Financial

&
Management
Accounting
MBAZC415

Sajin John
2020HB58042

SAJIN JOHN 0

TABLE OF CONTENTS
MODULE 1: INTRODUCTION TO ACCOUNTING ..................................................................................................................... 3
WHAT IS ACCOUNTING? ......................................................................................................................................................................................... 3
Fundamentals of accounting ........................................................................................................................................................................... 3
Introductions to financial statements ......................................................................................................................................................... 3
Forms of Business Organization .................................................................................................................................................................... 3
Users and Uses of Financial Information ................................................................................................................................................... 4
Business Activities ................................................................................................................................................................................................ 4
Communications with Users ............................................................................................................................................................................ 5
Annual Reports ...................................................................................................................................................................................................... 7
MODULE 2: GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) ..................................................................... 8
BALANCE SHEET PRINCIPLES ................................................................................................................................................................................ 8
Monetary Measurement Concept .................................................................................................................................................................. 8
Business Entity Concept ..................................................................................................................................................................................... 8
Periodicity Concept .............................................................................................................................................................................................. 8
Going Concern Concept ...................................................................................................................................................................................... 8
Cost Concept ........................................................................................................................................................................................................... 8
Dual aspect (Double entry system) ............................................................................................................................................................... 8
INCOME STATEMENT CONCEPTS ........................................................................................................................................................................... 9
Accounting Period Concept .............................................................................................................................................................................. 9
Conservatism Concept ........................................................................................................................................................................................ 9
Realization Concept ............................................................................................................................................................................................. 9
Matching Concept ................................................................................................................................................................................................. 9
Consistency Concept ............................................................................................................................................................................................ 9
Materiality Concept ............................................................................................................................................................................................. 9
ACCOUNTING EQUATION ...................................................................................................................................................................................... 11
The Accounting Process .................................................................................................................................................................................. 11
EXERCISE – IDENTIFY ASSETS, LIABILITIES, INCOME & EXPENSES ............................................................................................................. 12
THE CLASSIFIED BALANCE SHEET ..................................................................................................................................................................... 13
MODULE 3: JOURNAL ................................................................................................................................................................. 14
WHAT IS JOURNAL? .............................................................................................................................................................................................. 14
RULES OF DEBIT AND CREDIT ............................................................................................................................................................................. 14
MODULE 4: LEDGER POSTING ................................................................................................................................................. 15
MEANING AND FORMAT OF ACCOUNT - T ACCOUNTS ...................................................................................................................................... 15
The T-Account ................................................................................................................................................................................................... 15
Ledger ..................................................................................................................................................................................................................... 15
HOW TO POST JOURNAL ENTRIES INTO LEDGER? ............................................................................................................................................. 16
MODULE 5: TRIAL BALANCE .................................................................................................................................................... 17
FORMAT OF TRIAL BALANCE ................................................................................................................................................................................ 17
PREPARATION OF TRIAL BALANCE ..................................................................................................................................................................... 17
ERRORS IN PREPARATION OF TRIAL BALANCE ................................................................................................................................................. 18
Errors that don’t affect the Trial Balance .............................................................................................................................................. 18
Errors that affect the Trial Balance .......................................................................................................................................................... 18
MODULE 6: FINAL ACCOUNTS ................................................................................................................................................. 19
PREPARATION OF FINAL ACCOUNTS ................................................................................................................................................................... 19
ADJUSTMENTS FOR TRANSACTIONS AFTER CLOSING OF ACCOUNTS ............................................................................................................. 19
COst of Goods Sold & Gross Profit ............................................................................................................................................................... 19
Adjusting Entries ............................................................................................................................................................................................... 19
Types of Adjusting Entries ............................................................................................................................................................................. 19
Bad Debts .............................................................................................................................................................................................................. 19
MODULE 7: THE STATEMENT OF CASH FLOWS ................................................................................................................. 20
INTRODUCTION TO CASH FLOW STATEMENT ................................................................................................................................................... 20
Categories of Activities .................................................................................................................................................................................... 20

SAJIN JOHN 1

 Significant Noncash Transactions ............................................................................................................................................................. 20
Organization of the Statement of Cash Flows ....................................................................................................................................... 20
Computing Cash flow from Operating Activities ................................................................................................................................. 21
MODULE 8: RATIO ANALYSIS .................................................................................................................................................. 23
INTRODUCTION TO RATIO ANALYSIS ................................................................................................................................................................. 23
MODULE 9: COST-VOLUME PROFIT ANALYSIS .................................................................................................................. 25
INTRODUCTION TO COST VOLUME PROFIT ANALYSIS .................................................................................................................................... 25
Cost-Volume (C-V) Diagram ......................................................................................................................................................................... 25
MODULE 10: CAPITAL BUDGETING ....................................................................................................................................... 28
CAPITAL BUDGETING ............................................................................................................................................................................................ 28
The Contribution Margin ............................................................................................................................................................................... 28
Differential Costs ............................................................................................................................................................................................... 28
Sunk Cost ............................................................................................................................................................................................................... 28
Opportunity Cost ................................................................................................................................................................................................ 28
Disposal Value ..................................................................................................................................................................................................... 28
Importance of Time Span ............................................................................................................................................................................... 29
Objective of Alternative Choice Problem ................................................................................................................................................. 29
Type of Alternative Choice Problems ........................................................................................................................................................ 29
Net Present Value (NPV) Rule ...................................................................................................................................................................... 29
Internal Rate of Return (IRR) Method ...................................................................................................................................................... 30

SAJIN JOHN 2

MODULE 1: INTRODUCTION TO ACCOUNTING
WHAT IS ACCOUNTING?

FUNDAMENTALS OF ACCOUNTING FORMS OF BUSINESS ORGANIZATION

Invoices – each of which highlights the details of a Sole Proprietorship / Trader
transaction • Simple to establish
Receipts – each of which verifies that a payment has • Owner controlled
been made • Tax advantages
The fundamental principles of accounting as outlined Partnership
by the Father of Accounting, namely, Fra Luca Pacioli • Simple to establish
in his seminal—“Summa de arithmetica, geometria. • Shared control
Proportionietproportionalita” (Summary of Arithmetic, • Broader skills and resources
Geometry, Proportions and Proportionality) —have not • Tax advantages
changed in essence since 1494, and these rules still
form the basis of modern accounting. Corporation (Private/Public Company)
“Accounting is the art of recording, classifying and • Easier to transfer ownership
summarizing, in a significant manner, and in term of • Easier to raise funds
money, transactions and events which are in part at least • No personal liability
of a financial character, and interpreting the results • Stakeholders are: Shareholder’s, Suppliers,
thereof.” --- American Institute of Certified Public Customers, Government, Management,
Accountants (AICPA) Employees
• Stakeholders depend on the financial statement to
o Identification of Financial Transactions and
Events understand the company’s progress.
o Measuring the Identified Transactions
o Recording – each and every transaction – in CHARACTERISTICS OF BUSINESS FIRMS
journal
o Classifying – because going through all Features Sole Partnership Limited
transactions is tedious – in ledger Traders Company
o Summarizing – to have a bird’s eye view of Ownership Single Min: 2 - Private
state of business – in trial balance & final Owner Max: 100 Limited [2 –
accounts [Indian 200
Partnership shareholders]
o In terms of money – only monetary - Public
Act 1932 & IC
transactions Act 2013] Limited
o Interpretation – make sense of financial data. (listed – Min: 7
Analysis of financial statements. shareholder
and no upper
Accounting is a systematic process of identifying, limit)
measuring, recording, classifying, summarizing Decision – Completely Flexible, Very rigid:
interpreting and communicating financial information. making flexible partners may approval from
disagree shareholders
Suitability Small Small, Large, very
INTRODUCTIONS TO FINANCIAL business medium large that
STATEMENTS and small require public
capital capital
Forms of Business Organization

• Sole Proprietorship, Partnership, Corporation

Users and uses of Financial

information
• Internal Users, External Users

Business Activities

• Financing, Investing, Operating

Communication with users

• Income Statement
• Balance sheet
• Statement of cash flows

SAJIN JOHN 3



BUSINESS ACTIVITIES
USERS AND USES OF FINANCIAL The environment within which accounting exists is
INFORMATION formally known as the accounting information system.
Internal Users: The accounting information system keeps track of the
• Management: results of each of the business activities i.e. Financing,
Which product line is profitable, and Investing, Operating.
which one should be eliminated?
E.g.: Which PepsiCo product line is the
most profitable? Should any product
lines be eliminated?
• Marketing:
What price should we charge to maximize profit?
E.g.: What price should Apple charge for an iPod to FINANCING ACTIVITIES
maximize the company’s net income? Two primary sources of outside funds are:
• Finance: 1. Borrowing money (debt financing)
Do I have cash pay
dividend/employee salaries? • Amounts owned are called liabilities
E.g.: Is cash sufficient to pay dividend to • Party to whom amounts are owed are
Microsoft stockholders creditors
• Human resources: • Notes payable and bonds payable are
can company afford pay hike different types of liabilities.
this year? 2. Issuing (selling) shares of stock for cash
E.g.: Can General Motors
• Payments to stockholders are called
afford to give its employees pay
raises this year?
dividends.

