MB0025 - Financial and Management Accounting

Reference Books:

1. Accounting for managers by Jawahara Lal. 2. Financial Accounting by S.N.Maheswari. 3. Financial Accounting for Managers by R.Narayana Swamy. 4. Introduction to Management by Anthony Reece. 5. Management Accounting by Manmohan and Goel. 6. Cost and Management Accounting to Horugren etal.

Financial and Management Accounting MB 0025

Contents

Unit 1

Financial Accounting – An Introduction 1

Unit 2

Accounting Concepts, Principles, Bases and Policies 14

Unit 3

Double Entry Accounting 29

Unit 4

Primary Books 48

Unit 5

Secondary Books 71

Unit 6

Trial Balance 86

Unit 7

Final Accounts 105

Unit 8

Introduction to Management Accounting 140

Unit 9

Financial Statement Analysis 149 Edition: Fall 2008

Contents Unit 10

Funds Flow Analysis 184

Unit 11

Cash Flow Analysis 229

Unit 12

Understanding Cost 243

Unit 13

Marginal Costing and Break Even Analysis 264

Unit 14

Budgetary Control 281

Unit 15

Standard Costing 300

Edition: Fall 2008

BKID – B0668

Dr. K. Jayakumar Vice Chancellor Sikkim Manipal University of Health, Medical, and Technological studies

Prof. Nandagopal V. B. Director and Dean Sikkim Manipal University of Health, Medical, and Technological studies.

Board of Studies Dr. T. V. Narasimha Rao Professor, Manipal Universal Learning

Prof. K. V. Varambally Director, Manipal Institute of Management, Manipal

Ms. Vimala Parthasarathy Asst. Professor, Sikkim Manipal University of Health, Medical and Technological studies.

Mr. Shankar Jagannathan Former Group Treasurer Wipro Technologies Limited, Bangalore

Ms. Sadhana Dash Senor Manager HR Microsoft India corporation ( Pvt) limited

Mr. Abraham Mathews Chief Financial Officer Infosys BPO, Bangalore

Mr. Pankaj Khanna Director, HR, Fidelity Mutual Fund

Content Preparation Team Peer Review By

1. Dr. Y. Rajaram Dr. Nagesh Malavalli Adjunct Faculty, Manipal Universal Learning Principal & Professor of Finance & Accounting

M.P. Birla Institute of Management, Bangalore

2. Mr. S. N. Dorai Raj Retd Principal & Professor of commerce, Seshadripuram College, Bangalore.

Edition: Fall 2008

This book is a distance education module comprising of collection of learning material for our students.

All rights reserved. No part of this work may be reproduced in any form by any means without permission in writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim.

Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd., Manipal – 576 104. Printed at Manipal Press Limited, Manipal.

INTRODUCTION

Accounting is a systematic effect of collecting. Classifying and analyzing financial information for

effective use in decision making activities. There are two facts of accounting namely Financial

Accounting and Management Accounting. While financial accounting is concerned with recording and

preparation of financial statements, management accounting focuses on using the information for

planning, decision making and controlling the financial activities of business enterprise. In view of the

fast changing scenario world over, MBA students should acquaint themselves with rudiments of the

subject. This book contains 15 Units.

Unit 1: Financial Accounting – An Introduction

Presents an overview of meaning, purpose and evolution of accounting and introduces

basic terminology.

Unit 2: Accounting Concepts, Principles, Bases and Policies

Briefly describes the accounting concepts and assumption in financial accounting.

Unit 3: Double Entry Accounting

Deals with basic accounting principles of Double – entry system.

Unit 4: Primary Books

Contains details of primary books General journal and subsidiary books.

Unit 5: Secondary Books

Covers the process of posting from primary books to ledger, which is called secondary

book.

Unit 6: Trial Balance

Deals with the process of preparing trial balance, errors and rectification.

Unit 7: Final Accounts

Describes the Preparation of final accounts – Trading A/c, P & L A/c and Balance sheet.

Unit 8: Introduction to Management Accounting

Presents the meaning and scope of Management Accounting.

Unit 9: Financial Statement Analysis

Deals with ratio analysis as a part of analysis of financial statements.

Unit 10: Funds Flow Analysis

Focuses on fund flow analysis.

Unit 11: Cash Flow Analysis

Gives a brief sketch of cash analysis.

Unit 12: Understanding Cost

Throws light on meaning and role of cost accounting.

Unit 13: Marginal Costing and Break Even Analysis

Introduces the tool of marginal costing and its usage.

Unit 14: Budgetary Control

Provides an insight of budgets – as a means of control.

Unit 15: Standard Costing

Introduces the technique of standard costing as an effective controlling system.

Financial and Management Accounting Unit 1

Sikkim Manipal University 1

Unit 1 Financial Accounting – An Introduction

Structure:

1.1 Introductions

Objectives

1.2 Evolution

Self Assessment Questions 1

1.3 Need


1.4 Meaning of Accountancy, book – keeping and Accounting


1.5 Characteristics


1.6 Functions and objectives of accounting


1.7 Difference between book – keeping and accounting, accountancy


1.8 Financial accounting and management accounting


1.9 Basic terms

Self Assessment Question 8

1.10 Summary

Terminal Questions

Answer to SAQs and TQs

1.1 Introduction

Accounting is a branch of knowledge, concerned with recording classifying, analyzing and

reporting financial information to owners, bankers, creditors, government and host of

stakeholders regarding the financial performance of organizations - business or bon-business

entities. Over a period of time, accounting has assumed a status of a science and an art. In order

to achieve uniformity globally, international standards have also emerged in accounting. In this

Unit, the historical perspective of Accounting, its meaning, functions and basic terms used in the

subject are discussed.



Learning Objectives:

After studying this unit, you should be able to understand the following

1. To expose the students with meaning, need and purpose of accounting.

2. To know the functions Accounting.

3. To understand the difference between Financial Accounting and Management Accounting.

4. To acquaint with the basic terminology used in the subject.

1.2 Evolution of Financial Accounting

Any branch of knowledge does not emerge all of a sudden. Knowledge is a product of continuous

intellectual exercise and the changes in the environmental and social demands. Accounting is an

ancient art. Michael Russel in his article ‘Evolution of Accounting’ points out that as early as 8500

B.C, accounting was existing. Archeologists have found clay tokens as old as 8500 BC in

Mesopotamia which were usually cones, disks, spheres and pellets. These tokens correspond to

such commodities like sheep, clothing or bread. They were used in the Middle West in keeping

records. Similarly in ancient civilizations like China, Babylonia, Greece and Egypt, record keeping

was in practice in the same manner as stated above. During 3600 BC in Babylonia payment of

salaries was recorded in clay tablets. The rulers of these civilizations kept track of labour and

material costs by using accounting methods.

In an article published by John R. Alexander on ‘History of Accounting’, he stated that an

improved system of book keeping known as double entry book keeping was introduced in 14th

century and the following seven key ingredients were responsible for the creation of double entry

book keeping.

• Private property: The power to change ownership, because book keeping is concerned with

recording the facts about property and property rights

• Capital: Wealth productively employed, because otherwise commerce would be trivial and

credit would not exist

• Commerce: The interchange of goods on a widespread level, because purely local trading in

small volume would not create the sort of press of business needed to spur the creation of an

organized system to replace the existing hodgepodge of record keeping

• Credit: The present use of future goods, because there would have been little impetus to

record transactions completed on the spot.



• Writing: A mechanism for making a permanent record in a common language given the limits

of human memory.

• Money: The common denominator for exchange, since there is no need for book keeping

except as it reduces transactions to a set of monetary values.

• Arithmetic: A means of computing the monetary details of the deal.

Double entry records first came out during 1340 A.D. in Genoa. In 1494, the first systematic

record keeping was formulated by Fra Luca Pacioli a Franciscan monk and one of the most

celebrated mathematicians to this day. Pacioli is considered as the father of accounting.

Michael Russel, in his article states that industrial revolution, which brought paradigm changes in

the working and business transactions paved way to the specialized field of accounting called

‘cost accounting’ in order to meet the need for the analysis of various costs. Mean while,

corporate form of organisation came into being which made it necessary to report financial

information to the owners (shareholders) by the management. Virtually management and

ownership got separated and to instill confidence of the shareholders, managers had to submit

reports, as prepared on the basis of accounting information.

Welsch and Anthony, in their book’ Fundamentals of Financial Accounting’, comment that the

growth of business organizations in size, particularly publicly held corporations, has brought

pressure from stock holders, potential investors, creditors, government agencies, and the public

at large, for increased financial disclosure. The public’s right to know more about organizations

that directly or indirectly affect them (whether or not they are shareholders) is being increasingly,

recognized as essential. An open society is one that has a high degree of freedom at the

individual level and typically evidences an effective commitment to measuring the quality of life

attained. These characteristics make it essential that the members of the society be provided

adequate, understandable, and dependable financial information from the major institutions that

comprise it. So accountants have a greater responsibility of not only being accurate but also

transparent to the possible extent.

At present, there have been tremendous advancements in accounting to meet the needs brought

about by information technology. Work is done faster, more accurate, and more dependable by

using computers. Business can be transacted without even facing one another and accounting

has become so customer friendly that records and reports are generated instantaneously to all

parties concerned.

Self Assessment Questions 1:



1. __________ is the father of Accounting.

2. A new accounting system called _______ emerged during industrial revolution.

3. Double Entry book keeping was introduced during ___________ century.

1.3 Need

Economic activities are carried on by trading and non-trading organizations, the former with profit

motive and the latter with a focus on service. Business is prominently carried on under different

forms of organizations, namely sole trading, partnership, Hindu undivided family firms (HUF),

cooperative societies and companies. Having invested capital in the business, one has to find out

at the end of a particular period whether the business has yielded any profit or loss; any assets

are created; the liabilities payable; total expenses incurred; total revenues generated and so on

and so forth. Innumerable business transactions might have taken place during the period and

remembering all transactions is humanly impossible, let alone finding the results of the

transactions. Even to put them in a computer, it requires a systematic approach to record,

classify, analyse and report the financial data to the stake holders of a business enterprise.

Precisely for this purpose, financial accounting is needed.

Proprietor/s in case of sole trading and partnership firms, members in case of cooperative

institutions, shareholders in case of companies, suppliers, customers, tax authorities, banking

institutions, lenders, borrowers, employees, government agencies and general public are the

various parties interested in the financial information of a business enterprise and each one them

is interested in different aspects of the business. Accounting information has to be supplied in a

prescribed manner to these parties and this information is contained in the form of different

statements such as trading account, profit and loss account, balance sheet, cash flow statement,

fund flow statement, statement of investments and so on. While a proprietor/

partner/member/shareholder is interested in profit and loss account and balance sheet, bankers

are interested in cash and fund flow statements in addition to P&L account and balance sheet,

government is interested in the amount of tax collections, employees are interested in P&L

account, customers, in total sales, suppliers in cash statements, security analysts in the ratio

analysis of various financial parameters of the business organization. Financial accounting fulfills

the aspirations of the above parties regarding the enterprise. Thus Accounting has emerged for

two purposes, namely to record all business transactions since one can not remember them and

communicate the results of financial data to all interested parties.




1. What are the two purposes of accounting?

2. Shareholders of a company are interested in ______ and _______ of a business.

3. Bankers are interested in _________ and _______ besides P&L A/C and balance sheet.

1.4 Meaning of Accountancy, Book-keeping and Accounting

Book-keeping, accounting and accountancy are the terms used in the science of financial

accounting. Book-keeping means recording of business transactions in the books of accounts in

accordance with the principles of accounting. Book keeping is an adjunct for accounting. Day to

day transactions are entered in a systematic manner to facilitate the preparation of profit and loss

account, balance sheet and other statements containing information about debtors, creditors, tax

payment etc., For the purpose of recording the financial data, debit and credit principles are

adopted so that cross checking is made possible, summary of each account is known at the end

of an accounting period.

Accounting on the other hand is the discipline of measuring, communicating and interpreting

financial activities and it is widely referred to as language of business.

Way back in 1941, the definition for the word Accounting was given by the Committee on

Terminology of the American Institute of Chartered Public Accountants, (AICPA)thus, ‘accounting

is an art of recording, classifying and summarizing in a significant manner and terms of money

transactions and events which are, in part at least, of a financial character, and interpreting the

results thereof.’

The American Accounting Association (AAA) in 1966 provided the following definition:

“Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgements and decisions by users of the information”

In 1970, the AICPA emphasized accounting with reference to the concept of information..

Accounting is treated as a service activity. The function of accounting is to provide quantitative

information, primarily financial in nature, and about economic activities, that is intended to be

useful in making economic decisions.

Accountancy is the profession and the practitioners of accountancy are called accountants.

Therefore book keeping is the basic activity of recording, accounting is the analysis and reporting

function and accountancy is the profession of carrying the above activities.




1. What is book keeping?

2. Define Accounting.

3. Accountancy is a __________ and the practitioners of accountancy are __________ .

1.5 Characteristics of Accounting

From the above definitions of Accounting, one can list out the characteristics of accounting:

1. Accounting is an art and science: Recording and maintenance of accounts of various

transactions needs special skill and knowledge. Reading and interpreting the results, obtained

by the accounting system requires experience. From this angle, accounting is an art.

Accountants are endowed with this special skill and aptitude and it is difficult to acquire

proficiency in this art. It is like a doctor who diagnoses and prescribes medicines just by

looking to the medical reports, an accountant on a gaze of the financial reports can find out

the financial health of an enterprise and suggests measures to improve the financial position.

Accounting is also a science, not like physics or chemistry, but it is an exacting science.

Accounting is governed by definite principles, rules, concepts, conventions and policies. A

systematic and scientific approach is adopted to classify, record, analyse and interpret the

accounting information.

2. Accounting involves a process of identifying, classifying and recording financial information,

expressed in terms of money. All financial transactions are expressed in terms of money.

Incomes, expenses, acquisition of assets, payment of liabilities, capital of shareholders etc.,

are stated in money terms and all transactions are broadly classified as related to definite

heads of account, namely – personal, real and nominal. After classification, they are recorded

in the books of original entry as per the accounting principles. The book of original entry is

called Journal. From Journal, the transactions are summarized under each head of relevant

account and posting takes place to a book called ledger. At the end of a particular accounting

period, the gist or the net balance of all ledger accounts is aggregated to prepare a trail

balance. From trial balance, it is possible to prepare trading, profit and loss accounts and

balance sheet.

3. Events of non financial nature can not be recorded, even though such events may have an

impact on the operational results of the enterprise. For instance financial manager and

production manager of a concern do not have good relationship and owing to this the

production process is affected and subsequently the profitability. This event of non financial

nature can not be reflected in accounts.



4. Accounting is an information system. The results of analysis and interpretation are

communicated to the management and other interested parties. Internal control is effectively

exercised and accountability is ensured through accounting information.

5. It helps in taking managerial decisions.


1. The book of original entry is called __________ .

2. Profitability of an enterprise is affected if the finance manager and production manager do not

agree each other. Does this picture in accounts?

1.6 Functions and Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves the following functions

and objectives.

a) Systematic recording of all business events or transactions and subsequent posting to ledger

to finally prepare financial statements – profit and loss account and balance sheet.

b) Reporting the results to management, shareholders, creditors, bankers, investors, stock

brokers, stock exchanges, employees, governments etc.,

c) Satisfying the statutory requirements, especially of Registrar of Companies, SEBI (Securities

Exchange Board of India) in case the company is listed, tax authorities (sales tax, excise,

customs, income tax) and government in order to protect the interest of general public.

d) Protecting the properties of business by recording them on the date of acquisition and

showing their accounts in the balance sheet.

e) It helps for internal control by holding the concerned persons responsible for any errors,

lapses or under performance. Equally it helps to identify the strong areas of excellent

performance and subsequently pin point the individuals or departments to be rewarded or

appreciated.

f) Accounting is a tool for effective planning. Current year’s financial performance becomes the

basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for

controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the

functions of accounting.


1. State any two functions of accounting.

2. Name the different parties to whom accounting information has to be reported?



1.7 Differences between Book Keeping and Accounting

As already said, book keeping is a system of recording the day to day transactions in the books of

enterprise. Accounting enjoys wider scope and includes not only book keeping but also analysis,

interpretation and reporting of financial information. The later part of accounting is the core

function of accounting. Now - a-days, owing to information technology, ready made packages like

Tally are available, which facilitate entry of transactions and preparation of ledger accounts are

made easy. In case of large industrial enterprises and multi national corporations, regular journal

entries are not recorded owing to very large number of transactions taking place day in and day

out. On the other hand subsidiary books such as cash book, sales book, purchases book, bills

receivable book are prepared and ledger accounts are drawn from them. The differences

between book keeping and accounting are as under:

Book keeping Accounting

• It is a process of recording the

transactions in books of accounts

• It includes recording, analyzing and

communicating

• Adopt principles of accounting for

recording

• Analysing and interpreting requires skill,

knowledge and experience

• Book keeping is an adjunct to

accounting

• Accounting starts when book keeping ends

• The objective is to prepare final

accounts and balance sheet at the

end of accounting period

• The objective is to inquire and find out the

reasons for financial results and

communicate the results to all stakeholders

in a manner they understand.


1. When book keeping ends, ________________ commences.

2. State two differences between book keeping and accounting.

1.8 Financial Accounting and Management Accounting

Financial accounting is the preparation and communication of financial information to outsiders

such as creditors, bankers, government, customers and so on. Another objective of financial

accounting is to give complete picture of the enterprise to shareholders. Management accounting

on the other hand aims at preparing and reporting the financial data to the management on

regular basis. Management is entrusted with the responsibility of taking appropriate decisions,

planning, performance evaluation, control, management of costs, cost determination etc., For



both financial accounting and management accounting the financial data is the same and the

reports prepared in financial accounting are also used in management accounting But the

following are major differences between Financial accounting and Management accounting.

Financial accounting Management accounting

• The primary users of financial

accounting information are

shareholders, creditors, government

authorities, employees etc.,

• Top, middle and lower level managers use

the information for planning and decision

making

• Accounting information is always

expressed in terms of money

• Management accounting may adopt any

measurement unit like labour hours, machine

hours or product units for the purpose of

analysis

• Financial data is presented for a

definite period, say one year or a

quarter

• Reports are prepared on continuous basis,

monthly or weekly or even daily

• Financial accounting focuses on

historical data

• Management accounting is oriented towards

future

• Financial accounting is a discipline by

itself and has its own principles,

policies and conventions

• Management accounting makes use of other

disciplines like economics, management,

information system, operation research etc.,


1. Management accounting is concerned with _____________.

2. State any two differences between Financial accounting and Management accounting.

1.9 Basic Terms

To understand the subject, proper understanding of the following terms is essential.

1. Transaction: It is transfer of money or goods or service from one person or account to

another person or account. For example, purchase of goods, sale of goods, payment of cash

towards rent, receipt of cash towards interest on loans given, cash brought in as capital

dividend paid to share holders etc are all transactions. There are cash transactions, credit

transactions and paper transactions. In all cash transactions, cash is paid or received

immediately. Ex: Rama paid cash Rs.10000 for purchase of goods. Krishna sells goods for

cash Rs1000.Credit transaction is one where there is a promise to pay/receive cash at a

future date. EX: Rama purchases goods from Gopal and promises to pay cash one month

after the date. Paper transaction is one where there is no cash inflow or outflow but



adjustment is made in the records only. Bad debts of previous year are written off;

depreciation provided on fixed assets etc.,

2. Capital: Funds brought in to start business, by the owner/s. In the case of a company,

capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed

capital and that capital used for day to day affairs of business is known as working capital.

From business point of view, Capital is a liability.

3. Assets: Every enterprise has assets. Land and buildings, plant and machinery, furniture and

fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, by the

use of which business is carried on. Assets may be fixed, current, liquid or fictitious. Fixed

assets are those which are held for use in the production or supply of goods and services.

Ex: plant and machinery, which is used fairly for long period. Current assets are those which

are held or receivable within a year or within the operating cycle of the business. They are

intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors,

bills receivable, cash at bank etc., Liquid assets are those which can be easily converted

into cash and for instance, cash in hand, cash at bank, marketable investments etc.,

Fictitious assets are in the form of such expenses which could not be written off during the

period of their incidence. For example, promotional expenses of a company which could not

be treated as expenditure in the year of incidence are shown as fictitious asset.

4. Liability: Obligation to be fulfilled in future with respect to payment towards acquisition of an

asset or performance of a service. Current liability is that obligation which has to be satisfied

within a year. For example, payment to be made sundry creditors for the goods supplied by

them on credit; bills payable accepted by the businessman; overdraft raised by the

businessman in a bank etc.

5. Goods: Commodities or articles purchased for resale are called goods. Furniture items

dealt by a furniture dealer constitute goods for that business. If rice dealer purchases

furniture, not for resale but for use, it is called purchase of asset and the same furniture

becomes asset. Rice for rice dealer is goods, because he purchases only for resale.

6. Trade: Purchase and sale of goods is called trade.

7. Purchases: It refers to goods bought in exchange for cash or credit. In case of credit

purchase, goods are received against a promise to pay the price for the same at a future

date.



8. Sales: Goods sold to customers either for cash or for credit are regarded as sales. In case

of cash sales, cash is received immediately and in case of credit sales, cash will be received

at a future date.

9. Sole trader: A single individual carrying on business with or without the help of his kith and

kin is called sole trader.

10. Partnership: It is a relationship between partners to contribute capital to start business,

agree to distribute profits and losses in an agreed proportion and the business being carried

on by all or any one acting for all. Partnership firm refers to business where as the

partnership refers to relationship caused by agreement.

11. Joint Stock Company: It is an organization, for which the capital is contributed by

shareholders to carry on business and it is registered under Companies Act and it has a

legal entity, having perpetual existence and a common seal.

12. Debtor: Debtor is a person who owes some thing to business. A person to whom goods are

sold on credit becomes a trade debtor to the business.

13. Creditor: A creditor is a person to whom the business owes some thing. For example, a

person from whom goods are purchased on credit and amount is yet to be paid is called a

trade creditor.

14. Stock: Total goods kept on hand by a trader or industrial enterprise on a given date. It

represents unsold part of goods.


1. A company is registered under ___________ .

2. A partnership is ___________ among partners.

3. Rama & Co., owned by Govind. Is it a firm or sole trader?

4. If A purchases goods from B, A is ___________ to B and B is _________ to A.

5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable after one month. Is it a

cash sale or credit sale?

6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000 into his business. Is it

capital?

Terminal Questions

1. Briefly describe the meaning of accountancy, book-keeping and accounting.

2. Write the differences between accounting and book-keeping.



3. Brief describe the need and evolution of accounting.

4. State the meaning of the folling terms

a. Transaction

b. Assets

c. Joint stock company

d. Goods

e. Trade.

Answer for Self Assessment Questions


1. Fra Luca Pacioli

2. Cost Accounting

3. 14th Century


1. Record all business transactions and communicate the results to interested parties.

2. Profit and loss and balance sheet

3. Cash flow and fund flow statements


1. Recording business transactions as per accounting principles

2. Accounting is the discipline of measuring, communicating and interpreting financial

activities.

3. Profession, accountants.


1. Journal

2. No, because this is not financial in nature.


1. Systematic recording, reporting, Satisfying statutory requirements, protecting the properties,

internal control, tool for effective planning (Any two).

2. Shareholders, creditors, bankers, brokers, debtors, customers, suppliers, Government etc.


1. Accounting



2. Book keeping is a process of recording but accounting is not only recording but also analyzing

and communicating; book keeping requires the knowledge of accounting principles but

accounting requires not only knowledge but also skill and experience.


1. Taking decisions, planning, evaluating and controlling

2. FA considers historical data and MA focuses on future; FA is a discipline by itself but

MA makes use of other disciplines like economics, information system etc.


1. Companies Act,

2. An agreement

3. Sole Trading concern

4. Debtor, Creditor

5. Credit sale

6. Yes, it is capital.

Answer for Terminal Questions:

1. Refer to unit 1.2






Unit 2 Accounting Concepts, Principles, Bases and Policies

Structure

2.1 Introductions

Objectives

2.2 Accounting concepts, principles, bases and policies – meaning


2.3 Types of accounting concepts


2.3.1 Business entity concept


2.3.2 Going concern concept


2.3.3 Money measurement concept


2.3.4 Periodicity concept


2.3.5 Accrual concept


2.4 Basic Principles


2.4.1 Principle of Income recognition


2.4.2 Principle of expense


2.4.3 Principle of matching cost and revenue


2.4.4 Principle of Historical cost


2.4.5 Principle of full disclosure


2.4.6 Double aspect principle




2.4.7 Modifying Principle


2.4.8 Principle of materiality


2.4.9 Principle of consistency


2.4.10 Principle of conservatism or prudence


Terminal Questions


2.1 Introduction:

Any subject for that matter, is based on certain postulates, concepts and policies. Before

understanding the subject, one has to go through the basic assumptions on which the subject is

built upon. Accounting is a reflection of all business transactions expressed in terms of money

relating to a definite period of time and the object of accounting being finding out profit or loss

arising out of transactions and finally to judge the financial position of the business organization.

In this Unit, the concepts, the basic principles and policies of accounting are briefly described.



1. To know the meaning of concepts, principles and policies basing on which Accounting

science has emerged.

2. To expose the students to different concepts of accounting.

3. To have an insight into the basic principles of accounting.

2.2 Accounting concepts, principles, bases and policies

As we have understood in the Unit 1, accounting is the language of business and it is concerned

with measurement of financial performance of a business by recording, analyzing and reporting

the business results for the sake of stakeholders. Since all stakeholders should understand the

accounting language in the same sense, certain principles, concepts and policies of accounting

have been laid down. Principles are basically the rules of action adopted by the accountants

universally while recording accounting transactions. The principles are doctrines associated with



theory and procedures and current practices of accounting. These principles may be classified as

concepts and conventions. While concepts are in the form of assumptions or conditions,

conventions are those customs and traditions which guide the accountants while preparing

accounting statements. For instance business is started with an assumption that it shall be

continued for a long period of time and no body promotes a business organization to close it

down within a short period. Basing on this assumption, business man purchases fixed assets,

uses them and values them from time to time. This is a strong assumption that any businessman

approaches with. Such assumption is called a concept. To give an example for convention,

inventory (stock) in a business is valued at the end of an accounting period, at cost or market

price which ever is lower. This is an accepted convention or a practice or a principle in

accounting. On the other hand, an accounting policy is one which is adopted by management,

relevant to the situations. For example, every asset should be depreciated (this is a concept) at

the end of an accounting period. The practice is to adopt fixed installment or diminishing balance

method or any other method of depreciation.(this is a convention). The policy of the management

may be to adhere to fixed installment method of depreciation and it is their choice. Therefore no

management can exercise discretion regarding fundamental presumptions of accounting. But

every management has a choice of making an accounting policy.

It is not out of place to mention that in order to bring uniformity in terminology, accounting

concepts, conventions, and assumptions, the Institute of Chartered Accountants of India (ICAI)

established Accounting Standards Board (ASB) in 1977. The principal objective of ASB is to

formulate accounting standards so that such standards will be established by the council of ICAI.

While formulating the accounting standards, ASB will give due consideration to the International

Accounting Standards and try to integrate them to the extent possible. It also considers the

customs, practices, laws and usages prevailing in Indian business. There are altogether 30

accounting standards issued by ASB which have to be adopted by management of different

enterprises to improve the quality of presentation of financial statements in our country.


1. Accounting principles are _______ , associated with theory and practice of accountings.

2. Principles are classified as ________ and ________.

3. Assets may be depreciated on fixed installment method or reducing balance method. Is this a

concept or convention?

4. A business is started with an assumption of making profit. Is this assumption, a concept or

convention?



5. The purpose of establishing ICAI and ASB is to ________.

6. How many accounting standards are issued by ASB so far?

2. 3 Types of Accounting concepts

As said earlier, concepts are the basic assumptions or conditions upon which the science of

accounting is based. There are five basic concepts of accounting, namely – business entity

concept, which is also termed as separate entity concept, going concern concept, money

measurement concept, periodicity concept and accrual concept. Each concept is discussed

below.


1. What are the different types of accounting concepts?

2.3.1 Business Entity Concept

The essence of this concept is that business is a separate entity and it is different from the owner

or the proprietor. This is true in the case all forms of organization. If X starts business, he should

not mix up his personal properties with that of the business. When he invests his funds into the

business, it is regarded as capital to the business and capital is a liability from the business point

of view. If X withdraws any money from the business, it is deductable from the capital and to that

extent the liability of the business towards the owner is reduced. On the other hand, if the

proprietor withdraws money from the business for business purposes, then it is treated as

expenditure to the business.This legal separation between business and ownership is kept in

mind while recording the transactions in the books of business.


1. Business entity concept is also termed as __________.

2. Business and its owner are _______________ entities .

3. Can personal properties of owner be mixed with the properties of business properties?

4. Capital brought in by proprietor to the business is _______ to the business.

5. Profits earned in business form an addition to _____________ of the owner.

2.3.2 Going concern concept

The fundamental assumption is that the business entity will continue fairly for a long time to

come. There is no reason why an enterprise should be promoted for a short period only to

liquidate the business in the foreseeable future. This assumption is called “going concern

concept”. For this reason accountants value fixed assets on historical cost method. Had the



business been set up to last for a short period, fixed assets should have been valued at a market

price. Besides, going concern concept provides for amortization of the cost of fixed assets over

the life time of the assets. For example, an entrepreneur purchases a plant for Rs. One crore and

it has a life of 10 years. During this period, he sets aside every year certain funds from the

income of the business so that it would help him for replacement of the asset at the end of ten

years. This process of amortization presupposes that the enterprise will continue to do business

fairly for long time.


1. Can a company be promoted to last only for a month?

2. A business concern continues to function for ________. This is the essence of going concern

concept.

3. Do you purchase a building for your business to last for a short period or long period?

4. What is the underlying intention in making a provision every year when an asset is

purchased?

2.3.3 Money Measurement Concept

All transactions of a business are recorded in terms of money. An event or a transaction that can

not be expressed in money terms, can not find place in the books of account. The honesty of the

employees, dynamism of the selling agents, promptness and integrity of the cashier, even though

influence the business results, can not be brought to the books of accounts. Besides it makes no

sense if a business has 10 tons of raw material, five vehicles, one premises and a few items of

furniture, unless all these assets are expressed in terms of some monetary value. If it is said that

the value of these assets is Rs. two crores, it makes a lot of sense. Money is the common

denominator in which the business transactions should be expressed.


1. Can honesty of an employee be expressed in terms of money?

2. Transactions should be stated in terms of _______________.

3. We have in a business 5 chairs, one godown, 2 tons of cement. What does it mean?

4. Money is common _______ in which the business transactions should be expressed.

2.3.4 Periodicity Concept

The time interval for which accounts are prepared is an important factor, even though we assume

long life for a business. The time interval is usually one year and this period is called accounting

year. Often the accounting period could be half year or even a quarter. The financial statements



should be prepared at the end of each accounting period so that income statement shows profit

or loss for the accounting period. So also a balance sheet is prepared to depict the financial

position of the business.


1. The time interval for which accounts are prepared is called ____________.

2. What is the usual accounting period?

3. The expenses of a business are Rs.500000. Why does this statement not make any sense?

2.3.5 Accrual Concept

Profit earned or loss suffered for an accounting period is the result of both cash and credit

transactions. It is possible that certain incomes are earned but not received and similarly

expenses incurred but not yet paid during an accounting period. But it is relevant to consider

them while computing the financial results just because they are related to the specific accounting

period. For example, interest receivable on Fixed deposit for the year ending 31-12-2006 is Rs.

12000 but it is actually credited to the bank account only in February 2007. For calculating the

income from interest, the amount Rs.12000 is considered even though it is not received before

31-12-2006. This amount is called accrued interest. Similarly the expenses which are incurred for

the accounting period, might be paid only after the accounting period. Such accrued expenses

are deducted while calculating the profit for the accounting period. This is the accrual concept.


1. Interest earned but not received within an accounting period is called _______.

2. Salary payable for December, 2004 but paid in January, 2005 is known as

_________________ for 2004.

3. Accrued items should be _________ to compute profit or los for the said period.

4. Accrual concept considers not only cash transactions but also ______ transactions.

2.4 Basic principles

As stated above basic principles are the rules basing on which accounting takes place and these

rules are universally accepted. There are ten such basic principles, namely principle of income

recognition, principle of expense, principle of matching cost and revenue, historical cost principle,

principle of full disclosure, double aspect principle, modifying principle, principle of materiality,

principle of consistency and principle of conservatism. A brief description is in the following

paragraphs.




1. Basic principles of Accountancy are _____________ accepted.

2. How many basic principles of accountancy are there?

2.4.1 Principle of Income Recognition

According to this concept, revenue is considered as being earned on the date on which it is

realized., i.e., the date on which goods and services are transferred to customers for cash or for

promise. It should further be noted that it is the amount which the customers are expected to pay

which shall be recorded. In effect, only revenue which is actually realized should be taken to profit

and loss account. Unreaslised revenue should not be taken into consideration for determining the

profit. For example, a sale is considered to be made when the property in goods (ownership) is

transferred from the seller to buyer. Similarly, when a businessman receives an order for the sale

of such products, yet to be manufactured, then revenue is said to have been generated when the

products are ready and physically present in deliverable state and payment is received or

promised to be received but not when the order is received.


1. Income is considered as earned only when it is ____________.

2. Income is realized whether it is actually received in cash or promised to be received . Is it

True or False?

3. Income realized is different from cash received. Is it true or false?

4. A sale is made on credit. Does it constitute income realization?

5. An order is received for sale of goods. Is it realisation of income?

6. An order is received with an advance of Rs.100000 cash. Can this be called income?

2.4.2 Principle of Expense

Expenses are different from payments. A payment becomes expenditure or an expense only

when such payment is revenue in nature and made for consideration. Salaries are paid for having

received the services of the employees and so it is an expense. If furniture is bought, it is not

expenditure because it is a capital payment. Therefore all revenue expenses are transferred to

profit and loss account to ascertain profit or loss of the business undertaking. In other words,

there are revenue expenses and capital expenses. While revenue expenses are charged against

profit, capital expenses are shown in the balance sheet as assets.


1. A cash payment may be a revenue payment or capital payment. Is it true or false?



2. A payment which is revenue in nature is expenditure. Is it true or false?

3. Plant is purchased and payment is made. Is it an expenditure or acquisition of asset?

4. All revenue expenses are charged against ––––––––––––– .

5. Capital payments resulting in acquisition of assets appear in the balance sheet. True or

False?

2.4.3 Principle of Matching Cost and Revenue

Revenue earned during a period is compared with the expenditure incurred to earn that income,

whether the expenditure is paid during that period or not. This is matching cost and revenue

principle, which is important to find out the profit earned for that period. Here costs are reported

as expenses in the accounting period in which the revenue associated with those costs is

reported. For example, sales revenue reported in 2005 is Rs 50 lakh. The expenses to earn this

revenue, comprising purchases, wages, salaries, sales commission and so on amount to Rs. 30

Lakh. It is possible that some of these costs might be payable actually in 2006. Even then, they

are considered only for the period 2005, when the sales revenue was earned. Adjustments are

made for outstanding and prepaid expenses as well as outstanding and pre received incomes

while preparing the final accounts for the accounting period.


1. Matching concept of accounting considers only revenue incomes and expenses relating to a

particular accounting period. True or False?

2. Incomes and expenses for an accounting period are considered to compute _____ .

3. Expenditure paid or payable and revenue earned whether realised or not in cash are taken

into account to find out profit or loss. True or False?

4. For the actual revenue received, outstanding incomes are ________ and pre-received

incomes are_________________ to find out the revenue income for the given period.

5. For the actual revenue expenses (costs) paid during the accounting period, outstanding

expenses are _____ and prepaid expenses are _____ to find out expenses for the accounting

period.

2.4.4 Principle of Historical Costs

This is called ‘cost’ principle. All assets are recoded at the cost of acquisition and this cost is the

basis for all subsequent accounting for the assets. The expenses and the goods purchased are

all shown at the value at which they are incurred. The assets are constantly reduced in their value

by charging depreciation against their cost to present their book value in the balance sheet. For



example, land bought for Rs.5,00,000 will be shown at that price only and market value will not

be considered. In financial statements, historical cost is considered but not market value for the

purpose of consistency. However, on account of inflationary situations, this cost concept does not

portray correct picture of the business and so inflation accounting has emerged.


1. All assets are shown at historical cost in balance sheet. True or False?

2. Depreciation is charged against the historical cost of assets. True or False?

3. Historical cost is the cost at which an asset is actually purchased. True or False?

4. A machinery is bought for Rs.200000 and its market value is Rs.80000. Which of these

values, do you consider reasonable to mention in the balance sheet?

5. Inflation accounting has emerged as a result of limitation of historical cost concept. True or

False?

2.4.5 Principle of Full Disclosure

The business enterprise should disclose relevant information to all the parties concerned with the

organization. It means that any information of substance or of interest to the average investors

will have to be disclosed in the financial statements. For example, the liabilities of the business

should be stated along with assets. If only assets are exhibited without disclosing liabilities, it

amounts to fraud. The Companies Act, 1956 requires that income statement and balance sheet

of a company must give a fair and true view of the state of affairs of the company.


1. The principle of full disclosure implies that information which is of ___________ should be

stated in financial statements.

2. The material information that is disclosed should be of great interest to the average investors.

True or False?

3. Non-disclosure of material information amounts to ___________.

4. Disclosing about assets without disclosing about liabilities is against to the principle of full

disclosure. True or False?

2.4.6 Double Aspect Principle

This concept is the most fundamental one for accounting. A business entity is an independent

unit and it receives benefits from some and gives benefits to some other. Benefit received and

benefit given should always match and balance. For instance capital, say Rs.20000 provided by



the proprietor is a liability to the business and it is used for purchasing goods Rs.10000, kept in

bank account of the business Rs.8000 and the balance held in cash.Rs.2000. The goods, cash at

bank and cash in hand (10000 + 8000 + 2000) are regarded as assets. The total liabilities

balance with total of assets. This is dual aspect of accounting. The established principle of

accounting is that for every debit there is an equivalent credit and this is called double entry

principle of accounting.


1. Under dual aspect principle, total benefits received by business should match with total

benefits given. True or False?

2. Total liabilities should be equal to ___________ as per dual aspect principle.

3. For every debit, there should be an equivalent credit. This is called _________ of accounting.

2.4.7 Modifying Principle

The modifying principle states that the cost of applying a principle should not be more than the

benefit derived from. If the cost is more than the benefit, then that principle should be modified.

This is called cost-benefit principle. There should be flexibility in adopting a principle and the

advantage out of the principle should over weigh the cost of implementing the principle.


1. Modifying principle is also known as _____________.

2. The advantage out of the Principle should over weigh the cost of implementing the principle

itself. True or False?

3. If the establishment of costing department is too high that the cost of the products produced in

the organisation is going to overshoot by50%., far more than the market price. Is it advisable

to have cost-department?

2.4.8 Principle of Materiality

While important details of financial status must be informed to all relevant parties, insignificant

facts, which do not influence any decisions of the investors or any interested group, need not be

communicated. Such less significant facts are not regarded as material facts. What is material

and what is not material depends upon the nature of information and the party to whom the

information is provided. While income has to be shown for income tax purposes, the amount can

be rounded off to the nearest ten. And fraction does not matter. When we send statement to a



debtor, all details have to be presented. The same information about the debtors need not be

given in great detail, while sending the information to the Registrar of companies.


1. Principle of materiality states that relevant information should be given to relevant parties.

True or False?

2. Details of debtors should be given to creditors. True or False?

3. What is material information to one party may not be so for another party. True or False?

4. The method of depreciation adopted should be disclosed to Income Tax Authorities. True or

False?

2.4.9 Principle of Consistency

Consistency is required to help comparison of financial data from one period to another. Once a

method of accounting is adopted, it should not be changed. For instance, stock is valued under

FIFO method in an year and it should not be valued under LIFO method in another year. If assets

are depreciated under diminishing balance method, it should be continued for ever. It should not

be changed.

Self Assessment Questions 17 :

1. The purpose of principle of consistency is to help for ______ from one period to another

period.

2. Consistency principle helps for proper assessment of profit or loss. True or False?

2.4.10 Principle of Conservatism or Prudence

Accountant follow the rule “anticipate no profit but provide for all anticipated losses “Whenever

risk is expected, provision should be made. The value of investments is normally taken at cost,

even if the market value is higher than the cost. If the market value expected is lower than the

cost, then provision should be made by charging profit and creating investment fluctuation fund.

This is the principle of conservatism and it does not mean that the income or the value of assets

should be intentionally under stated.


1. Provision should be made whenever _____________ is expected.

2. The underlying spirit of principle of conservatism is __________ .

3. The prices of shares in which the business has invested are going up. Do you consider

advisable to provide any provision for that?



Terminal Questions:

1. What are the basic principles of Accountancy?

2. The salaries paid in 2004 Rs.500000; Salaries outstanding Rs.20000; Salaries paid in

advance for 2005 Rs.30000; What is the actual salary expenditure for 2004? What is the

accounting principle involved in this?

3. What is wrong if assets like buildings are shown at market value in the balance sheet?

4. A business receives capital of Rs.100000 and a loan is raised for Rs.50000. This is

represented by cash Rs.15000; Machinery Rs.85000; Furniture Rs.20000 and goods

Rs30000. Find the total debits and credits from business point of view. What principle of

accounting is underlying in this case?



1. Doctrines

2. Concepts, conventions

3. Convention

4. Concept

5. Bringing uniformity in accounting terminology and principles

6. 30


1. Business entity concept, Going concept, Money measurement concept, Periodicity concept,

and Accrual concept.


1. Separate entity concept

2. separate

3. No

4. Liability

5. capital


1. No

2. Long time

3. Long period

4. To replace it after a certain period.




1. No

2. Money value

3. It makes no sense unless expressed in terms of money value

4. Denominator


1. Accounting period

2. Year

3. It is because it does not indicate for what period the expenditure is.


1. Accrued interest

2. Accrued salary

3. Added

4. Credit


1. Universally

2. Ten


1. Realised

2. True

3. True

4. Yes

5. No

6. No


1. True

2. True

3. Asset Acquisition

4. Profit

5. True




1. True

2. Profit or loss

3. True

4. Added, Deducted

5. Added, Deducted


1. True

2. True

3. True

4. Rs.200000

5. True


1. Substance

2. True

3. Fraud

4. True


1. True

2. b) Total Assets

3. c) Double entry principle


1. Cost-benefit principle

2. True

3. No


1. True

2. False

3. True

4. True




1. Comparison

2. True


1. Risk

2. Anticipate no profit but provide for all anticipated losses

3. No.

Answers for Terminal Question:

1. Income recognition, principle of expense, matching of cost and revenue, historical cost

principle, full disclosure principle, double aspect principle, modifying principle, materiality

principle, consistency principle and conservatism principle.

2. Rs.490000 (500000 + 20000 – 30000); Matching cost and revenue principle.

3. If assets like building are shown at market value instead of historical cost in the balance

sheet, the profit or loss arising out of such valuation is against to the principle of income

recognition. The profit or loss is said to arise only when the asset is sold or revalued for a

specific purpose. The day when the assets are valued, the market value may be high and

later the prices may fall. Therefore it is wrong to consider the unrealized or anticipated profit.

Hence the assets should be shown at historical cost in the balance sheet.

4. Benefits received Rs.150000 (Capital Rs.100000 + Loan Rs.50000); Benefit given Rs.150000

(Cash Rs.15000 + Machinery Rs.85000 + Furniture Rs.20000 + Goods Rs.30000). It is as per

double aspect principle.



Unit 3 Double Entry Accounting

Structure

3.1 Introduction

Objectives

3.2 Meaning of double entry accounting


3.3 Cash and mercantile system of double entry system


3.4 Accounting trail


3.5 Transactions and events


3.6 Preparation of vouchers


3.7 Financial statements and their nature


3.8 Accounting equation


3.9 Effect of transactions on accounting equation


3.10 Meaning and rules of debit and credit Short Answer Questions


Terminal Questions


3.1 Introduction: The dual aspect concept of accounting is a fullproof system of recording, having the advantage

of internal checking. The very fact that every transaction is recorded of its debit and credit

aspects indicates that the final accounts of an organization takes into consideration every small or

big transaction and the impact is every account is absorbed in the preparation of final financial

statements. Double entry book keeping is definitely an improvement and more systematically



designed than single entry system, where only a few personal and real accounts are considered.

In this unit, the process of accounting – recording, journalizing, posting, ledger balancing,

preparation of trial balance, preparation of final statements of accounts – is described along with

the effect of every transaction on accounting equation. The rules of debit and credit as applicable

to various types of accounts are also discussed.

Learning Objectives: After studying this unit, you should be able to understand the following

1. To know what double entry book keeping means.

2. To understand the process of accounting, known as accounting trail.

3. To know the nature of financial statements.

4. To formulate an Accounting equation basing on debits and credits.

5. To know practically the impact of each transaction on the Accounting Equation.

6. To summarize the rules of debit and credit as applicable to different types of accounts.

The students should be able to appreciate the double entry system and know the accounting

process.

3.2 Meaning of Double Entry Accounting We have learnt that the dual aspect recording is the most important accounting concept.

According to the concept, every business transaction involves receiving aspect and giving aspect.

If capital is brought in by the owner of the business unit, the owner is the giver of the benefit and

the business unit is the receiver of the benefit. It is a liability to the business unit and it is equally

balanced by an asset in the business unit, in the form of cash received towards capital. Therefore

every liability is represented by an asset. This is also expressed as every debit has an equivalent

credit.

The logic adopted in double entry accounting can well be understood by an illustration. We shall

consider five transactions and show how they are accounted for in the books of the business.

a. Mr. Abhi brings Rs.100000 cash as capital into his business.

b. He purchases furniture to his shop Rs.10000

c. He buys goods for cash Rs.50000

d. He sells goods worth Rs.30000 for Rs.40000 on credit to Arjun

e. He pays wages to servants Rs.1000



In the first transaction, the business receives capital in cash and so capital account and cash

account are affected. Capital is a liability and cash is an asset to the business.

Capital Rs.100000 (Liability) = Cash Rs.100000 (Asset)

In the second transaction, Furniture is purchased for cash and so furniture account and cash

account are affected. This transaction can be reflected as under

Capital Rs.100000 Cash Rs. (100000 10000) 90000

Furniture 10000

100000 100000

The third transaction is buying goods for cash, which means that stock of goods are received and

cash balance is reduced and this can be reflected in the statement as under.

Capital Rs.100000 Cash Rs (90000 – 50000) 40000

Furniture 10000

Stock of goods 50000

100000 100000

The fourth transaction is a credit transaction of selling goods for Rs40000, the cost of which is

only Rs. 30000 to Arjun. So the accounts affected are goods account, Arjun account and profit

account. Since the profit belongs to the owner and it is fair to add it to the owner’s capital. The

effect of this transaction can appear on the statement as shown below:

Capital Rs. 100000 Cash 40000

Profit 10000 Furniture 10000

Stock of goods(5000030000) 20000

Arjun (Debtor) 40000

110000 110000

The fifth transaction is payment of wages, which means that cash account is affected and profit is

reduced as a result of the expenditure(wages account). This changes the statement as shown

below:



Capital Rs. 100000 Cash (40000 – 1000) 39000

Profit (100001000) Furniture 10000

9000 Stock of goods 20000

Arjun 40000

109000 109000

From the above illustration, it is clear that every transaction has dual effect and recording these

two aspects which are known as debit and credit aspects is the fundamental idea behind double

entry system of book keeping. So the meaning of double entry system is that every transaction is

recorded by identifying the two or more accounts affected therein and suitably reflect them in the

financial statements. This is a system where internal cross checking is ensured.


1. The system of recording transactions based on dual aspect concept is called i) Double account system

ii) Double entry system

iii) Single entry system

2. Show the dual aspect effect of the following transactions on the assets and liabilities of

business.

a. Purchased goods for cash Rs.80000

b. Purchased delivery van on credit for Rs.400000

c. Paid Rs.5000 to a supplier of goods on credit

d. The proprietor withdrew Rs.20000 from the bank account of business for Personal

expenses.

3.3 Cash and mercantile system of double entry system

There are two systems of double entry book keeping namely cash system and mercantile system.

In case of cash system, transactions are recorded only if cash is received or paid. Government

accounting is done basing on this system. On the other hand, mercantile system is one where

both cash and credit transactions are recorded. Besides, outstanding expenses or incomes also

find place in the mercantile system. It is fair enough to adopt mercantile system because when an

event takes place, it gets recorded irrespective of its immediate impact on the cash position. In

case of credit transactions, cash does not flow immediately but it takes place at a future point of



time. Transactions like sales or purchases on credit, salary payable, rent receivable, interest

accrued but not received, depreciation provided etc., influence on the financial position of the

business unit and therefore they should be recorded. Mercantile system facilitates this. Hence

double entry recognizes the fact that every transaction, whether cash or credit, influences at least

two accounts – one representing debit aspect and another credit aspect.

Self Assessment Questions 2: 1. The two systems of double entry book keeping are ________ and __________ .

2. Government accounting is based on mercantile system. True or false?

3. All credit transactions come under mercantile system. True or False?

4. Interest receivable, rent receivable, dividend receivable are recorded in cash system of book

keeping. True or False?

5. Profit as per cash system and mercantile system of double entry show different figures. True

or False

3.4 Accounting Trail Accounting trail is the process of identifying the transactions or events, preparation of vouchers,

recording them as journal entries, preparation of ledger accounts, balancing the ledger accounts,

incorporating all adjustments, preparation of a trail balance and finally preparing the financial

statements and balance sheet. It is a sequential order in which the accounting process flows. All

transactions are recorded first in a book called journal. The transactions are posted to the

respective accounts, maintained in a separate book called ledger. Later, all adjustments such as

opening entries, closing entries, adjusting entries are made in a book called journal proper and

there from, the ledger balances are summarized to form a trial balance. From trial balance,

trading account, profit and loss account and balance sheet are prepared.

The identification of the accounts affected in the transactions is a major task. There are three

types of accounts, namely personal accounts, real accounts and nominal accounts. An account is

a summary of transactions pertaining to a particular head.

Personal accounts include accounts of natural persons, such as Abhi account, Mohan’s account,

Sonali account etc; artificial personal accounts such as Syndicate Bank account, X Co. Ltd

account, a club account etc; representative personal account like outstanding rent account,

salaries payable account etc.

Real accounts are those which may be tangible real accounts and intangible real accounts.

Tangible real accounts relate to things that can be touched, felt, physically measurable. Building



account, furniture account, stock account, cash account etc are tangible real accounts. Intangible

real accounts are such that they can not be seen or touched. They can be measured in terms of

money such as goodwill, patent rights etc.

Nominal accounts are also known as impersonal accounts. They are in the form of expenses or

losses, incomes or gains. They do not really exist in physical form, but behind every nominal

account cash is involved. For example, salary account is a nominal account and when salary is

paid, the reality is the cash goes out and there is nothing salary in physical form. Therefore salary

account is regarded as nominal account. Similarly all expenses and losses and all incomes and

gains accounts are regarded as nominal accounts.

Self Assessment Questions 3: 1. Accounting trial is a process starting from identifying the transactions or events to preparation

of final statement of accounts. True or False 2. There are three types of accounts namely ____________ and ________________. 3. A trial balance is the summarized form of ledger balances. True or False 4. Classify the following accounts into personal, real and nominal

i) Bank of Baroda Account ii) Printing and stationery expenses Machinery Outstanding salary iii) Copy Rights iv) Sock of goods v) Loan given to Krishna vi) Loan from Bank vii) Dividend received viii) Discount Account

3.5 Transactions and Events A transaction is a business activity involving transfer of money or money’s worth. It may be cash

transaction or credit transaction. In cash transaction cash flows immediately where as in credit

transaction cash will be paid or received at future date. Assets acquired or sold, liabilities incurred

or paid, expenses paid or payable, incomes received or receivable – are all business

transactions. But there are events which are neither cash nor credit transactions but it has an

impact on the financial position of a business. These events may include provision for bad debts,

provision for repairs, depreciation, taxation, transfer of profit towards reserve fund or sinking fund

or investment fluctuation fund, etc., Events happen as a result of internal policies or external

needs. In accounting, transactions and events have equal relevance and they must be recorded

to arrive at the financial results of the business concern.

Self Assessment Questions 4: 1. A transaction is a business activity where there is transfer of money or money’s worth.

True or False

2. An event happens as a result of internal policy of an organization. True or False



3. Business transactions and events have equal importance in finding the financial results of the

business concern. True or False?

4. Identify the following as transactions or events as the case may be.

i) Depreciation of assets ii) Tax rates iii) Acquisition of assets iv) Selling an asset v) Transfer

of profits to Reserve Fund

3.6 Preparation of Vouchers A voucher is a document in support of a business transaction. It may be a receipt, a counterfoil of

a receipt, an invoice or even correspondence with the concerned parties. Usually in large

organizations, voucher system is adopted to record payments. Some organizations will have

printed voucher book and each voucher contains the number of voucher, date, the name of

payee to whom the payment is made, the amount, the purpose for which payment is made,

signature of the person authorized to pay and the person who receives the payment. For

instance, Ram has supplied to us goods worth Rs5000, for which he has given an invoice. This

invoice itself can be regarded as voucher, against which the payment is made. If carriage charges

of Rs100 are paid, we prepare a voucher and take the signature of the person who receives it.

When we pay cash, the receiver will give us a receipt, that itself becomes a voucher. Vouchers

are often prepared basing on the invoices received or goods received returns. The actual

payment may be made partially or completely and it may be made in course of time. In such

cases, they are entered in Voucher register. The payment of a voucher is recorded in cheque

register. The system has the following advantages:

1. It safeguards all cash disbursements

2. Total amount payable to creditors can be found out with the help of unpaid

3. vouchers.

4. Internal check is ensured

5. Information about future cash requirements can be found out.

However, the system is not suitable for small organizations because it involves personnel and the

cost of maintenance.


1. Voucher system is adopted to record payments. True or False?

2. Voucher system is suitable for small organizations. True or False?

3. Voucher is a document showing the__________for which payment is made.

4. Voucher system ensures internal check . True or False?



3.7 Financial statements and their nature Financial statements are prepared to find out the profit or loss at the end of an accounting period.

In a trading concern, trading account and profit and loss account are prepared. The purpose of

preparing trading account is to find out the gross profit / loss. Similarly, profit and loss account is

prepared to find out net profit / loss. Both these accounts are revenue accounts. In other words,

all revenue receipts and revenue payments are considered. Revenue expenses are those which

are incurred in day to day business activities. Examples may include wages, carriage expenses,

insurance premium paid on stocks, salaries, printing, stationary, administrative expenses, selling

expenses and so on. Revenue receipts are called incomes and the examples include rent

received, sales made, interest received, dividend received, discount received, royalty received,

compensation received etc. More details about trading and profit and loss account are given in

Unit 7.

