8 (a) - Master Budget

The master budget is the aggregation of all lower-level budgets produced by a company's various
functional areas, and also includes budgeted financial statements, a cash forecast, and a financing
plan. The master budget is typically presented in either a monthly or quarterly format, or usually
covers a company's entire fiscal year. An explanatory text may be included with the master budget,
which explains the company's strategic direction, how the master budget will assist in accomplishing
specific goals, and the management actions needed to achieve the budget. There may also be a
discussion of the headcount changes that are required to achieve the budget.
A master budget is the central planning tool that a management team uses to direct the activities of
a corporation, as well as to judge the performance of its various responsibility centres. It is
customary for the senior management team to review a number of iterations of the master budget
and incorporate modifications until it arrives at a budget that allocates funds to achieve the desired
results. Hopefully, a company uses participative budgeting to arrive at this final budget, but it may
also be imposed on the organization by senior management, with little input from other employees.
The budgets that roll up into the master budget include:
Direct labour budget
Direct materials budget
Ending finished goods budget
Manufacturing overhead budget
Production budget
Sales budget
Selling and administrative expense budget
Cash Budget

The cash budget contains an itemization of the projected sources and uses of cash in a future period.
This budget is used to ascertain whether company operations and other activities will provide a
sufficient amount of cash to meet projected cash requirements. If not, management must find
additional funding sources.
The inputs to the cash budget come from several other budgets. The results of the cash budget are
used in the financing budget, which itemizes investments, debt, and both interest income and
interest expense.
The cash budget is comprised of two main areas, which are Sources of Cash and Uses of Cash. The
Sources of Cash section contains the beginning cash balance, as well as cash receipts from cash sales,
accounts receivable collections, and the sale of assets. The Uses of Cash section contains all planned
cash expenditures, which comes from the Direct Materials Budget, Direct Labour
Budget, Manufacturing Overhead Budget, and Selling and Administrative Expense budget. It may
also contain line items for fixed asset purchases and dividends to shareholders.
If there are any unusually large cash balances indicated in the cash budget, these balances are dealt
with in the financing budget, where suitable investments are indicated for them. Similarly, if there
are any negative balances in the cash budget, the financing budget indicates the timing and amount
of any debt or equity needed to offset these balances.
8 (b) - An inventory valuation allows a company to provide a monetary value for items that make up
their inventory. Inventories are usually the largest current asset of a business, and proper
measurement of them is necessary to assure accurate financial statements. If inventory is not
properly measured, expenses and revenues cannot be properly matched and a company could make
poor business decisions.
Inventory valuation methods are used to calculate the cost of goods sold and cost of ending
inventory. Following are the most widely used inventory valuation methods:
First-In, First-Out Method
Last-In, First-Out Method
Average Cost Method
First-in-First-Out Method (FIFO)
According to FIFO, it is assumed that items from the inventory are sold in the order in which they are
purchased or produced. This means that cost of older inventory is charged to cost of goods sold first
and the ending inventory consists of those goods which are purchased or produced later. This is the
most widely used method for inventory valuation. FIFO method is closer to actual physical flow of
goods because companies normally sell goods in order in which they are purchased or produced.
Last-in-First-Out Method (LIFO)
This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed
that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost
of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower.
This is because the cost goods sold mostly consists of newer higher priced goods and ending
inventory cost consists of older low priced items.
Average Cost Method (AVCO)
Under average cost method, weighted average cost per unit is calculated for the entire inventory on
hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as
follows:
Weighted Average Cost Per Unit=
Total Cost of Goods in Inventory
Total Units in Inventory
The weighted average cost as calculated above is multiplied by number of units sold to get cost of
goods sold and with number of units in ending inventory to obtain cost of ending inventory.



which means the goods that are unsold are the ones that were most recently added to the
inventory. Conversely, LIFO is Last In, First Out, which means goods most recently added to the
inventory are sold first so the unsold goods are ones that were added to the inventory the
earliest. LIFO accounting is not permitted by the IFRS standards so it is less popular. It does,
however, allow the inventory valuation to be lower in inflationary times.
Comparison chart

