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Subject :Accounting for Managers Updated by:Dr. Mahesh Chand Garg

Course Code : CP-104
Lesson No. : 1
FINANCIAL ACCOUNTING : MEANING, NATURE AND ROLE
OF ACCOUNTING
STRUCTURE
1.0 Objective
1.1 Introduction
1.2 Origin and Growth of Accounting
1.3 Meaning of Accounting
1.4 Distinction between Book-Keeping and Accounting
1.5 Distinction between Accounting and Accountancy
1.6 Nature of Accounting
1.7 Objectives of Accounting
1.8 Users of Accounting Information
1.9 Branches of Accounting
1.10 Role of Accounting
1.11 Limitations of Accounting
1.12 Systems of Accounting
1.13 Summary
1.14 Keywords
1.15 Self Assessment Questions
1.16 Suggested Readings
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1.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define accounting and trace the origin and growth of accounting.
(b) Distinguish between book-keeping and accounting.
(c) Explain the nature and objectives of accounting.
(d) Discuss the branches, role and limitations of accounting.
1.1 INTRODUCTION
Accounting has rightly been termed as the language of the business.
The basic function of a language is to serve as a means of communication
Accounting also serves this function. It communicates the results of business
operations to various parties who have some stake in the business viz., the
proprietor, creditors, investors, Government and other agencies. Though
accounting is generally associated with business but it is not only business which
makes use of accounting. Persons like housewives, Government and other
individuals also make use of a accounting. For example, a housewife has to keep a
record of the money received and spent by her during a particular period. She can
record her receipts of money on one page of her "household diary" while payments
for different items such as milk, food, clothing, house, education etc. on some
other page or pages of her diary in a chronological order. Such a record will help
her in knowing about :
(i) The sources from which she received cash and the purposes for which it
was utilised.
(ii) Whether her receipts are more than her payments or vice-versa?
(iii) The balance of cash in hand or deficit, if any at the end of a period.
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In case the housewife records her transactions regularly, she can
collect valuable information about the nature of her receipts and payments. For
example, she can find out the total amount spent by her during a period (say a
year) on different items say milk, food, education, entertainment, etc. Similarly
she can find the sources of her receipts such as salary of her husband, rent from
property, cash gifts from her relatives, etc. Thus, at the end of a period (say a
year) she can see for herself about her financial position i.e., what she owns and
what she owes. This will help her in planning her future income and expenses (or
making out a budget) to a great extent.
The need for accounting is all the more great for a person who is
running a business. He must know : (i) What he owns? (ii) What he owes? (iii)
Whether he has earn a profit or suffered a loss on account of running a business?
(iv) What is his financial position i.e. whether he will be in a position to meet all
his commitments in the near future or he is in the process of becoming a bankrupt.
1.2 ORIGIN AND GROWTH OF ACCOUNTING
Accounting is as old as money itself. However, the act of accounting
was not as developed as it is today because in the early stages of civilisation, the
number of transactions to be recorded were so small that each businessman was
able to record and check for himself all his transactions. Accounting was practised
in India twenty three centuries ago as is clear from the book named "Arthashastra"
written by Kautilya, King Chandragupta's minister. This book not only relates to
politics and economics, but also explain the art of proper keeping of accounts.
However, the modern system of accounting based on the principles of double
entry
system owes it origin to Luco Pacioli who first published the principles of Double
Entry System in 1494 at Venice in Italy. Thus, the art of accounting has been
practised for centuries but it is only in the late thirties that the study of the subject
'accounting' has been taken up seriously.
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1.3 MEANING OF ACCOUNTING
The main purpose of accounting is to ascertain profit or loss during
a specified period, to show financial condition of the business on a particular
date and to have control over the firm's property. Such accounting records are
required to be maintained to measure the income of the business and communicate
the information so that it may be used by managers, owners and other interested
parties. Accounting is a discipline which records, classifies, summarises and
interprets financial information about the activities of a concern so that intelligent
decisions can be made about the concern. The American Institute of Certified
Public Accountants has defined the Financial Accounting as "the art of recording,
classifying and summarising in as significant manner and in terms of money
transactions and events which in part, at least of a financial character, and
interpreting the results thereof". American Accounting Association defines
accounting as "the process of identifying, measuring, and communicating
economic
information to permit informed judgements and decisions by users of the
information.
From the above the following attributes of accounting emerge :
(i) Recording : It is concerned with the recording of financial transactions in
an orderly manner, soon after their occurrence In the proper books of accounts.
(ii) Classifying : It Is concerned with the systematic analysis of the recorded
data so as to accumulate the transactions of similar type at one place. This function
is performed by maintaining the ledger in which different accounts are opened to
which related transactions are posted.
(iii) Summarising : It is concerned with the preparation and presentation of
the classified data in a manner useful to the users. This function involves the
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preparation of financial statements such as Income Statement, Balance Sheet,
Statement of Changes in Financial Position, Statement of Cash Flow, Statement
of Value Added.
(iv) Interpreting : Nowadays, the aforesaid three functions are performed by
electronic data processing devices and the accountant has to concentrate mainly
on the interpretation aspects of accounting. The accountants should interpret the
statements in a manner useful to action. The accountant should explain not only
what has happened but also (a) why it happened, and (b) what is likely to happen
under specified conditions.
1.4 DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING
Book-keeping is a part of accounting and is concerned with the
recording of transactions which is often routine and clerical in nature, whereas
accounting performs other functions as well, viz., measurement and
communication, besides recording. An accountant is required to have a much
higher level of knowledge, conceptual understanding and analytical skill than is
required of the book-keeper.
An accountant designs the accounting system, supervises and checks
the work of the book-keeper, prepares the reports based on the recorded data and
interprets the reports. Nowadays, he is required to take part in matters of
management, control and planning of economic resources.
1.5 DISTINCTION BETWEEN ACCOUNTING AND ACCOUNTANCY
Although in practice Accountancy and Accounting are used
interchangeably yet there is a thin line of demarcation between them. The word
Accountancy is used for the profession of accountants - who do the work of
accounting and are knowledgeable persons. Accounting is concerned with
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recording all business transactions systematically and then arranging in the form
of various accounts and financial statements. And it is a distinct discipline like
economics, physics, astronomy etc. The word accounting tries to explain the
nature
of the work of the accountants (professionals) and the word Accountancy refers
to the profession these people adopt.
1.6 NATURE OF ACCOUNTING
The various definitions and explanations of accounting has been
propounded by different accounting experts from time to time and the following
aspects comprise the nature of accounting :
i ) Accounting as a service activity
Accounting is a service activity. Its function is to provide quantitative
information, primarily financial in nature, about economic entities that is intended
to be useful in making economic decisions, in making reasoned choices among
alternative courses of action. It means that accounting collects financial
information for the various users for taking decisions and tackling business issues.
Accounting in itself cannot create wealth though, if it produces information which
is useful to others, it may assist in wealth creation and maintenance.
(ii) Accounting as a profession
Accounting is very much a profession. A profession is a career that
involve the acquiring of a specialised formal education before rendering any
service. Accounting is a systematized body of knowledge developed with the
development of trade and business over the past century. The accounting
education
is being imparted to the examinees by national and international recognised the
bodies like The Institute of Chartered Accountants of India (ICAI), New Delhi in
India and American Institute of Certified Public Accountants (AICPA) in USA
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etc. The candidate must pass a vigorous examination in Accounting Theory,
Accounting Practice, Auditing and Business Law. The members of the
professional
bodies usually have their own associations or organisations, where in they are
required to be enrolled compulsorily as Associate member of the Institute of
Chartered Accountants (A.C.A.) and fellow of the Institute of Chartered
Accountants (F.C.A.). In a way, accountancy as a profession has attained the
stature
comparable with that of lawyer, medicine or architecture.
(iii) Accounting as a social force
In early days, accounting was only to serve the interest of the owners.
Under the changing business environment the discipline of accounting and the
accountant both have to watch and protect the interests of other people who are
directly or indirectly linked with the operation of modern business. The society
is composed of people as customer, shareholders, creditors and investors. The
accounting information/data is to be used to solve the problems of the public at
large such as determination and controlling of prices. Therefore, safeguarding of
public interest can better be facilitated with the help of proper, adequate and
reliable accounting information and as a result of it the society at large is
benefited.
(iv) Accounting as a language
Accounting is rightly referred the "language of business". It is one
means of reporting and communicating information about a business. As one has
to learn a new language to converse and communicate, so also accounting is to be
learned and practised to communicate business events.
A language and accounting have common features as regards rules
and symbols. Both are based and propounded on fundamental rules and symbols.
In language these are known as grammatical rules and in accounting, these are
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termed as accounting rules. The expression, exhibition and presentation of
accounting data such as a numerals and words and debits and credit are accepted
as symbols which are unique to the discipline of accounting.
(v) Accounting as science or art
Science is a systematised body of knowledge. It establishes a
relationship of cause and effect in the various related phenomenon. It is also based
on some fundamental principles. Accounting has its own principles e.g. the double
entry system, which explains that every transaction has two fold aspect i.e. debit
and credit. It also lays down rules of journalising. So we can say that accounting
is a science.
Art requires a perfect knowledge, interest and experience to do a
work efficiently. Art also teaches us how to do a work in the best possible way by
making the best use of the available resources. Accounting is an art as it also
requires knowledge, interest and experience to maintain the books of accounts in
a systematic manner. Everybody cannot become a good accountant. It can be
concluded from the above discussion that accounting is an art as well as a science.
(vi) Accounting as an information system
Accounting discipline will be the most useful one in the acquisition
of all the business knowledge in the near future. You will realise that people will
be constantly exposed to accounting information in their everyday life. Accounting
information serves both profit-seeking business and non-profit organisations. The
accounting system of a profit-seeking organisation is an information system
designed to provide relevant financial information on the resources of a business
and the effect of their use. Information is relevant and valuable if the decision
makers can use it to evaluate the financial consequences of various alternatives.
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Accounting generally does not generate the basic information (raw financial data),
rather the raw financial data result from the day to day transactions of the business.
As an information system, accounting links an information source
or transmitter (generally the accountant), a channel of communication (generally
the financial statements) and a set of receivers (external users).
1.7 OBJECTIVES OF ACCOUNTING
The following are the main objectives of accounting :
1. To keep systematic records : Accounting is done to keep a systematic
record of financial transactions. In the absence of accounting there would have
been terrific burden on human memory which in most cases would have been
impossible to bear.
2. To protect business properties : Accounting provides protection to
business properties from unjustified and unwarranted use. This is possible on
account of accounting supplying the following information to the manager or the
proprietor:
(i) The amount of the proprietor's funds invested in the business.
(ii) How much the business have to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) cash
in hand, (c) cash at bank, (d) stock of raw materials, work-in-progress
and finished goods?
Information about the above matters helps the proprietor in assuring
that the funds of the business are not necessarily kept idle or underutilised.
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3. To ascertain the operational profit or loss : Accounting helps in
ascertaining the net profit earned or loss suffered on account of carrying the
business. This is done by keeping a proper record of revenues and expense of a
particular period. The Profit and Loss Account is prepared at the end of a period
and if the amount of revenue for the period is more than the expenditure incurred
in earning that revenue, there is said to be a profit. In case the expenditure exceeds
the revenue, there is said to be a loss.
Profit and Loss Account will help the management, investors,
creditors, etc. in knowing whether the business has proved to be remunerative or
not. In case it has not proved to be remunerative or profitable, the cause of such a
state of affairs will be investigated and necessary remedial steps will be taken.
4. To ascertain the financial position of the business : The Profit and Loss
Account gives the amount of profit or loss made by the business during a
particular
period. However, it is not enough. The businessman must know about his financial
position i.e. where he stands ?, what he owes and what he owns? This objective is
served by the Balance Sheet or Position Statement. The Balance Sheet is a
statement of assets and liabilities of the business on a particular date. It serves as
barometer for ascertaining the financial health of the business.
5. To facilitate rational decision making : Accounting these days has taken
upon itself the task of collection, analysis and reporting of information at the
required points of time to the required levels of authority in order to facilitate
rational decision-making. The American Accounting Association has also stressed
this point while defining the term accounting when it says that accounting is the
process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information. Of course,
this is by no means an easy task. However, the accounting bodies all over the
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world and particularly the International Accounting Standards Committee, have
been trying to grapple with this problem and have achieved success in laying
down
some basic postulates on the basis of which the accounting statements have to be
prepared.
6. Information System : Accounting functions as an information system for
collecting and communicating economic information about the business enterprise.
This information helps the management in taking appropriate decisions. This
function, as stated, is gaining tremendous importance these days.
1.8 USERS OF ACCOUNTING INFORMATION
The basic objective of accounting is to provide information which is
useful for persons inside the organisation and for persons or groups outside the
organisation. Accounting is the discipline that provides information on which
external and internal users of the information may base decisions that result in
the allocation of economic resources in society.
I. External Users of Accounting Information : External users are those
groups or persons who are outside the organisation for whom accounting function
is performed. Following can be the various external users of accounting
information:
1. Investors, Those who are interested in investing money in an organisation
are interested in knowing the financial health of the organisation of know how
safe the investment already made is and how safe their proposed investment will
be. To know the financial health, they need accounting information which will
help them in evaluating the past performance and future prospects of the
organisation. Thus, investors for their investment decisions are dependent upon
accounting information included in the financial statements. They can know the
profitability and the financial position of the organisation in which they are
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interested to make that investment by making a study of the accounting
information
given in the financial statements of the organisation.
2. Creditors. Creditors (i.e. supplier of goods and services on credit, bankers
and other lenders of money) want to know the financial position of a concern
before giving loans or granting credit. They want to be sure that the concern will
not experience difficulty in making their payment in time i.e. liquid position of
the concern is satisfactory. To know the liquid position, they need accounting
information relating to current assets, quick assets and current liabilities which
is available in the financial statements.
3. Members of Non-profit Organisations. Members of non-profit
organisations such as schools, colleges, hospitals, clubs, charitable institutions
etc. need accounting information to know how their contributed funds are being
utilised and to ascertain if the organisation deserves continued support or support
should be withdrawn keeping in view the bad performance depicted by the
accounting information and diverted to another organisation. In knowing the
performance of such organisations, criterion will not be the profit made but the
main criterion will be the service provided to the society.
4. Government. Central and State Governments are interested in the accounting
information because they want to know earnings or sales for a particular period
for purposes of taxation. Income tax returns are examples of financial reports
which are prepared with information taken directly from accounting records.
Governments also needs accounting information for compiling statistics
concerning business which, in turn helps in compiling national accounts.
5. Consumers. Consumers need accounting information for establishing good
accounting control so that cost of production may be reduced with the resultant
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reduction of the prices of goods they buy. Sometimes, prices for some goods are
fixed by the Government, so it needs accounting information to fix reasonable
prices so that consumers and manufacturers are not exploited. Prices are fixed
keeping in view fair return to manufacturers on their investments shown in the
accounting records.
6. Research Scholars. Accounting information, being a mirror of the financial
performance of a business organisation, is of immense value to the research
scholars who wants to make a study to the financial operations of a particular
firm. To make a study into the financial operations of a particular firm, the
research
scholar needs detailed accounting information relating to purchases, sales,
expenses, cost of materials used, current assets, current liabilities, fixed assets,
long term liabilities and shareholders' funds which is available in the accounting
records maintained by the firm.
II Internal Users of Accounting Information. Internal users of accounting
information are those persons or groups which are within the organisation.
Following are such internal users :
1. Owners. The owners provide funds for the operations of a business and
they want to know whether their funds are being properly used or not. They need
accounting information to know the profitability and the financial position of the
concern in which they have invested their funds. The financial statements prepared
from time to time from accounting records depicts them the profitability and the
financial position.
2. Management. Management is the art of getting work done through others,
the management should ensure that the subordinates are doing work properly.
Accounting information is an aid in this respect because it helps a manager in
appraising the performance of the subordinates. Actual performance of the
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employees can be compared with the budgeted performance they were expected
to achieve and remedial action can be taken if the actual performance is not upto
the mark. Thus, accounting information provides "the eyes and ears to
management".
The most important functions of management are planning and
controlling. Preparation of various budgets, such as sales budget, production
budget, cash budget, capital expenditure budget etc., is an important part of
planning function and the starting point for the preparation of the budgets is the
accounting information for the previous year. Controlling is the function of seeing
that programmes laid down in various budgets are being actually achieved i.e.
actual
performance ascertained from accounting is compared with the budgeted
performance, enabling the manager to exercise controlling case of weak
performance. Accounting information is also helpful to the management in fixing
reasonable selling prices. In a competitive economy, a price should be based on
cost plus a reasonable rate of return. If a firm quotes a price which exceeds cost
plus a reasonable rate of return, it probably will not get the order. On the other
hand, if the firm quotes a price which is less than its cost, it will be given the
order but will incur a loss on account of price being lower than the cost. So,
selling prices should always be fixed on the basis of accounting data to get the
reasonable margin of profit on sales.
3. Employees. Employees are interested in the financial position of a concern
they serve particularly when payment of bonus depends upon the size of the
profits
earned. They seek accounting information to know that the bonus being paid to
them is correct.
1.9 BRANCHES OF ACCOUNTING
To meet the ever increasing demands made on accounting by different
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interested parties such as owners, management, creditors, taxation authorities etc.,
the various branches have come into existence. There are as follows :
1. Financial accounting. The object of financial accounting is to ascertain
the results (profit or loss) of business operations during the particular period and
to state the financial position (balance sheet) as on a date at the end of the period.
2. Cost accounting. The object of cost accounting is to find out the cost of
goods produced or services rendered by a business. It also helps the business in
controlling the costs by indicating avoidable losses and wastes.
3. Management accounting. The object of management accounting is to supply
relevant information at appropriate time to the management to enable it to take
decisions and effect control.
In this lesson we are concerned only with financial accounting.
Financial accounting is the oldest and other branches have developed from it. The
objects of financial accounting, as stated above, can be achieved only by recording
the financial transactions in a systematic manner according to a set of principles.
The art of recording financial transactions and events in a systematic manner in
the books of account is known as book-keeping. However, mere record of
transactions is not enough. The recorded information has to be classified, analysed
and presented in a manner in which business results and financial position can be
ascertained.
1.10 ROLE OF ACCOUNTING
Accounting plays an important and useful role by developing the
information for providing answers to many questions faced by the users of
accounting information :
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(1) How good or bad is the financial condition of the business?
(2) Has the business activity resulted in a profit or loss ?
(3) How well the different departments of the business have performed in the
past?
(4) Which activities or products have been profitable?
(5) Out of the existing products which should be discontinued and the production
of which commodities should be increased?
(6) Whether to buy a component from the market or to manufacture the same?
(7) Whether the cost of production is reasonable or excessive?
(8) What has been the impact of existing policies on the profitability of the
business?
(9) What are the likely results of new policy decisions on future earning
capacity of the business?
(10) In the light of past performance of the business how should it plan for future
to ensure desired results?
Above mentioned are few examples of the types of questions faced
by the users of accounting information. These can be satisfactorily answered with
the help of suitable and necessary information provided by accounting.
Besides, accounting is also useful in the following respects :
(a) Increased volume of business results in large number of transactions and
no businessman can remember everything. Accounting records obviate the
necessity of remembering various transactions.
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(b) Accounting records, prepared on the basis of uniform practices, will enable
a business to compare results of one period with another period.
(c) Taxation authorities (both income tax and sales tax) are likely to believe
the facts contained in the set of accounting books if maintained according
to generally accepted accounting principles.
(d) Accounting records, backed up by proper and authenticated vouchers, are
good evidence in a court of law.
(e) If a business is to be sold as a going concern, then the values of different
assets as shown by the balance sheet helps in bargaining proper price for
the business.
1.11 LIMITATIONS OF FINANCIAL ACCOUNTING
Advantages of accounting discussed in this lesson do not suggest that
accounting is free from limitations. Any one who is using accounting information
should be well aware of its limitations also. Following are the limitations :
(a) Financial accounting permits alternative treatments
No doubt accounting is based on concepts and it follows "generally
accepted accounting principles", but there exist more than one principle for the
treatment of any one item. This permits alternative treatments within the
framework of generally accepted accounting principles. For example, the closing
stock of a business may be valued by any one of the following methods : FIFO
(First-in-first-out); LIFO (Last-in-first-out); Average price, Standard price etc.,
Application of different methods will give different results but the methods are
generally accepted. So, the results are not comparable.
(b) Financial accounting is Influenced by personal judgements
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Inspite of the fact that convention of objectivity is respected in
accounting but to record certain events estimates have to be made which requires
personal judgement. It is very difficult to expect accuracy in future estimates and
objectivity suffers. For example, in order to determine the amount of depreciation
to be charged every year for the use of fixed asset it is required to estimate (a)
future life of the asset, and (b) scrap value of the asset. Thus in accounting we do
not determine but measure the income. In other words, the income disclosed by
accounting is not authoritative but approximation.
(c) Financial accounting ignores important non-monetary information
Financial accounting takes into consideration only those transactions
and events which can be described in money. The transactions and events,
however
important, if non-monetary in nature are ignored i.e., not recorded. For example,
extent of competition faced by the business, technical innovations possessed by
the business, loyalty and efficiency of the employees etc. are the important matters
in which management of the business is highly interested but accounting is not
tailored to take note of such matters. Thus any user of financial information is,
naturally, deprived of vital information which is of non-monetary character.
(d) Financial accounting does not provide timely information
Financial accounting is designed to supply information in the form
of statements (Balance Sheet and Profit and Loss Account) for a period, normally,
one year. So the information is, at best, of historical interest and only postmortem
analysis of the past can be conducted. The business requires timely information
at frequent intervals to enable the management to plan and take corrective action.
For example, if a business has budgeted that during the current year sales should
be Rs. 12,00,000 then it requires information – whether the sales in the first
month of the year amounted to Rs. 1,00,000 or less or more? Traditionally,
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financial accounting is not supposed to supply information at shorter intervals
than one year.
(e) Financial accounting does not provide detailed analysis
The information supplied by the financial accounting is in reality
aggregate of the financial transactions during the course of the year. Of course, it
enables to study the overall results of the business activity during the accounting
period. For proper running of the business the information is required regarding
the cost, revenue and profit of each product but financial accounting does not
provide such detailed information product-wise. For example, if a business has
earned a total profit of, say, Rs. 5,00,000 during the accounting year and it sells
three products namely petrol, diesel and mobile oil and wants to know profit
earned
by each product. Financial accounting is not likely to help him.
(f) Financial accounting does not disclose the present value of the business
In financial accounting the position of the business as on a particular
date is shown by a statement known as balance sheet. In balance sheet the assets
are shown on the basis of going concern concept. Thus it is presumed that business
has relatively longer life and will continue to exist indefinitely, hence the asset
values are going concern values. The realised value of each asset if sold today
can't be known by studying the balance sheet.
1.12 SYSTEMS OF ACCOUNTING
The following are the main systems of recording business
transactions:
(a) Cash System. Under this system, actual cash receipts and actual cash
payments are recorded. Credit transactions are not recorded at all until the cash
in actually received or paid. The Receipts and Payments Account prepared in case
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of non-trading concerns such as a charitable institution, a club, a school, a college,
etc. and professional men like a lawyer, a doctor, a chartered accountant etc. can
be cited as the best example of cash system. This system does not make a
complete
record of financial transactions of a trading period as it does not record
outstanding transactions like outstanding expenses and outstanding incomes. The
system being based on a record of actual cash receipts and actual cash payments
will not be able to disclose correct profit or loss for a particular period and will
not exhibit true financial position of the business on a particular day.
(b) Mercantile (Accrual) system. Under this system all transactions relating to
a period are recorded in the books of account i.e., in addition to actual receipts
and payments of cash income receivable and expenses payable are also recorded.
This system gives a complete picture of the financial transactions of the business
as it makes a record of all transactions relating to a period. The system being
based on a complete record of the financial transactions discloses correct profit
or loss for a particular period and also exhibits true financial position of the
business on a particular day.
1.13 SUMMARY
Accounting can be understood as the language of financial decisions.
It is an ongoing process of performance measurement and reporting the results to
decision makers. The discipline of accounting can be traced back to very early
times of human civilization. With the advancement of industry, modern day
accounting has become formalized and structured. A person who maintains
accounts is known as the account. The information generated by accounting is
used by various interested groups like, individuals, managers, investors, creditors,
government, regulatory agencies, taxation authorities, employee, trade unions,
consumers and general public. Depending upon purpose and method, accounting
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can be broadly three types; financial accounting, cost accounting and management
accounting. Financial accounting is primarily concerned with the preparation of
financial statements. It is used on certain well-defined concepts and conventions
and helps in framing broad financial policies. However, it suffers from certain
limitations.
1.14 KEYWORDS
Book-keeping: It is the art of recording in the books of accounts the monetary
aspect of commercial or financial transactions.
Accounting: It is the means of collecting, summarising and reporting in monetary
terms, information about the business.
Financial accounting: Financial accounting deals with the maintenance of books
of accounts with a view to ascertain the profitability and the financial status of
the business.
Transaction: A transaction is a stimulus from one person and a related response
from the another.
1.15 SELF ASSESSMENT QUESTIONS
1. Define accounting. Discuss the objectives of accounting.
2. What are the various interested parties which use accounting information?
3. What is meant by book-keeping and accounting? Is accounting a science or art?
4. Briefly describe the various branches of accounting.
5. Distinguish between :
(a) Accounting and Accountancy
(b) Cash and Mercantile System of Accounting
(1)
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 2
ACCOUNTING CONCEPTS AND CONVENTIONS
STRUCTURE
2.0 Objective
2.1 Introduction
2.2 Meaning and essential features of Accounting Principles
2.3 Accounting Principles
2.4 Accounting Concepts
2.5 Accounting Conventions
2.6 Accounting Standards
2.7 Summary
2.8 Keywords
2.9 Self Assessment Questions
2.10 Suggested Readings
2.0 OBJECTIVE
After studying this lesson, you should be able :
(a) to know the need for a conceptual frame work of accounting;
(b) to understand and describe the generally accepted accounting
principles (GAAP); and
(c) to appreciate the importance and advantages of uniformity in
accounting policies and practices.
2.1 INTRODUCTION
Accounting is often called the language of business because the purpose of
accounting is to communicate or report the results of business operations and its
various aspects to various users of accounting information. In fact, today,
accounting
statements or reports are needed by various groups such as shareholders, creditors,
potential investors, columnist of financial newspapers, proprietors and others.
In view of the utility of accounting reports to various interested parties, it becomes
imperative to make this language capable of commonly understood by all.
Account(
2)
ing could become an intelligible and commonly understood language if it is based
on generally accepted accounting principles. Hence, you must be familiar with
the accounting principles behind financial statements to understand and
use them properly.
2.2 MEANING AND FEATURES OF ACCOUNTING PRINCIPLES
For searching the goals of the accounting profession and for expanding
knowledge in this field, a logical and useful set of principles and procedures
are to be developed. We know that while driving our vehicles, follow
a standard traffic rules. Without adhering traffic rules, there would be
much chaos on the road. Similarly, some principles apply to accounting.
Thus, the accounting profession cannot reach its goals in the absence of a
set rules to guide the efforts of accountants and auditors. The rules and
principles of accounting are commonly referred to as the conceptual framework
of accounting.
Accounting principles have been defined by the Canadian Institute of
Chartered Accountants as “The body of doctrines commonly associated with
the theory and procedure of accounting serving as an explanation of current
practices and as a guide for the selection of conventions or procedures
where alternatives exists. Rules governing the formation of accounting axioms
and the principles derived from them have arisen from common experience,
historical precedent statements by individuals and professional bodies
and regulations of Governmental agencies”. According to Hendriksen
(1997), Accounting theory may be defined as logical reasoning in the form
of a set of broad principles that (i) provide a general frame of reference by
which accounting practice can be evaluated, and (ii) guide the development
of new practices and procedures. Theory may also be used to explain existing
practices to obtain a better understanding of them. But the most important
goal of accounting theory should be to provide a coherent set of logi(
3)
cal principles that form the general frame of reference for the evaluation
and development of sound accounting practices.
The American Institute of Certified Public Accountants (AICPA) has
advocated the use of the word” Principle” in the sense in which it means
“rule of action”. It discuses the generally accepted accounting principles
as follows :
Financial statements are the product of a process in which a large
volume of data about aspects of the economic activities of an enterprise
are accumulated, analysed and reported. This process should be carried out
in conformity with generally accepted accounting principles. These principles
represent the most current consensus about how accounting information
should be recorded, what information should be disclosed, how it
should be disclosed, and which financial statement should be prepared. Thus,
generally accepted principles and standards provide a common financial
language to enable informed users to read and interpret financial statements.
Generally accepted accounting principles encompass the conventions,
rules and procedures necessary to define accepted accounting practice at a
particular time....... generally accepted accounting principles include not
only broad guidelines of general application, but also detailed practices
and procedures (Source : AICPA Statement of the Accounting Principles
Board No. 4, “Basic Concepts and Accounting Principles underlying Financial
Statements of Business Enterprises “, October, 1970, pp 54-55)
According to ‘Dictionary of Accounting’ prepared by Prof. P.N. Abroal,
“Accounting standards refer to accounting rules and procedures which are relating
to measurement, valuation and disclosure prepared by such bodies as the
Accounting Standards Committee (ASC) of a particular country”. Thus, we may
define Accounting Principles as those rules of action or conduct which are
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adopted by the accountants universally while recording accounting transactions.
Accounting principles are man-made. They are accepted because they are believed
to be useful. The general acceptance of an accounting principle usually
depends on how well it meets the following three basic norms :
a) Usefulness b) Objectiveness, and c) Feasibility
A principle is useful to the extent that it results in meaningful or
relevant information to those who need to know about a certain business. In
other words, an accounting rule, which does not increase the utility of the
records to its readers, is not accepted as an accounting principles. A principle
is objective to the extent that the information is not influenced by
the personal bias or Judgement of those who furnished it. Accounting principle
is said to be objective when it is solidly supported by facts. Objectivity
means reliability which also means that the accuracy of the information
reported can be verified. Accounting principles should be such as are practicable.
A principle is feasible when it can be implemented without undue
difficulty or cost. Although these three features are generally found in accounting
principles, an optimum balance of three is struck in some cases
for adopting a particular rule as an accounting principle. For example, the
principle of making the provision for doubtful debts is found on feasibility
and usefulness though it is less objective. This is because of the fact that
such provisions are not supported by any outside evidence.
2.3 ACCOUNTING PRINCIPLES
In dealing with the framework of accounting theory, we are confronted
with a serious problem arising from differences in terminology. A number
of words and terms have been used by different authors to express and
explain the same idea or notion. The various terms used for describing the
basic ideas are: concepts, postulates, propositions, assumptions, underly(
5)
ing principles, fundamentals, conventions, doctrines, rules, axioms, etc. Each
of these terms is capable of precise definition. But, the accounting profession
has served to give them lose and overlapping meanings. One author
may describe the same idea or notion as a concept and another as a convention
and still another as postulate. For example, the separate business entity
idea has been described by one author as a concept and by another as
conventions. It is better for us not to waste our time to discuss the precise
meaning of generic terms as the wide diversity in these terms can only serve
to confuse the learner. We do feel, however, that some of these terms/ideas
have a better claim to be called ‘concepts ‘ while the rest should be called
‘conventions’. The term ‘Concept’ is used to connote the accounting postulates,
i.e., necessary assumptions and ideas which are fundamental to accounting
practice. In other words, fundamental accounting concepts are
broad general assumptions which underline the periodic financial statements
of business enterprises. The reason why some of the these terms should be
called concepts is that they are basic assumptions and have a direct bearing
on the quality of financial accounting information. The term ‘convention’
is used to signify customs or tradition as a guide to the preparation of accounting
statements. The following are the important accounting concepts
and conventions:
Accounting Concepts Accounting Conventions
♦Separate Business Entity ♦Convention of Materiality
Concept ♦Convention of Conservatism
♦Money Measurement Concept ♦Convention of consistency
♦Dual Aspect Concept
♦Going Concern Concept
♦Accounting Period Concept
♦Cost Concept
♦The Matching Concept
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♦Accrual Concept
♦Realisation Concept
2.4 ACCOUNTING CONCEPTS
The more important accounting concepts are briefly described as follows:
1. Separate Business Entity Concept. In accounting we make a distinction
between business and the owner. All the books of accounts records
day to day financial transactions from the view point of the business rather
than from that of the owner. The proprietor is considered as a creditor to
the extent of the capital brought in business by him. For instance, when a
person invests Rs. 10 lakh into a business, it will be treated that the business
has borrowed that much money from the owner and it will be shown as
a ‘liability’ in the books of accounts of business. Similarly, if the owner of
a shop were to take cash from the cash box for meeting certain personal
expenditure, the accounts would show that cash had been reduced even though
it does not make any difference to the owner himself. Thus, in recording a
transaction the important question is how does it affects the business ? For
example, if the owner puts cash into the business, he has a claim against the
business for capital brought in.
In sofar as a limited company is concerned, this distinction can be easily
maintained
because a company has a legal entity of its own. Like a natural person it can
engage itself in economic activities of buying, selling, producing, lending,
borrowing
and consuming of goods and services. However, it is difficult to show this
distinction
in the case of sole proprietorship and partnership. Nevertheless, accounting
still maintains separation of business and owner. It may be noted that it is only
for accounting purpose that partnerships and sole proprietorship are treated as
separate
from the owner (s), though law does not make such distinction. Infact, the business
entity concept is applied to make it possible for the owners to assess the
performance
of their business and performance of those whose manage the enterprise.
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The managers are responsible for the proper use of funds supplied by owners,
banks and others.
2. Money Measurement Concept. In accounting, only those business
transactions are recorded which can be expressed in terms of money. In
other words, a fact or transaction or happening which cannot be expressed
in terms of money is not recorded in the accounting books. As money is
accepted not only as a medium of exchange but also as a store of value, it
has a very important advantage since a number of assets and equities, which
are otherwise different, can be measured and expressed in terms of a common
denominator.
We must realise that this concept imposes two limitations. Firstly,
there are several facts which though very important to the business, cannot
be recorded in the books of accounts because they cannot be expressed in
money terms. For example, general health condition of the Managing Director
of the company, working conditions in which a worker has to work,
sales policy pursued by the enterprise, quality of product introduced by the
enterprise, though exert a great influence on the productivity and profitability
of the enterprise, are not recorded in the books. Similarly, the fact
that a strike is about to begin because employees are dissatisfied with the
poor working conditions in the factory will not be recorded even though
this event is of great concern to the business. You will agree that all these
have a bearing on the future profitability of the company.
Secondly, use of money implies that we assume stable or constant value
of rupee. Taking this assumption means that the changes in the money value
in future dates are conveniently ignored. For example, a piece of land purchased
in 1990 for Rs. 2 lakh and another bought for the same amount in
1998 are recorded at the same price, although the first purchased in 1990
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may be worth two times higher than the value recorded in the books because
of rise in land values. Infact, most accountants know fully well that
purchasing power of rupee does change but very few recognise this fact in
accounting books and make allowance for changing price level.
3. Dual Aspect Concept. Financial accounting records all the transactions
and events involving financial element. Each of such transactions
requires two aspects to be recorded. The recognition of these two aspects
of every transaction is known as a dual aspect analysis. According to this
concept every business transactions has dual effect. For example, if a firm
sells goods of Rs. 10,000 this transaction involves two aspects. One aspect
is the delivery of goods and the other aspect is immediate receipt of cash
(in the case of cash sales). Infact, the term ‘double entry’ book keeping has
come into vogue because for every transaction two entries are made. According
to this system the total amount debited always equals the total
amount credited. It follows from ‘dual aspect concept’ that at any point in
time owners’ equity and liabilities for any accounting entity will be equal
to assets owned by that entity. This idea is fundamental to accounting and
could be expressed as the following equalities:
Assets = Liabilities + Owners Equity ...............(1)
Owners Equity = Assets - Liabilities ...............(2)
The above relationship is known as the ‘Accounting Equation’. The term
‘Owners Equity’ denotes the resources supplied by the owners of the entity
while the term ‘liabilities’ denotes the claim of outside parties such as creditors,
debenture-holders, bank against the assets of the business. Assets are
the resources owned by a business. The total of assets will be equal to total
of liabilities plus owners capital because all assets of the business are
claimed by either owners or outsiders.
4. Going Concern Concept. Accounting assumes that the business
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entity will continue to operate for a long time in the future unless there is
good evidence to the contrary. The enterprise is viewed as a going concern,
that is, as continuing in operations, at least in the foreseeable future. In
other words, there is neither the intention nor the necessity to liquidate the
particular business venture in the predictable future. Because of this assumption,
the accountant while valuing the assets do not take into account
forced sale value of them. Infact, the assumption that the business is not
expected to be liquidated in the foreseeable future establishes the basis for
many of the valuations and allocations in accounting. For example, the accountant
charges depreciation of fixed assets values. It is this assumption
which underlies the decision of investors to commit capital to enterprise.
Only on the basis of this assumption can the accounting process remain
stable and achieve the objective of correctly reporting and recording on
the capital invested, the efficiency of management, and the position of the
enterprise as a going concern. However, if the accountant has good reasons
to believe that the business, or some part of it is going to be liquidated or
that it will cease to operate (say within six-month or a year), then the resources
could be reported at their current values. If this concept is not followed,
International Accounting Standard requires the disclosure of the fact
in the financial statements together with reasons.
5. Accounting Period Concept. This concept requires that the life
of the business should be divided into appropriate segments for studying
the financial results shown by the enterprise after each segment. Although
the results of operations of a specific enterprise can be known precisely
only after the business has ceased to operate, its assets have been sold off
and liabilities paid off, the knowledge of the results periodically is also
necessary. Those who are interested in the operating results of business
obviously cannot wait till the end. The requirements of these parties force
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the businessman ‘to stop’ and ‘see back’ how things are going on. Thus, the
accountant must report for the changes in the wealth of a firm for short
time periods. A year is the most common interval on account of prevailing
practice, tradition and government requirements. Some firms adopt financial
year of the government, some other calendar year. Although a twelve
month period is adopted for external reporting, a shorter span of interval,
say one month or three month is applied for internal reporting purposes.
This concept poses difficulty for the process of allocation of long
term costs. All the revenues and all the cost relating to the year in operation
have to be taken into account while matching the earnings and the cost
of those earnings for the any accounting period. This holds good irrespective
of whether or not they have been received in cash or paid in cash. Despite
the difficulties which stem from this concept, short term reports are
of vital importance to owners, management, creditors and other interested
parties. Hence, the accountants have no option but to resolve such difficulties.
6. Cost Concept. The term ‘assets’ denotes the resources land building,
machinery etc. owned by a business. The money values that are assigned
to assets are derived from the cost concept. According to this concept an
asset is ordinarily entered on the accounting records at the price paid to
acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset
would be recorded in the books at Rs. 5 lakh, even if its market value at that
time happens to be Rs. 6 lakh. Thus, assets are recorded at their original
purchase price and this cost is the basis for all subsequent accounting for
the business. The assets shown in the financial statements do not necessarily
indicate their present market values. The term ‘book value’ is used for
amount shown in the accounting records.
The cost concept does not mean that all assets remain on the account(
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ing records at their original cost for all times to come. The asset may
systematically
be reduced in its value by charging ‘depreciation’, which will
be discussed in detail in a subsequent lesson. Depreciation have the effect
of reducing profit of each period. The prime purpose of depreciation is to
allocate the cost of an asset over its useful life and not to adjust its cost.
However, a balance sheet based on this concept can be very misleading as
it shows assets at cost even when there are wide difference between their
costs and market values. Despite this limitation you will find that the cost
concept meets all the three basic norms of relevance, objectivity and feasibility.
7. The Matching concept. This concept is based on the accounting
period concept. In reality we match revenues and expenses during the accounting
periods. Matching is the entire process of periodic earnings measurement,
often described as a process of matching expenses with revenues.
In other words, income made by the enterprise during a period can be measured
only when the revenue earned during a period is compared with the
expenditure incurred for earning that revenue. Broadly speaking revenue is
the total amount realised from the sale of goods or provision of services
together with earnings from interest, dividend, and other items of income.
Expenses are cost incurred in connection with the earnings of revenues.
Costs incurred do not become expenses until the goods or services in question
are exchanged. Cost is not synonymous with expense since expense is
sacrifice made, resource consumed in relation to revenues earned during
an accounting period. Only costs that have expired during an accounting
period are considered as expenses. For example, if a commission is paid in
January, 2002, for services enjoyed in November, 2001, that commission
should be taken as the cost for services rendered in November 2001. On
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account of this concept, adjustments are made for all prepaid expenses,
outstanding expenses, accrued income, etc, while preparing periodic reports.
8. Accrual Concept. It is generally accepted in accounting that the
basis of reporting income is accrual. Accrual concept makes a distinction
between the receipt of cash and the right to receive it, and the payment of
cash and the legal obligation to pay it. This concept provides a guideline to
the accountant as to how he should treat the cash receipts and the right
related thereto. Accrual principle tries to evaluate every transaction in terms
of its impact on the owner’s equity. The essence of the accrual concept is
that net income arises from events that change the owner’s equity in a specified
period and that these are not necessarily the same as change in the
cash position of the business. Thus it helps in proper measurement of income.
9. Realisation Concept. Realisation is technically understood as
the process of converting non-cash resources and rights into money. As
accounting principle, it is used to identify precisely the amount of revenue
to be recognised and the amount of expense to be matched to such revenue
for the purpose of income measurement. According to realisation concept
revenue is recognised when sale is made. Sale is considered to be made at
the point when the property in goods passes to the buyer and he becomes
legally liable to pay. This implies that revenue is generally realised when
goods are delivered or services are rendered. The rationale is that delivery
validates a claim against the customer. However, in case of long run construction
contracts revenue is often recognised on the basis of a propor(
13)
tionate or partial completion method. Similarly, in case of long run instalment
sales contracts, revenue is regarded as realised only in proportion to
the actual cash collection. In fact, both these cases are the exceptions to
the notion that an exchange is needed to justify the realisation of revenue.
2.5 ACCOUNTING CONVENTIONS
1. Convention of Materiality. Materiality concept states that items
of small significance need not be given strict theoretically correct treatment.
Infact, there are many events in business which are insignificant in
nature. The cost of recording and showing in financial statement such events
may not be well justified by the utility derived from that information. For
example, an ordinary calculator costing Rs. 100 may last for ten years.
However, the effort involved in allocating its cost over the ten year period
is not worth the benefit that can be derived from this operation. The cost
incurred on calculator may be treated as the expense of the period in which
it is purchased. Similarly, when a statement of outstanding debtors is prepared
for sending to top management, figures may be rounded to the nearest
ten or hundred.
This convention will unnecessarily overburden an accountant with
more details in case he is unable to find an objective distinction between
material and immaterial events. It should be noted that an item material for
one party may be immaterial for another. Actually, there are no hard and
fast rule to draw the line between material and immaterial events and hence,
It is a matter of judgement and common sense. Despite this limitation, It is
necessary to disclose all material information to make the financial statements
clear and understandable. This is required as per IAS-1 and also reiterated
in IAS-5. As per IAS-1, materiality should govern the selection and
application of accounting policies.
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2. Convention of Conservatism. This concept requires that the accountants
must follow the policy of ‘’playing safe” while recording business
transactions and events. That is why, the accountant follow the rule
anticipate no profit but provide for all possible losses, while recording the
business events. This rule means that an accountant should record lowest
possible value for assets and revenues, and the highest possible value for
liabilities and expenses. According to this concept, revenues or gains should
be recognised only when they are realised in the form of cash or assets
(i.e. debts) the ultimate cash realisation of which can be assessed with reasonable
certainty. Further, provision must be made for all known liabilities,
expenses and losses, Probable losses regarding all contingencies
should also be provided for. ‘Valuing the stock in trade at market price or
cost price which ever is less’, ‘making the provision for doubtful debts on
debtors in anticipation of actual bad debts’, ‘adopting written down value
method of depreciation as against straight line method’, not providing for
discount on creditors but providing for discount on debtors’, are some of
the examples of the application of the convention of conservatism.
The principle of conservatism may also invite criticism if not applied
cautiously. For example, when the accountant create secret reserves,
by creating excess provision for bad and doubtful debts, depreciation, etc.
The financial statements do not present a true and fair view of state of
affairs. American Institute of Certified Public Accountant have also indicated
that this concept need to be applied with much more caution and care
as over conservatism may result in misrepresentation.
4. Convention of Consistency. The convention of consistency requires
that once a firm decided on certain accounting policies and methods
and has used these for some time, it should continue to follow the same
methods or procedures for all subsequent similar events and transactions
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unless it has a sound reason to do otherwise. In other worlds, accounting
practices should remain unchanged from one period to another. For example,
if depreciation is charged on fixed assets according to straight line method,
this method should be followed year after year. Analogously, if stock is
valued at ‘cost or market price whichever is less’, this principle should be
applied in each subsequent year.
However, this principle does not forbid introduction of improved
accounting techniques. If for valid reasons the company makes any departure
from the method so far in use, then the effect of the change must be
clearly stated in the financial statements in the year of change. The application
of the principle of consistency is necessary for the purpose of comparison.
One could draw valid conclusions from the comparison of data drawn
from financial statements of one year with that of the other year. But the
inconsistency in the application of accounting methods might significantly
affect the reported data.
2.6 ACCOUNTING STANDARDS
The accounting concepts and conventions discussed in the foregoing
pages are the core elements in the theory of accounting. These principles,
however, permit a variety of alternative practices to co-exist. On account
of this the financial results of different companies can not be compared
and evaluated unless full information is available about the accounting methods
which have been used. The lack of uniformity among accounting practices
have made it difficult to compare the financial results of different
companies. It means that there should not be too much discretion to companies
and their accountants to present financial information the way they
like. In other words, the information contained in financial statements should
conform to carefully considered standards. Obviously, accounting standards
are needed to :
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a) provide a basic framework for preparing financial statements to be
uniformly followed by all business enterprises,
b) make the financial statements of one firm comparable with the other
firm and the financial statements of one period with the financial
statements of another period of the same firm,
c) make the financial statements credible and reliable, and
d) create general sense of confidence among the outside users of financial
statements.
In this context unless there are reasonably appropriate standards,
neither the purpose of the individual investor nor that of the nation as a
whole can be served. In order to harmonise accounting policies and to evolve
standards the need in the USA was felt with the establishment of Securities
and Exchange Commission (SEC) in 1933. In 1957, a research oriented
organisation called Accounting Principles Boards (APB) was formed to spell
out the fundamental accounting principles. After this the Financial Accounting
Standards Board (FASB) was formed in 1973, in USA. At the international
level, the need for standardisation was felt and therefore, an International
Congress of accountants was organised in Sydney, Australia in 1972
to ensure the desired level of uniformity in accounting practices. Keeping
this in view, International Accounting Standards Committee (IASC) was
formed and was entrusted with the responsibility of formulating international
standards.
In order to harmonise varying accounting policies and practices, the
Institute of Chartered Accountants of India (ICAI) formed the Accounting
Standards Board (ASB) in April, 1977. ASB includes representatives from
industry and government. The main function of the ASB is to formulate
accounting
standards. This Board of the Institute of Chartered Accountants of
India has so far formulated around 27 Accounting Standards, the list of these
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accounting standards is furnished. Regarding the position of Accounting
standards in India, it has been stated that the standards have been developed
without first establishing the essential theoretical framework. As a result,
accounting standards lack direction and coherence. This type of limitation
also existed in UK and USA but it was remedied long back.
Hence, there is an emergent need to make an attempt to develop a conceptual
framework and also revise suitably the Indian Accounting Standards to
reduce the number of alternative treatments.
2.7 SUMMARY
Accounting principles have been defined as the body of doctrines
commonly associated with the theory and procedure of accounting serving
as an explanation of current practices and as a guide for the selection of
conventions or procedures where alternatives exists. Rules governing the
formation of accounting axioms and the principles derived from them have
arisen from common experience, historical precedent statements by individuals
and professional bodies and regulations of Governmental agencies. The general
acceptance of an accounting principle usually depends on how well it meets
the following three basic norms: a) Usefulness b) Objectiveness, and c) Feasibility
The various terms used for describing the basic ideas are: concepts,
postulates, propositions, assumptions, underlying principles, fundamentals,
conventions, doctrines, rules, axioms, etc. Some of these terms/ideas have
a better claim to be called ‘concepts ‘ while the rest should be called
‘conventions’.
The term ‘Concept’ is used to connote the accounting postulates,
i.e., necessary assumptions and ideas which are fundamental to accounting
practice. In other words, fundamental accounting concepts are broad general
assumptions which underline the periodic financial statements of business
enterprises. The term ‘convention’ is used to signify customs or tradi(
18)
tion as a guide to the preparation of accounting statements. The important
accounting concepts and conventions include Separate Business Entity Concept,
Money Measurement Concept, Dual Aspect Concept, Going Concern
Concept, Accounting Period Concept, Cost Concept, The Matching Concept,
Accrual Concept, Realisation ConceptConvention of Materiality,
Convention of Conservatism and Convention of consistency. In order to
harmonise accounting policies and to evolve standards ‘International Accounting
Standards Committee’ was formed and was entrusted with the responsibility
of formulating international standards. Similarly, the Institute
of Chartered Accountants of India (ICAI) formed the Accounting Standards
Board in April, 1977 which has issued as many as 29 accounting standards
over the years.
2.8 KEYWORDS
Accounting principle: Accounting principles are the assumptions and roles
of accounting, the methods and procedures of accounting and the application
of these rules, methods and procedures to the actual practice of accounting.
Accounting concept: It refers to assumptions and conditions on which
accounting system is based.
Accounting convention: Accounting convention refers to the customs and
traditions followed by accountants as guidelines while preparing accounting
statements.
2.9 SELF-ASSESSMENT QUESTIONS
1. State whether the following statements are true or false :
a) The ‘materiality concept’ refers to the state of ignoring small items
and values from accounts.
b) Accounting principles are rules of action or conduct which are
adopted by the accountants universally while recording accounting transac(
19)
tions.
c) The ‘separate entity concept’ of accounting is not applicable to sole
trading concerns and partnership concerns.
d) The ‘dual aspect’ concept result in the accounting equation:
Capital+Liabilities = Assets.
e) The ‘conservatism concept’ leads to the exclusion of all unrealised
profits.
f) The balance sheet based on ‘Cost concept’ is of no use to a potential
investor.
g) Accounting standards are statements prescribed by government regulatory
bodies.
h) Accounting statements are statements prescribed by professional
accounting bodies.
i) Accounting concepts are broad assumptions.
Ans : a) False b) True c) False d) True e) True
f) True g) False h) True i) True
2. Choose the correct answer from the alternations given :
(I) Accounting standards are statements prescribed by
a) Law b) Bodies of shareholders
c) Professional accounting bodies
(II) Accounting Principles are generally based on
a) Practicability b) Subjectivity
c) Convenience in recording
(III) The Policy of ‘anticipate no profit and provide for all possible
losses’ arises due to convention of
a) Consistency b) Disclosure c) Conservatism
(IV) Which is the accounting concept that requires the practice of
crediting closing stock to the trading account
1
Subject :Accounting for Managers Updated by:Dr. Mahesh Chand Garg
Course Code : CP-104
Lesson No. : 3
ACCOUNTING PROCESS : EQUATION, RULES,
PREPARATION OF JOURNAL AND LEDGER
STRUCTURE
3.0 Objective
3.1 Introduction
3.2 Accounting Equation
3.3 Rules of Debit and Credit
3.4 Meaning and format of Journal.
3.4.1 Meaning of Journalising
3.4.2 Compound Journal Entry
3.4.3 Opening Entry
3.4.4 Goods Account
3.5 Ledger
3.5.1 Relationship between Journal and Ledger
3.5.2 Posting
3.5.3 Rules of Posting
3.5.4 Balancing of an Account
3.6 Summary
3.7 Keywords
3.8 Self Assessment Questions
3.9 Suggested Readings
3.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define accounting equation
(b) Make the classification of accounts
(c) Explain the stages in accounting process
2
3.1 INTRODUCTION
Any economic transaction or event of a business which can be expressed in
monetary terms should be recorded. Traditionally, accounting is a method of
collecting, recording, classifying, summarizing, presenting and interpreting
financial data of an economic activity. The series of business transactions occurs
during the accounting period and its recording is referred to an accounting process/
mechanism. An accounting process is a complete sequence of accounting
procedures which are repeated in the same order during each accounting period.
Therefore, accounting process involves the following steps :
i ) Identification of Transaction : In accounting, only financial transactions
are recorded. A financial transaction is an event which can be expressed in terms
of money and which brings change in the financial position of a business
enterprise.
An event is an incident or a happening which may or may not bring any change in
the financial position of a business enterprise. Therefore, all transactions are
events but all events are not transactions. A transaction is a complete action, to an
expected or possible future action. In every transaction, there is movement of
value from one source to another. For example, when goods are purchased for
cash, there is a movement of goods from the seller to the buyer and a movement
of cash from buyer to the seller. Transactions may be external (between a business
entity and a second party, e.g., goods sold on credit to Hari or internal (do not
involve second party, e.g., depreciation charged on the machinery).
Illustration 1
State with reasons whether the following events are transactions or
not to Mr. Nikhil, Proprietor, Delhi Computers
(i) Mr. Nikhil started business with capital (brought in cash)Rs. 40,000.
(ii) Paid salaries to staff Rs. 5,000.
3
(iii) Purchased machinery for Rs. 20,000 in cash.
(iv) Placed an order with Sen & Co. for goods for Rs. 5,000.
(v) Opened a Bank account by depositing Rs. 4,000.
(vi) Received pass book from bank.
(vii) Appointed Sohan as Manager on a salary of Rs. 4,000 per month.
(viii)Received interest from bank Rs. 500.
(ix) Received a price list from Lalit.
Solution :
Here, each event is to be considered from the view point of Mr.
Nikhil's business. Those events which will change the financial position of the
business of Mr. Nikhil, should be regarded as transaction.
(i) It is a transaction, because it changes the financial position of Mr. Nikhil's
business. Cash will increase by Rs. 40,000 and Capital will increase by Rs.
40,000.
(ii) It is a transaction, because it changes the financial position of Mr. Nikhil's
business. Cash will decrease by Rs. 5,000 and Salaries (expenses) will
increase by Rs. 5,000
(iii) It is a transaction, because it changes the financial position of Mr. Nikhil's
business. Machinery comes in and cash goes out.
(iv) It is not a transaction, because it does not change the financial position of
the business.
(v) It is a transaction, because it changes the financial position of the business.
Bank balance will increase by Rs. 4,000 and cash balance will decrease by
Rs. 4,000.
4
(vi) It is also not a transaction, because it does not change the financial position
of Mr. Nikhil.
(vii) It is also not a transaction, because it does not change the financial position
of Mr. Nikhil.
(viii) It is a transaction, because it changes the financial position of Mr. Nikhil's
business.
(ix) It is not a transaction, because it does not change the financial position of
the business of Mr. Nikhil.
ii) Recording the transaction : Journal is the first book of original entry in
which all transactions are recorded event-wise and date-wise and presents a
historical record of all monetary transactions. Journal may further be divided into
sub-journals as well.
iii) Classifying : Accounting is the art of classifying business transactions.
Classification means statement setting out for a period where all the similar
transactions relating to a person, a thing, expense, or any other subject are grouped
together under appropriate heads of accounts.
iv) Summarising : Summarising is the art of making the activities of the
business enterprise as classified in the ledger for the use of management or other
user groups i.e. sundry debtors, sundry creditors etc. Summarisation helps in the
preparation of Profit and Loss Account and Balance sheet for a particular financial
year.
v) Analysis and Interpretation : The financial information or data is recorded
in the books of account must further be analysed and interpreted so to draw
meaningful conclusions. Thus, analysis of accounting information will help the
5
management to assess in the performance of business operation and forming future
plans also.
vi) Presentation or reporting of financial information : The end users of
accounting statements must be benefited from analysis and interpretation of data
as some of them are the "share holders" and other one the "stake holders".
Comparison of past and present statements and reports, use of ratios and trend
analysis are the different tools of analysis and interpretation.
From the above discussion one can conclude that accounting is an
art which starts and includes steps right from recording of business transactions
of monetary character to the communicating or reporting the results thereof to
the various interested parties. For this purpose, the transactions are classified
into various accounts, the description of which follows in the next section.
3.2 ACCOUNTING EQUATION
Dual concept states that 'for every debit, there is a credit'. Every
transaction should have two-sided effect to the extent of same amount. This
concept
has resulted in accounting equation which states that at any point of time assets
of any entity must be equal (in monetary terms) to the total of owner's equity and
outsider's liabilities. In other words, accounting equation is a statement of equality
between the assets and the sources which finance the assets and is expressed as :
Assets = Sources of Finance
Assets may be tangible e.g. land, building, plant, machinery,
equipment, furniture, investments, cash, bank, stock, debtors etc. or intangible
e.g. patent rights, trade marks, goodwill etc.,
Sources include internal i.e. capital provided by the owner and
external i.e. liabilities. Liabilities are the obligations of the business to others/
6
outsiders. The above equation gets expanded.
Assets = Liabilities + Capital
All transactions of a business can be referred to this equation :
Assets = Liabilities + Owner's equity
To further explain the transaction of revenues, expenses, losses and
gains, the equation can be expanded thus :
Assets + Expenses = Liabilities + Revenue + Owner's equity
or Assets = Liabilities + (Revenue – Expenses) + Owner's equity
or Assets = Liabilities + Owner's equity + Owner's equity
(income) which ultimately becomes
Assets = Liabilities + Owner's equity
Let us consider the facts of the following case, step by step, to
understand as to how the equation remains true even in changed circumstances.
