PONJESLY COLLEGE OF ENGINEERING

NAGERCOIL

BA 5103 ACCOUNTING FOR MANAGEMENT

Prepared by
Dr.G.Arumugasamy
Department of Management Studies

1
 Acknowledgement

First and foremost, we would like to thank the ALMIGHTY GOD who gave us the

inspiration to take-up this task.

We would like to acknowledge our deep sense of gratitude to our honourable

Chairman Shri.Pon Robert Singh M.A., for his soft words, continuous encouragement

towards achieving academic excellence.

We are thankful to our Principal Dr.Thyagarajan Ph.D for his valuable suggestions
and guidance.

We would like to thank our Director Prof S. Arulson Daniel M.Sc., M.Phil, for his

help, encouragement and professionalism throughout this time.

We would like to express our gratitude to many people who saw us through this book,

to all those who provided support, allowed to quote their remarks and assisted in the editing,

proof reading and design.

Finally we would like to thank my family members, who supported and encouraged me in

spite of all the time it took me away from them. It was a long and difficult journey for them.

Suggestions and comments for further improvements of this book are most welcome.

Dr.G.Arumugasamy

2
 CONTENTS

S.NO PARTICULARS Page No

1.1 UNIT I FINANCIAL ACCOUNTING INTRODUCTION 7

1.2 THE TERMS USED IN FINANCIAL ACCOUNTING 9

1.3 THE CLASSIFICATION OF ACCOUNTING 12

1.4 ACCOUNTING PRINCIPLES 13

1.5 COST ACCOUNTING 20

1.6 MANAGEMENT ACCOUNITNG 21

1.7 FUNCTIONS OF ACCOUTING 22

1.8 GROUPS INTERESTED IN ACCOUNTING INFORMATION 25

1.9 COMPONENTS OF BALANCESHEET 26

1.10 FINAL ACCOUNTING FORMAT 28

1.11 BALANCE SHEET CONCEPT 36

1.12 INFLATION ACCOUNTING 39

1.13 HUMAN RESOURCE ACCOUNTING 42

1.14 SOCIAL RESPONSIBILITY ACCOUNTING 45

2.1 UNIT II NATURE OF A COMPANY 49

2.2 TYPES OF COMPANY 50

2.3 THE FORMATION OF COMPANY 52

2.4 DEFFERRED SHARES 53

2.5 LIMITATIONS OF SHARE CAPITAL 56

2.6 ALLOTMENT OF SHARES 58

2.7 EMPLOYEE STOCK OPTION 60

3
2.8 BUY BACK SECURITIES 62

2.9 PROFIT & LOSS PRIOR TO NCORPORATION 65

3.1 UNIT III INTRODUCTION 76

3.2 METHODS OF FINANCIAL STATEMENT ANALYSIS 78

3.3 FINANCIAL ANALYSIS SERVES 82

3.4 NATURE OF FINANCIAL ANALYSIS 84

3.5 TYPES OF FINANCIAL ANALYSIS 85

3.6 CLASSIFICATION OF RATIOS 86

4.1 UNIT IV INTRODUCTIN 121

4,2 ADVANTAGES OF COST ACCOUNTING 121

4.3 COST CONCEPT 122

4.4 METHODS OF COST 123

4,5 COST SHEET 125

4.6 STANDARD COSTING 126

4.7 TYPES OF VARIANCES 127

4.8 OVERHEAD ANALYSIS 131

4.9 PROFIT VARIANCES 133

4.10 BUDGET 133

4.11 MARGINAL COSTING 137

4.12 FEACTURES OF MARGINALCOSTING 138

4.13 LIMITATIONS OF MARGINAL COSTING 139

4.14 BREAK EVEN POINT 141

4.14 DEMERITS OF BREAK EVEN PONT 141

5.1 UNIT V INTRODUCTION 1.43

4
5.2 CHARACTERISTICS OF COPUTER 143

5.3 COMPONENTS OF COMPUTER 144

5.4 ROLE OF COMPUTER IN ACCOUNTING 145

5.5 NEED OF COMPUTER ACCOUNITNG 147

5.6 LIMITATIONS OF COMPUTERISED ACCOUNTIGN 149

5.6 DIFFERENCE BETWEEN MANUAL ACCOUNTING & 150

COMPUTERISED ACCOUNITNG

5
 SYLLABUS

UNIT I FINANCIAL ACCOUNTING

Introduction to Financial, Cost and Management Accounting- Generally accepted

accounting principles, Conventions and Concepts-Balance sheet and related
concepts-Profit and Loss account and related concepts - Introduction to inflation
accounting-Introduction to human resources accounting.

UNIT II COMPANY ACCOUNTS

Meaning of Company -Maintenance of Books of Account-Statutory Books- Profit or

Loss Prior to incorporation- Final Accounts of Company- Alteration of share capital-
Preferential allotment, Employees stock option- Buy back of securities.

UNIT III ANALYSIS OF FINANCIAL STATEMENTS

Analysis of financial statements – Financial ratio analysis, cash flow (as per
Accounting Standard 3) and funds flow statement analysis.

UNIT IV COST ACCOUNTING

Cost Accounts - Classification of manufacturing costs - Accounting for

manufacturing costs. Cost Accounting Systems: Job order costing - Process
costing- Activity Based Costing- Costing and the value chain- Target costing-
Marginal costing including decision making- Budgetary Control & Variance
Analysis - Standard cost system.

UNIT V ACCOUNTING IN COMPUTERISED ENVIRONMENT 12

Significance of Computerized Accounting System- Codification and Grouping

of Accounts- Maintaining the hierarchy of ledgers- Prepackaged Accounting
software.

6
 UNIT I

FINANCIAL ACCOUNTING
1.1 INTRODUCTION

Accounting is aptly called the language of business. This designation is

applied to accounting because it is the method of communicating business
information. The basic function of any language is to serve as a means of
communication. Accounting duly serves this function. The task of learning accounting
is essentially the same as the task of learning a new language. But the acceleration of
change in business organization has contributed to increase the complexities in this
language. Like other languages, it is undergoing continuous change in an attempt to
discover better means of communications. To enable the accounting language to
convey the same meaning to all stakeholders, it should be made standard. To make it a
standard language certain accounting principles, concepts and standards have been
developed over a period of time. This lesson dwells upon the different dimensions of
accounting, accounting concepts, accounting principles and the accounting standards.
1.1.1 EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved, as have medicine, law and
most other fields of human activity in response to the social and economic needs of
society. People in all civilizations have maintained various types of records of business
activities. The oldest known are clay tablet records of the payment of wages in
Babylonia around 600 BC. accounting was practiced in India twenty-four centuries ago
as is clear from kautilya’s book ‘arthshastra’ which clearly indicates the existence and
need of proper accounting and audit.
For the most part, early accounting dealt only with limited aspects of the
financial operations of private or governmental enterprises. Complete accounting
system for an enterprise which came to be called as “double entry system” was
developed in Italy in the 15th century. The first known description of the system was
published there in 1494 by a Franciscan monk by the name Luca Pacioli.
The expanded business operations initiated by the industrial revolution required
increasingly large amounts of money which in turn resulted in the development of the
corporation form of organizations. As corporations became larger, an increasing
number of individuals and institutions looked to accountants to provide economic
information about these enterprises. For e.g. Prospective investors and creditors sought
information about a corporation’s financial status. Government agencies required
financial information for purposes of taxation and regulation. Thus accounting began to
expand its function of meeting the needs of relatively few owners to a public role of
meeting the needs of a variety of interested parties.
1.1.2 BOOK KEEPING AND ACCOUNTING
Book-keeping is that branch of knowledge which tells us how to keep a record
of business transactions. It is considered as an art of recording systematically the
various types of transactions that occur in a business concern in the books of accounts.
According to spicer and pegler, “book-keeping is the art of recording all money
transactions, so that the financial position of an undertaking and its relationship to both
its proprietors and to outside persons can be readily ascertained”. Accounting is a term
which refers to a systematic study of the principles and methods of keeping accounts.

7
 Accountancy and book-keeping are related terms; the former relates to the theoretical
study and the latter refers to the practical work.

1.1.3 DEFINITION OF ACCOUNTING

Before attempting to define A three popular definitions on the subject:
Accounting has been defined by the American Accounting Association committee as:
“The process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the
Information”. This may be considered as a good definition because of its focus on
accounting as an aid to decision making.
The American institute of certified and public accountants committee on terminology
defined accounting as:
“Accounting is the art of recording, classifying and summarizing, in a significant
manner and in terms of money, transactions and events which are, in part at least, of
a financial character and interpreting the results thereof ”. of all definitions
available, this is the most acceptable one because it encompasses all the functions
which the modern accounting system performs.
Another popular definition on accounting was given by American accounting
principles board in 1970, which defined it as:
“Accounting is a service society. Its function is to provide quantitative information,
primarily financial in nature, about economic entities that is useful in making
economic decision, in making reasoned choices among alternative courses of
action”.
This is a very relevant definition in a present context of business units facing the
situation of selecting the best among the various alternatives available. The special
feature of this definition is that it has designated accounting as a service activity
.
OBJECTIVES OF FINANCIAL STATEMENTS

The basic objective of financial statements according to AICPA is ‘to provide

qualitative financial information about the business enterprise that is useful to
statement users, particularly owners and creditors in making economic decisions.
Apart from this the other important objectives are :
1) To provide information about the economic activities of the enterprise to several
external groups who, otherwise have no access to such information.
2) To provide useful information to investors and creditors in taking decisions relating to
investment and lending.
3) To provide information to potential investors in evaluating the earning power of the
enterprise.
4) To provide economic information to the owners to judge the management on its
stewardship of the resources of the enterprise and the achievements of the corporate
objectives.
5) To provide information which enables the investors to compare the performance with
similar other undertakings and take appropriate decisions regarding retention or
8
 disinvestments of their holdings.
6) To provide information regarding accounting policies and contingent liabilities of the
enterprise as these have a barring in predicting, comparing and evaluating the earning
power of the enterprise.

1.1.4 FUNCTIONS OF FINANCIAL ACCOUNTING:

❖ Keeping systematic records
❖
Protecting the properties of the business
❖
Communicating the results to the stake holders of the business
❖ Meeting the legal requirements

1.1.5 LIMITATIONS OF FINANCIAL ACCOUNTING

Only transactions which can be measured in terms of money can be recorded in the
books of accounts. Events however important they may be to the business do not find
a place in the accounts if they cannot be measured in terms of money.
➢
According to the cost concept assets are recorded at the cost at which they are
acquired and therefore ignore the changes in values of assets brought about by
changing value of money and market factors.
➢
There is conflict between one accounting principle and another. For example, current
assets are valued on the basis of cost or market price whichever less according to the
principle of conservatism is. Therefore in one year cost basis may be taken, whereas
in another year market price may be taken. This principle contravenes the principle of
consistency.
➢
The balance sheet is largely the result of the personal judgment of the accountant with
regard to the adoption of accounting policies and as such objectivity factor is lost.
➢
Financial accounting can be understood only by persons who have accounting
knowledge.
➢
Inter firm comparison and comparative study of two periods is not possible under this
system as required past information cannot be made available.

1.2 THE TERMS USED IN FINANCIAL ACCOUNTING.

* Purchase day book
This book is maintained mainly to record credit purchases of goods. The term
‘goods’ refers to all such commodities and services in which the firm normally deals.
Hence, cash purchases of goods or purchase of assets are not recorded in this book.
Entries are made in this book from inward invoices of credit purchases. It is also
known as ‘bought book’ or ‘purchase journal’ or ‘invoice book’

* Sales day book

It is also known as ‘sold book’ or ‘sales journal’. All credit sales of goods are
recorded in this book. Cash sales and credit sales of assets are not shown in this book.
“Outward invoices” form the basis for making entries in the sales and must be
9
 authenticated.
* Purchase return book
It is also called as ‘returns outward book’. Goods returned to suppliers which
were originally purchased on credit are recorded in this book.
* Sales return book
It is also called as ‘returns inward book’. Goods returned by customers which were
originally sold on credit are recorded in this book. Here it includes ‘credit note no’
instead of ‘debit note no.
* Bills receivable book
This is maintained to keep a detailed record of all the bills receivable received
by the firm. This book provides a medium for posting bills receivable transactions.
* Bills payable book
This book is maintained to keep a detailed record of all bills payables accepted
by the firm.
* Cash book
In most of the business concerns, the number of cash transactions will be
large. Hence, a separate cash book is maintained for recording such transactions. This
keeps a record of cash receipt and cash payment. It plays a dual role. It is a book of
original entry as well as book of final entry (ledger). There are four types of cash
book.
Simple cash book
Two column cash book
Three column cash book
Petty cash book
* Journal
It is a book of original entry or prime entry which records the transactions in a
chronological order.
* Ledger
It is a book of main entry. It is nothing but a summary statement of all
transaction relating persons, assets or liabilities and expenses or incomes which have
taken place during a period of time showing their net effect.
* Trial balance
It is a list of all balances standing on the ledger accounts and cash book of a
concern. It is a statement with debit and credit balance.
* Subsidiary books
In bigger concerns transactions are numerous so posting in journal and
different ledger account will be very difficult. So the journal is sub-divided into
various subsidiary books which is used for recording transactions of similar nature
* Transactions
Transactions are those activities of businessmen, which involve transfer of
money or goods or services between to persons or to accounts. When cash paid
immediately then it is cash transaction. When cash received or paid in future data it is
credit transaction..
10
 * Goods
The term goods include all merchandise, commodities, etc, in which a trader
deals in the normal course of business. Thus, commodities bought for resale are
treated as goods. E.g. For furniture dealer, furniture is a good and for others it is a
asset.
* Book – keeping.
It means recording business transactions in a set of account books in a
systematic or proper manner.
* Assets
According to Finny & Miller ‘Assets are future economic benefits, the rights
which are owned or controlled by an organization or individual. It is also defined as
anything of value owned by a business’.
* Liability
According to Finny & Miller ‘Liabilities are debits, they are amounts owned to
creditors, theses the claims of those who are not owners are called liabilities’. In
simple it is a ‘debt repayable to outsiders by the businesses.
* Capital
It represents owners fund invested in a business. It may be original amount
invested by the owner or original contribution adjusted for profits and drawings. It is
also known as ‘owners’ equity’ or ‘net worth’.
* Revenue
It is defined as the inflow of assets which result in an increase in the owners equity. It
includes all incomes like sales receipt, etc. The receipts of capital nature like
additional capital, etc. are not a part of revenue.
* Expenses
It is spent in order to produce and sell the goods and services which bring in
the revenue. Expenses may be defined as ‘the cost of the use of things services for the
purpose of generating revenue. It may be capital or revenue expenses.
* Purchase
Buying of goods with the intention of resale is called purchases. If cash in paid
immediately for the purchase, it is cash purchase. If the payment is postponed, it is
credit purchases.
* Sales
Selling of goods in the normal course of business is termed as sales. If cash is
received immediately it is cash sales. If the payment for sale is postponed, it is credit
sales.
* Purchase returns
These are the goods returned by the trader to the supplier because of poor
quality or defects in the goods, supplied. It is also known as ‘return outwards’ or
‘return to suppliers’.
* Sales returns
When the trader receives back goods from the customer for poor quality or
defects in the goods sold out, it will be called as ‘sales return’ or ‘return inwards’ or

11
 ‘returns from customers’.
* Stock
It refers to goods lying unsold on a particular date. The stock of goods at the
end of the accounting period is called ‘closing stock’ and the stock at the beginning of
an accounting period is called ‘opening stock’.
* Debtors
A person who receives a benefit without giving money or money’s worth
immediately, but liable to pay in future is a debtor. Debtor can be a ‘trade debtor’ if he
buys goods on credit, others are non-trade debtors.
* Creditors
A person who gives a benefit without receiving money or money’s worth
immediately but, liable to claim in future is a creditor. Creditor can be ‘trade creditor’
if he supplies goods on credit. Others are non-trade creditors.
* Drawings
Any amount of money or money’s worth withdrawn by the owners of the
business is termed as drawings. It is usually subtracted from capital.
* Equity or net worth
It is also known as capital.
* Turnover
It is also called as ‘sales’.
* Work – In progress
It is a value of semi or partly finished goods at the time of preparation of cost sheet.

1.3 THE CLASSIFICATION OF ACCOUNTING

Accounting broadly classified two types are,

1. Personal Accounts
2. Impersonal Accounts – Real Account, Nominal Account
(i) Personal Account
Account of personal with which the business has dealings is known as
personal accounts. A separate account is prepared for each person.
(a) Natural Persons
The name of an individual, customer or suppliers, etc, both males and females
are included in it.
(b) Artificial persons or legal bodies:
Firms account, limited companies, educational institutions, bank account, co-
operative society, etc., are known an artificial persons account.
(c) Representative Personal Accounts
All accounts representing outstanding expenses and accrued or prepaid
incomes are representative personal accounts e.g. prepaid insurance, outstanding
wages, etc.,
When a person starts a business he is called proprietor. This proprietor is
12
 represented by capital account for all that he investor in business and by drawings
accounts for all that which he withdrawn from business. So, capital account and
drawings account are also personal accounts.
(ii) Real accounts
Accounts in which the business records the real things owned by it i.e., assets
of the business are known as real accounts. It is of two types, tangible and intangible
real accounts. The assets which can be touched and felt and they have no physical
shape e.g. trademark, goodwill etc., are intangible real accounts.
(ii) Nominal accounts
It relates to the items which exist in name only. Accounts which record
expenses, losses, incomes and gains of the business are known as nominal accounts.
E.g. rent account, postage account, etc. The double entry system of book-keeping is a
scientific and complete system. Hence the transactions should be recorded according
to the following:
(i) Personal Accounts
“Debit the receiver, Credit the giver”
.
(ii) Real Accounts
“Debit what comes, Credit what goes out”
(iii) Nominal Accounts
“Debit all expenses and losses, Credit all incomes and gains”.
These are the varies rules for making entries under double entry system.

1.4 ACCOUNTING PRINCIPLES (GAAP – generally accepted accounting

principles)

What is an accounting principle or concept or convention or standard? Do they

mean the same thing? Or does each one has its own meaning? These are all questions
for which there is no definite answer because there is ample confusion and
controversy as to the meaning and nature of accounting principles. We do not want to
enter into this controversial discussion because the reader may fall a prey to the
controversies and confusions and lose the spirit of the subject. The rules and
conventions of accounting are commonly referred to as principles. The American
institute of certified public accountants has defined the accounting principle as, “a
general law or rule adopted or professed as a guide to action; a settled ground or
basis of conduct or practice”. It may be noted that the definition describes the
accounting principle as a general law or rule that is to be used as a guide to action.
The Canadian institute of chartered accountants has defined accounting principles as,
“the body of doctrines commonly associated with the theory and procedure of
accounting, serving as explanation of current practices and as a guide for the
selection of conventions or procedures where alternatives exist”. This definition also
makes it clear that accounting principles serve as a guide to action.
The peculiar nature of accounting principles is that they are manmade. Unlike
the principles of physics, chemistry etc. They were not deducted from basic axiom.
Instead they have evolved. This has been clearly brought out by the Canadian institute
of chartered accountants in the second part of their definition on accounting
13
principles: “rules governing the foundation of accounting actions and the principles
derived from them have arisen from common experiences, historical precedent,
statements by individuals and professional bodies and regulation of governmental
agencies”. Since the accounting principles are man-made they cannot be static and are
bound to change in response to the changing needs of the society It may be stated that
accounting principles are changing but the change in them is permanent. Accounting
principles are judged on their general acceptability to the makers and users of
financial statements and reports. They present a generally accepted and uniform view
of the accounting profession in relation to good accounting practice and procedures.
Hence the name generally accepted accounting principles.

Accounting principles, rules of conduct and action are described by various

terms such as concepts, conventions, doctrines, tenets, assumptions, axioms,
postulates, etc. But for our purpose we shall use all these terms synonymously except
for a little difference between the two terms – concepts and conventions. The term
“concept” is used to connote accounting postulates i.e. Necessary assumptions or
conditions upon which accounting is based. The term convention is used to signify
customs or traditions as a guide to the preparation of accounting statements.

1.4.1 Accounting Concepts

The important accounting concepts are discussed hereunder:

Business Entity Concept:

It is generally accepted that the moment a business enterprise is started it attains a
separate entity as distinct from the persons who own it. In recording the transactions
of a business, the important question is: How do these transactions affect the business
enterprise? The question as to how these transactions affect the proprietors is quite
irrelevant. This concept is extremely useful in keeping business affairs strictly free
from the effect of private affairs of the proprietors. In the absence of this concept the
private affairs and business affairs are mingled together in such a way that the true
profit or loss of the business enterprise cannot be ascertained nor its financial position.
To quote an example, if a proprietor has taken rs.5000/- from the business for paying
house tax for his residence, the amount should be deducted from the capital
contributed by him. Instead if it is added to the other business expenses then the profit
will be reduced by rs.5000/- and also his capital more by the same amount. This
affects the results of the business and also its financial position. Not only this, since
the profit is lowered, the consequential tax payment also will be less which is against
the provisions of the income-tax act.

Going Concern Concept:

This concept assumes that the business enterprise will continue to operate for
a fairly long period in the future. The significance of this concept is that the
accountant while valuing the assets of the enterprise does not take into account their
current resale values as there is no immediate expectation of selling it. Moreover,
depreciation on fixed assets is charged on the basis of their expected life rather than
on their market values. When there is conclusive evidence that the business enterprise
14
has a limited life, the accounting procedures should be appropriate to the expected
terminal date of the enterprise. In such cases, the financial statements could clearly
disclose the limited life of the enterprise and should be prepared from the ‘quitting
concern’ point of view rather than from a ‘going concern’ point of view.
Money Measurement Concept:
Accounting records only those transactions which can be expressed in
monetary terms. This feature is well emphasized in the two definitions on accounting
as given by the American institute of certified public accountants and the American
accounting principles board. The importance of this concept is that money provides a
common denomination by means of which heterogeneous facts about a business
enterprise can be expressed and measured in a much better way. For e.g. When it is
stated that a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery
items, 3000 square meters of land and building etc., these amounts cannot be added
together to produce a meaningful total of what the business owns. However, by
expressing these items in monetary terms such as rs.1,00,000 cash, rs.5,00,000 worth
raw materials, rs,10,00,000 worth machinery items and rs.30,00,000 worth land and
building – such an addition is possible.
A serious limitation of this concept is that accounting does not take into
account pertinent non-monetary items which may significantly affect the enterprise.
For instance, accounting does not give information about the poor health of the
chairman, serious misunderstanding between the production and sales manager etc.,
which have serious bearing on the prospects of the enterprise. Another limitation of
this concept is that money is expressed in terms of its value at the time a transaction is
recorded in the accounts. Subsequent changes in the purchasing power of money are
not taken into account.

Cost Concept:
This concept is yet another fundamental concept of accounting which is
closely related to the going-concern concept. As per this concept:
(i) An asset is ordinarily entered in the accounting records at the price paid
to acquire it i.e., at its cost and (ii) this cost is the basis for all subsequent accounting
for the asset. The implication of this concept is that the purchase of an asset is
recorded in the books at the price actually paid for it irrespective of its market value.
For e.g. If a business buys a building for rs.3,00,000, the asset would be recorded in
the books as rs.3,00,000 even if its market value at that time happens to be
rs.4,00,000. However, this concept does not mean that the asset will always be shown
at cost. This cost becomes the basis for all future accounting of the asset. It means that
the asset may systematically be reduced in its value by changing depreciation. The
significant advantage of this concept is that it brings in objectivity in the preparations
and presentation of financial statements. But like the money measurement concept,
this concept also does not take into account subsequent changes in the purchasing
power of money due to inflationary pressures. This is the reason for the growing
importance of inflation accounting.
Dual Aspect Concept (Double Entry System):
This concept is the core of accounting. According to this concept every
business transaction has a dual aspect. This concept is explained in detail below:
The properties owned by a business enterprise are referred to as assets and the
rights or claims to the various parties against the assets are referred to as equities. The
relationship between the two may be expressed in the form of an equation as follows:
15
Equities = Assets
Equities may be subdivided into two principal types: the rights of creditors and
the rights of owners. The rights of creditors represent debts of the business and are
called liabilities. The rights of the owners are called capital.
Expansion of the equation to give recognition to the two types of equities
results in the following which is known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place ‘liabilities’ before ‘capital’ because creditors have
priority in the repayment of their claims as compared to that of owners. Sometimes
greater emphasis is given to the residual claim of the owners by transferring liabilities
to the other side of the equation as:
Capital = Assets – Liabilities
All business transactions, however simple or complex they are, result in a
change in the three basic elements of the equation. This is well explained with the
help of the following series of examples:
(i) Mr. Prasad commenced business with a capital of rs.3,000: the result of
this transaction is that the business, being a separate entity, gets cash-asset of
rs.30,000 and has to pay to Mr. Prasad rs.30,000, his capital.
This transaction can be expressed in the form of the equation as follows:

Capital = Assets

Prasad Cash

30,000 30,000

(ii) Purchased furniture for rs.5, 000: the effect of this transaction is
that cash is reduced by rs.5, 000 and a new asset viz. Furniture worth rs.5, 000 comes
in, thereby, rendering no change in the total assets of the business. The equation after
this transaction will be:

Capital=Assets

Prasad Cash + Furniture

30,000 25,000 + 5,000

(iii) Borrowed Rs.20, 000 from Mr. Gopal: as a result of this

transaction both the sides of the equation increase by rs.20, 000; cash balance is
increased and a liability to Mr. Gopal is created. The equation will appear as follows:
Liabilities + Capital = Assets

16
Creditors + Prasad Cash + Furniture
20,000 30,000 45,000 5,000

(iv) Purchased goods for cash Rs.30, 000: this transaction does not
affect the liabilities side total nor the asset side total. Only the composition of the total
assets changes i.e. Cash is reduced by Rs.30, 000 and a new asset viz. Stock worth
Rs.30, 000 comes in. The equation after this transaction will be as follows:
Liabilities + Capital =Asset

Creditors Prasad Cash + Stock + Furniture

20,000 30,000 15,000 30,000 5,000

(v) Goods worth Rs.10, 000 are sold on credit to Ganesh for rs.12, 000. The
result is that stock is reduced by rs.10,000 a new asset namely debtor( Mr. Ganesh) for
Rs.12,000 comes into picture and the capital of Mr. Prasad increases by Rs.2,000 as
the profit on the sale of goods belongs to the owner. Now the accounting equation will
look as under:

Liabilities + Capital = Asset

Creditors Prasad Cash + Debtors + Stock + Furniture

20,000 32,000 15,000 12,000 20,000 5,000

(vi) Paid electricity charges rs.300: this transaction reduces both the cash
balance and Mr. Prasad’s capital by rs.300. This is so because the expenditure reduces
the business profit which in turn reduces the equity.
The equation after this will be:

Liabilities + Capital =Assets

Creditors + Prasad Cash + Debtors + Stock + Furniture

20,000 31,700 14,700 12,000 20,000 5,000

Thus it may be seen that whatever is the nature of transaction, the accounting equation
always tallies and should tally. The system of recording transactions based on this
concept is called double entry system.
Accounting Period Concept:
In accordance with the going concern concept it is usually assumed that the
life of a business is indefinitely long. But owners and other interested parties cannot
17
wait until the business has been wound up for obtaining information about its results
and financial position. For e.g. If for ten years no accounts have been prepared and if
the business has been consistently incurring losses, there may not be any capital at all
at the end of the tenth year which will be known only at that time. This would result in
the compulsory winding up of the business. But, if at frequent intervals information
are made available as to how things are going, then corrective measures may be
suggested and remedial action may be taken. That is why, pacioli wrote as early as in
1494: ‘frequent accounting makes for only friendship’. This need leads to the
accounting period concept.
According to this concept accounting measures activities for a specified
interval of time called the accounting period. For the purpose of reporting to various
interested parties one year is the usual accounting period. Though pacioli wrote that
books should be closed each year especially in a partnership, it applies to all types of
business organizations.
Periodic Matching Of Costs and Revenues:
This concept is based on the accounting period concept. It is widely accepted
that desire of making profit is the most important motivation to keep the proprietors
engaged in business activities. Hence a major share of attention of the accountant is
being devoted towards evolving appropriate techniques of measuring profits. One
such technique is periodic matching of costs and revenues.
In order to ascertain the profits made by the business during a period, the
accountant should match the revenues of the period with the costs of that period. By
‘matching’ we mean appropriate association of related revenues and expenses
pertaining to a particular accounting period. To put it in other words, profits made by
a business in a particular accounting period can be ascertained only when the revenues
earned during that period are compared with the expenses incurred for earning that
revenue. The question as to when the payment was actually received or made is
irrelevant. For e.g. In a business enterprise which adopts calendar year as accounting
year, if rent for December 1989 was paid in January 1990, the rent so paid should be
taken as the expenditure of the year 1989, revenues of that year should be matched
with the costs incurred for earning that revenue including the rent for December 1989,
though paid in January 1990. It is on account of this concept that adjustments are
made for outstanding expenses, accrued incomes, prepaid expenses etc. While
preparing financial statements at the end of the accounting period.
The system of accounting which follows this concept is called as mercantile
system. In contrast to this there is another system of accounting called as cash system
of accounting where entries are made only when cash is received or paid, no entry
being made when a payment or receipt is merely due.
Realization Concept:
Realization refers to inflows of cash or claims to cash like bills receivables,
debtors etc. Arising from the sale of assets or rendering of services. According to
realization concept, revenues are usually recognized in the period in which goods
were sold to customers or in which services were rendered. Sale is considered to be
made at the point when the property in goods passes to the buyer and he becomes
legally liable to pay. To illustrate this point, let us consider the case of a, a
manufacturer who produces goods on receipt of orders. When an order is received
from b, a starts the process of production and delivers the goods to b when the
production is complete. B makes payment on receipt of goods. In this example, the
sale will be presumed to have been made not at the time when goods are delivered to
b. A second aspect of the realization concept is that the amount recognized as revenue
18
 is the amount that is reasonably certain to be realized. However, lot of reasoning has
to be applied to ascertain as to how certain ‘reasonably certain’ is … yet, one thing is
clear, that is, the amount of revenue to be recorded may be less than the sales value of
the goods sold and services rendered. For e.g. when goods are sold at a discount,
revenue is recorded not at the list price but at the amount at which sale is made.
Similarly, it is on account of this aspect of the concept that when sales are made on
credit, though entry is made for the full amount of sales, the estimated amount of bad
debts is treated as an expense and the effect on net income is the same as if the
revenue were reported as the amount of sales minus the estimated amount of bad
debts.
1.4.2 Accounting Conventions
Convention Of Conservatism:
It is a world of uncertainty. So it is always better to pursue the policy of
playing safe. This is the principle behind the convention of conservatism. According
to this convention the accountant must be very careful while recognizing increases in
an enterprise’s profits rather than recognizing decreases in profits. For this the
accountants have to follow the rule, anticipate no profit, provide for all possible
losses, while recording business transactions. It is on account of this convention that
the inventory is valued at cost or market price whichever is less, i.e. When the market
price of the inventories has fallen below its cost price it is shown at market price i.e.
The possible loss is provided and when it is above the cost price it is shown at cost
price i.e. The anticipated profit is not recorded. It is for the same reason that provision
for bad and doubtful debts, provision for fluctuation in investments, etc., are created.
This concept affects principally the current assets.
Convention of Full Disclosure:
The emergence of joint stock company form of business organization resulted
in the divorce between ownership and management. This necessitated the full
disclosure of accounting information about the enterprise to the owners and various
other interested parties. Thus the convention of full disclosure became important. By
this convention it is implied that accounts must be honestly prepared and all material
information must be adequately disclosed therein. But it does not mean that all
information that someone desires are to be disclosed in the financial statements. It
only implies that there should be adequate disclosure of information which is of
considerable value to owners, investors, creditors, government, etc. In sachar
committee report (1978), it has been emphasized that openness in company affairs is
the best way to secure responsible behaviour. It is in accordance with this convention
that companies act, banking companies regulation act, insurance act etc., have
prescribed preform of financial statements to enable the concerned companies to
disclose sufficient information. The practice of appending notes relating to various
facts on items which do not find place in financial statements is also in pursuance to
this convention. The following are some examples:

(a) contingent liabilities appearing as a note

(b) market value of investments appearing as a note

(c) schedule of advances in case of banking companies

19
 Convention Of Consistency:
According to this concept it is essential that accounting procedures, practices
and method should remain unchanged from one accounting period to another. This
enables comparison of performance in one accounting period with that in the past. For
e.g. If material issues are priced on the basis of fifo method the same basis should be
followed year after year. Similarly, if depreciation is charged on fixed assets
according to diminishing balance method it should be done in subsequent year also.
But consistency never implies inflexibility as not to permit the introduction of
improved techniques of accounting. However if introduction of a new technique
results in inflating or deflating the figures of profit as compared to the previous
methods, the fact should be well disclosed in the financial statement.
Convention of Materiality:
The implication of this convention is that accountant should attach importance
to material details and ignore insignificant ones. In the absence of this distinction,
accounting will unnecessarily be overburdened with minute details. The question as to
what is a material detail and what is not is left to the discretion of the individual
accountant. Further, an item should be regarded as material if there is reason to
believe that knowledge of it would influence the decision of informed investor. Some
examples of material financial information are: fall in the value of stock, loss of
markets due to competition, change in the demand pattern due to change in
government regulations, etc. Examples of insignificant financial information are:
rounding of income to nearest ten for tax purposes etc. Sometimes if it is felt that an
immaterial item must be disclosed, the same may be shown as footnote or in
parenthesis according to its relative importance.
Introduction to Financial, Cost and Management Accounting- Generally accepted
accounting principles, Conventions and Concepts-Balance sheet and related concepts-
Profit and Loss account and related concepts - Introduction to inflation accounting-
Introduction to human resources accounting.
Accounting has been termed as the language of business. The basic function of
accounting thus is to communicate the operating results of the business to the stake
holders and shareholders of a business
.
1.5 COST ACCOUNTING

DEFINITION: According to the Institute of Cost and Works Accountants (ICWA),

London, Cost accounting is “the process of accounting for costs from the point at
which expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centers and cost units.
In its widest usage it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of the profitability of
activities carried out or planned.”

OBJECTIVES OF COST ACCOUNTING:

1) To aid in the development of long range plans by providing cost data that acts as a
basis for projecting data for planning.
2) To ensure efficient cost control by communicating essential data costs at regular
intervals and thus minimize the cost of manufacturing.
20
3) Determine cost of products or activities, which is useful in the determination of
selling price or quotation.
4) To identify profitability of each product, process, department etc. of the business
5) To provide management with information in connection with various operational
problems by comparing the actual cost with standard cost, which
reveals the discrepancies or variances?

