CONTENTS

Unit Contents Page No.

1 INTRODUCTION TO FINANCIAL ACCOUNTING 1-17

2 ACCOUNTING MECHANICS 18-47

3 INTRODUCTION TO INTERNATIONAL ACCOUNTING STANDARDS 48-54

4 INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 55-73

TECHNIQUES OF MANAGEMENT ACCOUNTING

5 74-85
(BUDGETARY CONTROL)

TECHNIQUES OF MANAGEMENT ACCOUNTING

6 86-112
(STANDARD COSTING &MARGINAL COSTING)
 Financial & Management
Accounting

UNIT - I NOTES
INTRODUCTION TO FINANCIAL
ACCOUNTING

Introduction / Overview
In this first part of the subject, we need to see Financial Accounting and
preparation of Financial Statements.
In this chapter, we are going to see meaning of Financial Accounting, Scope
& Objectives. Similarly, we will focus on the assumptions (GAAP’s- Generally
Accepted Accounting Principles) on which financial accounting is based.

Key Words
Financial Accounting, Scope & Objectives, GAAP’s, Accounting cycle.

1.1 FINANCIAL ACCOUNTING

1.1.1 Meaning of Financial Accounting

1. “Accounting is both the science and art of correctly recording in books
of accounts all those business transactions that result in the transfer of
money or money’s worth”.
2. It may also be defined as the art of recording mercantile transactions
in a regular and systematic manner; the art of keeping accounts in such
a manner that a man may ascertain correct result of his business
activities at the end of a definite period and also can know the true
state of affairs of his/her business and properties by an inspection of
his/her books.
3. Accounting has been defined as, “The art of recording, classifying and
summarizing in a significant manner in terms of money, transactions
and events which are, in part at least, of financial character, and
interpreting the results there of. ” This definition has given by the
AICPA. (American Institute of Certified Public Accountants)
4. Accounting is the process of recording, classifying, summarizing,
analyzing & interpreting the financial transactions & communicating
the results thereof to the persons interested in such information”. Introduction to
Financial
Accounting 1
 Financial & Management Accounting has become a discipline now-a-days. It passed a long
Accounting historical process. Now it implicates our daily lives, business and
social life.
NOTES
1.1.2 Scope of Financial Accounting
• The scope of field of accounting is very wide.
• Accounting is needed not only by business class but also by non-business
class. Starting from the private life of a man, the financial activities of
school, college, club, society, hospitals and government institutions
come within the purview of accounting.
• The jurisdiction of accounting also includes the financial activities of
professionals including doctors, engineers and lawyers.
• It is essential to maintain accounts of non-profit organizations like
school, college, hospital, club, society etc
• The monetary transactions which take place in the private life of a man
are recorded properly in the books of accounts; it becomes possible to
ascertain his receipts and expenditure as well as personal assets and
properly in the books of accounts, it becomes possible to ascertain his
receipts and expenditure as well as his personal assets and liabilities.
• In the same way, it is necessary to keep accounts of professionals like
service-holders, doctors, lawyers, actors/actress etc. to ascertain their
incomes and calculation of income-tax on the basis of those incomes.
• Maintaining accounting is practiced to determine the income and
expenditure of different government offices and public bodies as well as
to run those offices and organizations properly.
• By preparing and evaluating national plan and budget with the help of
accounting it is possible to know the development and deterioration of
the country.
• Hence, in a nutshell, we can say that the scope of accounting is wide
enough to cover all the fields of the society.

1.1.3 Objectives of Financial Accounting

The principal object of accounting is to keep permanent record of all
monetary transactions effected by a person or the enterprise during a definite
period and ascertainment of results of those transactions at the end of the said
period.
i) Proper Recording of Transactions: The first and foremost object of
accounting is to keep record of monetary transactions in a systematic
manner.
Introduction to ii) Determination of Results / To Ascertain Profit or Loss of the Business:
Financial Every person or institution is always interested to know the results of
2 Accounting
 his/its monetary transactions at the end of a definite period. So, Financial & Management
ascertainment of result of financial transactions is an important object Accounting
of accounting.
iii) Ascertainment of Financial Position: Another object of accounting is NOTES
the ascertainment of debtors and creditors, assets and liabilities and
the overall financial position.
iv) Supplying financial information: Another important object of
accounting is to make available all sorts of financial reports and
statement to all parties interested in the affairs of the concerned
institution as soon as possible after preparing those reports and
statements.
v) Defalcation Prevented: Another special object of accounting is the
prevention of defalcation of money made through fraud by the officials
of the institution as well as control of expenditure.
vi) To Facilitate Rational Decision Making:

1.2 ACCOUNTING CONCEPTS, CONVENTIONS & PRINCIPLES

1.2.1: Accounting Concepts

• Accounting is a language of the business.
• Financial statements prepared by the Accountant communicate financial
information to the various stakeholders for decision making purpose.
• Hence, it is important that financial statements prepared by different
organizations should be prepared on uniform basis. E.g.
• There should be consistency over a period of time in the preparation of
the financial statements. If every Accountant starts following his own
norms & ideas for accounting of different items, then there will be utter
confusion.
• To avoid confusion & to achieve uniformity, accounting process is
applied within the conceptual framework of ‘Generally Accepted
Accounting Principles-GAAPs’.
• GAAPs is used to describe rules developed for the preparation of the
financial statements & are called Concepts, Conventions & Principles,
etc.
• These GAAPs are the backbone of the Accounting information system,
w/out which the whole system can’t even stand erectly.
• These Principles are the ground rules, which define the parameters &
constraints within which Accounting reports are generated.
3
 Financial & Management • Accounting Principles are the basic norms & assumptions on which the
Accounting whole Accounting system has been developed & established.
• These conceptual frameworks, GAAPs & Accounting standards are
NOTES considered as the theory base of Accounting.
• Accounting concepts define the assumptions on the basis of which
financial statements of a business entity are prepared.
• Accounting Concepts are the necessary assumptions or conditions upon
which Accounting is based. These are developed to convey the same
meaning to all people.
• Concept means Idea or Notion, which has universal application.
• These have been developed over the years from experience, reason, usage
& necessity.
1. Business-Entity Concept: It states that business enterprise is having
a ‘Separate Identity’ apart from its owner.
Accountants should treat a business as distinct from its Owner.
Business transactions are recorded in the business books of accounts
& owner’s transactions in his personal books of A/cs.
This concept helps in keeping business affairs free from the influence
of personal affairs of the owner. This basic concept is applied to all
the organizations:
Sole Proprietorship, Partnership Firm or Joint stock Cos.-Corporate
entities.
The business is liable to the owner for capital investment made by the
owner. Since, the owner invested the capital, which is also called ‘Risk
Capital’, he has claim on the ‘Profit of the enterprise’.
E.g. If a ‘Proprietor/Owner’ invests Rs.1 Lakhs in the ‘Business’, it is
deemed that the owner has given Rs.1 Lakhs to the ‘Business’ & it is
shown as a ‘Liability’ in the books of the ‘Business’. Because Business
has to ultimately repay it to the Owner. Similarly, if the Owner
withdraws Rs.10, 000 from the business, it is charged to him.
2. Money Measurement Concept: As per this concept, only those
transactions which can be measured in terms of money are recorded.
In Accounting, everything is recorded in terms of money. E.g. Sale &
purchase of goods, payment of expenses & receipt of income, etc.
Events or transactions which can’t be expressed in terms of money are
not recorded in the books of A/cs, even if they are very important or
useful for the business.
Measuring unit for money is taken as the Currency of the ruling
Introduction to country. I.e. the ruling currency of a country provides a common
Financial
denomination for the value of material objects.
4 Accounting
3. Cost Concept (Objectivity Concept): This concept doesn’t recognize Financial & Management
the Realizable / Replacement value/ Real Worth of an asset. As per Accounting
this concept:
a. An Asset is ordinarily recorded at the price paid to acquire it- NOTES
Acquisition cost.
b. This Cost is the basis for all subsequent accounting for the
Asset.
This concept is highly ‘Objective & free from all bias’.
It implies that the figures shown in the Accounting records should be
based on Objective evidence & not on the subjective views of a person.
The Cost concept doesn’t mean that the Asset will always be shown at
Cost. It only means that cost becomes the basis for all subsequent
accounting for the Asset.
Thus, the assets recorded at cost at the time of purchase may
systematically be reduced by the process of depreciation. These assets
ultimately disappear from the B/S when they have been fully
depreciated (sold as scrap).
Cost concept also implies that if nothing has been paid to acquire an
asset, it can’t be shown as an ‘Asset’ in the books of A/cs.
This concept brings objectivity in the preparation & presentation of
financial statements.
4. Going Concern Concept: It is assumed that the business will continue
for a fairly long time, unless & until it has entered into a state of
Liquidation.
The valuation of assets of a business entity is dependent on this
assumption. Traditionally Accountants follow ‘Historical Cost
concept’. As per this concept, the accountant doesn’t take into a/c the
forced sale values of Assets while valuing them.
Similarly, depreciation on assets is provided on the basis of expected
life of the assets rather than on their market values.
5. Dual Aspect Concept: This is the Basis concept of Accounting. As
per this concept, ‘Every business transaction has a dual effect.’
E.g. Vijay starts business with cash Rs. 5 Lakhs. There are two aspects
of this transaction: ‘Asset A/c & Capital A/c’.
The business gets ‘Asset’, Cash Rs. 5 Lakhs & on the other hand, the
business owes Rs. 5 Lakhs to Vijay as his capital.
This can be expressed in the form of equation.
Total Assets = Total Liabilities……E.g.

5
 Financial & Management • Dual Aspect Concept is the Core of Double Entry Book Keeping. Dual
Accounting aspect can result in :
1. It increases one Asset & decreases other Asset- A new machine
NOTES is purchased paying Rs. 50,000 cash.
2. It increases one Asset & simultaneously increases liability - A
new machine is purchased of Rs. 50,000 on credit basis.
3. It decreases one Asset & decreases a liability- cash paid to repay
bank loan of Rs.1 Lakhs.
4. It increases one Liability & decreases other liability- Raised bank
loan of Rs.60,000 to pay off creditors.
• So every transaction & event has 2 aspects: this gives the basic
Accounting equation,
• Equity + Liabilities= Assets.

6. Accrual Concept:
Accrual system is a method where by revenue & expenses are
identified with specific periods of time like a month, half year or a
year.
This concept implies recording of revenues & expenses of a particular
Accounting period, whether they are received/ paid in cash or not.
Under cash system of Accounting, the revenues & expenses are
recorded only if they are actually received / paid in cash, irrespective
of the Accounting period to which they belong.
Financial statements prepared on the Accrual basis inform users not
only of past events involving the payments & receipts of cash but also
of obligations to pay cash in the future & of resources that represent
cash to be received In the future. Revenue is the gross inflow of cash,
receivables & other consideration arising in the course of ordinary
activities of the business. E.g. sale of goods, rendering of services &
from the use by others of business’s resources yielding interest,
royalties & dividends.
Expense is a cost relating to the operations of an Accounting period
or to the revenue earned during the period or the benefits of which
don’t extend beyond that period.
As per Accrual concept- Revenue- Expenses= Profit.
Accrual concept provides the foundation on which the structure of
present day Accounting has been developed.
Accrual means recognition of revenue & costs as they are earned or
Introduction to incurred & not as money received or paid. Accrual concept relates to
Financial measurement of income, identifying assets & liabilities.
6 Accounting
7. Realization Concept: Financial & Management
Accounting
It closely follows the Cost concept. Any change in value of an Asset
is to be recorded only when the business realizes it.
NOTES
When an Asset is recorded at historical cost of Rs.5 Lakhs & even if
its current cost is Rs.50 Lakhs, such change is not counted unless there
is certainty that such change will materialize.
As per this, profit should be accounted for only when it is actually
realized.
Revenue is recognized only when sale is effected or the services are
rendered.
Sale is considered to be made when the property in goods passes to
the buyer & he is legally liable to pay. But, in order to recognize
‘Revenue’, receipt of cash is not essential. Even credit sale results in
realization as it creates a definite Asset called ‘Debtors/Receivables’.
However, some incomes like commission, rent & interest are shown
in P&L A/c on Accrual basis though they may not be realized in cash
on the date of preparing accounts.
Economists are highly critical about the Realization concept. As per
them, this concept creates value distortion & makes Accounting
meaningless.
Now days, the Revaluation of Assets has become a widely accepted
practice when the change in value is of permanent nature.
Accountants adjust such value change through creation of capital
reserves.
E.g. Land
8. Matching Concept: In this concept, all the expenses matched with
the revenue of that period should only be taken into consideration.
In the financial statements of the business, if any revenue is recognized
then expenses related to earn that revenue should also be recognized.
E.g. cost of production & sales for generating sales.
It is based on Accrual concept as it considers the occurrence of
expenses & income & don’t concentrate on actual inflow or outflow
of cash.
It is not necessary that every expense identify every income. Some
expenses are directly related to the revenue & some are time bound.
E.g. selling expenses directly relate to sales while rent, salaries are
time bound & recorded on Accrual basis for a particular Accounting
period.
Hence, Periodicity concept has also been followed while applying
7
 Financial & Management Matching concept. Accrual, Matching & Periodicity concept works
Accounting together for Income measurement & recognition of Assets &
Liabilities.
NOTES E.g. Mr.Vinod started cloth business. He purchased 10,000 pieces
garments @Rs.100 per piece & sold 8,000 pieces@Rs.150 per piece
during the Accounting period of 12 months- 1st Jan., 2016 to 31st Dec.,
2016.
He also paid shop rent @ Rs.3, 000 pm for 11 months & paid Rs. 8
Lakhs to the suppliers of garments & received Rs.10 Lakhs from
customers.
Periodicity concept fixes up the time frame for which the performance
is to be measured & financial position is to be appraised. That is 01-
01-2016 to 31-12-2016 for measurement of revenue & identifying ‘A
& L’ during it.
Accrual concept operates to measure revenue 8000*150 which accrued
during 2016, not the cash received Rs.10 Lakhs & also the expenses
correctly i.e. 36,000 not 33,000. How much is profit?
12, 00,000-(10, 00,000+36,000) = 1, 64,000.
Absolutely ….NO.
Because matching links ‘Revenue with Expenses.’
Revenue-Expenses= Profit; but this unqualified equation may create
misconception. Hence, it should be-
Periodic Revenue - Matched Expenses = Periodic Profit.
From the Revenue of an Accounting period, such expenses are
deducted which are expended to generate the revenue to determine
profit of that period.
12, 00,000 – (8, 00,000+ 36,000) = Rs.3, 64,000 – Profit.
Cash = Receipts – payments; 10 Lakhs – 8.33 Lakhs= 1.67 Lakhs.

1.2.2: Accounting Conventions

1. Convention of Consistency: The comparison of one Accounting
period with the other is possible when the convention of Consistency
is followed. It means Accounting from one Accounting period to
another.
E.g. Method of Depreciation, valuation of Stock - a co. may adopt
SLM method, RBM method or any other method of providing
depreciation on fixed assets. But, it is expects that the co. follows a
particular method of depreciation consistently.
Introduction to
Financial Any change from one method to another will lead to inconsistency &
8 Accounting should be avoided.
 However, consistency doesn’t mean non-flexibility. It should permit Financial & Management
introduction of improved techniques of Accounting. Accounting

• The Accounting policy can be changed in exceptional cases.

‘Consistency convention’ has following advantages: NOTES

1. Ensures comparability of financial statements of different years;

2. Eliminates an element of uncertainty regarding the Accounting
procedure to be followed;
3. Eliminates the element of personal bias regarding preparation of
a/cs & Accounting reports.
2. Convention of Materiality: “All the items having significant
economic effect on the business should be disclosed in the financial
statements & any insignificant items which will only increase the work
of the Accountant but will not be relevant to the users need shouldn’t
be disclosed in the financial statements.” The Accountant should attach
importance to material details & ignore insignificant details.
If this is not done, A/cs will be overburdened with minute details.
However, the term ‘Materiality’ is subjective term.
It is on the judgment, common sense & discretion of the Accountant
that which item is material & which is not.
E.g. Stationary purchased by the business though not used fully in the
Accounting year, will still be shown as an ‘expense’ of that year.
Similarly, Depreciation On small items like Books, Calculators etc. is
taken as 100% in the year of purchase itself though used by the co. for
more than one year. This is because the amt of books or calculator is
very small to be shown in B/S though it is Asset of the Co.
The ‘Materiality’ depends not only upon the amount of the item but
also upon the size of business, nature, level of information & level of
the person making the decision, etc.
Moreover, an item material to one person may be immaterial to another
person.
3. Convention of Full Disclosure:
As per this, the Accounting reports/ Financial Statements should
disclose full & fair information to the Owners, creditors, investors &
others.
This means that the accounts must be honestly prepared & they must
disclose all material information.
• It doesn’t mean that all information or information of any kind is
to be included in Accounting or Financial statements. The term
‘Disclosure’ implies that there must be sufficient disclosure of
9
 Financial & Management information which is of material interest to different stakeholders
Accounting in business. The Accountant shouldn’t allow any secret reserves
to be created.
NOTES • Due to this convention, following benefits are there:
1. Prepared A/cs convey true & correct information;
2. The Profit/Loss of the business is correctly calculated;
3. The B/S shows true position of the Financial Health of B.;
4. Proper Dividend & Taxes may be paid to the Owners & Govt.
respectively.
4. Convention of Conservatism: It refers to the policy of ‘Playing safe’.
As per it, all prospective losses are taken into consideration but not
prospective profits.
In other words, “provide for all possible losses but don’t anticipate any
profits”. E.g. valuation of stock at cost / market price whichever is
lower is as per this concept.
However, this is criticized on the ground that it goes not only against
convention of full disclosure but also against the concept of matching
costs & revenues.
It encourages creation of secret reserves by making excess provision
of Dep., bad & doubtful debts, etc.
The income statement shows a lower net income & B/S overstates the
Liabilities & understates the Assets.
E.g. making provision for doubtful debts & discount on Debtors and
not providing for discount on Creditors.

1.3 ACCOUNTING CYCLE

Accounting cycle is a step-by-step process of recording, classification and

summarization of economic transactions of a business. It generates useful
financial information in the form of financial statements including income
statement, balance sheet, cash flow statement and statement of changes in equity.
The time period principle requires that a business should prepare its
financial statements on periodic basis. Therefore accounting cycle is followed
once during each accounting period. Accounting Cycle starts from the recording
of individual transactions and ends on the preparation of financial statements and
closing entries.
Introduction to
Financial Accounting Cycle Steps
10 Accounting
 This cycle starts with a business event. Bookkeepers analyze the transaction Financial & Management
and record it in the general journal with a journal entry. The debits and credits Accounting
from the journal are then posted to the general ledger where an unadjusted trial
balance can be prepared. NOTES
After accountants and management analyze the balances on the unadjusted
trial balance, they can then make end of period adjustments like depreciation
expense and expense accruals. These adjusted journal entries are posted to the
trial balance turning it into an adjusted trial balance.
Now that all the end of the year adjustments are made and the adjusted trial
balance matches the subsidiary accounts, financial statements can be prepared.
After financial statements are published and released to the public, the company
can close its books for the period. Closing entries are made and posted to the
post closing trial balance.
At the start of the next accounting period, occasionally reversing journal
entries are made to cancel out the accrual entries made in the previous period.
After the reversing entries are posted, the accounting cycle starts all over again
with the occurrence of a new business transaction.
Here are the 9 main steps in the traditional accounting cycle.
1. — Identify business events, analyze these transactions, and record
them as journal entries
2. — Post journal entries to applicable T-accounts or ledger accounts
3. — Prepare an unadjusted trial balance from the general ledger
4. — Analyze the trial balance and make end of period adjusting entries
5. — Post adjusting journal entries and prepare the adjusted trial balance
6. — Use the adjusted trial balance to prepare financial statements
7. — Close all temporary income statement accounts with closing entries
8. — Prepare the post closing trial balance for the next accounting period
9. — Prepare reversing entries to cancel temporary adjusting entries if
applicable

1.4 ROLE OF ACCOUNTANT

An accountant has several roles and responsibilities to meet in their job,

both in terms of their competence at carrying out accounting practices as well as
their ethics and approach to the job.