Illustration 2
1. Commenced business with cash Rs. 50,000
2. Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000
3. Sold goods for cash Rs. 40,000 costing Rs. 30,000
4. Rent paid Rs. 500
5. Bought furniture Rs. 5,000 on credit
6. Bought refrigerator for personal use Rs. 5,000
Solution :
1. Business receives cash Rs. 50,000 (asset) and it owes Rs. 50,000 to the
proprietor as his capital i.e. equity.
7
Assets (=) Liabilities (+) Owner's equity
Cash Rs. 50,000 Nil Capital Rs. 50,000
(2) Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000. Business
has acquired asset namely – goods worth Rs. 50,000 and another asset namely =
cash has decreased by Rs. 20,000 while liability– creditors have been created of
Rs. 30,000.
Assets (=) Liabilities (+) Owner's equity
Cash 30,000 Creditors 30,000 Capital 50,000
Goods 50,000
80,000 30,000 50,000
(3) Sold goods for cash Rs. 40,000 costing Rs. 30,000
This transaction has resulted in decrease of goods by Rs. 30,000 and
increase in cash by Rs. 40,000 thus Increasing equity by Rs. 10,000
Assets (=) Liabilities (+) Owner's equity
Cash 70,000 Creditors 30,000 Capital 60,000
Goods 20,000
90,000 30,000 60,000
(4) Rent paid Rs. 500
This transaction has resulted in an expenditure of Rs. 500 effecting decrease
of cash and equity by Rs. 500 each.
Assets (=) Liabilities (+) Owner's equity
Cash 69,500 Creditors 30,000 Capital 59,500
Goods 20,000
89,500 30,000 59,500
8
(5) Bought furniture on credit Rs. 5,000
This transaction results in acquiring an asset namely furniture worth Rs.
5,000 and increasing creditors by Rs. 5,000
Assets (=) Liabilities (+) Owner's equity
Cash 69,500 Creditors 35,000 Capital 59,500
Goods 20,000
Furniture 5,000 59,500
94,500 35,000
(6) Bought refrigerator for personal use Rs. 5,000. This transaction will have
the effect of reducing both cash as well as capital by Rs. 5,000 each.
Assets (=) Liabilities (+) Owner's equity
Cash 64,500 Creditors 35,000 Capital 54,500
Goods 20,000
Furniture 5,000
89,500 35,000 54,500
Account
An account is a summary of the relevant transactions at one place
relating to a particular head. It records not only the amount of transaction but also
their effect and direction.
Classification of Accounts
The classification of accounts is given as follows :
1. Personal Accounts : Accounts which are related to individuals, firms,
companies, co-operative societies, banks, financial institutions are known as
personal accounts. The personal accounts may further be classified into three
9
categories :
(i) Natural Personal Accounts : Accounts of individuals (natural persons)
such as Akhils' A/c, Rajesh's A/c, Sohan's A/c are natural personal accounts.
(ii) Artificial Personal Accounts : Accounts of firms, companies, banks,
financial institutions such as Reliance Industries Ltd., Lions Club, M/s Sham &
Sons, Punjab National Bank, National College are artificial personal accounts.
iii) Representative Personal Accounts : The accounts recording transactions
relating to limited expenses and incomes are classified as nominal accounts. But
in certain cases (due to the matching concept of accounting) the amount on a
particular date, is payable to the individuals or recoverable from individuals. Such
amount (i) relates to the particular head of expenditure or income and (ii)
represents persons to whom it is payable or from whom it is recoverable. Such
accounts are classified as representative personal account e.g., Wages outstanding
account, Pre-paid insurance account etc.
2. Real Accounts : Real accounts are the accounts related to assets/properties.
These may be classified into tangible real account and intangible real account.
The accounts relating to tangible assets (which can be touched, purchased and
sold) such as building, plant, machinery, cash, furniture etc. are classified as
tangible real accounts. Intangible real accounts (which do not have physical shape)
are the accounts related to intangible assets such as goodwill, trademarks,
copyrights, patents etc.
3. Nominal Accounts : The accounts relating to income, expenses, losses
and gains are classified as nominal accounts. For example Wages Account, Rent
Account, Interest Account, Salary Account, Bad Debts Accounts, Purchases;
Account etc. fall in the category of nominal accounts.
10
3.3 RULES OF DEBIT AND CREDIT
Basically, debit means to enter an amount to the left side of an account
and credit means to enter an amount to the right side of an account. In the
abbreviated form Dr. stands for debit and Cr. stands for credit. Both debit and
credit may represent either increase or decrease depending upon the nature of an
account.
The Rules for Debit and Credit are given below :
Types of Accounts Rules for Debit Rules for Credit
(a) For Personal Accounts Debit the receiver Credit the giver
(b) For Real Accounts Debit what comes in Credit what goes out
(c) For Nominal Accounts Debit all expenses Credit all incomes and
and losses gains
Illustration 3 : How will you classify the following into personal, real and
nominal
accounts ?
(i) Investments
(ii) Freehold Premises
(iii) Accrued Interest to Ram
(iv) Haryana Agro Industries Corporation
(v) Janata Mechanical Works
(vi) Salary Account
(vii) Loose Tools Accounts
(viii)Purchases Account
(ix) Corporation Bank Ltd.
11
(x) Capital Account
(xi) Brokerage Account
(xii) Toll Tax Account
(xiii) Dividend Received Account
(xiv) Royalty Account
(xv) Sales Account
Solution :
Real Account : (i), (ii), (vii), (viii), (xv)
Nominal Account : (vi), (xi), (xii), (xiii), (xiv)
Personal Account : (iii), (iv), (v), (ix), (x)
3.4 MEANING AND FORMAT OF A JOURNAL
Journal is a historical record of business transactions or events. The word
journal comes from the French word "Jour" meaning "day". It is a book of original
or prime entry written up from the various source documents. Journal is a primary
book for recording the day to day transactions in a chronological order i.e. in the
order in which they occur. The journal is a form of diary for business transactions.
This is also called the book of first entry since every transaction is recorded
firstly in the journal. The format of a journal is shown as follows :
Journal
Date Particulars L.F. Debit Credit
(Rs.) (Rs.)
12
(a) Date Column : This column shows the date on which the transaction is
recorded. The year and month is written once, till they change.
(b) Particular Column : Under this column, first the names of the accounts to
be debited, then the names of the accounts to be credited and lastly, the narration
(i.e. a brief explanation of the transaction) are entered.
(c) L.F., i.e. Ledger Folio Column : Under this column, the ledger page number
containing the relevant account is entered at the time of posting.
(d) Debit amount Column : Under this column, the amount to be debited is
entered.
(e) Credit amount Column : Under this column, the amount to be credited is
entered.
3.4.1 Meaning of Journalising
The process of recording a transaction in the journal is called
journalising. The various steps to be followed in journalising business transactions
are given below :
Step 1 Ascertain what accounts are involved in a transaction.
Step 2 Ascertain what is the nature of the accounts involved.
Step 3 Ascertain which rule of debit and credit is applicable for each of the
accounts involved.
Step 4 Ascertain which account is to be debited and which is to be credited.
Step 5 Record the date of transaction in the 'Date column'.
Step 6 Write the name of the account to be debited, very close to the left hand
side i.e. the line demarcating the 'Date column' and the 'Particulars
13
column') along with the abbreviation 'Dr.' on the same line against the
name of the account in the 'Particulars column' and the amount to be
debited in the 'Debit Amount column' against the name of the account.
Step 7 Write the name of the account to be credited in the next line preceded by
the word 'To' at a few spaces towards right in the 'Particulars column' and
the amount to be credited in the 'Credit Amount column' against the name
of the account.
Step 8 Write 'Narration' (i.e. a brief description of the transaction) within brackets
in the next line in the 'Particulars column'.
Step 9 Draw a line across the entire 'Particulars column' to separate one Journal
Entry from the other.
Advantages of Journal
1. The transactions are recorded in journal as and when they occur so the
chances of error is minimized.
2. It help in preparation of ledger.
3. Any transfer from one account to another account is made through Journal.
4. The entry recorded in journal are self explanatory as it includes narration
also.
5. It can record any such transaction which cannot be entered in any other
books of account.
6. Every transaction is recorded in chronological order (date wise) so the
chances of manipulations are reduced.
7. Journal shows all information in respect of a transaction at one place.
8. The closing balances of previous year of accounts related to assets and
liabilities can be brought forward to the next year by passing journal entry
in journal.
14
Illustration 4 : From the following transactions of Nikhil, find out the nature of
accounts and also state which account should be debited and which should be
credited :
i) Rent paid
ii) Interest received
iii) Purchased furniture for cash
iv) Machinery sold in cash
v) Outstanding salaries
vi) Paid to Surinder
Solution :
Analysis of Transactions
Transaction Accounts Nature of Debit/
Involved Accounts Credit
i) Rent paid Rent Account Nominal Account Debit
Cash Account Real Account Credit
ii) Interest Received Cash Account Real Account Debit
Interest Account Nominal Credit
iii) Purchased furniture for cash Furniture Account Real Account Debit
Cash Account Real Account Credit
iv) Machinery sold in cash Cash Account Real Account Debit
Machinery Account Real Account Credit
v) Outstanding Salary Salary Account Nominal Account Debit
Outstanding Salary Personal Account Credit
Account
vi) Paid to Surinder Surinder's Account Personal Account Debit
Cash Account Real Account Credit
15
Illustration 5 : Journalise the following transactions :
2005 Rs.
Jan. 1 Mohan started business with cash 80,000
Jan. 6 Purchased goods from Ram on credit 30,000
Jan. 8 Sold goods on cash 6,000
Jan. 15 Bought Furniture from Yash for cash 8,000
Jan. 18 Paid Salary to manager 6,500
Jan. 20 Paid Rent to land lord in cash 1,000
Solution :
Journal
Date Particulars L.F. Debit Credit
2005 Cash Account Dr. 80,000
To Mohan's Capital Account 80,000
(Being business started with cash)
" 6 Purchases Account Dr. 30,000
To Ram's Account 30,000
(Being purchase on credit)
" 8 Cash Account Dr. 6,000
To Sales Account 6,000
(Being sold goods for cash)
" 15 Furniture Account Dr. 8,000
To Cash Account
(Being bought furniture for cash) 8,000
" 18 Salary Account Dr. 6,500
To Cash Account 6,500
(Being salary paid to manager)
" 20 Rent Account Dr. 1,000
To Cash Account 1,000
(Being rent paid to land lord)
16
3.4.2 Compound Journal Entries
When more than two accounts are involved in a transaction and the
transaction is recorded by means of a single journal entry instead of passing
several
journal entries, such single journal entry is termed as 'Compound Journal Entry'.
Illustration 6 : Journalise the following :
2005
Nov. 1 Paid to Arun Rs. 5,250 discount allowed by him Rs.50
6 Received from Somesh Rs. 1,900 and from Komesh Rs. 400
8 Goods purchased for cash Rs. 4,000
Furniture purchased for cash Rs. 3,000
Paid cash to Raman Rs. 2,090
Paid Salary in cash Rs. 7,600
Paid Rent in cash Rs. 1,400
Solution :
Journal
Date Particulars L.F. Debit(Rs.) Credit(Rs.)
2005
Nov.1 Arun's Account Dr. 5,300
To Cash Account 5,250
To Discount Received Account 50
(Being the cash paid to Arun and discount received)
Nov.6 Cash Account Dr. 2,300
To Somesh's Account 1,900
To Komesh's Account 400
(Being cash received)
Nov.8 Purchases Account Dr. 4,000
Furniture Account Dr. 3,000
Raman's Account Dr. 2,090
Salary Account Dr. 7,600
Rent Account Dr. 1,400
To Cash Account 18,090
(Being the cash paid )
17
3.4.3 Opening Entry
A journal entry by means of which the balances of various assets,
liabilities and capital appearing in the balance sheet of previous accounting period
are brought forward in the books of the current accounting period, is known as
'Opening Entry'. While passing an opening entry, all assets accounts (individually)
are debited and all liabilities accounts (individually) are credited and the Net worth
(i.e. excess of assets over liabilities) is credited to Proprietor's Capital Account
(in case of a proprietary concern) or Partners' Capital Accounts (in case of a
partnership concern).
Illustration 7 On Ist April 2006, Singh's assets and liabilities stood as follows :
Assets : Cash Rs. 6,000; Bank Rs. 17,000; Stock Rs. 3,000; Bills
Receivable Rs.7,000; Debtors Rs. 3,000; Building Rs.70,000;
Investments Rs. 30,000; Furniture Rs. 4,000
Liabilities : Bills payable Rs. 5000, Creditors Rs. 9000, Ram's Loan Rs. 13000
Pass an opening Journal entry.
18
Solution :
Journal
Date Particulars L.F. Debit(Rs.) Credit (Rs.)
2006
April 1 Cash Account Dr. 6,000
Bank Account Dr. 17,000
Stock Account Dr. 3,000
Bills Receivable Account Dr. 7,000
Debtors Account Dr. 3,000
Building Account Dr. 70,000
Investment Account Dr. 30,000
Furniture Dr. 4,000
To Bills payable Account 5,000
To Creditor's Account 9,000
To Ram's loan Account 13,000
To Singh's capital 1,13,000
(Being the opening balances of assets and liabilities)
1,40,000 1,40,000
3.4.4 Goods Account
In accounting the meaning of goods is restricted to only those articles
which are purchased by a businessman with an intention to sell it. For example, if
a businessman purchased typewriter, it will be goods for him if he deals in
typewriter but if he deals in other business say clothes then typewriter will be
asset for him and clothes will be goods.
Sub-Division of Goods Accounts
The goods account is not opened in accounting books. In place of
goods account the following accounts are opened in the books of accounts :
Purchases Account : This is opened for goods purchased on cash and credit.
Sales Account : This account is opened for the goods sold on cash and credit.
19
Purchase Returns Account or Return Outward Account : This account is
opened for the goods returned to suppliers.
Sales Returns Account or Return Inward Account : This account is opened for
the goods returned by customers.
IMPORTANT CONSIDERATIONS FOR RECORDING THE BUSINESS
TRANSACTIONS
1. Trade Discount
Trade discount is usually allowed on the list price of the goods. It may be
allowed by producer to wholesaler and by wholesaler to retailer for purchase of
goods in
large quantity. It is not recorded in the books of account and entry is made only
with the net
amount paid or received. For example purchased goods of list price Rs. 8,000 at
15% trade
discount from X. In this case the following entry will be passed :
Rs. Rs.
Purchases Account Dr. 6,800
To X 6,800
(Being goods purchased at 15%
trade discount less list price)
2. Cash Discount
Cash discount is a concession allowed by seller to buyer to encourage
him to make early cash payment. It is a Nominal Account. The person who allows
discount, treat it as an expense and debits in his books and it is called discount
allowed
and the person who receives discount, treat it as an income and it is called discount
received and credited in his books of account as "Discount Received Account."
For
example, X owes Rs. 6,000 to Y. He pays Rs. 5,950 in full settlement against the
amount due. In the books of X, the journal entry will be :
20
Rs. Rs.
Y Dr. 6,000
To Cash Account 5,950
To Discount Received account 50
(Being Cash paid and discount received)
In the books of Y Rs. Rs.
Cash Account Dr. 5,950
Discount Allowed Account Dr. 50
To X 6,000
(Being cash received and discount allowed)
3. Goods distributed as free samples
Some times business distribute goods as free samples for the purpose
of advertisement. In this case, Advertisement Account is debited and Purchases
Account is credited. For example, goods costing Rs. 8000 were distributed as
free sample. To record this transaction following entry will be passed :
Rs.
Rs.
Advertisement Account Dr. 8,000
To Purchases Account 8,000
4. Interest on capital
Interest paid on capital is an expense. Therefore interest account
should be debited. On the other hand the capital of the business increases. So the
capital account should be credited. The entry will be as follows :
Interest on Capital Account Dr.
To Capital Account
21
5. Interest charged on Drawings
If the interest is charged on drawings then it will be an increase in
the income of business, so interest on drawings will be credited. On the other
hand there will be increase in drawings or decrease in Capital. So Drawings
Account will be debited. To record this, following entry will be passed :
Drawing Account/Capital Account Dr.
To Interest on Drawing Account
6. Depreciation charged on Fixed Assets
Depreciation is the gradual, permanent decrease in the value of an
asset due to wear and tear and many other causes. Depreciation is an expense so
the following entry will be passed :
Depreciation Account Dr.
To Asset Account
7. Bad Debts
Sometimes a debtor of business fails to pay the amount due from
him. Reasons may be many e.g. he may become insolvent or he may die. Such
irrecoverable amount is a loss to the business. To record this following entry will
be passed :
Bad Debts Account Dr.
To Debtor's Account
8. Bad Debts Recovered
When any amount becomes irrecoverable from any costumer or
debtor his account is closed in the books. If in future any amount is recovered
from him then his personal account will not be credited because that does not
exist in the books. So the following entry is passed :
Cash Account Dr.
To Bad Debts Recovered Account
22
9. Purchase and Sale of investment
When business has some surplus money it may invest this amount is
shares, debentures or other types of securities. When these securities are
purchased, these are recorded at the purchase price paid. At the time of sale of
investment the sale price of an investment is recorded in the books of accounts.
The following entry is passed to record the purchase of investment :
Investment Account Dr.
To Cash Account
In case of sale of these securities the entry will be :
Cash Account Dr.
To Investment Account
10. Loss of Goods by Fire/Accident/theft
A business may suffer loss of goods on account of fire, theft or
accident. It is a business loss and a nominal account. It also reduces the goods at
cost price, and increases the loss/expenses of the business. The entry will be
passed
as :
Loss by fire/Accident/theft Account Dr.(for loss)
Insurance Company Account Dr. (for insurance claim admitted)
To Purchases Account
11. Income Tax Paid
Income Tax paid should be debited to Capital Account or Drawings
Account and credited to Cash Account in case of sole proprietorship and
partnership firms. The reason behind this is that income tax is a personal expense
for the sole trader and partners because it is paid on income of proprietor. The
entry will be as follows :
23
Capital Account/Drawing Account Dr.
To Cash Account
12. Bank Charges
Bank provide various services to their customers. Bank deducts some
charges by debiting the account of customers. It is an expense for the business.
To record this, Bank charges account is debited and bank account is credited in
the books of customer.
13. Drawings Account
It is a personal account of the proprietor. When the businessman
withdraws cash or goods from the business for his personal/domestic use it is
called as 'drawings'. Drawings reduce the capital as well as goods/cash balance of
the business. The journal entry is :
Drawings Account Dr.
To Cash Account
To Purchases Account
14. Personal expenses of the proprietor
When the private expenses such as life insurance premium, income tax, home
telephone bill, tuition fees of the son of the proprietor etc. are paid out of the cash
or bank
account of business it should be debited to the Drawings Account of the
proprietor.
15. Sale of Asset/Property
When the asset of a business is sold, there may occur a profit or loss
on its sale. Its journal entry is :
(i) In case there is a profit on sale of Property/Assets
Cash/Bank Account Dr.
To Asset/Property Account
To Profit on sale of Asset Account
24
(ii) In case of a loss on sale of asset
Cash/Bank Account Dr.
Loss on sale of Asset Account Dr.
To Asset Account
16. Amount paid or Received on behalf of customer
(i) When the business entity pays the amount on behalf of old reputed
customers such as carriage in anticipation of recovering the same later on, carriage
account should not be opened because carriage is not the expense of the seller. It
should be debited/charged to customer's Personal account.
(ii) When the business entity receives the amount on behalf of customers
from the third party as mutually settled between the third party and the customer,
the account of the third party/person making the payment should not be opened in
the books of the receiving entity. The journal entry in the books of the entity is :
Cash/Bank Account Dr.
To Customer/Debtor's Account
17. Amount paid on behalf of creditors
When the creditors/supplier instructs the business entity to make
payment on their behalf, the amount so paid should be debited to creditors account
and liability of the business will decrease accordingly.
18. The events affecting business but they do not involve any transfer/exchange
of money for the time being, they would not be recorded in the financial books.
19. Paid wages/installation charges for erection of machinery
Wages and installation charges are the expenses of nominal nature.
But for erection of machinery no separate account should be opened for such
expenses because these expenses are of capital nature and it will be
merged/debited
25
to the cost of assets i.e. machinery. The journal entry is:
Machinery Account Dr.
To Cash/Bank Account
(Being wages/installation charges paid
for the erection of machinery)
3.5 LEDGER
Journal is a daily record of all business transactions. In the journal
all transactions relating to persons, expenses, assets, liabilities and incomes are
recorded. Journal does not give a complete picture of the fundamental elements
of book keeping i.e. properties, liabilities, proprietorship accounts and expenses
and incomes at a glance and at one place. Business transactions being recurring in
nature, a number of entries are made for a particular type of transactions such as
sales, purchases, receipts and payments of cash, expenses etc., through out the
accounting year. The entries are therefore scattered over in the Journal. In fact,
the whole Journal will have to be gone through to find out the combined effect of
various transactions on a particular account. In case, at any time, a businessman
wants to now :
i) How much he has to pay to the suppliers/creditors of goods ?
ii) How much he has to receive from the customers ?
iii) What is the total amount of purchases and sales made during a particular
period?
iv) How much cash has been spent/incurred on various items of expenses such
as salaries, rent, carriage, stationery etc.
v) What is the amount of profit or loss made during a particular period ?
vi) What is the financial position of the unit on a particular date ?
The above mentioned information cannot be easily gathered from the
journal itself because the details of such information is scattered all over the
26
journal. It is thus of dire need to get a summarised/grouped record of all the
transactions relating to a particular person, or a thing or an expenditure to take
managerial decisions. The mechanics of collecting, assembling and summarising
all transactions of similar nature at one place can better be served by a book
known
as 'ledger' i.e. a classified head of accounts.
Ledger is a principal book of accounts of the enterprise. It is rightly
called as the 'King of Books'. Ledger is a set of accounts. Ledger contains the
various personal, real and nominal accounts in which all business transactions of
the entity are recorded. The main function of the ledger is to classify and
summarise all the items appearing in Journal and other books of original entry
under appropriate head/set of accounts so that at the end of the accounting period,
each account contains the complete information of all transaction relating to it.
A ledger therefore is a collection of accounts and may be defined as a summary
statement of all the transactions relating to a person, asset, expense or income
which have taken place during a given period of time and shows their net effect.
3.5.1 Relationship between Journal and Ledger
Journal and Ledger are the most useful books kept by a business
entity. The points of distinction between the two are given below :
1. The journal is a book of original entry where as the ledger is the main book
of account.
2. In the journal business transactions are recorded as and when they occur
i.e. date-wise. However posting from the journal is done periodically, may
be weekly, fortnightly as per the convenience of the business.
3. The journal does not disclose the complete position of an account. On the
other hand, the ledger indicates the position of each account debit wise or
credit wise, as the case may be. In this way, the net position of each account
is known immediately.
27
4. The record of transactions in the journal is in the form of journal entries
whereas the record in the ledger is in the form of an account.
Utility of a Ledger
The main utilities of a ledger are summarised as under :
(a) It provides complete information about all accounts in one book.
(b) It enables the ascertainment of the main items of revenues and expenses
(c) It enables the ascertainment of the value of assets and liabilities.
(d) It facilitates the preparation of Final Accounts.
Format of a Ledger Account
A ledger account can be prepared in any one of the following two
forms:
Form 1
Name of the Account ..............
Dr. Cr.
Date Particulars Journal Amount Date Particulars Journal Amount
Folio (Rs.) Folio (Rs.)
Form 2
Name of the Account...............
Date Particulars Journal Debit Credit Dr./Cr. Balance
Folio Amount Amount Rs.
Rs. Rs.
28
3.5.2 Posting
Posting refers to the process of transferring debit and credit amounts
from the Journal or subsidiary books to the respective heads of accounts in the
ledger. Journal will have at a minimum of one debit and one credit for each
transaction. The ledger will have either a debit or a credit for each account used
in the Journal. Posting may be done daily, weekly fort nightly or monthly
according
to the convenience and requirements of the business, but care should be taken to
complete it before the preparation of annual financial statements.
3.5.3 Procedure/Rules of Posting
The following rules should be followed while posting business
transactions to respective accounts in the ledger from the journal :
i) Enter the date and year of the transaction in the date column.
ii) Open separate account in the ledger for each person, asset, revenue, liability,
expense, income and loss appearing in the Journal.
iii) The appropriate/relevant account debited in the Journal will be debited in
the ledger, but the reference should be given of the other account which
has been credited.
iv) Similarly, the account credited in the Journal should be credited in the
ledger, but the reference has to be given of the other account which has
been debited in the Journal.
v) The debit posting should be prefixed by the word 'To' and credit posting
should be prefixed by the word 'By'.
vi) In the Journal Folio (J.F.) column the page number of the book of original
entry (Journal) is entered. This is explained with the following example :
Illustration 8 : Goods sold to Ravi for Rs. 1000 on credit on Ist April 2006.
Record this transaction in the journal and the ledger.
29
Solution :
The journal entry will be
Date Particulars L.F. Dr. (Rs.) Cr.(Rs.)
2006 Ravi's Account Dr. 1,000
April 1 To Sales Account 1,000
(Being Credit Sales of Goods to Ravi)
The above journal entry will appear in the ledger in two accounts as
follows. On the debit side of Ravi's Account, we will write "To Sales Account"
and
on the credit side of Sales Account we will write "By Ravi's Account".
Dr. Ravi's Account Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
2006 To Sales Account 1,000
April 1
Dr. Sales's Account Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
2006
April1 By Ravi's Account 1,000
Posting of Compound Journal Entry
When a single entry is passed to record more than one transaction, it
is known as a compound journal entry. However, it will be treated as several
separate entries while posting. The following example will make the point clear:
30
Illustration 9
Rs.
2006 March 31 Purchased stationary 1,000
Paid salary 7,000
Paid wages 600
Paid rent 1,200
Pass the necessary journal entry and prepare ledger accounts.
Solution :
The Journal entry will be
Date Particulars Dr. (Rs.) Cr.(Rs.)
2006 Stationary Account Dr. 1,000
March 31 Salary Account Dr. 7,000
Wages Account Dr. 600
Rent Account Dr. 1,200
To Cash Account 9,800
(Being cash paid for the above)
Then it will be posted as under :
Dr. Stationary's Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 To Cash Account 1,000
March 31
Dr. Salary's Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 To Cash Account 7,000
March 31
31
Dr. Rent Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 To Cash Account 1200
March 31
Dr. Wages Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 To Cash Account 600
March 31
Dr. Cash Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006
March 31 By Stationary A/c 1,000
March 31 By Salary A/c 7,000
March 31 By Rent A/c 1,200
March 31 By Wages A/c 600
3.5.4 Balancing of an Account
After transferring the entries from Journal to the ledger, the next
stage is to ascertain the net effect of all the transactions posted to relevant account.
When the posting is completed, most of the accounts may have entries on both
sides of the accounts i.e. debit entries and credits entries. The process of finding
out the difference between the totals of the two sides of a Ledger account is
known as balancing and the difference of the total debits and the total credits of
accounts is known as balance.
32
If the total of the credit side is bigger than the total of the debit side,
the difference is known as credit balance. In the reverse case, it is called debit
balance.
Steps for Balancing Ledger Account
Ledger accounts may be balanced as and when it is required. The
balances of various accounts are ascertained as under :
1. Make the total of both sides of an account in a worksheet.
2. Write down the higher amount on the side obtained e.g. if the total of the
debit side is 6,000 and the credit side is 5,500, the amount Rs. 6,000 is first
inserted in the total on the debit side.
3. Also write down the same total on the other side of the account i.e. the
total of Rs. 6,000 is written against the total on the credit side also.
4. Find out the difference between the two sides of the account. In this example
debit side is more than credit side; therefore, there is a debit balance of Rs. 500.
5. This debit balance of Rs. 500 is to be shown as "By Balance c/d" in the
account on the credit side.
6. Finally, the amount of the closing balance should be brought down as the
opening balance at the beginning of the next day. Remember that if the opening
balance is not written on the next day, the balancing is incomplete.
Balancing of different accounts
Balancing is done either weekly, monthly, quarterly, biannually or
annually, depending on the requirements of the business concern.
Personal Accounts : Personal accounts are balanced regularly to know the
amounts due to the persons or due from the persons. A debit balance of this
account
indicate that the person concerned is a debtor of the business concern and a credit
balance indicates that he is a creditor of the business concern. If a personal account
shows no balance at all, it means that the amount due to him or due from him is
settled in full.
33
Real Accounts : Real accounts are generally balanced at the end of the accounting
year when final accounts are prepared and always shows debit balances. But, bank
account may show either a debit balance or a credit balance.
Nominal Accounts : In fact, nominal accounts are not balanced, as they are to be
closed by transferring them to the final accounts i.e. Trading and Profit and Loss
Account.
Illustration 10 : Enter the following transactions in the Journal of Ramesh, and
post them to the Ledger.
2006 Rs.
Jan. 1 Assets in hand : Cash Rs. 630; Cash at Bank Rs. 23,100;
Stock of goods; Rs. 26,400; M. & Co., Rs. 6,750.
Liabilities : Marathi & Co. Rs. 3,880; Ram & Sons Rs. 3000.
" 2 Received a cheque from M. & Co. in full settlement 6,650
" 4 Sold goods to Chand & Sons on credit 1,440
Carriage paid 35
Sold goods to G. & Co. for cash 3,120
" 5 Brought goods from Ram & Sons on credit 4,000
Paid Marathi & Co. by cheque in full settlement 3,800
" 6 Bought goods from Chatterjee 6,300
" 13 Returned goods to Chatterjee (not being up to specifications) 300
" 16 Goods used personally by proprietor 50
" 17 Sold goods to M. & Co 5,000
" 20 Cheque received from Chand & Sons 1,440
" 22 Bank advises Chand & Sons cheque returned unpaid
" 24 Cash deposited with bank 2,000
" 27 Cheque sent to Chatterjee (Discount allowed Rs. 150) 5,850
" 31 Paid salaries 600
Paid rent 300
Drew for personal use out of bank 500
34
Solution :
Journal
Date Particulars L.F. Dr. (Rs.) Cr. (Rs.)
2006
Jan. 1 Cash A/c Dr. 630
Bank A/c Dr. 23,100
Stock of Goods A/c Dr. 26,400
M. & Co. Dr. 6,750
To Marathi & Co. 3,880
To Ram & Sons 3,000
To Ramesh's Capital A/c 50,000
(Being balances of various assets
& liabilities brought forward)
2 Bank A/c Dr. 6,650
Discount Allowed A/c Dr. 100
To M. & Co. 6,750
(Being a cheque received from M.
& Co. & Discount allowed)
4 Chand & Sons A/c Dr. 1,440
To Sales A/c 1,440
(Being goods sold on credit)
4 Carriage Outwards A/c Dr. 35
To Cash A/c 35
(Being the carriage paid)
4 Cash A/c Dr. 3,120
To Sales A/c 3,120
(Being goods sold for cash)
5 Purchases A/c Dr. 4,000
To Ram & Sons 4,000
(Being goods purchased on credit)
35
5 Marathi & Co. A/c Dr. 3,880
To Bank A/c 3,800
To Discount A/c 80
(Being payment made to Marathi & Co.
in full settlement & discount received)
6 Purchases A/c Dr. 6,300
To Chatterjee 6,300
(Being goods purchased on credit)
13 Chatterjee Dr. 300
To Returns Outwards A/c 300
(Being goods returned to Chatterjee)
16 Drawings A/c Dr. 50
To Purchases A/c 50
(Being goods withdrawn for
personal use)
17 M. & Co. Dr. 5,000
To Sales A/c 5,000
(Being goods sold on credit)
20. Bank A/c Dr. 1,440
To Chand & Sons A/c 1,440
(Being a cheque received from
Chand & Sons)
22 Chand & Sons A/c Dr. 1,440
To Bank A/c 1,440
(Being the cheque of Chand &
Sons dishonoured)
24 Bank A/c Dr. 2,000
To Cash A/c 2,000
(Being cash deposited into bank)
36
27 Chatterjee A/c Dr. 6,000
To Bank A/c 5,850
To Discount Received A/c 150
(Being payment made to Chatterjee
and discount received)
31 Salaries A/c Dr. 600
To Cash A/c 600
(Being salaries paid)
31 Rent A/c Dr. 300
To Cash A/c 300
(Being rent paid)
31 Drawings A/c Dr. 500
To Bank A/c 500
(Being cash withdrawn from bank
for personal use)
Ledger of Ramesh
Dr. Capital Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 31 To Balance c/d 50,000 Jan.1 By Balance b/f 50,000
50,000 50,000
Feb. 1 By Balance b/d 50,000
Dr. Stock of Goods Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 1 To Balance b/f 26,400 Jan.31 By Balance c/d 26,400
26,400 26,400
Feb.1 Balance b/d 26,400
37
Dr. Cash Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 1 To Balance b/f 630 Jan. 4 By Carriage Out-
4 To Sales A/c 3,120 wards A/c 35
24 By Bank A/c 2,000
31 By Salaries A/c 600
31 By Rent A/c 300
31 By Balance c/d 815
3,750 3,750
Feb.1 To Balance b/d 815
Dr. Bank Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 1 To Balance b/f 23,100 Jan. 5 By Marathi & Co. 3,800
2 To M. & Co. 6,650 22 By Chand & Sons 1,440
20 To Chand & Sons 1,440 27 By Chatterjee 5,850
24 To Cash A/c 2,000 31 By Drawings 500
31 By Balance c/d 21,600
33,190 33,190
Feb.1 Balance b/d 21,600
Dr. M. & Co.'s Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 1 To Balance b/f 6,750 Jan. 1 By Bank A/c 6,650
17 To Sales A/c 5,000 2 By Discount
Allowed A/c 100
By Balance c/d 5,000
11,750 11,750
Feb.1 To Balance b/d 5,000
38
Dr. Marathi & Co.'s Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 5 To Bank A/c 3,800 Jan. 1 By Balance b/f 3,880
5 To Discount
Received A/c 80
3,880 3,880
Dr. Ram & Sons's Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 1 By Balance b/f 3,000
Jan. 31 To Balance c/d 7,000 5 By Purchase A/c 4,000
7,000 7,000
Feb. 1 By Balance b/d 7,000
Dr. Chand & Sons' Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan.4 To Sales A/c 1,440 Jan. 20 By Bank A/c 1,440
22 To Bank A/c 1,440 31 By balance c/d 1,440
2,880 2,880
Feb. 1 To Balance b/d 1,440
Dr. Chatterjee's Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 13 To Returns Jan. 6 By Purchases A/c 6,300
Outwards A/c 300
27 To Bank A/c 5,850
27 To Discount
Received A/c 150
6,300 6,300
39
Dr. Purchases Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 5 To Ram & Sons 4,000 Jan.16 By Drawings A/c 50
6 To Chatterjee 6,300 Jan. 31 By Balance c/d 10,250
10,300 10,300
Feb. 1 To Balance b/d 10,250
Dr. Sales Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006
Jan. 4 By Chand & Sons A/c 1,440
4 By Cash A/c 3,120
Jan. 31 To Balance c/d 9,560 17 By M. & Co. 5,000
9,560 9,560
Feb.1 By Balance b/d 9,560
Dr. Discount Allowed Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 2 To M. & Co. 100 Jan. 31 By Balance c/d 100
100 100
Feb. 1 To Balance c/d 100
Dr. Carriage Outwards Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 4 To Cash A/c 35 Jan. 31 By Balance c/d 35
35 35
Feb. 1 To Balance b/d 35
40
Dr. Discount Received Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 5 By Marathi & Co. 80
Jan. 31 To Balance c/d 230 27 By Chatterjee A/c 150
230 230
Feb. 1 By Balance b/d 230
Dr. Return Outwards Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 31 To balance c/d 300 Jan. 13 By Chatterjee 300
300 300
Feb. 1 By Balance b/d 300
Dr. Drawings Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 16 To Purchases A/c 50
31 To Bank A/c 500 Jan. 31 By Balance c/d 550
550 550
Feb. 1 To Balance b/d 550
Dr. Salaries Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 3 To Cash A/c 600 Jan. 31 By Balance c/d 600
600 600
Feb. 1 To Balance b/d 600
41
Dr. Rent Account Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
2006 2006
Jan. 31 To Cash A/c 300 Jan. 31 By Balance c/d 300
300 300
Feb. 1 To Balance b/d 300
3.6 SUMMARY
Accounting as an information system is the process of identifying, measuring
and communicating the economic information of an organisation to its users who
need the information for making decisions. An accounting process is a complete
sequence with the recording of the transactions and ending with the preparation
of the final accounts. Journal is concerned with the recording of financial
transactions in an orderly manner, soon after their occurrence. The function of
systematic analysis of the recorded data to accumulate the transactions of similar
type at one place is performed by maintaining the ledger in which different
accounts are opened to which transactions are posted.
3.7 KEYWORDS
Accounting equation: Accounting equations is an accounting formula expressing
equivalence of the two expressions of assets and liabilities.
Journal: Journal is a tabular record in which business transactions are recorded
in a chronological order.
Journal entry: The record of the transaction in the journal is called a journal
entry.
Ledger: Ledger is the principal book of accounts where similar transactions
relating to a particular person or thing are recorded.
42
Posting: It is the process of transferring debit and credit amounts from the journal
or subsidiary books to the respective heads of accounts in the ledger.
Compound journal entry: A journal entry which includes more than one debit or
more than one credit is called compound journal entry.
3.8 SELF ASSESSMENT QUESTIONS
1. What is meant by Journal ? Enumerate the steps in journalising.
2. Define ledger. Explain the procedure for balancing a ledger account.
3. What is meant by posting? How is posting made from the journal in the
ledger? Explain with suitable examples.
4. Pass necessary Journal entries in the books of Narender for the month of
March, 2006 :
i) An old machinery appearing in books exchanged for a new machinery of
Rs. 5,000.
ii) Issued a cheque for Rs. 1,000 in favour of landlord for a rent for the month
of March.
iii) Paid electricity bill of Rs. 450 by cheque.
iv) The goods destroyed by theft Rs. 3,000.
v) Paid wages for the installation of machinery Rs. 5,000.
vi) Accrued interest Rs. 1100.
vii) Goods worth Rs. 4,000 given away by way of charity.
viii) Goods taken by Proprietor worth Rs. 10,000 for personal use.
5. From the following transactions of Mr. Kamal Mahajan write up journal
43
entries and post them into ledger.
2006
Jan.1 Assets-Cash in hand Rs. 2,000, Cash at bank Rs. 5,000, Stock of goods Rs.
4,000, Machinery Rs. 9000, Furniture Rs. 2,000, Sham owes Rs. 500,
Ram owes Rs. 3,500. Liabilities - Loan Rs. 4,000; sum owing to Y Rs.
3,000.
Jan.2 Sold goods to Pawan Rs. 3,000.
Jan. 5 Received Rs. 2,950 from Pawan in full settlement of his accounts.
Jan. 6 Payment made to Y Rs. 1,975 by cheque, he allowed discount of Rs. 25.
Jan. 8 Old furniture sold for Rs. 200.
Jan. 10 Ram pays Rs. 3,400 by cheque and discount allowed to him Rs. 100,
cheque deposited in bank.
Jan. 13 Paid for repairs to machinery Rs. 250
Jan. 15 Bank intimates the cheque of Ram has been returned dishonoured.
Jan. 18 Paid municipal taxes Rs. 200.
Jan. 22 Bought goods from Sita & Co. Rs. 1,000.
Jan. 25 Goods worth Rs. 600 given away as charity.
Jan. 31 Returned goods to Sita & Co. Rs. 1,000.
Jan. 31 An amount which was written off as bad debts in 1998 recovered Rs.
1,000.
44
6. Pass necessary journal entries and post them in the appropriate Ledger
Accounts of Kamal for the month of January 2006 :
1 Started business with Rs. 2,00,000 in the bank and Rs. 40,000 cash.
1 Bought shop fitting Rs. 40,000 and a van Rs. 60,000, both paid by cheque.
2 Paid rent by cheque Rs. 5,000.
3 Bought goods for resale on credit from Zakir & Co. Rs. 50,000.
5 Cash sales Rs. 5,000.
8 Paid wages of assistant in cash Rs. 1,000.
10 Paid insurance by cheque Rs. 500
12 Cash sales Rs. 8,000
15 Goods returned to Zakir & Co. Rs. 6,000.
17 Paid Zakir & Co. Rs. 30,000 by cheque.
24 Bought stationery and paid in cash Rs. 500.
25 Cash sales Rs. 15,000.
27 Paid Rao & Co. Rs. 14,000 by cheque.
31 Paid Rs. 20,000 into the bank.
3.9 SUGGESTED READINGS
1. S.N. Maheshwari, Advanced Accountancy
2. R.L. Gupta, Advanced Accountancy
3 M.C. Sukhla and T.S. Grewal, Advanced Accounts
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 4
TRIAL BALANCE
STRUCTURE
4.0 Objective
4.1 Introduction
4.2 Objectives of Preparing Trial Balance
4.3 Limitations of Trial Balance
4.4 Methods of Preparation Of Trial Balance
4.5 Accounting Errors
4.6 Steps for Location of Errors
4.7 Summary
4.8 Keywords
4.9 Self Assessment Questions
4.10 Suggested Readings
4.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define Trial Balance and explain the methods of
preparation of Trial Balance.
(b) Define accounting errors and steps for location of
accounting errors.
1
4.1 INTRODUCTION
A Trial Balance is a two-column schedule listing the titles and
balances of all the accounts in the order in which they appear in the
ledger. The debit balances are listed in the left-hand column and the
credit balances in the right-hand column. In the case of the General
Ledger, the totals of the two columns should agree.
We, now, know the fundamental principle of double entry system
of accounting where for every debit, there must be a corresponding
credit. Therefore, for every debit or a series of debits given to one or
several accounts, there is a corresponding credit or a series of credits of
an equal amount given to some other account or accounts and viceversa.
Hence, according to this principle, the sum total of debit amounts
must equal the credit amounts of the ledger at any date. If the various
accounts in the ledger are balanced, then the total of all debit balances
must be equal to the total of all credit balances. If the same is not true
then the books of accounts are arithmetically inaccurate.
It is, therefore, at the end of the financial year or at any other
time, the balances of all the ledger accounts are extracted and are
recorded in a statement known as Trial Balance and finally totalled up
to see whether the total of debit balances is equal to the total of credit
balances. A Trial Balance may thus be defined as a statement of debit
and credit totals or balances extracted from the various accounts in the
ledger books with a view to test the arithmetical accuracy of the books.
The agreement of the Trial Balance reveals that both the aspects
of each transaction have been recorded and that the books are
arithmetically accurate. If both the sides of Trial Balance do not agree
2
to each other, it shows that there are some errors, which must be
detected and rectified if the correct final accounts are to be prepared.
Thus, Trial Balance forms a connecting link between the ledger
accounts and the final accounts.
4.2 OBJECTIVES OF PREPARING TRIAL BALANCE
The following are the main objectives of preparing the trial
balance:
(i) To check the arithmetical accuracy of books of
accounts: According to the principle of double entry
system of book-keeping, every business transaction has two
aspects, debit and credit. So, the agreement of the trial
balance is a proof of the arithmetical accuracy of the books
of accounts. However, it is not a conclusive evidence of their
accuracy as their may be certain errors, which the Trial
Balance may not be able to disclose.
(ii) Helpful in preparing final accounts: The trial balance
records the balances of all the ledger accounts at one place
which helps in the preparation of final accounts, i.e.
Trading and Profit and Loss Account and Balance Sheet.
But, unless the trial balance agrees, the final accounts
cannot be prepared. So, if the trial balance does not agree,
errors are located and necessary corrections are made at
the earliest, so that there may not be unnecessary delay in
the preparation of the final accounts.
3
(iii) To serve as an aid to the management: By comparing
the trial balances of different years changes in figures of
certain important items such as purchases, sales, debtors
etc. are ascertained and their analysis is made for taking
managerial decisions. So, it serves as an aid to the
management.
4.3 LIMITATIONS OF TRIAL BALANCE
The following are the main limitations of the Trial Balance:
(i) Trial Balance can be prepared only in those concerns where
double entry system of accounting is adopted.
(ii) Though trial balance gives arithmetic accuracy of the books
of accounts but there are certain errors, which are not
disclosed by the trial balance. That is why it is said that
trial balance is not a conclusive proof of the accuracy of the
books of accounts.
(iii) If trial balance is not prepared correctly then the final
accounts prepared will not reflect the true and fair view of
the state of affairs of the business. Whatever conclusions
and decisions are made by the various groups of persons
will not be correct and will mislead such persons.
4.4 METHODS OF PREPARATION OF TRIAL BALANCE
A trial balance can be prepared by the following two methods:
4
1. Total method: In this method, the debit and credit totals
of each account are shown in the two amount columns (one
for the debit total and the other for the credit total).
2. Balance Method: In this method, the difference of each
amount is extracted. If debit side of an account is bigger in
amount than the credit side, the difference is put in the
debit column of the Trial Balance and if the credit side is
bigger, the difference is written in the credit column of the
Trial Balance.
A specimen of the Trial Balance is given as follows:
TRIAL BALANCE OF …………… AS ON ……………..
Serial
No.
Name of the Account
Dr.
Balance
Rs.
Cr.
Balance
Rs.
Of the two methods of the trial balance preparation, the second is
usually used in practice because it facilitates the preparation of the
final accounts.
Illustration 4.1: The following Trial Balance has been prepared
wrongly. You are asked to prepare the Trial Balance correctly.
5
Name of Accounts
Debit
Balance (Rs.)
Credit
Balance (Rs.)
Cash in hand 7,000
Purchases returns 8,000
Wages 8,000
Establishment expenses 12,000
Sales returns 7,000
Capital 22,000
Carriage outwards 2,000
Discount received 1,200
Commission earned 800
Machinery 20,000
Stock 10,000
Debtors 8,000
Creditors 12,000
Sales 44,000
Purchases 1,28,000
Bank overdraft 1,14,000
Manufacturing expenses 14,000
Loan from Ashok 14,000
Carriage inward 1,000
Interest on investments 1,000
Total 2,17,000 2,17,000
6
Solution: Correct Trial Balance as on ……..
Name of Accounts
Debit
Balance (Rs.)
Credit
Balance (Rs.)
Cash in hand 7,000
Purchases returns 8,000
Wages 8,000
Establishment expenses 12,000
Sales returns 7,000
Capital 22,000
Carriage outwards 2,000
Discount received 1,200
Commission earned 800
Machinery 20,000
Stock 10,000
Debtors 8,000
Creditors 12,000
Sales 44,000
Purchases 1,28,000
Bank overdraft 1,14,000
Manufacturing expenses 14,000
Loan from Ashok 14,000
Carriage inward 1,000
Interest on investments 1,000
Total 2,17,000 2,17,000
4.5 ACCOUNTING ERRORS
If the two sides of a trial balance agree it is a prima facie evidence
of the arithmetical accuracy of the entries made in the Ledger. But even
7
if the trial balance agrees, it does not necessarily mean that the
accounting records are free from all errors, because there are certain
types of errors, which are not revealed by a Trial Balance. Therefore a
Trial Balance should not be regarded as a conclusive proof of accuracy
of accounts.
In accounting an error is a mistake committed by the book-keeper
(Accountant/Accounts Clerk) while recording or maintaining the books
of accounts. An error is an innocent and non-deliberate act or lapse on
the part of the persons involved in recording business transactions. It
may occur while the transactions are originally recorded in the books of
original entries i.e. Journal, Purchase Book, Sales Book, Purchase
Return Book, Sales Return Book, Bills Receivable Book, Bills Payable
Book and Cash Book, or while the ledger accounts are posted or
balanced or even when the trial balance is prepared. These errors may
affect the arithmetical accuracy of the trial balance or may defeat the
very purpose of accounting. These errors can be classified as follows:
1. Clerical errors
2. Errors of Principle
A brief description of the above errors is given below:
(a) Clerical errors
Clerical errors are those errors, which are committed by the
clerical staff during the course of recording business transactions in the
books of accounts. These errors are:
1. Errors of omission
2. Errors of commission
3. Compensating errors
8
4. Errors of duplication
Errors of omission: When business transaction is either
completely or partly omitted to be recorded in the books of prime entry
it is called an ‘error of omission’. When a business transaction is
omitted completely, it is called a ‘complete error of omission”, and when
a business transaction is partly omitted, it is called a “partial error of
omission”. A complete error of omission does not affect the agreement of
trial balance whereas a partial error of omission may or may not affect
the agreement of trial balance.
Omission of recording a business transaction either completely or
partly, omission of ledger posting, omission of casting and balancing of
an account and omission of carrying forward are some examples of the
errors of omission.
An example of a complete error of omission is goods purchased or
sold may not be recorded in the purchase book or sales book at all. This
error will not affect the trial balance. An example of a partial error of
omission is goods purchased for Rs. 5,500 recorded in Purchase Book for
Rs. 550. This is a partial error of omission. This error will also not affect
the agreement of trial balance. Another example of a partial error of
omission is that if goods purchased for Rs. 5,500 is recorded in the
Purchase Book for Rs. 5,500 but the personal account of the supplier is
not posted with any amount on the credit side in the ledger, it is a
partial error of omission and it will affect the agreement of trial
balance.
Error of commission: Such errors are generally committed by
the clerical staff due to their negligence during the course of recording
9
business transactions in the books of accounts. Though, the rules of
debit and credit are followed properly yet some mistakes are committed.
These mistakes may be due to wrong posting of a business transaction
either to a wrong account or on the wrong side of an account, or due to
wrong casting (addition) i.e. over-casting or under-casting or due to
wrong balancing of the accounts in the ledger.
Compensating errors: Compensating errors are those errors,
which cancel or compensate themselves. These errors arise when an
error is either compensated or counter-balanced by another error or
errors so that of the other on the debit or credit side neutralizes the
adverse effect of one on credit side or debit side. For example, overposting
on one side may be compensated by under posting of an equal
amount on the same side of the same account or over posting of one side
of an account may be compensated by an equal overprinting on the
opposite side of some other account. But these errors do not affect the
trial balance.
Errors of duplication: When a business transaction is recorded
twice in the prime books and posted in the Ledger in the respective
accounts twice, the error is known as the ‘Error of Duplication’. These
errors do not affect the trial balance.
(b) Errors of principle
When a business transaction is recorded in the books of original
entries by violating the basic/fundamental principles of accountancy it
is called an error of principle. Some examples of these errors are:
10
(i) When revenue expenditure is treated as capital expenditure
or vice-versa, e.g. building purchased is debited to the
purchase account instead of the building account.
(ii) Revenue expenses debited to the personal account instead
of the expenses account, e.g. salary paid to Mr. Ashok, a
clerk, for the month of June, debited to Ashok’s account
instead of salary account. These errors do not affect the
Trial Balance.
The disagreement of the Trial Balance will disclose the
following errors:
(i) An item omitted to be posted from a subsidiary book into
the Ledger i.e. a purchase of Rs. 6,000 from Satpal omitted
to be credited to his account. As a result of this error, the
figure of sundry creditors to be shown in the Trial Balance
will reduce by Rs. 6,000 and the total of the credit side of
the Trial Balance will be Rs. 6,000 less as compared to the
debit side of the Trial Balance.
(ii) Posting of wrong amount to a ledger account i.e. credit sale
of Rs. 12,000 to Nisha wrongly posted to her account as Rs.
1,200. The effect of this error will be that the figure of
sundry debtors will reduce by Rs. 10,800 and the total of
the debit side of the Trial Balance will be Rs. 10,800 less
than the total of the credit side of the Trial Balance.
(iii) Posting an amount to the wrong side of the ledger account
i.e. Rs. 150 discount allowed to a customer wrongly posted
11
to the credit instead of the debit of the Discount Account.
As a result of this error, the credit side of the Trial Balance
will exceed by Rs. 300 (double the amount of the error).
(iv) Wrong additions or balancing of ledger account, i.e. while
balancing Capital Account at the end of the financial year,
credit balance of Rs. 1,89,000 wrongly taken as Rs.
1,79,000. As a result of this error, the credit total of the
Trial Balance will be short by Rs. 10,000.
(v) Wrong totalling of subsidiary books, i.e. Sales Book is
overcast by Rs. 1,000. As a result of this error, Credit side
of the Trial Balance will be excess by Rs. 1,000 because
Sales Account will appear at a higher figure on the credit
side of the Trial Balance.
(vi) An item in the subsidiary book posted twice to a ledger
account, i.e. a payment of Rs. 9,000 to a creditors posted
twice to his account.
(vii) Omission of a balance of an account in the Trial Balance,
i.e. cash and bank balances may have been omitted to be
included in the Trial Balance.
(viii) Balance of some account wrongly entered in the Trial
Balance i.e. a balance of Rs. 614 in Stationery Account
wrongly entered as Rs. 416 in the Trial Balance.
(ix) Balance of some account written to the wrong side of the
Trial Balance, i.e., balance of Commission Earned Account
12
wrongly shown to the debit side instead of the credit side of
the Trial Balance.
(x) An error in the totalling of the Trial Balance will bring the
disagreement of the Trial Balance.
Illustration 4.2: Ramniwas, a book-keeper, taking out a trial
balance as on 31st March 2005, found that its debit and credit columns
did not agree. He proceeded to check the entries and discovered the
following errors:
1. A credit sale of Rs. 1,000 to Ajay had been correctly entered
in the Sales Book but Ajay’s Account had been debited with
Rs. 100 only.
2. The total of the Bills Payable Book Rs. 5,000 had been
posted to the credit of Bills Receivable Account.
3. Rs. 2,500 paid to Ram had been wrongly posted to Shyam.
4. Rs. 100 owing by a customer had been omitted from the list
of debtors.
5. The discount column of the Cash Book representing
discount allowed to customer has been over-added by Rs.
10.
6. Goods worth Rs. 100 taken by the proprietor omitted to be
recorded in the books.
7. Depreciation on furniture Rs. 100, had not been posted to
Depreciation Account.
8. The total of Sales Book had been added Rs. 1,000 short.
Which of the above errors caused the totals of the Trial Balance to
disagree and by how much did the totals differ?
13
Solution: The effect of the above noted errors on the Trial
Balance will be as follows:
1. Ajay’s account has been given fewer debits for Rs. 900, so
the debit side of the Trial Balance would be short by s. 900.
2. This error will not affect the agreement of the Trial Balance
because the posting of the Bills Payable Book has been
made to the correct side but in the wrong Account. The
credit given to Bills Receivable Account instead of Bills
Payable Account does not affect the agreement of the Trial
Balance.
3. This error will not affect the agreement of the Trial Balance
because the amount paid has been posted to right side
through to a wrong account.
4. Sundry debtors have been shown in the Trial Balance with
a less amount of Rs. 100, so debit side of the Trial Balance
is short by Rs. 100.
5. Discount Account has been given an excess debit of Rs. 10
so debit side of the Trial Balance exceeds by Rs. 10.
6. This error will have no affect on the agreement of the Trial
Balance because the dual aspect of the entry has been
omitted i.e., neither of the two accounts involved in this
transaction has been given debit or credit.
14
7. Depreciation of furniture has not been debited to
Depreciation Account, so debit side of the Trial Balance will
be short by Rs. 100.
8. Sales Account has been given less credit for Rs. 1,000, so
credit side of the Trial Balance would be short by Rs. 1,000.
The combined affect of all the errors is that the credit side of the
Trial Balance would exceed the debit side by Rs. 90.
4.6 STEPS FOR LOCATION OF ERRORS
Whenever a Trial Balance disagrees, the following steps should
be taken to locate the causes of the difference:
1. Recheck the total of the Trial Balance and ascertain the
exact amount difference in the Trial Balance.
2. Divide the difference of the Trial Balance by two and find
out if there is any balance of the same amount in the Trial
Balance. It may be that such a balance might have been
recorded on the wrong side of the Trial Balance, thus
causing a difference of double the amount.
3. If the mistake is not located by the above steps, the
difference in the Trial Balance should be divided by 9. If the
difference is evenly divisible by 9, the error may be due to
transposition or transplacement of figures. A transposition
occurs when 57 is written as 75, 197 as 791 and so on. A
transplacement takes place when the digits of the numbers
are moved to the left or right e.g. when Rs. 5,694 is written
15
as Rs. 56.94 or s. 569.40. If there is a transposition or
transplacement of figures, the search can be narrowed
down to numbers where these errors might have been
made.
4. See that the balances of all accounts including cash and
bank balances have been included in the Trial Balance.
5. See that the opening balances have been correctly brought
forward in the current year’s books.
6. If the difference is of a large amount, compare the Trial
Balance of the current year with that of the previous year
and see that the figures under similar head of account are
approximately the same as those of the previous year and
whether their balances fall on the same side of the Trial
Balance. If the difference between the previous year figures
and the current year figures is large one, establish the
causes of difference.
7. If the above listed steps fail to detect the errors, check your
work as follows:
(i) Check the totals of the subsidiary books paying
particular attention to carry forwards.
(ii) Check the posting made from the Journal or
subsidiary books in the ledger.
(iii) Re-check the balances extracted from ledger.
(iv) Re-cast the list of balances.
16
If all the efforts fail to locate the errors, all the books of primary
entry (subsidiary books) must be cast, and, if necessary, the postings to
the ledger should be re-checked.
4.7 SUMMARY
As air, food and water are indispensable to life, Trial Balance is
indispensable to accounting. It serves as a lubricant for the smooth
movement and completion of the accounting cycle. Moreover, it forms a
useful connecting link between ledger accounts and final accounts. The
agreement of a Trial Balance is not a conclusive proof as to the absolute
accuracy of the books. It only gives an indication of the arithmetical
accuracy. Even if both the sides of trial Balance agree to each other yet
there may be some errors in the books of accounts.