LIMITATIONS OF COST ACCOUNTING

Cost Accounting like other branches of accountancy is not an exact science but
is an art which was developed through theories and accounting practices based on
reasoning and commonsense. These practices are dynamic and evolving. Hence, it
lacks a uniform procedure applicable to all the industries across. It has to be
customized for each industry, company etc.
1.6 MANAGEMENT ACCOUNTING

DEFINITION: According to M.A.Sahaf Management Accounting is “ a system for

gathering, summarizing, reporting and interpreting accounting data and other financial
information primarily for the internal needs of the management. It is designed to assist
internal management in the efficient formulation, execution and appraisal of business
plans.”
Management Accounting covers not only the use of financial data and a part of
costing theory but extends beyond. It scope covers
1. Financial accounting
2. Cost accounting
3. Financial statement analysis
4. Budgeting
5. Inflation accounting
6. Management reporting
7. Quantitative techniques
8. Tax accounting
9. Internal audit
10. Office services

FUNCTIONS OF MANAGEMENT ACCOUNTING:

➢
To help the management in planning, forecasting and policy formulation
➢
To help in analysis and interpretation of financial information
➢
To help in decision making- long term as well as short term
➢
To help in controlling and coordinating the business operations
➢
To communicate and report the operational results to the share and stock holders
of the business.
➢
To motivate the employees by encouraging them to look forward
➢
To help the management in tax administration
21
 TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING:

➢
Financial planning
➢
Analysis of financial statements
➢
Cost accounting
➢
Standard costing
➢
Marginal costing
➢
Budgetary control
➢
Funds flow analysis
➢
Management reporting
Statistical analysis
➢

ADVANTAGES OF MANAGEMENT ACCOUNTING:

➢
It increases efficiency of business operations
➢
It ensures efficient regulation of business activities
➢
It ensures utilization of available resources and thereby increase the return on
capital employed.
➢
It ensures effective control of performance
➢
It helps in evaluating the efficiency of the company’s business policies

LIMITATIONS OF MANAGEMENT ACCOUNTING:

➢
It is based on historical data, as such it suffers from the drawbacks of the
financial statements.
➢
The application of management accounting tools and techniques requires
people who are knowledgeable in subjects such as accounting, costing, economics,
taxation, statistics, mathematics, etc.
➢
Though management accounting attempts to analyses both qualitative and
quantitative factors that influence a decision, the elements of intuition in managerial
decision making have not been completely eliminated.
➢
The installation of management accounting system is expensive and hence not
suitable for small firms.

1.7 FUNCTIONS OF ACCOUNTING

Individuals engaged in such areas of business as finance, production, marketing,
personnel and general management need not be expert accountants but their
effectiveness is no doubt increased if they have a good understanding of accounting
principles. Everyone engaged in business activity, from the bottom level employee to

22
 the chief executive and owner, comes into contact with accounting. The higher the level
of authority and responsibility, the greater is the need for an understanding of
accounting concepts and terminology. A study conducted in United States revealed that
the most common background of chief executive officers in United States corporations
was finance and accounting. Interviews with several corporate executives drew the
following comments:
“…… my training in accounting and auditing practice has been extremely valuable
to me throughout”. “a knowledge of accounting carried with it understanding of the
establishment and maintenance of sound financial controls- is an area which is
absolutely essential to a chief executive officer”.
Though accounting is generally associated with business, it is not only business
people who make use of accounting but also many individuals in non-business areas
that make use of accounting data and need to understand accounting principles and
terminology. For e.g. an engineer responsible for selecting the most desirable solution
to a technical manufacturing problem may consider cost accounting data to be the
decisive factor. Lawyers want accounting data in tax cases and damages from breach of
contract. Governmental agencies rely on an accounting data in evaluating the efficiency
of government operations and for approving the feasibility of proposed taxation and
spending programs. Accounting thus plays an important role in modern society and
broadly speaking all citizens are affected by accounting in some way or the other.
Accounting which is so important to all, discharges the following vital functions:

 Keeping Systematic Records:

This is the fundamental function of accounting. The transactions of the business
are properly recorded, classified and summarized into final financial statements –
income statement and the balance sheet.
 Protecting The Business Properties:
The second function of accounting is to protect the properties of the business by
maintaining proper record of various assets and thus enabling the management to
exercise proper control over them.
 Communicating The Results:
As accounting has been designated as the language of business, its third
function is to communicate financial information in respect of net profits, assets,
liabilities, etc., to the interested parties.
 Meeting Legal Requirements:
The fourth and last function of accounting is to devise such a system as will
meet the legal requirements. The provisions of various laws such as the companies act,
income tax act, etc., require the submission of various statements like income tax
returns, annual accounts and so on. Accounting system aims at fulfilling this
requirement of law.
It may be noted that the functions stated above are those of financial accounting alone.
The other branches of accounting, about which we are going to see later in this lesson,
have their special functions with the common objective of assisting the management in
its task of planning, control and coordination of business activities. Of all the branches
of accounting, management accounting is the most important from the management
point of view.

23
 As accounting is the language of business, the primary aim of accounting, like
any other language, is to serve as a means of communication. Most of the world’s work
is done through organizations – groups of people who work together to accomplish one
or more objectives. In doing its work, an organization uses resources – men, material,
money and machine and various services. To work effectively, the people in
organization need information about these sources and the results achieved through
using them. People outside the organization need similar information to make
judgments about the organization. Accounting is the system that provides such
information.
Any system has three features, viz., input, processes and output. Accounting as
a social science can be viewed as an information system, since it has all the three
features i.e., inputs (raw data), processes (men and equipment) and outputs (reports and
information). Accounting information is composed principally of financial data about
business transactions. The mere records of transactions are of little use in making
“informed judgments and decisions”. The recorded data must be sorted and summarized
before significant analysis can be prepared. Some of the reports to the enterprise
manager and to others who need economic information may be made frequently; other
reports are issued only at longer intervals. The usefulness of reports is often enhanced
by various types of percentage and trend analyses. The “basic raw materials” of
accounting are composed of business transactions data. Its “primary end products” are
composed of various summaries, analyses and reports.
The information needs of a business enterprise can be outlined and illustrated with the
help of the following chart:

Chart Showing Types Of Information

Information

Non-quantitative Quantitative

Information Information

Accounting Non- accounting

Information Information

Operating Financial Management Cost

Information Information Information Information

24
 The chart clearly presents the different types of information that might be
useful to all sorts of individuals interested in the business enterprise. As seen from the
chart, accounting supplies the quantitative information. The special feature of
accounting as a kind of a quantitative information and as distinguished from other
types of quantitative information is that it usually is expressed in monetary terms.
In this connection it is worthwhile to recall the definitions of accounting as
given by the American institute of certified and public accountants and by the
American accounting principles board. The types of accounting information may be
classified into four categories: (1) operating information, (2) financial accounting
information
(3) Management accounting information and (4) cost accounting information.

Operating Information:
By operating information, we mean the information which is required to
conduct the day-to-day activities. Examples of operating information are: amount of
wages paid and payable to employees, information about the stock of finished goods
available for sale and each one’s cost and selling price, information about amounts
owed to and owing by the business enterprise, information about stock of raw
materials, spare parts and accessories and so on. By far, the largest quantity of
accounting information provides the raw data (input) for financial accounting,
management accounting and cost accounting.
The industrial revolution in England posed a challenge to the development of
accounting as a tool of industrial management. This necessitated the development of
costing techniques as guides to management action. Cost accounting emphasizes the
determination and the control of costs. It is concerned primarily with the cost of
manufacturing processes. In addition, one of the principal functions of cost accounting
is to assemble and interpret cost data, both actual and prospective, for the use of
management in controlling current operations and in planning for the future.
All of the activities described above are related to accounting and in all of
them the focus is on providing accounting information to enable decisions to be made.

1.8 GROUPS INTERESTED IN ACCOUNTING INFORMATION

There are several groups of people who are interested in the accounting
information relating to the business enterprise. Following are some of them:
Shareholders:
Shareholders as owners are interested in knowing the profitability of the
business transactions and the distribution of capital in the form of assets and
liabilities. In fact, accounting developed several centuries ago to supply information to
those who had invested their funds in business enterprise.
Management:
With the advent of Joint Stock Company form of organization the gap between
ownership and management widened. In most cases the shareholders act merely as
renders of capital and the management of the company passes into the hands of
professional managers. The accounting disclosures greatly help them in knowing
about what has happened and what should be done to improve the profitability and
financial position of the enterprise.
25
Potential Investors:

An individual who is planning to make an investment in a business would like

to know about its profitability and financial position. An analysis of the financial
statements would help him in this respect.
Creditors:
As creditors have extended credit to the company, they are much worried
about the repaying capacity of the company. For this purpose they require its financial
statements, an analysis of which will tell about the solvency position of the company.
Government:
Any popular government has to keep a watch on big businesses regarding the
manner in which they build business empires without regard to the interests of the
community. Restricting monopolies is something that is common even in capitalist
countries. For this, it is necessary that proper accounts are made available to the
government. Also, accounting data are required for collection of sale-tax, income-tax,
excise duty etc.
Employees:
Like creditors, employees are interested in the financial statements in view of
various profit sharing and bonus schemes. Their interest may further increase when
they hold shares of the companies in which they are employed.
Researchers:
Researchers are interested in interpreting the financial statements of the
concern for a given objective.
Citizens:
Any citizen may be interested in the accounting records of business enterprises
including public utilities and government companies as a voter and tax payer
.
1.9 COMPONENTS OF BALANCE SHEET

The Profit & Loss Account aims to monitor profit. It has three parts.
1) The Trading Account: This records the money in (revenue) and out (costs) of the
business as a result of the business’ ‘trading’ i.e. buying and selling. This might be
buying raw materials and selling finished goods; it might be buying goods wholesale
and selling them retail. The figure at the end of this section is the Gross Profit
. 2) The Profit and Loss Account: This starts with the Gross Profit and adds to it any
further costs and revenues, including overheads. These further costs and revenues
which may be in the nature of other operating, administrative, selling and distribution
expenses. This account also includes expenses which are from any other activities not
directly related to trading (non-operating).
An example is interest on investments. Thus, profit and loss account contains all other
expenses and losses, incomes and gains of the business for the accounting year for
which financial statements are being prepared. In this process, it follows the
mercantile basis of accounting (i.e., it takes into account all paid and payable
expenses, and received and receivable receipts). The net result of profit and loss
26
account is called as net profit. The main feature of profit and loss account is that it
takes into account all expenses and incomes that belong to the current accounting
year and excludes those expenses and incomes that belong either to the previous
period or the future period.
3) The Appropriation Account. This shows how the profit is ‘appropriated’ or
divided between the three uses mentioned above.

INTRODUCTION TO THE TRADING ACCOUNT:

A Trading account is a statement prepared by a firm to ascertain its trading results for
the accounting year. Just like Profit & Loss account, it is also prepared for the year
ending. It takes into account the various trading expenses (usually all direct expenses)
and incomes. The net result will be either trading / gross profit or gross loss. In case
of a manufacturing concern, it will prepare an additional statement called a
manufacturing account. A manufacturing account is prepared by a manufacturer to
ascertain the cost of goods manufactured during the current accounting year.

27
 1.10 FINAL ACCOUNTING - FORMATS
FORMAT OF TRIAL BALANCE:
Trial Balance of XXXX as on Mar 31, XXXX
Particulars Debit Credit
Capital XXXX
Cash in Hand XXXX
Cash at Bank XXXX
Purchase XXXX
Purchase Return XXXX
Sales XXXX
Sales Return XXXX
Accounts Receivable XXXX
Accounts Payable XXXX
Bills Receivable XXXX
Bills Payable XXXX
Salaries XXXX
Wages XXXX
Trade Expenses XXXX
Office Expenses XXXX
Commission Paid XXXX
Commission Received XXXX
Postage & Telegram XXXX
Sundry Creditors XXXX
Sundry Debtors XXXX
Machinery XXXX
Furniture XXXX
Equipment XXXX
Land & Building etc XXXX

Total XXXXX XXXXX

28
 FORMAT OF TRADING AND PROFIT & LOSS ACCOUNT:
Trading and Profit & Loss Account of M/s XXXX for the year ended Mar 31,
XXXX
Date Particulars Amount Date Particulars Amount
To Opening Stock xxx By Sales
Add: Purchase xxx
xx Less: Sales Return XXXX
xx XXXX
xxx XXXX (Or Return Inward) XXXX
Less: Purchase Return xx XXXX By Closing Stock
(Or Return Outward) XXXX By Gross Loss
To Wages XXXX (Balancing Figure)
To Carriage In ward XXXX
To Gas, Fuel Charges XXXX
To Packaging Charges XXXX
To Other Factory Expenses
To Gross Profit XXXXX XXXXX
(Balancing Figure)
To Gross Loss XXXX By Gross Profit XXXX
To Office Salaries & Wages XXXX By Cash discount Received XXXX
To Office Rent, Rates & Taxes XXXX By Bad Debts Recovered XXXX
To Office Lighting XXXX By Income from Investment XXXX
To Office Insurance XXXX By Commission Received XXXX
To Trade Expenses XXXX By Interest on Deposits XXXX
To Printing & Stationery XXXX By Gain on Sale of Fixed
To Postage & Telegrams XXXX Assets XXXX
To Legal Expenses XXXX By Net Loss XXXX
To Audit Fees XXXX (Transferred to Capital
To Telephone Expenses XXXX Account (B/S))
To General Expenses XXXX
To Cash Discount Allowed XXXX
To Interest on Capital XXXX
To Interest on Loans XXXX
To Discount (or) Rebate on
Bills of Exchange XXXX
To Bad Debts XXXX
To Store Charges XXXX
To Cartage, Freight, Cartage
Outwards XXXX
To Cost of Samples,
Catalogue Expenses XXXX
To Salesmen’s Salaries,
Expenses & Commission XXXX
To Advertising Expenses XXXX
To Depreciation on FA’s XXXX
To Net Profit ( N/P) XXXX

29
 (Transferred to Capital
Account (B/S))
XXXXX XXXXX

FORMAT OF BALANCE SHEET:

Balance Sheet of M/s XXXX as on Mar 31, XXXX
Liabilities Amount Assets Amount
Capital Current Assets:
xxx Cash in Hand XXXX
Add: Net Profit Cash at Bank XXXX
xxx Sundry Debtors XXXX
Bills Receivable XXXX
xxx Prepaid Expenses XXXX
Less: Drawings xxx XXXX Accrued Income XXXX
Int. on Drawings xxx XXXX Closing Stock XXXX
Income Tax xxx Fixes Assets:
xxx Furniture
XXXX xxx
Reserve & Surplus XXXX Plant & Machinery
XXXX xxx
Current Liabilities XXXX Land & Buildings XXXX
Bills Payable XXXX xxx XXXX
Sundry Creditors Less: Depreciation XXXX
Bank Overdraft xxx XXXX
Outstanding Expenses XXXX
Income Received in Advance XXXX Patent XXXX
Goodwill XXXX
Long-term Liabilities Copy Right
Mortgage Loan XXXXX Investments: XXXXX
Debentures Govt. Securities
Other Investments

30
1, From the following information, prepare a Trading Account of M/s. ABC Traders for the
year ended 31st March, 2011:

`
Opening Inventory 1,00,000
Purchases 6,72,000
Carriage Inwards 30,000
Wages 50,000
Sales 11,00,000
Returns inward 1,00,000
Returns outward 72,000
Closing Inventory 2,00,000

Solution
In the books of M/s. ABC Traders

Trading Account for the year ended 31st March, 2011

Dr. Cr.
Particulars Amount Particulars Amount

` ` ` `

To Opening Inventory 1,00,000 By Sales 11,00,000

To Purchases 6,72,000 Less : Returns

Inward (1,00,000) 10,00,000
Less : Returns

outward (72,000) 6,00,000 By Closing Inventory 2,00,000

To Carriage Inwards 30,000

To Wages 50,000

To Gross profit 4,20,000

12,00,000 12,00,000

31
2, Revenue, Expenses and Gross Profit Balances of M/s ABC Traders for the year ended on 31st

March 2011 were as follows:

Gross Profit ` 4,20,000, Salaries ` 1,10,000, Discount (Cr.), ` 18,000, Discount (Dr.) `
19,000, Bad Debts ` 17,000, Depreciation ` 65,000, Legal Charges ` 25,000, Consultancy
Fees ` 32,000, Audit Fees ` 1,000, Electricity Charges ` 17,000, Telephone, Postage and
Telegrams ` 12,000, Stationery ` 27,000, Interest paid on Loans ` 70,000.
Prepare Profit and Loss Account of M/s ABC Traders for the year ended on 31st March,
2011.

Profit and Loss Account

For the year ended 31st March, 2011

. Cr.

Particulars Amount Particulars Amount

` `

To Salaries 1,10,000 By Gross Profit 4,20,000

“ Legal Charges 25,000 By Discount received 18,000

“ Consultancy Fees 32,000

“ Audit Fees 1,000

“ Electricity Charges 17,000

“ Telephone, Postage &

Telegrams 12,000

“ Stationery 27,000

“ Depreciation 65,000

“ Discount Allowed 19,000

“ Bad Debts 17,000

“ Interest 70,000

32
 “ Net Profit 43,000

4,38,000 4,38,000

3, The following trial balance have been

Dr. Cr.
taken out from the books of XYZ as on 31st
$ $
December, 2005.

Plant and Machinery 100,000

Opening stock 60,000

Purchases 160,000

Building 170,000

Carriage inward 3,400

Carriage outward 5,000

Wages 32,000

Sundry debtors 100,000

Salaries 24,000

Furniture 36,000

Trade expense 12,000

Discount on sales 1,900

Advertisement 5,000

Bad debts 1,800

Drawings 10,000

Bills receivable 50,000

Insurance 4,400

Bank balances 20,000

Sales 480,000

Interest received 2,000

Sundry creditors 40,000

3
, Bank loan 100,000

33
 Discount on purchases 2,000

Capital 171,500

795,500 795,500

Closing stock is valued at $90,000

Required: Prepare the trading and profit and loss account of the business for the year ended
31.12.2005 and a balance sheet as at that date.

XYZ
Trading and Profit and Loss Account
For the year ended 31st, December 2005

Opening stock 60,000 Sales 480,000

Less
Purchases 160,000 1,900 478,100
discount
Less discount 2,000 158,000
Closing
90,000
stock
Carriage inward 3,400
Wages 32,000
Gross profit (transferred to P&L) 314,700

568,100 568,000

Gross
profit
Carriage outward 5,000 314,700
(transferre
d to P&L)
Interest
Salaries 24,000 2,000
received
Trade expenses 12,000
Advertisement 5,000

34
Bad debts 1,800
Insurance 4,400
Net profit (transferred to capital) 264,500

316,700 316,700

Note: Discount on purchases and discount on sales are deducted from purchases and sales
respectively. They may be shown on the credit and debit side of profit and loss account
respectively and it will not affect the net profit of the business. The gross profit will be affected
if discount is treated so.

XYZ
Balance Sheet
For the year ended 31st, December 2005

Assets $ Liabilities $
Current Assets: Current Liabilities:
Bank balance 20,000 Sundry creditors 40,000
Bills receivable 50,000 Bank loan 100,000
Sundry debtors 100,000 Fixed and Long Term:
Closing stock 90,000 Capital 171,500
Fixed Assets: +Net profit 264,500
Furniture 36,000
Plant and Machinery 100,000 -Drawings 10,000 426,000
Building 170,000

566,000 566,000

35
 THE BALANCE SHEET AND RELATED CONCEPTS:

According to Howard, a Balance sheet may be defined as – ‘a statement which

reports the values owned by the enterprise and the claims of the creditors and
owners against these properties’.
The Balance sheet is a statement that is prepared usually on the last day of the
accounting year, showing the financial position of the concern as on that date. It
comprises of a list of assets, liabilities and capital. An asset is any right or thing
that is owned by a business. Assets include land, buildings, equipment and
anything else a business owns that can be given a value in money terms for the
purpose of financial reporting. To acquire its assets, a business may have to
obtain money from various sources in addition to its owners (shareholders) or
from retained profits. The various amounts of money owed by a business are
called its liabilities. To provide additional information to the user, assets and
liabilities are usually classified in the balance sheet as:
- Current: those due to be repaid (Current liabilities) or converted into
cash within 12 months of the balance sheet date(Current Assets).
- Long-term: those due to be repaid (Long term liabilities) or converted
into cash more than 12 months after the balance sheet date (Fixed Assets).
Fixed Assets:
A further classification other than long-term or current is also used for assets. A
"fixed asset" is an asset which is intended to be of a permanent nature and which
is used by the business to provide the capability to conduct its trade. Examples of
"tangible fixed assets" include plant & machinery, land & buildings and motor
vehicles. "Intangible fixed assets" may include goodwill, patents, trademarks
and brands - although they may only be included if they have been "acquired".
Investments in other companies which are intended to be held for the long-term
can also be shown under the fixed asset heading.
Capital:
As well as borrowing from banks and other sources, all companies receive
finance from their owners. This money is generally available for the life of the
business and is normally only repaid when the company is "wound up". To
distinguish between the liabilities owed to third parties and to the business
owners, the latter is referred to as the "capital" or "equity capital" of the
company. In addition, undistributed profits are re-invested in company assets
(such as stocks, equipment and the bank balance). Although these "retained
profits" may be available for distribution to shareholders – and may be paid out
as dividends as a future date - they are added to the equity capital of the business
in arriving at the total "equity shareholders' funds".

At any time, therefore, the capital of a business is equal to the assets (usually
cash) received from the shareholders plus any profits made by the company
through trading that remain undistributed
The basic functions of a balance sheet are:
1. It gives the financial position of a company on any given date
36
2. It gives the liquidity picture of the concern
3. It gives the solvency position of the concern

COMMON ADJUSTMENTS AFFECTING THE PREPARATION OF

BALANCE SHEET ARE:

1. Income received in advance: Income received in respect of which service has

not been rendered is known as income received in advance. In order to calculate
the exact profit or less made during the year, such income should not be taken in
to account while preparing profit and loss account. Hence this amount must be
deducted from the respective income account in the profit and loss account and
must be treated as a liability in the balance sheet. The adjustment entry is
Income account Dr.
To income received in advance.
2. Closing stock: Closing stock appears on the credit side of trading account and
assets side of balance sheet if it is given in the adjustments. If it is given in the
trial balance it will appear only on the assets side of the balance sheet. The entry
passed is
Closing Stock A/c Dr.
To Trading Account.
3. Outstanding expenses: Outstanding expenses refer to those expenses which
have become due during the accounting period for which financial statements are
being prepared, but not yet have been paid. Such expenses if given in the
adjustments, should be added to the respective expenditure account on the debit
side of profit and loss account and must be shown as liabilities in the balance
sheet. If such expenses are given in the trial balance they should be recorded only
on the liability side of the balance sheet. The journal entry to be passed is
Respective Expenditure A/c Dr.
To Outstanding Expenditure
4. Pre-paid expenses: They are those expenses which have been paid in advance.
They are also known as un-expired expenses. If given in adjustments, they
should be deducted from the respective expenditure account on the debit side of
the profit and loss account and must be shown on the asset side of the balance
sheet. If given in the trial balance, they must be shown only on the asset side of
the balance sheet. The adjustment entry is
Pre-paid expenditure A/c Dr.
To Respective Expenditure
5. Outstanding or accrued income: This is the income which has been earned
during the current accounting year and has become due but not yet received by
the firm. If given in the adjustments, it must be added to the respective income
account on the credit side of the profit and loss account and must be shown on
the assets side of the balance sheet. But if given in the trial balance, it must be
shown only on the asset side of the balance sheet. The entry is
37
 Outstanding/Accrued Income A/c Dr.
To Respective Income
6. Depreciation: It is a reduction in the value of the asset due to wear and tear,
lapse of time, obsolescence, exhaustion and accident. It is charged on fixed assets
of the business. If given in the adjustments, it must be shown on the debit side of
the profit and loss account and must be deducted from the respective asset
account in the balance sheet. If given in the trial balance, it must be shown only
on the debit side of the profit and loss account. The entry is
Depreciation A/c Dr.
To Respective Fixed Asset

7. Bad Debts: They represent that portion of credit sales (debtors) that had become
bad due to the inability of the debtor to repay the amount. It is a loss to the
business and gain to the debtor. This is a real loss to the business and as such
must be deducted from the debtors before deducting any reserves created on
debtors. If given in the adjustments it must be shown on the debit side of the
profit and loss account and must be deducted from the debtors account on the
asset side of the balance sheet. If given in the trial balance this amount must be
shown only in the profit and loss account. The entry is
Bad debts A/c Dr.
To Debtor’s personal account
8. Provision for bad debts: This represents a provision made by the business for
any potential bad debts. It is charged to the profit and loss account debit side and
must be deducted from the debtors after deducting the bad debts if any on the
asset side of the balance sheet, if given in the adjustments. If given in the trial
balance, it must be considered only in preparing the profit and loss account. The
entry is
Profit and loss A/c Dr.
To Provision for bad debts
9. Provision for doubtful debts: This represents a provision made by the business
for any potential doubtful debts. If given in the adjustments, it must be charged to
the profit and loss account debit side and must be deducted from the debtors after
deducting the bad debts (if any) and reserve for bad debts on the asset side of the
balance sheet. If given in the trial balance, it must be considered only in
preparing the profit and loss account. The entry is
Profit and loss A/c Dr.
To Provision for doubtful debts
10. Provision for doubtful debts: This represents a provision made by the business
for any potential discount to be allowed to the debtors. If given in the
adjustments, it must be charged to the profit and loss account debit side and must
be deducted from the debtors after deducting the bad debts (if any), reserve for
bad debts (if any) and reserve for doubtful debts (if any) on the asset side of the
balance sheet. If given in the trial balance, it must be considered only in
preparing the profit and loss account. The entry is
38
 Profit and loss A/c Dr.
To Provision for discount on debtors
11. Reserve for discount on creditors: This represents a provision made by the
business for any potential discount to be allowed by the creditors of the business.
If given in the adjustments, it must be charged to the profit and loss account
credit side and must be deducted from the creditors on the liabilities side of the
balance sheet. If given in the trial balance, it must be considered only in
preparing the profit and loss account. The entry is
Reserve for discount on creditors A/c Dr
To Profit and Loss A/c

12. Interest on capital: This is the return the owners of the business will get for
investing in the business. Usually it is paid or added to the capital at a fixed
percentage. If given in the adjustments, it is shown on the debit side of the profit
and loss account and is usually added to the capital account on the liabilities side
of the balance sheet. If given in the trial balance, it must be shown on the debit
side of profit and loss account. The entries are :
Profit and Loss A/c
To Interest on capital
Interest on capital A/c Dr
To capital A/c
13. Interest on Drawings: Drawings represents the withdrawals made by the owners
during the accounting year either in the form of stock, cash or withdrawal from
bank for personal use. They must be deducted from the capital account on the
liabilities side of the balance sheet. Sometimes, firms charge interest on such
drawings made by the owners to discourage them from withdrawing their
investment. Usually it is levied as a fixed percentage. It is an income to the
business and a loss to the owner. Hence, if given in the adjustments, it must be
shown on the credit side of the profit and loss account and deducted from the
capital in the balance sheet. If given in the trial balance, it must be shown only in
the profit and loss account. The respective entries are:
Interest on Drawings A/c Dr
To Profit and loss A/c
Interest on Drawings A/c Dr
To capital A/c

1.12 INFLATION ACCOUNTING

Its normally refers to the increasing trend in general price levels. In

economic sense, it refers to a state in which the purchasing power of money goes
down. According to “American Institute of Certified Public Accountants define,
‘Inflation accounting as a system of accounting, which purports to record as a
built-in mechanism, all economic events in terms of current cost’. It is a system
39
 of accounting like traditional accounting.
It is a method designed to show the effect of changing costs and prices on affairs
of a business unit doing the course of relative accounting period. The realization
principle is not rigidly followed, particularly in the case of recording fixed assets
and long-term loans.

REASONS FOR DISCREPENCIES IN ACCOUNTS DUE TO ADOPTION OF

HISTORICAL COST ACCOUNTS

1. Recording of fixed assets at their historical costs

2. Recording of inventory at historical cost instead of current cost
3. Recording of other assets and liabilities without taking into account their current
values

ISSUES IN INFLATION ACCOUNTING:

1. Adjustment Of Historic Cost Data: In the early days of inflation accounting
development, business houses often used to debate whether the historic cost data
should be adjusted for inflation induced price level changes or not. But, later they
started to follow it all the same while preparing their financial statements.

2. Adjustment Items: While adjusting items for inflation, there are 2 approaches
one can take – 1) covering the adjustment of all financial items, 2) covering the
adjustment of only those items that have direct impact on financial results
3. Use Of Index No: The opinion of experts is varied on the use of index numbers
for adjusting the financial accounts. They can either use general purchasing
power index or specific index number. Mostly the use of general purchasing
power index is recommended as (a) it replaces the monetary unit of measurement
which ceases to be stable during the changing price level (b) it provides the
uniform standard of measurement for comparing diverse resources
(c) it can be used for restating assets as well as shareholders capital (d) it
communicates information regarding utilization of funds and profits gained to
the proprietors

TECHNIQUES OF INFLATION ACCOUNTING

The most important techniques developed by professional institutes and
accountants to deal with inflationary conditions are (1) Current purchasing
power – [CPP], (2) Replacement cost accounting method [RCA], (3) Current
value accounting method [CVA] and (4) Current cost accounting method [CCA].
1. Current Purchasing Power [CPP] : This is a very popular method among
professional institutes. Under this system the business keeps its accounts
maintained under financial accounting system {i.e. conventional historical cost
basis}. Then at the end of the account period supplementary statements must be
40
 prepared showing all the items of financial statements in terms of the value of a
rupee to which they relate. These supplementary statements indicate the changes
in the financial conditions of the concern during the financial period as a result
of changes in the purchasing power of a rupee. For this purpose general price
index is used.
2. Replacement cost accounting method [RCA] : This method attempts to resolve
financial reporting problems that arise during the periods of rapidly changing
prices. It states that firms should create fixed asset replacement provision in the
Profit and loss account which is adequate to meet the requirements. Thus the
charges to profit and loss account are governed by the replacement cost of each
item rather than the depreciation cost. This concept requires that the reported
amount of expenses is to be measured at the time of asset expiration. Further all
the non-monetary items must be reported at the respective replacement cost as on
the balance sheet date.
3. Current value accounting method [CVA] : Under this method all items of
balance sheet are shown at current values. According to this method, the net
assets at the beginning and at the end of the accounting period are ascertained
and difference is implied to be profit or loss for the period. It attempts to reflect
economic reality to the preparation of financial statements by using current
values for reporting various items in the balance sheet.
4. Current cost accounting method [CCA] : This method had been suggested as a
base for financial reporting by Sandilands Committee appointed by the British
Committee in 1973 to solve the problem of price level changes. The Committee
reported that CPP may be used along with either historical cost or value
accounting.

ADVANTAGES OF INFLATION ACCOUNTING

1. It reflects an accurate picture of the profitability of the concern as it matches its

current revenues with its current costs. It keeps that capital intact as it does not
allow payment of dividend and taxes out of capital.
2. It enables a comparative study of the profitability of various concerns set up at
different periods.
3. As depreciation is charged on current value of assets, it is easier for the concern
to replace the assets.
4. By providing accurate financial information to the various interested parties, it
discharges the social obligation of the business.
5. It enables the company to realize a realistic price for its shares in the investment
market.

DIS-ADVANTAGES OF INFLATION ACCOUNTING

1. It is a complicated, confusing and time consuming process as it requires lot of
work.
2. The adjusted financial statements are difficult to be understood, analyzed and
41
 interpreted by a common man. If proper conversion method is not adopted the
information provided may be inaccurate.
3. Income Tax Act of 1961 does not recognize the depreciation charged on current
value of fixed assets. Hence it is not suitable for tax purposes.
4. During inflation profits are overstated as lower depreciation is charged to fixed
assets.

1.12 HUMAN RESOURCE ACCOUNTING CONCEPTS

The concept of HR accounting was not known to the world till the early 60’s.
During this period, few experts like Hermanson, Hekimian, Jones and
RensisLikert had recognized HR as assets just like any other tangible or
intangible assets.
Definition of Human Resource Accounting (Hra)
The term ‘HR Accounting’ implies accounting for Human resources –
namely, the knowledgeable, trained and loyal employees who participate in the
earning process and total assets. Different authors have defined HR Accounting
in different terms. According to the American Accounting Association (1973),
HR Accounting is ‘the process of identifying and measuring data about human
resources and communicating the information to interested parties’. In the words
of Stephen Knauf – HR Accounting is ‘the measurement and quantification of
human organization inputs, such as recruiting, training, experience and
commitment’.
Thus, HR Accounting had been defined by many authors in different ways. In
essence, it represents a systematic attempt to assess the value of human resource
of an organization.

THE PROCESS OF HRA

The process of HR Accounting includes – identification and

measurement or quantification of human resource in an organization and its
reflection in its annual reports or financial statements.

THE OBJECTIVES OF HRA

The objectives of HR accounting are:

1. To provide relevant information about the human resource to the
management and aid in its decision making
2. To help management in evaluating the performance of its personnel and
calculate its return on investment
3. To help the management in planning and controlling the various functions
or activities related with its human resource such as – man power planning,
recruiting, training and retirement etc.

