Accounting for Decision Making

UNIT I

Introduction to Financial Accounting, Management Accounting, Generally Accepted

Accounting Principles(GAAP), Double Entry System, Preparation of Journal, Ledger
and Trial Balance, Preparation of Final Accounts, Trading, Profit and Loss Accounts
and Balance Sheet, Reading the Financial Statement

INTRODUCTION
Accounting is aptly called the language of business. This designation is
applied to accounting because it is the method of communicating business
information. The basic function of any language is to serve as a means of
communication. Accounting duly serves this function. The task of learning accounting
is essentially the same as the task of learning a new language. But the acceleration of
change in business organization has contributed to increase the complexities in this
language. Like other languages, it is undergoing continuous change in an attempt to
discover better means of communications. To enable the accounting language to
convey the same meaning to all stakeholders, it should be made standard. To make it
a standard language certain accounting principles, concepts and standards have been
developed over a period of time. This lesson dwells upon the different dimensions of
accounting, accounting concepts, accounting principles and the accounting standards.

EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved, as have medicine, law
and most other fields of human activity in response to the social and economic needs
of society. People in all civilizations have maintained various types of records of
business activities. The oldest known are clay tablet records of the payment of wages
in Babylonia around 600 BC. Accounting was practiced in India twenty-four centuries
ago as is clear from kautilya’s book ‘arthshastra’ which clearly indicates the existence
and need have proper accounting and audit. For the most part, early accounting dealt
only with limited aspects of the financial operations of private or governmental
enterprises. Complete accounting system for an enterprise which came to be called as

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 “double entry system” was developed in Italy in the 15th century. The first known
description of the system was published there in 1494 by a Franciscan monk by the
name Luca Pacioli.

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:
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 as a profession
Accounting is very much a profession. A profession is a career that
involve the acquiring of a specialized 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 recognized 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 etc.
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.
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 practiced to communicate business events.

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 Accounting as science or art
Science is a systematized 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 journalizing. So we can say that accounting
is a science.

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 realize that
people will be constantly exposed to accounting information in their every day life.
Accounting information serves both profit-seeking business and non-profit
organizations.

OBJECTIVES OFACCOUNTING
 keeping.To provide information about the whole activities of the business
enterprises both to the owner and external groups.
 To provide information for decision making.
 To provide useful information to investors and creditors, so that they can take
decision on investment and lending.
 It facilitate comparison of record.
 To effectively direct and control the organization human and material resources.
 Assessment of soundness of a firm.
 To facilitate social function and control.

DEFINITION OF ACCOUNTING

“Accounting is the art of recording, classifying and summarizing, in a significant

manner and in terms of money, transactions and events which are, in part at least, of
a financial character and interpreting the results thereof”. of all definitions available,
this is the most acceptable one because it encompasses all the functions which the
modern accounting system performs.

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Accounting is a systematic record of the daily events of a business. It leads to
presentation of a complete financial picture. Accounting in its elementary stages is
called book keeping.
Book keeping: Recording the business transaction in a set of books systematically.

OBJECTIVES OF FINANCIAL STATEMENTS

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

qualitative financial information about the business enterprise that is useful to
statement users, particularly owners and creditors in making economic decisions. Apart
from this the other important objectives are: To provide information about the
economic activities of the enterprise to several external groups who, otherwise have no
access to such information.

1) To provide useful information to investors and creditors in taking decisions relating

to investment and lending.
2) To provide information to potential investors in evaluating the earning power of the
enterprise.
3) To provide economic information to the owners to judge the management on its
stewardship of the resources of the enterprise and the achievements of the corporate
objectives.
4) To provide information which enables the investors to compare the performance
with similar other undertakings and take appropriate decisions regarding retention
or disinvestments of their holdings.
5) To provide information regarding accounting policies and contingent liabilities of
the enterprise as these have a barring in predicting, comparing and evaluating the
earning power of the enterprise.

LIMITATIONS OF FINANCIAL ACCOUNTING

Only transactions which can be measured in terms of money can be recorded in the
books of accounts. Events however important they may be to the business do not find a
place in the accounts if they cannot be measured in terms of money.