After preparing final accounts, a balance sheet is prepared containing capital and liabilities on

one side and assets on the other side of a statement. Balance sheet is a statement of affairs and

not an account. Liabilities of a business include trade creditors, bills payable, bank over draft,

loans payable, outstanding expenses, prereceived incomes etc. Capital of the owner, which is

called equity, is added with liabilities on the left side of the balance sheet. Assets of a business

include fixed assets like buildings, plant, machinery, furniture etc; current assets like sundry

debtors, bills receivable, closing stock of materials, outstanding incomes, prepaid expenses, cash

in hand, cash at bank etc., Trading account or profit and loss account and balance sheet are

prepared at the end of a particular accounting period, say one year. In Unit 7, details about

balance sheet preparation are given.

Self Assessment Questions 6: 1. Trading account and Profit and loss account are revenue accounts. True or False?

2. What is the purpose of preparing Trading Account?

3. What is the end result of preparing profit and loss account?

4. Is balance sheet an account? What is it otherwise?

5. What items are shown on the left hand side of balance sheet?

6. Assets are shown on which side of balance sheet?

7. What is the purpose of preparing a balance sheet?



3.8 Accounting equation The preparation of balance sheet is the final step in accounting process. The accounting equation

indicates that the sources of funds should be equal to uses of funds. In other words, proprietor’s

equity and liabilities to outsiders should be equal to assets.

Sources of Funds = Application of funds OR

Owner’s equity = Asset OR

Owner’s equity + outside liabilities = Assets OR

L + P = A, where L is liabilities, P is proprietor’ equity and A

means assets. From this equation, the following expressions can be obtained

L = A – P

P = A – L

A – L – P = Zero

Self Assessment Questions 7: 1. Liabilities plus Equity is equal to ____________________________.

2. Assets minus liabilities to outsiders is equal to __________________.

3. If assets are Rs.5 lakhs, liabilities are Rs.3 lakhs, find out equity.

4. If Owner’s equity is Rs3 lakhs, Outsider liabilities are Rs.2 lakhs, Owner’s share of profit is

Rs.1 lakhs, find out the total value of assets.

5. Every transaction influences balance sheet and it is shown by accounting equation True or

False?

3.9 Effect of Transactions on Accounting Equation As said earlier, every transaction has its effect on the balance sheet equation. This has been

amply illustrated while discussing the meaning of double entry. The dual aspect of a transaction

is reflected on the balance sheet, ultimately making liabilities side equal to asset side of a

balance sheet. The following are the possible sets of transactions that can change the values of

assets and liabilities but the changes are equal on both sides of balance sheet.

1. Increase in one asset with a decrease in another asset. For example, goods are purchased

for cash. It affects cash balance to come down and stock balance increases and both of

them are assets.

2. An increase in one asset with an equal amount of increase in liability. For example, a

building is purchased for business for Rs500000 by raising a loan from bank. Here an asset

is created and a loan is also raised and the balance sheet tallies.



3. An increase in asset with an equivalent rise in the proprietor’s equity. When an additional

capital is obtained in cash, Cash account on the asset side increases and capital account on

the liabilities side also increases with the same amount.

4. An increase in a liability causing an equal amount of decrease in another liability. Ex: A

bank’s overdraft is paid out of debenture amount collected. Here debenture liability

increases with an equal amount of decrease in bank’s overdraft.

5. Increase in a liability, followed by decrease in proprietor’s equity. If debentures are issued for

the purpose of paying redeemable preference shares, the owner’s equity gets reduced and

an additional liability of debentures is added up.

6. Decrease in an asset and equivalent decrease in a liability. For instance, bills payable are

paid out by cheque. The bank balance which is an asset is decreased and correspondingly

the liability of bills payable is also decreased.

7. Decrease in an asset and corresponding decrease in owner’s equity. If capital is paid out for

any reason, cash to that extent is decreased on the asset side and the capital is reduced to

that extent on the liabilities side.

Self Assessment Questions 8: 1. The principle of accounting equation is that the total of assets should be equal to total of

liabilities side. True or False.

2. Show how the accounting equation is affected in the following transactions

a. Lal started business with Rs20000 cash

b. He purchased goods on credit Rs.80000

c. He sold goods costing Rs.25000 for Rs.30000 on cash.

d. He purchased furniture for cash Rs14000

e. He sold goods to Hari costing Rs500 for Rs.800

f. He received dividend on securities Rs.2000

3.10 Meaning and rules of debit and credit Debit and credit are the two words basic for accounting. Debit represents receiving aspect and

credit represents giving aspect. However the meaning of debit and credit depends upon the

classification of accounts. An account, as we have understood is a summary of transactions

pertaining to a particular head. The account may be personal, real and nominal. Before grasping

the rules of debit and credit as applicable to various classes of accounts, it is necessary to know

how an account appears in the books of accounts. An account is recorded in a ‘ T ‘ form, the left



side indicating the debit of the account and the right side representing the credit of the account.

On the left side of an account the columns are date, particulars, ledger folio and amount and

similarly on the right side (credit side), the columns are date, particulars, ledger folio and amount.

The following illustration may be observed:

CASH ACCOUNT

Debit Side Credit Side Date particulars Ledger Amount

Folio (Rs) Date Particulars Ledger Amount

Folio (Rs)

2005 2005 Jan. 1 To Balance brought down 20000 Jan 05 By salaries 10900

Jan15 To Joseph 35 10900 Jan 25 By Furniture 123 6000

Jan 28 To Sales 18 108900 Jan 30 By purchases 19 58800

Jan 31 By Rent 298 7500 By balance c/d 56600

139800 139800

Feb 1 To balance b / d 56600

Observe from the above form of an account the following:

1. The balance brought down is the closing balance of the last month, December,2004

2. The amount received from Joseph is Rs.10900 and his account is prepared in the in the page

number 35 of the ledger. Similarly from sales and its account is found in the ledger folio

(page) 18.

3. The credit side contains payment of cash towards salary, furniture, purchase of goods and

rent respectively on different dates.

4. The balance carried down is the closing balance on the last day of January, 2005 and it is

brought down as opening balance on Feb,1

5. On the debit side, ‘To’ and credit side ‘By’ are the prefix used for every entry as a matter of

convention.

There is a standard form of drawing a ledger account. It is similar to that of a pass book issued by

a bank. The above illustration is shown in the standard form.



CASH ACCOUNT

Date Particulars Post. Ref. Debit Credit Balance

2005 LF Rs Rs Rs

Jan 1 Opening balance b /d 20000 20000

Jan 5 Salaries 10900 9100

Jan 15 Joseph 35 10900 20000

Jan 25 Furniture 123 6000 14000

Jan 28 Sales 18 108900 122900

Jan 30 Purchases 19 58800 64100

Jan 31 Rent 298 7500 56600

The rules of debit and credit for different classes of accounts are the following

1. In respect of personal accounts : Debit the receiver and credit the giver

2. In respect of real accounts : Debit what comes in and credit what goes out

3. In respect of nominal accounts : Debit all expenses and losses and credit all incomes

and gains.

The following steps should be remembered to apply debit and credit principles

a) Identify the accounts affected in a transaction from business point of view

b) If a personal account is involved, find whether the person is receiver or giver of benefit

c) If the real account is affected, find whether it is coming in or going out

d) If the account is nominal account, find out if it is expenditure or income or loss or gain.

e) Apply the suitable principle to debit or credit the respective affected account.

Illustration: Show what accounts are affected in the following transactions. Also show the accounting equation for the transactions

1. Madan commenced business with cash Rs. 70000

2. Purchased goods on credit 14000

3. Withdrew for private use 3000

4. Goods purchased for cash 12000

5. Paid wages 5000

6. Paid to creditors 10000

7. Sold goods on credit (cost price Rs18000) 22000

8. Sold goods for cash (Cost price Rs.3000) 6000

9. Purchased furniture for cash 5000



10. Received from debtors 11000

Solution:

Transaction No

Accounts affected in the books of the business

Account to be debited and account to be credited

01 Capital account and cash account

Cash account being real account is debited and Capital account being personal account is credited

02 Goods account and creditors account

Goods account being real account is debited and creditor’s account being personal account is credited

03 Personal drawings account and cash account

Drawings account being personal account is debited and cash account being real account is credited

04 Goods account and cash account

Goods account being real account is debited and cash account being real account is credited

05 Wages account and cash account

Wages account being nominal account is debited and cash account being real account is credited

06 Cash account and creditors account

Creditor’s account being personal account is debited and cash account being real account is credited

07 Goods account, Debtor’s account and profit account

Debtor’s account being personal account is debited, profit transferred to capital account being personal account is credited and goods account being real account is also credited

09 Furniture account and Cash account

Furniture account being real account is debited and cash account being real account is credited

10 Cash account and debtor’s account

Cash account being real account is debited and debtor’s account being personal account is credited.



Accounting equations for the transactions

Transaction Assets = Liabilities + Owners Equity

Cash + Goods + Debtors + Furniture + =

Creditors +

Madan’s capital

01 70000 70000

02 14000 14000

03 3000 3000

04 12000 +12000

05 5000 5000

06 10000 10000

07 18000 22000 +4000

08 +6000 3000 +3000

09 5000 5000

10 +11000 11000

End equation 52000 + 5000 + 11000 + 5000 + 4000 + 69000

73000 73000


1. Rules of debit and credit are different for different types of accounts. True or False?

2. Debit the receiver and _______________ the giver.

3. Debit all assets and credit all ________________.

4. Debit _____________________ and credit what goes out.

5. All expenses are ___________________ type of accounts.

6. Incomes and gains are always _________ as per principle of debit and credit for nominal

accounts.

7. Capital is ____________________ when it is withdrawn.

8. When cash is received from debtors, debtor’s account is ______ .

Terminal Questions

1. The accounting equation is Assets = _______________ + _______________.

2. State the meaning of double entry book keeping.



3. State the remarkable difference between cash system and mercantile system of double

entry.

4. State the important accounting trail.

5. Classify the following accounts as personal, real and nominal

a. Land account b. outstanding expenses account c. capital account

d. ABC co Ltd., account e. Discount received account f. salaries account

6. A voucher is a document which _______________ cash disbursement.

7. What is a trading account?

8. The result of a trading account is ____________ or _______________.

9. Net profit or net loss is the result of ____________________account.

10. Give a list of any four items of assets.

11. Name any four items that appear on the liabilities side of balance sheet.

12. Balance sheet is a ________________________ of affairs of a business.

13. Find the value of the following:

a. If the total assets are Rs87000 and the liabilities are Rs47000, find out the amount of

capital.

b. If the capital of proprietor is Rs400000 and the total assets are Rs600000, what is the

amount of liabilities to outsiders?

c. If creditors are Rs56000, bank overdraft is Rs100000 and outstanding expenses are

Rs.8000, what is the total amount of assets?

d. Fixed assets are Rs.70000 and current assets are Rs.100000 and the creditors are

Rs.30000. What is capital?

14. Show the effect of the following transactions on assets, liabilities and owner’s

Equity of the business:

i. Ganesh started business with a capital of Rs.40000

9. He purchased stock of goods Rs.30000

10. Sold goods on cash Rs.40000, cost of which is Rs25000

11. Bought goods on credit Rs.10000

12. Sold goods on credit for Rs18000, the cost of which being Rs10000

13. Paid Sales commission Rs.5000

14. Received cash discount Rs3000

15. Purchased furniture Rs.10000.



16. Received cash from debtors Rs.15000

17. Paid cash to creditors Rs.6000.

Answer for Self Assessment Questions Self Assessment Questions 1:

1. Double entry system 2. a. Stock of goods increases and cash balance is reduced

b. Delivery Van is an asset and the supplier of the delivery van becomes a creditor and it

appears as liability

c. Creditor’s balance is reduced on liabilities side and cash paid brings down the cash

balance on the asset side

d. The bank balance comes down on asset side and capital account is reduced by the

amount of drawings on the liabilities side.

Self Assessment Questions 2: 1. Cash system, Mercantile system

2. False

3. True

4. False

5. True. Self Assessment Questions 3:

1. True

2. Personal, real and nominal

3. True

i. Personal ii. Nominal iii. Real iv. Personal v. Real vi. Real vii. Personal viii. Personal ix. Nominal x. Nominal




1. True

2. True

3. True

4. i) Event ii) Event iii) Transaction iv) Transaction v) Event


1. True 2. False 3. Purpose 4. True

Self Assessment Questions 6: 1. True

2. To find out gross profit or gross loss

3. To find out net profit or loss

4. No. It is a statement of assets and liabilities

5. Capital, liabilities are shown on the left hand side of Balance Sheet

6. On right hand side

7. To know the financial position of the business.

Self Assessment Questions 7: 1. Assets

2. Equity

3. Rs.2 lakh

4. Assets are Rs.6 lakh

5. True

Self Assessment Questions 8: a) True

b)

i. Lal’s capital increases on liabilities side and Cash balance increases on the asset side by

Rs.20000

ii. Creditors on liabilities side and stock of goods on the asset side increase by Rs.80000

iii. Profit of Rs.5000 is added to capital on the liabilities side, stock of goods is reduced by

Rs.25000 and Cash balance increases by Rs.30000



iv. Furniture value increases by Rs.14000 on the asset side, Cash balance is reduced by

Rs.14,000, thus making no effect on liabilities side.

v. Hari appears as debtor on the asset side for Rs.800, Stock of goods gets reduced by

Rs.500 on the asset side but on liability side the profit of Rs.300 is added to capital.

vi. Cash balance on asset side increases by Rs2000, dividend being income results in profit

of Rs.2000 and so added to capital on liability side.


1. True

2. Credit

3. Liabilities

4. What comes in

5. Nominal

6. Credited

7. Debited

8. Credited.

Answers for Terminal Questions: 1. Liabilities + Owner’s capital

2. Every transaction has two aspects, debit and credit and for every debit, there is equivalent

credit.

3. 3.All cash transactions are recorded in cash system, while both cash and credit transactions

are recorded in mercantile system

4. Identification of accounts affected in transactions, recording them in Journal, post them to

ledger, balance the ledger accounts, prepare trial balance, finally prepare final accounts.

5. a) Real b) Personal c) personal d) Personal e) Nominal f) Nominal

6. Records

7. Account showing the result of trading activities (Purchase and sale of goods)

8. Gross profit or gross loss

9. Profit and Loss Account

10. Land and Buildings, Plant and Machinery, Furniture and Fixtures, Debtors, Cash in hand,

and Bank, Closing stock etc.

11. Bills Payable, creditors, Bank overdraft, Capital etc.,

12. Statement



13. a) Rs.40000 b) Rs.200000 c) Rs.164000 d) Rs.140000

14. Refer to Illustration under sub head 9.



Unit 4 Primary Books

Structure:

4.1 Introduction

Objectives

4.2 Introduction to Primary books


4.3 Journal


4.4 Ground rules of journal entry


4.5 Types of journal


4.6 Purchases Day book


4.7 Sales day book


4.8 Return Outward book


4.9 Return inward book


4.10 Bills receivable book


4.11 Bills payable book


4.12 Cash book



Terminal Questions




4.1 Introduction

The accounting process actually begins with recording the transactions in an accounting book.

This book of original recording is called primary book and of course all transactions are recorded

basing on certain documents like invoices, vouchers or receipts etc., All transactions should

invariably be entered through the primary accounting books. Other wise, the final results of the

business concern project a distorted position or end up in preparing unreliable statements. So

making entries in the primary books is the basis for further accounting treatment such as posting

to ledger, preparation of trial balance etc.,



1. To know the various primary books, containing original entries.

2. To record transactions in General Journal adopting debit and credit principles.

3. To know in brief about subsidiary books

4. To open purchases day book and Purchase Returns Book.

5. To open Sales day book and Sales Returns Book.

6. To know about Bill Transactions.

7. To prepare Bills Receivable Book and Bills Payable Book.

8. To open Cash Book with Cash column only.

9. To understand the preparation of Cash Book with Cash and Bank Columns.

10. To understand the preparation of Cash Book with cash, bank and discount columns.

11. To know the preparation of Petty Cash Book.

12. To know how to prepare ledger accounts from individual subsidiary books.

4.2 Introduction to Primary Books

Journal is a book of original entry. In French, ‘jour’ means ‘a day’. Therefore journal is basically a

day book in which transactions are first entered in a systematic manner adopting the principles of

debit and credit. If a business organization is very small and the number of transactions taking

place each day are limited, then all the transactions can easily be recorded in the journal. But it is

not so, in case of organizations of large scale, where hundreds of transactions take place. To

facilitate convenient way of entering transactions, journal is subdivided into several books of

original entry, namely purchases, sales, cash, bills receivable, bills payable, returns inwards,

returns outwards books. They are also regarded as primary books or subsidiary books. When



once the transactions are recorded in the journal or other subsidiary books, posting is made to

ledger. It is also possible that entries are made directly to ledger accounts without bringing them

to journal at all. However, to help in cross checking, both journal and ledger accounts are

prepared.


1. Book of original entry is called ______________________________.

2. Do you regard subsidiary books as primary books of original entry?

3. Transactions are first recorded in the journal and later posted to ____________________.

4.3 Journal

It is a book containing systematic recording of transactions. The entry made is known as journal

entry and the process of writing the journal entry is called journalizing. Each page of the journal is

numbered and it is called journal folio (JF). Entries are made date wise and they reflect what

account is debited and what account is credited. The form of a journal is given below.

JOURNAL

Date Particulars Ledger Folio

Debit

Rs.

Credit

Rs.

2-4-2005 Cash A/c Dr

To Capital A/c

(Being capital brought in cash)

100000

100000

3-4-2005 Furniture A/c Dr

To cash A/c

(Being furniture purchased for cash)

20000

20000

The ledger folio mentioned in the third column indicates the number of page in the ledger book

where the respective account summary is stated. For instance, the cash account is separately

mentioned in page number 120 of the ledger book, then the ledger folio is 120. Similarly the folio

number is given to other accounts. Usually the entry is read as ‘cash account debtor to capital

account’ and so on. For every journal entry, narration is given to briefly describe the transaction.


1. What is journal?

2. What does a Ledger folio indicate ?



4.4 Ground rules of journal entry

As discussed earlier, a transaction affects at least two accounts and the accounts may be

personal or real or nominal. For each class of accounts, the rules of debit and credit are also

discussed. ‘Debit the receiver and credit the giver’ is the principle for personal accounts; ‘debit

what comes in and credit what goes out’ is the rule for real accounts and ‘debit all expenses and

losses and credit all incomes and gains’ is the rule for nominal accounts. To draw journal entries,

the following steps be followed:

a) Identify the accounts affected in the given transaction

b) Classify the accounts as personal, real or nominal

c) Apply the relevant rule for debit and credit to determine what account to debit and what

account to credit

d) Write the journal entry as described above.

e) Give the narration for the transaction.

Illustration 1

Enter the following transactions in the books of Gopichand

1. 10-5-2004 Started business with capital of Rs.50000

2. 12-5-2004 Bought goods worth Rs.30000

3. 14-5-2004 Sold goods to Ram Charan for Rs.5000 for cash

4. 15-5-2004 Sold goods to Kanthilal Rs.12000 on credit

5. 20-5-2004 Paid wages to daily workers Rs.300

Answer

Journal Entries in the books of Gopichand

Date Particulars LF Debit (Rs.) Credit (Rs.)

10-5-04 Cash A/c Dr

To Capital A/c

(Being capital brought in cash)

50000

50000

12-5-04 Goods A/c Dr

To Cash A/c

(Being Goods purchased for cash)

30000

30000

14-5-04

Cash A/c Dr

To Goods A/c

(Being goods sold on cash to Ram Charan)

5000

5000

15-5-04 Kanthilal A/c Dr

To Goods a/c

(Being goods sold on credit to Kanthilal)

12000

12000

20-5-04 Wages A/c Dr 300



To Cash A/c

(Being wages paid to daily workers)

300

97300 97300

Note:

1. The fourth transaction is a credit transaction and so the name of the debtor, Kanthilal is

debited and the goods account is credited because goods are going out and it is real account

2. The fifth transaction involves an expense and wages account is a nominal account. It is thus

debited and since cash account is real account and it is going out and therefore it is credited.

3. At the end of accounting period, the total of debits should be equal to total of credits.


1. All assets should be debited and all liabilities should be ___________________.

2. When interest is received in cash, Cash account is debited and _____ account is credited

3. If bank overdraft is raised, the overdraft account is ________ and cash account is _____.

4. When creditors are paid out, ______is debited and _____________ account is credited.

5. If furniture is bought for cash from X Co Ltd., the company account is not credited. Why?

6. If wages are paid for construction of business premises, ___________ A/c is debited and

_____________ A/c is credited.

7. Write the journal entries for the following transactions in the books of Y Co Ltd.,

i) Advance of Rs. 500000 received from Damodar & Bros for the supply of goods.

ii) Sales tax paid Rs. 40000

iii) Amount drawn from Bank of Baroda for miscellaneous expenses Rs. 5000.

4.5 Types of Journal

Journal is a book of original entry and only one journal is maintained if the business is very small

in size and the transactions are limited. However, if the transactions are multifarious, then

subsidiary books which are known as books of original entry are prepared. The types of journal

include purchases book, sales book, purchase returns book, sales returns book, bills receivable

book, bills payable book, cash book and journal proper. The entries are made in these books

straight without recording in usual journal. From the respective books, posting is made to ledger.

In fact, from the entries made in the subsidiary books, journalizing can be done. A detailed note is

given in the following paragraphs on each of the subsidiary books.

Self Assessment Questions 4: State True or False

1. All subsidiary books are also journal because they are books of original entry.



2. All such transaction which cannot be included under different subsidiary books are entered in

journal proper.

3. Can we post the transactions to ledger accounts from the entries made in subsidiary books ?

4. The purpose of subsidiary books is to classify enumerable transactions into various functional

activities.

4.5 Purchases Book/purchases day book

Purchases book is also called purchases journal. Only credit purchases of goods are recorded in

this journal. ‘Goods’ mean items or commodities procured for resale. Cash purchases are

recorded in cash book and credit purchases are recorded in purchases book. The form of a

purchases book is given below.

Purchases Book of Johnson and Johnson Co

Date Name of Supplier Ledger Folio Inward Invoice No

Amount

Rs.

2006

August 5

8

16

Rao Bros, Bangalore

Snow white Co,

Best & Company

Total

567

87

146

36,000

45,000

29,000

1,10,000

Inward invoice is the document sent by the supplier while selling the goods. Every invoice

received is numbered and this number is stated in the purchases book for reference. From the

above entries made in the purchases book, it is possible to record journal entries. Whenever,

purchases are made, goods account is debited because it is real account and the supplier’s

account is credited because the supplier is the giver and it is personal account. The journal

entries for the above transactions appear as under:

Journal entries in the books Johnson and Johnson Co.,

Date Particulars LF Debit

Rs.

Credit

Rs.

5-8-06 Goods A/c Dr

Rao Bros A/c

(Being goods purchased on credit)

36,000

36,000

8-8-06 Goods A/c Dr

Snow White Co A/c

(Being Goods purchased on Credit)

45,000

45,000

16-8-06 Goods A/c Dr 29,000



To Best & Co A/c 29,000

Total 1,10,000 1,10,000

Observe that in every case of credit purchase, the supplier’s account is credited and goods

account is debited.

At the end of the day or week or month, the total of purchases is transferred to one ledger

account known as Purchases account in the ledger.


State True or False

1. All purchases cash or credit are entered into purchases day book.

2. Purchases of goods and other assets can also be recorded in purchase book.

3. Inwards Invoice is a document to verify the quantity, price and other details of goods

purchased.

4. Purchases made from Mr. Ganesh an credit Rs 6000, entered in the purchases book. What is

the journal entry ?

4.7 Sales book or Sales Day book

Sales book or sales day book contains the details of credit sales of goods made during a

particular period. The total of the sales book is transferred to ledger to an account called sales

account. The parties to whom credit sales are made are known as trade debtors. All debtors are

classified as personal accounts and for each party, ledger account is prepared in the ledger.

Sales account shows credit balance and debtor’s account shows debit balance. A pro forma of

sales book is as given under.

Sales book of Raghu Medicals

Date Name of customer/debtor Ledger Folio

Outward Invoice No.

Amount

Rs.

4-3-05 French Medicals 476 6,800

18-3-05 Mandara stores 477 19,200

28-3-05 Shaw Medical and General Stores

478 85,000

Total 1,11,000

Outward Invoice number is the number of the invoice issued by the businessman to the customer.

The total of Rs. 1,11,000 will be transferred to sales account in the ledger. Similarly the

respective ledger accounts of the customers will be prepared in the ledger.




1. Sales day book contains only credit sales of goods made.

2. Sale of any other asset other than goods is also recorded in sales day book.

3. Persons to whom sales are made on credit are called ________.

4. Outward invoice is a document issued to customer, when the goods are sold on credit.

4.8 Purchase Returns Book

When the businessman purchases the goods and finds that the goods are not as per the

specifications or the goods are damaged or for any other valid reason, he may decide to return

the goods to the supplier from whom the goods were purchased. All such purchase returns are

recorded in a journal called purchase returns book. Normally the supplier’s account is credited

when the purchases are made. If the goods are returned, then a debit note will be sent and the

number of debit note is recorded in the purchase returns book.

Purchase Returns Book of Johnson and Johnson Co.,

Date Name of supplier Ledger folio Debit

note No.

Amount

Rs.

2006 August, 12 Snow White Co 25 5000

24 Best & Co 26 7000

Total 12,000

The total of the book is transferred to ledger to an account called purchase returns account,

which shows credit balance. The respective personal accounts of the suppliers/creditors are

debited in their respective ledger accounts.


1. Purchase returns are also called returns outwards.

2. Purchase returns take place when the goods bought are not as for the specification.

3. When goods, bought, are returned, suppliers account is _________ and purchase return

account is _____________.

4. Debit note is a document to slow the supplies account being debited.

4.9 Sales Returns Book

Just as goods which do not conform with specifications are sent back to suppliers, our customers

may also send the goods sold to them back to us owing to similar reasons. Then a credit note is

prepared to show that the customer’s/debtor’s account is credited to the extent of the value of the

goods returned by them to us. Goods are received from the customers and a credit note is sent to

them.



Sales Returns Book of Raghu Medicals

Date Name of customer/debtor LF Credit Note

No.

Amount

Rs.

10-3-05 French Medicals 56 2,000

30-3-05 Shaw Medicals and Gen. Stores 57 4,000

Total 6,000

As usual the total of the book is transferred to an account called sales returns account in the

ledger and this account shows debit balance. The respective personal accounts of the customers

are credited with the value of the goods returned by them.


1. Sales return are also called returns inwards.

2. Credit not is a document to indicate that the goods are recived as returned by customers.

3. Credit noted is sent by _____________ to __________.

4.10 Bills Receivable Book

When a businessman sells goods on credit, he does not receive cash immediately. But the

businessman requires cash for which he draws a bill of exchange against the customer and the

customer accepts it. Such a bill of exchange can be discounted with a banker for commission.

The businessman who draws the bill is called drawer and the customer on whom it is drawn is

drawee or acceptor. So bill of exchange is a document in writing, promising to pay a certain sum

of money or money’s worth to the drawer at a certain date for value received. The businessman

maintains a journal/ subsidiary book containing the details of the bills receivable. The bills

receivable account shows debit balance and the amount receivable against them is an asset.

Bills Receivable Book of Sham Sundar & Co.,

No. of the bill

Date of Receipt

Date of the bill

From Whom

received Acceptor

Where payable

Term of the bill

Due Date LF Amount

Rs. Remarks

1 04-7-04 04-7-04 Mr.X Mr. X Delhi 3 mths 7-10-04 7,000

2 1-8-04 01-8-04 Mr. Y Mr. Y Noida 4 mths 4-12-04 9,000

3 9-9-04 09-9-04 Mr. A Mr. A Agra 3 mths 12-12-04 12,000

4 10-9-04 10-9-04 Mr. B Mr. B Delhi 4 mnth 13-1-05 10,000

38,000

For every bill the due date is calculated after adding three days of grace. The person from whom

the bill is received and the person who accepted the bill could be the same person or different

persons. The total of the bill receivable is transferred to bills receivable account in the ledger.




1. A bill is an instrument in writing similar to that of a promissory note.

2. Who is a drawer of a bill of exchange in a business ?

3. Who is the acceptor of a bill of exchange in a business ?

4. Bills Receivable account shows _____________- balance.

5. Can bills receivable be discounted ?

4.11 Bills Payable Book

What is bills receivable for a drawer, is bills payable to the drawee. In a business concern,

proprietor draws bills on debtors and accepts bills drawn by trade creditors. All such bills

accepted by the proprietor are recorded in a separate book called bills payable book. The sum of

the value of bills payable for a period ending will be transferred to the ledger. Usually bills

payable account shows credit balance and hence is a liability. The form of bills payable book is

given here under.

Bills Payable Book of Sun Shine Co.,

No. of the bill

Date of the bill

To whom given

Drawer Payee Where

payable Term of the bill

Due date

LF Amount

Rs

Date paid

Re-marks

1 2000

June 07

Ram & Co Ram & Co Ram & Co.

Agra 3 months 2000

Sept 10

56,000

2 June 12 Sundaram Sundaram Sundaram Delhi 4 months Oct 15 72,000

3 June 20 KV & Co KV & Co KV & Co Chennai 5 months Nov 23 50,000

Total 1,78,000


1. Bills accepted by the proprietor of the business and drawn by supplies are called _________.

2. Every bill has ________ number of grace days .

3. Bill payable account shows _________ balance.

4. Bill payable represent ________.

5. when bills payable account is credited ________ account is debited.

4. 12 Cash Book

Cash book is an important subsidiary book and a book of original entry. It is a record of cash

receipts and cash payments made during a particular period. On the right hand side, receipts are

recorded and on the left hand side, payments are recorded. A simple cash book has two sides,

receipts side and payment side. The receipts are on debit side and the payments are on credit



side. Just as a ledger account, the words ‘To’ and ‘By’ are used. Cash book may also contain

cash column and bank column. Cash column represents cash in the business and bank column

represents cash kept in the bank. Bank column of cash book is a reflection of bank pass book.

In this connection, it is important to note that in a few transactions, affecting both cash and bank

accounts, contra entries are drawn. For example, cash is deposited in the bank is a transaction in

which cash goes out and bank is the receiver. In cash account, it is recorded as payment and in

bank account it is treated as a receipt. Similarly when cash is withdrawn from bank for office

purpose, contra entry is drawn, debiting cash account and crediting bank account.

Cash book containing cash and bank columns is known as two column cash book. In the case of

three column cash book, on the receipt side, cash, bank and discount allowed columns are

stated. On the credit side, cash, bank and discount received columns are mentioned.

Single column Cash Book of Rekha & Bros

Date Receipts Cash

Rs.

Date Payments Cash

Rs.

2003

July 1

4

10

20

28

30

To Balance b/d

To Sales

To Interest on FD

To Commission

To Sale of goods

To Balagopalan

4,500

8,050

2,000

4,000

10,000

5,000

2003

July 1

3

14

20

28

31

By Rent of shop

By Postage

By Purchases

By Stationery

By wages

By Narasimhan

By balance c/d

500

50

7,000

800

2,000

9,000

13,800

33,550 33,550

Two-Column Cash Book of Sampson Co.,

Date Receipts Cash (Rs.)

Bank (Rs.)

Date Payments Cash (Rs)

Bank (Rs)

2003

Apr 5

6

7

11

20

To Balance b/d

To Sales

To Ashok Co

To Beta Co

To Sales

1,500

900

500

13,000

2,000

2,350

2003

April 2

5

8

15

30

By Wages

By Electricity

By repairs

By Yenki Ltd

By Balance c/d

50

400

2,350

400

10,800

6,150

2,800 17,350 2,800 17,350



Three-Column Cash Book of Janardhan Works

Date Receipts

Discount

Rs

Cash

Rs

Bank

Rs Date Payments

Discount

Rs

Cash

Rs

Bank

Rs

2002

Jan 2

5

10

15

30

31

To balance b/d

To Patel

To Neelima

To Bank C

To Cash C

To Dividend from X Co

100

3,700

2,400

3,000

4,500

6,000

1,000

2,000

2002

Jan 6

3

15

22

30

31

31

By wages

By Agarwal

By Cash C

By drawings

By Bank C

By rent

By bal c/d

50

1,550

950

1,000

5,600

3,000

2,000

1,500

7,000

100 9,100 13,500 50 9,100 13,500

Note the following points from the above illustration:

a) Discount column on the debit side represents discount allowed and on the credit side, it

represents discount received. Balancing is not done for these columns for a simple reason to

find out separately the discount allowed and received.

b) There are two contra entries each on 15th and 30th. On 15th the transaction is cash withdrawn

from bank Rs. 3,000. It is a payment from bank and it is receipt to business cash. Similarly on

30th Cash is deposited to bank Rs.1000. It is a receipt to the bank account and payment from

cash account.

c) To indicate contra entry, ‘C’ is mentioned against the entry.

d) Drawings represent the amount withdrawn from bank for business purposes.

e) Dividend from X Co is received by cheque and the company should have remitted the

dividend directly to the bank account of the businessman.

f) The balance c/d is the closing balance for the month of January 2002 and this becomes

opening balance for February, 2002.


State True or False

1. Cash book and cash account are one and the same.

2. Cash book may be single column, two column or three column are.

3. Trade discount allowed to customers or received from suppliers are not recorded in cash

book.



4. cash discount allowed to customers appears an ____ side of cash book. Cash discount

received appears are ____ side of cash book.

5. discount columns are independently totaled and not balanced.

6. Bank columns of cash book indicates Bank transations made by business man.

7. contra entry is an entry where both cash account and bank account are affected.

4.12 (a) Petty Cash Book

In large organizations, petty expenses like stationery, postage, stamps, refreshments, carriage,

cartage, daily wages etc are incurred day in and day out. All these expenses are more in number

and very insignificant in value. To look after payment of such expenses, a separate petty cashier

is appointed, who obtains a definite sum of money at the beginning of a month and gives a

statement of account at the end of the period to the chief cashier. To record such payments, a

separate book, known as petty cash book is maintained.

There is a distinct method, namely imprest system which is adopted in maintaining such petty

cash book. Under this system, at the beginning of a month, a definite sum of money is given by

chief cashier to petty cashier for petty expenses. At the commencement of the next period, the

petty cashier receives money equal to what is spent during the earlier period. For instance, in the

beginning of January, 2004, a sum of Rs.10000 is given to petty cashier assuming that such

miscellaneous expenses may be to the order of Rs.10000. By the end of January, it may be

found that the actual expenses are only Rs.9000. Then the chief cashier will reimburse Rs.9000

so that the opening balance for the month of February will be Rs.10000. This is also called

analytical petty cash book.


State True or False

1. Petty cash book is maintained in case of petty organization.

2. Imprest system of cash book is a system where the expenses paid are reimbursed.

3. The closing balance in case of imprest system of petty cash book always remains the same .

4. Imprest system of cash book is also called analytical cash book.

Illustration:

Enter the following transactions in an analytical petty cash book.

2005

November 1st . Received a cheque for petty cash Rs.1000

2nd . Paid bus fare to messengers Rs50



4th . Paid auto fare Rs.70

10th . Postal stamps purchased Rs.80

12th . Paid for stationery Rs90

15th . Paid for carriage Rs.60

16th . Purchased envelopes Rs.50

20th . Wages paid Rs 100 .

25th . Tips given to driver Rs.50

30th . Telephone calls paid Rs. 20

Amt

Recd

Rs

CBF Date Particulars V

No

Total

Payments

Rs

Analysis of payments LF Ledger

A/cs

1,000

Nov

1st

2nd

4th

10th

12th

15th

16th

20th

25th

30th

Nov

30th

Dec 1st

To Bank

By bus fare

ByAutofare

By postal

By Stationery

By Carriage

By Envelopes

By Wages

By tips

By Telegram

By Balance C/d

50

70

80

90

60

50

100

50

20

570

430

1,000

Tra

Rs

Post

Rs

Carr

Rs

P&S

Rs

Wages

Rs

Sundry Exps Rs

50

70

___120

80

____80

60

20

80

90

50

140

100

____

100

50

_____

50

Note:

1. CBF stands for cash book folio

2. V.No stands for Voucher No

3. Tra stands for Travelling expenses

4. Carr indicates Carriage expenses



5. P & S stands for printing and stationery

Terminal Question

1. Purchases book records___________________ purchases.

2. Cash purchases are recorded on-_____________ side of cash book..

3. Credit sales are entered in ____________________________ book.

4. Record a journal entry for drawings made for personal purposes of the businessman.

5. If drawings are made from bank for office purpose, what is the entry?

6. During the year, if the total owner’s equity of Beta Co increased from Rs50,000 to Rs60000, it

is because of earnings made during the year. Is this statement necessarily true?

7. Complete the following matrix by entering either debit or credit in each cell.

Item Increases Decreases

Assets

Liabilities

Owner’s equity

Income

Expenses

8. Listed below a number of transactions. Identify which account to be debited and which

account to be credited, as shown for the first transaction.

Transaction Debit Credit

Paid to Gopal, a creditor Gopal account Cash account

Paid rent in advance for the next year

Purchased stationery

Paid rent for the proprietor’s house

Purchases machinery on part payment

Charged customers for services provided

Collected cash for the services provided

Received a cheque from customer on account

Paid dividend

Paid wages for construction of business premises

Paid interest charges on loan

Electricity bill paid

Salaries paid



9. Journalise the following transactions in the books of Harinam Singh for the month of April,

2005.

Rs.

1st Harinam Singh started business with cash 60,000

2nd

Purchased furniture for cash 10,000

4th

Purchased goods for cash 25,000

5th

Bought goods from Karmesh 25,000

7th

Sold goods for cash 44,000

9th

Sold goods to Ramesh 30,000

10th

Paid cash Kamalnath 15,000

11th

Received cash from Ramanath 10,000

18th

Purchased goods from Sohan Kumar 12,000

25th

Purchased computers on credit from Shivshankar 28,000

29th Paid salaries 7,000

30th

Withdrew cash for personal use from the office 10,000

30th

Paid wages 5,500

10. Record the following transactions in the subsidiary books of Ramachandra and Sons of

Chennai and show the totals of each book for the month of January, 2000.

Date Transaction Amount (Rs.)

Jan 1 Bought goods from Das Gupta 20,000

2 Sold to Sen Gupta 12,500

3 Sold goods to Ramesh 30,000

5 Bought goods from Suresh 15,000

7 Sold goods to Anand 13,000

8 Received goods returned by Sen Gupta 5,500

9 Purchased goods from Shyam Sundar 16,000

10 Roy bought goods from us 25,000

11 Roy returned goods to us 3,000

14 Sold goods to Ram 45,000

16 Bought goods from Naresh 20,000

20 Returned goods to Naresh 4,000

22 Purchased furniture from Vibhu 10,000

30 Sold goods on cash to Khadju 9,000

30 Paid cash to Suresh 10,000



11. Enter the following transactions in the single column cash book of Gopichand.

March, 2003

1st .Commenced business with cash 20000

2nd Bought goods for cash 5000

3rd . Sold goods for cash 4000

4th . Goods purchased from Ravi Kumar 10000

10th .Paid to Ravi Kumar 7000

14th . Cash sales 8000

18th . Purchased furniture for office 4000

22nd . Paid wages 500

25th . Paid rent 600

30th . Received Commission 4000

30th . Withdrew for personal purpose 1000

31st . Paid salary 900

12. Record the following transactions in two column cash book(Cash and Bank)in the books of

Soft Silk Co., for the month of July, 2004.Find out the closing balances.

July, 2004 Rs.

01st . Opening balance b/d(Cash) 14,500

(Bank) 7,000

04th . Cash purchases 6,700

05th . Rent for June month paid by cheque 2,500

09th . Cash sales 15,200

12th . Dividend received from X Co and paid it into bank 4,350

15th . Cash deposited into bank 5,000

18th . cash paid to Rahim Bros to settle his account 10,000

20th . Repairs paid 1,000

22nd . Commission paid by cheque 2,000

23rd . Customer, Deepak remitted to our bank account 20,000

25th . Cash withdrawn from bank for office use 5,000

27th . Drawings made from business cash for personal purposes 2,000

28th . Purchased stationery by cash 3,000

30th . Cash withdrawn for personel use from bank 1,400



13. Enter the following transactions in the cash book with discount, cash and bank columns

May 1st . Balance of cash in hand Rs. 14000; bank overdraft at bank Rs.5000

4th Invested further capital Rs. 10000 out of which Rs.6000 was deposited in the bank.

6th . Sold goods for cash Rs. 30000

6th Collected from debtors of last year Rs. 80000; Discount allowed to them Rs. 2000.

10th . Purchased goods for cash Rs. 55,000

11th . Paid Ram Vilas, our creditor Rs. 25,000; discount allowed by him Rs.650

13th . Commission paid to our agent Rs. 5,300

14th . Office furniture purchased for cash Rs. 2,000

14th . Rent paid Rs 400; electricity charges paid Rs. 1,000

14th . Drew cheque for personal use Rs. 7,000

17th . Cash sales Rs. 25,000

18th . Collection from Atal Bihari Rs.40,000, deposited in the bank on 19th April.

19th . Drew from the bank for office use Rs.5,000

22nd . Drew cheque for petty expenses Rs.1,500

24th . Dividend received by cheque Rs.500, deposited in the bank on the same day.

25th . Commission received by cheque Rs.2,300, de[posited in the bank on 28th April

29th . Drew from the bank for salary of the office staff Rs15,000

30th . Deposited cash in the bank Rs.10,000.



1. Journal

2. Yes

3. Ledger


1. It is a book containing the entry of transactions

2. It indicates the pages number in which the summary of respective account is found in ledger.


1. credited

2. Interest

3. Credited, debited

4. Creditor’s account, cash

5. Because it is cash transaction and X co is insignificant.

6. Business premises, cash

7. i. Cash A/c Dr 5,00,000 to damodar & Bros 5,00,000 ( Being advance received )



ii. Sales Tax A/c 40,000, To cash A/c 40,000 ( sales Tax paid )

iii. Cash A/c the 5000 To BOB A/c 5000 ( cash drawn for mis.expenses )


1. True

2. True

3. Yes

4. True


1. False

2. False

3. True

4. Purchases A/c Dr To Ganesh account ( Being purchases made )


1. True

2. False

3. Debtors

4. True


1. True

2. True

3. Debited, Credited

4. True


1. True

2. True

3. Business, Customer.


1. True

2. Owner of the business who is the seller

3. Customer / debtor

4. Debit

5. Yes




1. Bills payable

2. Three

3. Credit

4. Liability

5. Supplier’s account / Creditors account


1. True

2. True

3. True

4. Debit, Credit

5. True

6. True

7. True.


1. False

2. True

3. False

4. True


Answer

1. Credit

2. Credit

3. Sales Day

4. Drawing are A/c , Dr To Cash a/c

5. Cash account Dr To bank account.

6. The statement is true if additional capital is not brought in during the year. Owner’s equity

increases if profits are added or additional capital is brought in.

7.

Debit Credit

Credit Debit

Credit Debit

Credit Debit

Debit Credit



8.

9.

1 1st Cash a/c Debited Capital a/c Credited

2 2nd

Furniture a/c Debited Cash a/c Credited

3 4th Goods a/c Debited Cash a/c Credited

4 5th Purchases a/c Debited Kamalesh a/c Credited

5 7th Cash a/c Debited Goods a/c Credited

6 9th Ramesh a/c Debited Sales a/c Credited

7 10th

Kamel nath a/c Debited Cash a/c Credited

8 11th

Cash a/c Debited Kamanath a/c Credited

9 18th

Purchases a/c Debited Sohan Kuma Credited

10 25th

Computers a/c Debited Shiva Shankar Credited

11 29th

Salaries a/c Debited Cash a/c Credited

12 30th

Drawings a/c Debited Cash a/c Credited

10.

Total of Purchases Day book:

Das Gupta Rs. 20,000

Suresh Rs. 15,000

Shyan sunda Rs. 16,000

Naresh Rs. 4,000

Rs. 55,000

Purchase Returns Book

Prepaid Expenses Cash

Stationery Cash

Drawings Cash

Machinery Supplier

Customers Services

Cash Customers

Cash Customers

Dividend Cash

Business Premises Cash

Interest on loan Cash

Electricity Cash

Salaries Cash



Naresh Rs. 4,000

Sales Returns Book

Sen Gupta Rs. 5,500

Roy Rs. 3000

Rs. 8,500

Total sales Day book

Sen Gupts Rs. 12,500

Ramesh Rs. 30,000

Anand Rs. 13,000

Ray Rs. 25,000

Ram Rs. 45,000

Rs. 1,25,500

11. Cash Book

To Capital 20,000 By Goods 5000

To Sales 4,000 By Ravi Kumar 7000

To Sales 8,000 By office furniture 4000

To Commission 4,000 By wages 500

By rent 600

By drawings 1000

By salary 900

By bal c/d 17,000

36,000 36,000

Hint: Goods Purchased from Ravi Kumar is a credit purchase.

12.

Cash Bank Cash Bank

To Opening bal b/d 14,500 7000 By Purchases 6700

To Sales 15,200 By Rent 2500

To Cash 5000 By dividend 4350

To Deepak 20,000 By bank 5000

To Bank ( c ) By Rahim & Bus 10,000

By repairs 1000

By commission paid 2000

By cash ( c ) 5000

By drawings 2000

By stationery 3000

By drawings 1400



By bal c/o 7000 16750

24,700 32,000 24,700 32,000

To Bal b/d 7,000 16,750

13. Cash Book

Discount Rs

Cash Rs

Bank Rs

Discount Rs

Cash Rs

Bank Rs

To bal b/d 14,000 By purchase 55,000

To bal b/d ( OD) 5000 By Ram vilas 650 25,000

To Capital 4000 6000 By commission 5,300

To Sales 30,000 By office furniture 2000

To Debtors 2000 80,000 By rent 400

To Sales 25,000 By electricity 1000

To Atal Bihari 40,000 By drawings 7000

To Cash ( c) 4,000 By banks ( c) 40,000

To Bank 5,000 By cash ( c) 5,000

To Dividend 500 By petty expenses 1,500

To Commission 2300 By bank ( c) 2,300

To Cash ( c) 2300 By salary 15,000

To Cash ( c) 15,000 By bank ( c) 15,000

By c/d 54,300 40,300

Total 2000 2,00,300 68,800 Total 650 2,00,300 68,800



Unit 5 Secondary Books

Structure

5.1 Introduction

Objectives

5.2 Types

Self Assessment Questions 1 to 7

5.3 Posting technique in the ledger


Terminal Questions


5.1 Introduction Journal is the book of original entry and all transactions are recorded first in that book. We have

also learnt that there are subsidiary books, which are different types of journal and in large

organizations, these subsidiary books are maintained as books of original entry. However there is

a book called Journal Proper, which is also a type of journal in which transactions which can not

be entered in any other subsidiary books, shall be recorded. For instance, a loan is declared as

bad and it should be written off. This is not a cash transaction non the less a credit transaction.

But it should be recorded in some book. Similarly depreciation on assets has to be provided; rent

paid in advance ; taxes paid in advance, outstanding expenses payable and so many such

transactions have to be recorded for a fair calculation of profit or loss. To facilitate recording of

such transactions, a separate book called journal proper is maintained. It is only after all

transactions are entered into various books, ledger accounts are prepared entirely in a different

book namely ledger. The process of recording the transactions in the ledger is known as posting.

Since ledger is prepared basing on journal, it is known as secondary book.


1. To know what secondary books are.

2. To know what Journal proper is and its purpose.

3. To know what a ledger and ledger account mean.

4. To understand the posting of transactions from General Journal

5. To know the technique of posting transactions from subsidiary books



5.2 Types There are three types of ledger, namely debtors ledger, creditors ledger and general ledger. Debtors ledger contains accounts of debtors to whom goods are sold on credit. Creditors ledger contains accounts of creditors from whom goods are purchased on credit. General ledger contains real accounts, nominal accounts and all personal accounts, other than debtors and creditors accounts. Before understanding about posting transactions to ledger, it is useful to understand about journal proper.

Journal proper contains the following aspects: a) Opening journal entries b) Closing journal entries c) Adjusting entries d) Rectification entries e) Transferring entries f) Credit purchase of assets and sale of assets g) Withdrawal of goods by the proprietor for his personal use h) Loss of goods due to natural causes

Self Assessment Questions 1: 1. Ledger is also known as _____________.

2. Journal proper contains ______________.

3. Is Ledger an account or a book ?

4. The three types of secondary books are _____,______ and ______________. 5. Furniture of the office used by the proprietor in his house. where do you find an entry for

this transaction in business books? 6. What ever is recorded in journal proper is also posted to ledger.(state whether it is True /

False).

5.2 a. Opening Journal entries: In the case of running business, all the assets and liabilities of the previous year should be brought down to the current year and therefore an entry is drawn debiting all assets account and crediting liabilities account and the difference being credited to capital account. In a business on 31 st Dec, 2004, the following assets and liabilities were there: Cash at bank Rs50000; Furniture Rs.48000; Plant and machinery Rs200000; Debtors Rs.100000; Stock in trade Rs.20000; Creditors Rs.50000; Bank loan Rs.45000. On 1 st of January, 2005the assets and liabilities have to be brought in and so in Journal Proper the following entry is recorded.

Date Particulars Ledger Folio Debit Rs Credit Rs 1105 Cash at Bank A/c Dr 50000



Furniture A/c Dr P and M A/c Dr Debtor’s A/c Dr Stock In trade A/c Dr

To Creditors A/c To Bank Loan A/c To Capital A/c (Diff)

(Being assets and liabilities of the previous year brought in)

48000 200000 100000 20000

50000 45000 323000

Similarly, a newly set up business may commence its activities with some assets and liabilities.

Then the assets are debited and liabilities are credited and the difference is transferred to capital

account.

Self Assessment Questions 2 1. Opening journal entries are drawn at the commencement of accounting period. (state whether

it is True / False).

2. When all assets are debited and all liabilities are credited, the difference is transferred to

___________ account.

3. If opening liabilities including capital are more than assets, to what account the difference is

transferred ?

5.2 b. Closing entries Closing entries are drawn at the end of accounting period and the purpose is to close down

several account balances for the current period. The accounts of assets and liabilities will not be

closed because they continue to exist further. All expenses and income accounts are closed by

transferring them to the respective revenue accounts such as Trading account and Profit and

Loss account. For example, salaries paid during the year are closed by transferring to P & L

account, debiting P & L account and crediting Salaries account, so that the salaries account of

the current year does not again appear in the next year. More details about closing entries will be

dealt with in Unit 7.


1. All revenue accounts are closed at the end accounting period. ( state whether it is True /

False).

2. All trade expenses are closed by debiting trading account and crediting _____ accounts.

3. _______ account are closed by transferring them to P & L account.



4. Are assets and liabilities accounts closed at the end of the accounting year ? (state whether it

is Yes / No).

5.2 c. Adjusting entries

After the closure of accounting year, there might be a few more transactions left over and which

are not incorporated into journal or ledger, owing to omission and practical difficulties. For

example, closing stock should be valued on the last day of the accounting period. If the stock is

so large containing several items, it is possible that the calculation is not made along with

physical verification. In such a case, an adjusting entry is made to bring that item into account.

Similarly, with regard to rent paid in advance, expenses outstanding, incomes received in

advance etc adjusting entries are made in Journal proper. If they are not considered, the profit or

loss reflected by the final accounts will not give the correct picture for the accounting period. More

details about adjusting entries will be discussed in Unit 7.

Self Assessment Questions 4 1. Transaction which are out of trial balance have to be adjusted for proper calculation of profit /

loss.( state whether it is True / False ).

2. What is the adjusting entry in the following cases

a. Depreciation of Building

b. Closing stock

c. Prepaid Insurance

d. Outstanding salaries

e. Stock used for personal purposes

5.2 d. Rectification entries Errors are natural and rectification is a must to arrive at exact position of profit or loss and balance sheet. These errors may or may not be disclosed by trail balance. Casting errors, omissions, commissions, principle errors, compensatory errors etc can occur in the process of accounting. They have to be identified and rectification entries have to be recorded. For example, wages which are paid for construction of a building are wrongly debited to wages account. By doing so, the expenses are increased and the resultant profit is reduced. Really speaking, the wages paid for construction, being a part and parcel of building account, should have been debited to building account. Therefore to rectify this error, building account should be debited and wages account should be credited so that building account gets enhanced and wages account gets reduced. Such rectification entries are drawn in Journal proper. More details are available in Unit 6.



Self Assessment Questions 5 1. Errors occur in the course of accounting and they influence the profit calculation of the

business concern ( State whether it is True or False ). 2. What are the broad categories of errors ? 3. Rectification entries are drawn in _____________.

5.2 e. Transferring entries When the balance of one account is transferred to another account, transferring entry is made. For instance, drawings made by proprietor should be reduced from his capital account. To facilitate this, drawings account, which shows debit balance, is credited and capital account is debited (because capital is reduced as a result of drawings). This is a transferring entry and it is recorded in Journal proper.

Self Assessment Questions 6 1. When an account showing debit balance, when transferred, should be _______ and vice

versa.

2. The cost of stock destroy in fire should be transferred to which account? what is the entry for

that ?

3. When drawing are transferred to capital. What is the entry?

5.2 f. Credit purchase of assets and sale of assets Normally, purchase of goods either on cash or credit, get recorded in cash account or purchases

account respectively. Cash purchase of assets, like furniture or plant or machinery also get

recorded in cash account. But credit purchase of assets, as mentioned above, can not be entered

in purchase account or cash account because they are not goods. Hence such entries are

recorded in Journal proper, by debiting asset account and crediting the personal account of the

supplier of the assets. Similarly, when these assets are sold, an entry is made debiting cash

account or personal account of the buyer as the case may be and crediting the concerned asset

account. For example, an asset of Rs.5000 is sold for Rs.3000 to Shaym & Bros, who promised

to pay the amount later. Then Shyam & Bros account is debited with Rs3000, Loss on sale of

asset account is also debited by Rs.2000 and the concerned asset account is credited with the

book value Rs5000. The loss sustained in the process is transferred to Profit and Loss account

later.

5.2 g. Withdrawal of goods by proprietor for his personal purpose If a proprietor uses the goods of his business for his personal purpose, this should also be

recorded. Since this transaction is not a sale, it can not be transferred to sales account. But it



should be regarded as drawings account and it should be debited and the goods which are going

out of business should be credited.

5.2 h. Loss of goods and assets due to natural causes

Goods may be lost on fire or as a result of any natural calamity. The cost of such goods should

be reduced out of the stock of goods. Goods which insured may also be lost. A part of the value

of the cost may be recovered. The part not recovered is transferred to P & L A/c. The cost of

goods lost is debited and the stock account is credited. Owing to natural causes, wear and tear is

caused to assets. Even if the assets are not used, there is obsolescence and as a result,

depreciation has to be provided. This is a loss and therefore depreciation is debited and the

concerned asset account is credited. Such implied loses are recorded in journal proper.