4.8 KEYWORDS
Trial Balance: A Trial Balance is a statement of debit and credit
balances extracted from all the ledgers with a view to ascertain
arithmetical accuracy of posting of all transactions into the respective
ledgers.
Clerical Errors: Those errors which are committed by the clerical staff
during the course of recording business transactions in the books of
accounts is known as clerical errors.
Compensating Errors: Compensating errors are those errors which
cancel or compensate themselves.
17
Errors of Principle: When a transaction is recorded in the books of
accounts by violating the basic principle of accounting, it is called an
error of principle.
4.9 SELF ASSESSMENT QUESTIONS
1. What do you mean by a Trial Balance? Discuss the
objectives and methods of preparing a Trial Balance.
2. Is the agreement of Trial Balance a conclusive proof of the
accuracy of books of accounts? If not, what are the errors,
which remain undetected by the Trial Balance?
3. In case of disagreement of the Trial Balance in what order
you would follow to locate the errors?
4. The cashbook of Mr. Sheru shows Rs. 8,364 as bank balance
on 31st December 2005. But you find that this does not
agree with the balance as shown by passbook. On scrutiny
you find the following discrepancies:
(a) On 15th Dec. 2005 the payment side of cashbook was
undercast by Rs. 100.
(b) A cheque for Rs. 131 issued on 25th December 2005
was taken in cash column.
(c) One deposit of Rs. 150 was recorded in cash book as if
there is not bank column therein.
(d) On 18th Dec. 2005 the debit balance of Rs. 1,526 as on
the previous day was brought forward as credit
balance.
18
(e) Of the total cheques amounting to Rs. 11,514 drawn
in last week of December 2005, cheques aggregating
Rs. 7,815 encashed in December.
(f) Dividends of Rs. 250 collected by bank and
subscription of Rs. 200 paid by it were not recorded in
cash book.
(g) One outgoing cheque of Rs. 350 was recorded twice in
the cash book.
5. From the following Trial Balance (containing obvious
errors) prepare a correct Trial Balance:
Dr. (Rs.) Cr. (Rs.)
Purchases 60,000
Reverse fund 20,000
Sales 1,00,000
Purchase returns 1,000
Sales returns 2,000
Opening stock 30,000
Closing stock 40,000
Expenses 20,000
Outstanding expenses 2,000
Bank balance 5,000
Assets 50,000
Debtors 80,000
Creditors 30,000
Capital 94,000
Suspense account (difference in books) 10,000
2,72,000 2,72,000
19
6. The following balances appear in various accounts on
31.12.2005. You are asked to prepare a Trial Balance:
Rs. Rs.
Capital 20,000 Apprentice premium 300
Machinery 8,000 Insurance premium 200
Building 9,000 Interest on investment 600
Rates and taxes 500 Investments 6,000
Debtors 6,000 Bank charges 100
Stationery 900 Printing 300
Bills payable 1,950 Creditors 3,000
Loan from Raju and Co. 8,000 Office expenses 650
Opening stock 500 Wages 1,200
Bank 1,500 Sales 9,000
Cash 500 Purchases 3,500
Drawings 2,000 Furniture 2,000
4.10 SUGGESTED READINGS
1. Aggarwal and Jain, Advanced Financial Accounting.
2. S.N. Maheshwari, Introduction to Accounting.
3. R.L. Gupta, Advanced Accountancy.
4. Shukla and Grewal, Advanced Accounts.
5. Tulsin, Financial Accounting.
20
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 5
SUBSIDIARY BOOKS
STRUCTURE
5.0 Objective
5.1 Introduction
5.2 Classification of Accounts
5.3 Rules of Debit and Credit
5.4 Journal, Ledger and Balancing
5.5 Subsidiary Books
5.6 Benefits of Specific Journals
5.7 Cash Book
5.8 Summary
5.9 Keywords
5.10 Self assessment questions
5.11 Suggested readings
5.0 OBJECTIVE
The main objective of this lesson is to make the students lean about the
preparing of a Subsidiary Books and their relevance in accounting process
while preparing the financial statements or books of accounts of an
organization.
5.1 INTRODUCTION
Any economic transaction or event of a business, which can be
expressed in monetary terms, should be recorded. Traditionally, accounting is
a method of collecting, recording, classifying, summarizing, presenting and
1
interpreting financial data aspect of an economic activity. The series of
business transaction occurring during the accounting period and its recording
is referred to an accounting process/mechanism. An accounting process is a
complete sequence of accounting procedures, which are repeated, in the same
order during each accounting period. Therefore, accounting process involves
the following stages or steps starting from identification of business
transaction and ending with reverse entries for prepaid and occurred
expenses:
1. Identification of transaction
A number of transactions take place in a business enterprise in a
particular accounting year. Every transaction or event, which occurs, must
influence the financial position of a business enterprise. These transactions
may be external (between a business entity and second party) or internal (not
involve second party) i.e. depreciation etc.
2. Recording the transaction
Journal is the first book of original entry in which all transactions are
recorded event wise and date-wise and presenting a historical record of all
monetary transactions. Journal may further be divided into sub-journals as
well.
3. Classifying
Accounting is the art of classifying business transactions. Classification
means statement setting out for a period where all the similar transactions
relating to a person, a thing, expense, or any other subject are grouped
together under appropriate heads of accounts.
2
4. Summarizing
Summarizing is the art of making the activities of the business
enterprise as classified in the ledger for the use of management or other user
groups i.e. sundry debtors, sundry creditors etc. Summarization helps in the
preparation of Profit and Loss Account and Balance Sheet for a particular
fiscal year.
5. Analysis and interpretation
The financial information or data is recorded in the books of account
must further be analyzed and interpreted so to draw meaningful conclusions.
Thus, analysis of accounting information will help the management to assess
in the performance of business operation and forming future plans also.
6. Presentation or reporting of financial information
The end users of accounting statements must be benefited from
analysis and interpretation of data as some of them are the ‘stock-holders’
and other one the ‘stake holders’. Comparison of past and present statements
and reports, use of ratios and trend analysis are the different tools of analysis
and interpretation.
From the above discussion one can conclude that accounting is an art
which starts and includes steps right from recording of business transactions
of monetary character to the communicating or reporting the results thereof
to the various interested parties. For this purpose, the transactions are
classified into various accounts, the description of which follows in the next
section.
3
5.2 CLASSIFICATION OF ACCOUNTS
An account is a summary of the relevant transactions at one place
relating to a particular head. It records not only the amount of transaction
but also their effect and direction. The classification of accounts is given
below:
1. Personal accounts
Accounts, which are related with accounts of individuals, firms,
companies, co-operative societies, financial institutions are known as personal
accounts. The personal accounts may further be classified into three
categories:
(i) Natural personal accounts: Accounts of individuals (natural
persons) such as Akhils’ A/c, Rajesh’s A/c, and Sohan’s A/c are
natural personal accounts.
(ii) Artificial personal accounts: Accounts of firms, companies,
institutions such as Reliance Industries Ltd., Lions Club, M/s
Sham and Sons, National College are artificial personal
accounts.
(iii) Representative personal accounts: The accounts which represent
some person such as wages outstanding account, prepaid
insurance account, accrued interest account are considered as
representative personal accounts.
2. Real accounts
Real accounts are the accounts related to assets/properties. These may
be classified into tangible real account and intangible real account. The
accounts relating to tangible assets such as building, plant, machinery, cash,
4
furniture etc. are classified as tangible real accounts. Intangible real accounts
are the accounts related to intangible assets such as goodwill, trademarks,
copyrights, patents etc.
3. Nominal accounts
The accounts relating to income, expenses, losses and gains are
classified as nominal accounts. For example, Wages account, Rent account,
Interest account, Salary account, Bad debts accounts etc. fall in the category
of nominal accounts.
5.3 RULES OF DEBIT AND CREDIT
Basically, debit means to enter an amount on the left side of an account
and credit means to enter an amount of the right side on an account. In the
abbreviated form Dr. stands for debit and Cr. Stands for credit. Both debit
and credit may represent either increase or decrease depending upon the
nature of an account.
Rules for debit and credit
Types of accounts Rules for debit Rules for credit
(a) For personal accounts Debit the receiver Credit the giver
(b) For real accounts Debit what comes in Credit what goes out
(c) For nominal accounts Debit all expenses
and losses
Credit all incomes
and gains
5.4 JOURNAL, LEDGER AND BALANCING
Journal
A journal is a book in which transactions are recorded in the order in
which they occur i.e. in chronological order. A journal is called a book of prime
entry (also called a book of original entry) because all business transactions
5
are entered first in this book. The process of recording a transaction in the
journal is called journalising. An entry made in the journal is called a Journal
Entry.
Ledger
Ledger is a principal book of accounts of the enterprise. It is rightly
called as the ‘King of Books’. Ledger is a set of accounts. An accounting
system typically contains a large number of accounts and the number of
accounts can be added as they are needed and anticipated. Ledger contains
the various personal, real and nominal accounts in which all business
transactions of the entity are recorded. The main function of the ledger is to
classify and summarize all the items appearing in Journal and other books of
original entry under appropriate head/set of accounts so that at the end of the
accounting period, each account contains the complete entire information of
all transaction relating to it. So ledger is a book of final entry wherein all the
accounts find their place. Thus, to have a consolidated view of the similar
transactions different accounts are prepared in the ledger. A ledger therefore
is a collection of accounts and may be defined as a summary statement of all
the transactions relating to a person, asset, expense or income which have
taken place during a given period of time and shows their net effect.
Balancing of different accounts
Balancing is done either weekly, monthly quarterly, biannually or
annually, depending on the requirements of the business concern.
Personal accounts
Personal accounts are balanced regularly to know the amounts due to
the persons or due from the persons. A debit balance of this account indicate
that the person concerned is a debtor of the business concern and a credit
6
balance indicates that he is a creditor of the business concern. If a personal
account shows no balance at all, it means that the amount due to him or due
from him is settled in full.
Real accounts
Real accounts are generally balanced at the end of the accounting year
when final accounts are prepared and always shows debit balances. But, bank
account may show either a debit balance or a credit balance.
Nominal accounts
In fact, nominal accounts are not balanced, as they are to be closed by
transferring them to the final accounts i.e. Trading and Profit and Loss
Account.
5.5 SUBSIDIARY BOOKS
When numbers of transactions are large, it is practically impossible to
record all the transactions through one journal because of the following
reasons:
(a) The system of recording all transactions in a journal requires
(i) Writing down of the name of the account involved as many
times as the transactions occur; and
(ii) An individual posting of each account debited and credited
and hence, involves the repetitive journalizing and posting
labour.
(b) Such a system does not provide the information on a prompt
basis.
7
(c) Such a system does not facilitate the installation of an internal
check system since only one person can handle the journal.
(d) The journal becomes bulky and voluminous.
To overcome the shortcomings of the use of the journal only as a book
of original entry, the journal is sub-divided into special journals. It is subdivided
in such a way that a separate book is used for each category of
transactions, which are repetitive in nature and are sufficiently large in
number. Subsidiary books refer to the journals meant for specific transactions
of similar nature.
The proforma and number of special journals vary according to the
requirements of each enterprise. In any large business, the following special
journals are generally used:
Name of the special journal Specific transactions to be
recorded
I. Cash Journal
(a) Single column cash book Cash transactions
(b) Double column cash
book
Cash and discount transactions
(c) Triple column cash book Cash, bank and discount transactions
(d) Petty cash book Petty cash transactions
II. Goods journal
(a) Purchase book Credit purchase of goods
(b) Sales book Credit sales of goods
(c) Sales returns book (or
Return Inwards book)
Goods returned by those customers to
whom goods were sold on credit
(d) Purchase returns book
(or Return outwards
book)
Goods returned to those suppliers
from whom goods were purchased on
credit
8
III. Bills journal
(a) Bills receivable book Bills receivable drawn
(b) Bills payable book Bills payable accepted
IV. Journal proper Transactions not covered elsewhere
5.6 BENEFITS OF SPECIFIC JOURNALS
The benefits of using special journals are as under:
(a) Facilitates: The accounting work can be divided among many
persons.
(b) Permits the installation of internal check system: The
accounting work can be divided in such a manner that another
person automatically checks the work of one person. With the
use of internal check, the possibility of occurrence of error/fraud
may be avoided.
(c) Permits the use of specialized skill: The accounting work
requiring specialized skill may be assigned to a person
possessing the required skills. With the use of a specialized skill,
prompt, economical and more accurate supply of accounting
information may be obtained.
(d) Time and labour saving in journalizing and posting: For
instance, when a Sales Book is kept, the name of the sales
account will not be required to be written down in the Journal as
many times as the sales transactions occur and at the same
time, sales account will not be required to be posted again and
again since, only a periodic total of sales book is posted to the
sales account.
9
5.7 CASH BOOK
A cash book is a special journal, which is used for recording all cash
receipts and cash payments.
5.7.1 Cash book-both a journal and a ledger
The cash book is a book of original entry (or prime entry) since
transactions are recorded for the first time from the source documents. The
cash book is a ledger in the sense that it is designed in the form of a cash
account and records cash receipts on the debit side and cash payments on the
credit side. Thus, the cash book is both a journal and a ledger.
5.7.2 Types of cash book
The various types of cash book from the point of view of uses may be as
follows:
1. Single-column cash book: This cash book has one amount
column on each side. All cash receipts are recorded on the receipt
side and all cash payments on the payment side. In fact, this
book is nothing but a Cash Account. Hence, there is no need to
open this account in the ledger. Its format is shown below:
SINGLE-COLUMN CASH BOOK
Receipts Payments
Date Particulars L.F.
Amount
(Rs.)
Date Particulars L.F.
Amount
(Rs.)
10
2. Two-column cash book: This cash book has two amount
columns (one for cash and another for discount) one each side.
All cash receipts and discount allowed are recorded on the
receipt side and all cash payments and discount received are
recorded on the payment side. It format is shown as follows:
CASH BOOK WITH DISCOUNT COLUMN
Receipt Payment
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
3. Three-column cash book: This cash book has three amount
columns (one for cash, one for bank and one for discount) on each
side. All cash receipts, deposits into bank and discount allowed
are recorded on receipt side and all cash payments, withdrawls
from bank and discount received are recorded on the payment
side. In fact, a three-column cash book serves the purpose of
Cash Account as well as Bank Account. Hence, there is no need
to open these two accounts in the ledger. Its format is shown
below:
THREE-COLUMN CASH BOOK
Receipts Payments
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
Bank
(Rs.)
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
Bank
(Rs.)
11
12
Illustration 5.1: Prepare a three-column cash book from the following
particulars of Jan. 2006:
1. Cash in hand Rs. 50,000
2. Paid into bank Rs. 10,000
3. Bought goods from Harris for Rs. 500 for cash.
4. Bought goods for Rs. 2,000 paid cheque for them, discount
allowed 1%.
5. Sold goods to Mohan for cash Rs. 250.
6. Bank notified that Shay’s cheque has been returned dishonoured
and debited to the account in respect of charges Rs. 10.
7. Shay settled his account by means of a cheque for Rs. 820, Rs. 20
being interest charged.
8. Withdrew from bank Rs. 10,000.
9. Withdrew for personal use Rs. 1,000.
10. Paid trade expenses Rs. 2,000.
11. Withdrew from bank for private expenses Rs. 1,500.
12. Issued cheque to Ram Saran for purchase of furniture Rs. 1,575.
13. Rajesh who owned us Rs. 500 became bankrupt and paid us 50
paisa in a rupee.
14. Received payment of a loan of Rs. 5,000 and deposited Rs. 3,000
out of it into bank.
15. Paid rent to landlord by a cheque of Rs. 500.
16. Interest allowed by bank Rs. 30.
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
Bank
(Rs.)
Date Particulars L.F. Discount
(Rs.)
Cash
(Rs.)
Bank
(Rs.)
2006 2006
Jan. 1 To Balance c/d 50,000 Jan. 2 By Bank A/c C 10,000
2 To cash C 10,000 3 By purchases A/c 500
5 To Sales A/c 250 4 By Purchases A/c 20 1,980
6 To Shay 100 700 8 By Typewriter 200
11 To Shay 800 9 By Shay 100 700
To Interest 20 By Bank charges 10
12 To Bank C 10,000 12 By Cash C 10,000
29 To Rajesh 250 22 By Drawings 1,000
30 To Loans 5,000 24 By Trade expenses 2,000
30 To Cash C 3,000 25 By drawings 1,500
To Interest 30
To Balance c/d
(Bank overdraft)
120 1,765 27 By Furniture 1575
30 By Bank 3000
30 By Rent 500
By Bank charges 50
By Balance c/d 49,100
Total 120 65,500 16,315 Total 120 65,500 16315
THREE-COLUMN CASH BOOK
13
14
Contra entry: An accounting transaction involves two accounts and
there may be a transaction where both cash account and bank account are
involved. Since in the ledger there is no separate cash account and bank
account, therefore, no posting will be done from the cash book to the ledger in
case of such a transaction. The transaction will be recorded on both the side of
the cash book. Such an accounting entry, which is recorded on the both the
sides of the cash book, is known as contra entry. In order to give hint for the
purpose the word ‘C’ is written in the ledger folio.
4. Petty cash book: This book is used for the purpose of recording
the petty expenses so that the main cash book is relieved of the
detailed records of these petty expenses. Normally, one person is
handed over a small amount to meet the petty expenses of a
given period (say, week, fortnight or month) and is authorized to
make such payments and to record them in a separate cash
book. Such person, such amount and such cash books are called
as ‘Petty Cashier’, ‘Imprest’ and ‘Petty cash Book’ respectively.
The Petty Cash Book may or may not be maintained on ‘Imprest
System’. Under both the systems (i.e. Imprest and Non-imprest),
the petty cashier submits the Petty Cash Book to the Head
Cashier who examines the Petty Cash Book. Under the Imprest
system, the Head Cashier makes the reimbursement of the
amount spent by the Petty Cashier but under Non-imprest
system, the Head Cashier may handover the Cash to the Petty
Cashier equal to/more than less than the amount spent. The
format of Petty Cash Book may be designed according to the
requirements of the business.
15
Receipts Payments
Date Particulars
Cash
Book
Folio
Date Particulars
Voucher
No.
Postage
Telegram
(Rs.)
Conveyance
Travelling
(Rs.)
Staff Welfare
Entertainment
(Rs.)
Cartage
(Rs.)
Printing
and
Stationary
(Rs.)
Miscellaneous
Items (Rs.)
Total
5.8 SUMMARY
According as an information system is the process of identifying,
measuring and communicating the economic information of an organization
to its users who need the information for making decisions. An accounting
process is a complete sequence with the recording of the transactions and
ending with the preparation of the final accounts. Journal is concerned with
the recording of financial transactions in an orderly manner, soon after their
occurrence. Maintaining the ledger in which different accounts are opened to
which transactions are posted performs the function of systematic analysis of
the recorded data to accumulate the transactions of similar type at one place.
When number of transactions are large, it is practically impossible to record
all the transactions through one journal, the journal is subdivided in such a
way that a separate book is used for each category of transactions which are
repetitive in nature and are sufficiently large in number. All such books are
known as subsidiary books or special journals.
5.9 KEYWORDS
Cash book: Cash book is a book in which receipts and payment of cash are
recorded.
Petty cash book: A petty cash book is used to record all cash payments of
smaller demoniations.
Contra entry: If the same entry appears on both debit and credit side then
the entry is referred to as contra entry.
5.10 SELF ASSESSMENT QUESTIONS
1. What is meant by posting? How is posting made from the journal
in the ledger? Explain with suitable examples.
16
2. What do you understand by subsidiary books? Describe the
purpose of preparing such books.
3. Pass necessary journal entries in the books of Hardener for the
month of March 2001:
i) An old machinery appearing in books exchanged for a new
machinery of Rs. 5,000.
ii) Issued a cheque for Rs. 1,000 in favour of landlord for a
rent for the month of March.
iii) Paid electricity bill of Rs. 450 by cheque.
iv) The goods destroyed by theft Rs. 3,000.
v) Paid wages for the installation of machinery Rs. 5,000.
vi) Accrued interest Rs. 1100.
vii) Goods worth Rs. 4,000 given away by way of charity.
viii) Goods taken by Proprietor worth Rs. 10,000 for personal
use.
4. Pass necessary journal entries and post them in the appropriate
subsidiary books of Kampala for the month of January 2001:
i) Started business with Rs. 2,00,000 in the bank and Rs.
40,000 cash.
ii) Bought shop fitting Rs. 40,000 and a van Rs. 60,000, both
paid by cheque.
iii) Paid rent by cheque Rs. 5,000.
17
iv) Bought goods for resale on credit from Fakir and Co. Rs.
50,000.
v) Cash sales Rs. 5,000.
vi) Paid wages of assistant in cash Rs. 1,000.
vii) Paid insurance by cheque Rs. 500
viii) Cash sales Rs. 8,000
ix) Goods returned to Fakir and Co. Rs. 6,000
x) Paid Fakir and Co. Rs. 30,000 by cheque.
xi) Bought stationery and paid in cash Rs. 500.
xii) Cash sales Rs. 15,000.
xiii) Paid Raju and Co. Rs. 14,000 by cheque.
xiv) Paid Rs. 20,000 into the bank.
5.11 SUGGESTED READINGS
1. Aggarwal and Jain, Advanced Financial Accounting.
2. R.L. Gupta, Advanced Accountancy.
3. Sukhla and Grewal, Advanced Accounts.
18
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 6
INVENTORY VALUATION METHODS
STRUCTURE
6.0 Objective
6.1 Introduction
6.2 Objectives of Inventory Valuation
6.3 Methods of recording inventory
6.4 Methods of Valuation of Inventories
6.6 Summary
6.7 Keywords
6.8 Self Assessment Questions
6.9 Suggested Readings
6.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Understand the meaning and objectives of inventory
valuation.
(b) Describe the methods of recording and valuation of
inventories.
(c) Explain the advantages, disadvantages and suitability of
various methods of inventory valuation.
6.1 INTRODUCTION
The literary meaning of the word inventory is stock of goods. To
the finance manager, inventory connotes the value of raw materials,
1
consumable, spares, work-in-progress, finished goods and scrap in
which a company’s funds have been invested. It constitutes the second
largest items after fixed assets in the financial statements, particularly
of manufacturing organisation. It is why that inventory valuation and
inventory control have become very important functions of the
accountants and finance managers. The persons interested in the
accounting information assume that the financial statements contain
accurate information. However, it is often observed that the financial
statements don’t provide actual information about some of the items,
e.g. inventory and depreciation. This may be because of the variety of
inventory valuation methods available with the accountant.
According to the International Accounting Standard-2 (IAS-2),
‘Inventories’ mean tangible property held;
(a) for sale in the ordinary course of business,
(b) in the process of production for such sale, or
(c) for consumption in the production of goods or services for
sale.
Hence, the term inventory includes stock of (i) raw material and
components, (ii) work-in-progress and finished goods. In case of
manufacturing concern, inventory consists of raw materials,
components, stores, semi-finished products and finished goods in case of
a trading concern inventory primarily consists of finished goods.
6.2 OBJECTIVES OF INVENTORY VALUATION
Following are the objectives of inventory valuation:
2
a) Determination of Income: A major objective of inventory
valuation is the proper determination of income through the process of
matching appropriate cost against revenues. Gross profit is found out
by deducting cost of goods sold from sales. Cost of goods sold is
purchases plus opening stock minus closing stock. Hence, closing stock
must be properly valued and brought into accounts. Over valuation of
closing stock leads to inflation of the current year profits and deflation
of the profits of succeeding years. Similarly, undervaluation leads to
deflation of current years profit and inflation of the profit of the
succeeding years.
b) Determination of financial position: In the balance
sheet, “inventory’ is a very important item. It is to be shown as current
asset in the balance sheet at the end of the year. If the inventory is not
properly and correctly valued, to that extent the balance sheet does not
give true and fair view of the financial position of the business. Keeping
in view the above objectives the auditor’s duty in relation to the
verification and valuation of inventories becomes more important.
Therefore, while verifying he should ensure that stock taking is done by
responsible a officer, stock figures match with that of stock registers,
and the basis of valuation has been consistently the same from year to
year. Moreover, he should carry out test checks to ensure the accuracy
of valuation.
6.3 METHODS OF RECORDING INVENTORY
The records of quantity and value of inventory can be made in
two ways. These as follows:
(i) Periodic Inventory System
3
(ii) Perpetual Inventory System
I) Periodic Inventory System: Under this system the
quantity and value of inventory is ascertained by physically counting
the stock at the end of the year and as on the accounting date. In case of
big business houses, annual stock taking may even take a week at the
end of the year in finalising the stock in hand on continuous basis. In
case of this system certain items are physically counted, while others
are weighed in kilos or tonnes or measured in litters. For stock taking
stock sheets are used. The firms evolve such a performa of stock sheet
on which all the relevant informations like particulars of inventory,
numbers of units, price per unit, total value, etc. can be listed and
added so as to get the figure of inventory. This method offers the
advantage of simplicity. Also, there is no used to maintain the various
records to be maintained under perpetual inventory system. However,
the limitation of this method is that discrepancies and losses in
inventory will never come to light as it makes no accounting for theft,
losses, shrinkage and wastage.
II) Perpetual Inventory System: This system provides as
running record of inventories on hand because under this method stock
registers are maintained which will give the inventory balance at any
time desired. According to the Institute of Cost and Management
Accountants, London, it is “a system of records maintained by the
controlling department which reflects the physical movement of stocks
and their current balance.” The stores ledger will give the balance of
raw materials, work-in-progress and finished goods on hand. Because of
this it is for the management to provide for continuous stock-taking, so
4
that by comparing the physical balance with book balance, any
discrepancies are ascertained immediately.
In this system business need not be suspended for the purpose of
stock taking. The main advantage of this method is that it provides
details about the quantity and value of stock of each item all times.
Thus it provides a basis for control. The main drawback of this system
is that it requires elaborate organisation and records and, therefore, it
is more expensive.
6.4 METHODS OF VALUATION OF INVENTORIES
The basic methods of valuation of inventories are as follows:
(a) Historical cost based method
(b) Sale price based method
(c) Lower of cost or sale price
Methods based on Historical cost
According to AS-2 historical cost is the aggregate of costs of
purchases, costs of conversion and other costs incurred in the normal
course of business in bringing the inventories to their present locations
and condition. Cost of purchase comprises purchase price, duties and
taxes, freight inwards and other expenditure directly attributable to
acquisitions. However, selling expenses such as advertisement expenses
or storage cost should not be included.
The valuation of inventory at cost price will be in consonance with
the realisation concept. According to this concept, revenue is not
realised until the sale is complete and the inventory is converted into
5
either cash or accounts receivable. There can thus be no recognition of
revenue accretion except at the point of sale.
This is a method with very high objectivity since the inventory
valuer has to base it on a transaction which is completely verifiable.
The main limitation of this method is its inability to distinguish
operational gains from holding gains during period of inflation. (Note:
Holding gain refers to profits which arises as a result of holding
inventories during inflation). They may be attributed to the fact that
this method matches the past inventories against revenues which have
current relations. Thus, this system will result in the inclusion of
“inventory profits” (i.e. holding gain) in the income statements during
periods of rising prices.
Now, we shall describe the various methods for assigning
historical costs to inventory and goods sold.
1. First In First Out Method (FIFO): This method is based
on the assumption that the materials which are purchased first are
issued first. Issues of inventory are priced in order of their purchases.
Inventory issues/sales are priced on the same basis until the first lot of
material of goods purchased is exhausted. Thus, units issued are priced
at the oldest cost price listed on the stock ledger sheets. Under this
system it is not necessary that the material which were longest in stock
are exhausted first. But the use of FIFO necessarily mean that the
oldest costs are first used for accounting purposes. In practice, an
endeavour is made by most business houses to sell of oldest
merchandise or materials first. Hence when this system is followed the
closing stock does not consist of most recently purchased goods.
6
Advantages. The following are the advantages of this method:
(i) This method is easy to operate, provided the prices of
materials do not fluctuate frequently.
(ii) It gives such a value of closing stock which is vary near to
current market prices since closing inventory is made of
most recently purchased goods.
(iii) It is a realistic method because it takes into account the
normal procedure of issuing goods/inventory, i.e. the
materials are issued to production in the order of their
receipts.
(iv) As it is based on historical cost, no unrealised profit enters
into the financial statements for the period.
Disadvantages: This method suffers from the following
limitations:
(i) Because of violent changes in prices of materials, it involves
somewhat complicated calculations and, therefore, it
involves somewhat complicated calculations and, therefore,
increase the changes of clerical errors.
(ii) The prices of issues of materials may not reflect current
market prices and, therefore, during the period of inflation,
the charge to production is unreasonably low.
(iii) Comparison between different jobs executed by the firm
becomes sometimes difficult. A job commenced a few
minutes before another job might have consumes the supply
of lower priced stock. This is particularly because of that
7
the fact the first job might have completely exhausted the
supply of materials of a particular lot.
Suitability: FIFO method is considered more suitable during the
periods of falling prices. The reason is that the higher price at which
the purchase of materials was made earlier stands recovered in cost.
This method is suitable when the size of purchases is large but not
much frequent. The moderate fluctuations in the prices of materials,
and easy comparison between different jobs are also the important
conditions for the use of this method.
Illustration 1: The following is the record of receipts of certain
materials during the month of January 2006:
Jan. 2 Received 500 Units @ Rs.20 per unit
Jan. 3 Received 400 Units @ Rs. 21 per unit
Jan. 15 Received 300 Units @ Rs. 19 per unit
Jan. 28 Received 400 Units @ Rs. 20 per unit
The physical inventory taken on 31st January, 2006 shows that
there are 600 units in hand. Compute the inventory value on 31st
January, 2006 by FIFO method.
Solution: Under FIFO method, closing inventory includes recent
purchases at most recent prices. Hence, the value of the inventory on
31st January will be as follows:
January 28 Purchases 400 units @ Rs. 20 = Rs. 8000
January 15 Purchases 200 units @ Rs. 19 = Rs. 3800
Rs. 11, 800
Here, the value of inventory as on 31st January 2006 has been
arrived as on the presupposition that the firm uses periodic inventory
8
system, the value of inventory would remain the same even if the
perpetual inventory system is in use. To take an example, if out of 1000
units issued, 300 units were issued on January 5, while 700 units were
issued on January 16, the valuation of inventory using perpetual
inventory system will be done as follows:
STOCK LEDGER
Receipts Issues Balance Date
Qty. Rate Amount
(Rs.)
Qty. Rate Amount
(Rs.)
Qty. Amount
(Rs.)
Jan.2 500 20 10,000 -- -- -- 500 10,000
Jan.3 400 21 8.400 -- -- -- 900 18,400
Jan. 5 -- -- -- 300 20 6000 600 12,400
Jan.l5 300 19 5,700 -- -- -- 900 18,100
Jan.16 -- -- -- 200 20 4,000
400 21 8,400
100 19 1,900 200 3,800
Jan.28 400 20 8,000 -- -- -- 600 11,800
From the above stock ledger it is obvious that the value of ending
inventory under FIFO method is same in case of both periodic and
perpetual inventory systems.
2. Last in First Out Method (LIFO): Under this method, it
is assumed that the material/goods purchased in the last are issued
first for production and those received first issued/sold last. In case a
new delivery is received before the first lot is fully used, price become
the ‘last-in’ price and is used for pricing issued until either the lot is
exhausted or a new delivery is received.
9
As stated above, materials are issued to production at cost which
may be vary near to current marked price. However, inventories at the
end will be valued at old prices which may be out of tune with the
current maked price.
Advantages
(i) This method takes into account the current market
circumstances while valuing materials issued to various
jobs or ascertaining the cost of goods sold.
(ii) No unrealised profit or loss is usually made in case this
method is followed.
Disadvantages
(i) The stock in hand is valued at a price which have become
out-of-date when compared with the current inventory
prices.
(ii) This method may not be acceptable for taxation purposes
since the value of closing inventory may be quite different
from the current market value.
(iii) Comparison among similar jobs is very difficult because
they may bear different issue prices for materials
consumed.
Suitability: This method is most suitable for materials which are
of a bulky and non-perishable type.
Illustration 2: With the information given in illustration (1),
compute the inventory value on 31st Jan. 1998 by LIFO method. Also
10
prepare a store ledger account showing how the receipts and issues on
5th Jan and 700 units issued on 16th January 2006.
Solution: Under LIFO method, closing inventory includes most
old purchases remaining unissued till last date. Hence, valuation of
inventory under periodic inventory system would be as follows:
Hence, the value of the inventory on 31st January will be as
follows:
Jan. 2 Purchases 200 units @Rs.20 = Rs. 4,000
Jan. 28* Purchases 400 units @Rs.20 = Rs.8,000
Rs. 12,000
Valuation of Inventory under perpetual inventory system
STOCK LEDGER
Receipts Issues Balance Date
Qty Rate Amt.
(Rs.)
Qty Rate Amt.
(Rs.)
Qty Amt.
(Rs.)
Jan 2 500 20 10,000 - - - 500 10,000
Jan 3 400 21 8,400 - - - 900 18,400
Jan 5 - - - 300 21 6,300 600 12,100
Jan 15 300 19 5,700 - - - 900 17,800
Jan 16 - - - 300 19 5,700
100 21 2,100
300 19 6,000 200 4,000
Jan 28 400 20 8,000 - - - 600 12,000
Jan 31 - - - - - - 600 12,000
11
*Closing entry of 600 units includes 200 units purchased on 2nd
January but remained unissued and 400 units purchased on 28th
January remaining unissued upto 31st January.
Implications of FIFO and LIFO method in case of rising
and falling prices: Both these methods value the products
manufactured at true costs because both are based on actual cost. But
in period of rising and falling prices both have conflicting result.
In periods of rising prices the cost of production will be lower in
case of FIFO method. This is simply because of the lowest material cost.
Contrary to this, LIFO method will result in charging products at
highest materials cost. Thus in case of rising price the application of
FIFO method will result in higher profitability, and higher income tax
liability, whereas the application of LIFO method result in lower
profitability, which in turn will reduce income tax liability.
In periods of falling market, the cost of product will tend to be low
with reference to the overall cost of inventory in case material cost is to
be charged according to LIFO method. Hence, this method will be
resulting in inflating of profits and increasing the tax liability. The
reverse will be the case if FIFO method is followed. Production will be
relatively overcharged. This will deflate the profits and reduce the
income tax liability.
In periods of falling prices the ending inventory will be valued in
FIFO method at a price lower than in case of LIFO method. The reverse
will be the case when the prices are rising. Interestingly, on the basis of
above discussion, it may be concluded that in periods of falling prices,
LIFO method tends to give a more meaningful balance sheet but less
12
realistic income statement, whereas FIFO method gives a more
meaningful income statement but a less realistic balance sheet. The
reverse will be the situation in periods of rising prices.
Now the question arises about the superiority of the LIFO and
FIFO methods. Based on forgoing discussion about implications of these
methods in case of both rising and falling markets, it may be concluded
that each method has its own merits and demerits depending upon the
circumstances prevailing at a particular moment of time. Thus, no
generalisation can be made regarding superiority of LIFO over FIFO or
vice-versa.
3. Highest-in-First-our (HIFO): According to this method,
the highest priced materials are treated as being issued first
irrespective of the date of purchase. In fact, the inventory of materials
or goods are kept at the lowest possible price. In periods of rising prices
the closing inventory is undervalued and thus secret reserves are
created. However, the highest cost of materials is recovered first.
Consequently, the closing inventory amount remains at the minimum
value. Hence, this method is very appropriate when the prices are
frequently fluctuating. As this method involves calculation more than
that of LIFO and FIFO methods, it has not been adopted widely.
4. Base stock method: The base stock method assume that
each business firm whether small or large must held a minimum
quantity of materials finished foods at all times in order to carry on
business smoothly. These minimum quantity of inventories are valued
at the cost at which the base stock was acquired. It is assumed that the
base stock is created out of the lot purchased. Inventories over and
13
above the base stock are valued according to some other appropriate
method such as FIFO, LIFO, etc.
AS-2 recommends the use of this method in exception
circumstances only. This is because of the fact that a large number of
companies customarily maintain a minimum stock level at all times
irrespective of its requirement. Actually, sometimes base stock method
is used without its justification. Therefore, this method requires a clear
existence of the circumstances which require that a minimum level of
charging out inventory of raw material and finished goods at actual cost
along with merits and demerits of the method which is used for
valuation other than the base stock method.
5. Specific Identification Method: Under this method,
each item of inventory is identified with its cost. The value of inventory
will be constituted by the aggregate of various cost so identified. This
method is very suitable for job order industries which carry out
individual or goods have been purchased for a specific job or customer.
In other words, this method can be applied only where materials used
can be specifically and big items such as high quality furniture,
paintings, metal jewellery, cars, etc.
However, this method is not appropriate in most industries
because of practical problems. For instance, in case of manufacturing
company having numerous items of inventory, the task of identifying
the cost of every individual item of inventory becomes very
cumbersome. Also, it promotes the chances of manipulating the cost of
goods sold. It can be done by selecting items that have a relatively high
cost or a relatively low cost, as he desires.
14
Example: Suppose that following information is available from
records:
Opening inventory of material as on Jan. 1 , 2000 at Rs.20 = 200
units.
Purchases of materials as on Jan. 16, 2000 at Rs. 24 = 100 units.
Purchases of materials as on Jan.26, 2000 at Rs.30 = 150 units
Total units available for sale = 450 units
Units sold during January = 260 units
Inventory of materials at January end = 190 units
Now, if it assumed that the firm selected 200 items of materials
that had a unit cost of Rs. 20 and 60 units of items that had a unit cost
Rs. 24, the cost of goods sold for the firm would be as follow:
Cost of 200 items = 200 × 20 = Rs. 4000
Cost of 60 items = 60 × 24 = Rs. 1440
Rs. 5440
Whereas, if 260 items having highest cost are selected, then the
cost of goods sold would be Rs. 7100 [(l50×30) + (l00×24) + (10×20)].
5. Simple average Price (SAP): This is the average of prices
of different lots of purchase. Under this method no consideration is
given to the quantity of purchases in various lots. For example the
purchases of 500 units of materials at Rs. 10 per unit are made as on
5th January, 1995 and 800 units of materials at Rs. 14 per unit on 10th
January. If at the end 200 units remains unissued/unsold, these will be
valued at Rs. 12 = [(10 + 14)/2]per unit and hence, the closing inventory
will be shown at Rs. 2400 (200 × 12 = 2400). Infact, this method
operated on the principle that when items of materials are purchased in
15
big lots and are put in godown, their identity is lost and, therefore,
issues should be priced at the average price of the lots in godown.
6. Weighted Average Price (WAP): Under this method, the
quantity of material purchased in various lots of purchases is
considered as weight while pricing the materials. Weighted average
price is calculated by dividing the total cost of material in stock by the
total quantity of material at the end. When this method is adopted, the
question of profit or loss out of varying prices does not arise because it
evens out the effect of widely fluctuating prices of different lots of
purchases. This method is very popular because it reduces calculations
and is based on quantity and value of material purchased.
Illustration 3: The following are the details of transactions
regarding receipt and issue of materials:
Date Quantity received Rate Quantity
issued
Jan.2, 2006 100 Rs. 1.00 —
Jan.9, 2006 150 Rs. l.20 —
Jan.14, 2006 — — 125
Jan.17, 2006 250 Rs. l.30 —
Jan.19, 2006 — — 100
You are required to prepare a stock ledger pricing the issue at (i)
Simple average price and (ii) Weighted average price.
Solution
(i) Simple Average Price Method:
16
STOCK LEDGER
Date Receipts Issues Balance
2006 Qty. Rate Amount Qty. Rate Amount Qty. Amount
Jan.2 100 l.00 100 — — — 100 100
Jan.9 150 1.20 180 — — — 250 280
Jan.14 — — — 125 1.10a 137.50 125 143
Jan.17 250 1.30 325 - - — — 375 518
Jan.19 — — — 100 1.25b 125.00 275 393
Working Notes
Average price on 14.1.2006 = (1.00 + 1.20)/2 = Rs. 1.10
Average price on 19.1.2006 = (1.20 + 1.30)/2 = Rs. 1.25
The price of the purchases that were made on 2nd January has
been ignored while computing average price on 19.1.2006 since we have
assumed that issue of 125 units on 14.1.2006 comprises all the 100
units purchased on 2.1.2006.
(i) Weighted Average Price Method
Date Receipts Issues Balance
2006 Qty. Rate Amt Qty. Rate Amt Qty. Amt
Jan.2 100 1.00 100 -- - - -- 100 100
Jan.9 150 1.20 180 -- -- -- 250 280
Jan.14 -- -- -- 125 1.12 140 125 140
Jan.17 250 1.30 325 -- -- -- 375 465
Jan. 19 -- -- -- 100 1.24 124 275 341
Working Notes
Weighted average price on January 14=280/250= 1.12
17
Weighted average price on January 19 = 465/375 = 1.24
Illustration 4: The Hisar Dal Mills Ltd. does not maintain a
perpetual inventory of gram which it buys and issues to the mills. The
physical inventory taken of 31st March, 2005 shows the following
quantity of gram on hand:
10 tonnes @ 840 per tonne.
The purchases during April as follows:
5-4-1995 100 tonnes @ 850 per tonne
15-4-1995 50 tonnes @ Rs. 900 per tonne
29-4-1995 10 tonnes @ Rs. 920 per tonne
A physical inventory on 30th April, 2005 shows a stock of 15
tonnes of gram on hand. Complete inventory value on 30th April, 2005
by (i) FIFO method (ii) Weighted Average Price Method.
Solution
(i) FIFO Method. In case of FIFO method, earlier purchases
are charged to earlier issues and the ending inventory includes the
most recent purchases at the most recent prices. Thus, stock of 15
tonnes include 10 tonnes @ Rs. 920 per tonne purchased on 29-4-2005
and 5 tonnes @ Rs. 900 per tonne purchased on 15-4-2005. The
inventory valuation will be as follows:
10 tonnes @ Rs. 920 per tonne Rs. 9,200
5 tonnes @ Rs. 900 per tonne Rs. 4,500
Inventory value on 30.4.05 Rs. 13,700
18
(ii) Weighted Average Price Method
10 tonnes @Rs. 840 8,400
100 tonnes @Rs. 850 85,000
50 tonnes @Rs.900 45,000
10 tonnes @Rs. 920 9200
170 tonnes 1,47,600
Average price per tonne = 1,4,600/170 = 868.24
Closing inventory (30-4-05): 15 tonnes @ Rs. 868.24=Rs. 13,023.60
B. Method Based on Sale Price: The inventories may be
valued at marked or sale prices. Important among these prices are
current selling prices, and net realisable value. Both of these are
discussed as follows:
1. Current Selling Prices: The method is used in case of the
product of which market as well as prices are controlled by a
Government. Marketing costs being negligible are ignored under this
method. This method is followed in the case of sugar industries, metal
industries, etc.
2. Net Realisable Value. According to IAS-2, the net
realisable value means, “the estimate selling price in the ordinary
course of business costs of completion and less costs necessarily to be
incurred in order to make the sale.” Estimates of net realisable value
should not be guided by temporary fluctuations in market prices.
However, these should be arrived at after taking into consideration all
expenses which might have to be incurred for making sales. Such cases
where it is difficult to estimate the appropriate costs, say agriculture
19
output, inventory are valued consistently at market values. This
procedure of valuation is accepted because of the saleability of the
output at quoted prices.
C. The Lower of Cost or Market Price (LCM Rule)
This method is based on the accounting principle of’ conservatism
according to which profits should not be anticipated but all losses
foreseen should be provided for. For instance, the ending inventory
consist of items purchased at cost of Rs.210 per unit. But the market
price has fallen to Rs.200 per unit at the time of valuation of inventory.
Hence, the items should be valued at Rs.200 per unit. This rule violate
the matching concept which requires matching of revenues with the
related product costs. This method also leads to inconsistency since in
one year the valuation may be based on cost while in another it may be
based on market price. However, even the critics of this rule favour the
application of this rule for valuing obsolete or damaged inventories.
About inventories valuation AS-2, recommends that the general
rule of valuing inventories should be at lower of historical cost and net
realisable value subject to certain exceptions. The historical of the
inventories should normally be determined by using ‘FIFO’, ‘LIFO’ or
Average ‘Cost’ method. Inventory of by-products cannot be separately
determined. It should be valued at net realisable value.
LCM rule can be applied in anyone of the following ways:
1. Aggregate/total inventory method: In this method, cost
price of the total inventory is ascertained and then compared with total
net realisable price to arise at stock valuation.
20
2. Group Method: Under this method, groups are formed of
similar or interchangeable articles of inventory. The cost and the net
realisable value of each group so formed are found out. The LCM rule is
applied to each group.
3. Item-by-item-method: According to this method, the cost
and net realisable prices of each item of inventory are found out and the
lower of the figures is taken into account for valuation of inventory.
Both IAS-2 and AS-2 have recommended the use of “Group method” and
“Item-by-Item” method for valuation of inventory. The first method
namely “Aggregate or Total Inventory method” have not been
recommended by both the standards. The learner’s will understand the
difference between all the three methods from the following illustration.
Illustration 5: Given the following data about inventors as at
31st December, 2005.
Category No. of Items Cost (Rs.) Net Realisable Value (Rs.)
A 10 21 20
A 16 15 14
B 20 30 40
B 10 18 16
C 9 40 45
C 7 30 25
D 8 8 10
D865
21
Calculate the value of inventory on the basis of lower of cost and
net realisable value (1) by the aggregate method, (2) by the group and
(3) by item-by-item method.
Solution
1. Aggregate Method:
Unit Price Quantity X Price Quantity
Cost
(Rs.)
Net
realisable
Value (Rs.)
Cost
(Rs.)
Net Realisable
Value (Rs.)
LCM (Rs.)
10 20 21 200 210
16 15 14 240 224
20 30 40 600 800
10 18 16 180 160
9 40 45 360 405
7 30 25 210 175
8 8 10 64 80
8 6 5 48 40
1902 2094 1902
2. Group Method:
Unit Price Qty X Price Group Qty
Cost
(Rs.)
Net
Realisable
Value
Cost
(Rs.)
Net
Realisable
Value
Lower of
cost or net
Realisable
value
Group A 10 20 21 200 210
16 15 14 240 224
440 434 434
Group B 20 30 40 600 800
22
10 18 16 180 160
780 960 780
Group C 9 40 45 360 405
7 30 25 210 175
570 580 570
Group D 8 8 10 64 80
8 6 5 48 40
112 120 112
1896
3. Item-by-item method
Unit Price Quantity X Price Quantity
Cost (Rs.) Net
realisable
value (Rs.)
Cost (Rs.) Net
realisable
value (Rs.)
Lower of
Cost or Net
Realisable
Value (Rs.)
10 20 21 200 210 200
16 15 14 240 224 224
20 30 40 600 800 600
10 18 16 180 160 160
9 40 45 360 405 360
7 30 25 210 175 175
8 8 10 64 80 64
8 6 5 48 40 40
1823
5. Valuation of inventory for Balance Sheet purpose
In certain cases, it is not possible for the business to take
inventory on the date of balance sheet. It might have been taken on a
date earlier or later than the date of balance sheet. In such a case,
when student are required to calculate the value of stock on the date of
preparation of final accounts, then they should take into consideration
23
information about additional transactions which occur during the
period. For example, if value of stock on 28th March is given, then in
order to find the value of stock on 31st March all purchases between
these dates will be added. Likewise, if value of stock on 4th April is
given and value of stock on the proceeding 31st March is required then
purchases during the period will be deducted and issues/sales (at
acquisition price) during this period will be added. Both of the above
mentioned cases could be understood and elaborated as under:
(i) When the Position of stock is given on a date prior to the
balance sheet date
In this case, the following adjustments will generally be required:
(a) Add purchases made during the period.
(b) Deduct purchases returns during the said period.
(c) Deduct inventory issued/sold between the two dates.
(d) Add sales returns between the two dates.
(ii) When the position of stock is given on a date after the
balance sheet date
For example, if the balance sheet is to be prepared as on 31st
March, 2005 and the stock position has been given as on 15th April,
2005 the following adjustments will be required:
(a) Less purchases made between 1st April, 2005 to 15th April,
2005.
(b) Add purchases returns between 1st April, 2005 to 15th April,
2005.
(c) Add sales (at cost price) between 1st April, 2005 to 15th
April, 2005.
24
(d) Less sales returns between 1st April, 2005 to 15th April,
2005.
Illustration 6: The financial year of Sultan S. & Co. ends on 31st
December 2005. Stock taking continues upto 10th January, 2006. You
are required to determine, the value of costing stock (at cost) as on 31st
December, 2005 from the following information:
(i) The closing stock (valued at cost) came to Rs. 50,000 on
10th January, 2006.
(ii) Purchases made in the first 10 days of January 2006
amounted to Rs. 2000.
(iii) Sales made from 1st January to 10th January in 2006
amounted to Rs. 8000. The firm makes a gross profit of 25%
on sales.
Solution: Valuation of closing stock
Value of stock as on January 10, 2006 50,000
Less: Purchases after 31st December 2,000
48,000
Add: Cost of goods sold during first
10 days of January, 2006 (75% of 8000) 6,000
Value of stock as on 31st Dec. 2005 54,000
Illustration 7: The financial year of Mr. Ratan Lal & Co. ends on
30th June 2006, but the actual stock is physically only on 7th July,
2006, when it is estimated at Rs. 20,000.
Additional information:
1. Purchases between 30th June and July are Rs. 2000.
25
2. Purchases returns between 30th June and 7th July are Rs.
200.
3. Sales between 30th June and 7th July are Rs. 4000.
4. Sales returns between 30th June and 7th July are Rs. 100.
5. The firm makes a gross profit at 25% on cost.
Calculate the value of stock on 30th June, 2006.
Solution
MR RATAN LAL & CO.
VALUATION OF CLOSING STOCK
Stock as on July 7 Rs. 20,000
Less: Purchases between June 30 and July 7 2,000
18,000
Add: Purchases returns between June 30 and July 7 200
18,200
Add: Sales (at cost price) between June 30 and July 7
[4000-one fifth of 4,000]
3,200
21,400
Less: Sales returns (at cost price) between June 30 and
July 7 [Rs.100-20]
80
Stock on June 30, 2006 21,320
Illustration 8: The Profit and Loss Account of Cardamom for the
year ended 31st December, 2005 showed a net profit of Rs. 2,400 after
taking into account the closing stock of Rs. 2,400. On a scrutiny of the
books the following information could be obtained:
26
(1) Cardamom has taken goods valued Rs. 800 for his personal
use without making entry in the books.
(2) Purchases of the year included Rs. 400 spent on acquisition
of a ceiling fan for his shop.
(3) Invoices for goods amounting to Rs.2600 have been entered
on 29th December, but such goods were not included in
stock.
(4) Rs. 350 have been included in closing stock in respect of
goods purchased and invoiced on 28th December, 2005 but
included in purchases for January 2006.
(5) Sale of goods amounting to Rs. 405 sold and delivered in
December, 2005 had been entered in January, 2006 sales.
You are required to ascertain the correct amount of closing stock
as on 31st December, 2005 and the adjusted net profit for the year
ended on that date.
Solution
Calculation of stock as on December 31, 2005:
Stock (as given already) Rs. 2400
Add Purchase not included Rs. 2600
Rs. 5000
PROFIT AND LOSS ADJUSTMENT ACCOUNT
Rs. Rs.
To supplier’s account* 350 By Profit (given) 2,400
To Net Profit
(balancing figure)
6,255 By Drawings 800
27
By Fixtures and Fittings
(Ceiling Fan)
400
By Closing Stock (Goods
in transit)
2,600
By Customer’s account 405
6,605 6,605
*The treatment of these items in 2006 will have to be cancelled.
6.6 SUMMARY
The word ‘inventory’ means stock of goods. To the finance
manager, inventory connotes the value of raw materials, consumable,
spares, work-in-progress, finished goods and scrap in which a
company’s funds have been invested. A major objective of inventory
valuation is the proper determination of income through the process of
matching appropriate cost against revenues. The records of quantity
and value of inventory can be made in two ways: (i) Periodic inventory
system; (ii) Perpetual inventory system. The basic methods of valuation
of inventories are: (a) Historical cost based method; (b) Sale price based
method; (c) Lower of cost or sale price
6.7 KEYWORDS
Market Price: Market price means net realisable value in the ordinary
course of business.
Cost: Cost means the total of the amount paid to the supplier and the
expenses incurred till the goods reach the firm’s premises but expenses
thereafter will not be included.
28
Periodic Inventory System: In this system, the quantity and the
value of inventory is ascertained by physically counting the stock at the
end of the year and as on the accounting date.
Net Realisable Value: It is the estimated selling price in the ordinary
course of business less the estimated cost of completion and the
estimated costs necessary to make the sale.
6.8 SELF ASSESSMENT QUESTIONS
1. What are the various methods of inventory valuation?
Discuss the impact of each method on working results.
2. What is the principle behind valuation of inventory at cost
or market price whichever is lower?
3. Differentiate the following:
(a) LIFO and FIFO method
(b) Periodic inventory valuation and Perpetual inventory
valuation
(c) Item-by-item method and Group method
4. What is the need of valuing inventory properly? Discuss. To
what extent this need is fulfilled by various methods of
valuing inventories.
5. Arvind Ltd. uses large quantities of a sweetening material
for its products. The following figure relates to this material
during the calendar year 2000:
Quarter
ended
(Tonnes)
Purchases Invoice Cost
per Tonne
Rs.
Consumption
(Tonnes)
March 31 1,000 620 600
29
June 30 2,100 630 1,200
September 30 700 640 1,500
December 31 1,200 670 1,350
The stock of material on December 31, 1999 was 1,000
tonnes valued for accounting purposes at cost of Rs. 600 a
tonne. Delivery of goods to the factory is made on the first
day of each quarter. You are required to compute the value
of stock as on December 31, 2000 applying LIFO and FIFO
methods.
6. Purchases of certain product during March, 2004 are set
out below:
March 1 100 units @ Rs. 10
12 100 units @ Rs. 9.80
15 50 units @ Rs. 9.60
20 100 units @ Rs. 9.40
Units sold during the month were as follows:
March 10 80 units
14 100 units
30 90 units
No opening inventories
You are required to determine the cost of goods sold for
March under three different valuation methods viz, FIFO,
LIFO and Weighted Average Cost.
7. M/s Swadeshi Cotton Mills Ltd. take a periodic inventory of
their stock of chemically at the end of each month. The
physical inventory taken on 30 shows a balance of 1,000
litres of chemically in hand @ Rs. 2.28 per litre.
The following purchases were made during July:
30
July 1 14,000 litres @ Rs. 2.30 per litre
July 7 10,000 litres @ Rs. 2.32 per litre
July 1 14,000 litres @ Rs. 2.30 per litre
July 25 5,000 litres @ Rs. 2.35 per litre
A physical inventory on July 31 discloses that there is a
stock of 10,000 litres. You are required to compute the
inventory value on July 31, by each of the following
methods:
(i) First in First out; (ii) Last in First out; and (iii) Average
cost method.
8. Following are the details regarding inventories of a
manufacturing concern as on 31st December, 2005:
Inventories categories Cost (Rs.) Market Prices (Rs.)
Category 1: A 6,000 9,000
B 10,000 9,500
Category 2: C 15,000 17,000
D 20,000 14,000
Total 51,000 49,000
You are required to determine inventory value using “lower of
cost or market value basis”, according to each of the following methods:
(i) Aggregate or total inventory method; (ii) Group method; (iii)
Item-by-item method.
9. The financial year of Shri X ends on 31st March, 2004, but
the stock in hand was physically verified only on 7th April,
2004. You are required to determine the value of closing
stock (at cost) as at 31st March, 2004 from the following
information:
31
(i) The stock (valued at cost) as verified on 7th April,
2004 was Rs. 15,000.
(ii) Sales have been entered in the sales day book only
after the despatch of goods and sales returns only on
receipt of goods.
(iii) Purchases have been entered in the purchases day
book on receipt of the purchases invoice irrespective
of the date of the goods.
(iv) Sales as per the sales day book for the period 1st
April, 2004 to 7th April, 2004 (before the actual
verification) amounted to Rs. 6,000 of which goods of
a sale value of Rs. 1,000 had not been delivered at the
time of verification.
(v) Purchases as per the purchases day book for the
period 1st April, 2004 to 7th April, 2004 (before the
actual verification) amounted to Rs. 6,000 of which
goods for purchase of Rs. 1,500 had not been received
at the date of verification and goods for purchases of
Rs. 2,000 had been received prior to 31st March, 2004.
(vi) In respect of goods costing Rs. 5,000 received prior to
31st March invoices had not been received up to the
date of verification of stock.
(vii) The gross profit is 20% on sales.
6.9 SUGGESTED READINGS
1. Financial Accounting by Tulsian.
2. Introduction to Financial Accounting by S.N. Maheshwari.
3. Advanced Accountancy by R.L. Gupta.
32
(1)
SUBJECT : ACCOUNTING FOR MANAGERS
COURSE CODE : CP-104 UPDATED BY: DR. M.C. GARG
LESSON NO. : 7
DEPRECIATION ACCOUNTING AND POLICY
STRUCTURE
7.0 Objective
7.1 Meaning of Depreciation
7.2 Causes of Depreciation
7.3 Need for Providing Depreciation
7.4 Basic Elements of Depreciation
7.5 Methods of Calculating Depreciation
7.6 Methods of Recording Depreciation
7.7 Sale of an Asset
7.8 Change of Depreciation Method
7.9 Summary
7.10 Keywords
7.11 Self Assessment Questions
7.12 Suggested Readings
7.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define depreciation and describe the causes of depreciation.