42
 ADVANTAGES OF HRA
 The various advantages a firm can enjoy by establishing HR Accounting
are as follows:
 Its adoption acts as a motivating factor for the employees of the concern
as it is reflected in its financial statements
 It helps the management in identifying and controlling several problems
related with human resources
 It enables the management in efficiently using its man power by
providing quantified information about its HR
 By considering HR as an asset in its financial statements, it provides a
measure of profitability
 It helps the investors or potential investors in assessing the true value of a
firm by providing realistic information about its HR

DISADVANTAGES OF HRA
At the same time, a firm may also face certain limitations in implementing HRA
such as
 HR as an asset cannot be owned by any firm.
 Quantification of HR value is subjective in nature and there is no common
valuation model existing which can be used across the industries or by all the
companies in the same industry
 As its establishment and implementation involves huge cost, it may not suit
small firms
The concept of HRA is not recognized by tax authorities and has only
academic value
 There is no objective procedure to be followed in the valuation of the HR, hence
comparative analysis may not be possible, and even if possible, may not be
reliable

TECHNIQUES OF VALUATION OF HR

There are around eight techniques for valuation of HR. They are as follows:
1. Historical cost Method: This method was developed by RensisLikert and his
associates and was adopted by R.G.Barrycorporation, Ohio, Colombia, USA, in
1968. This method involves capitalization of the costs incurred on HR related
activities such as – recruitment, selection, placement, training and learning etc,
and amortized over the expected length of services of the employees. The un
expired cost represents the firm’s investment in HR. In case an employee leaves
the organization before the expiry of the expected services’ life period, the firm
shall write off the entire amount of un expired cost against the revenue of the
period during which he or she leaves.
43
2. Replacement Cost Method: This method was initially developed by Hekimian
& Jones. According to this method, a firm’s HR value is its replacement cost.
According to Flamholtz, this replacement cost may be – i) individual
replacement cost – which refers to the cost of replacing an employee with an
equivalent substitute in terms of skill, ability and knowledge and ii) positional
replacement cost – which refers to the cost of replacing the set of services
expected to be rendered by an employee at the respective positions he holds and
will hold at present and in future. Thus, the HR value will appear in the financial
statements at its replacement cost.
3. Opportunity cost method: This method has been suggested by Hekimian and
Jones and refers to the valuation of HR on the basis of an employee’s value in
alternative uses, i.e, opportunity cost. This cost refers to the price other divisions
are willing to pay for the service of an employee working in another division of
an organization.
4. Capitalization of Salary method: This method had been proposed by
BaruchLev and Aba Schwartz in terms of economic value of HR. According to
them, the salaries payable to employees during their stay with the organization
may be used in valuing the HR of an organization. Thus the value of HR is the
present value of future earnings of homogeneous group of employees.
5. Economic valuation method: This values the HR of an organization by
considering the present worth of the employees’ future service expected to be
derived during their stay with the organization. Under this method, the valuation
of HR involves 3 steps – 1) estimation of employee’s future services, 2) multiply
step 1 by the employee’s rate of pay and 3) Multiply step 2 by the rate of return
on investment. This would give the present worth of employee’s service.
6. Return on efforts employed method: Under this method, HR valuation is done
on the basis of the quantifying the efforts made by the individuals for the
organizational benefits by taking into account factors such as –positions an
employee holds, degree of excellence employee achieves, and the experience of
the employee.
7. Adjusted discounted future wages method: This model has been developed by
Roger. H. Hermanson. Under this method, HR valuation is done on the basis of
relative efficiency of an organization in the industry. This model capitalizes the
extra profit a firm earns over and above that of the industry expectations.
As such, this model involves 4 steps – 1) estimation of 5 years (succeeding)
wages and salaries payable to different levels of employees 2) finding out the
present value of such estimated amount at the normal rate of return of the
industry, 3) determining the average efficiency ratio (the co.’s average rate of
return for the past 5 yrs.)/ Industry’s average rate of return for the past 5 yrs.) for
5 years, 4) finding out the present value of future services of the co.’s by
multiplying the discount value (as in 2nd step) by the firm’s efficiency ratio (as
calculated in 3rd step)

44
8. Reward valuation method: This model has been developed by Flamholtz and is
commonly known as – the stochastic rewards valuation model. It values the HR
of a concern on the basis of an employee’s value to an organization at various
service states (roles) that he is expected to occupy during the span of his working
life with the organization. This model involves – estimation of an employee’s
expected service life, identifying the set of service roles he may occupy during
his service life, estimating the value derived by an organization at a particular
service state of a person for the specified time period, estimating the probability
that a person will occupy at possible mutually exclusive service state at specified
future times, quantifying the total services derived by the organization from all
its employees, and discounting the total value thus arrived at to its present value
at a pre-determined rate
.
1.13 SOCIAL RESPONSIBILITY ACCOUNTING:

This branch is the newest field of accounting and is the most difficult to
describe concisely. It owes its birth to increasing social awareness which has
been particularly noticeable over the last three decades or so. Social
responsibility accounting is so called because it not only measures the economic
effects of business decisions but also their social effects, which have previously
been considered to be immeasurable. Social responsibilities of business can no
longer remain as a passive chapter in the text books of commerce but are
increasingly coming under greater scrutiny. Social workers and people’s welfare
organizations are drawing the attention of all concerned towards the social
effects of business decisions. The management is being held responsible not only
for the efficient conduct of business as reflected by increased profitability but
also for what it contributes to social well-being and progress

45
 Two Marks:

1. Define Accounting? (May/June 2011)

2. Write Short note on Cost Accounting? (May/June 2011) (Jan 2013)
3. What is the Position of Ledger in Book Keeping? (May/June 2012)
4. Define Inflation Accounting? (May/June 2012),(June 2013)
5. What are the Functions of Accounting? (Apr/May 2011)
6. What is Provision for Doubtful Debts? (Apr/May 2011)
7. What is Money Measurement Concept? (Jan/2012)
8. Explain Management Accounting Information? (Jan/2012)
9. What is Profit and Loss Account? (Jan/2012)
10. What do you mean by GAAP? (Jan/2013)
11. What are the functions of Accounting? (NOV/DEC2013)
12. What is inflation accounting? (NOV/DEC2013)
13. What is financial accounting? (JAN 2014)
14. What are personal accounts? (JAN 2014)
15. What is GAAP? (MAY/JUNE 2014)
16. What is human resource accounting? (MAY/JUNE 2014)
17. Mention The objectives of accounting. (JAN 2015)
18. Define the term human resource accounting. (JAN 2015)
19. Define management accounting. (APR/MA 2015)
20. What is GAAP? (APR/MA 2015)

16 Marks:
1. Explain the difference branches of Accounting with their Significances?
(May/June 2011)
2. Evaluate the Generally Accepted Accounting Conventions? (May/June
2011),(Jan/2013)
3. What is Nature of Accounting? In What ways accounting information is Useful
to
creditors, Investors and Employees of a business Enterprise? (May/June 2012),
(Jan/2012)
4. Explain the Importance of Various Accounting Concepts & Conventions?
(May/June 2012), (Jan2013)
5. Mention the Accounting Conventions and Explain? (Nov/Dec 2011)
6. Explain the concept of Inflation accounting. Discuss its Merits & Demerits?
(Nov/Dec 2011)
7. “Management Accounting is the best tool for the Management to achieve higher
46
 profits and Efficient Operations” Discuss. (Apr/May 2011)
8. What are the Objectives, Importance & Advantages of Human resource
accounting? Explain. (Jan/2012)

9. Discuss the Brief about Accounting Concepts. (NOV/DEC2013)

10. What is Human resource accounting? State the advantages and limitations.
(NOV/DEC2013)
11. Distinguish between profit and loss account and balance sheet using an
Illustration. (JAN 2014)
12. Explain the concepts of human resource accounting. State its importance. Which
objections are generally leveled against HRA? (JAN 2014)
13. A Ltd. was registered with an authorized capital of Rs. 6,00,000 in equity
shares of Rs.10 each. The following is its Trial balance on 31st March,
2009. (MAY/JUNE 2014)

Particulars Debit Credit

Goodwill 25,000 -
Cash 750 -
Bank 39,900 -
Purchase 1,85,000 -
Preliminary expenses 5,000 -
Share capital - 4,00,00
12% debentures - 4,00,00
Profit and loss account — 26,250
Calls in arrears 7,500 -
Premises 3,00,000 -
Plant and machinery 3,30,000 -
Interim dividend 39,250 -

SaIes - 4,15,000
Stock 75,000 -
Furniture 7,200 _
Sundry debtors 87,000 _
Wages 84,865 _
General expenses 6,835 -
Freight and carriage 13,115 -

47
 Salaries 14,500 -
Directors' fees 5,725 —
Bad debts 2,110 -
Debenture interest paid 18,000 —
Bills payable - 37,000
Sundry creditors 40,000
General reserve - 25,000
Provision for bad debts - 3,500
12,46,750 12,46,750

Prepare Profit and Loss a/c profit and loss appropriation a/c and Balance
sheet in proper form after making the following adjustments :

(i) Depreciate plant and machinery by 15%

(ii) Write off Rs.500 from preliminary expenses

(iii) Provide for 6 months interest on debentures

(iv) Leave bad and doubtful debts provision at 5% on sundry debtors

(v) Provide for income tax at 50%

(vi) Stock on 31.3.2010 was Rs. 95,000

48
 UNIT-II
COMPANY ACCOUNTS:

Meaning of company – maintenance in book of accounts – Statutory Books –

Profit or Loss prior to incorporation – Final Accounts of Company – Alteration
of share capital – preference allotment. Employee’s stock option -Buy back of
securities.

2.1 NATURE OF A COMPANY

The company is one of the forms of organization. It has its distinctive

characteristics and advantages which make it suitable for different purposes.
Legal Meaning
According to section 3(1) (i) of The Companies Act, 1956, “Company means a
company formed and registered under this Act or an existing company”.
On analyzing the aforesaid definitions the following characteristics of a
company are revealed:
1. An artificial person created by law: A company is called an artificial person
because it does not take birth like a natural person but comes into existence
through law. Being the creation of law, the company possesses only those
properties which are conferred upon it by its charter.
2. Separate Legal Entity:
A company is a separate legal entity as distinct from its members; therefore it is
separate at law from its shareholders, directors, promoters etc. and as such is
conferred with rights and is subject to certain duties and obligations.
3. Perpetual Existence: The term perpetual existence means the continued
existence. The death, insolvency or unsoundness of mind of its members or
transfer of shares by its members does not in any way affect the existence of the
company. Members may come and members may go but the company goes on
forever. The company can be compared with flowing river where water
(members) keeps on changing continuously; still the identity of the river
(company) remains the same.
4. Common Seal: The term Common Seal means the official signature of the
company. Since the company being an artificial person cannot sign its name on a
document, every company is required to have its common seal with its name
engraved on the same. This seal acts as the official signature of the company.
Any document bearing the common seal of the company and duly witnessed by
at least two directors will be binding on the company.
5. Limited Liability: In case of a company limited by share, the liability of a
member is limited up to the amount remaining unpaid on the shares held by a
member.
6. Free Transferability of shares: The shares of a public company are freely
transferable. A shareholder can transfer association, even a public limited
49
 company can put certain restrictions on the transfer of shares but it cannot
altogether stop it. A shareholder of public company possessing fully paid up
shares is at liberty to transfer his shares to anyone he likes in accordance with the
manner provided for in the articles of association of the company.

2.2 TYPES OF COMPANIES

The companies can be classified under the three categories as follows:

 Basis of incorporation
 Basis of liability
 Basis of control

1. Basis of incorporation: This is further divided into three categories.

They are as follows:
a) Charted company: A company incorporated under a special charter granted by
the king or Queen of England is called “charted Company”. The familiar
examples of charted company are the East India Company and the Bank of
England. This type of company cannot now be formed in India.
b) Statutory Company: A statutory company is one which is created by a special
Act of Parliament or a state legislature. Such companies are usually formed for
achieving a purpose related with public utilities. The nature and powers of such
companies are laid down in the special Act under which they are created. A
statutory company has also a separate legal entity is conducted under the control
and supervision of the Auditor General of India and the annual report of working
is required to be placed before the Parliament or state legislature, a the case may
be. Example, Reserve Bank of India.
c) Registered or Incorporated Company: A registered company is one which is
registered in accordance with the provisions of the Companies Act of 1956 and
also includes the existing companies. Existing company means a company
formed and registered under any of the previous laws.
A registered company may either be a private company or a public company. It is
explained as follows:
1. Private Company- A private company means a company which has a
minimum paid up capital of Rs.1,00,000 or such higher paid up capital as may be
prescribed, and by its articles-
Restricts the right to transfer its shares, if any
Limits the number of its members to fifty, and
Prohibits any invitation to the public to shares in or debentures of the company.
Prohibits any invitation or acceptance of deposits from persons other than its
members, directors or their relatives.

II- Public Company

50
 A Public company means a company which is either
a) not a private company and has a minimum paid up capital of Rs 5,00,000
or such higher paid-up capital as may be prescribed: or
b) is a private company which is subsidiary of public company.
2. Based on Liability
On the basis of liability, an incorporated company may either be
i) A company limited by shares
ii) A company limited by guarantee
iii) An unlimited company

i) Company Limited by Shares- A Company limited by shares is a company in which

the liability of its members is limited by its memorandum to the amount unpaid
on the share respectively held by them. The companies limited by shares may be
either public companies or private companies. If a member has paid the full
amount of shares, then his liability shall be nil.
ii) Company Limited by Guarantee- A Company limited by guarantee is a company
in which the liability of its members is limited by its memorandum to such an
amount as the members may respectively undertake to contribute to the assets of
the company in the event of its being wound up.
iii) Unlimited Company- An unlimited company is a company in which the liability of
its members is not limited by its memorandum. In other words, the liability of
members is unlimited. The members of such companies may be required to pay
company’s losses from their personnel property.
3. Based on Control
On the basis of control, the companies may be grouped as follows:
1. Government Company- A government company means any company in which
at least 51% of the paid up share capital is held by the central government or by
any state government or partly by the central government and partly by one or
more state governments and includes a company which is a subsidiary of a
government company as thus defined.
Example: Hindustan Aeronautics Ltd.
2. Non-Government Company- A company which may not be termed as a
government company as defined in Section 617 is regarded as a non-government
company
3. Foreign Company- A foreign company means a company, which is
incorporated in a country outside India under the law of that country. After the
establishment of business in India, the relevant documents must be filed with the
registrar of companies within 30 days from the date of establishment.
4. Domestic Company-A company which cannot be termed as foreign company
under the provisions of the companies act as a domestic company.
5. Holding and Subsidiary Company- If one company controls the other
company, the controlling company may be termed as the “Holding Company”
and company so controlled may be termed as a “Subsidiary Company”.
51
 6. Multi National Company
A multinational company is huge industrial organization which-
a) Operate in more than one country
b) Carries out production, marketing and research activities on international scale
in those countries, and
c) Attempts to maximize profits world over.

2.3 THE FORMATION OF COMPANY


Preparation of documents

Filling of documents

Payments of necessary payments

Registration of a company

Certificate of incorporation
Preparation and Filling of Documents:
Preparation and filling of documents for the formation of a
company following documents are filled with the registrar of joint companies of
the state in which registered office of the company is indented to be located;
a. Memorandum of association duly stamped, signed and witnessed.
b. Articles of association duly stamped, signed and witnessed.
c. A list of the directors who have agreed to become the first director of this
company.
d. Directors consent to act also take up the qualification shares.
e. A declaration by a competent person that all the requirement of this Act.
f. The agreement
Such a declaration may be given by act of the following person;
i. An advocate of the Supreme or High Court
ii. An attorney or a pleader entitled to appear before High Court
iii. A secretary or a Chartered Accountant in whole time basis and engaged in the
formation of the company
iv. A person named in the Articles of association as director or manager or secretary
of the company
Payment of fees and issue of certificate of incorporation:
• The registrar, on being satisfied, registers the Memorandum and Articles of
association and will certify under his hand that the company is incorporated and
in the case of a limited company that the company is limited. Before registration
the payment of fees is a formality.
• The certificate of incorporation is an important document in as much as it
52
 evidences the existence of the company from the date on which the certificate
has been issued.
• It is conclusive evidence of the fact that the company has been registered the
effect of the certificate is to give the company a distinct and separate entity.
Perpetual succession. Common seal, and make all members a body corporate
The certificate of incorporation is the conclusive evidence of the
registration of the company and cannot be cancelled afterwards even if some
regulations are subsequently detected. The only remedy for undoing the effect of
registration is to wind up the company according to provisions of the company
Act.

2.3.1SHARES

Total capital of the company is divided into small unit of denomination.

One of the units into which the capital of the company is divided is called a
share. No trading concern can run without capital.
Share capital constitutes the basic of the capital structure of the company.
Ownership of a company is verified in its shareholders and a share represents the
extent of ownership or interest in the assets and profits of the company. In this
sense, a share may be defined as one of the equal parts into which the capital of a
company is divided, entitling the holder of the share to a proportion of the
profits.

2.3.2 CLASSES OF SHARES

Companies usually issue three classes of shares, namely

a. Equity shares
b. Preference shares
c. Deferred shares

Equity shares: Equity shares are shares, one who holds are called as real owner
of the organization or company. The act defines an equity share in a negative
way. An equity share is one which is not a preference share. These are normally
risk bearing shares.
In olden days the equity shareholders do not receive any dividends. But in
modern days they receive substantial dividends. During liquidation of a company
they are paid-out but are usually entitled to all the surplus assets after the
payment of creditors and preference shareholders.
The value of these shares in the market fluctuates with the fortunes of the
company. A wise investor in equity shares not only receives regular dividends
but is also assured of capital appreciation.

53
 Preference shares: Preference shares are simply called priority shares. That is at
the time of declaration of dividend and insolvency one who have priority is
called as preference share.
The company act defines a preference share as that part of the share capital of
the company which enjoy preferential right as to,
➢
The payment of dividend at a fixed rate during the lifetime of the company.
➢
The return of capital on winding up of the company.
It is expressed that a share to be called a preference share must enjoy both the
preferential rights. A preference shareholder cannot compel the company to pay
dividend. Preferential shareholders do not enjoy voting rights except when
➢
Dividend is outstanding for more than two years in the case of cumulative
preference shares.
➢
For more than three years in the case of cumulative preference shares.

TYPES OF PREFERENCE SHARES:

❖
Participating preference shares
❖
Non-participating preference shares
❖
Cumulative preference shares
❖
Non-cumulative preference shares
❖
Redeemable preference shares
❖
Irredeemable preference shares
a. Participating preference shares: It is otherwise called priority shares. It means
declaration of dividend and company insolvency participating preference
shareholders get first priority.
b. Non-participating preference shares: It is otherwise called non priority shares.
In this case the non-participating preference shareholders should not get any
priority to get back their dividend and other settlements.
c. Cumulative preference shares: In the case of cumulative preference shares
dividends accumulated when not paid. So when the company wants to pay any
dividend to equity shareholders, it must first pay arrears of such dividends to
cumulative preference shareholders. If the company goes into liquidation, arrears
of dividend are not payable unless they are either declared or article of
association contains express provision in this regard.
d. Non-cumulative preferential shares: Non-cumulative preference shares are
shares where the arrears of dividend do not accumulate. If a dividend is not
declared in any year then it lapses.
e. Redeemable preference shares: Those shares redeemable within a stipulated
period accordance with the terms of issue. After amendment in 1988 such shares
must be redeemed within a period of 10 years.
f. Irredeemable preference shares: Those shares which can be redeemed only in
the event of company’s liquidation. However, after amendment of companies
54
 Act, 1988, companies are not permitted to issue prior to the amendment of the
act in 1988.

2.4 DEFERRED SHARES

These are also known as founder’s shares or management shares. These

are usually allotted to promoters and their friends at the time of formation of the
company. These share usually carry disproportionate voting rights and right to
substantial dividends from the profits left after paying off preference and equity
dividend. Public limited companies, subsidiary of such companies and private
companies deemed to be public limited companies cannot issue such shares after
the commencement of the companies act, 1956.
Private limited companies are enjoying the privilege
.
2.4.1THE TYPES OF SHARE CAPITAL
➢
Authorized share capital
➢
Issued share capital
➢
Subscribed share capital
➢
Called-up share capital
➢
Paid up share capital
➢
Partly paid up capital
a. Authorized share capital: this is the maximum capital that the company is
authorized to rise. This amount is stated in the memorandum of association.
This is also called as registered capital or nominal capital.
b. Issued capital: this represents the capital which is offered to public for
subscription. The difference between authorized capital and issued capital
represents the capital. The form requires the statement of different classes of
capital under the head “issued capital”.
c. Subscribed capital: subscribed capital refers to that part of the issued capital
which has been subscribed by public and also allotted to the directors of the
company. Under this capital also the company should give particulars of
different types of share capital information as must also be given regarding
shares allotted for consideration other than cash and shares allotted as fully paid
up by way of bonus shares. The sources from which bonus shares are issued
must also be stated.
d. Called-up capital: it is refers to that part of the subscribed capital which has
been called up by the company for payment.
e. Paid-up capital: it is refers to that part of the called-up which has been actually
paid up by the shareholders might have defaulted in paying the allotment or call
money. Such amount defaulted is known as calls in arrears. From the called up
capital, calls in arrear is deducted to obtain the paid up capital. Calls in arrears
due from directors have to be stated separately.

55
 Statutory Books
Statutory Books are the official records kept by the company relating to all
legal and statutory matters.
A company's statutory books are usually kept at the registered office of the
company. The books should be available to the general public for inspection
during reasonable office hours.
The typical contents of a company's statutory book are:
* the register of shareholders
* the register of company directors and secretaries
* the register of company directors' interests
* the register of charges
* The register of interests in shares if the company is a PLC.

2.5 ALTERATION OF SHARE CAPITAL

-According to Section 94 a company limited by shares or guarantee and having

a share capital may alter its share capital, if authorized by AOA and by
passing an ordinary resolution in certain ways like:
• Increasing the capital by issuing new shares or
• Consolidating or dividing the share face values
• Converting fully paid shares into stock and vice versa or
• Cancelling shares not taken up
• Notice of alteration of capital should be given to roc in e-form no. 5 within
thirty days of such alteration
• Default in this case will make the company and every officer of the company
liable to a fine extending up to rs. 500 per day during which the default continues
• The power to alter should be exercised bona fide in the interest of the company
• The increased capital may consist of preference shares, provided that this is not
inconsistent with rights given by the memorandum of association.

NATURE OF STOCK
-As per Section 2(46) share includes stock except where a distinction between
stock and shares is expressed or implied. A stockholder has the same rights as to
dividends as a shareholder.
-A company can only convert fully paid shares into stock and cannot directly
issue stock
REDUCTION OF SHARE CAPITAL
-It means reduction of issued, subscribed and paid-up capital of the company
and as per Section 100, it is possible if the articles of the company so authorize
and when confirmed by Court/Tribunal
56
-It may be necessary for various reasons like to meet trading losses,
heavy capital expenses etc.
-It may be done by reducing or extinguishing the liability in respect of
uncalled or unpaid capital or by paying back paid up capital not wanted by
the company or by paying back the paid up capital on the condition that it
may be called up again or by writing off the lost capital
-While confirming the same, the Court must ensure that the interests of
creditors, shareholders and general public must be protected
-However, in the following cases, the reduction does not call for
sanction of Court/Tribunal
--Surrender of shares (The Companies Act does not expressly provide for
surrender except that surrender is possible if AOA permits and where the shares
otherwise may be forfeited
-Forfeiture of shares
--Diminution of capital (Where the company cancels shares which have not
been taken or agreed to be taken by any person)
--Redemption of redeemable preference shares.
--Purchase of shares of a member by the Company under
Section 402. --Buy-back of its own shares under Section
77A.
-An unlimited company to which Section 100 does not apply, can reduce its
capital in any manner that its Memorandum and Articles of Association allow
-It must be ensured that the effect of a reduction does not disqualify any
director when it relates to qualification shares
-After confirming the reduction, the Court/Tribunal may also direct that the
words “and reduced” be added to the company’s name for a specified period,
and that the company must publish the reasons for the reduction with a view to
giving proper information to the public.
-The Court’s/Tribunal’s order confirming the reduction together with the
minutes giving the details of the company’s share capital, as altered, should be
delivered to the Registrar who will register them. The reduction takes effect
only on registration of the order and minutes, and not before. The Registrar
will then issue a certificate of registration which will be conclusive evidence
Diminution of share capital is not a reduction of capital
(i) Where the company cancels shares which have not been taken or
agreed to be taken by any person [Section 94(1)(e)];
(ii) Where redeemable preference shares are redeemed in
accordance with the provisions of Section 80;
(iii) Where any shares are forfeited for non-payment of calls and
such forfeiture amounts to reduction of capital.
(iv) Where the company buys-back its own shares under Section 77A of
the Act. In all these cases, the procedure for reduction of capital as laid down
in Section 100 is not attracted.
57
 -PENALTY: If any officer of the company knowingly conceals the name of
any creditor entitled to object to the reduction or knowingly misrepresents the
nature or amount of the debt or claim of any creditor etc., he shall be liable to
be punishable with

COMPANY PROHIBITED TO BUY ITS OWN SHARES OR TO

FINANCE THEIR PURCHASE
-Section 77(1) provides that a company limited by shares, or by guarantee
and having a share capital cannot buy its own shares as that would involve a
reduction of share capital without the court’s consent.
There are, however, certain exceptions to this rule like:
(a) A company may redeem its redeemable preference shares under
Section 80 of the Act.
(b) A banking company may lend money in the ordinary course of business.
(c) A company may provide financial assistance to employees other than
directors for purchasing fully paid up shares, an amount

(d) A company may buy its own shares from any member in pursuance
of a Court’s order under Section 402 of the Companies Act.

2.6 ALLOTMENT OF SHARES

-“Allotment” of shares means the act of appropriation by the Board of

directors of the company out of the previously un-appropriated capital of a
company of a certain number of shares to persons who have made
applications for shares
-The re-issue of forfeited shares does not constitute appropriation out of
inappropriate capital, and therefore is not an allotment and a company need not
file return in e-Form No. 2 in respect of the re-issue of forfeited shares.
Notice of Allotment
-An allotment is the acceptance of an offer to take shares by an applicant, and
like any other acceptance it must be communicated by way of notice.

GENERAL PRINCIPLES REGARDING ALLOTMENT

(1) The allotment should be made by proper authority, i.e. the Board
Directors or a committee duly authorized to allot shares. – The Board should be
duly constituted and a valid resolution for allotment must be passed
(2) Allotment of shares must be made within a reasonable time
(3) The allotment should be absolute and unconditional
(4)The allotment must be communicated. – Posting to proper address is valid
though the letter may be lost in transit
58
(5) Allotment against a written application only
(6) Allotment should not be in contravention of any other law like allotment to a
minor.

STATUTORY PROVISIONS REGARDING ALLOTMENT

(a) The Company wanting to make a public issue should apply to one or
more recognized stock exchange(s) for listing u/s 73 and if listing permission
is not granted within prescribed period by any of the stock exchanges named
in the prospectus, the entire allotment is void.
(b) The company shall file with the Registrar, a prospectus or a statement
in lieu of prospectus in e-form 19 or e-form 20, as the case may be, before
making an allotment signed by every person who is named therein as a
director.
(c) The company shall receive in cash, application money which shall not
be less than 5 percent of the nominal value of the shares and the amount must
be kept in a scheduled bank in a separate account till the allotment is made and
until the certificate to commence business has been obtained under Section 149
of the Companies Act, 1956. [Section 69]
(d) If minimum subscription, as provided in the prospectus, has not been
received by the company, all amounts received must be refunded and
allotment, if made is void
(e) No allotment shall be made where a prospectus is issued generally
until the beginning of the fifth day after the date on which the prospectus is
so issued or such later date as may be specified in the prospectus. This date
is known as the “date of opening of the subscription list” (Section 72).
(f) Closing of the Subscription List — SEBI (Disclosure and Investor
Protection) Guidelines 2000 provide that the subscription list must be kept
open for at least 3 working days and not more than 10 working days and in
the case of Infrastructure Company, the maximum period is 21 working
days. In case of Rights issue, the SEBI guidelines provide that the issue shall
remain open for at least 30 days and not more than 60 days.
(g) If the company having a share capital does not issue prospectus it cannot
proceed with the allotment unless it files with the Registrar of Companies at least
3 days before the first allotment a Statement in lieu of prospectus in eform 20 in
Schedule III and must contain the particulars and reports set out therein.
Allotment of Shares/Debentures to be listed on Stock Exchange if made to
public after issue of prospectus
-As per Section 73, every public issue must be listed and if permission is not
granted within 10 weeks from closure of subscription list or is refused before,
the allotment is void.
-However, where a stock exchange refuses to grant an application or fails to
dispose it off within 10 weeks, the company may, under Section 22 of the
Securities Contracts (Regulation) Act, 1956 appeal to the Securities Appellate
Tribunal against the refusal:

59
(1) Within 15 days from the date of the refusal, or
(2) Within 15 days from the date of the expiry of 10 weeks.
-As per Section 73(2) if allotment is void as above, the company must repay
the application money immediately and if it is not repaid within 8 days, the
company and every director of company who is an
Officer in default shall on and from the expiry of the eighth day, be jointly and
severally liable to repay that money with interest @ 15% p.a.
Basis of Allotment
-As per Clause 44 of listing agreement, allotment of securities offered to public
shall be made within 30 days of closure of public Issue. If it is not done so or if
refund order is not dispatched to investors within 30 days from the date of
closure of issue, then the Company shall pay interest @ 15% p.a. as per the
listing agreement.
Over Subscription
-As per SEBI (ICDR) Regulations, 2009 oversubscription can be retained not
exceeding 10% of the net offers for the purpose of rounding off to the nearer
multiple of 100.
Minimum Subscription
As per Section 69(1) no allotment can be made in a public issue until the
minimum subscription stated in the prospectus has been subscribed and the
amount payable on application has been received in cash by the company. –
Such minimum subscriptions should be 90 percent of the issue including
devolvement on underwriter’s subscription
-As per the provisions of the Act, it must be received within 120 days of opening
of issue but as per SEBI requirements, it must be received within 60 days
from closure - If it is not so received, the amount received should be returned
within next 10 days and if not so returned, the directors are liable to return the
same with interest
Letter of Allotment
-The company sends this letter to allottees and they surrender the same in
exchange for shares certificates when they are subsequently issued
Letter of Renunciation
-Under Section 81, when a Public Company makes a right issue to existing
shareholders, they have an option to renounce the shares in favour of any other
person, through a letter of renunciation – If the renounce does not accept the
offer, BOD of the company may dispose of those shares in any manner in the
best interest of the company

2.7 EMPLOYEE STOCK OPTION

Employee Stock Option Scheme means the option given to the Whole
Time Directors, Officers and Employees of the Company which gives them a
right or benefit to purchase or subscribe the securities offered by the Company at
60
 a predetermined price at a future date. The idea behind sock option is to motivate
the employees by linking the profitability of the Company.

Eligibility to participate in ESOS:-

• Option shall be granted only to the eligible permanent employees of
the Company subject to the following:-
• An employee who is a promoter or belongs to the promoter group shall not be
eligible to participate in the ESOS.
• A director who either by himself or through his relative or through anybody
corporate, directly or indirectly holds more than 10% of the outstanding equity
shares of the company shall not be eligible to participate in the ESOS.
Disclosure to the Grantees:-
No ESOS can be offered by the Company unless the disclosure regarding risk
involve, brief of Company, Terms and Conditions of ESOS has been made to
the prospective grantees.
Compensation Committee:-
No ESOS can be offered unless the company has constituted a Compensation
Committee for administration and superintendence of the ESOS. The
Compensation Committee, consisting of the majority of independent
directors, shall formulate the detailed terms and conditions of the ESOS.
Shareholders’ Approval:-
Shares can be issued under ESOS with the approval of shareholders by way
of Special Resolution. The explanatory statement of the notice and the
resolution proposed to be passed in general meeting shall include details
regarding the ESOS. Approval of shareholders by way of separate resolution
in the general meeting shall require in case grant of option to identified
employees, during any one year, equal to or exceeding 1% of the issued
capital of the company.

Variation of terms of ESOS:-

The Company, by special resolution, may various the terms, including the
pricing, of the ESOS offered but not yet exercised by the employees provided
such variation is not prejudicial to the interest of the option holders.
Lock in Period:-
There shall be a minimum period of one year between the grant of option and
vesting of option. However the Company shall have the freedom to specify the
lock in period for the shares issued pursuant to exercise of option. The
employees shall not have any right to receive dividend or to vote or in any
manner enjoy the benefits of a shareholder in respect of option granted to him,
till the shares are issued on exercise of option.
Non transferability of option:-
The option granted to an employee shall not be transferable to any person; the
option can only be exercised by the employee to who the option is granted.
61
 The option cannot be transferred, pledged, hypothecated, mortgaged or
otherwise alienated in any manner. This is a personal right only to the offeree.
Disclosure in Directors’ Report:-
The Board of Directors shall disclose either in Directors’ Report or in
the annexure to the Directors’ Report the details of ESOS.
Certificate from the Auditors:-
The Board of Directors shall place before the shareholders a certificate from the
auditors of the company that the scheme has been implemented in accordance
with these guidelines and in accordance with the resolution of the company in
the general meeting.
Procedure for Granting of Shares Under ESOS
1. Hold board meeting for
a. Approving the ESOS
b. Calling and Approving the notice of AGM/EGM for passing
special resolution
c. Constituting the compensation committee
2. In case of listed company advance notice to the Stock
Exchange and after the Board Meeting, outcome of the Board
Meeting is also to be notified immediately.
3. Send three copies of notice to the Stock Exchange.
4. Make disclosures to the grantees.
5. Hold general meeting and pass required special resolution.
6. Intimation to SE along with the certified copy of special resolution.
7. The company shall appoint a registered merchant banker for the
implementation of ESOS as per guidelines till the stage of framing the ESOS
and obtaining in principal approval from the stock exchange. 8. File form 23
within 30 days of the special resolution to register the resolution with ROC.
9. Obtain in principal approval from SE.
10. Prepare a list of options exercised by employees.
11. Hold board meeting for allotment of shares.
12. File a return of allotment in form 2 to the ROC within 30 days.
13. Give intimation to NSDL/CDSL regarding corporate actions.

2.8 BUY BACK SECURITIES

Buyback of Shares:
Buyback of shares means that any company may purchase their own shares or
other specified securities. According to section 77A (1) of the companies Act
1999, a company may purchase its own shares or other securities out of:
(i) Its free reserves or
62
(ii) The securities premium account or
(iii) The proceeds of any shares or other specified securities.
Specified securities include employees’ stock option or other securities as may
be notified by the Central Government from time to time. Buyback of shares of
any kind is not allowed out of fresh issue of shares of the same kind. In other
words, if equity shares are to be bought back, preference shares or debentures
may be issued for buyback of equity shares. Companies are allowed to buy back
their own shares if they fulfill certain conditions as given in section 77A (2) of
the companies Act 1999.
No company shall purchase its own shares or other specified securities unless:
(a) The buyback is authorized by its articles.
(b) A Special resolution has been passed in general meeting of the company
authorizing the buyback.
(c) The buyback is for less than 25% of the total paid up capital and free
reserves of the company.
(d) It also provide that buyback shall not be exceed 25% of total paid up capital.
(e) The debt equity ratio should not be more than 2:1 after such buyback.

(f) All the shares or other specified securities for buyback are fully paid up.
(g) The buyback of the shares or other specified securities listed on any
recognized stock exchange is in accordance with the regulations made by the
Securities and Exchange Board of India in this behalf.
(h) The buyback in respect of shares or other specified securities other those
specified in clause
(i) The buyback should be completed within 12 months from the date of
passing the special resolution.
SEBI guidelines:
The following are the important points:
1. Buyback of shares cannot be from any person through negotiated deals
whether on or after stock exchange or through spot transactions or through
private management. Therefore a company is required to make public
announcement in at least one National Daily all with wide circulation where
registered office of the company is situated.
2. Public announcement among other things specify the following:
(j) Specified date i.e. the date of the dispatch of the offer letter shall not be
less than earlier than 30 days but not later than 42 days.
(k) SEBI shall be informed by the company with in seven working days from
the date of public announcement.
(l) The offer for buyback shall remain open to the members for a period of
not less than 15 days but not exceeding 30 days. However the opening date for
the offer shall not be earlier than 7 days or later than 30 days from the specified
date.
63
 (m) The company shall complete the verification of offers within 15 days from
the date of closure and shares lodged shall be deemed to have been accepted
unless communication of rejection is made within 15 days from the date of
closure.