External Users:
INVESTING ACTIVITIES
• Investors: Purchase of resources a company needs to operate.
Profitability, financial ratios, etc
Three Principles: • Property, Plant, and equipment.
o Analyses the long-term evolution and • E.g.: Computers, delivery trucks, furniture,
management principles of a company buildings, etc.
before investing • Resources owned by a business are called assets
o Products him or herself from losses • Investments are another example of an investing
by diversifying investments activity
o Never looks for crazy profits, but
focuses on safe and steady returns OPERATING ACTIVITIES
E.g.: Is General Electric Once a business has the assets it needs, it can begin its
earning satisfactory operations.
income?
• Revenues – Amounts earned from the sale of
How does Disney compare
products (sale revenue, service revenue, and
in size and profitability
interest revenue).
with Time Warner?
• Inventory – Goods available for sale to customers.
• Creditors: • Accounts receivable – Right to receive money
Financial statements from a customer as the result of a sale.
E.g.: Will United • Expenses – cost of assets consumed, or services
Airlines be able to pay used. (cost of goods sold, selling, marketing,
its debts as they come administrative, interest, and income taxes
due? expense)
• Liabilities – arising from expenses include
accounts payable, interest payable, wages
payable, sales taxes payable, and income taxes
payable.
• Net Income – when revenues exceed expenses.
• Net Loss – when expenses exceed revenues.

SAJIN JOHN 4

COMMUNICATIONS WITH USERS
Companies prepare four financial statements from the
summarized accounting data:
Retained
Income Balance Statement of
Earnings
Statement Sheet Cash Flows
Statement

The Standard-Setting Environment
Generally Accepted Accounting Principles (GAAP) –
A set of rules and practices, having substantial
authoritative support, that the accounting profession
recognizes as a general guide for financial reporting
purposes.
Standard-setting bodies:
o Securities and Exchange Commission (SEC) • Time period is the same as that covered by the
o Financial Accounting Standards Board (FASB) income statement.
o International Accounting Standards Board (IASB) • Users can evaluate dividend payment practices.
o Public Company Accounting Oversight Board • Retained earnings is the income left after paying
(PCAOB) all liability of the business
International Note: • RE = actual profit of the business.
• Retail Earnings = Revenue – Expenses -
The primary types of financial statements required by
Dividends
International Financial Reporting (IFRS) and U.S.
• Changes in retained earnings.
generally accepted accounting principles (GAAP) are
• A company, or a corporation, at the discretion of
the same.
its board of directors, can pay some of its income,
Over 115 countries use international standards usually after a profitable period, to stockholders,
(called IFRS/GAAP) as dividends and keep the remainder as retained
earnings.
INCOME STATEMENT
• Reports revenues and expenses for a specific
period of time.
• Net income – revenues exceed expenses.
• Net loss – expenses exceed revenues.
• Past net income provides information for
predicting future net income.
• Net Income = Total Revenue – Total Expenses
• Financial Performance

RETAINED EARNINGS STATEMENT

• Net income is needed to determine the ending
balance in retained earnings.
• Statement shows amounts and causes of changes
in retained earnings during the period.

SAJIN JOHN 5

BALANCE SHEET
• Reports assets and claims to assets at a specific
point in time.
• Assets = Liabilities + Stockholders’ Equity
(Owners capital).
• A = L + OE
• WHAT === WHO
Assets === WHO has claim
Assets === Others Claim + My Claim
Assets === Liabilities + Owners’ Equity
Car (15K) = Bank Loan(13K) + Cash (2K)

• Lists assets first, followed by stockholders’ equity,
CURRENT ASSETS
liabilities
• Strength and liquidity – Statement of financial • Current assets have a useful economic life of one
position year or less and can be converted easily into cash.
• Such assets in this class include cash and cash
equivalents, accounts receivable, and inventory
NONCURRENT ASSETS
• Noncurrent assets are assets that cannot be turned
into cash easily.
• They also have an expected life span of more than
a year.
• This can refer to tangible assets such as plant and
machinery, buildings, and land.
• Noncurrent assets can include intangible assets
such as goodwill, patents, or copyrights.
• Intangible assets are not physical in nature, are
usually not capitalized, and can make or destroy a
company, for example, the value of a brand name,
should not be underestimated.
• Depreciation is calculated and subtracted from
tangible assets, which represents the economic
cost of the asset over its useful life.
CURRENT LIABILITIES
• Current liabilities are the company’s liabilities that
will come due, or must be honoured, within one
year.
• This includes both shorter-term borrowings, such
as accounts payables, together with the current
portion of longer-term borrowing, such as the
latest interest payment on a multi-year loan.
NONCURRENT LIABILITIES
• Long-term liabilities are debts and other non-debt
financial obligations, which are due more than at
least one year from the date of the balance sheet.
STOCKHOLDERS’ EQUITY
• Shareholders’ equity is the amount of money that
was initially invested into a business.
• If a company decides to reinvest its net earnings
into the company (after taxes), these retained
earnings will be moved from the income
statement onto the balance sheet and into the
stockholders or shareholder’s equity account.

SAJIN JOHN 6

 STATEMENT OF CASH FLOWS
• Cash flow statement provides detail about the
sources and uses of cash during an accounting
period.
• The balance sheet shows the cash balance on a
particular date, but it does not explain the change
in the cash position since the last balance sheet
date.
• Helps in answering below queries:
o Where did cash come from during the period?
o How was cash used during the period?
o What was the change in the cash balance
during the period?
The cash flows are broken under three heads:
i. Cash flow from operating activities—sources and
uses of cash arising directly from the main
revenue generating activities of the organization.
ii. Cash flow from investing activities—sources and
uses of cash related to investing in long-term
assets including long-term investments. This also
includes the income generated from these long-
term investments. ANNUAL REPORTS
iii. Cash flow from financing activities—sources and U.S. Companies that are publicly traded must provide
uses of cash related to funds raising activities shareholders with an annual report.
including repayment of loans, payment of interest
The annual report always includes:
on borrowed funds and payments of dividends on
shares. - Financial statements.
- Management discussion and analysis.
- Notes to the financial statements.
- Auditor’s report
AUDITORS REPORT
Auditor’s opinion as to the fairness of the presentation
of the financial position and results of operations and
their conformance with generally accepted accounting
principles.

SAJIN JOHN 7

MODULE 2: GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
BALANCE SHEET PRINCIPLES
recording business transactions as if the business will
MONETARY MEASUREMENT CONCEPT continue to operate for an indefinite period of time.
Requires that only those things that can be expressed E.g.: Healthcare Pharmaceutical Limited has 3 plants
in money are included in the accounting records located at Delhi, Mumbai and Pune. The company has
Money measurement concept makes it possible to decided to shut down the Pune plant and sell its assets
aggregate different types of assets, liabilities, revenues either as a running unit or in a piecemeal manner. What is
and expenses by expressing them in a common unit of the implication of such a decision in the books of accounts
reporting. of the company?
In respect of Pune plant, the going concern
Scenario 1: A business owns
assumption has been violated as such the assets
• Rs30,000 of cash should be shown at their liquidation value. For the
• 6000 pounds of raw materials other two plants, going concern continues to hold
• 50,000 square feet of building space good.
• Can’t be added together
Scenario 2: A business own COST CONCEPT
• Rs30,000 of cash Actual cost paid. Record
• Rs9000 of raw materials the assets at their costs.
• Rs150,000 of trucks (instead of the current
• Rs40000 of building market value).
• Can be added together Cost concept lends
objectivity to the financial statements as a long-term
asset will continue to be shown at its historical cost
BUSINESS ENTITY CONCEPT
irrespective of fluctuation in the market price. However
Stats that every economic entity can be separately
a permanent fall in value is recognized.
identified and accounted for. (Separate from its
owners) E.g.: Industrial Lab Limited bought a piece of land for ₹
5 million in the year 1970. The company has used the
Separate entity concept ensures that the personal
land to set up an industrial unit. The current market
affairs of the proprietor are not mixed with business
price of the land is ₹ 20 million. At what value this asset
transactions resulting in correct ascertainment of
should be shown in the financial statements of the
business results and financial position.
company?
E.g.: Ram Manohar & Sons is a proprietorship firm owned
The land will continue to appear at its historical
by Mr. Ram Manohar. During the year 2017, the firm
bought goods worth ₹ 1,000,000. Goods costing ₹ 100,000 cost, i.e., ₹ 5 million irrespective of its current
were consumed by Mr. Ram Manohar for personal market price following cost concept.
purposes. The remaining goods were sold for ₹ 9,60,000.
What is the profit or loss for the year? DUAL ASPECT (DOUBLE ENTRY SYSTEM)
Total purchases ₹ 1,000,000 A transaction impacts at
Goods Consumed costing ₹ 100,000 least two accounts
So, Remaining Goods costing ₹ 900,000
Remaining Goods sold for ₹ 960,000 An account is a record for an
Hence, Profit of ₹ 60,000 (₹ 960,000 – ₹ 900,000) item
Debit and Credit
PERIODICITY CONCEPT Assets = Liabilities + Owners’ Capital
States that the life of a business Double entry bookkeeping – every transaction
can be divided into artificial affects at least two accounts in such a way that Assets =
time periods. Capital + Liabilities.
Assets = Capital + Liabilities
Cash ₹ = ₹ ₹
800000 1000000 700000
GOING CONCERN CONCEPT
Furniture ₹
The business will remain in the
200000
operation for the foreseeable
future. Machines ₹
700000
Going concern
concept requires a longer term view to be taken for