Ethics and Approach

It is the responsibility of an accountant to ensure they’re working within
11
 Financial & Management the law at all times. For example, an accountant might give advice on how a
Accounting person could reduce their tax bill, but they shouldn’t be advising a person to do
something illegal, such as deliberately misinforming the relevant authority about
NOTES business revenues or earnings, for example.
An accountant should also notify the relevant authorities if they become
aware of a person or business that is breaking the law within their financial
affairs.

Impartiality
It is crucial that accountants maintain their impartiality; their role is to
advise clients and act as they’re instructed, not to try to sell services. Yes,
accountants will naturally tell clients what additional services they provide and
how they might benefit from using them, but they shouldn’t be pushy or insistent
while doing so.
An Accountant’s Job Role Accountancy is one of the most detailed and
diverse roles in the finance industry and as such accountants are required to be
competent in a number of areas.

An Accountant’s Job Role

Accountancy is one of the most detailed and diverse roles in the finance
industry and as such accountants are required to be competent in a number of
areas.
The role of an accountant includes the following:
• Prepare profit and loss statements on behalf of a business.
• Set up accounting practices and procedures for new companies and
advise on how to manage these.
• Analyze budgets and other financial information and advise where
savings could be made.
• Help to produce budgets for businesses and implement strategies for cost
savings.
• Ensure company accounts and tax returns are prepared and filed correctly
and on time.
It is such a diverse role that these areas might not ever be explored by some
within the industry, although this is a typical representation of what an accountant
will do.
It is important that an accountant has impeccable standards when it comes
to both competence and behaviour, as without them they’ll be unable to do their
job correctly and potentially harm their organization, certainly their own
reputation, and perhaps even the whole industry.
Introduction to
Financial
12 Accounting
 Financial & Management
Accounting
1.5 BRANCHES OF ACCOUNTING
NOTES
Accounting has a very wide scope. It is divided in the following branches:
• Financial Accounting: It is the process of recording, classifying,
summerising, analyzing, interpreting and communicating financial
statements to all stakeholders.
• Cost Accounting: It is the process of accounting and controlling the cost
of product or services. It focuses on accurate ascertainment and control
of costs.
Management Accounting: It is an accounting for management. It involves
techniques of cost control.

1.6 END USERS OF FINANCIAL STATEMENTS

After following the accounting cycle, the Financial Statements are prepared
at the end of accounting year i.e. Income Statement and Balance Sheet. The
following are the end users of Financial Statements.
• Owners (shareholders): Financial Statements help the owners to get
financial information which is used for decision making about their
investment.
• Management: Financial Statements are analyzed by the management and
used for decision making.
• Customers: Whenever there is a long term contract between company
and its customers, financial statements are useful to know the
creditworthiness of the business.
• Suppliers: Financial statements help the suppliers to know the liquidity
position of the business.
• Lenders: Lenders assess the creditworthiness of business by using
financial statements. On the basis of that loans are sanctioned to the
clients.
• Government: Government bodies especially tax authorities are interested
in firm’s financial position for taxation and regulatory purpose. Taxes are
calculated on the basis of financial results.
• Investors: Financial statements are analyzed to know financial position
of the business and decision making of buying, selling or holding stocks
is dependent on financial results of the business.
• Employees are interested in profitability and stability of the business. 13
 Financial & Management Financial statements are useful to them to know financial performance
Accounting of the business.
• General public: Other persons like researcher, students, analysts uses the
NOTES financial statements of the business.

A. Questions

Multiple Choice Questions- MCQ’s

1. Which of the following principles assumes that a business will
continue for a long time?
(A) Historical cost
(B) Periodicity
(C) Objectivity
(D) Going concern
2. Accountants use Generally Accepted Accounting Principles (GAAP)
to make the financial information communicated
(A) Relevant
(B) Reliable
(C) Comparable
(D) Profitable
3. One of the detailed rules used to record business transaction is
(A) Objectivity
(B) Accrual
(C) Double entry system of book keeping
(D) Going Concern
4. Which of the following highlights the correct order of the stages in the
accounting cycle?
(A) Journalizing, final accounts, posting to the ledger and trial
balance
(B) Journalizing, posting to the ledger, trial balance and final
accounts
(C) Posting to the ledger, trial balance, final accounts and journalizing
(D) Posting to the ledger, journalizing, final accounts and trial balance
5. The elements of the accounting equation are
I. Assets
Introduction to
Financial II. Liabilities
14 Accounting
 III. Trial Balance Financial & Management
Accounting
IV. Capital
(A) I, II and III
NOTES
(B) I, II and IV
(C) I, III and IV
(D) II, III and IV
6. Which of the following jobs check accounting in ledgers and financial
statements?
(A) Financial
(B) Audit
(C) Management
(D) Budget Analysis
7. Which of the following describes the practical framework of
bookkeeping?
(A) Classifying, recording and summarizing
(B) Reporting, analyzing and interpreting
(C) Classifying, analyzing and interpreting
(D) Recording, summarizing and reporting
8. Using "lower of cost and net realizable value" for the purpose of
inventory valuation is the implementation of which of the following
concepts?
(A) Going concern concept
(B) Separate Entity Concept
(C) Prudence Concept
(D) Correction Concept
9. The concept of separate entity is applicable to which of following types
of businesses?
(A) Sole Trading concern
(B) Corporation
(C) Partnership
(D) All of above
10. Does Prudence concept allow a business to build substantially higher
reserves or provisions than that are actually required?
(A) Yes
15
 Financial & Management (B) No
Accounting
(C) To some extent
(D) It depends on the type of business.
NOTES
11. The revenue recognition principal dictates that all types of incomes
should be recorded or recognized when:
(A) Cash is received
(B) At the end of accounting period
(C) When they are earned
(D) When interest is paid
12. The matching concept matches which of the following?
A) Asset with liabilities
B) Capital with income
C) Revenues with expenses
D) Expenses with capital
13. The allocation of owner's private expenses to his/her business violates
which of the following?
A) Accrual concept
B) Matching concept
C) Separate business entity concept
D) Consistency concept
14. The going concern concept assumes that
A) The entity continue running for foreseeable future
B) The entity continue running until the end of accounting period
C) The entity will close its operating in 10 years
D) The entity can't be liquidated
15. Which of the following is time span into which the total life of a
business is divided for the purpose of preparing financial statements?
A) Fiscal year
B) Calendar year
C) Accounting period
D) Accrual period
16. Showing purchased office equipment in financial statements is the
Introduction to application of which accounting concept?
Financial
16 Accounting
 A) Historical cost convention Financial & Management
Accounting
B) Materiality
C) Prudence
NOTES
D) Matching concept

Descriptive Questions
1. Explain the Accounting concepts & conventions in detail.
2. Define Financial Accounting? Explain the Scope & objectives of
financial accounting.
3. What is Accounting cycle? Explain the process of Accounting Cycle.
4. Write Short notes on the following:
a. Dual Aspect concept;
b. Accrual Concept;
c. Business Entity Concept
d. Role of Accountant
e. Convention of Full disclosure.
f. Convention of Materiality.

Exercise
The students can visit any small manufacturing, CA Firm and ask them
about the practices followed while recoding transactions. Students will come to
know the practical application of the GAAP’s used in every business
(Small/Large)
*****

17
 Financial & Management
Accounting

UNIT - II
NOTES
ACCOUNTING MECHANICS

Introduction / Overview
In this unit, we will see the process of Accounting. I.e. Initially all activities
happening in a business are recorded as ‘Transactions’ in the form of Journal
entries, ‘Journal entries’ are further converted into Ledger Accounts & a ‘Trial
Balance’ is prepared on the basis of Ledger Accounts.
After preparing the Trial balance, we prepare the ‘Final Accounts for sole
trading concern’ which is the sole objective of Financial Accounting. Preparations
of final accounts involve preparing Trading A/c, Profit & Loss A/c and Balance
Sheet.

Key Words
Double Entry System of Book keeping, Debit, Credit, Journal, Ledger, Trial
Balance, Final Accounts.

2.1 ACCOUNTING PROCESS

2.1.1 Principles of Double Entry Book Keeping

At the outset, let’s see the transactions first. Transaction is defined as all
activities in business which is expressed in the form of money.
E.g. Purchase of raw material, payment of different expenses like wages,
salaries, advertising, commission, etc.
The basic principle of double entry bookkeeping is that there are always
two entries for every transaction. One entry is known as a credit entry and the
other a debit entry.
The most scientific and reliable method of accounting is Double Entry
System. One must have a clear conception about the nature of transaction to
understand double entry system.
Every transaction involves two parties or accounts – one account gives the
benefit and the other receives it. It is called dual entity of transaction. In every
transaction the account receiving benefit is debited and the account giving benefit
is credited.
The process of keeping account by accepting this dual entity i.e. debiting
one account for a definite amount of money and crediting the other account for
18 Accounting Mechanics the same amount is called double entry system of book keeping.
 Double entry system of Accounting gives an equation for every journal Financial & Management
entry recorded in business: Accounting

Total of All Debits= Total of All Credits

NOTES
(For every debit entry, there is an equal & corresponding credit entry in
every business transaction)
Let’s see now types of accounts so that we can understand the process of
passing of accounting entries.
There are 3 types of Accounts:
1. Real Accounts;
2. Personal Accounts;
3. Nominal Accounts.

1. Real Accounts
All assets of a firm, which are tangible or intangible, fall under the
category “Real Accounts“.
Tangible real accounts are related to things that can be touched and felt
physically. A few examples of tangible real accounts are building, machinery,
stock, land, etc.
Intangible real accounts are related to things that can’t be touched and felt
physically. A few examples of such real accounts are goodwill, patents,
trademarks, etc.

Golden rule for real accounts

Example
The transaction below shows the interaction of two different real accounts:
one is furniture and the other is cash, both of them are assets of the company
and hence classified as real accounts.

Purchased furniture for 10,000 in cash

*Amount will be 10,000 in both debit and credit.

Accounting Mechanics 19
 Financial & Management 2. Personal Accounts
Accounting
These accounts are related to individuals, firms, companies, etc. A few
examples of personal accounts include debtors, creditors, banks,
NOTES outstanding/prepaid accounts, accounts of credit customers, accounts of goods
suppliers, capital, drawings, etc.
Natural personal accounts: This type of personal accounts is the simplest
to understand out of all and includes all God’s creations that have the ability to
deal, who, in most cases, are people.E.g. Kumar’s A/C, Adam’s A/C, etc.
Artificial personal accounts: Personal accounts which are created artificially
by law, such as corporate bodies and institutions, are called Artificial personal
accounts. E.g. Pvt Ltd companies, LLCs, LLPs, clubs, schools, etc.
Representative personal accounts: Accounts which represent a certain
person or a group directly or indirectly. E.g. let’s say that wages are paid in
advance to an employee a wage prepaid account will be opened in the books of
accounts. This wages prepaid account is a representative personal account
indirectly linked to the person.

Golden rule for personal accounts

Example
The transaction below demonstrates the interaction between two different
personal accounts, one of which is a private limited company and the other one
is a bank.

Paid to Unreal Pvt Ltd. 24,000 by cheque

*Amount will be 24,000 in both debit and credit.

3. Nominal Accounts
Accounts which are related to expenses, losses, incomes or gains are called
Nominal accounts. The dictionary meaning of the word “nominal” is “existing
in name only” and the meaning remains absolutely true in accounting sense too,
because nominal accounts do not really exist in physical form, but behind every
20 Accounting Mechanics
nominal account money is involved. E.g. Purchase A/C, Salary A/C, Sales A/C, Financial & Management
Commission received A/C, etc. Accounting

The final result of all nominal accounts is either profit or loss which is then
transferred to the capital account. NOTES

Golden rule for nominal accounts

Example : The following example shows a transaction where a nominal

account deals with a real a/c.

Purchased good for 15,000 in cash

The amount will be 15,000 in both debit and credit.

A. Journal: Journal is a book of ‘Original entry’. All transactions
happening in a business are first recorded in Journal books of accounts;
hence it is also called as book of Prime entry.
Following is the format for recording Journal entries:

Details of the format

1. Date: In this column, ‘Date’ of the transaction is entered.
2. Particulars: Here, the transaction is recorded in the form of Debit &
Credit with the help of rules of accounting i.e. Real, Personal &
Nominal Accounts.
3. L.F.(Ledger Folio) : In this column, page number (Folio) of the ledger
account is entered where this journal entry is recorded.
4. Debit: Here, the amount to be debited is entered.
5. Credit: Here, the amount to be debited is entered.
Note: After passing journal entry, we need to write down the brief
explanation of the transaction which is called Accounting Mechanics 21
 Financial & Management ‘Narration’. ‘Narration’ always starts with ‘Being’.
Accounting
As an example for how to record journal entries, following are the journal
entries in the required format which we have seen while reading types of
NOTES accounts:.

B. Ledger Account
An Account is a systematic record of all transactions related to an
Asset/Liability/Expenses & losses/Incomes & gains.
Ledger account is also called as secondary books of accounts as it is
dependent on journal entries only. The preparation of Ledger Account is
mandatory as it gives the clear idea of what has happened in a particular account
for a specific period of time.
E.g. based on the above journal entry example, if we prepare ledger
accounts then the following accounts should be prepared.

22 Accounting Mechanics
 1. Furniture A/c; Financial & Management
Accounting
2. Cash A/c;
3. Unreal Pvt.Ltd. A/c;
NOTES
4. Bank A/c;
5. Purchases A/c
A Ledger Account is equally divided into two sides (Four columns each on
both sides i.e. Date, Particulars, J.F., Amount) on Debit & Credit side, the left
hand side of the Ledger is called as Debit & right hand side is called as Credit
side.
Posting: The process of transferring journal entries into ledger accounts is
called as Posting
Following is the format for a ledger A/c
Dr Cr

Details of the format

1. Date: In this column, ‘Date’ of the transaction is entered.
2. Particulars: Here, the transaction is recorded on the Debit side with
prefix ‘To’ & on credit side with prefix ‘By’
3. Rule of Posting in Ledger A/c: The A/c which is debited in journal
entry should also be debited in its respective ledger A/c with prefix
‘To’ and followed with its corresponding Credit Name in the journal
entry. Similarly, an A/c which is credited in a journal entry should also
be credited in its respective ledger A/c with prefix ‘By’ and followed
with corresponding Debit Name in the journal entry.
4. J.F.(Journal Folio) : In this column, page number (Folio) of the journal
entry where it is recorded in Journal book is entered
5. Debit: Here, the amount to be debited is entered.
6. Credit: Here, the amount to be debited is entered.
7. Balancing of Ledger A/c: after posting all the journal entries into
respective ledger accounts, the next most important part is to do the
balancing of every ledger account. Balancing involves doing rough
total of both sides i.e. Debit & Credit side and then whichever side is
lower as compared to other, the balancing figure should be written on
lighter side to make the total equal on both the sides.

Accounting Mechanics 23
 Financial & Management If Debit side is more than Credit side, then the balance is called as ‘Debit
Accounting Balance’ & it is to be written on Credit Side as ‘By Balance c/d’. Further, if Credit
side is more than Debit side, then the balance is called as ‘Credit Balance’ & it
NOTES is to be written on Debit Side as ‘To Balance c/d’.

C. Trial Balance
As we know that the basic principle of double entry system of accounting
is that for every debit, there must be a corresponding credit. Thus, for every debit
or a series of debts given to single or several accounts, there is a corresponding
credit or series of debits given to some other account or accounts and vice versa.
It follows, therefore, that the sum total of debit amount and credit amount of
ledger should be tally for the particular period.
But whereas if the various accounts in the Ledger are balanced, then the
sum total of all debit balances must be tally with the total of all credit balances
if the books of accounts are arithmetically accurate and authenticated.
Thus, at the end of the financial year the balances of all the ledger accounts
are extracted and are written up in trial balance (a type of financial report) and
finally summed up to see if the total of debit balances and the total credit balances
respectively should be tallied. A trial balance may also be stated as statement of
sum total of debit and credit balances extracted from the various accounts in the
ledger with a view to examine the mathematical exactness of the books. The
accordance of the trial balance discloses that both the feature of each and every
transaction has been recorded and that the books are arithmetically accurate. If
the trial balance does not agree, it shows that there are some errors which must
be detected and retrieve if the accurate financial report is to be made. Thus, Trial
balance provides a bridge relationship to the ledger accounts and the final
statement.
There are various objectives of preparing Trial balance which are
mentioned below:
• To have balances of all the accounts of the ledger in order to avoid the
necessity of going through the pages of the ledger to find it out.
• To have material for preparation of the financial statement of the
organization.
• To have the arithmetic accuracy of the books of accounts because of the
agreement of the trial balance.
• To have a proof that the double entry of each transaction has been
recorded because of its agreement.
• To provide guidance in an identification of errors.

24 Accounting Mechanics
 Preparation of Trial Balance Financial & Management
Accounting

NOTES

D. Final Accounts / Financial statements of Sole trading Concern.

After having checked the accuracy of the books of accounts through
preparation of Trial Balance, businessman wants to ascertain the profit earned
or loss suffered during the year and also the financial position of his business at
the end of the year. For this purpose he prepares ‘Final Accounts’ which are also
termed as ‘Financial Statement’. These include the following:
1. Trading Account
2. Profit and Loss Account
3. Balance Sheet

1. Trading Account
Trading account is prepared for calculating the gross profit or gross loss
arising or incurred as a result of the trading activities of a business. In other
worlds, it is prepared to show the result of manufacturing, buying and selling of
goods. If the amount of sales exceeds the amount of purchases and the expenses
directly connected with such purchases, the difference is termed as gross profit.
On the contrary, if the purchases and direct expenses exceed the sales, the
difference is called gross loss. A Trading Account records the amount of
purchases of goods and also the expenses which are incurred in bringing that
commodity to a saleable state. IN other words, all expenses which relate to either
purchase of raw material for manufacturing of goods are recorded in the Trading
Account. All such expenses are called ‘Direct Expenses’.
According to J.R. Batliboi, “The Trading Account shows the results of
buying and selling of goods. In preparing this account, the general establishment
charges are ignored and only the transaction in goods are included.”
Sometimes, a Trading Account is also called ‘Good A/c’ because all the
transaction relating to goods are recorded in it. Such as (i) Opening Stock, (ii)
Purchases, (iii) Purchases Returns, (iv) Sales, (v) Sales Returns, (vi) Closing
Accounting Mechanics 25
 Financial & Management Stock, (vii) Expenses incurred on manufacturing of goods, and (viii) Expenses
Accounting incurred on purchasing and bringing the goods to the trading place. All such
expenses are summarised and recorded in the Trading Account at the end of the
NOTES year.

Need and Importance of Trading Account

Preparation of Trading Account serves the following objectives:
1. It provides information about Gross Profit and Gross Loss: It informs
of the gross profit or gross loss as a result of buying and selling the
goods during the year. The percentage of Current Year’s gross profit
on the amount of sales can be calculated and compared with those of
the previous years. Thus, it provides data for comparison, analysis and
planning for a future period.
2. It provides information about the direct expenses: All the expenses
incurred on the purchase and manufacturing of goods are recorded in
the trading account in a summarised form. Percentage of such expenses
on sales can be calculated and compared with those of the previous
years. In this way it enables the management to control and rationalise
the expenses.
3. Comparison of closing stock with those of the previous years: closing
stock has to be valued and recorded in a trading account. This stock
can be compared with the closing stock of the previous years and if
the stock shows an increasing trend, the reasons may be inquired into.
4. t provides safety against possible losses: If the ratio of gross profit has
decreased in comparison to the preceding year, the businessman can
take effective measures to safeguard himself against future losses. For
example, he may increase the sale price of his gods or may proceed
to analyse and control the direct expenses.

