down. Thereafter, the reasons for the variances are ascertained
and necessary steps are taken to prevent their recurrence.
Marginal Costing
It refers to the ascertainment of marginal costs by differentiating between fixed
costs and variable costs and the effect on profit of the changes in volume or type of
output. In this case, only the variable costs are charged to products or operations
while fixed costs are charged to profit and loss account of the period in which they
arise.
Uniform Costing
A technique where standardized principles and methods of cost accounting are
employed by a number of different companies and firms, is termed as uniform
costing. This helps in comparing performance of one firm with that of another.
Direct Costing
The practice of charging all direct costs to operations, process or products leaving
all indirect costs to be written off against profits in the period in which they arise,
is termed as direct costing.
Absorption Costing
The practice of charging all costs both variable and fixed to operation, process or
products or process is termed as absorption costing.
Activity Based Costing
In a business organization, Activity-Based Costing (ABC) is a method of assigning
the organization's resource costs through activities to the products and services
provided to its customers. It is defined as a technique of cost attribution to cost
units on the basis of benefits received from indirect activities, e.g. ordering, setting
up, assuring quality. ABC involves identification of costs with each cost driving
activity and making it as the basis of apportionment of costs over different
products or jobs on the basis of the number of activities required for their
completion. It is basically used for apportionment of overheads costs in an
organisation having products that differ in volume and complexity of production.
Under this technique, the overhead costs of the organisation are identified with
each activity which is acting as a cost driver i.e. the the cause for incurrence of
overhead cost. Such cost drivers may be purchase orders issued, quality
inspections, maintanance requests, material receipts, inventory movements, power
consumed, machine time, etc. Having identified the overhead costs with each cost
centre, cost per unit of cost driver can be ascertained. The overhead costs can be
assigned to jobs on the basis of number of activities required for their completion.
This is generally used as a tool for understanding product and customer cost and
profitability. As such, ABC has predominately been used to support strategic
decisions such as pricing, outsourcing and identification and measurement of
process improvement initiatives.
ABC principles are used: (i) to focus management attention on the total cost to
produce a product or service, and (ii) as the basis for full cost recovery. Support
services are particularly suitable for activity-based resourcing because they
produce identifiable and measurable units of output.
Activity-Based Costing encourages managers to identify which activities are value
added—those that will best accomplish a mission, deliver a service, or meet a
customer demand. It improves operational efficiency and enhances decision-
making through better, more meaningful cost information.
Elements of Cost:
There are three broad elements of costs:
(1) Material: The substance from which the product is made is known as material.
It can be direct as well as indirect.
Direct material: It refers to those materials which become a major part of the
finished product and can be easily traceable to the units. Direct materials include:
(i) All materials specifically purchased for a particular job/process.
(ii) All material acquired and latter requisitioned from stores.
(iii) Components purchased or produced.
(iv) Primary packing materials.
(v) Material passing from one process to another.
Indirect material: All material which is used for purposes ancillary to production
and which can be conveniently assigned to specific physical units is termed as
indirect materials. Examples, oil, grease, consumable stores, printing and
stationary material etc.
(2) Labour: Labour cost can be classified into direct labour and indirect labour.
Direct labour: It is defined as the wages paid to workers who are engaged in the
production process whose time can be conveniently and economically traceable to
units of products. For example, wages paid to compositors in a printing press, to
workers in the foundry in cast iron works etc.
Indirect labour: Labour employed for the purpose of carrying tasks incidental to
goods or services provided, is indirect labour. It cannot be practically traced to
specific units of output. Examples, wages of store-keepers, foreman, time-keepers,
supervisors, inspectors etc.
(3) Expenses: Expenses may be direct or indirect.
Direct expenses: These expenses are incurred on a specific cost unit and
identifiable with the cost unit. Examples are cost of special layout, design or
drawings, hiring of a particular tool or equipment for a job; fees paid to consultants
in connection with a job etc.
Indirect expenses: These are expenses which cannot be directly, conveniently and
wholly allocated to cost centre or cost units. Examples are rent, rates and taxes,
insurance, power, lighting and heating, depreciation etc.
It is to be noted that the term overheads has a wider meaning than the term indirect
expenses. Overheads include the cost of indirect material, indirect labour and
indirect expenses. overheads may be classified as
(a) production or manufacturing overheads, (b) administration overheads, (c)
selling overheads, and (d) distribution overheads.
The various elements of cost can be illustrated by the following chart:
Output- Unit Costing:
Unit costing refers to the costing procedure, under which costs are accumulated
and analyzed under different elements of cost and then cost per unit is ascertained
by dividing the total cost by number of units produced. It is ideally used in case of
concerns producing a single article on large scale by continuous manufacture. The
units of output are identical. The products are homogenous. Concern using single
or
output costing produces basically one product or two or more grades of one
product.
It is not necessary to maintain separate cost accounts under this system. as all the
information required can be obtained only by organizing and analyzing the
financial accounts. On dividing the total expenditure incurred by the number of
units produced, the cost per unit is ascertained. This system of costing is suitable
for breweries, collieries, cement works, steel, brick making, floor mills etc. In all
these cases the unit cost of the article produced requires to be ascertained.
The information on expenditure incurred on material, labour and direct expenses
can be available without any special difficulty. The works and administration
expenses actually incurred also are included in the total cost. Items of indirect
expenses which are paid at periodical intervals are included in cost accounts on the
basis of estimates. Selling and distributing expenses are not included in cost sheets
since these have no connection with the quantity produced, If, however, it is
decided to include them, the same also are estimated on the basis of past
experience.