FIFO LIFO
Stands for First in, first out Last in, first out
Unsold
inventory
Unsold inventory comprises goods
acquired most recently.
Unsold inventory comprises the earliest
acquired goods.
Restrictions There are no GAAP or IFRS restrictions for
using FIFO; both allow this accounting
method to be used.
IFRS does not allow using LIFO for accounting.
Effect of
Inflation
If costs are increasing, the items acquired
first were cheaper. This decreases the cost
of goods sold (COGS) under FIFO and
increases profit. The income tax is larger.
Value of unsold inventory is also higher.
If costs are increasing, then recently acquired
items are more expensive. This increases the
cost of goods sold (COGS) under LIFO and
decreases the net profit. The income tax is
smaller. Value of unsold inventory is lower.
Effect of
Deflation
Converse to the inflation scenario,
accounting profit (and therefore tax) is
lower using FIFO in a deflationary period.
Value of unsold inventory, is lower.
Using LIFO for a deflationary period results in
both accounting profit and value of unsold
inventory being higher.
Record
keeping
Since oldest items are sold first, the
number of records to be maintained
decreases.
Since newest items are sold first, the oldest
items may remain in the inventory for many
years. This increases the number of records
to be maintained.
Fluctuations Only the newest items remain in the
inventory and the cost is more recent.
Hence, there is no unusual increase or
decrease in cost of goods sold.
Goods from number of years ago may remain
in the inventory. Selling them may result in
reporting unusual increase or decrease in
cost of goods.

Effect of Inflation-- If costs are increasing, the items acquired first were cheaper. This decreases the
cost of goods sold (COGS) under FIFO and increases profit. The income tax is larger. Value of unsold
inventory is also higher. If costs are increasing, then recently acquired items are more expensive.
This increases the cost of goods sold (COGS) under LIFO and decreases the net profit. The income tax
is smaller. Value of unsold inventory is lower.
During a period of steady or rising prices, inventory value will be same under cost or lower of cost or
market method. When there is a fall in prices, a cost based inventory will be higher than that valued
at a lower of cost or market method. A taxpayer gains a larger profit during valuation on the basis of
cost for the accounting year. Generally, over a period of two years or more, the total profit or loss
under cost or lower of cost or market method will be the same. However, the total tax will be
different.
Inventory rules are not considered uniform. The best accounting practice prevalent in the industry
should be given effect[iii]. When a taxpayer has used one inventory valuation for more than one
accounting year the consistency in the practice should be given more weight than application of a
new inventory valuation method. However, the prior used method should be in accordance with the
regulations. The IRS has the right to question a method of valuation of inventory [iv]. If the method
a taxpayer is using for valuing inventory does not reflect income, the taxpayer can be asked to
change it[v]. When a taxpayer has more than one trade or business, the IRS can require consistency
in the inventory valuation method. The method used in one trade or business should be followed in
another business as well. However, the same method of valuation can be applied only when the
method clearly reflects income.
Accounting Standard (AS) 2 Valuation of Inventories requires valuation of stocks on the basis of
absorption costing method. This means that the value of closing stock would include all variable and
a fair proportion of fixed manufacturing overheads attributable to the stock. Please note that except
where specific references are made, the article is based on the personal opinion of the author. There
may be alternatives which may be better than that indicated in this article.
Scope :
This article illustrates how the provisions of Accounting Standard can be put into practice. The article
does not go into detail of all the provisions of the Standard. For definitions of the terms, one may
refer to the Standard. It also deals with issues arising due to difference in AS 2 and Sec.145A of the
Income Tax Act, 1961 and documentation to be maintained in order to justify that the audit was
performed in accordance with the applicable audit standards.
Overview :
This article discusses the following points:
1. Basis of Valuation of Inventories
Raw Materials
Work-in-Process
Finished Goods
Normal Production Capacity
Fixed Manufacturing Overheads
Over / Under absorption
2. Implications of FIFO Method
3. Application in case of multi-product lines
4. Deferred Tax
5. Concept of Materiality
6. Documentation
Basis of Valuation:
Accounting Standard (AS) 2 require valuation of stocks at the lower of cost or net realizable value.
Cost includes those costs/expenses incurred in bringing the inventories to their present location and
condition. The valuation may be done on the following basis:
Raw Materials: Price as shown in invoice including duties and taxes (other than those subsequently
recoverable by the enterprise from the taxing authorities such as CENVAT, Sales-tax set-off), freight
inwards and other expenses directly attributable to the acquisition. Trade discounts, rebates, duty
drawbacks and other similar items are deducted in determining the costs of purchase.
Work-in-process: Cost of purchase as calculated above and all variable manufacturing overheads
and a fair proportion of fixed manufacturing overheads as estimated on the basis of Normal
Production Capacity applicable to the percentage of completion of production of Finished Goods.
Example showing Apportionment of Fixed Manufacturing overheads:
Normal Production Capacity: 10,000 units
Total Annual Fixed Manufacturing Overheads: Rs.1,00,000/-
Fixed Manufacturing Overhead Absorption Rate = Rs.1,00,000 / 10,000 units = Rs.10 per unit
Total goods in process at the end of the year : 100 units
Percentage of completion: 75%
Therefore, fixed manufacturing overheads attributable to the stock in process will be: Rs.10 * 100
units * 75% = Rs.750