Preparation of Trading Account

Trading Account is a Nominal Account and all expenses which relate to
either purchase or manufacturing of goods are written on the Dr. side of the
Trading Account.
Item written on the Debit Side of the Trading Account:
1. Opening Stock: The stock of goods remaining unsold at the end of the
previous year is termed as the opening stock of the current year. In
other words, the closing stock of the last year becomes the opening
stock of the current year. Opening Stock will include the following:
I. Opening Stock of Raw Material.
II. Opening Stock of Semi-finished goods, and
III. Opening Stock of Finished goods.
26 Accounting Mechanics
2. Purchases and Purchases Returns: Goods which have been bought for Financial & Management
resale are termed as Purchases and goods which are returned to Accounting
suppliers are termed as purchase returns or returns outwards. Purchase
Account will be given on the debit side of the trial balance and NOTES
Purchase Return Account on the credit side of the trial balance.
Purchase returns will be shown as a deduction from Purchases on the
debit side of the trading account. Purchases include cash as well as
credit purchases.
3. Direct Expenses: All expenses incurred in purchasing the goods,
bringing them to the godown and manufacture of goods is called
direct expenses. Direct expenses include the following:
I. Wages: Wages are paid to workers who are directly engaged in
the loading, unloading and production of goods and as such
are debited to the trading account. It should be noted that:
(i) If the item ‘Wages and Salaries’ is given in the question it will
be shown on the trading account. On the contrary, if ‘Salaries
and Wages’ is given it will be shown on the profit & loss
account.
(ii) If wages are paid for bringing a new machine or for its installation
it will be added to the cost of the machine and hence will not
be shown in the trading account.
II. Carriage or Carriage Inwards or Freight: These expenses should
be debited to trading account because these are generally paid
for bringing the goods to the factory or place of business.
However, if any carriage or freight is paid on bringing an asset,
the amount should be added to the asset account and must not
be debited to trading account.
III. Manufacturing Expenses: All expenses incurred in the
manufacture of goods are shown on the debit side of the
trading account such as Coal, Gas, Fuel, Water, Power, Factory
Rent, Factory Lighting etc.
IV. Dock Charges: These are the charges levied on ships and their
cargo while entering or leaving docks. If dock charges are
paid on import of goods they are shown on the debit side of
trading account. In the absence of specific instructions, these are
debited to trading account.
V. Import Duty or Custom Duty: Custom Duty is paid on import as
well as on export of goods. Custom duty when paid on the
purchase of goods is charged to trading account. In the
absence of specific instructions, these are debited to trading
account.
VI. Octroi: This is levied by the Municipal Committee when the Accounting Mechanics 27
 Financial & Management goods enter the city and hence debited to trading account.
Accounting
VII. Royalty: This is the amount paid to the owner of a mine or patent
for using his right or patent. Royalty is usually charged to
NOTES trading account because it increases the cost of production.
However, if it is specifically stated in the question that the
Royalty is based on sales, it will be charged to Profit and
Loss account.

Items written on the Cr. Side of the Trading Account

1. Sales and Sales Returns: Both Cash and Credit sales will be included
in sales. The sales account will be a credit balance whereas, the sales
return account or returns inwards account will be a debit balance. Sales
return will be deducted out of Sales on the credit side of the trading
account.
2. Closing Stock: The goods remaining unsold at the end of the year are
known as Closing Stock. It is valued at cost price or market price
whichever is less. It includes the closing stock of raw material, Closing
Stock of semi-finished goods and Closing Stock of finished goods.
Normally, the Closing Stock is given outside the Trail Balance. This is so
because its valuation is made after the accounts have been closed. It is
incorporated in the books by means of the following entry:
Closing Stock A/c Dr.
To Trading A/c
(Closing Stock transferred to Trading A/c)
When the above entry is passed, the Closing Stock Account is opened. On
the one hand, it will be posted to the credit side of the trading account and on the
other hand, will be shown on the Assets side of the Balance Sheet, in order to
complete the double entry. Sometimes, the Closing Stock is given inside the Trail
Balance. This means that the entry to incorporate the closing stock in the books
has already been passed. It would imply that the Closing Stock must have been
deducted out of Purchases Account. Hence, in such a case, Closing Stock will
not be shown in the Trading Account but will appear on the Assets side of the
Balance Sheet only.
Format of Trading Account
TRADING A/C
Dr for the year ended…………….. Cr

28 Accounting Mechanics
 Financial & Management
Accounting

NOTES

Notes:
(1) In the heading of the Trading Account the words ‘For the year ended…
…’ are used. Because it discloses the position of the business for the
full accounting year and not at a particular point of time.
(2) No separate column for date is prepared in the Final Accounts because
the date will be already mentioned in the heading itself.
(3) No column for L.F. is prepared in Final Accounts because these are
prepared from trial balance and not from ledge accounts directly.

2. Profit And Loss Account

Trading account only discloses the gross profit earned as a result of buying
and selling of goods. However, a businessman has to incur a number of expenses
which are not taken to trading account. Hence, a businessman is more interested
in knowing the net profit earned or net loss incurred during the year. Accounting Mechanics 29
 Financial & Management As such, a Profit & Loss Account is prepared which contains all the items
Accounting of losses and gains pertaining to the accounting period. According to Prof. Carter,
“A Profit & Loss Account is an account into which all gains and losses are
NOTES collected, in order to ascertain the excess gains over the losses or vice-versa”.

Need and Importance of Profit & Loss A/c

1. To Ascertain the Net Profit or Net Loss: A Trading Account only
discloses the Gross Profit earned as a result of trading activities,
whereas the Profit & Loss Account discloses the net profit (or net loss)
available to the proprietor and credited to his capital account.
2. Comparison with previous years’ profit: The net profit of the current
year can be compared with that of the previous years. It enables the
businessman to know whether the business is being conducted
efficiently or no.
3. Control on Expenses: Profit & Loss Account helps in comparing
various expenses with the expenses of the previous year. Also the
percentage of each individual expenses to net profit is calculated and
compared with the similar ratio of previous years. Such comparison
will be helpful in taking concrete steps for controlling the unnecessary
expenses.
4. Helpful in the preparation of Balance Sheet: A Balance Sheet can only
be prepared after ascertaining the Net Profit through the preparation
of Profit and Loss Account.

Preparation of Profit and Loss Account

A Profit and Loss Account is started with the amount of gross profit or gross
loss brought down from the Trading Account. As such, all those expenses and
losses which have not been debited to the Trading Account are now debited to
Profit & Loss Account.
These expenses include administrative expenses, selling expenses,
distribution expenses etc. These are called ‘Indirect Expenses’. Profit and Loss
Account is a Nominal Account and as such, all the expenses and losses are shown
on its debit side and all the incomes and gains are shown on its credit side.

Items written on the Dr. side of Profit & Loss Account

1. Gross Loss: If trading account discloses Gross Loss, it is shown on the
debit side first of all.
2. Office and Administrative Expenses: Such as salary of office
employees, office rent, lighting, postage, printing, legal charges, audit
fee etc.
3. Selling and Distribution Expenses: Such as advertisement charges,
commission, carriage outwards, bad-debts, packing charges etc.
30 Accounting Mechanics
 4. Miscellaneous Expenses: Such as interest on loan, interest on capital, Financial & Management
repair charges, depreciation, charity etc. Accounting

Items written on the Cr. side of Profit & Loss Account NOTES
1. Gross Profit: the starting point of the Cr. side of Profit and Loss
Account is the gross profit brought down from the Trading Account.
2. Other Incomes and Gains: All items of incomes and gains are shown
on the credit side of the Profit & Loss Account, such as income from
investments, rent received, discount received, commission earned,
interest received, dividend received etc.
If the credit side of the profit and loss account exceeds that of debit side,
the difference is termed as net profit. On the other hand, the excess of the debit
side over the credit side is termed as net loss. Net profit is added to the capital
whereas net loss is deducted from the capital.
Format of Profit and Loss Account
PROFIT AND LOSS A/C
(for the year ending………….)
Dr. Cr.

Accounting Mechanics 31
 Financial & Management
Accounting

NOTES

Notes
(1) Those expenses which are not related to the business are not written
in the Profit and Loss Account such as (i) Domestic and household
expenses of the proprietor, (ii) Income-Tax, and (iii) Life Insurance
Premium etc. These expenses are known as Drawings and deducted
from Capital at the liabilities side of the Balance Sheet.
(2) Only those items of expenses and incomes are shown in the Profit &
Loss Account which have not been shown in the Trading Account.

3. Balance-Sheet
After ascertaining the net profit or loss of the business enterprise, the
businessman would also like to know the exact financial position of his business.
32 Accounting Mechanics For this purpose a statement is prepared which contains all the Assets and
Liabilities of the business enterprise. The statement so prepared is called a Financial & Management
Balance Sheet because it is a sheet of balances of ledger accounts which are still Accounting
open after the transfer of all nominal accounts to the Trading and Profit & Loss
Account. Balances of all the personal and real accounts are grouped as assets and NOTES
liabilities. Liabilities are shown on the left hand side o the Balance Sheet and
assets on the right hand side.
Definitions: A Balance Sheet has been defined as follows:
In the words of Karlson, “A business form showing what is owed and what
the proprietor is worth is called a Balance Sheet.”
According to A. Palmer, “The Balance Sheet is a statement at a particular
date showing on one side the trader’s property and possessions and on the other
hand the liabilities.”
According to J.R. Batliboi, “A Balance Sheet is a statement prepared with
a view to measure the exact financial position of a business on a certain fixed
date.”

Need and Importance of Preparing a Balance Sheet

The purposes of preparing a Balance Sheet are as follows:
1. The main purpose of preparing a Balance Sheet is to ascertain the true
financial position of the business at a particular point of time.
2. It helps in ascertaining the nature and cost of various assets o the
business such as the amount of Closing Stock, amount owing from
Debtors, amount of fictitious assets etc.
3. It helps in determining the nature and amount of various liabilities of
the business.
4. It gives information about the exact amount of capital at the end of the
year and the addition or deduction made into it in the current year.
5. It helps in finding out whether the firm is solvent or not. The firm is
solvent if the assets exceed the external liabilities. It would be
insolvent if opposite is the case.
6. It helps in preparing the Opening Entries at the beginning of the next
year.

Grouping and Marshalling of Assets and Liabilities in

Balance Sheet
The Assets and Liabilities shown in the Balance Sheet are properly grouped
and presented in a particular order. The term ‘grouping’ means showing the items
of similar nature under a common heading. For example, the amount owing from
various customers will be shown under the heading ‘Sundry Debtors’. Similarly,
under the heading ‘Current Assets’, the balance of Cash, bank, debtors, stock etc.
will be shown. 33
Accounting Mechanics
 Financial & Management ‘Marshalling’ is the arrangement of various assets and liabilities in a proper
Accounting order. Marshalling can be made in one of the following two ways:
1. In the Order of Liquidity: According to this method, an asset which is
NOTES most easily convertible into Cash such as Cash in hand is written first
and then will follow those asses which are comparatively less easily
convertible, so that the least liquid asset such as goodwill, is shown
last.
In the same way, those liabilities which are to be paid at the earliest
will be written first. In other words, current liabilities are written first
of all, then fixed or long-term liabilities and lastly, the proprietor’s
capital.
In the Order of Permanence: This method is exactly the reverse of the
first method discussed above. Assets which are most difficult to be
converted into cash such as Goodwill are written first and the assets
which are most liquid such as Cash in hand are written last.
Similarly, those liabilities which are to be paid last, will be written
first. In other words, the proprietor’s capital is written first of all, then
fixed or long term liabilities and lastly, the current liabilities. Joint
stock companies are required under the Companies Act to prepare their
Balance Sheet in the order of permanence.
It is essential to understand the classification of various assets and liabilities
before preparing a Balance Sheet.

Classification of Assets
According to the nature of assets, these may be classified into the following:
1. Fixed Assets: Fixed assets are those which are acquired for continued
use and last for many years such as Land & Building, Plant and
Machinery, Motor Vehicles, Furniture etc. According to Finney &
Miller, “Fixed Assets are assets of a relatively permanent nature used
in the operations of business and not intended for sale.”
As the purpose of keeping such assets is not to sell but use them,
changes in their market values are ignored and these are always shown
in the Balance Sheet at cost less depreciation.
2. Current Assets: Current assets are those which are either in the form
of cash or can be easily converted into cash within one year of the
date of Balance Sheet. In the words of Hovard & Upton, “The current
assets are usually defined as those assets which are convertible into
cash through the normal course of business within a short time
ordinarily in a year.”
Current assets include Cash, Bills Receivable, Short Term Investments,
Debtors, Prepaid Expenses, Accrued Income, Closing Stock etc. While
valuing these assets, Closing Stock is valued at cost or realisable value
34 Accounting Mechanics
 whichever is less and a reasonable provision for doubtful debts is Financial & Management
deducted out of Sundry Debtors. Accounting

3. Liquid Assets: Liquid assets are those which are either in the form of
Cash or can be quickly converted into cash, such as Cash, Bills NOTES
Receivable, Short Term Investments, Debtors, Accrued Income etc. In
other words, if Prepaid Expenses and Closing Stock are excluded from
Current Assets, the balance will be Liquid Assets.
4. Fictitious or Nominal Assets: These are the assets which cannot be
realised in Cash or no further benefit can be derived from these assets.
Such assets include Debit balance of P & L A/c and the expenditure
not yet written off such as Advertisement Expenses etc. These assets
are not really assets but are shown on the Assets side only for the
purpose of transferring them to the Profit & Loss Account gradually
over a period of time.
5. Wasting Assets: These are the assets which are exhausted or
consumed over a period of time such as mines and oil wells. Their
value reduces through being worked. These also include Patents and
the properties taken on lease for a defi9nite period of time.
6. Tangible and Intangible Assets: Tangible asses are those which have
a physical existence or which can be seen and felt like Plant and
Machinery, Building, Furniture, Stock, Cash etc. Intangible assets are
those which do not have any physical existence or which cannot been
seen or felt such as the Goodwill, Trade Marks, Patents etc. Intangible
assets are as much valuable as tangible assets because they also help
the firm in earning profits. For example, Goodwill helps in attracting
customers and patents are actually the know-how which help in
producing the goods.

Classification of Liabilities
According to their nature, the liabilities may be classified as follows:
1. Fixed or Long-term Liabilities: Those liabilities which are to be repaid
after one year or more are termed as long-term liabilities. These
include Public Deposits, Long-term Loans, Debentures etc.
2. Current or Short-term Liabilities: Those liabilities which are expected
to be paid within one year of the date of the Balance Sheet are termed
as current or short-term liabilities. These include Bank Overdraft,
Creditors, Bills Payable, Outstanding expenses etc.
3. Contingent Liabilities: These are the liabilities which will become
payable only on the happening of some specific event, otherwise not.
Such as:
(i) Liabilities for bill discounted: In case a bill discounted from the
bank is dishonoured by the acceptor on the due date, the firm will
become liable to the bank. Accounting Mechanics 35
 Financial & Management (ii) Liability in respect of a suit pending in a court of law: This would
Accounting become an actual liability if the suit is decided against the firm.
(iii) Liability in respect of a guarantee given for another person: The
NOTES firm would become liable to pay the amount if the person for
whom guarantee is given fails to meet his obligation.
Contingent liabilities are not shown in the Balance Sheet: They are,
however, shown as a footnote just below the balance sheet so that their existence
may be revealed.
Generally, sole proprietors and partnership firms prepare their Balance Sheet
in the order of liquidity. Proforma of a Balance Sheet in the order of liquidity
will be as follows:
BALANCE SHEET
as on or as at………………….

36 Accounting Mechanics
Notes Financial & Management
Accounting
(1) The words ‘As at’ or ‘As on’ are used in the heading of the Balance
Sheet. Because it is true only for the date on which it is prepared.
NOTES
(2) The total of both the sides of the Balance Sheet is always equal.
(3) Prepaid expenses are treated as current assets. Though Cash cannot be
realised from prepaid expenses, the service will be available against
these without further payment.

ADJUSTMENT ENTRIES
many adjustment because earlier we have not passed any journal entry , so
at the time of making final account we have to adjust them .

Accounting Mechanics 37
 Financial & Management
Accounting

NOTES

Following points should be noted for preparing Final Accounts:

1. If a trial balance is not given in the question, it is better to prepare a
Trial Balance first of all.It should be remembered that all items which
appear in the Trial Balance should be shown only once whereas items
which appear outside the Trial Balance, known as adjustments, have
to be shown at two places.
2. The items which appear on the debit side of the Trial Balance should
be shown either on the debit side of the Trading or Profit and Loss A/c
or on the Assets side of the Balance Sheet.
3. The items which appear on the credit side of the Trial Balance should
38 Accounting Mechanics
 be shown either on the credit side of the Trading or Profit & Loss A/c Financial & Management
or on the Liabilities side of the Balance Sheet. Accounting

4. All accounts relating to Goods such as Purchases, Sales, Purchase

Returns and Sales Returns are written in the Trading Account. In NOTES
addition to these, the Trading Account will also be debited with all
expenses which are directly related to either purchase or manufacturing
of goods. All the remaining expenses or the balances of the Nominal
Accounts are shown in the Profit & Loss Account.
5. The balances of Personal and Real Accounts are always shown in the
Balance Sheet.
6. If the expenses in respect of ‘Rent’ and ‘Lighting’ are clearly stated as
having been incurred in respect of factory, these will be shown in the
Trading Account, otherwise these will be shown in Profit & Loss
Account. For example, if ‘Factory Rent’ is given in the question, it
will be shown in Trading Account. Instead, if ‘Rent’ is given, it will
be shown in Profit & Loss Account.
7. If a trial balance is not given in the question, and it is not clearly stated
whether a particular item is expense or income, it will be treated as
expense such as Discount, commission, Brokerage or Rent etc.
8. The total of both sides of the Balance Sheet will always be equal.

Illustration
From the following Trial Balance of Radhe Shyam Trading and Profit and
Loss A/c for the year ending 31st December, 2017 and Balance Sheet as on that
date.
The Closing Stock on 31st December, 2017 was valued at Rs. 2,50,000.

Accounting Mechanics 39
 Financial & Management
Accounting

NOTES

Solution
TRADING AND PROFIT & LOSS ACCOUNT
for the year ending 31st December, 2017

40 Accounting Mechanics
 BALANCE SHEET Financial & Management
Accounting
As on 31st December, 2017

NOTES

Note: The heading of Trading A/c and Profit & Loss A/c is put collectively
as ‘Trading and Profit & Loss A/c’. The first part of this Account is Trading A/c,
whereas the second part is Profit & Loss A/c. Trading Account, in fact, is apart
of Profit & Loss Account.

Sums for Practice

1. From the following balances prepare a Trading, Profit & Loss Account
and Balance Sheet.

Accounting Mechanics 41
 Financial & Management
Accounting

NOTES

Q.2 From the following balances, prepare Final Accounts as on 31st

March, 2018.