Advantages of Buy Back of Shares:

1. The buyback facility enable the company. is manage their cash

effectively. Many company. in this country are faced with a problem of surplus
cash without having any idea of where to invest them. It would be better for them
to return surplus cash to shareholders rather than to go on spending simply for
want to alternative.
2. Companies having large amount of free reserves are free is use funds to
acquire shares and other specified securities under the buyback process.
3. Buyback shares in helpful co. to reduce its share capital.
4. Buyback of shares is helpful to improvement in the values of shares.
5. Avoid high financial risk and ensure maximum return to the shareholders.
6. Buyback of shares helps the promoters to formulate an effective defenses
strategy against hostile takeover bids.
Disadvantages of buy back of shares:
1. All the control of buy back of shares in the hands of promoters, so results
of co.’s which the position of minority shareholders in weak.
2. The promoters before the buy back, may understand the earnings by
manipulating accounting policies and highlight other unfavourable factors
affecting the earnings.
3. High buy back of share may lead to artificial manipulation of stock prices
in the stock exchange. Confusion is much more.
MODES OF BUY BACK :
Buy back of shares or other specified securities can be done through various
sources which have been illustrated under sub section 5 of section 77A, they are
as follows:-
a) From the existing security holders on a proportionate basis or
b) From the open market, through ;
i) stock market
ii) book building process
c) From odd lots, that is to say where the lot of securities of a public company,
whose shares are listed on a recognized stock exchange, is smaller than such
marketable
lot, as may be specified by the stock exchange; or
c) by purchasing the securities issued to employees of the company under a scheme
of stock option or sweat equity.
64
 REGISTER OF SECURITIES BOUGHT BACK :

Section 77A(9) prescribes for the manner in which a register shall be maintained
a register of shares so bought back and enter therein the following particulars:-
i) The consideration paid for the securities bought back.
ii) The date of cancellation of securities
Iii) The date of extinguishing and physically destroying of securities.
iv) Other particulars as may be prescribed.
The shares or the securities so bought back shall be physically destroyed within
seven days from the last date f completion of such buy back.

2.9 INTRODUCTION TO PROFITS/LOSS PRIOR TO INCORPORATION:

When a running business is taken over from a date prior to its
incorporation/commencement, the profit earned up to the date of
incorporation/commencement (incorporation, in case of private company; and
commencement, in case of public company) is known as ‘Pre-incorporation profit’.
The same is to be treated as capital profit since these are profits which have been earned
before the company came into existence. In short, the profit earned after the date of
purchase of business is called ‘Post-incorporation or Post-acquisition profit’ and the
profit earned before the date of purchase of business is termed as ‘Pre-incorporation
profit’.
For example, X Ltd. was incorporated on 1st April 2006, took over a running business,
Y Ltd., from 1st January 2006 and it closed its accounts on 31st December 2006. Now,
the company X Ltd. is entitled not only to the profit/loss made by Y Ltd. from 1st April
to 31st December 2006 but also to the profit/loss made by Y Ltd. from 1st January 2006
to 31st March 2006.
Thus, any profit/loss made before the incorporation is known as “Profit (Loss) Prior to
Incorporation” which is treated as a capital profit and the same cannot be distributed as
business profit. Hence, it cannot be distributed by way of dividend.
The same is to be transferred to Capital Reserve or may be adjusted against Goodwill.
“Loss prior to incorporation” is treated as a capital loss and, hence, the same is shown
under the head “Miscellaneous Expenditure” in the assets side of the Balance Sheet.

Method of Computation of Profits/Loss Prior to Incorporation:

In order to ascertain the profit prior to incorporation a Profit and Loss Account is to be
prepared at the date of incorporation. But in practice, the same set of books of accounts
is maintained throughout the accounting year
A Profit and Loss Account is prepared at the end of the year and thereafter the
profits (or losses) between the two periods are allocated:
(i) From the date of purchase to the date of incorporation or pre-incorporation period;
65
(ii) From the date of incorporation to the closing of the accounting year or post-
incorporation period.
Method of Accounting of Profit/Loss Prior to Incorporation:
Steps may be suggested for ascertaining profit or loss prior to incorporation:
Step I:
A Trading Account should be prepared at first for the whole period, i.e., between the
date of purchase and the date of final accounts, in order to calculate the amount of gross
profit.

Step II:
Calculate the following two ratios:
(i) Sales Ratio:
Amount of sales should be calculated for the pre-incorporation and post-incorporation
periods.

(ii) Time Ratio:

It is calculated after considering the time period, i.e., one is required to calculate the
period falling between the date of purchase and the date of incorporation and the period
between the date of incorporation and the date of presenting final accounts.
Step III:
A statement should be prepared for calculating the amount of net profit before and
after incorporation separately on the following principle:
(i) Gross Profit should be allocated for the two periods on the basis of sales ratio which
will present the gross profit for the two separate periods, viz. pre-incorporation and post-
incorporation.
(ii) Fixed Expenses or expenses incurred on the basis of time, viz., Rent, Salary,
Depreciation, Interest, etc. should be allocated for the two periods on the basis of time
ratio.
(iii) Variable Expenses or expenses connected with sales should be allocated for the two
periods on the basis of sales ratio.
(iv) Certain expenses, viz., partners’ salary, directors’ salary, preliminary expenses,
interest on debentures, etc. are not apportioned since they relate to a particular
period. For example, partners’ salary is to be charged against pre-acquisition
profit whereas directors’ remuneration, debenture interest, etc. are to be charged
against post-acquisition profit.

66
List of Expenses: Allocated on the basis of Sales/Turnover:
(a) Gross Profit
(b) Selling Expenses
(c) Advertisement
(d) Carriage Outwards
(e) Rent
(f) Discount Allowed
(g) Salesmen’s Salaries
(h) Commission to Salesmen
(i) Promotion Expenses for Sales
(j) Distributions Expenses (Variable Portions)
(k) Free Samples given
(l) Expenses incurred for After-Sale Service, etc.
(m) Delivery Van Expenses.
List of Expenses: Allocated on the basis of Time:
(a) Office and Administration Expenses
(b) Salaries to Office Staff
(c) Rent, Rates and Taxes
(d) Depreciation on Fixed Assets
(e) Printing and Stationery
(f) Insurance
(g) Audit Fees
(h) Miscellaneous Expenses
(i) Distribution Expenses (Fixed Portion)
(j) Travelling Expenses (General)
(k) Interest of Debenture
(l) General Expenses
(m) Expenses Fixed in Nature.

67
Application/Accounting Treatment of Profit/Loss Prior to Incorporation:
(a) Pre-incorporation Profit:
Since “Profit prior to Incorporation” is a Capital Profit the same should be written
off against:
(i) Preliminary Expenses Account
(ii) Formation Expenses Account
(iii) Liquidation Expenses Account
(iv) Write down the value of Fixed Assets, if any
(v) Goodwill Account
(vi) Balance, if any, transferred to Capital Reserve.
(b) Pre-incorporation Loss:
Since “Pre-incorporation Loss” is a Capital Loss the same is adjusted against
(i) Any Capital Profit
(ii) Debited to Goodwill Account
(iii) Writing-off Fictitious Assets
(iv) Capital Reserve.

68
69
Illustration 1:
S. Ltd was registered on 1st January 2000 to buy over the business of M/s P. Ltd. as on
1st October 2008 and obtained its certificate for commencement of business on 1st
February 2009.
The accounts of the company for the period ended 30th September 2009 disclosed
the following facts:
(i) The turnover for the whole period amounted to Rs. 3,00,000 of which Rs. 50,000
related to the period from 1st October 2008 to 1st February 2009.
(ii) The Trading Account showed a Gross Profit of Rs. 1,20,000.

(iii) TMoon Ltd., which was incorporated on 1st June 2009, took over the business
of N, a proprietary concern, from 1st January 2009, for Rs. 1,00,000 on condition
that all profits earned from 1.1.2009 shall belong to the company. Following are the
data for Profit and Loss Account for the year ended 31st December 2009:
Gross Profit Rs. 2,00,000; Salaries and Bonus Rs. 15,000; Rent Rs. 1,000; Bad Debts
Rs. 5,000; Preliminary Expenses Rs. 9,000; Commission on Sales Rs. 12,000; Interest
payable to or against purchase consideration Rs. 1,000; Directors’ fees Rs. 3,000;
Managing Directors’ Remuneration Rs. 14,600; Establishment Charges Rs. 21,000;
Depreciation Rs. 10,000; and Advertisement Rs. 27,000.
(a) Sales for first six months amounted to Rs. 10,00,000; rate of gross profit being 12%
on sales. In the second six months, rate of gross profit was 8% on sales. Commission on
sales was at 6% throughout the year. Question of stock and work-in-progress does not
arise in the business.
(b) N used to carry out the business up to 31.5.2009 in own premises without any
depreciable assets on cash sales basis only.
(c) Advertisement for the first six months was at the rate of Rs. 4,000 per month.
Prepare a Statement of Profit Account for pre-incorporation and post-incorporation
periods in columnar form stating against each items the basis of segregation. How much
was the pre-incorporation profit? Take calendar months as of equal length. Confine to
the data given only.

70
Workings:
Thus pre-incorporation profits amounted to Rs. 57,082. Gross Profit amounted to Rs. 2,
00,000 for 12 months. Profits for 1st 6 months amounted to Rs. 1, 20,000 (Rs. 10,
00,000 x 12/100) and profits for the next 6 months being the balance i.e., Rs. 80,000 (Rs.
2, 00,000 – Rs. 1, 20,000) which is 8% of sales. Sales for next 6 months Rs. 10, 00,000
(Rs. 80,000 x 100/8), assuming sales being spread evenly from month to month. Sales
ratio for the 2 periods is 5: 7; Selling Commission will be apportioned on that basis.
Illustration 3:
Mr. X formed a private limited company under the name and style of Exe. Pvt. Ltd. to
take over his existing business as from 1st April 2006 but the company was not
incorporated till 1.7.2006. No entries relating to transfer of the business was entered in
the books, which were carried on without a break till 31st March 2007.

The following Balances were extracted from the books as on 31st March 2007:

71
You are also given:
(a) Stock on 31st March 2007 amounted to Rs. 44,000.
(b) The Gross Profit Ratio is constant and monthly sales in April ’06, Feb. ’07 and
March ’07 are double the average monthly sales of the year.
(c) The purchase consideration was agreed to be satisfied by the issue of 3,000 Equity
Shares of Rs. 100 each.
(d) The Preliminary Expenses are to be written-off.
(e) You are to assume that carriage outwards and travellers’ commission vary in direct
proportion to sales.

he following items appear in the Profit and Loss Account:

72
Notes:
1. Expenses which are related to Sales are apportioned on the basis of turnover (i.e., 1:
5).
2. Other expenses are apportioned on the basis of time only (i.e., 1: 2).
3. Preliminary expenses could also be charged against capital reserve out of profit prior
to incorporation.

73
 Two Mark Questions

1. What is preferential allotment? (APR/MA 2015)

2. What is stock option? (APR/MA 2015)
3. Define company? (JAN 2015)
4. What is ESOP? (JAN 2015)
5. What is allotment of shares? (JANUARY 2014)
6. What is forfeiture of shares? (JANUARY 2014)
7. Define a 'joint stock company'. (MAY/JUNE 2014.)
8. What do you mean by employees stock option scheme? (MAY/JUNE 2014.)
9. Distinguish between private company and public company. (NOV/DEC2013)
10. What is Buy-Back of securities? (NOV/DEC2013)
11. What is preferential allotment? (MAY/JUNE 2013)
12. Mention any two methods of alteration of share capital. (MAY/JUNE 2013)
13. What is profit and loss account? (January 2012)
14. What is compound journal entry? (January 2012)
15. What is Preferential Allotment? (MAY/JUNE 2012)
16. Describe the features of a corporate organization’s. (Jan 2011)
17. Explain why buy back of shares are done. (Jan 2011)
18. What is mean by capital reduction? ( JUNE 2011)
19. Which expenses are called as preliminary expenses? ( JUNE 2011)
20. What is meaning of company? (NOV/DEC2011)
21. Write the formula for debt-equity ratio? (NOV/DEC2011)
PART B
1. What are statutory books? Explain its types. (JAN 2015)
2. Illustrate the errors which are disclosed by the Trial Balance with suitable
examples. (JAN 2015)
3. Under circumstance of profit or loss prior to incorporation arises? What are the
accounting treatment for profit and loss prior to incorporation? (APR/MA 2015)
4. Define a company and state its essential characteristics. Explain the documents
that have to file with the Registrar of companies for getting a company in
corporate. (JANUARY 2014)
5. Explain the different modes of alteration of share capital as per the provision of
sections 94 to 97 of the companies act. (JANUARY 2014)

74
 You are required to prepare a statement showing profit earned by the company in the pre and
post incorporation periods. The total sales for the year took place in the ratio of 1 : 2 before and
after incorporation respectively.
7. Discus about the statutory Books of Accounts that are to be maintained by public limited
company. (NOV/DEC2013)
8. Discuss the provisions relating Buy-Back of securities under the company’s act
1956. (MAY/JUNE 2013)
9. Write shorts Notes on: (MAY/JUNE 2012)
1) Buy Back of Securities
2) Employees Stocks Option
3) Statutory books
4) Shares allotted on Prorata basis.
10. Why are stock option plans popular with software companies? (Jan 2011)
11. Write a note on preferential allotment. (Jan 2011)
12. What are financial accounts? What purpose do they serve? Explain the various adjustments
affecting the preparation of balance sheet. (NOV/DEC2011)

75
 UNIT III
ANALYSIS OF FINANCIAL STATEMENTS

Analysis of financial statements – Financial ratio analysis, cash flow (as per
Accounting Standard 3) and funds flow statement analysis.

3.1 INTRODUCTION
Presentation of financial statements is the important part of accounting process. To
provide more meaningful information to enable the owners, investors, creditors or users of
financial statements to evaluate the operational efficiency of the concern during the particular
period. More useful information are required from the financial statements to make the
purposeful decisions about the profitability and financial soundness of the concern. In order to
fulfill the needs of the above. it is essential to consider analysis and interpretation of financial
statements.

3.1.1MEANING OF ANALYSIS AND INTERPRETATIONS

The term "Analysis" refers to rearrangement of the data given in the financial
statements. In other words, simplification of data by methodical classification of the data given
in the financial statements.
The term "interpretation" refers to "explaining the meaning and significance of the data
so simplified.
“Both analysis and interpretations are closely connected and inter related. They are
complementary to each other. Therefore presentation of information becomes more purposeful
and meaningful-both analysis and interpretations are to be considered.
Metcalf and Tigard have defined financial statement analysis and interpretations as a
process of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm's position and performance.
The facts and figures in the financial statements can be transformed into meaningful and
useful figures through a process called "Analysis and Interpretations."
In other words, financial statement analysis and interpretation refer to the process of
establishing the meaningful relationship between the items of the two financial statements with
the objective of identifying the financial and operational strengths and weaknesses.

3.1.2 TYPES OF ANALYSIS AND INTERPRETATIONS

The analysis and interpretation of financial statements can be classified into different
categories depending upon:
I. The Materials Used
II. Modus Operandi (Methods of Operations to be followed)

76
 1. On the basis of Materials Used:
(a) External Analysis.
(b) Internal Analysis.

II. On the basis of Modus Operandi

(a) Vertical Analysis.
(b) Horizontal Analysis.

The following chart shows the classification of financial analysis:

I. On the Basis of Materials Used

On the basis of materials used the analysis and interpretations of financial statements may be
Classified into

(a) External Analysis and

(b) Internal Analysis.

(a) External Analysis

This analysis meant for the outsiders of the business firm. Outsiders may be investors,
creditors, suppliers, government agencies, shareholders etc. These external people have to rely
only on these published financial statements for important decision making. This analysis serves
only a limited purpose due to non-availability of detailed information.

(b) Internal Analysis

Internal analysis performed by the persons who are internal to the organization. These
internal people who have access to the books of accounts and other information related to the

77
 business. Such analysis can be done for the purpose of assisting managerial personnel to take
corrective action and appropriate decisions.

II. On the basis of Modus Operandi

On the basis of Modus operandi, the analysis and interpretation of financial statements
may be classified into: (a) Horizontal Analysis and (b) Vertical Analysis.
(a) Horizontal Analysis
Analysis is also termed as Dynamic Analysis. Under this type of analysis, comparison of
the trend of each item in the financial statements over the number of years are reviewed or
analyzed. This type of comparison helps to identify the trend in
age 59 various indicators of performance. In this type of analysis, current year figures are
compared with base year for figures are presented horizontally over a number of columns.

(b) Vertical Analysis

Vertical Analysis is also termed as Static Analysis. Under this type of analysis, a
number of ratios used for measuring the meaningful quantitative relationship between the items
of financial statements during the particular period. This type of analysis is useful in comparing
the performance, efficiency and profitability of several companies in the same group or
divisions in the same company.

Rearrangement of Income Statements

Financial statements should be rearranged for proper analysis and interpretations of
these statements. It enables to measure the performance of operational efficiency and
profitability of a concern during particular period.

3.2 METHODS OF FINANCIAL STATEMENT ANALYSIS

 Comparative Financial Statement Analysis

This is a major tool for making horizontal analysis. Under this technique, statements (either
Balance Sheets or Profit & Loss accounts) for two years or more are analyzed. The data is
arranged side by side. And the changes from one period to another period are calculated and
analyzed as to the reasons and suitable inferences are drawn from them.
Comparative Financial Statement analysis provides information to assess the direction of
change in the business. Financial statements are presented as on a particular date for a particular
period. The financial statement Balance Sheet indicates the financial position as at the end of an
accounting period and the financial statement Income Statement shows the operating and non-
operating results for a period. But financial managers and top management are also interested in
knowing whether the business is moving in a favorable or an unfavorable direction. For this
purpose, figures of current year have to be compared with those of the previous years. In

78
 analyzing this way, comparative financial statements are prepared.
Comparative Financial Statement Analysis is also called as Horizontal analysis. The
Comparative Financial Statement provides information about two or more years' figures as well
as any increase or decrease from the previous year's figure and it's percentage of increase or
decrease. This kind of analysis helps in identifying the major improvements and weaknesses
Comparative statements are financial statements that cover a different time frame, but
are formatted in a manner that makes comparing line items from one period to those of a
different period an easy process. This quality means that the comparative statement is a
financial statement that lends itself well to the process of comparative analysis. Many
companies make use of standardized formats in accounting functions that make the generation
of a comparative statement quick and easy.

FEATURES OF COMPARITIVE STATEMENTS:-

1) A comparative statement adds meaning to the financial data.

2) It is used to effectively measure the conduct of the business activities.
3) Comparative statement analysis is used for intra firm analysis and inters firm analysis.
4) A comparative statement analysis indicates change in amount as well as change in percentage.
5) A positive change in amount and percentage indicates an increase and a negative change in
amount and percentage indicates a decrease.
6) If the value in the first year is zero then change in percentage cannot be indicated. This
is the limitation of comparative statement analysis. While interpreting the results
qualitative inferences need to be drawn.
7) It is a popular tool useful for analysis by the financial analysts.
8) A comparative statement analysis cannot be used to compare more than two years financial
data.

 COMMON SIZE FINANCIAL STATEMENTS

Common size ratios are used to compare financial statements of different-size

companies or of the same company over different periods. By expressing the items in
proportion to some size-related measure, standardized financial statements can be created,
revealing trends and providing insight into how the different companies compare. Total
Assets.
The ratios often are expressed as percentages of the reference amount. Common size
statements usually are prepared for the income statement and balance sheet, expressing
information as follows:
• Income statement items - expressed as a percentage of total revenue

79
• Balance sheet items - expressed as a percentage of total assets
The following example income statement shows both the rupee amounts and the
common size ratios:

FEATURES OF COMMON SIZE STATEMENT

1) A common size statement analysis indicates the relation of each component to the whole.
2) In case of a Common Size Income statement analysis Net Sales is taken as 100% and in case
of Common Size Balance Sheet analysis total funds available/total capital employed is
considered as 100%.
3) It is used for vertical financial analysis and comparison of two business enterprises or
two years financial data.
4) Absolute figures from the financial statement are difficult to compare but when converted and
expressed as percentage of net sales in case of income statement and in case of Balance Sheet
as percentage of total net assets or total funds employed it becomes more meaningful to relate.
5) A common size analysis is a type of ratio analysis where in case of income statement sales
is the denominator (base) and in case of Balance Sheet funds
employed or total net assets is the denominator (base) and all items are expressed as a
relation to it.
6) In case of common size statement analysis the absolute figures are converted to proportions
for the purpose of inter-firm as well as intra-firm analysis.

Limitations
As with financial statements in general, the interpretation of common size statements is subject
to many of the limitations in the accounting data used to construct them. For example:
1. Different accounting policies may be used by different firms or within the same firm at different
points in time. Adjustments should be made for such differences.
2. Different firms may use different accounting calendars, so the accounting periods may not be
directly comparable.

TREND STATEMENT
Trend analysis calculates the percentage change for one account over a period of time of two
years or more.
Trend analysis involves the usage of past figures for comparison. Trend percentages are
calculated for some important items like sales revenue, net income etc. Under this kind of
analysis, information for a number of years is taken up and one year, which is usually the first
year, is taken as the base year. Each item of the base year is taken as 100 and on that base, the
percentage for other years are computed. This analysis will help in finding out the percentage of
increase or decrease in each item with respect to the base year.

80
 Percentage change
To calculate te percentage change between two periods:
Calculate the amount of the increase/ (decrease) for the period by subtracting the earlier
year from the later year. If the difference is negative, the change is a decrease and if the
difference is positive, it is an increase..

FEATURES OF TREND ANALYSIS

1) In case of a trend analysis all the given years are arranged in an ascending order.
2) The first year is termed as the “Base year” and all figures of the base year are taken as
100%.
3) Item in the subsequent years are compared with that of the base year.
4) If the percentages in the following years is above 100% it indicates an increase over
the base year and if the percentages are below 100% it indicates a decrease over the
base year.
5) A trend analysis gives a better picture of the overall performance of the business.
6) A trend analysis helps in analyzing the financial performance over a period of time.
7) A trend analysis indicates in which direction a business is moving i.e. upward or
downwards.
8) A trend analysis facilitates effective comparative study of the financial performance
over a period of time.
9) For trend analysis at least three years financial data is essential. Broader the base the more
reliable is the data and analysis.

RATIO ANALYSIS
Numerical relationship between two numbers. In the words of kennedy and mcmullen,
“the relationship of one item to another expressed in simple mathematical form is known as a
ratio”. Thus, the ratio is a measuring device to judge the growth, development and present
condition of a concern. It plays an important role in measuring the comparative significance of
the income and position statement. Accounting ratios are expressed in the form of time,
proportion, percentage, or per one rupee. Ratio analysis is not only a technique to point out
relationship between two figures but also points out the devices to measure the fundamental
strengths or weaknesses of a concern. As james c.van horne observes: “to evaluate the financial
condition and performance of a firm, the financial analyst needs certain yardsticks. One of the
yardsticks frequently used is a ratio. The main purpose of ratio analysis is to measure past
performance and project future trends. It is also used for inter-firm and intra-firm comparison as a
measure of comparative productivity. The significance of the various components of financial

81
 statements can be judged only by ratio analysis. The financial analyst x-rays the financial
conditions of a concern by the use of various ratios and if the conditions are not found to be
favourable, suitable steps can be taken to overcome the limitations. The main objectives of ratio
analysis are:

3.3 FINANCIAL ANALYSIS SERVES

THE FOLLOWING PURPOSES:

1. Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it.
Financial analysis helps in ascertaining whether adequate profits are being earned on the capital
invested in the business or not. It also helps in knowing the capacity to pay the interest and
dividend.

2. Indicating the trend of Achievements

Financial statements of the previous years can be compared and the trend regarding various
expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets
and liabilities can be compared and the future prospects of the business can be envisaged.
Assessing the growth potential of the business. The trend and other analysis of the business
provide sufficient information indicating the growth potential of the business.

3. Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management to make a
comparative study of the profitability of various firms engaged in similar businesses. Such
comparison also helps the management to study the position of their firm in respect of sales,
expenses, profitability and utilizing capital, etc.

3. Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business. Analysis
also helps in taking decisions, whether funds required for the purchase of new machines and
equipment’s are provided from internal sources of the business or not if yes, how much? And
also to assess how much funds have been received from external sources.

82
 5. Assess solvency of the firm
The different tools of an analysis tell us whether the firm has sufficient funds to meet its
short term and long term liabilities or not.

PARTIES INTERESTED
Analysis of financial statements has become very significant due to widespread interest of
various parties in the financial results of a business unit. The various parties interested in the
analysis of financial statements are:

(i) Investors :
Shareholders or proprietors of the business are interested in the well being of the business. They
like to know the earning capacity of the business and its prospects of future growth.
(ii) Management :
The management is interested in the financial position and performance of the enterprise as a
whole and of its various divisions. It helps them in preparing budgets and assessing the
performance of various departmental heads.
(iii) Trade unions :
They are interested in financial statements for negotiating the wages or salaries or bonus
agreement with the management.
(iv) Lenders :
Lenders to the business like debenture holders, suppliers of loans and lease are interested to
know short term as well as long term solvency position of the entity.

(v) Suppliers and trade creditors :

The suppliers and other creditors are interested to know about the solvency of the business i.e.
the ability of the company to meet the debts as and when they fall due.
(vi) Tax authorities :
Tax authorities are interested in financial statements for determining the tax liability.

(vii) Researchers:
They are interested in financial statements in undertaking research work in business affairs
and practices.
(viii) Employees :
They are interested to know the growth of profit. As a result of which they can demand
better remuneration and congenial working environment.

83
(ix) Government and their agencies :
Government and their agencies need financial information to regulate the activities of the
enterprises/ industries and determine taxation policy. They suggest measures to formulate
policies and regulations.
(x) Stock exchange :
The stock exchange members take interest in financial statements for the purpose of
analysis because they provide useful financial information about companies. Thus, we find that
different parties have interest in financial statements for different reasons

3.4 NATURE OF FINANCIAL ANALYSIS

The focus of financial analysis is on the key figures contained in the financial
statements and the significant relationship that exists between them. “analyzing financial statements is
a process of evaluating the relationship between the component parts of the financial statements to
obtain a better understanding of a firm’s position and performance”. The type of relationship to be
investigated depends upon the objective and purpose of evaluation. The purpose of evaluation of
financial statements differs among various groups: creditors, shareholders, potential investors,
management and so on. For example, short-term creditors are primarily interested in judging the
firm’s ability to pay its currently-maturing obligations. The relevant information for them is the
composition of the short-term (current) liabilities. The debenture-holders or financial institutions
granting long-term loans would be concerned with examining the capital structures, past and
projected earnings and changes in the financial position. The shareholders as well as potential
investors would naturally be interested in the earnings per share and dividends per share as these
factors are likely to have a significant bearing on the market price of shares. The management of
the firms, in contrast, analyses the financial statements for self-evaluation and decision making.

The first task of the financial analyst is to select the information relevant to the decision
under consideration from the total information contained in the financial statements. The second
step involved in financial analysis is to arrange the information in such a way as to highlight
significant relationships. The final step is the interpretation and drawing of inferences and
conclusions. In brief, financial analysis is the process of selection, relation and evaluation.

84
3.5 TYPES OF FINANCIAL ANALYSIS

Financial analysis may be classified on the basis of parties who are undertaking the
analysis and on the basis of methodology of analysis. On the basis of the parties who are doing
the analysis, financial analysis is classified into external analysis and internal analysis.

External Analysis:
When the parties external to the business like creditors, investors, etc. Do the analysis, the
analysis is known as external analysis. This analysis is done by them to know the credit-
worthiness of the concern, its financial viability, its profitability, etc.

Internal Analysis:

This analysis is done by persons who have control over the books of accounts and other
information of the concern. Normally this analysis is done by management people to enable them
to get relevant information to take vital business decision.

On the basis of methodology adopted for analysis, financial analysis may be either horizontal
analysis or vertical analysis.

Horizontal Analysis:

When financial statements of a number of years are analyzed, then the analysis is known
as horizontal analysis. In this type of analysis, figures of the current year are compared with the
standard or base year. This type of analysis will give an insight into the concern’s performance
over a period of years. This analysis is otherwise called as dynamic analysis as it extends over a
number of years.

Vertical Analysis:
This type of analysis establishes a quantitative relationship of the various items in the
financial statements on a particular date. For e.g. the ratios of various expenditure items in terms
of sales for a particular year can be calculated. The other name for this analysis is `static analysis’
as it relies upon one year figures only.

85
 3.6 CLASSIFICATION OF RATIOS

Financial ratios may be categorized in various ways. Van Horne has divided financial
ratios into four categories, viz., liquidity, debt, profitability and coverage ratios. The first two
types of ratios are computed from the balance sheet. The last two are computed from the income
statement and sometimes, from both the statements. For the purpose of analysis, the present
lesson gives a detailed description of ratios, the formula used for their computation and their
significance. The ratios have been categorized under the following headings:-

(i) ratios for analysis of capital structure or leverage.

(ii) ratios for fixed assets analysis.

(iii) ratios for analysis of turnover.

(iv) ratios for analysis of liquidity position.

(v) ratios for analysis of profitability.

(vi) ratios for analysis of operational efficiency.

3.6.1 CAPITAL STRUCTURE OR LEVERAGE RATIOS

Financial strength indicates the soundness of the financial resources of an organization to
perform its operations in the long run. The parties associated with the organization are interested
in knowing the financial strength of the organization. Financial strength is directly associated
with the operational ability of the organization and its efficient management of resources. The
financial strength analysis can be made with the help of the following ratios:

(1) Debt-equity ratio

(2) Capital gearing ratio

(3) Financial leverage

(4) Proprietary ratio and

(5) Interest coverage.

86
Debt-Equity Ratio:
The debt-equity ratio is determined to ascertain the soundness of the long-term financial
policies of the company. This ratio indicates the proportion between the shareholders’ funds (i.e.
Tangible net worth) and the total borrowed funds. Ideal ratio is 1. In other words, the investor
may take debt equity ratio as quite satisfactory if shareholders’ funds are equal to borrowed
funds. However, creditors would prefer a low debt-equity ratio as they are much concerned about
the security of their investment. This ratio can be calculated by dividing the total debt by
shareholders’ equity. For the purpose of calculation of this ratio, the term shareholders’ equity
includes share capital, reserves and surplus and borrowed funds which includes both long-term
funds and short-term funds.

Debt
Debt-equity ratio = -----------

Equity

A high ratio indicates that the claims of creditors are higher as compared to owners’ funds and a
low debt-equity ratio may result in a higher claim of equity.

Capital Gearing Ratio: This ratio establishes the relationship between the fixed interest-
bearing securities and equity shares of a company. It is calculated as follows:

Fixed interest-bearing securities

Capital gearing ratio = -------------------------------------
Equity shareholders’ funds

Fixed-interest bearing securities carry with them the fixed rate of dividend or interest and include
preference share capital and debentures. A firm is said to be highly geared if the lion’s share of
the total capital is in the form of fixed interest-bearing securities or this ratio is more than one. If
this ratio is less than one, it is said to be low geared. If it is exactly one, it is evenly geared. This
ratio must be carefully planned as it affects the firm’s capacity to maintain a uniform dividend
policy during difficult trading periods that may occur. Too much capital should not be raised by
way of debentures, because debentures do not share in business losses.

87
3.6.2 FINANCIAL LEVERAGE RATIO:
Financial leverage results from the presence of fixed financial charges in the firm’s
income stream. These fixed charges do not vary with the earnings before interest and tax (debit)
or operating profits. They have to be paid regardless of the amount of earnings before interest and
taxes available to pay them. After paying them, the operating profits (debit) belong to the
ordinary shareholders. Financial leverage is concerned with the effects of changes in earnings
before interest and taxes on the earnings available to equity holders. It is defined as the ability of
a firm to use fixed financial charges to magnify the effects of changes in debit on the firm’s
earning per share. Financial leverage and trading on equity are synonymous terms. The debit is
calculated by adding back the interest (interest on loan capital + interest on long term loans +
interest on other loans) and taxes to the amount of net profit. Financial leverage ratio is calculated
by dividing by debit (earnings before tax). Neither a very high leverage nor a very low leverage
represents a sound picture.

Proprietary Ratio:
This ratio establishes the relationship between the proprietors’ funds and the total tangible
assets. The general financial strength of a firm can be understood from this ratio. The ratio is of
particular importance to the creditors who can find out the proportion of shareholders’ funds in
the capital assets employed in the business. A high ratio shows that a concern is less dependent
on outside funds for capital. A high ratio suggests sound financial strength of a firm due to
greater margin of owners’ funds against outside sources of finance and a greater margin of safety
for the creditors. A low ratio indicates a small amount of owners’ funds to finance total assets and
more dependence on outside funds for working capital. In the form of formula this ratio can be
expressed as:-

Net Worth
Proprietary Ratio = --------------
Total Assets
Interest Coverage:
This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-
term loan is concerned. It is determined by dividing the operating profits or earnings before
interest and taxes (debit) by the fixed interest charges on loans. Thus,

EBIT
Interest Coverage = ----------

88
 Interest

It should be noted that this ratio uses the concept of net profits before taxes because interest is
tax-deductible so that tax is calculated after paying interest on long-term loans.
This ratio, as the name suggests, shows how many times the interest charges are covered by the
debit out of which they will be paid. In other words, it indicates the extent to which a fall in debit
is tolerable in the sense that the ability of the firm to service its debts would not be adversely
affected. From the point of view of creditors, the larger the coverage, the greater the ability of the
firm to handle fixed-charge liabilities and the more assured the payment of interest to the
creditors. However, too high a ratio may imply unused debt capacity. In contrast, a low ratio is
danger signal that the firm is using excessive debt and does not have the ability to offer assured
payment of interest to the creditors.

3.6.3 FIXED ASSETS ANALYSIS

The successful operation of a business generally requires some assets of fixed character.
These assets are used primarily in producing goods and in operating the business. With the help
of these, raw materials are converted into finished products. Fixed assets are not meant for sale
and are kept as a rule permanently in the business in order to carry on day-to-day operations.

Analysis of fixed assets is very important from investors’ point of view because investors
are more concerned with long term assets. Fixed assets are properties of non-current nature which
are acquired to provide facilities to carry on business. They include land, building, equipment,
furniture, etc. They are generally shown in balance sheet by aggregating them into groups of
gross block as reduced by the accumulated amount of depreciation till date. Investment in fixed
assets is of a permanent nature and therefore should be financed by owners’ funds (permanent
sources of funds). The owners’ funds should be sufficient to provide for fixed assets. Fixed assets
are generally financed by owners’ equity and long-term borrowings. The long-term borrowings
are in the form of long-term loans and of almost permanent nature. Under such a situation it
becomes more or less irrelevant to relate the fixed assets with only the owners’ equity. Therefore,
the analysis of the source of financing of fixed assets has been done with the help of the
following ratios:-

(a) Fixed Assets To Net Worth

(b) Fixed Assets To Long-Term Funds

Fixed Assets to Net Worth:, “this ratio indicates the relationship between net worth (i.e.
Shareholders’ funds) and investments in net fixed assets (i.e. Gross block minus depreciation)”.