Cost sheet
Cost sheet is a document which provides for the assembly of the detailed cost of a
cost centre or cost unit. It is a periodical statement of cost designed to show in
detail the various components of cost of goods produced like prime cost, factory
cost, cost of production, total cost and cost per unit. A specimen of a simple cost
sheet is given below:

If possible the cost sheet should have columns for (i) total cost; (ii) percentage to
total cost; (iii) cost per unit; and (iv) corresponding figures of the pervious period
and clear figures for each element of cost.
Treatment of stock
Stock requires special treatment while preparing a cost sheet. Stock may be of raw
materials, work-in progress and finished goods.
Stock of Raw Materials
If opening stock of raw material, purchase of raw materials and closing stock of
raw materials are given, then, raw material consumed can be calculated as follows:
Opening stock of raw materials
Add: Purchase of raw materials
Less: Closing stock of raw materials
Value of raw materials consumed
Stock of Work-in-Progress
Work-in-progress is valued at prime cost or works cost basis, but latter is preferred.
If it is valued at works or factory cost then opening and closing stock will be
adjusted as follows :
Prime cost —
Add: Factory overheads —
Work-in-progress (beginning) —
Less: Work-in-progress (closing) —
Works cost
Stock of Finished Goods
If opening and closing stock of finished goods are given, then these must be
adjusted before calculating cost of goods sold:
Cost of production
Add: Opening stock of finished goods
Less: Closing stock of finished goods
Cost of goods sold
USES OF COST SHEET
(i) It gives total cost and cost per unit for a particular period.
(ii) It gives information to management for cost control.
(iii) It provides comparative study of actual current costs with the cost of
corresponding periods, thus causes of inefficiencies and wastage can be known and
suitably corrected by management.
(iv) It acts as a guide to manufacture in formulation of suitable and definite
policies and in fixing up the selling price.
ITEMS EXCLUDED FROM COST SHEET
The following items are of financial nature and thus not included while preparing a
cost sheet.
(i) Cash discount
(ii) Interest paid
(iii) Preliminary expenses written off
(iv) Goodwill written off
(v) Provision for taxation
(vi) Provision for bad debts
(vii) Transfer to reserves
(viii) Donations
(ix) Income tax paid
(x) Dividend paid
(xi) Profit/loss on sale of assets
 (xii) Damages payable at law etc.