The value of Closing Stock on 31st March, 2018 was Rs. 2, 54,000.
Q.3 Following is the Trial Balance of Krishna Enterprise for the year
ended 31st March, 2016.You are required to prepare Trading,
Profit and Loss A/c for the year ended 31st March, 2016 and
Balance Sheet as on that date after considering the adjustments:

42 Accounting Mechanics
 Financial & Management
Accounting

NOTES

Adjustments
1. Closing stock was valued at Rs.20,000.
Q.4. From the following Trial Balance of Akash Ltd. Prepare Final
Accounts for the Year ended 31stDecember, 2017
Adjustments / Additional Information
1. Stock on 31st December 2017 was Rs. 45,000 at cost & Rs.
50,000 at Market value.
2. There were outstanding liabilities in respect of Rent Rs. 2500 &
Wages Rs. 2000.
3. Insurance paid in advance amounted to Rs. 1500
4. Depreciate the following : Machinery @ 10%, Premises @ 15%
& Furniture @ 5%

Accounting Mechanics 43
 Financial & Management
Accounting

NOTES

44 Accounting Mechanics
 Q. 5. Prepare a Trail Balance from the following balance of Neelam Traders Financial & Management
for the year ended 31st March, 2018. Accounting

NOTES

Objective Questions

Q.1 Fill In Blanks

1. -----is the excess of Assets over Liabilities.
2. ----is the motivation for making prompt payment.
3. ---------is not recorded in the Books of Accounts.
4. Goodwill is an -----Asset.
5. --------is a Statement but not an Account.
6. Wear & Tear on Fixed Assets is Called --------
7. In Book Keeping, only ------- transactions are recorded.
8. The Asset that can be seen & touched is --------Asset.
9. If a business suffers loss, the ------of the owner/Proprietor decreases.
10. There are ----Parties to a cheque.
11. A ---is a Debt which can’t be recovered.
12. Bad-Debts indicate -------for the business due to Debtors.
13. Copyright, Patent, Trademark is ---------Assets.
Accounting Mechanics 45
 Financial & Management 14. ----------can be seen & touched.
Accounting
15. -------is closely related to Realization Concept.
16. Real Account always has always a----------balance.
NOTES
17. --------Account can have Debit or Credit Balance.
18. When Proprietor brings cash in the business, Capital Account is -----
& Cash Account is ----
19. ----- Assets are Valued at Cost less Depreciation.
20. The ----- is a book of Prime entry.
21. ------is the document on which the entry is passed in the Journal.
22. --------- is a brief description of the transaction.
23. A reduction allowed on the ---------price of the Goods is called Trade
Discount.
24. A Discount is Income to the Buyer & Loss to the Seller.
25. ------means a page.
26. Goods taken by the Proprietor for his personal use are called as -----

Q.2 State True or False with reasons

1. Loan Taken for a Long period is a Current Liability –.
2. Loan Taken for a Long period is a Fixed Liability –
3. Loan Taken for a Short period is a Current Liability – .
4. Excess of Income over Expenditure is called Profit – .
5. Excess of Expenditure over Income is called Profit – .
6. Excess of Expenditure over Income is called Loss–
7. A Voucher is a document that supports a payment made by the
business- .
8. Accounting is the language of the business- .
9. Nominal Accounts are the Accounts of Assets- .
10. Real Accounts are the Accounts of Assets- .
11. Nominal Accounts are the Accounts of Expenses, Losses, Incomes &
Gains- .
12. Personal Accounts always show Debit Balance- .
13. Nominal Accounts are also called as Fictitious/Temporary Accounts-
14. The expression Depreciation 5% & 5%p.a. conveys the same meaning-
15. An accounting year can be a Financial Year or Calendar year- .

46 Accounting Mechanics 16. Accounting involves communication- .

17. A Creditor is a person to whom an amount is owed- . Financial & Management
Accounting
18. A Debtor is a person to whom an amount is owed- .
19. A Debtor is a Current Asset for the business- .
NOTES
20. Goodwill is not a Tangible Asset- .
21. Bank of India is a Real Account- .
22. Bank of India is a Personal Account- .
23. Indirect Expenses are recorded in Trading Account- .
24. Direct Expenses are recorded in Trading Account- .
25. Indirect Expenses are recorded in Profit & Loss Account- .
26. Journal is a book of Prime Entry- .
27. Ledger is Secondary Book of Account- .
28. Ledger is dependent on Journal book- .
29. Ledger is an Independent Book- .
30. Journal is an Independent Book- .
31. Postings are entered in Journal book-.
32. Postings are entered in Ledger book-.

*****

Accounting Mechanics 47
 Financial & Management
Accounting

UNIT - III
NOTES
INTRODUCTION TO
INTERNATIONAL ACCOUNTING
STANDARDS

Introduction / Overview
In the earlier chapter, we have seen how the accounting cycle works i.e. all
business transactions are entered into Journal, then all accounts are posted to
ledger, the summary is prepared i.e. Trial balance and at the end of the year Final
Accounts are prepared. Trading Account, Profit & Loss Account and Balance
Sheet. It is compulsory to publish Annual Report for every joint stock company.
To have uniformity in the preparation of final accounts, accounting standards are
formed and followed. In this chapter, we are going to see the emergence and need
of International Financial Reporting Standards (IFRS) and the role of
International Accounting standards
Learning Objectives: To understand the concept of Accounting Standards,
Need and emergence of International Financial Reporting Standards (IFRS).
Key Words: Financial Reporting, International Accounting Standards,
International Financial Reporting Standards (IFRS),

3.1 DEVELOPMENT OF INTERNATIONAL ACCOUNTING

AND FINANCIAL REPORTING RULES:

Financial Accounting aims to record, process, communicate and report on

the business activities of an organization through financial statements with a main
objective to help various user groups like management, investors, shareholders,
creditors and tax authorities. To help the users, it is necessary that financial
statements of different organizations are prepared on uniform basis. It is also
required to have comparison of financial statements of two years, consistency is
maintained over a period of time.
If every organization follows its own notion about the accounting terms like
revenue, expenses, assets, liabilities and income there will be complete chaos.
The figures of profit will be different as every business is following different
perception of various terms. Thus, there is need of Accounting Standards.
Introduction to
International
48 Accounting
3.1.1 Need of Financial Reporting Standards: Financial & Management
Accounting
In the current era of Globalization and uncertain business environment, the
stakeholders in any organization would like to have transparent and accurate
financial reporting. In addition to key stakeholders, bankers, creditors would be NOTES
using the financial statements of the organization to make financial decisions.
Therefore, financial reporting plays very important role. It must be unbiased,
comparable, transparent and uniform. Hence, it is important to have sound
financial reporting governed by a comprehensive Accounting Standards for every
country.
In India, the Accounting Standards are managed by the Institute of
Chartered Accountants of India through Accounting Standard board (ASB) since
1977.

3.1.2 Objectives and functions of ASB

The following are the objectives of Accounting Standard Board:
(i) To conceive and suggest areas in which Accounting Standards need to
be developed.
(ii) To formulate Accounting Standards with a view to assist the council
of ICAI in evolving and establishing Accounting Standards in India.
(iii) To see how far the relevant International Accounting Standards or
International Reporting Standards can be adopted while formulating
the Accounting Standards and to adopt the same.
(iv) To review at regular intervals, Accounting Standards form the point
of view of acceptance or changed conditions and if necessary revise
the same.
(v) To provide guidance on implementation of Accounting Standards
The ASB has also been responsible for propagating the Accounting
Standards and of persuading the concerned parties to adopt the same in the
preparation and presentation of financial statements.

3.1.2 Scope of Accounting Standards

Accounting Standards give guidance as how to deal with a particular
transactions and also bring clarity for the presentation and disclosure of financial
statements. Efforts will be made to issue Accounting Standards which are in
conformity with the provisions of the applicable law, customs, usages and
business environment in India. However, if the local regulatory requirements
have any specific expectations on the presentations of financial statements, then
the Accounting Standards will not override such regulations.

3.1.3 Procedure for issuing Accounting Standard

Based on the industry requirements and prevailing business environment,
Introduction to
Accounting Standard Board (ASB) normally determines the area where the
International
Accounting Standards need to be considered. Accounting 49
 Financial & Management Once such selection is done and prioritization is completed, a study group
Accounting is formed for collecting thoughts from members of various institutions. In the
formation of study groups, provision will be made for wide participation by the
NOTES members of the institute and others.
The draft standard should talk about the objective, scope, definitions, any
recognition and measurement principles, or logic used and presentation and
disclosure requirements.
ASB will consider the preliminary draft prepared by the study group and if
any revision is required ASB will make the same or refer the same to the study
group.
ASB will circulate the draft of Accounting Standard to the council members
of the ICAI, the views are taken on the draft. On the basis of comments received
and discussions with the representatives of specified bodies, the ASB will finalize
the exposure draft of proposed Accounting Standard.
Once draft is submitted, it will go through few rounds amongst the council
members of the institute and later submitted to the ICAI council. Once approved,
it will be formally communicated to public for adoption with effective date of
applicability.

3.1.4 Compliance with the Accounting Standard

The Accounting Standards becomes mandatory from the respective date
mentioned. It will be duty of the members of the institute to examine whether
the accounting standard is complied within the presentation of financial
statements covered by their audit.
In case of non compliance observations, the auditors have to make
appropriate disclosure on their audit report for the benefit of the users of the
financial statements.
Ensuring compliance with the accounting standards while preparing the
financial statements, is the responsibility of the management.
Financial statements cannot be described as complying with the Accounting
Standards unless they comply with all the requirements of each applicable
standard and appropriate disclosure for the non adoption of any specific
applicable standard.

Indian Accounting Standards

The Institute of Chartered Accountants of India has issued Accounting
Standards covering various aspects. For details refer the website
http://www.icai.org

International Accounting Standards

Introduction to All countries follow the Accounting Standards laid down by the empowered
International Accounting Standard Board. Accounting Standards are designed by the
50 Accounting
professional bodies in conjunction with the financial body (or Board) with due Financial & Management
consideration to industry practice / recommendation. Accounting

United States of America use Generally Accepted Accounting Principles

(US GAAP). Accounting Standards are issued by the American Institute of NOTES
Certified Public Accountants (AICPA) in consultation with Financial Accounting
Standards Board (FASB).

3.1.5 International Financial Reporting Standards (IFRS)

As mentioned above, each country has its own way of presentation of
Financial Reports. In India, Accounting Standards are issued by ICAI, US follows
US GAAP, UK follows UK GAAP. GAAPs are framed based on regulations and
policies as per their legal and statutory requirements.
Due to globalization, there is a need for organizations in different countries
to invest in other countries and create a global enterprise. In order to bring
uniformity in presentation of Financial Reports, International Financial Reporting
Standards (IFRS) is being recommended for uniform presentation of Financial
Reports across the globe.
IFRS: ‘International Financial Reporting Standards are principles based
standards, interpretations and the framework (1989) adopted by the International
Accounting Standards Board (IASB).’
Indian Accounting Standards are the standards issued by the Central
Government in consultation with the National Advisory Committee on
Accounting Standards (NACAS). Since the beginning of the 21st century, in the
later half, the move is to harmonize the Indian financial reporting practices with
the international financial reporting norms. The International Financial Reporting
Standards mean the International Accounting Standards issued between 1973 and
2001 by the International Accounting Standards Committee (IASC). Accounting
Standards interpretations issued by Standard Interpretation Committee (SIC) of
IASC, International Financial Reporting Standards issued from 2001 onwards
by the IASB and the interpretations issued by the International Financial
Reporting Interpretations Committee (IFRIC) of the IASB. IASB is a privately
funded international Accounting Standards setter based in London.

At present, there are

• International Accounting Standards (IASs)
• Interpretations issued by Standards Interpretations Committee
• International Financial Reporting Standards (IFRS)
• Interpretations issued by International Financial Reporting Interpretations
Committee.

Introduction to
International
Accounting 51
 Financial & Management Structure of IFRS
Accounting
The harmonization of the country specific reporting with global reporting
practices may be achieved by the following either:
NOTES
Adoption approach
Adaption (Convergence approach)
Given the increased focus and need of having one global accounting
standards, all the countries are in process of moving towards International
Financial Reporting Standards. Two approaches are followed by the countries
Adoption and Convergence.
Adoption of IFRS means following the IFRS in toto i.e. as it is without any
exception.
Convergence with IFRS means achieving harmony with IFRS. In other
words, Convergence with IFRS can be considered as designing and applying the
national accounting standards to ensure that financial statements prepared in
accordance with the national accounting standards draw an unreserved
compliance with IFRSs.
Paragraph 14 of the International Accounting Standard (IAS) 1 states that
financial Statements shall not be described as complying with IFRS unless they
comply with all the requirements of IFRS However, the IASB accepts in its
statement of best practice: working relationship between the IASB and other
accounting standards setters that adding disclosure requirements or removing
optional treatment does not create non compliance with IFRS. Thus, convergence
with IFRS means adoption of IFRS with the aforesaid exceptions, where
necessary.
There has been a lot of debate in the past, whether India should adopt IFRS
or it should converge its own accounting standards with IFRS. Finally, it was
decided by the Government of India, in consultation with the ICAI and the
National Advisory Committee on accounting standards (NACAS) constituted
under section 210A of the Companies Act 1956, that India should converge its
national accounting standards with IFRS and should not adopt the same. To
achieve this, Indian Accounting Standards are revised to fall in line with IFRS.
The Ministry of Corporate Affairs has notified 35 converged Indian accounting
standards.
In view of the benefits of convergence with IFRS to the Indian economy,
investors, industry and the accounting professionals, ICAI has also made a road
map for converging with IFRS within a time frame. Keeping in view the complex
nature of IFRS and the extent of differences between the existing As and the
corresponding IFRS , the ICAI has recommended that IFRS should be adopted
by for the public interest entities such as listed entities, banks and insurance
Introduction to entities and large sized entities from the accounting period beginning on or after
International 1st April, 2011.
52 Accounting
 In order to facilitate reference to the existing Indian Accounting Standards, Financial & Management
along with the IFRS number the existing accounting standards numbers are Accounting
revised called Ind AS.
NOTES
Advantages of IFRS
• It enhances Indian companies to raise and attract foreign capital at low
cost.
• It escapes from multiple reporting requirements for multinationals
• Avoids reporting under different GAAPs.
• It enables harmonization of accounting standards across the globe.
• It is a step ahead from traditional historical cost approach to concept of
fair valuation.

IFRS for Small and Medium Enterprises (SMEs)

The IFRS for SMEs Standard is a small Standard (approximately 250 pages)
that is tailored for small companies. These standards focuses on the information
needs of lenders, creditors and other users of SME financial statements who are
interested primarily in information about cash flows, liquidity and solvency. And
it takes into account the costs to SMEs and the capabilities of SMEs to prepare
financial information.
While based on the principles in full IFRS Standards, the IFRS for SMEs
Standard is stand-alone. It is organised by topic.
For detailed study of the standards and list of standards, visit the
following websites:
www.iasplus.com
http://ifrsonline.in
www.ifrs.org
www.ifrs.com

Exercises for Self Learning Questions

Q.1 What is the need for International Financial Reporting Standards
(IFRS)?
Q.2 Write a detailed note on Development of International Accounting
and Financial Reporting rules.
Q.3 Explain the importance of ‘International Financial Reporting
Standards’ (IFRS).
Q.4 Write a detailed note on ‘International Financial Reporting Standards’
(IFRS).
Q.5 Explain the importance of ‘International Accounting Standards’. Introduction to
Q.6 Write a detailed note on ‘International Accounting Standards’. International
Accounting 53
 Financial & Management Multiple Choice Questions
Accounting
1. In India, the Accounting Standards are managed by the Institute of
Chartered Accountants of India through:
NOTES a) Accounting Board
b) Accounting Standard board
c) Financial Reporting Board
d) None of above
Ans: B
2. Ensuring compliance with the accounting standards while preparing
the financial statements, is the responsibility of:
a) ICAI
b) ASB
c) Management
d) Auditors
Ans: C
3. United States of America use:
a) US GAAP
b) GAAP
c) Reportinf Standards
d) None of Avove
Ans: A
4. The following are the advantages of IFRS:
a) It enhances Indian companies to raise and attract foreign capital
at low cost.
b) It escapes from multiple reporting requirements for
multinationals
c) Avoids reporting under different GAAPs.
d) All of above
Ans: D
Activity: Visit the websites of Institute of Chartered Accountants of India
and IFRS. Read and understand the Accounting standards and its application.
Understand the Concept of ‘Ind AS’.

References
i) S N Maheshwari, Financial Accounting,Vikas publications, Fifth
Edition
ii) Dr. Sakshi Vasudeva, Accounting for Business Managers, Himalaya
Publishing House
iii) Pauline Weetman, Financial and Management Accounting – An
introduction, 5th edition
iv) Dr. Ashok Sehgal, Fundamentals of Financial Accounting, Taxmann’s
4th edition
Introduction to
International *****
54 Accounting
 Financial & Management
Accounting

UNIT - IV NOTES
INTRODUCTION TO COST AND
MANAGEMENT ACCOUNTING

Introduction / Overview
In the first part of the subject, we have seen Financial Accounting and
preparation of Financial Statements. Now question is after looking at the whole
procedure of Financial Accounting, what is the need of Cost Accounting?
In this chapter, we are going to see other two branches of Accounting i.e.
Cost Accounting and Management Accounting. The chapter covers meaning and
importance of Cost Accounting and Management Accounting and how it defers
from Financial Accounting. The chapter also focuses on nature and scope of
Management Accounting.
Learning Objectives: To understand the Nature and Scope of Cost
Accounting and Management Accounting, To learn how to prepare Cost Sheet

Key Words
Cost Sheet, Classification of Costs, Cost Accounting, Management
Accounting

4.1 COST ACCOUNTING

4.1.1 Limitations of Financial Accounting

Cost Accounting has come into picture as there are certain limitations of
Financial Accounting. Financial Accounting cannot provide all the information
required by management. Now let us see limitations of Financial Accounting:
i) Focuses on overall performance: Financial Accounting considers
information about business as a whole. Financial Statements i.e. Profit
& Loss A/c gives profit earned or loss incurred by the company as a
whole and Balance Sheet gives Assets and Liabilities of business as a
whole. Thus, it cannot provide product wise department wise data.
ii) Provides Historical Costs: Historical cost means the cost which is
recorded after it is incurred. In Financial Accounting, all expenses and
income are recorded after it is incurred. The costs are never determined Introduction to Cost and
in advance. Thus, historical costs are not useful for decision making. Management
Accounting 55
 Financial & Management iii) Performance cannot be evaluated: Financial Accounting keeps the
Accounting record of business as a whole. Department wise, Product wise records
are not maintained. So performance cannot be evaluated.
NOTES iv) Cost Control is not possible: As the costs are not determined in
advance, targets cannot be given and control is not possible.
v) Price fixation is not possible: Product wise costs are not ascertained
in Financial Accounting, so it is not possible to decide the price of the
products.
vi) Cannot supply useful data to Management: Financial Accounting
cannot provide useful data to management in taking various decisions
like selection of profitable Product Mix, Make or Buy decision,
Introduction of new product, closure of business
After discussing the above points related to limitations of Financial
Accounting, to overcome these limitations there is need of Cost Accounting and
Management Accounting.

4.1.2 Meaning of Cost Accounting

Definitions: The Institute of Cost Accountants of India has defined Cost
Accounting as “Accounting for costs classification and analysis of expenditure
as will enable the total cost of any particular unit of production to be ascertained
with reasonable degree of accuracy and at the same time to disclose exactly how
such total cost is constituted”.
L. C. Cropper’s definition “Cost Accounting means a specialized application
of the general principles of Accounting in order to ascertain the cost of producing
and marketing any unit of manufacture or of carrying our any particular job or
contract.”
In simple words, cost accounting is a formal system of accounting for costs
by means of which costs of products and services are ascertained and controlled.