➢
According to the cost concept assets are recorded at the cost at which they are

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

THE CLASSIFICATION OF ACCOUNTING or TYPES OF ACCOUNTING

Accounting broadly classified two types are,

1. Personal Accounts
2. Impersonal Accounts – Real Account, Nominal Account

(i) Personal Account

Account of personal with which the business has dealings is known as personal
accounts. A separate account is prepared for each person.

(a) Natural Persons

The name of an individual, customer or suppliers, etc., both males and females
are included in it.

(b) Artificial persons or legal bodies:

Firms account, limited companies, educational institutions, bank account,

co-operative society, etc., are known an artificial persons account.

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(c) Representative Personal Accounts

All accounts representing outstanding expenses and accrued or prepaid incomes

are representative personal accounts e.g. prepaid insurance, outstanding wages, etc.,

When a person starts a business he is called proprietor. This proprietor is

represented by capital account for all that he investor in business and by drawings
accounts for all that which he withdrawn from business. So, capital account and
drawings account are also personal accounts.

(ii) Real accounts

Accounts in which the business records the real things owned by it i.e., assets
of the business are known as real accounts. It is of two types, tangible and intangible
real accounts. The assets which can be touched and felt and they have no physical
shape e.g. trademark, goodwill etc., are intangible real accounts.

(ii) Nominal accounts

It relates to the items which exist in name only. Accounts which record
expenses, losses, incomes and gains of the business are known as nominal accounts.
E.g. rent account, postage account, etc. The double entry system of book-keeping is a
scientific and complete system.

Accounting Rules

(i) Personal Accounts

“Debit the receiver

Credit the giver”

.(ii) Real Accounts

“Debit what comes

Credit what goes out”

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(iii) Nominal Accounts

“Debit all expenses and losses

Credit all incomes and gains”.

Two System of Accounting

1.Single entry system of book keeping

under this system. Only the cash book and personal ledger are maintained. Real and
nominal account are not maintained under this system, no fixed assets, purchase,
sales, expenses, income tec. Can be found under this system. Trial balance cannot be
prepared. It is not possible to prepare the final account and balance sheet.

2.Double Entry System of book keeping

Each transaction has two aspects. One is receiving aspect. Other is giving
aspect. In double entry system the receiving aspect is denoted as Debit aspect and the
giving aspect is denoted as credit aspect. When transaction are entered by taking into
account both of these aspects. It is called double entry system. For every transaction
one account is to be debited and other is credited in order to have complete record of
account.

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 ACCOUNTING PRINCIPLES (GAAP – GENERALLY
ACCEPTED ACCOUNTING PRINCIPLES)

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

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

1.Accounint Concept 2.Accounting Conventions

1.Accounting Concepts

1.Business Entity Concept

2.Going Concern Concept
3.Money Measurement Concept
4.Cost Concept
5.Dual Aspect Concept
6.Realization Concept
7.Accounting Period Concept

The important accounting concepts are discussed hereunder:

1.Business Entity Concept:

This concept denotes that a business unit is separate and distinct from the owners.
Therefore, it is necessary to record the business transactions separately to distinguish
from the owners personal transactions. This concept has now extended to accounting
for various division of a firm in order to ascertain the results of each division.

example, if a proprietor has taken rs.5000/- from the business for paying house tax for
his residence, the amount should be deducted from the capital contributed by him.
Instead if it is added to the other business expenses then the profit will be reduced by

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rs.5000/- and also his capital more by the same amount. This affects the results of the
business and also its financial position.

2.Going Concern Concept:

This concept assumes that the business enterprise will continue to operate for a
fairly long period in the future. The significance of this concept is that the accountant
while valuing the assets of the enterprise does not take into account their current resale
values as there is no immediate expectation of selling it. Moreover, depreciation on
fixed assets is charged on the basis of their expected life rather than on their market
values. When there is conclusive evidence that the business enterprise has a limited
life, the accounting procedures should be appropriate to the expected terminal date of
the enterprise.