Self Assessment Questions 7 1. Credit purchase of assets is not included in purchases account because assets are not

goods. ( state whether it is True or False ).

2. The profit or loss in the sale of assets should be transferred to ________account.

3. Office cash if used by the proprietor is treated as personal drawings ( state whether it is True /

False )

4. A part of the business premises being used by the proprietor for his residence. The rent

payable for that portion is drawings. ( state whether it is Yes / No ).

5. Loss of asset as a result of wear and tear is called _______.

6. Loss of goods as a result of fire accident is transferred to ____ account.

5.3 Posting Technique to Ledger – Form of a ledger account Having understood the journal and journal proper, the next important stage of accounting is

preparation of ledger accounts in a book called ledger. The book contains the summary of

transactions concerning to various heads of accounts for a given period. Posting is made to

ledger accounts from journal entries and at the end of the accounting period, each ledger account

is balanced. For each ledger account, a few items appear on the debit side and a few on the

credit side. While balancing the account, amount on the debit side may be more than that of

credit side, and vice versa. The excess of debit over credit is called debit balance carried down to

credit side of the account. Similarly, excess of credit over debit is known as credit balance

brought down to debit side of the account. For example, observe the following account of Rama,

a customer.



Debit Rama’s Account Credit Date Particulars JF Amount Date Particulars JF Amount 2202 4202 12202 25202 26202 28202

1302

To balance b/d To sales To Sales To Sales To Sales To Sales

To balance b/d

5,000 27,000 30,000 6,000 4,000 13,000

85,000

28,000

8202 9202 15202 28202 28202 28202

By Cash By Sales returns By Bank By Cash By Discount By balance c/d

6,000 4,000 25,000 20,000 2,000 28,000

85,000

Note: 1. Every account has four columns on debit side and four columns on the credit side.

2. At the end of period, total of debit side is Rs.85000 and the credit amount is Rs.57000. The

balance of Rs.28000 is in excess of debit over credit and is stated on credit side in order to

balance the account to an equal amount of Rs85000

3. The closing balance of the account for February month becomes opening balance for the

month of March.

4. JF stands for journal folio, where from the transaction is obtained.

5. For closing balance, it is called balance carried down and for opening balance, it is balance

brought down.

Posting technique

Posting is done either from journal or any subsidiary book.

For example, there is a transaction that goods are sold to Krishna for cash Rs5,000. The journal

entry in the journal is Cash account is debited and goods account is credited with an equal

amount. In the ledger, on the debit side of cash account, we write ‘To goods’ Rs.5000 and in the

goods account, we write ‘By cash Rs.5000. It is shown here below:

Journal entry Cash account Dr Rs. 5000

To Goods account Rs. 5000

(Being goods sold to Krishna on cash)



Ledger in the books of business

CASH ACCOUNT

Particulars Amount (Rs) Particulars Amount (Rs)

To goods 5,000

GOODS ACCOUNT


By cash 5,000

From the entries in the subsidiary book also, ledger accounts can be prepared. For example, the

total of purchases book for the month of January 2004 is Rs.56000. The purchases are made

from supplier ‘A’ Rs.26,000; ‘B’ 20000 and from ‘C’ Rs.10000.We can find the entries in the

ledger as shown below.

A’s Account


January 2004 To balance c/d 26,000

January 2004 By Purchases 26,000

February 2004 By bal b/d 26,000

B’s Account



January 2004 By Purchases 20,000

Feb, 2004 By balance b/d 20,000

C’s Account





January 2004 By Purchases !0,000

Feb, 2004 By bal b/d 10,000

Purchases Account


January 2004

To Sundries 56,000

January 2004

By balance c/d 56,000

Feb, 2004

To balance b/d 56,000

Self Assessment Questions 8 1. Ledger is regarded as _______________________ book.

2. Transactions that are not recorded in other journals, are incorporated in _______

3. What is a closing entry?

4. Rent account is closed by debiting P & L account and crediting ________account.

5. If assets brought in by proprietor are Rs400000 and liabilities are Rs150000, what opening

entry, do you draw in journal proper?

6. Out of salaries paid for the year 2005, Rs.6000 is related to the year 2006. How do you

adjust this gap? And what entry do you pass?

7. What is balancing of ledger account?

8. Can we draw journal entries from ledger?

9. If Rama has sold goods to Krishna Rs4000 on credit, draw journal entries in the books of

Rama and Krishna.

10. State any two differences between journal and ledger.

11. Cash account and cash book look alike. Is it a ledger account or mere subsidiary book?

Illustration Journalise the following transactions and open only the personal accounts in the ledger.



2001

July 1

Govind Singh started business with the following

assets:

Cash

Goods

Furniture

Amount

Rs.

20,000

10,000

5,000

July 5 Sold goods to Raghavan

Sold goods for cash

5,000

3,000

July 9 Received from Raghavan on account 3,000

July 12 Purchased goods from Mukundan 9,000

July 15 Paid Mukundan 5,000

July 20 Paid interest to Mukundan 100

July 30 Paid stationery charges

Paid Salaries

Paid rent

600

250

160

Solution

Journal entries in the books of Govind Singh

Date Particulars LF Debit (Rs) Credit (Rs)

2001 July 1 Cash account Dr

Stock account Dr

Furniture account Dr

To Capital account

(Being assets brought in as capital)

20,000

10,000

5,000 35,000

July 5 Raghavan account Dr

Cash account Dr

To Sales account

(Being sales made in cash and on credit

to Raghavan)

5,000

3,000 8,000

July 9 Cash account Dr

To Raghavan account

3,000 3,000



(Being cash received from Raghavan)

July 12 Purchases account Dr

To Mukundan’s account

(Being goods purchased on credit from

Mukundan)

9,000 9,000

July 15 Mukundan’s account Dr

To Cash account

(Being cash paid to Mukundan on

account)

5,000 5,000

July 20 Interest account Dr

To Cash account

(Being interest paid to Mukundan)

100 100

July 30 Stationery account Dr

Salaries account Dr

Rent account Dr

To cash account

(Being the above expenses paid out)

600

250

160 1,010

In this problem, there are 12 ledger accounts affected, namely Cash, furniture, stock, Raghavan,

sales, purchases, Mukundan, interest, stationery, salaries, rent accounts. However, the personal

accounts are Raghvan’s account and Mukundan’s account. These ledger accounts appear in the

following manner in the ledger.

Dr Raghavan’s Account in the books of Govind Singh Cr

Particulars Amount

(Rs)

Particulars Amount

( Rs)

July, 5 To Sales 5,000 July 9 By Cash

July 31 By Balance c/d

3,000

2,000

5,000 5,000

August, 1 To balance b/d 2,000

The above account shows that Raghavan is owing to Govind Singh Rs.2000 as on 31 st July and

this is the opening balance for August.



Dr Mukundan’s Account in the books of Govind Singh Cr

Particulars Amount (Rs)

Particulars Amount (Rs)

July 15 To cash

July 31 To balance c/d

5,000

4,000

July 12 By purchases 9,000

9,000 9,000

August 1 st By balance b/d 4,000

This means that Mukundan is owing to Govind Singh Rs.4000 as on 31 st July and this is the

opening balance for August 1 st .

Summary Ledger accounts are prepared from General journal and other subsidiary books including Journal

proper. All transactions are posted to ledger accounts and some of them show debit balance and

some other credit balance. For convenience of the students, the following table gives a fair idea

of what account usually shows what balance.

Name of the account Debit / credit balance

Capital Credit

Personal Drawings Debit

Creditors Credit

Bills Payable Credit

Bank overdraft Credit

Loans from others Credit

Outstanding expenses Credit

Pre received incomes Credit

Reserves for future expenses or losses Credit

All items of incomes Credit

Cash in hand or at bank Debit

Assets such as furniture, buildings, plant, machinery, tools, stock



of goods, etc Debit

Debtors, Bills receivable Debit

Loans given to others Debit

Investments made Debit

All expenses such as wages, carriage, insurance, salaries,

printing and stationery, advertising, commission paid, interest

paid, etc Debit

Prepaid insurance, rent or any prepaid expenses Debit

Outstanding incomes Debit

Losses like depreciation, loss in the revaluation of assets or sale

of assets,

Debit

Any other asset Debit

Terminal Questions 1. A company is engaged in the following transactions in June. You are required to record

transactions in general journal.

1. Received cash from customers Rs.14000

2. Returned goods to suppliers Rs.4000

6. Paid for type writer purchased on credit on May 4, Rs.6000

10. Received cash for services provided Rs.Rs.2300

13. Paid for supplies purchased Rs5600

18. Paid telephone bill for the month Rs.8400

20. Provided professional services for Rs.9000 to the customer who paid advance

Of Rs2000

30. Paid salaries for the month of June Rs3400

2. Mr. Lakshminarayana set up a finance company. The following transactions took place in the

month of January. Draw the journal entries

a) Began business by depositing Rs60000 in bank in the name of the company.

b) Paid office rent for two months in advance Rs.6000

c) Purchased office supplies on credit from ‘C’ Rs.3000

d) Purchased office equipment for cash Rs.5000



e) Received cash for the services rendered Rs.10000

f) Paid security guard salary Rs.3000

g) Paid to a creditor ‘C’ on his account Rs.1200

h) Billed customers for services provided Rs.9500

i) Paid insurance premium for the month Rs.500

j) Paid advertisement charges Rs. 2000

k) Collected amounts due from customers Rs.5000

l) Purchased office supplies for cash Rs.800

m) Paid telephone expenses Rs.700

n) Paid electricity expenses Rs.200

3. Prepare ledger accounts for the journal entries recorded for the transactions as given in the

exercise 2.

4. Record the following transactions in the personal account of Mr. Ravindranath and balance

the account at the end of each month. Find out the closing balance for each month.


Self Assessment Questions 1 1. Secondary book

2. All such transactions which are not entered in any other journal

Date Particulars Amount

Rs.

1998

September 1

4

4

15

18

October 1

3

21

31

Sold goods to Ravindranath

Received from Ravindranath

Allowed him a discount

Ravindranath bought goods

Received from Ravindranath cash on account

Balance from last month

Sold goods to Ravindranath

Received from Ravindranath cash

Allowed him discount

Received cash in full settlement of account

54250

51538

2712

60000

20000

?

10000

3960

40

?



3. Book.

4. Journal proper and Ledger.

2. Journal proper

3. True.

Self Assessment Questions 2 1. True

2. Capital

3. Goodwill


1. True

2. Trade expenses

3. All expenses other than trade expenses

4. No. Self Assessment Questions 4 1. True

2. a. Depreciation is debited & building account is credited

b. Closing stock A/c is debited and trading A/c is credited

c. Prepaid expenses account is debited and insurance A/c is credited

d. Salaries A/c is debited and outstanding expenses account is credited.

e. Drawings A/c is debited and stock account is credited.


2. Errors that can be disclosed by trial balance and errors that cannot be disclosed by trial

balance

3. Journal proper.

Self Assessment Questions 6 1. Credited

2. Trading account, stock destroy of account is debited and stock account is credited.

3. Account is debited and drawings account is credited.


1. True

2. P & L



3. True

4. Yes

5. Depreciation

6. P & L

Self Assessment Questions 8 1. Secondary

2. Journal proper

3. Closing entry is an entry to close expenses, incomes (revenue items ) to the respective

revenue accounts( Trading and P & L A/c ).

4. Rent

5. Assets account Dr 4,00,000

To Liabilities account 1,50,000

To Capital account 2,50,000( Difference)

6. The salary paid in advance is Rs 6,000. It should be deducted out of salaries paid in 2005.

The entry is : Prepaid salaries A/c 6000

To Salaries A/c 6000

( Being salary paid in advance adjusted ).

7. Balancing of a ledger account means finding out excess of debit over credit or vice versa

and equating both debit and credit sides of account.

8. Yes

9. Books of Rama: Krishna’s A/c Dr

To sales account.

Books of Krishna : Purchases A/c Dr

To Rama’s account.

10. a. Journal is a book of original entry where as ledger is a secondary book.

b. Journal includes General journal and subsidiary books. But ledger does not.

11. cash account is both a subsidiary book and a ledger account.

Answer for Terminal Questions: 1. Refer to unit 5.3 illustration.

2. Refer to unit 5.3 illustration.

3. Refer to unit 5.3 illustration

4. Closing balance Sept 30 Debit balance b/d 40,000.



Closing balance Oct 31 Balance Nil.

Amount paid in full settlement is Rs 46,000.



Unit 6 Trial Balance

Structure

6.1 Introduction Objectives

6.2 Meaning Self Assessment Questions 1

6.3 Objectives Self Assessment Questions 2

6.4 Methods of preparing trial balance: Total Method and Balance Method Self Assessment Questions 3

6.5 Preparation op Trial balance Self Assessment Questions 4

6.6 Errors and their rectification Self Assessment Questions 5

6.7 Errors disclosed by a Trial Balance Self Assessment Questions 6

6.8 Errors not disclosed by Trial Balance Self Assessment Questions 7

6.9 Steps to locate the errors 6.10 Trial Balance and adjustments

Self Assessment Questions 8 Terminal Questions Answer to SAQs and TQs

6.1 Introduction Journal and ledger are the books containing the details of business transactions which have taken place during a particular period. The purpose of these records is preparation of final accounts – trading account, profit and loss account and balance sheet. Before attempting to prepare final accounts, a summary of the transactions, as depicted by ledger should be available in a form that is easy to classify the assets, liabilities, expenses and incomes. While expenses and incomes are used to prepare trading and profit and loss accounts, assets and liabilities are presented in the balance sheet. Trial Balance stands as a bridge between primary and secondary books on one hand and final statements of accounts on the other hand.





1. To know the meaning and format of trial balance. 2. To understand the objectives of preparing a trial balance 3. To know the guidelines to prepare a trial balance. 4. To identify and rectify the errors that can be disclosed by trial balance 5. To identify and rectify the errors that can not be disclosed by trial balance 6. To know the steps to locate the errors. 7. To prepare trial balance after incorporating adjustments.

6.2 Meaning Trial Balance is a statement containing the various ledger balances on a particular date. It is used

to verify the equality of debits and credits in the ledger. When the total of debit balances equals

the total of credit balances, the ledger is said to be in balance. A trial balance is prepared as

follows:

TRIAL BALANCE AS ON 31 ST MARCH,

Particulars Debit Rs.

Credit Rs.

Cash account Capital account Purchases account Mohan account (creditor) Sales account

1,20,000

40,000

1,00,000

20,000 40,000

Total 1,60,000 1,60,000

Self Assessment Questions 1 1. The purpose of preparing journal and ledger accounts is to prepare __________. 2. The final accounts include _________, ____________ and ________. 3. Trial balance is regarded as a bridge between primary and secondary books and

preparation of final accounts (True / False ). 4. Trial balance contains debit balances and credit balances. (True / False )

5. If trial balance tallies, balance sheet also tallies. (True / false )



6.3 Objectives There are three objectives of preparing a trial balance.

a) To check the arithmetic accuracy of entries made. In double entry, every debit has an

equivalent credit. Even in General Journal, we have seen that the total of debits equals the

total of credits. Similarly, if the debits and credits tally in a trial balance, it indicates that the

books of account are arithmetically accurate. If the two sides do not tally, it is sure that errors

have crept in.

b) Basis for financial statements. As stated earlier, trial balance is a bridge between ledger and

final statements. It is only through trial balance, trading account, profit and loss account and

balance sheet are prepared. If trial balance tallies, it means that the final statements should

invariably tally.

c) It is a summarised ledger. The position of a ledger account be judged simply by looking at the

trial balance. It is because, all ledger accounts, after being balanced, are grouped as those

showing debit and those showing credit balances. They must be equal in value.


1. Trial balance checks the arithmetic accuracy of debits and credits ( True / False)

2. Trial balance is a summary of ledger accounts. So, if ledger accounts are properly prepared

and balanced, trial balance tallies ( True / False).

6.4 Methods of preparing Trial Balance Totals method and Balance method are the two techniques of preparing trial balance. In the first

method, the totals of debits and credits of every account are shown in the trial balance. For

instance, a cash account shows Rs.45000 as debit total (Receipts) and Rs35000 as credit total

(Payments). Both these totals are carried to trial balance. The same logic is applied for all other

accounts. Then also the trial balance tallies In the second method, instead of transferring the

totals of both debit and credit, the net balance Rs.10000 (45000 – 35000) is shown on the debit

side of trial balance. Same principle is adopted for all other accounts. The trial balance tallies. In

the former method, more details can be understood but it is cumbersome. The second method

gives the gist of the account and second method is popular.

Self Assessment Questions 3 1. Trial Balance is prepared either under total method or balance method ( True / False).

2. Which method is popular ?



3. What ever be the method of preparing trial balance, debit total should be equal to total of

credit (True / False ).

6.5 Preparation of Trial Balance A trial balance can be prepared just as an account having debit side and credit side. It can also be prepared by enlisting all ledger accounts one below the other and showing their respective debit or credit balances on separate columns. Both methods are equally prevalent.

However, the following steps should be followed to prepare a Trial Balance. a) Prepare the ledger accounts b) Balance them at the end of accounting period c) Group all accounts showing debit balance and show them of left hand side of trial balance d) Group all those accounts showing credit balance and show them on the right hand side of trial

balance. e) Total the debits and credits and they must be equal, what ever be the method of preparing the

trial balance.

Self Assessment Questions 4 1. How do you prepare trial balance ?

2. If total of debits and credits do not tally, do you suspect any errors ?

Illustration:

The following are the ledger accounts of Mr. X as on 31 st December, 1998. Prepare a trial

balance. Dr. Cash Account Cr.


Rs. Date Particulars

Amount Rs.

1404 24—04 16404 26404

To balance b/d To Sales To Mohan To Sales

50,000 45,000 35,000 10,000

6404 10404 14404 18404 20404 22404

30404

By Cash By Kumar By Purchases By creditors By Furniture By Wages By Printing By Comm By Electricity By Telephone

5,000 29,000 50,000 20,000 5,000 500

1,000 2,000 500

1,000



By salaries By balance c/d

4,000 22,000

1,40,000 1,40,000

1504 To balance b/d 22,000

Building Account



Amount Rs.

1404 To balance b/d 2,00,000 30404 By balance c/d 2,00,000 1504 To balance b/d 2,00,000

Furniture Account

Date Particulars Amount Rs.


1404 20404

To balance b/d To Cash

10,000 5,000 30404 By balance c/d 15,000 15,000 15,000

1504 To balance b/d 15,000 Bank Fixed Deposit Account



Amount Rs.

1404 12404

To balance b/d To Interest

1,00,000 7,000 30404 By balance c/d 1,07,000

1,07,000 1,07,000 1504 To balance b/d 1,07,000

Stock Account



1404 To balance b/d 25,000 30404 By balance c/d 25,000 1504 To balance b/d 25,000

Creditor’s Account



18404 30404

To Cash To balance c/d

20,000 15,000

1404 By balance b/d 35,000



35,000 35,000 1504 By balance b/d 15,000

Capital Account



30404 To balance c/d 3,50,000 1404 By balance b/d 3,50,000 35,000 3,50,000

1504 By balance b/d 3,50,000

Purchases Account

Date Particulars Amount Rs,


4404 14404

To Kumar To Cash To Sarin

30,000 50,000 15,000

30404 By balance c/d 95,000

95,000 95,000 1504 To balance b/d 95,000

Sales Account



30404 To balance c/d 95,000 2404 8404 26404

By Cash By Mohan By Cash

45,000 40,000 10,000

95,000 95,000 1504 By balance b/d 95,000

Kumar Account



10404 To Cash To discount

29,000 1,000

4404 By Purchases 30,000

30,000 30,000



Repairs Account



6404 To Cash 5,000 30404 By balance c/d 5,000 5,000 5,000


Mohan Account



8404 To sales 40,000 16404 30404

By Cash By balance c/d

35,000 5,000

40,000 40,000


Discount Received Account



30404 To balance c/d 1,000 10404 By Kumar 1,000 1,000 1,000


Interest on Fixed Deposit Account



30404 To balance c/d 7,000 12404 By Bank FD 7,000 7,000 7,000


Wages Account



22404 To Cash 500 30404 By balance c/d 500 500 500

1504 To balance b/d 500



Printing Account Date Particulars Amount

Rs. Date Particulars Amount

Rs. 22404 To Cash 1,000 30404 By balance c/d 1,000

1,000 1,000 1504 To balance b/d 1,000

Commission Account





Electricity Account Date Particulars Amount

Rs. Date Particulars Amount

Rs. 30404 To Cash 500 30404 By balance c/d 500

500 500 1504 To balance b/d 500

Telephone Account





Salaries Account




1504 To balance b/d 4000

Sarin’s Account



30404 To balance c/d 15,000 28404 By Purchases 15,000



15,000 15,000 1504 To balance b/d 15,000

Solution TRIAL BALANCE AS ON 30 TH APRIL, 2004

Debit balances Amount Rs. Credit balances Amount Rs.

Cash 22,000 Creditors 15,000 Building 2,00,000 Capital 3,50,000 Furniture 15,000 Sales 95,000 Bank FD 1,07,000 Discount received 1,000 Stock 25,000 Interest on FD 7,000 Purchases 95,000 Sarin 15,000 Repairs 5,000 Mohan 5,000 Wages 500 Printing 1,000 Commission 2,000 Salaries 4,000 Telephone 1,000 Electricity 500 Total 4,83,000 Total 4,83,000 6.6 Errors and their rectification An error is unintentionally committed mistake. Trial Balance, if does not tally, is a clear indication

that there are some errors committed. The errors may be committed at various stages –

journalizing, posting, casting (totaling), balancing, transferring to trial balance and so on. Mere

tallying the trial balance does not ensure error free statement. For example, if a transaction is

completely omitted, the trial balance still tallies. But there is inherent error. Errors whether

disclosed or not disclosed by trial balance, have to be corrected or rectified in order to obtain the

correct picture of profit or loss. It should be remembered that errors will have their impact not only

on profit but also on the asset and liability position of the business organization.

Self Assessment Questions 5 1. Errors can be committed at all stages, commencing from journalizing, posting, costing,

balancing, transferring the closing balances, etc. (True / False).

2. Errors of omission, error of principle and compensating errors are not disclosed by trial

balance (True / False).



3. Errors of costing, posting to wrong side of an account, wrong amount etc can be detected by

trial balance (True / False).

6.7 Errors disclosed by Trial Balance Those errors that can be disclosed by trial balance can easily be located. As soon as the trial

balance does not tally, the accountant can proceed to find out the spots where the errors might

have been committed. The total amount of difference in the trial balance is temporarily transferred

to a ‘Suspense Account’ so that it can be mitigated as and when the errors get rectified. Therefore the suspense account gets debited or credited as the case may be for rectification of

this type of errors. The following are the errors which are disclosed by trial balance:

a) Posting a wrong amount: While posting an entry from subsidiary book to ledger,

b) this mistake may happen. For example, Cash received from Rama Rs1150 is posted to

Rama’s ledger account as Rs.1500, while it is correctly recorded in cash account. As a result

of this error, trial balance does not tally. To rectify this Rama’s account should be debited by

Rs350 (1500 – 1150) and credit should be given to suspense account.

c) Posting to the wrong side of an account: This error is committed while posting entries from subsidiary books to ledger. For instance, Sales made to Krishna Rs5000 is transferred to

credit side of Krishna’s account in the ledger. This error can be rectified by debiting Krishna’s

account by Rs1000 and crediting suspense account. Note that the amount debited is double

the actual amount.

d) Wrong totaling: Both under casting and over casting are detected by trial balance. If any account is wrongly totaled, it gets reflected in the trial balance. To illustrate, purchases book

total is Rs.5800. If it totaled as Rs.5700 or 5900, the difference will be shown in the trial

balance. To rectify this, first find out what is the normal balance shown by the account

wrongly totaled. If it is debit balance and it is under cast, the same account can be debited

and credit is given to suspense account. If it is over cast, the respective account should be

credited by the amount of difference and debit is given to suspense account. It is quite

opposite in case the respective account is one which normally shows credit balance.

e) Omitting to post an entry from subsidiary book to ledger: If an entry made in the

subsidiary book does not get posted to ledger, the trial balance does not tally. For instance,

rent paid Rs2000 recorded in cash account but is not posted to rent account at all. To rectify

such error, the respective account should be debited or credited as the case may be and

suspense account is credited or debited as the case may be.



f) Omission of an account altogether from being shown in trial balance: For instance,

advertisement account which shows a debit balance is completely omitted from trial balance.

This can be rectified by bringing it to trial balance and suspense account can be credited and

advertisement account is debited.

g) Posting an amount to a correct account more than once: This results in imbalance in the trial balance. The concerned account which is posted twice should be cancelled and

suspense account to be suitably debited or credited as the case may be.

h) Posting an item to the same side of two different ledger accounts: If two accounts are

debited /credited for the same transaction, this type of error occurs. For example, Furniture

purchased should be debited to furniture account only. If it is posted to furniture account and

purchases account, then the difference arises in the trial balance. To rectify this, the ledger

account to which it is debited wrongly should be credited and suitably suspense account is

debited.

Self Assessment Questions 6 1. Suspense account is the difference between debit total and credit total of a trial balance.

( True / false ).

2. Suspense account is created temporarily and later, it is removed as and when errors are

detected and suitable rectified ( True / False ).

3. if amount paid to Rama Rs 500 is credited to Ramanan accounts, what rectification entry

should be made ?

4. Instead of putting Rs. 1500 to debit of wages account, Rs 15000 is recorded. What impact, it

has an profit ?

5. How do you rectify the above error ?

6. Telephone expenses of Rs 2500 is entered in cost account but not posted to ledger. How do

your rectify ?

7. Rs. 2116 interest paid an loan is posted to interest accounts once as Rs 2611 and second

time as Rs. 2161. How do you rectify?

6.8 Errors not disclosed by Trial Balance There are four errors regarded as those which do not affect trial balance and it is difficult to locate

them. A brief description of the four errors is offered in the following paragraphs:

a) Error of omission: Error of omission occurs when a transaction is completely omitted from

the books of accounts. If purchase of goods from Jairam on credit is not recorded at all either



in the general journal or in the purchases book, it is termed as error of omission. Since both

aspects – debit and credit – of the transaction are missing, the trial balance is not affected at

all. To rectify such errors, the transaction should be recorded when it is traced.

b) Error of commission: If the error of wrong posting, wrong casting, wrong calculation etc.,

committed in the books of original entry or ledger, it is said to be error commission. For

instance, purchase invoice of Rs.1730 may have been entered as Rs.1370 in the purchases

book itself, then in the subsequent ledger accounts, the same mistake continues and thereby

can not be disclosed by trial balance. The difference of Rs.360 (17301370) should be added

to purchases account and to the respective supplier’s account. The error can be detected only

when the original invoice is referred to after getting the complaint from the supplier. In the

above example, purchases account is debited and the concerned supplier’s account is

credited to rectify the error. Such errors have repercussion on the profit or loss of the

organization. From the above example, additional purchases will have to be incorporated and

to that extent the expenses will be increased or profit will be affected.

c) Error of principle: While drawing journal entries, often error of principle is committed and this

goes un noticed because it does not affect the total of trial balance. For instance, ‘wages’ paid

to workers engaged in the construction of building of the organization, constitutes part of the

cost of the building. So the wages paid should be debited to building account but not wages

account. If the building account is debited, the value of the asset appears in the balance sheet

and the expenditure is actually capitalized. In case the wages are treated as usual revenue

expenditure, they are deducted from profit. The error here is wages account is debited and

not building account. Therefore to rectify this, building account should be debited and wages

account should be credited to erase. Similarly, treating incomes as liabilities, providing

insufficient provision for bad and doubtful debts, inadequate depreciation against assets etc.,

come under errors of principle. They must be rectified by applying the correct principles of

accountancy.

d) Compensating errors: It is also called offsetting error. Compensating error is one which is counter balanced by another error. If the account of Mr. X is to be debited for Rs1000, but it is

debited for Rs100 while the account of Mrs X account is to be debited Rs.100 but it is debited

by Rs.1000, the first error is compensated by the second error and therefore the trial balance

is not affected. This comes to light only at a later stage. To rectify the error, Mr. X account

should be debited by Rs.900 where as Mrs. X account should be credited by Rs.900.




1. If error of wrong posting, wrong costing, wrong calculation are committed in the books of

original entry or secondary books, such errors are called ________.

2. Error of commission affects trial balance (True / False).

3. Furniture purchased for cash Rs 5000/ is to recorded in journal. What type of error is this ?

4. Error of omission can be detected only after a careful review of ledger balances of previous

years (True / False).

5. Error of principle affects the value of revenue and capital items (True / False).

6. It is very difficult to find out the compensating errors. (True / False).

6.9 Steps to locate the Errors The following steps help to locate the errors. In spite of the efforts, if the difference in the trial

balance persists, a suspense account may be created and subsequently the suspense account

can be eliminated as and when the errors are located and rectification is made.

i) Check both sides of the trial balance to ensure that mistake of totaling is not there.

ii) Check the totals of debtors and creditors accounts

iii) Find out whether all ledger balances are carried to trial balance

iv) Verify the totals of all ledger accounts

v) Divide the amount of difference in the trial balance by 2 and see if any item of the debit or

credit side, equal to that amount has been posted to the opposite side.

vi) Check whether the opening balances are brought down correctly from the previous

accounting period

vii) Make a comparison with trial balance of the previous year to find out if there are any items

missing.

viii) Where the difference in the trial balance is divisible by 9 then the difference is likely to be

due to misplacement of figures like 12 for 21; 24 for 42;36 for 63 and so on.

6.10 Trial Balance and adjustments When errors are located, they should be rectified. It is not a good practice nor does it have any

legal sanction to erase the mistakes and re write the correct ones. Rectification entries are

recorded in General journal or journal proper. The following illustrations are given to show how to

rectify the different types of errors.


1. Summary of all ledger balances is called ______________________ .



2. Trial balance is necessary to prepare _________________________ .

3. The broad two categories of errors are a)________________ b) ____________.

4. Is casting error of principle or error of commission?

5. Purchase of machinery is included in the purchases book. What type of error is it?

6. What is error of omission? Illustrate.

7. What are the errors that can not be disclosed by trial balance?

8. The sum of errors in accounting is transferred temporarily to _________ account.

9. In which journal do you make rectification entries?

10. State any four steps to locate errors.

11. If sales account is under cast by Rs.45, what is the rectification entry?

12. Returns inwards book is over cast by Rs9, write rectification entry.

13. salary paid to Gopal is debited to his personal account. What is the rectification entry to

correct the error?

14. Discount received Rs50 is transferred to the debit side of discount account. Write the

rectification entry.

15. An invoice of purchase for Rs.760 is entered as Rs.670. What type of error is this? How to

rectify this error?

Illustration 1

An accountant finds that the trial balance of his client did not tally and it showed an excess credit

of Rs.69.74. He transferred it to a suspense account and later discovered the following errors.

a) Rs.44.37 paid to Anand has been credited to his account as Rs34.37.

b) A purchase of Rs.145.50 has been posted as Rs154.50 to the purchases account

c) An expenditure of Rs.158 on repairs has been debited to the Buildings account

d) Rs.80 was allowed by B as discount which has not been entered in the books.

e) A sum of Rs.125.05 realized on the sale of old furniture has been posted to the sales account.

Give journal entries to rectify the errors and show the suspense account as it would appear after

adjustments.

Solution

Date Particulars LF Debit (Rs.) Credit (Rs.) 1 Anand’s account Dr

To suspense account (Being wrong amount, wrong ly credited to Anand’s a/c

78.74 78.74



2

3

4

5.

rectified) Suspense account Dr

To Purchases account (Being over debit of purchase account rectified) Repairs account Dr To Buildings account (Being wrong debit given to building account rectified) B’s account Dr To Discount received a/c (Being discount received from B, omitted earlier, brought to account) Sales account Dr To old furniture account (Being sale of old furniture wrongly transferred to sales account rectified)

9.00

158.00

80.00

125.05

9.00

158.00

80.00

125.05

Suspense Account



To Difference in trial balance To Purchases a/c

69.74 9.00

By Anand’s a/c 78.74

78.74 78.74

Note:

1. The excess of credit balance of trial balance means that the total of credit is more than debit

by Rs69.74 and so the difference is shown on the debit side of suspense account.

2. When amount is paid to Anand, his account should have been debited. On the other hand, his

account was credited and that too with a wrong figures. To rectify this double error, Anand’s

account has to be debited with Rs.78.74 (Rs.44.37 + 34.37) and the suspense account is

credited.

3. Purchases account was over debited by Rs9 and so Purchases account is credited to nullify

the effect and suspense account is debited.



4. Repairs spent on building are, by mistake, debited to buildings account. This is error of

principle. So repairs account is debited and buildings account is credited to rectify the

mistake.

5. Discount received from B has not been taken to records. This is an error of omission.

Therefore, it is now brought to accounts. This has not affected the trial balance.

6. When old furniture is sold, the furniture account should have been credited. On the other

hand, sales account was credited against to the principle of accounting. To rectify the error,

sales account is debited and old furniture account is credited.

Illustration 2

The trial balance of Evergreen Co Ltd., taken out as on 31 st December, 2002 did not tally and the

difference was carried to suspense account. The following errors were detected subsequently.

a) Sales book total for November was under cast by Rs1200.

b) Purchase of new equipment costing Rs.9475 has been posted to Purchases A/c.

c) Discount received Rs1250 and discount allowed Rs850 in September 2002 have been posted

to wrong sides of discount account

d) A cheque received from Mr Longford for Rs.1500 for goods sold to him on credit earlier,

though entered correctly in the cash book has been posted in his account as Rs.1050

e) Stocks worth Rs.255 taken for use of Mr Dayananda, the Managing Director, has been

entered in sales day book.

f) While carrying forward, the total in Returns Inwards Book has been taken as Rs.674 instead

of Rs.647.

g) An amount paid to cashier, Mr. Ramachandra, Rs.775 as salary for November month has

been debited to his personal account as Rs757.

Pass journal entries and draw up the suspense account.

Solution

Journal Proper of Evergreen Co Ltd.,

Date Particulars L F Debit Rs.

Credit Rs.

31122002 Suspense account Dr To Sales account

(Being under casting of sales book rectified)

1,200 1,200

31122002 New Equipment account Dr To Purchases account

9,475 9,475



(Being wrong debit given to purchases account rectified) 31122002 Discount allowed account Dr

Suspense account Dr To Discount received a/c

(Being discount received and discount allowed posted to wrong sides of discount account rectified)

1,700 800

2,500

31122002 Suspense account Dr To Longford account

(Being short credit given to Longford rectified)

450 450

31122002 Sales account Dr To suspense account

(Being stock used for personal purpose wrongly credited to sales account rectified)

255 255

31122002 Suspense account Dr To Returns Inwards account

(Being excess debit given to returns inwards account to the extent of Rs27, now rectified)

27 27

31122002 Salary account Dr To Ramachandra ‘s a/c To Suspense a/c

(Being the wrong debit of salary to the personal account of Ramachandra now rectified)

775 757 18

Dr SUSPENSE ACCOUNT Cr

Particulars Amount Rs.


To sales account To Discount received a/c To Longford To Returns Inwards a/c

1,200 800 450 27

By Sales By Salary By balance c/d

255 18

2,204

Total 2,477 Total 2,477

Terminal Questions 1. Prepare a trial balance from the following



Purchases 8,225 Premium on lease 1,200 Wages 1,025 Loan on mortgage 2,500 Sales 12,450 Plant and machinery 2,000 Arun’s capital 13,500 Provision for doubtful debts 300



Stock on 1198 1,500 Sundry debtors 16,550 Salary 410 Trade charges 200 Rent and taxes 162 Bad debts 200

Sundry creditors 2,572 (Ans: Rs .31322).

2. The following Trial balance was extracted from the books Chetan, a small businessman. Do

you think that it is correct? If not, rewrite it in the correct form.

Debits Rs. Credits Rs. Stock Purchases Returns outwards Discount received Wages and salaries Rent and rates Sundry debtors Bank Overdraft

8250 12750 700 800 2500 1850 7600 2450

Capital Sales Returns inwards Discount allowed Scooty Carriage charges Sundry Creditors Bills payable

10000 15900 1590 800 1750 700 7250 690

(Ans: Rs. 37,790).

3. Mr. Abhijit was unable to tally Trial balance last year and wrote off the difference to the

Suspense account. He appointed a chartered accountant who examined the old books and

found the following mistakes.

a) Purchase of a cycle was debited to conveyance account Rs.3000

b) Purchase account was over cast by Rs.10000

c) A credit purchase of goods from Padam for Rs4000 was entered as sale.

d) Receipt of cash from Allum was posted to the account of Arun Rs.3000

e) Receipt of cash from Cherag was posted to the debit side of his account Rs.6000

f) Rs.1000 due by Mr. Zavahir was omitted to be taken to trial balance.

g) Sales of goods to Mr. Rajaram for Rs6000 was omitted to be recorded.

h) Payment of Rs.5050 for purchase was wrongly posted as Rs.5500 in purchases account..

Suggest the necessary rectification entries. Prepare suspense account.



1. Final Accounts



2. Trading A/c, P & L A/c, Balance sheet.

3. True

4. True

5. False


2. True


2. Balance method

3. True

Self Assessment Questions 4 1. Group all ledger accounts showing debit balance and group all accounts showing credit

balance. summaries them total of debit is equal to total of credit.

2. Yes


2. True

3. True


2. True

3. Rama account should be Debited by Rs 500, Ramanan’s account should be debited by Rs

500 and credit should be given suspense account Rs 1000.

4. Profit – (gross ) is Reduced by Rs 13500.

5. Wages account is credited by Rs 13500 and debit is given to suspense A/c.

6. Telephone expenses account is debited and suspense account is credited

7. Total amount debited to interest account is Rs 2611 + 2161 = 4772.

The correct amount by crediting interest account and debiting suspense account with similar

amount.




1. Error of commission

2. False

3. Error of omission

4. True

5. True

6. True

Self Assessment Questions 8 1. Trial balance.

2. final accounts

3. Error that are disclosed by trial balance and those which cannot be disclosed by trial

balance.

4. Error of commission.

5. Error of principle.

6. Omitting completely a transaction from books of original entry. Sales made to Raghu Rs

120 completely ignored.

7. Error of omission, commission, principle, compendating error.

8. suspense account.

9. Journal proper

10. check the total of both sides of trial balance, total debtors & creditors, verify whether

balancing is done correctly, check the totals of ledger balances etc.

11. suspense account is debited and sales account is credited.

12. suspense a/c is debited and sales returns a/c is credited.

13. Salary a/c is debited and Gopal a/c is credited.

14. Discount a/c is credited by Rs 100 and suspense a/c is debited

15. This is an error of omission. By checking the original invoice document, it can be rectified.

Debit purchases account and credit the creditor’s account.

Terminal Question Answers :

1. Refer to unit 6.5 Ans – Rs 31322

2. Refer to Unit 6.5 Ans – Rs 37790

3. Refer to unit 6.10 Ans Suspense A/c Excess debit over Credit is Rs 5450.



Unit 7 Final Accounts

Structure:

7.1 Final Accounts – Introduction

Objectives

7.2 Adjustments before preparing final accounts


7.2.1 Outstanding expenses


7.2.2 Prepaid Expenses


7.2.3 Accrued Income


7.2.4 Income received in advance


7.2.5 Depreciation


7.2.6 Bad Debts


7.2.7 Provision for Doubtful Debts


7.2.8 Reserve for Discount on debtors:


7.2.9 Reserve for discount on creditors


7.2.10 Closing stock




7.3 Trading Account


7.4 Preparation of Trading Account


7.5 Profit and Loss Account

7.6 Preparation of Profit and Loss Account


7.7 Balance Sheet – Meaning


7.8 Preparation of Balance Sheet


Terminal Questions


7.1 Final Accounts – Introduction

The last step of accounting process is preparation of final accounts. Final accounts are Trading

account and Profit and Loss Account with respect to any trading organization. If it is non trading

organization like a club or an Educational Institution, Receipt and Payment Account and Income

and Expenditure Account are the final accounts. In case of a manufacturing unit, a Manufacturing

account is prepared in addition to Trading Account. Profit and Loss Account is prepared by all

trading and manufacturing units. Balance Sheet is closely associated with these final accounts.

But Balance Sheet is not an account. It is a statement of assets and liabilities of business

organization prepared at the final stage of the accounting process. Therefore balance sheet is

regarded as a part of final accounts. The purpose of preparing final accounts is to find out the end

result of business at the end of an accounting period, may it be profit or loss.

The basis for preparing final accounts is the Trial Balance. For Trial Balance, the ledger balances

are the root. For ledger accounts, the journal entries or entries in the subsidiary books (Books of

original entry) are the roots. Hence the final accounts reflect the original business transactions,

which are systematically and scientifically recorded, classified, and analyzed. Final accounts

provide bundle of information for decision making activities.



1. To know the meaning and purpose of final accounts

2. To identify the items of Trading Account



3. To identify the items of Profit and Loss Account

4. To identify the items of assets and liabilities of a Balance Sheet and modes of preparing it.

5. To know the adjustments such as Reserve for bad debts, Reserve for discounts on Debtors,

Reserve for discount on Creditors, bad debts out side the trial balance.

6. To understand the adjustments like depreciation on assets, closing stock, stock lost in fire,

goods given as samples, goods used for personal purpose etc.,

7. To know the adjustments of prepaid expenses, outstanding expenses, pre-received incomes,

outstand incomes etc.

8. To prepare Balance Sheet without any adjustments from trial balance.

9. To prepare Balance Sheet with adjustments.

7.2 Adjustments before preparing final accounts

The Generally Accepted Accounting Principles (GAAP) supports the accrual basis of accounting,

according to which revenue is recognized when it is earned and expenses are recognized when

they are incurred, irrespective of their actual receipt or actual payment.

If the accrual basis of accounting is used, adjusting entries are required at the end of the period

to record any changes in assets, liabilities, revenue incomes, revenue expenses, previously

unrecognized. Adjusting entries are regarded as internal transactions. For instance, salaries are

paid in advance to a few employees and the excess paid in the current period, should be

adjusted to the coming period and what is paid in advance now should not be charged against

the revenues relating to the current period. Similarly, insurance paid in advance, rent paid in

advance etc., Like wise incomes received in advance should not be considered for the current

period. On the other hand, expenses yet to be paid for the current period should be charged

against the current period’s income. On the same lines, incomes yet to be received for the current

period should be considered as incomes for the current period whether actually received in cash

or not. Every asset is subject to wear and tear and the value of the asset gets reduced even if the

loss on account of this is not recorded by means of a journal entry. Some stock of goods at the

end of the period is left over and it has to be valued and be taken to accounts for fair computation

of profit. Such internal adjustments have to be made and recorded before preparing Trading

Account, Profit and Loss Account and Balance Sheet. The adjustments to be incorporated are

briefly described in the following paragraphs.




1. Final account are prepared from trial balance, trial balance from ledger accounts and ledger

account from books of original entry. So final accounts are reflection of original transaction

(state True / False ).

2. Final accounts speak about profit or loss as on a particular day ( state True and False )

3. Balance sheet tells the value of assets and liability as standing an a the last day of

accounting period ? ( True / False )

4. Adjustment in final accounts is necessitated because of accrual basis of accounting (state

True / False ).

5. Adjusting entries are also regarded as ______ .

6. Adjustments such as outstanding and prepaid / received items are needed to find out

_____________.

7. Adjustment entries are made before preparing tracking and P & L and balance sheet

(True/False ).

7.2.1 Outstanding expenses

Expenses due but not yet paid are known as outstanding expenses. Wages, salaries, rent,

commission etc payable in the current month are paid in the following month. If final accounts are

prepared for year ending 31st December, then the expenses payable for December will be paid in

January of next year. The extent to which the amount belongs to the current year but payable in

the next year is called outstanding expenses. To record that aspect, the journal entry drawn in the

Journal proper is:

Concerned Expenses account Dr

To outstanding Expenses account.

Outstanding expenses account indicates liability for the current year and it will appear in the

balance sheet.

Example: Advertisement expenses for year 31-12-2003 outstanding is Rs.5000. The journal

entry is

Advertisement expenses account Dr 5000

To Outstanding expenses account 5000


1. Expenses due but not yet paid are known as ___________.

2. What is the entry if salaries are outstanding ?



3. If ‘outstanding expenses’ appear in trial balance, what does it mean ?

4. Outstanding expenses appear an assets side of balance sheet ( state True / False ).

7.2.2 Prepaid Expenses

Expenses paid in advance are regarded as prepaid expenses. Prepaid expenses form an asset

and therefore prepaid expenses account is debited. For example, insurance premium is paid

from April, 2004 to March, 2005 and the amount is Rs.3600. The financial year ends by 31st

December, 2004. Therefore the premium relating to Jan, Feb and Mar of 2005 Rs.900 is said to

have been paid in advance. To record this internal adjustment, the entry is

Prepaid Expenses account Dr 900

To Insurance account 900

Note that outstanding or prepaid expenses accounts are regarded as personal accounts.


1. Expenses paid even before incurred. They are know as _____.

2. Prepaid expenses appear on the asset side of balance sheet. ( state True / False).

3. Opening balance of prepaid insurance is Rs 1000; insurance paid during the year Rs. 5600;

Insurance paid in advance include in the above is Rs 800: Find out actual expenditure for

insurance for the current year.

4. Prepaid expenses account is a personal account ( True / False).

7.2.3 Accrued Income

Accrued income is also called outstanding income. Outstanding income account is a personal

account and it represents an asset. This account is credited and the concerned income account

is debited in the journal proper as an adjusting entry. The entry is

Outstanding incomes account Dr

To Concerned income account

Example

Interest accrued on Fixed Deposit of Rs 200000 at 12% simple interest on 31-12-2006, not yet

received. The entry is

Outstanding incomes account Dr 24,000

To interest on FD account 24,000

Outstanding Income account appears as an asset in the balance sheet.


1. Income earned but not received is called ____________.



2. Outstanding income is an asset ( state True / False ).

3. Outstanding income is a personal account. (True / False ).

7.2.4 Income received in advance

Just as income is accrued, there are instances where income is received in advance. The amount

is shown as liability in the balance sheet and it shows a credit balance. The adjusting entry to

record the income received in advance is

Concerned item of income account Dr

To Income received in advance account

Example

Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts are finalized on 31-

12-2005. Therefore rent received for January, February and March of 2006 is said to have been

received in advance Rs.12000. The entry is

Rent received account Dr 12000

To Income received in advance a/c 12000


1. Any income received in advance is a liability (state True / False ).

2. What is the adjusting entry for rent received in advance ?

3. Income received in advance in the current year is ________ from the unearned item of

income received.

7.2.5 Depreciation

Depreciation is reduction in the value of an asset due to constant use of the same, which is called

wear and tear. Fixed assets like, buildings, plant, machinery, furniture etc., are subject to

depreciation. Whenever, an asset is depreciated, its value goes down and therefore it is a loss to

the organization. Depreciation account is debited and the concerned asset account is credited.

The item of depreciation may appear in the trial balance, which means that already the

concerned asset is reduced by the amount of depreciation. If depreciation is given as an

additional adjustment, then the depreciation amount should be charged against profit and loss

account on one hand and the concerned asset account is reduced on the other hand in the

balance sheet.

There are two popular methods of depreciation, namely fixed installment method and reducing

balance method. In fixed installment method, depreciation is calculated on cost of the asset. In

case of reducing balance method (Diminishing balance method), the depreciation is charged on



the reducing balance of the book value of the asset. Reducing balance method is more popular

and well recognized.

Example

Building is of the book value of Rs.400000. It is depreciated at 10% on fixed installment method.

Show the journal entry and how does it appear in the balance sheet?

Solution

The entry for depreciation is

Depreciation account Dr 40,000

To Building account 40,000

Depreciation being a loss is transferred to profit and loss account and in the balance

sheet, the value of Building is shown as Rs.400000 – 40000 = 360000.

Note: For the second year the depreciation will be Rs.40000 if the asset is depreciated under

fixed installment method. If it is depreciated under reducing balance method, the depreciation for

the second year is Rs.36000 (10% of 360000).


1. Depreciation is for __________ of an asset.

2. What entry is drawn if depreciation is provided ?

3. When depreciation account is transferred to P & L A/c , what entry do you draw ?

4. If depreciation to be provided in the adjustments, what do you understand by this ?

5. What is the method of depreciation recognized by Indian Income Tax Act?

6. If depreciation appears in the trial balance, what does it indicate ?

7.2.6 Bad Debts

Bad debts are those debts which are not recovered. Bad debts form loss to the business and

reduce the amount of debtors. Since bad debts are losses, they are debited and the debtor’s

account is credited because the outstanding amount of debtors comes down.

If bad debts are identified well before preparing trial balance, then bad debts appear in the trial

balance and they should be taken to the debit side of profit and loss account. Since debtors

account is already reduced by the amount of bad debts, it does not require any further adjustment

in the balance sheet.

If bad debts are shown outside the trial balance, which means that they are identified after the

preparation of Trial Balance, then two adjustments should be incorporated. One – bad debts



should be charged against profits in P & L A/C and the second – the debtor’s account should be

reduced by the amount of bad debts in the balance sheet on the asset side.

Example

The sundry debtors for the year 2005 are Rs.50000. The bad debts amounted to Rs.4000 as on

31-12-2005 already shown in the trail balance. Write off further bad debts Rs5000. Show how

the above internal adjustments appear in the final accounts.

Solution

• There are bad debts shown in the trial balance Rs4000 and not shown in the trial balance

Rs.5000. To incorporate those bad debts not yet shown in the trial balance, the adjusting

entry is

Bad debts account Dr 5000

To Debtor’s account 5000

• In the profit and loss account of 2005, the total bad debts appearing on the debit side are Rs.

9000(4000 + 5000)

• In the balance sheet, on the asset side, the amount of debtors is Rs45000(50000 -5000).


1. Unrecovered debts are called ______.

2. Bad debts are not expenses but they form losses. (state True / false )

3. What is the entry made in journal proper, if bad debts are recorded.

4. What entry do you make to close the bad debts ?

5. What impact bad debts have on profits ?

6. If bad debts are recovered, what entry can be drawn ?

7.2.7 Provision for Doubtful Debts

Debts that can not be recovered are called bad debts but debts, the recovery of which is doubtful,

are called doubtful debts. From the past experience of the business proprietor, what percentage

of good debts may become bad in future, can be estimated and in the current year itself an equal

amount of profit be set aside. This provision is known as Reserve for Bad Debts or Provision for

Doubtful Debts or Reserve for Doubtful Debts.

Since the provision for bad debts is a charge against current year profit, the adjusting entry is to

debit P & L A/C and credit Provision for Bad Debts Account.

Profit and Loss Account Dr

To Provision for bad debts account



Provision for bad debts is a liability to be incurred in future and so it should appear on the liability

side of balance sheet. However, the convention is - RBD (Reserve for Bad and Doubtful Debts) is

deducted from the amount of good debtors. The important note here is that RBD is computed as

a percentage of good debts, which means total debtors minus bad debts unadjusted.

Provision for bad and doubtful debts is a running account and every year the amount keeps on

changing because from the provision made in the current year, bad debts occurring in the

following year have to be adjusted and additional amount of provision to be made is calculated.

Every year, the amount transferred to P & L A/C is B + N – O, where B stands for bad debts; N

stands for new provision and O stands for old reserve. For example, the old reserve stands at

Rs.15000 and bad debts to be adjusted is Rs4000 and new reserve to be maintained is Rs18000.

The amount to be charged against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The

formula can also be shown as

N - O + B = 18000 – 15000 + 4000 = 7000


1. What is the difference between Bad debts and doubtful debts?

2. Provision is made for Debts which have become bad (state True / False ).

3. Provision for Doubtful debts is a change against the profits of the firm (state True / False )

4. Bad debts incurred in the subsequent period are written off against reserve for bad debts

(state True / False ).

5. What is the entry for writing off of bad debts against RBD?

6. If RBD is fresly to be provided, what entry can be draw?

7. RBD is calculated on debtors which are good and so any bad debts out side trial balance

should be deducted out of total debtors (state True / False ).

Illustration:

On 1st January 2006, the RBD account stood at Rs.9000 in the books of a merchant. The bad

debts written off during the year ended 31st December, 2006 amounted to Rs.4800 and Sundry

Debtors stood at Rs.480000. It was desired to maintain the reserve for bad debts at 5% on

Debtors. During the year 2007 bad debts written off amounted to Rs.12000 and sundry debtors

on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was required. Show the

journal entries for recording the above transactions and write up the bad debts reserve account.



Solution

Journal Entries


Rs.

Credit

Rs.

2006

Dec, 31st

Dec, 31st

Dec 31st

2007

Dec, 31st

Dec 31st

Dec 31st

Bad debts account Dr

To Sundry Debtors Account

(Being the bad debts written off)

Bad Debts Reserve account Dr

To Bad Debts account

(Being bad debts set off against RBD)


To Bad Debts Reserve account

(Being additional RBD made to bring the

reserve to 5% of 480000)

Bad debts account Dr

To Sundry Debtors account

(Being bad debts written off )

Bad debts Reserve account Dr

To bad debts account

(Being bad debts written off against RBD)

Profit and loss Account Dr

To Bad debts reserve account

(Being additional RBD made to bring the

reserve to 5% of 380000)

4800

4800

19800

12000

12000

7000

4800

4800

19800

12000

12000

7000

NOTE:

On January 1st 2006, the RBD account stands at Rs9000 and during the year the actual bad

debts are Rs4800 and so there is unused balance of Rs.4200 (9000 -4800). It is desirable to

have reserve of 5% of 480000 – Rs24000. Therefore additional reserve required to be provided in

P & L A/C is Rs19800 (24000 – 4200).

Similarly during 2007 the actual bad debts are Rs.12000 and the available reserve is used for

writing it off. Still there is a balance left over is Rs.12000 (24000 – 12000). The additional reserve

to be maintained is 5% of 380000, that comes to Rs19000. So the additional amount to be

provided in P & L A/C in 2007 is Rs.7000 (19000 – 12000).



Reserve for Bad Debts Account

Dr Cr

Date Particulars JF Amount

Rs. Date Particulars JF

Amount

Rs.