4.1.3 Objectives and Importance of Cost Accounting

After looking at the definition and meaning of Cost Accounting, now we
will learn the main objectives of Cost Accounting:
i) Ascertainment of Costs: In Cost Accounting, cost of each unit of
production, job, process is ascertained by following formal and
authentic process. In Cost Accounting, costs are also pre-determined
for control purpose. To ascertain the costs accurately, various methods
and techniques are employed.
ii) Cost Control and Cost Reduction: The main aim of Cost Accounting
is to improve profitability by controlling and reducing the costs. The
specialized techniques of cost control like Standard Costing,
Introduction to Cost and
Budgetary Control are applied. In today’s globalized era, selling price
Management
56 Accounting cannot be increased. It is mandatory to focus on Cost Control and Cost
 Reduction by applying various techniques. Financial & Management
Accounting
iii) Helps in formation of Business Policy: Cost data provides guidelines
for various managerial decisions like Make or Buy decision, launching
new product. Cost Accounting serves the needs of management in NOTES
conducting the business with utmost efficiency.
iv) Fixation of Selling Price: On the basis of accurate cost of product or
services, the business can fix the selling price. At the time of recession,
it can be decided to what extent selling price can be reduced with the
help of Cost Accounting data.
Thus, Cost Accounting is the important basis for decision making and policy
formulation.

4.1.4 Important Concepts of Cost Accounting

Cost Centre: For the purpose of ascertainment of costs, the whole
organization is divided into small parts or sections. Each small part is treated as
Cost centre. Of which cost is ascertained. A location, person or item of equipment
for which costs may be ascertained and used for the purpose of control is called
Cost Centre.

Cost centres are of two types

Personal Cost Centre: Cost centre which consists of a person of a group
of persons is called personal cost centre. For example, The organization is divided
into persons called Sales Manager, Production Manager Human Resource
Department Head. The costs are ascertained person wise.
Impersonal Cost Centre: These cost centre which consists a location,
equipment are called Impersonal cost centres. Costs are ascertained to the cost
centres. For example, Production Department, Sales Department, Human
Resource Department. These cost centres are divided into Production Cost
Centres and Service Cost centres. Service cost centres provide service to
Production cost Centres.
While implementing Cost Accounting system in the organization, The first
step the cost accountant takes is determination of cost centres. The purpose of
ascertaining the cost of a cost centre is cost control.

Cost Unit
Cost Unit goes a step further by breaking up the cost into smaller division,
thereby helping in ascertaining cost of products or services.
A cost unit is defined as unit of production or service in relation to which
costs are ascertained. For example, in cement company, cost per tonneis
ascertained and expressed. In textile mill, cost per meter is ascertained and
expressed. Costs units are divided into Simple cost unit and Composite Cost unit. Introduction to Cost and
Management
Accounting 57
 Financial & Management Single Cost Unit: Where single cost unit can serve the purpose of
Accounting ascertaining costs Single cist unit is identified and used. For example, Cost unit
produced, Cost per Tonne, Cost per Meter.
NOTES Composite Cost Unit: Where single cost unit does not serve the purpose
more than one unit are identified. For example, in transport industry, cost per
Kilometer Passenger is ascertained. In goods transportation, cost per Tonne
Kilometer is ascertained.
Thus, Determination of Cost centre and cost unit is the basic step in
implementation of Cost Accounting system.

4.2 CLASSIFICATION OF COSTS

The costs are classified on various basis for important purposes.

The above chart explains how costs are classified on various basis. Now let
us see in detail the classification of costs.

i) Elementwise classification
The cost of any product or service is composed of three elements i.e.
Material, Labour and Expenses. Each of these elements are again divided into
Direct Cost and Indirect Cost.
• Material Cost: Material cost is “The cost of commodities supplied to an
undertaking”. Material cost includes cost of procurement, Freight paid
on purchases, taxes paid, insurance directly attributed to the acquisition
of material. Material cost is divided into Direct Material and Indirect
Material.
Direct Material: The material which can be conveniently identified with
and allocated to the product or service is called Direct Material. Direct
material generally becomesa part of the finished product. For example,
cotton used in textile, plywood used in furniture, leather used in shoes,
Steel used in machines. However, the material with negligible value is
treated as Indirect material because value of such material is so small that
it is quite difficult to measure it. For example, nails used in furniture,
thread used in garments.
Introduction to Cost and
Indirect Material: The material which cannot be conveniently identified
Management
58 Accounting with and allocated to the product or service is called Indirect Material.
 These are generally minor in importance. Such as small and relatively Financial & Management
inexpensive items which may become part of finished products. For Accounting
example pins, screws, nuts, bolts, thread. The items of material which do
not become part of finished product for example coal, lubricating oil, NOTES
grease.
• Labour Cost: Labour cost is “The cost of remuneration (Wages, Salary,
Commission, Bonus) of the employees of an undertaking”. Labour cost
includes all fringe benefits like PF, Gratuity, incentive bonus. Labour cost
is divided into Direct Labour and Indirect Labour.
Direct Labour: Wages paid to workers directly engaged in converting
raw material into finished products. These wages can be conveniently
identified with a particular product or service. For example, wages paid
to a machine operator are direct wages.
Indirect Labour: The remuneration which cannot be conveniently
identified with a particular product or service is called Indirect Labour.
For example, salary of manager.
• Expenses: All costs other than material and labour are termed as
expenses. “The cost of services provided to an undertaking and notional
cost of the use of owned assets.”Expenses are divided into Direct
Expenses and Indirect Expenses.
Direct Expenses: “Direct Expenses are those expenses which can be
identified with and allocated to cost of product or service.”These
expenses are specifically incurred in connection with a particular job or
product. For example, Royalty paid in mining, Hire of special plant, Cost
of special drawing, design, layout.
Indirect Expenses: All indirect costs other than indirect material and
indirect labour are termed as indirect expenses. These cannot be directly
identified with a particular product or service. For example, Rent,
Depreciation, Insurance, Repairs, Advertising.

Equations
Material Cost + Labour Cost + Expenses = Total Cost
Direct Material + Direct Labour + Direct Expenses = Prime Cost
Indirect Material + Indirect Labour + Indirect Expenses = Overheads

ii) Function wise Classification

As per the equation given above, the total of indirect material, indirect
labour and indirect expenses is called overheads. The overheads are further
classified according to functions of organization as follows:
• Production Overheads: Production overheads are also known as Factory Introduction to Cost and
overheads, Works overheads or Manufacturing overheads. The overheads Management
Accounting 59
 Financial & Management which are concerned with the production function are called factory
Accounting overheads. Factory overheads include indirect material, indirect labour
and indirect expenses incurred in factory.
NOTES For example, Indirect Material like coal, oil, grease, cotton waste used
in factory. Indirect labour like Works manager salary, wages of factory
sweeper and Indirect expenses like insurance of factory building, factory
lighting, power.
Thus, Factory Overheads include all costs starting from purchase of
material till the finished goods are ready in factory.
• Office and Administrative Overheads: These overheads are related with
the administration function. For example, costs incurred in formulating
policies, planning and control, directing, motivating. It includes Indirect
Material like stationary used in office, postage, Indirect Labour like salary
of office staff, salary of managing director, and Indorect Expenses like
office lighting, power, telephone expenses, sundry office expenses.
• Selling and Distribution Overheads: Selling overhead is a cost of
promoting sales and retaining customers. “The cost of seeking to create
and stimulate demand and of securing orders.” For example,
advertisement expenses, samples and free gifts, salary of salesmen.
Distribution Overheads include all expenditure incurred from the
completed product till it reaches to the customer. For example, carriage
outward, warehousing cost, commission of distributors.

iii) Behaviour wise Classification

Under behavior wise classification, the costs are classified according to the
behavior of costs with respect change in volume of production. Costs behave
differently when level of rises or falls. On the basis of behavior or variability,
costs are classified into variable, semi variable and fixed costs.
• Fixed Costs: The costs which remain constant though there is change in
volume of production are called Fixed costs. The features of Fixed cost
are as follows:
• These costs remain constant in total over a specific range of activity for
a specified period of time. These costs do not increase or decrease when
the volume of production changes. For example building rent, managerial
salary remain constant in total with change in volume of output.
• Fixed cost per unit decreases when volume of production increases and
vice versa.
• Fixed costs can be controlled mostly at the level of top management.

Introduction to Cost and

Management
60 Accounting
 Let us take example of behavior of fixed cost with graphical presentation. Financial & Management
Accounting
The following information is available of Amrut Ltd.
No. of units produced Total Fixed Cost Fixed cost per unit
NOTES
200 Units Rs. 2,00,000 Rs. 1,000
400 Units Rs. 2,00,000 Rs. 500
600 Units Rs. 2,00,000 Rs. 333
800 Units Rs. 2,00,000 Rs. 250

Graphical presentation of Total Fixed Cost

Interpretation: In the above graph, number of units produced are shown on

X axis and Total Fixed cost is shown on Y axis. The graph is parallel to X axis.
It means whatever be the level of production, Total Fixed cost remains constant.

Graphical presentation of Fixed Cost per unit

Interpretation:In the above graph, number of units produced are shown on

X axis and Fixed cost per unit is shown on Y axis. The graph says that as the
number of units are increased the fixed cost per unit is increased in the same
proportion.
• Variable Cost: The costs which vary in direct proportion with the volume
of output are called variable costs. The features of variable costs are as
follows:
• Variable costs changes in direct proportion with volume of production.
Introduction to Cost and
As the volume of production increases variable cost increases and vice
Management
versa. Accounting 61
 Financial & Management • Variable cost per unit remains constant.
Accounting
• Variable costs can be controlled by functional managers.
Let us understand behavior of variable cost with example and graphical
NOTES
presentation.
Abhay Ltd. produces product X with the following cost structure.
No. of units produced Variable cost per unit Total Variable Cost
1,000 Units Rs. 500 Rs. 5,00,000
1,500 Units Rs. 500 Rs. 7,50,000
2,000 Units Rs. 500 Rs. 10,00,000
2,500 Units Rs. 500 Rs. 12,50,000

Graphical presentation of Total Variable Cost

Interpretation: In the above graph, number of units produced are shown on

X axis and total variable costs are shown on Y axis. The graph says that as the
number of units are increased the Total variable cost is increased in the same
proportion.

Graphical presentation of Variable Cost per unit

Interpretation: In the above graph, number of units produced are shown on

X axis and Variable Cost per unit is shown on Y axis. The graph is parallel to X
Introduction to Cost and
axis. It means whatever be the level of production, Variable cost per unit remains
Management
62 Accounting constant.
 Thus, it is observed that behavior of variable cost is exactly opposite of Financial & Management
fixed cost. Accounting

• Semi Variable Costs: The costs which are not 100% fixed and not 100%
variable are classified as Semi variable costs. A semi variable cost has a NOTES
fixed element below which it will not fall at any level of output. For
example, Supervision costs, Maintenance and repairs, Telephone
expenses, Depreciation and Light and power. One has to study every semi
variable cost minutely to study the fixed element and variable element
in it. Thus, the graph of every semi variable cost differs with the nature
of cost.

iv) Time Wise Classification

On the basis of time of consumption, costs are classified into Historical
costs and pre-determined costs.
• Historical Costs: The costs which are ascertained after these have been
incurred are called historical costs. Historical costs are actual costs. These
costs are not useful for control purpose. For example, purchased material
worth Rs. 50,000 is called historical cost.
• Pre-determined Costs: The costs which are determined in advance
before incurring are called pre-determined costs. These are future costs.
These costs are used for the purpose of Planning and Control.

v) On the basis of Controllability

On the basis of controllability, the costs are classified as Controllable costs
and non controllable costs.
• Controllable Costs: The costs which may be regulated at a given level
of management authority are called controllable costs. Variable costs are
generally controllable by department heads. For example, cost of raw
material may be controlled by purchase department head.
• Non Controllable Costs: The costs which cannot be influenced by the
action of a specific member of authority is called non controllable costs.
For example, it is very difficult to control costs like factory rent,
managerial salary.
Thus, the controllability of costs depends upon level and scope of
management authority and time. The costs which are non controllable in short
term can be controllable in long term.

vi) On the basis of Normality

On the basis of normality, the costs are classified as Normal costs and
Abnormal Costs.
• Normal Costs: The costs which are incurred during normal production Introduction to Cost and
cycle are called normal costs. For example, Cost of material, labour Management
Accounting 63
 Financial & Management expenses incurred.Normal costs are absorbed in the cost of product as it
Accounting is part of regular production cycle.
• Abnormal Costs: The costs which are not incurred during normal
NOTES production cycle are called normal costs. These costs are incurred over
and above the normal production costs. These costs are incurred due to
abnormal reasons. For example, loss by fire, loss in transit. These costs
are not absorbed in the cost of product. They are charged to costing profit
and loss account.

vii) Other costs

The costs which cannot be categorized in above classification are classified
as Other costs.
• Sunk Cost: A sunk cost is an expenditure made in past that cannot be
changed and over which management has no control. These costs are not
useful for decision making. For example, cost of land purchased in 1992
is not relevant in deciding whether to sell the land or hold it.
• Opportunity Cost: Opportunity cost is the cost of opportunity lost. It is
the sacrifice involved in accepting an alternative under consideration. It
measures the benefit that is lost or sacrificed. For example, a company
has deposited Rs. 1 Lakh in bank at 10% p.a. interest. Now it is
considering a proposal to invest this amount in debentures where the yield
is 17 % p.a. if the company decided to invest in debentures, it will have
to forgo Bank interest of Rs. 10,000 p.a. which is opportunity cost.
• Out of pocket Cost: The costs which require cash payment to be made
are called pot of pocket costs. Out of pocket costs are useful for decision
making. For example, while making decision of export pricing only out
of pocket costs are considered i.e. payment required to be made for
material, labour and expenses.

4.3 COST SHEET

Cost Sheet is a statement which is prepared periodically to provide detailed

cost of a cost centre or cost unit. A Cost Sheet also shows various components of
cost.
While preparing Cost Sheet, we use Element wise and Function wise
classification of costs. Now we will see the format of Cost Sheet.

Introduction to Cost and

Management
64 Accounting
 Format of Cost Sheet Financial & Management
Accounting

NOTES

The above format shows how the costs are presented in the Cost Sheet under
various headings. Now to understand the above classification of costs, let us solve
the following practical questions.
Overhead Absorption Rate: As per the nature of overheads, overhead
absorption rates are calculated by following procedure in Cost Accounting.

4.4 MANAGEMENT ACCOUNTING

As we have seen the two branches of Accounting Financial Accounting and

Cost Accounting, the other branch of Accounting is called Management
Accounting which has still broader scope. In simple words, “Management
Accounting is concerned with accounting information that is useful to
management.” By R. Anthony.
Definition: “A system of collection and presentation of relevant economic
information relating to an enterprise for planning, controlling and decision
making.” by Institute of Cost Accountants of India.
Introduction to Cost and
Thus, it is clear from the above definitions that the basic objective of Management
Management Accounting is to help management in carrying out its functions. Accounting 65
 Financial & Management 4.4.1 Characteristics or Nature of Management Accounting
Accounting
The following are the characteristics of Management Accounting
• Internal use: The information provided by Management Accounting is
NOTES
exclusively for the use by management for internal use. The information
is strictly confidential. It is not shared with other stakeholders.
• Purely optional in nature: Management Accounting is not compulsory
by law. It is purely optional in nature. But as it is very useful for
management in carrying out its functions and thus implemented by every
organization.
• Not a separate branch of Accounting: Management Accounting is not
a separate branch of Accounting. It uses information derived from
Financial Accounting, Cost Accounting and other required data.
• Concerned with Future: Management Accounting focuses on future. It
uses predetermined costs i.e. costs determined in advance for planning,
decision making and control.
• Useful in Decision Making and Control: The main aim of Management
Accounting is to assist the management in decision making and control.
The management accountant prepares the reports as per the requirement
of management. The data is provided to the management which helps the
management in decision making and control.
• Flexible in presentation of information: As Management Accounting
is not compulsory by law, there are no standard formats of presentation
of information. The management accountant can decide the way of
presentation as per the requirements of management.

4.4.2 Scope of Management Accounting

Management Accounting has a very wide scope. The following points
shows the scope of Management Accounting.
• Financial Accounting: Financial Accounting provides basic historical
data of the organization for a certain accounting period. This data gives
all facts and figures to the management accountant.
• Cost Accounting: Cost Accounting provides the data of costs of product
or service. There are techniques of cost control which are implemented
in Cost Accounting and the data is considered in Management
Accounting for decision making. Management Accounting uses the
information provided by Cost Accounting.
• Statistical Tools: Various tools of analyzing and presenting statistical
data like graphs, tables, charts are used by the Management Accounting.
Management Accountant uses statistical techniques in analyzing the data
Introduction to Cost and collected for decision making and presentation.
Management
66 Accounting
 • Internal Control and Internal Audit: Management Accountant depends Financial & Management
upon Internal Control techniques used as well as Internal Audit which Accounting
helps in cost control.
• Financial Analysis and Interpretation: Management Accountant NOTES
employs various financial analysis techniques to analyze and interpret
financial data like ratio analysis, fund flow analysis. The analysis helps
management in interpretation of data and decision making.
• Tax Planning: While making decisions, the management accountant has
to consider the tax aspects of proposal after studying Tax Laws. This
helps the management to minimize the tax liability.

4.4.3 Objectives / Functions of Management Accounting

The main Objectives / Functions of Management Accounting are as follows:
• Planning: As Management Accounting is future oriented and costs are
determined in advance, it helps the management in carrying out planning.
In the techniques like Budgetary Control and Standard Costing, the costs
are determined in advance. Management can do forecasting and can
prepare short term and long term plans of action.
• Coordinating: Management Accounting techniques aim to coordinate
between various departments. For example, while implementing
budgetary control, the budget is prepared and implemented in all
departments and the reports are to be given by all departments. Thus,
coordination has to be done. In standard costing technique, the standards
are set and assigned to all departments. These techniques help in
coordination.
• Communication: Management Accounting system generates systematic
channels of communication. In Budgetary control as well as standard
costing, initially budgets or standards are assigned and at the end of actual
cost is incurred the departments report it to higher authorities. Thus,
formal channels of communication are created amongst the organization.
• Controlling: Cost control is the main objective and function of
Management Accounting. Standard Costing, Budgetary Control,
Inventory Control, Ratio Analysis are the main techniques applied for
the purpose of control over the organizational functions.
• Decision making: Decision making is very important objective of
Management Accounting. The techniques of Management Accounting
helps the management in short term and long term decision making. For
example, Marginal Costing, Differential Costing.
• Financial Analysis and Interpretation: In order to make financial data Introduction to Cost and
easily understandable and usable, the Management Accounting offers Management
Accounting 67
 Financial & Management various techniques which helps in interpretation of data and decision
Accounting making. Ration Analysis, Funds Flow Analysis, Cash Flow Analysis are
the techniques used for interpretation of financial data.
NOTES
4.4.4 Distinction between Financial Accounting and
Management Accounting
Financial Accounting and Management Accounting are two major branches
of accounting information system. Bothe are concerned with financial data. But
there are various points of differences. Now we are going to see, how these two
branches of accounting are different from each other.

• Users
Financial Accounting: Financial Accounting information is mainly useful
to external users like investors, shareholders, creditors, Government authorities.
The main objective of Financial Accounting is to disclose the Financial
Statements to outsiders.
Management Accounting: Management Accounting information is mainly
useful to internal users i.e. management.

• Statutory Requirement
Financial Accounting: Financial Accounting is compulsory be law.
Companies Act, Income tax Act gives statutory requirements in Financial
Accounting.
Management Accounting: Management Accounting is not compulsory by
law. It is purely voluntary in nature. But, as Management Accounting has high
utility it is adopted by all organizations.

• Time
Financial Accounting: Financial Accounting is historical in nature. It is
concerned with recording transactions which have already taken place. It
represents past and historical data.
Management Accounting: Management Accounting is future oriented. The
costs are determined in advance. It helps in planning and forecasting.