3.Money Measurement Concept:

Accounting records only those transactions which can be expressed in

monetary terms. This feature is well emphasized in the two definitions on accounting
as given by the American institute of certified public accountants and the American
accounting principles board. The importance of this concept is that money provides a
common denomination by means of which heterogeneous facts about a business
enterprise can be expressed and measured in a much better way. For e.g. When it is
stated that a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery
items, 3000 square meters of land and building etc., these amounts cannot be added
together to produce a meaningful total of what the business owns. However, by
expressing these items in monetary terms such as rs.1,00,000 cash, rs.5,00,000 worth
raw materials, rs,10,00,000 worth machinery items and rs.30,00,000 worth land and
building – such an addition is possible.

4.Cost Concept:

This concept is yet another fundamental concept of accounting which is closely

related to the going-concern concept. As per this concept: The transaction are entered
in the books of accounts at the amount actually involved.

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 Eg. If a firm purchase a land for Rs.200000 but considers it as worthy
Rs.400000 the purchase will be recorded at Rs.200000 and not at any more.

5. Dual Aspect Concept (Double Entry System):

Each transaction has two aspects. One is receiving aspect. Other is giving
aspect. In double entry system the receiving aspect is denoted as Debit aspect and the
giving aspect is denoted as credit aspect. When transaction are entered by taking into
account both of these aspects. It is called double entry system. For every transaction
one account is to be debited and other is credited in order to have complete record of
account.

6.Accounting Period Concept:

In accordance with the going concern concept it is usually assumed that the life
of a business is indefinitely long. But owners and other interested parties cannot wait
until the business has been wound up for obtaining information about its results and
financial position. For e.g. If for ten years no accounts have been prepared and if the
business has been consistently incurring losses, there may not be any capital at all at
the end of the tenth year which will be known only at that time. This would result in
the compulsory winding up of the business. But, if at frequent intervals information are
made available as to how things are going, then corrective measures may be suggested
and remedial action may be taken. That is why, pacioli wrote as early as in 1494:
‘frequent accounting makes for only friendship’. This need leads to the accounting
period concept.

According to this concept accounting measures activities for a specified interval

of time called the accounting period. For the purpose of reporting to various interested
parties one year is the usual accounting period. Though pacioli wrote that books should
be closed each year especially in a partnership, it applies to all types of business
organizations.

7.Realization Concept:

Accounting is a historical record of transactions. It records what has happened

unless money has realized. Either cash has been received from the customer. No sales

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can be said to have taken place and no profit or income can be said to have arisen.
Realization refers to inflows of cash or claims to cash like bills receivables, debtors etc.
Arising from the sale of assets or rendering of services. According to realization
concept, revenues are usually recognized in the period in which goods were sold to
customers or in which services were rendered. Sale is considered to be made at the
point when the property in goods passes to the buyer and he becomes legally liable to
pay. To illustrate this point, let us consider the case of a, a manufacturer who produces
goods on receipt of orders. When an order is received from b, a starts the process of
production and delivers the goods to b when the production is complete. B makes
payment on receipt of goods. In this example, the sale will be presumed to have been
made not at the time when goods are delivered to b. A second aspect of the realization
concept is that the amount recognized as revenue is the amount that is reasonably
certain to be realized.

Accounting Conventions

1.Convention of consistency
2.Convention of full disclosure
3.Convention of Conservatism
4.Convention of Materiality
Convention of consistency

According to this concept it is essential that accounting procedures, practices

and method should remain unchanged from one accounting period to another. This
enables comparison of performance in one accounting period with that in the past. For
e.g. If material issues are priced on the basis of FIFO method the same basis should be
followed year after year. Similarly, if depreciation is charged on fixed assets according
to diminishing balance method it should be done in subsequent year also. But
consistency never implies inflexibility as not to permit the introduction of improved
techniques of accounting. However if introduction of a new technique results in
inflating or deflating the figures of profit as compared to the previous methods, the fact
should be well disclosed in the financial statement.