2006

Dec, 31st

To bad debts

To balance c/d

4800

24000

2006

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

9000

19800

Total 28800 Total 28800

2007

Dec,31st

To bad debts

To balance c/d

12000

19000

2007

Jan 1st

Dec 31st

By balance b/d

By P&L A/C

24000

7000


7.2.8 Reserve for Discount on debtors:

There are two types of discounts allowed to customers in a business. One is trade discount and

another is cash discount. Trade discount is given to customers to retain the customers and it is

shown in the invoice itself. It means that trade discount does not come to accounting records at

all. But cash discount is allowed to customers to encourage them to pay cash promptly at the

earliest. Normally cash discount gets recorded in cash account. Out of experience, a

businessman can guess how much of cash discount he may have to give on customer’s

accounts. Cash discount given to debtors is always a loss and is shown as expenditure in the

Profit and Loss Account. After anticipating the amount of cash discount allowable, a provision is

made in the current year itself. In the subsequent years, the actual discount allowed is set off

against the provision for discount on debtors. Every year, the amount of provision for discount on

debtors is deducted from the profits. The entry for making the provision is


To Provision for discount on debtors account

Just as in the case of provision for bad and doubtful debts, the bad debts are first written off

against provision for bad debts and later the required amount of provision is provided in the P&L

A/c, similar procedure takes place in the case of provision for discount on debtors. The following

guide lines may be kept in mind while dealing with the reserve for discount on debtors

1. If a reserve for discount on debtors is not existing and cash discount is allowed, then transfer

the discount to P&L account.

2. Any fresh reserve for discount on debtors is to be made, debit the P&L A ccount with the

amount of reserve.



3. If provision for discount on debtors exists at the time of providing discount, then write off the

discount from the provision already made for the purpose.

4. New provision should then be calculated and only as much as required to bring the existing

provision to the new figure should be debited to P&L Account.

5. If the new provision required is lower than the provision already existing (old), then the

difference shows profit and transfer the same to P&L Account.


1. what is the aim of giving cash discount ?

2. If discount is allowed against receivables, what entry do you draw in journal proper?

3. Provision for Discount on debtors is a charge against P & L a/c. (state True / False).

4. Provision for discount on debtors appears as a liablility in the balance sheet ( state True /

False )

5. What is the basis for calculating provision for discount an debtors?

Illustration

The following items are found in the trial balance of Praksh on 31st December 2000.

Sundry Debtors Rs. 160000

Bad Debts written off 9000

Discount allowed to Debtors 1800

Reserve for Bad and doubtful Debts 31-12-1999 16500

Reserve for discount on Debtors 31-12-1999 3200

You are required to provide for the bad and doubtful debts at 5% and for discount on debtors at

2%. Give necessary journal entries and show bad debts account, bad debts reserve account,

discount account and provision for discount on debtors account.

Solution


Rs.

Credit

Rs.

2000 Dec, 31st

Dec 31st

RBD account Dr

To Bad Debts account

(Being bad debts written off against existing RBD)

P & L Account Dr

To RBD account

(Being addition to RBD to make the new RBD equal to 5% of 160000)

9000

500

9000



Dec 31st

Dec 31st

Reserve for discount on debtors account Dr

To Discount on Drs A/c

(Being discount on debtors written off against Reserve for discount on Debtors)

P & L Account Dr

To Reserve for discount

On debtors account

( Being additional reserve made to make the new reserve for discount on debtors to 2% of 152000)

1800

1640

500

1800

1640

NOTE:

1. The amount debited to P&L Account towards RBD is computed as follows

Old RBD = Rs. 16500

Less Bad debts = 9000

Balance = 7500

New RBD @5% on160000 = 8000

RBD to be provided = 500 (8000-7500)

2. The amount debited to P&L Account towards Reserve for Discount on Debtors is computed

as follows:

Good Debtors = 160000 – 8000 (New RBD)=152000

Old Res for Dis On Drs = Rs. 3200

Less Discount on Drs = 1800

Balance Reserve = 1400

New Res for Disc at 2%

On good drs 152000 = 3040

Res for Discount to be

Provided now = 1640 (3040 -1400)

Bad Debts Account

Dr Cr



Amount

Rs.

2000

Dec, 31st

To Sundry debtors account

9000

2000

Dec 31st

By RBD account

9000




Reserve for Bad Debts Account

Dr Cr


Rs.


Rs.

2000

Dec, 31st

To bad debts

To balance c/d

9000

8000

2000

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

16500

500


Discount on Debtors Account

Dr Cr



Amount

Rs.

2000

Dec, 31st

To Sundry debtors account

1800

2000

Dec 31st

By Reserve for Discount on Debtors A/C

1800


Reserve for Discount on Debtors Account

Dr Cr



Amount

Rs.

2000

Dec, 31st

To Discount on Debtors

To balance c/d

1800

3040

2000

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

3200

1640


In the balance sheet, the Sundry debtors are reduced by bad debts shown out side the trial

balance, the new RBD, discount on debtors shown out side the trial balance and the new

Reserve for discount on debtors.

7.2.9 Reserve for discount on creditors

Just as reserve is for discount on debtors is created, reserve for discount on creditors is also

created. Businessman expects that he would receive discounts from suppliers (creditors), when

the businessman remits cash to them. Anticipating some percentage of creditors being received

as discount in the coming year, the business proprietor makes a provision for the expected

income in the current year itself. Discount on creditors is an income and therefore reserve for



discount on creditors is debited and profit and loss account is credited to show it as anticipated

profit. In the subsequent year, when discount on creditors is actually received, it is first set of

against provision for discount on creditors and the difference between the new provision for

discount on creditors and the balance of old provision left over is carried to P&L Account.

Discount on creditors is income and to that extent the creditors due is reduced. So the journal

entry to record them is

Creditor’s account Dr

To discount on creditors account

Later if the discount received is adjusted against reserve for discount on creditors, the entry will

be

Discount on creditor’s account Dr

To Reserve for discount on creditors

When provision for discount on creditors is made in P&L Account, the entry will be

Reserve for discount on creditors account Dr

To Profit and loss account

The amount of provision for discount on creditors is calculated at a percentage on creditors. In

the balance sheet, creditors are shown after deducting reserve for discount on creditors.


1. Discount on creditors is an item of income (state True / false ).

2. Provision for discount on creditors is shown as an anticipated income (State True/False ).

3. How do you treat provision for discount an creditors in balance sheet ?

4. Discount received from creditors subsequently is changed against provision for discount on

creditors. (state True / False ).

7.2.10 Closing stock

Stock of goods – raw materials, semi finished goods, finished goods – at the end of the

accounting year should be considered for preparing trading account and balance sheet. It is an

internal adjustment. Closing stock is normally valued at cost or market price which ever is lower,

even though there are several other methods to value stock. Closing stock does not appear in the

trial balance because the value of it is ascertained only after the preparation of trial balance. To

bring to the records, a journal entry is passed in journal proper by debiting closing stock account

and crediting trading account. In the balance sheet, closing stock appears as an asset.




6. what is the popular valuation method of closing stock ?

7. what is the entry for adjusting the closing stock ?

8. what does happen in case closing stock is not considered for computing gross profit ?

9. Closing stock always appears as an asset in balance sheet. (state True / false).

7.3 Trading Account

Trading account shows gross profit or gross loss arising out of trading activities. Trade means

buying and selling. The account mainly focuses on finding the result of goods bought and goods

sold. Interestingly, goods are bought for a cost and the proprietor incurs a few items of purchase

expenses and the goods are sold at a price higher or lower than the cost incurred. At the end of

accounting period, some stock is left over and it should be valued so as to calculate the profit or

loss from the cost of goods sold. Therefore, opening stock of goods, cost of purchases made,

expenses on purchases are taken on debit side of the trading account. On the credit side of the

account, the sales of goods and the value of closing stock are shown. The excess of credit over

debit is gross profit and vice versa. The gross profit or gross loss is transferred to Profit and Loss

Account. The format of a Trading Account is given below:

Dr Trading Account for the year ending- - - - Cr

Particulars Rs. Particulars Rs.

To opening stock

To Purchases

Less Purchase returns/returns outwards

To Carriage inwards

To freight and octroi

To wages

Add outstanding wages

Less prepaid wages

To fuel and power

To Gas, coal, electricity for production

To Import duty and clearing charges

To stores consumed

To factory rent, insurance, factory expenses

To other direct expenses

To Royalty paid

To Profit and Loss A/c (Gross Profit)

By sales

Less returns inwards/sales returns

By Closing stock

Note: For every expenditure, outstanding and prepaid aspects must be considered.



From the above account, it is easy to learn the transferring entries made to close the accounts of

expenses and incomes. The transferring entries are

1. Trading account Dr

To opening stock a/c

To purchases a/c/

To Wages a/c

To Royalty paid a/c etc

(Being all expenses of trading transferred to trading account)

2. Sales account Dr

Closing stock account Dr

To Trading account

(Being sales and closing stock transferred to trading account)

3. Trading account Dr

To Profit and Loss Account

(Being gross profit carried forward to P&L A/C)

4. Profit and Loss Account Dr

To Trading account

(Being gross loss transferred to P&L Account)


1. Trading account is an account showing profit on cost of goods sold.( state True / False).

2. Cost of goods sold include opening stock + Purchase expenses – closing stock. (state True/

False ).

3. Gross profit is ______minus cost of goods sold.

4. Gross profit or loss is transferred to ___________ account.

7.4 Preparation of Trading Account

To prepare Trading Account, the following steps may be followed:

a) Identify the items of expenses relating to trading and show them on the debit side of Trading

Account.

b) Effect the adjustments such as outstanding or prepaid to the relevant items of expenses

c) Show the sales less returns and closing stock on the credit side of trading account



d) The difference is gross profit if credit total is more than debit and gross loss if debit total is

more than credit.

e) Transfer the gross profit or gross los to Profit and Loss Account as the case may be.


1. Do you consider gross purchases or net purchases while preparing trading account ?

2. Do trading concerns prepare manufacturing account ?

Illustration

From the following balances extracted from Trial balance, prepare Trading Account. The closing

stock at the end of the period is Rs56000

Particulars Amount in

Rs.

Stock on 1-1-2004

Returns inwards

Returns outwards

Purchases

Debtors

Creditors

Carriage inwards

Carriage outwards

Import duty on materials received from abroad

Clearing charges

Rent of business shop

Royalty paid to extract materials

Fire insurance on stock

Wages paid to workers

Office salaries

Cash discount

Gas, electricity and water

Sales

70700

2000

3000

102000

56000

45000

5000

4000

6000

7000

12000

10000

2000

8000

10000

1000

4000

250000



Dr TRADING ACCOUNT FOR THE YEAR ENDING - - - - Cr

Particulars Rs Particulars Rs

To stock on 1-1-2004

To Purchases 102000

Less Returns

Outwards 3000

To Carriage inwards

To import duty

To Clearing charges

To Royalty

To Fire Insurance

To Wages

To Gas, electricity, water

To P & L Account (GP)

70700

99000

5000

6000

7000

10000

2000

8000

4000

91300

By sales 250000

Less Returns

Inwards 3000

By Closing stock

247000

56000

303000

303000

7.5 Profit and Loss Account

Profit and los account is an important final account in the sense that the net result of the business

in the form of net profit or net loss is disclosed by preparing the same. All business expenses like

administrative expenses, office expenses, selling and distribution expenses are shown on the

debit side of the account. Besides, all provisions made for different purposes such as reserve for

bad debts, reserve for discount on debtors, reserve for repairs, depreciation etc., also picture on

the debit side of the account. On the credit side of the account, all incomes of revenue in nature,

reserve for discount on creditors and gross profit carried from trading account are mentioned.

In this connection, it is important to note that Trading and Profit and Loss Account are regarded

as revenue accounts. Any capital receipts or capital payments are not considered while preparing

them. In brief, revenue receipts are those which are received regularly arising out of day to day

activities of the business and similarly revenue payments, which are known as expenses are

incurred regularly and for every day functions of the business. Capital receipts are in the form of



sources of funds such as capital received, sale of capital asset like building etc., Capital

payments are those spent for acquisition of capital assets, incurring capital expenditure etc.,

The transferring entries are drawn to prepare Profit and loss account. They are


To all expenses account To Transfer all expenses

2. All Incomes account Dr

To Profit and Loss Account To Transfer all incomes


To Capital account To Transfer Net Profit to Capital

4. Capital account Dr

To Profit and Loss Account To Transfer Net loss to Capital

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING ---

Dr Cr


To Trading Account (GL)

To Salaries + Out standing

–Prepaid salaries as per

adjustments

To Rent of the premises

To Travelling expenses

To Rates and Taxes

To Printing and stationery

To Postage and Telegram

To Telephone charges

To Insurance –Prepaid

amount as per adjustment

To Interest paid

To Discount allowed

To Sundry expenses

To Advertisement

By Trading account (GP)

By Interest earned +

Accrued interest as per

adjustments

By Commission earned

By discount earned

By Rent received

By Bad debts recovered

By Interest on drawings

By Reserve for discount on

Creditors

By Dividends received

By Royalty Received

By Capital Account( Net

Loss)



To Commission

To Carriage outwards

To Bad Debts

To Reserve for Bad debts

To Reserve for discount on

Debtors

To Depreciation

To Legal charges

To Audit fee

To Interest on Capital

To Capital Account (Net

Profit)

7.6 Preparation of Profit and Loss Account

The following steps may help to prepare Profit and Loss Account

1. Identify the expenses and bring them to debit side of P&L Account

2. Identify the revenue incomes and put them on the credit side of P&L Account

3. Check whether all adjustments like outstanding, prepaid, pre received expenses and incomes

as the case may be are brought to the account

4. Check the transfer of reserves to the relevant sides of the account

5. Transfer the net profit / net loss to the capital account


1. What types of expenses are shown on the debit side of P & L account ?

2. P & L account is revenue account showing the revenue net profit or loss for the accounting

period(state True / False ).

3. Painting for a new building, Installation expenses paid to install a plant, amount spent for

advertising for promotion of sale of a product are revenue expenses (state True / False ).

4. Net profit / loss is carried to owners equity / capital (state True / False )



Illustration

The following Trial Balance is extracted from the books of a merchant on 31-12-2004.

Particulars Rs

Furniture and fittings

Motor Vehicles

Buildings

Capital Account

Bad Debts

Provision for Bad debts

Sundry Debtors

Sundry Creditors

Stock on 1-1-2004

Purchases

Sales

Bank Over Draft

Sales Returns

Purchase Returns

Advertising

Interest on Bank Over Draft

Commission

Cash

Taxes and Insurance

General Expenses

Salaries

640

6250

7500

12500

125

200

3800

2500

3460

5475

15450

2850

200

125

450

118

375

650

1250

782

3300

The following adjustments are to be made.

1. Stock in hand on 31-12-2004 was Rs3250

2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and Motor Vehicles @

20%.

3. Rs.85 is due for interest on bank overdraft.

4. Salaries of Rs300 and taxes Rs.120 are outstanding.

5. Insurance amounting to Rs.100 is prepaid

6. One-third of the commission received is in respect of work to be done next year



7. Write off a further sum of Rs.100 as bad debts and provision for bad and doubtful debts to be

made equal to 10% on sundry debtors.

8. Prepare Trading Account and Profit and Loss Account.

9. Dr Trading Account for the year ending 31-12-2004 Cr


To Stock on1-1-2004

To Purchases 5475

Less returns 125

To P & L A/C (GP)

3460

5350

9690

By Sales 15450

Les Returns 200

By Closing Stock

15250

3250


Profit and Loss Account for the year ending 31-12-2004

Dr Cr


To Salaries 3300

Add Outstanding 300

To Advertising

To Interest on OD 118

Add Outstanding Int 85

To Taxes and Insurance 1250

Add Out standing tax 120

1370

Less Prepaid Insurance 100

To General expenses

To bad debts

To RBD(New) 370

Less old RBD balance 100

To Depreciation:

On Bldgs @ 5% 375

On FF @ 10% 64

On M Vehicles @20% 1250

To Capital Account (NP)

3600

450

203

1270

782

125

270

1689

1551

By Trading Account (GP)

By Commission 375

Less Pre-received 125

9690

250




Note:

Sundry Debtors are Rs.3800 and there have been bad debts outside TB Rs100. The good

debtors are Rs.3700. The new RBD is 10% of 3700, i.e.Rs370. The old RBD unspent is Rs100

(200 -100). Therefore RBD to be charged against profit is Rs270

7.7 Balance Sheet

Balance Sheet is the sum and substance of financial performance a business undertaking. It

shows the assets and liabilities of business on a particular day. It is not an account but is a

statement of affairs. The statement of assets and liabilities is prepared, having two sides, left

side containing capital and liabilities and on the right side, containing assets and properties. Often

the statement is prepared vertically, mentioning sources of funds first and later application of

funds. Sources of funds indicate capital and liabilities and application of funds indicate assets.

Balance Sheet is prepared from Trial Balance. In case of sole trader organization and Partnership

organization, the format of preparing Balance Sheet is arranged basing on liquidity of the assets.

In case of Companies, the Companies Act, 1956 has specified a definite pattern of preparing

Balance Sheet. Both the models of preparing Balance Sheet are stated here under.

BALANCE SHEET FOR THE YEAR ENDING 31-12-2003 OF Mr. X

Capital and Liabilities Rs Assets Rs

Sundry Creditors Less Reserve for Discount on Creditors Bills Payable Bank Over Draft Loans Borrowed Outstanding Expenses Pre-received Incomes Capital (Opening) Add Additions to capital Add interest on capital if any Add Net profit as per P&L a/c Less personal drawings Less Net loss as per P&L A/C

Cash in hand Cash at Bank Land and Building Add Additions if any Less depreciation Plant and Machinery less depreciation Furniture and Fixtures less depreciation Sundry debtors Less Bad debts out side Trial Balance Less Reserve for Bad Debts Less Reserve for discount on Debtors Bills Receivable Loans and advances given to others + Interest outstanding Investments + outstanding income on investments Other outstanding incomes Pre-paid expenses Closing stock

Total Total



The Format of Balance Sheet of a Company


Capital:

Authorised, Issued,

Subscribed,Called up,

Paid-Up capital with

adjustments

Reserves and Surplus

Loans and Borrowings

Long Term Loans

Short Term Loans

Current Liabilities:

Sundry Creditors, B/P,

Outstanding expenses, pre-

received incomes, dividends

payable, etc.,

Fixed Assets:

Goodwill, Land

Buildings,Furniture, Fixtures,

Equipment, Plant, Machinery,

Copy Rights, Patents

Investments

Loans and Advances

Current Assets:

Debtors, B/R, Inventory,

Cash, Bank, Outstanding

incomes, Prepaid expenses

etc

Total

Total


1. The two sides of a balance sheets are ____ and ___________.

2. balance sheet is prepared on the bases of trial balance. (state True / False ).

3. balance sheet portrays the financial soundness of a concern (state True / False).

7.8 Preparation of Balance Sheet:

A few guide lines are given here under to prepare balance Sheet of a business concern. Balance

Sheet is not an account and there is nothing like debit side and credit side. If Trial Balance tallies,

naturally Balance Sheet also tallies:

1. Identify all assets from the trial balance. Assets are shown on the debit side of T.B

2. Identify all liabilities from the Trial Balance and they are on the credit side of TB.

3. Make a mark of items with respect to which adjustments are given out side the TB

4. All adjustments should find place in two places, one either in Trading account or in Profit and

Loss Account and another invariably Balance Sheet. For example, closing Stock given

outside TB is first shown on the credit side of Trading Account and it is shown as an asset in



the Balance Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and later

shown as a deduction from Sundry Debtors in the Balance Sheet. Similarly depreciation is

charged against profits first and later deducted from the book value of concerned asset in the

balance sheet.

Illustration 1

From the Trial Balance given in para 6, prepare Balance Sheet of the merchant as on 31-12-

2004.

Solution

Balance Sheet as on 31-12-2004


Sundry Creditors

Bank Over Draft 2850

Add interest due 85

Commission received in

advance

Outstanding Taxes

Outstanding Salaries

Capital 12500

Add Net Profit 1551

2500

2935

125

120

300

14051

Cash

Building 7500

Less Depreciation 375

Furniture and Fixtures 640


Motor Vehicle 6250


Sundry Debtors 3800

Less bad debts as per

Adjustments 100

Balance 3700

Less Reserve for Bad

Debts(New) 370

Closing Stock

Pre-Paid Insurance

650

7125

576

5000

3330

3250

100


NOTE: Every adjustment given outside Trial Balance finds place in two accounts –Trading

account / Profit and Loss Account and invariably in Balance Sheet.




1. What is the purpose of creating Reserve for Bad debts?

2. State the purpose of creating reserve for discount on creditors.

3. Insurance paid on 1-1-2000 up to 31-12-2000 Rs.4800. If the books are closed on 31-7-2000,

what is the amount of prepaid insurance?

4. Select the most appropriate answer.

i) Sales are equal to a) Cost of goods sold + Profit b) Cost of goods Sold – Gross

Profit c) Gross Profit – Cost of Goods sold

ii) Interest on Drawings is a) Expenditure for the business b) Expense for the business

c) Gain for the business

iii) Goods given as samples should be credited to a) Advertisement account

b) Sales account c) Purchases account

iv) Out standing salaries are shown as a) an expense b) a liability c) an asset

v) Income tax paid by a sole trader on his business income should be

a) debited to the Trading Account b) debited to P&L Account c) deducted from

capital account in the Balance Sheet

5. Stock at the end, if appears in the Trial Balance is taken only to the Balance Sheet – Yes or

No?

6. Goods taken by the proprietor for personal use are credited to sales account – Yes or No?

7. Salary paid in advance is not an expense because it neither reduces assets nor increases

liabilities. – Yes or No?

8. Balance Sheet is an account because it is included in the scope of final accounts – Yes or No

Terminal Questions.

1. In taking out a Trial Balance, a Book keeper finds that debit total exceeds the credit total by

Rs.611. The amount is placed to the credit of a newly opened Suspense Account.

Subsequently the following mistakes were discovered. You are required to pass the

necessary entries for rectifying the mistakes, and show how Suspense account.

(a) Sales day book was over cast by Rs.1000

(b) A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna

(c) General expenses Rs.180 were posted as 801

(d) Cash received from Bhatt was debited to his account RS.450

(e) While carrying forward the total from one page of the Purchases book to the next, the

amount of Rs.1235 was entered as Rs.1325.



2. Rectify the following errors:

(i) Furniture purchases for Rs.2500 was debited to Purchases account

(ii) A sum of Rs.500 paid to Lalitha was debited to Shantha

(iii) A bill receivable for Rs.1000 received from Kumar has been omitted to be entered.

(iv) Goods worth Rs2040 taken away by the proprietor were debited to Bharath

(v) An engine purchased for Rs.12500 had been posted to Purchases account

3. An accountant could not tally the Trial Balance. The difference was temporarily transferred to

Suspense account for preparing the final accounts. The following errors were later

discovered.

(a) The sales book was under cast by Rs.500

(b) Entertainment expenses Rs.950 though entered in the cash book were omitted to be

posted in the ledger.

(c) Discount column of the receipt side of cash book was wrongly added as Rs114 instead of

Rs.144.

(d) Commission of Rs.250 paid, was posted twice, once to discount account and once to

Commission account.

(e) A sale of Rs.169 to Rama Murthy though correctly entered in sales book, was posted

wrongly to his account as Rs.196.

(f) A purchase from Neeraj of Rs.290 though correctly entered in purchases book was

wrongly debited to his personal account.

You are required to

1. Pass the necessary rectifying entries

2. Prepare Suspense account

3. State the effect of each of the rectification on the profit.

What would be the correct profit originally arrived at was Rs.10000?

4. The trial balance of Raj Bahadur of Vijayanagaram as on 31-12-2005 is given below.Prepare

Trading Account, Profit and Loss Account and Balance Sheet for year ending 31-12-2005

after taking into consideration the following adjustments.

(a) Stock on 31-12-2005 was 15000

(b) Debts worth Rs.2000 should be written off as bad

(c) Depreciate Machinery by 5% and Motor Van by 15%

(d) Reserve for bad and doubtful debts should be increased by Rs.600

(e) Commission accrued and not received Rs.500



(f) Goods worthRs.500 were used by the proprietor for his personal use

(g) On September,2005, a fire broke out in the shop and goods worth Rs.2000 were

completely destroyed. The insurance company accepted a claim of Rs.1500 only and paid

the amount on January 1st 2006.

TRIAL BALANCE AS ON 31-12-2005

Particulars Debit in Rs Credit in Rs

Capital

Drawings

Opening Stock

Purchases and Sales

Returns

Discounts

Commission

Income Tax paid

Office Salaries

Advertising

Sundry Debtors and creditors

Reserve for Doubtful Debts

Manufacturing Wages

Bills Receivable and Payable

Carriage

Machinery

Motor Vans

Land and Buildings

Office Expenses

Cash at Bank

Cash in Hand

7500

12000

86000

2000

500

700

17300

2000

1700

85000

8600

5000

600

40000

7000

10000

1500

6000

2300

295700

85000

170000

1000

700

1000

30000

3000

5000

295700

Ans: Gross Profit Rs.79300; Net Profit: 52350; BS163650



5. On 31st December,2003 the following trial balance has been extracted.

Rs Rs

Drawings

Sundry Debtors

Interest on loan

Cash in hand

Stock (1-1-2003)

Motor Vehicles

Cash at Bank

Land and buildings

Purchases

Salaries

Carriage in

Carriage out

General Expenses

Bills receivable

4000

20500

300

4000

6050

10000

5600

62000

97500

8600

4100

2200

5100

7050

Establishment

Rent, rates and insurance

Advertisement

Credit Balances

Capital account

Sundry creditors

Loan on mortgage

Bad debts Provision

Sales

Purchase returns

Discounts

Bills payable

Rent received

9100

5000

4160

50000

12000

15700

2000

170000

1460

500

3000

600

Adjustments

1. Depreciate land and buildings at 5% and Motor Vehicles at 15%

2. Interest on loan is at 5% taken on 1st January,2003

3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due.

4. There has been a fire on 1st January, 2003 destroying goods worth Rs.200

5. The bad debts provision is to be brought up to 5% on Sundry debtors

6. The stock in hand on 31-12-2003 was valued at Rs16000

7. Goods costing Rs.1000 were taken away by the proprietor for his personal use, but no entry

has been made in the books of accounts

8. Prepaid insurance amounted to Rs.500

9. Provide for Manager’s commission at 5% on net profit after charging such commission.

Prepare Trading & P&L a/c and balance sheet.



6. A firm had the following Balances on 1st January 2000

(a) Provision for bad debts Rs7500

(b) Provision for discount on debtors 3600

(c) Provision for discount on creditors 3000

During the year Bad debts amounted to Rs.6000, Discounts allowed were Rs300 and

discounts received were Rs.600. During 2001, bad debts amounted to Rs.5000 and discounts

allowed and received were respectively Rs.6000 and Rs1500.

Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off of bad debts, but

after allowing discounts. On December 31st, 2000, the amount of debtors was Rs.57000 after

writing off the bad debts but before allowing discounts. Total creditors on these two dates

were Rs.60000 and Rs.75000 respectively.

It is the firm’s policy to maintain a provision of 5% against bad and doubtful debts and 3 % for

discount on debtors and a provision of 3% for discount on creditors.

Show the accounts relating to provision on Debtors and provision on creditors for the year

2000 and 2001 (Ans: Provision for bad debts-2000 Rs.6900 and 2001 Rs.2850; Provision for

discount on debtors – 2000 Rs.3933, 2001 Rs.1530; Provision for discount on creditors –

2000 Rs.1800, 2001 Rs2250)

7. In a business, Sundry debtors were Rs.40000 at the beginning of the year and there was 5%

Reserve for Doubtful Debts and also 5%Rreserve for Discount on Debtors. During the year

the actual bad debts amounted to Rs.1600 and the discount allowed were Rs.1700. At the

close of the year, the debtors were Rs.50000; and the percentage of the two reserves have to

be maintained as at beginning. Show ledger accounts.

Answer for Self Assessment Questions.


1. True

2. False

3. True.

4. True

5. Internal transactions

6. profit / loss for the accounting period

7. Time.




1. Outstanding expenses

2. Salaries account Dr To outstanding expenses account

3. It means t hat they are already considered.

4. False.


1. Prepaid expenses

2. True

3. 1000 + 5600 – 800 = 5800

4. True.


1. Accrued or outstanding income

2. True

3. True


1. True

2. Rent account Dr

To Income received in advance account

3. Deducted.


1. Wear & tear / usage

2. Depreciation a/c Dr

To asset account

3. P & L a/c Dr

To Depreciation a/c

4. It means that the concerned asset is get to be depreciated

5. Diminishing(Reducing) balance method.

6. It indicates that the asset is already depreciated and depreciation should be transferred only

to P & L a/c.




1. Bad debts

2. True

3. Bad debts a/c Dr

To Debtor a/c

4. P & L a/c Dr

To Bad debts a/c

5. Profits are reduced.

6. Cash a/c Dr.

To Bad-debts recovered a/c.


1. Bad debts are totally not recoverable, doubtful debts may be recovered.

2. False

3. True

4. True

5. R.B.D a/c Dr

To bad debts account.

6. P & L a/c Dr

To R BD a/c

7. True


1. To encourage customers to make quisk & prompt payment.

2. Cash discount a/c Dr

To Debtors a/c

3. True

4. True

5. Good debtors (Meaning total debtors- Bad debts outside trial balance-RBD )


1. True

2. True

3. Deduct the provision from the amount of creditors

4. True.




1. Cost on market price which ever is lower

2. Closing stock is debited and trading account is credited

3. Gross profit is reduced by not considering unsold stock

4. True.


1. True

2. True

3. Sales

4. P & L


1. Net purchases meaning (Total purchases – purchase returns – stock destroyed – stock used

for personal use ).

2. No, because they do not manufacture any product.


1. Indirect expenses office & administrative expenses, selling & distribution expenses etc.

2. True

3. False

4. True


1. Assets, liablities

2. True

3. True


1. To write off bad debts against the reserve and reduce the pressure on cuurent profits.

2. to provide for anticipated profits.

3. Rs 2000 relating to 5 months ( 1.8.2000 to 31.12.2000)

4. i) a ii) c iii) c iv) b v) c

5. Yes



6. No

7. Yes

8. No

Answer for Terminal Question:

1. Refer to unit 6.10.



4. Refer to unit 7.4, 7.6, 7.8.

Ans: Gross profit Rs 79300, Net profit Rs 52350

Balance sheet Rs 163650.

5. Refer to unit 7.4, 7.6 & 7.8

Gross Profit Rs 81010; Net Profit Rs 40706; Commission Rs 2034;

Balance Sheet Total Rs 1,20,025

6. Refer to unit 7.2.7, 7.2.8, 7.2.9

Answer : Provision for Bad debts 2000 – Rs 6900 ; 2001 – Rs 2850.

Provision for discount on debtors 2000 – Rs 3933; 2001- Rs 1530

Provision for discount on creditors 2000 – Rs 1800; 2001 – Rs 2,250.

7. Refer to unit 7.2.7, 7.2.8

Closing Balance of RBD Rs 2,500

Closing Balance of Reserve for Discount on Debtors Rs 2,375.

RBD Transferred to P & L account Rs 2,100

Reserve for Discount Transferred to P & L account Rs 2,175



Unit 8 Introduction to Management Accounting

Structure:

8.1 Introduction

Objectives

8.2 Decision Making


8.3 Meaning and scope


8.4 Cost analysis

8.5 Budgetary control


8.6 Standard costing

8.7 Financial analysis


8.8 Relevant cost


8.9 Management accounting framework

8.10 Function of management accounting


8.11 Special features

8.12 Merits and Demerits

8.13 Distinction between M.A and F.A

Terminal Questions


8.1 Introduction Management accounting is an accounting service to the management. It assists the managers in

the formulation of policy, taking a decision, control of execution. It focuses in increasing the

managerial efficiency. Hence management accounting is also called as “Accounting for

Management”. Learning Objectives: After studying this unit, you should be able to understand the following

1. Spell out the meaning, scope, functions, special features, role of Management accounting,

2. Expose the cost analysis,



3. Appreciate the budgetary control,

4. Deal with standard costing,

5. Recognize the merits and demerits of management accounting,

6. Identify the differences between management accounting and financial accounting,

7. Perform some basic financial analysis.

8.2 Decision Making as a Nucleus of Management Decisionmaking in any business organization( individuals or groups of individuals) is primarily a

function of management. Decisions are normally taken under uncertainty. Decision under trial

and error or intuition will not end in good results. Scientific decision need to be made from time to

time. For this, the management has to rely on the information supplied by professionals and

specialized agencies. One of the important components in information collection is in the field of

internal financial information. Accounting acts as a basis upon which crucial decisions can be

made. The financial statements prepared in its traditional form may not convey the required

information for taking decisions. The financial information need to be finetuned for use by the

busy management. This function is being performed by the management accounting.


1. Decision making is a painful game (True or false).

2. Decision based on trial and error method bring in good results (true/false).

3. Decisions are normally based on financial statements (true or false) .

4. Financial information need to be ________ For use by management.

8.3 Meaning And Scope Management accounting is an accounting service to the management. It covers all those services

by which the accounting department can assist the managers in the formulation of policy, taking a

decision, the control of its execution and the appreciation of effectiveness.

As regards the scope of management accounting, it is very wide. It is based on historical

financial data. It is concerned with future. It uses the information available from different walks of

life like Political Science, Statistics, Mathematics, Economics, Cost Accounting and Financial

Accounting. The main purpose of management accounting is to utilize information in solving the

business problems and taking scientific decisions. Hence, it is difficult to pinpoint the exact scope.

The Management Accountant seek to support management decision making by the provision of

information and the analysis of financial performance. As the data is required for internal



purposes, the management accountant is not constrained by the need to comply with regulations

of the format for presentations. The main scope is :

1. To identify and calculate costs of production. This is known as Cost Accounting

2. To provide estimates for future expenses and revenues. This is known as Budgeting

3. To identify inefficiencies within the organization

4. To control costs and manage the flow of cash

5. To seek opportunities e.g. to identify “tax breaks”, possible cost savings and movements in

foreign exchange rates which could be exploited by the organization.

The main management accounting techniques are:

1. Breakeven analysis

2. Costing

3. Budgeting

4. Ratio Analysis

5. Variance analysis

Self Assessment Questions 2 1. Function of accounting department is _______, ________, _______, ______ .

2. Main purpose of Management accounting is _______ and ______________ .

8.4 Cost Analysis M.A take into account some of the concept of cost accounting technique. The cost analysis is an

important aspect. A management accountant has to face questions such as “what will our cost be

next year”. This deceptively simple boundary question.

Such question can occur in virtually every aspect of work and knowledge of the patterns of cost

behavior and ways that future cost can be predicted is fundamental requirement when concerns

with decision makers.

8.5 Budgetary Control Modern business world is full of competition, uncertainty and exposed to different types of risks.

The complexity of managerial problems has led to development of various managerial tools,

techniques and procedures useful for the management in managing the business successfully. In

this direction, planning and control plays an important role. Budgeting is the most common and

powerful standard device of palling and control.



Budgetary control is a technique of managerial control through budgets.. A budget is a

quantitative expression of plan of action. . It is a predetermined detailed plan of action

developed as a guide for future operation. According to Wheldon “Budgetary control is the

planning in advance of the various functions of business so that the business as a whole can be

controlled”. Budgetary controls deals with planning, coordination, recording appraisal and follow

up of actions.


1. Budget is ____________ _________________ Plan of action

2. Budgetary controls deals with _______, ________, _______, _____, _____ .

8.6 Standard Costing and Variance Analysis Businesses need to plan and budget for their future activities if their objecti are to be achieved.

Planning and budgeting are not enough. It is necessary to monitor progress against the planned

outcomes to establish significant differences and to permit corrective action to take place. This

means that performance must be regularly assessed, differences identified and plans revised..

Although the ultimate objectives may not change, the way in which they are to be achieved may

be very different and might make additional demands on resources than originally anticipated.

A standard is a specified quantity or money amount that has been estimated with reference to

past experience and the future expectations of efficiency levels, productivity and prices. Product

or service costs can be estimated by ascertaining amount of material if applicable, and direct

labour spent on each unit. This might be determined by observing what quantity of material is

used in a product and at which price it may be purchased. It will also involve estimating how long

a particular type of direct employees spend on various aspects of making the product or

providing the service and what the various wage rates are for each type of labour involved.

Therefore, the setting of these standards is a subjective process. The acceptable or desired

standards may vary from manager to subordinate, from individual to individual. Standard costing

makes the planning and budgeting easier and avoids the problem of completely reformulating

budgets every period. Standards also provide a controlling mechanism where behavior is

modified through motivation and appraisal. Standard costing allows management to locate

operational problems. Standard costing is best applied to manufacturing concerns where many

products are produced and their components numerous.

Deviation from standards is called variance. In budgeting language, a difference is known as

variance. Differences between budgeted and actual performance will be referred to as variances.



8.7 Financial Analysis It is the process of determining the significant operating and financial characteristics of a firm from

accounting data. An organization has to deal with three areas viz. financial records and external

reports, accounting for management decisions and internal reports and finally financial

assessment and analysis. Financial statement analysis is therefore largely a study of relationship

among the various financial factors in a business . It is the process of selection, relation and

evaluation. The focus of financial analysis is on key figures in financial statements and the

significant relationship that exists between them. The technique of financial analysis is typically

devoted to evaluate the past, present and projected performance of a business firm. Financial

analysis is commonly called “the analysis and interpretation of financial statements”.

Self Assessment Questions 4 1. An organization has to deal with three areas _______, _______ and ______ .

2. Financial analysis is also known as _______________________________ .

8.8 Relevant Cost Management decision is based on relevant costs. Costs incurred in the past is sunk cost.

Whether to replace a machine or a not is a decision not based on how much was invested to buy

that machine. This is based on comparative cash inflows from replacements and additional

investments necessary net of realization of the old asset. Thus, sunk costs are not relevant

costs.

Thus management accounting accumulates cost data but classifies them into relevant costs to

aid management decisionmaking. Discretionary costs are incurred at the discretion of the

management. A percentage of profit may be used for research and development. Unless

discretions are compulsions, these should not be treated as relevant costs.

Self Assessment Questions 5 1. Sunk cost is ________________________.

2. Sunk costs are not __________________ Costs.

3. A _______________________ is used for research and development.

8.9 Management Accounting Framework For offering accounting and financial advice as well as for capitalizing the available opportunities

for future development, it is necessary that an effective development, it is necessary that an

effective frame must should be designed. The management accountant must organize the whose

accounting division in such a way that there is prompt and immediate recording of the entire



information flow into the department from functional and service department. The frame must

concentrate on.

• Getting rid of routine work

• Reporting actual and planned performance

• Fixing organizational responsibilities

• Application of new modern and modified practices of analyzing and interpreting results.

• Designing of sound and efficient organization taking into account the native and size of the

business unit.

8.10 Functions of Management Accounting Management Accounting functions nay be said to include all activities with collecting, processing ,

interpreting and presenting information to management. More specifically, the functions are as

follows:

Forecasting and Planning: Short and long term forecasts are very essential. Planning the future operations of a business is crucial. Necessary information and data for forecasting should

be provided from time to time. Various tools and techniques should be made use of.

Organizing: Organizing of finance and accounting functions is an important function of management accounting.

Coordinating: Coordination increases the efficiency of an organization and maximizes its profits.

Controlling performance: The management accounting is very helpful in controlling the financial performance of the organization through financial reporting, budgeting, financial analysis .

Communication: It is an important medium of communication. The management reporting

mechanism is a typical example of communicating the results to the superiors.

Other functions: Management accounting serves in a number of other ways. It supplies useful information to different functional authorities. It provides accounting information and advice for

price determination and pricing decisions. It also helps in making certain strategic decisions,

decisions regarding seasonal or temporary suspension of production, make or buy decisions,

replacement decisions.


1. Management functions include ________, ________, ________, _________ .

2. Controlling performance is done through _______,__________,________ .



8.11 Special Features Of Management Accounting Accounting principles are manmade. Unlike the principle of natural science, accounting

principles were not deducted from axioms, nor is their validity verifiable by observation and

experiment. They have been evolved as “ necessity is the mother of invention” Based on this the

special features are:

1. Selective in Nature : It is technique of selective nature. It picks up only those data which are relevant for decision making.

2. Provides Data : The function is to provide data and not the decision. It can inform but it

cannot prescribe.

3. Future oriented: It helps in planning for the future decision and hence future oriented.

4. Cause and effect relationship : M.A studies the causes of profits or losses since the profit and loss account does not tell the reasons for profit or losses. M.A analyses the

results of different variables on the profits and the profitability.

5. NonAdherence of rules : M.A does not follows set rules and formats like financial

accounting. The basic task is to motivate management action. Hence M.A is on the utility

of information and not on formats and legal presentation.

6. Economic Reality : Accounting data and information represents the economic activities

but M.A is used to guide future planning and decision making thereby representing the

underling economic realities in a clear and unambiguous manner.

7. Goal congruence : M.A normally encourages all employees to act in a fashion which contributes to the overall objectives.

8. Information system : An organization comprises a number of information system or

networks. In other accounting system the information system are rarely integrated. But in

M.A these are designed in accordance with the principle of system theory to make it more

efficient.

9. Quantitative Techniques : Certain aspects of management accounting particularly in the

area of planning and decision making, statistical and operational research techniques are

used extensively, By use of it, a particular solution is being refined for cost effectiveness.

10. Uncertainty : Conditions of certainty are said to exist when a single point estimate can be made which will be exactly archived. Conversely, Uncertainty exists where there are

various possible outcomes or results or values.



8.12 Merits and Demerits of Management Accounting Merits 1. Efficient palling and effective organization which are the end product of the system of

management accounting bring systematic regularity in the business activities.

2. Maximum return on capital employed is ensured by the use of management accounting

because it helps in the functions of planning, coordination and control

3. Better and improved services by management to customers are assured by this system.

4. Management accounting removes unacceptable standards or substandards.

5. Industrial relations may be improved by adoption of management accounting principles.

6. Eliminations of various types of wastages, production defectives and other related work

deficiencies are removed with the help of management accounting.

7. Economic uplift of community and development of nation’s economy can be achieved by the

use of management accounting.

Demerits 1. Most of the information used in Management accounting are derived from financial accounting

records or cost accounting records other records. As such fairness and accuracy of decisions

deduced depends to a greater extent upon fairness and accuracy of these original records.

2. Decisions or conclusions derived are insignificant unless properly executed at all levels of

business operations.

3. Management accounting is a mere tool for management. It cannot substitute for

management.

4. The evolution has been on account of interalia development of new theories in other

sciences. Hence there is a need to have a comprehensive knowledge and understanding of

all these related disciplines to derive the full advantage.

5. Management accounting is still in its evolutionary stage. Hence, there is an uncertainty in its

use.

6. The installation of management accounting is a costly affair and as such it has very limited

scope for its use.

8.13 Distinction Between Management Accounting And Financial Accounting Management accounting initially is said to emanate from financial accounting in the sense that

financial accounting in the beginning designed to supply information in the form of statements for

management use. In fact, both management accounting and financial accounting are



complementary in nature to each other. But they are distinguished in terms of kind and relative

importance of the problems involved

Area Financial Accounting Management Accounting

Objective Limited to the preparation for external use

Information is collected for internal communication and use.

Process Recoding of financial transactions

Data is collected for internal use

Nature It is objective It is Subjective

Flexibility It is rigid It is flexible

Data Emphasis on Past data It lays stress on future

Precision It is precise It is approximation

Legality It is a legal Document It is voluntary

Unitization It covers entire organization

It is based on activity, Department, Division

Audit Compulsory Voluntary

Publication Mandatory Voluntary

Terminal Questions 1. Briefly explain the merits and demerits of Management Accounting.

2. Distinguish between Management Accounting and Financial Accounting

3. Describe briefly the scope of Management Accounting.

4. Describe the functions of Management Accounting.

5. Define Standard Costing and Variance Analysis.


Self Assessment Questions 1 1. False

2. True

3. False

4. Finetuned

Self Assessment Questions 2 1. To prepare financial statements

2. Formulation of policy and taking decision.



3. Breakeven analysis, Costing, Budgeting, Ratio analysis, Variance analysis.

Self Assessment Questions 3 1. Most powerful.

2. Planning and appraisal


1. Financial ,external reports, Accounting.

2. Analysis and interpretation of financial statements

Self Assessment Questions 5 1. Past cost

2. Relevant.

3. Percentage of profit.


1. All functional Activities

2. Financial documents.

Answer for Terminal Questions: 1. Refer to unit 8.12







Unit 9 Financial Statement Analysis

Structure 9.1 Introduction

Objectives


9.2 Meaning of Ratio


9.3 Meaning of ratio analysis

9.4 Scope


9.5 Advantages


9.6 Classification


9.7 Liquidity


9.8 Solvency


9.9 Profitability


9.10 Activity


9.11 Leverage


9.12 Limitation


9.13 Computation

Terminal Questions


9.1 Introduction “Every fact that is learned becomes a key to other facts” – E.Y. Youmans. Based on this, this

Unit deals with analysis of financial statements, the functions of which is to identify and highlight



the firm’s strengths and weaknesses. The objective of ratio analysis is to provide with the

financial information necessary to make financial decisions. Learning Objectives: After studying this unit, you should be able to understand the following

1. Understand the concept of ratio analysis and its role in comparative analysis 2. Explain the fundamental relationship between the gross profit ratio, the expenses to sales

ratio and the net profit margin ratio.

3. Define and calculate the three primary ratios which explain how well a business is utilizing the resources to generate revenue and profit.

Ratio analysis can provide you with this information in three steps: 1. Calculate the firm’s ratios for the current or recent period . Ratios are calculated from the

firm’s income statement or balance sheet It is helpful and sometimes necessary to have the

financial statement independently audited.

2. Compare these ratios to those calculated in past records. The purpose of this

comparison is to identify tendencies in the firm’s ratios. This is known as trend analysis.

3. Compare the ratios to industry averages to show how the company compares to firms of the

same size in its industry. This process is known as Cross sectional analysis.

After completing the analysis, one can have a great deal of information on how the company is

doing both over a period of time and compared to other firms in its industry.


1. Ratios are calculated from _____________ Statement and _____________.

2. Identifying tendencies in the firm’s ratio is known as ___________ analysis.

3. Comparing firm’s ratio with industry ratios is known as __________ analysis.

4. Ratios enable a company to have _______________ data.

9.2 Meaning of Ratio Absolute numbers tell very little. Assume that two companies A and B, operating within the same

industry supply the information:

Company

A B

NET PROFIT in Rs. 10,000 1,00,000



One can easily say that Company B makes the most profit. But which company is most

profitable? The answer for this will naturally call for further additional information relating to profit

such as size of the company, the total sales it generates or to how much capital is invested in it.

Hence, an assessment or a judgment is made based on making some sort of comparison.

Extending the example,

A B

Net Profit 10,000 1,00,000

Sales 2,00,000 5,00,000

Net worth (Capital and Reserves) 1,00,000 2,00,000

If net profit is compared with Sales, an assessment can be made on which company generates

the most net profit per Re.1 received from customers. Company A : Net Profit/ sales * 100 i.e. 5

percent and Company B it is 20 percent. If the net profit is expressed in terms of investments

made by the owners in each company, it is Net Profit / Net worth *100. For Company A, it is

10% and for it is 25%. It is also known as Return on Capital Employed. ROCE. Ratios are useful

in two ways:

1. To make interbusiness comparisons

2. To make comparisons across financial periods

A ratio is simply one number expressed in terms of another. It is a means of highlighting in

arithmetical terms the relationship between figures drawn from various financial statements.

Therefore, it refers to the numerical or quantitative relationship between two variables or items. A

ratio expresses simply in one number the result of comparison between two figures. It is

calculated by dividing one figure by the other. The quotient so obtained is the ratio of the figures.

Ratio can be expressed in the following three forms:

1. As proportion

2. As percentage

3. As turnover or rate

The Dictionary meaning of Analysis is “separation or breaking up of anything into its elements or

component parts”. Ratio Analysis is, therefore, a technique of analysis and interpretation of

financial statements. Ratio analysis is the process of establishing and interpreting various ratios

for helping in making certain decisions. It involves the methods of calculating and interpreting

financial ratios to assess the firm’s performance and status.




1. a) Ratios are useful to make ____________ and _________________.

2. Ratio is __________________________________________.

3. Ratio refers to ________________________________ relationship.

4. The answer for a division is known as _______________________.

5. Ratio can be expressed in three ways _________,_______,___________.

6. Ratio analysis is ____________________________________.

9.3 Meaning Of Ratio Analysis The Dictionary meaning of Analysis is “ separation or breaking up of anything into its elements or

component parts”. Ratio analysis is therefore a technique of analysis and interpreting various

ratios for helping in making certain decisions. It involves the methods of calculating and

interpreting financial ratios to assess the firm’s performance and status

9.4 Scope The ratio analysis is one of the most powerful tools of financial analysis. The firm is answerable

to the owners, the creditors and employees. The firm can reach a number of parties. On the

other hand, parties interested in the business can compute ratios based on the financial

statements of the firm. The analysis is not restricted to any one aspect but takes into account all

aspects such as earning capacity of the firm, financial obligation, liquidity and solvency aspects,

liquidity and profitability concepts.

Self Assessment Questions 3: 1. Ratio analysis is power tool _______________________.

2. ratios are based on _______________________.

3. Ratio indicates ___________________________.

9.5 Advantages The various advantages of ratio analysis are as follows: a) Financial Forecasting and Planning Ratio analysis helps in the financial forecasting and planning activities. Ratios based on the past

sales are useful in planning the financial position . Based on this, future trends are set.

b) Decision Making

Ratio analysis throws light on the degree of efficiency. It is also concerned with the management

and utilization of the assets. Thus, it enables for making strategic decisions.



c) Comparison

With the help of ratio analysis, ideal ratios can be composed. These can be used for comparison

in respect of the firm’s progress and performance, interfirm comparison with industry average.

d) Financial Solvency Ratios are useful tools. It indicates the trends in the financial solvency of the firm. Long term

solvency refers to the financial liability of a firm. It can also evaluate the short term liquidity

position of the firm. .

e) Communication The financial strength and weaknesses of a firm are communicated in a more easy and

understandable manner by the use of ratios. The information contained in the financial

statements is conveyed in a meaningful manner. It, thus, helps in the communication and

enhance the value of the financial statements.

f) Efficiency Evaluation It evaluates the overall efficiency of the business entity. Ratio analysis is an effective instrument

which, when properly used, is useful to assess important characteristics of business liquidity,

solvency, profitability. A critical study of these aspects may enable conclusions relating to

capabilities of business. g) Control It helps in making effective control of the business. Actual results can be compared with the

established standard and to take corrective action at the right time.

h) Other uses Financial ratios are very helpful in the early and proper diagnosis and financial health of the firm.


1. There are major ______________________ advantages. 2. Financial forecasting is useful for ___________________. 3. Decision making concerned with ______________________. 4. Comparison is for ________________________________. 5. Financial solvency includes ________________________. 6. Communication enhances _________________ statements. 7. Evaluation done for ______________________________. 8. Through control,________________________________.



9.6 Classifications Of Ratios The diagrammatic representation of ratios are as follows :


1. Types of ratios are _____________________________________.

2. Liquidity ratios consist of ______________________________.

3. Solvency ratio consists of ______________________________.

4. Profitability ratio consists of ____________________________ .

5. Activity ratio consists of _______________________________.

9.7 Liquidity Ratio It means the liquidity of the firm. Liquidity is the ability of the firm to meet its current liabilities as

they fall due. Since the liquidity is basic to continuous operations of the firm, it is necessary to

determine the degree of liquidity of the firm. These are important because liquidity is close to the

heart of the firm. A firm may have a high level of long term assets and substantial net income,

but if they do not have enough cash on hand or assets that can be turned into cash fairly quickly,

they will not be able to operate day to day. The liquidity ratios examine the current portion of the

balance sheet : current assets and current liabilities. The implicit assumption is that current

assets will be used to pay off current liabilities. This makes sense due to the matching principle

(match the maturity of the debt with the duration of the need) e.g. one would not take a five year

bank loan to pay off an account payable due in thirty days.

There are two ratios that determine how liquid a firm is : the current ratio and quick ratio.


1. Liquidity is the ability ________________________.

TYPE OF RATIO

LIQUIDITY SOLVENCY PROFITABLITY ACTIVITY LEVERAGE

Current liquid

Debt Equity

Gross Profit Net Profit Operating

STO DTO CTO

Gearing TI to LT



2. Liquidity ratios deal with ______________________. 3. Liquidity ratios place importance on _____________. 4. Two ratios that determine liquidity _______________.

Current Ratio

It is one of the popular financial ratios. It measures the firm’s ability to meet its short term

obligations. This is achieved by comparing the current assets of a business with its current

liabilities.. The formula for current ratio is :

Current Ratio = Current Assets / Current Liabilities

Example:

A B Current Assets Rs. Rs.

Stock 3,000 60,000

Debtors 16,000 Nil

Cash 5,000 Nil

Current Liabilities

Creditors 24,000 Nil Bank Overdraft Nil 10,000

The liquidity of the firms are determined by the amount of working capital available to the

business. This is defined as current assets minus current liabilities. The current ratio is not

expressed as a percentage but as a proportion. The current ratio of the above two firms are: 1 for

A and 5 for B. The ratio reveals a considerable difference between the two companies.

Company B is five times more liquid than company A. Company A can only just cover its

obligations to creditors in the short term, yet Company B can cover its obligation to the bank five

times over.

Although company A would be less vulnerable if its ratio was higher, it can be argued that to have

a ratio that is too high indicates inefficiency, in that too much working capital is available, which

might be better invested in fixed assets. However, it is important to identify the specific types of

current assets that are excessive such as

1. Excessive stock levels, indicating poor stock control or a decline in sales volume

2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts

3. Excessive cash or near cash equivalents, indicating a lack of suitable investment

opportunities in capital projects.



A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is

acceptable. However, the current ratio may vary from less than one in such industries as fast

foods to more than two in the telephone apparatus manufacturing industry. Consequently, it is

important too utilize the industry averages.

A ratio that is much higher than the industry average indicates that the firm may have excessive

current assets. Further investigation may demonstrate the cause of the excess. One reason may

be that the firm is having trouble in the collection of its debtors or has high inventory, both of

which will be identified through the use of other ratios. Another reason may be that the firm is

holding too much cash or short term investments which could be earning more money if they

were invested in long term instruments. Still another reason for a high ratio is that the firm may

be at a specific point in its business cycle. The company that sells woolen goods in winter is

expected to have high inventory in November, December, January and high debtors in February.

A ratio which is much lower than the industry average indicates that the firm is having liquidity

problems, meaning that it may not be able to meet its short term obligations. Accordingly, an

extremely low current ratio should be a red flag to the company being analyzed.

The components of current assets and current liabilities are:

Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock, prepaid

expenses, trade investments, marketable securities

Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or accrued

expenses, tax payable, provision for tax, dividends payable.

Example: Given: Current Ratio is 2.5 and working capital is Rs.1,80,000. Calculate the Current

Assets and current liabilities.