• Accounting Standards
Financial Accounting: Accounting Standards issued by ICAI are
compulsory in preparation of Financial Accounting reports.
Management Accounting: There are no standards set in Management
Accounting. It depends upon the Management Accountant how to present the
report.
Introduction to Cost and
Management
68 Accounting
• Monetary records Financial & Management
Accounting
Financial Accounting: As per the Money Measurement accounting
concept, the transactions which can be measured in terms of money can only be
entered in the books of accounts. NOTES
Management Accounting: In the reports of Management Accounting
monetary and non monetary units are included. For example, number of hours,
units produced are included in the reports.

• Timing of reporting
Financial Accounting: At the end of every financial year i.e. 31st March,
it is compulsory to publish financial statements. Annual Reports are prepared by
every company and anyone can access the annual reports. Thus, the convention
of Disclosure is applied here.
Management Accounting: Management Accounting reports are completele
confidential and not disclosed to anyone. The reports are prepared strictly for the
management and internal use.

• Audit
Financial Accounting: Audit of Financial Accounting is compulsory be
law by the Chartered Accountant. The Auditor’s Report is the main content of
Annual Report.
Management Accounting: Management Accounting Reports are Not
audited as they are prepared for internal use. The reports are neither published
nor audited.

• Types of Statements
Financial Accounting: Income Statement and Balance Sheet are prepared
in Financial Accounting which are used for external use.
Management Accounting: In Management Accounting special purpose
reports are prepared like performance report, Sales manager Report or any
specific report.

Exercises for self learning

Descriptive Questions
Q.1 Define Management Accounting. Explain Nature and Scope of
Management Accounting.
Q.2 What are the functions of Management Accounting?
Q.3 Write a note on Limitations of Financial Accounting.
Q.4 Define Cost Accounting. Explain Objectives and Importance of Cost
Accounting. Introduction to Cost and
Management
Q.5 Write a detailed note on ‘Classification of Costs’. Accounting 69
 Financial & Management Q.6 Distinguish between Financial Accounting and Management
Accounting Accounting.
Q. 7 What do you mean by ‘Cost Sheet’? Give the format of ‘Cost Sheet’.
NOTES
Q. 8 “Management Accounting is the necessity of the current era of
globalization” Discuss the statement.
Q. 9 Write Short Noted on:
i) Cost centre and Cost Unit
ii) Elements of Cost
iii) Fixed cost and variable Cost
iv) Scope of Management Accounting
v) Controllable Costs
vi) Function wise classification of costs.
vii) Opportunity Cost
viii) Out of pocket cost
ix) Usefulness of Management Accounting

Multiple Choice Questions

Q.1 Financial Accounting is ______________ in nature.
a) Future oriented
b) Historical
c) Statistical
d) None of above
Ans: B
Q.2 The characteristic of Fixed cost is
a) It remains constant in total and cost per unit decreases as volume
increases.
b) It changes with volume of production
c) It remains fixed for ever.
d) Cost per unit remains constant.
Ans: A
Q.3 Management Accounting uses information from
a) Financial Accounting
b) Cost Accounting
c) Statistics

Introduction to Cost and d) All of above

Management Ans: D
70 Accounting
Q.4 The characteristic of Normal cost is Financial & Management
Accounting
a) Normal Cost is always fixed
b) Normal Cost is always variable
NOTES
c) Normal Cost is absorbed in the cost of product or service.
d) Normal cost is charged to Costing Profit & Loss Account
Ans: C
Q.5 Controllable Costs are
a) Always fixed
b) Always variable
c) Within the control of Management
d) Abnormal in nature
Ans: C
Q.6 Composite Cost unit is
a) One cost unit
b) More than one cost unit
c) Simple in nature
d) None of above
Ans: B
Q.7 Cost Sheet is
a) A statement of Total cost
b) Profit & Loss statement
c) Balance Sheet
d) None of above
Ans: A
Q.8 Cost of sales include
a) Selling Overheads
b) Profit
c) Loss
d) None of above
Ans: A
Q.9 Cost of Consumables is:
a) Direct Material Cost Introduction to Cost and
b) Indirect Material Cost Management
Accounting 71
 Financial & Management c) Direct labour Cost
Accounting d) Indirect Labour Cost
Ans. B
NOTES Q. 10 Total of Indirect Costs is called:
a) Prime cost
b) Factory Cost
c) Overheads
d) Administrative Cost
Ans: C
Q. 11 Cost Accounting focuses on
a) Cost Ascertainment
b) Reporting to outsiders
c) Finding out Profit
d) Finding out productivity
Ans: A
Q. 12 Management Accounting is concerned with information useful to:
a) Management
b) Employees
c) Society
d) Government
Ans: A
Q. 13 Management Accounting is purely in nature
a) Compulsory
b) Voluntary
Ans: B
Q. 14 Budgeted Cost is:
a) Predetermined Cost
b) Historical Cost
c) Controllable Cos
d) Normal Cost
Ans: A
Q. 15 Management Accounting Reports are
a) Uniform
b) As per Requirement
c) Standard
d) As per Law
Ans: B
Introduction to Cost and
Management
72 Accounting
 Q. 16 Cost Accounting is based on Double Entry Book Keeping System Financial & Management
Accounting
a) True
b) False
NOTES
Ans: B
Q. 17 Cost Accounting System is a prerequisite of Management Accounting
a) True
b) False
Ans: A
Q. 18 Small Organization finds it difficult to afford a system of Management
Accounting
a) True
b) False
Ans: A
Q. 19 Management Accounting is purely in nature
a) Compulsory
b) Voluntary
Ans: B
Q. 20 Management Accounting apply non-monetary units of measurement
a) True
b) False
Ans: A
Q. 21 Cost Accounting is a part of Management Accounting
a) True
b) False
Ans: A

Refrences
i) M N Arora, Cost and Management Accounting,Vikas publications,
Eighth Edition
ii) Colin Drury of Huddersfield, Cost and Management Accounting:6th
edition, ISBN 18440349X
iii) Pauline Weetman, Financial and Management Accounting – An
introduction, 5th edition

***** Introduction to Cost and

Management
Accounting 73
 Financial & Management
Accounting

UNIT - V
NOTES
TECHNIQUES OF MANAGEMENT
ACCOUNTING
(BUDGETARY CONTROL)

Introduction / Overview
This unit covers the aspects like meaning, objectives, advantages &
disadvantages of Budgeting. Budgeting is an important tool for a business along
with standard costing to reduce/control cost. Budgetary control helps a business
in maximizing profits & minimizing cost.
We will see practical examples on cash & flexible budget. Different types
of budgets will also be observed in this topic.

Key Words
Budget, Budgetary control, Cash Budget, Flexible Budget.

5.1 BUDGETING & BUDGETARY CONTROL

5.1.1 Meaning of Budgeting & Budgetary Control

Budgetary control is the process by which budgets are prepared for the
future period and are compared with the actual performance for finding out
variances, if any. The comparison of budgeted figures with actual figures will
help the management to find out variances and take corrective actions without
any delay.

Objectives of Budgetary Control

The main objectives of budgetary control are given below:
1. Defining the objectives of the enterprise.
2. Providing plans for achieving the objectives so defined.
3. Coordinating the activities of various departments.
4. Operating various departments and cost centres economically and
efficiently.
Techniques of 5. Increasing the profitability by eliminating waste.
Management
6. Centralizing the control system.
74 Accounting
 7. Correcting variances from sit standards. Financial & Management
Accounting
8. Fixing the responsibility of various individuals in the enterprise.

Advantages of Budgetary Control NOTES

Budgetary control has become an important tool of an organization to
control costs and to maximize profits. Some of the advantages of budgetary
control are:
1. It defines the goals, plans and policies of the enterprise. If there is no
definite aim then the efforts will be wasted in achieving some other
aims.
2. Budgetary control fixes targets. Each and every department is forced
to work efficiently to reach the target. Thus, it is an effective method
of controlling the activities of various departments of a business unit.
3. It secures better co-ordination among various departments.
4. In case the performance is below expectation, budgetary control helps
the management in finding up the responsibility.
5. It helps in reducing the cost of production by eliminating the wasteful
expenditure.
6. By promoting cost consciousness among the employees, budgetary
control brings in efficiency and economy.
7. Budgetary control facilitates centralized control with decentralized
activity.
8. As everything is planned and provided in advance, it helps in smooth
running of business enterprise.
9. It tells the management as to where action is required for solving
problems without delay.

Disadvantages or Limitations of Budgetary Control

The following are the limitations of budgetary control
1. It is really difficult to prepare the budgets accurately under inflationary
conditions.
2. Budget involves a heavy expenditure which small business concerns
cannot afford.
3. Budgets are prepared for the future period which is always uncertain.
In future, conditions may change which will upset the budgets. Thus,
future uncertainties minimize the utility of budgetary control system.
4. Budgetary control is only a management tool. It cannot replace
management in decision-making because it is not a substitute for Techniques of
management. Management
Accounting 75
 Financial & Management 5. The success of budgetary control depends upon the support of the top
Accounting management. If there is lack of support from top management, then
this will fail.
NOTES
5.1.2 Types of Budget
The budget forecasts the future expenses of the company and helps in
allocating the funds to the different areas or departments of the business to meet
their necessary expenses. The budgets help in measuring the past performance
and predict the future performance by allocating the funds to the different areas.
In budgeting, there are different types of the budget that help the business
to maximize its assets and increase its revenue. Let us have a look at different
types of budget.

1. Production Cost Budget

A product Cost Budget is the summary of material budget, labour budget,
and factory overhead budget. A Production Cost Budget is also known as
Manufacturing Budget that consists of three budgets namely:
(i) Material budget;
(ii) Labour budget;
(iii) Factory overhead budget.

2. Zero Base Budgeting

Zero Base Budgeting is an operating planning and budgeting process which
requires each manager to justify his entire budget requests in detail from scratch.
Each manager has to justify why he should spend any money at all. This approach
requires that all activities be identified as decision on packages which would be
evaluated by a systematic analysis and ranked in order of importance.
Leonard Merewit has defined ZBB as a “technique which complements and
links the existing planning, budgeting and review process. It identifies
alternatives and efficient methods of utilizing limited resources in effective
attainment of selected benefits. It is a flexible management approach which
provides a credible rationale for re-allocating resources by focusing on a
systematic review and justification of the funding and performance levels of
current programmes or activities”.

Stages of Zero Base Budgeting

1. Corporate objectives should be established and laid down in detail.
2. Each separate activity of the organization is identified and called
decision package. A decision package is a document that identifies
each activity and describes it in such a fashion so that management
can (i) evaluate it and rank it against other activities competing for
Techniques of
Management limited and scarce resources, and (ii) decide to approve or
76 Accounting disapprove it.
 3. Budget staff will compile operating expenses for packages approved Financial & Management
by the depart- mental head. Accounting

Advantages of Zero Base Budgeting NOTES

Zero Base Budgeting has some distinct advantages; some of them are
outlined below:
(i) The proposals for funds are strictly considered on merit basis and funds
are allocated on the basis of priority.
(ii) This technique motivates managers to evolve cost effective ways of
performing jobs. New ideas also emerge.
(iii) Obsolete operations and wastages are identified and eliminated.
(iv) Decision packages improve coordination within the firm and
strengthen communi¬cation between different departments.
(v) Managers become aware of the value of inputs helping them to identify
priorities.
(vi) Zero Base Budgeting is particularly useful in areas like service
departments where it is often difficult to identify and quantity output.
(vii) ZBB aims at motivating the staff to take greater interest in the job
because it involves staff in decision making process.
(viii) ZBB is useful especially for service departments where it may be
difficult to identify output.

3. Performance Budget
Traditional budgeting does not provide a link between inputs in financial
terms and output in physical terms. The term ‘Performance Budget’ was
originally used in U.S.A. by the first Hoover Commission in 1949 when it
recommended the adoption of a budget based on functions, programmes and
activities.

Definition
A performance budget is a work plan which expresses for achievement in
respect of various responsibility levels based on accepted norms and standards.
The National Institute of Bank Management, Mumbai has defined the
performance budgeting technique as “the process of analyzing identifying,
simplifying and crystallizing specific performance objectives of a job to be
achieved over a period, within the frame work of organizational objectives, the
purposes and objectives of the job. The technique is characterized by its specific
direction towards the business objectives of the organization”.
The above definition lays stress on the achievement of specific goals over
a period of time. The technique of performance budgeting calls for preparation Techniques of
of periodic performance reports which compare budget and actual performance Management
Accounting 77
 Financial & Management to locate existing variances. Their preparation is greatly facilitated if the authority
Accounting and responsibility for the incurrence of each cost element is clearly defined within
the firm’s organizational structure.
NOTES
4. Sales Budget
Sales Budget is one of the functional budgets. Since sales forecast is the
starting point of budgeting, sales budget assumes primary importance. The sales
budget represents the total sales in physical quantities and values for a future
budget period. Here the quantity that can be sold is the key factor for many
business undertakings.
The purpose of sales budget is not to estimate or guess what the actual sales
will be, but rather to develop a plan with clearly defined objectives towards which
operational efforts are directed.

5. Production Budget
A production budget incorporates the estimates of the total volume of
production with the scheduling of operations by days, weeks and months. The
production manager is responsible for the preparation of production budget. It is
normally prepared in quantitative terms as units of output, tones of production.
It is to be noted that sales budget should be used as basis for production estimates
and forecasts.

6. Cash Budget
The Cash Budget is one of the most important budgets to be prepared. It
represents the cash requirements of the business during the budget period.
It contains detailed estimates of cash receipts (cash inflows) and
disbursements (cash outflows) either for the budget period or some other specific
period. It is a useful tool in cash management of organizations as it reveals
potential cash shortages as well as potential excess cash.

Objectives of Cash Budget

Cash budget is prepared with the following objectives:
(i) It indicates the cash availability for taking advantage of cash discount.
(ii) It indicates the cash requirement needed for capital expenditure for
business expansion.
(iii) It determines the amount of loan to be taken from banks to manage
working capital for a short period.
(iv) It shows the availability of excess funds for short-term investments to
increase income of the organization.
(v) Cash Budget helps the management in planning the financial
Techniques of requirements of bond redemption, payments to pension and retirement
Management
funds.
78 Accounting
 (vi) Efficient cash management is possible if cash budget is prepared. Financial & Management
Accounting
Cash budgets help management to avoid having unnecessary idle cash on
the one hand, and unnecessary ‘nerve-racking’ cash deficiencies, on the other.
NOTES
7. Flexible Budget
Before discussing flexible budget it seems to be appropriate to highlight
upon fixed budget. According to ICMA, London, “a fixed budget is a budget
designed to remain unchanged irrespective of level of activity actually attained”.
Thus, a budget prepared for fixed level of activity is known as fixed budget.
In fixed budgetary control, the budgets prepared are based on one level of
output, a level which has been carefully planned. In fact, fixed budget presents
expected sales revenue, costs and profits or losses for a definite level of activity,
a level which has carefully been planned to equate sales and production at the
most profitable rate.
Significantly, targets of fixed budget do not change with the changes of
level of activity. It is true; in some companies it becomes extremely difficult to
forecast sales with even a reasonable chance of success.
This situation may arise in case of following companies:
(i) Companies that are greatly affected by weather condition, e.g., the soft
drink industry;
(ii) Which frequently introduce new products, e.g. the food camping
industry;
(iii) Companies in which production is carried out only when order is
received, e.g. Ship building industry;
(iv) Companies that are affected by changes in fashion; and
(v) Where large output is intended for export, e.g. production of
consumers’ goods.

Definition of Flexible Budget

The I.C.M.A. defines flexible budget as, “budget which is designed to
change in accordance with the level of activity actually attained”.
The flexible budget (also called variable budget) is based on knowledge of
cost behaviour pattern. It is prepared for a range, rather than a single level of
activity. It is essentially a set of budgets that can be tailored to any level of
activity. Ideally, the flexible budget is compiled after obtaining a detailed analysis
of how each cost is affected by changes in activity.
In fixed budgetary control, the budget is prepared on the basis of one level
of output, a level which has been carefully planned to equate sales and production
at the most profitable rate. But if the level of output actually achieved differs Techniques of
considerably from that budgeted, large variances will arise. In some companies Management
Accounting 79
 Financial & Management it seems extremely difficult to forecast sales with even a reasonable chance of
Accounting success.
This situation may arise in case of the following companies:
NOTES
(i) Companies greatly affected by weather conditions, e.g. there is a great
demand of cold drinks while demand falls during winter;
(ii) Companies that introduce frequently new products, e.g. food canning
industry;
(iii) In which production is carried on only after receiving order;
(iv) Companies affected by change of fashion, e.g. millinery trade; and
(v) Where a large part of the output is intended for export, e.g. air
conditioning equipment.
Flexible budgetary control has been developed with the objectives of
changing the budget figures progressively to correspond with the actual output
achieved. Some companies operate flexible budgets in conjunction with a fixed
budget.
The preparation of flexible budgets necessitates the analysis of all overheads
into fixed, variable and semi-variable costs. This analysis is very much significant
in preparing flexible budget because varying levels of output need to be
considered and they will have a different effect on each class of overhead.

Significance of Flexible Budgeting

The following advantages can be derived from flexible budgeting:
(i) It presents a detailed picture of output, costs, sales and profit for
varying levels of business operations which makes the marginal
analysis more practicable and feasible;
(ii) Flexible budget is an indispensable tool for achieving cost reduction
and cost control;
(iii) Flexible budget is useful to forecast for varying level of operations;
(iv) It makes possible the comparison of actual performance and budgeted
one for actual level of operation in a very easy and understandable
way.

Operational Areas of Flexible Budget

Preparation of flexible budget is needed in the following cases
(i) Where the business is subject to the vagaries of nature like agro-based
industries, soft drinks, woolen industries etc.
(ii) Where the demand for the product depends upon customers’ tastes and
Techniques of fashion like cotton textile and garment industries.
Management (iii) Where production is carried out only after receiving the customer’s
80 Accounting
 orders. Financial & Management
Accounting
(iv) Where business depends heavily on export markets.
(v) Where sales are unpredictable due to typical nature of business and
NOTES
influence of external factors e.g. luxury goods.
(vi) Where customer’s reaction towards a new product is almost impossible
to foresee and predict.

Solved sum on Flexible Budget & Cash Budget

The following are the data of ABC Company for the month of June 2013.
The Company is working at the capacity of 80%. It produces 8,000 units. The
details are as follows:

Techniques of
Management
Accounting 81
 Financial & Management 2. From the following information available from a company, prepare
Accounting Cash Budget (monthly) for April, May and June, 2003:

NOTES

3. From the following information prepare a cash budget for the quarter
ending 30.6.2000:

Techniques of
Management
82 Accounting
 (iii) Purchases are paid one month after. Financial & Management
Accounting
(iv) Wages—25% in arrears in the following month.
(v) Other expenses are paid at a lag of one month.
NOTES
(vi) Income Tax Rs.25,000 due on or before 30.6.2000.

4. Prepare a flexible budget for production at 80% and 100% activity on

the basis of the following information:
Production at 50% capacity 10,000 units
Raw materials Rs.100 per unit

Techniques of
Management
Accounting 83
 Financial & Management Direct labour Rs.50 per unit
Accounting Expenses Rs.20 per unit Factory expenses Rs.1, 00, 000 (60% fixed)
Administration expenses 60,000 (50% variable)
NOTES
Sums for Practice
1. Prepare Flexible Budget from the following data. Ascertain the

2. From the following figures of ‘Gemini Ltd.’, Prepare Cash Budget for
Four months March to June, 2019 assuming cash in hand on 1st march,
2019 of Rs.50, 000.

Additional Information
1. Period of credit allowed by Suppliers is 2 Months;
Techniques of 2. 10 % of the Purchases are on cash Basis.
Management
3. 5% commission is paid on total sales in the next month of sales.
84 Accounting
 4. 25% of sales is for Cash & the period of credit allowed to customers Financial & Management
for credit sales is 1 month; Accounting

5. Delay in payment of wages & expenses is half month & one month
respectively; NOTES

6. Income tax Rs.50, 000 is to be paid in June,2019

3. Prepare Flexible Budget from the following data. Given figures are
for 60% capacity of production. Prepare Budget for 8,000 (80%) &
9,000 (90%) capacity.