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Convention of Full Disclosure:

Good accounting practice also demands that all significant information should
be disclosed. The emergence of joint stock company form of business organization
resulted in the divorce between ownership and management. This necessitated the full
disclosure of accounting information about the enterprise to the owners and various
other interested parties. Thus the convention of full disclosure became important. By
this convention it is implied that accounts must be honestly prepared and all material
information must be adequately disclosed therein. But it does not mean that all
information that someone desires are to be disclosed in the financial statements. It only
implies that there should be adequate disclosure of information which is of
considerable value to owners, investors, creditors, government, etc.

Convention of Conservatism:

It is a world of uncertainty. So it is always better to pursue the policy of playing safe.

This is the principle behind the convention of conservatism. According to this
convention the accountant must be very careful while recognizing increases in an
enterprise’s profits rather than recognizing decreases in profits. For this the
accountants have to follow the rule, anticipate no profit, provide for all possible
losses, while recording business transactions. It is on account of this convention that
the inventory is valued at cost or market price whichever is less, i.e. When the market
price of the inventories has fallen below its cost price it is shown at market price i.e.
The possible loss is provided and when it is above the cost price it is shown at cost
price i.e. The anticipated profit is not recorded. It is for the same reason that provision
for bad and doubtful debts, provision for fluctuation in investments, etc., are created.
This concept affects principally the current assets.

Convention of Materiality:

Materiality depends on the amount involved in the transaction. The accountant

should recorded an item as material even though it is of small amount if its knowledge
seems to influence the decision of the proprietors. Accounts contain all the material
and immaterial facts. All material fact should be disclosed in the final account.
Immaterial facts like minor expenses can be mixed with material facts. The implication

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of this convention is that accountant should attach importance to material details and
ignore insignificant ones. In the absence of this distinction, accounting will
unnecessarily be overburdened with minute details. The question as to what is a
material detail and what is not is left to the discretion of the individual accountant.
Further, an item should be regarded as material if there is reason to believe that
knowledge of it would influence the decision of informed investor. Some examples of
material financial information are: fall in the value of stock, loss of markets due to
competition, change in the demand pattern due to change in government regulations,
etc. Examples of insignificant financial information are: rounding of income to nearest
ten for tax purposes etc.

FUNCTIONS OF FINANCIAL ACCOUNTING:

❖ Keeping systematic records

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

 Keeping Systematic Records:

This is the fundamental function of accounting. The transactions of the business

are properly recorded, classified and summarized into final financial statements –
income statement and the balance sheet.

 Protecting The Business Properties:

The second function of accounting is to protect the properties of the business by

maintaining proper record of various assets and thus enabling the management to
exercise proper control over them.

 Communicating The Results:

As accounting has been designated as the language of business, its third

function is to communicate financial information in respect of net profits, assets,
liabilities, etc., to the interested parties.

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 Meeting Legal Requirements:

The fourth and last function of accounting is to devise such a system as will
meet the legal requirements. The provisions of various laws such as the companies act,
income tax act, etc., require the submission of various statements like income tax
returns, annual accounts and so on. Accounting system aims at fulfilling this
requirement of law.

COMPONENTS OF BALANCE SHEET

The Profit & Loss Account aims to monitor profit. It has three parts.

1) The Trading Account: This records the money in (revenue) and out (costs) of the
business as a result of the business’ ‘trading’ i.e. buying and selling. This might be
buying raw materials and selling finished goods; it might be buying goods wholesale
and selling them retail. The figure at the end of this section is the Gross Profit

. 2) The Profit and Loss Account: This starts with the Gross Profit and adds to it any
further costs and revenues, including overheads. These further costs and revenues
which may be in the nature of other operating, administrative, selling and distribution
expenses. This account also includes expenses which are from any other activities not
directly related to trading (non-operating).An example is interest on investments. Thus,
profit and loss account contains all other expenses and losses, incomes and gains of the
business for the accounting year for which financial statements are being prepared. In
this process, it follows the mercantile basis of accounting (i.e., it takes into account all
paid and payable expenses, and received and receivable receipts). The net result of
profit and loss account is called as net profit. The main feature of profit and loss
account is that it takes into account all expenses and incomes that belong to the current
accounting year and excludes those expenses and incomes that belong either to the
previous period or the future period.