(b) Discuss the various methods of charging depreciation.
(c) Explain the accounting treatment of depreciation
7.1 MEANING OF DEPRECIATION
Generally, the term depreciation is used to denote decrease in value but in
accounting, this term is used to denote decrease in the book value of fixed asset.
Depreciation is the permanent and continuous decrease in the book value of a
fixed
asset due to use, affluxion of time, obsolescence, expiration of legal rights or any
other cause. According to the Institute of Chartered Accountants of England and
(2)
Wales, “Depreciation represents that part of the cost of a fixed asset to its owner
which is not recoverable when the asset is finally out of use by him. Provision
against this loss of capital is an integral cost of conducting the business during the
effective commercial life of the asset and is not dependent on the amount of profit
earned”.
Depreciation is not the result of fluctuations in the value of fixed assets since, the
fluctuation is concerned with the market price of the fixed asset whereas the
depreciation is concerned with the historical cost.
An analysis of the definition given above highlights the characteristics of
depreciation as follows :
(a) It is related to fixed assets only.
(b) It is a fall in the book value of an asset.
(c) The fall in the book value of an asset is due to the use of the asset in business
operations, effluxion of time, obsolescence, expiration of legal rights or
any other cause.
(d) It is a permanent decrease in the book value of an asset.
(e) It is a continuous decrease in the book value of an asset.
Depreciation, Depletion and Amortisation
The terms depreciation, depletion and amortisation are used often interchangeably.
However, these different terms have been developed in accounting usage for
describing this process for different types of assets. These terms have been
described as follows:
Depreciation
Depreciation is concerned with charging the cost of man made fixed assets to
operation (and not with determination of asset value for the balance sheet). In
other
words, the term 'depreciation' is used when expired utility of physical asset
(building,
machinery, or equipment) is to be recorded.
Depletion
This term is applied to the process of removing an available but irreplaceable
(3)
resource such as extracting coal from a coal miner or oil out of an oil well.
Depletion differs from depreciation in that the former implies removal of a natural
resource, while the latter implies a reduction in the service capacity of an asset.
Amortisation
The process of writing off intangible assets is termed as amortisation. The
intangible
assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the
books of account, Many of these assets have a limited useful life and are,
therefore,
written off.
Obsolescence
It refers to the decline in the useful life of an asset because of factors like (i)
technological advancements, (ii) changes in the market demand of the product,
(iii)
legal or other restrictions, or (iv) improvement in production process.
Meaning of Depreciation Accounting
According to the American Institute of Certified Public Accountants (AICPA),
“Depreciation Accounting is a system of accounting which aims to distribute cost
or
the basic value of tangible capital assets less salvage (if any), over the estimated
useful
life of the unit (which may be group of assets) in a systematic and rational manner.
It is
a process of allocation and not of valuation.
7.2 CAUSES OF DEPRECIATION
The main causes of depreciation include the following :
(a) Physical wear and tear : When the fixed assets are put to use, the value of
such assets may decrease. Such decrease in the value of assets is said to be due to
physical wear and tear.
(b) With the passage of time : When the assets are exposed to the forces of nature
like whether, winds, rains, etc., the value of such assets may decrease even if they
are
not put to any use.
(c) Changes in economic environment : The value of an asset may decrease due
to decrease in the demand of the asset. The demand of the asset may decrease due
to
technological changes, changes in the habits of consumers etc.
(4)
(d) Expiration of legal rights : When the use of an asset (e.g., patents, leases) is
governed by the time bound arrangement, the value of such assets may decrease
with
the passage of time.
7.3 NEED FOR PROVIDING DEPRECIATION
The need for providing depreciation in accounting records arises due to any one or
more of the following objectives to be achieved :
(a) To ascertain true results of operations : For proper matching of costs with
revenues, it is necessary to charge the depreciation (cost) against income (revenue)
in
each accounting period. Unless the depreciation is charged against income, the
result
of operations would stand overstated. As a result the Income Statement would fail
to
present a true and fair view of the result of operations of an accounting entity.
(b) To present true and fair view of the financial position : For presenting a
true and fair view of the financial position, it is necessary to charge the
depreciation. If
the depreciation is not charged, the unexpired cost of the asset concerned would be
overstated. As a result, the Position Statement (i.e. the Balance Sheet) would not
present
a true and fair view of the financial position of an accounting entity.
(c) To ascertain the true cost of production : For ascertaining the cost of
production, it is necessary to charge depreciation as an item of cost of production.
If
the depreciation on fixed assets is not charged, the cost records, would not present
a
true and fair view of the cost of production.
(d) To comply with legal requirements: In case of companies, it is compulsory
to charge depreciation on fixed assets before it declares dividend [Sec. 205(1) of
the
Companies Act, 1956].
(e) To accumulate funds for replacement of assets : A portion of profits is set
aside in the form of depreciation and accumulated each year to provide a definite
amount
at a certain future date for the specific purpose of replacement of the asset at the
end
of its useful life.
7.4 BASIC ELEMENTS OF DEPRECIATION
In order to assess depreciation amount to be charged in respect of an asset in an
accounting period the following three important factors should be considered :
(5)
1. Cost of the asset : The knowledge about the cost of the asset is very essential
for determining the amount of depreciation to be charged to the profit and
loss account. The cost of the asset includes the invoice price of the asset
less any trade discount plus all costs essential to make the asset usable.
Cost of transportation and transit insurance are included in acquisition cost.
However, the financial charges such as interest on money borrowed for the
purchase for the purchase of the asset, should no be included in the cost of
the asset.
2. Estimated life of the asset : Estimated life generally means that for how
many years or hours an asset could be used in business with ordinary repairs
for generating revenues. For estimating useful life of an asset one must begin
with the consideration of its physical life and the modifications, if any, made,
factors of obsolescence and experience with similar assets. Infact, the
economic life of an asset is shorter than its physical life. The physical life
is based mostly on internal policies such as intensity of use, repairs,
maintenance and replacements. The economic life, on the other hand, is based
mostly on external factors such as obsolescence from technological changes.
3. Scrap. Value of the Asset : The salvage value of the asset is that value which
is estimated to be realised on account of the sale of the asset at the end of
its useful life. This value should be calculated after deducting the disposal
costs from the sale value of the asset. If the scrap value is considered as
insignificant, it is normally regarded as nil
7.5 METHODS OF CALCULATING DEPRECIATION
The following are various methods of allocating depreciation in use :
1. Fixed instalment method or straight line method.
2. Machine hour rate method.
3. Diminishing Balance method.
4. Sum of years digits method
5. Annuity method
6. Depreciation Fund Method
7. Insurance Policy Method
8. Depletion Method.
(6)
1. Straight Line Method : This is also known as fixed instalment method.
Under this method the depreciation is charged on the uniform basis year
after year. When the amount of depreciation charged yearly under this method
is plotted on a graph paper, we shall get a straight line. Thus, the straight line
method assumes that depreciations is a function, of time rather than use in
the sense that each accounting period received the same benefit from using
the asset as every other period. The formula for calculating depreciation
charge for each accounting period is :
amount of annual Depreciation =
For example, if an asset cost Rs. 50,000 and it will have a residual value of Rs.
2000 at the end of its useful life of 10 years, the amount of annual depreciation
will be Rs. 4800 and it will be calculated as follow :
Depreciation =
This method has many shortcomings. First, it does not take into consideration the
seasonal fluctuations, booms and depression. The amount of depreciation is the
same in that year in which the machine is used day and night to that in the another
year in which it is used for some months. Second, it ignores the interest on the
money spent on the acquisition of that asset. Third, the total charge for use of asset
(i.e., depreciation and repairs) goes on increasing form year to year though the
assets might have been use uniformly from year to year. For example, repairs cost
together with depreciation charge in the beginning years is much less than what it
is in the later year. Thus, each subsequent year is burdened with grater charge for
the use of asset on account of increasing cost on repairs.
Illustration - I : H. Ltd. purchased a machinery on 1st January. 2000 for Rs.
29000
and spent Rs. 2000 on its cartage and Rs. 1,000 on its erection. Machinery is
estimated to have a scrap value of Rs. 5000 at the end of its useful life of 5 year.
The accounts are closed every year on 31st December. Prepare the machinery
account for five years charging depreciation according to straight line method.
(7)
Solution :
Machinery Account
Date Particulars Rs. Date Particulars Rs.
1990 To Bank 22000 Dec. 31 By Depreciation 4000
Jan. 1 To Bank 2000 " By Balance C/d 21000
To Bank 1000
25000 25000
2001 To Balance b/d 21000 2001 By Depreciation 4000
Jan.1 Dec.31 Balance c/d 17000
21000 21000
2002 To Balance/b/c 17000 2002 By Depreciation 4000
Jan.1 Dec. 31 By Balance c/d 13000
17000 17000
2003 To Balance b/c 13000 2003 By Depreciation 4000
Jan.1 Dec.31 By Balance 9000
13000 13000
2004 To Balance b/d 9000 2004 By Depreciation 4000
Jan.1 Dec.31 By Balance c/d 5000
9000 9000
This method is very suitable particularly in case of those assets which get
depreciated
more on account of expire of period e.g. lease hold properties, patents, etc.
2. Machine Hour Rate Method : In case of this method, the running
time of the asset is taken into account for the purpose of calculating the
amount of depreciation. It is suitable for charging depreciation on plant and
machinery, air-crafts, gliders, etc. The amount of depreciation is calculated
as follows :
For example, if machinery has been purchased for Rs. 20000 and it will
have a scrap value of Rs. 1000 at the end of its useful life of 1900 hours, the
amount of depreciation per hour will be computed as follows :
(8)
Depreciation =
=
= Rs. 10 per hour
If in a particular year, the machine runs for 490 hours, the amount of depreciation
will be Rs. 4900 (i.e., Rs. 10x490). It is obvious from this example that under
machine hour rate method the amount of depreciation is closely related with the
frequency of use of an asset. The simplicity in calculations and under standing is
the main advantage of this methods. However, it can be used only in case of those
assets whose life can be measured in terms of working time.
3. Written Down Value Method : This is also known as Diminishing Balance
method. Under the diminishing balance method depreciation is charged at fixed
rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the
amount of depreciation goes on decreasing every year. Under this method also the
amount of depreciation is transferred to profit and loss account in each of the year
and in the balance sheet the asset is shown at book value after reducing
depreciation
from it. For example, if an asset is purchased for Rs. 10,000 and depreciation is to
be charged at 20% p.a. on reducing balance system then the depreciation for the
first year will be Rs. 2000. In the second year, it will Rs. 1600 (i.e. 20% of 8000),
in the third year Rs. 1280 (i.e. 20% of 6400) and so on. The rate of depreciation
under this method can be computed by using the following formula :
Depreciation rate = -1
For example, if the cost of an asset is 27000, scrap value Rs. 3375, economic life
3 year, the rate of depreciation would be :
Depreciation Rate = 1-3
= 1 - = 50%
(9)
Merits of Diminishing Balance Method : (i) It is very easy to understand and
calculate the amount of depreciation despite the early variation in the book value
after depreciation (ii) This method put an equal burden for use of the asset on each
subsequent year since the amount of depreciation goes on decreasing for each
subsequent year while the charge for repairs goes on increasing for each
subsequent
year. (iii) This method has also been approved by the income tax act applicable in
India (iv) Asset is never reduced to zero because if the rate of depreciation is (say)
20%. Then even when asset is reduced to very small value, there must remain the
80% of that small value as on written off balance.
Demerit : (i) It ignores the interest on the capital committed to purchase that
asset. (ii) It does not provide adequately for replacing the asset at the end of its
life. (iii) The calculation of rate of depreciation is not so simple. (iv) The formula
for calculating the rate of depreciation can be applied only when there is some
residual of the asset.
Suitability : This method is suitable in those cases where the receipts are expected
to decline as the asset gets older and, it is believed that the allocation of
depreciation
of depreciation ought to be related to the pattern of assets expected receipts.
Illustration 2 : A company purchases Machinery on 1st April 1990 for Rs.
20,000. Prepare the machinery account for three years charging depreciation @
25% p.a. according to the written Down value Method.
Machinery Account
Date Particulars Rs. Date Particulars Rs.
1990 To Bank 20000 2001 By Depreciation 5000
Apr. 1 Mar. 31 By Balance C/d 15000
20000 20000
2001 To Balance b/d 15000 2002 By Depreciation 3750
Apr.1 Mar.31 By Balance c/d 11250
15000 15000
2002 To Balance b/d 11250 2003 By Depriciation 2812.5
Apr/ Mar.31 By Balance c/d 8437.5
11250 11250
(10)
4. Sum of Years digits (SYD) Method: Under this method also the amount of
depreciation goes on diminishing in the future years similar to that under
diminishing Balance method.
For calculating the amount of depreciation to be charged to the profit and loss
account this method takes into account cost, scrape value, and life of the asset. The
following formula is used for determining depreciation :
For example, an asset having an effective life of 5 years is purchased at a cost of
Rs. 20,000. It is estimated that its scrap value at the end of its effective life will be
Rs. 2000. The depreciation on this asset, if SYD method is followed, will be
calculated as follows from one to five years :
Year Depreciation Amount
1 = __________ x 18000 = Rs. 6000
2. = __________ x 18000 = Rs. 4800
3. = __________ x 18000 = Rs. 3600
4. = __________ x 18000 = Rs. 2400
5. = __________ x 18000 = Rs. 1200
5. Annuity Method : Sofar we have described such methods of charging
depreciation which ignore the interest factor. Also, some times it becomes
inconvenient for a company to follow any of the methods discussed earlier. Under
such circumstances the company may use some special depreciation systems.
Annuity method is one of these special systems of depreciation. Under this system,
the depreciation is charged on the basis that besides losing the acquisition cost of
the asset the business also loses interest on the amount used for purchasing the
asset. Here, interest refers to that income which the business would have earned
otherwise if the money used in buying the asset would have been committed in
(11)
some other profitable investment. Therefore, under the annuity method the amount
of total depreciation is determined by adding the cost of the and interest thereon at
an expected rate. The annuity table is used to help in the determination of the
amount
of depreciation. A specimen of Annuity Table is as follows :
Annuity Table
Year 3% 4% 5% 6%
4 0.269027 0.275490 0.282012 0.288591
5 0.218335 0.224627 0.230975 0.237376
6 0.184598 0.190762 0.197012 0.203363
7. 0.160506 0.166610 0.172820 0.179135
8. 0.142456 0.148528 0.154722 0.161036
9. 0.128434 0.134493 0.140690 0.147022
10. 0.117231 0.12391 0.129505 0.135868
In case depreciation is charged according to this method, the following accounting entries
are
passed :
(i) Purchase of an asset
Asset Account Dr.
To Bank
(ii) For Charging interest
Asset Account Dr.
To Interest Account
(iii) For Charging depreciation :
Depreciation Account Dr.
To Asset Account
Evaluation of Annuity Method
Merits : (i) This method keep into account interest on money spent on the purchase of
the asset. (ii) The value of the asset become zero at the end of life.
Demerits. (i) This method is comparatively more difficult than the methods discussed so
far.
(ii) It makes no arrangement of money to replace the old asset with the new one at the
expiry
of its life. (iii) Under this method the burden on the profit and loss account is no similar
in each
year because the depreciation remains constant year after year but the interest goes on
decreasing.
Illustration 3. On 1st January, 2000 a firm purchased a leasehold property for 4 year at a
cost of Rs. 24000. It decides to depreciate the lease by Annuity Method by charging
interest
at 5% per annum. The Annuity Table shows that the annual necessary to write off Rs. 1 at
5%
Rs. 0.282012. You are required to prepare the lease Hold Property Account for four years
and show the net amount to be charged to the profit and loss account for these four years.
(12)
Lease Hold Property Account
Date Particulars Rs. Date Particulars Rs.
2000 To Bank 24000.00 2000 By Depreciation 6768.29
Jan. 1 Dec. 31
To interest 1200.00 Dec.31 By balance c/d 18431.71
25200.00 25200.00
2001 To balance b/d 18431.71 2001 By Depreciation 6768.29
Jan.1 Dec.31
Dec.31 To Interest 921.59 Dec.31 By Balance c/d 12585.01
19353.30 19353.30
2002 To balance b/d 12585.01 2002 By Depreciation 6768.29
Jan.1 Dec.31
Dec. 31 To Interest 629.25 Dec.31 By Balance c/d 6445.97
13214.26 13214.26
2003 To balance b/d 6445.97 2003 By Depreciation 6768.29
Jan.1 Dec.31 By Balance c/d 9000
Dec.31 To Interest 322.30 13000
6768.27 6768.27
Net Amount chargeable to the profit and loss account
Year Depreciation Interest Credited Net Charge
debited against Profit
2000 6768.29 1200.00 5568.29
2001 6768.29 921.59 5846.70
2002 6768.29 629.25 6139.04
2003 6768.29 322.30 6445.99
Rs. 27073.16 3073.14 24000.02
6. Depreciation Fund Method : Business assets become useless at the expiry
of their life and, therefore, need replacement. However, all the methods of
depreciation discussed above do not help in accumulating the amount which can
be
readily available for the replacement of the asset its useful life comes to an end
(13)
Depreciation fund method takes care of such a contingency as it incorporates the
benefits of depreciating the asset as well as accumulating the necessary amount for
its replacement. Under this method, the amount of depreciation charged from the
profit and loss account is invested in certain securities carrying a particular rate of
interest. The interest received on the investment in such securities is also invested
every year together with the amount of annual depreciation. In the last of the life
of
asset the depreciation amount is set aside interest is received as usual. But the
amount is not invested because the amount is immediately needed for the purchase
of new asset. Rather all the investments so far accumulated are sold away. Cash
realised on the sale of investments is utilised for the purchase of new asset. The
following accounting entries are generally made in order to work out this system
of depreciation.
1. At the end of the first year
(i) for setting aside the amount of depreciation : The amount to be charge
by way of depreciation is determined on the basis of sinking Fund Table given as
an
Appendix at the end of every book of accountancy.
Depreciation Account Dr.
To Depreciation Fund Account (or Sinking Fund A/c)
(ii) For investing the amount charged by way of depreciation :
Depreciation Fund Investment A/c Dr.
To Bank A/c
In the second and subsequent years
(i) For receiving interest. The interest on the balance of Depreciation
Fund Investment outstanding in the beginning of each year will be received by the
end of the year. This entry is :
Bank Account Dr.
To Depreciation Fund Account
(ii) For setting aside the amount of depreciation
Profit and Loss A/c Dr.
To Depreciation Fund A/c
(iii) For investing the amount
Depreciation Fund Investment A/c Dr.
To Bank A/c
(Annual instalment of depreciation and interest received invested)
(14)
3. In the last year
(i) For receiving interest :
Bank A/c Dr.
To Depreciation Fund A/c
(ii) For setting aside the amount of depreciation
Profit and loss A/c Dr.
To depreciation Fund A/c
Note : In the last year no investment will be made, because the amount is
immediately required for the purchase of new asset.
(iii) For the sale of investment :
Bank A/c Dr.
To Depreciation Fund Investment A/c
(iv) For the transfer of profit or loss on sale on investments : The profit
or loss on the sale of these investments is transferred to the Depreciation Fund
Account.
The entry for loss :
Depreciation Fund A/c Dr.
To Depreciation Fund Investment A/c
The entry for profit
Depreciation Fund Investment A/c
To Depreciation Fund A/c
(v) For the sale of old asset :
Bank A/c Dr.
To asset A/c
(vi) The depreciation fund is transferred to asset account and any balance
left in the asset account is transferred to profit and loss account. The entry is :
Depreciation Fund A/c. Dr.
To asset A/c
(vii) The balance in Asset Account represents profit or loss. Therefore it
will be transferred to the profit and loss account.
(15)
(viii) The cash realised on the sale of investments and the old asset is utilised
for the purchase of new asset.
Illustration 4. Amitabh Company Ltd. purchased 4 year lease on January ,
2000 for Rs. 60,000. The company decided to charge depreciation according to
depreciation fund method. It is expected that investments will earn interest @5%
p.a. Sinking Fund Table shows that Rs. 0.232012 invested each year will produce
Rs. 1 at the end of 4 years at 5% p.a. At the expiry of lease , the Depreciation Fund
Investments were sold for Rs. 45200. A new lease is purchased for Rs. ................
on 1.1.2004. Show the journal entries and prepare the necessary accounts in the
book the company.
Journal
Date Particulars Debit Credit
1.1.2000 Lease A/c Dr. 60,000 60,000
To Bank A/c
(Being the purchase of lease)
31.12.00 Depreciation A/c Dr. 13920.7 13920.7
To Depreciation Fund A/c
(Being annual amount of depreciation
as per sinking fund tables)
31.12.00 Depreciation Fund Investment A/c Dr. 13920.7 13920.7
. To Bank A/c
(Being purchase of the investments
against the depreciation fund)
31.12.01 Bank A/c Dr. 696.0 696.0
To depreciation fund A/c
(Being the receipt of interest on
depreciation fund investment A/c
transfer to depreciation fund A/c
31.12.01 Depreciation A/c Dr. 13920.7 13920.7
To Depreciation Fund A/c
(Being annual depreciation set-aside)
(16)
31.12.01 Depreciation Fund Investment A/c Dr. 14616.7 14616.7
To Bank A/c
(Being purchase of the investments
against the depreciation fund)
31.12.02 Bank Account Dr. 1426.9 1426.9
To depreciation fund A/c
Being receipt of interest and its
transfer to depreciation fund A/c)
31.12.02 Depreciation A/c Dr. 13920.7 13920.7
To depreciation fund A/c
(Being annual depreciation set aside
31.12.02 Depreciation Fund Investment A/c Dr. 15347.6 15347.6
To Bank A/c
(Being purchase of investments)
31.12.03 Bank A/c Dr. 2194.3 2194.3
to depreciation fund A/c
(Being receipt of interest on
depreciation fund investment
31.12.03 Depreciation A/c Dr. 13920.7 13920.7
To depreciation A/c
(Being annual depreciation set aside)
31.12.00 Bank A/c Dr. 45200 45200
To depreciation fund investment A/c
(being sale of Dep fund investment A/c)
31.12.03 Depreciation Fund Investment A/c Dr. 1315.0 1315.0
To depreciation fund A/c
(Being profit on sale investment
transferred)
(17)
31.12.03 Depreciation fund A/c Dr. 61315.0 61315.0
to lease A/c
(Being the transfer of depreciation
fund A/c to lease A/c)
31.12.03 Lease A/c Dr. 1315.0 1315.0
To PCL A/c
(Being Balance of lease A/c
transferred to place
1.1.04 Lease A/c Dr. 70000.0 70000.0
To Bank A/c
Depreciation Fund Account
Date Particulars Rs. Date Particulars Rs.
31.12.00 By Balance c/d 13920.7 31.12.00 By Dep. a/c 13920.7
13920.7 13920.7
31.12.01 To Balance c/d 28537.4 1.1.01 By Balance b/d 13920.7
31.12.01 By Bank A/c Int. 696.0
31.12.01 By Dec. a/c 13920.4
28537.4 28537.4
31.12.02 By Balance c/d 43885.0 1.1.02 By Balance c/d 28537.4
31.12.02 By Bank A/c Int. 1426.9
31.12.02 By Dep. A/c 13920.7
43885.0 43885.0
31.12.03 To lease A/c 61315.0 1.1.03 By Balance b/d 43885.0
31.12.03 By Bank Interest 3194.3
31.12.03 By Dep. a/c 61315.0
61315.0 61315.0
(18)
Lease Account
Date Particulars Rs. Date Particulars Rs.
1.1.00 To Bank A/c 60000 31.12.00 By Balance c/d 60000
60000 60000
1.1.01 To Balance b/d 60000 31.12.01 By Balance c/d 60000
60000 60000
1.1.02 To Balance b/d 60000 31.12.02 By Balance c/d 60000
60000 60000
1.1.03 To Balance b/d 60000 31.12.03 By Balance c/d 60000
60000 60000
31.12.03 To Balance b/d 60000
31.12.03 To P & L A/c 1315
(Profit) 61315 61315
Depreciation Fund Investment A/c
Date Particulars Rs. Date Particulars Rs.
31.12.00 To Bank A/c 13920.7 31.12.00 By Balance c/d 13920.7
13920.7 13920.7
1.1.01 To Balance b/d 13920.7 31.12.01 By Balance c/d 28537.4
31.12.02 To Bank A/c 14616.7
28537.4 28537.4
1.1.02 To Balance b/d 28537.4 31.12.02 By Balance c/d 43885.0
31.12.02 To Bank A/c 15347.6
43885.0 43885.0
1.1.03 To Balance b/d 43885.0 31.12.03 By Bank a/c 45200.0
To Dep. Fund a/c 1315.0
45200.0 45200.0
7. Insurance Policy Method : Under this method, instead of investing the
money in securities an insurance policy for the required amount is taken. The
amount
(19)
of the policy is such that it is adequate to replace the asset when it is worn out. A
fixed sum equal to the amount do depreciation is paid as premium every year.
Company receiving premium allows a small rate of interest on compound basis. At
the maturity of the policy, the insurance company pays the agreed amount with
which the new asset can be purchased. Accounting entries will be made as
follows.
1. First and every subsequent years :
(a) Depreciation Insurance policy A/c Dr.
To Bank
(Entry in the beginning of the year for payment of insurance premium)
(b) Profit and loss Account Dr.
To Depreciation fund A/c
(Entry at the end of the year for providing depreciation )
2. Last year :
(a) Bank A/c Dr.
To Depreciation Policy A/c
(Entry for the amount of policy received)
(b) For transfer of profit on insurance policy :
Depreciation Insurance Policy A/c Dr.
To Depreciation Fund A/c
(c) For transfer of accumulated depreciation to the asset account :
Depreciation Fund A/c Dr.
To Asset A/c
(d) On purchase of new asset :
On purchase of new asset :
New Asset A/c Dr.
To Bank
Illustration 5. On 1.1.2003, a firm purchased a lease for four years for Rs.
50,000. It decided to provide for its replacement by means of an insurance policy
for Rs. 50,000. The annual premium is Rs. 11,000. On 1.1.1997, the lease is
renewed
(20)
for a further period of 4 years for the same amount. Show the necessary ledger
accounts.
Lease Account
Date Particulars Rs. Date Particulars Rs.
1.1.03 To Bank A/c 50000 31.12.03 By Balance c/d 50000
1.1.04 To Balance b/d 50000 31.12.04 By Balance c/d 50000
1.1.05 To Bank A/c 50000 31.12.05 By Balance c/d 50000
1.1.06 To Bank A/c 50000 31.12.06 By Balance c/d 50000
Depreciation Insurance Policy A/c
Date Particulars Rs. Date Particulars Rs.
1.1.03 To Balance A/c 11000 31.12.03 By Balance c/d 11000
1.1.04 To Balance b/d 11000 31.12.04 By Balance c/d 22000
To Bank A/c 11000
22000 22000
1.1.05 To Balance b/d 22000 31.12.05 By Balance c/d 33000
To Bank A/c 11000
33000 33000
1.1.06 To Balance b/d 33000 31.12.06 By Bank 50000
To Bank 11000
Dec.31 To profit 6000
Transferred to
Dep. Fund A/c
50000 50000
(21)
Depreciation Fund Account
Date Particulars Rs. Date Particulars Rs.
1.1.03 To Balance c/d 11000 31.12.03 By P. & L c/c 11000
1.1.04 To Balance c/d 22000 31.12.04 By Balance b/d 11000
Dec. 31 By P. & L a/c 11000
22000 22000
1.1.05 To Balance c/d 33000 31.12.05 By Balance b/d 22000
By P. & L. a/c 11000
33000 33000
1.1.06 To Lease a/c 50000 31.12.06 By Balance b/d 33000
Dec. 31 By P. & L. a/c 11000
Dec. 31 By Dep. Insurance 6000
Policy a/c
50000 50000
8. Depletion Method : This is also known as productive output method.
In this method it is essential to make an estimate of the units of output the asset
will produce in its life time. This method is suitable in case of mines, queries, etc.,
where it is possible to make an estimate of the total output likely to be available.
Depreciation is calculated per unit of output. Formula for calculating the
depreciation rate is as under: r =
Example : If a mine is purchased for 50,000 and it is estimated that the total
quantity of mineral in the mine is 1,00,000 tonnes, the rate of depreciation would
be :
r
=
Rs. 50,000 = Rs. 0.5
1,00,000
Hence, the rate of depreciation is 50 praise per tonne. In case output in a year is
20,000 tonnes, the amount of depreciation to be charged to the profit and loss
account would be Rs. 10,000 (i.e., 20,000 tonnes X Rs. 0.50).
(22)
This method is useful where the output can be measured effectively, and the utility
of the asset is directly related to its production use. Thus, the method provides the
benefit of correlating the amount of depreciation with the productive use of asset.
7.6 METHODS OF RECORDING DEPRECIATION
In order to record depreciation, a provision for depreciation may or may
not be maintained. In case a ‘Provision for Depreciation Account’ is maintained,
the
respective asset appears at its original cost since the depreciation is credited to
‘Provision for Depreciation Account’ instead of the ‘Respective Asset Account’.
In
case a ‘Provision for Depreciation Account’ is not maintained, the respective asset
appears at a written down value since the depreciation is credited to the
‘Respective
Asset Account’. The accounting entries under both these cases are summarised as
under:
Case When a Provision for Depreciation When a Provision for Depreciation
Account is maintained Account is not maintained
(a) For providing Depreciation Dr. Depreciation A/c Dr.
depreciation To Provision for To Asset A/c
Depreciation
(b) For closure of Profit and Loss A/c Dr. Profit and Loss A/c Dr.
Depreciation A/c To Depreciation A/c To Depreciation A/c
(c) On disposal of an (i) For transfer of original (i) For recording sale proceeds
Asset cost of asset disposed off Cash A/c/Bank A/c Dr.
Asset Disposal A/c Dr. To Asset A/c
To Asset A/c (ii) For transfer of Profit/loss on
(ii) For transfer of accumulated asset disposed off
depreciation on asset disposed (a) In case of profit
off Asset A/c Dr.
Provision for Depreciation A/c Dr. To Profit and Loss A/c
To Asset Disposal A/c (b) In case of loss, reverse of
(iii) For recording sale proceeds the above entry will be passed.
Cash A/c/Bank A/c Dr.
To Asset Disposal A/c
(iv) For transfer of the balance in
Asset Disposal Account
(a) In case of profit
Asset Disposal A/c Dr.
To Profit & Loss A/c
(b) In case of loss, reverse of the
above entry will be passed.
(23)
Notes :
(i) Book Value as on date of Sale = Original Cost–Total Depreciation till date of
sale
(ii) Profit=Sale Proceeds – Book Value as on date of sale
(iii) Loss=Book value as on date of sale – Sale Proceeds
(iv) In case of exchange of an asset, sale proceeds imply the ‘Trade in allowance’
(i.e. the amount at which the vendor agrees to acquire the old asset).
(v) In case of destruction/damage of an insured asset by fire or accident, sale
proceeds imply claim admitted by Insurance company together with salvage
value (if any).
Illustration 6 : On Ist Jan. 2006, X Ltd. purchased a machinery for Rs. 12,00,000.
On
Ist July 1998, a part of the machinery purchased on Ist Jan. 2006 for Rs. 80,0000
was
sold for Rs. 45,000 and a new machinery at a cost of Rs. 1,58,000 was purchased
and
installed on the same date. The company has adopted the method of providing
10% p.a.
depreciation on the original cost of the machinery.
Required : Show the necessary leader accounts assuming that (a) Provision for
Depreciation Account is not maintained, (b) Provision for Depreciation Account is
maintained.
Solution :
(a) When Provision for Depreciation Account is not maintained
Dr. Machinery Account Cr.
Date Particulars Rs. Date Particulars Rs.
01.01.06 To Bank A/c 12,00,000 31.12.06 By Depreciation A/c 1,20,000
By Balance c/d 10,80,000
12,00,000 12,00,000
01.01.97 To Balance b/d 10,80,000 31.12.97 By Depreciation A/c 1,20,000
By Balance c/d 9,60,000
10,80,000 10,80,000
01.01.98 To Balance b/d 9,60,000 01.07.98 By Bank A/c 45,000
01.07.98 To Bank A/c 1,58,000 By Profit & Loss A/c 15,000
31.12.98 By Depreciation A/c 1,23,900
By Balance c/d 9,34,100
11,18,000 11,18,000
(24)
(b) When ‘Provision for Depreciation Account is maintained
Dr. Machinery Account (at original cost) Cr.
Date Particulars Rs. Date Particulars Rs.
01.01.06 To Bank A/c 12,00,000 31.12.06 By Balance c/d 12,00,000
01.01.97 To Balance b/d 12,00,000 31.12.97 By Balance c/d 12,00,000
01.01.98 To Balance b/d 12,00,000 01.07.98 By Asset Disposal A/c 80,000
01.07.98 To Bank A/c 1,58,000 31.12.98 By Balance c/d 12,78,000
13,58,000 13,58,000
Dr. Provision or Depreciation Account Cr.
Date Particulars Rs. Date Particulars Rs.
31.12.06 To Balance c/d 1,20,000 31.12.06 By Profit & Loss A/c 1,20,000
31.12.97 To Balance c/d 2,40,000 01.01.97 By Balance b/d 1,20,000
31.12.97 By Profit & Loss A/c 1,20,000
2,40,000 2,40,000
01.07.98 To Asset Disposal A/c 20,000 01.01.98 By Balance b/d 2,40,000
31.12.98 To Balance c/d 3,43,900 31.12.98 By Profit & Loss A/c 1,23,900
3,63,900 3,63,900
Dr. Asset Disposal Account Cr.
Date Particulars Rs. Date Particulars Rs.
01.07.98 To Machinery A/c 80,000 01.07.98 By Provision for
Depreciation A/c 20,000
By Bank A/c 45,000
By Profit & Loss A/c 15,000
(Loss on sale)
80,000 80,000
Working Notes :
(i) Calculation of Loss on Sale of Machinery Rs.
A. Original Cost as on 1.1.06 80,000
B. Less : Depreciation @ 10% p.a. on Rs. 80,000 8,000
C. Balance as on 1.1.97 (A–B) 72,000
D. Less : Depreciation @ 10% p.a. on Rs. 80,000 8,000
E. Balance as on 1.1.98 (C–D) 64,000
(25)
F. Less : Depreciation @ 10% p.a. on Rs. 80,000 for 6 months 4,000
G. Balance as on 1.7.98 (E–F) 60,000
H. Less: Sale proceeds 45,000
I. Loss on Sale (G–H) 15,000
(ii) Calculation of Depreciation for 1998
(a) On Rs. 11,20,000 for 1 year 1,12,000
(b) On Rs. 60,000 for 1/2 year 4,000
(c) On Rs. 1,58,000 for 1/2 year 7,900
1,23,900
Illustration 7 : Rahul Ltd. which depreciates the machines @ 25% p.a. on the
reducing
balance method, provides you the following particulars :
Cost on 31.12.95 Rs. 2,46,000. Provision for Depreciation (on
31.12.95) Rs. 1,24,000. No amounts being charged in the year of sale but full
charge is
being made for the years during which addition is made. On 1.7.97, one new
machine
was purchased for Rs. 24,000 and old machinery purchased on 1.7.1994 for Rs.
20,000
was discarded but could not be sold immediately. However, it was expected to
realise
Rs. 5,000 for same. Prepare (a) machinery Account, (b) Provision for Depreciation
Account, and (c) Machinery Disposal Account for the years 1996 and 1997.
Solution
Dr. Machinery Account Cr.
Date Particulars Rs. Date Particulars Rs.
01.01.96 To Balance b/d 2,46,000 31.12.96 By Balance c/d 2,46,000
01.01.97 To Balance b/d 2,46,000 01.07.97 By Machinery
01.07.97 To Bank A/c 24,000 Disposal A/c 20,000
31.12.97 By Balance c/d 2,50,000
2,70,000 2,70,000
Dr. Provision for Depreciation Account Cr.
Date Particulars Rs. Date Particulars Rs.
31.12.96 To Balance c/d 1,54,500 01.01.96 By Balance b/d 1,24,000
31.12.96 By Depreciation A/c
[25% of (Rs. 2,46,000)
- Rs. 1,24,000] 30,500
1,54,500 1,54,500
(26)
01.07.97 To Machinery 11,563 01.01.97 By Balance b/d 1,54,500
Disposal a/c 31.12.97 By Depreciation
31.12.97 By Balance c/d 1,69,703 [25% of (Rs. 2,50,000-
Rs. 1,54,500+Rs.11,563] 26,766
1,81,266 1,81,266
Dr. Machinery Disposal Account Cr.
Date Particulars Rs. Date Particulars Rs.
01.07.97 To Machinery 20,000 01.07.97 By Provision for
Depreciation A/c 11,563
By P&L A/c (Loss)
(Purchase concept) 3,437
By Balance c/d 5,000
20,000 20,000
Working Note : Calculation of Depreciation provided on Machine discarded
Book Accumulated
Value Depreciation
Rs. Rs.
A. Original Cost 20,000 –
B. Less : Depreciation for 1994 5,000 5,000
C. Book value on 1.1.1995 15,000
D. Less : Depreciation for 1995 3,750 3,750
E. Book Value on 1.1.1996 11,250
F. Less : Depreciation for 1996 2,813 2,813
8,437 11,563
7.7 SALE OF AN ASSET
An enterprise may sell an asset either because of obsolescence or inadequacy or
even for other reasons. In case an asset is sold during the course of the year, the
amount realised should be credited to the Asset Account. The amount of
depreciation for the period of which the asset has been used should be written off
in the usual manner. Any balance in the Asset Account will represent profit or loss
on disposal of the asset. This balance in the Asset Account should be transferred to
the profit and loss account.
(27)
Illustration 8: A company purchased a machinery costing Rs. 60,000 on
1.4.2000. The accounting year of the company ends on 31st December every year.
The company further purchased machinery on 1st October, 2000 costing Rs.
40,000.
On 1st January, 2002, one-third of the machinery which was installed on 1.4.2000,
became obsolete and was sold for Rs. 5000. Show how the machinery account
would
appear in the books of the company. The depreciation is to be charged at 10% p.a.
on written down value method.
Machinery Account
Date Particulars Rs. Date Particulars Rs.
1.4.00 To Bank 60000 31.12.00 By Depreciation 45000
Oct. 1 To Bank 40000 on Rs. 60000 for
9 month on Rs.
40000 for 3 month 1000
Dec.31 By Balance c/d 94500
100000 100000
1.1.01 To Balance b/d 94500 31.12.01 By Depreciation 9450
on Rs. 94500 for
1 year
Dec. 31 By Balance c/d 85050
94500 94500
1.1.02 To Balance b/d 85050 31.12.01 By Bank (sale pro) 5000
Jan. 1 By Profit Loss
account loss on sale
(16650-5000) 11650
Dec. 31 By Depreciation 6840
Dec. 31 By Balance c/d 61560
85050 85050
*Total written down value as on Jan. 1, 2002 85050
Less written down value of 1/3 of Machinery
sold (2000-(1500+1850) 16650
68400
Depreciation at 10% on Rs. 68400 6840
(28)
Depreciation on an asset purchased in the course of a year
Two alternatives are available regarding charging of depreciation on assets which
have been bought during the course of an accounting year. These are as follows :
1. Depreciation may be charged only for the part of the year for which the
asset could have been made available for use after purchase of it.
2. Depreciation may be charged for the full year irrespective of the date of
purchase. It will be ascertained at the given rate of depreciation. The Income tax
authorities also permit this.
Important Note : If there is no specific instruction in the question about
depreciation,
the students should give the assumption made by them in this regard. But, in case
rate of depreciation has been given as a certain percentage per annum and the
purchasing date has been given, it is suggested to calculate depreciation only for
the part of the year for which the asset has been made available for its use.
7.8 CHANGE OF DEPRECIATION METHOD
To ensure comparability of results from year to year, it is essential that once a
method of depreciation is selected by the management it should be followed
consistently. However, sometimes a change in the method of depreciation may be
required. The change may be required either because of statutory compulsion or
required by an accounting standard or change would result in more appropriate
presentational the financial statements.
The change in the method of depreciation may be desired from the current year
onwards. In such a case, depreciation will be charged according to the new method
from the current year.
Illustration : 9 Om Ltd. purchased a computer for Rs. 50,000 on 1.1.2003. It has
five years life and a salvage value of Rs. 5,000. Depreciation was provided on
straight
line basis. With effect from 1.1.2005, the company decided to change the method
of depreciation to Diminishing Balance method @20% p.a. Prepare computer
account from 2003 to 2006. Assume, the company prepare final accounts on 31st
December every year.
(29)
Computer Account
Date Particulars Rs. Date Particulars Rs.
1.1.03 To Cash A/c 50000 31.12.03 By Depreciation 9000
" By Balance c/d 41000
50000 50000
1.1.04 To Balance b/d 41000 31.12.04 By Depreciation 9000
" By Balance c/d 32000
41000 41000
1.1.05 To Balance b/d 32000 31.12.05 By Depreciation 6400
" By Balance c/d 25600
32000 32000
1.1.06 To Balance b/d 25600 31.12.06 By Depreciation 5120
" By Balance c/d 20480
25600 25600
Working Notes :
1) Depreciation on straight line basis = Rs. 50000 -5000 = Rs. 9000
5
2) Depreciation on written down value basis during 2005
(Book value Rs. 32000) = Rs 32000 x 20 = Rs. 6400
100
Change in the Method of Depreciation from a back date
Sometimes a change in the method of depreciation is effected retrospectively. In
such a case, the following steps are required :
(i) Find out the depreciation which has already been charged according to the
old method or at the old rate.
(ii) Compute the amount of depreciation that is to be charged according to the
new method form the back date upto the end of the previous year.
(iii) Find the difference, if any, under (i) and (ii) mentioned above.
(iv) In the current year in addition to the depreciation for the current year charge
also the difference found under step (iii).
(30)
Illustration 10: Taking the facts as in the illustration 7, prepare computer account
for 2005 and 2006, if the firm decides on 1.1.2005 to charge depreciation
according
to Diminishing Balance method. Assume the change in the depreciation policy is
effected by the firm since the date of purchase.
Solution :
Computer Account
Date Particulars Rs. Date Particulars Rs.
1.1.05 To Balance 32000 31.12.05 By Depreciation
Difference for Nil
earlier year (1)
current year (2) 6400
Dec. 31 By Balance c/d 25600
32000 32000
1.1.06 To Balance 25600 31.12.06 By Depreciation 5150
" By Balance 20480
25600 25600
Working Notes :
1) 1.1.2003 Acquisition cost of computer 50000
31.12.03 Depreciation @ 20% p.a. on 50000 10000
1.1.04 Balance 40000
31.12.04 Depreciation @ 20% on Rs/ 4000 8000
Depreciation according to Diminishing
Balance 18000
method for the year 2003 and 2004 (10,000+8,000)
Less Depreciation according to straight line basis 18000
(9000+9000) Nil
Difference
2) 1.195 Balance 32000
(31)
31.12.05 Depreciation @ 20% p.a. on 32000 6400
1.1.06 Balance 25600
31.12.06 Depreciation @ 20% on 25600 5120
31.12.06 Balance 20480
7.9 SUMMARY
Depreciation is a gradual reduction in the economic value of an asset from any
cause. The depreciation occurs because of constant use, passage of time, depletion,
obsolescence, accidents and permanent fall in the market value. The need for
providing depreciation arises to ascertain the profit or losses, to show the assets at
its reasonable value, for replacement of assets, to reduce income tax, etc. The
various
methods of allocating depreciation include : fixed instalment methods, machine
hour rate method, diminishing balance method, sum of years digits method,
annuity
method, depreciation fund method, insurance policy method and depletion
method.
The straight line method is very suitable particularly in case of those assets which
get depreciated more on account of expire of period i.e. lease hold properties,
patents etc. Diminishing balance method is suitable in those cases where the
receipts are expected to decline as the asset gets older and, it is believed that the
allocation of depreciation ought to be related to the pattern of assets expected
receipts. In case an asset is sold during the course of the year, the amount realised
should be credited to the Asset Account. The amount of depreciation for the period
of which the asset has been used should be written off in the usual manner. Any
balance in the Asset Account will represent profit or loss on disposal of the asset.
7.10 KEYWORDS
Depreciation: It is the gradual and permanent decrease in the value of an asset
from any cause.
Depletion: Depletion refers to the reduction in the workable quantity of a wasting
asset.
Obsolescence: It represents loss in the value of an asset on account of its
becoming
obsolete or out of date.
Fixed instalment method: Under this method, the assets are depreciated at a
fixed
amount throughout its life span.
Written down value method: Under this method, the depreciation is calculated
every year on the diminishing value of the asset.
(32)
7.11 SELF ASSESSMENT QUESTIONS
1. Why is it necessary to calculate depreciation ? Discuss various factors which
are considered for calculating depreciation
2. How do the matching principle and going concern concept apply to
depreciation.
3. Distinguish between the following :
(a) Straight line method and diminishing balance method.
(b) Annuity method and depreciation Fund method.
(c) Depreciation and depletion
4. Explain the circumstances under which different methods of depreciation
can be employed.
5. Discuss the advantages and disadvantage of Insurance Policy Method and
Straight Line Methods.
6. What is 'sum of the year-digits method' to depreciation ? In what way does it
differ from sinking fund method of depreciation
7. A firm purchases a plant for a sum of Rs. 10,000 on 1st January 2000.
Installation charges are Rs. 2,000. Plant is estimated to have a scrap value of Rs.
1,000 at the end of its useful life of five years. You are required to prepare the
plant account for five years charging depreciation according to Straight Line
Method
8. A transport company purchases 5 trucks at Rs. 2,00,000 each on April 1, 2006.
The company writes off depreciation @ 20% per annum on original cost and
observes
calendar year as its accounting year. On October 1, 1998 one of the trucks is
involved
in an accident and is completely destroyed. Insurance company pays Rs. 90,000 in
full
settlement of claim. On the same day, the company purchases a used truck for Rs.
1,00,000 and spends Rs. 20,000 on its overhauling. Prepare Truck Account for the
three years ending on 31st December 2005.
[Loss on one truck Rs. 10,000, Book Value–Old trucks Rs. 3,60,000, New Truck Rs.
1,14,000].
9. A plant is purchased for Rs. 20,000. It is depreciated at 5% per annum on
reducing balance for five years when it becomes obsolete due to new method of
production and is scrapped. The scrap produces Rs. 5,385. Show the plant account
in the ledger.
(An Loss on sale Rs. 10,091; Depreciation 1st year Rs. 1,000; 2nd years Rs. 950;
3rd year Rs. 902; 4th year RS. 857; 5th year Rs. 815.)
(33)
10. The machinery account of a factory showed a balance of Rs. 1,90,000 on 1st
January 1998. 1st accounts were made up on 31st December each year and
depreciation is written off at 10% p.a. under the Diminishing Balance Method.
On 1st June 1998, New Machinery is acquired at a cost of Rs. 28,000 and
installation charges incurred in erecting the machines works out to Rs. 892 on the
same date. On 1st June 1998 a machine which had cost Rs. 6,000 on 1st January
2003 was sold for Rs. 750, another machine which had cost Rs. 600 on 1st January
2004, was scrapped on the same date and it realised nothing.
Write up plant and Machinery Account for the year 1998, allowing the same
rate of Depreciation as in the past calculating Depreciation to the nearest multiple
of a Rupee. (Ans. Loss on Sale Rs. 2,645, Loss on scrapping Rs. 377, Closing
Balance Rs. 1,94,665).
11. A company purchased a four years lease on January, 1, 1985 for Rs. 20,150.
It is decided to provide for the replacement of the lease at the end of four years by
setting up a Depreciation Fund. It is expected that investments will fetch interest at
4 per cent. Sinking Fund tables show that to provide the requisite sum at 4 percent
at the end of four years, an investment of Rs. 4,745.02 is required. Investments are
made to the nearest rupee.
On December 31, 1988, the investments are sold for Rs. 14,830 On 1st
January, 1989, the same lease is renewed for a further period of 4 years by
payment
of Rs. 22,000.
Show journal entries and give the important ledger account to record the
above. (Ans. Amount credited to the profit and loss account at the end of
December,
1988 Rs. 17,56)
12. Chillies Ltd, acquired a long-term lease of property on payment of Rs. 60,000.
A leasehold Redemption Policy was taken out on which an annual premium of Rs.
1,440 was payable. The surender value of the policy on 31st March, 1997 was Rs.
12,896 to which amount the policy account stood adjusted. Next premium was
paid on 20th December, 1997 and the surrender value on 31st March, 1978 was
Rs.
14,444.
(i) Show the Redemption fund account and the policy account for the year ended
31st March, 1998
(ii) Assuming that of maturity, a sum of Rs. 60,100 was received and the balance
in policy account then stood at Rs. 59,920 give the ledger accounts showing the
entries necessary to close the accounts concerned. (Ans. (i) Balance at the end of
1998 Fund A/c & Policy A/c Rs. 14,444 (ii) Transfer to P & L a/c profit on
maturity
Rs. 100).
1
Subject :Accounting for Managers Updated by: Dr. Mahesh Chand Garg
Course Code : CP-104
Lesson No. : 8
PREPARATION OF FINAL ACCOUNTS OF NONCORPORATE
ENTITIES
STRUCTURE
8.0 Objective
8.1 Introduction
8.2 Trading Account
8.3 Manufacturing Account
8.4 Profit and Loss Account
8.5 Balance Sheet
8.5.1 Classification of Assets and Liabilities
8.5.2 Grouping and Marshalling of Assets and Liabilities
8.6 Adjustment Entries
8.7 Summary
8.8 Keywords
8.9 Self Assessment Questions
8.10 Suggested Readings
8.0 OBJECTIVE
This lesson will make you familiar with preparation of
* Trading Account.
* Manufacturing Account.
* Profit and Loss Account.
* Balance Sheet.
* Final accounts giving effect to adjustments.
8.1 INTRODUCTION
The transactions of a business enterprise for the accounting period
are first recorded in the books of original entry, then posted therefrom into
the ledger and lastly tested as to their arithmetical accuracy with the help
of trial balance. After the preparation of the trial balance, every businessman
is interested in knowing about two more facts. They are : (i) Whether he
2
has earned a profit or suffered a loss during the period covered by the trial
balance, and (ii) Where does he stand now? In other words, what is his
financial position?
For the above said purposes, the businessman prepares financial
statements for his business i.e. he prepares the Trading and Profit and Loss
Account and Balance Sheet at the end of the accounting period. These
financial statements are popularly known as final accounts. The preparation
of financial statements depends upon whether the business concern is a
trading concern or manufacturing concern. If the business concern is a
trading concern, it has to prepare the following accounts along with the
Balance Sheet :
(i) Trading Account; and
(ii) Profit and Loss Account.
But, if the business concern is a manufacturing concern, it has to
prepare the following accounts along with the Balance Sheet:
(i) Manufacturing Account;
(ii) Trading Account ; and
(iii) Profit and Loss Account.
Basically, two types of statements are prepared namely "Income
Statement" and 'Position Statement". The Income Statement is generally
known as Profit and Loss Account. This Profit and Loss Account is further
sub-divided either into three parts or two parts according to the nature of
the business. As stated above, if the concern is a manufacturing one, the
Profit and Loss Account is divided into three sub-sections viz, Manufacturing
Account, Trading Account and Profit and Loss Account. On the other hand,
if it is a trading concern, then this account is divided into two sub-sections,
namely Trading Account and Profit and Loss Account.
The second statement i.e. the "Position Statement" which is popularly
known as the "Balance Sheet" is prepared by every type of business concern.
3
The Balance Sheet is a statement which shows the position of the assets,
liabilities and capital in money terms, of an accounting entity as on a given
date. A Balance Sheet is a formal representation of the accounting equation
indicating that the assets are always equal, in value, to the liabilities plus capital.
Trading Account is prepared to know the Gross Profit or Gross Loss.
Profit and Loss Account discloses net profit or net loss of the business.
Balance sheet shows the financial position of the business on a given date.
For preparing final accounts, certain accounts representing incomes or
expenses are closed either by transferring to Trading Account or Profit and
Loss Account. Any Account which cannot find a place in any of these two
accounts goes to the Balance Sheet.
8.2 TRADING ACCOUNT
After the preparation of trial balance, the next step is to prepare
Trading Account. Trading Account is one of the financial statements which
shows the result of buying and selling of goods and/or services during an
accounting period. The main objective of preparing the Trading Account is
to ascertain gross profit or gross loss during the accounting period. Gross
Profit is said to have been made when the sale proceeds exceed the cost of
goods sold. Conversely, when sale proceeds are less than the cost of goods
sold, gross loss is incurred. For the purpose of calculating cost of goods
sold, we have to take into consideration opening stock, purchases, direct
expenses on purchasing or manufacturing the goods and closing stock. The
balance of this account i.e. gross profit or gross loss is transferred to the
Profit and Loss Account.
Format of Trading Account
A Trading Account is prepared in "T" form just like every other
account. Though it is an account, yet it is not exactly an ordinary ledger
4
account. It is one of the accounts which are prepared only once in an
accounting period to ascertain the gross profit or gross loss of the business.
As it is prepared once in a year, columns for date and journal folio are not
provided. While preparing a Trading Account, an important point that must
be kept in mind is that a closing journal entry is to be recorded in the journal
proper. At the end of every accounting period, items of revenue and direct
expenses are closed by transferring their respective balances to the Trading
Account. The format of a Trading Account and the usually appearing entries
therein are shown below :
TRADING ACCOUNT
For the year ended 31st March, 2006
Particulars Amount Particulars Amount
Rs. Rs.
To Opening Stock By Sales
To Purchases Less Sales Returns
Less Purchases Returns By Closing Stock
To Direct Expenses: By Gross Loss
Carriage Inward transferred to
Freight and Insurance P & L A/c
Wages
Fuel, Power and Lighting
expenses
Manufacturing Expenses
Coal, Water and Gas
Motive Power
Octroi
Import Duty
Custom Duty
Consumable Stores
Royalty on manufactured
Goods
Packing charges
To Gross Profit transferred
to P & L A/c
5
Balancing of Trading Account
After recording the relevant items of various accounts in the
respective sides of the Trading Account, the balance is calculated to
ascertain Gross Profit or Gross Loss. If the total of the credit side is more
than that of the debit side, the excess represents Gross Profit. Conversely,
if the total the debit side is more than that of the credit side, the excess
represents Gross Loss. Gross Profit is transferred to the credit side of the
Profit and Loss Account and Gross loss to the debit side of the Profit and
Loss Account.
Closing Entries for Trading Account
The journal entries necessary to transfer opening stock,
purchases, sales and returns to the Trading Account are called closing
entries, as they serve to close these accounts. These are as follows:
1. For transfer of opening stock, purchases and direct
expenses to Trading A/c
Trading A/c Dr.
To Stock (Opening) A/c
To Purchases A/c
To Direct Expenses A/c
(Being opening stock, purchases and direct expenses transferred to
Trading Account)
2. For transfer of sales and closing stock to Trading A/c
Sales A/c Dr.
Stock (Closing) A/c Dr.
To Trading A/c
(Being sales, closing stock transferred to Trading Account)
6
3.(a) For Gross Profit
Trading A/c Dr.
To Profit & Loss A/c
(Being gross profit transferred to Profit and Loss Account)
(b) For Gross Loss
Profit & Loss A/c Dr.
To Trading A/c
(Being gross loss transferred to Profit and Loss Account)
Important Points Regarding Trading Account
1. Stock
The term 'stock' includes goods lying unsold on a particular date.
The stock may be of two types:
(a) Opening stock
(b) Closing stock
Opening stock refers to the closing stock of unsold goods at the
end of previous accounting period which has been brought forward in the
current accounting period. This is shown on the debit side of the Trading
Account.
Closing stock refers to the stock of unsold goods at the end of
the current accounting period. Closing stock is valued either at cost price
or at market price whichever is less. Such valuation of stock is based on the
principle of conservatism which lays down that the expected profit should
not be taken into account but all possible losses should be duly provided
for.
Closing stock is an item which is not generally available in the
trial balance. If it is given in Trial Balance, it is not to be shown on the
credit side of Trading Account but appears only in the Balance Sheet as an
7
asset. But if it is given outside the trial balance, it is to be shown on the
credit side of the Trading Account as well as on the asset side of the Balance
Sheet.
2. Purchases
Purchases refer to those goods which have been bought for resale.
It includes both cash and credit purchases of goods. The following items
are shown by way of deduction from the amount of purchases:
(a) Purchases Returns or Return Outwards.
(b) Goods withdrawn by proprietor for his personal use.
(c) Goods received on consignment basis or on approval basis or on hire
purchase.
(d) Goods distributed by way of free samples.
(e) Goods given as charity.
3. Direct Expenses
Direct expenses are those expenses which are directly attributable
to the purchase of goods or to bring the goods in saleable condition. Some
example of direct expenses are as under:
(a) Carriage Inward
Carriage paid for bringing the goods to the godown is treated as
carriage inward and it is debited to Trading Account.
(b) Freight and insurance
Freight and insurance paid for acquiring goods or making them
saleable is debited to Trading Account. If it is paid for the sale of goods,
then it is to be charged (debited) to Profit and Loss Account.
(c) Wages
Wages incurred in a business are direct expenses, when they are
incurred on manufacturing or merchandise or on making it saleable. Other
8
wages are indirect wages. Only direct wages are debited to the Trading
Account. Other wages are debited to the Profit and Loss Account. If it is
not mentioned whether wages are direct or indirect, it should be assumed
as direct and should appear in the Trading Account.