Objective Questions
Q. 1 State whether the following statements are True or false:
1. Fixed cost is a cost which remains constant;
2. Fixed cost per unit is always changing;
3. Variable cost per unit is always constant;
4. Total Cost= Fixed cost +Variable cost;
5. Flexible budget is a budget which is always fixed;
6. Cash Budget is an historical budget;
7. Budget is an estimation or forecast of future expenses & revenues of
the business;
8. Flexible Budget divides the costs as fixed, variable & semi-variable
costs; Techniques of
***** Management
Accounting 85
 Financial & Management
Accounting

UNIT - VI
NOTES
TECHNIQUES OF MANAGEMENT
ACCOUNTING (STANDARD COSTING
&MARGINAL COSTING)

Introduction / Overview
As we have seen in the earlier chapter, Cost Control is the main objective
of techniques of Management Accounting. Budgetary control technique is very
popular in the organization to have control on indirect costs. Generally, to have
control on direct costs, Standard costing technique is used. Marginal Costing
technique is used for decision making. In this chapter we are going to see the
theoretical aspects and practical application of both the techniques.
Learning Objectives: To understand the application of techniques of Cost
control and to know how to carry out Variance Analysis and Cost Volume Profit
Analysis practically.
Key Words: Cost Control, Variance Analysis, Standard Cost, Marginal
Cost, Break Even Analysis

6.1 STANDARD COSTING – MEANING AND APPLICATION

Standard Costing system is based on the ascertainment and use of

predetermined cost. Now let us see the meaning of Standard Cost. The word
standard means uniform or criterion for measuring the efficiency.
Definition of Standard Cost:“A predetermined cost which is computed in
advance of production on the basis of specification of all the factors affecting
costs and used in standard costing.” ICMA, London
“The standard cost is a pre-determined cost which determines what each
product or service should cost under given circumstances.” Brown and Howard
It is clear from the above definitions that standard cost is determined in
advance after carrying out scientific study which is used as criterion to know the
performance. It related to product, service, process or operation. Standard cost
is determined for a normal level of efficiency or operation.

Techniques of
Management
86 Accounting
Concept of Standard Costing Financial & Management
Accounting
Standard Costing is a system of Cost Accounting under which costs are
determined in advance of each element i.e. Material, Labour and Overheads.
NOTES
Definition of Standard Costing: “The preparation and use of standard
costs, their comparison with actual cost and the analysis of variance to their
causes and points of incidence.”
The above definition tells about the process of Standard Costing. Now we
will see in detail the process of implementation of Standard Costing.

Process of implementation of Standard Costing

The Flow Chart below will explain abpout the procedure of implementation
of Standard Costing technique within organization

The above process of implementation of Standard Costing clearly tells about

how the whole organization and its departments are involved in the application
of the technique.
It creates top down and bottom up approach of hierarchy. The standards are
set and assigned to the lower management and after carrying out comparison,
the shop floor reports to the top management about reasons of difference between
standard and actual.
Thus, the technique helps the management in overall co-ordination and
control.
Techniques of
Management
Accounting 87
 Financial & Management
Accounting
6.2 OBJECTIVES / FUNCTIONS OF STANDARD COSTING
NOTES
The following are the main objectives or functions of standard Costing:
• Providing yardstick to measure performance: To provide a formal basis
or yardstick to measure performance and efficiency of producing a
standard product is the main objective of Standard costing.
• Effective Cost Control: The most important advantage of standard costing
is that it facilitates the control of costs. Control is exercised by Variance
analysis.
• Helps the Management: It helps the management to perform the functions
of planning, organizing, co-ordinating, motivating and controlling
effectively.
• Planning: As the costs are pre-determined, it helps in planning,
forecasting and preparation of budget.
• Guidance to Management: It provides guidance on possible ways of
improving performance.
• Facilitates delegation of authority: It helps in delegation of authority and
assigning responsibilities.
• Co-ordination &Communication: It creates formal communication
channels within the organization and helps in the function of
coordination.
• Provides Incentives: It helps evaluating performance of employees and
giving incentives to the employees.
• Decision making: It helps the management in decision making.
• Motivation: As the standards are set and given in advance, it gives target
to the employees and motivates them to achieve the same.
• Culture of Cost Consciousness: As the success depends upon achieving
the standard cost, it creates the culture of cost consciousness within the
organization.
• Simplification and Standardization of Operations: It needs fixation of
standards for each element of cost. It involves time and motion study,
work study of different operations and scientific analysis of costs. Thus,
it results into simplification and standardization of operations.
• Eliminates waste: Due to implementation of standard costing, material
wastage, idle time gets reduced.
Techniques of • Profit Forecasting: As the costs are determined in advance, profit
Management forecasting becomes possible.
88 Accounting
 • “Management by Exception” principle is applied in the implementation Financial & Management
of standard costing. Accounting

• Economical and Simple: Standard costing results in reduction in paper

workin accounting and needs fewer number of forms and records. NOTES

6.3 ESSENTIALS OF STANDARD COSTING

Before implementing the technique of standard costing there are some

prerequisites. The following are the preliminaries to be considered:
• There should be well defined organization structure. So that as per
hierarchy level, the standards can be set, assigned and reported.
• Establishment of Cost Centers: Initially, the organization should establish
Cost Centres with clearly defined areas of responsibilities.
• Setting Standard Costs: The success of standard costing technique
depends on the reliability, accuracy and acceptance of standards. All
factors should be considered before setting standards. Scientific study
should be carried out by experts to set accurate standards.
• Organizational Culture: There should be positive culture in the
organization to accept the challenge to attain the standard cost assigned
to the respective department.If the employees take it in the positive spirit
to achieve the standard cost, then only the technique will be successful.

6.4 VARIANCE ANALYSIS

Variance analysis is the most important step in standard costing technique.

The success of this technique depends upon variance analysis its observations
and taking corrective measures.
Cost variance is the difference between standard cost and actual cost
incurred during certain period. The important aspect of variance analysis is to
separate controllable and uncontrollable variances. Controllable variances are
focused and after analyzing the reasons, the cost is reduced.

Favorable and Adverse Variances

Standard costs and Actual costs are compared while carrying out variance
analysis. If the actual cost is more than standard cost, it is adverse to the
management as the profit margin goes down, so it is called ‘Adverse Variance’.
For such variances A is written in the bracket like (A).
If the Actual cost is less than Standard cost, it is favorable to the
Techniques of
management as the profit margin increases. For such variances, F is written in Management
the bracket like (F). Accounting 89
 Financial & Management The variances occur due to various reasons as follows
Accounting
• Quantity of material is used more than standard set
• Price for material paid is more than standard set
NOTES
• Wastage of quantity of material
• Not able to avail trade discount or cash discount
• Inefficient purchasing
• Change in quality of material
• Change in tax rates
• Rush purchases
• Change in design or specifications of product, increase in quantity of
material used
• Defect in machinery or equipments used
Now we will see the actual calculations of variance analysis. Let us start
with Material Cost Variances.

6.4.1 Material Cost Variances

To have control on Material costs, the variance analysis is carried out. The
first and important step is setting standard for material cost.
To set standard material cost, two important elements are required to be
studied, Quantity and Price. To set standard quantity, the quality of finished
products required is set first. Accordingly, the study is carried out how much
material is required to produce one unit of finished goods.
After Standard Quantity of material is set, the next step is to set Standard
Price of the product. For setting standard price, quotations are invited from
various suppliers of the material and comparison is carried out. Trade discounts
and Cash discounts are studied from various suppliers and the best quotation is
selected. Thus, the least price is set for material.
After the standard is set, the target is given to the workers manufacturing
goods. After a specified period, actual costs are found out and then, variance
analysis is carried out for Material costs by applying the formula.
Now let us study the formulae to calculate material cost variance.
Material Cost Variance (MCV) = (SQ×SP) – (AQ × AP)
Material Price Variance (MPV) = (SP – AP) × AQ
Material Usage Variance (MUV) = (SQ – AQ) × SP
Where SP = Standard Price

Techniques of SQ = Standard Quantity

Management AQ = Actual Quantity
90 Accounting
 AP = Actual Price Financial & Management
Accounting
Check: The algebraic sum of Material Price Variance and Material Usage
Variance Should be equal to Material Cost variance.
NOTES
MPV + MUV = MCV
Now we will see the application of these formulae by following illustrations:

Illustration 1:
From the following particulars of Nirmiti Ltd. you are required to Compute:
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage Variance
Quantity of Material purchased 62,000 units
Value of Material purchased Rs. 1,80,000
Standard Quantity set per ton of output 60 Units of raw material
Standard Price of Material Rs. 2.75 per unit
Opening Stock of Raw material Nil
Closing Stock of Raw material 1,000 Units
Output during the period 100 tons
Note: In this questions, standard quantity of material set is given, so forst
we are required to calculate Standard Quantity, Standard Price, Actual Quantity
and Actual price.

Solution
Working Note 1: Standard Quantity
To produce 1 ton of output, 60 units
Actually tons produced are 100 tons, so standard quantity 60 ×100 = 60,000 units
Working Note 2: Actual Quantity
Actual quantity consumed =
Opening stock of raw material + Purchases – Closing Stock of raw material
0 + 62,000 units – 1,000 units = 61,000 units
Working Note 3: Actual Price
Actual Price = Value of material purchased / No. of units purchased
= Rs. 1,80,000 / 62,000 = Rs. 2.90

Techniques of
Management
Accounting 91
 Financial & Management Now let us put the data into the table:
Accounting

NOTES
Now let us calculate variances by using the formula:
Material Cost Variance: (SQ × SP) – (AQ × AP)
(60,000 × 2.75) – (61,000 × 2.90) = 1,65,000 – 176,900 = 11,900 (A)
Material Price Variance: (SP – AP)× AQ
(2.75 – 2.90) × 61,000= 9,150 (A)
Material Usage Variance: (SQ – AQ) ×SP
(60,000 – 61,000) × 2.75 = 2,750 (A)
Cross Verification: MPV + MUV =MCV
9,150 (A) + 2,750 (A) = 11,900 (A)
Interpretation: As number of units of raw material consumed are more,
MUV is adverse. As actual price paid for material is more than standard price,
MPV is also adverse and MCV is adverse.
Material Mix Variance(MMV): When more than one material is used in
manufacturing finished goods, Material Mix variance is calculated. Suppose, two
types of raw materials are used in manufacturing final product i.e. A & B, then
standard proportion of both types of materials has to be fixed For example, 40%
A and 60% B. This is called Standard Mix. In Material Mix Variance, Standard
Mix and Actual Mix arecompared. Revised Standard quantity is calculated to
calculate this variance. Revised Standard Quantity is Actual quantity put in the
standard proportion.
Now we will see the formula to calculate MMV.
MMV = (Revised Standard Quantity – Actual Quantity) × Standard Price.
MMV = (RSQ – AQ) × SP
Let us see the application of the formula.

Illustration II
Nihar Ltd. has applied the technique of standard costing. The following
information is available.
You are required to calculate all variances for Material X and Y:
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage Variance
Techniques of
Management (d) Material Mix Variance
92 Accounting
 Financial & Management
Accounting

Solution NOTES
Note: As More than one material is used to manufacture the finished
product, all variances are calculated for material X, Y and total as follows:
Material Cost Variance: (SQ × SP) – (AQ × AP)
Material X: (90 × 120) – (100 × 125) = 10,800 – 12,500 = 1,700 (A)
Material Y: (60 × 150) – (65 × 146) = 9,000 – 9,490 = 490 (A)
Total = 2,190 (A)

Material Price Variance: (SP – AP)× AQ

Material X: (120 – 125) × 100 = 500 (A)
Material Y: (150 – 146)× 65 = 260 (F)
Total = 240 (A)
Material Usage Variance: (SQ – AQ) ×SP
Material X: (90 – 100) × 120 = 1,200 (A)
Material Y: (60 – 65)×150 = 750 (A)
Tota = 1,950 (A)
Cross Verification: MPV + MUV =MCV
240 (A) + 1,950 (A) = 2,190 (A)
Now let us calculate MMV, as more than one material is used.
Material Mix Variance: (RSQ – AQ) × SP
RSQ = Actual Quantity put into standard proportion
Material X: 165 × 90 / 150 = 99 units
Material Y: 165 × 60 / 150 = 66 units
Material Mix Variance: (RSQ – AQ) × SP
Material X: (99 – 100) × 120 = 120 (A)
Material Y: (66 – 65) × 150 = 150 (F)
Total = 30 (F)
Note: While calculating total, type of variance has to be seen. Adverse
variance has negative sign and Favorable variance has positive sign. As per
mathematical rules, the total is taken and sin is applied.
Techniques of
Management
Accounting 93
 Financial & Management 6.4.2 Labour Cost Variances
Accounting
In the above illustrations, we have seen calculation of Labour Cost
Variances. There is similarity in variance analysis of Material costs and labour
NOTES costs as both are direct costs.
The two important elements of labour costs are time and rate. So, while
setting standard labour cost, two factors are required to be studied i.e. standard
time and standard rate.
Scientific study is required to be carried out to set standard time to
manufacture the product. Generally, detailed time and motion study is carried
out where the job is divided into standard order to complete. The time is measured
to carry out the job.
At the same time, the rate of payment to labouris also standardized. After
the standard is set, the target is given to the workers manufacturing goods to
complete the job in given time. At the end of certain period, actual time is
measured and variance analysis is carried out.
The variances are studied and report is submitted to the top management.
The following are the reasons for Labour cost variances:
• Actual time required is more than standard time due to poor working
conditions
• Defective equipments, machinery
• Use of defective or non standard material
• Inefficient workers
• Incompetent supervision
• Insufficient training to workers
• Change in method of operation
• Time wasted due to non availability of resources
• Change in basic wage rate
• Unscheduled over time
• Employed different grades of workers than standard set
• Use of different methods of wage payment
Now let us study the formulae to calculateLabour cost variance.
Labour Cost Variance (LCV) = (ST×SR) – (AT × AR)
Labour Rate Variance (LRV) = (SR – AR) × AT
Labour Efficiency Variance (LEV) = (ST – AT) × SR

Techniques of Where SR = Standard Rate

Management ST = Standard Time
94 Accounting
 AT = Actual Time Financial & Management
Accounting
AR = Actual Rate
Check: The algebraic sum of LabourRate Variance and LabourEfficiency
NOTES
Variance Should be equal to Labour Cost variance.
LRV + LEV = LCV
Now we will see the application of these formulae by following illustrations:

Illustration 3
From the following particulars of Lucky Ltd. you are required to Compute:
(a) Labour Rate Variance
(b) Labour Efficiency Variance
(c) Labour Cost Variance
Standard time per unit set: 5 hours
Actual Time worked: 10,200 hours
Standard Rate of wages: Rs. 50 per hour
Actual Output: 2000 units
Actual Wages paid: Rs. 4,99,800
Solution:
Note: In this questions, standard time of labour is given, so first we are
required to calculate Standard Time, Standard Rate, Actual Time and Actual Rate.
Working Note 1: Standard Time
Standard time per unit set: 5 hours
Actually units produced are 2,000 units, so standard time,
5 hours ×2,000units = 10,000 hours
Working Note 2: Actual Rate
Actual Rate = Wages paid / No. of hours worked
= Rs. 4,99,800/ 10,200 hours = Rs. 49 / hour
Now let us put the data into the table:

Now let us calculate variances by using the formula:

Laour Cost Variance: (ST × SR) – (AT × AR)
(10,000 × 50) – (10,200 × 49) = 5,00,000 – 4,99,800 = 200 (F) Techniques of
Management
Accounting 95
 Financial & Management Labour Rate Variance: (SR – AR) × AT
Accounting
(50 – 49) × 10,200= 10,200 (F)
Labour Efficiency Variance: (ST – AT) × SP
NOTES
(10,000 – 10,200) × 50 = 10,000 (A)
Cross Verification: LRV + LEV =LCV
10,200 (F) + 10,000 (A) = 200 (F)
Interpretation: As actual rate paid to the labour is less than standard rate
set, LRV is favorable as well as LCV is favorable.
As number of hours worked are increased, LEV is adverse.
Labour Mix Variance (MMV): When more than one type of labour is
required in manufacturing finished goods, Labour Mix variance is calculated.
Suppose, two types of labour are used in manufacturing final product i.e. Skilled
and Unskilled, then standard proportion of both types of labour has to be fixed
For example, 60% Skilled lanour and 40% Unskilled labour. This is called
Standard Mix. In Labour Mix Variance, Standard Mix and Actual Mix are
compared. Revised Standard Time is found out to calculate this variance. Revised
Standard Time is Actual time put in the standard proportion.
Now we will see the formula to calculate LMV.
LMV = (Revised Standard Time – Actual Time) × Standard Price.
LMV = (RST – AT) × SP
Let us see the application of the formula.

Illustration II
Pradhan Ltd. has applied the technique of standard costing. The following
information is available.
You are required to calculate all variances for Skilled, Semiskilled and
Unskilled Labour:
(a) Labour Cost Variance
(b) Labour Price Variance
(c) Labour Usage Variance
(d) LabourMix Variance

Solution
Note: As More than one type of labour is required to manufacture the
Techniques of
finished product, all variances are calculated for Skilled, Semiskilled, Unskilled
Management
96 and total as follows:
Accounting
 Labour Cost Variance: (ST × SP) – (AT × AP) Financial & Management
Accounting
Skilled: (5,000 × 1,000) – (5,200 × 1,050) = 50,00,000 – 54,60,000= 4,60,000 (A)
Semiskilled: (8,000 × 500) – (8,500 × 510) = 40,00,000 – 43,35,000 = 3,35,000 (A)
NOTES
Unskilled: (10,000 × 200) – (10,300 ×190) = 20,00,000–19,57,000 = 43,000 (F)
Total = 7,52,000 (A)
Labour Rate Variance: (SP – AP) × AT
Skilled:(1,000 – 1,050) × 5,200 = 2,60,000(A)
Semiskilled: (500 - 510)×8,500 = 85,000 (A)
Unskilled:(200 – 190)× 10,300 = 1,03,000(F)
Total = 2,42,000 (A)
LabourEfficiency Variance: (ST – AT) × SP
Skilled: (5,000 – 5,200) × 1000 = 2,00,000 (A)
Semiskilled: (8,000 – 8,500) ×500 = 2,50,000 (A)
Unskilled:(10,000 – 10,300)× 200 = 60,000 (A)
Total = 5,10,000 (A)
Cross Verification: LRV + LEV = LCV
2,42,000 (A) + 5,10,000 (A) = 7,52,000 (A)
Now let us calculate LMV, as more than one type of labour is required
Labour Mix Variance: (RST – AT) × SP
RST = Actual Time put into standard proportion
Skilled: 24,000 × 5,000 / 23,000 = 5,217
Semiskilled: 24,000 × 8,000 / 23,000 = 8,348
Unskilled: 24,000 × 10,000 / 23,000 = 10,435
Labour Mix Variance: (RST – AT) × SP
Skilled: (5,217 – 5,200) × 1,000 = 17,000 (A)
Semiskilled: (8,348 – 8,500) ×500 = 76,000 (A)
Unskilled: (10,435 – 10,300) × 200 = 27,000 (F)
Total = 66,000 (A)
Conclusion: Thus, we have seen through illustrations of Material cost
variances and Labour cost variances, how standards are set, compared and control
is achieved through standard costing technique.
Now after studying standards costing technique, we will learn about
Marginal costing technique of management accounting. This technique is mainly Techniques of
used for decision making. Management
Accounting 97
 Financial & Management
Accounting
6.5 MARGINAL COSTING
NOTES
Marginal Costing is one of the important techniques of Management
Accounting. The main focus of this technique is to help the management in
decision making and planning at various volumes of production. Now let us
understand the various concepts used in marginal costing.