SAJIN JOHN 8

INCOME STATEMENT CONCEPTS

ACCOUNTING PERIOD CONCEPT MATCHING CONCEPT

Accounting measures activities for a specific interval When a given event affects both revenues and
of time. expenses, the effect on each should be recognized in
the same accounting period.
One year is the usual accounting year
First revenue and then costs
Interim report – quarterly
Matching concept for correct ascertainment of profits,
Accounting period is usually a period of 12 months. expenses incurred to earn revenue are matched against
Additionally, interim reports are prepared to meet the the revenue earned. Both revenue and related expenses
requirement of users for more concurrent information. must be accounted for in the same accounting period.
E.g.: ABC Limited was keeping its books of accounts on E.g.: During the year, Smart Trading Limited bought
a calendar year basis. After preparing its accounts for goods worth ₹ 1,350,000. It also had goods worth ₹
the year 2014, it decided to change its accounting 200,000 in stock which were bought during the previous
period to financial year basis. How would the switch year. At the end of the year, goods costing ₹ 450,000 are
over happen in terms of accounting period? still unsold. Remaining goods have been sold during the
The accounts for the year 2015–16 will be for year for ₹ 1,400,000. Ascertain the cost of goods sold
fifteen months i.e. from 1st January 2015 to 31st during the year and profit or loss for the year.
March 2016. Thereafter, regular financial year The total cost of goods available for sale is made up of
will be followed. the goods from the previous year (opening stock)
amounting to ₹ 200,000 and goods bought during the
CONSERVATISM CONCEPT year amounting to ₹ 1,350,000. Out of this, goods
Recognizing expenses and liabilities as soon as costing ₹ 450,000 are still unsold (closing stock). The
possible when there is uncertainty about the outcome, cost of goods sold can be calculated as:
but to only recognize revenues and assets when they Opening stock + Purchases – Closing stock = ₹ 1,100,000.
are reasonably certain
The company has earned ₹ 1,400,000 from sales of
Conservatism concept prefers accounting policies that goods. By matching the cost of goods sold against this
understate rather than overstate profits; ignore income, the profit for the year comes to ₹ 300,000.
probable gains but account for probable losses.
E.g.: unearned Rs. 100/- CONSISTENCY CONCEPT
E.g.: Reliable Limited sells goods on credit basis. At the end Once an entity has decided on one accounting method,
of the year, it has a total outstanding of ₹ 120 million from it should use the same method for all subsequent
its customers. The past experience shows that about 5% of events of the same character unless it has a sound
the customers invariably default. How do we account for reason to change.
this anticipated loss?
Consistency concept facilitates inter-period
As based upon past experience 5% loss is comparison by requiring that same accounting policies
reasonably probable, the company will make a are followed period after period. Change in accounting
provision for anticipated losses at ₹ 6 million. This policies, if any, must be adequately disclosed.
will appear in the statement of profit and loss for
the year as an expense. In the balance sheet, E.g.: Red Swan Auto Limited is proposing to change its
receivables will be shown at ₹ 114 million, i.e., net accounting policy for the valuation of inventories as the
of the provisions. management feels that it would lead to better
estimation of cost of inventories. Can they do so?
REALIZATION CONCEPT Yes, Red Swan Auto can change its accounting
Amount of revenue should be recognized from a given policy for better estimation of cost. However,
sale. the company needs to disclose the change in
accounting policy. The impact of change also
Realization: inflows of cash or claims to cash must be quantified and disclosed.
Accrual: Income is recognized when earned, expenses
are recognized when incurred irrespective of when
MATERIALITY CONCEPT
received or paid.
Insignificant events may be disregarded, but there
E.g.: Account receivable – A customer buys Rs. 50/- must be full disclosure of all-important information.
worth of items at a grocery store.
No agreement on the line separating material events
from immaterial events.
Materiality concept provide all information that is
relevant to the users but avoid unnecessary details.

SAJIN JOHN 9

E.g.: In the statement of profit and loss of Tee Ltd. about In case of Tee Ltd. vital details are being lost as
60% of the expenses have been clubbed under the 60% of the expenses are being clubbed as
heading ‘miscellaneous expenses’, whereas Cee Ltd. has ‘miscellaneous expenses. The company should
reported all heads of expenses separately including analyze its expenses under relevant heads and
about 100 different types of expenses which together disclose accordingly. Cee Ltd., on the other
constitute only 10% of the total expenses in rupee terms. hand, is over disclosing. It can club a number of
What are your views? expense heads as miscellaneous and make
financial statements simpler.

SAJIN JOHN 10

ACCOUNTING EQUATION
ANALYSING TRANSACTIONS
The process of identifying the specific effects of
Assets Liabilities
Owners economic events on the account equation
Equity

Assets = Liabilities + Owners’ Equity

An asset is a resource that gives benefits to its
owner. An enterprise should consider a resource its Owners’ Equity = Common Stock + Retained Earning
asset if (a) it controls the resource, and (b) the Retained Earnings = Revenues – Expenses –
resource is expected to give benefits. Dividends (or drawing)
A liability is an obligation that requires to Net Income = Revenues – Expenses
settled by given up assets. Usually, it requires payment Gross Margin = Sales revenue – Cost of Sales
of cash.
Equity is net assets, i.e. the difference between
THE ACCOUNTING PROCESS
an enterprise’s assets and its liabilities. The equity of
1. Analysis of transactions
a business enterprise increases through investments
• Select the two/more impacting accounts and
by owners and profits from operations and decreases
analyse which is debit or credit
through distributions to owners and losses from
2. Journalizing Original Entries
operations.
• Recording the results of the transaction
Revenues are amounts charged to customers analysis in the journal
for goods and service provided. 3. Posting
Expenses are the cost of earning revenues. • Process of recording changes in ledger
Net profit is the excess of revenues over accounts exactly as specified by journal
expenses entries.
4. Adjusting Entries
Net loss is the excess of expenses over • At the end of accounting period, judgment is
revenues. involved in deciding on the adjustment
Dividends are distributions to shareholders. entries.
Retained earnings represent the profit kept • These are journalized as done for existing.
in the business. 5. Closing Entries
• Accounts are closed, journalized and posted.
6. Financial statements
• Financial Statements are prepared.

SAJIN JOHN 11

EXERCISE – IDENTIFY ASSETS, LIABILITIES, INCOME & EXPENSES
Headings Asset Liability Income Expense Type of Explanation
A/c
Cash Real A/c Current Assets. Cash in Hand
Bank Balance Real A/c Current Asset
Office Equipment Real A/c Life > 1 year; Non-Current Asset
Stock of goods Real A/c Life < 1 year; Current Asset
Rent for Building Nominal Indirect Exp. Either paid or to be
paid
Electricity bills Nominal Indirect Expense. Operating
Expense
Furniture Real Non-Current, Fixed, Tangible
Asset
Goodwill Real Non-Current, Intangible Asset
Advertising Nominal Indirect Expense. Operating
Expense
Interest on Non-Operating Income
investments
Vehicle Real Non-Current Asset
Petrol / Repairs / Nominal
Dep
Capital Personal
Drawings Personal
Purchase (Goods) Nominal
Sales (Goods) Nominal
Carriage Nominal
Duty on Purchase Nominal
Discount Allowed Nominal
Commission Nominal
Insurance Nominal
Cash at Bank Real
Bank overdraft Personal
Rent Nominal
Salary Nominal
Loan from Bank Personal
Loss by fire/theft Nominal Loss

SAJIN JOHN 12

THE CLASSIFIED BALANCE SHEET
• Presents a snapshot at a point in time. Non-current assets – Intangible Assets
• To improve understanding, companies group • Assets that do not have physical substance.
similar assets and similar liabilities together. • Include goodwill, patents, copyrights, and
STANDARD CLASSIFICATIONS: trademarks or trade names.