(d) Fuel, Power and Lighting Expenses
Fuel and power expenses are incurred for running the machines.
Being directly related to production, these are considered as direct expenses
and debited to Trading Account. Lighting expenses of factory are also
charged to Trading Account, but lighting expenses of administrative office
or sales office are charged to Profit and Loss Account.
(e) Octroi
When goods are purchased within municipality limits, generally
octroi duty has to be paid on it. It is debited to Trading Account.
(f) Packing Charges
There are certain types of goods which cannot be sold without a
container or proper packing. These form a part of the finished product. One
example is ink, which cannot be sold without a bottle. These type of packing
charges are debited to Trading Account. But if the goods are packed for
their safe despatch to customers, i.e. packing meant for transportation or
fancy packing meant for advertisement, will appear in the Profit and Loss
Account.
(g) Manufacturing Expenses
All expenses incurred in manufacturing the goods in the factory
such as factory rent, factory insurance etc. are debited to Trading Account.
(h) Royalties
These are the payments made to a patentee, author or landlord
for the right to use his patent, copyright or land. If royalty is paid on the
9
basis of production, it is debited to Trading Account and if it is paid on the
basis of sales, it is debited to Profit and Loss Account.
4. Sales
Sales include both cash and credit sales of those goods which
were purchased for resale purposes. Some customers might return the goods
sold to them (called sales return) which are deducted from the sales in the
inner column and net amount is shown in the outer column. While
ascertaining the amount of sales, the following points need attention:
(a) If a fixed asset such as furniture, machinery etc. is sold, it should
not be included in sales.
(b) Goods sold on consignment or on hire purchase or on sale or
return basis should be recorded separately.
(c) If goods have been sold but not yet despatched, these should not
be shown under sales but are to be included in closing stock.
(d) Sales of goods on behalf of others and forward sales should also
be excluded from sales.
Illustration 1: From the following information, prepare the Trading Account
for the year ending on 31March 2002 :
Opening Stock Rs. 1,50,000, Cash Sales Rs. 60,000, Credit
Sales Rs. 12,00,000, Returns Outwards Rs. 10,000, Wages Rs. 4,000,
Carriage Inward Rs. 1,000, Freight Inward Rs. 3,000, Octroi Rs. 2,000, Cash
Purchases Rs. 50,000, Credit Purchases Rs. 10,00,000, Returns Inward Rs.
20,000, Closing Stock as on 31.3.2002 Rs. 84,000.
10
Solution :
Trading Account
Dr. for the year ending on 31March, 2002 Cr.
Particulars Rs. Particulars Rs.
To Opening Stock 1,50,000 By Sales
To Purchases Cash Sales 60,000
Cash Purchases 50,000 Credit Sales 12,00,000
Credit Purchases 10,00,000 Total Sales 12,60,000
Total Purchase 10,50,000 Less : Return
Less : Return Inward 20,000 12,40,000
Outwards 10,000 10,40,000 By Closing Stock 84,000
To Freight Inwards 3,000
To Octroi 2,000
To Carriage Inwards 1,000
To Wages 4,000
To Gross Profit tfd. to P&L A/c 1,24,000
13,24,000 13,24,000
8.3 MANUFACTURING ACCOUNT
Manufacturing Account is prepared by an enterprise engaged
in manufacturing activities. It is prepared to ascertain the cost of goods
manufactured during an accounting period. This account is closed by
transferring its balance to the debit of the Trading Account. A general format
of a Manufacturing Account is shown below :
11
Dr. Manufacturing Account of ...... for the period ending on........
Cr.
Particulars Rs. Particulars Rs.
To Opening Work-in-progress By Sale of Scrap
To Raw material consumed By Closing Work-in-progress
Opening Stock By Trading Account
Add : Purchases (Cost of goods produced transferred)
Add : Cartage Inwards
Add : Freight Inwards
Less : Return Outwards
Less : Closing Stock
To Wages
To Salary of Works Manager
To Power, Electricity & Water
To Fuel
To Postage & Telephone
To Depreciation on :
Plant & Machinery
Factory Land & Buildings
To Repairs to :
Plant & Machinery
Factory Land & Building
To Insurance
Plant & Machinery
Factory Land & Building
To Rent and Taxes
To General Expenses
To Royalty based on production
12
DIFFERENCE BETWEEN TRADING ACCOUNT AND
MANUFACTURING ACCOUNT
Illustration 2 : From the following information, prepare a Manufacturing Account
for the year ending on 31 March 2002 :
Rs. Rs.
Work-in-progress (1.4.2001) 4,000 Wages 20,000
Raw Material (31.3.2002) 90,000 Salary of Works Manager 8,000
Carriage Inwards 3,000 Power, Electricity & Water 6,000
Freight Inwards 2,000 Fuel 4,000
Return Outwards 2,700 Depreciation :
Sales of Scrap 1,000 Plant & Machinery 8,000
Work-in-progress (31.3.2002) 5,000 Factory Building 4,000
Raw Materials (1.4.2001) 74,000 Repairs & Insurance :
Raw Material Purchased 45,000 Plant & Machinery 6,000
General Expenses 2,000 Factory Building 2,000
Factory Rent & Taxes 10,000
Trading Account
1. Trading Account is prepared to
find out the Gross Profit/Gross
Loss.
2. The balance of the Trading
account is transferred to the
Profit and Loss Account.
3. Sale of scrap is not shown in the
Trading Account.
4. Stocks of finished goods are
shown in the Trading Account.
5. Trading Account is a part of the
Profit and Loss Account.
Manufacturing Account
Manufacturing account is prepared
to find out the cost of goods
produced.
The balance of the Manufacturing
Account is transferred to the
Trading Account.
Sale of crap is shown in the
Manufacturing Account.
Stocks of raw materials and workin-
progress are shown in the
Manufacturing Account.
Manufacturing Account is a part of
the Trading Account.
13
Solution :
Manufacturing Account
Dr. for the year ending on 31 March 2002 Cr.
Particulars Rs. Particulars Rs.
To Opening WIP 4,000 By Sale of Scrap 1,000
To Raw Materials consumed By Closing WIP 5,000
Opening Stock 74,000 By Trading A/c (Cost of goods
Add : Purchases 45,000 manufactured transferred) 99,800
Add : Carriage Inwards 3,000
Add : Freight Inwards 2,000
Less : Returns Outwards 2,200
Less : Closing Stock 90,000 31,800
To Wages 20,000
To Salary of Works Managers 8,000
To Power, Electricity & Water 6,000
To Fuel 4,000
To Depreciation
Plant & Machinery 8,000
Factory Building 4,000
To Repairs & Insurance
Plant & Machinery 6,000
Factory Building 2,000
To Factory Rent & Taxes 10,000
To General Expenses 2,000
1,05,800 1,05,800
8.4 PROFIT AND LOSS ACCOUNT
Trading Account results in the gross profit/loss made by a
businessman on purchasing and selling of goods. It does not take into
consideration the other operating expenses incurred by him during the course
of running the business. Besides this, a businessman may have other sources
of income. In order to ascertain the true profit or loss which the business
has made during a particular period, it is necessary that all such expenses
and incomes should be considered. Profit and Loss Account considers all
14
such expenses and incomes and gives the net profit made or net loss suffered
by a business during a particular period. All the indirect revenue expenses
and losses are shown on the debit side of the Profit and Loss Account, where
as all indirect revenue incomes are shown on the credit side of the Profit
and Loss Account.
Profit and Loss Account measures net income by matching
revenues and expenses according to the accounting principles. Net income
is the difference between total revenues and total expenses. In this
connection, we must remember that all the expenses, for the period are to
be debited to this account - whether paid or not. If it is paid in advance or
outstanding, proper adjustments are to be made (Discussed later). Likewise
all revenues, whether received or not are to be credited. Revenue if received
in advance or accrued but not received, proper adjustment is required.
A proforma of the Profit and Loss Account showing probable items
therein is as follows :
15
PROFIT AND LOSS ACCOUNT
For the year ended ...............
Particulars Rs. Particulars Rs.
To Gross Loss b/d By Gross Profit b/d
To Management Expenses: By Other Income :
Rent, Rates and Taxes Discount received
Heating and Lighting Commission received
Office Salaries By Non-trading Interest :
Printing & Stationary Bank Interest
Postage & Telegrams Rent of property let-out
Telephone Charges Dividend from shares
Legal Charges By Abnormal Gains :
Audit Fees Profit on sale of machinery
Insurance Profit on sale of investment
General Expenses By Net Loss transferred to
To Selling and Distribution Capital Account
Expenses :
Advertisement
Tavellers' Salaries
Expenses & Commission
Godown Rent
Export Expenses
Carriage Outwards
Bank Charges
Agent's Commission
Upkeep of Motor Lorries
To Depreciation and
Maintenance :
Depreciation
Repairs & Maintenance
To Financial Expenses :
Discount Allowed
Interest on Loans
Discount on Bills
To Abnormal Losses:
Loss by fire (not
covered by Insurance)
Loss on Sale of Fixed
Assets
Loss on Sale of Investments
To Net profit transferred to
Capital A/c
16
Important Points in Profit and Loss Account
(i) Salaries. These include salaries paid to office, godowns and
warehouse staff and should be shown in Profit and Loss Account being
indirect expenses. Salaries to partners must be debited separately.
If salaries are paid after deduction of Income tax or Provident Fund then
these should be added back to the salaries in order to have gross figure of salaries
to be shown in Profit and Loss Account. If salaries are paid in kind by providing
certain facilities to the employees such as house free of rent, meals or cloth or
washing facility free of charge, then the value of such facilities should be regarded
as salaries.
(ii) Rent, Rates and Taxes. These include offices and warehouse rent, municipal
rates and taxes. Factory rent, rates and taxes should be debited to Trading Account
and others to Profit and Loss Account. If any rent is received on subletting of the
building, the same should be shown separately on the credit side of the Profit and
Loss Account. If rent is paid after deduction of some taxes then these should be
added back to know the correct amount of rent payable.
(iii) Interest. Interest paid on loans, overdrafts and bills overdue is an expense
and is taken to the debit side of Profit and Loss Account. Interest received on loans
advanced by the firm, on deposits and on securities is a gain and is shown on the
credit side of Profit and Loss Account. Interest on capital should be shown
separately
on the debit side and interest on drawing on the credit side of Profit and Loss
Account.
(iv) Commission. Commission received for doing the work of other firms may
be credited to Profit and Loss Account as a gain and commission payable to the
agents employed to sell the firm's goods is debited to Profit and Loss Account as
an expense.
(v) Repairs. Repairs and small renewals or replacements relating to the plant
and machinery, fixtures, fittings and utensils etc. are generally included under this
17
heading and such expenditure, being as expense, is debited to Profit and Loss
Account.
(vi) Depreciation. It is an expense due to wear and tear, lapse of time and
exhaustion of assets used in business. This is loss sustained by fixed assets and
should be charged to Profit and Loss Account.
(vii) Advertising . All sums spent on advertising should be charged to Profit and
Loss Account. If a large amount is paid under a contract covering two or three
years, proportionate part should be charged to Profit and Loss Account and the
balance appears as an asset in the Balance Sheet.
Expenses not to be shown in Profit and Loss Account
(i) Domestic and Household Expenses. These expenses are not shown in Profit
and Loss Account, as these are personal expenses of the proprietor and should be
treated as drawings.
(ii) Income tax. It should be treated as a personal expense of the proprietor and
added to drawing. It should not be shown as an expense in Profit and Loss
Account.
(iii) Life Insurance Premium. Premium paid on the life police of the proprietor
should be charged to the Drawings Account.
Closing Entries for Profit and Loss Account
(i) For transfer of various expenses to Profit & Loss A/c
Profit and Loss A/c Dr.
To Various Expenses A/c
(Being various indirect expenses transferred to Profit and Loss
Account)
(ii) For transfer of various incomes and gains to Profit & Loss A/c
Various Incomes & Gains A/c Dr.
To Profit & Loss A/c
(Being various incomes & gains transferred to Profit and Loss
Account)
18
(iii)(a) For Net Profit
Profit & Loss A/c Dr.
To Capital A/c
(Being Net Profit transferred to capital
(b) For Net Loss
Capital A/c Dr.
To Profit & Loss A/c
(Being Net Loss transferred to Capital Account)
DISTINCTION BETWEEN TRADING ACCOUNT AND
PROFIT AND LOSS ACCOUNT
Trading Account
1. Trading Account is prepared as
a part or section of the Profit
and Loss Account.
2. Direct Expenses are taken in
Trading Account.
3. Gross Profit or Gross Loss is
ascertained from Trading
Account.
4. The Balance of the Trading
Account i.e. Gross Profit or
Gross Loss is transferred to the
Profit and Loss Account.
5. Items of account written in the
Trading Account are few as
compared the Profit and Loss
Account.
Profit and Loss Account
Profit and Loss Account is
prepared as a main account.
Indirect expenses are taken in
Profit and Loss Account.
Net Profit or Net Loss is
ascertained from the Profit and
Loss Account.
The balance of the Profit and
Loss Account i.e. Net Profit or
Net Loss is transferred to
proprietor's Capital Account.
Items of accounts written in the
Profit and Loss Account are
much more as compared to the
Trading Account.
8.5 BALANCE SHEET
A Balance Sheet is a statement of financial position of a
business concern at a given date. It is called a Balance Sheet because it is a
sheet of balances of those ledger accounts which have not been closed till
the preparation of Trading and Profit and Loss Account. After the preparation
19
of Trading and Profit and Loss Account the balances left in the trial balance
represent either personal or real accounts. In other words, they either
represent assets or liabilities existing on a particular date. Excess of assets
over liabilities represent the capital and is indicative of the financial
soundness of a company.
A Balance Sheet is also described as a "Statement showing
the Sources and Applications of Capital". It is a statement and not an account
and prepared from real and personal accounts. The left hand side of the
Balance Sheet may be viewed as description of the sources from which the
business has obtained the capital with which it currently operates and the
right hand side as a description of the form in which that capital is invested
on a specified date.
Characteristics
The characteristics of a Balance Sheet are summarised as under:
(a) A Balance Sheet is only a statement and not an account. It has no
debit side or credit side. The headings of the two sides are 'Assets'
and 'Liabilities'.
(b) A Balance Sheet is prepared at a particular point of time and not for
a particular period. The information contained in the Balance Sheet
is true only at that particular point of time at which it is prepared.
(c) A Balance Sheet is a summary of balances of those ledger accounts
which have not been closed by transfer to Trading and Profit and Loss
Account.
(d) A Balance Sheet shows the nature and value of assets and the nature
and the amount of liabilities at a given date.
20
8.5.1 Classification of Assets and Liabilities
Assets
Assets are the properties possessed by a business and the
amount due to it from others. The various types of assets are :
(a) Fixed Assets
All assets which are acquired for the purpose of using them in the
conduct of business operations and not for reselling to earn profit are called
fixed assets. These assets are not readily convertible into cash in the normal
course of business operations. Examples are land and building, furniture,
machinery, etc.
(b)Current Assets
All assets which are acquired for reselling during the course of
business are to be treated as current assets. Examples are cash and bank
balances, inventory, accounts receivables, etc.
(c)Tangible Assets
These are definite assets which can be seen, touched and have volume
such as machinery, cash, stock, etc.
(d) Intangible Assets
Those assets which cannot be seen, touched and have no volume but
have value are called intangible assets. Goodwill, patents and trade marks
are examples of such assets.
(e) Fictitious Assets
Fictitious assets are not assets at all since they are not represented
by any tangible possession. They appear on the asset side simply because
of a debit balance in a particular account not yet written off e.g. provision
for discount on creditors, discount on issue of shares etc.
21
(f) Wasting Assets
Such assets as mines, quarries etc. that become exhausted or reduce
in value by their working are called wasting assets.
Liabilities
A liability is an amount which a business is legally bound to
pay. It is a claim by an outsider on the assets of a business. The liabilities
of a business concern may be classified as :
(a) Fixed Liabilities
These are those liabilities which are payable only on the
termination of the business such as capital contributed by the owner.
(b) Long Term Liabilities
The liabilities or obligations of a business which are not payable within
the next accounting period but will be payable within next five to ten years
are known as long term liabilities. Public deposits, debentures, bank loan
are the examples of long term liabilities.
(c) Current Liabilities
All short term obligations generally due and payable within one year
are current liabilities. This includes trade creditors, bills payable etc.
(d) Contingent Liabilities
A contingent liability is one which is not an actual liability but which
may become an actual one on the happening of some event which is uncertain.
Thus such liabilities have two characteristics : (a) uncertainty as to whether the
amount will be payable at all, and (b) uncertainty about the amount involved.
Examples of such liabilities are :
(a) Claims against the companies not acknowledged as debts.
(b) Uncalled liability on partly paid up shares.
(c) Arrears of fixed cumulative dividend.
(d) Estimated amount of contracts remaining to be executed on capital
account and not provided for.
22
(e) Liability of a case pending in the court.
(f) Bills of exchange, guarantees given against a particular firm or person.
8.5.2 Grouping and Marshalling of Assets and Liabilities
The arrangement of assets and liabilities in certain groups and in a
particular order is called Grouping and Marshalling of the Balance Sheet of a
business. Assets and liabilities can be arranged in the Balance Sheet into two
ways :
(i) In order of liquidity.
(ii) In order of permanence.
(i) In order of liquidity. When assets and liabilities are arranged according
to their reliability and payment preferences, such an order is called liquidity
order. Such arrangement is given in the Balance Sheet (I).
Balance Sheet (I)
Liabilities Rs. Assets Rs.
Current Liabilities : Liquid Assets :
Bills Payable Cash in Hand
Sundry Creditors Cash at Bank
Bank Overdraft Floating Assets :
Long Term Liabilities : Sundry Debtors
Loan from Bank Investments
Debentures Bill Receivable
Fixed Liabilities : Stock in Trade
Capital Prepaid Expenses
Fixed Assets :
Machinery
Building
Furniture & Fixtures
Motor Car
Fictitious Assets :
Advertisement
Misc. Expenses
Profit & Loss A/c
Intangible Assets
Goodwill
Patents
Copyright
23
(ii) In order of permanence. When the order is reversed from that what is
followed in case of liquidity, it is called order of permanence. This order is
followed in case of joint stock companies compulsorily but can be followed in
other forms of business organisations also. Fixed assets and liabilities are shown
first on the assumption that these will be sold or paid only on the insolvency of
a business. This order of Balance Sheet is given below in Balance Sheet (II).
Balance Sheet (II)
Liabilities Rs. Assets Rs.
Fixed Liabilities Intangible Assets
Long Term Liabilities Fictitious Assets
Current Liabilities Fixed Assets
Floating Assets
Liquid Assets
Illustration 3: The following balances are extracted from the books of Nikhil &
Co. on 31st March, 2002. You are required to make the necessary closing entries
and to prepare the Trading and Profit and Loss Account and a Balance Sheet as on
that date :
Rs. Rs.
Opening Stock 500 Commission (Cr.) 200
B/R 2,250 Returns Outwards 250
Purchases 19,500 Trade Expenses 100
Wages 1,400 Office Fixtures 500
Insurance 550 Cash in Hand 250
Sundry Debtors 15,000 Cash at Bank 2,375
Carriage Inwards 400 Rent & Taxes 550
Commission (Dr.) 400 Carriage Outwards 725
Interest on Capital 350 Sales 25,000
Stationary 225 Bills Payable 1,500
Returns Inwards 650 Creditors 9,825
Capital 8,950
The Closing Stock was valued at Rs. 12,500.
24
Solution :
Closing Entries
Date Particulars Dr. Cr.
Amount Amount
2002 Rs. Rs.
March 31 Trading Account Dr. 22,450
To Stock A/c 500
To Purchases A/c 19,500
To Wages A/c 1,400
To Returns Inwards A/c 650
To Carriage Inwards A/c 400
(Being balance transferred)
" Sales A/c Dr. 25,000
Returns Outwards A/c Dr. 250
To Trading Account 25,250
(Being balances transferred)
Closing Stock A/c Dr. 12,500
To Trading A/c 12,500
(Being value of closing stock)
" Trading Account Dr. 15,300
To Profit and Loss A/c 15,300
(Being gross profit transferred)
" Profit and Loss Account Dr. 2,900
To Insurance A/c 550
To Commission A/c 400
To Interest on Capital A/c 350
To Stationary A/c 225
To Trade Expenses A/c 100
To Rent and Taxes A/c 550
To Carriage Outwards A/c 725
(Being balances transferred)
" Commission A/c Dr. 200
To Profit & Loss A/c 200
(Being balance transferred)
" Profit and Loss A/c Dr. 12,600
To Capital A/c 12,600
(Being net profit transferred)
25
Trading & Profit and Loss A/c of Messers Nikhil & Co.
for the year ended 31st March, 2002
Particulars Rs. Particulars Rs.
To Opening Stock 500 By Sales 25,000
To Purchases 19,500 Less : Returns Inwards 650 24,350
Less: Returns Outwards250 19,250 By Closing Stock 12,500
To Wages 1,400
To Carriage Inwards 400
To Gross Profit c/d 15,300
36,850 36,850
To Insurance 550 By Gross Profit b/d 15,300
To Commission 400 By Commission 200
To Interest on Capital 350
To Stationary 225
To Trade Expenses 100
To Rent and Taxes 550
To Carriage Outwards 725
To Net Profit transferred to Capital A/c12,600
15,500 15,500
Balance Sheet of Messers Nikhil & Co.
as on 31st March, 2002
Liabilities Rs. Assets Rs.
Creditors 9,825 Cash in Hand 250
Bills Payable 1,500 Cash at Bank 2,375
Capital Bill Receivable 2,250
March 31, 2002
8,950 Stock 12,500
Add : Net Profit 12,600 21,550 Sundry Debtors 15,000
Office Fixtures 500
32,875 32,875
26
8.6 ADJUSTMENT ENTRIES
While preparing Trading and Profit and Loss Account one point
that must be kept in mind is that expenses and incomes for the full trading
period are to be taken into consideration. For example if an expense has
been incurred but not paid during that period, liability for the unpaid amount
should be created before the accounts can be said to show the profit or
loss. All expenses and incomes should properly be adjusted through entries.
These entries which are passed at the end of the accounting period are
called adjusting entries . Some important adjustments which are to be made
at the end of the accounting year are discussed in the following pages.
1. Closing Stock
This is the stock which remained unsold at the end of the
accounting period. Unless it is considered while preparing the Trading
Account, the gross profit shall not be correct. Adjusting entry for closing
stock is as under :
Closing Stock Account Dr.
To Trading Account
(Being closing stock brought in to books)
Treatment in final accounts
(i) Closing stock is shown on the credit side of Trading Account.
(ii) At same value it will be shown as an asset in the Balance Sheet.
2. Outstanding Expenses
Expenses which have become due and have not been paid by the
end of financial year, are called outstanding expenses.
For example, when Profit and Loss Account is being prepared on
31st March 31, 2002, it may be found that salaries for the month of March have
become due on March 31, 2002 but have not been paid till that date. This must
27
be shown on the debit side of Profit and Loss Account being prepared on March
31, 2002. The entry will be as under :
Salary account Dr.
To Outstanding salary account
(Being salary due but not paid)
Treatment in final accounts :
(i) The amount of outstanding salary shall be added to particular
expenses on the debit side of Profit and Loss Account.
(ii) In balance sheet the same amount will be shown as a liability.
3. Unexpired or Prepaid Expenses
Those expenses which have been paid in advance, i.e., whose benefit
will be available in future are called unexpired or prepaid expenses. For example,
if a fire insurance policy is taken for a year paying Rs. 1,000 as insurance
premium on Ist July, 2000 and will expire on 30th June, 2001, the position on
31st March 2001, when accounts are closed, will be that Rs. 750, i.e., premium
from Ist July, 2000 to 31st March, 2001 will be an expense but Rs. 250 i.e.,
premium from Ist April, 2001 to 30th June, 2001 will be unexpired expense. In
order to bring this into account on 31st March, 2001, the following entry will
be passed :
Prepaid Insurance Premium A/c Dr. Rs. 250
To Insurance Premium A/c Rs. 250
The two-fold effect of prepaid expenses will be :
(i) Prepaid expenses will be shown in the Profit and Loss Account by way of
deduction from the expenses and
28
(ii) These will be shown on the assets side of the Balance Sheet as prepaid
expenses. In the beginning of the next year, a reverse entry will be passed
to nullify the effect of adjusting entry.
4. Accrued Income
That income which has been earned but not received during the accounting
year is called accrued income. For example, if the business has invested Rs.
10,000 in 5% gilt edged securities on Ist April, 2001 but during the year Rs.
350 has been received as interest on securities. Then Rs. 150 interest on
securities earned and due for payment on 31st March, 2002 but not received,
will be accrued interest for the year 2001-2002. In order to bring accrued interest
into books of account, the following adjusting entry will be passed :
Accrued Interest A/c Dr. Rs. 150
To Interest A/c Rs. 150
The two-fold effect of accrued income will be :
(i) It will be shown on the credit side of Profit and Loss Account by way of
addition to the income, and
(ii) It will be shown on the assets side of the Balance Sheet as Accrued
Income.
Next year, in the beginning, a reverse entry will be passed in order to
eliminate the effect of adjusting entry and to bring the same to the correct
position.
5. Income Received in Advance
Income received but not earned during the accounting year is called as
income received in advance. For example, if building has been given to a tenant
on Rs. 2,400 per annum but during the year Rs. 3,000 has been received, then
Rs. 600 will be income received in advance. In order to bring this into books of
29
account, the following adjusting entry will be made at the end of the accounting
year :
Rent A/c Dr. Rs. 600
To Rent Received in Advance Account Rs. 600
The two-fold effect of this adjustment will be :
(i) It is shown on the credit side of Profit and Loss Account by way of
deduction from the income, and
(ii) It is shown on the liabilities side of the Balance sheet as income received
in advance.
A reverse entry will be passed at the beginning of the next year to
nullify the effect of adjusting entry.
6. Depreciation
Depreciation is the reduction in the value of fixed asset due to
its use, wear and tear or obsolescence. When an asset is used for earning
purposes, it is necessary that reduction due to its use, must be charged to
the Profit and Loss Account of that year in order to show correct profit or
loss and to show the asset at its correct value in the Balance Sheet. There
are various methods of charging depreciation on fixed assets. Suppose
machinery for Rs.10,000 is purchased on 1.1.2001, 20% p.a. is the rate of
depreciation. Then Rs.2,000 will be depreciation for the year 2001 and will
be brought into account by passing the following adjusting entry :
Depreciation A/c Dr. Rs.2,000
To Machinery A/c Rs.2,000
The two-fold effect of depreciation will be :
(i) Depreciation is shown on the debit side of Profit and Loss
Account, and
30
(ii) It is shown on the asset side of the Balance Sheet by way of
deduction from the value of concerned asset.
7. Interest on Capital
The amount of capital invested by the trader in his business is
just like a loan by the firm. Charging interest on capital is based on the
argument that if the same amount of capital were invested in some securities
elsewhere, the businessman would have received interest thereon. Such
interest on capital is not actually paid to the businessman. Interest on capital
is a gain to the businessman because it increases its capital, but it is a loss
to the business concern.
Interest is calculated on the opening balance of the capital at
the given rate for the full accounting period. If some additional amount of
capital has been brought in the business during the course of accounting
period, interest on such additional amount of capital is calculated from the
date of introduction to the end of the accounting period. The following
adjustment entry is passed for allowing interest on capital :
Interest on Capital Account Dr.
To Capital Account
Treatment in final accounts
(i) Interest allowed on capital is an expense for the business and
is debited to Profit and Loss Account, i.e. it is shown on the debit
side of the Profit and Loss Account.
(ii) Such interest is not actually paid in cash to the businessman
but added to his capital account. Hence, it is shown as an addition
to capital on the liabilities side of the Balance Sheet.
8. Interest of Drawings
It interest on capital is allowed, it is but natural that interest
on drawings should be charged from the proprietor, as drawings reduce
31
capital. Suppose during an accounting year, drawings are Rs.10,000 and
interest on drawings is Rs.500. In order to bring this into account, the
following entry will be passed :
Drawings A/c Dr. Rs.500
To Interest on Drawings A/c Rs.500
The two-fold effect of interest on drawings will be :
(i) Interest on drawings will be shown on the credit side of Profit
and Loss Account, and
(ii) Shown on the liabilities side of the Balance Sheet by way of
addition to the drawings which are ultimately deducted from the
capital.
9. Bad Debts
Debts which cannot be recovered or become irrecoverable are
called bad debts. It is a loss for the business. Such a loss is recorded in the
books by making following adjustment entry :
Bad Debts A/c Dr.
To Sundry Debtors A/c
The two-fold effect of bad debts will be that bad debts will be :
(i) Shown on the debit side of Profit and Loss Account, and
(ii) Shown on the assets side of the Balance Sheet by way of deduction from
sundry debtors.
10. Provisions for Doubtful Debts
In addition to the actual bad debts, a business unit may find on
the last day of the accounting period that certain debts are doubtful, i.e.,
the amount to be received from debtors may or may not be received. The
amount of doubtful debts is calculated either by carefully examining the
position of each debtor individually and summing up the amount of doubtful
32
debts from various debtors or it may be computed (as is usually done) on
the basis of some percentage (say 5%) of debtors at the end of the
accounting period. The percentage to be adopted is usually based upon the
past experience of the business. The reasons for making provision for
doubtful debts are two as discussed below :
(a) Loss caused by likely bad debts must be charged to the Profit and
Loss Account of the period for which credit sales have been made to
ascertain correct profit of the period.
(b) For showing the true position of realisable amount of debtors in the
Balance Sheet, i.e., provision for doubtful debts will be deducted from
the amount of debtors to be shown in the Balance Sheet.
For example, sundry debtors on 31.03.2002 are Rs.55,200.
Further bad debts are Rs.200. Provision for doubtful debts @ 5% is to be
made on debtors. In order to bring the provision for doubtful debts of
Rs.2,750, i.e., 5% on Rs.55,000 (55,200-200), the following entry will be
made :
Profit and Loss A/c Dr. Rs.2,750
To Provision for Doubtful Debts A/c Rs.2,750
It may be carefully noted that further bad debts (if any) will be
first deducted from debtors and then a fixed percentage will be applied on
the remaining debtors left after deducting further debts. It is so because
percentage is for likely bad debts and not for bad debts which have been
decided to be written off.
Treatment in final accounts
(i) The amount of provision for doubtful debts is a provision against a
possible loss so it should be debited to Profit and Loss Account.
33
(ii) The amount of provision for doubtful debts is deducted from sundry
debtors on the assets side of the Balance Sheet.
11. Provision for Discount on Debtors
It is a normal practice in business to allow discount to
customers for prompt payment and it constitutes a substantial sum.
Sometimes the goods are sold on credit to customers in one accounting
period whereas the payment of the same is received in the next accounting
period and discount is to be allowed. It is a prudent policy to charge this
expenditure (discount allowed) to the period in which sales have been made,
so a provision is created in the same manner, as in case of provision for
doubtful debts i.e.
Profit and Loss Account Dr.
To Provision for Discount on Debtors Account
Treatment in final accounts
(i) Provision for discount on debtors is a probable loss, so it should be
shown on the debit side of Profit and Loss Account.
(ii) Amount of provision for discount on debtors is deducted from sundry
debtors on the assets side of the Balance Sheet.
Note : Such provision is made on debtors after deduction of further bad
debts and provision for doubtful debts because discount is allowable to
debtors who intend to make the payment.
12. Reserve for Discount on Creditors
Prompt payments to creditors enables a businessman to earn
discount from them. When a businessman receives cash discount regularly,
he can make a provision for such discount since he is likely to receive the
discount from his creditors in the following years also. The discount
received being a profit, the provision for discount on creditors amounts to
an addition to the profit.
34
Accounting treatment of Reserve for Discount on Creditors is
just reverse of that in the case of Provision for Discount on Debtors. The
adjustment entries for Reserve for Discount on Creditors is as follows :
Reserve for Discount on Creditors Account Dr.
To Profit and Loss Account
Treatment in final accounts
i) Reserve for discount on creditors is shown on the credit side of Profit
and Loss Account.
ii) In the liabilities side of the Balance Sheet, the reserve for discount
on creditors is shown by way of deductions from Sundry Creditors.
13. Deferred Revenue Expenditure
The expenditure done in the initial stage but the benefit of which will
also be available in subsequent years is called deferred revenue expenditure.
Part of such expenditure will be written off in each year and the rest will be
capitalised. The entry for this expenditure (say advertisement Rs. 2,000 which
will be spread over 5 years) will be :
Profit and Loss A/c Dr. Rs. 400
To Advertisement A/c Rs. 400
The two-fold effect of such expenditure will be :
(i) It is shown on the debit side of Profit and Loss Account, and
(ii) It is shown on the assets side by way of deduction from capitalised
expense.
14. Loss of Stock by Fire
In business, the loss of stock may occur due to fire. The position of the
business may be :
35
(a) All the stock is fully insured.
(b) The stock is partly insured.
(c) The stock is not insured at all.
If the stock is fully insured, the whole loss (say Rs. 15,000) will
be claimed from the insurance company. The following entry will be passed :
Insurance Co. A/c Dr. Rs. 15,000
To Trading A/c Rs. 15,000
The double effect on this entry will be :
(i) It will be shown on the credit side of the Trading Account, and
(ii) It is shown on the assets side of the Balance Sheet.
If the stock is not fully insured, the loss of stock covered by
insurance policy (say Rs. 10,000) will be claimed from the insurance company
and the rest of the amount (say Rs. 5,000) will be loss for the business. The
following entry will be passed:
Insurance Co. A/c Dr. Rs. 10,000
Profit & Loss A/c Dr. Rs. 5,000
To Trading A/c Rs. 15,000
The two-fold effect of this entry will be :
(i) It will be shown on the credit side of the Trading Account with the value
of stock and shown on the debit side of the Profit and Loss Account for
that part of the stock which is not insured, and
(ii) It is shown on the assets side of the Balance Sheet with the amount which
is to be realised from the Insurance Co., i.e., that part of the loss which is
insured.
36
If the stock is not insured at all, whole of the loss (say Rs. 15,000)
will be borne by the firm. The entry for this will be :
Profit and Loss A/c Dr. Rs. 15,000
To Trading A/c Rs. 15,000
The double effect of this entry will be :
(i) It is shown on the credit side of the Trading Account, and
(ii) It is shown on the debit side of the Profit and Loss Account.
16. Goods Distributed as Free Samples
Sometimes in order to promote the sale of goods, some of the produced
goods are distributed as free samples. For example, if goods worth Rs. 2,000
are distributed as free samples then it will be an advertisement for the concern
and on other hand stock will be less by such goods. In order to bring this into
books of account, the following entry is passed :
Advertisement A/c Dr. Rs. 2,000
To Trading or Purchases A/c Rs. 2,000
The two-fold effect of this entry will be :
(i) It is shown on the credit side of the Trading Account, or deducted from
the purchases, and
(ii) It is also shown on the credit side of the Profit and Loss Account as
advertisement expenses.
Illustration 4 : From the following Trial Balance of Mr. Nitin, prepare Trading
and Profit and Loss Account for the year ending 31st March, 2002 and Balance
Sheet on that date :
37
Debit Balance Rs. Credit Balance Rs.
Drawings 14,200 Capital 85,000
Plant and Machinery 19,000 Sales 2,38,120
Stock on Ist April, 2001 29,200 Discount Received 1,200
Purchases 2,07,240 Provision for Doubtful Debts 2,100
Bills Receivable 4,800 Returns outward 5,820
Returns Inwards 4,200 Apprenticeship premiums 2,400
Cash in hand 960 Bank Overdraft 4,000
Sundry Debtors 64,000 Sundry Creditors 20,000
Bad debts 3,440 Bills Payable 3,600
Sundry Expenses 8,800
Rent 2,400
Rates and Taxes 4,000
3,62,240 3,62,240
Adjustments :
(i) Interest is charged on capital @ 5% per annum.
(ii) Provide for Doubtful Debts at 5% on sundry debtors.
(iii) Depreciation is charged on Plant and Machinery @ 10% p.a.
(iv) Outstanding Rent was Rs. 800
(v) There were prepaid taxes for Rs. 1,600.
(vi) Apprenticeship Premium Rs. 400 was to be carried forward.
(vii) The value of stock on 31st March 2001 was Rs. 34,000.
38
Solution :
Trading and Profit and Loss Account
Dr. for the year ending 31st March, 2002 Cr.
Particulars Rs. Particulars Rs.
To Opening Stock 29,200 By Sales 2,38,120
To Purchases 2,07,240 Less Returns Inwards 4,200 2,33,920
Less Returns Outwards 5,820 2,01,420 By Closing Stock 34,000
To Gross Profit c/d 37,300
2,67,920 2,67,920
To Sundry Expenses 8,800 By Gross Profit b/d 37,300
To Rent 2,400
Add O/S rent 800 3,200 By Apprenticeship Premium2,400
Less Carried forward 400 2,000
To Rates and Taxes 4,000
Less P/P rates and insurance 1,600 2,400 By Discount Received 1,200
To Depreciation on Plant & Machinery 1,900
To Provision for Bad debts :
Bad debts 3,440
Add New Provision required 3,200
6,640
Less Old Provision 2,100 4,540
To Interest on Capital 4,250
To Net Profit (Transferred to
capital account) 15,410
40,500 40,500
Balance Sheet
as on 31st March, 2002
Liabilities Rs . Assets Rs.
Capital 85,000 Plant and Machinery 19,000
Add Interest on Capital 4,250 Less Depreciation @ 10% 1,900 17,100
Add Net Profit 15,410
1,04,660 Closing Stock 34,000
Less drawings 14,200 90,460 Sundry Debtors 64,000
Bank overdraft 4,000 Less New Provision for
Sundry Creditors 20,000 Doubtful debt @ 5% 3,200 60,800
Bills Payable 3,600 Bills Receivable 4,800
Outstanding Rent 800
Apprenticeship Premium 400 Cash in hand 960
received in advance Prepaid rates and insurance 1,600
1,19,260 1,19,260
39
8.7 SUMMARY
Financial statements are the means of conveying to management, owners
and interested outsiders a concise picture of profitability and financial position
of the business. The preparation of the final accounts is not the first step in the
accounting process but they are the end products of the accounting process which
give a concise accounting information of the accounting period after the
accounting period is over. In order to know the profit or loss earned by a firm,
Trading and Profit and Loss Account is prepared. Balance Sheet will portray the
financial condition of the firm on a particular date.
8.8 KEYWORDS
Trading account: It is an account which is prepared to ascertain the gross profit
or loss of the business.
Manufacturing account: It is prepared in order to know the cost of production
of goods or services manufactured.
Profit and Loss account: The object of profit and Loss Account is to reveal
the net profit or loss of the business.
Balance sheet: A balance sheet is a statement which portrays the financial
position of the business.
Grouping and marshalling of assets and liabilities: The arrangement of
assets and liabilities in certain groups and in a particular order is called grouping
and marshalling of the balance sheet of a business.
Prepaid expenses: Those expenses which have been paid in advance i.e. whose
benefit will be available in future are called prepaid expenses.
40
8.9 SELF ASSESSMENT QUESTIONS
1. Distinguish between Trading Account and Profit & Loss Account.
Give a specimen of Trading and Profit & Loss Account with imaginary
figures.
2. What is a Balance Sheet? What do you understand by Marshalling
used in the Balance Sheet ? Illustrate the different forms of
marshalling.
3. What are closing entries. Give the closing entries which are passed
at the end of the accounting period.
4. What are adjustment entries? Why are these necessary for preparing
final account.
5. Prepare a Trading Account of a businessman for the year ending 31st
December, 1998 from the following data :
Rs.
Stock on 1.1.1998 2,40,000
Cash purchases for the year 2,08,000
Credit purchases for the year 4, 00,000
Cash sales for the year 3,50,000
Credit sales for the year 6,00,000
Purchases returns during the year 8,000
Sales returns during the year 10,000
Direct expenses incurred :
Freight 10,000
Carriage 2,000
Import Duty 8,000
Clearing Charges 12,000
Cost of goods distributed as free samples during the year 5,000
Goods withdrawn by the trader for personal use 2,000
Stock damaged by fire during the year 13,000
The cost of unsold stock on 31st December, 1998 was Rs.1,20,000
but its market value was Rs.1,50,000.
41
6. The following Trading and Profit and Loss Account has been prepared
by a junior accountant of a firm. Criticise it and redraft it correctly.,
TRADING & PROFIT AND LOSS A/c
For the year ended 31st March, 1999
Particulars Rs. Particulars Rs.
To Opening stock of raw By Closing stock of raw
material 7,352 material 9,368
To Purchases 63,681 By Sales 1,70,852
To Sundry creditors 25,375 By Sundry debtors 40,659
To Carriage inwards 2,654 By Gross Loss c/d 8,182
To Carriage outwards 394
To Salaries 24,370
To Wages 51,963
To Rent, Rates & Taxes 3,981
To Repairs to factory 35,368
To Insurance 13,923
2,29,061 2,29,061
PROFIT & LOSS ACCOUNT
Particulars Rs. Particulars Rs.
To Gross Loss b/d 8,182 By Bank overdraft 17,681
To Interest on loans 6,180 By Interest on bank 123
To Dividend from overdraft
investments 9,375 By net loss transferred 39,691
To Furniture purchases 17,681 to Balance Sheet
To Telephone charges 985
To Electric charges 2,756
To Depreciation - Plant & 663
machinery
To Charges general 11,673
57,495 57,495
42
7. On 31st March, 1997, Mr. Rohin's Debtors totalled Rs. 11,600, While
making up final accounts of his business, he created a provision of 5% on debtors
for doubtful debts. During the year ending on 31st March, 1998, actual bad debts
were Rs. 480. Sundry Debtors on 31st March, 1998 amounted to Rs. 15,000 on
which a provision of 5% was considered necessary.
Show : i) Adjusting entries for two years.
ii) Provision for Doubtful Debts Account for two years.
8. On 31st March, 2002 the following Trial Balance was extracted from
the books of Mr. Deepak Kumar :
Debit Balances Rs. Credit Balances Rs.
Sundry Debtors 20,100 Capital 28,000
Drawings 3,000 Loan On Mortgage 9,500
Bills receivable 6,882 Rent Received 250
Interest on Loan 300 Bill Payable 2,614
Cash at Bank 3,555 Discount Received 540
Motor Van 10,000 Sales 1,10,243
Stock on Ist April, 2001 6,839 Sundry Creditor 10,401
Cash in hand 2,050 Bad debts Reserve 710
Land and Building 12,000 Return Inwards 1,346
General Expenses 3,489
Advertising 3,264
Rent, Rates, Taxes and Insurance 2,891
Salaries 9,097
Bad debts 525
Purchases 66,458
Returns Inwards 7,821
Carriage Inwards 2,929
Carriage Outwards 2,404
1,63,604 1,63,604
43
Preparing Trading and Profit and Loss Account for the year ending
31st March, 2002 and Balance Sheet as on that after making following
adjustments :
(i) Closing stock is valued at Rs. 6,250
(ii) Depreciate Land and Building at 2%, Motor van at 20%
(iii) Salaries Rs. 750 and rates Rs. 350 are outstanding.
(iv) Goods costing Rs. 500 were sent to a customer on sale or return for Rs.
600.
(v) Goods costing Rs. 1,000 were taken by proprietor for private use, had
been treated as credit sales.
(vi) Prepaid insurance Rs. 150.
(vii) Provision for Bad debts is to be maintained at 5% on Debtors.
(viii) Provide interest on loan on mortgage 6% p.a. for 6 months.
(ix) Provide for manager's commission at 10% on net profits after charging
such commission.
8.10 SUGGESTED READINGS
1. R.L. Gupta, Advanced Accountancy.
2. S.N. Maheshwari, Advanced Accountancy.
3. M.C. Shukla, T.S. Grewal, Advanced Accounts.
1
Subject :Accounting for Managers Updated by:Dr. Mahesh Chand Garg
Course Code : CP-104
Lesson No. : 9
PREPARATION OF FINAL ACCOUNTS OF A JOINT STOCK
COMPANY AND ACCOUNTING PACKAGES LIKE TALLY, EX
STRUCTURE
9.0 Objective
9.1 Introduction
9.2 General Requirements of Companies Act
9.3 Form and contents of Profit and Loss Account
9.4 Profit and Loss Appropriation Account
9.5 Forms and Contents of Balance Sheet
9.6 Accounting Treatment of Special Items
9.7 Accounting Packages
9.8 Summary
9.9 Keywords
9.10 Self Assessment Questions
9.11 Suggested Readings
9.0 OBJECTIVES
You will learn from this lesson :
(a) Requirements of the Companies Act for presentation of Final Accounts of
a Company.
(b) Treatment of Special Items relating to Company Final Accounts
(c) Accounting Packages
9.1 INTRODUCTION
The joint stock companies, are legally required to prepare a set of
financial statements to periodically assess the profits earned and to know the
financial position of the company as on a specified date. Thus, like other business
2
enterprises, a limited company prepares the Income Statement and the Balance
Sheet at the close of accounting year. However, in the case of companies
registered
under the Companies Act, the Act specifies that the books of accounts be
maintained and also prescribes the format and contents in which financial
statements are to be prepared. In addition to this, the Act provides that accounts
must be audited by an external person called the auditor and the auditor has to
submit its report in the prescribed format to the shareholders.
Since the owners or shareholders elect Board of Directors to manage
company affairs and rely on the ability and skills of these directors to conduct
the business in the most profitable manner, the Companies Act tries to protect
the shareholders interest by prescribing a set of convents according to which the
financial statements are to be prepared and presented to the shareholders. The
objective of the Companies Act in laying down various provisions with regard to
accounts and audit is to ensure that adequate information is provided to the
shareholders in order for them to judge the performance of the directors during
an accounting period. The legal requirements laid down by the Companies Act
therefore, assume a great importance in the preparation of the financial statements
of a joint stock company. It is further relevant to point out here that the general
principles for the preparation of profit and loss account and balance sheet of a
company are the same as applicable to a sole proprietor/partnership business
except that in case of a company these are prepared as per the set proforma with
details as given in the Act. Whereas in case of individual proprietor or partnership
no proforma has been prescribed. In case of a company accounts, relevant
provisions of the companies law are to be taken care of.
9.1 GENERAL REQUIREMENTS OF COMPANIES ACT
Books of Accounts
Section 209 of the Companies Act prescribes for the maintenance
of books of accounts by a company. According to this section, every company
should keep at its registered office proper books of accounts with respect to :
3
(a) all sums of money received and expended by the company and the matters
in respect of which the receipt and expenditure take place
(b) all sales and purchases of goods by the company
(c) the assets and liabilities of the company.
Further, in the case of companies which are engaged in manufacturing,
production, processing or mining activities, in addition to the financial accounts
mentioned above, a set of cost accounts (if prescribed by the Central Government)
must be maintained to show the utilization of material, labour and other items of
cost.
This section also specifies that a company will not be deemed to be
maintaining proper books of accounts unless,
(i) all books necessary to give a true and fair view of the state of affairs of the
company and to explain the transactions are maintained, and
(ii) the books of accounts are maintained on accrual basis and according to the
double entry system of accounting.
Preparation of Final Accounts
From sections 210-233 of the Companies Act deal with those
provisions which have bearing on the preparation, presentation and publication of
final accounts of a company. A brief description of these provisions is as follows:
1. Section 210 deals with the preparation and presentation of the final accounts
of a company at its annual general meeting.
2. Section 211 prescribes 'form' and 'contents' of the Balance Sheet and Profit
and Loss Account.
3. Section 212 provides for disclosure of certain details in the Balance Sheet
of a holding company in respect of its subsidiaries.
4
4. Section 213 provides for the financial year of the holding company and
subsidiary company.
5. Section 214 makes provisions regarding the rights of the representatives
of the holding company to inspect books of account kept by any of its
subsidiaries.
6. Section 215 provides that the Balance Sheet and Profit and Loss Account
of a company shall be authenticated (signed) on behalf of the board of
directors by its manager or secretary, if any, and by not less than two
directors of the company, one of whom shall be a managing director, where
there is one.
7. Section 216 provides that the Profit and Loss Account shall be treated as
an annexure to the Balance Sheet and auditor's report as an enclosure thereto.
8. Section 217 provides that the report of the board of directors should be
attached to every Balance Sheet laid before the shareholders at one general
meeting.
9. Section 218 provides for penalty for improper issue, circulation or
publication of Balance Sheet or Profit and Loss Account.
10. Section 219 deals with the right of the members to copies of Balance Sheet
and Profit and Loss Account, auditor's report and every other document
required by law to be annexed or attached to the Balanced Sheet which is to
be presented in the general meeting.
11. Section 220 provides that three copies of Balance Sheet and Profit and
Loss Account have to be sent to the registrar within 30 days after an annual
general meeting.
5
12. Section 221 prescribes for giving details of the payments made to any
director or other person, any other company, body corporate, firm or person.
13. Section 222 provides that where any information which is required to be
given in the accounts and is allowed to be given in the statement annexed to
the accounts, it may be given in the board's report instead of in the account.
Such a report of the directors shall be treated as an annexure to the accounts
and the auditors shall report thereon only in so far as it gives the said
information.
14. Section 223 deals with certain companies like banking company, insurance,
company, etc. who are required as per this section, to publish a statement
in the form in Table F in Schedule I of the Companies Act.
The Companies Act further specifies the following with regard to
the annual accounts to be drawn up by a company :
(i) At every annual general meeting of the shareholders, the board of directors
of the company should lay before the shareholders, a Balance Sheet as at
the end of the accounting period which has just ended and also a Profit and
Loss Account for such accounting period.
(ii) The annual accounts of the company must be submitted in an annual general
meeting within six months counted from the last day of the accounting period
to which the accounts relate.
The periods to which the accounts relate is known as the financial
year and it may be less than, equal to or greater than 12 months but cannot exceed
15 months. Where special permission has been granted by the registrar, the
financial year may be extended to eighteen months.
6
9.3 FORM AND CONTENTS OF PROFIT AND LOSS ACCOUNT
The Companies Act, 1956, has not prescribed any standard format in
which this account is to be presented. Section 211 (2) simply states that it will
contain such information which may help in disclosing a true and fair view of the
operations of the company and shall comply with the requirements of Part II
Schedule VI so far as they are applicable thereto. The Profit and Loss Account
should also disclose every material feature, including credits or receipts and debits
or expenses in respect of non-recurring transactions or transactions of an
exceptional nature. Various items of receipts and expenses should be arranged
under the most convenient heads. The legal requirements with regard to Profit
and Loss Account are summarised below :
Revenues
With respect to revenues received by a company, the following are required to be
shown as per Part II of Schedule VI :
(a) The turnover or the aggregate amount of sales effected by the company. If
more than one class of goods have been sold by the company, then the amount
of sales in respect of each class of goods sold along with details of
quantities sold should be disclosed.
(b) In the case of companies rendering or supplying services, the gross income
derived from services rendered or supplied.
(c) Amount of income from investment distinguishing between trade
investments and other investments
(d) Other income, specifying the nature of income.
(e) Profits on investments.
7
(f) Profits (which are material in amount) in respect of transactions which are
of a kind not usually undertaken by the company or undertaken in
circumstances of an exceptional or non-recurring nature.
(g) Miscellaneous income.
(h) Dividends from subsidiary companies.
Expenses
The following are the expenses which must be disclosed in the Profit
and Loss Account :
(a) In the case of manufacturing companies, the value of the raw materials
consumed, giving item-wise break-up and the quantities consumed. While
giving this break-up, as far as possible, all important basic raw materials
should be shown as separate items. In the case of intermediates or
components procured from other manufacturers are consumed, if the number
of items are too many to be included in the break-up, then such items should
be grouped under suitable headings without mentioning the quantities.
However, all those items which in value individually account for 10 per
cent or more of the total value of the raw material consumed should be
shown distinctly in the break up with details of quantities consumed.
(b) In the case of manufacturing companies, the opening and closing stock of
goods produced, giving break-up in respect of each class of goods indicating
the quantities of each class of goods produced.
(c) In the case of trading companies, the value of purchases made and of the
opening and closing stocks. This information should be provided in respect
of each class of goods traded by the company. The quantity details should
also be provided.
8
(d) If a company is both a manufacturing and a trading company, it is sufficient
if the total amounts are shown in respect of the opening and closing stocks,
purchases, sales and consumption of raw material with value and quantity
details.
(e) In the case of companies having works in progress, the opening and closing
values of the works in progress.
(f) The amount provided for depreciation, renewals or diminution in value of
fixed assets. If no provision has been made for depreciation, this fact should
be stated and the quantum of arrears of depreciation should be disclosed by
way of a note.
(g) Consumption of stores and spare parts.
(h) Power and fuel.
(i) Repairs to buildings.
(j) Repairs to machinery.
(k) Salaries, wages and bonus.
(l) Contribution to provident fund and other funds.
(m) Workmen and staff welfare expenses.
(n) Insurance.
(o) Rates and taxes, excluding taxes on income.
(p) Miscellaneous expenses. Any item under which expenses exceed one per
cent of the total revenue of the company or Rs. 5,000, whichever is higher,
must be shown as a separate and distinct item against an appropriate account
head in the Profit and Loss Account and should not be combined with any
other item and shown under this head of 'Miscellaneous Expenses'.
9
(q) Losses on investments.
(r) Losses on transactions which are of a kind, not usually undertaken by the
company or undertaken in circumstances of an exceptional or non-recurring
nature.
(s) The amount of interest on the company's debentures and other fixed loans
stating separately the amount of interest, if any, paid or payable to the
managing director or manager.
(t) The amount of income tax payable.
(u) The aggregate amount of the dividends paid, and proposed, and stating
whether such amounts are subject to deduction of income-tax or not.
(v) Provisions for losses of subsidiary companies.
(w) Amounts reserved for repayment of share capital and repayment of loans.
(x) Any material amounts set aide to reserves, but not including provisions made
to meet any specific liability, contingency or commitment. Any material
amounts withdrawn from such reserves.
(y) Any material amounts set aside to provisions made for meeting specified
liabilities, contingencies or commitments. Any material amounts withdrawn
form such provisions, as no longer required.
In addition to the above expenses, expenses relating to sales, such as
commission paid to sole selling agents and other selling agents, brokerage and
discount on sales, other than the usual trade discount should also be shown
separately.
The amount by which any items shown in the Profit and Loss Account
are affected by any change in the basis of accounting, if material, should be
disclosed separately.
10
In respect of all items shown in the Profit and Loss Account, the
corresponding amounts for the immediately proceeding financial year should also
be given.
Notes to Profit and Loss Account
According to Part II of Schedule VI, certain information has to be
provided by way of notes to Profit and Loss Account. The information to be so
provided is outlined below :
1. The following payments provided or made during the financial year to the
directors (including managing directors or manager, if any, by the company, the
subsidiaries of the company and any other person) :
(a) Managerial remuneration paid or payable under Section 198 of the
Companies Act.
(b) Other allowances and commission including guarantee commission.
(c) Any other perquisites or benefits in cash or in kind (stating approximate
money value where practicable).
(d) Pensions.
(e) Gratuities.
(f) Payments from provident funds, in excess of own subscriptions and interest
thereon.
(g) Compensation for loss of office.
(h) Consideration in connection with retirement from office.
If commission is payable to the directors including managing director
or manager as a percentage of profits, then the notes should give a statement
showing the computation of net profit in accordance with the Act and also gives
details of the calculation of such commission.
11
2. The notes should contain detailed information with regard to amounts paid
to the auditor, whether as fees, expenses or otherwise for services rendered. These
payments should be classified into payments received by the auditor as :
(a) Auditor
(b) As adviser, or in any other capacity, in respect of
(i) taxation matters
(ii) company law matters
(iii) management services, and
(c) In any other manner.
3. In the case of manufacturing companies, the notes should give detailed
quantitative information in respect of each class of goods manufactured with
regard
to the following :
(a) The licensed capacity (where license is in force)
(b) The installed capacity and
(c) The actual production
4. The notes to the Profit and Loss Account should also contain the following
information :
(a) Value of imports calculated on C.I.F. basis by the company during the
financial year in respect of :
(i) raw materials
(ii) components and spare parts
(iii) capital goods.
12
(b) Expenditure in foreign currency during the financial year on account of
royalty, know-how, professional consultation fees, interest and other
matters.
(c) Value of all imported raw materials, spare parts and components consumed
during the financial year and the value of all indigenous raw materials, spare
parts and components similarly consumed and the percentage of each of
total consumption
(d) The amount remitted during the year in foreign currencies on account of
dividends, with a specific mention of the non-resident shareholders and the
number of shares held by them on which dividends were paid.
(e) Earnings in foreign exchange classified under the following heads, namely:
(i) Export of good calculated in F.O.B. basis
(ii) Royalty, know-how, professional and consultation fees
(iii) Interest and dividend
(iv) Other income, indicating the nature thereof.
5. The notes to the Profit and Loss Account should also contain break-up of
the expenditure incurred on employees who
(i) If employed throughout the financial year were in receipt of remuneration
for that year which in the aggregate was not less than Rs. 3,00,000 or
(ii) if employed for part of the financial year were in receipt of remuneration
for any part of that year at a rate which in the aggregate was not less than
Rs. 25,000 per month.
This note should also indicate the number of employees falling in
each of the above two categories. Usually the remuneration paid is broken up
into:
13
(a) Salaries, perquisite, etc. and
(b) Contribution to provident fund and other funds.