Unit- 4

Contract Costing:
Contract costing is a process of tracking costs that are associated with a specific
contract. Hence, this can be a specialized form of job costing. Nevertheless, this
system only applies to jobs which include a contractual bond. For a better
understanding, let us check an example. A company bids for a large project with a
prospective client, wherein both agree to a contract of reimbursement to the
company.
Objectives of Contract Costing
There are only two major objectives of contract costing:
 Find a comparison between the actual cost with an estimated cost
 Analyse cost to provide a basis for cost-plus pricing
 Calculate profit over the long-term contract
 Guidance for managing resource utilisation

Features of Contract Costing:

The list below highlights the features of contract costing:
 Then, after carefully including clients' requirements, a contract is drawn.
Therefore, it is highly unlikely that any of these contracts would be similar
 Each of these contracts is a distinct cost unit for the purposes of accumulating costs
 The structure of cost contact states that there are more direct expenditures in the
form of materials, wages, and usage of stores or plants. Here, only a minimum
charge is applicable for appointed overheads
 Contracts are for a longer period, typically more than a year
 The work is done at the site because it is difficult to exercise cost control
 Each contract has separate accounts to determine profitability
 Every contract work that involves construction must be done at customers’ sites
and not on factory premises
 The amount a client pays depends on the work completion stages, which need prior
approval
 In case of any delay in completing the work, contractees are liable to charge
penalties. Similarly, the contractors get bonuses if they complete the work on time
 Sometimes, an original contract is divided into several parts, out of which
specialists assign some jobs through outsourcing
 The people in charge can purchase plants and equipment or hire them for a
particular period
 These contracts include difficulty in valuation or work-in-progress status at the end
of each accounting period
 Mostly these contracts take one year or more to complete. Hence, it is common to
transfer a certain percentage to their account by the end of each accounting year
until the completion of the project

PREPARING A CONTRACT ACCOUNT

CONTRACT A/C

Particulars ` Particulars `
To Materials By materials returned **

a. Purchased directly ** By Material sold (cost

price)
**
b. Issue from site **

c. Supplied by contractee **
To Wages and salaries ** By WIP
To Other direct Expenses ** **
 To Sub-contractor fees ** Work certified Work
**
Uncertified

To Plant & Machinery By Materials at site **

(purchase price/Book value)
**
To Indirect expenditure ** By Plant and
(apportioned share of machinery(WDV)
**
overheads)
To Notional profit (Surplus) **
Total ** Total **

Material Cost:
All materials supplied from the stores or purchased directly for the contract are
debited to the concerned contract account. In case the return of surplus material
appears uneconomical on account of high cost of transportation, the same is sold
and the concerned contract account is credited with the sale price. Any loss or
profit arising therefrom is transferred to the Profit and Loss Account. Any theft,
or destruction of material by fire represent a loss and as such, the same is
transferred to the Profit and Loss Account. If the contractee has supplied some
materials without affecting the contract price, no accounting entries will be made
in the contract account, only a note may be given about it.

Labour Cost:
Labour actually employed on the site of the contract is regarded as direct
(irrespective of the nature of the task performed) and the wages paid to them are
charged to the concerned contract directly.

Direct Expenses:
Direct expenses (if any) are directly charged to the concerned contract.

Indirect Expenses:
Indirect expenses (such as expenses of engineers, surveyors, supervisors etc.)
may be distributed over several contracts as a percentage of cost of materials,
or wages paid or of the prime cost.
Plant and Machinery : The value of the plant in a contract may be either debited
to contract account and the written down value thereof at the end of the year
entered on the credit side for closing the contract account, or only a charge
(depreciation) for use of the plant may be debited to the contract account.

Sub-Contract: Sub-contract costs are also debited to the Contract Account.

Cost of work certified : All building contractors received payments periodically

known as “running payment” on the basis of the architect‟s or surveyor‟s
certificates. But payments are not equal to the value of the work certified, a small
percentage of the amount due is retained as security for any defective work which
may be discovered later within the guarantee period.

The amount retained is called retention money. The full value of the work
certified should be credited to the Contract Account and debited to the account of
the contract.

Mathematically :
Cost of work certified = Cost of work to date – (Cost of work uncertified + Material
in hand+ Plant at site)

Work uncertified : It represents the cost of the work which has been carried out
by the contractor but has not been certified by the contractee‟s architect. It is
always shown at cost price.
Micellaneous Accounts:
 (*) Transfer the entire amount to contract A/c on completion of contract.

Process Costing

With process costing, companies determine item cost by tracking the cost of each
stage in the production process, instead of tracking costs for each individual item.
After adding up the cost of all the steps in the process, they divide the total cost by
the number of items. This is called the cost per unit. For example, a paper company
might track the cost of each stage in the process of turning wood pulp into reams of
paper, then divide the total cost by the number of reams to get the cost per ream.