Liabilities &
Assets Stakeholders'
Equity
• Current Assets • Current Liabilities
• Long-term • Long-term
investments liabilities
• Property, plant, • Stockholders'
and equipment equity Current Liabilities
• Intangiable assets • Obligations the company is to pay within the
next year or operating cycle, whichever is
Current Assets longer.
• Assets that a company expects to convert to • Common examples are
cash or use up within one year or the o accounts payable,
operating cycle, whichever is longer. o salaries and wages payable,
• Common types of current assets are: o notes payable,
o Cash, o accrued expenses,
o Marketable securities, o Deferred revenues (Unearned revenue)
o Accounts receivable, o interest payable, and
o Investments, o income taxes payable.
o Receivables, Long-Term Liabilities
o Inventories,
o Prepaid expenses. • Obligations a company expects to pay after
one year.
• Include
o bonds payable,
o mortgages payable,
o long-term notes payable,
o lease liabilities, and
o pension liabilities.

Non-current assets – Long-term Investments
• Investments in stocks and bonds of other
corporations that are help for more than one
year.
• Long-term assets: Investment in real estate
• Long-term notes receivable
Non-current assets – Property, Plant, and
Equipment

• Long useful lives.
• Currently used in operations Stockholders’ Equity
• Includes land, buildings, equipment, delivery • Common stock – investments of assets into the
vehicles, and furniture. business by the stockholders.
• Depreciation – allocating the cost of assets to a • Retained earnings – income retained for use in
number of years. business.
• Accumulated depreciation – total amount of
depreciation expensed thus far in the asset’s

life.
• Also sometimes called as fixed assets or plant
assets.

SAJIN JOHN 13

MODULE 3: JOURNAL
WHAT IS JOURNAL?
Journal is a date-wise record of all the • Debit account first and closer to left margin.
transactions with details of the accounts debited and • Credit account followed with indent.
credited and the amount of each transaction. • Can have multiple debit/credit accounts
The Journal is called the book of original entry or 3. Debit & Credit amounts
primary book because this is the accounting record • Respective amounts in credit/debit columns
where we first record transactions. for each account entered alongside.
4. Brief explanation of the transaction
Special Journals are used to record
5. Posting Reference (LF/PF)
transactions of specific types.
• Ledger Posting reference for respective
E.g.: the purchase journal records credit purchases, account
the sales journal records credit sales,
the cash book records cash receipts & payments.
Journal Entry to have below items:
1. Date
• Enter Year, month & date.
• No need to enter year/month for subsequent
records
2. Account Name (under Particulars column)

RULES OF DEBIT AND CREDIT
Below three sets of rules apply to decide if the account • Cheque for our utility bill à Cash (-) || Utilities
is debited or credited. Expense
Any of the three rules can be used to determine. Cash (Cr) – Utilities Expense (Dr)
----------------------- RULE 1 ------------------------ • Office equipment purchase à Cash (-) ||
Equipment
Debit Credit
Cash (Cr) – Equipment (Dr)
Real Accounts What comes in What goes out
• Service Provided but client promised to pay next
Personal A/c Receiver Giver month. (ultimately cash will increase)
Nominal A/c Expenses & Incomes & A/c Receivable (Dr) – Revenue (Cr)
Losses Gains Cash (Dr) – A/c Receivable (Cr) ß next month
----------------------- RULE 2 ------------------------
Examples:
Journal Entry for below transactions:
Date Transactions

01-Jan Deposited Rs. 25000
02-Jan Borrows Rs 12,500 from bank

03-Jan Buys Inventory Rs 5000 in cash
Asset = Liabilities + Capital + Revenues – Expenses – Sells merchandise inventory that cost 500
Drawings (or Dividend) 04-Jan
for 750 Cash
Asset + Expenses + Drawings (or Dividends) = Liabilities
+ Capital + Revenues
Effect Assets, Expenses, Liabilities,
Drawings, Capital,
Dividends Revenues
Increase Debit Credit
Decrease Credit Debit
----------------------- RULE 3 ------------------------
Determine what effect a transaction has or will have on
cash. Remember, Increase in Cash is Debit.
For Instance:
• Cash received for consultancy Job à Cash (+) ||
Revenue
Cash (Dr) – Revenue (Cr)

SAJIN JOHN 14

MODULE 4: LEDGER POSTING
MEANING AND FORMAT OF ACCOUNT - T ACCOUNTS
A double-entry system records every transaction with
equal debits and credits. LEDGER
Assets = Liabilities + Equity The Ledger is comprised of the entire group
of accounts maintained by a company.
The T-ACCOUNT Posting is the process of transferring information
The common form of an account has three parts: from journal to the ledger.
1. Title – describing the asset, liability or equity Ledger is posted from the information gathered from
account Journal entry.
2. Debit side, or left side Ledger can be posted either using T-account format or
3. Credit side, or right side standard (or traditional) form.
This form of account is called a T-account because it Traditional Ledger has below items (on each side
looks like a letter T, as shown below: Debit/Credit):
1. Account heading
2. Date
3. Post Journal Reference (journal Pg. No.)
4. Particulars
5. Amount

• T-account is merely a shorthand term for the

entire ledger account.
• The T-account has a left and a right side.
• As a convention that we’ve adopted over the
years
• Left side of T-account as debit side & Temporary account: A general ledger account that
• Right side of T-account as credit side. begins each accounting year with zero balance. Then
• The word debit and credit have no specific at the end of the year its account balance is removed
meaning other than that they represent a left by transferring the amount to another account.
and right side of the ledger account. Ex: Sales Revenue, Wage Expense
Format for T-account is as follows: At the end of the accounting period, companies
transfer the temporary account balances to the
permanent stockholder’s equity account – Retained
Earnings.

SAJIN JOHN 15

HOW TO POST JOURNAL ENTRIES INTO LEDGER?
Posting the Journal Entries for the example shown Now, Using T-account format:
under Journal Entry (earlier section) January 2020
Using Traditional/Standard Method:
January 2020

SAJIN JOHN 16

MODULE 5: TRIAL BALANCE
FORMAT OF TRIAL BALANCE
The trial balance is a list of account balances at a given Format of Trial Balance is as follows (with no
time. adjustment):
• Accounts are listed in the order in which they
appear in the ledger.
• Order of presentation in trial balance is:
Asset
Liabilities
Stockholders’ equity
Revenues
Expenses
• Purpose is to prove that debits equal credits.
• May also uncover errors in journalizing and
posting.
• Useful in the preparation of financial statements.

PREPARATION OF TRIAL BALANCE
Trial Balance is created with the help of ledger. Income Statement can be fetched using the Trial
So, for the example shared in earlier section, using the balance. For the ITC trial balance, below is the Income
ledger below trial balance is created: Statement:

During adjustments done at the end of accounting
year, all temporary accounts will be closed and moved
to a summary account.

Below is the adjusted trial balance sheet:
Balance sheet created with the help of trial balance:

SAJIN JOHN 17

ERRORS IN PREPARATION OF TRIAL BALANCE
A trial balance that balances is a necessary condition
for error-free accounting, but it is not a sufficient ERRORS THAT AFFECT THE TRIAL BALANCE
condition. Error Type Example Effect
In most cases, a correcting entry would be necessary Omitting a Omitted the Trade
to fix the error. debit debit to trade receivables
receivables less
Omitting a Omitted the Cash more
ERRORS THAT DON’T AFFECT THE TRIAL credit credit to cash
BALANCE Recording a Credited Cash less
Error Type Example Effect
debit as a credit instead of
Incorrect Recorded rent Rent expense debiting cash
Classification paid as less, and
Recording a Debited Revenue from
telephone telephone
credit as a debit instead of services less
expense expense more crediting
Omission Omitted the A/c receivables revenue
credit sale ad revenue less
Recording Debited Cash is
Repetition Recorded the Cash balance different equipment and changed
purchase less, and office amounts in cash
twice supplies more debit and credit incorrectly
Compensating Recorded Rs. Cash & revenue Transposing Debited office Office supplies
error 200 in both less digits supplies expense more
cash & expense 8100
revenue as 1800
Such error is handled, by adding a counter entry in
Journal. i.e. reversing the calculation effect. Since these errors contravene double entry, the trial
For instance, balance will not balance. We initially note the
Rent Exp (Dr) 1500 difference as suspense.
Telephone Exp (Cr) 1500