Solution: Given data is working capital, hence :

Working capital = Current assets minus current liabilities

Current Ratio = CA / CL

In the absence of any value, the current liability is always taken as 1 unit

2.5 = CA / 1 and cross multiplying , CA is 2.5

Working capital ratio is 2.5, then substituting the values,

2.5 = 2.5 minus 1 or WC = 1.5

For 1.5 WCR = Working capital value is Rs1,80,000



For 2.5 CAR, the current asset is Rs.1,80,000 x 2.5 / 1.5 = Rs.3,00,000

For 1 CLR, the current liability is 1,80,000 x 2.5 / 1 = Rs.1,20,000

Self Assessment Questions 7: 1. Current Ratio is___________________________________ ratio.

2. Current ratio measures ____________________________.

3. Current ratio compares ___________________________.

4. The formula for current ratio is _____________________.

5. Current ratio is expressed in _______________________.

6. The rule of thumb in Current ratio is ___________________.

7. Working capital is the result of _______________________.

8. The working capital is Rs.80,000 and its current ratio is 5. What are the

9. current assets and current liabilities.

Liquid Ratio It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except that it

excludes inventory which is generally the least liquid current asset. The reason for eliminating

inventory may be due to two primary factors

a. Many types of inventory cannot be easily sold because they are partially completed items,

obsolete items, special purpose items.

b. The items are typically sold on credit. This results in the creation of

trade debtors or bills receivables before being converted into cash.

Citing the example, in the case of company B, the only current asset that it carries is stock. The

question must be asked : is this level of stock too high or might it be essential to this type of

business ?

As stock is the least liquid of the current assets, prudence requires that liquidity be looked at in

another way. If current assets excluding stock are compared with current liabilities, a more

cautious assessment of the liquidity of the two companies is given.. This ratio is calculated as

follows:

Acid Test Ratio = Current assets less Stock / current liabilities

The quick ratios for companies A and B are as follows :

A = 24,000 3,000 / 24,000 = 0.875

B = 50,000 50,000 / 10,000 = 0



This time the quick ratio indicates that company A has a considerably better liquidity from this

point of view and company B is dangerously insolvent.

Illustration:

Given that Current ratio is 3.5, acid test ratio is 1.5 and working capital is Rs.6,50,000. Compute

current assets, current liabilities, liquid assets Solution:

Given data, Working capital = Current Assets minus current liabilities

Where current liability is taken as 1

CR = CA /.CL = 3.5 = CA / CL

Crossmultiply = 3.5 x 1 = Current Assets

Working Capital Ratio is therefore : CAR – CLR or 3.5 minus 1 or 2.5

For 2.5 WCR, the amount is Rs.6,50,000

For 3.5, CAR, the current asset is 6,50,000 x 3.5 / 2.5 or Rs.9,10,000

For 1, CLR, the current liability is 6,50,000 x 1 /2.5 or Rs.2,60,000

Liquid asset is based on Acid Test Ratio where, 1.5 = LA / CL

Liquid asset, therefore, are = 2,60,000 x 1.5 or Rs.3,90,000

Problem: Given Current ratio 1.5 :1; Quick ratio 1 : 1 and Current liabilities Rs.50,000. Calculate current assets, quick assets and inventory.

Solution: Given Current ratio : 1. 5 : 1 and value of current liabilities Rs.50,000

Current assets : CR = CA /e 1.5 = CA / 50,000 or CA = Rs.75,000

Quick Asset : QR = QA / 1 or 1 = QA / 50,000 or Rs.50,000

Inventory = CA – QA or 75,000 – 50,000 or Rs.25,000

Problem: Assuming the Current ratio of DR Ltd is 2, state in each of the following cases whether the ratio will improve or decline or will have no change.

(a) payment of current liability (b) purchase of fixed assets (c) cash collected from customers

(d) Bills receivable dishonored and (e) issue of new shares.

Solution: CR = CA / CL where 2 = CA / 1 or CA = 2 and CL = 1 a) Payment of current liability : Current ratio will improve. The reason is that when current ratio

is 2:1, payment of current liability will reduce the same amount in the numerator and

denominator. Hence, the ratio will improve.

b) Purchase of fixed assets : here, the current ratio will decline.



c) Cash collection : Current ratio will not be changed because cash will increase and debtors

will decrease

d) BR dishonored : Current ratio will not change. Reason is that BR will decrease and debtors

will increase

e) Issue of new shares : Current ratio will improve because cash balance will increase.

Self Assessment Questions 8: 1. Liquid Ratio is also known as ________________________.

2. Liquid ratio excludes _______________________________.

3. The reason for exclusion is __________________________.

4. The formula to calculate the liquid ratio is ______________.

5. Payment to current liability will improve _______________.

6. For Bills dishonored, Current ratio _____________________.

7. For issue of new share, current ratio ____________________.

8. For purchase of fixed assets ___________________________.

9. For cash collection, __________________________________.

10. Given CR is 1.75. Liquid ratio is 1.25.. Net working capital is Rs.1,50,000. Calculate (a)

current assets (b) current liabilities and (c) liquid assets and stock.

11. DR’s current ratio is 5.5 : 1 . Quick ratio is 4 to 1. Inventory is Rs.30,000.find out the current

liabilities.

12. Given CR is 2.5. Liquid ratio 1.5 working capital Rs.6,00,000, Bank overdraft Rs.10,000.

Calculate Current assets, current liabilities. Stock and liquid assets.

9.8 Solvency Ratios The ratios are analyzed on the basis of long term financial position of a firm. It is also known as

test of solvency or analyzing the debt. Many financial analysts are interested in the relative use

of debt and equity in the firm. Debt refers to outside borrowings by the firm.

The debt position of a firm indicates the amount of other people’s money being used in

attempting to generate profits. The long term debts are of much importance to the firm since a

firm is expected to commit the payment of periodic interest over the long run. In addition,

repayment of loan after the expiry of maturity date has to be planned.

Since the creditor’s claims must be satisfied before the distribution of earnings to shareholders,

present and prospective shareholders pay close attention to the degree of indebtedness and



ability to repay the debts. Lenders are also equally concerned about the indebtedness and the

repayment modes. Hence, the solvency of the firm in particular needs consideration.


1. Solvency ratio are analyzed on __________________________basis.

2. Solvency ratio is also known as ______________________.

3. Solvency ratio is combination of ____________________.

4. Debt refers to ____________________________________.

5. Lenders are concerned about ________ and ____________.

Debt Ratio

Debt ratios are important because debt is widely considered to be a measure of the health of the

firm and the risk associated with it. If a firm has high debt, they have fixed payments which must

be made. This means that limited funds may be directed to debt payment (either principal or

interest or both) instead of investments. .

The debt ratio is :

Total Liabilities / total assets

This ratio tells you how much of the firm’s assets are financed with debt. A high debt ratio

indicates that the firm may be carrying too much debt. This is of concern to the firm because it

may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a

firm in this situation is considered risky because short term financing is limited and may not be

available in an emergency.

A low debt means that the firm has a low level of liabilities compared to its total assets. Such a

ratio indicates that the firm is not risky because it has plenty of financing available when

compared to its need. However, a low ratio may also indicate that the firm should take on more

debt. The reason for this is that the ability to borrow is considered a resource and a firm with low

debt may not be taking advantage of this resource.

Self Assessment Questions 10: 1. Debt is considered as _________ Of the firm and ________ Associated ________.

2. The formula is __________________________.

3. High debt ratio indicates __________________.

4. The result of high debt ___________________.

5. Short term financing is ____________________.

6. A low debt ratio indicates __________________.



Debt : Equity Ratio

The debt : equity ratio is :

Long term Debt / Shareholder’s equity

The debtequity ratio deals with the long term liabilities and equity portion of the balance sheet.

Note that shareholders’ equity includes retained earning (Equity may also be known as net

worth). The debtequity ratio provides information on the capital structure (relationship between

debt and equity) of the firm. Such information is important because it affects the value of the firm.

The value of the firm is important because it has an impact on the ability to raise funds., either

through increased borrowing or the sale of shares or both.

A high debtequity ratio indicates a poor capital structure because it signifies that the firm has

high debt in comparison to its level of shareholders’ equity. This means that the firm’s creditors

may be concerned about the repayment of debt, which in turn leads to high interest rates, which

in turn leads to higher required returns on the firm’s potential investments..

A low debt equity ratio is an indication that the firm is in sound financial position and therefore is

not considered risky. Normally, the debt equity ratio vary tremendously from industry to industry.

Problem: The Balance Sheet of DR Ltd is as follows :

Assets: Fixed Assets 10,00,000

Current Assets 5,00,000

Represented by: Current Liabilities 1,00,000

Reserves and surplus 1,00,000

10 % Debentures 2,00,000

6 % Preference Share capital 3,00,000

Equity Share capital 8,00,000

Calculate the Debt Ratio and Debtequity ratio.

Solution: Debt Ratio : Total Liabilities to outsiders / total assets

: Debentures + Trade creditors / Fixed + current assets

3,00,000 / 15,00,000 or 1 : 5



Debt – equity ratio : Outsiders’ funds / shareholders’ equity

Outsiders’ funds 10 % Debentures only + Sundry Creditors

Shareholders’ funds Equity Share capital + Preference share capital + Reserves

3,00,000 / 12,00,000 or 1 : 4

Self Assessment Questions 11: 1. Debt equity deals with ____________________________.

2. Shareholders equity is ____________________________.

3. The formula is __________________________________.

4. Debt equity provides information on_________________.

5. Capital structure refers to _________________________.

6. Capital structure affects ___________________________.

7. value is important to raise _________________________.

8. Raising of funds is done through ____________________.

9. High debt indicates _______________________________.

10. Creditors may get upset over _______________________.

11. Low debt indicates ______________________________

12. Low debt is not __________________________________ .

13. Debt equity ratio _____________ from industry to industry.

9.9 Profitability Ratios A firm’s profitability can be assessed relative to sales, assets, equity or share value. The

profitability ratios are important because they indicate whether the firm is doing what it set out to

do : make a profit and provide a return to its investors. There are many measures of profitability.

Each relates the returns of the firm with regard to the sales, assets, equity or share value. As a

group, these measures enable to evaluate the firm’s earnings. The criteria for earnings can be

related to a given level of sales,. A certain level of assets, the owner’s investment or share value.

Earnings result in profits. Without profits, a firm may be handicapped to attract outside capital.

The income statement of the firm shows the total profits earned by the firm during the preceding

fiscal period. The important ratios which highlight the profitability of a firm would be as follows:

Self Assessment Questions 12: 1. Profitability ratio is important as ______________________.

2. Profitability can be assed to ___________________________.

3. Profitability ratio evaluates firm’s _____________________.



4. Earnings result in ___________________________________.

5. Without profit, ______________________Cannot be attracted.

Gross Profit Ratio

It measures the percentage of each sales value remaining after the firm has paid for its goods.

The higher the gross profit margin, the better and lower the relative cost of merchandise sold.

Thus, it serves an important tool in shaping the pricing policy of the firm. The formula is :

Gross Profit = ( Gross Profit / Sales ) x 100

Where Gross profit = Sales minus Cost of goods sold (COGS)

Net Sales = Cash Sales + Credit Sales minus Sales Returns

It is normally expressed as a percentage. If we deduct gross profit ratio from 100, the ratio of

COGS is obtained..

Problem

DR Ltd provides the following information.

Cash Sales Rs.8,00,000; Credit Sales Rs.10,000; COGS Rs.15,80,000 and Return Inwards

Rs.20,000. Calculate Gross Profit Ratio and ratio of COGS.

Solution GPR: GP / Net Sales x 100 : Gross Profit : Net Sales minus COGS

Net Sales : Gross Sales minus Return Inwards

Gross Sales : Cash + Credit Sales

8,00,000+10,00,000 minus 20,000 or Rs.17,80,000

Gross Profit : 17,80,000 minus 15,80,000 or Rs.2,00,000

GPR 2,00,000 /17,80,000 x 100 or 11.2 %

Ratio of COGS : 100 – GP Ratio or 100 – 11.2 or 88.76 %

Self Assessment Questions 13: 1. Gross profit measures __________________ of each sales value.

2. Gross profit measures __________________.

3. The formula is _________________________.

4. Gross profit is _________________________.

5. Net sales is ____________________________.

6. Gross Profit ratio is expressed as ___________.



Expenses Ratio

These ratios indicate the relationship of various expenses to net sales. Individual expenses are

calculated based on the net sales and indicated as a percentage to net sales.

Self Assessment Questions 14: 1. Expense ratio indicate ____________________of expenses to net sales.

2. Individual expenses are calculated on ___________________.

Net Profit Ratio It is also known as Net Profit Margin. It measures the percentage of each sales in rupee after all

expenses including taxes have been deducted This ratio provides considerable insight into the

overall efficiency of the business. A higher ratio speaks about the overall efficiency of the

business. It also focuses the attention of the better utilization of total resources. A lower ratio

would mean a poor financial planning and low efficiency. A net profit margin of 1 percent or less

would be unusual for a grocery store which a net profit margin of 10 percent would be low for a

retail stores. It is divided by net income by net sales. The formula is :

Net Profit Ratio = (Net Profit after taxes / Net Sales ) x 100

The net profits are calculated after excluding the income tax, the nonoperating incomes and

nonoperating expenses. It is expressed as a percentage on net sales..

Example: The income statement of DR Ltd is as follows:

To Opening Stock 2,00,000 By Sales 12,00,000

Purchases 8,00,000 Closing Stock 1,00,000

Direct Expenses 1,00,000

Gross Profit 2,00,000

13,00,000 13,00,000

To Admn Expenses 1,00,000 By Gross Profit 2,00,000

Selling Expenses 80,000 Profit on sale of

Investments 60,000

NonOperating exp 40,000 Dividends received 40,000

Net Profit 80,000

3,00,000 3,00,000

Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and

Expense Ratio.



Solution

Gross Profit Ratio = GP / New Sales x 100 or 2,00,000 / 12,00,000 x 100 or 16.61 %

Net Profit ratio = NP after tax / Net Sales x 100 or 80,000 / 12,00,000 x 100 or 6.67 %

Operating Ratio = COGS + operating expenses / Net Sales x 100

Sales minus Gross profit = COGS

10,00,000+1,00,000+80,000 / 12,00,000 x 100 or 98.33 %

Operating Profit = 100 – 98.33 or 16.67 % Ratio

Admn Expenses Ratio = Admn Expenses/Net sales x 100 or 1,00,000/12,00,000 x 100 8.33 %

Selling Expense Ratio = Selling Expenses/Net Sales x 100 or 80,000/12,00,000 x 100 or 6.67 %

Self Assessment Questions 15: 1. Net profit is known as __________________________.

2. Net profit measures percentage of each _________________ after ___________.

3. Net profit provides _________________________ of business.

4. Net profit focuses on ________________________.

5. Low ratio refers to __________________________.

6. The formula is _____________________________.

7. Calculation is based on ______________________.

9.10 Activity Ratios These are used to measure the speed with which various accounts are converted into sales or cash. Measures of liquidity are generally inadequate due to the composition of the firm’s current

assets and current liabilities. The activity ratios are also known as turnover ratios. Some of the

turnover ratios are as follows :

Stock Turnover Ratio : STO Debtors Turnover Ratio : DTO

Creditors Turnover Ratio : CTO

Self Assessment Questions 16: 1. Activity ratios measure __________________________________.

2. Measures of liquidity is inadequate due to __________________.

3. STO, DTO, CTO are also known as ________________________________.



Stock Turnover Ratio

I t commonly measures the activity or liquidity of the firm’s stock.. The STO is also known as

stock velocity. Velocity refers to “speed” with which an object travel. Here, it is the speed on

converting the stock into sales then to cash. It indicates the number of times the stock has been

turned over as cash during a given period of time. It evaluates the efficiency with which a firm is

able to manage its stock.

If the cost of goods sold )COGS) is known, the STO can be calculated as follows:

STO = COGS / Average stock at cost

Where COGS = Net Sales – Gross Profit

Average Stock = Opening + Closing Stock / 2

If COGS is not known, it can be computed as follows:

STO = Net Sales / Stock

Example: DR Ltd provides the following Stock: Opening Rs.75,000; Closing Rs.1,00,000. Credit Sales Rs.2,00,000. Cash sales

Rs. 50,000. Gross Profit 25 %. Calculate the Stock Turnover Ratio

Solution: STO = COGS / Average stock

COGS = Net Sales – Gross Profit

Net Sales = Cash Sales + Credit Sales or 2,00,000 + 50,000 or 2,50,000

Average stock = Opening + closing stock / 2 or 75,000 + 1,00,000 / 2 or 87,500 Gross Profit = 25 % on Rs.2,50,000 or 62,500 COGS = 2,50,000 – 62,500 or 1,87,500

STO = 187,500 / 87,500 or 2.14 times.


1. STR measures ______________________________.

2. STR is also known as _______________________.

3. Velocity refers to ___________________________.

4. STR commonly refers to _____________________.

5. STR evaluates the ___________________________.

6. The formula for STR is ______________________.

7. COGS is __________________________________.

8. Average Stock is ____________________________.



9. If COGS not given, the formula is _______________.

Debtors Turnover Ratio : DTO It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors

include the Bills Receivable also. The Bills receivables are written promise of trade debtors.

Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay

cash. Thus, debtors are expected to be converted into cash within a short period. Therefore, it is

included in the current assets. It is calculated as follows :

DTO = ( Debtors + BR / Net credit sales) x Number of working days

DTO indicates the velocity of debt collection of firm. It indicates the number of times average

debtors convert themselves over into cash during a year. Debtors care should always be taken

on gross value/ Do not deduct the bad debts or provision for doubtful debts. It is expressed as the

number of times.

If DTO is given in months, convert it into a common base period. If it is given as a number of times, do not reduce it to a base period.

Example: Total sales of a firm Rs.5,00,000, of which the credit sales are Rs.3,65,000.Sundry Debtors and Bills receivable are Rs.50,000 and Rs.2,000 respectively

Calculate the DTO. Solution: DTO = Debtors + BR / Net credit sales x 365

50,000 + 2,000 / 3,65,000 x 365 or 52 days

Self Assessment Questions 18: 1. DTO is also known as ___________________________.

2. Birth of debtors is from _________________________.

3. Debtors are based on ____________________________.

4. Debtors include ________________________________.

5. Total debts include _____________________________.

6. Bills receivable is _______________________________.

7. Trade debtors are provided with ___________________ credit time .

8. Debtors are included in ___________________________.

9. Formula for DTO ________________________________.

10. Net credit sales include ___________________________.

11. DTO involves in _________________________________.

12. Total sales R.1,00,000. Cash sales Rs.20,000. Opening Debtors Rs.10,000,



13. Debtors at close Rs.15,000. BR opening Rs.7,500 and at close Rs.12,500.

14. Calculate DTO.

15. Total annual sales Rs.10,00,000 and BR or Rs.1,60,000. How rapidly must BR

16. be collected if the management wants to reduce the BR to Rs.1,20,000?

Creditors Turnover Ratio : CTO Creditors come into being out of credit purchases. Creditors include both trade creditors and bills

payables. It is included in the current liability since the payment has to be made within three

months normally. The formula is as follows :

CTO = ( Creditors + Bills Payable / Credit purchases ) x 100

Where credit purchases = Total purchases minus cash purchases

Example: Total purchases Rs.1,00,000. Cash purchases Rs.20,000. Discount Provision on creditors Rs.1,000. Purchase returns Rs.2,000. Creditors at close Rs.30,000. Bills payable at

close Rs.25,000. Calculate CTO.

Solution: Credit purchases = Total purchase – cash purchase – purchase return

1,00,000 – 20,000 – 2,000 or Rs.78,000 CTO = 30,000 + 25,000 / 78,000 x 365 or 257 days

The Reserve for discount on creditors should not be considered for calculating the net credit

sales.


1. The birth of creditors __________________________ .

2. Creditors include ___________________________ .

3. Creditors are ______________________________ .

4. The formula is ____________________________ .

5. Credit purchases ____________________________ .

9.11 Leverage Ratio A firm’s capital structure is the relation of debt to equity as sources of the firm’s assets.. Normally

both the owners and the creditors of the business will be interested in analyzing its capital

structure. The ratios that deal with the leverage are as follows :




1. Leverage ratio refers to _____________________________ .

2. It is based on ____________________________________ .

Capital Gearing Ratio: : It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the

preference share capital and the debentures as against the equity funds provided by the equity

shareholders. The ratio is calculated as:

Capital Gearing Ratio : Fixed cost bearing capital / variable cost bearing capital

Where fixed cost bearing capital = preference share capital, debentures , long term bank

borrowings.

Variable cost bearing capital = equity share capital, reserves and surplus.

If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm

is said to be highly geared. On the reverse, it is low geared.

Example: The capital structure of two companies, Neverdowell and Goodfornothing Ltd are

as follows:

NDW GDF

Equity Share Capital (Rs.) 10,00,000 6,00,000

6 % Preference Share Capital 3,00,000 4,00,000


Reserves and Surplus 2,00,000 2,00,000

Solution:

Capital Gearing Ratio : NDW : 3,00,000 / 12,00,000 or 0.25:1 GDF : 6,00000 / 8,00,000 or 0.75 : 1

The capital of NDW is low geared when compared to GDF.


1. CGR relies on ______________________________ .

2. Fixed cost securities include _________________ .

3. The ratio is _______________________________ .

4. Variable cost bearing capital include ___________ .



Debtequity Ratio:

The ratio compares the debt with equity. Debt refers to long term loans and liabilities.

Redeemable Preference shares are also considered as debt. This measure is helpful to assess

the soundness of the longterm financial policies. It determines the relative stake of outsiders and

shareholders in the company . Lower the ratio, it is considered more comfortable for the creditors

financial position. 2 : 1 is taken as a satisfactory debt – equity ratio. However, it is not a very

satisfactory measure. since the nominal values may bear very little relationship to their current

market values. The calculation is as follows:

Debt – equity Ratio = Long term debts / Shareholders’ funds + Long term debts

Self Assessment Questions 22: 1. DER compares ______________ with _____________________ .

2. Debt refers to _______________________________________ .

3. Redeemable Preference shares are taken as _______________ .

4. DER determines ________________________________ stake.

5. Lower ratio indicates __________________________________ .

6. ________________________________________ Rule of thumb.

7. Formula _____________________________________________ .

Example: The capital structure of DR Ltd is as follows :

Equity Share Capital : 10,00,000

Redeemable Preference Capital 5,00,000


Long term liabilities 2,00,000

Reserves and surplus 2,00,000

Calculate the Capital Gearing Ratio and Ratio of Total Investment to Longterm liabilities

Solution: CGR : Fixed Cost bearing capital / variable cost bearing capital

10,00,000 / 12,00,000 or 0.83 : 1 TI to LTL : Equity Share capital + Reserves and surplus + Long term

Liabilities / Long term liabilities

22,00,000 / 10,00,000 or 2.2 : 1

9.12 Limitations Of Ratio Analysis



Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance comes

from proper use of these ratios. Misuse or mishandling of these ratios and using them without

proper context may lead the analyst or management to a wrong direction. The person who uses

these ratios should be well versed and should possess expertise knowledge about making proper

use of these ratios. Like all tools, ratios also suffer from several ‘ifs’ and ‘buts’ and for a thorough

understanding of proper use of these ratios. There are certain limiting factors in the case of ratio

analysis. These limiting factors are :

1. The user should possess the practical knowledge about the concerns and the industry in

general.

2. Ratios are not an end. They are only means to an end.

3. A single ratio in itself is not important. The trend is more significant in the analysis.

Comparison of ratios should be made.

4. For comparative purposes, there should be a standard ratio. There is no such standards

prescribed for the ratios.

5. The accuracy and correctness of ratios are totally dependent upon the reliability of the data

contained in the financial statement on the basis of which ratios are calculated.

6. To use ratios, first of all there should be uniformity in the accounting plan used by both the

firms. In addition. There must be consistency in the preparation of financial statement and

recording the transactions from year to year within that concern.

7. Ratios become meaningless if detached from the details from which they are derived. The

should be used as supplementary and not substitution of the original absolute figures.

8. Time lag in calculation and communicating the same should not be unnecessarily too

much.

9. The method of presentation should be precise and without any ambiguity.

10. Price level changes make the ratio analysis meaningless.

11. Interfirm comparison should never be undertaken iin the case of concerns which are not

associated or comparable.

12. All techniques concerning the ratio analysis should be taken into account.

Self Assessment Questions 23: 1. One should possess ___________________ about the concern.

2. Ratios are not _______________ But ______________________.

3. Ratio should be studied ________________________________ .

4. Comparison of ratios is done with the help of _______________ .

5. _________________________ Make ratio analysis meaningless.



9.13 Computation of Ratios Problem 1:

Extracts from financial account of DR ltd are given below

Year 2006 Year 2007

Assets

Stock 10,000 20,000

Debtors 30,000 30,000

Payment in advance 2,000

Cash in hand 20,000 15,000

Liabilities

Sundry creditors 25,000 30,000

Bills payable 15,000 12,000

Bank Overdraft 5,000 Sales amounted to Rs.3,50,000 2006 an Rs.3,00,000 in 2008. Compute the solvency position of

DR.

Solution: Shortterm solvency analysis

Current Ratio : CA / CL or Year 2006 : 62,000 / 40,000 or 1.55 : 1

2007 : 65,000 / 47,000 or 1.38 : 1

Liquid Ratio : LA / Liquid liabilities For 2006 : 52,000 / 40,000 or 1.30 : 1

2007 : 45,000 / 42,000 or 1.07 : 1

Bank overdraft is not included in liquid liabilities as it tends to become some sort of a permanent

mode of financing.

Inventory turnover ratio : Net sales / average inventory

For 2006 : 3,50,000 / 10,000 or 35 : 1

2007 : 3,00,000 / 15,000 or 20 : 1

The liquid position is not sound. The current ratio I the year 2006 does not appear to be good

enough as it is below the rule of thumb i.e. 2 : 1 . In the year 2007, the position has further

deteriorated to 1.38: 1. The later ratio shows a definite weakening in the solvency position of the

company. As regards the acid test ratio, it is satisfactory in the year 2006 and not alarming in the

year 2007. However, the fall in the cash balance and appearance of bank overdraft in the year



shows a definite deterioration in the financial position. Moreover, because of factors concerning

sales, stock and debtors, the quick ratio is likely to soon deteriorate.

As regards inventory turnover ratio, it indicates an alarming deterioration in the year 2007. The

disproportionate rise in the percentage of stock to total current assets from 16% in the year 2006

to 31 % in the year 2007 is also a matter of concern. This shows over purchase of materials

which needs through investigation.

A comparison of debtors turnover ratios of the two years indicates worsening of the company’s

liquid position. There will be much cause of worry if the sales is only to a few customers.

LONG TERM RATIOS

Debt to equity ratio : External equities / Internal equities

For 2006 : 40,000 / 22,000 or 1.82 : 1

2007 : 47,000 / 18,000 or 2.61 : 1

Proprietary Ratio : Shareholders’ Equities / Total Equities

For 2006 : 22,000 / 62,000 or 0.35 : 1

2007 : 18,000 / 65,000 or 0.28 : 1

From the long term point of view, the financial position of DR is very unsatisfactory as the debt to

equity ratio and proprietary ratio are far off the norm in both years. The situation has worsened

in the year 2007 resulting in a serious decline in the shareholders’ equity. The company seems

to be heavily banking upon the creditors’ funds.

The overall conclusion of the above analysis is that the solvency position of DR is not

satisfactory and needs careful planning.

Problem 1 A manufacturer of stoves sells to retailers on terms 2 .5 % discount in 30 days, 60 days net. The

debtors and receivables at the end of December of past three years and net sales for all these

three years are as under.

Year

2005 2006 2007

Debtors 54,842 33,932 85,582

Bills Receivable 4,212 3,686 9,242

Net Sales 2 ,68,466 3,47,392 4,43,126

Determine the average collection period for each of these three years and comment.

Solution: Collection period : Trade receivables / Net credit sales x Number of working days



Year 2005 : 59,054 / 2,68,466 x 365 = 80 days

2006 37,618 / 3,37,392 x 365 = 41 days 2007 94,824 / 4,43,126 x 365 = 78 days

The average collection period in all the three years has been within standard period 80 days, i.e.

60 + 1/3 of 60 days . Hence, it is good.

Problem 2: DR purchases goods both on cash and credit terms. The following particulars are obtained from the books:

Total purchases Rs.2,00,000. Cash purchases Rs.20,000. Purchase returns Rs.34,000. Creditors

at the end Rs.70,000. Bills payable at the end Rs.40,000. Reserve for discount on creditors

Rs.5,000. Calculate average payment period.

Solution: Calculation of net credit purchases : Total purchases minus cash purchases minus purchase

returns or Rs.3,00,000 – 20,000 – 34,000 or Rs.1,46,000.

Average payment period : Creditors + Bills payable / Net credit purchases x 365 days

70,000 + 40,000 / 1,46,000 x 365 days or 275 days.

Problem 3 : From the following Balance sheet , compute the Balance Sheet ratios Assets: Plant and Machinery Rs.2,00,000. Land and Building Rs.2,00,000. Stock Rs.1,50,000.

Debtors Rs.50,000 and Cash balances Rs.1,00,000 = Rs.7,00,000

Liabilities: Equity Share capital Rs.2,00,000. 6 % Preference Share capital Rs.1,00,000. 8 %

Debentures Rs.1,00,000. Reserves and surplus Rs.1,00,000. Long term loan Rs.50,000.

Creditors Rs.1,00,000. Bank overdraft Rs.50,000 = Rs.7,00,000.

Solution: Current Ratio: CA / CL or 3,00,000 / 1,50,000 or 2: 1

Liquid Ratio: LA / CL or 1,50,000 / 150,000 or 1 : 1

Absolute Liquid Ratio: Absolute liquid assets / current liabilities or 1,00,000 / 1,50,000

Or 1 ; 0.67

Proprietary Ratio: Proprietors’ equity /current liabilities or 4,00,000 / 7,00,000 or 0.57 : 1

Assets Proprietary Ratio: Fixed assets / Proprietors’ equity or 4,00,000 / 4,00,000 or 1:1

Current assets to proprietors’ equity: Current assets/ Proprietors’ equity or 4,00,000 / 4,00,000 or 1 : 1

Debt Equity Ratio: Total debts / Proprietors’ equity or 3,00,000 / 4,00,000 or 0.75 : 1

Stock to Current asset Ratio: Stock / Current assets or 1,50,000 / 3,00,000 or 0.50:1



Stock to working capital ratio: Stock/working capital or 1,50,000 / 1,50,000 or 1:1

Current assets to working capital ratio: CA / WC or 3,00,000 / 1,50,000 or 2:1

Current assets to Liquid assets ratio: CA / LA or 3,00,000 / 1,50,000 or 2:1

Long term funds to working capital ratio: All long term funds / working capital or 2,50,000 /

1,50,000 or 1.67 : 1

Tangible assets to working capital ratio: Tangible assets / current liabilities or 4,00,000 / 1,50,000

or 2.67 : 1

Tangible assets to current liabilities ratio: Tangible assets / current liabilitieisi or 4,00,000 /

1,50,000 or 2.67 : 1

Capital Gearing Ratio: Equity share capital / Preference shares + Debentures or 2,00,000 /

2,00,000 or 1:1

Problem 4: A factory engaged in an industry which is capital intensive has been in operation for

ten years. The capital employed is Rs.17,00,000, out of which Rs.10,00,000 represent equity

capital and reserves, Rs.5,00,,, long term borrowings on Debentures and Rs.2,00,000 cash credit

from banks. The working capital of the company is Rs.8,50,000 made up of stocks Rs.3,00,000,

Stores Rs.1,40,000, Debtors Rs.3,50,000, Advances and deposits Rs.60,000. Annual Sales

Rs.8,00,000. Calculate current ratio, liquidity ratio, debt equity ratio, proprietary ratio, Fixed

assets to proprietors’ funds, Fixed asset ratio.

Solution: Current Ratio : 8,50,000 / 2,00,000 or 4.25 : 1

Liquidity Ratio = 4,10,000 / 2,00,000 or 2.05 : 1

Debt equity ratio : 7,00,000 / 10,00,000 or 0.7 : 1

Proprietary ratio : 10,00,000 / 17,00,000 or 0.59 : 1

FA to Proprietors’ fund or 8,50,000 / 10,000 or 0.85 : 1

Fixed assets ratio or 8,50,000 / 15,00,000 or 0.57 : 1

Problem 5: The ratios relating to DR Ltd are given below

Gross profit ratio 15 %. Stock velocity : 6 months. Debtors velocity 3 months. Creditors velocity 3

months. The gross profit for the year amounts Rs.60,000. Closing stock is equal to opening stock.

Find sales, closing stock, sundry debtors and sundry creditors.

Solution: Gross Profit Ratio = Gross Profit / sales and 100 or 15 % = 60,000 / sales x 100 or Sales is

Rs. 4,00,000.



Closing stock = Basis stock velocity or Cost of goods sold / average stock where

COGS = Sales – Gross profit or Rs.4,00,000 – Rs.60,000 or Rs.3,40,000

6 months = 3,40,000 / Average stock of Average stock is Rs.6,80,000.

Since opening and closing stocks are the same, the closing stock is Rs.6,80,000

Sundry Debtors : Basis Debtors velocity = Total debtors / sales x Number of months

Total Debtors is 4,00,000 x 3 /12 or Rs.1,00,000

Sundry Creditors : Total creditors / purchases x Number of months

Where Purchases = Opening stock + purchases closing stock or Rs.3,40,000

Creditors = 3,40,000 x 3/12 or Rs.85,000

Problem 6: Prepare a Balance sheet from the following Current Ratio 1.4. Liquid Ratio 1. Stock turnover Ratio 8. GP Ratio 20 %. Debt collection period

1.5 months. Reserves and surplus to capital 0.6. Turnover to fixed assets 1.6. Capital Gearing

Ratio 0.5. Fixed assets to net worth 1.25. Sales Rs.10,00,000.

Solution: Calculation of cost of Sales : Sales – Gross profit 10,00,000 minus 2,00,000 (20 %

of 10,00,000) Rs. 8,00,000.

Closing Stock: Cost of sales / Stock Turn over Ratio or 8,00,000 / 8 or Rs.1,00,000

Fixed Assets: Cost Sales / FA turnover or 8,00,000 / 1.6 or Rs.5,00,000

Debtors: Total sales x Debt collection period of 10,00,000 x 1.5 / 12 or Rs.1,25,000

Current assets based on liquid ratio: Current Ratio is 1.4. Therefore Stock is Current Ratio

minus Liquid Ratio of 1.4 minus 1.0 or o.4 or Value of stock x current ratio / stock ratio o 1,00,000

x 1.4 /4 or Rs.3,50,000

Liquid assets = Current assets minus stock or 2,50,000 minus 1.25,000 or Rs.1,25,000

Cash balances : Liquid assets minus Debtors or 2,50,000 minus 1,25,000 or Rs.1,25,000

Current Liabilities : Current Ratio is 1.4

Therefore, current liabilities is Current assets / current ratio or 3,50,000 / 1.4 or Rs.2,50,000

Net Worth : Fixed Assets / FA to net worth or 5,00,000 / 1.25 or Rs.4,00,000

Reserves and Surplus : Ratio 0.6

Let the Capital be 1

Add: Reserves and surplus which is 0.6, hence it is 1.6



Reserves and surplus will be : Shareholders funds x Reserves / Total ratio or 4,000 x 0.6 / 1.6 or

Rs. 1,50,000

Share Capital : Shareholders funds minus Reserves or 4,00,000 minus 1,50,000 or Rs.2,50,000

Long term Liabilities : Capital Gearing ratio is 0.5

Share capital x Gearing ratio or 4,00,000 x 0.5 or Rs.2,00,000

BALANCE SHEET

Liabilities Assets

Share capital 2,50,000 Fixed Assets 5,00,000

Reserves and Surplus 1,50,000 Stock 1,00,000

Long term Liabilities 2,00,000 Debtors 1,20,000

Current Liabilities 2,50,000 Cash balances 1,25,000

8,50,000 8,50,000

Terminal Questions:

Problem 1:

Calculate Current ratio, acid test ratio.: Cash in hand Rs.3,000. Cash at Bank Rs.65,000. Bills

receivable Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses Rs.2,000.

Creditors Rs.1,20,000. Bills payable Rs.20,000.

Problem 2: Calculate : Debts to equity Ratio and Proprietary ratio : Equity share capital Rs.5,00,000.

Preference share capital Rs.3,00,000. Reserves Rs.2,00,000. Current liabilities Rs.1,00,000. 8 %

Debentures Rs.3,00,000. Fixed assets Rs.10,00,000. Current assets Rs.4,00,000

Problem 3:

The current assets and current liabilities were Rs.16,00,000 and Rs.8,00,000 respectively. What

is the effect of each of the following transactions individually and totally on the current ratio : 1. Purchase of new machinery for Rs.5,00,000

2. Purchase of new machinery for Rs.10,00,000 on a medium term loan from a bank with 20 %

margin.

3. Payment of a dividend of Rs.2,00,000 of which Rs.0.47 lakh was tax deducted at source.

4. Materials purchased costing Rs.5,00,000 in respect of which bank financed Rs.3,00,000.



Problem 4:

The current ratio is 2 : 1. Which of the following suggestions would improve the ratio, which

would reduce it and which would not change it.

a) to pay a current liability

b) to sell a motor car for cash at a slight loss

c) to borrow money for short time on an interest bearing ;promissory note

d) to purchase stock for cash

e) to give an interest bearing promissory note to a creditor to whom money was to be paid.

Answer for Self Assessment Questions Self Assessment Questions 1: 1. Income and balance sheet

2. Trend

3. Cross sectional

4. Comparative

Self Assessment Questions 2: 1. Interbusiness comparison and across financial period

2. One number expressed in terms of another

3. Numerical or quantitative

4. Quotient

5. Proportion, percentage and turnover

6. Process of establishing and interpreting ratios for decision making


1. Financial analysis

2. Financial statements

3. Liquidity, solvency and profitability aspects

Self Assessment Questions 4: 1. Eight

2. For forecasting and planning activities

3. Management and utilization of asset

4. Firm’s progress and performance

5. Short term and long term liquidity position

6. Value of the financial statements

7. Overall efficiency of the business entity



8. Actual results can be compared with established standards

Self Assessment Questions 5: 1. Current and liquid

2. Debt and equity

3. GP, NP, and operating

4. STO,DTO and CTO

5. Gearing.

Self Assessment Questions 6: 1. To meet current liability

2. Current assets and current liabilities

3. Matching principle

4. Current ratio and quick ratio.

Self Assessment Questions 7: 1. Financial

2. Short term obligations

3. Current and current liabilities

4. Current assets : current liabilities or current assets / current liabilities

5. Proportion

6. 2 : 1

7. Current assets minus current liabilities.

8. CA 1,00,000 and CL 20,000

Self Assessment Questions 8: 1. Quick, acid test

2. Stock

3. Stock cannot b e sold easily and stock typically sold on credit

4. Current stock minus stock / current liabilities

5. Will not change

6. Will improve

7. CR will decline

8. CR will not change.

9. 3,50,000; 2,00,000, 2,50,000 and Rs.1,00,000.

10. Rs.20,000

11. CA Rs.1,00,000, CL Rs.40,000, Stock Rs.40,000 and LA Rs.60,000.




1. Long term financial position

2. Test of solvency

3. Debt and equity

4. Outside borrowings

5. Indebtedness and repayment

Self Assessment Questions 10: 1. Health and risk

2. Total liabilities / total assets.

3. Too much of debt

4. Inability to repay debt

5. Limited

6. Non risky situations.


1. Long term liabilities and equity portion in Balance sheet

2. Equity share capital + Reserves and surplus

3. Long term debt / shareholders’ equity

4. Capital structure

5. Relationship between debt and equity

6. Value of the firm

7. Funds

8. Increased borrowings or sale of shares or both

9. Poor capital structure.

10. Repayment of debt

11. Sound financial position

12. Risky

13. Vary


1. Tells the status

2. Sales, assets, equity or share value

3. Earnings

4. Profits

5. Capital.




1. Percentage

2. Pricing policy

3. Gross profit / sales x 100

4. Sales minus Cost of goods sold

5. Cash + credit sales minus returns

6. Percentage.

Self Assessment Questions 14: 1. Relationship

2. Net sales

Self Assessment Questions 15: 1. NP margin

2. Sales in rupee, expenses and taxes

3. Overall efficiency

4. Overall efficiency

5. Poor financing planning and low efficiencies

6. f ) Net profit after taxes / net sales x 100

7. Income statement


1. Speed

2. Composition of Current assets and current liabilities

3. Turnover.

Self Assessment Questions 17: 1. Firm’s stock

2. Inventory turnover, stock velocity

3. Speed of converting stock into sales to cash

4. Number of times turnover

5. Efficiency to manage stock

6. Cost of Goods Sold (COGS) / Average stock

7. Net sales minus gross profit.

8. Opening + Closing stock / 2

9. Net sales / Stock




1. Debtors velocity

2. credit sales

3. Gross value

4. Bad debts and reserve e for doubtful debts

5. Trade debtors and Bill receivable

6. Written

7. Three months

8. Current assets

9. Debtors + Bills receivable / net credit sales x number of working days.

10. Sales minus return inwards

11. Velocity of debt collection

12. DTO 3.56

13. Collection period 43 days.

Self Assessment Questions 19: 1. Credit purchases

2. Trade creditors + bills payable

3. Current liabilities

4. Creditors + BP / credit purchases x Number of days.

5. Credit purchases minus return outwards.


1. Relation of debt and equity

2. Capital structure.


1. Fixed cost bearing securities.

2. Preference share capital + debentures.

3. Fixed cost bearing securities / variable cost bearing capital .

4. Equity share capital + reserves and surplus.


1. debt, equity

2. Long term loans and liabilities

3. Long term debt

4. relative



5. comfort zone

6. 2 : 1

7. Long term debts / Shareholders’ funds + long term debt

Self Assessment Questions 23: 1. Comprehensive and practical knowledge

2. Ends but means

3. In totality

4. Standards

5. Price level changes


1. Refer to units 9.7

2. Refer to units 9.8 & 9.13

3. (1) Decrease (2) decrease (3) decrease (4) increase

4. (a) increase (b) increase (c) decrease (d) no change (e) no change



Unit 10 Funds Flow Analysis

Structure: 10.1 Introduction

Objectives

10.2 Meaning


10.3 Concept


10.4 Technique


10.5 Sources


10.6 Increase in funds


10.7 Decrease in Assets


10.8 Increase in Liabilities


10.9 Increase in Networth


10.10 Sources


10.11 Increase in Assets

Self Assessment Questions10

10.12 Decrease in Liabilities


10.13 Networth


10.14 Flow of funds


10.15 Transaction not affecting flow


10.16 Steps in preparation of funds flow statements




10.17 Computation of changes in working capital


10.18 Layout


10.19 Treatment of certain items


Terminal Questions


10.1 Introduction The usefulness of developing certain financial statements as an aid to evaluate past and / or

present performance of a business concern is unquestionable and beyond any dispute. The

Income Statement reports the revenues earned and expenses incurred or outstanding. The

Balance Sheet conveys about the deployment of funds in various assets and equities The Fund

Flow analysis is a modern technique of analyzing the movement of “funds” of a concern. The

Fund Flow statement shows the movement of funds between two balance sheet dates. As per

Robert N. Anthony “the Funds Flow statement describes the sources from which additional funds

were derived and the use to which these funds were put”. Such a statement is becoming more

and more popular and is being increasingly published as part of the annual accounts. Para 20 of

International Accounting Standards 7 reads as follows :

“A statement of changes in financial position should be included as an integral part of financial

statements. The statement of changes in financial position should be presented for each period

for which the income statement is prepared”.

The inclusion of such a statement, therefore, is very helpful to improve the understanding of the

operations and activities of an enterprise for the reporting period. Learning Objectives: After studying this unit, you should be able to understand the following

1. Understand the meaning and the concepts of funds flow statement.

2. Familiar with techniques of fund flow statement.

3. Preparation of fund flow statement.



10.2 Meaning of Fund Flow Statement Statement of Sources and Uses of Funds is a statement which depicts the sources from which

funds are obtained and the uses to which they are being put. It is essentially derived from the

analysis of changes which have occurred in assets and equities between two Balance Sheets

periods. It is not the endproduct of accounting records. The statement speaks about the

changes in financial items of Balance Sheets prepared at two different dates. Therefore, the

funds flow indicates the inflows and outflows of funds during a particular accounting period

generally a year. The flow exhibits the movements of funds in both the directions – inside and

outside the business. As such, the term ‘flow’ in the context of funds indicates the transfer of

cash or cash equivalent from asset to equity or one equity to another equity or from one asset to

another asset.


1. Fund flow statement is _________ From _________ Changes in _____ and ____. 2. FFS speaks about changes in _______________________ Balance Sheets. 3. Flow exhibits the flows _______________ And ________________ business. 4. Flow refers to transfer of ___________________ And __________________.

10.3 Concept of Fund The term “funds” has been defined in a number of ways in financial circles. The three common

usages of the term are cash , working capita and total financial resources..

Cash: Under this concept, the term “funds” is used only in the sense of cash. Here, only the changes in cash are considered. Hence, the statement is called “Cash Flow statement. This statement aims at listing the various items which bring about changes in the cash balance

between two balance sheet dates. Cash planning becomes useful for control purposes.

Using this method has certain disadvantages. Since cash is considered as short term assets,

they are subjected to short term fluctuations. A delay in making payment to suppliers and a

provision of one month’s credit for making a payment of land purchases may show sufficient cash

flow . They may reflect a satisfactory position. But it is not a reality. Therefore, cash equivalent concept of fund is useful only for short term financial planning and not for long term or

general financial position assessment.

Working Capital: Working capital is Current asserts minus current liabilities. It is an

alternative measure of the changes in the financial position. All those transactions which increase



or decrease working capital are included in this statement. It excludes all such items which do

not affect the working capital. The working capital concept of funds is in conformity with normal

accounting procedures. Hence, a funds flow statement based on this concept fits well with the

other statements. Moreover, working capital is also a measure of short term liquidity of the firm.

Therefore, an analysis of factors bringing about a change in the amount of net working capital is

useful for decision making by shareholders, creditors and management. Due to these reasons,

the working capital approach to funds is more useful than the cash approach.

Total Financial Resources : The term “funds” is very often used in the sense of useful financial resources also. Cash approach and working capital approach both are incomplete and

inadequate to the extent that they omit a few major financial and investment transactions. Such

items do not affect net working capital. But, if they are included, they would certainly provide

qualitative information for the decision making.,

For example issuing equity shares and debentures for purchase of buildings or assets shall not

have any effect on the working capital. But it is a significant financial transaction that should be

disclosed. Therefore, this concept seems to be the best approach to disclose the changes in the

financial position as compared to other concepts. It is in conformity with the statutory regulations

and legal requirements.


1. The three common funds are __________________________.

2. Cash planning is used for ____________________________.

3. Cash equivalent is used for ___________________________.

4. Working capital is __________________________________.

5. Non working capital items are ________________________.

6. Working capital means ______________________________.

7. Total financial resources considers _____________________.

8. Total financial resources provide _______________________.

Objectives: The main objectives of the funds flow statement is normally based on the purpose its going to be

served. These are :

a) to help in understanding the changes that are likely to take place in the assets and liabilities

portfolio. These may not be readily available from the income statement.



b) To inform the stakeholders as to how a firm can use the funds which are available at its

disposal.

c) To bring out the financial strengths and weaknesses of the business.


1. The objectives of FFS is to identify ______________ in ______. and ____. 2. FFS is to bring out _______________________.

10.4 Techniques Of Preparing A Funds Flow Statement Like other accounting statements, the structure of Fund Flow Statement is based on the equality

of financial assets and liabilities including capital. The basic understanding is that the funds are

obtained through profit, external borrowings or by issue of shares. If funds are not available

readily from these sources, the other alternative available is to sell the fixed assets and

investments. . The preparation of Funds Flow Statement is normally based on the following to

bring to scientific method of preparation.

a) Schedule of working capital changes

b) Statement of Sources and Uses of Fund.

Schedule of Working Capital Changes : It is also known as “Comparative change in Working

Capital Statement” or “Working Capital Variation Statement”. The net change in working capital

is projected here in the place of individual changes in all the current assets and current liabilities

in the Funds Flow Statement. The statement indicates the amount of working capital at the end of

two years. It shows the increase or decrease in the individual items of current assets and current

liabilities. The effect of the changes in the individual items of the current assets and current

liabilities on working capital is also presented clearly and precisely. The difference in the amount

of working capital at the end of two years will depict either the increase or decease in working

capital. While ascertaining the increase or decrease in individual items of current assets and

current liabilities and its impact on working capital, the following Rules should be taken into

account.

i) increase in Current Assets will increase the Working Capital

ii) Decrease in Current Assets will decrease the Working Capital

iii) Increase of Current Liabilities will decrease the Working Capital

iv) Decrease in Current Liabilities will increase the Working Capital



It is, therefore, noted that the changes in the items of current assets are positively correlated to

the changes in the working capital. On the other hand, changes in current liabilities are inversely

related to the changes in the working capital.

Self Assessment Questions 4 1. FFS is based on ___________________________.

2. FFS is prepared based on ___________________.

3. Working capital schedule indicates the ______________________.

4. Increase in current assets ___________________ the Working capital.

5. Decrease in CA _____________________________________ the WC.

6. Increase in CL ______________________________________ the WC.

7. Decrease in CL ______________________________________ the WC.

8. Changes in CA ________________________________ changes in WC.

9. Changes in CL ________________________________ changes in WC.

10.5 Sources of Funds The transactions that increase the working capital are sources of funds. Following may the

sources of funds in a concern.

Funds from operations : Profit earned by the concern during the current year is deemed to be

the source of funds. It is very important source of funds inflow. Net profit is arrived at by

deducting cost of goods sold and other expenses from total sales revenue. However, the profit so

calculated is seldom equal to the funds from operations because there are many items which are

debited or credited in the Profit and Loss Account which do not affect working capital. Therefore,

in calculating the funds from operations, the following adjustments must be kept in mind:

Items to be added back to net profit : a. Nonfund revenue deductions: These are items which are debited to Profit and Loss

account. These do not cause outflow of funds such as depreciation and depletion on non

current assets, amortization of fictitious and intangible assets, preliminary expenses,

redemption of preference shares or debentures, deferred charges, advertising suspense

account written off. If non fund expenditures does not affect the current assets such as

unexpired insurance, do not add back. So also, all allowances for income tax payable in

future years are excluded.



b. Nontrading charges or losses : These items which were debited to Profit and Loss account

reduce the profits but they do not cause any outflow of funds. Hence, profit should be

corrected by adding back all such charges and losses. These include appropriation of

retained earnings such as general reserve, dividend equalization fund, reserve for

contingencies, sinking fund. In addition the dividend on shares must be added back since it

is an appropriation and not trading charge. The losses arising out of sale of land, buildings,

machinery, long term investments which were written off to the profit and loss account must

be added back. Do not add the loss arising out of sale of a current asset such short term

investments. It is a trading loss and hence it will not require any adjustment. The amount set

aside as provision for current taxation will also be added back. This will be considered only

when the provision for taxation is treated as a charge on profits.

Items to be deducted from Net Profit. The non fund and non trading revenue receipts or incomes must be deducted

Net profit in order to compute funds from operations. The items are:

(a) Dividend received or receivable: Although this transaction increases the current assets such as cash and debtors, it is not a trading income. Hence, it should be deducted from the

net profits to determine the funds from operations.

(b) Retransfer of excess provisions: Where the provisions made for taxation, depreciation,

doubtful debts exceed the genuine requirements, the excess amount is transferred back to

the Profit and loss account. It does not create any inflow of funds since it is an accounting

entry. Hence, deduct it.

(c) Profit on sale of non current assets: It is a non trading income. Hence it must be

eliminated from the amount of profit.

(d) Appreciation in fixed assets: The amount of appreciation on revaluation of fixed assets is

normally credited to the profit and loss account. If it is so, deduct it from the profit to compute

the funds from operations.

Self Assessment Questions 5 1. Increase in working capital ____________________.

2. Decrease in WC _____________________________.

3. Net profit is ________________________________.

4. Items to be added back to net profit are __________.

5. Some of nonfund revenue items _______________.



6. Non trading losses include ___________________.

10.6 Increse in Funds In a nutshell, the sources of funds can be observed as follows :

a) increase of fresh shares derived from increase in share capital.

b) Issue of debentures derived from increase in debentures.

c) Raising of new loan derived from increase in long term loans

d) Sale of fixed assets for cash or for other current assets derived from decrease in fixed assets

and additional information.

e) Non trading income

f) Profit from operations before deducting non cash items of expenses and losses and before

additional non cash, non trading incomes.

g) Decrease in working capital derived from the Schedule of Working capital changes.


1. Increase in share capital is ___________________________ of cash. 2. Increase in debentures _______________________________ of cash. 3. Increase in raising loans ______________________________. 4. sale of fixed assets __________________________________. 5. Non trading income is _______________________________. 6. Profit from operations is _____________________________. 7. Decrease in working capital is ________________________.

10.7 Decrease in Assets Decrease in assets is always a source of funds for the business. Decrease may be in many

ways: such as cash received from debtors, sale of goods for cash, Bills realized, sale of assets,

fixed assets through provision for depreciation or amortization of fictitious assets. Decrease in an

item of assets results in either a parallel decrease in some other liabilities or a parallel increase in

some other item of assets example repayment of bank loan.. It should be remembered at the

very outset that the decrease is ascertained by comparing the cost of fixed assets and not by

comparing the written down value i.e cost less depreciation. If fixed assets have been shown not

at cost but at written down value, then cost may be ascertained by adding total depreciation

written off todate (generally known as accumulated depreciation) to the written down value The

decrease in fixed assets results in sale of fixed assets. Specific information is generally given in



the problem about this. The decrease in fixed assets not on account of depreciation or writing off

is known as sale of fixed assets. It must be noticed that the total sale proceeds and not the cost

of fixed assets sold are shown as source of fund. If the information in respect of sale of fixed

assets is not clearly given, the following steps should be taken to find out the value of sale

proceeds.

Cost of Fixed Assets (Previous Year) ………………

Less: Cost of Fixed Assets of Current year ( ………………)

Cost of Fixed Assets x x x x x x x x

ADD : Profit or DEDUCT loss on sale ………………………

Sale Proceeds to be treated as source XXXXXXXXXXXXXX

The amount of profit or loss on sale of fixed assets for the above purpose derived from profit and

loss account or from capital reserve or from any specific reserve. This is based on the fact that

such profit or loss are credited or debited or transferred to these accounts in accordance with the

accounting principles. It must be remembered that profit or loss on sale of fixed assets are not

included in profit from operation for the purpose of this Fund Flow Statement.

If such profit or loss has been included in Profit and Loss Account , adjustment has to be made.