 Process costing is an important product costing method for manufacturing

companies that mass produce a large volume of similar products or units of output.
 Process costing is widely used in industries such as oil refining, food production,
chemical processing, textiles, glass, cement and paint manufacture.
 When using process costing, companies determine item cost by tracking the cost of
each stage in the production process, then divide the total cost by the number of
items produced.
 Companies can calculate costs using several different methods, including weighted
average costing, standard costing and first in, first out (FIFO) costing.

Homogeneous items are products that cannot be distinguished from one another —
for example, a bin of screws of the same size and type. These similar products all
generally flow through a number of stages during the production process. To use
the process costing approach to accounting, companies determine the direct costs
and manufacturing overhead for each of those stages.

These stages include direct and indirect costs. Direct costs are those directly
incurred for production, such as raw materials and machine operators’ wages.
Overhead often includes indirect costs such as equipment maintenance and facility
rent, as well as the wages of administrative staff who aren’t directly involved in
making the products.

Companies often break down these costs into direct materials and conversion costs.
Direct materials are the materials consumed at each stage; conversion costs are
process-related costs such as payroll and manufacturing overhead.

At many companies, a different department handles each stage in the production

process. Each department prepares a report that details its direct materials, direct
labor and manufacturing overhead costs. The company then aggregates these
reports to analyze total product cost.

5 Steps in Process Costing

To accurately estimate the cost of producing each unit, process costing takes into
account work in progress — items that have entered but not completed the
production process — at the start and end of each period. Here are five primary
steps in process costing.

1. Analyze inventory: Analyze the flow of items during the period to

determine the amount of inventory at the beginning of the period, how many
items were started during the period, how many were completed and
transferred out and how many were incomplete at the end of the period.

2. Calculate equivalent units: Process costing uses the concept of equivalent

units to account for items that are unfinished at the end of each period. For
this step, multiply the number of incomplete units at the end of the period by
a percentage representing their progress through the production process. For
example, if there are 2,000 units of inventory still in progress and they’re
75% complete, they are equivalent to 1,500 units for process costing
purposes (2,000 x .75 = 1,500).

3. Calculate applicable costs: Total the costs for all production stages,
including both direct materials and conversion costs.
 4. Calculate cost per unit: Divide the total cost by the number of units. This
calculation includes both completed units and equivalent units. So, if a
business completed 4,000 products and another 1,000 units got halfway
through production, the applicable costs would be divided by 4,000 +
(1,000/2) = 4,500 units. If all the costs added up across all departments to
produce those units was $16,875, simply divide the cost by the number of
units to arrive at $3.75 per unit produced.

5. Allocate costs to complete and incomplete products: Allocate costs for

the completed and ending work-in-progress inventory to the corresponding
accounts. This helps determine how much money is tied up in current work-
in-progress inventory. In the above example, since the equivalent of 500
units are in progress and it cost $3.75 to produce each unit, the work-in-
progress inventory cost is $1,875 (500 x $3.75). And the complete product
inventory cost is 4,000 x $3.75 = $15,000.

Types of Process Costing

In process costing there are three different ways to calculate costs: weighted
average, standard costing and first-in first-out (FIFO). Carefully selecting the
method that best meets your business needs is a best accounting practice.

 Weighted average costs: This is the simplest method of calculating cost.

Companies add all costs for the current period and divide by the total number of
units completed and transferred out, plus the equivalent units of work-in-progress
at the end of the period. It’s used for cases where cost fluctuations from period to
period are minor.