SAJIN JOHN 18

MODULE 6: FINAL ACCOUNTS
PREPARATION OF FINAL ACCOUNTS
Once the Trial balance is ready, then below statements 4. Statement of Retained Earnings
are prepared with the help of it. • This is for beginning and ending balances of
1. Unadjusted Trial Balance retained earnings, net profit, and dividends.
2. Adjusted Trial Balance • This is calculated or formulated by
• Trial balance generated post adjustments considering all the revenues, expenses and
3. Statement of Profit and Loss dividends
• This is for revenue and expense items 5. Balance Sheet
• This is calculated or formulated by • This is for asset, liability, and equity items.
considering all the Revenues and Expenses
from the trial balance

ADJUSTMENTS FOR TRANSACTIONS AFTER CLOSING OF ACCOUNTS
Accruals
COST OF GOODS SOLD & GROSS PROFIT 1. Accrued revenues: Revenues for services
𝐶𝑂𝐺𝑆 = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 performed but not yet received in cash or
+ 𝐷𝑖𝑟𝑒𝑐𝑡 𝐸𝑥𝑜𝑒𝑛𝑠𝑒𝑠 − 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘 recorded.
𝐺𝑜𝑟𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆 2. Accrued expenses: Expenses incurred but not yet
paid in cash or recorded.
ADJUSTING ENTRIES
• Ensure that the revenue recognition and expense BAD DEBTS
recognition principles are followed. Bad debts (or Credit losses) are the difference
• Are required every time a company prepares between the amounts due to an entity and the
financial statements. amounts it expects to receive.
• Includes one income statement account and one
balance sheet account.
• Never include cash

WHY ADJUSTING ENTRIES NEEDED?

Adjusting entries are required to handle temporary
accounts as well as any sort-of adjustment required in
case of pre-paid expenses/income or to consider
depreciation. Like below example:
• Buying a mobile handset worth Rs20,000. After
one year?
• Paid rent in advance Rs6000 for six months. After
one-month company prepares a statement. How
• Your company received Rs1,00,000 in advance for
providing software solution to another company
for two years. After one year, assume you
provided half of the service.
• Your company has performed services worth
Rs2000, but not received cash.
• Wages were not paid from 1st March 31 March
2018, will be paid 2 April 2018.

TYPES OF ADJUSTING ENTRIES

Deferrals
1. Prepaid expenses: Expenses paid in cash and
recorded as assets before they are used or
consumed.
2. Unearned revenues: Cash received before service
are performed.

SAJIN JOHN 19

MODULE 7: THE STATEMENT OF CASH FLOWS
INTRODUCTION TO CASH FLOW STATEMENT
• The purpose of cash flow statement is to provide o Sale of property, plant, and equipment
information about inflows and outflows of cash o Sale of other non-current assets
from operating activities, investing activities and Uses (Outflows)
financing activities during the year at one place.
• Cash flows are inflows and outflows of cash and • Activities that involve spending cash
equivalents. o Cash dividends
o Repayment of borrowings
• Cash includes
o Repurchase of stock
o cash in hand and
o Purchase of property, plant, and equipment.
o demand deposits.
o Purchase of non-current assets.
• Cash equivalents are
o short-term investments that can be quickly
converted into cash without any significant SIGNIFICANT NONCASH TRANSACTIONS
risk of change in value. • Non-cash transactions
o Highly liquid • Significant investing and financing activities that
o Convertible to known amounts of cash did not involve cash
o Mature in no more than 90 days (GAAP) • E.g., conversion of a convertible bond into stock,
o Subject to insignificant risk of changes in value purchase of a building with a note payable
(IASB) • Not reported in body of statement of cash flows,
• Cash equivalents are held as a substitute to cash narrative statement of supplemental disclosure.
and not as investments.
• Cash flow associated with an entity’s operating,
investing, and financing activities during a period. ORGANIZATION OF THE STATEMENT OF
• Reconciles changes in cash account on balance CASH FLOWS
sheet (i.e., beginning balance to ending balance).
• Need for Cash flow statement is due to Income CASH FLOW FROM OPERATIONS
Statement is based on Accrual basis (i.e., entry is Consists in cash transactions affecting the firm’s Net
made when an event/transaction is agreed even if Income. Cash flow changes deriving from the Income
actual transaction is pending). Statement can be considered as operating.
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔 + 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔) o Cash Inflow
= 𝑁𝐸𝑇 𝐶𝐴𝑆𝐻 𝐹𝐿𝑂𝑊 • Cash received from customers
𝐸𝑛𝑑𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 − 𝐵𝑖𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 • Sales revenues
= 𝑁𝐸𝑇 𝐶𝐴𝑆𝐻 𝐹𝐿𝑂𝑊 • Dividend received
• Other sources
IMPACT OF PRODUCT (CORPORATE) LIFE o Cash Outflow
CYCLE ON CASH FLOWS • Cash paid to suppliers
• Cash paid Employees
• Taxes
• Interest on loan

CASH FLOW FROM INVESTING

Investments in Fixed Assets and other Long-term
Investments
o Cash Inflow
• Disposing of long-lived assets (e.g., property,
plant, equipment).
• Disposing of investments in securities (i.e.,
other than cash equivalents)

• Collecting loans
o Cash Outflow
CATEGORIES OF ACTIVITIES • Acquiring long-lived assets (e.g., property,
Sources (Inflows) plant, equipment)
• Activities that generate cash • Making investments in securities (i.e., other
o Operations than cash equivalents)
o New borrowings • Lending money.
o New stock issues

SAJIN JOHN 20

CASH FLOW FROM FINANCING INDIRECT METHOD
Cash transactions affecting a firm’s capital structure Net Profit ßà NetCash Flow
o Cash Inflow The two are converted by making adjustments for
• Borrowing of cash transactions that have an impact on net income, but do
• Issuance of equity securities not have an immediate cash effect
o Cash Outflow We make three type of adjustments:
• Repaying loans
1. Non-cash items: (add)
• Retiring equity securities
Bad debt expense, depreciation, depletion, and
• Payment of dividends
amortization
2. Non-operating items: (add expense, subtract
income)
Non-operating items such as gains & losses on
disposal of fixed assets and investments, interest
income, and interest expense
3. Changes in working/current capital items:
Deduct increase (add decrease) in account
receivables, inventories, prepaid expenses.
Add increase (deduct decrease) in account
payables.
Example:

COMPUTING CASH FLOW FROM OPERATING

ACTIVITIES

DIRECT METHOD
Cash from Operating Activities
- Cash received from customers
𝑪𝒂𝒔𝒉 𝒓𝒆𝒗𝒆𝒊𝒗𝒆𝒅 𝒇𝒓𝒐𝒎 𝒄𝒖𝒔𝒕𝒐𝒎𝒆𝒓
= 𝑺𝒂𝒍𝒆𝒔 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
+ 𝑫𝒆𝒄𝒓𝒆𝒂𝒔𝒆 (−𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆)𝒊𝒏 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆
− 𝑾𝒓𝒊𝒕𝒆𝒐𝒇𝒇𝒔

- Cash paid to suppliers & Employees

𝑪𝒂𝒔𝒉 𝒑𝒂𝒊𝒅 𝒕𝒐 𝒔𝒖𝒑𝒑𝒍𝒊𝒆𝒓𝒔 & 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒔
= 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅
+ 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 & 𝒂𝒅𝒎𝒊𝒏𝒊𝒔𝒕𝒓𝒂𝒕𝒊𝒗𝒆 (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈) 𝒆𝒙𝒑𝒆𝒏𝒔𝒆
− 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒂 − 𝑩𝒂𝒅 𝒅𝒆𝒃𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒃
+ 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 (−𝑫𝒆𝒄𝒓𝒆𝒂𝒔𝒆) 𝒊𝒏 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔
+ 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 (−𝑫𝒆𝒄𝒓𝒆𝒂𝒔𝒆) 𝒊𝒏 𝒑𝒓𝒆𝒑𝒂𝒊𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
+ 𝑫𝒆𝒄𝒓𝒆𝒂𝒔𝒆(−𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆) 𝒊𝒏 𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒑𝒂𝒚𝒂𝒃𝒍𝒆
𝑎: 𝑖𝑓 𝑖𝑛𝑐𝑙𝑢𝑑𝑒𝑑 𝑖𝑛 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝑏: 𝑖𝑓 𝑖𝑛𝑐𝑙𝑢𝑑𝑒𝑑 𝑖𝑛 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 & 𝑎𝑑𝑚𝑖𝑛(𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔)𝑒𝑥𝑝𝑒𝑛𝑠𝑒