9.4 PROFIT AND LOSS APPROPRIATION ACCOUNT
Sometimes companies divide their income statement into three parts:
(a) Trading Account
(b) Profit and Loss Account
(c) Profit and Loss Appropriation Account
The account showing the disposal of profits is known as Profit and
Loss Appropriation Account. The balance on Profit and Loss Account is
transferred
to this Profit and Loss Appropriation Account. Profits available for dividend to
shareholders are known as divisible profits. The Directors may decide to retain a
certain amount to strengthen the companies finances. The amount retained may
take the form of transfer to various reserves and funds. It is a wise policy to keep
aside certain portion of divisible profit in the form of reserves and funds before
distributing entire divisible profits among the shareholders as dividend. Therefore,
the account which shows how the divisible profits of the company have been dealt
with is known as Profit and Loss Appropriation Account, as appropriation means
to keep aside.
The amount brought forward from the previous year is put on the
credit side together with current year's profit. On the debit side of this account,
the following items are usually found :
i) Transfer to General Reserve.
ii) Transfer to Dividend Equalisation Fund (Dividend Equalisation Fund means
a fund created out of profits available for dividend for the purpose of stable
dividend policy i.e. making the rate of dividend uniform from year to year).
iii) Transfer to Sinking Fund for Redemption of Debentures.
14
iv) Dividend (Interim/Final, paid or proposed).
v) Balance if any, carried to Balance Sheet. Therefore, this Account, generally
appears as under :
Profit and Loss Appropriation Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Bal. b/d (Dr. bal. from By Balance b/d from last year
last year if any, as per (As per Trial Balance)
Trial Balance) By Savings in the provision
To Net Loss during the year, for Taxation
if any By Net Profit during the
To General Reserve year (as per P&L A/c)
(transfer) By Transfer from Reserves,
To Dividend Equalisation if any
Fund (transfer) By Bal. c/d to Balance Sheet
To Sinking Fund for Redemption
of Debentures
To Transfer to other
Reserves & Funds
To Dividend
(Interim or Final,
Paid/ proposed)
To Balance c/d to
Balance Sheet
9.5 FORM AND CONTENTS OF BALANCE SHEET
According to Section 210 of the Companies Act, a company is
required to prepare a Balance Sheet at the end of each trading period. Section 211
requires the Balance Sheet to be set up in the prescribed form. This provision is
not applicable to banking, insurance, electricity and the other companies governed
by special Acts. The Central Government has also the power to exempt any class
of companies from compliance with the requirement of the prescribed form if it
15
deems to be in public interest. The object of prescribing the form is to elicit
proper information from the company so as to give a 'true and fair' view of the
state of the company's affairs. As a matter of fact both window dressing and
creating
secret reserves will be considered against the provisions of Section 211.
Schedule VI, Part I gives the prescribed form of a company's Balance
Sheet. Notes and instructions regarding various items have been given in brackets
below each item. It may be noted that if information required to be given under
any of the items or sub-items in the prescribed form cannot be conveniently given
on account of lack of space, it may be given in a separate schedule or schedules.
Such schedules will be annexed to and form part of the Balance Sheet.
Schedule VI, Part I permits presentation of Balance Sheet both in
horizontal as well as vertical forms. The forms with necessary notes, explanations,
etc., are given below :
16
A. HORIZONTAL FORM OF BALANCE SHEET
SCHEDULE VI, PART I
(See Section 211)Balance Sheet of ............ (Here enter the name of the company) as
on..............(Here enter the date as at which the balance sheet is made out)
Figures
Figures
Figures
Figures
for the
for the
for the
for the
previous
Liabilities
current
previous
Assets
current
year
year
year
year
Rs.
Rs.
Rs.
Rs.
(1)
(2)
(3)
(4)
(5)
(6)
Share Capital :Authorised...........Shares of Rs. ........ each
Issued :
(distinguishing between the variousclasses of capital and stating theparticulars specified
below, inrespect of each class) .... shares ofRs....... each.
Subscribed:
(distinguishing between the variousclasses of capital and stating theparticulars specified
below, inrespect of each class) .... shares ofRs....... each. Rs. ..... called up.
(Of the above shares.....shares are allotted as fullypaid up pursuant to contract without
payments beingreceived in cash)
(Of the above shares... shares are allotted as fullypaid up by way of bonus shares).
Fixed Assets :Distinguishing as far as possible betweenexpenditure upon :(a) goodwill(b)
land(c) buildings(d) leaseholds(e) railway sidings(f) plant and machinery(g) furniture and
fittings(h) development of property(i) patents, trade marks and designs(j) livestock,
and(k) vehicles, etc.(Under each head the original cost and the additionsthereto and
deductions therefrom during the year,and the total depreciation written off or
providedshall be allotted under the different asset heads anddeducted in arriving at the
value of Fixed Assets.
17
(Specify the sources from which bonus shares areissued, e.g., capitalisation of profits or
Reserves orfrom Shares Premium Account.Less :
Calls unpaid :(ii) By Directors(iii) By others
Add:
Forfeited shares :(amount originally paid up)(Any capital profit on reissue of
forfeitedshares should be transferred to CapitalReserve)
Notes :1.
Terms of redemption or conversion (if any) ofany redeemable preference capital are to
bestated together with earliest date of redemptionor conversion.
2.
Particulars of any option on unissued ShareCapital are to be specified.
3.
Particulars to the different classes of preferenceshares are to be given.These particulars
are to be given along with ShareCapital.In the case of subsidiary companies, the number
ofshares held by the holding company as well as bythe ultimate holding company and its
subsidiariesshall be separately stated in respect of SubscribedShare Capital. The auditor
is not required to certifythe correctness of such shareholdings as certifiedby the
management.Reserves and Surplus :1.
Capital Reserves
2.
Capital Redemption Reserves
In every case where the original cost cannot beascertained, without unreasonable expense
or delay,the valuation shown by the books is to be given. Forthe purpose of this
paragraph, such valuation shallbe the net amount at which an asset stood in thecompany's
books at the commencement of this Actafter deduction of the amounts previously
providedor written off for depreciation or diminution in values,and where any such asset
is sold, the amount of saleproceeds shall be shown as deduction.Where sums have been
written off on a reductionof capital or a revaluation of assets, every BalanceSheet, (after
the first Balance Sheet) subsequent tothe reduction or revaluation shall show the
reducedfigures with the date of the reduction in place of theoriginal cost.Each Balance
Sheet for the first five yearssubsequent to the date of the reduction, shall showalso the
amount of the reduction made.Similarly, where sums have been added by writingup the
assets, every Balance Sheet subsequent to such
writing up shall show the increased figures with thedate of the increase in place of the
original cost. EachBalance Sheet for the first five years subsequent tothe date of the
writing up shall also show the amountof increase made.Investments :Showing nature of
investments and mode ofvaluation, for example, cost or market value, anddistinguishing
between :1.
Investments in Government or Trust Securities.
2.
Investment in shares, debentures or bonds
(1)
(
2
)
(3)
(4)
(
5
)
(6)
18
3.
Shares Premium Account (Showing details ofits utilisation in the manner provided in
Section78 in the year of utilisation).
4.
Other reserves specifying the nature of eachReserve and the amount in respect
thereof.Less :
Debit balance in Profit and LossAccount (if any)(The debit balance in the Profit and Loss
Accountshall be shown as a deduction from the uncommittedreserves, if any)5.
Surplus, i.e. balance in Profit and Loss Accountafter providing for proposed allocations
namely;Dividend, Bonus or Reserves
6.
Proposed additions to Reserves.
7.
Sinking Funds.(Additions and deductions since last balance sheetto be shown under each
of the specified heads. Theword "funds" in relation to any "Reserve" should beused only
where such Reserve is specificallyrepresented by earmarked investments).Secured
Loans :1.
Debentures.
2.
Loans and Advances from Banks
3.
Loans and Advances from Subsidiaries.
4.
Other Loans and Advances.(Loans from directors and/or manager should beshown
separately). Interest accrued and due onSecured Loans should be included under
theappropriate sub-heads under the head "SecuredLoans".
(Showing separately shares fully paid up and partlypaid up and also distinguishing the
different classesof shares and showing also in similar detailsinvestment in shares,
debentures or bonds ofsubsidiary companies).3.
Immovable properties
4.
Investments in the capital of partnership firms(Aggregate amount of company's
quotedinvestments and also the market value thereof shallbe shown).(Aggregate amount
of company's unquotedinvestment shall also be shown).Current Assets, Loans and
Advances :(A) Current Assets :1.
Interest Accrued on Investments.
2.
Stores and Spare Parts.
3.
Loose Tools
4.
Stock-in-Trade
5.
Work-in-Progress[In respect of (2) and (4), mode of valuation ofstock shall be stated and
the amount in respect ofraw materials shall also be stated separately wherepracticable.
Mode of valuation of work-in-progressshall be stated].6.
Sundry Debtors
(a)
Debts Outstanding for a period exceeding sixmonths.(b)
Other DebtsLess : Provision(The amounts to be shown under Sundry Debtorsshall
include the amounts due in respect of goods
(1)
(2)
(3)
(4)
(
5
)
(6)
19
The nature of security to be specified in each case.Where loans have been guaranteed by
managers and/ordirectors a mention thereof shall also be made and alsothe aggregate
amount of such loans under each head.In case of Debentures, terms of redemption or
conversion(if any) are to be stated together with earliest date ofredemption or
conversion.Unsecured Loans :1.
Fixed Deposits
2.
Loans and Advances from Subsidiaries
3.
Short Term Loans and Advances :
(a) From Banks
(b) From Others(Short term loans include those which are due forrepayment not later
than one year as at the date of balancesheet).4.
Other Loans and Advances :(a) From Banks
(b) From Others(Loans from directors and/or manager should be shownseparately.Interest
accrued and due on Unsecured Loans should beincluded under the appropriate sub-head
under the head"Unsecured Loans".Where Loans have been guaranteed by manager,
and/ordirectors, a mention thereof shall also be made togetherwith the aggregate amount
of such loans under such head.This does not apply to Fixed Deposits).Current
Liabilities and Provisions :A. Correct Liabilities1.
Acceptances.
2.
Sundry Creditors
3
.
Subsidiary Companies
4.
Advance payments and unexpired discounts for theportion for which value has still to be
given, i.e., in thecase of the following companies :Newspapers, Fire Insurance,
Thereatres, Clubs,Banking, Steamship companies, etc.
sold or services r
endered or in respect of othercontractual obligations but shall not include the amountswhich
are in the nature of loans or adv
ances).In regard to sundry debtors particulars to be givenseparately of :(
a)
debts considered good and in respect of which thecompany is fully secured;
(b)
debts considered good for which the company holdsno security other than the debtor's
personal security;and
(
c)
debts considered doubtful or bad.Debts due by directors or other officers of the companyor
any of them either severally or jointly with any otherperson or debts due by firms or private
companiesrespectively in which any director is a partner or adirector or a member to be
separately stated.Debts due from other companies under the samemanagement within the
meaning of sub-section(IB) ofSection 370 to be disclosed with the names of thecompanies.
The maximum amount due by directors orother officers of the company at any time during
theyear to be shown by way of a note.The Provision to be shown under this head should
notexceed the amount of debts stated to be considereddoubtful or bad and any surplus of such
Provision, ifalready created, should be shown at every closing under"Reserves and Surplus"
(in the Liabilities side) under aseparate sub-head "Reserve for Doubtful or BadDebts".7A.
Cash balance on hand.
7B.
Bank Balance :(a) with Scheduled Banks.(b) with others.(In regard to Bank balances
particulars to be givenseparately of :(a) the balances lying with Scheduled Banks on
currentaccounts, call accounts and deposit accounts(b)
the names of the bankers other than ScheduledBanks and the balances lying with each such
banker oncurrent account, call account and deposit account andthe maximum amount
outstanding at any time during theyear with each such banker; and
(1)
(2)
(3)
(4)
(5
)
(6)
20
5.
Unclaimed Dividends.
6.
Other Liabilities (if any).
7.
Interest accrued but not due on loans.B. Provisions8.
Provision for Taxation.
9.
Proposed Dividends.
10.
For Contingencies.
11
.
For Provident Fund Scheme.
12.
For Insurance, pension and similar staff benefitschemes.
13.
Other provisions.A foot-note to the balance sheet may be added to showseparately :
1.
Claims against the company not acknowledged asdebts.
2.
Uncalled liability on shares partly paid.
3.
Arrears of fixed cumulative dividends.(The period for which the dividends are in arrears
or ifthere is more than one class of shares, the dividends oneach such class that are in
arrears shall be started. Theamount shall be stated before deduction of income-tax,except
that in the case of tax-free dividends the amountshall be shown free of income-tax and
the fact that it is soshown shall be stated).4.
Estimated amount of contracts remaining to beexecuted on capital account and not
provided for.
5.
Other moneys for which the company is contingentlyliable.The amount of any guarantees
given by the company onbehalf of directors or other officers of the company shallbe
stated and where practicable, the general nature andamount of each such contingent
liability, if material shall
also be specified.
(c)
the nature of the interest, if any, of any director orhis relative in each of the bankers
(other thanScheduled Banks referred to in (b) above)).(B) Loans and Advances :8.
(a)
Advances and loans to subsidiaries.
(b)
Advances and loans to partnership firm inwhich the company or any of its subsidiariesis a
partner.
9.
Bills of Exchange.
10.
Advances recoverable in cash or in kind or forvalue to be received, e.g., Rates, Taxes,
Insurance,
etc.
11.
Balances with Customs, Port Trust, etc. (where
payable on demand).[The instructions regarding Sundry Debtors applyto "Loans and
Advances" also. The amounts duefrom other companies under the same
managementwithin the meaning of sub-section (IB) of Section370 should also be given
with the names ofcompanies; the maximum amount due from everyone of these at any
time during the year must besown].Miscellaneous Expenditure(to the extent not written
off or adjusted).1.
Preliminary expenses.
2.
Expenses including commission or brokerage orunder-writing or subscription of shares
ordebentures.
3.
Discount allowed on the issue of shares or debentures.
4.
Interest paid out of capital during construction (alsostating the rate of interest).
5.
Development expenditure not adjusted.
6.
Others sums (specifying nature).Profit and Loss Account(Show here the debit balance
of Profit and LossAccount carried forward after deduction of theuncommitted reserves, if
any).
(1)
(2)
(3)
(4)
(
5)
(6)
21
Notes :
1. Paise can also be given in addition to Rupees, if desired.
2. Dividends declared by subsidiary companies after the date of the Balance Sheet
should not be included unless they are in respect of a period which closed on or
before the date of the Balance Sheet.
3. Any reference to benefits expected from contracts to the extent not executed
shall
not be made in the Balance Sheet but shall be made in the Board's report.
4. Particulars of any redeemed debentures which the company has power to issue
should be given.
5. Where any of the company's debentures are held by a nominee or a trustee for
the
company, the nominal amount of the debentures and the amount at which they are
stated in the books of the company shall be stated.
6. A statement of investments (whether shown under "Investments" or under
"Current
Assets" as Stock-in-Trade) separately classifying trade investments and other
investments should be annexed to the Balance Sheet, showing the names of the
bodies corporate (including separately the names of the bodies corporate under the
same management) in whose shares or debentures, investments have been made
(including all investments whether existing or not, made subsequent to the date as
at which the previous Balance Sheet was made out) and the nature and extent of
the
investments so made in each such body corporate; provided that in the case of an
investment company, that is to say, a company whose principal business is the
acquisition of shares, stock, debentures or other securities, it shall be sufficient if
the statement shows only the investments existing on the date as at which the
Balance
22
Sheet has been made out. In regard to the investments in the capital of partnership
firms, the names of the firms (with the names of all their partners, total capital and
the shares of each partner) shall be given in the statement.
7. If, in the opinion of the Board, any of the current assets, loans and advances
have
not a value on realisation in the ordinary course of business at least equal to the
amount at which they are stated, the fact that the Board is of that opinion shall be
stated.
8. Except in the case of the first Balance Sheet laid before the company after the
commencement of the Act, the corresponding amounts of the immediately
preceding
financial year for all items shown in the Balance Sheet shall be also given in the
Balance Sheet. The requirements in this behalf shall in case of companies
preparing
quarterly or half-yearly accounts, etc., relate to the Balance Sheet for the
corresponding date in the previous year.
9. Current accounts with Directors and Manager, whether they are in credit or
debit,
shall be shown separately.
10. The information required to be given under any of the items or sub-items in the
Form, if it cannot be conveniently included in the Balance Sheet itself, shall be
furnished in a separate Schedule or Schedules to the annexed to and form part of
the Balance Sheet. This is recommended when items are numerous.
11. Where the original cost of fixed assets and additions and deductions thereto,
relate
to any fixed asset which has been acquired from a country outside India, and in
consequence of a change in the rate of exchange at any time after the acquisition
of
such assets, there has been an increase or reduction in the liability of the company,
as expressed in India currency, for making payment towards the whole or a part of
23
the cost of the asset, or for repayment of the whole or a part of moneys borrowed
by the company from any person, directly or indirectly, in any foreign currency
specifically for the purpose of acquiring the asset (being in either case the liability
existing immediately before the date on which the change in the rate of exchange
takes effect), the amount by which the liability is so increased or reduced during
the year, shall be added to, or as the case may be, deducted from the cost, and the
amount arrived at after such addition or deduction shall be taken to be the cost of
the fixed assets.
Explanation 1: This paragraph shall apply in relation to all Balance Sheets that
may be
made out as at the 6th day of June, 1966, or any day thereafter and where, at the
date of
issue of the notification of the Government of India, in the Ministry of Industrial
Development and Company Affairs (Department of Company Affairs), G.S.R. No.
129,
dated the 3rd day of January, 1968, any Balance Sheet in relation to which the
paragraph
applies, has already been made out and laid before the company in annual general
meeting,
the adjustment referred to in this paragraph may be made in the first Balance Sheet
made
out after the issue of the said notification.
Explanation 2 : In this paragraph, unless the context otherwise requires, the
expressions
"rate of exchange", "foreign currency" shall have the meanings respectively
assigned to
them under sub-section (1) of section 43A of the Income Tax Act, 1961 (43 of
1961), and
Explanation 2 and Explanation 3 of the said sub-section shall, as far as may be,
apply in
relation to the said paragraph as they apply to the said sub-section (1).
24
B. VERTICAL FORM
Name of the Company ................
Balance Sheet as at .....................
Schedule Figures as at the Figures as at the
No. end of current end of previous
financial year financial year
(1) (2) (3) (4)
1. Sources of Funds
(1) Shareholders funds :
(a) Capital
(b) Reserves and surplus
(2) Loans funds :
(a) Secured loans
(b) Unsecured loans
Total
II Application of Funds
(1) Fixed assets :
(a) Gross block
(b) Less : depreciation
(c) Net block
(d) Capital work-in-progress
(2) Investments
(3) Current assets, loans and advances:
(a) Inventories
(b) Sundry debtors
(c) Cash and bank balances
(d) Other current assets
(e) Loans and advances
Less : Current Liabilities & provisions
(a) Liabilities
(b) Provisions
Net current assets
(4) (a) Miscellaneous Expenditure to the
extent not written off or adjusted
(b) Profit and Loss Account
Total
25
Notes :
1. Details under each of the items in Vertical Balance Sheet shall be given in
separate
Schedules. The Schedules shall incorporate all the information required to be
given under A-Horizontal Form read with notes containing general instructions
of preparation of Balance Sheet.
2. The Schedules referred to above, accounting policies and explanatory notes that
may be attached shall form an integral part of the Balance Sheet.
3. The figures in the Balance Sheet may be rounded off to the nearest '000 or '00
as may be convenient or may be expressed in terms of decimals of thousands.
4. A footnote to the Balance Sheet may he added to show separately contingent
liabilities.
In India, a joint stock company can prepare its Balance Sheet either in
horizontal or vertical form. Of the two forms of the Balance Sheet, vertical form is
a
better form because it speaks out the correlation of every item with the other items
and coveys more meaning to the layman.
Abridged Balance Sheet
As an economy device, the Companies (Amendment) Act, 1988 introduced
the concept of Abridged Balance Sheet vide Section 219(1) (b) (iv). As per this
provisions, the companies need not send the detailed Balance Sheet together with
many
schedules and reports to shareholders and may send only the abridged Balance
Sheet,
Profit and Loss Account, Directors's Report and Auditors' Report as annual report.
Numerous schedules to the Balance Sheet and detailed statements need not be a
part
of the annual report. However, SEBI has prescribed that a detailed Balance Sheet
has to
be furnished in the case of listed companies.
26
9.6 ACCOUNTING TREATMENT OF SPECIAL ITEMS
In addition to the provisions and general principles prescribed for the
preparation of financial statements of a company, there are some items which
require
specific accounting treatment.
1. Interest on Debentures
Debentures interest is a business expenses and therefore, it is a charge
against profit and as such Profit and Loss Account is debited with the total amount
of
interest payable during the accounting year whether the company has earned the
profit
or not.
2. Discount on the Issue of Debentures
Discount or costs, e.g. commission, brokerage, etc. incurred on the issue
of debentures should normally be written off as early as possible but in no case
later
than the date of redemption. The unwritten balance will be shown in the Balance
Sheet
under Miscellaneous expenditure on the asset side.
3. Preliminary Expenses
Such expenses include the costs of formation of a company and since
their amount is usually large, it is not desirable to write off them in one year.
Instated
preliminary expenses are spread over a number of years and Profit and Loss
Account
is debited with certain fraction every year. The unwritten amount is shown under
Miscellaneous Expenditures on the asset side of the Balance Sheet.
4. Call-in-Arrears
This item represents the amount not paid by the shareholders on the calls
made on them by the company. If this item is given in the trial balance, it is shown
in
the Balance Sheet on the liabilities side as a deduction from the called up amount
under the main head of share capital. But if this item is given outside the trial
balance
as an adjustment, it would mean that the trial balance shows only the paid up
capital and
27
not called up capital. The amount of call-in-arrears is then added to the paid up
capital
to make the later as called up capital and then deducted again.
5. Calls-in Advance
It is a debt on the company until the calls are made and the amount
received in advance is adjusted. A company may also pay interest on calls-in-
advance
and the rate of interest is usually stated in the articles. It should be treated as a
current
liability and shown under the heading current liabilities and provisions.
6. Auditors Payments
Payments made to auditors for auditing the accounts and for doing any
other work for the company should be mentioned separately.
7. Managerial Remuneration
The remuneration paid to managerial personal (e.g. directors, managing
directors or manager) of a company in any form or made is charge against profits
and
thus shown in the debit side of the Profit and Loss Account. The mode of payment
of
the remuneration may include the fee for attending the meetings of the Board,
monthly
salary, a fixed percentage of profit and so on.
The Companies Act has imposed severe restrictions on the managerial
remuneration payable by a public company or a private company which is a
subsidiary
of a public company.
Section 198(i) provides that the total managerial remuneration in respect
of any year is subject to an overall limit of 11 per cent of the net profits of the
company
in that year.
8. Dividends
Dividends may be defined as the share of profits that is payable to each
shareholder of the company. The Companies Act lays down that dividends can be
paid
out of profits only and prohibits the payment of any dividend out of capital. Also,
28
dividends shall be paid in cash only. A company may pay dividends from any or
all of
the three following sources :
(I) profits of the current year
(II) undisturbed profits of previous years
(III) moneys provided by the Central or any State Government for the payment of
dividends in pursuance of a guarantee given by the Government concerned.
A dividend once declared, becomes a debt. Dividend is paid out of profits
on paid-up capital of the company. Calls-in-Advance cannot be treated as part of
paid
up capital for declaration of dividends.
(a) Proposed Dividend : The dividend recommended by the directors is termed as
"Proposed Dividend". Unless otherwise stated, the dividend at given rate is
calculated
on paid-up capital and it is (amount of proposed dividend) is debited to Profit and
Loss
Appropriation Account and shown on the liability side of the Balance Sheet under
the
heading "Provisions".
(b) Interim Dividend : An Interim Dividend is a dividend paid by the directors at
any
time between two annual general meetings. It is always debited to Profit and Loss
Appropriation Account. The interim dividend is usually paid for a period of six
months.
Its calculation depends upon the language of the rate of dividend.
The directors may recommend another dividend when the final figures
of profits are available. Such dividend is known as final dividend. When final
dividend
is declared, interim dividend is not adjusted unless the resolution specifies
otherwise.
(c) Unclaimed Dividend : Dividend declared but not claimed by some shareholders
for some reason, such amount of dividend (not claimed) is known as "Unclaimed
Dividend". It is always shown on the liability side of the Balance Sheet under the
heading
"Current Liabilities".
29
Illustration-1 : The Steamship Company Limited has an Authorised Capital of
1,50,000
Equity Shares of Rs. 100 each. The following balances have been extracted on
31st
March, 2002 from the books of the company :
Rs. Rs.
Subscribed Capital 1,00,00,000 Dividend Equalisation Reserve 21,00,000
Steamers at cost 1,31,00,000 Provision for Doubtful Debts 2,62,000
Purchase of S.S. Jalaganga Unclaimed Dividends 89,250
on 1.10.2001 40,75,000 Sundry Creditors 9,93,500
Furniture and Fittings less Final Call unpaid on 2,500 shares 62,500
Depreciation Rs. 36,000 1,42,500 Stock of Provision, Stores,Coal etc. 3,58,000
Unexpired Insurance 1,88,250 Investments (at cost in shares of
General Reserve 26,00,000 Companies) 8,54,000
Steamer's Purchase Reserve 8,02,500 Dividend accrued on the above 22,500
Provisions and Stores 26,03,000 Voyage Receipts 1,11,89,450
Coal 31,89,000 Steamer's Depreciation Account 37,00,000
Book Debts of which Dividend from Investments 78,900
Rs. 2,87,500 are doubtful 16,59,000 Profit and Loss Account
Loan to Directors 75,000 (Credit Balance) 1,29,000
Miscellaneous Voyage Expenses 31,51,000 Cash and Bank
Expenses of Management 16,04,000 Balances 8,60,850
You are required to prepare the Profit and Loss Account and the Balance Sheet of
the Company in a form which complies with the requirements of the Companies
Act, after
taking the following information into consideration and after necessary
assumptions :
1. The Articles of Association of the Company provide as under :
(a) Depreciation at the rate of 6% should be charged to the Profit and Loss
Account on the original cost of steamers owned by the Company;
(b) Surplus, if any, over the book value of a steamer on realisation should be
provided for;
(c) In the event of inadequacy of profits, Dividend Equalisation Reserve should
be made use of to the extent it is necessary to make good the deficiency in
the proposed amount of dividend.
2. S.S. Jalbharat was acquired at a cost of Rs. 35,00,000 on 1.8.1999. It met with
an
accident on 1.12.2001 and proved a total loss. The underwriters have agreed to
settle the claim for Rs. 17,50,000.
3. The Equity shares on which the final call was unpaid were forfeited by the
Board
during the year and have not been reissued.
30
4. Furniture is to be depreciated a ten per cent on original cost.
5. In the Profit and Loss Account of the year 1999-2000, a provision of Rs.
1,25,000
was made in respect of a claim for damages. This claim was settled in December,
2001 for Rs. 89,000 and the balance of the provision is included in the item
"Sundry
Creditors".
6. The directors propose to pay a dividend of Rs.5 per share, subject to deduction
of
tax.
Solution :
Profit and Loss Account of the Steamship Company Ltd.
Dr. for the year ending 31st March, 2002 Cr.
Rs. Rs.
To Coal Consumed 31,89,000 By Voyage Receipts 1,11,89,450
To Provision and Stores 26,03,000 By Dividend from Investments 78,900
To Miscellaneous Voyage Expenses 31,51,000 By Net Loss c/d 14,47,000
To Expenses of Management 16,04,000
To Depreciation :
Steamers 8,20,500
Furniture and Fittings 17,850
8,38,350
To Loss on S.S. Jalbharat
destroyed in an accident (1) 13,30,000
1,27,15,350 1,27,15,350
To Net Loss b/d 14,47,000 By Balance b/d from previous year 1,29,000
To Proposed Dividend @ Rs. 5 per By Provision for claim no longer
share on 97,500 shares 4,87,500 required (1,25,000-89,000) 36,000
By Transfer from Dividend
Equalisation Reserve 3,22,500
By Balance carried to the Balance Sheet 14,47,000
19,34,500 19,34,500
31
Working Notes :
(1) Loss on S.S. Jalbharat destroyed in an accident has been calculated as follows :
Rs.
Cost of S.S. Jalbharat purchased in 1999-2000 35,00,000
Less : Depreciation for 2 years (1999-2000 & 2000-2001) @ 6% on original cost
4,20,000
Book value on 1.4.2001 30,80,000
Less : Claim admitted by the underwriters 17,50,000
Loss 13,30,000
Balance Sheet of Steamship Company Limited
as on 31st March, 2001
Rs. Rs.
Share Capital– as per Schedule A 99,37,500 Fixed Assets– as per Schedule D 96,99,150
Reserve and Surplus–as per Schedule B 37,33,000 Investment–Share at Cost 8,54,000
Current Liabilities and Provisions– Current Assets, Loans and Advances
as per Schedule C 15,34,250 as per Schedule E 46,51,600
1,52,04,750 1,52,04,750
SCHEDULES FORMING PART OF THE BALANCE SHEET
Schedule A : Share Capital
Authorised : 1,50,000 Equity Shares of Rs. 100 each 1,50,00,000
Issued : 1,00,000 Equity Shares of Rs. 100 each 1,00,00,000
Subscribed : 97,500 (1,00,000–2,500 shares forfeited) Equity
Shares of Rs. 100 each fully paid up 97,50,000
Add : Forfeited Shares (Amount received on 2,500 shares forfeited) 1,87,500
99,37,500
Schedule B : Reserves and Surplus
Rs Rs.
Steamers' Purchase Reserve 8,02,500
General Reserve : Balance on 1.4.2001 26,00,000
Less : Debit Balance of Profit and Loss Account 14,47,000 11,53,000
Dividend Equalisation Reserve : Balance on 1.4.2001 21,00,000
Less : Transfer Profit and Loss Account 3,22,500 17,77,500
37,33,000
32
Schedule D : Fixed Assets
Cost
Depreciation
Assets
Cost upto
Addition
Cost of
Cost
Depreciation
On assets
During
Upto
Net Book
31.3.2001
During
Assets
upto
upto
sold or destroyed
the year
31.3.2002
Value
2001-2002
sold or
31.3.2002
31.3.2001
upto 31.3.2001
2001-02
destroyed
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Steamers
1,31,00,000
40,75,000
35,00,000
1,36,75,000
37,00,000
4,20,000
8,20,500
41,00,500
95,74,500
Furniture
1,78,500
–
–
1,78,500
36,000
–
17,850
53,850
1,24,650
andFittings
1,32,78,500
40,75,000
35,00,000
1,38,53,500
37,36,000
4,20,000
8,38,350
41,54,350
96,99,150
33
Schedule C : Current Liabilities and Provisions
Rs. Rs.
Current Liabilities :
Sundry Creditors (Less claim of Rs. 36,000 no longer required) 9,57,500
Unclaimed Dividends 89,250 10,46,750
Provisions :
Proposed Dividend 4,87,500
15,34,250
Schedule E : Current Assets, Loans and Advances
Rs. Rs.
A. Current Assets :
Accrued Dividends on Investments 22,500
Stock of Provisions, Stores, Coals etc. 3,58,000
Book Debts (Unsecured-assumed) :
More than 6 months (assumed) 2,50,000
Others (assumed) 14,09,000
16,59,000
Less : Provision for Bad Debts 2,62,000 13,97,000
Debts Considered Good 13,71,500
Debts Considered Doubtful 2,87,500
16,59,000
Cash and Bank Balance : 8,60,850
B. Loans and Advances : 26,38,350
Claim Due from Underwriters 17,50,000
Loans to Directors 75,000
Prepaid Insurance 1,88,250 20,13,250
46,51,600
34
9.7 ACCOUNTING PACKAGES
Since mid-seventies, there has been an incredible change in the way people
work and do business. One of the most significant contributors to this change is
the large
scale acceptance of computers. Computers have also made place in the area of
accounting.
Nowadays, there are financial accounting softwares that are used to store and
maintain
daily business transactions like purchase, sales, receipts, payments, purchase
returns, sales
returns, deposits and withdrawals etc.
Tally
Tally is the number one financial accounting package in India and is also
used abroad. With Tally you could be the owner, the financial controller,
accountant, manager,
auditor or anyone connected with accounts. Tally is a popular software because:
1. It is user friendly and can be used even by everyone giving you full control over
every aspect of your business accounting.
2. No more wait for day-ends to have a quick look of the financial status of your
Business/Firms. Tally provide instant results.
3. Do more memorisation of codes for accounts, Debtors and Creditors.
4. It is flexible and can be customised to suit your daily work schedules and needs
like
Customising Vouchers, Balance Sheets etc.
5. Highly secured against data tempering. Different labels of security designed
with
different privileges to access and use the data.
6. Help features to bail you out from any confusion.
35
Ex
Ex is a financial accounting software and is a product of Tata Consultancy
Services. There are two products under Ex
a) Ex Personal Accountant
b) Ex Next Generation
a) Ex Personal Accountant : Ex Personal Accountant is a new re-engineered
accounting software that helps keep track of every aspect of a business at a pick of
mouse
and keeps pace with changing business needs. It is a fully functional business
accounting
software. It is simple, easy to use, goes online in seconds and requires no support
at all. It
is designed to run on Windows 95/98/NT and above.
Features :
1. Ready templates for individuals, traders and manufacturers.
2. Fully support multi-company accounting.
3. Stock management - allows the user to generate Stock Statements and Stock
Valuation
Reports.
4. Generic document facility yet flexible enough to match various invoicing needs.
5. Do exhaustive reports designed in consultation with chartered accountants to
meet
statutory and business requirements.
6. Quick information retrieval of any customers/supplies.
7. Smart Finder – An easy to use tool for adhoc queries.
8. Data Export – Supports export of selected reports to MS Word and MS
Excelallows
you to create your own report formats.
36
9. Full support for dot matrix printing apart from support for laserjet/deskjet
through
windows.
b) Ex Next Generation : Ex Next Generation is comprehensive business
accounting
software with document designer and extensive reporting capabilities perfect for
medium
sized businesses. For larger corporations with higher volume requirements, the
robust,
reliable and extendable accounting solution is - the Ex Next Generation 1.5 Multi
User on
SQL Server 7.0 TM.
Features :
1. Easy to use Graphical User Interface
2. Security at the individual activity level – Different passwords can be set for
various
activities.
3. Layout designing of various documents
4. Code-Less Accounting
5. Multi-Company Accounting
6. Smart Finder facility for Ledgers and other documents
7. Monitoring of receivables and payables
8. Stock valuation
– Two methods are used i.e.Weighted Average method and Moving Weighted
Average Method
9. Company accounts Consolidation Facility
10. OLE Automation Support
11. 32 bit Open Database Connectivity (ODBC)
37
9.8 SUMMARY
Final accounts, as we know, are prepared to show business profit over a period
of time and to reveal the business position (financial) at a point of time. A
company, like
any other forms of business organisation, has also to prepare its final accounts
every year.
Preparation of final accounts is compulsory for a company. The Companies Act
has made
it obligatory for every limited company to prepare, present and publish its final
accounts
every year, in order to protect and safeguard the interest of the Owners. Section
209 and
Section 210 deal with the provisions of preparation of final accounts for a
company. Section
209 makes it compulsory for a company to keep certain books of account and
Section 210
governs the preparation of the final accounts.
9.9 KEYWORDS
Revenue: Revenue is the monetary expression of the aggregate of products or
services
transferred by an enterprise to its customers during a period of time.
Profit and loss appropriation account: The account showing the disposal of
profits is
known as profit and loss appropriation account.
Dividend: Dividends may be defined as the share of profits that is payable to each
shareholder of the company.
Deferred revenue expenditure: When a huge amount is spent on the expense and
its
effect is to last for a long time, it is called a deferred revenue expenditures.
9.10 SELF ASSESSMENT QUESTIONS
1. "Every Balance Sheet of Company shall give a true and fair view of the state of
affairs of the company as at the end of the financial year and shall subject to the
provision of Section 211 of the Companies Act, be in the form set out in Part I of
Schedule VI......."
Amplify and give the form of Balance Sheet.
38
2. What are the various heads under which profits are usually appropriated by
companies
and for what reason?
3. The authorised capital of X Limited is Rs. 5,00,000 consisting of 2,000 6%
preference shares of Rs. 100 each and 30,000 equity shares of Rs. 10 each. The
following
was the Trial Balance of X Limited as on 31.3.2000 :
TRIAL BALANCE
as on 31.3.2000
Dr. Cr.
Rs. Rs.
Investment in shares at cost 50,000
Purchases 4,90,500
Selling expenses 79,100
Stock on 1.4.1999 1,45,200
Salaries and wages 52,000
Cash on hand 12,000
Interim preference dividend for the half year to 30.9.99 6,000
Discount on issue of Debentures 2,000
Preliminary expenses 1,000
Bills receivable 41,500
Interest on Bank Overdraft 7,800
Interest on Debentures upto 30.9.99 3,750
Sundry Debtors and Creditors 50,100 87,850
Freehold property at cost 3,50,000
Furniture at cost less Depreciation of Rs. 15,000 35,000
6% Preference share capital 2,00,000
Equity share capital fully paid up 2,00,000
5% Mortgage Debentures secured on freehold properties 1,50,000
Income Tax paid in advance for 1999-2000 10,000
Dividends 4,250
39
Profit and Loss A/c (1.4.1999) 28,500
Sales (Net) 6,70,350
Bank Overdraft secured by hypothecation of stocks and receivables 1,50,000
Technical know-how fees at cost paid during the year 1,50,000
Audit fees 5,000
14,90,950 14,90,950
You are required to prepare the Profit and Loss Account for the year ended
31.3.2000
and the Balance Sheet as on that date after taking into account the following :
(a) Closing stock was valued at Rs. 1,42,500
(b) Purchases include Rs. 5,000 worth of goods and articles distributed among
valued customers.
(c) Salaries and wages include Rs. 2,000 being wages incurred for installation
of electrical fittings which were recorded under "Furniture".
(d) Bills receivable include Rs. 1,500 being dishonoured bills, 50% of which
had been consider irrecoverable.
(e) Bills receivable of Rs. 2,000 maturing after 31.3.2000 were discounted.
(f) Depreciation on furniture is to be charged at 10% on written down value.
(g) Rs. 1,000 of Discount on issue of Debentures to be written off.
(h) Interest on debentures for the half year ending on 31.3.2000 was due on that
date.
(i) Provide provision for taxation Rs. 4,000.
(j) Technical know how fees is to be written off over a period of 10 years. Rs.
500 of preliminary expenses to be written off.
(k) Salaries and wages include Rs. 10,000 being the Directors' remuneration.
(l) Sundry Debtors include Rs. 6,000 debts due for more than six months.
1
Subject : Accounting for Managers Updated by: Dr. M.C. Garg
Course Code : CP-104
Lesson : 10
COST ACCOUNTING : Nature and Scope
STRUCTURE
10.0 Objective
10.1 Introduction
10.2 Meaning and Nature of Cost Accountancy
10.3 Scope of Costing
10.4 Cost Accounting Vs Financial Accounting
10.5 Cost Accounting Vs. Management Accounting
10.6 Usefulness of Cost Accounting to Managers
10.7 Methods of Costing
10.8 Techniques of Costing
10.9 Concept of Cost
10.10 Cost Centre and Cost Unit
10.11 Cost Concepts
10.12 Classification of Cost
10.13 Components of Total Cost
10.14 Cost Sheet
10.15 Summary
10.16 Keywords
10.17 Self Assessment Questions
10.18 Suggested Readings
10.0 OBJECTIVE
After reading this lesson students must be able
(i) to understand meaning, nature, scope and usefulness of costing
accountancy
(ii) to differentiate and classify the various cost concepts and
(iii) to prepare cost sheets
10.1 INTRODUCTION
In the modern business world, the nature and functioning of business
organizations have become very complicated. They have to serve the needs of
variety of parties who are interested in the functioning of the business. These
2
parties constitute the owners, creditors, employees, government agencies, tax
authorities, prospective investors, and last but not the least the management
of the business. The business has to serve the needs of these different category
of people by way of supplying various information from time to time. In order
to satisfy the needs of all these group of people a sound organization of
accounting system is very essential. In the ancient days the information required
by those who were interested with a business organization was met by practising
a system of accounting known as financial accounting system. Financial
accounting is mainly concerned with preparation of two important statements,
viz., income statement (or profit and loss account) and positional statement
(or Balance sheet). This information served the needs of all those who are not
directly associated with management of business. Thus financial accounts are
concerned with external reporting as it provides information to external
authorities. But management of every business organization is interested to
know much more than the usual information supplied to outsiders. In order to
carry out its functions of planning, decision-making and control, it requires
additional cost data. The financial accounts to some extent fails to provide
required cost data to management and hence a new system of accounting which
could provide internal report to management was conceived of.
10.2 MEANING AND NATURE OF COST ACCOUNTANCY
Cost accountancy is a wide term. It means and includes the principles,
conventions, techniques and systems which are employed in a business to plan
and control the utilization of its resources. It is defined as "the application of
costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived therefrom for the purposes
of managerial decision making"–C.I.M.A. London.
Cost accountancy is thus the science, art and practice of a cost accountant. It
is a science in the sense that it is a body of systematic knowledge which a cost
accountant should possess for the proper discharge of his duties and
responsibilities. It is an art as it requires the ability and skill on the part of a
cost accountant in applying the principles of cost accountancy to various
managerial problems like price fixation, cost control, etc. Practice refers to
constant efforts on the part of cost accountant in the field of cost accountancy.
The theoretical knowledge alone would not enable a cost accountant, to deal
with the intricacies, he should have sufficient practical training.
Cost accountancy includes several subjects. These are costing,
cost accounting, cost control and cost audit. These are described below :
3
Costing : Costing refers to the process of cost finding. It is defined as "the
technique and process of ascertaining costs". It has also been defined as "the
classifying, recording and appropriate allocation of expenditure for the
determination of costs, the relation of these costs to sales value and the
ascertainment of profitability. Thus costing consists of principles and rules
which are used for determining : (a) the cost of manufacturing a product like
chemical, television, etc. and (b) the cost of providing a service, i.e., electricity,
transport, etc.
Cost Accounting : Cost accounting is a system by means of which costs of
products or services are ascertained and controlled. It is defined as "the
application of accounting and costing principles, methods and techniques in
the ascertainment of costs and the analysis of savings and/or excesses as
compared with previous experience or with standards".
Thus, whereas costing is simply cost finding, which can be carried out by means
of memorandum statements, arithmetic process etc., cost accounting denotes
the formal accounting mechanism by means of which costs are ascertained. In
simple words, costing means finding out the cost of something, and cost
accounting means costing using double entry book keeping methods as a basis
for ascertainment of costs. However, cost accounting and costing are often
used interchangeably.
Cost Control : Cost control is the function of keeping costs within prescribed
limits. In other words, cost control is compelling actual costs to conform to
planned costs. Amongst the various techniques used for cost control, the two
most popular are budgetary control and standard costing. These will be
discussed in detail in lessons 13 and 14 respectively.
Cost Audit : Cost audit is the specific application of auditing principles and
procedures in the fields of cost accounting. It is defined as the verification of
cost accounts and a check on the adherence to the cost accounting plan. It has
thus two functions - (a) to verify that the cost accounts have been correctly
maintained and compiled, and (b) to check that principles laid down have been
properly followed.
10.3 SCOPE OF COSTING
Cost accounting is not applicable only to manufacturing concerns. Its
applications are in fact much wider. All types of activities, manufacturing and
non-manufacturing, in which monetary value is involved, should consider the
use of cost accounting. Wholesale and retail businesses, banking and insurance
companies, railways, airways, shipping and road transport companies, hotels,
hospitals, schools, colleges and universities, all may employ cost accounting
4
techniques to operate efficiently. It is only a matter of recognition by the
management of the applicability of these concepts and techniques in their own
fields of endeavour.
10.4 COST ACCOUNTING VS. FINANCIAL ACCOUNTING
Financial accounting, as pointed out previously, is concerned with recording,
classifying and summarizing financial transactions pertaining to an accounting
period. The basic objective is to provide a commentary to the shareholders
and outside parties on the financial status of an enterprise in the form of a
profit and loss account and balance sheet. The profit or loss of business
operations is revealed through these statements year after year, observing the
statutory requirements of the Companies Act, 1956.
Cost accounting, on the other hand, aims at providing prompt cost data for
managerial planning, controlling and decision making. It offers a complete
explanation as to how the scarce inputs are put to use in business. The sources
of efficiency or inefficiency are revealed through periodic reports. The profit
or loss relating to each job, department or product can also be found out easily.
The following table 10.1 tries to draw the curtain between financial accounting
and cost accounting :
Basis of Financial Accounting Cost Accounting
distinction
Statutory These accounts have to be prepared Maintenance of these accounts
Requirements pared according to the legal requirements is voluntary except in certain
of Companies Act and Income Tax Act industries where it has been
made obligatory to keep
cost records
under the Companies Act.
Purpose The main purpose of financial accounting The main purpose of cost
is to prepare profit and loss account and accounting is to provide detailed
balance sheet for reporting to owners and cost information to management
and outside agencies i.e., external users i.e., internal users.
Analysis of Financial accounts reveal the profit or Cost accounts show the detailed
cost and loss of the business as a whole during cost and profit data for each
Profit a particular period. It does not show product line, department,
the figures of cost and profit for individual process etc.
products, departments and processes, etc.
Periodicity Profit and Loss Account and Cost reporting is a continuous
of Reporting Balance Sheet are prepared process and may be daily,
periodically, usually on an annual weekly, monthly, etc.
basis.
5
Control It keeps records of financial It is used as a detailed
aspect transactions and does not attach system of controls. It takes
any importance to control the help of certain special
aspect. techniques like standard
costing and budgetary control.
Nature It is concerned with historical records. Cost accounting does not end
The historical nature of financial with what has happened in the
accounting can be easily understood past. It extends to plans and
in the context of the purposes for policies to improve performance
which it was designed. in the future.
Nature of General purpose statements like Profit It generates special purpose
statements and Loss Account and Balance Sheet statements and reports like
prepared are prepared by it. Report of Loss of Materials,
Report That is to say that financial accounting Idle Times Report, Variance Report
must produce information that is used by etc. Cost accounting identifies
many classes of people none of whom the user, discusses his problems
have explicitly defined information needs. and needs and provides
tailored information.
Classification Financial accounting classifies records Cost accounting records and
of and analyses transactions in subjective classifies expenditure according
Records manner i.e. according to nature of to the purpose for which cost is
expenditure. incurred.
10.5 COST ACCOUNTING Vs MANAGEMENT ACCOUNTING
Cost accounting and management accounting are both internal to an
organisation. Both have, more or less, the same objective of assisting
management in its planning, decision making etc. It is not worthwhile to
distinguish the two inter-related disciplines as two branches of accounting.
Consider what experts opine in this regard.
Dobson : Management accounting is so broad and comprehensive that it includes
both financial and cost accounting.
C.T. Horngren : Cost accounting is management accounting plus a small part
of financial accounting.
It is because of the overlapping nature of the two in many areas, that everyone
talks of cost and management accounting as a single discipline. However, some
distinctions can be drawn thus :
6
Table10.2: Distinction between Cost Accounting and Management
Accounting
Point of distinction Cost accounting Management accounting
Coverage It deals with ascertainment, It is concerned with the
allocation, distribution and impact and effect aspects
accounting aspects of costs of costs.
Position in the Cost accountant is generally Management accountant
hierarchy placed at a lower level of assumes a superior
hierarchy than a management level in the management
accountant. hierarchy.
Approach Narrow, as the focus is Wider, as one may have
primarily on cost data to use certain economic
and statistical data along
with costing data to assist
managerial decision
making.
Emphasis It lays emphasis on cost It is used as a decision
ascertainment and cost making technique.
control.
Scope The scope of cost accounting It Makes use of other
is limited to important techniques like funds
techniques like variable flow, ratio analysis,
costing, break-even cash flow etc. in
analysis and standard costing. addition to variable
costing, break-even
analysis and standard
costing. This includes
financial accounting,
tax planning and tax accounting.
Focus It focuses on short It focuses on short
term planning. range and long range
Sophisticated tools not planning and uses
employed for forecasting sophisticated technique
purposes. in the planning and control
process.
Orientation It deals with data supplied Futuristic in orientation,
by financial accounting, is more predictive in
orientation is not futuristic. nature than cost
accounting.
7
Evolution The evolution of cost It draws heavily on cost
accounting is mainly due to data and other information
the limitations of financial derived from cost accounting
accounting. It is merely an extension
of the managerial aspects of
cost accounting.
Purpose Its main purpose is to report Its main objective is to
current and prospective costs of provide all accounting
product, service, department, information relevant for use
job or process in formulation of policies,
planning, controlling,
decision making etc. to
ensure maximum profits.
10.6 USEFULNESS OF COST ACCOUNTING TO MANAGERS
The shortcomings inherent in financial accounting have made the management
to realise the importance of cost accounting. Whatever may be the type of
business, it involves expenditure on labour, materials and other items required
for manufacturing and disposing of the product. Moreover, big business requires
delegation of responsibility, division of labour and specialisation. Management
has to avoid the possibility of waste at each stage. Management has to ensure
that no machine remains idle, efficient labour gets due initiative, proper
utilisation of by-products is made and costs are properly ascertained. Besides
management, creditors and employees are also benefited in numerous ways by
installation of a good costing system in an industrial organisation. Cost
accounting increases the overall productivity of an industrial establishment
and, therefore, serves as an important tool in bringing prosperity to the nation.
The various advantages derived by managements on account of a good costing
system can be put as follows :
1. Useful in periods of depression and competition: During trade
depression the business cannot afford to have leakages which pass unchecked.
The management should know where economies may be sought, waste
eliminated and efficiency increased. The business has to wage a war for its
survival. The management should know the actual cost of their products before
embarking on any scheme of reducing the prices or giving tenders. Costing
system facilitates this.
2. Helps in pricing decisions : Though economic law of supply and
demand and activities of the competitors, to a great extent, determine the price
8
of the article, cost to the producer does play an important part. The producer
can take necessary guidance from his costing records.
3. Helps in estimates : Adequate costing records provide a reliable basis
upon which tenders and estimates may be prepared. The chances of losing a
contract on account of over-rating or the loss in the execution of a contract
due to under-rating can be minimised. Thus, "ascertained costs provide a
measure for estimates, a guide to policy, and a control over current production.
4. Cost Accounting helps in channelising production on right lines :
Costing makes possible for the management to distinguish between profitable
and non-profitable activities. Profits can be maximised by concentrating or
profitable operations and eliminating non-profitable ones.
5. Helps in reducing wastage :As it is possible to know the cost of the
article at every stage, it becomes possible to check various forms of waste,
such as of time, expense etc., or in the use of machinery, equipment and tools.
6. Costing makes comparison possible : If the costing records are
regularly kept, comparative cost data for different periods and various volumes
of production will be available. It will help the management in forming future
lines of action.
7. Provides data for periodical profit and loss accounts : Adequate
costing records supply to the management such data as may be necessary for
preparation of profit and loss account and balance sheet, at such intervals as
may be desired by the management. It also explains in detail the sources of
profit or loss revealed by the financial accounts, thus helps in presentation of
better information before the management.
8. Costing results into increased efficiency : Losses due to wastage of
materials, idle time of workers, poor supervision etc. will be disclosed if the
various operations involved in manufacturing a product are studied by a cost
accountant. The efficiency can be measured and costs controlled and through
it various devices can be framed to increase the efficiency.
9. Costing helps in inventory control and cost reduction : Costing
furnishes control which management requires in respect of stock of materials,
work-in-progress and finished goods. Costs can be reduced in the long-run
when alternates are tried. This is particularly important in the present-day
content of global competition. Cost accounting has assumed special
significance beyond cost control this way.
9
10. Helps in increasing productivity : Productivity of material and labour
is required to be increased to have growth and more profitability in the
organisation. Costing renders great assistance in measuring productivity and
suggest ways to improve it.
10.7 METHODS OF COSTING
The basic principles of ascertaining costs are the same in every system of cost
accounting. However, the methods of analysing and presenting the cost may
vary from industry to industry. The method to be used in collecting and
presenting costs will depend upon the nature of production. Basically there
are two methods of costing, namely. Job costing and Process costing.
Job costing : Job costing is used where production is not repetitive and is
done against orders. The work is usually carried out within the factory. Each
job is treated as a distinct unit, and related costs are recorded separately. This
type of costing is suitable to printers, machine tool manufacturers, job
foundries, furniture manufactures etc. The following methods are commonly
associated with job costing :
Batch costing : Where the cost of a group of product is ascertained, it is
called 'batch costing'. In this case a batch of similar products is treated as a
job. Costs are collected according to batch order number and the total cost is
divided by the numbers in a batch to find the unit cost of each product. Batch
costing is generally followed in general engineering factories which produce
components in convenient batches, biscuit factories, bakeries and
pharmaceutical industries.
Contract costing : A contract is a big job and, hence, takes a longer time to
complete. For each individual contract, account is kept to record related
expenses in a separate manner. It is usually followed by concerns involved in
construction work e.g. building roads, bridge and buildings etc.
Process Costing : Where an article has to undergo distinct processes before
completion, it is often desirable to find out the cost of that article at each
process. A separate account for each process is opened and all expenses are
charged thereon. The cost of the product at each stage is, thus, accounted for.
The output of one process becomes the input to the next process. Hence, the
process cost per unit in different processes is added to find out the total cost
per unit at the end. Process costing is often found in such industries as
chemicals, oil, textiles, plastics, paints, rubber, food processors, flour, glass,
cement, mining and meat packing. The following methods are used in process
costing :
10
Output/Unit Costing : This method is followed by concerns producing a single
article or a few articles which are identical and capable of being expressed in
simple, quantitative units. This is used in industries like mines, quarries, oil
drilling, cement works, breweries, brick works etc. for example, a tonne of
coal in collieries, one thousand bricks in brick works etc. The object here is
to find out the cost per unit of output and the cost of each item of such cost. A
cost sheet is prepared for a definite period. The cost per unit is calculated by
dividing the total expenditure incurred during a given period by the number of
units produced during the same period.
Operating Costing : This method is applicable where services are rendered
rather than goods produced. The procedure is same as in the case of unit
costing. The total expenses of the operation are divided by the units and cost
per unit of service is arrived at. This is followed in transport undertakings,
municipalities, hospitals, hotels etc.
Multiple Costing : Some products are so complex that no single system of
costing is applicable. Where a concern manufactures a number of components
to be assembled into a complete article, no one method would be suitable, as
each component differs from the other in respect of materials and the
manufacturing process. In such cases, it is necessary to find out the cost of
each component and also the final product by combining the various methods
discussed above. This type of costing is followed to cost such products as
radios, aeroplanes, cycles, watches, machine tools, refrigerators, electric
motors etc.
Operating Costing : In this method each operation at each stage of production
or process is separately identified and costed. The procedure is somewhat
similar to the one followed in process costing. Process costing involves the
costing of large areas of activity whereas operation costing is confined to every
minute operation of each process. This method is followed in industries with a
continuous flow of work, producing articles of a standard nature, and which
pass through several distinct operations in a sequence to completion. Since
this method provides for a minute analysis of cost, it ensures greater accuracy
and better control of costs. The costs of each operation per unit and cost per
unit upto each stage of operation can be calculated quite easily. This method is
in force in industries where toys, leather and engineering goods are
manufactured.
Departmental Costing : When costs are ascertained department by
department, such a method is called 'departmental costing'. Where the factory
is divided into a number of departments, this method is followed. The total
11
cost of each department is ascertained and divided by the total units produced
in that department in order to obtain the cost per unit. This method is followed
by departmental stores, publishing houses etc.
10.8 TECHNIQUES OF COSTING
In addition to the different costing methods, various techniques are also used
to find the costs. These techniques may be grouped under the following heads:
Historical Absorption Costing : It is the ascertainment of costs after they
have been incurred. It is defined as the practice of charging all costs, both
variable and fixed, to operations, process or products. It is also known as
traditional costing. Since costs are ascertained after they have been incurred,
it does not help in exercising control over costs. However, It is useful in
submitting tenders, preparing job estimates etc.
Marginal Costing : It refers to the ascertainment of costs by differentiating
between fixed costs and variable costs. In this technique fixed costs are not
treated as product costs. They are recovered from the contribution (the
difference between sales and variable cost of sales). The marginal or variable
cost of sales includes direct material, direct wages, direct expenses and variable
overhead. This technique helps management in taking important policy
decisions such as product pricing in times of competition, whether to make
or not, selection of product mix etc.
Differential Costing : Differential cost is the difference in total cost between
alternatives evaluated to assist decision making. This technique draws the
curtain between variable costs and fixed costs. It takes into consideration fixed
costs also (unlike marginal costing) for decision making under certain
circumstances. This technique considers all the revenue and cost differences
amongst the alternative courses of action to assist management in arriving at
an appropriate decision.
Standard Costing : It refers to the ascertainment and use of standard costs
and the measurement and analysis of variances. Standard cost is a predetermined
cost which is computed in advance of production on the basis of a specification
of all factors affecting costs. The standards are fixed for each element of
cost. To find out variances, the standard costs are compared with actual costs.
The variances are investigated later on and wherever necessary, rectificational
steps are initiated promptly. The technique helps in measuring the efficiency
of operations from time to time.