89
The higher the ratio the lesser would be the protection to creditors. If the ratio is less than 1, it
indicates that the net worth exceeds fixed assets. It will further indicate that the working capital is
partly financed by shareholders’ funds. If the ratio exceeds 1, it would mean that part of the fixed
assets has been provided by creditors. The formula for derivation of this ratio is:-

Net Fixed Assets

Fixed Assets to Net worth Ratio = ------------------
Net Worth

Fixed Assets To Long-Term Funds: this ratio establishes the relationship

Between the fixed assets and long-term funds and it is obtained by the formula:

Fixed Assets
3.6.4 FIXED ASSET RATIO = --------------------
Long-Term Funds

The ratio should be less than one. If it is less than one, it shows that a part of the working
capital has been financed through long-term funds. This is desirable because a part of working
capital termed as “core working capital” is more or less of a fixed nature. The ideal ratio is 0.67.If
this ratio is more than one, it indicates that a part of current liability is invested in long-term
assets. This is a dangerous position. Fixed assets include “net fixed assets” i.e. Original cost less
depreciation to date and trade investments including shares in subsidiaries. Long-term funds
include share capital, reserves and long-term borrowings.

3.6.5 ANALYSIS OF TURNOVER (OR) ANALYSIS OF EFFICIENCY

Turnover ratios also referred to as activity ratios are concerned with measuring the
efficiency in asset management. Sometimes, these ratios are also called as efficiency ratios or
asset utilization ratios. The efficiency with which the assets are used would be reflected in the
speed and rapidity with which assets are converted into sales. The greater the rate of turnover or
conversion, the more efficient the utilization /management, other things being equal. For this
reason such ratios are also designated as turnover ratios. Turnover is the primary mode for
measuring the extent of efficient employment of assets by relating the assets to sales. An activity
ratio may, therefore, be defined as a test of the relationship between sales (more appropriately

90
 with cost of sales) and the various assets of a firm. Depending upon the various types of assets,
there are various types of activity ratios. Some of the more widely used turnover ratios are:-

ՖՖ Fixed Assets Turnover Ratio

ՖՖ Current Assets Turnover Ratio

ՖՖ Working Assets Turnover Ratio

ՖՖ Inventory (Or Stock) Turnover Ratio

ՖՖ Debtors Turnover Ratio

ՖՖ Creditors Turnover Ratio

3.6.6 FIXED ASSETS TURNOVER RATIO:

The fixed assets turnover ratio measures the efficiency with which the firm is utilizing its
investment in fixed assets, such as land, building, plant and machinery, furniture, etc. It also
indicates the adequacy of sales in relation to investment in fixed assets. The fixed assets turnover
ratio is sales divided by the net fixed assets (i.e., the depreciated value of fixed assets).

Sales
Fixed Assets Turnover Ratio = ----------------
Net Fixed Assets

The turnover of fixed assets can provide a good indicator for judging the efficiency with which
fixed assets are utilized in the firm. A high fixed assets turnover ratio indicates efficient
utilization of fixed assets in generating operating revenue. A low ratio signifies idle capacity,
inefficient utilization and management of fixed assets.

CURRENT ASSETS TURNOVER RATIO:

The current assets turnover ratio ascertains the efficiency with which current assets are
used in a business. Professor Guthmann observes that “current assets turnover is to give an
overall impression of how rapidly the total investment in current assets is being turned”. This
ratio is strongly associated with efficient utilization of costs, receivables and inventory. A higher
value of this ratio indicates greater circulation of current assets while a low ratio indicates a
stagnation of the flow of current assets. The formula for the computation of current assets
turnover ratio is:

Sales

91
Current Assets Turnover Ratio = -----------------
Current Assets
Working Capital Turnover Ratio: this ratio shows the number of times working capital is
turned-over in a stated period. Working capital turnover ratio reflects the extent to which a
business is operating on a small amount of working capital in relation to sales. The ratio is
calculated by the following formula:-

Sales
Working Capital Turnover Ratio = ----------------------
Net Working Capital

The higher the ratio, the lower is the investment in working capital and greater are the
profits. However, a very high turnover of working capital is a sign of over trading and may put
the firm into financial difficulties. On the other hand, a low working capital turnover ratio
indicates that working capital is not efficiently utilized.

INVENTORY TURNOVER RATIO:

The inventory turnover ratio, also known as stock turnover ratio normally establishes the
relationship between cost of goods sold and average inventory. This ratio indicates whether
investment in inventory is within proper limit or not. In the words of S.C.Kuchal, “this
relationship expresses the frequency with which average level of inventory investment is turned
over through operations”. The formula for the computation of this ratio may be expressed thus:

Cost of Goods Sold

Inventory Turnover Ratio = -------------------------
Average Inventory

In general, a high inventory turnover ratio is better than a low ratio. A high ratio
implies good inventory management. A very high ratio indicates under-investment in, or very
low level of inventory which results in the firm being out of stock and incurring high stock-out
cost. A very low inventory turnover ratio is dangerous. It signifies excessive inventory or over-
investment in inventory. A very low ratio may be the results of inferior quality goods, over-
valuation of closing inventory, and stock of unsalable/obsolete goods.

92
 DEBTORS TURNOVER RATIO AND COLLECTION PERIOD:
One of the major activity ratios is the receivables or debtors turnover ratio. Allied and
closely related to this is the average collection period. It shows how quickly receivables or
debtors are converted into cash. In other words, the debtor’s turnover ratio is a test of the
liquidity of the debtors of a firm. The liquidity of a firm’s receivables can be examined in two
ways:

(i) Debtors/ receivables turnover and (ii) average collection period. The debtor’s turnover shows
the relationship between credit sales and debtors of a firm. Thus,
Net Credit Sales

Debtors Turnover Ratio = -Average Debtors / Net credit sales

Net credit sales consist of gross credit sales minus returns if any, from the customers.
Average debtors are the simple average of debtors at the beginning and at the end of the year.

Long collection period reflects that payments by debtors are delayed. In general, short
collection period (high turnover ratio) is preferable.

Creditors’ Turnover Ratio And Debt Payment Period:

Creditors’ turnover ratio indicates the speed with which the payments for credit
purchases are made to the creditors. This ratio can be computed as follows:-

Average Accounts Payable

Creditors’ Turnover Ratio = -----------------------------

Net Credit Purchases

The term accounts payable include trade creditors and bills payable. A high ratio
indicates that creditors are not paid in time while a low ratio gives an idea that the business is
not taking full advantage of credit period allowed by the creditors.

93
 ANALYSIS OF LIQUIDITY POSITION
The liquidity ratios measure the ability of a firm to meet its short-term obligations and
reflect the short-term financial strength/solvency of a firm. The term liquidity is described as
convertibility of assets ultimately into cash in the course of normal business operations and the
maintenance of a regular cash flow. A sound liquid position is of primary concern to
management from the point of view of meeting current liabilities as and when they mature as
well as for assuring continuity of operations. Liquidity position of a firm depends upon the
amount invested in current assets and the nature of current assets. The under mentioned ratios
are used to measure the liquidity position:-

ՖՖ current ratio

ՖՖ liquid (or) quick ratio

ՖՖ cash to current assets ratio

ՖՖ cash to working capital ratio

CURRENT RATIO:

The most widely used measure of liquid position of an enterprise is the current ratio,
i.e., the ratio of the firm’s current assets to current liabilities. It is calculated by dividing
current assets by current liabilities:

Current Assets
Current Ratio = -------------------
Current Liabilities

The current assets of a firm represent those assets which can be in the ordinary course
of business, converted into cash within a short period of time, normally not exceeding one year
and include cash and bank balance, marketable securities, inventory of raw materials, semi-
finished (work-in-progress) and finished goods, debtors net of provision for bad and doubtful
debts, bills receivable and pre-paid expenses. The current liabilities defined as liabilities which
are short-term maturing obligations to be met, as originally contemplated, within a year,
consist of trade creditors, bills payable, bank credit, and provision for taxation, dividends
payable and outstanding expenses. N.l.hingorani and others observe:

94
“current ratio is a tool for measuring the short-term stability or ability of the company to
carry on its day-to-day work and meet the short-term commitments earlier”. Generally 2:1 is
considered ideal for a concern i.e., current assets should be twice of the current liabilities. If
the current assets are two times of the current liabilities, there will be no adverse effect on
business operations when the payment of current liabilities is made. If the ratio is less than 2,
difficulty may be experienced in the payment of current liabilities and day-to-day operations
of the business may suffer. If the ratio is higher than 2, it is very comfortable for the creditors
but, for the concern, it indicates idle funds and lack of enthusiasm for work.

Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a firm’s ability to convert
its current assets quickly into cash in order to meet its current liabilities. It is a measure of
judging the immediate ability of the firm to pay-off its current obligations. It is calculated by
dividing the quick assets by current liabilities:

Quick Assets
LIQUID RATIO = ---------------------
Current Liabilities

The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Thus quick assets consists of
cash, marketable securities and accounts receivable. Inventories are excluded from quick
assets because they are slower to convert into cash and generally exhibit more uncertainty as
to the conversion price.

This ratio provides a more stringent test of solvency. 1:1 ratio is considered ideal ratio
for a firm because it is wise to keep the liquid assets at least equal to the current liabilities at
all times.

CASH TO CURRENT ASSETS RATIO:

Efficient management of the inflow and outflow of cash plays a crucial role in the
overall performance of a business. Cash is the most liquid form of assets which safeguards the
security interest of a business. Cash including bank balances plays a vital role in the total net
working capital. The ratio of cash to working capital signifies the proportion of cash to the
total net working capital and can be calculated by dividing the cash including bank balance by
the working capital. Thus,

95
 Cash
Cash To Working Capital Ratio = --------------------
Working Capital

Cash is not an end in itself, it is a means to achieve the end. Therefore, only a required
amount of cash is necessary to meet day-to-day operations. A higher proportion of cash may
lead to shrinkage of profits due to idleness of resources of a firm.

ANALYSIS OF PROFITABILITY
Profitability is a measure of efficiency and control. It indicates the efficiency or
effectiveness with which the operations of the business are carried on. Poor operational
performance may result in poor sales and therefore low profits. Low profitability may be due
to lack of control over expenses resulting in low profits. Profitability ratios are employed by
management in order to assess how efficiently they carry on business operations. Profitability
is the main base for liquidity as well as solvency. Creditors, banks and financial institutions
are interested in profitability ratios since they indicate liquidity or capacity of the business to
meet interest obligations and regular and improved profits enhance the long term solvency
position of the business. Owners are interested in profitability for they indicate the growth and
also the rate of return on their investments. The importance of measuring profitability has been
stressed by Hingorani, Ramanathan and Grewal in these words: “a measure of profitability is
the overall measure of efficiency”.

An appraisal of the financial position of any enterprise is incomplete unless its overall
profitability is measured in relation to the sales, assets, capital employed, net worth and
earnings per share. The following ratios are used to measure the profitability position from
various angles:

ՖՖ Gross Profit Ratio

ՖՖ Net Profit Ratio

ՖՖ Return On Capital Employed

ՖՖ Operating Ratio

ՖՖ Operating Profit Ratio

ՖՖ Return On Owners’ Equity

96
ՖՖ Earnings Per Share

ՖՖ Dividend Pay Out Ratio

GROSS PROFIT RATIO:

The gross profit ratio or gross profit margin ratio expresses the relationship of gross
profit on sales / net sales. B.r.rao opines that “gross profit margin ratio indicates the gross
margin of profits on the net sales and from this margin only, all expenses are met and
finally net income emerges”. The basic components for the computation of this ratio are gross
profits and net sales. `net sales’ means total sales minus sales returns and `gross profit’ means
the difference between net sales and cost of goods sold. The formula used to compute gross
profit ratio is:

Gross Profit
Gross Profit Ratio = ------------------ X 100
Sales

Gross profit ratio indicates to what extent the selling prices of goods per unit may be
reduced without incurring losses on operations. A low gross profit ratio will suggest decline in
business which may be due to insufficient sales, higher cost of production with the existing or
reduced selling price or the all-round inefficient management. A high gross profit ratio is a
sign of good and effective management.

NET PROFIT RATIO:

Net profit is a good indicator of the efficiency of a firm. Net profit ratio or net profit
margin ratio is determined by relating net income after taxes to net sales. Net profit here is the
balance of profit and loss account which is arrived at after considering all non-operating
incomes such as interest on investments, dividends received, etc. And non-operating expenses
like loss on sale of investments, provisions for contingent liabilities, etc. This ratio indicates
net margin earned on a sale of rs.100. The formula for calculating the ratio is:

Net Profit
Net Profit Ratio = ---------------- X 100
Sales

97
 This ratio is widely used as a measure of overall profitability and is very useful for
proprietors. A higher ratio indicates better position.

RETURN ON CAPITAL EMPLOYED:

The prime objective of making investments in any business is to obtain satisfactory
return on capital invested. Hence, the return on capital employed is used as a measure of
success of a business in realizing this objective. Otherwise known as return on investments,
this is the overall profitability ratio. It indicates the percentage of return on capital employed in
the business and it can be used to show the efficiency of the business as a whole. The formula
for calculating the ratio is:

Operating Profit
Return on Capital Employed = --------------------- X 100
Capital Employed

The term “capital employed” means [share capital + reserves and surplus + long term
loans] minus [non-business assets + fictitious assets] and the term “operating profit” means
profit before interest and tax. The term `interest’ means interest on long-term borrowings.
Non-trading income should be excluded for the above purpose. A higher ratio indicates that
the funds are invested profitably.

OPERATING RATIO:
This ratio establishes the relationship between total operating expenses and sales.
Total operating expenses includes cost of goods sold plus other operating expenses. A higher
ratio indicates that operating expenses are high and the profit margin is less and therefore
lower the ratio, better is the position. The operating ratio is an index of the efficiency of the
conduct of business operations. An ideal norm for this ratio is between 75% to 85% in a
manufacturing concern. The formula for calculating the operating ratio is thus:

Cost Of Goods Sold + Operating Experience

Operating Ratio = ----------------------------------------------------- X 100
Sales
Operating Profit Ratio: this ratio indicates net-margin earned on a sale of rs.100. It is
calculated as follows:

98
 Net Operating Profit
Operating Profit Ratio = ------------------------- X 100
Sales

The operating profit ratio helps in determining the efficiency with which affairs of the
business are being managed. An increase in the ratio over the previous period indicates
improvement in the operational efficiency of the business provided the gross profit ratio is
constant. Operating profit is estimated without considering non-operating income such as
profit on sale of fixed assets, interest on investments and non-operating expenses such as loss
on sale of fixed assets. This is thus, an effective tool to measure the profitability of a business
concern.

RETURN ON OWNERS’ EQUITY (OR) SHAREHOLDERS’ FUND (OR) THE NET

WORTH:
The ratio of return on owners’ equity is a valuable measure for judging the profitability
of an organization. This ratio helps the shareholders of a firm to know the return on investment
in terms of profits. Shareholders are always interested in knowing as to what return they
earned on their invested capital since they bear all the risk, participate in management and are
entitled to all the profits remaining after all outside claims including preference dividend are
met in full. This ratio is computed as a percentage by using the formula:

Net Profit after Interest and Tax

Return on Owners’ Equity = ------------------------------------------ X 100
Owners’ Equity (Net Worth)

This is the single most important ratio to judge whether the firm has earned a
satisfactory return for its equity-shareholders or not. A higher ratio indicates the better
utilization of owners’ fund and higher productivity. A low ratio may indicate that the business
is not very successful because of inefficient and ineffective management and over investment
in assets.

99
EARNINGS PER SHARE (EPS):
The profitability of a firm from the point of view of the ordinary shareholders is
analyzed through the ratio `EPS’. It measures the profit available to the equity shareholders on
a per share basis, i.e. the amount that they can get on every share held. It is calculated by
dividing the profits available to the shareholders by the number of the outstanding shares. The
profits available to the ordinary shareholders are represented by net profit after taxes and
preference dividend.

Net Profit after Tax – Preference Dividend

Earnings per Share = ----------------------------------------------------
Number of Equity Shares

This ratio is an important index because it indicates whether the wealth of each
shareholder on a per-share basis has changed over the period. The performance and prospects
of the firm are affected by eps. If eps increases, there is a possibility that the company may pay
more dividend or issue bonus shares. In short, the market price of the share of a firm will be
affected by all these factors.

DIVIDEND PAY OUT RATIO:

This ratio measures the relationship between the earnings belonging to the ordinary
shareholders and the dividend paid to them. In other words, the dividend payout ratio shows
what percentage share of the net profits after taxes and preference dividend is paid out as
dividend to the equity shareholders. It can be calculated by dividing the total dividend paid to
the owners by the earnings available to them. The formula for computing this ratio is:

Dividend per Equity Share

Dividend Payout Ratio = -------------------------------
Earnings per Share

This ratio is very important from shareholder’s point of view as its tells him that if a firm has
used whole, or substantially the whole of its earnings for paying dividend and retained nothing
for future growth and expansion purposes, then there will be very dim chances of capital
appreciation in the price of shares of such firms. In other words, an investor who is more
interested in capital appreciation must look for a firm having low payout ratio.

100
 ANALYSIS OF OPERATIONAL EFFICIENCY
The operational efficiency of an organization is its ability to utilize the available
resources to the maximum extent. Success or failure of a business in the economic sense is
judged in relation to expectations, returns on invested capital and objectives of the business
concern. There are many techniques available for evaluating financial as well as operational
performance of a firm. The two important techniques adopted in this study are:

1. Turnover to capital employed or return on investment (ROI)

2. Financial operations ratio

TURNOVER TO CAPITAL EMPLOYED:

This is the ratio of operating revenue to capital employed. This is one of the important
ratios to find out the efficiency with which the firms are utilizing their capital. It signifies the
number of times the total capital employed was turned into sales volumes. The term capital
employed includes total assets minus current liabilities. The ratio for calculating turnover to
capital employed (in percentage) is:

Operating Revenue / Capital Employed * 100

The higher the ratio, the better is the position.
FINANCIAL OPERATIONS RATIO:
The efficiency of the financial management of a firm is calculated through financial
operations ratio. This ratio is a calculating device of the cost and the return of financial
charges. This ratio signifies a relationship between net profit after tax and operating profit. The
formula for the computation of this ratio is:

Net Profit After Tax

Financial Operations Ratio = --------------------------- X 100
Operating Profit

Here, the term “operating profit” means sales minus operating expenses. A higher ratio
indicates the better financial performance of the firm.

101
 RATIOS FROM SHAREHOLDERS’ POINT OF VIEW
1. Preference dividend cover: this ratio expresses net profit after tax as so many
times of preference dividend payable. This is calculated as:

Net Profit after Tax

-------------------------
Preference Dividend
2. Equity Dividend Cover: this ratio gives information about net profit
available to equity shareholders. This ratio expresses profit as number of times of equity
dividend payable. This ratio is calculated using
the following formula:

Net Profit After Tax – Preference Dividend

-------------------------------------------------
Equity Dividend

3. Dividend Yield On Equity Shares Or Yield Ratio: this ratio interprets dividend as a
percentage of market price per share. It is calculated as:

Dividend Per Share

--------------------------- X 100
Market Price Per Share

4. Price Earnings Ratio: this ratio tells how many times of earnings per share is the market price
of the share of a company. The formula to calculate this ratio is:

Market Price Per Share

---------------------------
Earnings Per Share

102
Illustration 1: the following are the financial statements of yesye limited for the year
2005.

Balance Sheet As At 31-12-2005

Rs. Rs.
Equity Share Capital 1,00,000 Fixed Assets 1,50,000
General Reserve 90,000 Stock 42,500
Profit & Loss Balance 7,500 debtors 19,000
Sundry Creditors 35,000 Cash 61,000
6% Debentures 30,000 Proposed
Dividends 10,000
2,72,500 2,72,500

---------------------------------------------------------------------------------

Trading And Profit And Loss Account

For The Year Ended 31-12-2005
Rs. Rs.
To Cost Of Goods Sold 1,80,000 By Sales 3 ,00,000
To Gross Profit C/D 1,20,000

3,00,000 3,00,000

To Expenses 1,00,000 By Gross Profit B/D 1,20,000

To Net Profit 20,000

1,20,000 1,20,000

103
 You are required to compute the following:

1) Current Ratio

2) Acid Test Ratio

3) Gross Profit Ratio

4) Debtors’ Turnover Ratio

5) Fixed Assets To Net Tangible Worth

6) Turnover To Fixed Assets

Solution:

Current Assets
1) Current Ratio = ---------------------
Current Liabilities

1,22,500
= ----------- = 2.7:1.
45,000

Quick Assets
2) Acid Test Ratio = -------------------
Quick Liabilities

80,000
= ----------- = 1.8:1.
45,000

Gross Profit
3) Gross Profit Ratio = ---------------------- X 100
Sales

1,20,000

104
 = ------------- X 100 = 40%
3,00,000
Net Sales
4) Debtors’ Turnover Ratio = ---------------------
Average Debtors

3,00,000

= ------------- = 15.78 Times.

19,000

No. Of Days In The Year

Collection Period = -----------------------------

Debtors’ Turnover

365

= ----------- = 23 Days

15.78

5) Fixed Asset To Fixed Assets

Net Tangible Worth = ----------------------- X 100

Proprietor’s Fund

105
 1,50,000

= ------------- X 100 = 76%

1,97,500

Net Sales

6) Turnover To Fixed Assets = ------------------

Fixed Assets

3,00,000

= ----------- = 2 Times
1,50,000

106
 CASH FLOW STATEMENTS

Cash flow statement is not a substitute of income statement, i.e. a profit and loss
accounts and a balance sheet. It provides additional information and explains the reasons for
changes in cash and cash equivalents, derived from financial statement at two points of time

DEFINITIONS OF CASH FLOW STATEMENT

✓
Chas flows are inflows and outflows of cash and cash equivalents.
✓
Cash equivalents are short term, high liquid investments that are readily convertible
into known amounts of cash and which are subject an insignificant risk of changes in value.
✓
Cash compromise cash on hand and demand deposits with bank.
✓
Investing activities are the acquisition and disposal of long term assets and other
investment not including in cash equivalent.

SCOPE CASH FLOW STATEMENT

✓
An enterprise should prepare a cash flow statement and should presents it for each period
for which financial statements are presented.
✓
Cash flow statements are interested in how the enterprise generates and uses cash and
cash equivalents.

✓
Enterprise need cash for essentially the same reasons, however different their principal
revenue producing activities might be.
✓
Enterprise need cash to conduct their operations, to pay their obligations, and to provide
returns to their investors.

107
Illustration‐1

The following are Balance Sheet and Income Statement of Om ltd.

Liabilities 1.1.06 31.12.06 Assets 1.1.06 31.12.06

Share capital 1,80,000 2,22,000 Fixed Assets:

Profit & loss A/c 75,900 81,900 Land 24,000 48,000
Creditors 1,20,000 1,17,000 Building 1,80,000 2,88,000
Outstanding Expenses 12,000 24,000 Current Assets:
Provision for tax 6,000 6,600 Cash 30,000 36,000
Prov. for Dep. on building 60,000 66,000 Debtors 84,000 93,000
Stock 1,32,000 48,000
Advances 3,900 4,500

4,53,900 5,17,500 4,53,900 5,17,500

Information: Company
sold building during the year, cost price of which was Rs. 36,000

108
 Profit and loss account For
year ended 31.3.06

Particular RS Particular RS

To Cost of sales 9,90,000 By Net sales 12,60,000

To Wages & salaries 1,20,000
To Gross profit c/d 1,50,000

12,60,000 12,60,000

To Operating Exp. 40,000 By Gross profit 1,50,000

To Depreciation 30,000 By Profit on sale of Building 6,000
To Provision for tax 44,000
To Net profit 42,000

1,56,000 1,56,000

To proposed Dividend 36,000 By Balance b/d 75,900

To balance Carried to 81,900 By Net Profit (transf.) 42,000
balance sheet
1,17,900 1,17,900

You are

Particulars Rs Particulars Rs

To Bank (tax paid ) 43,400 By Balance b/d 6,000

To Balance c/d 6,600 By P & L A/c. (provision) 44,000

50,000 50,000

109
 Building A/c

Particulars Rs Particulars Rs
To Balance b/d 1,80,000 By Dep. Provision a/c 24,000
To P & L A/c. (profit on sale) By Bank(sale) 18,000
To Bank (purchase) By Balance c/d 2,88,000

3,30,000

on building A/c

Particulars Particulars Rs
To Building a/c(dep.) By Balance b/d 60,000
To Balance c/d By P & L A/c. (current 30,000
dep.)

90,000 90,000

Adjusted Loss

Particulars Rs Rs
To Provision for tax 44,000 By Balance b/d 75,900
To Prov. for dep. on building 30,000 By Profit on sale of
To Dividend paid 36,000 building 6,000
To Balance c/d 81,900 By Adj. Profit 1,10,000

1,91,900 1,91,900

110
 Cash flow statement of Om Ltd for the year ending on

31.3.06 (As per A. S. ‐ 3)

Particulars Amount Amount

Rs. Rs.

(1) Cash Flow from Operating Activities:

Profit before tax (after non‐cash items) 1,10,000
Add/Less: Changes in Working Capital
- Inc. in debtors (9,000)
- Dec. in stocks 84,000
- Inc. in advances (600)
- Dec. in creditors (3,000)
required to p
- Inc. in Outstanding expenses 12,000

Cash flows from operating activities 1,93,400

Less: Tax Paid 43,400

NET CASH FLOW FROM OPERATING
ACTIVITES (A) 1,50,000
(2) Cash Flow from Investing Activities:
- Purchase of Land (refer question assets side) (24,000)
- Purchase of Building (refer building A/c.) (1,44,000)
- Sale of building (refer building A/c.) 18,000
NET CASH FLOW FROM INVESTING
ACTIVITES (B) (1,50,000)
(3) Cash Flow from Financing Activities:
- Issued Equity Shares 42,000
- Dividend paid (36,000)
NET CASH FLOW FROM FINANCING
ACTIVITIES (C) 6,000
6,000
NET CASH FLOW FROM ALL
111
ACTIVITES (A+B+C)

Add: Opening Cash and Bank Balance 30,000

Closing Cash and Bank Balance 36,000

112
 Illustration: 2

The summarized balance sheet of Bhadresh Ltd. as on 31.12.05 and 31.12.2006 are as
follows:

Liabilities 2005 2006 Assets 2005 2006

Share capital 4,50,000 4,50,000 Fixed asset 4,00,000 3,20,000

General Reserve 3,00,000 3,10,000 Investment 50,000 60,000
P & l a/c 56,000 68,000 Stock 2,40,000 2,10,000
Creditors 1,68,000 1,34,000 Debtor 2,10,000 4,55,000
Tax provision 75,000 10,000 Bank 1,49,000 1,97,000
Mortgage loan ‐ 2,70,000

10,49,000 12,42,000 10,49,000 12,42,000

Additional Details:
1. Investment costing Rs. 8,000 were sold for Rs. 8,500
2. Tax provision made during the year was Rs. 9,000
3. During the year part of fixed assets costing Rs 10,000 was sold for Rs 12,000 and
the profit was included in P & L A/c. You are required to prepare cash flow
statement for 2006.

113
Solution:

Cash flow statement for the year ended 31.12.2006

Particular Rs. Rs.

1.Cash flows from operating activities:

Net profit before tax (Rs. 28,500 in case Profit on sale 31,000
on Investment & Fixed Asset not considered)
Adjustment for:
Dep. 70,000
Profit on sale of investment (500)
Profit on sale of Fixed assets (2,000)
Dec. in stock 30,000
Dec. in creditor (34,000)
Inc. in debtor (2,45,000)
Income tax paid (74,000)

Net cash from operating activities (2,24,500)

114
2. Cash flows from investing activities:
Investment purchased (18,000)
Sale of investment 8,500
Sale of Fixed assets 12,000
Net cash from investing activities 2,500
3.Cash flows from financing activities:

Mortgage loan taken 2,70,000

Net Cash Flow from all activities (A + B +
C) 48,000
Add: opening cash balance 1,49,000

Closing cash balance 1,97,000

Fixed Assets A/c

Particulars Rs Particulars Rs

To Balance b/d 4,00,000 By Bank a/c 12,000

To Profit and Loss a/c 2,000 By Dep. 70,000
By Balance c/d 3,20,000

4,02,000 4,02,000

Provision for tax A/c

Particulars Rs Particulars Rs

To Bank (tax paid ) 74,000 By Balance b/d 75,000

By P & L A/c
To Balance c/d 10,000 (provision) 9,000

84,000 84,000

115
 Investment A/c

Particulars Rs Particulars Rs

To Balance b/d 50,000 By Bank(sale) 8,500

To P & L A/c 500 By Balance c/d 60,000

To Bank (purchase) 18,000

68,500 68,500

Adjusted P & L A/c

Particulars Rs Particulars Rs

To Provision for tax 9,000 By Balance b/d 56,000

To Provision for G.R. 10,000 By Profit on sale of Inv. 500
To Balance c/d 68,000 By Profit on sale of F.A. 2,000
By Adjusted Profit 28,500
87,000 87,000

116
 FUND FLOW STATEMENT

The fund flow statement is a financial statement which reveals the methods by
which the business has been financed and how it has used its funds between the
opening and closing balance sheet dates. The statement is known by various titles,
such as, statement of sources and applications of funds, statement of changes in
working capital, where got and gone statement and statement of provided and applied.

Definition

“A statement of sources and application of funds is a technical device designed

to analyze the changes in the financial condition of a business enterprise between two
dates.” ----Foulke

“The fund flow statement describes the sources from which additional funds
were derived and the use to which these sources were put.” ----Anthony

Procedure for Preparing a Fund Flow Statement

Funds flow statement is a method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statements
dates. so, funds flow statement is prepared by comparing two balance sheets and with
the help of such other information derived from the accounts as may be needed. The
preparation of a fund flow statement consists of three parts:
1. Statement or schedule of changes in working capital
2. Statement of fund from operation
3. Statement of sources and application of funds.
1. Statement or schedule of changes in working capital

117
118
119
 Two Marks Questions

Part-A

1) What do you understand by analysis and interpretation of financial statements?

May 2011

2) Define Ratio Analysis? May 2011, Jan 2012

3) State the limitations of ratio analysis. June 2010
4) What are the objectives of financial statements? Jan 2012
5) Write the importance of Analysis and Interpretation of Financial Statements?

May 2012

6) What are financial statements? May 2013

7) What are the sources of cash inflow? May 2013
8) Write the formula for debt-equity ratio? Dec 2011
9) What is a fund flow statement? Dec 2010
10) What do you by ‘flow of funds’? June 2011
11) What are funds from operations? (NOV/DEC2013)
12) What are profitable ratios? (NOV/DEC2013)
13) Write a short note on operating ratio. (JANUARY 2014)
14)Define cash flow statement. (JANUARY 2014)
15) Define the term fund. (MAY/JUNE 2014)

120
 .
UNIT-4

COST ACCOUNTING

Cost Accounts - Classification of manufacturing costs - Accounting for manufacturing

costs. Cost Accounting Systems: Job order costing - Process costing- Activity Based
Costing- Costing and the value chain- Target costing- Marginal costing including
decision making- Budgetary Control & Variance Analysis - Standard cost system

4.1 INTRODUCTION
Cost accounting is “The process of accounting for costs from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centers and cost units. In its widest usage it embraces the preparation of
statistical data, the application of cost control methods and the ascertainment of the
profitability of activities carried out or planned.”

THE OBJECTIVES OF COST ACCOUNTING?

• To aid in the development of long range plans by providing cost data that acts as
a basis for projecting data for planning.
• To ensure efficient cost control by communicating essential data costs at regular
intervals and thus minimize the cost of manufacturing.
• Determine cost of products or activities, which is useful in the determination of
selling price or quotation.

4.2 THE ADVANTAGES COST ACCOUNTINGS

a. It aids in effective decision making

b. It helps in cost reduction
c. It is helpful in fixation of selling price
d. It leads to effective inventory control
e. It helps in the reduction of wastage

THE DISADVANTAGES COST ACCOUNTING

• It is expensive and as such may not be useful for small businesses

• It is based on estimations
• It may not be applicable to all types of industries

121
 • Sometimes, the errors in financial statements may get reflected in cost
accounts

4.3 COST CONCEPTS / CLASSIFICATION OF COSTS

a. According to functions

i. Production cost / factory cost / manufacturing cost

ii. Administration cost / office cost
iii. Selling cost
iv. Distribution cost
b. According to the nature of the costs

i. Fixed cost
ii. Variable cost
iii. Semi – variable or semi-fixed cost
iv. Step costs
c. According to the controllability

i. Controllable cost (controllable through authority and

responsibility laid down by the organizational structure)

ii. Uncontrollable cost(Un controllable through authority and

responsibility laid down by the organizational structure)

d. According to normality
i. Normal cost
ii. Abnormal cost
e. According to relevance to decision making

i. Shut down cost (fixed cost)

ii. Sunk cost (historical or past paid cost)
iii. Imputed cost (non- cash cost which is calculated)
iv. Replacement cost (cost of replacing assets)

v. Conversion cost(cost of converting raw material into finished

stock)

122
 f. Others
i. Out of pocket cost (Cash expenses)

ii. Relevant cost and irrelevant cost (relevant to the decision at

hand)
iii. Opportunity cost (cost of an opportunity lost)
iv. Imputed or Hypothetical cost (non-cash expenditure)

v. Direct cost and indirect cost (based on traceability to the final

product or service)

vi. Product costs and period costs (fixed costs and variable
costs)
vii. Decision making costs and accounting costs

viii. Avoidable / escapable costs and unavoidable

ix. Differential, incremental or decrement costs
x. Traceable, untraceable / common costs
xi. Joint costs and common costs etc.

4.4 METHODS OF COSTING:

1. Job costing:
Job costing is the basic costing method applicable to those industries where the
work consist of separate contracts, jobs, or batches, each of which is authorized by a
specific order or contract.

2. Contract costing:
It is the form of specific order costing, generally applicable where work is
undertaken to customer’s special requirements and each order is of long duration such
as a building construction etc.
3. Batch costing:
It is that form of specific order costing which applies where similar articles are
manufactured in batches either for sale or for use within the undertaking.