- Cash paid for taxes

𝐈𝐧𝐜𝐨𝐦𝐞 𝐭𝐚𝐱 𝐩𝐚𝐢𝐝
= 𝐈𝐧𝐜𝐨𝐦𝐞 𝐭𝐚𝐱 𝐞𝐱𝐩𝐞𝐧𝐬𝐞
+ 𝐃𝐞𝐜𝐫𝐞𝐚𝐬𝐞(−𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞) 𝐢𝐧 𝐭𝐚𝐱
Cash from Investing Activities
- Capital Expenditures
Cash from Financing Activities
- Payments on long-term debt
SAJIN JOHN 21

Using balance sheet, we calculate change in current Interest Income: 5400
capital items, i.e., Ending balance – Starting balance Dividend Income: 2000
Loss on sale of plant: 3800
Interest expense: 5700
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒𝑠
= 14000 + 3800 + 2000 − 6300
− 5400 − 2000 + 3800 + 5700
= 15600
3. Changes in working/current capital items:
Increase in Inventories: 7200
Increase in Account Receivables: 11200
Decrease in Prepaid Expenses: 300
Decrease in Account Payables: 18000

𝐶𝑎𝑠ℎ 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠

= 15600 − 7200 − 11200 + 300
OPERATING ACTIVITIES (DIRECT METHOD): − 18000 = −20500
𝐶𝑎𝑠ℎ 𝑟𝑒𝑣𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑐𝑢𝑠𝑡𝑜𝑚𝑒𝑟
= 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
+ 𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒 (−𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒)𝑖𝑛 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
− 𝑊𝑟𝑖𝑡𝑒𝑜𝑓𝑓𝑠
𝐶𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑐𝑢𝑠𝑡𝑜𝑚𝑒𝑟
= 75800 − 9800 − 1400 = 64600
𝐶𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟𝑠 & 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑠
= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
+ 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 & 𝑎𝑑𝑚𝑖𝑛𝑖𝑠𝑡𝑟𝑎𝑡𝑖𝑣𝑒 (𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔) 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
− 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 # − 𝐵𝑎𝑑 𝑑𝑒𝑏𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 $
+ 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 (−𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒) 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
+ 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 (−𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒) 𝑖𝑛 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
+ 𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒(−𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒) 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝐶𝑎𝑠ℎ 𝑃𝑎𝑖𝑑 𝑡𝑜 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟 𝑎𝑛𝑑 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠
= 53700 + 12300 − 3800 − 2000
+ 7200 − 300 + 18000 = 85100
Hence,
𝐶𝑎𝑠ℎ 𝐺𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = 64600 − 85100
INVESTING & FINANCIAL ACTIVITIES
= 20500
Segregating the additional information provided
Income tax paid = Income tax expense
1. Investing activity (purchase – subtract)
+ Decrease(−Increase) in tax 2. Investing activity (sold – add)
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 𝑝𝑎𝑖𝑑 = 2200 + 1800 = 4000 3. Non-cash activity – not to be considered
4. Investing activity (paid – subtract)
5. Investing activity (sold – add)
6. Financing activity (received – add)
7. Financing activity (received – add)
8. Cash Management – considered in operating
9. Cash Management – considered in operating

OPERATING ACTIVITIES (INDIRECT METHOD)

Profile before income tax = 14000
Adjustments (data from Income & Expense
statement),
1. Non-cash items: (add)
Depreciation Expense: 3800
Bad Debt Expense: 2000

2. Non-operating items: (add expense, subtract

income)
Gain on Sale of Land: 6300

SAJIN JOHN 22

MODULE 8: RATIO ANALYSIS
INTRODUCTION TO RATIO ANALYSIS
𝑃𝑟𝑖𝑐𝑒 / 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜
RETURN OF ASSET (ROA) 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=
Return on assets (ROA) reflects how much the firm 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆)
has earned on the investment of all the financial
resources committed to the firm. GROSS PROFIT MARGIN
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡 It shows how much profit remains after paying for
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒) the direct costs of the product.
=
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐺𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒
𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 (𝑝𝑟𝑜𝑓𝑖𝑡)
RETURN ON INVESTED CAPITAL =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Return on invested capital focuses more on the use of Why is it important?
permanent capital
• First, the cost of sales, which determines the
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 gross profit, is usually the single largest expense
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)
= position in the income statement.
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑂𝑤𝑛𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 • Second, even the most efficiently run company
cannot survive without sufficient gross profit to
pay for the various fixed costs, interest payments
RETURN ON SHAREHOLDERS’ (OWNERS) and taxes incurred as a result of running a
EQUITY (ROE) business.
Return on shareholders’ equity (ROE) reflects how • A decrease in gross profit margins - an increase
much the firm has earned on the funds invested by in input prices, a decrease in selling prices, or a
the shareholders. combination of both.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 % 𝐸𝑞𝑢𝑖𝑡𝑦 = PROFIT MARGIN
𝑂𝑤𝑛𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
INVESTMENT CAPITAL TURNOVER
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 ASSET TURNOVER
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
= 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑟𝑢𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑎𝑣𝑒𝑟𝑎𝑔𝑒)

PROFIT MARGIN OR RETURN ON SALE This ratio should only be used for comparisons
within an industry.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = More meaningful if the ratio is used for individual
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
companies over time.
RETURN ON INVESTMENT (ROI)
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 EQUITY TURNOVER
= 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
× 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑂𝑤𝑛𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
= ×
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
=
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

EARNINGS PER SHARE

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

PRICE/EARNING RATION (P/E)

The price/earnings ratio (P/E) is the best indicator of
how investors judge the firm’s future performance.

SAJIN JOHN 23

CAPITAL INTENSITY DIVIDEND YIELD
The capital intensity ratio focuses only on the usage 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 =
of property, plant, and equipment. Companies with a 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
high ratio are particularly vulnerable to cyclical
fluctuations. DIVIDEND PAYOUT
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 =
𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦, 𝑝𝑙𝑎𝑛𝑡 & 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

WORKING CAPITAL TURNOVER DAYS’ CASH

Working capital is current assets minus current 𝐶𝑎𝑠ℎ
𝐷𝑎𝑦𝑠 % 𝐶𝑎𝑠ℎ =
liabilities 𝐶𝑎𝑠ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠/365
𝑆𝑎𝑙𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 DAYS’ RECEIVABLES
𝑆𝑎𝑙𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
= 𝐷𝑎𝑦𝑠 % 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑆𝑎𝑙𝑒𝑠⁄365

DAY’S’ PAYABLE DAYS’ INVENTORY

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑎𝑦𝑠 % 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 = 𝐷𝑎𝑦𝑠 % 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝑃𝑟𝑒𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠/365 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠/365
Operating payables include accounts payable,
accrued wages and payroll taxes, and other items that INVENTORY TURNOVER
represent deferred payments for operating expenses. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
CASH CONVERSION CYCLE
The cash conversion cycle (CCC) is a metric that CURRENT RATIO
expresses the time (measured in days) it takes for a 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
company to convert its investments in inventory and 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
other resources into cash flows from sales.
𝐶𝐶𝐶 = 𝐷𝐼𝑂 + 𝐷𝑆𝑂 − 𝐷𝑃𝑂 ACID-TEST (QUICK) RATIO
𝐷𝐼𝑂: 𝐷𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑀𝑜𝑛𝑒𝑡𝑜𝑟𝑦 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
(𝑑𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦) 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑆𝑂: 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝐷𝑃𝑂: 𝐷𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
FINANCIAL LEVERAGE RATIO
i.e. 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑎𝑠ℎ 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝐶𝑦𝑐𝑙𝑒 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜𝑛 =
𝑂𝑤𝑛𝑒𝑟𝑠 % 𝐸𝑞𝑢𝑖𝑡𝑦
= 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑
+ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑
DEBT/EQUITY RATIO
+ 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑦𝑐𝑙𝑒
𝐿𝑜𝑟𝑛 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
− 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 𝐷𝑒𝑏𝑡 / 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑂𝑤𝑛𝑒𝑟𝑠 % 𝐸𝑞𝑢𝑖𝑡𝑦
The result of this calculation is a measure of liquidity;
it also indicates the time interval for which additional
short-term financing might be needed to support a TIMES INTEREST EARNED
spurt in sales. 𝑇𝑖𝑚𝑒𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑
𝑃𝑟𝑒𝑡𝑎𝑥 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
=
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