Practical Difficulties in Installing Costing System : Apart from technical
costing problems, a cost accountant is confronted with certain practical
12
difficulties in installing a costing system. These are :
1. Lack of support of management : In order to make the costing system
a success, it must have the whole-hearted support of every member of the
management. Many a time, the costing system is introduced at the behest of
the Managing Director or the Financial Director without the support of
functional managers. They view the system as an interference in their work
and do not make use of the system.
Before the system is installed, the cost accountant should ensure that the
management is fully committed to the costing system. A sense of cost
consciousness should be created in their minds by explaining them that the
system is for their benefit. A cost manual should be prepared and distributed
to them giving the details and functions of the system.
2. Resistance from the accounting staff : The existing accounting staff
may not welcome the new system. This may be because they look with
suspicion at a system which is not known to them. The co-operation of the
employees should be sought by convincing them that the system is needed to
supplement the financial accounting system and that it is for the betterment of
all.
3. Noncooperation of Working and Supervisory Staff : Correct activity
data which is supplied by supervisory staff and workers is necessary for a
costing system. They may not co-operate and resist the additional paper work
arising as a result of the introduction of the system. Such resistance generally
arises out of ignorance. Proper education should be given to the staff regarding
benefits of the system and the important roles they have to play to make it
successful.
4. Shortage of Trained Staff : In the initial stages, there may be shortage
of trained costing staff. The staff should be properly trained so that costing
department can run efficiently.
10.9 CONCEPT OF COST
The scope of term 'cost' is extremely broad and general. It is therefore, not
easy to define or explain this term without leaving any doubt concerning its
meaning. Cost accountants, economists and others develop the concept of cost
according to their needs. This concept should, therefore, be studied in relation
to its purpose and use. Some of the definitions of 'cost' are reproduced below:
Cost is "the amount of expenditure (actual or notional) incurred on or
attributable to a given thing". (C.I.M.A. London). Cost is "an exchange price, a
13
foregoing, a sacrifice made to secure benefit". (A tentative set of Broad
Accounting Principles for Business Enterprises).
Cost should be distinguished from expenses and losses though in practice the
terms cost and expenses are sometimes used synonymously. An expense is
defined as including "all expired costs which are deductible from revenue".
When a portion of the service potential of an asset is consumed, that portion
of its cost is re-classified as an expense.
10.10 COST CENTRE AND COST UNIT
Cost is ascertained by cost centres or cost units or by both. The terms are
discussed below :
Cost Centre : A cost centre is "a location, person, or item of equipment or
group of these for which costs may be ascertained and used for the purpose of
control". Thus, a cost centre refers to a section of the business to which costs
can be charged. It may be a location (a department, a sales area), an item of
equipment (a machine, a delivery van), a person (a salesman, a machine
operator) or a group of these (two automatic machines operated by one
workman).
A cost centre is primarily of two types :
(a) Personal cost centre–which consists of a person or a group of persons.
(b) Impersonal cost centre– which consists of a location or an item of
equipment or group of these.
From functional point of view, cost centres may be of the following two types:
(a) Production cost centre–those cost centres where actual production work
takes place. Examples are melting shop, machine shop, welding shop, finishing
shop, etc.
(b) Service cost centre– those cost centres which are ancillary to and render
services to production cost centres. Examples of service cost centres are power
house, tool room, stores department, repair shop, canteen, etc. Cost incurred
in service cost centres are of indirect type.
Cost accountant sets up cost centres to enable him to ascertain the costs the
needs to know. A cost centre is charged with all the costs that relate to it, eg..
if a cost centre is a machine, it will be charged with the costs of power, light,
depreciation and its share of rent etc. The purpose of ascertaining the cost of
a cost centre is cost control. The person incharge of a cost centre is held
responsible for the control of cost of that centre.
14
The number of cost centres and the size of each vary from one undertaking to
another. It all depends upon the expenditure involved and requirements of the
management of the purpose of cost control. A large number of cost centres
tend to be expensive but having too few cost centres defeat the very purpose
of control.
Cost Unit : It has been seen above that cost centres help in ascertaining the
costs by location, equipment or person. Cost unit is a step further which breaks
up the cost into smaller sub-divisions and helps in ascertaining the cost of
saleable products or services.
A cost unit is a "unit of product, service or time in relation to which cost may be
ascertained or expressed", (C.I.M.A. London). Cost units are the 'things' that the
business is set up to provide of which cost is ascertained. For example, in a
sugar mill, the cost per tonne of sugar may be ascertained, in a textile mill the
cost per-metre of cloth may be ascertained. Thus a tonne of sugar and 'metre' of
cloth are cost units. In short, cost unit is unit of measurement of cost.
All sorts of cost units are adopted, the criterion for adoption being the
applicability of particular cost unit to the circumstances under consideration.
Broadly, cost unit may be :
(i) Units of production, e.g. a metre of cloth, a ream of paper, a tonne of
steel, a metre of cable, etc. or
(ii) Units of service , e.g. passenger miles, cinema seats, consulting hours etc.
A few more examples of cost units in various Industries are given below :
Industry Cost Unit
Bricks 1000 bricks
Cement Tonne
Chemicals Tonne, kilogram, litre, gallon, etc.
Carpets Square foot
Pencils Dozen or gross
Electricity Kilowatt hour (KWH)
Transport Passenger kilometer or tonne kilometre
Printing Press Thousand copies
Cotton or jute Bale
Timber Cubic foot
Mines Tonne
Hotel Room per day
Shoes Pair or dozen pairs
15
Note : The cost units and cost centres should be those which are readily
understood and accepted by all concerned.
10.11 COST CONCEPTS
The clear understanding of various cost concepts is essential for
the study of cost accounting and cost systems. Description of these concepts
follows now.
Product and period costs - The product cost is aggregate of costs that are
associated with a unit of product. Such costs may or may not include an element
of overheads depending upon the type of costing system in force- absorption
or direct. Product costs are related to goods produced or purchased for resale
and are initially identifiable as part of inventory. These product or inventory
costs become expenses in the form of cost of goods sold only when the
inventory is sold. Product cost is associated with unit of output. The costs of
inputs in forming the product viz., the direct material, direct labour, factory
overhead constitute the product costs.
The period cost is a cost that tends to be unaffected by changes in level of
activity during a given period of time. Period cost is associated with a time
period rather than manufacturing activity and these costs are deducted as
expenses during the current period without having been previously classified
as product costs. Selling and distribution costs are period costs and are
deducted from the revenue without their being regarded as part of the inventory
cost.
Common and joint costs : The common cost is an indirect cost that is incurred
for the general benefit of a number of departments or for the whole enterprise
and which is necessary for present and future operations. The joint costs are
the cost of either a single process or a series of processes that simultaneously
produce two or more products of significant relative sales value.
Short-run and long-run costs : The short-run costs are costs that vary with
output when fixed plant and capital equipment remain the same and become
relevant when a firm has to decide whether or not to produce more in the
immediate future. The long-run-costs are those which vary with output when
all input factors including plant and equipment vary and become relevant when
the firm has to decide whether to set up a new plant or to expand the existing
one.
Past and future cost : The past costs are actual costs incurred in the past and
are generally contained in the financial accounts. These costs report past events
and the time lag between event and its reporting makes the information out of
16
date and irrelevant for decision-making. These costs will just act as a guide
for future course of action.
The future costs are costs expected to be incurred at a later date and are the
only costs that matter for managerial decisions because they are subject to
management control. Future costs are relevant for managerial decision making
in cost control, profit projections, appraisal of capital expenditure,
introduction of new products, expansion programmes and pricing etc.
Controllable and non-controllable costs :The concept of responsibility
accounting leads directly to the classification of costs as controllable or
uncontrollable. The controllable cost is a cost chargeable to a budget or cost
centre, which can be influenced by the actions of the person in whom control
the centre is vested. It is always not possible to predetermine responsibility,
because the reason for deviation from expected performance may only become
evident later. For example excessive scrap may arise from inadequate
supervision or from latent defect in purchased material. The controllable cost
is a cost that can be influenced and regulated during a given time span by the
actions of a particular individual within an organisation.
The controllability of cost depends upon the level of responsibility under
consideration. Direct costs are generally controllable by the shop level
management. The uncontrollable cost is a cost that is beyond the control (i.e.
uninfluenced by actions) of a given individual during a given period of time.
The distinction between controllable and uncontrollable costs are not very sharp
and may be left to individual judgement. Some expenditure which may be
uncontrollable on the short-term basis can be controllable on long-term basis,
There are certain costs which are really difficult to control due to the following
reasons.
* Physical hazards arising due to flood, fire, strike, lockout etc.
* Economic risks such as increased competition, change in fashion or
model, higher prices of inputs, import restrictions, etc.
* Political risk like change in Government policy, political unrests, war
etc.
* Technological risk such as change in design, know-how etc.
Replacement and Historical Costs : The Replacement costs and Historical
costs are two methods for carrying assets in the balance sheet and establishing
the amounts of costs that are used to determine income.
17
The Replacement cost is a cost at which material identical to that is to be
replaced could be purchased at the date of valuation (as distinct from actual
cost price at the date of purchase). The replacement cost is a cost of replacing
an asset at any given point of time either at present or the future (excluding
any element attributable to improvement).
The Historical cost is the actual cost, determined after the event. Historical
cost valuation states costs of plant and materials, for example, at the price
originally paid for them whereas replacement cost valuation states the costs at
prices that would have to be paid currently. Costs reported by conventional
financial accounts are based on historical valuations. But during periods of
changing price level, historical costs may not be correct basis for projecting
future costs. Naturally historical costs must be adjusted to reflect current or
future price levels.
Out of pocket and Book Costs : The out of pocket cost is a cost that will
necessitate a corresponding outflow of cash. The costs involving cash outlay
or payment to other parties are termed as out of pocket costs. Book costs are
those which do not require current cash payments. Depreciation, is a notional
cost in which no cash transaction is involved. The distinction between out of
pocket costs and book costs primarily shows how costs affect the cash position.
Out of pocket costs are relevant in some decision making problems such as
fluctuation of prices during recession, make or buy decisions etc. Book costs
can be converted into out of pocket costs by selling the assets and having item
on hire. Rent would then replace depreciation and interest.
Imputed and Sunk Costs : The imputed cost is a cost which does not involve
actual cash outlay, which are used only for the purpose of decision making and
performance evaluation. Imputed cost is a hypothetical cost from the point of
view of financial accounting. Interest on capital is common type of imputed
cost. No actual payment of interest is made but the basic concept is that, had
the funds been invested elsewhere they would have earned interest.
Thus, imputed costs are a type of opportunity costs.
The Sunk costs are those costs that have been invested in a project and which
will not be recovered if the project is terminated. The sunk cost is one for
which the expenditure has taken place in the past. This cost is not affected by
a particular decision under consideration. Sunk costs are always results of
decisions taken in the past. This cost cannot be changed by any decision in
future. Investment in plant and machinery as soon as it is installed its cost is
sunk cost and is not relevant for decisions. Amortization of past expenses e.g.
depreciation is sunk cost. Sunk costs will remain the same irrespective of the
18
alternative selected. Thus, it need not be considered by the management in
evaluating the alternatives as it is common to all of them. It is important to
observe that an unavoidable cost may not be a sunk cost. The Managing
Director's salary is generally unavoidable and also out of pocket but not sunk
cost.
Relevant and Irrelevant Costs : The relevant cost is a cost appropriate in
aiding to make specific management decisions. Business decisions involve
planning for future and consideration of several alternative courses of action.
In this process the costs which are affected by the decisions are future costs.
Such costs are called relevant costs because they are pertinent to the decisions
in hand. The cost is said to be relevant if it helps the manager in taking a right
decision in furtherance of the company's objectives.
Opportunity and Incremental Costs : The opportunity cost is the value of a
benefit sacrificed in favour of an alternative course of action. It is the maximum
amount that could be obtained at any given point of time if a resource was sold
or put to the most valuable alternative use that would be practicable. The
opportunity cost of a good or service is measured in terms of revenue which
could have been earned by employing that good or service in some other
alternative uses. Opportunity cost can be defined as the revenue forgone by
not making the best alternative use. Opportunity cost is the prospective change
in cost following the adoption of an alternative machine process, raw materials
etc. It is the cost of opportunity lost by diversion of an input factor from use
to another.
The Incremental cost is the extra cost of taking one course of action rather
than another. It is also called as different cost. The incremental cost is the
additional cost due to a change in the level of nature of business activity. The
change may take several forms e.g., changing the channel of distribution, adding
a new machine, replacing a machine by a better machine, execution of export
order etc. Incremental costs will be different in case of different alternatives.
Hence, incremental costs are relevant to the management in the analysis for
decision making.
Marginal cost : The marginal cost is the variable cost of one unit of a product
or a service i.e., a cost which would be avoided if the unit was not produced or
provided. In this context a unit in usually either a single article or a standard
measure such as litre or kilogram, but may in certain circumstances be an
operation, process or part of an organisation. The marginal cost is 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. The marginal costing
19
technique is the process of ascertaining marginal costs and of the effects of
changes in volume of type of output on profit by differentiating between fixed
and variable costs.
Notional cost : The notional cost is a hypothetical cost taken into account in
a particular situation to represent the benefit enjoyed by an entity in respect
of which no actual expense is incurred.
10.12 CLASSIFICATION OF COST
The process of grouping costs according to their common characteristics is
called classification of cost. It is a systematic placement of like items together
according to their common features. The followings are the important ways of
classifying costs.
A) Classification According to Functions : This is a traditional
classification. A business has to perform a number of functions like
manufacturing, administration, selling, distribution and research. Cost may have
to be ascertained for each of these functions. On this basis, costs are classified
into the following groups :
(i) Manufacturing cost : This is the cost of the sequence of operations
which begins with supplying materials, labour and services and ends with
completion of production.
(ii) Administration cost : This is general administrative cost and includes
all expenditure incurred in formulating the policy, directing the organisation
and controlling the operations of an undertaking, which is not directly related
to production, selling and distribution, research and development activity or
function.
(iii) Selling and distribution costs : Selling cost is the cost of seeking to
create and simulating demand and of securing orders.
Distribution cost is the cost of sequence of operations which
begins with making the packed product available for despatch and ends with
making the reconditioned returned empty package for re-use. The various items
included in manufacturing administrative, selling and distribution costs are
available in Table 10.3
20
Table 10.3
Functional Classification of Costs
Manufacturing Costs
Materials
Labour
Factory rent
Depreciation
Power & lighting
Insurance
Stores Keeping
Administration Costs
Accounts office expenses
Audit fees
Legal expenses
Office rent
Director's remuneration
Postage
(iv) Research and development cost : Research cost is the cost of
searching new or improved products or methods. It comprises wages and
salaries of research staff, payments to outside research organisations, materials
used in laboratories and research departments, etc.
After completion of research, the management may decide to produce a new
improved product or to employ a new or improved method. Development cost
is the cost of the process which begins with the implementation of the decision
to produce a new product or to employ a new or improved method and ends
with the commencement of formal production of that product or by that method.
Pre-production cost is that part of the development cost which is incurred in
making in trial production run preliminary to formal production.
B) Classification based on cost behaviour : Depending on the variability
behaviour costs can be classified into variable and fixed costs.
(a) Variable cost : The variable cost is a cost that tends to vary in accordance
with level of activity within the relevant range and within a given period of
time. The Prime product costs i.e., direct material, direct labour and direct
expenses tend to vary in direct proportion to the level of activity. An increase
in the volume means a proportionate increase in the total variable costs and a
decrease in volume will lead to a proportionate decline in the total variable
Selling Costs
Advertising
Salaries & Commissions of salesmen
Showroom expenses
Samples
Travel expenses
Distribution Costs
Packing costs
Carriage outward
Warehousing costs
Upkeep and running costs of delivery vans
21
costs. There is a linear relationship between volume and variable costs. They
are constant per unit.
Variable costs have an explicit physical relationship with a selected measure
of activity and exists an optimum cause and effect relationship between the
input and output. Therefore variable costs are also known as engineered costs.
All variable costs are not engineered costs. Some of the variable components
which are termed as discretionary variable costs and such costs will vary with
fluctuations in the levels of activity merely because of the policy of the
management. The variable element of research and development or
advertisement costs, which are discretionary by nature may increase with
increased activity and management may decide to spend more in periods of
increased activity.
(b) Fixed cost : The fixed cost is a cost that tends to be unaffected by
changes in the level of activity during a given period of time. The fixed costs
remain constant in the total regardless of changes in volume upto a certain
level of output. They are not affected by changes in the volume of production.
There is an inverse relationship between volume and fixed cost per unit. Fixed
costs tend to remain constant for all levels of activity within a certain range. It
follows that some fixed costs will continue to be incurred even when the activity
comes down to nil. Some fixed costs are liable to change from one period to
another. For example salaries bill may go up because of annual increments or
due to change in the pay rates and due to pay structure.
(c) Semi-variable cost or semi-fixed cost : Many costs fall between these
two extremes. They are called as semi-variable cost or semi-fixed costs. They
are neither perfectly variable nor absolutely fixed in relation to changes in
volume. They change in the same direction as volume but not in direct
proportion thereto. An example is found in telephone charges. The rental
element is a fixed cost whereas charges for call made are a variable cost. The
distinction between fixed and variable cost is important in forecasting the effect
of short-run changes in volume upon costs and profits. This distinction has
also given rise to the concepts of Marginal Costing, Direct Costing, Flexible
Budgeting. Costs which have neither a linear or curvilinear relationship with
output but they move in steps with fluctuations in activity levels. These are
called stepped up costs. Basically these are fixed costs upto a certain level of
activity specified but they change as soon as a new range is reached. Such costs
are semi variable in the long-term but fixed in the short-term. Certain variable
costs tend to vary during specific periods for reasons not related to fluctuations
in activity level. For example, increased maintenance cost during periods of
low production, increased costs on air-conditioning in summer. Costs which
22
fluctuate with volume of production but after certain stage of production has
reached the fluctuations in cost is disproportionate. It changes either at a
retarded or accelerated rate.
C) Committed and Discretionary costs : It is shown above that costs may
be classified into fixed and variable. Fixed costs may be further classified as
committed costs and discretionary (or programmed) costs. This classification
is based on the degree to which firm is locked into the asset or service that is
generating the fixed cost.
Fixed cost is committed if it is incurred in maintaining physical facilities and
management set up. Committed costs cannot be avoided in the short run. For
example, salary of the managing director may represent a committed cost if,
by policy, the managing director is not to be released unless the firm is
liquidated. Similarly, depreciation of plant and equipment is committed because
these facilities cannot be easily changed in the short run.
Discretionary fixed costs are those which can be avoided by management. Such
costs are not permanent. Advertising, research and development cost, salaries
of low level managers are examples of discretionary costs because these costs
may be avoided or reduced in the short run if so desired by the managements.
This classification into committed and discretionary costs is important from
the point of view of cost control and decision making.
D) Financial Costs :
Cash costs : Cash costs are those sacrifices that are reflected in actual
cash outflows. Business transactions usually involve both reward (or revenue)
and sacrifice (or cost) with the difference between the two being gain (or profit).
Thus
Reward-Sacrifice = Gain
Revenue - Cost = Profit
Non-cash costs : Non-cash costs are financial sacrifices that do not involve
cash outlays at the time when the cost is recognised. These costs are found in
deprecation, opportunity costs etc.
(b) Non-Financial costs : Non financial costs are those costs that are not
directly traceable through a company's cash flow. While such costs (e.g., low
morale of employees) certainly involve scarifies and they may lead eventually,
in complex ways to a reduced cash flow in the future. They do not represent an
immediate cash outlays.
23
The above cost concepts are based on several factors like controllability,
period, situation, input-output relationship, opportunity, urgency, historical,
product, etc. The clear understanding of costs concepts will help the
management in analysis of costs, reporting, cost control and decision making.
E) Product Costs and Period Costs : Product costs are those costs which
are necessary for prediction and which will not be incurred if there is not
production. These consist of direct materials, direct labour and some of the
factory overhead. Product costs are 'absorbed by' or 'attached to' the units
produced.
Period costs are those which are not necessary for production and are written
off as expenses in the period in which these are incurred. Such cost are incurred
for a time period and are charged to Profit and Loss Account of the period,
rent, salary of company executives, travel expenses are examples of period
costs. These costs are not inventoried i.e. these are not included in the value
of closing stocks.
Classification into product and period cost is important from the point of view
of profit determination. This is so because product cost is carried forward to
the next accounting period as part of the unsold finished stock whereas period
cost is written off in the accounting period in which it is incurred.
F) Classification according to Identifiability with Cost Units : Costs are
classified into direct and indirect on the basis of their identiability with cost
units or jobs or processes :
(i) Direct costs : These are those costs which are incurred for and may be
conveniently identified with a particular cost unit, process or department.
(ii) Indirect costs : These costs cannot be conveniently identified with a
particular cost unit, process or department. These are general costs and are
incurred for the benefit of a number of cost units or cost centres.
Cost of raw materials used, wages of machine operators are common examples
of direct costs. Examples of indirect costs are rent, repairs, depreciation,
managerial salaries, coal, lubricating oil, wages of foreman, etc.
Costs are not traced or identified directly to a product for one of the three
reasons :
1. It is impossible to do so e.g., rent of building etc.
2. It is not convenient or feasible to do so e.g., nails used in furniture,
sewing thread, etc.
24
3. Management chooses not to do so i.e. many companies classify certain
items of cost as indirect because it is customary in the industry to do so e.g.,
carriage inward etc.
This classification is important from the point of view of accurate
ascertainment of cost. Direct costs of product can be conveniently determined
while the indirect costs have to be arbitrarily apportioned to various cost units.
For example, in readymade garments, the cost of cloth and wages of tailor are
accurately ascertained without any difficulty and are thus direct costs. But the
rent of factory, managerial salaries, etc., which are indirect costs, have to be
apportioned to various cost units on some arbitrary basis and cannot be
accurately ascertained.
G) Classification According to Controllability : The costs can also be
classified into controllable and uncontrollable :
(i) Controllable costs : These are the costs which may be directly regulated
at a given level of management authority. Variable costs are generally
controllable by department heads. For example, cost of raw material may be
controlled by purchasing in larger quantities.
(ii) Uncontrollable costs : These are those costs which cannot be
influenced by the action of a specified member of an enterprise. Fixed costs
are generally uncontrollable. For example, it is very difficult to control costs
like factory rent, managerial salaries, etc.
Two important points should be noted regarding this classification. First,
controllable costs cannot be distinguished from uncontrollable costs without
specifying the level and scope of management authority. In other words, a cost
which is uncontrollable at one level of management may be controllable at
another level of management. Secondly, in the long-run all costs are
controllable.
10.13 COMPONENTS OF TOTAL COST
Prime cost : It consists of direct material, direct labour and direct expenses. It
is also known as basic, first or flat cost.
Factory cost : It comprises of prime cost and, in addition, works or factory
overheads which include costs of indirect material, indirect labour, and indirect
expenses of the factory. The cost is also known as works cost, production or
manufacturing cost.
Office Cost : If office and administrative overheads are added to factory cost,
office cost is arrived at. This is also termed as administrative cost or the total
cost of production.
25
Total Cost : Selling and distribution overheads are added to the total cost of
production to get the total cost or the cost of sales.
10.14 COST SHEET
The components of cost explained above can be presented in the form of a
statement. Such a statement of cost giving total cost, cost per unit alongwith
different cost components of is termed as a cost sheet. The computation of
different cost components and preparation is a cost sheet can be understood
with the following illustration :
Illustration 10.1 : Calculate the Prime cost, Factory cost, Total cost of
production and Cost of sales from the following particulars :
Rs. Rs.
Raw Materials consumed ...... 20,000
Wages paid to labourers ...... 5,000
Directly chargeable expenses ...... 1000
Oil & Waste ...... 100
Wages of Foremen ...... 1,000
Storekeepers' Wages ...... 500
Electric Power ...... 200
Lighting : Factory 500
Office 200 700
Rent : Factory 2,000
Office 1,000 3,000
Repairs & Renewals :
Factory Plant 500
Machinery 1,000
Office Premises 200 1,700
Depreciation :
Office Premises 500
Plant & Machinery 200 700
Consumable Stores ...... 1,000
Manager's Salary ...... 2,000
Directors' Fees ...... 500
Office Printing & Stationery ...... 200
Telephone Charges ...... 50
Postage & Telegrams ...... 100
Salesmen's Commission & Salary ...... 500
Travelling Expenses ...... 200
Advertising ...... 500
Warehouse Charges ...... 200
Carriage Outward ...... 150
26
Solution : COST SHEET
Rs. Rs.
Direct material : Raw material consumed 20000
Direct labour : Wages paid to labourers 5000
Direct expenses : Directly chargeable expenses 1000
PRIME COST 26,000
Add : Factory Overheads :
Indirect material : Consumable stores 1,000
Oil and waste 100 1,100
Indirect labour : Wages of foreman 1,000
Storekeepers' wages 500 1,500
Indirect expenses : Electric power 200
Factory lighting 500
Factory rent 2,000
Repairs & Renewals :
Plant 500
Machinery 1,000
Depreciation :
Plant & machinery 200 4,400 7,000
FACTORY OR WORKS COST 33,000
Add : Office and administrative overheads :
Indirect material : Office printing and stationery 200
Indirect labour : Manager's salary 2,000
Directors' fees 500 2,500
Indirect expenses : Office lighting 200
Office rent 1,000
Repairs and renewals
office premises 200
Dep. on office premises 500
Telephone charges 50
Postage & telegrams 100 2,050 4,750
TOTAL COST OF PRODUCTION 37750
Add: Selling & Distribution overheads :
Indirect labour : Salesmen's commission
and salary 500
Indirect expenses : Travelling expenses 200
Advertising 500
Warehouse charges 200
Carriage outward 150 1,050 1,550
COST OF SALES 39,300
27
Illustration 10.2 : The following figures have been extracted from the books
of XYZ Ltd. for the year ending 31st March, 2000.
Rs.
Direct materials 70,000
Direct wages 75,000
Indirect wages 10,000
Other direct expenses 15,000
Factory rent and rates 5,000
Office rent and rates 500
Indirect materials 500
Depreciation of plant 1,500
Depreciation of office furniture 100
Managing Director's remuneration 12,000
General factory expenses 5,700
General office expenses 1,000
General selling expenses 1,000
Travelling expenses 1,100
Office salaries 4,500
Carriage outward 1,000
Advertisements 2,000
Sales 2,50,000
From the above figures, calculate the following :
(a) Prime cost
(b) Works cost
(c) Cost of production
(d) Cost of sales
(e) Net profit
Solution :
XYZ LTD.
Cost Sheet for the year ending 31st March, 2000
R s . Rs.
Direct materials consumed 70,000
Direct wages 75,000
Direct expenses 15,000
Prime Cost 1,60,000
Factory overhead :
Indirect wages 10,000
Factory rent & rates 5,000
Indirect materials 500
Depreciation of plant 1,500
General factory expenses 5,700 22,700
28
Works cost 1,82,700
Office and Administration Overhead
Office rent and rates 500
Depreciation of office furniture 100
Managing Director's remuneration 12,000
Office salaries 4,500
General office expenses 1,000 18,100
Cost of Production 2,00,800
Selling and distribution overhead :
Travelling expenses 1,100
Carriage outward 1,000
Advertisements 2,000
General selling expenses 1,000 5,100
Cost of Sales 2,05,900
Profit 44,100
Sales 2,50,000
10.15 SUMMARY
Whatever may be the type of business, it involves expenditure on labour,
materials and other items required for manufacturing and disposing of the
product. Moreover, big business requires delegation of responsibility, division
of labour and specialisation. Management has to avoid the possibility of waste
at each stage. Management has to ensure that no machine remains idle, efficient
labour gets due initiative, proper utilisation of by-products is made and costs
are properly ascertained. Besides management, creditors and employees are
also benefited in numerous ways by installation of a good costing system in an
industrial organisation. Cost accounting increases the overall productivity of
an industrial establishment and, therefore, serves as an important tool in
bringing prosperity to the nation. The basic principles of ascertaining costs
are the same in every system of cost accounting. However, the methods of
analysing and presenting the cost may vary from industry to industry. The
method to be used in collecting and presenting costs will depend upon the
nature of production. Basically there are two methods of costing, namely. Job
costing and Process costing. Cost is ascertained by cost centres or cost units
or by both. The components of cost when presented in the form of a statement.
Such a statement of cost giving total cost, cost per unit alongwith different
cost components of is termed as a cost sheet.
10.16 KEYWORDS
Cost: The technique and process of ascertaining the cost is defined as costing.
Cost accounting: It is that branch of accounting which deals with the
29
classification, recording, allocation, summarisation and reporting of current
and prospective costs.
Cost control: It represents the employment of management devices in the
performance of any necessary operation so that pre-established objectives may
be attained at the lowest possible outlay for goods and services.
Cost unit: A cost unit is a unit of finished product, service or time or
combination of these in relation to which cost is ascertained and expressed.
Cost centre: A cost centre refers to a section of a factory for which costs are
accumulated separately.
Cost sheet: A cost sheet is a statement which shows the details regarding the
total cost of the job or a product.
10.17 SELF ASSESSMENT QUESTIONS
1. Define costing and discuss briefly its objectives and advantages.
2. State the differences between Financial Accounting, Cost Accounting
and Management Accounting. Explain how financial accounts are
inadequate to measure the performance of an industry.
3. "A good system of costing serves as a means of control over expenditure
and helps to secure economy in manufacture" Discuss.
4. What are the main benefits that may be expected from the installation
of costing system in a manufacturing business.
5. Describe, in brief, the various methods of costing.
6. Distinguish between 'Product and period Cost'
7. Write short note on 'Cost Centre' and 'Cost Unit'
8. Distinguish between :
(a) controllable costs and uncontrollable costs.
(b) Variable cost and direct cost.
(c) Cost control and profit control
(d) Sunk cost and Out of Pocket cost.
(e) Job costing and process costing.
9. "Costs may be classified in a variety of ways accord to their nature and
the information needs of management". Explain and discuss this statement
giving examples of classifications required for different purposes.
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 11
INTRODUCTION TO MANAGEMENT
ACCOUNTING
STRUCTURE
11.0 Objective
11.1 Introduction
11.2 Classification of Accounting
11.3 Functions and Limitations of Financial Accounting
11.4 Emergence of Management Accounting
11.5 Functions of Management Accounting
11.6 Scope of Management Accounting
11.7 Distinction between Management and Financial Accounting
11.8 Cost Accounting and Management Accounting
11.9 Utility of Management Accounting
11.10 Limitations of Management Accounting
11.11 The Management Accountant
11.12 Summary
11.13 Keywords
11.14 Self Assessment Questions
11.15 Suggested Readings
1
11.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define management accounting and explain the functions
and scope of management accounting.
(b) Differentiate between Financial and Management
accounting, and cost and management accounting.
(c) Discuss the role of management accountant.
11.1 INTRODUCTION
Accounting has been clearly defined as "the measurement and
communication process of financial and economic data". The science of
accounting is still in the evolutionary process. The traditional
accounting, later styled as single entry from of book-keeping, was in
vogue right from time immemorial. The modest beginning of accounting
took the form of Financial Accounting based on double entry system.
Under this method all business transactions were at first recorded in
the books of prime entry, posted into respective ledger accounts,
balances were struck and the trial balances were prepared from and out
of which the annual Profit and Loss Account and Balance Sheet of a
business concern were prepared. The final accounts of a concern called
as the ‘traditional package’, helped the management in the process of
decision-making.
2
Generally speaking, the science of management seeks to organize
the quantitative factors of a business decision, while the art of
management consists in weighing the qualitative factors in the scale of
the manager’s judgement, experience and insight to produce the best
decision in the circumstances. Managers in the past, wholly relied on
their intuition and experience in making business decisions vitally
affecting the survival and success of their business units. But with the
increase in the size and complexity of business due to a variety of
factors like large scale operation, application of sophisticated modern
technology, management has become more complex and cumbersome.
To cope up with the increasing needs of large-scale business, the
modern managers need meaningful and timely data for making
decisions.
Accounting can be broadly classified into three types: (a) financial
accounting, (b) cost accounting, and (c) management accounting. These
three cannot be put in water-tight compartment classification; each one
supplements the other. In fact, financial accounting provides the basis
for cost accounting as well as management accounting and in the
ultimate analysis management accounting includes part of cost
accounting.
11.2 FUNCTIONS AND LIMITATIONS OF FINANCIAL
ACCOUNTING
The American Institute of Certified Public Accountants has
defined Financial Accounting as ‘the art of recording, classifying and
summarising in a significant manner and in terms of money,
transactions and events which are in part at least of a financial
character, and interpreting the results thereof’.
3
Accounting is the language effectively employed to communicate
the financial information of a business unit to various parties interested
in its progress such as proprietors, creditors, investors, employees,
consumers, the Government, etc. Financial accounting concerns that
part of accounting which is meant to serve all parties externally to the
operating responsibility of the firm, e.g., creditors, investors, employees,
regulatory bodies and the general public. But management accounting
is designed for use in the operational needs of the firm.
Functions of Financial Accounting
Financial Accounting is supposed to perform the following
functions:
1. Recording: Since all business transactions cannot be kept
in memory, they have got to be systematically recorded and
pass through journals, ledgers and work sheets before they
could take the forms of final accounts. This aspect of
financial accounting has assumed considerable importance
with the limitation of human memory.
2. Validating: With the universal acceptance and
enforcement of accounting principles, every recorded entry
in the books of accounts maintained by a business unit
gives validity or authenticity to all such transactions so
recorded.
3. Communicating: This is an important function of
financial accounting. Accounting serves as a language for
communicating the financial facts about the enterprise or
4
activity most effectively to all concerned interested in using
and interpreting them.
4. Interpreting: This aspect helps in unfolding the total
financial picture of an undertaking and investing the same
with more meaning.
As Professor Theodore Levitt of Harvard Business School
remarked recently, “data do not yield information except with the
intervention of mind. Information does not yield meaning except with
the intervention of imagination”. The intervention of both mind and
imagination are needed to make the data meaningful.
Limitations of Financial Accounting
Financial Accounting like any other branch of knowledge, is not
without limitations. The fast changing conditions and environmental
factors have brought the limitations of financial accounting to the fore.
1. Nature of business: All the business in modern times
have undergone radical changes and as the management
needs a variety of data for decision making purpose.
Financial accounting is not in a position to meet the
requirements of the management in the important task of
decision making process.
2. Shift in emphasis: There is a shift in the emphasis in
accounting in modern times from what it was once– a mere
record keeping in analysis and interpretation necessitated
by the management. As a result, the role of the accountant
5
has been changed from that of a mere book keeper to a
more important role of a financial advisor.
3. Technological revolution: With the profile and
advancement in science and technology very minute and
detailed break-up of all types of data concerning various
parts of a business unit have become a must for the
management in its day-to-day functioning. It is clear that
financial accounting with its simple structure is not in a
position to cater to the requirements of the management on
the above lines.
4. Importance of budgeting and planning: The
importance of budgeting and planning in any business unit
is realised in modern times. Financial accounting furnishes
only a postmortem of past records. It is an accepted
principle that the past is often of little or no guidance to the
future; yet the latter is the main concern of management,
and therefore some aid, other than the, conventional
financial accounts is essential.
5. Government regulations: Financial accounting is
primarily concerned with objectively quantifiable
information and it does not take cognisance of sweeping
changes and conditions brought by the government
regulations will have a far reaching effect on the
productivity as well as profitability of a business concern
and they cannot be ignored.
6
6. Varying informational needs: The present day
management is of three-tier system. Accordingly the
informational needs of the different levels of management
vary widely. They cannot be met wholly by the existing
financial accounting. The annual Profit and Loss Account
and Balance Sheet considered as a ‘movie’ and a ‘still
photograph’ of a company respectively have been an end in
themselves even though the story they tell is already out of
date and is past history.
11.4 EMERGENCE OF MANAGEMENT ACCOUNTING
With the advancement of science and technology more
sophisticated equipments and gadgets have been put into operation in
the realm of accounting as well. This has changed the accounting from
a mere device of recording to a powerful tool of forecasting, budgeting
and budgetary control. Thus, financial accounting has been
supplemented with financial and cost control, budgeting and budgetary
control and also production planning and control besides reporting on
business performance. Precisely, it has led to the emergence of
management accounting.
The term ‘Management Accounting’ is of recent origin even in the
USA. This term was first coined and used by the British Team of
Accountants that visited the United States in 1950 under the auspices
of Anglo-American Productivity Council. Since then management
accounting has grown into a full fledged subject and is looked upon as a
subject distinct from accounting in recent years. It is also otherwise
7
known as “Management-Oriented Accounting” or “Accounting for
Management”.
In common parlance Management Accounting refers to the
modern concept of accounts as an effective tool in the hands of the
management as against the traditional package of accounts. The
primary object is to furnish all the relevant financial and statistical
information focusing on every phase of activity in the organization. This
means that management accounting, in the words of W.M. Harper, is
concerned with “(a) management need for information regarding the
economic operation of the enterprise and (b) the actual direct
management of cash.”
The Institute of Chartered Accountants of England and Wales
has defined Management Accounting as ‘any form of accounting which
enables a business to be conducted more efficiently be regarded as
Management Accounting”. Management Accounting, according to J.
Batty “is the term used to describe the accounting methods, systems,
and techniques which, coupled with special knowledge and ability,
assist management in its task of maximising profits or minimizing
losses.” Robert Anthony opined that “Management Accounting is
concerned with accounting information which is useful to
management”. Shillinglaw has stated that accounting, which serves
management by providing information as to the cost or profit associated
with some portion of firm’s total operations, is called managerial
accounting. But the most acceptable definition of Management
Accounting has been furnished by the management accounting Team of
Anglo-American Council on Productivity in its Report which reads:
“Management Accounting is the presentation of accounting information
8
in such a way as to assist management in the creation of policy and the
day-to-day operation of an undertaking. The technique of accounting is
of extreme importance as it works in the most nearly universal medium
available for the expression of facts so that facts of great diversity can
be presented in the same picture. It is not the presentation of these
pictures that is the function of management but the use of them.”
All these definitions of Management Accounting reveal the
following salient features:
1. It is a merger of “management” and “accounting”.
2. It is concerned with accounting information which is useful
to management in maximizing profits or minimizing losses.
3. It is concerned with the improvement in the efficiency of
the various phases of management. Briefly management
accounting with all its paraphernalia, does not supplement
financial accounting as is errorneously misunderstood, but
supplement the basic structure of traditional package of
accounts to cater to the diversified requirements of modern
management.
In the absence of an internationally accepted definition of
management accounting, experts have used different terms to refer to
managerial accounting such as business environment accounting,
control accounting, decision accounting, responsibility accounting, etc.
It is called responsibility accounting, since it provides accounting and
statistical information to different levels of management to satisfy their
needs.
9
11.4 FUNCTIONS OF MANAGEMENT ACCOUNTING
Broadly speaking the functions of management accounting
embrace all activities concerning collection of statistical data,
processing, analysing, interpreting and presentation of the same in a
condensed capsule form, to satisfy the needs of different levels of
management. The main functions of management accounting are
discussed below:
1. Management accounting involves forecasts and planning of
future operations of the business in the light of the past as
well as present achievements. The formulation of business
budgets will be immensely useful in guiding both shortterm
and long-term operations of the business in a most
effective manner.
2. Management accounting does not confine itself merely to
financial data to assist the management in the decisionmaking
process but frequently draws upon various sources
other than accounting for qualitative information which
cannot be converted into monetary terms. For this purpose,
engineering records, case studies, minutes of meetings,
productivity reports, special surveys and other business
documents are greatly relied upon.
3. Management accounting furnishes accounting data and
statistical information required for the decision-making
process in management which vitally affects the survival
and the success of the business. This is affected through
classification as well as combination of sales for different
10
months and their break-up according to the class of
products, types of customers, terms of credit, territory, etc.
4. Management accounting, though concerned with past
records, maintenance of values, allocation and fixation of
responsibilities and the evaluation of the future
developments, is primarily concerned with the analysis and
interpretation of data which provide a new vista to the
management. Thus, the analysis and interpretation of data
which are considered as the backbone of management
accounting, provide the necessary basis or infrastructure
for a focus on all the phases of management.
5. Management accounting establishes standards of
performance in the different realms of activities in such
way that any deviation therefrom can be easily measured
leading to further investigation of the causes and
institution of prompt remedial measures for rectifying the
same. This is made possible through budgetary control and
standard costing which are essential adjuncts of
management accounting.
6. Management accounting furnishes statistical information
according to the varying requirements of the different levels
of management, at periodic intervals. The three-tier
management which is in vogue in the recent times requires
information of various types at different intervals, e.g., the
top level management requires information in a capsule
from covering all aspects of the business at relatively long
11
intervals whilst detailed analysis relating to a particular
aspect of the business at short intervals will suffice the
persons in the lower rungs of the management ladder.
11.6 SCOPE OF MANAGEMENT ACCOUNTING
The scope of Management Accounting is very wide and broadbased
and it includes within its fold, a variety of aspects of business
operations. The following are some of the areas of specialization
included within the ambit of management accounting:
1. Financial Accounting: This pertains to recording of all
business transactions in the books of prime entry, posting
them into respective ledger accounts, balancing them and
preparing a trial balance, from and out of which a profit
and loss account showing the results of the business and
also a balance sheet depicting assets and liabilities of the
business concern are prepared. This in turn forms the basis
for analysis and interpretation for furnishing meaningful
data to the management.
2. Cost Accounting: Costing refers to the classification,
recording and allocation of expenditures for the
determination of the cost of products or services, ensuring
management control over the same. This includes the
determination of cost of every order, job, contract, process,
or unit as may be required. This helps in the sharpening of
the internal aspects of financial accounting.
12
3. Forecasting and budgeting: This refers to the
formulation of budgets and forecasts, using standard norms
in co-operation with operating and other departments of a
business concern. The ultimate success of any budgeting
depends on the proper setting of target figures in the
budgets and the actual realization of the same in practice,
without even a slight deviation due to external reasons
beyond the control of the management.
4. Cost control techniques: These serve as effective tools for
comparing the actual results with the predetermined
figures as laid down in budgets. They greatly help in
translating the budgets into operating plans.
5. Statistical data: It is concerned with the supply of
necessary statistical data and particulars needed by various
departments of the business concern. This includes as
stated earlier, statistical compilation of case studies,
engineering records, minutes of meetings, special surveys
and many other business documents.
6. Taxation: This necessitates the computation of profits in
accordance with the provisions of the Income Tax Act and
also prompt filing of returns periodically and payment of
taxes.
7. Methods and procedures: They are concerned with
standardization of methods and procedures in all fields of
management for improving efficiency as well as for
reducing the cost considerably. This also involves the
13
preparation and issuance of accounting and other manuals
which will provide the guidelines for others.
8. Office services: This mainly relates to the maintenance of
data processing and other office management services,
stencilling and duplicating, dealing of inward and outward
mails, etc.
9. Internal audit: The effectiveness of the final audit
depends in turn on the internal audit coverage in existence
in any business concern.
Management accounting represents a happy blending of the two
older professions of ‘Management’ and ‘Accounting’. The two important
elements in the success of a business concern are accounting control
and management efficiency. These two determinants are completely
merged in management accounting through the harnessing of
accounting for improving the efficiency of management.
Management accounting greatly assists the management in
achieving better results by making a clear shift in emphasis from mere
recording of transactions to their analysis and interpretation to give a
new vista to the management. It concerns with the tools and techniques
of formulation of budgets and pre-setting of standards as well as
evaluation of deviations in actual performance and also implementation
of prompt remedial measures. In short, management accounting
eliminates intuition from the field of business management and
broadens the services of accounting to management.
14
11.7 DISTINCTION BETWEEN MANAGEMENT AND FINANCIAL
ACCOUNTING
Though management accounting and financial accounting cannot
be put in watertight compartment classification, it should be
remembered that the former is only an off-shoot of the latter. Precisely,
management accounting supplements the functions of financial
accounting in as much as it provides the necessary accounting data and
statistical information needed by the management for improving the
efficiency as a whole. Despite the close inter-relationship that exists,
there are certain points of difference between the two and they are
discussed below:
1. Focus: In management accounting the main focus is on the
internal details of any particular aspect of business
operation, whereas in financial accounting the main focus is
on the enterprise as a whole covering all the aspects of the
business operation. In management accounting
performance, evaluation and reports are concerned with
individual departments, products, type of inventories,
purchases, sales or other sub-divisions of the business
enterprise. In financial accounting the balance sheet and
the income statement reveal the overall performance of the
enterprise as a whole for a specific period.
2. Nature: Management accounting is mainly concerned with
the future plants and policies, whereas financial accounting is
concerned with historical records relating to the past.
Management relies on the past records for formulation of
future plans and hence, the interdependence of management
15
accounting and financial accounting serves a limited purpose
of throwing light on the events and results of the past. The
forward looking management accounting greatly helps the
management in improving the results in future through
various tools and techniques of budgeting and budgetary
control, standard costing, profit planning, etc.
3. Characteristics: Management accounting lays emphasis
on those characteristics which increase the value of
information put to variety of uses, like flexibility,
approximation, comparability, etc., whereas financial
accounting lays emphasis on those characteristics of
information like objectivity, validity, absoluteness, etc. This
marked difference sometimes creates a serious doubt as to
whether both the characteristics can be preserved within
the same structure.
4. Dispatch: Management accounting stresses on furnishing
of information more quickly to facilitate the management in
the decision-making process than is the case in financial
accounting, since it is considered as a post-mortem of past
records. In management accounting, up-to-date information
and current figures provide the necessary foundation for
formulation of budgets and forecasts for the improvement of
the results in the future. It is well known that in financial
accounting, the intervening time lag between the end of
financial year and the preparation and presentation of final
accounts for that year could not be reduced beyond a point.
16
5. Obligatory: In modern times a business concern is free to
install the system of management accounting. It is more or
less obligatory on the part of every business concern to
adopt financial accounting for disclosing the results of the
business to the rightful owners.
6. Legal formalities: Since a business concern is free to
install the system of management accounting there is no
statutory regulation fixing the norms and standards for
preparation and presentation of accounting statements.
Needless to state that these statements can be adapted to
the changing needs of the management since they are meant
for internal use, whereas, financial accounting statements
are standardised and meant for external use. The provisions
of the Companies Act in force govern the preparation and
presentation of annual final accounts of companies.
7. Type of data: Management accounting makes use of a
variety of data which are highly descriptive, statistical,
subjective, and relate to the future, whilst financial
accounting makes use of data which are precisely
quantitative, objective, and monetary and relate to the past.
The end-use of management accounting is not restricted
and hence, can be used to an unlimited extent by the
management accordingly as necessitated by the changing
circumstances and environmental factors. But it is clear
that the ultimate object of financial accounting ends with
the preparation and presentation of final accounts in any
business concern.
17
8. Precision: Management accounting lays no emphasis on
precision as the data and particulars compiled are merely
estimates and relate to the future. But in financial
accounting precision is stressed greatly since the past result
of the business is reflected through them.
11.8 COST ACCOUNTING AND MANAGEMENT ACCOUNTING
Cost Accounting is the process of accounting for costs. It embraces
the accounting procedures relating to recording of all income and
expenditure and the preparation of periodical statements and reports
with the object of ascertaining and controlling costs. It is, thus, the
formal mechanism by means of which the costs of products or services
are ascertained and controlled. On the other hand, management
accounting involves collecting, analysing, interpreting and presenting
all accounting information which is useful to the management. It is
closely associated with management control which comprises planning,
executing, measuring and evaluating the performance of an
organization. Thus, management accounting draws heavily on cost data
and other information derived from cost accounting. Today cost
accounting is generally indistinguishable from the so-called
management accounting or internal accounting because it serves
multiple purposes.
However, management accounting can be distinguished from cost
accounting in one important respect. Management accounting has a
wider scope as compared to cost accounting. Cost accounting deals
primarily with cost data while management accounting involves the
considerations of both cost and revenue. Management accounting is an
18
all inclusive accounting information system that covers financial
accounting, cost accounting and all aspects of financial management.
But it is not a substitute for other accounting functions. It involves a
continuous process of reporting cost, financial and other relevant data
in an analytical and informative way to management.
We should not be very much concerned with the boundaries of
cost accounting and management accounting since they are
complementary in nature. In the absence of a suitable system of cost
accounting, management will not be in a position to have detailed cost
information and their function is bound to lose significance, on the
other hand, the management cannot effectively use the cost data unless
it has been reported to them in a meaningful and informative form.
11.8 UTILITY OF MANAGEMENT ACCOUNTING
Management accounting provides invaluable services to
management in all of its functions. The basic functions of management
are: (i) Planning (ii) Controlling, (iii) Coordinating, (iv) Organising, (v)
Motivating, and (vi) Communicating. Management accounting helps in
performance of each of these functions effectively as explained below:
(i) Planning: It involves formulation of policies, setting up of
goals and initiating necessary programmes for achievement
of the goals. Management accounting makes an important
contribution in performance of this function. It makes
available the relevant data after pruning and analysing
them suitably for effective planning and decision-making.
19
(ii) Controlling: It involves evaluation of performance keeping
in view that the actual performance coincides with the
planned one, and remedial measures are taken in the event
of variation between the two. The techniques of budgetary
control, standard costing and departmental operating
statements greatly help in performing this function. As a
matter of fact the entire system of control is designed and
operated by the management accountant designated as
controller.
(iii) Coordinating: It involves interlinking of different
divisions of the business enterprise in a way so as to
achieve the objectives of the organisation as a whole. Thus,
perfect coordination is required among production,
purchase, finance, personnel, sales, departments, etc.,
Effective coordination is achieved through departmental
budgets and reports which form the nucleus of management
accounting.
(iv) Organising: It involves grouping of operative action in a
way as to identify the authority and responsibility within
the organization. Management accounting here also plays a
prominent role. The whole organization is divided into
suitable profit or cost centres. A sound system of internal
control and internal audit for each of the cost or profit
centres helps in organizing and establishing a sound
business structure.
20
(v) Motivating: It involves maintenance of a high degree of
morale in the organization. Conditions should be such that
each person gives his best to realise the goals of the
enterprise. The superiors should be in a position to find out
whom to demote or promote or to reward penalise.
Periodical departmental profit and loss accounts, budgets
and reports go a long way in achieving this objective.
(vi) Communicating: It involves transmission of data, results,
etc. both to the insiders as well as outsiders. The orders of
the superiors should be communicated to the subordinates
while the results achieved by the subordinates should be
reported to the superiors. Moreover, the management owes
a duty to the creditors, prospective investors, shareholders,
etc., to communicate to them about the progress, financial
position, etc. of the enterprise, Management accounting
helps the management in performance of this function by
developing a suitable system of reporting which emphasises
and highlights the relevant facts.
Management accounting is thus helpful to the management in
every field of activity. This is the reason why management accountant
is considered not only a service arm to management but also a part of
management.
11.10 LIMITATIONS OF MANAGEMENT ACCOUNTING
Management accounting, as any other branch of knowledge, is
not without limitations. Though the emergence of management
accounting has greatly improved the managerial performance, yet the
21
new discipline has to face certain challenges and constraints
conditioned mostly by the external factors. These factors curtail the
effectiveness of management accounting and they are discussed below:
1. Continuance of intuitive decision-making: Management
accounting eliminates the intuitive decision-making process
of management and replaces it with scientific decisionmaking.
Unfortunately, much management is prone to take
the easy and simple path of intuitive decision-making rather
than the difficult but reliable scientific decision-making
process in the day-to-day management.
2. Broad-based scope: The scope of management accounting
is wide and broad-based and this creates many difficulties
in the implementation process. It is easy to record, analyse,
and interpret an historical event converted into monetary
terms in a most objective manner. But it will be difficult to
perform the same functions in respect of future and
unquantifiable situation in the light of the past records.
3. Comprehensive coverage: The fusion of a number of
subjects like financial accounting, statistics, engineering,
economics, taxation, etc. has culminated in the emergence
of management accounting. Under the circumstances, it
should be remembered that lack of knowledge and
understanding of any one or more of these subjects will
have its impact on the fixation of standards as well as
solutions to the problems connected with the management
performance.
22
4. Evolutionary stage: Management accounting is a new
discipline and growing subject too. It is still in the infancy
stage and undergoing evolutionary process. Naturally, it
faces certain obstacles and impediments before achieving
perfection and finality. This necessitates sharpening of the
analytical tools and improving of techniques for removing
the air of doubt as regards uncertainty in their applications.
5. Psychological resistance: The management accounting
system spells a radical change in the management
approach towards solving day-to-day problems confronted
by it. This calls for a bound to attract opposition especially
from the labour force misconstruing it as a tool meant for
their exploitation. Constant education about the benefits of
such a new technique alone will allay the fears of the labour
force by and large. Management accounting, as a new
discipline, is no exception to this rule and it encountered
psychological resistance at least in the initial stage.
6. Costly installation: For installation of a system of
management accounting in a business concern, an elaborate
organization and a large number of manuals are very
essential. This in turn escalates the establishment charges
such that only large scale organizations can afford to install
it.
11.13 THE MANAGEMENT ACCOUNTANT
Management accounting provides significant economic and
financial data to the management and the management Accountant is
23
the channel through which this information efficiently and effectively
flows to the Management.
The Management Accountant has a very significant role to
perform in the installation, development and functioning of an efficient
and effective management accounting system. He designs the
framework of the financial and cost control reports that provide each
managerial level with the most useful data at the most appropriate
time. He educates executives in the need for control information and
ways of using it. This is because his position is unique with respect to
information about the organization. Apart from top management no one
in the organization perhaps knows more about the various functions of
the organization than him. He is, therefore, sometimes described as the
Chief Intelligence Officer of the top management. He gathers
information, breaks it down, sifts it out and organises it into
meaningful categories. He separates relevant and irrelevant
information and then ranks relevant information according to degree of
importance to management. He reports relevant information in an
intelligible form to the management and sometimes also to those who
are interested in the information outside the company. He also
compares the actual performance with the planned one and reports and
interprets the results of operations to all levels of management and to
the owners of the business. Thus, in brief, management accountant or
controller is the person who designs the management information
system for the organization, operates it by means of interlocked
budgets, compute vacancies and exhorts others to institute corrective
measures. Mr. P.L. Tondon has explained beautifully the position of the
management accountant in the following words:
24
“The management accountant is exactly like the spokes in a
wheel, connecting the rim of the wheel and the hub receiving the
information. He processes the information and then returns the
processed information back to where it came from.”
Functions of the Management Accountant
It is the duty of the management accountant to keep all levels of
management informed of their real position. He has, therefore, varied
functions to perform. His important functions can be summarised as
follows:
1. Planning: He has to establish, coordinate and administer as
an integral part of management, an adequate plan for the
control of the operations. Such a plan would include profit
planning, programmes of capital investment and financing,
sales forecasts, expense budgets and cost standards.
2. Controlling: He has to compare actual performance with
operating plans and standards and to report and interpret
the results of operations to all levels of management and
the owners of the business. This is done through the
compilation of appropriate accounting and statistical
records and reports.
3. Coordinating: He consults all segments of management
responsible for policy or action. Such consultation might
concern any phase of the operation of the business having
to do with attainment of objectives and the effectiveness of
the organisation structures and policies.
25
4. Other functions
(i) He administers tax policies and procedures.
(ii) He supervises and coordinates the preparation of
reports to Government agencies.
(iii) He ensures fiscal protection for the assets of the
business through adequate internal control and
proper insurance coverage.
(iv) He carries out continuous appraisal of economic and
social forces, and the government influences, and
interprets their effect on then business.
It should be noted that the functions of a Management Accountant
are more of those of a ‘staff official’. He, in addition to processing
historical data, supplies a good deal of information concerning the future
operations, in line with the management’s needs. Besides serving top
management with information concerning the company as a whole, he
supplies detailed information to the line officers regarding alternative
plans and their profitability, which help them in decision-making. A a
matter of fact the Management Accountant should not bother himself
regarding the decision taken by the line officials after tendering advice
unless he has reasonable grounds to believe that such a decision is going
to affect the interests of the corporation adversely. In such an event also
he should report it to the concerned level of management with fact,
patience, firmness combined with politeness.
11.12 SUMMARY
Decision-making process, a vital function of the management, is
highly facilitated by the information flowing from different sources.
26
Management accounting is one of the most important area because the
information supplied by the management accounting are directly useful
the managerial decision-making. In the ultimate analysis the
businessman, like the army general in a battlefield confronted with a
particular situation, must take a careful decision affecting the survival
and success of the business. It is also highly imperative that a good
management accounting department must be able to furnish all
necessary facts of the situation along with various alternatives open to
the businessman in such a situation, and also the estimates of the
various costs and benefits arising out of different courses of action
suggested. The better the presentation of such information, the easier
would be the decision-making for the management.
In modern organization, when the problems of size, nature and
competition have growth up, the role of management accounting has
become more and more important. Today’s manager cannot take and
should not take any decision without being considering the information
supplied by the department of accounting and finance. The future of
good decision-making lies in good presentation of management
accounting information.
11.13 KEYWORDS
Management Accounting: Management accounting is concerned with
presentation of accounting information which helps management in the
formulation of policy and to facilitate management in discharging its
day-to-day activities.
Management Accountant: He is a person who collects and provides
accounting, cost accounting, economic and statistical information to the
27
management to assist them in the performance of managerial functions
and their evaluations.
Internal Audit: Internal audit is concerned with the verification of
books of accounts within the organisation.
11.14 Self Assessment Questions1. Discuss the importance of
Management Accounting for managerial decision-making.
State briefly the difference between management and
financial accounting.
2. “Management Accounting is the presentation of accounting
information in such a way as to assist the management in
the creation of policy and in day-to-day operation of the
undertaking”. Elucidate.