4. Process costing: This method of costing is applicable where goods or services result
from a sequence of continuous or repetitive operations or processes and products are
identical and cannot be segregated

123
5. Operation costing:

It refers to those methods where each operation in each stage of production or process
is separately calculated. Thereafter the cost of finished unit is determined
6. Unit costing/ Output costing / Single costing:

This method is used when the production is uniform and identical and a single article
is produced. The total production cost is divided by the no of units produced to get unit
or output cost Ex: mining, breweries etc.

7. Operating costing:

This method is employed where expenses are incurred for providing services such as
those rendered by transport cost, electricity cost etc.
8. Departmental costing:
This refers to the method of ascertaining the cost of operating a department or cost
Centre. Total cost of each department is ascertained and divided by total units
produced in that department to arrive at unit cost

9. Multiple / Composite costing:

Under this method, the cost of different sections of production is combined after
finding out the cost of each and every part manufactured. This method is applicable to
companies where a product comprises of many assembled parts.

10. Activity based costing:

Under this type of costing, costs are not allocated through various production and
service departments. Instead, they are traced to their originating activities in the first
stage and in the second stage, they are absorbed into the products according to the
extent of activities demanded by the products. The activity based costing system is a
system based on activities linking spending on resources to the products /services
produced /delivered to customers. This system is also known as ABC /ABM system.

The major benefits of adopting this system include

i) it does not under cost complex low volume products and over cost high volume
simple products because the cost drivers used by ABC system are unrelated to volume,
ii) It may result in improved cost control as the costs are broken into a no of activities
rather than into a few cost pools.
The major limitations of this system include –
i) It is very expensive to develop and maintain,

124
 ii) it does not measure the incremental costs required to make a product as it uses full
costing (which includes fixed costs also) instead of using incremental costs.
11. Target costing :
It is an integrated approach to determine product features, product price, product costs
and product design, that helps to ensure a company will earn reasonable profit on new
products. The components of the target costing process include (1) Target cost, which
is the cost of the resources that should be consumed to create a product, that can be
sold at a target price
(2) Target price – it is the estimated price for a product or service that potential
customers will pay.
(3) Target Operating Income per unit – It is the operating income that a company
aims to earn per each unit of a product or service sold.
(4) Target cost per unit – It is the estimated long run cost per unit of a product or
service that enables a company to achieve its target operating income per unit, when
selling at the target price.

4.5 COST SHEET

Cost sheet is a statement, which shows various components of total cost of a product.
It classifies and analyses the components of cost of a product. Previous periods data is
given in the cost sheet for comparative study. It is a statement which shows per unit
cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet.
The details of total cost presented in the form of a statement are termed as Cost sheet.
Cost sheet is prepared on the basis of :

1. Historical Cost
2. Estimated Cost
Importance of Cost Sheet
Cost ascertainment
The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet
helps in ascertainment of cost for the purpose of determining cost after they are
incurred. It also helps to ascertain the actual cost or estimated cost of a Job.
Fixation of selling price
To fix the selling price of a product or service, it is essential to prepare the cost
sheet. It helps in fixing selling price of a product or service by providing detailed
information of the cost.
Help in cost control
For controlling the cost of a product it is necessary for every manufacturing unit
to prepare a cost sheet. Estimated cost sheet helps in the control of material cost,
labour cost and overheads cost at every point of production.
Facilitates managerial decisions

125
 It helps in taking important decisions by the management such as: whether to
produce or buy a component, what prices of goods are to be quoted in the tender,
whether to retain or replace an existing machine etc.

4.6 STANDARD COSTING:

STANDARD COSTING is a technique which uses standards for costs and

revenues for the purpose of control through variance analysis. It can be used either
with operations or processes or with specific order type of cost accounting system.
A STANDARD COST is defined as ‘a pre-determined calculation of how
much costs should be under specified working conditions. It is built up from the
assessment of the value of cost elements and correlated technical specifications and
qualifications of materials, labor and other costs to the prices and / or wage rates
expected to apply during the period in which the standard cost is intended to be used.

PURPOSES OF STANDARD COSTING

1. Measuring efficiencies
2. Controlling and reducing costs
3. Simplifying costing procedure
4. Valuing inventories and
5. Setting selling prices
ADVANTAGES OF STANDARD COSTING
1. It provides a yardstick for measurement of performance
2. It facilitates ‘Management By Exception’
3. It enables the management to focus more on those expenses and activities which
indicate high favorable or adverse variances, thus saving lot of time and expense
4. It provides motivation for achieving high performance
5. It provides an opportunity for continuous re-appraisal of the methods of production,
production design, use of material etc, leading to cost reduction and establishing new
standards
6. It is easier and economical to operate.
7. It can be used as an aid to budgeting
8. It eliminates wastages by detecting variances and suggesting corrective measures for
them

LIMITATIONS OF STANDARD COSTING

1. It may be very difficult or impossible to fix standards for all operations
2. Wrong standards may result in wastage of time, money and energy
126
3. Standards must be reviewed from time to time, otherwise, they lose relevancy
4. It pre supposes determination of actual costs
ELEMENTS OF A STANDARD COSTING SYSTEM
1. Establishment of cost centre
2. Determination of quality of standard
3. Organization of standard costing
4. Setting of standards
5. Determination or accumulation of actual costs
6. Analyzing the variance between the standards and the actual
Variance Analysis
Standard Costing guides as a measuring rod to the management for
determination of "Variances" in order to evaluate the production performance. The
term "Variances" may be defined as the difference between Standard Cost and actual
cost for each element of cost incurred during a particular period.
The term "Variance Analysis" may be defined as the process of analyzing variance by
subdividing the total variance in such a way that management can assign responsibility
for off-Standard Performance. The variance may be favourable variance or
unfavourable variance. When the actual performance is better than the Standard, it
resents "Favourable Variance." Similarly, where actual performance is below the
standard it is called as "Unfavourable Variance."

4.7 TYPES OF VARIANCES

Variances are computed for all the three basic elements of cost – direct material, direct
labor and overhead variance

1. Direct material variance:

2. Direct labor variance and
3. Overhead variance

MATERIAL VARIANCES:
Direct Material Cost Variances (DMCV):

This variance is an overall difference in the standard direct material cost and
the actual direct material cost. This variance may exist because of difference in either
the price of the material or the quantity that is purchased.

MCV = Standard cost for actual production – Actual cost

= (Standard quantity x Standard price) – (Actual quantity x Actual price)

127
 Based on this, this variance has two components –

i) Material Price Variance (MPV):

This may be defined as the difference between the actual price and the standard price
of the materials consumed.

MPV = Actual quantity used (Standard price – Actual price)

Reasons for Price variance may be

xii. Changes in the market price of direct material

xiii. “Emergency buying” in smaller quantities
xiv. Cash discount not availed

xv. Carriage, freight and other charges absorbed instead of being

charged to the suppliers

xvi. Claims not made on the suppliers for substandard materials or

short receipt of materials

ii) Material Usage Variance (MUV):

This is the difference between the actual quantity of material consumed and standard
quantity which should have been consumed, expressed in terms of the standard price of
the material.

MUV = Standard price (Standard quantity for actual production – Actual quantity
used)

Reasons for usage variance may be

xvii. Defective material

xviii. Carelessness in the use of material
xix. Wastages due to bad methods or bad workmanship

xx. Change in the quality of materials used

xxi. Non-standard mix of materials used

128
Material Usage Variance can be split up further into two components (in process
industries) – a) Materials mix variance : It can be defined as that portion of direct
material usage variance which is the difference between the actual quantities of
ingredients used in a mixture at standard price and the total quantity of ingredients
used at the weighted average price per unit of ingredients as shown by the standard
cost sheet.

MMV = Standard Price (Standard Quantity – Actual Quantity)

(or) when standard is revised due to the shortage of a particular type of material

MMV = Standard Price (Revised Standard Quantity – Actual Quantity)

Where Revised standard quantity = Total weight of actual mix x Standard quantity
Total weight of standard mix

b) Direct material yield variance (MYV) : It has been defined by the ICMA,
London, as ‘the difference between the standard yield of the actual material input and
the actual yield, both valued at the standard material cost of the product’.

MYV = Standard yield rate (Standard yield – Actual yield)

(or) Standard Revised rate (Actual loss – Standard loss),

Where standard revised rate = Standard cost of standard mix
Net standard output

LABOUR VARIANCES:
Labor Cost Variance (LCV):

According to ICMA, London, ‘Labor cost variance is the difference between the
standard direct wages specified for the production achieved, whether completed or not
and actual direct wages incurred’. If the standard cost is higher, the variation is
favourable and vice versa.

LCV = Standard cost of labor – Actual cost of labor

= (Standard time x Standard rate) – (Actual time x Actual rate)
Labor Rate Variance (LRV):
According to ICMA, London, this variance is ‘the difference between the standard and
the actual direct labor rate per hour for the total hours worked’. If the standard rate is
higher, the variance is favourable and vice versa
129
 LRV = Actual time (Standard wage rate x Actual wage rate)
Reasons for rate variance may be:

xxii. Changes in the basic wage rates

xxiii. Faulty recruitment
xxiv. Overtime work at higher or lower than the specified rate

xxv. Change in the composition of the gang at a different rate from the
standard
xxvi. Employing people of different grades than planned

xxvii. Excessive overtime

xxviii. Higher or lower rate paid to casual laborers etc

xxix.
Labor Time or Labor Efficiency Variance (LEV):
This variance has been defined as – ‘that portion of the direct wages cost variance
which is the difference between the standard direct wages cost for the production
achieved whether completed or not, and the actual hours at standard rates (plus
incentive bonus). This variance may be favourable or unfavourable.

LEV = Standard rate (Standard time – Actual time)

Reasons for efficiency variance may be:

xxx. Bad workmanship due to inefficient training or incomplete
instructions or dissatisfaction among the workers
xxxi. Bad working conditions

xxxii. Production delays and hold-ups

xxxiii. Defective equipments, tools and materials
xxxiv. Defective supervision
xxxv.
Labor Idle Time Variance (LITV):

This variance arises because of the time during which the labor remains idle due to
abnormal reasons such as – power failure, strikes, machine breakdowns etc.
LITV = Abnormal idle time x Standard hourly rate
130
Labor Mix Variance or Gang Composition Variance (LMV): This is that part of
Labor cost variance that results from employing different grades of labor from the
standard fixed in advance. It is the difference between the standard composition of
workers and the actual gang of workers.
LMV = (Standard cost of standard mix) – (Standard cost of Actual mix)
Labor Yield Variance (LYV): It is the difference between the standard labor output
and actual output or yield.
If the actual production is more than the standard production, it would result in
favourable variance and vice versa.

4.8 OVERHEAD VARIANCES:

Unlike direct material and labor, the manufacturing overhead is not entirely variable
with the level of production. Therefore, standard costs for factory overheads are based
upon budgets rather than standards. These variances arise due to the differences
between the actual overhead cost incurred and the standard overhead cost charged to
production. There are two components to overhead variances – i) Variable Overhead
Variances and ii) Fixed Overhead Variances.
Variable Overhead Variance (VOHV):
This variance is defined by ICMA, London, as ‘the difference between the standard
variable production overhead absorbed in the production achieved, whether completed
or not, and the actual production overhead’. This variance can be divided into – i)
Variable Overhead Expenditure Variance and ii) Variable Overhead Efficiency
Variance.
VOHV= (Actual hours worked x Standard variable overhead rate per hour) – Actual
variable over heads
i) Variable overhead variance:
It is difference between actual overhead expenditure incurred and the standard variable
overheads set in for a particular period.
Variable overhead variance = (Standard variable overhead) – (Actual variable
overhead)
ii) Variable Overhead Efficiency Variance:
It shows the effect of change in labor efficiency overheads recovery.
Variable Overhead Efficiency Variance = Standard rate (Standard quantity – Actual
quantity) where Standard rate = (Standard time for actual output – Actual time)
Fixed Overhead Variance (FOV) :
Fixed overhead variance has been defined by ICMA, London, as ‘the difference
between the standard cost of fixed overhead absorbed in the production achieved,
whether completed or not, and the actual fixed overhead, attributed and charged to that
period’.
FOV = (Actual production x Standard fixed overhead recovery rate) – Actual
overheads incurred
This variance may be divide into – i) Fixed Overhead Expenditure Variance and ii)
Fixed Overhead Volume Variance.
131
 i) Fixed Overhead Expenditure Variance (FOEV):
This variance has been defined by ICMA, London as ‘the difference between the
budget cost allowance for production for a specified control period and the amount of
actual fixed expenditure attributed and charged to that period’.
FOEV = Budgeted fixed overhead – Actual fixed overhead
(Or) Budgetary quantity x Standard overhead rate – Actual Fixed overhead
ii) Fixed Overhead Volume Variance (FOVV):
This variance has been defined by ICMA, London as ‘that portion of the fixed
production overhead variance which is the difference between the standard cost
absorbed in the production achieved, whether completed or not, and the budget cost
allowance for a specified control period’.
FOVV = Standard Fixed overhead recovery rate (Actual quantity – Budgeted quantity)
Fixed Overhead Volume Variance can further be divided into – i) Capacity variance
and
ii) Productivity variance
i) Fixed Overhead Capacity Variance (FOCV):
This variance has been defined by ICMA, London as ‘that portion of the fixed
production overhead volume variance which is due to working at higher or lower
capacity than standard’.
FOCV= Standard recovery rate (Standard quantity – Budgeted quantity)

ii) Fixed Overhead Productivity Variance (FOPV):

This variance has been defined by ICMA, London as ‘that portion of the fixed
production overhead volume variance which is the difference between the standard
cost absorbed in the production achieved, whether completed or not, and the actual
direct labor hours worked (valued at the standard hourly absorption rate).

FOPV = Standard overhead rate (Actual quantity – Standard quantity)

Sometimes, another variance, called as calendar variance may also be calculated as –

Standard rate per hour (Possible hours – Budgeted hours) (or)
Standard rate per unit (Possible units – Budgeted units)

4.8.1 SALES REVENUE VARIANCE (SRV):

The word ‘Sales Variance’ is denoted by the expression ‘operating profit

variance due to sales’ by ICMA. It is defined as the difference between the budgeted
operating profit and the margin between the actual sales and the standard cost of those
sales’.

132
 This variance is subdivided into – i) Sales price variance and ii) Sales volume variance
i) Sales price variance (SPV): It is the difference between actual selling price and
standard selling price.
SPV = Actual quantity (Actual selling price – Standard selling price)

ii) Selling Volume Variance (SVV):

It is the difference between the actual no of units sold and the planned sale of units.
SVV = Standard selling price (Actual quantity – Standard quantity)

4.9 PROFIT VARIANCES

Sales variances are significant as they have a direct bearing on profits earned
by the organization. Hence, they can be used as the basis of determining profit
variance. The overall Profit Variance is divided into – i) Sales price variance and ii)
Sales Volume Variance, which is sub-divided into – a) Sales Price variance b) Sales
Volume Variance and iii) Cost Variance. Except Cost Variance, there is no difference
between the various Sales Variances and Profit Variances.
Overall Sales Variance = Standard / Budgeted profit – Actual profit (Unfavorable)

(Or) Actual Profit – Standard / Budgeted profit (Favorable)

Cost Variances: They arise when actual costs are different from standard costs.
Cost Variances = (Standard cost – Actual cost) Actual quantity sold (Favorable)
(or) (Actual cost – Standard cost) Actual quantity sold (Unfavorable)

4.10 CLASSIFICATOIN OF BUDGETS

Budgets can be classified on the basis of many bases. There are three popular
bases for classifying budgets. They are – time, functions and flexibility. Apart from
these classifications, several other budgets can also be found in practice such as –
performance budget, ZBB, control ratios etc.

On The Basis Of Time

• Long term budget: According to National Association of Accountants, America, a
long term budget is, a systematic and formalized process for purposeful directing and
controlling future operations towards a desired objective for periods extending beyond
one year.
• Short term budget: Short term budget covers a budget period of one year or less.
• Current budget: These budgets cover a very short period such as a month or a
quarter. They are essentially short term budgets adjusted to current conditions or
prevailing circumstances.

133
 On The Basis Of Functions
• Functional / Subsidiary budgets: A Functional budget is a budget of income or
expenditure appropriate to or the responsibility of functions, such as production, sales,
purchase etc. Each functional department prepares its own budget, and all these
functional budgets are integrated into the Master budget.
Sales budget: It gives details about volume, price and sales mix. It also gives details
about the quantity of sale, month-wise or quarter-wise, market-wise, area-wise and on
whatever other basis be important to the organization. The responsibility for
preparation of this budget falls on the sales manager. While preparing this budget,
he/she has to consider certain influencing factors such as – past sales figures and trend,
salesmen’s estimates, plant capacity, general trade practice, orders in hand, proposed
expansion or discontinuance of products, seasonal fluctuations, potential market,
availability of material and supply, finance etc.
Production budget: It includes details about the types, quantity and cost of goods and
services produced in the organization. The responsibility of preparing this budget falls
on the Works manager or departmental Works managers.
Production cost budget: It is divided into material cost budget, labour cost budget
and overhead cost budget, because cost of production includes material, labour and
overheads.
Materials budget: It includes details about the kinds and quantity of material required,
price paid for it, cost of transportation and storage, etc
Labor budget: It includes details about the types and number of workers, the number
of hours required, the wage rates and other allowances, the welfare and other facilities
provided and cost thereof etc.
Overheads budget: It gives details of items of factory overhead expenses, their
quantity and cost.
Research and Development budget: Every organization of some size, particularly, of
a manufacturing or technical type, has a Research and Development Department.
Expenses incurred by it are parts of operating cot, until efforts lead to some findings
that can be used for improvement of quality of product technology improvement,
and/or for producing something new, at which stage all expenses incurred are
capitalized.
Capital expenditure budget: This budget shows the estimated expenditure on fixed
assets such as land and buildings, plant and machinery, etc. It is a long term budget.
This budget is prepared to plan for replacement of old machines, increased demand of
products, expansion of activities, etc.
Cash budget: A Cash budget deals with cash, including its equivalent, like bank
balance and bills receivable. It shows the inflows of cash and outflows of cash during a
particular period of time. It can be prepared for a year, but for better control and
management of cash, its is normally prepared on monthly basis. It takes into account
only cash transactions.
• Master budget: This budget is prepared from, and summarizes the various functional
budgets. It is also called as summary budget. It generally includes details relating to
production, sales, stock, debtors, cash position, fixed assets etc., in addition to
important control ratios.

134
 On The Basis Of Flexibility

• Fixed budget: A Fixed budget is designed to remain unchanged irrespective of the

volume of output or turnover attained. The budget remains fixed over a given period
and does not change with the change in the volume of production or level of activity
attained.

• Flexible budget: It is also known as variable budget. A Flexible is designed to change

along with the changes in the output or turnover. It changes according to the levels of
activity.
Other Related Budgets
1. Performance budget : Performance budget involves evaluation of the performance
of the organization in the context of both specific and overall objectives of the
organization. According to National Institute of Bank Management, performance
budgeting is the process of analyzing, identifying, simplifying and crystallizing
specific performance objectives of a job to be achieved over a period in the frame
work of the organizational objectives, the purpose and the objectives of the job.
Performance budgeting requires preparation of performance reports which compare the
budget and actual data and show the variances existing between both. The
responsibility for preparing these reports lies on the respective departmental head.
Each departmental head will be supplied with a copy of the section of the master
budget appropriate to his sphere. This report may be prepared on a daily basis, weekly
basis, monthly basis or any basis based on the size of business and the budget period.
The purpose of submitting these reports is to convey promptly the information about
the deviations in actual and budgeted activity to the decision makers so that necessary
corrective actions can be taken to correct the deviations.
The various ADVANTAGES of Performance budgeting are as follows:

• It aims at continuous growth of the organization in the long-run.

• It enables the organization to be sensitive and adaptive, preventing it from
developing rigidities which may retard the process of growth.
• It facilitates performance appraisal

PRE-REQUISITES for a successful adoption of Performance budgeting are :

• It requires preparation of periodic performance reports.

• The accounting system should be sufficiently detailed and co-ordinated to

provide necessary data for reports designed for the particular use of the individual or
cost centres having primary responsibility for specific costs.
2. Zero base budget:
Zero base budgeting (ZBB) is a new technique which was first used by the US
135
 Department of Agriculture in 1961. Texas instruments, a n MNC, has used it in the
private sector. But, it was Peter.A.Pyhr who had designed its logical basic framework
in1970 and successfully developed, implemented and popularized the use of ZBB in
private sector. Hence, he is known as the ‘father of ZBB’. The technique became more
popular in USA when the then President of USA, Mr.Carter, in 1979, had issued a
mandate asking for the use of ZBB throughout the federal government agencies.
Though it had become popular in many countries, especially the common wealth
countries, in India, despite the various efforts of the Institute of Chartered Accountants
of India and the Institute of Costs and Works Accountants of India, it had not gained
popularity in India.

‘ZBB is a management tool which provides a systematic method of evaluating all

operations and programmes, current or new, allows for budget reductions and
expansions in a rational manner and allows re-allocation of sources from low to high
priority programmes’
A Zero base budget is not an old budget with incremental changes, as in the case of an
incremental budget. It starts with a scratch or a zero level and if an item is found to be
necessary it is included in the new budget, and if it is necessary, how much amount
should be budgeted for.

ZBB has many advantages to the management covering

1) It provides a solution for all the limitations of traditional budgeting by enabling
the top management to focus on key areas, alternatives and priorities of action
throughout the organization.
2) It enables the management to concentrate only on essential programs
3) It enables the management to approve departmental budgets on the basis of
cost benefit analysis.
4) It helps in identifying wasteful expenditure, and if desired, it can also be used
for suggesting alternative courses of action.
5) It can be used for introducing the system of Management by objectives, etc.
Even though there are many advantages with this type of budgeting, there are various
disadvantages also associated with its use. Some of them are –
1) Successful implementation of ZBB requires top management support. Its absence may
lead to implementation problems
2) There are other problems related to the implementation of the ZBB program such as
– fixing of suitable authority and responsibility for preparing the budgets, fixing the
minimum level of effort required, etc
3) It is expensive and may not suit smaller firms
4) It is time consuming and may not be relevant in taking emergency decisions. etc
3. Control ratios
Three important ratios are commonly used by the management to find out whether
the variations from budgeted results are favourable or unfavourable. These ratios are
expressed as percentages and any ratio beyond 100% is favourable and an ratio less
136
 than 100% is unfavourable. The three ratios are :

a) Activity Ratio: It is a measure of the level of activity attained over a period. Activity
ratio = Standard Hrs. for Actual Production x 100

Budgeted Hours
b) Capacity Ratio : This ration indicates whether and to what extent budgeted hours of
activity are actually utilized.
Capacity ratio = Actual hours worked x 100
Budgeted hours

c) Efficiency Ratio : This ratio indicates the degree of efficiency attained in production.
Efficiency ratio = Standard hours for actual prodn. x 100
Actual hours worked

7) A factory engaged in manufacturing plastic buckets is working at 40% capacity

and produces 10,000 buckets per month. The present cost break up for one bucket is
as under

Material Rs.10
Labor Rs.3
Overheads Rs.5 (60% fixed)

The selling price is Rs.20 per bucket. If it is desired to work the factory at 505
capacity, the selling price falls by 3%. At 90% capacity, the selling price falls by 5%
accompanied by a similar fall in the price of the material.

You are required to prepare a statement showing the profit at 50% and 90%
capacities and also calculate the break even points at the capacity production.

4.11 CONCEPTS OF MARGINAL COST & BREAK EVEN POINT

Meaning
Marginal Cost: The term Marginal Cost refers to the amount at any given volume of
output by which the aggregate costs are charged if the volume of output is changed by
one unit. Accordingly, it means that the added or additional cost of an extra unit of
output.
Marginal cost may also be defined as the "cost of producing one additional unit of
product." Thus, the concept marginal cost indicates wherever there is a change in the
volume of output; certainly there will be some change in the total cost. It is concerned
with the changes in variable costs. Fixed cost is treated as a period cost and is
137
 transferred to Profit and Loss Account.
Marginal Costing: Marginal Costing may be defined as "the ascertainment by
differentiating between fixed cost and variable cost, of marginal cost and of the effect
on profit of changes in volume or type of output." With marginal costing procedure
costs are separated into fixed and variable cost.
According to J. Batty, Marginal costing is "a technique of cost accounting pays special
attention to the behaviour of costs with changes in the volume of output." This
definition lays emphasis on the ascertainment of marginal costs and also the effect of
changes in volume or type of output on the company's profit.

4.12 FEATURES OF MARGINAL COSTING

(1) All elements of costs are classified into fixed and variable costs.

(2) Marginal costing is a technique of cost control and decision making.

(3) Variable costs are charged as the cost of production.

(4) Valuation of stock of work in progress and finished goods is done on the basis
of variable costs.

(5) Profit is calculated by deducting the fixed cost from the contribution, i.e.,
excess of selling

price over marginal cost of sales.

(6) Profitability of various levels of activity is determined by cost volume profit

analysis.

Advantages of Marginal Costing.

Important Decision Making Areas of Marginal Costing

The following are the important decision making areas where marginal costing
technique is used:

(I) pricing decisions in special circumstances:

(a) Pricing in periods of recession;

138
 (b) Use of differential selling prices.

(2) Acceptance of offer and submission of tenders.

(3) Make or buy decisions.

(4) Shutdown or continue decisions or alternative use of production facilities.

(5) Retain or replace a machine.

(6) Decisions as to whether to sell in the export market or in the home market.

(7) Change Vs status quo.

(8) Whether to expand or contract.

(9) Product mix decisions like for example :

(a) Selection of optimal product mix;

(b) Product substitution;

(c) Product discontinuance.

(10) Break-Even Analysis.

LIMITATIONS OF MARGINAL COSTING

(1) It may be very difficult to segregation of all costs into fixed and variable costs.
(2) Marginal Costing technique cannot be suitable for all type of industries. For
example, it is
Difficult to apply in ship-building, contract industries etc.
(3) The elimination of fixed overheads leads to difficulty in determination of
selling price.
(4) It assumes that the fixed costs are controllable, but in the long run all costs are
variable.
(5) Marginal Costing does not provide any standard for the evaluation of

139
performance which is provided by standard costing and budgetary control.
(6) With the development of advanced technology fixed expenses are proportionally
increased.
Therefore, the exclusion of fixed cost is less effective.
(7) Under marginal costing elimination of fixed costs results in the under valuation of
stock of
* FIXED COST: Fixed cost is a period cost and is usually unrelated to changes
in production. The total fixed cost remains constant for all levels of production
whereas the fixed cost per unit changes with changes in the production level.

* VARIABLE COST: Variable cost is a product cost and is usually directly

related to production. Total variable cost changes with changes in the production level,
but variable cost per unit remains the same for all levels of production.

* CONTRIBUTION: It is the difference between the sales and the marginal cost of
sales and it contributes towards fixed expenses and profit. It is different from the profit
which is the net gain in activity or the surplus and remains after deducting fixed
expenses from the total contribution. In marginal costing, the concept of contribution
is very important as it helps to find out the profitability of a product, department or
division, to have a better product mix, for profit planning and to maximize the profits
of a concern
Contribution = Sales – Variable cost (or) Fixed cost +Profit (or) Fixed cost – Loss

* MARGIN OF SAFETY (MOS): It refers to the difference between the actual sales
and break even sales. It represents a cushion to the creditors of the firm.

MOS = Actual sales – Break even sales (or) Profit (in Rs) (or) Profit (in units)

P/V ratio Contribution per unit

* ANGLE OF INCIDENCE: It is an angle that is formed when the total sales

line intercepts the total cost line from below in the breakeven chart. It is inferred that
higher the angle, higher is the profit, and lower the angle lower the profit.

* PROFIT VOLUME RATIO: It is also known as contribution to sales (C/S)

ratio. It is one of the most important ratios for studying the profitability of operations
of a business and establishes the relationship between contribution and sales. The
inference is – higher the P/V ratio, lesser will be the profit.
P/V ratio = Contribution x 100 (or) S –V (or) F +P (or) F-L (or) Change in profits x
100
Change in sales

140
 4.14` BREAK EVEN POINT: It represents a level of production where there is no
loss and there is no profit. In other words, it is a point where the total cost is equal to
total sales. Sales beyond this level represent profit and sales below this point represent
loss.

BEP (in value) = Fixed cost (or) Fixed overheads

(or) Fixed cost x sales

Contribution ratio 1 – Variable cost/sales Sales – Variable cost

(or) Fixed cost

P/V ratio

BEP (in units) = Fixed cost (or) Fixed cost

Contribution per unit Selling price per unit – Variable cost per unit

1. Margin of safety is known

2. Cost-Volume-Profit relationship is known
3. Helps in forecasting profit and growth
4. Helps in cost control
5. Helps in knowing profit at various levels
6. Helps in fixing target profit
7. Helps in forecasting the effect of change in price and angle of incidence

DEMERITS OF BREAKEVEN POINT

1. It ignores considerations such as effect of government policy changes, changes in the
marketing environment etc
2. Fixed cost, sales, total costs cannot be represented as straight lines
3. It is difficult to handle advertisement expenditure
4. Fixed costs also may change in the long run
5. It ignores economies of scale in production
6. Semi-variable costs are ignored
7. Volume of production and volume of sales are always not equal
8. Selling price may or may not be the same

141
 UTILITY OF BREAK EVEN POINT IN MANAGERIAL DECISION MAKING
1. It helps in determination of sales mix
2. It helps in exploring new markets
3. It helps in deciding about discontinuance of a product line
4. It helps in taking make or buy decisions
5. It helps in taking equipment replacement decisions
6. It aids in investment of assets
7. It aids in decision making relating to change Vs status quo – which may include
situations like – i) adoption of new method of operation ii) overtime Vs second shift or
iii) Sale Vs further processing etc
8. It helps in making decisions as to expand or contract
9. It helps in decisions relating to shut down or continue operating

142
 Unit-V

Accounting in Computerized Environment

5.1 INTRODUCTION.

Computer is an electronic device that can perform a variety of operations in

accordance with a set of instructions called programme. It is a fast data processing
electronic machine. It can provide solutions to all complicated situations. It accepts
data from the user converts the data into information and gives the desired result.
Therefore, we may define computer as a device that transforms data into information.
Data can be anything like marks obtained in various subjects. It can also be name, age,
sex, weight, height, etc. of all the students, savings, investments, etc., of a country.
Computer is defined in terms of its functions. Computer is a device that accepts data,
stores data, processes data as desired, retrieves the stored data as and when required
and prints the result in desired format.

5.2 CHARACTERISTICS OF COMPUTER

1. Speed
It can access and process data millions times faster than humans can. It can store data
and information in its memory, process them and produce the desired results. It is used
essentially as a data processor. All the computer operations are caused by electrical
pulses and travels at the speed of light. Most of the modern computers are capable of
performing 100 million calculations per second.
2. Storage
Computers have very large storage capacity. They have the capability of storing vast
amount of data or information. Computers have huge capacity to store data in a very
small physical space. Apart from storing information, today’s computers are also
capable of storing pictures and sound in digital form.
3. Accuracy
The accuracy of computer is very high and every calculation is performed with the
same accuracy. Errors occur because of human beings rather than technological
weakness, main sources of errors are wrong program by the user or inaccurate data.

4. Diligence
A computer is free from tiredness and lack of concentration. Even if it has to do 10
million calculations, it will do even the last one with the same accuracy and speed as
143
the first.
5. Versatility

Computer can perform wide range of jobs with speed, accuracy, and diligence. In any
organization, often it is the same computer that is used for diverse purposes such as
accounting, playing games, preparing electric bills, sending e-mail and so on.

6. Communication
Computers are being used as powerful communication tools. All the computers within
an office are connected by cable and it is possible to communicate with others in the
office through the network of computer.
7. Processing Power
Computer has come a long way today. They began as more prototypes at research
laboratories and went on to help the business organizations, and today, their reach is so
extensive that they are used almost everywhere. I the course of this evolution, they
have become faster, smaller, cheaper, more reliable and user friendly.

5.3 COMPONENTS OF COMPUTER

The following are the important components of computer

1. Input unit
Input is controlling the various input devices which are used for entering data into the
computer. The mostly input devices are keyboard, mouse, and scanner. Other such
devices are magnetic tape, magnetic disk, light pen, bar code reader, smart card reader,
etc. besides; there are other devices which respond to voice and physical touch.
Physical touch system is installed at airport for obtaining the online information about
departure and arrival of flight. The input unit is responsible for taking input and
converting it into binary system.
2. Central Processing Unit (CPU)

The CPU is the control centre for a computer. It guides, directs and governs its
performance. It is the brain of the computer. The main unit inside the computer is the
Central Processing Unit. Central Processing Unit is to computer as the brain is to
human body. This is used to store program, photos, graphics, and data and obey the
instructions in program. It is divided into three subunits.

a) Control Unit
144
 b) Memory Unit
c) Arithmetic Logic Unit (ALU)

Control Unit

Control unit controls and co-ordinates the activities of all the components of
the computer. This unit accepts input data and converts it into computer binary system.

Memory Unit
This unit stores data before being actually processed. The data so stored is
accessed and processed according to instructions which are also stored in the memory
section of computer well before such data is transmitted to the memory from input
devices.
Arithmetic and Logic Unit
It is responsible for performing all the arithmetical calculations and
computations such as addition, subtraction, division, and multiplication. It also
performs logical functions involving comparisons among variable and data items.
3. Output Unit
After processing the data, it ensures the convertibility of output into human readable
form that is understandable by the user. The commonly used output devices include
like monitor also called Visual Display Unit, printer etc.
5.4 ROLE OF COMPUTERS IN ACCOUNTING
The most popular system of recording of accounting transactions is manual
which requires maintaining books of accounts such as Journal, Cash book, special
purpose books, ledger and so on. The accountant is required to prepare summary of
transactions and financial statements manually.
The advanced technology involves various machines capable of performing
different accounting functions, for example, a billing machine. This machine is
capable of computing discount, adding net total an posting the requisite data to the
relevant accounts with substantial increase in the number of transactions, a machine
was developed which could store and process accounting data in no time. Such
advancement leads to number of growing successful organizations.

A newer version of machine is evolved with increased speed, storage, and processing
capacity. A computer to which they were connected operated these machines.
As a result, the maintenance of accounting data on a real-time basis became
almost essential. Now maintaining accounting records become more convenient with
145
 the computerized accounting.
The computerized accounting uses the concept of databases. For this purpose
an accounting software is used to implement a computerized accounting system. It
does away the necessity to create and maintain journals, ledgers, etc, which are
essential part of manual accounting. Some of the commonly used accounting
software’s are Tally, Cash
Manager, Best Books, etc.
Accounting software is used to implement a computerized accounting. The
computerized accounting is based on the concept of database. It is basic software
which allows access to the data contained in the data base. It is a system to manage
collection of data insuring at the same time that it remains reliable and confidential.

Following are the components of computerized accounting software.