If there is profit on sale of assets, the net profit disclosed by Profit and Loss Account is reduced

by the amount of profit earned on the sale of fixed assets. On the other hand, the net profit

shown by Profit and Loss Account is increased by the amount of loss incurred on the sale of fixed

assets.

Example:

The land and buildings account had a balance of Rs.5,00,000on Jan 2007. A piece of land has

been sold . There is no purchase. Rs.30,000 depreciation has been charged in 2007. The profit

on sale has been credited to Capital Reserve Account . The balance stood on January 1, 2007

was Rs.20,000 and Rs.50,000 on December 31. The balance of land and building account as on

December 31 is Rs.4,50,000. Find the sale proceeds.

Solution

Balance of land and building on Jan 1, 2007 5,00,000

LESS : Depreciation charged (30,000)

4,70,000



LESS: Balance of Land and Building on Dec 31 ( 4,50,000)

Cost of Land sold 20,000

ADD : Profit on sale (derived from capital reserve) 30,000

(closing minus opening balance

Rs.50,000 minus Rs.20,000) Sale Proceeds 50,000

Self Assessment Questions 7 1. Decrease in assets is _________________________________.

2. Profit or loss on sale of fixed assets ____________________.

10.8 Increase In Liabilities The increase in liabilities is always a source of funds for the business. It may occur as a result of

many transactions such as equity share capital or / and debentures to the public., purchase of

goods on credit. Outstanding expenses are also considered as source of funds since payments

are postponed and cash saved is parked in the business. A comparison of the amount of the

items of long term liabilities i.e debentures and mortgage and other loans for the current year and

previous year will disclose the increase or decrease in the long term liabilities. Additional

information should also be taken into account for determining the correct amount of increase or

decrease for the purpose of this statement.

Any increase on account of the issue of debentures for consideration other than cash or current

assets for the purchase of fixed assets or redeeming other debentures or preference shares

would not at all be shown in the statement because in such a case there is no flow of fund.


1. Increase in liability is ______________________ .

2. Outstanding expenses is __________________ .

10.9 Increase In NetWorth There can be only two main channels of increase in networth or equity :

a) procurement of more funds by issue of additional shares

b) through accumulation of retained earnings or profits in business

As the increased in owned funds is concerned, it happens only when the business has plans for

expansion, diversification, modernization. The increase in paidup equity



Share capital is not a regular feature. Its occurrence is only sporadic. But profit generated from

operations is a normal feature and is virtually a continuous process from year to year. Profit

earned during an operating period increases the new worth of the business and hence it is

always considered as a source of funds. Sometimes, the premium received on sale of equity

shares and credited to share premium account is also a source of funds as it adds to the size of

net worth .

Share capital consists of equity share capital and preference share capital. The change in equity

share capital is always in the form of increase; it can never be in the form of decrease. The

increase in equity share capital as per Balance Sheet values must be adjusted in terms of

additional information. If the increase has taken place on account of the issue of fresh shares,

only that portion of increase should be treated as sources which is due to the issue of fresh

shares for cash and other current assets. Increase on account of share issues for consideration

involving the purchase of fixed assets or redemption of preference shares or debentures shall

not partake the character of inflow of funds and hence should not be shown in the statement. If

fresh shares have been issued at premium, the amount of premium must be added to the

increase in share capital for the purpose of showing it as source of fund. If the fresh shares

have been issued at discount, the amount of discount must be deducted from the increase in

share capital because it does not involve inflow of fund.

Example:

The opening and closing balance of Share capital are Rs.6,00,000 and Rs.9,50,000 respectively.

The Preference Share capital included in opening balance is Rs.1,00,000. During the year,

Rs.75,000 worth of Preference shares were redeemed at 8 % premium. Bonus shares at Re.1

for every five equity shares held . In addition, a business was purchased by issue of Rs.90,000

shares at a premium of 10 %. The opening and closing balance in the Premium Account is

Rs.8,00,000 and Rs.14,000 respectively. Calculate the further fresh issue.

Solution:

Share capital at close 9,50,000 DEDUCT : Share capital opening 6,00,000 Less: Redemption of Preference

Shares ( 75,000) ( 5,25,000)

4,25,000 Deduct: Shares issued for noncash items (90,000)



3,35,000 DEDUCT : Bonus shares ( 1 / 5 x 5,00,000) (1,00,000) (1/5 of 6,00,000)

2,25,000 ADD: Share premium. (14,000 + 6,000 minus 8,000 minus 9,000) 3,000

Fresh issue of Shares 2,28,000

Self Assessment Questions 9 1. Decrease in net worth is through __________________________.

2. Increase in net worth is needed for ________________________.

3. Profit earned _________________________________ net worth.

4. Premium on shares is __________________________.

5. Change in equity shares is always ________________.

6. Decrease in preference share capital is ____________.

10.10 Sources Of Funds The use of funds results in cash outflows. The outflows are known as :application” of funds. The

uses of funds are mainly concerned with.

a) Redemption of Preference shares in cash derived from decrease in share capital.

b) Redemption of debentures in cash derived from decrease in debentures

c) Repayment of loan derived from decrease in long term loans

d) Purchase of fixed assets for consideration other than shares, debentures or long term debt

derived from increase in fixed assets and additional information.

e) Loss from operations

f) Payment of dividend in cash

Self Assessment Questions 10 1. Use of funds result in ________________________.

2. Redemption of Preference shares is _____________.

3. Redemption of debentures is __________________.

4. Redemption of long term loan is _______________.

5. Purchase of fixed asset is _____________________.

6. Loss from operations is ______________________.



7. Payment of dividend is ______________________.

10. 11 Increase In Assets The increase in fixed assets is known in the accounting language as “Purchase of fixed assets”.

In order to find out the increase in fixed assets, cost of fixed assets of previous year as reduced

by the cost of fixed assets sold during the current year is deducted from the cost of fixed assets of

the current year. In other words, the increase in fixed assets is calculated as under :

Cost of Current year fixed assets ………………

DEDUCT ; Cost of previous fixed assets ………..

LESS: Cost of fixed assets sold or

Written off during the

Current year (……….) (………………..)

INCREASE in fixed assets x x x x x x x

Example: The opening and closing written down balances of an asset are Rs.5,00,000 and

Rs.5,50,000. The accumulated depreciation has been Rs.1,50,000 at the beginning and

Rs.1,90,000 at the close. A machine costing Rs.30,000 (accumulated depreciation Rs.18,000)

was sold during the year for Rs.9,500. Calculate the purchase price of the fixed assets.

Solution Closing cost of asset (closing value + closing accumulated

Depreciation : 5,50,000 + 1,90,000 7,40,000

DEDUCT : Opening cost of Asset (opening

Value + opening accumulated Depreciation

5,00,000 + 1,50,000 6,50,000

Less : Cost of asset sold (30,000)

(6,20,000)

1,20,000

Sometimes, it may happen that the cost figures cannot be ascertained on the basis of information

available. Increase in fixed assets, in this case, has to be found out with reference to the written

down value along with annual depreciation. If no purchase of fixed assets were made during

the current year, then the value of fixed assets shown in the Balance Sheet of the current year



should be equal to the values of the previous year minus annual depreciation for current year.

The excess of current year’s value over previous year’s value minus annual depreciation will be

treated as increase. This will represent the purchase of fixed assets.

Current year written down value of Asset ……………..

DEDUCT ; Previous year WDV

of Asset ……………

Less: Current year Depreciation (…………) ( ……………..)

_______________

Increase in Fixed Asset being Purchases x x x x x x

Example: The written down value of a Machinery at the beginning and at close were Rs.2,00,000 and 1,75,000. An old machine whose written down value was Rs.12,000 was sold for Rs.6,500.

Rs.32,000 depreciation was charged during the current year. Calculate the purchase price.

Solution: Current year written down value of Machinery 1,75,000

DEDUCT : Previous year written down

Value of Machinery 2,00,000

Less : Current year depreciation ( 32,000)

1,68,000

Less: written down value of machine Sold ( 12,000)

(1,56,000)

Purchase price 19,000 Self Assessment Questions 11

1. Increase in fixed asset is known as _____________________.

2. Purchase is _______________________________________.

3. The excess of current year –minus (previous year + Depreciation) is treated as

________________.

10.12 Decrease In Liabilities It implies application which is the flow of funds out of business. Decrease in liability may be done

due increase in one or more liability items or due to decrease in one or more asset items. It may

also be partly due to increase in liability and partly due to decrease in assets. . Any amount of

premium on the redemption of debentures should be adjusted as deduction . Any decrease on



account of redemption of debentures through the issue of another debentures or preference

shares should also not be shown in the statement.

Example:

On January 1, 2007, the balance of 8 % Debentures Account stood at Rs.5,00,000. Rs.60,000

debentures were repaid at 5 percent premium. Rs.75,000 debentures were purchased at Rs.95

from the market and cancelled. The closing balance of debentures was Rs. 2,00,000. Calculate

the outflow of funds.

Solution: Opening balance of Debenture Account 5,00,000

LESS: Closing balance of Debenture Account ( 2,00,000)

Decrease 3,00,000

LESS : Discount on cancellation (Rs.75,000 / Face

Value of Rs.100 each or 750 debentures x

Rs.5 each (Rs.100 minus Rs.95) ( 1,250)

2,98,750

ADD: Premium (Rs.60,000 x 5 / 100) 3,000

Outflow of funds 3,01,750


1. Decrease in fixed liabilities ________________________ funds.

2. Premium on redemption of debentures is _____________ .

10.13 Net Worth It may be used due to (a) loss from operations (b) payment of cash dividend out of accumulated

reserves and (c) return of a part of paid up share capital to shareholders implying reduction of

share capital – a rare occurrence. If there is decrease in preference share capital and this

decrease is on account of redemption of these shares in cash or other current assets, such

decrease should be shown as use of fund. But the decrease on account of redemption by the

issue of another preference shares or equity shares or debentures, shall never be shown in the

statement because it will not involve outflow of fund. If the preference shares have been

redeemed at a premium, necessary adjustments should be made

Self Assessment Questions 13 1. New worth is due to _______________________.



2. Net worth is also due to ___________________.

3. Net worth can be ________________________.

10.14 Flow of Funds It refers to change in fund. Increase of funds of any transaction is a source and decrease of

funds in any transaction is application or uses of funds. But the transactions which do not result

in any change in the funds is called “Nonfund”. Flow of fund takes place when a business

transaction brings a change in the working capital. Such change may be increase or decrease.

The increase is a positive change and the decrease being the negative. These directions in

change are known as fund elements or fund factors. They are commonly known as “inflows” and

“outflows”. The basic rule is :

Flow of fund if a transaction involves :

a) Current assets and fixed assets that is machine sold for cash

b) Current assets and fixed liabilities that is issue of debentures to the public

c) Current assets and owner equity that is issue of shares for cash

d) Current liabilities and fixed assets that is transfer of assets to discharge a claim

e) Current liabilities and fixed liabilities that is conversion of creditors due by issue of

debentures.

f) Current liabilities and capital that is conversion of creditors into owner’s equity by issue of

equity shares.

Self Assessment Questions 14 1. Flow refers to __________________________.

2. Increase in funds _______________________.

3. Decrease in funds ______________________.

4. Non change is known as _________________.

5. Flow takes place due to __________________ working capital.

6. The increase in fund is a __________________ change.

7. The decrease in fund is a __________________ change.

10.15 Transactions that do not affect the flow of Funds a) Current assets and current liabilities creditors paid

b) Fixed assets and fixed liabilities purchase of assets for debentures

c) Fixed assets and capital purchase of assets by issue of equity shares.




1. Transactions not affecting flow are _______________________.

10.16 Steps In Preparation Of Funds Flow Statement There are three steps involved in the preparation of a Fund Flow Statement (FFS). They are as

follows:

a) Preparation of Statement of changes in working capital or Schedule of changes in working

capital.

b) Preparation of Adjusted Profit and Loss Account (APL)

c) Statement of changes in Financial position as per AS – 7

Self Assessment Questions 16 1. First step in preparation of FFS is __________________.

2. Second step in the preparation of FFS is _____________.

3. Third step in the preparation of FFS is _______________.

10. 17 Computation of Changes in Working Capital and Funds from Operations It is a customary practice that only the net changes in working capital should be shown in the

Fund Flow Statement instead of individual changes. Here, the current assets and current

liabilities are considered. For this purpose, a separate statement or schedule is being prepared.

Individual items are entered here. The opening and closing balances are entered one after the

other. The corresponding increase or decrease are entered based on the following rules :

a) Increase in a current asset item increases working capital.

b) Decrease in a current asset item decreases working capital.

c) Increase in a current liability item decreases working capital.

d) Decrease in a current liability item increases working capital .

Insert the total of current asset and current liabilities of both opening and closing periods. Say,

the total of current assets as A and that of total of current liabilities as B. Deduct A minus B. The

answer is known as net Working capital. If the working capital at the end of the current year is

more than the working capital at the end of previous year, the excess is called as “increase in

working capital”. Otherwise, if previous year’s working capital is more than the current year’s

working capital, the difference is called as “Decrease in working capital”. Increase in working

capital is shown as application of funds and decrease in working capital as source of funds in the

Funds Flow Statement.



The funds from operation can be found with the help of preparing an Adjusted Profit and Loss

Account.

Self Assessment Questions 17 1. Individual items are projected in ___________________.

2. Working capital equation is _______________________.

3. A is total _____________________________________.

4. B is total ____________________________________.

5. Working capital is _____________________________.

6. Net increase or decrease is ______________________.

10.18 Layout The layout for schedule of changes in Working Capital is as follows

Balances as on Effect on

Details Last Current Increase Decrease Year Year

CURRENT ASSETS Cash in hand Cash at Bank Sundry Debtors Bills Receivable Stock or Inventory Prepaid expenses

Total Current Assets, Say A

CURRENT LIABILITIES Sundry Creditors Bills Payable Bank Overdraft Outstanding expenses

Total Current Liabilities, Say B

NET WORKING CAPITAL A minus B

Increase or Decrease in Working



Capital (Balancing figure)

Example: DR Ltd provides the following information

Jan 1 Dec 31 In Rupees

Sundry Debtors 65,000 1,05,000 Cash in hand 13,000 20,000 Cash at Bank 15,000 20,000 Bills Receivable 16,000 30,000 Inventory 90,000 84,000 Bills Payables 12,000 8,000 Outstanding expenses 6,000 5,000 Sundry Creditors 30,000 58,000 Bank Overdraft 30,000 42,000 Short term Loans 32,000 36,000

Prepare a schedule of changes in working capital



Solution

Schedule of changes in Working Capital

Balances as on Effect of WC Details Jan 1 Dec 31 Increase Decrease

Current Assets Cash in hand 13,000 20,000 7,000 Cash at Bank 15,000 20,000 5,000 Sundry Debtors 65,000 1,05,000 40,000 Bills Receivable 16,000 30,000 14,000 Inventory 90,000 84,000 – 6,000 Total Current Assets, A 1,99,000 2,59,000 Current Liabilities Sundry Creditors 30,000 58,000 – 28,000 Bills Payables 12,000 8,000 4,000 Outstanding expenses 6,000 5,000 1,000 Bank Overdraft 30,000 42,000 – 12,000 Short term loans 32,000 36,000 – 4,000 Total Current Liabilities, B 1,10,000 1,49,000 Working Capital A minus B 89,000 1,10,000 Net Increase in working capital (balancing figure) 21,000 21,000

TOTAL 1,10,000 1,10,000 71,000 71,000



Example :

Prepare a statement of changes in working capital from the following information.

Jan 1 Dec 31 In Rupees

Share Capital 50,000 50,000 Retained earnings 14,000 40,000 Fixed Assets at cost 80,000 90,000 Provision for Depreciation on Fixed Assets 22,000 27,000 Investments in shares of subsidiaries 15,000 15,000 8% Debentures (redeemable in 5 equal annual instalment of Rs.20,000 each, from the current year) 20,000 –

Prepaid expenses 21,000 14,000 Outstanding expenses 5,000 12,000 Creditors and Bills Payables 30,000 25,000 Debtors and Bills Receivables 18,000 20,000 Cash and Bank balances 5,000 13,000 Provision for Doubtful Debts 4,000 2,000

Solution Statement of changes in working capital during the year

Details Balances as on Effect on WC

Jan 1 Dec 31 Increase Decrease Current Assets Cash and bank balances Debtors and B.R. Government Securities Prepaid expenses

Total, say A

Current Liabilities 8% Debentures Outstanding expenses Creditors and B.P. Provision for Doubtful Debts

5,000 18,000 6,000 21,000

50,000

13,000 20,000 12,000 14,000

59,000

8,000 2,000 6,000

–

–

–

5,000

7,000

20,000

7,000 20,000 5,000 30,000 4,000

20,000 12,000 25,000 2,000



Total, say B Working Capital : A minus B Net increase in working capital

59,000 39,000 3,000

29,000

( 9,000 ) 29,000

20,000

20,000 20,000 43,000 43,000

Adjusted Profit and Loss Account

The Layout is as follows:

Dr. Cr.

To By

Depreciation written off Profit and Loss account

Depreciation Provision last year from Balance

Preliminary expenses written Sheet

Off Profit on sale of investments

Goodwill written off Profit on sale of Fixed assets

Discount on issue of shares and Dividend and interest received

Debentures written off from trade investments

Fixed assets discarded or

Written off

Loss on sale of fixed assets FUNDS GENERATED FROM

Loss on sale of trade investments TRADING OPERATIONS

Transfer to General Reserve, (balancing figure) transferred

to Funds Flow Statement as

Sinking Funds, Reserve Funds application of funds

Transfer to other Reserves

Premium on redemption of

Preference Shares

Provision for Tax

Provision for Final or

Proposed Dividend

Interim Dividends

Net Profit as per closing current

Year Profit and Loss Account

TOTAL



NOTE : If debit total of APL is more than the credit total, the difference is Funds generated from

Operation : Record on the credit side of Adjusted Profit and Loss Account.

If credit total of APL is more than the debit total, the difference is funds lost in operations. Record

on the debit side of Adjusted Profit and Loss Account

The balancing figures should be transferred in opposite direction to Funds Flow statement..

Example 3: Calculate funds from operations from the following Profit and Loss Account

To By Expenses paid and 3,00,000 Gross Profit 4,50,000 Outstanding Depreciation 70,000 Gain on sale of land 60,000 Loss on sale of machine 4,000 Discount 200 Goodwill 20,000 Net Profit 1,15,800

5,10,000 5,10,000

Solution: ADJUSTED PROFIT AND LOSS ACCOUNT

To Rs. By Rs. Depreciation 70,000 Gain on sale of land 60,000 Goodwill written off 20,000 Funds from operations 1,50,000 Discount written off 200 (balancing figure) Loss on sale of machines 4,000 Net Profit 1,15,800

2,10,000 2,10,000

Example 4: Following are the extracts from the Balance sheets of DR Lt.

3132007 3132008 Rs. Rs.

Profit and Loss account 11,100 14,800 General Reserve 7,400 9,250 Goodwill 3,700 1,850 Provision for depreciation on asset 3,700 4,400 Preliminary expenses 2,200 1,500



During the year, the company sold land whose book value was Rs.50,000 for Rs.54,000 and paid

an interim dividend of Rs.2,000

Calculate funds from operations.

Solution ADJUSTED PROFIT AND LOSS ACCOUNT

To Rs By Rs.

General Reserve Balance brought down 11,100

(9,250 minus 7,400) 1,850 being opening balance

Goodwill written off Profit on sale of land 4,000

(3,700 minus 1.850) 1,850

Preliminary expenses

Written off 700 Funds generated from

Depreciation written operations (balancing

Off 700 figure) 6,800

Interim dividend paid 2,000

Closing balance of Profit

And Loss account 14,800

21,900 21,900

NOTES: 1. There is an increase in the balance in General Reserve. It implies that some amount has

been transferred to the account from the Profit and Loss account. This is an appropriation of

profit which does not result in any outflow of funds.

2. The balance in Goodwill Account and preliminary expenses account has come down which

indicates tht the difference has been written. This also does not result in an outflow of funds.

3. The increase in provision for depreciation is on account of current year’s depreciation which

does not result in any outflow of funds.

4. Profit on sale of land and interim dividend being nonoperating items are to be separately

shown as source and application of funds in the Funds Flow Statement.



Example 5: The following information is provided :

Opening balance of Plant Rs.1,32,500. Closing balance of Plant Rs.1,97,500. Provision for

Depreciation in Plant at the beginning 45,000; and at close Rs.61,000. During the year

Rs.65,000 worth of Plant was purchased in exchange for fully paid debentures and old Plant

costing Rs.40,000 was sold for Rs.34,000. Depreciation provided Rs.18,000. Calculate the flow

of funds.

Solution: Plant Account

To By

Opening Balance 1,32,500 Bank : Sale of Plant 34,000

Debenture Account 65,000 Provision for Depreciation

(Plant purchased) Account : Depreciation on

sold 18,000

Adjusted P&L Account

Profit on sale 12,000* Closing balance 1,97,500

Bank Account : Plant

Purchased (balancing

Figure) 40,000

2,49,500 2,49,500

Calculation of Profit on sale : 34,000 minus (40,000 – 18,000) = 12,000

Provision for Depreciation on Plant Account

To By

Plant Account

:Depreciation Opening Balance 45,000

On plant sold 18,000 APL : Current year

Closing Balance 61,000 Depreciation (bal.figure 34,000

79,000 79,000

Note: For all Asset Account, record the opening balance on the debit side and closing balance on the credit side of the concerned Asset Account. For all liabilities , record the opening balance on the credit side and the closing balance on the debit side.



10.19 TREATMENT OF CERTAIN ITEMS

There are certain items whose treatment is not uniform. Different authors differ differently. But,

in this study material, an uniformity is maintained. The likely arguments have been provided for

treating items on a particular principle. The items are :

Provision for Bad Debts Sometimes, it is shown as reserve for bad / doubtful debts. Actually, this item is shown as

deduction from total book debts to the asset side of the Balance Sheet. Therefore, this item

should be deducted from the amount of debtors shown in the schedule of working capital

changes. Since such treatment may complicate the calculation work, it is suggested that it should

be shown along with current liabilities, although, it does not belong to that category.

Provision for Tax:

DO not treat this item as a current liability. The Provision has to be made to meet the tax liability

of current year. If there is a Provision for last year, it has to be paid this year. Hence, the last

year Provision actually becomes the current year cash outflow. Hence record it in the Funds flow

statement.

Proposed Dividend

Normally, the proposed dividends are given as Balance Sheet item on the liability side. The

Directors propose the final dividend which needs to be approved by the General Meeting. Hence,

it is fair to assume that the proposed dividend is not a current liability. Do not show in the

schedule of working capital changes. The last year proposed dividend should be paid during the

current year, hence a cash outflow

Investments

It poses problems in its treatment. The Rule is :

a) if the investments are in the form of Government or other marketable securities, treat it as

current assets.

b) If it is mentioned as trade investments, that is investments in shares and debentures of

another companies, treat it as fixed assets.

c) If nothing is mentioned specifically, the treatment is :

: if investments have been sold simultaneously, treat it as current assets : in other cases, treat it as Fixed Assets.



Depreciation

Normally, the value of deprecation will be provided in the problem as an adjustment items.

Depreciation is a non cash item. It is, therefore, charged to Profit and Loss and recorded in the concerned Fixed Assets Account. If the depreciation is given as a percentage, calculate the value on the opening balance of the concerned account.. If the value of depreciation is not

given, it has to be found out as follows :

Opening balance of Fixed Assets ……..

ADD: Purchases …….

LESS : Fixed assets sold (…….)

LESS : Closing balance of fixed assets (…….)

Depreciation charges x x x

If a concern intends to show its fixed assets at its cost price, the periodic annual depreciation is

shown under “liabilities” side as Provision for Depreciation commonly known as Accumulated

Depreciation Fund Account. If there were to be an Accumulated Depreciation Fund Account in

already in operation, the current year depreciation is charged against this Provision for

accumulated Depreciation Account and not recorded directly into Adjusted Profit and Loss

Account . In other words, the current year depreciation is routed through the Provision Account.

Increase / Decrease in Fixed Assets The increase or decrease by means of cash is recorded in the FFS. Increase or decrease due to

purchase consideration through shares and debentures are not recorded.

Increase / Decrease in longterm liabilities Compare debentures and mortgages as per the Balance Sheet figures. Only consider if cash is

the main striker to cause the increase or decrease. If the changes were to be due to

consideration other than cash or current assets, do not record it in the FFS..

Hidden Items Prepare the necessary ledger accounts concerned in the fixed assets, fixed liabilities and share

capital and carry out all the necessary adjustments. The balancing figure, if any, would be the

cash transactions. For all non, cash transactions, concentrate on the Adjusted Profit and Loss

Account.




1. Provision is shown as _______________________

2. Provision for doubtful debts is _______________ from gross debtors

3. Provision is shown in _______________________

4. Provision for tax may be _____________________

5. If Provision for Tax is maintained , treat it in _________________

6. Proposed dividend is shown on ________________ of Balance sheet

7. Proposed dividends are to be approved by _____________________

8. Proposed divided. Is not considered as ________________________

9. Last year proposed dividend is cash __________________________

10. Government investments are _______________________________

11. Investments in shares and debentures are ______________________

12. Depreciation is _____________________

13. Depreciation is a ___________________

14. If Depreciation is given as a percentage, calculate on _____________

15. If Provision for depreciation account is maintained, charge the current depreciation to

_____________ and not to _______________________

16. Depreciation is charged only on _______________________________

Problem 6: The Balance Sheets are given below :

Year (Rs.in lakhs)

2006 2007

Fixed Assets 50 60

Investments 10 20

Current Assets 140 150

Share Capital 100 160

Profit and Loss Account 30 30

Debentures 10

Current Liabilities 60 40

Depreciation charges was Rs.6 lakhs. Prepare Fund Flow statement.



Solution:

Schedule of changes in working capital

2006 2007

Current Assets 140 150

LESS: Current liabilities ( 60 ) (40)

Working Capital : CA minus CL 80 110

Net Increase in working capital transferred to 30

FFS (application)

110 110


To By

Depreciation 6 Opening Balance 30

Closing Balance 30 Funds from Operations 6

36 36

Funds Flow Statement

Sources Applications Issue of Equity shares 60 Purchase of Fixed Assets 16

Funds from operation 6 Purchase of investment 10

Redemption of debenture 10

Increase in working capital 30

66 66



Problem 7 : From the following extracts, calculate funds from operations

Year

2006 2007

Profit and Loss account 50,000 80,000

Provision for taxation on 10,000 15,000

Proposed dividends 5,000 10,000

Additional information: Tax paid Rs.2,500. Dividends paid Rs.1,000.. Calculate funds from

operation taking provision for tax and provision for tax and proposed dividend as (a) non current

liabilities and (b) current liabilities.

Solution:

Provision for tax and proposed dividend are taken as noncurrent liabilities

To By

Income tax account 2,500 Opening balance 10,000

Tax paid Profit and loss account 7,500

Closing balance 15,000 provision made (balance

Figure)

17,500 17,500

Proposed Dividend Account To By

Dividend account being Opening balance 5000

Dividend paid during the Profit and loss account

Year 1,000 proposed dividend 6,000

Closing balance 10,000

11,000 11,000




To By

Provision for Tax 7,500 Opening balance 50,000

Proposed Dividend 6,000 Funds from operations

Closing balance 80,000 (balancing figure) 43,500

93,500 93,500

c) If Provision of tax and proposed dividend are taken as a current liability, funds from

operations will be the difference in Profit and Loss account at the beginning and the end of

the year.

NOTES

1. In case a) Income tax paid Rs.2,500 and Dividend paid Rs.1,000 are shown as application of

funds in the FFS.

2. In case (b), there is no need to prepare proposed dividend account and provision for tax

account,. However, the opening and closing balances of the two accounts are shown as

current liabilities in the statement of changes in working capital

Problem 8: The book value of trade investments of DR Ltd as on March 1, 2006 and March 31,

2007 was Rs.50,000 and Rs.70,000 respectively. During the year, Rs.5,000 was received as

dividends, of which Rs.2,000 pertained to preacquisition profits which have been credited to

Investments Account. Investments costing Rs.10,000 have been sold during the year for

Rs.10,000. Find the flow of funds on account of investments.

Solution: Investments Account

To By

Opening balance 50,000 Dividend Account : Pre

Bank Account : purchase acquisition profit 2,000

Of investments (balance 32,000 Bank : sale of investments 10,000


82,000 82,000



Notes:

1) The investments purchased were valued cumdividend. Hence, on receipt of dividends, they

were rightly credited to Investments. Hence there is no need for any further adjustment.

2) The investments sold has been at the book value. There is no profit or loss on account of the

transactions. If the transaction had resulted in profit, it will have to be deducted from net profit

to calculate funds from operations. In case of loss, it would be added to net profit to calculate

funds from operations.

Problem 9: Prepare a fun d flow statement of DR Ltd.

Year

2007 2008

Equity share capital 10,00,000 15,00,000

10 % Preference Share Capital 3,00,000

11 % debentures 8,00,000 6,00,000

Share Premium Account 1,00,000 95,000

Additional information (a) 10 % Preference shares have been redeemed at a premium of 10%,

the premium amount was charged to the share premium account (b) There has been a profit of

Rs.1,000 on the redemption of debentures.

Solution: Equity Share Capital

To By

Closing Balance 15,00,000 Opening balance 10,00,000

Bank (Fresh issue) 5,00,000

Balancing figure

15,00,000 15,00,000

Preference Share Capital Account

To By

Bank (Redemption) 3,30,000 Opening balance 3,00,000

Premium on redemption 30,000

3,30,000 3,30,000



Debentures Account

To By Bank (redemption) 1,99,000 Opening balance 8,00,000 Profit on redemption 1,000 Closing balance 6,00,000

8,00,000 8,00,000

Share Premium Account

To By Preference share 30,000 Opening balance 1,00,000 capital Closing balance 95,000 Equity share capital * 25,000

1,25,000 1,25,000

STATEMENT SHOWING SOURCES AND APPLICATION OF FUNDS

Equity share capital 5,00,000 Redemption of Preference shares 3,30,000

Share Premium 25,000 Redemption of Debentures 1,99,000

Decrease in working capital 4,000

5,29,000 5,29,000

Problem 10: The following are the summarized Balance Sheets of DR Ltd.

Liabilities 2006 2007 Share Capital 5,00,000 6,00,000 Reserves 1,50,000 1,80,000 Profit and Loss Account 40,000 65,000 Debentures 3,00,000 2,50,000 Creditors for goods 1,70,000 1,60,000 Provision for Income tax 60,000 80,000

12,20,000 12,20,000 Assets Fixed Assets 10,00,000 11,20,000 Less : Depreciation (3,70,000) (4,60,000) Stock 2,40,000 3,70,000 Book Debts 2,50,000 2,30,000 Cash 1,00,000 75,000

12,20,000 12,20,000

Prepare a Funds Flow statement



Solution:

Statement of changes in working capital

Balances as on Effect on W.C

2006 2007 Increase Decrease

Current Assets

Stock 2,40,000 3,70,000 1,30,000

Book Debts 2,50,000 2,30,000 20,000

Cash 1,00,000 75,000 25,000 .

Total CA say A 5,90,000 6,75,000

Current Liabilities

Creditors for goods 1,70,000 1,60,000 10,000

Provision for income tax 60,000 80,000 20,000

Total CL, say B 2,30,000 2,40,000

Working Capital, A – B 3,60,000 4,35,000

Increase in Working capital 75,000 75,000

Total 4,35,000 4,35,000 1,40,000 1,40,000


To By

Reserve 30,000 Opening balance 40,000

Depreciation 90,000 Funds from Operation 1.45,000

Closing balance 65,000 transferred to source

1,85,000 1,85,000



Statement showing Sources and Application of Funds

Sources Application

Issue of Share capital 1,00,000 Redemption of debentures 50,000

Funds from operation 1,45,000 Purchase of Fixed Assets 1,20,000

Increase in working capital 75,000

2,45,000 2,45,000

Notes: 1) The increase in General Reserve is due to transfer a part of profit of the current year and

hence the difference is transferred to APL since it’s a noncash item

2) The difference in depreciation is charged to APL, since it’s a noncash item.

3) Increase in Equity Share capital is assumed to be the fresh issue which is a cash item. It is

recoreded in FFS.

4) The difference is debentures is the redemption. It’s a cash item. Hence taken to FFS

5) Purchase of fixed asset is difference between the opening and closing balance of fixed

assets. It’s a cash item. Hence taken to FFS .

Problem 11

Prepare a Fund Flow Statement

Balance Sheets

2006 2007 2006 2007

Equity Share capital 50,000 65,000 Cash balances 15,000 9,000

Profit & Loss 14,750 17,000 Debtors 25,000 27,000

Trade Creditors 31,000 29,000 Investment 5,000

Mortgage 10,000 15,000 Fixed Assets 70,000 80,000

Short term loans 16,500 15,000 Less: Depreciation (25,250) (7,000)

Accrued expenses 7,500 8,000 Goodwill 5,000

1,29,750 1,49,000 1,29,750 1,49,000

Depreciation provided is Rs.4,750. Write off goodwill. Dividend paid Rs.3,500.



Solution:

Schedule of changes in working capital

Balances as on

2006 2007

Current Assets Cash 10,000 13,000 Debtors 25,000 27,000 Stock 40,000 35,000

Total current assets, say A 75,000 75,000 Current Liabilities Trade Creditors 29,000 31,000 Short term loans 15,000 16,500 Accrued expenses 8,000 7,500

Total current liabilities, say B 52,000 55,000

Working capital, A – B 20,000 24,000 Net increase in Working capital 4,000

Total 24,000 24,000


To By

Depreciation 1,750 Opening balance 30,000

Goodwill 5,000 Funds generated from

Dividend 3,500 operations 12,500


27,250 27,250



Funds Flow statement

Issue of fresh equity 15,000 Purchase of fixed assets 30,000

Sale of investment 5,000 Payments of dividends 3,500

Loan on mortgage 5,000 Increase in working capital 4,000

Funds from operations 12,500

37,500 37,500

Problem 12

The Balance Sheets of DR Ltd

Rupees in 000s

2006 2007 2006 20078

Share capital 50 100 Goodwill 15 25

Debenture 25 Plant 18 96

Profit and Loss 15 25 Stock 40 35

Proposed Dividend 5 6 Debtors 15 32.5

Creditors 20 30 Cash 8 9

Liabilities for expenses 5 3.5 Preliminary exp 4 2.5

100 200 100 200

A business was purchased during the year by the issue of 25,000 shares and 25,000 debentures.

Depreciation Rs.6,000 has been provided in the year. A machine has been sold for Rs.1,50,000,

the written down value being Rs.1,000. The business purchased had the following assets and

liabilities : Machine Rs.20,000, Stock Rs.5,000, Debtors Rs.15,000, Creditors Rs.5,000. Prepare

the Funds Flow Statement.

Solution

In this problem, another business concern was purchased whereby the assets and liabilities come

into business. For this purchase, the payment is through the issue of shares and debentures. If

the payment were to be in excess of assets and liabilities taken over, the excess payment is

known as “Goodwill”.



Assets taken over : Machine 20,000

Stock 5,000

Debtors 15,000

40,000

Less Creditors taken over ( 5,000 )

Net assets taken over 35,000

Total payments made : Share capital + Debentures 50,000

Excess payment being treated as Goodwill (50,00035,000) 15,000

Statement showing changes in working capital:

Balances as on

2006 2007 Current Assets Stock 40,000 35,000 Debtors 15,000 32,500 Cash 8,000 9,000

Total current assets, say A 63,000 76,500

Current Liabilities Sundry Creditors 20,000 30,000 Liabilities for expenses 5,000 3,500 Overdraft 5,000 10,500

Total current liabilities, say B 30,000 44,000

Working capital A – B 33,000 32,500 Decrease in working capital (source) 500

33,000 33,000




To By

Goodwill 5,000 Opening balance 15,000

Preliminary expenses 1,500 Profit on sale of Plant 500

Depreciation 6,000 Funds from operations 28,000

Proposed dividend 6,000


43,500 43,500

Funds Flow Statement

Issue of fresh shares for :

cash for current assets

Stock 5,000

Debtors 15,000

Less: Creditors (5,000) 15,000 Purchase of Plant 65,000

Sale of Plant 1,500 Payment of dividend 5,000

Funds from operations 28,000

Decrease in working

Capital 500

70,000 70,000

Terminal Question Problem 1: The balance in the Provision for taxation : opening Rs.30,000 and closing Rs.40,000. Taxes paid during the year was Rs.25,000. Calculate Funds from operation. (b) What

is the provision made during the year?



Problem 2: Extracts of Balance Sheets are given below :

2006 2007

Profit and Loss appropriation account 30,000 40,000

General Reserve 20,000 25,000

Goodwill 10,000 5,000

Preliminary expenses 6,000 4,000

Provision for Depreciation on Machinery 10,000 12,000

Calculate funds from operation

Problem 3: Calculate funds from operations: Profit and Loss Account

To By

Expenses 3,00,000 Gross profit 4,50,000

Depreciation 70,000 Gain on sale of land 60,000

Loss on sale of plant 4,000

Discount on Debenture 200

Goodwill 20,000

Net profit 1,15,800

5,10,000 5,10,000

Problem 4: Calculate funds from sale of Plant Plant (gross) 1,00,000 1,25,000

Additional information:

a) Loss on sale 1,000

b) Depreciation charged 14,000

c) Purchase of Plant 35,000



Problem: 5. The Balance Sheets are as follows

Capital 25,000 20,000 Cash 4,700 3,000

Profit and Loss 2,300 1,000 Debtors 11,500 12,000

Bills Payable 4,500 7,000 Land 6,600 5,000

Stock 9,000 8,000

31,800 28,000 31,800 28,000

Prepare a statement of Sources and uses of funds.

Answer Self Assessment Questions

Self Assessment Questions 1 1. Derived, changes, assets, equities

2. Two

3. Inside and outside

4. Cash and cash equivalents Self Assessment Questions 2 1. Cash, working capital, total financial resources

2. Control

3. Short term financial planning

4. Current assets minus current liabilities

5. Excluded

6. Short term liquidity

7. Both financial and investment transaction

8. Qualitative information

Self Assessment Questions 3 1. Changes, assets and liabilities

2. Financial strengths and weaknesses


1. Financial assets and liabilities including capital

2. Statement of changes in working capital, statement of sources and uses of funds



3. Net increase or decrease in individual items

4. Increases

5. Decreases

6. Decreases

7. Increases

8. Positively corelated

9. Inversely related

Self Assessment Questions 5 1. Application

2. Source

3. Gross profit – Cost of goods sold + expenses

4. Non fund revenue, non trading changes or losses

5. intangible assets and revenue items

6. Appropriation of retained earnings.

Self Assessment Questions 6 1. Inflow

2. Inflow

3. Inflow

4. Inflow

5. Inflow

6. Inflow

7. Inflow


1. Source

2. Excluded from fund flow statement.


1. Source of funds

2. Source of funds


1. Addition of shares, accumulated retained earnings

2. Expansion, diversification and modernization



3. Increases

4. Source

5. Increases and never decreases

6. Redemption

Self Assessment Questions 10 1. Outflow of cash

2. Outflow of cash

3. Outflow of cash

4. Outflow of cash

5. Outflow of cash

6. Outflow of cash

7. Outflow of cash.

Self Assessment Questions 11 1. Purchase

2. Current year minus previous year

3. Increase in fixed assets


1. Outflow

2. Deduction.


1. Loss of operation

2. Payment of cash dividend out of accumulated reserves

3. Part of paid up capital + reserves and surplus. Self Assessment Questions 14

1. Change of fund

2. Source

3. Application

4. Non fund

5. Change.

6. Positive



7. Negative.


1. Current assets and Current liabilities.


1. Schedule of changes in working capital 2. Adjusted Profit and Loss account 3. Funds flow statement


1. Two Balance sheet dates 2. (b) A minus B 3. (c) Current assets 4. Current liabilities 5. A minus B 6. Balancing figure.


1. Reserve

2. Deduction

3. Working capital changes

4. Considered as current liabilities

5. In Provision account

6. Liability

7. General Body Meeting

8. Current liability

9. Outflow

10. Current assets

11. Fixed assets

12. Fall in value

13. Non cash item

14. Opening balance



15. Provision account and not to Profit and Loss account

16. Fixed assets

Answer for Terminal Questions 1: 35,000, (b) Taxes paid is an application of funds.

2. Rs.24,000

3. Rs.1,50,000

4. Fund Rs.45,000; Accumulated Depreciation on plant sold Rs.9,000

5. Funds lost from operations. Rs.1,300, Decrease in WC Rs.4,700)



Unit 11 Cash Flow Analysis


Objectives

11.2 Meaning


11.3 Objective


11.4 Uses


11.5 Steps in preparation


11.6 Difference between CFS and FFS


11.7 Computation


Terminal Questions


11.1 Introduction The funds flow analysis deal with the flow of funds within and outside the organization. The main

focus of funds flow statement is to explain the changes which have taken place in net working

capital during the period under consideration. Funds flow statement normally fails to explain the

changes in cash balance. The movement of cash is of vital importance to the management. The

organization may become directionless if the cash inflows are not sufficient to meet the cash

outflows. Many a time, a management is posed with the paradox of huge profits and yet

impossible to pay dividends or even taxes. This is due to the ground realities that cash is either

not received or the cash received is drained out in other items. Hence, it has become a

necessity to have a cash flow analysis on a day to day basis. The statement shows the items

resulting in cash inflows and cash outflows.





1. Understand the meaning of cash flow statement.

2. Appreciate the uses of cash flow statement.

3. Acquaint with steps in preparation of CFS.

4. Distinguish between FFS and CFS.

5. Compute the CFS.

11.2 Meaning of Cash Flow Statement Cash flow statement, also known as “Statement Accounting for variations in cash” shows the

movement of cash and their causes during the period under consideration. The statement is

mainly prepared to show the impact of financial policies and procedures on the cash position. It

takes into account all the transactions that have a direct impact upon cash. Self Assessment Questions 1

1. CFS is also known as __________________.

2. CFS is prepared to Know ______________.

11.3 Objectives The main objective of cash flow analysis is to show the causes of changes in cash balances

during the period under consideration. The necessary information required to keep the

management of the real cash position, this statement is comes handy. It bring in the liquidity

position of the firm. It is of particular importance in short range planning. It enables a

management to take a strong short term financial decision relating to liquidity and ways and

means to achieve it.


1. Main objective of CFS is _______________.

2. CFS brings in ___________________ position.

3. CFS is ________________ of importance in ________ planning.

11.4 Uses of Cash Flow Statement The cash flow statement, being one of the important financial documents a firm has to possess ,

reveals the effective uses. First of all, it explains in depth the reasons for the low cash balance

available at a particular time. Based on this, it is possible to find the reasons for such a situation.



It also shows the major sources and uses of cash. By effectively maintaining the cash and

controlling the outflow of cash, it is possible to set in motion the smooth functioning of the

organization. It helps the financial decisions more effectively with regard to short term liquidity

position of an organization. Projections of cash inflows and outflows can be regulated based on

the records available in the past. Proper projections can be made once the reasons are

analyzed. Based on this, it is possible to liquidate the short term obligations without much fun

fare. Short term obligations need to be serviced so that the credit worthiness of an organization

can be carried on unabated.


1. CFS explain _______________ low cash balance.

2. CFS shows _________ flows.

3. CFS helps ________decision ______________ position.

11.5 Steps In Preparation Of Cash Flow Statement The Cash Flow Statement (CFS) is prepared with the help of Balance Sheet. , income statement.

The measurement of cash flow is primarily based on income statement. Under the CFS, the cash

basis technique is adopted. The measurement of cash flow is not measurement of net income.

The CFS depends primarily on determining cash receipts and disbursements over a given period.

The CFS is concerned with cash inflows sources of cash_ and cash outflows (application of

cash).The sources and application of cash are computed separately.

The various sources for cash inflows are :

Cash Sales : When a concern is doing its business on cash basis, the cash flows in out of sales

effected. When the cash sales are in vogue, it is quite natural that the business also effects its

purchases on cash basis. In addition, the operating expenses should be payable in cash.

Therefore the cash inflow should be as follows :

Cash inflow from cash sales = Cash sales – cash purchases – operating expenses. In addition, if the business is conducted both on cash and credit basis, then from the total sales

effected, deduct the credit sales. Therefore the cash sales is : Total sales – credit sales

OR Total sales – increase in debtors and Bills receivable.

So also, the cash purchases are also dealt with in the same manner as discussed with cash

sales.



Net Profit method : Cash from operations can be determined with the net profits figure also.

This method is handy when the amount of sales is not known In this case, non cash and non

trading expenses and losses are added back to net profit. From this, the income from

investments, increase in Accounts Receivable, increase in prepaid expenses, decrease in

outstanding expenses are deducted.

In addition to the above, operating profits are also considered as cash from operations, such as

increase in share capital, debentures, loans, other receipts such as dividends, interest on

investment, and reduction in or sale in assets.

Cash outflows : These refers to uses or application of cash. These arises due to operating loss,

redemption or repayment of redeemable preference shares or debentures, repayment of loans,

purchase of assets, other revenue payments such as dividend, income tax , interest,

compensation.

Self Assessment Questions 4 1. CFS is prepared with the help of ____________.

2. CFS is based on _________ technique.

3. CFS is ____________________.

4. Cash sales refers_________________.

5. Cash flow _______________________.

6. For credit transaction the equation is cash flow = total sales______________.

7. Cash outflow = total purchase ____________________.

8. Net profit method is used when __________ not known.

9. ______ and ______ added back to net profit.

10. Cash outflow refers to________________.

11.6 Difference Between Cash Flow And Funds Flow Statement The major differences between the two are :

1. FFS is related with accrual basis whereas CFS is on cash basis. For this the, it is

necessary to convert the accrual to cash basis.

2. In FFS, a Schedule of changes in working capital delinking the current assets and current

liabilities are made. But in FFS, no schedule is prepared.

3. FFS shows the causes of the changes in net working capital. CFS shows the causes for

the change in cash

4. In FFS, no opening or closing balances are recorded. But in CFS both are incorporated



5. FFS is not based on the Ledger mode. But CFS is prepared on the basis of Ledger

principles.

6. In FFS, “To” and “By” are indicated. In CFS, these are indicated.

7. In FFS, net effect of receipts and disbursements are recorded. In CFS only cash receipts

and payments are recorded.

8. FFS is concerned with the total provision of funds. CFS is concerned with only cash.

9. FFS is flexible but CFS is rigid

10. FFS is more relevant for long range financial strategy. CFS concentrates on short term

aspects mostly affecting the liquidity of the business.

Self Assessment Questions 5 1. FFS is __________ basis CFS is __________.

2. Statement of working capital is the _____________. And not the ______________.

3. In FFS __________ balance not recorded but CFS _____________.

4. CFS is ____________ mode but FFS_______

5. FFS ________ receipts are recorded in CFS________

6. FFS is _________ CFS ___________.

11.7 Computation Of Cash From Operations The Cash Flow Statement should be prepared as per the revised Accounting Standard issued by

the ICAI . Accounting Standards 3 specifies : “The cash flow statement should report cash flows

during the period classified by operating, investing and financing activities”. As per the revised

standard, there are two methods of preparing cash flow statement namely Direct method and

Indirect method. In this Study material, indirect method is adopted throughout.

Format CASH FLOW STATEMENT AS PER AS 3

For the year ended ………..

A Cash flow from operating activities :

Net profit before taxes and extraordinary items

ADJUSTMENTS FOR ;

1, Depreciation

2. Miscellaneous expenses written off

3. Loss on sale of fixed assets



4. interest expenses

5. Dividend income

Operating profit before working capital changes

ADD : Decrease in current assets

Increase in current liabilities

Deduct : Increase in current assets

Decrease in current liabilities

Cash Generated from operating activities

B. CASH FLOWS FROM INVESTING ACTIVITIES Purchase of fixed assets

Sale of fixed assets

Purchase of long term investment

Sale of long term investment

Interest received

Dividend received

Capital gain tax on income from sale of long term investment

Net cash from investing activities

C. CASH FLOWOS FROM FINANCING ACTIVITIES

Proceeds from issue of share capital

Proceeds from long term borrowing

Repayment of long term borrowings

Interest paid

Dividend paid

Tax on distributed profit

Net cash from Financing Activities

Total of A + B +C

Net Increase or Decrease in cash and cash equivalents

Add : Cash and cash equivalents opening balance

Cash and cash equivalents : closing balance

Classification of cash flows :



Cash flow statement has been divided into three parts namely:

1. Cash flows from Operating Activities

2. Cash flows from Investing Activities

3. Cash flows from Financing Activities

CASH FLOWS FROM OPEPRATING ACTIVITIES Meaning : Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.,. Therefore, they generally result

from the transactions and other events that enter into the determination of net profit or loss.

Object : The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain

the operating capability of the enterprise, pay dividends, repay loans and make new investments

without recourse to external source of financing. Information about the specific components of

future operating cash flows is useful in conjunction with other information in forecasting future

operating cash flows.


1. CFS is prepared as a per _________.

2. CFS deals with ____, __________, _____________activities .

3. CFS is based on 2 methods _____________ and _______________.

4. Operating Activity is based on __________.



Problem 1: Compute the cash flow from operating activities

Profit and Loss Account

To By

Cost of goods sold 4,00,000 Sales including cash sales 5,00,000

1,00,000

Office expenses 12,000 Profit on sale of land 30,000

Selling expenses 8,000 Interest on investment 20,000

Depreciation 6,000

Loss on sale of plant 4,000

Goodwill written off 3,000

Income tax 7,000

Net Profit 1,10,000

__________ _________

5,50,000 5,50,000

Position of current assets and current liabilities are as follows :

MARCH 31

2006 2007

Stock 30,000 28,000

Debtors 15,000 12,000

Bills Receivable 6,000 8,000

Creditors 10,000 12,000

Bills Payable 8,000 5,000

Outstanding expenses 4,000 5,000

Solution Statement showing cash flows from operating activities

Net Profit before tax and extraordinary items 1,10,000

ADD : income tax 7,000

Adjustments for Depreciation 6,000

Goodwill written off 3,000

:Loss on sale of plant 4,000



1,30,000

Less: Profit on sale of land 30,000

Interest received 20,000

( 50,000 )

Operating profit before working capital changes 80,000


Stock 2,000

Debtors 3,000

Increase in current liabilities : Creditors 2,000

Outstanding expenses 1,000

8,000

88,000

Less Increase in current assets : Bills Receivable 2,000

Decrease in current liabilities : Bills payable 3,000

( 5,000)

Cash generated from operating activities 83,000

Less : Payment of income tax ( 7,000 )

Net Cash from operating Activities 76,000

As per AS – 3, Net profit before taxation must be shown here.

Problem 2 : Calculate cash flow from operating activities

MARCH 31

2006 2007

Debtors 1,00,000 80,000



Creditors 30,000 40,000

Outstanding expenses 10,000 8,000

Income received in advance 1,000 800



Prepaid expenses 600 500

Accrued income 300 450

Operating profit before working capital changes Rs.3,80,000

Solution Statement showing cash flow from operating activities

Operating profit before working capital changes 3,80,000


Debtors 20,000

Prepaid expenses 100


Creditors 10,000

Outstanding expenses 2,000

32,100

4,12,100

Less : Increase in current assets

Bills receivable 5,000

Accrued income 150

Decrease in current liabilities

Bills payable 8,000

Income receivable in advance 200

(13,350)

Net cash from operating activities 3,98,750

Problem 3: The following is the position of current assets and current liabilities March 31

2006 2007

Short term loan 15,000 18,000

Creditors 30,000 8,000

Provision for Doubtful debts 1,200

Bills Payable 18,000 20,000

Stock in trade 15,000 13,000




Prepaid expenses 800 600

Outstanding expenses 300 500

Current year net loss is Rs.38,000. Calculate the cash flows

Solution Statement showing cash flows from operating activities

Net Loss ( 38,000 )

ADD: Decrease in Current Assets

Provision for doubtful debts 1,200

Stock 2,000



Outstanding expenses 200

Bills payable 2,000

+ 5,600

__________

32,400 )

DEDUCT ; Increase in current assets

Short term loan 3,000

Bills receivable 10,000

Creditors 22,000

+ 35,000

Net cash loan in operating activities ( 67,400 )

Problem 4: Following extracts are in respect of a company.

MARCH

2006 2007

Debtors 30,000 10,000

Stock 25,000 28,000

B.R. 40,000 8,000

Short term loan 10,000 11,000

Prepaid expenses 8,000 8,100



Creditors 10,000 20,000

B.P. 6,000 2,000

Outstanding expenses 600 300

The current year net loss is Rs.50,000. Calculate the cash flows.

Solution : Statement showing cash flows from operating activities

Net Loss ( 50,000 )

Add: Decrease in current assets

Debtors 20,000

B.R. 32,000


Creditors 10,000

+ 62,000

+ 12,000

DEDUCT : Increase in current assets

Stock 3,000



B.P. 4,000

Outstanding expenses 400

(8,500)

Net cash from operating activities + 3,500

Terminal Questions 1. What are the objectives of cash flow statements ?

2. Mention the steps involved in the preparation of CFS ?

3. Distinguish between cash flow and fund flow statements.

4. Compute cash flows from operating activities

March

2006 2007

Profit and loss account 1,00,000 80,000

Debtors 90,000 72,000



Bills receivable 50,000 48,000

Stock 60,000 42,000


Goodwill 20,000 8,000

Prepaid expenses 5,000 4,000

Creditors 26,000 38,000


5. Cash transactions in respect of DR Ltd are as follows :

Balance of cash on hand 70,000 Payment to creditors 25,00,000

Receipts from Debtors 30,00,000 Purchase of fixed assets 2,50,000

Issue of shares 8,00,000 Payment for overheads 1,50,000

Sale of fixed assets 2,00,000 Salaries 70,000

Income tax 1,00,000

Dividend paid 80,000

Repayment of loan 1,50,000

Closing balance of cash 7,70,000

40,70,000 40,70,000

Prepare a cash flow statement

Answer Self Assessment Questions:


1. Statement Accounting for variation in cash

2. Financial polices and procedures

Self Assessment Questions 2 1. show causes of changes.

2. Liquidity

3. short term.

Self Assessment Questions 3 1. reasons.

2. major



3. financial, short term liquidity

Self Assessment Questions 4 1. B.S. income statement.

2. cash basis

3. measurement of net income

4. sale through case only

5. cash sales – cash purchase – operating expenses.

6. credit sales

7. minus credit purchases

8. sales

9. cash and non trading expenses and losses.

10. application of cash.

Self Assessment Questions 5 1. accrual, cash

2. FFS , CFS

3. opening and closing, recorded.

4. ledger, not

5. net effect, cash receipts.

6. flexible, rigid.

Self Assessment Questions 6 1. AS 3

2. operating, investing and financing.