1) The Appropriation Account. This shows how the profit is ‘appropriated’ or

divided between the three uses mentioned above.

INTRODUCTION TO THE TRADING ACCOUNT:

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

FORMAT OF TRADING AND PROFIT & LOSS ACCOUNT:

Date Particulars Amount Date Particulars Amount
To Opening Stock By Sales
xxx xxx
Add: Purchase Less: Sales Return XXXX
xx xx XXXX
XXXX (Or Return Inward) XXXX
xxx XXXX By Closing Stock
Less: Purchase Return XXXX By Gross Loss
xx XXXX (Balancing Figure)
(Or Return XXXX
Outward) XXXX
To Wages XXXX
To Carriage In ward
To Gas, Fuel Charges XXXXX XXXXX
To Packaging Charges
To Other Factory Expenses
To Gross Profit
(Balancing Figure)
To Gross Loss XXXX By Gross Profit XXXX
To Office Salaries & Wages XXXX By Cash discount Received XXXX
To Office Rent, Rates & XXXX By Bad Debts Recovered XXXX
Taxes XXXX By Income from Investment XXXX
To Office Lighting XXXX By Commission Received XXXX
To Office Insurance XXXX By Interest on Deposits XXXX
To Trade Expenses XXXX By Gain on Sale of Fixed

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To Printing & Stationery XXXX Assets XXXX
To Postage & Telegrams XXXX By Net Loss XXXX
To Legal Expenses XXXX (Transferred to Capital
To Audit Fees XXXX Account (B/S))
To Telephone Expenses XXXX
To General Expenses XXXX
To Cash Discount Allowed XXXX
To Interest on Capital XXXX
To Interest on Loans
To Discount (or) Rebate on XXXX
Bills of Exchange XXXX
To Bad Debts XXXX
To Store Charges
To Cartage, Freight, Cartage XXXX
Outwards
To Cost of Samples, XXXX
Catalogue Expenses
To Salesmen’s Salaries, XXXX
Expenses & Commission XXXX
To Advertising Expenses XXXX
To Depreciation on FA’s XXXX
To Net Profit ( N/P)
(Transferred to Capital
Account (B/S)) XXXXX XXXXX

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

THE BALANCE SHEET AND RELATED CONCEPTS:

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

the values owned by the enterprise and the claims of the creditors and owners against

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these properties’.

The Balance sheet is a statement that is prepared usually on the last day of the
accounting year, showing the financial position of the concern as on that date. It
comprises of a list of assets, liabilities and capital. An asset is any right or thing that is
owned by a business. Assets include land, buildings, equipment and anything else a
business owns that can be given a value in money terms for the purpose of financial
reporting. To acquire its assets, a business may have to obtain money from various
sources in addition to its owners (shareholders) or from retained profits. The various
amounts of money owed by a business are called its liabilities. To provide additional
information to the user, assets and liabilities are usually classified in the balance sheet
as:

- Current: those due to be repaid (Current liabilities) or converted into cash within
12months of the balance sheet data (Current Assets).
- Long-term: those due to be repaid (Long term liabilities) or converted into cash
more than 12 months after the balance sheet data (Fixed Assets).

Fixed Assets:

A further classification other than long-term or current is also used for assets. A "fixed
asset" is an asset which is intended to be of a permanent nature and which is used by
the business to provide the capability to conduct its trade. Examples of "tangible fixed
assets"include plant & machinery, land & buildings and motor vehicles."Intangible
fixed assets"may include goodwill, patents, trademarks and brands - although theymay
only be included if they have been "acquired". Investments in other companies which
are intended to be held for the long-term can also be shown under the fixed asset
heading.

Capital:

As well as borrowing from banks and other sources, all companies receive finance
from their owners. This money is generally available for the life of the business and is
normally only repaid when the company is "wound up". To distinguish between the
liabilities owed to third parties and to the business owners, the latter is referred to as

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 the "capital" or "equity capital" of the company. In addition, undistributed profits
are re-invested in company assets (such as stocks, equipment and the bank balance).
Although these "retained profits" may be available for distribution to shareholders –
and may be paid out as dividends as a future date - they are added to the equity capital
of the business in arriving at the total "equity shareholders' funds".