6.5.1 Meaning of Marginal Cost

Definition: “The amount at any given volume of output by which aggregate
costs are changed, if volume of output is increased or decreased by one unit”
byC.I.M.A, London.
Thus, from the above definition, it is cleared that marginal cost is the total
variable cost of producing one unit i.e. additional cost of producing one additional
unit.
Under Marginal Costing, each and every cost is segregated into fixed and
variable cost. Semi variable costs are also divided into Fixed part and variable
part. Then total variable costs are taken together and that is called marginal cost.

6.5.2 Definition and Characteristics of Marginal Costing

Definition: “The accounting system in which variable costs are charged to
cost units and fixed costs of the period are written off in full against total
contribution. It’s special value is in decision making.” By C.I.M.A, LondonThus,
from the definition it is clear that marginal cost is used in Marginal Costing.

Characteristics of Marginal Costing

• Segregation of all costs into fixed and variable: First step in
implementing Marginal Costing is all costs are segregated into fixed and
variable. Semi variable costs are also segregated into fixed part and
variable part.
• Marginal cost as product cost: In Marginal Costing, only Marginal
costs are charged to products produced during the period.
• Fixed costs as period costs: Fixed costs are treated as period costs and
are deducted from total contribution to ascertain profit of the period.
• Contribution: Contribution is the important concept in Marginal Costing
which is mainly used in decision making. Contribution is the difference
between sales and marginal cost.
• Valuation of Inventory: The work in progress and finished stock are
values at marginal cost only under Marginal Costing.
Techniques of
Management • Pricing: Under Marginal Costing, prices are fixed at marginal costs and
98 Accounting contribution.
6.5.3 Advantages / Uses of Marginal costing Financial & Management
Accounting
• Helpful to Management: Marginal Costing provides very valuable data
in Cost- Volume Analysis which helps management in planning as well
as decision making. After analyzing the data many important decisions NOTES
can be taken like, fixing selling prices, make or buy decision, introducing
new product and selection of the most profitable product mix.
• Cost Control: As after classifying each and every cost as variable and
fixed cost, total variable costs are taken as marginal costs. It helps in the
process of cost control. The management can focus on marginal cost for
cost control purpose and pay less attention to fixed costs which are non
controllable in nature.
• No need of allocation and apportionment of Fixed Overheads: In
Marginal Costing, Fixed overheads are deducted from total contribution
and not allocated or apportioned. Thus, Over and under absorption of
overheads is avoided.
• Valuation of stock is realistic: Under Marginal Costing, valuation of
stocks is done on the basis of marginal costs. It becomes more realistic.
• Basis of Fixation of Pricing: As the marginal cost is well defined, it
becomes easy to take the decision of price fixation and tendering for
contract.
• Helps in Profit Planning: Under Marginal Costing, Cost–Volume–Profit
Analysis (CVP Analysis) is carried out. This helps in profit planning at
various volumes of production.
• Cost Analysis: As study is carried out for all costs and its classification,
the analysis of each cost can be easily carried out. It also helps in Cost
control and cost reduction.
Thus, from the above points, it is clear that Marginal Costing is the very
important and popular technique which is used mainly for decision making and
cost control.
Now, after knowing the theoretical background of Marginal Costing, let us
understand how Cost–Volume–Profit Analysis (CVP Analysis) is carried out.
CVP analysis is the most important part of Marginal Costing.

6.5.4 Cost–Volume–Profit Analysis (CVP Analysis)

Cost–Volume–Profit Analysis studies the inter relationship of three factors
of business operations:
(a) Cost of Production
(b) Volume of Production / Sales
(c) Profit Techniques of
Management
Accounting 99
 Financial & Management These three factors are inert related with each other in such a way that
Accounting equations can be formed by considering these factors.
Definition: “The study of the effects on future profits of changes in fixed
NOTES cost, variable cost, sales price, quantity and mix.”By C.I.M.A. London.

Break Even Analysis

Break Even Analysis is a very popular and widely used technique to study
CVP relationship. It is used for profit planning and planning of number of units
must be produced and sold.
Assumptions underlying Break Even Analysis
• All costs can be segregated as variable costs and fixed costs.
• Variable costs per unit remains constant and total variable cost varies in
direct proportion to the volume of production.
• Total fixed cost remains constant.
• Selling price remains constant
• The sales mix does not change if there are more than one product.
• Productivity per worker does not change.

Concepts used in Marginal Costing

Contribution
Contribution is the difference between Sales and Marginal Cost. It is the
contribution that each product makes to the profit. It is the most important
concept of Marginal Costing.

Total Contribution is calculated by adding contribution of all products. From

the total contribution fixed cost is deducted and profit is calculated.
The following is the way of presentation of Cost Sheet under Marginal
Costing:
Particulars Product P Product Q Total
Sales ***** **** *****
(-) Marginal Costs *** *** ****
_____________________________________________________
Contribution **** **** ****
(-) Total Fixed Costs ***
Techniques of _____________________________________________________
Management
100 Accounting Profit ****
 Thus, it is observed from the above statement that Fixed costs are not Financial & Management
absorbed in the cost of product. Fixed cost is deducted from Total contribution Accounting
and profit is calculated.
The formula is as follows NOTES

• Profit Volume Ratio (P/V Ratio)

It is the ratio of contribution to sales. The ratio is expressed as a
percentage. It indicates the relative profitability of different products.
When P/V ratio is given contribution can be calculated easily.
The formulae of P/V ratio is as follows:

From the above formula, contribution can be calculated when P/V ratio is
given.

If Profit is given for different periods, that can be compared and P/V ratio
can be calculated by the following formula:

Uses of P/V Ratio

P/V ratio is the main indicator of profitability of products. The profitability
of different sections such as sales area, customers, product lines can be known
from P/V ratio. It helps in profit planning, break even analysis. It helps in
planning volume of sales to achieve certain profit or margin of safety.
• Break Even Point (BEP)
Break Even Point is the point of volume of sales at which there is “No
Profit No Loss”. It is the minimum point of sales where the company
must reach to achieve no loss situation. Thus, it is the point where total
costs of the business are covered.

Note: Whenever the information is provided in number of units in the

Techniques of
question, BEP (In Units) can be found out.
Management
Accounting 101
 Financial & Management
Accounting

NOTES

There is one more formula to calculate Break Even Sales.

• Margin of Safety (M/S)

As the name suggests, it a margin of sales which is safe for the
organization. Margin of Safety is calculated by deducting the Break Even
Sales from Actual Sales. The management has to plan for higher Margin
of Safety situation. The Margin of Safety is the indicator of soundness
of business.

There is one more formula to calculate Margin of Safety

The Margin of Safety Ratio is calculated for interpretation and decision

making in percentage by following formula:

• Profit Planning:
As in Cost – Volume – Profit analysis, profit planning is very important.
If Sales, Marginal Costs and Fixed Costs are given the profit planning
can be done by following formula:

Thus, the management can set the target of required sales to achieve a
certain level of profit.
Now, let us understand the application of formulae by practical illustration.

Illustration I
The following information is available from the books of Ajanta Ltd.
Particulars Amount Rs.
Selling Price per unit Rs. 50
Marginal Cost per unit Rs. 35
Techniques of Number of units sold 10,000 units
Management
Fixed Cost Rs. 1,20,000
102 Accounting
You are required to calculate: Financial & Management
Accounting
i) Profit earned
ii) P/V Ratio
NOTES
iii) Break Even Point in units and in Sales
iv) Margin of Safety
v) Margin of Safety ratio
Solution
i) Profit earned:
The following formula is used to calculate contribution:
Selling Price – Marginal Cost = Contribution
Rs. 50 – Rs. 35 = Rs. 15
Number of units sold ×Contribution per unit=Total Contribution
Rs. 10,000 ×Rs. 15 = Rs. 1,50,000
Total Contribution – Fixed Cost =Profit
Rs. 1,50,000 – Rs. 1,20,000 =Rs. 30,000
Profit earned:Rs. 30,000

ii) P/V Ratio

Contribution / Sales × 100 P/V Ratio
1,50,000 / 5,00,000 = 0.30 ×100 = 30 %
P/V Ratio = 30%

iii) Break Even Point in units:

Fixed Cost / Contribution per unit = BEP in units
Rs. 1,20,000 / Rs. 15 = 8,000 Units
BEP in Sales = BEP in units
BEP in units = 8,000 Units×Rs. 50 = Rs. 4,00,000
BEP in Sales = Rs. 4,00,000

iv) Margin of Safety (M/S):

Actual Sales – Break Even Sales = Margin of Safety
Rs. 5,00,000 – Rs. 4,00,000 = Rs. 1,00,000
Margin of Safety = Rs. 1,00,000

v) Margin of Safety Ratio

Margin of Safety Ratio = M/S / Sales × 100
1,00,000 / 5,00,000 × 100 = 20% Techniques of
Management
Margin of Safety Ratio = 20% Accounting 103
 Financial & Management Illustration II
Accounting
The following information is available from the books of Arun Ltd.
Particulars Amt. Rs.
NOTES
Marginal Cost 1,50,000
Profit 35,000
P/V Ratio 25%
You are required to calculate:
(a) Sales
(b) Break Even Point
(c) Margin of Safety
(d) Margin of Safety Ratio

Solution
Note: In this question, number of units sold are not given. So we cannot
find out BEP in units. P/V ratio is given, with the help of this ratio, we can find
out sales of Arun Ltd.

(a) Sales

By using these two formulae, with Marginal Cost given in the question, we
can find out contribution and Sales.
Suppose, Sales are Rs. 100
As P/V Ratio is 25%,

100 ×25% = 25
Sales – Contribution = Marginal Cost
100 – 25 = 75
When 75 is Marginal Cost, Sales are 100
As 1,50,000 is Marginal cost, what will be sales?
Techniques of 1,50,000×100 / 75 =2,00,000
Management
104 Accounting Sales = 2,00,000
(b) Break Even Point Financial & Management
Accounting

NOTES
As P/V Ratio is given in the question, we have to find out Fixed Cost.
Contribution – Fixed Cost = Profit

Rs. 2,00,000×25%= 50,000

Profit given in the question, Rs. 35,000
Contribution – Profit = Fixed Cost
50,000 – 35,000 = 15,000
BEP = 15,000 / 0.25 = 60,000
BEP = Rs. 60,000

(c) Margin of Safety

2,00,000 – 60,000 = 1,40,000

Margin of Safety = 1,40,000

(d) Margin of Safety Ratio

1,40,000 / 2,00,000 × 100 = 70%

Margin of Safety Ratio = 70%

Illustration III
Sagar Ltd. provides you the following particulars:
Year Sales Profit
2016 Rs. 2,40,000 Rs. 18,000
2017 Rs. 2,80,000 Rs. 26,000
You are required to calculate:
(a) P/V Ratio
Techniques of
(b) Fixed Cost
Management
Accounting 105
 Financial & Management (c) Margin of Safety for both years
Accounting
(d) Profit when sales are Rs. 3,00,000
(e) Sales required to earn profit of Rs. 30,000
NOTES
Solution:
Note: In this question, the data is given in different format i.e. two years
data has been provided. Thus here, we have to use a different formula of change
in sales and profit.
It is assumed that Fixed Cost for both periods remains constant, Variable
cost per unit remains constant. Thus, Break Even Point for both periods will be
constant.
With the available data, let us find out the information asked for.

(a) P/V Ratio

Change in Profit = 26,000 – 18,000 = 8,000

Change in Sales = 2,80,000 – 2,40,000 = 40,000
P/V Ratio = 8,000 / 40,000 × 100 = 20%
P/V Ratio = 20%

(b) Fixed Cost

As we know P/V Ratio, by applying it on sales, we can find out Contribution
by using the data of either of two years. Let us take data of 2016.
Sales × P/V Ratio = Contribution
2,40,000 × 20% = 48,000
Contribution – Profit = Fixed Cost
48,000 – 18,000 = 30,000
Fixed Cost = 30,000

(c) Margin of Safety

First, let us find out Break Even Sales

Techniques of
Management
106 Accounting
 BES = 30,000 / 0.20 = 1,50,000 Financial & Management
Accounting
Year 2016: M/S = 2,40,000 – 1,50,000 = 90,000
Year 2017: M/S = 2,80,000 – 1,50,000 = 1,30,000
NOTES
M/S = 2016: 90,000 2017: 1,30,000

(d) Profit when sales are 3,00,000

Sales × P/V Ratio = Contribution
3,00,000× 20% = 60,000
Contribution – Fixed Cost = Profit
60,000 – 30,000 = 30,000
Profit = Rs. 30,000

(e) Sales required to earn profit of Rs. 30,000

Desired profit = 30,000

Required Sales = 30,000 + 30,000 = 60,000 / 0.2 = 3,00,000
Sales required to earn profit of Rs. 30,000 = 3,00,000

Illustration IV
Aman Ltd. provides you the following particulars:
Year Sales Total Cost
2016 Rs. 40,00,000 Rs. 35,00,000
2017 Rs. 60,00,000 Rs. 52,00,000
You are required to calculate:
(a) P/V Ratio
(b) Break Even Sales
(c) Margin of Safety for both years
(d) Profit when sales are Rs. 65,00,000
(e) Sales required to earn profit of Rs. 10,00,000
Solution
Note: In this question, the data is given in different format i.e. two years
data of sales and total cost has been provided. Initially, with sales and total cost,
we can find out profit. Thus here, we have to use a different formula of change
in sales and profit. Techniques of
Management
Accounting 107
 Financial & Management It is assumed that Fixed Cost for both periods remains constant, Variable
Accounting cost per unit remains constant. Thus, Break Even Point for both periods will be
constant.
NOTES With the available data, let us find out the information asked for.

(a) P/V Ratio

First let us find out the profit for both years.

Sales – Total cost = Profit
2016: 40,00,000 – 35,00,000 = 5,00,000
2017: 60,00,000 – 52,00,000 = 8,00,000
Change in Profit = 8,00,000 – 5,00,000 = 3,00,000
Change in Sales = 60,00,000 – 40,00,000 = 20,00,000
P/V Ratio = 3,00,000 / 20,00,000 × 100 = 15%
P/V Ratio = 15%

(b) Break Even Point

As we know P/V Ratio, by applying it on sales, we can find out Contribution
by using the data of either of two years. Let us take data of 2016.
Sales × P/V Ratio = Contribution
40,00,000 × 15% = 6,00,000
Contribution – Profit = Fixed Cost
6,00,000 – 5,00,000 = 1,00,000
BES = Fixed Cost / P/V Ratio
1,00,000 / 0.15 = 6,66,667

(c) Margin of Safety

Year 2016: M/S = 40,00,000 – 6,66,667 = 33,33,333

Year 2017: M/S = 60,00,000 – 6,66,667 = 53,33,333
M/S = 2016: 33,33,333 2017: 53,33,333

(d) Profit when sales are 65,00,000

Techniques of Sales × P/V Ratio = Contribution
Management 65,00,000× 15% = 9,75,000
108 Accounting
 Contribution – Fixed Cost = Profit Financial & Management
Accounting
9,75,000 – 1,00,000 = 8,75,000
Profit = Rs. 8,75,000
NOTES

(e) Sales required to earn profit of Rs. 10,00,000

Desired profit = 10,00,000

Required Sales = 10,00,000 + 1,00,000 = 11,00,000 / 0.15 = 73,33,333
Sales required to earn profit of Rs. 10,00,000 = 73,33,333
Thus, in this chapter we have seen two important and popular techniques
of cost control, standard costing and marginal costing.

Exercises for self learning

Descriptive Questions
Q. 1 What do you mean by Standard Cost? Define Standard Costing.
Q.2 Explain the process of implementing Standard Costing in a
manufacturing industry.
Q. 3 What are the objectives of Standard Costing?
Q. 4 Write a detailed note on ‘Variance Analysis’
Q. 5 What are the reasons of occurring Material Cost Variances and Labour
Cost Variances?
Q. 6 Elaborate on the advantages of Standard Costing.
Q. 7 Define Marginal Cost. How it is calculated?
Q. 8 Explain the characteristics of Marginal Coating.
Q. 9 “Marginal Costing is a very useful technique in the hands of
management.” Discuss the statement with examples.
Q. 10 Write a detailed note on ‘Cost – Volume – Profit Analysis’.
Q. 11 Write Short Notes on the following:
(a) Profit Volume Ratio
(b) Break Even Analysis
(c) Margin of Safety
(d) Profit Planning
(e) Labour Efficiency Variance
(f) Application of standard costing
(g) Treatment of Fixed Overheads under marginal Costing Techniques of
Management
(h) Decision making under Marginal Costing
Accounting 109
 Financial & Management Multiple Choice Questions
Accounting 1. Break even point means
(A) No profit – no loss
NOTES (B) Super profit
(C) Abnormal loss
(D) Business break down level
Answer: A
2. Sales = Rs. 50,000; variable cost = Rs. 30,000 then contribution = Rs.
(A) 80,000
(B) 20,000
(C) 0.60
(D) 1.67
Answer: B
3. Margin of safety =
(A) Sales – variable cost
(B) Contribution / variable cost
(C) Sales – break even point sales
(D) contribution – fixed cost
Answer: C
4. Profit =
(A) Sales – variable cost
(B) Contribution / variable cost
(C) Sales – break even point sales
(D) contribution – fixed cost
Answer: D
5. Contribution =
(A) Sales – variable cost
(B) Contribution / variable cost
(C) Sales – break even point sales
(D) profit + fixed cost
Answer: A
6. Under standard costing, the difference between planned performance
and budgeted performance is called as
(A) Deviation
(B) Variance
(C) Under performance
(D) Over performance
Answer: B

Techniques of
Management
110 Accounting
 7. If Sales = Rs. 10000 and Variable cost is Rs. 6000 the P/V ratio will Financial & Management
be Accounting

(A) 60%
NOTES
(B) 160%
(C) 40%
(D) None of the above
Answer: C
8. If contribution = Rs. 100 and Fixed cost is Rs. 120, there will be
(A) profit
(B) Loss
(C) BEP
(D) None of the above
Answer: B
9. There are following types of Variances:
(A) Adverse
(B) Favourable
(C) Nil
(D) All of above
Answer: D
10. Variance Means comparison of Actual with Standard
(A) True
(B) False
Answer: A

Practical Questions
1. Prerna Ltd. has applied the technique of standard costing. The
following information is available.
You are required to calculate all variances for Material P and Q
(e) Material Cost Variance
(f) Material Price Variance
(g) Material Usage Variance
(h) Material Mix Variance

Techniques of
Management
Accounting 111
 Financial & Management
Accounting

NOTES 2. Ketan Ltd. has applied the technique of standard costing. The
following information is available.
You are required to calculate all variances for Skilled, Semiskilled and
Unskilled Labour:
(e) Labour Cost Variance
(f) Labour Price Variance
(g) Labour Usage Variance
(h) LabourMix Variance

3. Amrut Ltd. provides you the following particulars:

Year Sales Profit
2016 Rs. 4,80,000 Rs. 36,000
2017 Rs. 5,60,000 Rs. 52,000
You are required to calculate:
i) P/V Ratio
ii) Fixed Cost
iii) Margin of Safety for both years
iv) Profit when sales are Rs. 3,00,000
v) Sales required to earn profit of Rs. 30,000

References
i) M N Arora, Cost and Management Accounting,Vikas publications,
Eighth Edition
ii) Colin Drury of Huddersfield, Cost and Management Accounting:6th
edition, ISBN 18440349X
iii) Pauline Weetman, Financial and Management Accounting – An
introduction, 5th edition.

*****
Techniques of
Management
112 Accounting