1. Preparation of accounting documents
Computer helps in preparing accounting documents like Cash Memo, Bills and
invoices etc., and preparing accounting vouchers.
2. Recording of transactions
Every day business transactions are recorded with the help of computer software
Logical scheme is implied for codification of account and transaction. Every account
and transaction is assigned a unique code. The grouping of accounts is done from the
first stage. This process simplifies the work of recording the transactions.

3. Preparation of Trial Balance and Financial statements

After recording of transaction, the data is transferred into ledger account automatically
by the computer. Trial Balance is prepared by the computer to check accuracy of the
records. With the help of trial balance the computer can be programmed to prepare
Trading, Profit and Loss account and Balance Sheet.
It is one of the transaction processing systems which are concerned with financial
transactions only. When a system contains only human resources it is called manual
system; when it uses only computer resources, it is called computerized system and
when it uses both human and computer resources, it is called computer-based system.
These steps can be explained with an example making use of Automatic Teller
Machine (ATM) facility by a Bank-Customer.

a. Data Entry
Processing presumes data entry. A bank customer operates an ATM facility to make a
withdrawal. The actions taken by the customer constitute data which is processed after
validation by the computerized personal banking system.
146
b. Data Validation
It ensures the accuracy and reliability of input data by comparing the
same with some predefined standards or known data. This validation is made by the
“Error Detection “and “Error Correction” procedures. The control mechanism,
wherein actual input data is compared with predetermined norm is meant to detect
errors while error correction procedures make suggestions for entering correct data
input. The Personal Identification Number (PIN) of the customer is validated with the
known data. If it is incorrect, a suggestion is made to indicate the PIN is invalid. Once
the PIN is validated, the amount of withdrawal being made is also checked to ensure
that it does not exceed a pre-specified limit of withdrawal.
c. Processing and Revaluation
The processing of data occurs almost instantaneously incase of online
transaction processing (OLTP) provided a valid data has been fed to the system. This
is called check input validity. Revalidation occurs to ensure that the transaction in
terms of delivery of money by ATM has been duly completed. This is called check
output validity.

d. Storage
Processed action, as described above, result into financial transaction
data i.e. withdrawal of money by a particular customer, are stored in transaction data
base of computerized personal banking system. This makes it absolutely clear that
only valid transactions are stored in the data base.
e. Information
The stored data is processed making use of the query facility to produce
desired information.
f. Reporting
Reports can be prepared on the basis of the required information
content according to the decision usefulness of the report.

5.5 NEED AND REQUIREMENTS OF COMPUTERIZED ACCOUNTING:

The need for computerized accounting arises from advantages of speed,
accuracy and lower cost of handling the business transactions.

a. Numerous Transactions

The computerized accounting system is capable of handling large

147
 number of transactions with speed and accuracy.

b. Instant Reporting

The computerized accounting system is capable of offering quick and

quality reporting because of its speed and accuracy.

c. Reduction in Paper Work

A manual accounting system requires a large physical storage space to
keep accounting records/books and vouchers/documents. The requirement of
stationery and books of accounts along with vouchers and documents is directly
dependent on the volume of the transactions beyond a certain point. There is dire need
to reduce the paper work and dispense with large volumes of books of accounts. This
can be achieved by introducing computerized accounting system.
d. Flexible Reporting
The reporting is flexible in computerized accounting system as
compared to manual accounting system. The reports of a manual accounting system
reveal balances of accounts on periodic basis while computerized accounting system is
capable of generating reports of any balance as when required and for any duration
which is within the accounting period.
e. Accounting Queries
There are accounting queries which are based on some external
parameters. For example, a query to identify customers who have not made the
payments within the permissible credit period can be easily answered by using the
structured query language (SQL).Support of database technology in the computerized
accounting system. But such an exercise in a manual accounting system is quite
difficult and expensive in terms of manpower used. It will still be worse in case the
credit period is changed.
g. Online Facility
Computerized accounting system offers online facility to store and
process transaction data so as to retrieve information to generate and view financial
reports.
h. Scalability
Computerized accounting systems are fully equipped with handling the
growing transactions of a fast growing business enterprise. The requirement of
additional manpower in accounts department is restricted to only the data operators for
storing additional vouchers. There is absolutely no additional cost of processing
148
additional transaction data.
h. Accuracy
The information content of reports generated by the computerized
accounting system is accurate and therefore quite reliable for decision making. In a
manual accounting system the reports and information are likely to be distorted,
inaccurate and therefore cannot be relied upon. It is so because it is being processed by
many people, especially when the number of transaction to be processed to produce
such information and report is quite large.
i. Security
Under manual accounting system it is very difficult to secure such
information because it is open to inspection by any eyes dealing with the books of
accounts. However, in computerized accounting system only the authorized users are
permitted to have access to accounting data. Securing provided by the computerized
accounting system is far superior compared to any security offered by the manual
accounting system.
5.6 BASIC REQUIREMENTS AND LIMITATIONS OF COMPUTERIZED
ACCOUNTING.

Basic Requirements of the Computerized Accounting System

Accounting Framework

It is the application environment of the computerized accounting

system. A healthy accounting framework in terms of accounting principles, coding and
grouping structure is a pre-condition for any computerized accounting system.
Operating Procedure
A well-conceived and designed operating procedure blended with
suitable operating environment of the enterprise is necessary to work with the
computerized accounting system.
The computerized accounting is one of the database-oriented
applications wherein the transaction data is stored in well-organized database. The
user operates on such database using the required interface and also takes the required
reports by suitable transformations of stored data into information. Therefore, the
fundamentals of computerized accounting include all the basic requirements of any
data base-oriented application in computers. On the basis of the discussions, these are
the following differences between manual accounting and computerized accounting.

LIMITATIONS OF A COMPUTER AND COMPUTERIZED ACCOUNTING

149
 1. Cost of Installation
Computer hardware and software needs to be updated from time to time with
availability of new versions. As a result heavy cost is incurred to purchase a new
hardware and software from time to time.
2.Cost of Training
To ensure efficient use of computer in accounting, new versions of hardware software
are introduced. This requires training and cost is incurred to train the staff personnel.

3. Self Decision Making

The computer cannot make a decision like human beings. It is to be guided by the
user.
4. Maintenance
Computer requires to be maintained properly to help maintain its efficiency. It requires
a neat, clean and controlled temperature to work efficiently.
5. Dangers for Health
Extensive use of computer may lead to many health problems such as
muscular pain, eyestrain, and backache, etc. This affects adversely the working
efficiency and increasing medical expenditure.

5.7 DIFFERENCE BETWEEN MANUAL ACCOUNTING AND

COMPUTERIZED ACCOUNTING

1. Recording of financial data content of these transactions is through books is stored in

well designed data base of original entry.
2. Classification Transactions recorded in the no such data duplications are made. Books
of original entry are in order to produce ledger accounts further classified by posting
the stored transaction data is them into ledger accounts. Processed to appear as
classified this results in transaction so that same is presented in the data duplicity form
of report.
3. Summarizing Transactions are summarized the generation of ledger accounts to
produce trial balance by is not necessary condition for ascertaining the balances of trial
balance various accounts.
4. Adjusting entries are made. There is nothing like making entries to adhere to the
principle of adjusting entries for errors and matching rectifications.
5. The preparation of financial statements assumes the statement is independent of
availability of trial balance producing the trial balance.

150
 Anna University Questions:

2 Marks:
1. Explain the Advantages of Prepackaged Accounting Software? June 2009
2. Discuss the Significance Of Computerized Accounting System? June 2010
3. Define Computerized Accounting? Dec 2010
4. What are the uses of Accounting Software? Jan 2012.
5. Give examples for Prepackage accounting software. Jan 2013
6. What is tally? (NOV/DEC-2013)
7. What are the advantages of computerized Accounting? (NOV/DEC-2013)
8. Why is there a need for computerized accounting? (January 2014)
9. Write a note on reserved account groups. (January 2014)
10. State any two limitations of computerized accounting. ( MAY/JUNE 2014)
11. What do you mean by computerized accounting? (January 2015)
12. Define the term codification. (January 2015)
13. Define Ledger. (Apr/May 2015)
14. What is tally? (Apr/May 2015)
16 Marks:
1. Explain the Advantages of Prepackaged Accounting Software? Jan 2012, 2013
2. Discuss the Significance Of Computerized Accounting System? June 2010, June
2009,2013
3. How is codification and grouping of accounts in a Computerized Environment
different from manual accounts? June 2009
4. Do you agree that a computerized environment of accounts will ensure flawless
accounting system? June 2010.
5. Explain Accounting Software? Jan 2012
6. Discuss the steps involved introducing computerized accounting systems in
organization. (NOV/D-2013)
7. Discuss about the grouping of Accounts in tally. (NOV/DEC-2013)
8. What is accounting software? Why should we use it? Explain its different types.
(January 2014)
9. Describe the various facilities to be provided by the user friendly accounting software
package. (8) (January 2014)
10. Explain the procedure involved in the creation, alteration and deletion of ledger
151
 accounts in tally. (8 ) (January 2014)
11. Explain the considerations for selecting Pre-packaged accounting software and discuss
its advantages and disadvantages. (MAY/JUNE 2014)
12. Explain the significance of computerized accounting and role of computer in
accountancy. ( MAY/JUNE 2014)

13. Discuss the steps involved in computerized accounting system. (8) (January 2015)
14. Enumerate the features, advantages and disadvantages of computerized accounting
system. (January 2015)
15. What is prepackaged accounting software? Discuss its merits and demerits. What are
the factors to be considered while selecting prepackaged software? (January 2015)
16. Discuss about need and advantages of computerized accounting system. (Apr/May
2015)
17. Explain the process of codification and grouping of accounts in accounting package
Tally. (Apr/May 2015)

152
 Important question answers

UNIT-I

1. Explain the various accounting concepts and conventions which are

used in the preparation of accounts.

Accounting concepts The term ‘Concept’ is used to mean necessary assumptions and
ideas which are fundamental to accounting practice. The various accounting concepts are
as follows:

Business Entity concept : For accounting purposes, the proprietor of an enterprise is

always considered to be separate and distinct from the business which he/she controls

Dual aspect concept: Every business transaction involves two aspects – a receipt and a
payment. In other words, every debit has an equal and corresponding credit. The dual
aspect concept is expressed as : Capital + Liabilities = Assets. This is known as ‘the
accounting equation’.

Going concern concept: Under this assumption, the enterprise is normally viewed as a
going concern. It is assumed that the enterprise has neither the intention nor the necessity
of liquidation of curtailing materially the scale of its operations. That is why assets are
valued on the basis of going concern concept and are depreciated on the basis of expected
life rather than on the basis of market value.

Accounting period concept: ‘Accounting year’ is the period of 12 months for which
accounts are to be prepared under the Companies Act and Banking Regulation Act.

Money measurement concept: In accounting, every event or transaction which can be

expressed in terms of money is recorded in the books of accounts. This concept does not
record any fact or happening, even though it is important to the business, in the books of
accounts if it cannot be expressed in terms of money. And as per this concept, a
transaction is recorded at its money value on the date of occurrence and the subsequent
changes in the money value are conveniently ignored.

Historical Cost concept : The underlying idea of cost concept is –i) asset is recorded at
the price paid to acquire it, that is, at cost and ii) this cost is the basis for all subsequent
accounting for the asset. Fixed assets are shown in the books of accounts at cost less
depreciation. Current assets are periodically valued at cost price or market price
whichever is less.

153
 Revenue recognition concept: In accounting, ‘revenue’ is the gross inflow of cash,
receivables or other considerations arising in the course of an enterprise from the sale of
goods, from the rendering of services and from the holding of assets. In the case of
revenue, the important question is at what stage, the transaction should be recognized and
recorded.

Periodic matching of cost and revenue concept: After the revenue recognition, all costs,
incurred in earning that revenue should be charged against that revenue in order to
determine the net income of the business.

Verifiable objective evidence concept: As per this concept, all accounting must be based
on objective evidence. In other words, the transactions should be supported by verifiable
documents.

Accrual concept: Under this concept, revenue recognition and costs for the relevant
period, depends on their realization and not on actual receipt or payment. In relation to revenue, the accounts should
exclude amounts relating to subsequent period and provide for revenue recognized, but not received in cash.
Likewise, in relation to costs, provide for costs incurred but not paid and exclude costs paid for subsequent period.

2. What are the various methods of measuring human resource accounting?

TECHNIQUES OF VALUATION OF HR

There are around eight techniques for valuation of HR. They are as follows

1. Historical cost Method: This method was developed by Rensis Likert and his
associates and was adopted by R.G.Barry Corporation, Ohio, Colombia, USA, in
1968. This method involves capitalization of the costs incurred on HR related
activities such as
– recruitment, selection, placement, training and learning etc, and amortized over the
expected length of services of the employees. The unexpired cost represents the firm’s
investment in HR. In case an employee leaves the organization before the expiry of the
expected services’ life period, the firm shall write off the entire amount of unexpired cost
against the revenue of the period during which he or she leaves.

2. Replacement Cost Method: This method was initially developed by Hekimian

and Jones. According to this method, a firm’s HR value is its replacement cost.
According to Flamholtz, this replacement cost may be – i) individual replacement
cost – which refers to the cost of replacing an employee with an equivalent substitute
in terms of skill, ability and knowledge and ii) positional replacement cost – which
refers to the cost of replacing the set of services expected to be rendered by an
employee at the respective positions he holds and will hold at present and in
154
 future. Thus, the HR value will appear in the financial statements at its replacement
cost.

3. Opportunity cost method: This method has been suggested by Hekimian and
Jones and refers to the valuation of HR on the basis of an employee’s value in
alternative uses, i.e., opportunity cost. This cost refers to the price other divisions are
willing to pay for the service of an employee working in another division of an
organization.
4. Capitalization of Salary method: This method had been proposed by Baruch
Lev and Aba Schwartz in terms of economic value of HR. According to them, the
salaries payable to employees during their stay with the organization may be used in
valuing the HR of an organization. Thus the value of HR is the present value of
future earnings of homogeneous group of employees..

5. Economic valuation method: The values the HR of an organization by

considering the present worth of the employees’ future service expected to be
derived during their stay with the organization. Under this method, the valuation of
HR involves 3 steps – 1) estimation of employee’s future services, 2) multiply step 1
by the employee’s rate of pay and 3) Multiply step 2 by the rate of return on
investment. This would give the present worth of employee’s service.

6. Return on efforts employed method: Under this method, HR valuation is done

on the basis of the quantifying the efforts made by the individuals for the
organizational benefits by taking into account factors such as –positions an
employee holds, degree of excellence employee achieves, and the experience of the
employee.

7. Adjusted discounted future wages method: This model has been developed by
Roger.H.Hermanson. Under this method, HR valuation is done on the basis of
relative efficiency of an organization in the industry. This model capitalizes the extra
profit a firm earns over and above that of the industry expectations.

As such, this model involves 4 steps –

1) Estimation of 5 years (succeeding) wages and salaries payable to different levels of employees

2) Finding out the present value of such estimated amount at the normal rate of return of the industry,

155
 3) Determining the average efficiency ratio (the co’s average rate of return for the past 5 yrs)/
Industry’s average rate of return for the past 5 yrs) for 5 years,

4) Finding out the present value of future services of the co’s Hr by multiplying the discount value
(as in 2nd step) by the firm’s efficiency ratio (as calculated in 3rd step)

Reward valuation method: This model has been developed by Flamholtz and is
commonly known as – the stochastic rewards valuation model. It values the HR of a
concern on the basis of an employee’s value to an organization at various service states
(roles) that he is expected to occupy during the span of his working life with the
organization. This model involves – estimation of an employee’s expected service life,
identifying the set of service roles he may occupy during his service life, estimating the
value derived by an organization at a particular service state of a person for the
specified time period, estimating the probability that a person will occupy at possible
mutually exclusive service state at specified future times, quantifying the total services
derived by the organization from all its employees, and discounting the total value thus
arrived at to its present value at a pre determined rate.

3. What is Accounting information system? Who are the users of

accounting information and based on the usage what are different
branches of accounting?

DEFINITION OF ACCOUNTING:

The American Institute of certified public accountants (AICPA) defines accounting as

“the art of recording, classifying and summarizing in a significant manner and in terms
of money transactions and events which are in part at least of a financial character and
interpreting the results thereof”.

FUNCTIONS OF FINANCIAL ACCOUNTING

1. Keeping systematic records
2. Protecting the properties of the business
3. Communicating the results to the stake holders of the business
4. Meeting the legal requirements

156
LIMITATIONS OF FINANCIAL ACCOUNTING
1. Only transactions which can be measured in terms of money can be recorded in
the books of accounts. However events which may be important to the business
do not find a place in the accounts if they cannot be measured in terms of money.
2. According to the cost concept assets are recorded at the cost at which they are
acquired and therefore, the changes in values of assets brought about by changing
value of money and market factors are ignored.
3. There is conflict between one accounting principle and another. For example,
current assets are valued on the basis of cost or market price whichever less
according to the principle of conservatism is. Therefore in one year cost basis
may be taken, whereas in another year market price may be taken. This principle
contravenes the principle of consistency.
4. The balance sheet is largely the result of the personal judgment of the accountant
with regard to the adoption of accounting policies and as such objectivity factor is
lost.
5. Financial accounting can be understood only by persons who have accounting
knowledge.
6. Inter firm comparison and comparative study of two periods is not possible under
this system as required past information cannot be made available.
7. Financial accounting does not indicate the cost behaviour, therefore cost control
cannot be adopted.

COST ACCOUNTING

DEFINITION: According to the Institute of Cost and Works Accountants (ICWA),

London, Cost accounting is “the process of accounting for costs from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship with
cost centers and cost units. In its widest usage it embraces the preparation of statistical
data, the application of cost control methods and the ascertainment of the profitability of
activities carried out or planned.”

OBJECTIVES OF COST ACCOUNTING:

1. To aid in the development of long range plans by providing cost data that acts as a
basis for projecting data for planning.
2. To ensure efficient cost control by communicating essential data costs at regular
intervals and thus minimize the cost of manufacturing.
3. Determine cost of products or activities, which is useful in the determination of
selling price or quotation.
4. To identify profitability of each product, process, department etc of the business
5. To provide management with information in connection with various operational
157
 problems by comparing the actual cost with standard cost, this reveals the
discrepancies or variances.

LIMITATIONS OF COST ACCOUNTING

Cost Accounting like other branches of accountancy is not an exact science but is an art
which was developed through theories and accounting practices based on reasoning and
commonsense. These practices are dynamic. Hence, it lacks a uniform procedure
applicable to all the industries across. It has to be customized for each industry, company
etc.

MANAGEMENT ACCOUNTING

DEFINITION: According to M.A.Sahaf, Management Accounting is “a system for

gathering, summarizing, reporting and interpreting accounting data and other financial
information primarily for the internal needs of the management. It is designed to assist
internal management in the efficient formulation, execution and appraisal of business
plans.”
Management Accounting covers not only the use of financial data and a part of costing
theory but extends beyond these aspects. It scope covers
1. Financial accounting
2. Cost accounting
3. Financial statement analysis
4. Budgeting
5.
6. Inflation accounting
7. Management reporting
8. Quantitative techniques
9. Tax accounting
10. Internal audit
11. Office services

FUNCTIONS OF MANAGEMENT ACCOUNTING:

1. To help the management in planning, forecasting and policy formulation
2. To help in analysis and interpretation of financial information
3. To help in decision making- long term as well as short term
4. To help in controlling and coordinating the business operations
5. To communicate and report the operational results to the share and stock holders
of the business.
6. To motivate the employees by encouraging them to look forward
7. To help the management in tax administration

158
TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING
1. Financial planning
2. Analysis of financial statements
3. Cost accounting
4. Standard costing
5. Marginal costing
6. Budgetary control
7. Funds flow analysis
8. Management reporting
9. Statistical analysis

ADVANTAGES OF MANAGEMENT ACCOUNTING:

1. It increases efficiency of business operations
2. It ensures efficient regulation of business activities
3. It ensures utilization of available resources and thereby increases the return on
capital employed.
4. It ensures effective control of performance
5. It helps in evaluating the efficiency of the companies’ business policies

LIMITATIONS OF MANAGEMENT ACCOUNTING:

1. It is based on historical data, and it suffers from the drawbacks of the financial
statements.
2. The application of management accounting tools and techniques requires people
who are knowledgeable in subjects such as accounting, costing, economics,
taxation, statistics, mathematics, etc.
3. Though management accounting attempts to analyse both qualitative and
quantitative factors that influence a decision, the elements of intuition in
managerial decision making have not been completely eliminated.
4. The installation of management accounting system is expensive and hence not
suitable for small firms.

4. Explain the concept related to balance sheet.

Accounting concepts The term ‘Concept’ is used to mean necessary assumptions and
ideas which are fundamental to accounting practice. The various accounting concepts are
as follows:

159
Business Entity concept : For accounting purposes, the proprietor of an enterprise is
always considered to be separate and distinct from the business which he/she controls

Dual aspect concept: Every business transaction involves two aspects – a receipt and a
payment. In other words, every debit has an equal and corresponding credit. The dual
aspect concept is expressed as: Capital + Liabilities = Assets. This is known as ‘the
accounting equation’.

Going concern concept: Under this assumption, the enterprise is normally viewed as a
going concern. It is assumed that the enterprise has neither the intention nor the necessity
of liquidation of curtailing materially the scale of its operations. That is why assets are
valued on the basis of going concern concept and are depreciated on the basis of expected
life rather than on the basis of market value.

Accounting period concept: ‘Accounting year’ is the period of 12 months for which
accounts are to be prepared under the Companies Act and Banking Regulation Act.

Money measurement concept: In accounting, every event or transaction which can be

expressed in terms of money is recorded in the books of accounts. This concept does not
record any fact or happening, even though it is important to the business, in the books of
accounts if it cannot be expressed in terms of money. And as per this concept, a
transaction is recorded at its money value on the date of occurrence and the subsequent
changes in the money value are conveniently ignored.

Historical Cost concept : The underlying idea of cost concept is –i) asset is recorded at
the price paid to acquire it, that is, at cost and ii) this cost is the basis for all subsequent
accounting for the asset. Fixed assets are shown in the books of accounts at cost less
depreciation. Current assets are periodically valued at cost price or market price
whichever less is.

Revenue recognition concept: In accounting, ‘revenue’ is the gross inflow of cash,

receivables or other considerations arising in the course of an enterprise from the sale of
goods, from the rendering of services and from the holding of assets. In the case of
revenue, the important question is at what stage, the transaction should be recognized and
recorded.

Periodic matching of cost and revenue concept: After the revenue recognition, all
costs, incurred in earning that revenue should be charged against that revenue in order to
determine the net income of the business.
Verifiable objective evidence concept: As per this concept, all accounting must be
based on objective evidence. In other words, the transactions should be supported by
verifiable documents.

160
 Accrual concept: Under this concept, revenue recognition and costs for the relevant
period, depends on their realization and not on actual receipt or payment. In relation to
revenue, the accounts should exclude amounts relating to subsequent period and provide
for revenue recognized, but not received in cash. Like wise, in relation to costs, provide
for costs incurred but not paid and exclude costs paid for subsequent period.

Accounting conventions
The term ‘convention’ is used to signify customs or traditions as a guide to the
preparation of accounting statements. The various accounting conventions are as follows.

Convention of disclosure: This convention implies that accounts must be honestly

prepared and all material information must be disclosed therein. The term ‘disclosure’
implies that there should be a sufficient disclosure of information which is of
material interest to proprietors, potential creditors and investors. This concept also
applies to events occurring after the balance sheet date and the date on which the
financial statements are authorized for issue, which are likely to have a substantial
influence on the earnings and financial position of the enterprise. Their non-disclosure
would affect the ability of the users of such statements to make proper evaluations and
decisions.

Convention of materiality: As per this convention, financial statements should disclose

all items which are material enough to effect evaluations or decisions. The American
Accounting Association (AAA) defines ‘materiality’ as “an item should be regarded as
material if there is reason to believe that knowledge of it would influence the decision of
informed investor”. Unimportant items can be either left out or merged with other items.
Sometimes, items are shown as footnotes or in parentheses according to their relative
importance.

Convention of consistency: Consistency, as used in accounting means that persistent

application of the same accounting procedures or method by a given firm from one time
period to the next so that the financial statements of different periods can be compared
meaningfully. This convention thus implies that in order to enable the management to
draw important and meaningful conclusions of performance over a period or between
different firms, accounting practices should remain unchanged for a fairly long time.

Convention of conservatism: According to this convention, the accountant should be

conservative in his/her approach in his opinions and selection of procedure. In
accounting, conservatism refers to the early recognition of unfavorable events. For
instance, all possible and expected losses must be provided for. On the other hand, gains
and other financial benefits should not be provided for unless they are realized. In other
words, ‘anticipate no profit and provide for all possible losses’.

161
5. Discuss the concept of Human Resource Accounting. Explain its
importance in the present context.
According to the American Accounting Association (1973), HR Accounting is ‘the
process of identifying and measuring data about human resources and communicating the
information to interested parties’. In the words of Stephen Knauf – HR Accounting is ‘the
measurement and quantification of human organization inputs, such as recruiting,
training, experience and commitment’.
 To provide relevant information about the human resource to the management and
aid in its decision making
 To help management in evaluating the performance of its personnel and calculate
its return on investment
 To help the management in planning and controlling the various functions or
activities related to its human resource such as – man power planning,
recruiting, training and retirement etc.

6. Differentiate between financial accounting and management accounting.

Management accounting and financial accounting comprise the two main branches of
accounting in general. To those unfamiliar with field, such a distinction may seem
gratuitous. However, the distinctions accounting are not merely nominal. Generally, data
related to events, transactions and activities within an organization form the common
source of information for management and financial accounting. There are six major
differences between them.

= Purpose =Financial accounting is designed to state the financial position of an

organization and provide information about its revenue generation/profits to stakeholders.
It is geared towards external information users- primarily regulators, government and
owners. Management accounting has an internal focus, on the other hand.
Accountants/accounting clerks prepare such information for internal managers, who use
it to aid and facilitate planning, decision-making and control.

= Legal requirement Mgt. accounting is optional - used solely at the discretion of an

organization’s managers. External stakeholders usually do not even view management
accounts. This is because there is no legal requirement for any organization to prepare
management accounts. Financial accounts are for external users. However, only limited
liability companies bear the legal obligation to produce these accounts.

= Format and standards =The formats of management accounts are exclusively at the
discretion of managers. However, financial reports must adhere to International Financial
Reporting Standards and International Accounting Standards. This makes financial
reports virtually standardized while management accounting formats and systems vary
162
widely among and within organizations.

= Scope =Financial accounts represent an aggregate of entities, activities and operations

for the whole organization, including any subsidiaries. The focus of management
accounts is far more specific, as it deals with particular activities, sections or
departments. Therefore, it has an inherently narrower focus than financial accounting.

= Content =Financial reports usually deals with financial information. In other words,
most things in a financial report are of a monetary nature (having a dollar value).
Management accounts incorporate both monetary and non-monetary measures, i.e.
financial and non-financial information. This does not mean that financial reports are not
complete- just that data needs to be transformed to monetary figures for financial reports.
After all, financial reports do not account for productivity or employee morale.

= Period covered =By nature, financial accounts provide a historical representation of an

organization’s operations for a defined period. Management accounts can provide aspects
of past operations and projections for future operations, since they are also planning and
decision-enabling tools.
The differences between te two types of accounting is significant to management and
accountants. Since information has objectives that information users define, production of
management accounts and financial accounts consider the needs of these users, whether
internal or external. Since financial reports for limited liability companies are mandatory
and regulated, it merely requires conformity.

7. Define Human Resources Accounting. Explain their uses and abuses?

HR Accounting is ‘the process of identifying and measuring data about human resources
and communicating the information to interested parties’. In the words of Stephen Knauf
– HR Accounting is ‘the measurement and quantification of human organization inputs,
such as recruiting, training, experience and commitment’.
The various advantages a firm can enjoy by establishing HR Accounting are as follows:
 Its adoption acts as a motivating factor for the employees of the concern as it is
reflected in its financial statements
 It helps the management in identifying and controlling several problems related to
human resources
 It enables the management in efficiently using its man power by providing
quantified information about its HR
 By considering HR as an asset in its financial statements, it provides a measure of
profitability
 It helps the investors or potential investors in assessing the true value of a firm by
providing realistic information about its HR.

163
At the same time, a firm may also face certain limitations in implementing HRA such as:
1. HR as an asset cannot be owned by any firm.
2. Quantification of HR value is subjective in nature and there is no common
valuation model which can be used across the industries or by all the companies
in the same industry
3. As its establishment and implementation involves huge cost, it may not suit small
firms.
4. The concept of HRA is not recognized by tax authorities and has only academic
value.
5. There is no objective procedure to be followed in the valuation of the HR, hence
comparative analysis may not be possible, and even if possible, may not be
reliable.

8. Differentiate between management accounting and cost accounting.

Point of difference Cost accounting Management Accounting

Objectives The objectives of cost The objective management
accounting is the accounting is to help the
ascertainment and control management in decision
of products or services making, planning, and
control.
Scope Cost accounting deals But management
primarily with cost data. accounting deals with both
cost and revenue.
Data used In cost accounting only Management accounting
those transaction which can uses both quantitative
be expressed in figures are information and qualitative
taken. Only quantitative information.
aspect is recorded in cost
accounting.
Nature Cost accounting uses both Management accounting is
past and present figures. concerned with the
projection of figures for
futures.

164
 UNIT-II

1. What is inventory? Describe the various methods of pricing issue of materials.

The term inventory includes stock of

(i) finished goods

(ii) work-in-progress and

(iii) raw materials and components. In case of a trading concern, inventory primarily
consists of finished goods while in case of a manufacturing concern; inventory consists of
raw materials, components, stores, work-in-process and finished goods.

Methods of valuation of inventories or Pricing Issues of Material:

Materials issued from stores should be valued at the rate they are carried in stock. The
various methods for pricing material issued from stores are classified as follows:

1) Specific identification method

This method is applicable to materials purchased for a particular job, order or process,
and identified when received either in stores or in the shop floor directly. Such materials
are usually non-standard and actual cost is charged to the job/order/process concern. No
question of difference arises out of such pricing.

2) First in First out (FIFO)

This method assumes that materials are used in the order in which they are received in
stores (chronologically). Hence the price of the first lot is charged to all issues till the
stock lasts. As a result closing stock will be valued at latest purchase price. This method
is useful in the slow moving or less frequently used materials of bulk items and high unit
costs.

3) Last in First out (LIFO)

This method assumes that the last receipt of stock is issued first. Hence issues are priced
at current prices, while stock remains at historical cost. This method is useful under the
165
inflationary conditions of the market. This method is useful for materials used less
frequently and under inflationary conditions.

4) Highest in First out (HIFO)

Under this method issues are valued at their highest price i.e. costliest items are issued at
first, and inventory is kept at lowest possible prices. Thus a secret reserve is created by
undervaluing stock. This method is complicated to administer if there are numerous
purchases within a short period. This method is mainly used for monopoly products or
cost plus contracts.

5) Base Stock Method

This method assumes that a minimum stock is always carried at original cost. The issues
are priced using one of the conventional method like FIFO, LIFO, etc, at actual costs.
This method will be suitable for tanning, smelting, oil refineries, etc. which use basic raw
materials like hides, non-ferrous metal, and crude oil for their products.

6) Next in First out (NIFO)

Under this method issues are valued at the price expected the next purchase i.e. price of
material which has been ordered but not yet received. Problem may arise if the price
ruling at the time of supply differs from the purchase order price. However this method
attempts to value issues at nearest to current market prices.

7) Weighted Average Price Method

This method gives due importance to quantities received also. Issue prices are calculated
at average cost price of materials in hand i.e. by dividing the value of materials in stock
by the quantities in stock. Weighted average price remains the same till the next issue is
received. Thus issue prices are derived at the time of receipt but not at the time of issues.
This method is suitable where wide fluctuation of prices occurs as it evens out prices over
the accounting period.

166
2. Explain preformation of a final account.

TRADING ACCOUNT

Dr Cr
TO BY
OPENING STOCK
PURCHASE XXX SALES XXX
LESS: PURCHASE RETURN XX LESS: SALES RETURN XXX XX
XXX X CLOSING X
WAGES XX STOCK XX
CARRIAGE X GROSS LOSS X
INWARD FUEL XX TRANSFERRED TO XX
AND POWER X PROFIT AND LOSS X
DIRECT XX ACCOUNT
EXPENSES X
GROSS PROFIT XX
HEATING AND X
LIGHTING XX
TRANSFERRED TO X
PROFIT AND LOSS XX
ACCOUNT X
XX
X
XX
X

XXX

XXX

167
 PROFIT AND LOSS ACCOUNT

Dr
Cr
TO BY

SALARIES XX GROSS PROFIT XX

RENT X DISCOUNT X
INSURANCE XX RECEIVED XX
CARRIAGE X COMMISSION X
OUTWARDS XX RECEIVED XX
TELEPHONE X REDUCTION IN PROVISION X
PROVISION FOR XX FOR XX
DEPRECIATION X BAD DEBT X
BAD DEBTS WRITTEN XX PROFIT ON SALE OF FIXED XX
OFF ADD: INCREASE IN X ASSET NET LOSS X
BAD DEBTS COST OF XX TRANSFERRED TO XX
SAMPLES X CAPITAL X
ADVERTISING XX ACCOUNT
INTEREST ON X XXX
LOAN XX
DISCOUNT X
ALLOWED TO NET XX
PROFIT X
TRANSFERRED TO XX
CAPITAL ACCOUNT X
XX
X
XX
X
XX
X

XXX
XXX XXX

168
 BALANCE SHEET

D
r
C
r
LIABILITIES RS RS ASSET RS RS
S
LONG FIXED ASSETS :
TERM
LIABILITI XXX PLANT AND XXX
ES: MACHINERY
XX LESS : PROVISION FOR XXX XXX
OWNER'S X XX DEPRECIATION XXX
CAPITAL XX X FURNITURE AND
ADD: NET PROFIT X XX FIXTURES XXX
FROM X LESS : PROVISION FOR
P&L DEPRECIATION
ACCOUNT XXX
LESS : DRAWINGS CURRENT ASSET :
XX XXX
BANK
X
OVERDRAFT STOCK
XX XXX
X SUNDRY XX
CURRENT XX DEBTORS LESS : X
LIABILITIES: X PROVISION FOR XX
XX BAD X
SUNDR X AND XX
Y DOUBTFUL DEBT X
CREDITORS BILLS XX
BILLS PAYABLE RECEIVABLE X
OUTSTANDING XX CASH AT BANK XX
EXPENSES X CASH IN HAND X
PREPAID
EXPENSES

169
 UNIT-III

1. What are the accounting ratios? Explain its uses and limitations.
A ‘Ratio: is defined as an arithmetical/quantitative/ numerical relationship between two
numbers. Ratio analysis is a very important and age old technique of financial analysis.