 Standard costs: This method uses an estimated standard cost for each process
stage instead of actual costs. Companies typically use this method when it’s too
difficult or time-consuming to collect current information about the real costs. It
can also be beneficial for businesses that make a wide range of items and find it
challenging to attribute precise costs to each of the products. The estimated totals
are compared to actual totals after a production run is finished, and the difference
is added to a variance account.
 First in, first out (FIFO): The most complicated process costing approach, FIFO
is used to obtain more precise product costing, especially in situations where costs
change significantly from one period to the next. FIFO assumes that the first units
in (i.e., work in progress at the beginning of the current period) are the first to be
completed. When calculating costs for the current period, it excludes costs incurred
during the previous period for those beginning work-in-progress unit

Reconciliation of Cost Accounts and Financial Accounts

Reconciliation of Cost and Financial Accounts is process to find all the reasons
behind disagreement in profit which is calculated as per cost accounts and as per
financial accounts. There are lots of items which are shown in the profit and loss
account only when we make it as per financial accounting rules. There are lots of
items which are shown in costing profit and loss account only when we calculate
profit as per cost accounting. Suppose, we have taken the profit or loss as per
financial accounts, we adjust it as per cost accounts. In the end of adjustments, we
see same profit as per cost accounts. If we have taken profit as per cost account, we
have to adjust items as per financial accounts. For this purpose, we make
reconciliation Statement. (a) Items included only in financial accounts There are
number of items which appear only in financial accounts, and not in cost accounts,
since they neither do nor relate to the manufacturing activities, such as,Purely
financial charges, reducing financial profit Losses on capital assets Stamp duty and
expenses on issue and transfer of stock, shares and bonds Loss on investments.
Discount on debentures, bonds, etc. Fines and penalties, Interest on bank loans.
Purely financial income, increasing financial profit Rent received Profit on sale of
assets Share transfer fee Share premium Interest on investment, bank deposits.
Dividends received. Appropriation of profit – donations and charities. (b) Items
included only in the cost accounts There are very few items which appear in cost
accounts, but not in financial accounts. Because, all expenditure incurred, whether
for cash or credit, passes though the financial accounts, and only relevant expenses
are incorporated in cost accounts. Hence, only item which can appear in cost
accounts but not in financial accounts is a notional charge, such as, (i) interest on
capital, which is not paid but included in cost accounts to show the notional cost of
employing capital, or (ii) rent i.e. charging a notional rent of premises owned by
the proprietor. (c) Items accounted for differently in cost accounting and financial
accounting Overhead – In cost accounts, overheads are applied to cost units at
predetermined rates based on estimates, and the amount recovered may differ from
actual expenses incurred. If such under-or over-recovery of overheads are not
charged off to costing profit and loss account, the profits on two sets of books will
differ. Stock valuation – In financial accounts, stock is valued at lower of cost or
market value. In cost accounts, stock is valued at cost adoption one of the methods,
such as FIFO, LIFO, average etc., which is suitable to the unit. Thus, there may be
difference in stock valuation, which will reflect difference in profit between the
two sets of books. Depreciation – If different basis is adopted for charging
depreciation in cost accounts as compared to financial accounts, the profits will
vary. Need for Reconciliation: In those concerns where there are no separate cost
and financial accounts, the problem of reconciliation does not arise. But where cost
and financial accounts are maintained independent of each other, it is imperative
that periodically two accounts are reconciled. Though both sets of books are
concerned with the same basic transactions but the figure of profit disclosed by the
former does not agree with that disclosed by the latter. Thus, reconciliation
between the results of the two sets of books is necessary due to the following
reasons: 1. To find out the reasons for the difference in the profit or loss in cost and
financial accounts and to indicate the position clearly and to be sure that no
mistakes pertaining to accounts have been committed.

2. To ensure the mathematical accuracy and reliability of cost accounts in order to

have cost ascertainment, cost control and to have a check on the financial accounts.

3. To contribute to the standardisation of policies regarding stock valuation,

depreciation and overheads.

4. To facilitate coordination and promote better cooperation between the activities

of financial and cost sections of the accounting department.

5. To place management in better position to acquaint itself with the reasons for the
variation in profits paving the way to more effective internal control. Methods of
Reconciliation: Reconciliation of costing and financial profits can be attempted
either:

(a) By preparing a Reconciliation Statement or

(b) By preparation a Memorandum Reconciliation Account. Reconciliation
Statement: When reconciliation is attempted by preparing a reconciliation
statement, profit shown by one set of accounts is taken as base profit and items of
difference are either added to it or deducted from it to arrive at the figure of profit
shown by other set of accounts

Procedure of Reconciliation: When there is a difference between the profits

disclosed by cost accounts and financial accounts, the following steps shall be
taken to prepare a Reconciliation Statement:

(I) Ascertain the various reasons of disagreement (as discussed above) between the
profits disclosed by two sets of books of accounts.