3. Explain the scope of management accounting. Discuss the
functions of management accountant.
4. How does management accounting differ from cost
accounting? Discuss the utility of management accounting.
5. Write short notes on the following:
(a) Financial accounting vs. cost accounting.
(b) Role of management accountant.
11.15 SUGGESTED READINGS
1. S.N. Mittal, Management and Financial Accounting.
2. Ravi M. Kishore, Advanced Management Accounting.
3. I.M. Pandey, Management Accounting.
4. S.N. Maheshwari, Management Accounting and Financial
Control.
5. Vinayakam, Principles of Management Accounting.
28
1
Subject : Accounting for Managers
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 12
ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS : Meaning, Importance, Limitations and Tools
STRUCTURE
12.0 Objective
12.1 Introduction
12.2 Meaning of Analysis and Interpretation of Financial Statements
12.3 Objectives of Financial Analysis
12.4 Tools of Financial Analysis
12.5 Summary
12.6 Keywords
12.7 Self Assessment Questions
12.8 Suggested Readings
12.0 OBJECTIVE
After reading this lesson the students must be able :
(i) To understand the meaning of financial statements and their analysis and
interpretation.
(ii) To apply various tools to analyse financial statements.
12.1 INTRODUCTION
The term financial statements generally refers to two basic statements
: (i) The Income Statement, and (ii) The Balance Sheet. Of course, a business may
also prepare a Statement of Retained Earnings, and a Statement of Changes in
financial Position in addition to the above two statements.
Financial statements are prepared primarily for decision-making. They
play a dominant role in setting the framework of managerial decisions. But the
information provided in the financial statements is not an end in itself as no
meaningful conclusions can be drawn from these statements alone. However, the
information provided in the financial statements is of immense use in making
decisions through analysis and interpretation of financial statements. Financial
analysis is the process of identifying the financial strengths and weaknesses of the
2
firm by properly establishing relationship between the items of the balance sheet
and the profit and loss account. There are various methods or techniques used in
analysing financial statements, such as comparative statements, common-size
statements, trend analysis, schedule of changes in working capital, funds flow,
cash flow analysis and ratio analysis.
12.2 MEANING OF ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS
An analysis of financial statements is the process of critically
examining in detail accounting information given in the financial statements. For
the purpose of analysis, individual items are studied, their interrelationships with
other related figures are established, the data is sometimes rearranged to have
better
understanding of the information with the help of different techniques or tools for
the purpose. Analysing financial statements is a process of evaluating relationship
between component parts of financial statements to obtain a better understanding
of firm's position and performance. The analysis of financial statements thus refers
to the treatment of the information contained in the financial statements in a way
so as to afford a full diagnosis of the profitability and financial position of the firm
concerned. For this purpose financial statements are classified methodically,
analysed and compared with the figures of previous years or other similar firms.
The term 'Analysis' and 'interpretation' though are closely related,
but distinction can be made between the two. Analysis means evaluating
relationship
between components of financial statements to understand firm's performance in a
better way. Various account balances appear in the financial statements. These
account balances do not represent homogeneous data so it is difficult to interpret
them and draw some conclusions. This requires an analysis of the data in the
financial
statements so as to bring some homogeneity to the figures shown in the financial
statements. Interpretation is thus drawing of inference and stating what the figures
in the financial statements really mean. Interpretation is dependent on interpreter
himself. Interpreter must have experience, understanding and intelligence to draw
correct conclusions from the analysed data.
12.3 OBJECTIVES OF FINANCIAL ANALYSIS
Analysis of financial statements is made to assess the financial
position and profitability of a concern. Analysis can be made through accounting
ratios, fitting trend line, common size statements, etc. Accounting ratios calculated
for a number of years show the trend of the change of position, i.e., whether the
3
trend is upward or downward or static. The ascertainment of trend helps us in
making
estimates for the future. Keeping in view the importance of accounting ratios the
accountant should calculate the ratios in appropriate form, as early as possible, for
presentation to management for managerial control. The main objectives of
analysis
of financial statements are :
(i) to assess the profitability of the concern;
(ii) to examine the operational efficiency of the concern as a whole and of its
various parts or departments;
(iii) to measure the short-term and long-term solvency of the concern for the
benefit of the debenture holders and trade creditors;
(iv) to undertake a comparative study in regard to one firm with another firm or
one department with another department; and
(v) to assess the financial stability of a business concern.
12.4 TOOLS OF FINANCIAL ANALYSIS
Financial Analyst can use a variety of tools for the purposes of analysis
and interpretation of financial statements particularly with a view to suit the
requirements of the specific enterprise. The principal tools are as under :
1. Comparative Financial Statements
2. Common-size Statements
3. Trend Analysis
4. Cash Flow Statement
5. Ratio Analysis
6. Funds Flow statements
1. Comparative Financial Statements : Comparative financial statements are
those statements which have been designed in a way so as to provide time
perspective
to the consideration of various elements of financial position embodied in such
statements. In these statements figures for two or more periods are placed side by
side to facilitate comparison.
Both the Income Statement and Balance Sheet can be prepared in the form of
Comparative
Financial Statements.
a) Comparative Income Statement
The comparative Income Statement is the study of the trend of the
same items/group of items in two or more Income Statements of the firm for
different periods. The changes in the Income Statement items over the period
would
4
help in forming opinion about the performance of the enterprise in its business
operations. The Interpretation of Comparative Income Statement would be as
follows:
(i) The changes in sales should be compared with the changes in cost of goods
sold. If increase in sales is more than the increase in the cost of goods sold,
then the profitability will improve.
ii) An increase in operating expenses or decrease in sales would imply decrease
in operating profit and a decrease in operating expenses or increase in sales
would imply increase in operating profit.
iii) The increase or decrease in net profit will give an idea about the overall
profitability of the concern.
Illustration 1 : The Income Statement of Sumit Ltd. are given for the years 2001
and 2002. Rearrange the figures in a comparative form and study the profitability
position of the firm :
Items 2001 (Rs.) 2002 (Rs.)
Net Sales 17,00,000 22,00,000
Less Cost of Goods Sold 12,00,000 15,00,000
Gross Profit 5,00,000 7,00,000
Less Operating Expenses
(Administration, Selling Distribution Expenses) 75,000 1,00,000
Operating Profit 4,25,000 6,00,000
Add Other Incomes 25,000 40,000
Earnings before Interest & Tax 4,50,000 6,40,000
Less Interest 40,000 40,000
Earnings before Tax 4,10,000 6,00,000
Less Tax Payable 84,000 1,60,000
Profit after Tax 3,26,000 4,40,000
5
Solution :
Comparative Income Statement
For the year ended 31st March, 2001 and 2002
Items 31.03.01 31.03.02 Increase Percentage
Rs. Rs. (Decrease) Increase
(Rs.) (Decrease)
Net Sales 17,00,000 22,00,000 5,00,000 29.41
Less Cost of Goods Sold 12,00,000 15,00,000 3,00,000 25.0
Gross Profit 5,00,000 7,00,000 2,00,000 40.0
Less Operating Expenses
(Administration Selling & Distribution
Expenses) 75,0000 1,00,000 25,000 33.3
Operating Profit 4,25,000 6,00,000 1,75,000 41.17
Add Other Incomes 25,000 40,000 15,000 60.0
Earning before Interest & Tax 4,50,000 6,40,000 1,90,000 42.2
Less Interest 40,000 40,000 – –
Earning before tax 4,10,000 6,00,000 1,90,000 46.34
Less Tax 84,000 1,60,000 76,000 90.5
Earnings after Tax 3,26,000 4,40,000 1,14,000 34.97
b) Comparative Balance Sheet
The comparative Balance Sheet analysis would highlight the trend of
various items and groups of items appearing in two or more Balance Sheets of a
firm on different dates. The changes in periodic balance sheet items would reflect
the changes in the financial position at two or more periods. The Interpretation of
Comparative Balance Sheets are as follows :
i) The increase in working capital would imply increase in the liquidity position
of the firm over the period and the decrease in working capital would imply
deterioration in the liquidity position of the firm.
(ii) An assessment about the long-term financial position can be made by studying
the changes in fixed assets, capital and long-term liabilities. If the increase
in capital and long-term liabilities is more than the increase in fixed assets,
it implies that a part of capital and long-term liabilities has been used for
financing a part of working capital as well. This will be a reflection of the
good financial policy. The reverse situation will be a signal towards increasing
degree of risk to which the long-term solvency of the concern would be
exposed to.
6
iii) The changes in retained earnings, reserves and surpluses will give an indication
about the trend in profitability of the concern. An increase in reserve and
surplus and the Profit and Loss Account is an indication of improvement in
profitability of the concern. The decrease in these accounts may imply
payment of dividends, issue of bonus shares or deterioration in profitability
of the concern.
Illustration 2 : From the following Balance Sheets of Ram Ltd. as on 31st
December,
2000 and 2001, prepare a comparative Balance Sheet for the concern :
Balance Sheet of Ram Ltd. as on
Liabilities 2000 (Rs.) 2001(Rs.) Assets 2000(Rs.) 2001Rs.)
Equity share capital 5,00,000 6,00,000 Land & Building 4,00,000 3,50,000
Reserves & surpluses 2,00,000 1,00,000 Plant & Machinery 2,40,000 2,90,000
Debentures 1,00,000 1,50,000 Furniture 25,000 30,000
Mortgage loan 80,000 1,00,000 Bills receivables 75,000 45,000
Bills Payable 30,000 25,000 S. Debtors 1,00,000 1,25,000
S. Creditors 50,000 60,000 Stock 1,13,000 1,72,000
Other current Liabilities 5,000 10,000 Prepaid Expenses 2,000 3,000
Cash & Bank Balance 10,000 30,000
9,65,000 10,45,000 9,65,000 10,45,000
Solution :
Comparative Balance Sheet of Ram Ltd.
Item Year Ending Increase Increase/
31.12.2000 31.12.2001 (Decrease) (Decrease)
(Rs.) (Rs.) (Rs.) (Percentage)
Fixed Assets
Land & Building 4,00,000 3,50,000 (50,000) (12.5)
Plant & Machinery 2,40,000 2,90,000 50,000 20.83
Furniture 25,000 30,000 5,000 20.0
Total Fixed Assets 6,65,000 6,70,000 5,000 0.75
Current Assets
Bills receivable 75,000 45,000 (30,000) (40.0)
S. Debtors 1,00,000 1,25,000 25,000 25.0
Stock 1,13,000 1,72,000 59,000 52.2
Prepaid Expenses 2,000 3,000 1,000 50.0
Cash & Bank Balance 10,000 30,000 20,000 200.0
Total Current Assets 3,00,000 3,75,000 75,000 25.0
Total Assets 9,65,000 10,45,000 80,000 8.29
7
Shareholders' Funds
Equity Share Capital 5,00,000 6,00,000 1,00,000 20.0
Reserves & Surpluses 2,00,000 1,00,000 (1,00,000) (50.0)
Total Shareholders Funds 7,00,000 7,00,000 00,000 0.0
Long-Term Loans
Debentures 1,00,000 1,50,000 50,000 50.0
Mortgage Loan 80,000 1,00,000 20,000 25.0
Total Long-Term Loans 1,80,000 2,50,000 70,000 38.9
Current Liabilities
Bills Payable 30,000 25,000 (5,000) (16.7)
S. Creditors 50,000 60,000 10,000 20.0
Other Current Liabilities 5,000 10,000 5,000 100.0
Total Current Liabilities 85,000 95,000 10,000 11.8
Total Liabilities 9,65,000 10,45,000 80,000 8.29
2. Common-size Financial Statements : Common-size Financial Statements
are those in which figures reported are converted into percentages to some
common
base. In the Income Statement the sale figure is assumed to be 100 and all
figures are expressed as a percentage of sales. Similarly in the Balance sheet the
total of assets or liabilities is taken as 100 and all the figures are expressed as a
percentage of this total.
a) Common Size Income Statement
In the case of Income Statement, the sales figure is assumed to be
equal to 100 and all other figures are expressed as percentage of sales. The
relationship between items of Income Statement and volume of sales is quite
significant since it would be helpful in evaluating operational activities of the
concern. The selling expenses will certainly go up with increase in sales. The
administrative and financial expenses may go up or may remain at the same level.
In
case of decline in sale, selling expenses should definitely decrease.
Illustration 3 : From the following Profit and Loss Accounts and the Balance
Sheets of Swadeshi Polytex Ltd. for the year ended 31st December 2000 and 2001,
you are required to prepare common size statements.
8
Profit and Loss Account
Particulars 2000 2001 Particulars 2000 2001
Rs. Rs. Rs. Rs.
To Cost of Goods sold 600 750 By Net Sales 800 1,000
To Operating Expenses :
Administration Expenses 20 20
Selling Expenses 30 40
To Net Profit 150 190
800 1,000 800 1,000
Balance Sheet
As on 31st December
(in lakhs of Rs.)
Liabilities 2000 2001 Assets 2000 2001
Bills Payable 50 75 Cash 100 140
Sundry Creditors 150 200 Debtors 200 300
Tax Payable 100 150 Stock 200 300
14% Debentures 100 150 Land 100 100
16% Preference Capital 300 300 Building 300 270
Equity Capital 400 400 Plant 300 270
Reserves 200 245 Furniture 100 140
1,300 1,520 1,300 1,520
Solution :
Swadeshi Polytex Limited
COMMON-SIZE INCOME STATEMENT
For the years ended 31st December 2000 and 2001
(Figures in percentages)
Particulars 2000 2001
Net Sales 100 100
Cost of Goods Sold 75 75
Gross Profit 25 25
Operating Expenses :
Administration Expenses 2.50 2
Selling Expenses 3.75 4
Total Operating Expenses 6.25 6
Operating Profit 18.75 19
9
Interpretation : The above statement shows that though in absolute terms, the
cost of goods sold has gone up, the percentage of its cost to sales remains
consistent
at 75%. This is the reason why the Gross Profit continues at 25% of sales.
Similarly, in absolute terms the amount of administration expenses remains the
same but as percentage to sales it has come down by 5%. Selling expenses have
increased by 25%. This all leads to net increase in net profit by 25% (i.e., from
18.75% to 19%).
b) Common Size Balance Sheet
For the purpose of common size Balance Sheet, the total of assets or
liabilities is taken as 100 and all the figures are expressed as percentage of the
total. In other words, each asset is expressed as percentage to total assets/liabilities
and each liability is expressed as percentage to total assets/liabilities. This
statement
will throw light on the solvency position of the concern by providing an analysis
of
pattern of financing both long-term and working capital needs of the concern.
Swadeshi Polytex Limited
COMMON-SIZE BALANCE SHEET
For the years ended 31st December 2000 and 2001
(Figures in percentage)
2000 2001
Assets 100 100
Current Assets :
Cash 7.70 9.21
Debtors 15.38 19.74
Stock 15.38 19.74
Total Current Assets 38.46 48.69
Fixed Assets :
Building 23.07 17.76
Plant 27.03 17.76
Furniture 7.70 9.21
Land 7.70 6.68
Total Fixed Assets 61.54 51.31
Total Assets 100 100
10
2000 2001
%%
Liabilities and Capital 100 100
Current Liabilities :
Bills Payable 3.84 4.93
Sundry Creditors 11.54 13.16
Taxes Payable 7.69 9.86
Total Current Liabilities 23.07 27.95
Long-term Liabilities :
14% Debentures 7.69 9.86
Capital & Reserves :
16% Preference Share Capital 23.10 19.72
Equity Share Capital 30.76 26.32
Reserves 15.38 16.15
Total Shareholder’s Funds 76.93 72.05
Total Liabilities and Capital 100 100
Interpretation : The percentage of current assets to total assets was 38.46 in
2000.
It has gone up to 48.69 in 2001. Similarly the percentage of current liabilities to
total liabilities (including capital) has also gone up from 23.07 to 27.95 in 2001.
Thus, the proportion of current assets has increased by a higher percentage (about
10) as compared to increase in the proportion of current liabilities (about 5). This
has improved the working capital position of the company. There has been a slight
deterioration in the debt-equity ratio though it continues to be very sound. The
proportion of shareholder’s funds in the total liabilities has come down from
69.24% to 62.19% while that of the debenture-holders has gone up from 7.69% to
9.86%.
3. Trend Analysis
The third tool of financial analysis is trend analysis. This is immensely
helpful in making a comparative study of the financial statements of several years.
Under this method trend percentages are calculated for each item of the financial
statement taking the figure of base year as 100. The starting year is usually taken
as
the base year. The trend percentages show the relationship of each item with its
preceding year's percentages. These percentages can also be presented in the form
of index numbers showing relative change in the financial data of certain period.
This will exhibit the direction, (i.e., upward or downward trend) to which the
concern
is proceeding. These trend ratios may be compared with industry ratios in order to
know the strong or weak points of a concern. These are calculated only for major
items instead of calculating for all items in the financial statements.
11
While calculating trend percentages, the following precautions may
be taken :
(a) The accounting principles and practices must be followed constantly over
the period for which the analysis is made. This is necessary to maintain
consistency
and comparability.
(b) The base year selected should be normal and representative year.
(c) Trend percentages should be calculated only for those items which have logical
relationship with one another.
(d) Trend percentages should also be carefully studied after considering the
absolute figures on which these are based. Otherwise, they may give misleading
conclusions.
(e) To make the comparison meaningful, trend percentages of the current year
should be adjusted in the light of price level changes as compared to base year.
Illustration 4 : Interpret the results of operations of a trading concern using trend
ratios, on the following information :
(Amount in '000 Rupees)
For the year ended 31st March
Items 2001 2000 1999 1998
Sales (net) 13,000 12,000 9,500 10,000
Cost of goods sold 7,280 6,960 5,890 6,000
Gross Profit 5,720 5,040 3,610 4,000
Selling Expenses 1,200 1,100 970 1,000
Net Operating Profit 4,520 3,940 2,640 3,000
Solution :
Trend Ratios
31st March, 1998=100
Items 1998 1999 2000 2001
Sales 100 95 120 130
Gross of Goods sold 100 98 116 121
Gross Profit 100 90 126 143
Selling Expenses 100 97 110 120
Net Operating Profit 100 88 131 150
12
Interpretation
From the above statement the following points are worth noting :
(a) The sales volume, cost of goods sold and selling expenses all declined in
1999 as compared to 1998 but the decrease in cost of goods sold and selling
expenses was lesser to the decrease in sales volume.
(b) The sales volume, cost of goods sold and selling expenses in 2000 and 2001
have increased in comparison to 1998 but the increase in cost of goods sold and
selling expenses is lesser to the increase in sales volume.
In conclusion, it can be said that a large proportion of cost of goods
sold and selling expenses is fixed and is not affected by changes in sales volume.
This fact also becomes clear from this fact that in 1999 when sales fell down, the
decrease in the company's net operating profit was faster to sales volume and in
2001 when the sales volume increased, the increase in company's net profit was
faster to sales volume.
4. Cash Flow Statement
A cash flow statement shows an entity's cash receipts classified by
major sources and its cash payments classified by major uses during a period. It
provides useful information about an entity's activities in generating cash from
operations to repay debt, distribute dividends or reinvest to maintain or expand its
operating capacity; about its financing activities, both debt and equity; and about
its
investment in fixed assets or current assets other than cash. In other words, a cash
flow statement lists down various items and their respective magnitude which
bring
about changes in the cash balance between two balance sheet dates. All the items
whether current or non-current which increase or decrease the balance of cash are
included in the cash flow statement. Therefore, the effect of changes in the current
assets and current liabilities during an accounting period on cash position, which is
not shown in a fund flow statement is depicted in a cash flow statement. The
depiction of all possible sources and application of cash in the cash flow statement
helps the financial manager in short term financial planning in a significant
manner
because the short term business obligations such as trade creditors, bank loans,
interest on debentures and dividend to shareholders can be met out of cash only.
The preparation of cash flow statement is also consistent with the
basic objective of financial reporting which is to provide information to investors,
creditors and others which would be useful in making rational decisions. The basic
13
objective is to enable the users of information to make prediction about cash flows
in an organisation since the ultimate success or failure of the business depends
upon the amount of cash generated. This objective is sought to be met by
preparing
a cash flow statement.
DISTINCTION BETWEEN FUND FLOW STATEMENT AND CASH
FLOW
STATEMENT
Some of the main difference between a fund flow statement and a
cash flow statement are described below :
1. Concept of funds : A fund flow statement is prepared on the basis of a
wider concept of funds i.e., net working capital (excess of current assets over
current
liabilities) whereas cash flow statement is based upon narrower concept of funds
i.e., cash only.
2. Basis of accounting : A fund flow statement can also be distinguished from
a cash flow statement from the point of view of the basis of accounting used for
preparing these statements. A fund flow statement is prepared on the basis of
accrual
basis of accounting, whereas a cash flow statement is based upon cash basis of
accounting. Due to this reason, adjustments for incomes received in advance,
incomes outstanding, prepaid expenses and outstanding expenses are made to
compute cash earned from operations of the business (refer to computation of
cash from operations). No such adjustments are made while computing funds from
operations in the funds flow statement.
3. Mode of preparation : A fund flow statement depicts the sources and
application of funds. If the total of sources is more than that of applications then it
represents increase in net working capital. On the other hand if the total of
applications of funds is more than that of sources then the difference represents
decrease in net working capital. A cash flow statement depicts opening and closing
balance of cash, and inflows and outflows of cash. In a cash flow statement, to the
opening balance of cash all the inflows of cash are added and from the resultant
total all the outflows of cash are deducted. The resultant balance is the closing
balance of cash. A cash flow statement is just like a cash account which starts with
opening balance of cash on the debit side to which receipts of cash are added and
from the resultant total, the total of all the payments of cash (shown on the credit
side) is deducted to find out the closing balance of cash.
14
4. Treatment of current assets and current liabilities : While preparing a
funds flow statement the changes in current assets and current liabilities are not
disclosed in the funds flow statement rather these changes are shown in a separate
statement known as schedule of changes in working capital. In a cash flow
statement
no distinction is made between current assets and fixed assets, and current
liabilities
and long-term liabilities. All changes are summarised in the cash flow statements.
5. Usefulness in planning : A cash flow statement aims at helping the
management in the process of short term financial planning. A cash flow statement
is useful to the management in assessing its ability to meet its short term
obligations
such as trade creditors, bank loans, interest on debentures, dividend to
shareholders
and so on. A fund flow statement on the other hand is very helpful in intermediate
and long-term planning, because though it is difficult to plan cash resources for
two, three or more years ahead yet one can plan adequate working capital for
future
periods.
Uses and Importance of Cash Flow Statements
Cash flow statements are of great importance to a financial manager.
The information contained in cash flow statement can help the management in the
field of short-run financial planning and cash control. Some of the important
advantages of cash flow statements are discussed below :
1) The projected cash flow statements if prepared in a business disclose surplus
or shortage of cash well in advance. This helps in arranging utilisation of
surplus cash as bank deposits or investment in marketable securities for
short periods. Should there be shortage of cash, arrangement can be mode
for raising the bank loan or sell marketable securities.
2. Cash flow statements are of extreme help in planning liquidation of debt,
replacement of plant and fixed assets and similar other decisions requiring
outflow of cash from the business as they provide information about the
cash generating ability of the business.
3. The cash flow statement pertaining to a particular year compared with the
budget for that year reveals the extent to which the actual sources and
applications of cash were in consonance with the budget. This exercise helps
in refining the planning process in future.
4. The inter-firm and temporal comparison of cash flow statements reveals the
trend in the liquidity position of a firm in comparison to other firms in the
15
industry. It can serve as a pointer to the need for taking corrective action if
it is observed that the management of cash in the firm is not effective.
5. Cash flows statements are more useful in short term financial analysis as
compared to fund flow statements since in the short run it is cash which is
more important for executing plans rather than working capital.
Limitations of Cash flow Statements
1. The possibility of window dressing in cash position is more than in the case
of working capital position of a business. The cash balance can easily be
maneuvered by deferring purchases and other payments, and speeding up
collections from debtors before the balance sheet date. The possibility of
such maneuvering is lesser in respect of working capital position. Therefore
a fund flow statement which shows reasons responsible for the changes in
the working capital presents a more realistic picture than cash flow statement.
2. The liquidity position of a business does not depend upon cash position only.
In addition to cash it is also dependent upon those assets also, which can be
converted into cash. Exclusion of these assets while assessing the liquidity
of a business obscures the true reporting of the ability of the business in
meeting it liabilities on becoming due for payment.
3. Equating of cash generated from the operations of the business with the net
operating income of the business is not fair because while computing cash
generated from business operations, depreciation on fixed assets is excluded.
This treatment leads to mismatch between the expenses and revenue while
determining the business results as no charge is made in the profit and Loss
account for the use of fixed assets.
4. Relatively larger amount of cash generated from business operations vis-avis
net profit earned may prompt the management to pay higher rate of
dividend, which in turn may affect the financial health of the firm adversely.
PROCEDURE FOR PREPARING A CASH FLOW STATEMENT
Cash flow statement shows the impact of various transactions on cash
position of a firm. It is prepared with the help of financial statements, i.e., balance
sheet and profit and loss account and some additional information. A cash flow
statement starts with the opening balance of cash and balance at bank, all the
inflows
of cash are added to the opening balance and the outflows of cash are deducted
from the total. The balance, i.e, opening balance of cash and bank balance plus
16
inflows of cash minus outflows of cash is reconciled with the closing balance of
cash. The preparation of cash flow statement involves the determining of :
(a) Inflows of cash.
(b) Outflows of cash.
(a) Sources of Cash Inflows :
The main sources of cash inflows are :
(1) Cash flow from operations.
(2) Increase in existing liabilities or creation of new liabilities.
(3) Reduction in or Sale of Assets.
(4) Non-trading Receipts.
(b) Application of Cash
(1) Cash lost in operation.
(2) Decrease in or discharge of liabilities.
(3) Increase in or purchase of assets.
(4) Non-trading payments.
Generally, cash flow statement is prepared in two forms :
(a) Report form
(b) T Form or an Account Form or Self Balancing Type
SPECIMEN OF REPORT FORM OF CASH FLOW STATEMENT
Cash balance in the beginning
Rs.
Add : Cash inflows :
Cash flow from operations
Sale of assets
Issue of shares
Issue of debentures
Raising of loans
Collection from debtors
Non trading receipts such as :
Dividend received
Income tax refund
Less : Applications or Outflows of cash :
Redemption of Preference shares
Redemption of debentures
Repayment of loans
17
Purchase of assets
Payment of dividend
Payment of taxes
Cash lost in operations
Cash Balance at the end
SPECIMEN OF T FORM OR AN ACCOUNT OF CASH FLOW
STATEMENT
Rs. Rs.
Cash balance in the beginning Outflow of Cash :
Add : Cash inflows : Redemption of Preference
Cash flow from operation Shares
Sale of Assets Redemption of Debentures
Issue of Shares Repayment of Loans
Issue of Debentures Purchase of Assets
Raising of Loans Payment of Dividends
Collection from Debtors Payment of Tax
Dividends Received Cash lost in Operations
Refund of tax Cash Balance at the end
SOURCE OF CASH INFLOWS
1. Cash from Operations or Cash Operating Profit
Cash from trading operations during the year is a very important source
of cash inflows. The net effect of various transactions in a business during a
particular period is either net profit or net loss. Usually, net profit results in inflow
of cash and net loss in outflow of cash. But it does not mean that cash generated
from trading operations in a year shall be equal to the net profit or that cash lost in
operations shall be identical with net loss. It may either be more or less. Even,
there may be a net loss in a business, but yet there may be a cash inflow from
operations. It is so because of certain non-operating (expenses or incomes)
charged
to the income statement, i.e., Profit and Loss Account.
How to Calculate Cash from Operations or Cash Operating Profit ?
There are three methods of determining cash from operations :
(a) From Cash Sales : Cash from operations can be calculated by deducting
cash purchases and cash operating expenses from cash sales, i.e. Cash from
18
Operations=
(Cash Sales) – (Cash Purchases + Cash Operating Expenses).
Cash sales are calculated by deducting credit sales or increase in
receivables from the total sales. From the cash sales, the cash purchases and cash
operating expenses are to be deducted. In the absence of any information, all
expenses may be assumed to be cash expenses. In case outstanding and prepaid
expenses are known/given, any decrease in outstanding expenses or increase in
prepaid expenses should be deducted from the corresponding figure.
(b) From Net Profit/Net Loss
Cash from operations can also be calculated with the help of net profit
or net loss. Under this method, net profit or net loss is adjusted for non-cash and
non-operating expenses and incomes as follows :
Calculation of Cash From Trading Operations
Amount
Net Profit (as given)
Add : Non cash and Non-operating items which have
already been debited to P & L A/c :
Depreciation
Transfer to Reserves
Transfer to Provisions
Goodwill written off
Preliminary expenses written off
Other intangible assets written off
Loss on sale or disposal of fixed assets
Increase in Accounts Payable
Increase in outstanding expenses
Decrease in prepaid expenses
Less : Non-cash and Non-operating items which have already
been credited to P & L A/c :
Increase in Accounts Receivables
Decrease in Outstanding Expenses
Increase in Prepaid Expenses
Cash from Operations
19
(C) Cash Operating Profit
Cash operating profit is also calculated with the help of net profit or
net loss. The difference in this method as compared to the above discussed method
is that increase or decrease in accounts payable and accounts receivable is not
adjusted while finding cash from operations and it is directly shown in the cash
flow statement as an inflow or outflow of cash as the cash may be. The cash from
operations so calculated is generally called operating profit.
Calculation of Cash Operating Profit
Amount
Net Profit (as given) or Closing Balance of Profit and Loss A/c
Add : Non-cash and non-operating items which have
already been debited to P& L A/c :
Depreciation
Transfers to Reserves and Provisions
Writing off intangible assets
Outstanding Expenses (current year)
Prepaid Expenses (previous year)
Loss on Sale of fixed Assets
Dividend Paid, etc.
Less : Non-cash and non-operating items which have already
been credited to P& L A/c :
Profit on Sale or disposal of fixed assets
Non-trading receipts such as dividend received, rent received, etc.
Re-transfers from provisions
(excess provisions charged back)
Outstanding income (current year)
Pre-received income (in previous year)
Opening balance of P&L A/c
Cash Operating Profit
Note: Generally the cash operating profit method has to be followed because of
its similarity with calculating funds from operations. However, if this method is
followed the following two points need particular care :
(i) Outstanding/Accrued Expenses : The outstanding/accrued expenses
represent those expenses which are although charged to profit and loss account but
no cash in paid during the year. For this reason, outstanding/accrued expenses of
20
the current year are added back while calculating cash operating profit. However if
some outstanding expenses of the previous year are also given, these may be
assumed
to have been paid during the year and hence shown as an outflow of cash in the
cash
flow statement.
(ii) Prepaid Expenses : Prepaid expenses are those expenses which are paid in
advance and hence result in the outflow of cash but are not charged to profit and
loss account because they do not relate to the current period of profit and loss
account. For this reason, prepaid expenses of the current year should be taken as
an
outflow of cash in the cash flow statement. But the expenses, if any, paid in the
previous year do not involve outflow of cash in the current year but are charged to
profit and loss account. Therefore, prepaid expenses of the previous year (related
to the current year) should be added back while calculating cash operating profit.
In
the similar way, we can deal with outstanding and pre-received incomes.
Illustration 5. Calculate Cash from operations from the following informations :
Rs.
Sales 70,000
Purchases 40,000
Expenses 8,000
Creditors at the end of the year 15,000
Creditors in the beginning of the year 12,000
Solution :
Rs. Rs.
Sales 70,000
Less : Purchases 40,000
Expenses 8,000 48,000
Profit for the year 22,000
Add : Creditors a the end of the year 15,000
37,000
Less : Creditors at the beginning of the year 12,000
Cash from operations 25,000
2. Increase in Existing Liabilities or Creation of new Liabilities
If there is an increase in existing liabilities or a new liability is created
during the year, it results in the flow of cash into the business. The liability may be
either a fixed long-term liability such as equity share capital, preference share
21
capital, debentures, long-term loans, etc. or a current liability such as sundry
creditors, bills payable, etc.
The inflow of cash may be either Actual of Notional
There is an actual inflow of cash when cash is actually received and
generally long-term liabilities result into actual inflow of cash, e.g.
For issue of Shares, during the year, the journal entry shall be
Cash A/c Dr.
To Share Capital A/c
So, actual cash flows into the business. In the same manner, issue of
debentures, raising of loans for cash, etc. result into actual inflows of cash. But
when the fixed liabilities are created in consideration of purchase of assets, i.e.,
other than cash, there is no inflow of actual cash. The journal entry for the issue of
debentures in lieu of purchase of machinery is :
Plant and Machinery A/c Dr.
To Debentures A/c
Usually, current liabilities result into inflow of notional cash.
For example, increase in sundry creditors implies purchase of goods on credit. In
this case although no cash in actually received but we may say that creditors have
given us loans which have been utilised in purchasing goods from them. Hence,
increase in the current liabilities may be taken as a source of inflow of cash and
decrease in current liabilities as an outflow of cash.
3. Reduction in or Sale of Assets
Whenever a reduction in or sale of any asset-fixed or current-takes
place (otherwise than depreciation) it results into inflow of actual or notional cash.
There is an actual inflow of cash when assets are sold for cash and notional cash
flows in when assets are sold or disposed off on credit. Thus, sale of building,
machinery or even reduction in current assets like stocks, debtors, etc. result in
inflow of actual notional cash.
4. Non-Trading Receipts
Sometimes, there may be non-trading receipts like dividend received,
rent received, refund of tax, etc. Such receipts or incomes are although non-trading
22
in nature but they result into inflow of cash and hence taken in the cash flow
statement.
APPLICATIONS OF CASH OR CASH OUTFLOWS
1. Cash Lost in Operations : Sometimes the net result of trading in a particular
period is a loss and some cash may be lost during that period in trading operations.
Such loss of cash in trading in called cash lost in operations and is shown as an
outflow of cash in Cash Flow Statement.
2. Decrease in or Discharge of Liabilities :Decrease in or discharge of any
liability, fixed or current results in outflow of cash either actual or notional. For
example, when redeemable preference shares are redeemed and loans are repaid, it
will amount to an outflow of actual cash. But when a liability is converted into
another, such as issue of shares for debentures, there will be a notional flow of
cash into the business.
3. Increase in or Purchase of Assets : Just like decrease in or sale of assets
is a source or inflow of cash, increase or purchase of any assets is a outflow or
application of cash.
4. Non Trading Payments : Payment of any non-trading expenses also
constitute outflow of cash. For example, payment of dividends, payment of
incometax,
etc.
Illustration 6 : The following details are available from a company.
Liabilities 31-12-98 31-12-99 Assets 31-12-98 31-12-99
Rs Rs. Rs. Rs.
Share Capital 70,000 74,000 Cash 9,000 7,800
Debentures 12,000 6,000 Debtors 14,900 17,700
Reserve for doubtful debts 700 800 Stock 49,200 42,700
Trade Creditors 10,360 11,840 Land 20,000 30,000
P & L A/c 10,040 10,560 Goodwill 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
Additional Information :(i) Dividend paid total Rs. 3,500, (ii) Land was purchased
for Rs. 10,000. Amount provided for amortisation of goodwill Rs. 5,000 and (iii)
Debentures paid off Rs. 6,000
Prepare Cash Flow Statement.
23
Solution :
Cash Flow Statement
(for the year ended 31.12.1999)
Rs. Rs.
Opening balance of cash Cash Outflows
on 1.1.1999 9,000 Purchase of Land 10,000
Add : Cash Inflows : Increase in Debtors 2,800
Issue of Share Capital 4,000 Redemption of Debentures 6,000
Increase in trade creditors 1,480 Dividends Paid 3,500
Cash inflow from operations 9,120 Closing balance of cash on
Decrease in stock 6,500 31.12.1999 7,800
30,100 30,100
Workings :
1. Cash inflow from operations
Adjusted Profit And Loss A/c
Rs. Rs.
To Dividend (non-operating) 3,500 By Balance b/d 10,040
To Goodwill (non-fund/cash) 5,000 By Cash inflow from operation 9,120
To Reserve for doubtful debts 100
To Balance c/d 10,560
19,160 19,160
Alternatively Rs.
Balance of P & L A/c on 31.12.1999 10,560
Add : non-fund/cash and non-operating items which
have already been debited to P & L A/c :
Dividend paid 3,500
Goodwill written off 5,000
Reserve for doubtful debts 100
19,160
Less : Opening balance of P & L A/c and non-operating
incomes :
Opening balance of P/L A/c
(on 31.12.1998) 10,040 10,040
Cash Inflow from operations 9,120
5. Ratio Analysis : This has been discussed in detail in Lesson No. 13.
6. Funds Flow Statement : This has been discussed in detail in Lesson No. 14.
24
12.5 SUMMARY
An analysis of financial statements is the process of critically examining in detail
accounting information given in the financial statements. For the purpose of
analysis,
individual items are studied, their interrelationships with other related figures are
established, the data is sometimes rearranged to have better understanding of the
information with the help of different techniques or tools for the purpose.
Analysing
financial statements is a process of evaluating relationship between component
parts of financial statements to obtain a better understanding of firm's position and
performance. The principal tools of financial analysis include comparative
financial
statements, common size statements, trend analysis, cash flow statements, ratio
analysis and fund flow statements.
12.6 KEYWORDS
Financial statement: Financial statements refers to formal and original statements
which are prepared to disclose financial health in the terms of profits, position,
and prospects as on a certain data.
Analysis of financial statement: It refers to the art of applying various tools to
know the behaviour of the accounting information.
Interpretation of financial statement: This refers to evaluating the performance
of the business.
Comparative financial statements: These enable comparison of financial
information for two or more years placed side by side.
Trend analysis: Trend analysis can be defined as the index numbers of the
movements of the various financial items on the financial statement for a number
of periods.
Cash flow statement: It is a statement designed to highlight upon the causes
which
brings changes in cash position between two balance sheet dates.
12.7 SELF ASSESSMENT QUESTIONS
1. What do you mean by analysis of financial statements? Discuss the different
methods used for the analysis and interpretation of financial statements.
2. What are comparative statements? What is their usefulness ?
3. What is meant by common-size statements? What purpose do they serve ?
4. How common-size statements are different from comparative statements ?
5. Distinguish between fund flow and cash flow statements. What are the
advantages
of preparing cash flow statements ?
25
6. Explain the different formats for preparing a cash flow statement. How this
statement can be used as a tool for planning and control?
7. From the following balance sheets of Pardeep Ltd. for the year ending 31st
March 1998 and 31st March 1999, prepare a comparative balance sheet of the
company and comment upon the financial position of the company.
Liabilities 31.3.1998 31.3.1999 Assets 31.3.1998 31.3.1999
(Rs.) (Rs.) (Rs.) (Rs.)
Equity Share Capital 3,00,000 4,00,000 Goodwill 60,000 55,000
10% Preference Share 80,000 50,000 Land & Building 1,25,000 85,000
Capital Reserve 5,000 20,000 Plant & Machinery 1,20,000 2,25,000
General reserve 26,000 40,000 Furniture 15,000 12,000
Profit and Loss Account 25,000 35,000 Trade Investments 12,000 48,000
Sundry Creditors 30,000 57,000 Sundry Debtors 65,000 1,05,000
Bills payable 12,000 9,000 Stock 90,000 84,000
Outstanding expenses 6,000 5,000 Bills Receivable 16,000 30,000
Proposed Dividend 30,000 42,000 Cash at Bank 15,000 20,000
Provision for tax 32,000 36,000 Cash in Hand 13,000 20,000
Preliminary Expenses 15,000 10,000
5,46,000 6,94,000 5,46,000 6,94,000
8. From the following figure of Shalu & Co., calculate the trend percentages,
taking
1991 as the base and interpret them :
(Rs. in lakhs)
Year Sales Cost of goods Stock Profit before
sold tax
1991 17.80 10.30 2.78 3.20
1992 20.40 12.50 3.24 4.05
1993 22.50 13.60 3.40 4.22
1994 28.10 15.80 3.44 5.25
1995 35.25 20.40 4.35 6.40
1996 40.30 25.00 4.70 6.90
9. Balance Sheets of M/s Pardeep & Co. as on 31.12.98 and 31.12.99 were as
follows:
Liabilities 1998 1999 Assets 1998 1999
(Rs.) (Rs.) (Rs.) (Rs.)
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs. White's Loan 25,000 – Debtors 30,000 50,00
Loan from P.N. Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Buildings 35,000 60,000
2,30,000 247,000 2,30,000 2,47,000
26
During the year a machine costing Rs. 10,000 (accumulated depreciation
Rs. 3,000) was sold for Rs. 5,000. The provision for depreciation against
machinery as
on 1.1.98 was Rs. 25,000 and on 31.12.1999 Rs. 40,000. Net profit for the year
1998
amounted to Rs. 45,000. You are required to prepare :
(a) Cash Flow Statement
(b) Funds (working capital) Flow Statement
10. The following are the Balance Sheets of Golu & Co Ltd. as on 31st December
1998 and 31st December 1999.
1998 1999 1998 1999
Liabilities Rs. Rs. Assets Rs. Rs.
Equity share capital 15,75,000 18,00,000 Fixed Assets 11,25,000 13,50,000
General Reserve 10,12,500 13,50,000 Additions 2,25,000 1,80,000
P/L Account 3,89,250 5,24,250 13,50,000 15,30,000
Trade creditors 15,75,000 20,25,000 Depreciation 4,50,000 7,20,000
Bank overdraft 25,87,500 31,50,000 9,00,000 8,10,000
Outstanding Expenses 1,80,000 2,07,000 Trade Investment 2,70,000 –
Provision for Taxation 4,43,250 8,32,500 Debtors 40,05,000 49,16,250
Proposed Dividend 3,37,500 3,37,500 Stock 29,25,000 45,00,000
81,00,000 1,02,26,250 81,00,000 1,02,26,250
The profit for the year 1999 as per profit and loss account after
providing for depreciation amounted to Rs. 1575000 which was further adjusted as
follows
Profit & Los Balance b/f 3,89,250
Profit after Depreciation 15,75,000
Add Profit on sale of Investment 45,000
20,09,250
Less : Provision for tax 8,10,000
Transfer dividend 3,37,500
Proposed dividend 3,37,500 14,85,000
Balance c/d 5,24,250
You are informed that
i) The sales and purchases of the year 1999 amounted to Rs. 180,00,000 and
Rs. 146,25,000 respectively.
ii) In arriving at the profit from the sales referred to above, the cost of sales,
administration and selling expenses were deducted.
You are required to prepare a cash flow statement.
1
Subject : Accounting for Managers
Course Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 13
ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS : RATIO ANALYSIS
STRUCTURE
13.0 Objective
13.1 Introduction
13.2 Meaning of Ratio Analysis
13.3 Interpretation of Financial Ratios
13.4 Managerial Uses of Ratio Analysis
13.5 Drawback of Ratio Analysis
13.6 Classification of Ratios
13.6.1 Liquidity Ratios
13.6.2 Activity Ratios
13.6.3 Leverage/Capital Structure
13.6.4 Coverage Ratios
13.6.5 Profitability Ratios
13.7 Summary
13.8 Keywords
13.9 Self Assessment Questions
13.10 Suggested Readings
13.0 OBJECTIVE
After reading this lesson you should be able to
(i) understand the meaning, uses and limitations of ratio analysis;
(ii) workout all the important ratios that are required to analyse liquidity
position, operational efficiency, capital structure, profitability and solvency
position of manufacturing, trading, and service concerns.
13.1 INTRODUCTION
An analysis of financial statements is the process of critically examining in detail
accounting information given in the financial statements. For the purpose of
analysis,
individual items are studied, their interrelationships with other related figures
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are established, the data is sometimes rearranged to have better understanding of
the information with the help of different techniques or tools for the purpose.
Analysing financial statements is a process of evaluating relationship between
component
parts of financial statements to obtain a better understanding of firm’s position
and performance. The analysis of financial statements thus refers to the treatment
of the information contained in the financial statements in a way so as to
afford a full diagnosis of the profitability and financial position of the firm
concerned.
For this purpose financial statements are classified methodically, analysed
and compared with the figures of previous years or other similar firms.
The term ‘Analysis’ and ‘interpretation’ though are closely related, but distinction
can be made between the two. Analysis means evaluating relationship between
components
of financial statements to understand firm’s performance in a better way.
Various account balances appear in the financial statements. These account
balances
do not represent homogeneous data so it is difficult to interpret them and
draw some conclusions. This requires an analysis of the data in the financial
statements
so as to bring some homogeneity to the figures shown in the financial statements.
Interpretation is thus drawing of inference and stating what the figures in
the financial statements really mean. Interpretation is dependent on interpreter
himself.
Interpreter must have experience, understanding and intelligence to draw correct
conclusions from the analysed data.
13.2 MEANING OF RATIO ANALYSIS
A ratio is a simple arithmetical expression of the relationship of one number to
another. According to Accountant's Handbook by Wixon, Kelland bedbord, "a
ratio"
is an expression of the quantitative relationship between two numbers". In simple
language ratio is one number expressed in terms of the other and can be worked
out
by dividing one number into the other. This relationship can be expressed as (i)
percentages, say, net profits are 20 per cent of sales (assuming net profits of Rs.
20,000 and sales of Rs. 1,00,000), (ii) fraction (net profit is one-fourth of sales)
and (iii) proportion of numbers (the relationship between net profits and sales is
1:4).
The rational of ratio analysis lies in the fact that it makes related information
comparable. A single figure by itself has no meaning but when expressed in terms
of a related figure, it yields significant inferences. Ratio analysis helps in financial
forecasting, making comparisons, evaluating solvency position of a firm, etc. For
instance, the fact that the net profits of a firm amount to, say, Rs. 20 lakhs throws
no light on its adequacy or otherwise. The figure of net profit has to be considered
in relation to other variables. How does it stand in relation to sales? What does it
represent by way of return on total assets used or total capital employed? In case
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net profits are shown in terms of their relationship with items such as sales, assets,
capital employed, equity capital and so on, meaningful conclusions can be drawn
regarding their adequacy. Ratio analysis, thus, as a quantitative tool, enables
analysts
to draw quantitative answers to questions such as : Are the net profits adequate ?
Are the assets being used efficiently? Can the firm meet its current obligations and
so on ? However, ratio analysis is not an end in itself. Calculation of mere ratios
does not serve any purpose, unless several appropriate ratios are analysed and
interpreted. The following are the four steps involved in the ratio analysis :
(i) Selection of relevant data from the financial statements depending upon the
objective of the analysis.
(ii) Calculation of appropriate ratios from the above data.
(iii) Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ratios
of some other firms or the comparison with ratios of industry to which
the firm belongs.
(iv) Interpretation of the ratio.
13.3 INTERPRETATION OF RATIOS
The interpretation of ratios is an important factor. Though calculation is also
important
but it is only a clerical task whereas interpretation needs skills, intelligence
and foresightedness. The interpretation of the ratios can be done in the following
ways :
1. Single Absolute Ratio: Generally speaking one cannot draw meaningful
conclusions when a single ratio is considered in isolation. But single ratios may be
studied in relation to certain rules of thumb which are based upon well proven
contentions as for example 2:1 is considered to be a good ratio for current assets
to current liabilities.
2. Groups of Ratio : Ratios may be interpreted by calculating a group of related
ratios. A single ratio supported by related additional ratios becomes more
understandable and meaningful.
3. Historical Comparisons : One of the easiest and most popular ways of
evaluating the performance of the firm is to compare its present ratios with the
past ratios called comparison over time.
4. Projected Ratios : Ratios can also be calculated for future standard based
upon the projected financial statements. Ratio calculation on actual financial
statements
can be used for comparison with the standard ratios to find out variance, if
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any. Such variance helps in interpreting and taking corrective action for
improvement
in future.
5. Inter-firm Comparison : Ratios of one firm can also be compared with
the ratios of some other selected firms in the same industry at the same point of
time.
13.4 MANAGERIAL USES OF RATIO ANALYSIS
The following are the important managerial uses of ratio analysis –
1. Helps in Financial Forecasting : Ratio analysis is very helfpful in financial
forecasting. Ratios relating to past sales, profits and financial position form the
basis for setting future trends.
2. Helps in Comparison : With the help of ratio analysis, ideal ratios can be
composed and they can be used for comparing a firm's progress and performance.
Inter-firm comparison or comparison with industry averages is made possible by
the ratio analysis.
3. Financial Solvency of the Firm : Ratio analysis indicates the trends in
financial solvency of the firm. Solvency has two dimensions-long-term solvency
and short-term solvency. Long-term solvency refers to the financial viability of a
firm and it is closely related with the existing financial structure. On the other
hand, short-term solvency is the liquidity position of the firm. With the help of
ratio analysis conclusions can be drawn regarding the firm's liquidity and longterm
solvency position.
4. Evaluation of Operating Efficiency : Ratio analysis throws light on the
degree of efficiency in the management and utilisation of its assets and resources.
Various activity ratios measure this kind of operational efficiency and indicate the
guidelines for economy in costs, operations and time.
5. Communication Value : Different financial ratios communicate the strength
and financial standing of the firm to the internal and external parties. They indicate
the over-all profitability of the firm.
6. Others Uses : Financial ratios are very helpful in the diagnosis of financial
health of a firm. They highlight the liquidity, solvency, profitability and capital
gearing etc. of the firm.
13.5 DRAW BACKS OF RATIO ANALYSIS
1. Limited use of a single ratio : Ratio can be useful only when they are
computed in a sufficient large number. A single ratio would not be able to convey
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anything. A the same time, if too many ratios are calculated, they are likely to
confuse instead of revealing any meaningful conclusion.
2. Effect of inherent limitations of accounting : Because ratios are computed
from historical accounting records, so they also possess those limitations and
weaknesses as accounting records possess.
4. Lack of proper standards : While making comparisons, it is always a
challenging job to find out an adequate standard. It is not possible to calculate
exact
and well accepted absolute standard, so a quality range is used for this purpose. If
actual performance is within this range, it may be regarded as satisfactory.
5. Past is not indicator of future : It is not always possible to make future
estimates on the basis of the past as it always does not come true.
6. No allowance for change in price level : While making comparisons of
ratios, no allowance for changes in general price level is made. A change in price
level can seriously affect the validity of comparisons of ratios computed for
different time periods.
7. Difference in definitions : Comparisons are also made difficult due to
differences in definitions of various financial terms. The terms like gross profit,
net profit, operating profit etc. have not precise definitions and an established
procedure for their computation.
8. Window Dressing : Financial statements can easily be window dressed to
present a better picture of its financial and profitability position to outsiders.
Hence
one has to be careful while making decision on the basis of ratios calculated from
such window dressing made by a firm.
9. Personal Bias : Ratios are only means of financial analysis and is not an
end in itself. Ratios have to be Interpreted carefully because the same ratio can be
looked at, in different ways.
13.6 CLASSIFICATION OF RATIOS
Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity
ratios (iii) Leverage/Capital structure ratios (iv) Coverage ratios (v) Profitability
ratios.
13.6.1 Liquidity Ratios : Liquidity refers to the ability of a firm to meet its
current
obligations as and when they become due. The importance of adequate liquidity in
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the sense of the ability of a firm to meet current/short-term obligations when they
become due for payment can hardly be overstressed. In fact, liquidity is a
prerequisite
for the very survival of a firm.
The ratios which indicate the liquidity of a firm are (i) net working capital, (ii)
current ratio, (iii) acid test/quick ratio, (iv) super quick ratio, (v) basic defensive
interval.
1. Net Working Capital : The first measurement of liquidity of a firm is to
compute its Net Working capital (NWC). NWC is really not a ratio, it is frequently
employed as a measure of a company's liquidity position. NWC represents the
excess
of current assets over current liabilities. A firm should have sufficient NWC in
order to be able to meet the claims of the creditors and the day-to-day needs of
business. The greater the amount of NWC, the greater the liquidity of the firm.
Inadequate working capital is the first sign of financial problems for a firm. It is
useful for purposes of internal control also.
NWC = Total Current Assets – Total Current Liabilities
Illustration 1. : The following data has been given in respect of two general
insurance firms. Calculate their NWC and comment upon the liquidity position.
Company X Company Y
Total Current Assets Rs. 2,80,000 Rs. 1,30,000
Total Current Liabilities Rs. 2,20,000 Rs. 1,10,000
Solution :
NWC = TCA–TCL
Company X : Rs. 2,80,000–Rs. 2,20,000 = Rs. 60,000.
Company Y : Rs. 1,30,000–Rs. 1,10,000 = Rs. 20,000.
X company has three times NWC in comparison to Y company, hence it is
more liquid. However, the size of NWC alone is not an appropriate measure of the
liquidity position of a firm. The composition of current assets is also important in
this respect.
2. Current Ratio : Current ratio is the most common ratio for measuring
liquidity. Being related to working capital analysis, it is also called the working
capital ratio. The current ratio is the ratio of total current assets to total current
liabilities.
Current Ratio =
Current Assets
Current Liabilities
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As a measure of short-term financial liquidity, it indicates the rupees of current
assets available for each rupee of current liability. The higher the current ratio, the
larger the amount of rupees available per rupee of current liability, the more the
firm's ability to meet current obligations and the greater the safety of funds of
short-term creditors. If the result is greater than 1, the firm presumably has
sufficient
current assets to meet its current liabilities. A ratio of 2:1 (two times current assets
of current liabilities) is considered satisfactory as a rule of thumb. Thus, a good
current ratio, in a way, provides a margin of safety to the creditors.
3. Acid-Test/Quick Ratio : One defect of the current ratio is that it fails to
convey any information on the composition of the current assets of a firm. A rupee
of cash is considered equivalent to a rupee of inventory or receivables. But it is not
so. A rupee of cash is more readily available to meet current obligations than a
rupee of, say, inventory. This impairs the usefulness of the current ratio. The
acidtest
ratio is a measure of liquidity designed to overcome this defect of the current
ratio. It is often referred to as quick ratio because it is a measurement of a firm's
ability to convert its current assets quickly into cash in order to meet its current
liabilities. Thus, it is a measure of quick or acid liquidity.
Acid-test ratio =
The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Included in this
category of current assets are (i) cash and bank balances; (ii) short-term
marketable
securities and (iii) debtors/receivables. Thus, the current assets which are excluded
are : prepaid expenses and inventory. The exclusion of inventory is based on the
reasoning that it is not easily and readily convertible into cash. Prepaid expenses
by their very nature are not available to pay off current debts. An acid-test ratio of
1:1 or greater is recommended.
4. Cash-Position Ratio or Super-Quick Ratio : It is a variant of Quick ratio.
When liquidity is highly restricted in terms of cash and cash equivalents, this ratio
should be calculated. It is calculated by dividing the super-quick current assets by
the current liabilities of a firm. The super-quick current assets are cash and
marketable securities. It can be calculated as below :
Cash-Position Ratio =
Quick assets
Current liabilities
Cash + Marketable Securities
Current Liabilities
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Illustration 2 : From the following information regarding current assets and
current
liabilities of a firm, comment upon the liquidity of the concern :
Current Assets : Rs.
Cash 50,000
Debtors 20,000
Bills Receivables 15,000
Stock 35,000
Investment in Govt. Securities 25,000
Prepaid Expenses 10,000
1,55,000
Current Liabilities :
Trade Creditors 27,000
Bills Payable 12,000
Outstanding Expenses 5,000
Provision for Taxation 18,000
Bank Overdraft 10,000
72,000
Solution :
(1) Current Ratio = = = 2.15:1
(2) Quick Ratio = = = 1.53:1
(3) Cash Position Ratio =
= = 1.04 : 1
13.6.2 Activity Ratios
Activity ratios which are also called efficiency ratio or asset utilisation ratios are
concerned with measuring the efficiency in asset management. The efficiency with
which the assets are used would be reflected in the speed and rapidity with which
assets are converted into sales. The greater is the rate of turnover or conversion,
the more efficient is the utilisation/management, other things being equal. For this
reason, such ratios are also designated as turnover ratios.
1. Inventory Turnover Ratio : It is computed as follows :
Inventory turnover ratio =
Current Assets
Current Liabilities
155000
72,000
Liquid Assets
Current Liabilities
110,000
72,000
Cash + Marketable Securities
Current Liabilities
75,000
72,000
Cost of goods sold
Average inventory
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The cost of goods sold means sales minus gross profit. The average inventory
refers
to the simple average of the opening and closing inventory. The ratio indicates
how
fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice
versa. A low ratio would signify that inventory does not sell fast and stays on the
shelf or in the warehouse for a loan time.
2. Debtors Turnover Ratio : This ratio is determined by dividing the net credit
sales by average debtors outstanding during the year. Thus,
Debtors turnover ratio =
Net credit sales consist of gross credit sales minus sales returns, if any, from
customers. Average debtors is the simple average of debtors at the beginning and
at
the end of year. The ratio measures how rapidly debts are collected. A high ratio is
indicative of shorter time-lag between credit sales and cash collection. A low ratio
shows that debts are not being collected rapidly.
3. Creditors Turnover Ratio : It is a ratio between net credit purchases and
the average amount of creditors outstanding during the year. It is calculated as
follows:
Creditors turnover ratio =
Net credit purchases = Gross credit purchases less returns to suppliers
Average creditors = Average of creditors outstanding at the beginning and at
the end of the year.
A low turnover ratio reflects liberal credit terms granted by suppliers, while a high
ratio shows that accounts are to be settled rapidly.
4. Average Age of Sundry Debtors : The average age of sundry debtors (or
accounts receivable), or average collection period is more meaningful figure to use
in evaluating the firm's credit and collection policies. The main objective of
calculating
average collection period is to find out cash inflow rate from realisation from
debtors.