At any time, therefore, the capital of a business is equal to the assets (usually cash)
received from the shareholders plus any profits made by the company through trading
that remain undistributed

The basic functions of a balance sheet are:

1. It gives the financial position of a company on any given date

2. It gives the liquidity picture of the concern
3. It gives the solvency position of the concern

DISTINCTION BETWEEN TRADING ACCOUNT AND PROFIT AND LOSS

ACCOUNT

Trading Account Profit and Loss Account

Trading Account is prepared as a part or section of the Profit and Loss Account is prepared
Profit and Loss Account. as a main account.
Indirect expenses are taken in Profit
1. Direct Expenses are taken in Trading Account.
and Loss Account.

2. Gross Profit or Gross Loss is a s c e r t a i n e d fr om

Net Profit or Net Loss is ascertained
T r a din g Account.
from the Profit and Loss Account.

3. The Balan ce of the Tra din g Account i.e. Gross The balance of the Profit and Loss
Profit or Gross Loss is transferred to the Profit and Account i.e. Net Profit or Net Loss is
Loss Account. transferred to proprietor's Capital
Account.

4. Items of account written in the Trading Account are

Items of accounts written in the Profit
few a s compared the Profit and Loss Account.
and Loss Account are much more as
compared to the Trading Account.

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 Difference between Trial Balance and Balance Sheet

Trial Balance Balance Sheet

It is a list of balances of all ledger It is a statement of assets and liabilities.
account

It comes the heading debit and credit

It contains the heading liabilities and
assets.

It is prepared, whenever desired at the It is prepared at the end of the trading

end of every month period.

It is generally prepared without giving It cannot be prepared without making

effect to any adjustments adjustments.

Difference between Financial accounting and Management Accounting

Financial Accounting Management Accounting

 It supplies information to  It supplies information to the
shareholders, creditors and management for internal use.
government authorities.  It makes use of descriptive and
 It makes use of historical data. statistical data for present and future
 It deals with position of business analysis.
as a whole.  It deals with assessing different unit
 It records only monetary or department.
transaction.  It records both monetary and non
 Reports are prepared at the end of monetary transaction.
the year.  Reports are prepared as and when
 It is objectives and based on required for management.
measurement.  It is subjective and based on
 All transaction is recorded at Judgment.

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 actual amount.  Sometimes approximate figures are
 Accounting principles and recorded.
convention are followed.  No such principles and conventions.

Difference Between Double entry and Single entry system

Double Entry System Single Entry System

Both debit and credit aspects of a Only one aspect of a transaction is
transaction are recorded recorded

All the three accounts namely personal, Only Personal a/c , cash a/c maintained
real, nominal are maintained

For every debit there is a corresponding

There may be a debit without a
and equal credit
corresponding and equal credit
Trial balance can be prepared
Trial balance can not be prepared

Trading, profit and loss account and

Can not be prepared
balance sheet can be prepared.

It is an imperfect and unscientific system

It is a perfect and scientific system

It involves less clerical work

It involves more clerical work

Tax authorities do not accept as such.

Tax authorities accept this method

21
Management Accounting

Management accounting is recent origin which was introduced during

1950. It got a gradual development and got a good shape only after 1970s. the reasons
of the development and growth of business manufacturing and trading activities.
Hence, the factors of competitions play a crucial role in the success of the industrial
units, provision of quality products at low prices. It provides technique for managerial
decision making, planning and control of the cost. This system of accounting is based
on the information of financial accounting. Management accounting is concerned with
the accounting to management. Financial accounting and cost accounting are not able
to provide the relevant information to management for managerial planning and
decision making. Financial accounting is providing the historical data in account form
as profit and loss account and balance sheet. Cost accounting analyses the different
elements related to the cost of production. But this information are not sufficient for
managerial planning and control. Hence a new accounting system called management
accounting.

Definition:

Management accounting is the presentation of accounting information in such a way as

to assist management in the creation of policy and the day to day operation of an
undertaking.