SAJIN JOHN 24

MODULE 9: COST-VOLUME PROFIT ANALYSIS
INTRODUCTION TO COST VOLUME PROFIT ANALYSIS
Illustration in the above figure.
BEHAVIOR OF COSTS • Y or vertical axis reflects total cost.
Cost-volume relationships. • X or horizontal axis reflects volume.
How costs behave as the level of activity changes • y = mx + b.
Types of costs o y is the cost at a volume of x.
o m is the rate of cost change per unit of
• Fixed (cost that do not vary, in total, at all with volume change, or the slope (variable costs).
volume) o b is the vertical intercept, which represents
o Those costs may increase with time the fixed cost component.
o The amount of fixed cost per unit of activity
decreases as volume increases
o Non-variable costs = items of cost that, in COST RELATIONS
total, do not vary at all with volume. 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 (𝑇𝐶)
o Examples: Building rent, property taxes, = 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 (𝑇𝐹𝐶)
management salaries. + 𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡(𝑇𝑉𝐶)
o Fixed cost per unit of activity decreases as the = 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
level of activity increases. + (𝑈𝑛𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡) × 𝑉𝑜𝑙𝑢𝑚𝑒
o For fixed costs, cost per unit is an average = 𝑇𝐹𝐶 + 𝑈𝑉𝐶 × 𝑋
cost. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡¢𝑉𝑜𝑙𝑢𝑚𝑒
o Fixed costs are fixed for a range of activity
and a limited period of time.
o Fixed costs may change for reasons such as a
deliberate management decision to change
them.
• Variable costs
o Volume: number of outputs produced
o Items of cost that vary, in total, directly and
proportionately with volume.
o Volume refers to activity level.
o Examples:
o Material costs varies with units sold.

o Electricity costs varies with production
hours. C-V relationship is often not linear.
o Stationery and postage costs varies with o Some items of costs may vary in steps
number of letters written. o Some cost functions are curved (curvilinear).
• Semi-variable costs o Segments of the curve can be approximated by a
o Combination of variable-cost and fixed cost straight line, each with its own relevant range.
items o Step function costs = items of cost vary in steps.
o It does not mean exactly As volume goes up
o The cost of operating an automobile is semi-
variable with respect to the number of miles • Total fixed cost remains constant
driven. • Total variable costs go up
• Per unit variable costs stays the same
• Per unit fixed cost goes down
COST-VOLUME (C-V) DIAGRAM • Per unit total cost goes down.
• As volume increases without limit, unit cost
approaches variable unit cost and fixed cost per
unit approaches zero.

STEP-FUNCTION COSTS
Step-function costs
o Incurred when costs are added in discrete
chunks, e.g., a supervisor for every 10.
Adding the “chunk”
o One supervisor for every additional 10
employees) of costs increases capacity.
SAJIN JOHN 25

Height of a stair step (riser) indicates Examples:
o The cost of adding o Sales commissions with minimum guarantees.
incremental o Managers slower to fire employees than to hire.
capacity.
Step width (tread) ESTIMATING THE COST-VOLUME
o It shows how much RELATIONSHIP
additional volume Four Methods:
of that activity can 1. Judgment or account-by-account method.
be serviced by this additional increment of o Each account in cost structure is estimated
capacity. and divided between fixed and variable costs.
If treads” are narrow and “risers” are low 2. Scatter diagram
o Plot a number of observations (perhaps prior
o i.e., steps are small, then the steps can be
period results) of costs and volumes on a
approximated by a variable cost line.
graph and visually draw a line of best fit.
o If is believed within the relevant time period that
3. High-low method
cost will remain within the relevant range for a
o Estimate total costs for two volume levels,
single stair step (tread), then the cost is
preferably one high level and one low level.
appropriately treated as a fixed cost for the time
o To determine slope (m) or variable cost per
period.
unit:
o Step functions are often hidden in C-V diagrams
as either variable or fixed costs. • Change in total cost between the two
points divided by change in units of output.
𝐻𝑖𝑔ℎ 𝐶𝑜𝑠𝑡 − 𝐿𝑜𝑤 𝐶𝑜𝑠𝑡
LIMITATIONS OF C-V RELATIONS 𝑆𝑙𝑜𝑝𝑒(𝑚) =
𝐻𝑖𝑔ℎ 𝑉𝑜𝑙𝑢𝑚𝑒 − 𝑉𝑜𝑙𝑢𝑚𝑒 𝐶𝑜𝑠𝑡
• A straight line approximates cost behavior only
within a certain range of volume, the relevant o To determine fixed costs (b):
range. • Subtract from total costs at either one of
o When volume approaches zero, management the points the unit volume times the unit
takes steps to reduce fixed costs. variable costs.
o When • TC = TFC + UVC*X
volume • TFC = TC – UVC*X
exceeds 4. Linear regression
relevant o Use a statistical method of fitting a line to a
range, fixed number of observations of volume and cost
costs (method of least squares or linear
increase. regression).
o Eliminate outliers, that is, unusual
observations (e.g., period during which there
• Relevant time was a strike).
period o Assumes the future will be the same as the
o Amount of variable costs depends on the time past (rarely a completely accurate
period over which behavior is estimated (the assumption).
relevant time period). o Scattergrams covering long periods of time
o If the time period is one day, few costs are may reflect nothing more than price changes
variable. over the period (drift).
o Over an extremely long time period, no costs
are fixed.
• Environmental assumptions must be made. PROFIT-GRAPH
o Wage rates, fringe benefits, material prices,
technology changes.

“STICKY” COSTS
o Sticky cost do not change.
o Generally considered variable but fall less with
decreases of activity than they rise with
increases.
o Managers tend to increase resources more
quickly when volume increase than they reduce
them when volume decrease.
o Stickiness varies across companies

SAJIN JOHN 26

UNIT CONTRIBUTION Suppose, T is the target profit to be achived.
Per Unit Contribution margin (marginal income) 𝑇𝑅 = 𝑈𝑅 × 𝑋 = 𝑇𝐹𝐶 + (𝑈𝑉𝐶 × 𝑋) + 𝑇
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝐹𝐶 + 𝑇
𝑋& =
= 𝑈𝑛𝑖𝑡 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑈𝑅 − 𝑈𝑉𝐶
− 𝑈𝑛𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 = 𝑈𝑅 − 𝑈𝑉𝐶 If, Profit after taxes (PAT) is considered,
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒, 𝐼 = (𝑈𝑅 − 𝑈𝑉𝐶) × 𝑋 − 𝑇𝐹𝐶 𝑃𝐴𝑇 = 𝑃𝑟𝑜𝑓𝑖𝑡 − (𝑃𝑟𝑜𝑓𝑖𝑡 × 𝑇𝑎𝑥)
i.e., Total income at any volume is unit contribution 𝑃𝐴𝑇 = 𝑇 − 𝑇 × 𝑇'#( = 𝑇(1 − 𝑇'#( )
(UR – UVC) times volume, minus Fixed Cost. 𝑃𝐴𝑇
𝑇=
Thus, contribution first covers the fixed costs and 1 − 𝑇'#(
then move towards the profit.
𝑇𝐹𝐶 + ¤𝑃𝐴𝑇¢(1 − 𝑇 ¥
'#( )
𝑋&'#( =
BREAKEVEN VOLUME 𝑈𝑅 − 𝑈𝑉𝐶
The break-even level of output is that level of output at
which a firm neither makes profits nor losses. It is the INFLUENCES ON COSTS
level • Changes in input prices.
Thus, Breakeven happens when Total Cost is same as • Rate at which volume changes - Rapid changes in
that of Total Revenue. i.e., at Zero profit. volume make it more difficult to change
personnel costs, therefore, the more likely costs
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑟 𝑈𝑛𝑖𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
depart from a straight-line relationship.
× 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝑈𝑅 × 𝑋
• Direction of change in volume. - Tends to be a lag
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡, 𝑇𝐶 = 𝑇𝐹𝐶 + (𝑈𝑉𝐶 × 𝑋) in cost changes.
At breakeven, TC = TR • Duration of change. - Temporary changes affects
𝑈𝑅 × 𝑋 = 𝑇𝐹𝐶 + (𝑈𝑉𝐶 × 𝑋) costs less than a long-term change.
• Prior knowledge of change allows planning for
𝑇𝐹𝐶 change.
𝑋=
𝑈𝑅 − 𝑈𝑉𝐶 • As productivity changes costs change.
𝑇𝐹𝐶 • Management discretion.
𝑖. 𝑒. , 𝑄 =
𝐴𝑅 − 𝐴𝑉𝐶 • Costs change because of management decisions.
From, Profit-graph the profit performance can be • Learning curves.
increased by o Productivity increases, i.e., unit production
• Increasing selling price (UR) costs decrease, as the company gains
• Decreasing variable cost (UVC) experience producing the product.
• Decreasing Fixed cost (TFC)
• Increasing Volume (X) PREVENTION COSTS
Thus, Support activities whose purpose is to reduce the
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 number of defects
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑣𝑜𝑙𝑢𝑚𝑒 (𝑈𝑛𝑖𝑡𝑠) =
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 APPRAISAL COSTS
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑣𝑜𝑙𝑢𝑚𝑒(𝑅𝑒𝑣𝑒𝑛𝑢𝑒) Incurred to identify defective products before the
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 products are shipped
=
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑐𝑒𝑛𝑡 INTERNAL FAILURE COSTS
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑐𝑒𝑛𝑡
= 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑎𝑠 𝑎 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑜𝑓 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 Incurred as a result of identifying defects before they
(𝑈𝑅 − 𝑈𝑉𝐶) are shipped
= EXTERNAL FAILURE COSTS
𝑈𝑅
Incurred as a result of defective products being
TOTAL PROFIT delivered to customers
Calculating number of volumes to earn a target profit.