3. Direct, Indirect.

4. profit and loss account

Answer for Terminal Questions 1. Refer to unit 11.2 and 11.3



4. Net cash from operating activities Rs 13,000

5. Net cash from operating activities Rs 1,80,000

Cash flows from investing activities Rs 50,000

Cash flows from financing activities Rs 5,70,000



Unit 12 Understanding Cost


Objectives

12.2 Meaning


12.3 Concepts

Self Assessment Question 2

12.4 Components


12.5 Total cost


12.6 Cost sheet


12.7 Format


12.8 Valuation of WIP


Terminal Questions


12.1 Introduction The need for accounting arose because of limitations of human memory. To preserve the

knowledge, various steps are taken both in the past and in future. It is necessary to record all the

business purposes. Accounting is a science as well ass an art of recording the business

transactions in the books of accounts systematically and scientifically.

Until the1980s, the Cost Accounting was in the domain of the Engineer. Its integration with

financial accounting started when Accountants started to audit the cost records. The costing

technique play a vital role in gathering and analyzing revenue and cost data to assist

management in decision making. The point of emphasis has logically shifted from cost

accumulation to cost analysis, a change from a limited cost finding function on to a broader



managerial function. All managerial policies and decisions permeate all phases of cost

accounting and cost information helps in :

Acquiring plant and machinery

Adding or reducing a product

Buying or making parts

Special pricing of products

Replacement of equipments.


1. Explain the meaning of cost.

2. Analyse the cost concepts.

3. Understand the element of cost.

4. Familiarize with components of total cost.

5. Prepare the statement of cost.

6. Understand the valuation procedure of work in progress.

12.2 Meaning Of Cost Cost is the amount of resources given up in exchange of some goods and services. The

resources are expressed in money or money’s equivalent. CIMA defines the term Cost as “ the

amount of expenditure (actual or notional) incurred on or attributable to a given thing.”. The given

thing may be taken as a product, service or any other activity. While the actual expenditure refers

to the amount spent , the notional expenditure does not involve in any cash outlay. It does not

reflect itself in the accounting records. But, it is important for the purpose of comparison of cost

and in decision making.

Self Assessment Questions 1 1. CA ___________ resources scarified .

2. Resource are in _________________.

12.3 Cost Concepts Cost represents expenses. It is a sacrifice in advance. It concerns with a release of something of

value. The cost is used :

The expected cost of a particular action. It is what the cost is expected to be in

choosing a course of action.



The cost of something purchase i.e. the price actually paid for it. It is the price paid or payable,

time of purchase of goods or services. The price paid is the amount of money, the holding of

which is foregone.

The cost of attaining some end – the sacrifices actually made to attain it experienced costs.


1. Cost is ________________.

2. cost __________ advance.

12.4 Component Or Element Of Cost Any product that is manufactured, whether a pin or a computer calls for consumption of some

resources. The management, for its planning and control function must know the cost of using

their resources. Therefore, the elements of costs are classified as materials, labor and

expenses. These three elements of cost would be grouped in to direct and indirect categories

Following are the three broad elements of cost

Materials

Labor

Expenses

Materials: The term materials may be defined as the substances from which products are

manufactured. These materials may be in a raw or a manufactured state. Materials may be

direct or indirect.

It is an accepted fact, based on statistics, that 75% of the total cost is in the form of raw materials.

These are the physical; items used in manufacturing. These are the physical items used in

manufacturing. These can be traced precisely and convincingly to the unit of product. It refers to

Cost

Direct Indirect

Raw Material

Labor Chargeable Expenses

Material Labor Overheads



all materials brought for being converted into finished product example log of wood awaiting to be

converted into doors and windows. Therefore, the term “raw” indicates that the firm using the

materials has not yet processed them. But what is raw material for one manufacturer might be a

finished product for another : for example bricks, cement, steel is a raw material for a

construction company where for a steel producing firm it is the final product. For admission to I

MBA, the raw materials are the graduates.

Indirect materials: These are materials which do ot become part of the product. These

materials are consumed in the course of production. These materials cannot be conveniently

assigned to specific physical units. Some of the indirect materials are consumable stores, oil,

lubricants, cotton wastes, printing and stationers. Indirect materials may relate to the factory, the

office and administration and the selling and distribution divisions.

Direct Labor: It represents wages payable / paid to those employees who directly engaged in the

conversion of raw materials into final product. They operate in the manufacturing machinery and

equipment. They directly handle the raw materials, work in process and the finished goods on

the production line. They account is to see whether the work done on a particular product or a

specific group of products.

Examples: In a furniture mart, the carpenters engaged in conversion of raw wood with sofa set, computer tables, windows, doors , benches are said to be the direct workers. In an engineering

workshop, the wages paid to the operators working with laths, drilling, cutting, shaping machines

can be specifically assigned to the products concerned. Therefore, the direct labor costs can be

traceable to individual products.

Indirect Labor: Indirect labor is the labor which is not directly engaged in the production operations. They are, however, engage themselves to help in the production operations. Such

labor does not alter the construction, composition or conditions of the product. Example

foreman’s salary, storekeepers salary, Factory manager’s salary etc. The indirect labor may

relate to the factory, office and administration and selling and distribution divisions.

Chargeable Expenses : The items are of expenses which may be allocated to a specific job, process or operation. The utility of expenses is exhausted on completion of the job concerned.

Therefore, logically, they are treated as direct expenses. The chargeable expenses are usually

incurred when the business concern undertakes some outside constructional work far away from

the principal premises, example widening of road by L & T construction company for the new

International Airport. The popular items fall under this category are:



a) cost of pattern, designs, drawings specifically prepared for a particular job

b) hire charges of special machinery, plant or equipment

c) architects and surveyors fees in connection with particular job or contracts.

d) Cost of any experimental work carried out for a particular job

Indirect expenses: These are those expenses which cannot be directly and conveniently allocated to specific cost units / cost centers.. They are apportioned. Examples are rent, rates

and insurance. They may relate to the factory, the office and administration and selling and

distribution divisions. These are now popularly known as “overheads”. These costs arise as a

result of overall operations of a business. These costs are shared by all the products. It includes

all manufacturing and nonmanufacturing suppliers and services. These costs cannot be

associated withy a particular product or unit. Overheads remain relatively constant from period to

period. At least they do not fluctuate in amount in relations to changing levels of factor

production. Overhead costs are classified by functions of an organization into :

Factory, works or manufacturing overheads

Administration, office, establishment or general overheads

Selling and distribution overheads.

Self Assessment Questions 3 1. Cost compose ________________

2. Direct cost include__________.

3. Indirect cost are know as ___________.

4. Raw refers to ______________.

5. Indirect materials cannot be _____________.

6. Direct labor is ____ for __________.

7. Indirect labor is engaged for ________.

8. Chargeable expenses are ____________

9. Chargeable expenses are______________________ expand.

10. Indirect expenses are ________________.

11. IDE are known as _________________.

12.5 Components Of Total Cost The components of total costs are based on functional classification. The various stages through

which the costs flow are:



Prime cost : It is the total of direct materials cost, direct labor cost and chargeable expenses/

Factory Cost : It consists of prime cost and factory overheads/

Office cost or Cost of Production: It comprises of factory cost and office and administration

overheads.

Total Cost : By adding selling and distribution expenses to cost of production, one can get the

total cost or cost of sales.


1. Prime cost is _______________.

2. Factory cost is _____________.

3. Cost of production is _____________.

4. Total cost is ___________________.

5. Sales is _________________.

6. Profit is __________________.

12.5 Statement Of Cost Sheet Cost sheet is a statement prepared to show the different components of the total cost. It

generally shows the total cost and sales as well as cost and selling price per unit. It is generally

presented in a tabular form.

Self Assessment Questions 5 1. Cost sheet shows ___________ cost.

2. It is prepared _________ form.



12.5 Format Specimen Of Cost Sheet Name of Company _______________________________

Cost sheet for the product __________________________

For the year ending _______________________________

Output in units

Particulars Total Per unit Rs. Rs.

Raw Materials consumed: Opening Stock of Raw Material ADD: Purchases of Raw materials Add: Carriage on purchases LESS: Closing stock of Raw material

Raw Material Consumed (RMC) x x x Director Labor x x x Chargeable Expenses x x x

Prime Cost XXX Factory overheads x x x

Factory Cost XXX Office and Administration Overheads x x x

Cost of Production XXX

Inventory valuation Opening stock of finished goods xxx Less: closing stock of finished goods : always

To be valued at cost of production ( xxx )

Cost of Goods Sold (COGS) XXX Selling and Distribution Overheads x x x

Total Cost of Cost of Sales XXX Profit (balancing figure) x x x

Sales Revenue or Sales XXX



Example:

Prepare a cost sheet Raw materials consumed Rs.1,60,000. Direct wages Rs.80,000. Factory

overheads Rs.16,000. Office overheads 10% of factory cost. Selling overheads Rs.12,000. Units

produced 4,000.Selling price per unit Rs.100.

Solution: Cost Sheet

Raw materials 1,60,000 Direct wages 80,000

Prime cost 2,40,000 Factory overheads 16,000

Factory Cost 2,56,000 Office overheads (10 % of factory cost) 25,600

Cost of Production 2,81,600 Less : Closing stock of finished goods to be valued at

Cost of production : 2,81,600 x 400 */ 4000** ( 28,160)

Cost of Goods Sold 2,53,440 Selling overheads 12,000

Cost of Sales / Total Cost 2,65,440 PROFIT (balancing figure) 94,560

Sales (3600 x Rs.100) 3,60,000

*Closing stock in units : Units produced minus units sold

**Denominator should be the current year production in units.

Items not included in Cost Sheet:

a) Income tax

b) Dividends to shareholders

c) Commission to managing directors

d) Capital losses i.e. loss out of sales

e) Interest on loan or debentures or bank interest

f) Donations

g) Capital expenditure

h) Discounts on shares and debentures

i) Premium on redemption of shares and debentures

j) Underwriting commission



k) Writing of goodwill, preliminary expenses

l) Reserve for bad debts

m) Transfer to all reserves or appropriation of profits

n) Share premium

o) Interest on capital

p) Drawing of proprietors

q) All personal expenses of owner

Self Assessment Questions 6 1. RMC is ___________.

2. COGS is _____________.

3. Closing inventory is valued _____________________.

4. Profit ______________ figure.

12.6 Valuation Of WorkinProgress In a manufacturing enterprise, there may be certain amount of goods in a partly manufactured

state at the end of a particular period. These are called as “semi manufactured goods” or “work

in progress”. The WIP is valued according to the value of raw material, labor and expenses

which has so far incurred to the date of closing of financial period. The work in progress has

usually three components:

Material work in progress cost to date

Labor to date

Manufacturing expenses incurred to date

The treatment of work in progress is to add the opening work in progress to the concerned cost

and deduct the closing work in progress against it.

Self Assessment Questions 7 1. WIP is nether ____________ nor __________.

2. WIP is treated as ________________.

3. Profit margin as total cost is _____________.

4. Profit margin as selling price is ___________.

5. 25% profit on SP is ______________.

6. 25% on TC is ___________.

Example: DR Ltd manufactures Electronic components. The following figures are supplied Rs.



Purchase of Raw Material 2,00,000. Direct labor 1,20,000. Carriage inwards 20,000

Manufacturing expenses 10,000. Stock of raw materials : opening 25,000, closing 75,000. Work

in progress on 1:4:2006 : Materials 2,000 Labor 5,000 Expenses 1,000. Calculate the Factory

cost..

Solution: COST OF PRODUCTION FOR THE YEAR ENDED 31 st March 2008

Direct Raw materials consumed: Opening stock of raw material 25,000

Add: Purchase of raw materials 2,00,000

Add: carriage inwards 20,000

Less: Closing stock of raw materials (75,000)

Add: Opening Work in progress of materials 5,000

Less: Closing work in progress of materials (2,000)

Raw materials consumed 1,73,000

Director Labor 1,20,000

Add: Opening WIP of labor 8,000

Less: Closing WIP of labor (5,000)

_________ 1,.23,000

___________ PRIME COST 2,96,000

FACTORY OVERHEADS

Manufacturing expenses 10,000

Add:: opening WIP of expenses 2,000

Less : Closing WIP of expenses ( 1,000)

___________ 11,000

____________ Factory Cost 3,07,000

Problem 1:

Calculate the cost of raw materials purchased: Opening stock of raw materials Rs.10,000.

Closing stock of raw materials Rs.15,000. Expenses on purchases Rs.5,000. Direct wages

Rs.50,000 Prime cost s Rs.1,00,000.



Solution:

Computation of cost of raw materials purchased

Opening Stock of raw materials 10,000

Add Purchases X

Expenses on purchases 5,000

___________

15,000 + X

Less closing stock of raw materials (15,000)

____________ Raw materials consumed X

Direct wages 50,000

_____________ Prime Cost 50,000 + X

Prime cost given in the problem is Rs.1,00,000

Hence substituting , 1,00,000 = 50,000 + X; Therefore X = Rs.50,000

Cost of Raw Materials is Rs.50,000



Problem 2:

Prepare a cost sheet:

Direct materials Rs.2,00,000. Factory expenses Rs.1,20,000. Office expenses Rs.90,000

Total sales Rs.6,50,000. Prime cost Rs.4,10,000 . 10 % of the output is in stock.

Solution: Cost Sheet

Direct materials 2,00,000

Direct wages (Prime cost minus Direct materials 2,10,000

_____________ Prime Cost 4,10,000

Factory expenses 1,20,000

_____________ Factory Cost 5,30,000

Office expenses 90,000

_____________

Cost of Production 6,20,000

Less: closing stock of finished goods 10 % of 6.20,000 ( 62,000.)

_____________

Cost of Sales 5,58,000

Profit (balancing figure) 92,000

_____________ SALES 6,50,000

Problem 3 : The following information is obtained:

Stock on Jan 1, 2007 : Raw materials 40,000; Finished goods 30, 000. Purchases of Raw

materials 2,40,000. Direct wages 1,36,000. Works expenses 70,400. Dividends paid 40,000.

Office expenses 24,000. Depreciation 10,000. Selling and Distribution expenses 32,000. Work in

progress : 1.1.2007 64,000. 31:.12.:2007 72,000. Goodwill written off 40,000. Stock on

31.12.2007 Raw materials 42,000 Finished goods 32,000. Sale of finished goods 5,50,000.

Payment of sales tax 16,000. Prepare a cost sheet.



Solution Cost Sheet

Opening stock of Raw materials 40,000 Add: Purchases of raw materials 2,40,000 Less: Closing stock of raw materials ( 42,000)

___________ Raw materials consumed 2,38,000

Direct wages 1,36,000 ____________

Prime Cost 3,74,000 Works Overheads Works expenses 70,400 Depreciation 10,000

____________ 4,54,400

Add : opening stock of WIP 64,000 Less: Closing stock of WIP ( 72,000)

____________ Works Cost 4,46,400

Office and Administration overheads Office expenses 24,000

____________ Cost of Production 4,70,400

Add : opening stock of finished goods 30,000 Less : Closing stock of finished goods ( 32,000)

____________ Cost of Goods sold 4,68,400

Selling and Distribution expenses 32,000 _____________

Cost of Sales 5,00,400 Sales Tax 16,000

_____________ Total Cost

5,16,400 Profit 33,600

_____________ Sales 5,50,000



Problem 4:

Prepare a cost sheet

Raw materials Rs.33,000. Unproductive wages Rs.10,500. Factory lighting Rs.2,200. Motive

power Rs.4,400. Director’s fees (Works) Rs.1,000. Factory cleaning Rs.500. Factory stationery

Rs.750. Loose tools written off Rs.600. Water supply Rs.1,200. Office insurance Rs.500.

Chargeable expenses Rs.3,000. Depreciation: Plant and machinery Rs.2,000. Office Building

Rs.1,000. Delivery vans Rs.200. Upkeep of Delivery van Rs.700. Commission on sales Rs.1,500.

Productive wages Rs.35,000. Factory rent and taxes Rs.7,500. Factory heating Rs.1,500.

Haulage Rs.3,000. Director’s fees (office) Rs.2,000. Sundry office expenses Rs.200. Office

stationery Rs.900. Rent and taxes (office) Rs.500. Factory insurance Rs.1,100. Legal expenses

Rs.400. rent of warehouse Rs.300. Bad debts Rs.100. Advertising Rs.300. Sales Department

salaries Rs.1,500. Bank charges Rs.50, Reserve for Doubtful debts Rs.100..Debenture interest

Rs.20,000. Income tax Rs.22,500. Total output 20,000 tons.

Solution

Statement of Cost (Production 20,000 tons)

Direct materials consumed 33,000

Productive wages 35,000

Chargeable expenses 3,000

____________ Prime Cost 71,000

Works Expenses Unproductive wages 10,500

Factory rent and taxes 7,500

Factory lighting 2,200

Factory heating 1,500

Motive power 4,400

Haulage 3,000

Director’s fees 1,000

Factory cleaning 500

Factory stationery 750

Loose tools written off 600

Water supply 1,200

Factory insurance 1,100



Depreciation of Plant and machinery 2,000

__________ 36,250

____________ Factory / Works cost 1,07,250

Office and Administration expenses

Director’s fees 2,000

Sundry expenses 200

Office stationery 900

Rent and taxes 500

Office insurance 500

Legal expenses 400

Bank charges 50

Depreciation of office building 1,000

_____________ 5,550

__________ Cost of Production 1,12,800

Selling and Distribution Expenses Rent of warehouse 300

Depreciation of Delivery vans 200

Bad debts 100

Advertising 300

Sales Department salaries 1,500

Upkeep of Delivery van 700

Commission on sales 1,500

4,600

Total Cost / Cost of Sales 1,17,400

Cost Per unit : Total Cost / No of Units produced : 117400 / 20,000 Rs.5.87

Note: Ignore reserve for doubtful debts. Ignore Income tax

Ignore Debenture interest



Problem 5:

The following extract refers to a commodity for the half year ending 31 st March 2008. Prepare a

cost statement.

Purchase of raw materials Rs.1,20,000. Rent, rate, insurance and works expenses Rs.40,000.

Direct wages Rs.1,00,000. Carriage inwards Rs.1,440. Opening stock Raw materials Rs.20,000,

Finished goods (1000 units) Rs.16,000. Closi9ng stock : raw material Rs.22,240 Finished Goods

(2,000 tons). Work in progress : opening Rs.4,800 and closing Rs.16,000. Sale of finished goods

Rs.3,00,000. Cost of factory Rs.8,000.

Advertising, discounts allowed and selling costs Re.1 per ton sold. Production during the year is

16,000 tons. Prepare a cost sheet.

Solution

Statement of Cost Direct materials

Opening stock or raw materials 20,000

Add: Purchases of raw materials 1,20,000

Add : carriage inwards 1,440

Less: Closing stock of raw materials (22,240)

____________ Raw materials consumed 1,19,200

Direct Wages 1,00,000

__________ Prime Cost 2,19,200

Works Expenses

Cost of factory 8,000

Rent, rate and insurance 40,000

Add: opening WIP 4,800

Less: Closing WIP (16,000)

__________ Factory / Works cost 2,56,000

Office and administration expenses Nil

__________

Cost of production 2,56,000



Inventory valuation

Opening stock of finished goods 16,000

Less : Closing stock of finished goods to be valued at cost of

Production (32,000)

__________

Cost of Good Sold 2,40,000

Selling and Distribution Expenses *

Advertisement and discount allowed 15,000

__________

Total Cost or cost of sales 2,55,000

Profit 45,000

__________

Sales** 3,00,000

*To be valued only at number of units sold. Opening stock of finished goods + production minus

closing stock = Number of units sold.

** Always to be valued at number of units sold. Number of units sold x Selling price per unit.

Tender Cost Sheet or Quotations

Frequently, a manufacturer of capital goods and consumer durable goods is required to quote the

price at which he can supply a particular article. Moreover, demand for certain seasonal articles

need to be taken into account. The manufacturer has to fix a competitive price to take care of

inflationary trends on the input. These aspects need an estimation at the production level itself.

For this purpose, consider the following principle:

Works expenses are based on direct wages

Office expenses are based on works / factory cost.

Finally, since the costs are estimated, the profits can be related either to cost or to the selling

price. The formula is : If profit percentage is given on Profit = Total Cost x given percentage ex. Cost price ie. On Total cost for 20 %, TC x 20/100 or 25%, it is TC x 25 / If profit percentage is given on Profit = Total cost x given percentage / 100

Selling price, bring the percentage minus same given percentage eg. For 20 % to cost price TC x 20 / 100 minus 20for 25%, it is

TC x 25 / 100 minus 25 %



Problem 6:

The cost data is as follows:

Raw materials consumed Rs.1,82,000. Direct wages Rs.40,000. Chargeable expenses

Rs.20,000. Opening stock of finished goods (1,000 units) Rs.32,000. Closing stock 2,000 units.

Factory overheads 100 % of direct labor. Office overheads 10% of works cost. Selling of

Distribution expenses Rs.4 per unit sold. Units produced 10,000. Profit markup 20% on selling

price. Prepare a cost sheet.

Solution STATEMENT OF COST

Raw materials consumed 1,82,000

Direct wages 40,000

Chargeable expenses 20,000

_____________ Prime Cost 2,42,000

Factory expenses at 100 % on direct wages 40,000

_____________

Works cost 2,82,000

Office and administrative expenses 10 % of works cost 28,200

_____________ Cost of Production 3,10,200

Inventory valuation

Opening stock of finished goods 32,000

Less : Closing stock of finished goods at COP (62,040)

_____________ Cost of Goods sold 2,80,160

Selling and Distribution overheads at Rs.4 per unit sold 36,000

_____________

Cost of Sales or Total sales 3,16,160

Profit 20 % on Selling Price : TC x 20 / 100 – 20 or . 3,16,160 x 20/100 – 80 79,040

Tender Price being sales 3,95,200



Terminal Questions:

1. The costing records show the following

Raw materials consumed Rs.3,30,400. Direct wages Rs.3,80,000. Closing stock of finished

goods Rs.1`,60,000. Administrative expenses Rs.40,000. Factory expenses Rs.70,000.

Sales Rs.7,56,000 Units produced and sold 4,000. The firm received a quotation for supply

of 1,000 units. Prepare a quotation based on the above data.

2. Costing Department provides the following information:

Total production 5,000 tons. Cost of raw materials consumed Rs.22,00,000. Direct wages

Rs.20,00,000. In direct factory wages Rs.1,00,000. Office expenses Rs.10,00,000. Public

Relations expenses Rs,.50,000. Expenses on testing laboratory Rs.60,000. Selling overheads

Rs.10,00,000. Salary of Managing Director Rs.50,000. Payment of income tax Rs.3,00,000.

Dividends paid Rs.5,00,000. A profit margin of 50 % on cost is provided. The Government

grants a special export subsidy of Rs.1,000 per ton. Prepare a cost sheet.

3. The Trading, profit and loss account of DR is given below

To Cost of materials

Consumed 2,00,000 By Sales 8,00,000

To Direct wages 2,00,000

To Works expenses 1,00,000

To Gross Profit 3,00,000

8,00,000 8,00,000

To Selling expenses 1,00,000 By Gross Profit 3,00,000

To Net Profit 2,00,000

3,00,000 3,00,000

The management estimates the following for the year ending 31 st March :

a) output and sales will be 2000 units.

b) Prices of materials and wages will go up by 25 % of previous year.

c) Works expenses will rise in proportion to the combined cost of materials and wages

d) Selling expenses per unit are estimated at Rs.50

Prepare a cost statement for quotation purposes so as too yield a profit of 10 % on selling price.




Self Assessment Questions 1 1. Amount of

2. Monetary term


1. Expense

2. Sacrifice in

Self Assessment Questions 3 1. Direct and Indirect

2. Raw material, labor, direct expenses

3. Overheads

4. Crude form of a substance.

5. Charged to product

6. Conversion of materials to finished products

7. Production operations

8. Allocated

9. Direct

10. Apportioned

11. Overheads


1. Aggregation of DM, DL and DE.

2. PC + FOHS

3. FC + AOSH

4. COP + DOSH

5. TC + profit

6. Sales – total cost.

Self Assessment Questions 5 1. Components

2. Tabular

Self Assessment Questions 6 1. Opening stock + purchase – closing stock.

2. COP + Inventory valuation.



3. At current year COP

4. Balancing figure between SP and TC.


1. Raw material, finished product.

2. Add opening WIP and deduct closing WIP

3. TC x given percentage.

4. (TC x given percentage) – 100 – given Percentage.

5. TC x 25 / 100 – 25.

6. TC x 25 / 100.

Answer for Terminal Questions 1. Cost of production for 4000 units Rs 8,20, 400; cost of production for 1000 units Rs 2,26,990.

Total cost (4000 units ) Rs 6,80,400 ; (1000 units) Rs 2,26,990; profit for quotation of 1000

units Rs 25,221.

2. Cost of production Rs 54, 60,000 per ton Rs 1092; Total cost Rs 64,60,000 ; per unit Rs

1,292.

3. Total cost of the tender Rs 13,50,000 ; Sales Rs 15,00,000



Unit 13 Marginal Costing and Break Even Analysis

Structure 13.1 Introduction

Objectives

13.2 Concept


13.3 Fixed cost


13.4 Variable Cost


13.5 Marginal cost

13.6 CVP analysis


13.7 Break Even Chart


13.8 Break Even Analysis


13.9 Break Even Point


13.10 Contribution margin


13.11 Equation approach


13.12 Target profit


13.13 Margin of safety


13.14 Application


13.15 Limitation


13.16 Useful equation




Terminal Questions


13.1 Introduction Information is a commodity. It can be purchased, produced and consumed. It can be of high or

low quality, timely or late, appropriate for its intended use or utterly irrelevant like all other goods

and services. Information entails both costs and benefits. While costs refer to other cost of

purchase, cost of compensation, cost of operating computers, cost of time spent by the

information users to read, understand and utilize the information, the benefits include improved

decisions, more effective planning, and greater efficiency of operations at lower costs and better

direction and control of operations.



1. Understand the concept of marginal cost.

2. Distinguish between fixed cost, Variable cost and Marginal Cost.

3. Familiarize with break even chart, break even analysis and break even point.

4. Understand the contribution marginal approach, equation approach, target profit

and margin of safety.

5. Practice the concepts in real life situations.

13.2. Concept Of Marginal Cost According to C.I.M.A. London, “Marginal Cost means the amount at any given volume of output

by which aggregate costs are changed if the volume of output is increased or decreased by one

unit”. Thus, marginal cost is the amount by which total cost changes when there is a change in

output by one unit. Marginal cost per unit remains unchanged irrespective of the level of activity

or output. It is also known as Variable Cost. Marginal cost is the sum total of direct material cost,

direct labor cost, variable direct expenses and all variable overheads. The marginal cost is the

same as the variable cost.


1. Marginal cost is sum total of ________.



13.3 Fixed Cost It involves the way a cost changes in relation to changes in the activity of an organization. The

activity refers to a measure of the organization’s output of products and services example number

of contact classes conducted, number of students passed in MBA, number of cars manufactured

by an Automobile industry, number of meals served by a hotel. The activities that cause costs to

be incurred are called “Cost Drivers”. A fixed cost remains unchanged in total as the level of

activity (cost drivers) varies. If activity increases or decreases say by 20 %, the total fixed costs

remain the same e.g. depreciation, property tax, rent to landlord. But fixed costs per unit will

change.

Self Assessment Questions 2 1. Fixed cost remains constant _________.

2. Fixed cost varies with ______________.

3. Variable cost remains constant with ____________.

13.4 Variable Cost A variable cost changes in total in direct proportion to a change in the level of activity or cost

driver. If activity increases, say by 20%, total variable cost also increases by 20 %. The total

variable cost increases proportionately with activity. Variable cost fixed per unit but varies in total.

Self Assessment Questions 3 1. Variable cost varies with _______________.

2. MC is extra cost incurred ________________.

13.5 Marginal Cost It is extra cost incurrent when one more unit is produced. It typically differs across different

ranges of production quantities because the efficiency of the production process changes. The

marginal cost of producing a unit declines as output increases. It is much more efficient to

produce more than to make only one.

13.6 Cost Volume Profit (CVP) Analysis This technique summarizes the effects of changes in an organization’s volume of activity on its

costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of

changes in selling prices, service fees, costs, incometax rates and the organization’s mix of

products or services. It provides management with a comprehensive over view of the effects on

revenue and costs of all kinds of short run financial changes



Although, the word “profit” appears in the term, CVP analysis is not confined to profit seeking

enterprises. Managers in non profit organizations also routinely use CVP analysis to examine the

effects of activity and other short run changes on revenue and costs. It is being used as a regular

organizational tool. . In CVP analysis, it is necessary that expenses should be categorized

according to their cost behavior that is fixed or variable.

Self Assessment Questions 4 1. CVP refers to change in ________________.

2. CVP provides _________________.

3. CVP is not ______________ concept.

4. CVP focuses on ________________ cost.

13.7 Break Even Chart It is a graphic or visual presentation of the relationship between costs, volume and profit. It

indicates the point of production at which there is neither profit nor loss. It also indicates the

estimated profit or loss at different levels of production. While constructing the chart, the

following assumption is normally considered.

a) Costs are classified into fixed and variable costs

b) Fixed costs shall remain fixed during the relevant volume range of graph.

c) Variable cost per unit will remain constant during the relevant volume range of graph

d) Selling price per unit will remain constant

e) Sales mix remains constant.

f) Production and sales volume are equal

g) There exists a linear relationship between costs and revenue.

h) Linear relationship is indicated by way of straight line.

Self Assessment Questions 5 1. BEP chart is ______________.

2. Its relation is between ________________.

3. It indicates the estimated ____________.

13.8 Break Even Analysis It is an extension of or even part of marginal costing. It is a technique of studying cost volume

profit relationship. Basically, the break even analysis is aimed at measuring the variations of cost



with volume. It is a simple method of presenting the effect of changes in volume on profits. It is

also known as CVP analysis. The various assumptions are:

a) All costs can be classified into fixed and variable

b) Sales mix will remain constant.

c) There will be no change in general price level

d) The state of technology, Methods of production and efficiency remain unchanged.

e) Costs and revenues are influenced only by volume

f) Cost and revenues are linear.

g) Stocks are valued at marginal cost

h) Unit produced and sold are same.


1. BEP studies ____________________ relationship.

13.9 Break Even Point BEP is the volume of activity where the organization’s revenues and expenses are equal. At a

particular amount of sales, the organizations have no profit or loss: it normally breaks even.

Self Assessment Questions 7 1. BEP is a ______________________.

Example DR sells 8,000 pens at Rs.16 per pen. The variable expenses amount to Rs.10 per pen. The

total fixed expenses are Rs.48, 000. Prepare an Income statement.

Solution

No. of pens produced 8,000

No. of pens sold 8,000

Unit selling price per pen Rs.16

Unit variable cost per pen Rs.10

Sales Revenue (Quantity sold x unit selling price)

8000 x Rs.16 1, 28,000

Less Variable Cost (8000x Rs.10) (80,000)

Less: Fixed expenses (48,000)



Profit or Loss Zero

Note that the income statement highlights the distinction between variable and fixed expenses.

13.10 Contribution Margin Approach The contribution margin approach refers to the total sales revenue minus the total variable

expenses. This is the amount of revenue that is available to contribute to covering fixed

expenses after all variable expenses have been covered or recovered.

DR’s firm will break even when the organization’s revenue from pen sales is equal to its

expenses. How many pens must be sold during one month for DR to breakeven?

Each pen sells for Rs.16, but Rs.10 of this is used to cover the variable expense per pen. This

leave Rs...6 per pen to contribute to covering the fixed expenses of Rs.48, 000. When enough

pens have been sold in one month so that these Rs.6 contributions per pen add up to Rs.48, 000,

the organization will break even for the month. The break even can be computed as follows:

Breakeven in Fixed Expenses

Units = __________________________________________________

Contribution of each pen towards covering fixed expenses

Rs.48, 000 / Rs.6 or 8,000 pens

The Rs.6 amount that remains of each pen’s price after the variable expenses are covered is

called the “Unit contribution margin”. The general formula for computing the break even sales

volume in units is:

BEP (in units) : Fixed expenses / unit contribution margin Sometimes, the management prefers that the BEP be expressed in sales rupees rather than unit.

The formula is:

BEP in Rupees: Fixed expenses / Contribution sales ratio The Contribution Sales Ratio is popularly known as “Marginal Contribution Sales Ratio – MCSR “.

Its traditional name is: ‘P/V Ratio. ’

Note: Kindly avoid using the term P / V Ratio and only use the modern concept “MCSR” MCSR = Contribution / Sales x 100

Where Contribution = Sales value minus variable expenses


1. Contribution margin is _______________.



2. BEP in units is _________________.

3. BEP in rupees is ___________________.

4. Contribution is ___________.

13.11 Equation Approach This approach is based on the profit equation. Income or profit is equal to sales revenue minus

expenses. If expenses are separated into variable and fixed expenses, the essence of income or

profit statement is captured by the following equation:

Sales minus Variable Cost = Fixed Cost + Profit S – V = F + P

The contribution margin and equation approaches are two equivalent techniques are two

equivalent techniques for finding g the BEP. Both the methods reach the same conclusion,

hence personal preference dictates which approach should be used.

Self Assessment Questions 9 1. Equation approach is based on ____________.

2. Sales – VC = _______________

3. SV = _________

4. SV = C _________________.

5. C = _______________.

6. C _______ = P.

13.12 Target Profit Based on the experiences gained, an organization may intend to increase the production and

sales. When an organization was to be on its optimum level, a direction will be provided to

achieve the maximum level. In this connection, if one intends to increase the current year

production to higher levels, no variable expenses would be incurred. A target net profit or income

may be decided in advance. To achieve this profit, efforts will be made to effect sales. The

problem of computing the volume of sales required to earn a particular target net profit is very

similar to the problem of finding the break even point. After all, the break even point is the

number of unit sales required to earn a target net profit of zero. The target net profit is known as

“desired profit”. The formula is:



Number of units to be sold: Fixed expenses + Desired or Target profit / Contribution per

unit

Example: Calculate sales in units and in rupees: Units produced 60,000. Selling price per unit

Rs.15. Profits to be earned is Rs.87, 500.

Solution: Sales required in units : Fixed expenses + target profit / contribution per unit or

1,50,000 + 87,500 / 15 10 or 47,500 units or Rs.47,500 x Rs.15 or Rs.7,12,500.


1. Number of units to be sold is _________.

2. Desired profit is also known as ____________.

3. A target profit is set ____________.

13.13 Margin Of Safety The safety margin of an enterprise is the /difference between the budgeted sales revenue and the

break even sales revenue. The safety margin gives management a feel for how close projected

operations are to the organization’s break even point. The formula is:

MOS = Profit / MCSR

Example: Calculate BEP and MOS: Sales at present 50,000 units per annum. Selling price Rs.6 per unit, Prime cost Rs.3 per unit.

Variable overheads Re.1 per unit. Fixed cost Rs.75, 000 per annum.

Solution: BEP = Fixed cost / (SP VC) per unit or 75,000 / 6 4 or 75,000 / 2 or 37,500 units. BEP in rupees: BEP in units x selling price per unit or 37,500 x Rs.6 or Rs.2, 25,000

MOS: Actual Sales – BEP Sales or (50,000 x 6) – 2, 25,000 or Rs.75, 000

Self Assessment Questions 11 1. MOS is ________________

2. MOS is calculated as _______________.

13.14 Applications Of Marginal Costs The marginal costing helps the management in taking many policy decisions. The vital areas

where these concepts are applied directly are as follows:

Level of activity planning: Normally, the managements will consider different levels of

production or selling activities to decide optimum level of activity. Such periodic exercise shall put



the organization in the right tract to achieve its goal. Since the optimum level of activity results in

the maximum contribution per unit, the planning can become a perfect execution tool.

Alternative methods of production: With the help of marginal costing techniques, it’s possible

to undertake decision about the alternate methods of production. All the decisions should be

focused at the greater contribution so that profit can be maintained at a balanced level.

Make or buy decision: Depending upon the situational ambience, the management can have a blue print on a vital decision. Management can think of outsourcing the production activities or to

undertake it within its purview. Based on the comparative statement of cost of manufacture with

the purchase price, decisions can be taken.

Fixation of Selling Price: While pricing a product, the marginal costing techniques can come

handy. While fixing a price for a product, it is prudent to take into account the recovery of

marginal cost in addition to get a reasonable contribution to cover fixed overheads. Pricing will be

at ease once the marginal cost and overall profitability of the concern are known.

Selection of optimum sales mix: The product mix plays an important role when a firm produces more than one product. The main focus will on profit maximization. With the help of marginal

costing techniques, it is possible to decide the best product mix which will result in maximum

profits to the firm.

New Product introduction: When a firm intends to diversify its activities or to expand its

existing markets, with the help of marginal costing techniques. By fixing the time horizon to

recover the fixed costs and profit, decisions can be taken for the introduction of new products.

Balancing of profits: As the economic trends gets changed on account of government fiscal policies and regulations, competition at the regional, national, and international levels, marginal

costing techniques can aid to bring out facts with regard to maintaining a desired level of profits.

Final balancing decisions: If the sales of the product were not encouraging to cover the fixed costs, it is quite natural that the firm may decide about its continuance. This may lead to

dovetailing or completely closing down the operations. Marginal costing helps the management

to take a sound decision.


1. The application is as _______________.

13.15 Limitations Of Marginal Costing There are certain limitations which can be described as follows:



Suitability: The techniques of marginal costing cannot be applied to all the concerns. When a

concern needs to carry large stocks by way of workinprogress, the technique becomes

redundant In addition; the marginal costing techniques are not suitable to industries working on

contract basis.

Inventory valuation difficulties: Since the work in progress and the closing inventories are

valued at marginal cost basis, it will not be a sound decision from the Balance Sheet point of

view. The main focus on the ‘true and fair value’ concept gets diluted and the very purpose of

exhibiting the financial position will get defeated.

Segregation of costs: Though the marginal costing principles call for the differentiation of costs

into fixed and variable, in actual practice it becomes difficult to classify them precisely. Many

overheads which are appear to be fixed and variable may not exactly align at various levels of

production. There is no logical method to segregate semivariable expenses into fixed and

variable.

Time factor: The marginal costing ignores the time factor which is very important for any costing

purposes. Ignoring the time would naturally relate to unreliable and incomplete basis for

comparing two alternative jobs.

Sales emphasis: Marginal costing principles are basically a salesoriented concept. While the

selling function gets the prominence, other functions are not given equal weight age. This would

be a major set back.

Self Assessment Questions 13 1. Limitation include ________________.

13.16 Useful Equations Of Marginal Costing

Some of the useful equation of marginal costing are as follows :

Basic equation : Sales Revenue – Variable Expenses = Fixed Expenses + Profit

Other derivations are as follows

Sales Revenue – Variable Expenses – Fixed Expenses = Profit

Sales – Variable cost s = Contribution

Contribution – Fixed costs = Profit

Sales – Contribution = Variable costs



Marginal Contribution Sales Ratio (MCSR) = Contribution / Sales x 100

MCSR also can be found out : Change in profit / change in sales x 100

MCSR x Sales = Contribution

Sales = Contribution / MCSR

Number of units to be sold = Fixed expenses + Desired Profit / Contribution per unit

Sales required to earn target net profit in Rupees : Fixed expenses + Profit / Marginal

contribution

BEP in units = Fixed expenses / MCSR contribution per unit

BEP in Rupees : BEP in units x Selling price per unit or

Fixed costs x Total sales / Total Sales Variable costs

Margin of Safety : Total Sales – Break Even sales OR

Profit / MCSR where Profit = Sales – Total Costs


1. Basic equation of M.C is __________.

2. Profit is __________.

Problem 1: Find the contribution and profit earned. Selling price per unit Rs.25. Variable cost

per unit Rs.20. Fixed Cost Rs.3,,05,000. Output 80,000 units.

Solution: Contribution = Sales – variable cost . Rs.25 – Rs.20 or Rs.5 or 80,000 x 5 =

Rs.4,00,000

Profit =Contribution – Fixed Cost or 4,00,000 – 3,05,000 = Rs.95,000

Problem 2: Calculate the profit earned. Fixed cost Rs.5,00,000. Variable cost R.10 per unit.

Selling price Rs.15 per unit. Output 150,000 units

Solution : S – V = F + P or ( 1,50,000 x 15) – (1,50,000 x 20 ) = 5,00,000 + Profit

Profit = 22,50,000 – 15,00,000 – 5,00,000 = Rs.2,50,000

Problem 3: Find the fixed costs : Sales Rs.2,00,000. Variable Cost Rs.40,000. Profit Rs.30,000

Solution : S – V = F + P or 2,00,000 – 40,000 = Fixed Cost + 30,000 Fixed Cost = 2,00,000 – 40,000 – 30,000 = Rs.1,30,000

Problem 4: Calculate the variable cost : Sales Rs.1,50,000. Profit Rs.40,000. Fixed cost Rs.30,000. Find the amount of variable cost.



Solution : S – V = F + P or 1,50,000 – V = 30,000 + 40,000 or 1,50,000 – 30,000 – 40,000 =

Rs.80,000

Problem 5: Calculate MCSR or P / V Ratio : Marginal cost Rs.24,000. Sales Rs.60,000

Solution: Contribution : Sales – Marginal Cost or 60,000 – 24,000 or 36,000

MCSR = Contribution / Sales x 100 or 36,000 / 60,000 x 100 or 60 %

Problem 6: The sales turn over and profit during two periods are as under: Period 1 Period 2

Sales Rs.20,000 Rs.30,000

Profit Rs.2,000 Rs.4,000

Calculate the MCSR.

Solution : MCSR = Change in Profit / Change in Sales x 100 or 4,000 2,00,000 / 30,000

20,000 x 100

2,000 / 4,000 x 100 or 20 %

Problem 7 : Calculate : MCSR. Total Sales Total Costs

Year ending 31 st December 2006 22,23,000 19,83,600

Year ending 31 st December 2007 24,51,000 21,43,200

Solution: Profit = Total Sales – Total Costs or For the year 2006 = 22,23,000 – 19,83,600 = 2,39,400

For the year 2007 = 24,51,000 – 21,43,200 = 3,07,800

MCSR = Change in profit / change in sales x 100 or 68,400 / 2,28,000 x 100 or 30 % Problem: 8 : Calculate the selling price if marginal cost is Rs.2,400 and MCSR is 20 %.

Solution: MCSR = 20%, therefore the variable cost is 100 – 20 = 80 %

Variable cost given is Rs.2,400 : Therefore, Selling price is 24000 / 80 %

Or Rs.3,000.

Problem 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40. Selling price per unit

Rs.80. Fixed expenses Rs.2,00,000. Output 10,000 units.

Solution: Contribution : Sales – variable costs or (10,000 x Rs.80) – (10,000 x Rs.40)

8,00,000 – 4,00,000 or Rs.4,00,000.

MCSR = Contribution / MCSR or 4,00,000 / 8,00,000 x 100 or 50 %



Problem 10. Calculate Break even point. Fixed costs Rs.80,000. Variable cost per unit Rs.4.

Sales Rs.2,00,000. The number of units involved coincides with expected volume of output.

Each unit sells at Rs.20.

Solution: BEP in units : Fixed expenses / contribution per unit Contribution = S – V or Rs.20 – Rs.4 or Rs.16

Rs.80,000 / Rs.16 or 5,000 units.

Problem 11: Calculate the Break even point : Sales Rs.2,00,000. Fixed expenses Rs.50,000. Variable expenses.Rs.1,00,000.

Solution: Since no information about the number of units produced and costs per unit is given, only Break even point in value can be ascertained.

BEP in Rs. = Fixed costs x Total sales / Total Sales – Variable costs

50,000 x 2,00,000 / 2,00,000 – 1,00,000 or Rs.1,00,000

Problem 12: Calculate MCSR and Break Even Point : Sales Rs.5,00,000. Fixed Costs Rs.1,00,000. Profit Rs.1,50,000.

Solution: MCSR = Contribution / Sales

Contribution = Fixed Costs + Profit or Rs.1,00,000 + Rs.1,50,000 = Rs.2,50,000

MCSR = 2,50,000 / 5,00,000 = 50%

BEP in Rs. = Fixed Costs / MCSR or 1,00,000 / 50 % or Rs.2,00,000.

Problem 13: Find BEP. Variable cost per unit Rs.12. Selling price per unit Rs.20. Fixed expenses Rs.60,000. What will be the selling price per unit if the BEP is brought down to 6000 units?

Solution: BEP in units : FC / CPU where CPU S V 20 – 12 or Rs.8, 60,000/8 or 7,500 units 7,500 units x Rs.20 = Rs.1,50,000.

Selling price if BEP is 6000 units : FC / CPU or FC / (SP – VP) per unit or 60,000 / (x – 12)

Let selling price be Rs .x

6,000 = 60,000 / x – 12 or 6000 (x – 12) = 60,000 or x = Rs.22 on simplification.

Problem 14: Calculate MCSR. (2) Profit when sales are Rs.20,000 (3) New BEP if selling price

is reduced by 20 %. Given Fixed expenses Rs.4,000 and Break even point Rs.10,000.

Solution: Basis BEP sales : BEP in volume : FC / MCSR

Cross multiplying, MCSR = FC / BEP Sales or 40,000 / 10,000 x 100 or 40 %.

Profit Calculate the contribution first; where MCSR = C/Sales

40 % x 20,000 = Contribution or Rs8,000



C = F + P or 8,000 = 4,000 + P or Profit = Rs.4,000.

New BEP is SP is reduced by 20 % : Let the original SP be Rs.x. Therefore, at 20 % reduction,

the Revised SP would become 20 % of x or .2x. Hence the revised SP would be x – 0.2x or 0.8x

New contribution is S – V or x – (60 % of x ) = C or 0.8x – 0.6x = 0.2x. SR = 0.2x / 0.8x or 0.25

BEP in volume = 4,000 / o.25 or Rs.16,000

Problem 15: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP sales Rs.40,000. Find the actual sales.

Solution: MCSR is based on BEP sales : BEP sales = FC / MCSR = FC / BEP sales or 8,000 / 40,000 = 0.2

Actual sales = FC + desired profit / MCSR or 8,000 + 2,000 /0.2 or Rs.50,000

Terminal Questions: 1. A factory is manufacturing sewing machines. The variable cost of each machine is Rs.200

and each machine is sold for Rs.250. Fixed costs are Rs.12,000. Calculate the BEP for

output.

2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000. Variable cost per

unit Rs.2 and Selling price per unit Rs.18. Also compute the margin of safety if the company

is earning a profit of Rs.36,000.

3. Calculate the breakeven point and turnover required to earn a profit of Rs.3,600. Fixed

overheads Rs.1,80,000. Variable cost per unit Rs. Selling price Rs.20. If the company is

earning a profit of Rs.36,000, express the margin of safety available to it.

4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit Rs.1,00,000. Sales

Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit when sales amounted Rs.12,00,000 (d)

sales required to earn a profit of Rs.2,00,000.

5. Given : Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit Rs.1,000. Selling price per

unit Rs.20. Calculate (a) sales and marginal cost of sales (b) new break even point if selling

price is reduced by 10 %.

6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %.

7. Calculate Break even sales and margin of safety. Given Sales Rs.10,00,000.Fixed costs

Rs.3,00,000 and Profit Rs.2,00,000.

8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs Rs.12,000. Compute

Break even sales, Margin of safety and sales to earn a profit of Rs.4,000.




Self Assessment Questions 1 1. DMC, DLC, variable overheads

Self Assessment Questions 2 1. In total.

2. Per unit.

3. Per unit


1. Total

2. With one more unit of production.


1. Cost, revenue and profits.

2. Comprehensive

3. Profit seeking

4. Categorization of

Self Assessment Questions 5 1. A visual presentation

2. Cost, volume and profit.

3. Profit or loss Self Assessment Questions 6 1. Cost, volume, profits.

Self Assessment Questions 7 1. No profit, no loss


1. Sales – TVC

2. FC / unit contribution margin

3. FC / MCSR

4. Sales – VC

Self Assessment Questions 9 1. Profit equation

2. FC + profit

3. F + P



4. Contribution

5. F + P

6. FC

Self Assessment Questions 10 1. FC + DP / MCSR

2. Target profit in advance.

Self Assessment Questions 11 1. Difference between Budget – BEP sales.

2. Profit / MCSR.

Self Assessment Questions 12 1. Activity planning.


1. Suitability, segregation of cost.


1. S – V = F + P

2. S – V – F

Answer for Terminal Questions

1. Contribution = S –V or 250 – 200 or Rs.50 : Therefore BEP = FC / Contribution or 12,000 /

500 or 240 units.

2. Contribution = S – V = 18 – 2 = 16. BEP in units = Fixed costs / contribution per unit or

1,60,000 / 16 or 10,000 units.

Margin of safety = Actual Sales less Breakeven sales :

The formula for actual sales is : fixed Cost + Desired profit / contribution per unit or 1,60,000

+ 36,000 / 16 or 12,250 units.

Therefore, margin of safety is 12,250 10,000 units or 2,250 units.

3. Contribution per unit = S – V or 20 – 2 = 18. BEP in Units : FC / CPU or

1,80,000 / 18 = 10,000 units.

Break even sales : BEP in units x Selling price = 10,000 x Rs.20 = Rs.2,00,000

Turnover required to earn a profit of Rs.36,000



Total Fixed overheads + Profit desired / CPU = 1,80,000 + 36,000 / 18 = 12,000 units or in

terms of rupees units x selling [rice = 12,000 x Rs.20 = Rs.2,40,000.

Margin of safety = Actual sales – Break even sales = Rs. 2,40,000 – Rs.2,00,000 =

Rs.40,000 or in terms of units 12,000 – 10,000 units = 2,000 units.

4. MCSR = Contribution / Sales x 100 = Contribution = S – V or Rs.4,00,000.

4,00,000 / 10,00,000 x 100 or 40%

Break even point = FC / MCSR = 3,00,000 / 0.4 = Rs.7,50,000

Profit when sales amounted to Rs.12,00,000 . Contribution 40 % Therefore total contribution

12,00,000 x 40 % = Rs.4,80,000 Less fixed costs Rs.3,00,000 = Rs.1,80,000, being profit.

Sales to earn a profit of Rs.2,00,000 = FC + Desired profit / MCSR or 3,00,000 + 2,00,000 /

40 % = Rs.12,50,000.

5. BEP = Fixed costs / MCSR = 20,000 = 4,000 / MCSR or MCSR = 4,000 / 20,000 x 100 =

20%

Contribution : Fixed cost – Profit = 4,000 + 1,000 = Rs.5,000.

MCSR = Contribution / Sales x 100 or 20 = 5,000 / Sales x 100 = Rs.25,000

Marginal cost of sales = Sales – Contribution or 25,000 – 5,000 = Rs.20,000

(b) If selling price is reduced by 10 % : New selling price = 20 – 2 = Rs.18

Variable cost = Rs.16 (20 – 20% of 20) = Rs.2

New MCSR = 2 /18 x 100. Therefore new break even sales = FC /SR or 4,000 / 100 or

Rs.36,000.

6. Margin of safety = Profit / 40 % = Rs.50,000

7. MCSR = Contribution / sales = 5,00,000 / 10,00,000 = 50 %.

Break even sales : Fixed costs / MCSR = 3,00,000 / 50 % = Rs.6,00,000

Margin of safety = Profit / MCSR = 2,00,000 / 50 % = Rs.4,00,000

8. Sales 20,000, Variable cost Rs.13,000, Total Cost Rs.16,000. Therefore, Fixed cost = Total

cost – variable cost = 16,000 – 12,000 = Rs.4,000. Profit = Contribution – Fixed Cost = 8,000

– 4,000 = 4,000. MCSR = Contribution / sales = 8,000 / 20,000 = 40 %.BEP in units : FC /

MCSR = 4,000 / 40% = 10,000.

Margin of safety = Profit / MCSR = 400 / 40 % = 10,000

Sales to earn a profit of Rs.4,000 = FC + Desired profit / MCSR = 4,000 + 4,000 / 40 % =

Rs.20,000.



Unit 14 Budgetary Control


Objectives

14.2 Meaning


14.3 Budgetary control


14.4 Objectives


14.5 Merits


14.6 Essential features


14.7 Steps


14.8 Types


14.9 Cast Budget


14.10 Flexible Budget


14.11 Limitation


Terminal Questions


14.1 Introduction In a competitive environment, the effective operation of a concern resulting into the excess of

income over expenditure fully depends upon “as to what extent the management follower proper

planning, effective coordination and dynamic control “. For all these aspects, it has become

necessary that management should plan for the future financial and physical requirements.



These are the basic criteria that a firm has to adopt to maintain its profitability and productivity.

The procedure for preparing plan in respect of future financial and physical requirements is

generally called “Budgeting”. It is a forward planning exercise. It involves the preparation inn

advance of the quantitative as well as the financial statements to indicate the intention of the

management in respect of the various aspects of the business. In a broader sense, it is

essentially an economic service. Budgeting requires a deeper understanding of the economic

system of the environment in which the business concern operates.



1. Understand the meaning of budget and budgetary control with its objects.

2. Analyze the merits, demerits, essential features of budgetary control.

3. Note the steps involved in the preparation of budgets.

4. Acquaint with various type of budgets.

5. Prepare cash and flexible budgets.

14.2 Meaning of A Budget It is a numerical statement expressing the plans, policies and goals of an enterprise for a definite

period in the future. Budgets are not actual but are estimated. It is therefore a financial and / or

quantitative statement prepared and approved prior to a definite period of time, of the policy to be

pursued during that period for the purpose of attaining a given objective. (Definition by Cost and

Management Accountants, England).

Self Assessment Questions 2: 1. Budget is ___________ statement.

2. Budget are _____________.

14.3 Budgetary Control It is applied to a system of management accounting control by which all operations and output

are forecasted far ahead as possible and actual results when known are compared with the

budget estimates.

Self Assessment Questions 3: 1. Budgetary control is ___________.



14.4 Objectives Budgeting is a forward planning. It basically serves as a tool for management control. The

objectives of budgeting may be taken as:

• To forecast and plan for future to avoid losses and to maximize profits.

• To help the concern in planning the activities both physical and financial.

• To bring about coordination between different functions of the enterprise.

• To control; actual actions by ensuring that actual are in tune with targets.

Budgeting and Planning: The planning normally deals with long term and short goals and

operations. The goals can be for the entire organization or departmentwise or group wise or

segment wise to achieve the maximum results and operational efficiency. After setting up

objectives in terms of plans, it becomes imperative to organize the factors of production to

convert into a reality and workable preposition. In budgeting, planning refers to the preparation of

budgets in respect of sales, advertisement, production, inventory, materials cost and

requirements, labor cost and requirements, expenses, research, capital expenditures, financial

plans. Planning through budgets brings together all segments of the concern in a cooperative

way and they are compelled to think seriously about the planning. The views get enlarged than

getting into contraction. Internal refinement, broad indexation of activities, concentrated details is

the essential features in planning. All the staff must be involved in the planning function to make

it more successful and purposeful.