(II) If profit as per cost account (or loss as per financial accounts) is taken as the
base: Add:

(i) Items of income included in financial accounts but not in cost accounts.

(ii) Items of expenditure (as interest on capital, rent on owned premises etc.)
included in cost accounts but not in financial accounts.

(iii) Amounts by which items of expenditure have been shown in excess in cost
accounts as compared to the corresponding entries in financial accounts.

(iv) Amounts by which items of income have been shown in excess in financial
accounts as compared to the corresponding entries in cost accounts.

(v) Over-absorption of overheads in cost accounts.

(vi) The amount by which closing stock of inventory is undervalued in cost

accounts.

(vii) The amount by which the opening stock of inventory is overvalued in cost
accounts.

(viii) Over charge of depreciation in cost accounts. Deduct: (i) Items of income
included in cost accounts but not in financial accounts. (ii) Items of expenditure
included in financial accounts but not in cost accounts. (iii) Amounts by which
items of income have been shown in excess in cost accounts over the
corresponding entries in financial accounts.

(iv) Amounts by which items of expenditure have been shown in excess in

financial accounts over the corresponding entries in cost accounts.

(v) Under-absorption of overheads in cost accounts.

(vi) The amount by which closing stock of inventory is overvalued in cost

accounts.

(vii) The amount by which the opening stock of inventory is undervalued in cost
accounts.

(viii) Under charge of depreciation in cost accounts.

(III) After making all the above additions and deductions, the resulting figure will
be profit as per financial accounts (or loss as per cash accounts).

Note: If profit as per financial accounts (or loss as per cost accounts) is taken as the
base, then items added shall be deducted and items to be deducted shall be added
i.e. the procedure shall be reversed.

Memorandum Reconciliation Account: Reconciliation can also be done by

preparing a Memorandum Reconciliation Account. This account is a memorandum
account only and does not form part of the double entry. When reconciliation is
attempted through Memorandum Reconciliation Account, profit to be taken as
“base profit” is shown like opening balance of this Account. All items of
differences required to be deducted are debited and those to be added are credited
to this Account, the balancing figure of this Account is the profit shown by other
set of Accounts. Reasons for disagreement between Profits as per financial
accounting and Profits as per cost accounting

The difference in the profitability of cost and financial records may be due to the
following reasons.
 1. Items included in the financial accounts but not in cost accounts. • Purely
financial income: such as interest received on bank deposits, interest and dividend
on investments, rent receivables, transfer fee received, profit on the sale of assets
etc. • Purely financial charges: such as losses due to scraping of machinery, losses
on the sale of investments and assets, interest paid on the bank loans, mortgages,
debentures etc., expenses of company’s transfer office, damages payable at law etc.
• Appropriation of profit: the appropriation of profit is again a matter which
concerns only financial accounts. Items like payment of income tax and dividends
transfer to reserve, heavy donations, writing off of preliminary expenses, goodwill
and patents appear only in profit and loss appropriation account and the costing
profit and loss a/c is not affected.

2. Items included in cost accounts only: There are certain items which are included
in cost accounts but not in financial accounts. They are: Charges in lieu of rent
where premises are owned, interest on capital employed in production but upon
which no interest is actually paid.

3. Under/Over absorption of overhead expenses: In cost accounts, overheads are

absorbed at predetermined rates which are based on past data. In the financial
accounts the actual amount incurred is taken into account. There arise a difference
between the actual expenses and the predetermined overheads charged to product
or job. If overheads are not fully recovered, which means that the amount of
overheads absorbed in cost accounts is less than the actual amount, the shortfall is
called as under recovery or under absorption. If overhead expenses recovered in
cost accounts are more than that of the actually incurred, it is called over
absorption. Thus, both the over and under recovery may cause the difference in the
profits of both the records.

4. Different basis of stock valuation: In cost accounts, the stock of finished goods
is valued at cost by FIFO, LIFO, average rate, etc. But, in financial accounts stocks
are valued either at cost or market price, whichever is less. The valuation of work-
in-progress may also lead to variation. In financial books only prime cost may be
taken into account for this purpose whereas in cost accounts, it may be valued at
prime cost plus factory overhead.
 5. Different basis of depreciation adopted: The rates and methods of charging
depreciation may be different in two sets of accounts.