SAJIN JOHN 27

MODULE 10: CAPITAL BUDGETING
CAPITAL BUDGETING
• Full costs and differential costs
o It comes from a company’s cost accounting DIFFERENTIAL COSTS
system. • Differential costs
o No comparable system for collecting o = incremental costs
differential costs. o = relevant costs
o Differential costs are assembled to meet o = out-of-pocket costs
analytical requirements of a specific problem. o = avoidable costs
• FULL COST ACCOUNTING SYSTEM • = variable costs(=marginal costs), if all
o It collects historical costs. alternatives involve operating at different volume
o It measures what the costs were. levels within the relevant range.
o Full cost of a product or other cost object = • May also include fixed costs if any alternative
sum of direct cost + fair share of applicable results in changes in step-function costs.
indirect costs. • Future costs, which may be best estimated by
• DIFFERENTIAL COSTS looking at past/historical costs.
o It relates to future. • Usually estimates are not precise unless
o It includes only those elements of cost that determined by contract.
are different under a certain set of conditions.
o It intends to show what costs will be if a
certain course of action is adopted. SUNK COST
o Rather than what costs were in the past • Sunk costs = a cost that has already been
o It will always be related to a specific incurred
alternative choice problem • And therefore, cannot be changed by any decision
• DIRECTS COSTS currently being considered.
o = costs that are traced directly to cost object. • e.g., all historical costs (since it exists because of
o Direct variable costs and its direct fixed costs action taken in the past.
such as depreciation • Not a differential cost.
o It can be traced directly • No decision made today can change what has
• INDIRECT COSTS already happened.
o = costs that are not traced directly to cost • If asset is used, it is depreciated,
object. • If it is disposed of, it is written off,
• In either event it is expensed.
THE CONTRIBUTION MARGIN
The Gross Margin formats - Separates costs by OPPORTUNITY COST
function • Value lost or sacrificed by giving up an
The Contribution Margin format alternative course of action.
• Not associated with cash outlays.
• Separates Costs
• Not measured in accounting records.
into Variable
• If an alternative requires resources that would
Expenses and
otherwise be used for income producing
Fixed Expenses.
purposes, opportunity cost is measured by
• The Contribution
income that would have been earned had
Margin shows
resources been invested otherwise.
how much
• Commonly used in economics.
revenue is left to
contribute to
Fixed Expenses. DISPOSAL VALUE
• This is a useful • The cost of the depreciable asset is supposed to
analytical tool be written off over its useful life.
for managerial • If machine is scrapped, its useful life has come to
accounting. an end.
• There will be estimation error if total cost of the
machine is not written of by that time.
• Useful life and residual value are correctly
estimated, then the net book value of the machine
will be zero.

SAJIN JOHN 28

• If the machine had a disposal value it would be • Three sub-categories
relevant because the machine’s sale would then o Problems involving Costs
bring additional cash o Problems involving revenues and costs
• Relevant and differential cost/revenue if one o Differential investments
alternative is to keep equipment and another
alternative is disposal.
PROBLEMS INVOLVING COSTS
One type of cost is traded off for another.
IMPORTANCE OF TIME SPAN • Change of method of operation.
• What costs are differential depends on time span. o The alternative being proposed is the
• If the proposal is to make only one additional adoption of some new method of performing
unit, only material cost may be differential. an activity.
• If the proposal is to produce an item over o The differentials costs of the proposed
foreseeable future, all items of production cost method are significantly lower than those of
would be differential. the present method, the method should be
• The longer the time span the more items of cost adopted
are differential. • Make or buy decisions (outsourcing choices)
• In the very long run full costs are differential o It pays outside firms to perform certain other
costs. activities.
• Economic order quantity decision.
OBJECTIVE OF ALTERNATIVE CHOICE o The optimum quantity to produce at one time
PROBLEM (the economic order quantity)
Seek alternative most likely to achieve objectives of o Trade off setup costs and inventory carrying
organization. costs.
In a profit-oriented business:
PROBLEMS INVOLVING BOTH REVENUES AND
• Objective of a company - Maximizing value of
COSTS
shareholders’ investment by making alternative
Best alternative has most differential income or
choices that earn a satisfactory return on
profit.
investment.
• Internal performance measure - Return on • Supply and demand analysis.
investment is usually measured using an o Lower selling price, the greater the demand
accounting and not a market-determined o Demand schedule (we need to precisely
measure of return. estimate the demand schedule). It is complex
• Other factors are also likely to influence decision. in competitive markets
o Supply schedule
Example:
• Contribution pricing.
• A manager is considering a proposal to buy a o Off-price (ups and downs) orders make some
certain machine to produce an item that is being contribution to fixed costs and profit.
produced manually. o Dumping: Selling surplus quantities of a
• Two alternatives product at a price below full cost
o Continue to make the item by manual • Discontinuing a product.
methods o If selling price is below its full cost, then it
o Buy the new machine gives signal that the product is being sold at
• Additional alternatives loss
o Buy a machine other than proposed • Adding a service.
o Improve the present manual methods
o Eliminate the production operation
altogether and buy the item from an outside NET PRESENT VALUE (NPV) RULE
source • The sum of (or the net of) the present value of all
• Some thoughts should be given to alternatives cash outflows and inflows related to an
investment.
• Many advantages and disadvantageous with each
alternative • Convert all cash outflows and inflows to their
present value (i.e., discounting)
• Utilize discount rate (also called cost of capital,
TYPE OF ALTERNATIVE CHOICE PROBLEMS required rate of return, hurdle rate).
• Objective os business: satisfactory return on • Compute present value factors with calculator or
investments lookup in table A or table B in the back of text
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠
𝑅𝑂𝐼 = =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

SAJIN JOHN 29

SUMMARY OF NET PRESENT VALUE (NPV)
METHOD
1. Select a required rate of return.
2. Estimate economic life of proposed project.
3. Estimate differential cash inflows for each year.
4. Determine net investment made at time zero
(and at later periods if needed).
5. Estimate terminal values at end of economic life.
6. Find present value of all inflows (and outflows)
by discounting.
7. Determine present value by subtracting net
investment (i.e., outflows) from present value of
inflows.
a. If NPV is zero or positive (and capital is
available) accept project.
b. If NPV is negative, reject project.
8. Take into account nonmonetary factors and reach
a decision.
𝐶* 𝐶+ 𝐶,
𝑁𝑃𝑉 = −𝐶) + + + ⋯+
1 + 𝑟 (1 + 𝑟) + (1 + 𝑟), PAYBACK PERIOD
−𝐶) : 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 Number of years over which investment outlay will
𝐶: 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 be recovered (paid back) from cash inflows.
𝑟: 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 Problems:
𝑇: 𝑇𝑖𝑚𝑒 • Does not consider time value of money.
• Does not consider differences in length of
economic life.

DISCOUNTED PAYBACK PERIOD

Same as payback method except discounts cash
inflows.
Number of years over which investment outlay will
PERPETUITY be recovered (paid back) from discounted cash
inflows.
𝐶
𝑃𝑉(𝐶 𝑖𝑛 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟
ANNUITY
𝑃𝑉(𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 𝐶 𝑓𝑜𝑟 𝑁 𝑝𝑒𝑟𝑖𝑜𝑑𝑠)
1 1
= 𝐶 × §1 − ¨
𝑟 (1 + 𝑟),
GROWING PERPETUITY
𝐶*
𝑃𝑉(𝑝𝑟𝑒𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑎𝑡 𝑔) =
𝑟−𝑔
GROWING ANNUITY
𝑃𝑉(𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑎𝑡 𝑔)
1 1+𝑔 ,
=𝐶ק ¨ ©1 − § ¨ ª
𝑟−𝑔 1+𝑟

INTERNAL RATE OF RETURN (IRR) METHOD

• Determine rate of return that equates present
value of cash inflows with present value of cash
outflows.
• Calculated rate is the internal rate of return (IRR)
or discounted cash flow (DCF) rate of return.
• Accept project if management is satisfied with
IRR.

SAJIN JOHN 30