Budgeting and Coordination: It deals with the combined efforts of all the people involved from the shop floor to the top management. Individual and collective wisdom should be considered in

the preparation of budgets at all levels to make it a workable document for translation into reality.

For this adequate communication at all levels should be established. It is very important that

each member of management is having perfect and clear cut knowledge. There must be

continuity to coordination. Budget may help us to evaluate and examine whether the members of

the management are working in a cooperative way or not

Budgeting and control: When one relates control function to budget, we find a system what is

generally termed as budgetary control. Control signifies such systematic efforts which help the

management to know whether actual performance is in line with predetermined goal, policy and

plans. It is basically a measurement tool. Yardsticks should be laid down. Standards must be

set up.

Therefore, the objectives can be summarized as follows:

• To conform with good business practice by planning for the future.



• To coordinate the various divisions of a business.

• To establish divisional and departmental responsibilities.

• To forecast operating activities and financial position.

• To operate most efficiently the divisions, departments and cost center.

• To avoid waste, to reduce expenses and to obtain the income desired.

• To obtain more economical use of capital available for the efficient operation.

• To provide more definite assurance of earning the proper return on capital employed.

• To centralize management control.

• To show the management where action is needed to remedy a situation.

• To help in controlling cash.

• To help in obtaining better inventory control and turnover.

Self Assessment Questions 4: 1. Budgetary is ____________ planning.

2. Planning deals with _________________.

14.5 Merits In order to help in planning, coordinating and control, budgets need to be prepared for every

organization to get the maximum benefit. Broadly, the merits are as follows:

1. It forces basic policies to initiatives

2. The budgetary control aims at the maximization of profits

3. Budgets fix the goals and targets without which operations lack direction

4. Reduction in cost and elimination of inefficiencies

5. Budgetary control facilitates to make ordered effort and brings about overall efficiency in

results.

6. Budgetary control ensures that the capital employed at a particular level is kept at a

minimum level

7. Budgetary control enables the management to decentralize responsibility without losing

control

8. It is a good guide to the management for making future plans. Based on budgetary control

realistic budgets can be drawn.

9. Budgetary control facilitates an intelligent and planned forecast of the future

10. Budgetary control acts as a safety signal for the management. It prevents wastages of all

types.



11. Budgetary control brings to light the inefficiencies and weakness on comparing actual

performance with budget. Management can take timely remedial measures.

12. Financial crisis can be avoided since budget provides advance information.

13. It is a guide to the management in the field of research and development in future.

Self Assessment Questions 5: 1. Major merits are __________.

14.6 Essential Features Of Budgetary Control An effective budgeting system should have essential features to get best results. In this direction,

the following may be considered as essential features of an effective budgeting.

Business Policies defined: The top management of an organization strives to have an action plan for every activity and for each department. Every budget should reflect the business policies

formulated from time to time. The policies should be precise and the same must be clearly

defined. No ambiguity should enter the document. Clear knowledge should be provided to all the

personnel concerned who are going to execute the policies. Periodic suggestions should be

called for.

Forecasting: Business forecasts are the foundation of budgets. Time and again discussions should be arranged to derive the most profitable combinations of forecasts. Better results can be

anticipated based on the sound forecasts. As far as possible, quantitative techniques should be

made use of while forecasting

Formation of Budget Committee: A budget committee is a group of representatives of various important departments in an organization. The functions of committee should be specified

clearly. The committee plays a vital role in the preparation and execution of budget estimated. It

brings coordination among other departments. It aids in the finalization of policies and programs.

Nonfinancial activities are also considered to make it a wholesome affair.

Accounting System: To make the budget a successful document, there should be proper flow

of accurate and timely information. The accounting adopted by the organization should be proper

and must be finetuned from time to time

Organizational efficiency: To make the budget preparation and its subsequent implementation a success, an efficient, adequate and best organization is necessary a budgeting system should

always be supported by a sound organizational structure. There must be a clear cut demarcation



of lines of authority and responsibility. There must also be a delegation of authority from top to

bottom line. .

Management Philosophy: Every management should set a healthy philosophy while opting for

the budget. Management must wholehear4tedly support the activities which developing a

budget. Encouragement should flow from top management. All the members must be involved to

make it a workable preposition and a dreamdriven document.

Reporting system: Proper feed back system should be established. Provision should be made for corrective measures whenever comparative measures are proposed.

Availability of statistical information: Since budgets are always prepared and expressed in quantitative terms, it is essential that sufficient and accurate relevant data should be made

available to each department.

Motivation: Since budget acts as a mirror, the entire organization should become smart in its

approach. Every employees both executive and nonexecutives should be made part of the

overall exercise. Employees should be persuaded than pressurized to appreciate the benefits of

the budgets so that the fruits can be shared by all the members of the organization.


1. Feature are meant for _________.

2. Forecasting is _______________.

3. Budget committee brings in _________.

14.7 Steps In Budgetary Control The procedure to be followed in the preparation and control of budget may differ from business to

business. But, a general pattern of outline of budget preparation and control may go a long way

to achieve the end results. The steps are as follows:

Formulation of policies: The business policies are the foundation stone of budget construction. Function policies should be formulated in advance. Longrange policies with short term

projections should be made for the functional areas such as sales, production, inventory, cash

management, capital expenditure.

Preparation of forecasts: Based on the formulated policies, forecast should be made in respect of each function. Activity based concepts should be introduced at the micro level for each

function Forecasts should not be considered as a mere estimates. Scientific methods should be



adopted for forecasting. Analysis of various factors based on past, and present, future forecast

should be made.

Preparation of budgets: Forecasts are converted into written codified document. Such written

documents can be used for coordination purposes. Function budgets will act as guidelines for

implementation.

Forecast combinations: While developing the budgets, through a Master Budget various

permutations and combination processes are considered and developed. Based on this,

establishment of the most preferred one which will yield optimum benefits should be considered.

All the factor components should be identified which are likely to cause disturbances while

implementing the budgets


1. Important steps in B.C _________________.

14.8 Types of Budgets The budgets are normally classified according to their nature. They are: (a) fixed budget. (b)

Flexible Budget. (c) Functional Budget

Fixed Budget: It is also known as static budgets. It is prepared for a fixed or standard volume of activity. They do not change with change in the volume of activity. They are prepared well in

advance Due to this, there are bound to be variances at the time of comparison. Hence, the

budget targets become unsuitable for the purpose of comparison. Wide deviations are noticed

due to changes in the volume of activity.

Flexible Budget: It is prepared with a view to take into account the periodic changes in the level

of activity attained. In this case, the revenues and costs targets are set in respect of different

levels of activity even from zero to 100 % of product ion volume. Such mechanism helps to

change revenues and cost targets for the actual level of activity and thus makes the comparison

more logical and scientific.

Functional Budget: These are also known as subsidiary budgets. These are prepared on the

basis of approved forecasts for individual department. Since departments are created based on

the functions, they are known as functional budgets. The functional budgets may vary in number

from business to business. The functional budgets include sales budget. Production budget,

selling and distribution overhead budget, plant budget, research and development budget,

overheads budget, financial budget such as cash budget and capital expenditure budget.




1. Classification of budget is based on __________.

2. Types of budgets are _____________.

14.9 Cash Budget A proper control over cash is very essential. Cash is an important component in any activity. The

control becomes inescapable. If cash is not properly managed or if it is mismanaged, the ultimate

result would be disastrous .In many times and in many business situations, business failures are

noticed due to the lacunae found in the cash management. Hence a cash budgeting occupies a

pivotal place in the study of Financial Management.

Cash budgeting is the process of forecasting the expected receipts known as cash inflows, and

expected payments known as cash outflows to meet the future obligations. The written statement

of receipts and payments form the cash budget. It is a crystal ball which enables one to observe

the future movements in cash position. It is a mere forecast of cash position of an undertaking

for a definite period of time. The period may be daily, weekly, monthly, quarterly, semiannually,

or annually. The major two components of cash budget would be forecast first the cash receipts

and then second forecasting the cash disbursements.

The receipts of cash are formatted as follows :

1. Opening balance of cash in hand and cash at bank

2. Cash sales

3. Collection from debtors to whom sales are effected on credit basis

4. College from Bills received

5. Interest and advances and loans granted

6. Dividends received from investments

7. Sale proceeds from capital assets

8. Proceeds from issue of shares and debentures

9. Other sources.

After determining the various sources, the quantum of receipt should be estimated. Past analysis

will help to identify the problem areas for effecting collection of cash.


1. It is prepared on _______________.

Problem 1: A large retail stores makes 25% of its sales for cash and the remainder on 30 days net. Due to faulty collection practice, there have been losses from bad debts to the extent of 1 %



of credit sales on average in the past. The experience of the store tells that normally 60 % of

credit sales are collected in the month following the sale, 25% in the second following month and

14 % in the third following month. Sales in the proceeding three months have been January 2007

Rs.80,000, February Rs.1,00,000 and March Rs.1,40,000. Sales for the next three months are

estimated as April Rs.1,50,000, May Rs.1,10,000 and June Rs.1,00,000. Prepare a schedule of

projected cash collection .

Solution:

Statement of expected Cash Receipts

Collection form April May June Cash sales 37,500 27,500 25,000 Collection from Debtors : January 8,400

February 18,750 10,500 March 63,000 36,350 14,700 April 67,500 28,125 May 49,500

Total 1,27,650 1,31,750 1,17,325

Assume that the credit policy is enforced strictly ,what would be the cash receipts.

Cash sales : Debtors 37,500 27,500 25,000 March 1,05,000 April 1,12,500 May 82,500

Total 1,42,500 1,40,000 1,07,500

Forecasts of cash payments : The items of expenditures differ from business to business. The normal items which come under the lists are :

1. Cash purchases

2. Payment to creditors or suppliers

3. Payments to Bills payable

4. Payment to employees in the nature of wages, salaries

5. Manufacturing, selling and distribution and administration expenses

6. Repayments of bank load and special obligations such as bonus, donations, advances

7. Interest and dividend payments



8. Capital expenditures for acquiring assets of enduring benefit

9. payment of tax liability

10. other expenses of periodic nature

The quantum of amount likely to be spend on the above each item is generally determined with

reference to functional budgets of the concerns. The policy of the management will also play a

crucial role. It is the policy which determines the ratio of cash purchases and credit purchases.

In many cases, the time lag affects the amount of expenditures to be incurred in a particular

period. The formula adopted for the expenses payable in next month is : month’s amount x time

lag

Problem 2: The following are the forecasts relating to wages and factory expenses.

July Aug Sept Oct Nov

Wages 32,000 32,000 32,000 40,000 32,000

Factory expenses 5,000 5,000 5,000 5,000 5,000

The lag in payment of wages is 1 / 8 month and that in case of factory expenses 1/ 2 month.

Estimate the amounts of wages and factory expenses payable in each month of September to

November. Solution

Statement showing the disbursements of cash

Particulars Sept Oct Nov

Wages: Aug 32,000 4,000

Sept 32,000 28,000 4,000

Oct 40,000 35,000 5,000

Nov 32,000 28,000

32,000 39,000 33,000

Factory expenses

Aug 5,000 2,500

Sept 5,000 2,500 2,500

Oct 5,000 2,500 2,500

Nov 5,000 2,500



5,000 5,000 5,000

Problem 3: The following information is provided in respect o DR Ltd. Prepare a Cash Budget for April, May

and June 2007.

Months Details Sales Purchases Wages Expenses (in Rupees)

Jan Actual 80,000 45,000 20,000 5,000

Feb Actual 80,000 40,000 18,000 6,000

March Actual 75,000 42,000 22,000 6,000

April Budget 90,000 50,000 24,000 7,000

May Budget 85,000 45,000 20,000 6,000

June Budget 80,000 35,000 18,000 5,000

Additional information:

a. 10 % of the purchases and 20 % of sales are for cash

b. The average collection period of the company is 1 / 2 month and the credit purchases are

paid regularly after one month.

c. Wages are paid half monthly and the rent of Rs.500 included in expenses is paid monthly.

Other expenses are paid after one mo nth lag.

d. Cash balance on April 1, 2007 may be assumed to be Rs.15,000.



Solution

DR Limited

CASH BUDGET

For the month ending June 2007

Particulars April May June

RECEIPTS

Opening Balance 15,000 27,200 35,700

Cash Sales 18,000 17,000 16,000

Collection from Debtors 66,000 70,000 66,000

Total , say A 99,000 1,14,200 1,17,700

PAYMENTS

Cash purchases 5,000 4,500 3,500

Payments to creditors 37,800 45,000 40,500

Wages 23,000 22,000 19,000

Rent 500 500 500

Other expenses 5,500 6,500 5,500

Total, say B 71,800 78,500 69,000

CLOSING CASH BALANCE, A – B 27,200 35,700 48,700

Problem 4:

DR is to start production on January 1, 2008. The prime cost of an unit is expected to be Rs.40

(Rs.16 per material and Rs.24 for labor). In addition, variable expenses per unit are expected to

be Rs.8 and fixed expenses per month Rs.30,000. Payment for materials is to be made in the

month following the purchases. Onethird of sales will be for cash and the rest on credit for

settlement in the following month. Expenses are payable in the month in which they are incurred.

The selling price is fixed at Rs.880 per unit. The number of units to be produced and sold are

expected to be : January 900, February 1,200./ March 1,800. April 2,000. May 2,100. June 2,400.

Draw a cash budget indicating cash requirements.



Solution

CASH BUDGET

For six months ending 30 th June

Particulars Jan Feb March April May June

RECEIPTS

Opening balance 34,800 37,600 32,400 5,867 17,600

Cash Sales 24,000 32,000 48,000 53,333 56,000 64,000

Collection from Debtors 48,000 64,000 96,000 1.06.667 1,12,000

Total, say A 24,000 45,200 74,400 1,16,933 1,56,800 1,93,600

PAYMENTS

Creditors 14,400 19,200 28,800 32,000 33,600

Wages 21,600 28,800 43,200 48,000 50,400 57,600

Variable Expenses 7,200 9,600 14,400 16,000 16,800 19,200

Fixed Expenses 30,000 30,000 30,000 30,000 30,000 30,000

Total, Say B 58,800 82,800 1,06,800 1,22,800 1,39,200 1,40,400

Closing balance :

A – B

Debit ( + ) Credit ( ) 34,800 37,600 32,400 5,867 17,600 53,200

Cr Cr. Cr Cr

Problem 5: DR wish to approach his Bankers for temporary overdraft facility for the period from June 1 to

August 30 th , 2007. During the period of these three months, DR will be manufacturing mostly for

stock. Prepare a cash budget for the above period.

Sales Purchases Wages

April 3.60,000 2,49,600 24,000 May 3,84,000 2,88,000 28,000 June 2,.16,000 4,.86,000 22,000 July 3,.48,000 4,.92,000 20,000 Aug 2,.52,000 5,.36,000 30,000



(a) 50 % of credit sales are realized inn the month following the sales and remaining in the

second following month.

(b) Creditors are paid in the month following the month of purchase

(c) Estimated cash as on June 1 is Rs.50,000

Solution DR

CASH BUDGET

For the period ending 20 th August

Particulars JUNE JULY AUGUST

RECEIPTS

Opening balance 50,000 1,12,000 ( 94,000 )

Collection from Debtors 3,72,000 3,00,000 2.82,000

Total, say A 4,22,000 4,12,000 1,88,000

PAYMENTS

Payments to creditors 2,88,000 4,86,000 4,92,000

Wages 22,000 20,000 30,000

Total, say B 3,10,000 5,06,000 5,22,000

Closing Balance A – B 1,12,000 94,000 3,34,000

Cr Cr

Overdraft needed NIL 94,000 2,40,000

Problem 6: Prepare a cash budget from January to April

Expected Purchases Expected Sales Jan 48,000 60,000 Feb 80,000 40,000 Mar 81,000 45,000 April 90,000 40,000

Wages to be paid to workers will be Rs.5,000 per month. Cash balance on January 1 may be assumed to be Rs.8,000. Management decides that : a) in case of deficit within the3 limit of Rs.10,000 arrangement can be made with the bank b) in the case of deficit exceeding Rs.10,000 but within a the limit of Rs.42,000 issue of

debentures is to be preferred. c) In the case of deficit exceeding Rs.42,000 the issue of equity shares is to be preferred.

Assume that this will be within the Authorized Capital.



Solution

CASH BUDGET

Particulars Jan Feb March April

RECEIPTS

Opening balance 8,000 15,000 30,000 (Cr) 71,000 (Cr)

Cash sales 60,000 40,000 45,000 40,000

Total, say A 68,000 55,000 75,000 31,000

PAYMENTS

Purchases 48,000 80,000 81,000 90,000

Wages 5,000 5,000 5,000 5,000

Total, say B 53,000 85,000 86,000 95,000

Closing Balance A – B 15,000 30,000 71,000 1,26,000

The total deficit of Rs,1,26,000 should be raised from the issue of Equity Shares.

14.10 Flexible Budget According to I.C.M.A, London, a flexible budget is “a budget which is designed to change in

accordance with the level of activity actually attained”. The basic idea of a flexible budget is that

there shall be some standard of cost and expenditures. Thus, a budget prepared in a manner to

give budgeted costs for any level of activity is, known as flexible budget. Such budget is

prepared after considering the variable and fixed elements of costs and the changes which may

be expected for each item at various levels of operations. .The main focus of flexible budget is to

re cognize the difference in behavior pattern of fixed and variable costs in relation to fluctuations

in production and sales . The flexible budget is, hence, designed to change appropriately with

such fluctuations. In flexible budget, data relating to costs and expenses may progressively be

changed in any month in accordance with actual output achieved. Costs and estimates are made

in advance based on standards. A maximum and a minimum levels of operation is made.

Comparison of budgeted with actual are made. Budgeted activities are taken as basis. The

principles of flexible budgeting concepts are applied to functional budget, master budgets.

Popularly, the flexible budget is adopted for production cost budget. In this area., the costs are

classified. A detailed classification is adopted such as variable, fixed and semivariables..



Adopting microlevel classifications, it is intended to pinpoint the various effects on each class of

overheads.


1. Flexible budget is _______________.

2. Main focus on flexible budget is ___________.

Problem 7: Draw a flexible budget for the level of operation at 70 %, 80 % and 90 %..

Variable overheads : at 80 % capacity. Indirect labor Rs.12,000. Stores and spares Rs.4,000.

Semivariable overheads at 80% capacity. Power (30 % fixed) Rs.20,000. Repairs and

maintenance at 60 % fixed Rs.2,000.

Fixed overheads : at 80 % : Depreciation Rs.11,000. Insurance Rs.3,000. Salaries Rs.10,000.

The estimated direct labor hours 1,24,000,.

Solution:

FLEXIBLE BUDGET (OVERHEADS)

For the period …………………

Particulars Level of operation

Basis 70 % 80 % 90 %

VARIABLE OVERHEADS

Indirect labor 10,500 12,000 13,500

Spares and 3,500 4,000 4,500

Total, say A 13,500 16,000 18,000

SEMI VARIABLE OVERHEADS

Power ( 30 % fixed ) consider 80 %

Power total 20,000 and segregate between

Variable and fixed . For fixed, maintain

Uniformity for all levels of production

30% x 20,000 6,000 6,000 6,000

Balance 70 % ,

proportionately calculate 12,250 14,000 15,750



Repairs and maintenance

60 % fixed on

Rs.2,000 (i.e. 80 % capacity) 1,200 1.200 1,200

40 % variable 700 800 900

Total, say B 34,150 38,000 41,850

FIXED OVERHEADS

Depreciation 11,000 11,000 11,000

Insurance 3,000 3,000 3,000

Salaries 10,000 10,000 10,000

Total, say C 24,000 24,000 24,000

Grand Total A + B + C 58,150 62,000 65,850

Estimated labor hours 1,08,500 1,24,000 1,39,500

Standard overhead rate / hour 0.54 0.50 0.48

Divide the grand total by estimated Labor hours.

14.11 Limitations Of Budgeting The main limitations of budgeting are as under : Budget plan : Since budget plans are based on estimates, the success or otherwise depends on the accuracy of basic estimates or forecasts. Due to this while making estimates, judgmental

decision may accrue. The results need to be interpreted very cautiously.

Rigidity: Since the estimates are quantitative expression of all relevant data, there is likely that finality attachment may become very clear. Such consideration may result in rigidity. Rigidity

may become a set back for the changing business conditions.

Replacement: Budgeting is not a substitute for management. It is essentially a tool of

management. Under no circumstances, it should be concluded that the budgeting is alone

sufficient to ensure success and to guarantee future profits.

Costly: The installation of budgeting system to an organization involve too much of costs. Its scientific approach will definitely call for huge cost allocation. Small concerns cannot afford to

take over huge costs for the establishment of business systems. Since the costs and revenues

and operational activities do not match in many occasions, the entire exercise will become costly.

The system should be adopted only when benefits exceed the costs.



Terminal Questions

1. What are the merits of budgets ?

2. Describe the essential features of budgetary control.

3. What are the steps in budgetary control ?

4. What are the limitations of budgeting ?

5. DR Ltd provides the following Profit and Loss Account for the year 2007.

Sales Rs.3,55,000 LESS : Expenses : Raw materials Rs.72,200. Expenses Rs.2,04,000.

Stores Rs.48,800. Interest Rs.20,000. Depreciation Rs.20,000. Loss : (Rs.11,200). The

company had been working at 60 % capacity during the year 2007. Of the expenses of

Rs.2,04,00, 25 % is variable. During the year 2008, production / sales volume at 80 % of

capacity is expected to be achieved. Fixed cost is, however, expected to increase by

Rs.12,000. Draw a 2008 Budget.

6. The expenses budget for production of 10,000 units in a factory are furnished below. In

rupees per unit.

Materials 70, Labor 25, Variable overheads 20, Fixed overheads (Rs.1,00,000) 10, variable

expenses (direct) 5, Selling expenses (10 % fixed) 13. Administrative expenses (Rs.50,000)

5. Distribution expenses (20 % fixed) 7. Prepare a budget for the production of (a) 8,000 units

and (b) 6,000 units. Assume that administrative expenses are rigid for all levels of production. Answer Self Assessment Questions Self Assessment Questions 1

1. Numerical

2. Estimated

Self Assessment Questions 2 1. Corrective action.

Self Assessment Questions 3 1. Forward

2. Long and short term goals

Self Assessment Questions 4 1. Fix financial goals

Self Assessment Questions 5 1. Best result

2. Foundation for business activities

3. Group of representatives



4. Coordination

Self Assessment Questions 6 1. Policy formulation, forecasting

Self Assessment Questions 7 1. Fixed, flexible, function

Self Assessment Questions 8 1. Process of cash flow forecast.

2. Weekly, monthly, quarterly, annually


1. Changes with level of activities

2. Recognize behavior pattern.

Answer for Terminal Questions 1. Refer to unit 14.5








Unit 15 Standard Costing Structure:

15.1 Introduction

Objectives

15.2 Definition


15.3 Meaning


15.4 Standard cost and BC


15.5 Establish or standard


15.6 Variance analysis


15.7 Material variance


15.8 Material price variance


15.9 Material usage


15.10 Material Mix


15.11 Material Yield


15.12 Direct labor variance


15.13 Labor Efficiency Variance


15.14 Labor rate variance


15.15 Labor mix variance


15.16 Labor yield variance




Terminal Questions


15.1 Introduction Standard costing is a very important system of cost control. It is a system which seeks to control

the cost of each unit or batch through determination before hand of what should be the cost and

then its comparison with actual cost. Through planned accounting procedures, the difference

between the actual and predetermined costs are analyzed and then promptly reported upon to

managers. Based on this, it is possible to take corrective and preventive action as well as employ

the data for planning, coordination and control.



1. Define the standard costing.

2. understand the meaning.

3. Differentiate between standard cost and budgetary control.

4. Acquaint with establishment of standards.

5. Practice the variance analysis.

15.2 Definition Of Standard Costing Standard costing may be defined as a technique of cost accounting which compares the standard

cost of each product or service with the actual cost to determine the efficiency of the operation so

that any remedial action may be taken immediately: Brown and Howard. According to J. Batty

“standard costing is a system of cost accounting which is designed to show in detail how much

each product should cost to produce and sell when a business is operating at a stated level of

efficiency and for a given volume of output”.


1. Standard cost is defined as ___________.

15.3 Meaning The meaning of standard costing is focused on the method of financial control. It compares the

predetermined and actual costs. It is normally associated closely with budgetary control;. Many

organizations use both the systems although one can be used without the other. Standard



costing is mainly applied to products and processes. Therefore, it is a technique that is more

commonly used in manufacturing organization, though it may also be useful in service industries.

As in budgetary control, it allows the comparison of predetermined costs and income with the

actual costs and income achieved. Any difference can then be investigated.

Self Assessment Questions 2 1. Standard cost is basically _________.

15.4 Standard Cost And Budgetary Control Both are closely interrelated. They both aim at the improvement of the system of managerial

control. They both achieve the same objective of maximum efficiency and cost control; by

establishing predetermined standards. They compare actual performance with the

predetermined standard. They take necessary steps to improve the situation wherever

necessary. Both techniques are forward looking. However, the following are some of the

differences identified.

1. The scope of budgetary control is wider. It is integrated plan of action, a coordinated plan in

respect of all functions of an enterprise The scope of standard costing, on the other hand, is

limited to the operating level. Here too, it is further linked to costs. Budgetary control is

extensive whereas standard costing is intensive in its application

2. Budgetary control deals with costs and revenues. But standard costing restricts only with

costs .

3. Budgetary control takes into account all activities such as production, sales, purchase3s,

finance, capital expenditure, personnel whereas standard costing is restricted to deal with

only costs.

4. Budgetary control targets are based on past actual adjusted to future trends. In Standard

costing, standards are based on technical assessment.

5. At the approach level, budgeted targets work as the maximum limit of expenses above which

the actual expenditure should not normally exceed. Under standard costing, standards are

attainable level of performance.

6. Budget are projection of final accounts. Standard costs are projection of only cost accounts.

7. Budgetary control emphasizes the forecasting aspect of the future operations. Standard

8. Costing scope and utility is limited to only operating level of the concern.

9. In budgetary control, the degree of variance analysis tends to be much less and variances are

not revealed through the accounts but are revealed in total. But in standard costing, variances



are analyzed in details according to their originating causes and ar3e revealed through

different accounts.

10. Budgetary control is possible even in parts of expenses according to the attitude of

management. A standard costing system can not be operated in parts. All items of

expenditure included in cost units are to be accounted for.

Self Assessment Questions 3 1. Standard cost and budget control _________.

15.5 Establishment Of Standards Under standard costing system, there is a need to determine the standard costs for each element

of cost. The standards are fixed for three main elements of cost namely direct material, direct

labor and overhead.

Standards should be fixed for each of them separately.

Direct Material : Standard material cost for each product should be predetermined. This will require the determination of material quantity standard and material price standard. The standard

quantity of each type of materials is determined by the engineering department on the basis of

past records, experience and chemical and engineering tests. While setting such standards, an

allowance should be made for the normal wastage of materials. The standard price for each item

of material is established after carefully studying the market conditions and forecasting the trend

of prices for a future period. This is done by cost accountant with the help of purchase officer.. Direct labor : The standard labor time and standard labor rate should be established. Standard

time for each grade of labor is fixed by the production engineering department on the basis of

time and motion study. In fixing the standard time due allowance should be made for fatigue,

tool setting, receiving instructions and normal idle time. The standard rates of pay for each

category of labor are fixed by the cost accountant with the help of personnel department.

Overheads : These are aggregate of indirect materials, indirect labor and indirect expenses/ Separate standards must be established for variable and fixed overheads. As variable overheads

per unit or per hour remain constant at each level of output / sales but total amount of variable

overheads tend to vary directly with volume of output / sales . Therefore, it is sufficient to

calculate only a standard variable overhead rate per unit or per hour. This is done by dividing the

total variable overheads for the budget period by the budgeted output. In respect of fixed

overheads standards are set for total fixed overheads for the budget period and the budgeted



output and standard fixed overhead rate is computed by dividing the budgeted fixed overheads

with budgeted output.


1. Standards are established for _____.

15.6 Cost Variance Analysis The distinctive feature of standard costing system is variance analysis. By definition, the term

“variance” means the variation or deviation of the actual from the standard. In standard costing, it

implies the difference between the actual cost and standard cost. Variances indicate the extent

to which standards set have been achieved. If properly recorded and analyzed , these variances

become very important and useful tool for managerial control.

Variances by themselves are not the end. They are computed to know the reasons and fix the

responsibility for any deviations of actual performances from pre determined targets. Based on

this corrective measures are proposed for adoption in future. Therefore, variance analysis is the

process of analyzing variances by subdividing the total variance in such a way that management

can assign responsibility for off standard performance It is hence a very useful means for

interpreting operating results and spotting situations calling for correction.

Variances are interpreted as favorable and unfavorable variances. Each variance is interpreted.

Interpretation helps in deciding whether a variance is favorable or unfavorable. When the actual

cost is less than the standard cost, the difference is termed as “favorable” or “credit” variance. On

the other hand, when actual cost exceeds the standard cost, the difference is termed as

“unfavorable”, “adverse” or “debit” variance. Ordinarily, a favorable variance is a sign of

efficiency of the organization whereas an unfavorable variance a sign of inefficiency. But in

variance analysis, this general logic may prove to be untrue. Therefore, all variances should be

interpreted in relation to each other and only the net result be reported to the management for

corrective action.

Controllable and Uncontrollable variances : The controllable variance can be identified as the

primary responsibility of a specified person or a department. F a variance is due to the factors

beyond the control of the concerned person or department, it is said to be uncontrollable. No

person or department can be held responsible for uncontrollable variances. Actually revision of

standards is required to remove such variances in future.




1. Variation refers ________.

2. Variances analysis is _________________.

3. Variances are interpreted as _____ and ____.

15.7 Material Variance It refers to material cost variance. It is the difference between the standard cost of materials

allowed for the actual output and the actual cost of materials used. It may be expressed as :

Material Cost Variance = Standard Cost – Actual Cost

Where standard cost = actual output x standard rate per unit of output

Or standard quantity of material for actual output x standard price per unit of material

Actual cost = actual quantity consumed x actual price per unit of material.

A favorable variance would result if actual cost is less than the standard cost and vice versa.

The material cost variance is the sum total of material price variance and material usage

variance.


1. Material variance is ______________.

Example: DR Ltd has decided to extend its range to include Denim Jackets. One jacket requires

a standard usage of 3 meters of direct material which has been set at a standard price of Rs.2.20

per meter. In the period, 80 jackets were made and 260 meters of material consumed at a cost

of Rs.1.95 per meter. Calculate the direct materials total variance. Solution: Calculate the standard quantity of materials for the actual level of production

For 1 jacket = standard usage is 3 meters

Therefore for 80 jackets, it is 80 x 3 meters / 1 or 240 meters

Consider the formula, (SQ x SP ) – (AQ x AP)

= (240 x Rs.20 ) = (260 x Rs.1.90 ) or Rs.528 – Rs.507

= Rs.21 (Favorable) variance.

The difference indicates that them company has spent less on materials than planned for the

level of production.



15.8 Material Price Variance Under Material price variance , the price paid for materials is different from the predetermined

price. It is calculated by multiplying the actual quantity of materials used with the difference

between standard and actual prices. The formula is :

Material Price Variance = (Standard Price – Actual Price ) x Actual quantity used

Shorten = ( SP – AP ) AQ

A favorable variance would result if the actual price is less than the standard price and vice versa.

Self Assessment Questions 7 1. Material price variance is __________.

Example : Calculate the direct material price variance from the data of DR Ltd above.

Solution : Formula : (SP – AP ) AQ or (Rs.2.20 – Rs.1.90) x 260 meters or Rs.78 FAV It is favorable because the company has paid less for the materials than planned for that level of

production

15. 9 Material Usage Variance It is also known as material quantity variance or efficiency variance. It is that portion of material

cost variance which measures the difference in material cost arising from higher or lessa

consumption of materials than the standard material consumption for the actual output. It is

calculated by multiplying the standard price with the difference between the standard and actual

quantitities of materials :

Material Usage Variance = (Standard Quantity Actual Quantity ) Standard Price

Shorten = (SQ – AQ) SP

A favorable variance would result if the actual quantity is less than the standard quantity and vice

versa.

Self Assessment Questions 8 1. Material usage is _______.

Example 1: Citing DR’s example : the direct material usage variance is :

(SQ – AQ ) SP or (240 – 260 meters) x Rs.2.20 per unit or Rs.44 (ADV)

It is adverse because the company has used more materials than planned for that level of

production.



Example 2: It is observed that one unit of product X requires 3 kgs of material M at Rs.2 per kg

During January 2008, 200 units of product X were produced consuming 620 kgs of material M,

all of which was purchased at Rs.1.80 per kg. Compute material cost variances.

Solution: Material Price Variance : ( SP – AP ) AQ or (2.00 – 1.80) x 620 o Rs.124 F Material Usage variance : (SQ – AQ ) SP where SQ for actual consumption is

200 x 3 kg / 1 kg 0r 600 kgs

(600 – 620_ Rs.2 or Rs.40 A

Material Cost Variance : Material Price Variance + Material Usage variance

124 (F) + 40 )A) or Rs.84 (FAV)

Example 3: For producing a commodity, the standard quantity of material was fixed 10 kgs and standard price was fixed at Rs.2 per kg. The actual quantity was consumed 12 kgs and the

actual price was Rs.1.90 per kg. Calculate the material variances.

Solution: MUV = (SQ – AQ) SP or (10 – 12) 2 or 2 x 2 or 4 ADV

MPV = (SP – AP ) SQ or (2 – 1.90 ) 12 or 1.20 FAV

MCV = (SQ x SR) – (AQ x AP) = (10 x 2 ) – (12 x 1.90) = 2.80 ADV

Example 4: Calculate the material variance. Standard Actual

Material for 80 kgs Output 1,65,000 kgs

Finished products 100 kgs Material used 2,00,000 kgs

Price per kg Rs.0.80 paid Actual cost Rs.1,70,000

Solution: Calculation of standard quantity For 80 kgs, finished products needs 100 kgs material

Therefore, for 1,65,000 kgs, it is 1,65,000 x 100 / 80

Or 2,06,250 kgs.

MUV = (SQ – AQ ) SP or (2,06,250 – 2,00,000) Rs.0.80

= Rs.5,000 FAV

MPV = (SP – AP ) AQ or (0.80 – 0.85 ) 2,00,000 or Rs.10,000, ADV

Cost of 2,00,000 kgs is Rs.1,70,000

Therefore, cost of one kg is 0.85

MCV = (SQ x SR) (AQ x AP )

(2,06,250 x 0.80) – (2,00,000 x 0.85)



= Rs.5,000 ADV.

Example 5: It is estimated that in the manufacture of a product, for each ton of materials

consumed 100 units should be produced. The standard price per ton of materials is Rs.10.

During the first week of January, 100 tons of materials were issued to the Production Department.

The purchase price of which was Rs.10.50 per ton. The actual output for the period was 10,250

units. Calculate the cost variances.

Solution: Standard rate of material : Standard cost per ton / standard output per ton or 10,250 units / 100 tons or 102.5 per ton

Material usage (SQ – AQ) Sp where SQ = Actual output / standard quantity or 10,250 / 100 tons

= 102.5 ton (one ton for 100 units Rs.10,250, the standard quantity is 102.5 tons. (102.5 – 100

tons) x Rs.10 or Rs.25 FAV

MPV = (SP – AP ) AQ (10 – 10.50 ) x 100 = Rs.50 ADV

MCV = (SQ x SP ) – (AQ x AP) or 102.5 x 10 – 100 x 10.50 or Rs.25 ADV

Example 6: A factory works on standard costing system. The standard esti8mates of material

for the manufacture of 1000 units of a commodity is 400 kg at Rs.2.50 per kg. When 2000 units

of a commodity are manufactured, it is found that 820 kgs of material is consumed at Rs.2.60 per

kg. Calculate the material variance

Solution : First calculate the standard quantity and standard cost.

Standard quantity : For manufacture of 1000 units, the standard estimates = 400 kgs.

Therefore, for actual manufactured quantity, the standard is 2000 x 400 / 1000 or 800 kgs.

Standard cost = Standard quantity x Standard rate or 800 x Rs.25 or Rs.2,000

Actual Cost = 820 x Rs.2.60 or Rs.2,132

Material cost variance = Standard cost – Actual cost or 2000 – 21312 or 132 ADV.

Material price variance = (SR – AR ) AQ or 2.50 – 2.60 x 820 or Rs.82 ADV

Material usage variance = 800 – 820 x 2.50 or Rs.50 ADV

15.10 Material Mix Variance This variance arises only when more than one type of materials are used in manufacturing the

product and the quantities of materials issued to production are not in proportion of standard mix.

It is defined as that portion of the direct materials usage variance which is due to difference

between the standard and actual, composition of a mixture. For calculating the mix variance, first



calculate the quantities of revised standard mix. This is calculated by dividing the total

quantities of actual mix in standard mix proportion. In the terminology of standard costing,

quantities of revised standard mix are referred to as “revised standard quantity”. Mix variance is

obtained by multiplying the standard price of materials with the difference between revised

standard quantity and actual quantity for each material. It may be expressed as follows:

Material Mix Variance = Revised standard quantity for each material – actual

MMV Quantity for each material) x standard price.

Where RSQ = standard quantity for each material / total of standard quantity of all types of

materials x actual mix total

RSQ = Total weight of actual mix / total weight of standard mix

X standard quantity.

A favorable variance would result if actual quantity is less than revised standard quantity and vice

versa.

Self Assessment Questions 9 1. Material mix variance to __________.

Example : The following extracts are extracted from the books of DR Ltd.

Standard Mix Actual Mix

Material Qty Rate Total Qty Rate Total

X 300 5 1,500 280 5 1,400

Y 200 10 2,000 220 10 2,200

Total 500 500

Calculate the material mix variance

Solution : Revised standard quantity = Total weight of actual mix / total weight of standard mix x standard

quantity

For Material X = 500 / 550 x 300 = 300

For Material Y = 500 /500 x 200 = 200



MMV = For X = (300 – 280)_ 5 = 100 FAV

Y = (200 – 220) 10 = 200 ADV

Total Mix variance 100 ADV

15.11 Material Yield Variance This variance arises only when the rate of output is known. It is that portion of the direct material

usage variance which is due to the difference between standard yield specified and actual yield

obtained. It measures the loss or saving due to wastage of materials. This variance is calculated

as follows :

MYV = (Standard yield – Actual Yield ) x standard rate per unit of output or

( Standard Loss – Actual Loss ) x standard rate per unit of output

where standard rate = standard cost of standard mix / standard output from standard mix

standard yield = standard output from standard mix / standard mix total x actual mix total MYV is

an output variance and hence a favorable variance would result if actual yield is more than

standard yield and vice versa.

Self Assessment Questions 10 1. Material yield variance is __________.

Example 1: The following extracts refer to DR Ltd.

Standard Mix Actual Mix

Material Qty Price Total Qty Price Total

X 60 5 300 56 5 280

Y 40 10 400 44 10 440

100 700 100 720

Loss 30 % 30 Loss 25 % 25

a. 75

Calculate the material yield variance.



Solution:

Material Yield Variance : (Standard yield – Actual yield) Standard rate

Where standard rate = Total cost of standard mix / net standard output or 700 / 70 = Rs.70

MYV = (70 – 75) 10 or Rs.50 ADV.

Example 2: DR manufactures a product X. It is estimated that for each ton of material

consumed, 100 articles should be produced. The standard price per ton of material is Rs.10.

During the first week of January 2008, 100 tons were issued to production, the price of which was

Rs.10.50 per ton. Production during the week was 10,200 articles. Compute the variances

Solution: Cost variance : Standard cost – Actual Cost or Rs.1,020 – Rs.1,050 = Rs.30 ADV

Working : Actual output x standard rate per unit of output or 10200 x 0.10 orRs.1,020

SR = Actual output / standard output per ton or 10,200 / 1`00 or 102 tons

Price variance : Actual quantity of input (Standard price – Actual Price) or ( 10 – 10.50) x 100 =

Rs.50 ADV

Usage Variance : (Standard quantity – Actual quantity) standard price or (102 – 100) x 10 or

Rs.20 FAV

Yield variance = (Standard yield – Actual yield ) standard rate per unit of output or (10,000 –

10,200 ) 0.10 or Rs.20 FAV

Working : Standard yield = Actual quantity of material x standard rate per ton of output or

100 x 100 = 10,000 articles.

Example 3 : The standard mix of product MS is as follows Materials Qty in kg Price per kg

A 50 5

B 20 4

C 30 10

The standard loss in production is 10 % of input . There is no scrap value. Actual production for

a month was 7,240 kgs of MS from 80 mixes. Actual purchases and consumption of materials

are :

A 4,160 5.50

B 1,680 3.75

C 2,560 9.50 Solution



Statement showing standard input requirements of 80 mixes of product MS

Material Standard Actual

SQ SR SC AQ AR AC

A 4000 5 20,000 4160 5.50 22,880

B 1600 4 6,400 1680 3.75 6,300

C 2400 10 24,000 2560 9.50 24,320

Total 8000 50,400 8400 53,500

Less Std. Loss 800

Final output 7200 50,400

SC per kg of finished product = 50,400 / 7200 kg = Rs.7 per kg

Cost variance : SC AC or 7 x 7240 53500 or Rs.2,820 ADV

Prince Variance : (SR – AR ) x A Q

A = Rs.2,080 ADV

B = Rs.420 FAV

C = Rs.1,280 FAV

Mix Variance = (RSQ – AQ ) SR

A = (8400 x 50 / 100) Rs.5 = 200 FAV

B = 8400 x 20 / 100 x Rs.4 Nil

C = 8400 x 30 / 100 x Rs.10 = 400 ADV

Total : 200 ADV

Yield variance = (SY – AY ) SR per kg

Standard yield = 8400 kg x 9 / 10 or 7560 klg

(7,560 – 7,240 ) Rs.7 or Rs.2,240 ADV

15.12 Direct Labour Variances The same principles apply to the calculation of Direct Labor variances as for the direct material

variances. Standards are established for the rate of pay to be paid for the production of particular

products and labor time taken for their production. The standard time taken is expressed in

standard hours or minutes and become the measure of output. By comparing the standard hours

allowed and the actual time taken, labor efficiency can be assessed. In practice, standard times

are established by work, time and method study techniques.



Direct Labor variance : It is the difference between actual labor cost and the standard labor

cost of production achieved. It is calculated as :

Total Labor Cost = Hours worked x Rate per hour

Labor Cost Variance = Standard Cost – Actual Cost

Shorten = SC AC Or (Standard labor hours x standard rate per hour ) – (Actual labor hours

x Actual rate per hour)

Self Assessment Questions 11 1. Direct labor variance is ___________.

Example: The management of DR Ltd decides that it takes 6 standard hours to make one Denim jacket and the standard rate paid to labor is Rs.8 per hour. The actual production is 900 units

and this took 5,100 hours at a rate of Rs.8.30 per hour. Calculate the direct labor total variance.

Solution : Calculate the standard labor hour for 900 jackets

For one Jacket production, the standard hour is 6

Therefore, for producing 900 units, the standard hour is 900 x 6 / 1 = 5,400 hours

DLV = (5,400 x 8) )5,100 x 8.30 ) = Rs.870 favorable.

A favorable variance would result when actual cost is less than standard cost and vice versa.

Labor cost variance is the sum total of labor rate variance, labor efficiency variance, rate

variance, idle time and labor calendar variance

15.13 Labour Efficiency Variance It is that portion of labor cost variance which is due to the difference between the standard lab or

hours specified for the activity i.e output achieved and the actual labor hours worked. It is

calculated by multiplying standard rate of wages with the difference between standard hours and

actual hours worked.

LEV = Standard hours – actual hours worked ) x standard rate

Shorten = (SH – AH ) SR

A favorable variance would result when actual hours worked are less than standard hours and

vice versa.


1. Labor efficiency variance to _________________.



Example : From the data above, calculate the labor efficiency variance;

Solution : (5400 standard hours – 5100 actual hours ) x Rs,8 standard rate Rs.2,400 FAV

15.14 Labor Rate Variance It is that portion of labor cost variance which is due to the difference between the standard rate

specified and actual rate paid. It is calculated by multiplying the actual hours paid with the

difference between standard rate specified and actual rate paid

Labor Rate variance = (Standard Rate – Actual Rate ) x actual hours paid

Shorten = ( SR – AR) AH

Self Assessment Questions 13 1. Labor rate variance is __________.

Example 1: Citing DR example, calculate the direct labor rate variance

Solution : (Rs.8 – 8.30 ) x 5,100 hours or Rs.1,530 ADV

Example 2: The production of a certain unit is assumed to require 18 hours labor at a rate of Rs.1.25 per hour. On completion of a unit, it was found that the time taken was 16 hours, the

wage rate being Rs.1.50 per hour. Calculate labor variances. Solution : Cost variance = Standard cost – actual cost

Rs.22.50 – Rs.24 or Rs.1.50 ADV

Working : SC = Standard hours x standard rate per hour = 18 x Rs.1.25 = Rs.22.50

OR

LCV = LEV + LRV

2.5 FAV + 4 ADV= 1.5 ADV

Efficiency variance = (Standard hours – actual hours worked)standard rate

( 18 – 16) x 1.25 or Rs.2..50 FAV

Rate variance = (Standard rate – actual rate) actual hours paid

(1.25 – 1.50) 16 or Rs.4 ADV

Labor Idle Time variance : It is that portion of labor cost variance which is due to abnormal idle

time of workers. This variance is calculated to show separately the effect of abnormal causes

affecting production such as failure of power supplies, machine break down, waiting for materials,

waiting for instructions, strike, lockouts. It is calculated as:

Labor idle time variance = Idle hours x standard hourly rate



This variance is always an adverse one.

Example 3: In the ma manufacture of a product, 200 employees are engaged at a rate of 50 paise per hour. A five day week of 40 hours is worked and the standard performance is set at

250 units per hour. During the first week in January, six employee were paid at 45 paise an hour

and four at 56 paise an hour, the remaining employees were paid at standard rates. The factory

stopped production for one hour due to power failure. Calculate variances.

Solution : Efficiency variance = (Std hours – actual hours worked ) x std rate (8000 – 7800) 0.50 or Rs.100 FAV

Rate variance = (SR – AR ) AH

(0.50 – 190 employees x 40 hours = Nil

(0.50 – 0.40 ) x 6 x 40 12 FAV

(0.50 .56 ) 4 x 40 9.60 ADV

Total 2.40 FAV

Idle time variance = Idle hours x std rate per hour

200 hrs and 0.50 or Rs.100 ADV

Labor cost variance = LEV +_ LRV + Idle time variance

100 FAV + 2.40 FAV + 100 ADV = Rs.2.40

15.15 Labour Mix Variance This variance arises only when different types of workers (women and men workers, trained,

semitrained and untrained workers, are employed in manufacturing. If actual working force of

different grades of workers is not in the predetermined ratio, then the mix variance will occur.

The variance shows to the management as to how much of the labor cost variance is due to the

changes in the composition of labor force. It is calculated as follows :

LMV = (Revised standard hours – actual hours worked) x standard hourly rate

Shorten (RSLH – ALH) x SR

Where revised standard hour = total time of actual worker / total time of standard workers x

standard labor rate.

Self Assessment Questions 14 1. Labor mix variance is _________________.

Example 1: The labor budget for a week is as follows :

40 skilled men at Rs.1.50 per hour for 80 hours



80 unskilled men at Re.1 per hour for 80 hours

Actual labor force was used are given below;


60 unskilled men at Re.1 per hour for 80 hours

Calculate labor mix variance.

Solution : Revised standard labor hours = total time of actual workers / total time of standard workers x standard labor hours

Skilled worker = 80 / 80 x 80 = 80 hours

Unskilled = 80 / 80 x 80 = 80 hours

LMV = Skilled = (3,200 – 4,800) 1.50 = Rs.2,400 ADV

Unskilled = (6,400 – 4,800) Re.1 = Rs.1,600 FAV

Total labor mix variance Rs.800 ADV.

15.16 Labor Yied Variance. This is due to the difference in the standard output specified and the actual output obtained. The

formula is as follows :

LYV : (Actual output – Standard output ) x standard cost per unit


1. Labor yield variance ________________.

Example 1: Actual output 460 units. Standard output 500 units. Standard rate of wages Rs.9 per

hour. A Standard time 2 hour per unit.

Solution : Standard cost per unit = Rs.9 x 2 hours = Rs.18

LYV = (AO – SO) SC or (460 – 500 units) x Rs.18 or Rs.720 ADV

Example 2: Calculate (a) Labor rate variance (b) labor efficiency variance (c) labor cost variance

Standard : Labor rate 0.24 paise per hour. Labor hours 3 per unit. Actual : Units produced 250. Labor rate 0.25 perise per hour. Hours worked 800.

Solution: LRV : (SR = AR) AH or Rs.8 ADV LEV = (SH – AH ) SR or Rs.12 ADV

LCV = (SLC – ALC) or (SH x SR) – (AH x AR) = Rs.20 ADV

Example 3 : The standard labor force of DR Ltd is as follows :



20 skilled men at Re.0.50 per hour for 40 hrs

40 semi skilled men at 0.35 per hour for 40 hrs.

During a certain week, the actual ,labor force was :


30 semi skilled men at 0.40 per hour

Analyze labor variance for 40 hours.

Solution : Calculation of standard hours

Actual hours : 30 x 40 = 1,200 hours

30 x 40 = 1.200 hours

20 x 40 = 800 hours

40 x 40 = 1,600 hours

Total 2,400 hours

Since standard hours and actual hours are the same in total there would be no labor efficiency

variance.

Labor cost variance : SLC – ALC or Rs.120 ADV

Labor rate variance : Skilled : (SR – AR) AH or Nil

Semi skilled (0.350.40) 1,200 or 60 ADV

Labor mix variance = ( SH – AH ) SR

Skilled (800 – 1200) x 0.50 or 200 ADV

Semi skilled (1,600 – 1,200)Rs.0.35 or 140 FAV

Example 4: A contract job is scheduled to be completed in 20 weeks with a labor force of 10 skilled workers, 4 semi skilled workers and 6 unskilled workers. The standard weekly wages of

each type of workers are : Skilled Rs.50, semi skilled Rs.40 and unskilled Rs.30. The work is

actually completed in 25 weeks with a labor force of 8 skilled, 5 semiskilled and 7 unskilled

workers and the actual weekly wage rates average Rs.55 for skilled, Rs.45 for semi skilled and

Rs.25 for unskilled workers. Analyze the variance.



Solution

Grade Standard Actual

No. Weeks Weekly rate Amount No. Weeks Rate AmountSkilled

10 20 Rs.50 10,000 8 25 Rs.55 11,000 Semiskilled

4 20 Rs.40 3,200 5 25 Rs.45 5,625 Unskilled

6 20 Rs.30 3,600 7 25 Rs.25 4,375

l 20 16,800 20 21,000

Skilled Semiskilled Unskilled

LRV = (SR – AR) AT 1,000 ADV 625 ADV 875 FAV

LEV = (ST – AT ) SR Nil 1,800 ADV 1.650 ADV

LMV (RSLH – ALH) SR 2500 FAV 1,000 ADV 750 ADV

Total 750 FAV

Labor cost variance : LRV + LEV = 750 + 3450 = 4200 ADV

Labor yield variance = (Actual weeks – standard weeks ) Standard rate per hour

(500 – 400 ) Rs.42 = Rs.4,200 ADV (16800 / (20 nos x 20 weeks)

RSLH : Total time of actual workers / total time of standard workers x Standard labor hours

500 / 400 x 200 = 250 = (250 – 200 ) 50 = Rs.2,500 FAV

500 / 400 x 80 = 100 = (100 – 125) 40 = Rs.1,000 ADV

500 / 400 x 120 = 150 = (150 – 175 ) x 30 = Rs.750 ADV

Terminal Questions 1. How is standard costing related to budgetary control ?

2. How do you fix standard for direct material, direct labor and direct overheads ?

3. Write short note on :

a. Material Price Variance

b. Material Mix Variance

c. Material Yield Variance.

4. Briefly describe labor mix variance and yield variance.

5. Compute price, usage, cost and mix variance



Material Standard Actual

Quantity Price Total Qty Price Total

A 6 1.50 9 5 2.40 12

B 2 3.5 7 1 6 6

6. Data given below pertain to DR Ltd

DEPARTMENT

A B

Actual gross wages 2,000 1,800

Standard hours produced 8,000 6,000

Standard rate per hour 0.30 0.35

Actual hours worked 8,000 5,800

Calculate labor variances.


Self Assessment Questions 1 1. Cost of each product


1. Finical control


1. Closely interrelated

Self Assessment Questions 4 1. Direct martial, direct labor, overheads


1. Deviation

2. Process of analysis

3. Favorable and adverse.


1. SC – AC




1. ( SP – AP) x AQ

Self Assessment Questions 8 1. SQ – AQ x SP


1. RSQ – AQ x SP


1. SY – AY x SR


1. SC – AC


1. SH – AH x SR

Self Assessment Questions 13 1. SR – AR x AH


1. RSLH – ALH x SR


1. AO – SO x SC

Answer for Terminal Questions 1. Refer to unit 15.4


3. Refer to unit 15.8, 15.10 and15.11

4. Refer to unit 15.15 and15.16

5. Price variance = (SR – AR) AQ for A = Rs.4.50 ADV

For B = Rs.2.50 ADV total Rs.7 ADV

Usage variance : (SQ – AQ ) SP for A = 1.50 FAV

For B = 3.50 FAV Total Rs.5 FAV

Cost Variance = MUV + MPV = 5 – 7 or 2 ADV

Mix variance = (RSQ – AQ ) SP where RSQ = A 6 /8 x 6 or 4.5 kgs



B 6 /8 x 2 or 1.5 kgs

For A (4.5 – 5) x 1.5 or 0.75 ADV

For B (1.5 – 1) x 3.5 or 1.75 FAV Therefore total 1 FAV

6. Standard labor cost ; Dept A 8000 x 0.30 = 2,400

B 6,000 x 0.35 = 2,100

Actual rate A 2000 ./ 8000 = 0..25

B 1800 / 5800 or 900 /29 paise

LRV = (SR – AR ) AH Dept A = (0.30 – 0.25) 8000 = 400 FAV

B = (.35 – 900 /25) x 5800 = 230 ADV

LEV = (SH – AH) SR For A = (8000 – 8000) x0.30 Nil

B = (6000 – 5800)0.35 70 ADV

LCV : (SLC – ALC For A (2400 – 2000) 400 FAV

B (2100 – 1800) 300 ADV

MB0025 - Financial and Management Accounting

Documents

Transcript of MB0025 - Financial and Management Accounting