Cost Audit

A cost audit examines an entity’s cost records and other linked information,
including a non-profit entity. The primary purpose of this method is to assure
stakeholders, such as shareholders, management, and regulatory authorities. The
cost information a company reports is reliable and in compliance with relevant
regulations and standards. It comprises of the following:

(a) Verification of the cost accounting records for the accuracy of the cost
accounts, cost reports, cost statements, and cost data and

(b) Examine these records to ensure they adhere to the cost accounting principles,
plans, procedures, and objectives.

The cost auditors’ approach should ensure that the cost accounting plan follows the
objectives set by the organization. Furthermore, the accounting system aims to
accomplish these goals. The cost auditor should also establish the correctness or
otherwise of the figures by vouching for verification, reconciliation, etc.

Objectives of Cost Audit

Verifying the accuracy of the cost data: The cost auditor examines a company’s
cost accounts and records to ensure that the reported cost data is accurate, reliable,
and free from material misstatements.

Enhancing cost control: It helps a company identify areas where it can improve
its cost control processes. Therefore, it results in cost savings and improved
profitability.

Identifying inefficiencies: It helps identify areas where a company may be

incurring unnecessary costs or where it can improve its production processes to
reduce costs.
 Ensuring compliance with regulations: A company complies with relevant
regulations and guidelines, such as those laid down by governmental agencies or
professional bodies.

Improving decision making: It gives management a better understanding of the

company’s cost structure. Moreover, it helps them to make more informed
decisions about cost-related matters.

Advantages of Cost Audit

Cost audit benefits the management, society, shareholders, and the government.
The advantages are as under:

Advantages to Management

 Management gets reliable data for its day-to-day operations like price fixing,
control, decision-making, etc.
 A proper reporting system to management will closely monitor all wastages.
 Inefficiencies in the company’s working will be brought to light to facilitate
corrective action.
 Management by exception becomes possible through allocating responsibilities
to individual managers.
 The budgetary control and standard costing system will be greatly facilitated.
 A company can establish a reliable check on the valuation of closing stock and
work-in-progress.
 It helps in the detection of errors and fraud.

Society

 Price fixing often involves this method. Therefore, according to Audit Cost data,
consumers are protected from exploitation by fixing prices.
 Since some industries do not allow price increases without proper justification,
such as increased production costs. This will reduce inflation and maintain
consumer living standards by limiting price hikes.

Shareholder
 It ensures that proper records are kept regarding purchases and utilization of
materials, expenses on wages, etc. It also ensures that the valuation of closing
stocks and work in progress is fair. Thus, companies can ensure their shareholders
a fair investment return.

Government

 When the Government enters into a cost-plus contract, a cost audit helps the
government reasonably fix the contract’s price.
 It fixes the ceiling prices of essential commodities, and thus, undue profiteering
is checked.
 This allows the government to focus on inefficient units.
 It enables the government to decide in favour of protecting certain industries.
 Consequent management action can create healthy competition among the
various units in the industry. This imposes an automatic check on inflation.
 It facilitates the settlement of trade disputes brought to the government.

Disadvantages of Cost Audit

While cost audits can provide many benefits, they also have some disadvantages.
Some of the major disadvantages include the following:

Cost: Conducting a cost audit can be costly and time-consuming. This process
requires the engagement of specialized auditors, who may charge high fees for
their services.

Complexity: It involves a detailed examination of a company’s cost accounts and

records, which can be complex and require high expertise.

Resistance from management: Companies may view cost audits as an intrusion

into their operations and resist the audit process. This can lead to a lack of
cooperation from management and a less effective audit process.

Difficulty in detecting fraud: A cost audit is not suitable to detect fraud.

Therefore, it can be difficult for auditors to identify fraudulent activities, especially
if they are well-concealed.
Limited scope: It only focuses on the cost aspects of a company’s operations. Also
it does not provide a comprehensive view of its financial performance.

Reliance on historical data: A cost audit is based on historical cost data. It does
not consider future trends or market conditions that may affect the cost of products
or services.