Uses of Ratio Analysis: There are various uses of Ratio analysis, some of which are as
follows:
 It helps in managerial decision making.
 It helps in financial forecasting and planning.
 It helps in communicating the financial strength of a concern.
 It helps in control.
 It is an essential part of budgetary control and standard costing.
 It helps an investor/prospective investor in decision making.
 It provides information to the creditors about the solvency of the firm.
 It helps the employees by providing information about the profitability of the
concern.
 It helps the government in policy making by providing financial information
about the industry/firm etc.
 It facilitates inter-firm; intra-firm; and firm-industry comparison.
Limitations of Ratio Analysis: In spite of the various uses of ratio analysis, it suffers
from certain limitations, some of which are given below.

1. Limited use of a single ratio: A single ratio does not convey any meaning. Ratios
are useful only when calculated in sufficient nos.
2. Lack of adequate standards: It is difficult to set ideal ratios for each firm/industry.
And also setting of standard ratios for all the firms in every industry is also
difficult.
3. Inherent limitations of accounting: As Ratio analysis is based on financial
statements, the analysis suffers from the limitations of financial statements.
4. Change of accounting procedure: If different methods are followed by different
firms for their valuation, comparison will practically be of no use.
5. Window dressing: Ratios based on dressed up (manipulated) financial information
are not of much use as they show unreliable position of the firm
6. Personal bias: Different people will interpret the same ratio in different ways.
Thus, there is always the possibility that interpretation of the data may be
170
 different for different people, and this in turn may result in many inferences for
the same data, which may be confusing.
7. Price level changes are not provided for in ratio analysis which may lead to a
misleading interpretation of business operations.
8. Ignorance of qualitative factors: Ratios are tools of quantitative analysis only and
normally qualitative factors which may generally influence the conclusions, (ex –
a high current ratio may not necessarily mean sound liquid position when current
assets include a large inventory consisting mostly of obsolete items) are ignored
while they are calculated.

2. State the uses and significance of cash flow

statement. Uses of cash flow statements:

1. It enables the effective planning and coordination of financial operations.

2. It enables proper allocation of cash among the various activities of the firm.
3. It aids the management in its investment decision.
4. It enables the management in properly analyzing the past business activities and plan
for future.
5. It gives the liquidity picture of the concern.

3. Differentiate fund flow statements and cash flow statements.

Cash Flow Statement Vs Funds Flow Statement: Both the Funds Flow Statement and the
Cash Flow Statement give almost similar picture of the firm. They don’t differ much
from each other. However, some of the differences between each other are as follows:
1. The Funds Flow Statement is much wider in purview than the Cash Flow Statement as
it indicates the changes in the Working Capital whereas the Cash Flow Statement
indicates the inflow and outflow of cash which is only one of the components of the
Working Capital.
2. Funds Flow Analysis is based on mercantile system of accounting whereas Cash Flow
Analysis is based on cash system of accounting.
3. Funds Flow Analysis is useful for long term planning as it provides more
comprehensive information than the Cash Flow Analysis which is more useful for short
term planning.
4. Funds Flow Analysis traces the inflows and outflows of funds whereas Cash Flow
Analysis traces the inflows and outflows of cash within the firm.
5. Funds Flow Analysis analyses the changes in the Working capital under a separate
statement known as schedule for changes in working capital whereas in Cash Flow
Analysis, the changes in both current and non-current items are done in a single
statement.
4. Explain the methods of financial statement analysis.
There are around five techniques of analyzing the Financial Statements. They are:
1. Comparative Financial Statements
171
 2. Common size Financial Statements
3. Trend Analysis
4. Ratio Analysis
5. Funds Flow and Cash Flow Analysis

5. Draw a specimen form of fund flow statement.

SCHEDULE OF CHANGES IN WORKING CAPITAL

Particulars Previous Year Current Year Increase Decrease

Current Assets

Current Liabilities

Increase/Decrease
in Working Capital

FUNDS FROM OPERATION OR ADJUSTED PROFIT &

LOSS ACCOUNT

TO BY

GOODWILL XX OPENING XX
GENERAL X BALANCE X
RESERVE XX REFUND OF TAX XX
PRELIMINARY EXPENSES X DIVIDEND X
DISCOUNT ON ISSUE OF XX RECEIVED XX
SHARE DEPRESSION OF X PROFIT ON SALE OF FIXED X
FIXED ASSET LOSS ON XX XX
FIXED ASSET DISCOUNT X ASSET FUND FROM X
ON ISSUE OF XX
DEBENTURES X OPERATION XX
PROVISION FOR TAX XX X
PROPOSED DIVIDEND X
XX XX
CLOSING BALANCE
X X
172
 XX
X
XX
X
XX
X
XX
X

STATEMENT OF SOURCES AND USES

SOURCES : USES :

FUNDS FROM OPERATION XX INCREASE IN WORKING XX

DECREASE IN WORKING X CAPITAL LOSS FROM X
CAPITAL XX OPERATION REDEMPTION XX
ISSUE OF SHARES X OF SHARES REDEMPTION X
ISSUE OF XX OF DEBENTURES XX
DEBENTURES X PAYMENT OF TAX X
SALES OF FIXED XX PAYMENT OF DIVIDEND XX
ASSET X PURCHASE OF FIXED X
BORROWING FROM BANK XX ASSETS DRAWINGS XX
X X
XX XX
X X
XX
XX X
X XX
X

XX
X

173
 UNIT IV

1. What is budget? Explain various types of budgets.

A BUDGET is a quantitative expression of a business plan for a specified future period,

usually a year.
BUDGET is the planned future course of action
BUDGET is a plan of action expressed in financial or non-financial terms.
BUDGET is a financial or quantitative statement prepared prior to a defined period of the
policy to be pursued during the period for that purpose of attaining a given objective -
ICMA.

DEFINITION OF BUDGET
According to the Institute of Cost & Management (ICMA), London, a BUDGET is ‘a
financial and / or quantitative statement, prepared and approved prior to a defined period
of time, of the policy to be pursued during that period for the purpose of attaining a given
objective. It may include income, expenditure and the employment of capital’.

CLASSIFICATOIN OF BUDGETS
Budgets can be classified on the basis of many bases. There are three popular bases for
classifying budgets. They are – time, functions and flexibility. Apart from these
classifications, several other budgets can also be found in practice such as – performance
174
 budget, ZBB, control ratios etc

ON THE BASIS OF TIME

 Long term budget: According to National Association of Accountants, America, a
long term budget is, a systematic and formalized process for purposeful directing and
controlling future operations towards a desired objective for periods extending
beyond one year.
 Short term budget : Short term budget covers a budget period of one year or less.
 Current budget : These budgets cover a very short period such as a month or a
quarter. They are essentially short term budgets adjusted to current conditions or
prevailing circumstances.

ON THE BASIS OF FUNCTIONS

 Functional / Subsidiary budgets: A Functional budget is a budget of income or
expenditure appropriate to or the responsibility of functions, such as production,
sales, purchase etc. Each functional department prepares its own budget, and all these
functional budgets are integrated into the Master budget.

Sales budget: It gives details about volume, price and sales mix. It also gives details
about the quantity of sale, month-wise or quarter-wise, market-wise, area-wise and on
whatever other basis be important to the organization. The responsibility for
preparation of this budget falls on the sales manager. While preparing this budget,
he/she has to consider certain influencing factors such as – past sales figures and
trend, salesmen’s estimates, plant capacity, general trade practice, orders in hand,
proposed expansion or discontinuance of products, seasonal fluctuations, potential
market, availability of material and supply, finance etc.

Production budget: It includes details about the types, quantity and cost of goods and
services produced in the organization. The responsibility of preparing this budget falls
on the Works manager or departmental Works managers.

Production cost budget: It is divided into material cost budget, labour cost budget
and overhead cost budget, because cost of production includes material, labour and
overheads.

Materials budget: It includes details about the kinds and quantity of material
required, price paid for it, cost of transportation and storage, etc

Labor budget: It includes details about the types and number of workers, the number
of hours required, the wage rates and other allowances, the welfare and other facilities
provided and cost thereof etc.

175
 Overheads budget: It gives details of items of factory overhead expenses, their
quantity and cost.

Research and Development budget: Every organization of some size, particularly, of

a manufacturing or technical type, has a Research and Development Department.
Expenses incurred by it are parts of operating cot, until efforts lead to some findings
that can be used for improvement of quality of product technology improvement,
and/or for producing something new, at which stage all expenses incurred are
capitalized.

Capital expenditure budget: This budget shows the estimated expenditure on fixed
assets such as land and buildings, plant and machinery, etc. It is a long term budget.
This budget is prepared to plan for replacement of old machines, increased demand of
products, expansion of activities, etc.

Cash budget: A Cash budget deals with cash, including its equivalent, like bank
balance and bills receivable. It shows the inflows of cash and outflows of cash during
a particular period of time. It can be prepared for a year, but for better control and
management of cash, it is normally prepared on monthly basis. It takes into account
only cash transactions.

 Master budget: This budget is prepared from, and summarizes the various functional
budgets. It is also called as summary budget. It generally includes details relating to
production, sales, stock, debtors, cash position, fixed assets etc, in addition to
important control ratios.

ON THE BASIS OF FLEXIBILITY

 Fixed budget: A Fixed budget is designed to remain unchanged irrespective of the

volume of output or turnover attained. The budget remains fixed over a given period
and does not change with the change in the volume of production or level of activity
attained.

 Flexible budget: It is also known as variable budget. A Flexible is designed to

change along with the changes in the output or turnover. It changes according to the
levels of activity.

2. What is meant by budgetary control system? Describe the

essential steps of a budgetary control system.
176
 BUDGET ARY CONTROL is the system of management control and accounting in
which all operations are forecasted as far as possible and are planned ahead and actual
results are compared with planned & forecasted ones - J.A.SCOTT.

STEPS IN BUDGETARY CONTROL

1. Quantification of plans in relation to production, sales, distribution and finance in
terms of goals and objectives set by the management. i.e., Prepare budgets for
each section of organization
2. Record actual performance
3. Compare actual & budgeted performances
4. Remedial action to be taken if there is any difference
5. Revise budgets if necessary
ESSENTIALS OF SUCCESSFUL BUDGETARY CONTROL
1. Top management support
2. Clearly defined organization structure
3. Efficient accounting system
4. Reporting of deviations
5. Motivation
6. Realistic targets
7. Participation of all departments concerned
8. Flexibility

3. Explain the application of marginal cost analysis for managerial decision making.
4. Marginal cost means the cost of the marginal or last unit produced. It is also defined
as the cost of one more or one less unit produced besides existing level of production. In
this connection, a unit may mean a single commodity, a dozen, a gross or any other
measure of goods.
For example, if a manufacturing firm produces X unit at a cost of 300 and X+1 units at a
cost of 320, the cost of an additional unit will be 20 which is marginal cost. Similarly if
the production of X-1 units comes down to 280, the cost of marginal unit will be 20
(300–280).

Features of Marginal Costing

The main features of marginal costing are as follows:

1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and
fixed costs. It is the variable cost on the basis of which production and sales policies
177
 are designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various
decisions. Marginal contribution is the difference between sales and marginal cost. It
forms the basis for judging the profitability of different products or departments.

Advantages and Disadvantages of Marginal Costing

Technique Advantages
 By not charging fixed overhead to cost of production, the effect of varying
charges per unit is avoided.
 It prevents the illogical carry forward in stock valuation of some proportion of
current year’s fixed overhead.
 The effects of alternative sales or production policies can be more readily
available and assessed, and decisions taken would yield the maximum return to
business.
 It eliminates large balances left in overhead control accounts which indicate the
difficulty of ascertaining an accurate overhead recovery rate.
 Practical cost control is greatly facilitated. By avoiding arbitrary allocation of
fixed overhead, efforts can be concentrated on maintaining a uniform and
consistent marginal cost. It is useful to various levels of management.
 It helps in short-term profit planning by breakeven and profitability analysis, both
in terms of quantity and graphs. Comparative profitability and performance
between two or more products and divisions can easily be assessed and brought to
the notice of management for decision making.

Disadvantages
1. The separation of costs into fixed and variable is difficult and
sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal
operating volume and this shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories affect profit and true
and fair view of financial affairs of an organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of
fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in
case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on
the actual and as such there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted
178
 by many. In order to know the net profit, we should not be satisfied with
contribution and hence, fixed overhead is also a valuable item. A system which
ignores fixed costs is less effective since a major portion of fixed cost is not taken
care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may
vary. Thus, the assumptions underlying the theory of marginal costing sometimes
becomes unrealistic. For long term profit planning, absorption costing is the only
answer.

4. Indicate the uses and abuses of standard costing.

Discuss in detail. Definition
The CIMA, London has defined standard cost as “a predetermined cost which is
calculated from management’s standards of efficient operations and the relevant
necessary expenditure.” They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a prescribed set of
working conditions. In other words, a standard cost is a planned cost for a unit of product
or service rendered.
The technique of using standard costs for the purposes of cost control is known as
standard costing. It is a system of cost accounting which is designed to find out how
much should be the cost of a product under the existing conditions. The actual cost can be
ascertained only when production is undertaken. The predetermined cost is compared to
the actual cost and a variance between the two enables the management to take necessary
corrective measures.

Advantages
Standard costing is a management control technique for every activity. It is not only
useful for cost control purposes but is also helpful in production planning and policy
formulation. It allows management by exception. In the light of various objectives of this
system, some of the advantages of this tool are given below:
1. Efficiency measurement-- The comparison of actual costs with
standard costs enables the management to evaluate performance of various cost
centers. In the absence of standard costing system, actual costs of different period may
be compared to measure efficiency. It is not proper to compare costs of different
period because circumstance of both the periods may be different. Still, a decision
about base period can be made with which actual performance can be compared.
2. Finding of variance-- The performance variances are
determined by comparing actual costs with standard costs. Management is able to spot
out the place of inefficiencies. It can fix responsibility for deviation in performance. It
is possible to take corrective measures at the earliest. A regular check on various
expenditures is also ensured by standard cost system.
3. Management by exception-- The targets of different individuals
are fixed if the performance is according to predetermined standards. In this case, there
179
 is nothing to worry. The attention of the management is drawn only when actual
performance is less than the budgeted performance. Management by exception means
that everybody is given a target to be achieved and management need not supervise
each and everything. The responsibilities are fixed and every body tries to achieve
his/her targets.
4. Cost control-- Every costing system aims at cost control and
cost reduction. The standards are being constantly analyzed and an effort is made to
improve efficiency. Whenever a variance occurs, the reasons are studied and
immediate corrective measures are undertaken. The action taken in spotting weak
points enables cost control system.
5. Right decisions-- It enables and provides useful information to
the management in taking important decisions. For example, the problem created by
inflating, rising prices. It can also be used to provide incentive plans for employees
etc.
6. Eliminating inefficiencies-- The setting of standards for
different elements of cost requires a detailed study of different aspects. The standards
are set differently for manufacturing, administrative and selling expenses. Improved
methods are used for setting these standards. The determination of manufacturing expenses
will require time and motion study for labor and effective material control devices for
materials. Similar studies will be needed for finding other expenses. All these studies will
make it possible to eliminate inefficiencies at different steps.

Limitations of Standard Costing

1. It cannot be used in those organizations where non-standard
products are produced. If the production is undertaken according to the customer
specifications, then each job will involve different amount of expenditures.
2. The process of setting standard is a difficult task, as it requires
technical skills. The time and motion study is required to be undertaken for this
purpose. These studies require a lot of time and money.
3. There are no inset circumstances to be considered for fixing
standards. The conditions under which standards are fixed do not remain static. With
the change in circumstances, if the standards are not revised the same become
impracticable.
4. The fixing of responsibility is not an easy task. The variances are
to be classified into controllable and uncontrollable variances. Standard costing is
applicable only for controllable variances.
For instance, if the industry changed the technology then the system will not be suitable.
In that case, we will have to change or revise the standards. A frequent revision of
standards will become costly.

5. Explain the elements of

Costs. Elements of costs
180
The cost of any product or service is the sum of various segments of the cost. Such
segments are treated as elements of cost e.g. the cost of a chair prepared out of a piece of
wood involves following cost elements:
Cost of raw materials (piece of wood)
Labor cost (wages paid to operator)
Overhead cost (Building and other services required for manufacturing chairs)

In general all types of manufacturing involve the following elements of cost:

 Direct material cost,

 Direct labor cost
 Direct expenses,
 Overhead cost;
 Factory overheads,
 Administrative overheads,
 selling and distribution overheads
 Direct materials cost:

Direct material cost in the cost of material (may be raw material unprocessed material
fully or partly processed material, components etc) used for the manufacture of the units.
It is directly traceable to the production units. The direct material cost includes the
purchase price as well as incidental expenses such as freight, insurance, loading and
unloading expenses, import duties etc. the expenses incurred or the primary packing
materials are also treated a direct material cost. The expenses incurred for grease and
oil, nails, etc leaning materials other consumable stores etc of common nature which
are not traceable to any point of production. So, they are treated as direct material cost
which forms a part of the overhead cost.

Direct labor cost: Direct labor cost consist of wages paid to the operators directly
engaged in the manufacturing of the product. It also includes the wages paid to all such
workers who are solely engaged in a particular type of production, job or contract which
are directly attributable to that specific cost unit e.g. wages paid to the worker engaged in
handling the product inside the department. Wages paid to the time keeper watchman
sweeper etc are common nature expenses and are treated as indirect labor expenses. They
are treated as indirect expenses and are treated as overhead costs.

Direct expenses are such expenses other than those incurred on direct material and direct
labor which can be directly attributed to the cost unit. Such expenses are specially
incurred on a particular job, contract or work order, e.g. cost of trial units, cost of special
designs drawings molds of patterns cost of hiring special tools and equipment,
181
consultancy for specific job etc.

It should be noted that direct cost, direct labor cost and direct expenses are collectively
known s prime cost.

Overhead costs: are the indirect costs which cannot be directly attributed to any particular
cost unit (i.e. a product, a job contract etc). They are also referred as overheads.
Aforesaid materials direct labor and direct expenses are treated as direct cost and all
expenses other than direct cost are treated as overheads or indirect expenses

Overheads are classified into the three groups:

(1) Factory overheads

(2) Administrative overheads, and
(3) Selling and distribution overheads

Factory overhead: Factory overheads include all indirect expenses which are incurred in
connection with the manufacture of a product. They are also known as works overheads,
or factory burden or works burden. Factory overheads may be fixed or variable. Fixed
factory overheads are those costs which do not vary with the volume of production e.g.
rent on factory building salary of watchman, time keeper, supervisor, expenses on labor,
welfare activities etc. Variable factory overheads vary directly with the volume of
production. They include cost of fuel and power, cost of repair and maintenance cost of
normal idle time of normal wastage and silage etc.

Administrative overheads include all those indirect expenses which are incurred in
respect of general administration and management of an enterprise. These expenses are of
common nature and are incurred for the business as a whole. They are apportioned
among cost units on some appropriate basis. Like factory overheads, administrative
overheads also tends be fixed and variable. The fixed administrative overheads include
rent and rates on office buildings, salaries to clerical staff, salaries to executives, salaries
to Managing director and directors’ legal charges audit fees etc. The variable expenses
may include items like stationery postage, telephone charges, Lighting and heating
expenses. They are more of a semi-variable mature.

Selling and distribution expenses are indirect costs which pertain to the marketing the
product or services. They are not directly related to the cost of the products, jobs,
contracts or services. Sometimes selling and distribution costs are separated with a view
to apportion these overheads on some accurate basis. Like other overheads they also
comprise on variable elements.

182
 UNIT-V

1. What are the functions performed by the

accounting system? Accounting
Information Systems (AISs)
Accounting Information Systems (AISs) combine the study and practice of
accounting with the design, implementation, and monitoring of information
systems. Such systems use modern information technology resources
together with traditional accounting controls and methods to provide users
the financial information necessary to manage their organizations.

AIS TECHNOLOGY

Input The input devices commonly associated with AIS include: standard
personal computers or workstations running applications; scanning devices
for standardized data entry; electronic communication devices for
electronic data interchange (EDI) and e- commerce. In addition, many
financial systems come "Web-enabled" to allow devices to connect to the
World Wide Web.
Process Basic processing is achieved through computer systems ranging
from individual personal computers to large-scale enterprise servers.
However, conceptually, the underlying processing model is still the
"double-entry" accounting system initially introduced in the fifteenth
century.
Output Output devices used include computer displays, impact and
nonimpact printers, and electronic communication devices for EDI and e-
commerce. The output content may encompass almost any type of financial
reports from budgets and tax reports to multinational financial statements.

MANAGEMENT INFORMATION SYSTEMS (MIS)

MISs are interactive human/machine systems that support decision making

for users both in and out of traditional organizational boundaries. These
systems are used to support an organization's daily operational activities;
current and future tactical decisions; and overall strategic direction. MISs
are made up of several major applications including, but not limited to, the
financial and human resources systems.
Financial applications make up the heart of an AIS in practice. Modules
commonly implemented include: general ledger, payables,
procurement/purchasing, receivables, billing, inventory, assets, projects,
and budgeting.
183
 Human resource applications make up another major part of modern
information systems. Modules commonly integrated with the AIS include:
human resources, benefits administration, pension administration, payroll,
and time and labor reporting.

AIS—INFORMATION SYSTEMS IN CONTEXT

AISs cover all business functions from backbone accounting transaction
processing systems to sophisticated financial management planning and
processing systems.
Financial reporting starts at the operational levels of the organization,
where the transaction processing systems capture important business events
such as normal production, purchasing, and selling activities. These events
(transactions) are classified and summarized for internal decision making
and for external financial reporting.
Cost accounting systems are used in manufacturing and service
environments. These allow organizations to track the costs associated with
the production of goods and/or performance of services. In addition, the
AIS can provide advanced analyses for improved resource allocation and
performance tracking.
Management accounting systems are used to allow organizational planning,
monitoring, and control for a variety of activities. This allows managerial-
level employees to have access to advanced reporting and statistical
analysis. The systems can be used to gather information, to develop various
scenarios, and to choose an optimal answer among alternative scenarios.

DEVELOPMENT
The development of an AIS includes five basic phases: planning, analysis,
design, implementation, and support. The time period associated with each
of these phases can be as short as a few weeks or as long as several years.
Planning—project management objectives and techniques The first
phase of systems development is the planning of the project. This entails
determination of the scope and objectives of the project, the definition of
project responsibilities, control requirements, project phases, project
budgets, and project deliverables.
Analysis The analysis phase is used to both determine and document the
accounting and business processes used by the organization. Such
processes are redesigned to take advantage of best practices or of the
operating characteristics of modern system solutions. Data analysis is a
thorough review of the accounting information that is currently being
collected by an organization. Current data are then compared to the data
that the organization should be using for managerial purposes. This method
is used primarily when designing accounting transaction processing
systems.
Decision analysis is a thorough review of the decisions a manager is
responsible for making. The primary decisions that managers are

184
responsible for are identified on an individual basis. Then models are
created to support the manager in gathering financial and related
information to develop and design alternatives, and to make actionable
choices. This method is valuable when decision support is the system's
primary objective. Process analysis is a thorough review of the
organization's business processes. Organizational processes are identified
and segmented into a series of events that either add or change data. These
processes can then be modified or reengineered to improve the
organization's operations in terms of lowering cost, improving service,
improving quality, or improving management information. This method is
appropriate when automation or reengineering is the system's primary
objective.
Design The design phase takes the conceptual results of the analysis phase
and develops detailed, specific designs that can be implemented in
subsequent phases. It involves the detailed design of all inputs, processing,
storage, and outputs of the proposed accounting system. Inputs may be
defined using screen layout tools and application generators. Processing can
be shown through the use of flowcharts or business process maps that
define the system logic, operations, and work flow. Logical data storage
designs are identified by modeling the relationships among the
organization's resources, events, and agents through diagrams. Also, entity
relationship diagram (ERD) modeling is used to document large-scale
database relationships. Output designs are documented through the use of a
variety of reporting tools such as report writers, data extraction tools, query
tools, and on-line analytical processing tools. In addition, all aspects of the
design phase can be performed with software tool sets provided by specific
software manufacturers.

Reporting is the driving force behind an AIS development. If the system

analysis and design are successful, the reporting process provides the
information that helps drive management decision making. Accounting
systems make use of a variety of scheduled and on-demand reports. The
reports can be tabular, showing data in a table or tables; graphic, using
images to convey information in a picture format; or matrices, to show
complex relationships in multiple dimensions.

There are numerous characteristics to consider when defining reporting

requirements. The reports must be accessible through the system's interface.
They should convey information in a proactive manner. They must be
relevant. Accuracy must be maintained. Lastly, reports must meet the
information processing (cognitive) style of the audience they are to inform.

Reports are of three basic types: A filter report that separates select data
from a database, such as a monthly check register; a responsibility report to
meet the needs of a specific user, such as a weekly sales report for a
regional sales manager; a comparative report to show period differences,
percentage breakdowns and variances between actual and budgeted
expenditures. An example would be the financial statement analytics
showing the expenses from the current year and prior year as a percentage

185
of sales.
Screen designs and system interfaces are the primary data capture devices
of AISs and are developed through a variety of tools. Storage is achieved
through the use of normalized databases that assure functionality and
flexibility.

Business process maps and flowcharts are used to document the operations
of the systems. Modern AISs use specialized databases and processing
designed specifically for accounting operations. This means that much of
the base processing capabilities come delivered with the accounting or
enterprise software.

Implementation The implementation phase consists of two primary parts:

construction and delivery. Construction includes the selection of hardware,
software and vendors for the implementation; building and testing the
network communication systems; building and testing the databases;
writing and testing the new program modifications; and installing and
testing the total system from a technical standpoint. Delivery is the process
of conducting final system and user acceptance testing; preparing the
conversion plan; installing the production database; training the users; and
converting all operations to the new system.

Tool sets are a variety of application development aids that are vendor-
specific and used for customization of delivered systems. They allow the
addition of fields and tables to the database, along with ability to create
screen and other interfaces for data capture. In addition, they help set
accessibility and security levels for adequate internal control within the
accounting applications.

Security exists in several forms. Physical security of the system must be

addressed. In typical AISs the equipment is located in a locked room with
access granted only to technicians. Software access controls are set at
several levels, depending on the size of the AIS. The first level of security
occurs at the network level, which protects the organization's
communication systems. Next is the operating system level security, which
protects the computing environment. Then, database security is enabled to
protect organizational data from theft, corruption, or other forms of
damage. Lastly, application security is used to keep unauthorized persons
from performing operations within the AIS. Testing is performed at four
levels. Stub or unit testing is used to insure the proper operation of
individual modifications. Program testing involves the interaction between
the individual modification and the program it enhances. System testing is
used to determine that the program modifications work within the AIS as a
whole. Acceptance testing ensures that the modifications meet user
expectations and that the entire AIS performs as designed.

Conversion entails the method used to change from an old AIS to a new
AIS. There are several methods for achieving this goal. One is to run the

186
 new and old systems in parallel for a specified period. A second method is
to directly cut over to the new system at a specified point. A third is to
phase in the system, either by location or system function. A fourth is to
pilot the new system at a specific site before converting the rest of the
organization.

Support The support phase has two objectives. The first is to update and
maintain the AIS. This includes fixing problems and updating the system
for business and environmental changes. For example, changes in generally
accepted accounting principles (GAAP) or tax laws might necessitate
changes to conversion or reference tables used for financial reporting. The
second objective of support is to continue development by continuously
improving the business through adjustments to the AIS caused by business
and environmental changes. These changes might result in future problems,
new opportunities, or management or governmental directives requiring
additional system modifications.

ATTESTATION
AISs change the way internal controls are implemented and the type of
audit trails that exist within a modern organization. The lack of traditional
forensic evidence, such as paper, necessitates the involvement of
accounting professionals in the design of such systems. Periodic
involvement of public auditing firms can be used to make sure the AIS is in
compliance with current internal control and financial reporting standards.
After implementation, the focus of attestation is the review and verification
of system operation. This requires adherence to standards such as ISO
9000-3 for software design and development as well as standards for
control of information technology.
Periodic functional business reviews should be conducted to be sure the
AIS remains in compliance with the intended business functions. Quality
standards dictate that this review should be done according to a periodic
schedule.

ENTERPRISE RESOURCE PLANNING (ERP)

ERP systems are large-scale information systems that impact an
organization's AIS. These systems permeate all aspects of the organization
and require technologies such as client/server and relational databases.
Other system types that currently impact AISs are supply chain
management (SCM) and customer relationship management (CRM).
Traditional AISs recorded financial information and produced financial
statements on a periodic basis according to GAAP pronouncements.
Modern ERP systems provide a broader view of organizational
information, enabling the use of advanced accounting techniques, such as
activity-based costing (ABC) and improved managerial reporting using a
variety of analytical techniques.

187
2. What are the features of computer or computerized accounting?

Computer and its characteristics

Computer is an electronic device that can perform a variety of operations in

accordance with a set of instructions called programme. It is a fast data
processing electronic machine. It can provide solutions to all complicated
situations. It accepts data from the user converts the data into information
and gives the desired result. Therefore, we may define computer as a device
that transforms data into information. Data can be anything like marks
obtained in various subjects. It can also be name, age, sex, weight, eight,
etc. of all the students, savings, investments, etc., of a country. Computer is
defined in terms of its functions. Computer is a device that accepts data,
stores data, processes data as desired, retrieves the stored data as and when
required and prints the result in desired format.
Characteristics of computer

A Computer is better than human being. It possesses some

characteristics. These are as follows:

Speed
It can access and process data millions times faster than humans can. It can
store data and information in its memory, process them and produce the
desired results. It is used essentially as a data processor. All the computer
operations are caused by electrical pulses and travels at the speed of light.
Most of the modern computers are capable of performing 100 million
calculations per second.

Storage
Computers have very large storage capacity. They have the capability of
storing vast amount of data or information. Computers have huge capacity
to store data in a very small physical space. Apart from storing information,
today’s computers are also capable of storing pictures and sound in digital
form.

Accuracy
The accuracy of computer is very high and every calculation is performed
with the same accuracy. Errors occur because of human beings rather than
technological weakness; main sources of errors are wrong program by the
user or inaccurate data.

188
Diligence
A computer is free from tiredness and lack of concentration. Even if it has
to do 10 million calculations, it will do even the last one with the same
accuracy and speed as the first.

Computer can perform wide range of jobs with speed, accuracy, and
diligence. In any organization, often it is the same computer that is used for
diverse purposes such as accounting, playing games, preparing electric
bills, sending e-mail and so on.

Communication
Computers are being used as powerful communication tools. All the
computers within an office are connected by cable and it is possible to
communicate with others in the office through the network of computer.

Processing Power
Computer has come a long way today. They began as mere prototypes at
research laboratories and went on to help the business organizations, and
today, their reach is so extensive that they are used almost everywhere. In
the course of this evolution, they have become faster, smaller, cheaper,
more reliable and user friendly.

3. What are the limitations of computerized accounting

system? The limitations of computer are depending upon
the operating environment they work in. These limitations
are given below as:

1.Cost of Installation
Computer hardware and software needs to be updated from time to time
with availability of new versions. As a result heavy cost is incurred to
purchase a new hardware and software from time to time.

2.Cost of Training
To ensure efficient use of computer in accounting, new versions of
hardware and software are introduced. This requires training and cost is
incurred to train the staff personnel.

3. Self Decision Making

The computer cannot make a decision like human beings. It is to be guided by the user.

4. Maintenance
189
 Computer requires to be maintained properly to help maintain its
efficiency. It requires a neat, clean and controlled temperature to work
efficiently.
5. Dangers for Health
Extensive use of computer may lead to many health problems such as
muscular pain, eyestrain, and backache, etc. This affects adversely the
working efficiency and increasing medical expenditure.

4. What are the difference between manual accounting and

computerized accounting?

Point of difference Manual accounting Computerized accounting

1. Recording Recording of financial Data content of these
transactions is through transactions is stored in well
books of original entry. designed data base.
2. Classification Transactions recorded in the No such data duplications is
books of original entry are made. In order to produce
further classified by posting ledger accounts the stored
them into ledger accounts. transaction data is
This results in transaction processed to appear as
data duplicity. classified so that same is
presented in the form of
report.
3. Summarizing Transactions are The generation of ledger
summarized to produce trial accounts is not necessary
balance by ascertaining the condition for trial balance.
balances of various
accounts.

4. Adjusting entries Adjusting entries are made There is nothing like

to adhere to the principle of making adjusting entries for
matching. errors and rectifications.

5. Financial statements The preparation of financial The preparation of financial

statements assumes the statements is independent of
availability of trial balance. producing the trial balance.

5. Enumerate the basic requirements of any computerized

accounting system.
Need and requirements of computerized accounting:
The need for computerized accounting arises from advantages of speed,
accuracy and lower cost of handling the business transactions.

190
1. Numerous Transactions
The computerized accounting system is capable of handling large number
of transactions with speed and accuracy.

2. Instant Reporting
The computerized accounting system is capable of offering quick and
quality reporting because of its speed and accuracy.

3. Reduction in paper work

A manual accounting system requires large physical storage space to keep
accounting records/books and vouchers/ documents. The requirement of
stationery and books of accounts along with vouchers and documents is
directly dependent on the volume of transactions beyond a certain point.
There is a dire need to reduce the paper work and dispense with large
volumes of books of accounts. This can be achieved by introducing
computerized accounting system.

4. Flexible reporting
The reporting is flexible in computerized accounting system as compared to
manual accounting system. The reports of a manual accounting system
reveal balances of accounts on periodic basis while computerized
accounting system is capable of generating reports of any balance as when
required and for any duration which is within the accounting period.

5. Accounting Queries
There are accounting queries which are based on some external parameters.
For example, a query to identify customers who have not made the
payments within the permissible credit period can be easily answered by
using the structured query language (SQL) support of database technology
in the computerized accounting system. But such an exercise in a manual
accounting system is quite difficult and expensive in terms of manpower
used. It will still be worse in case the credit period is changed.

6. On-line facility
Computerized accounting system offers online facility to store and
process transaction data so as to retrieve information to generate and view
financial reports.

7. Scalability
Computerized accounting systems are fully equipped with handling the
growing transactions of a fast growing business enterprise. The requirement
of additional manpower in Accounts department is restricted to only the
data operators for storing additional vouchers. There is absolutely no
additional cost of processing additional transaction data.

191
8. Accuracy
The information content of reports generated by the computerized
accounting system is accurate and therefore quite reliable for decision-
making. In a manual accounting system the reports and information are
likely to be distorted, inaccurate and therefore cannot be relied upon. It is
so because it is being processed by many people, especially when the
number of transactions to be processed to produce such information and
report is quite large.

9. Security
Under manual accounting system it is very difficult to secure such
information because it is open to inspection by any eyes dealing with the
books of accounts. However, in computerized accounting system only the
authorized users are permitted to have access to accounting data. Security
provided by the computerized accounting system is far superior compared
to any security offered by the manual accounting system.

192