 It facilitates for the preparation of statement with previous year result and give
estimation for the future.
 It present accounting information and explain them with statistical devices like
chart, graphs.
 It communicates the performance of various department to the top management
by report.
 It helps in overall control and coordination of business operation through
budgets.

22
Functions of Management Accounting

1. Provision of data
The important function of management accounting is the provision of relevant data to
the management for decision making purpose, it helps the management for proper
planning and control of the cost.

2. Modification of Data
Management accounting concerned with the modification of the financial data
provided by the management decision making. It modified data like working capital,
capital employed, debt and equity.

3. Analysis and Interpretation of Data

The functions of management accounting are to analyses the data in relation to the
previous period. It help to find out whether there is growth in the operating and
financial activities of a concern. It analyzed data rare properly interpreted for easy
identification for the management.

4. Communicating Function
Management accounting performs the functions of communication at various level of
management. The interpreted data are provided to top level management. On the basis
of the data decisions may be taken by the management which are communicated to
various employed in the lower level of management.

5.Fix standard at all level

Management accounting helps to fix standard of cost for various activities in an
organization. The standard related to material, labour and overheads are fixed on the
basis of the past data and experiences.

6. Functions of control

Management accounting helps to identify whether the actual performances are deviated
from the standard performance. If there is any deviation on the negative side, it
suggests some control measures to achieve efficiency at all levels.

23
Scope of Management Accounting

1.Financial Accounting

Management accounting is based on data of financial accounting. It analysis the profit

and loss account and balance sheet at various period and give more meaning for the
information in the financial accounting.

2.Cost accounting

Cost accounting is concerned with the ascertainment of cost at various level of

activities. Hence the cost data are more required for the management accounting for
further analysis so that relevant information can be provide to management.

3.Statisstical Method

Management accounting the statistical techniques like tabulations, diagrams and

graphs are mostly applied for analyzing the financial data.

4.Revaluation accounting

Is concerned with the effective representation of capital in fixed assets . the fixed
assets should be revalued to represent the real worth in order to ascertain the correct
measurement of the return on capital employed.

5.Budgetary Control

Management accounting helps to prepare the budget for various activities in an

organization. It also suggest various methods for controlling deviation in the actual
values with the budgeted values for difference activities.

6.Inventory Control

Inventory is a most important factor for a concern. High inventory or low inventory
are not good for a concern. High inventory means blocking more capital in inventory
and low inventory means interruption in production. The optimum inventory which is
most required is determined through the management accounting techniques.

24
7.Interim Report

The net results of the activities of a business is known only at the end of a financial
year through financial accounting. But management accounting provide interim report
to the owners and management. So that they can take business action.

8.Internal Audit

Internal audit is an audit conducted within an organization. For internal audit relevant
records are required which are provided by the management accounting. So that the
internal audit can be performed in an effective manner.

9.Financial Management: Is concerned with the management of the finance in a

company. It deals with the effective utilization of the finance so that the fair rate of
return on investment is achieved.

Tools and Techniques of Management Accounting

1.Financial Statement Analysis

Is concerned with the analysis of profit and loss account and balance
sheet of different period. It helps to find out the rate of growth of a concern. This
analysis done through comparative financial statement, common size statement and
ratio analysis.

2.Fund Flow Analysis

Fund flow analysis is an analysis to findout the movement of funds from

one period to another. It help to findout whether the fund is properly utilized or not in
a year when compared to previous year. It studies the fund from operation and
movement of working capital.

3.Cash flow analysis

Is an analysis about movement of cash from one period to another. It

25
help to find out the reason for the change of cash balance between two period. It
studies the cash from operation and movement of cash in a period.

4.Marginal cost

To fix the selling price and for other managerial decision like acceptance
or rejection of bulk order, to produce or to purchase. It is an analysis based on fixed
cost, variable cost and contribution. Aggregate cost are changed if the volume of
output is increased or decreased by one unit.

5.Standard Costing

It facilitate for fixing the standard for all activities in a concern and to
measure the variance of the actual from the standard. Hence the unfavorable variances
can be controlled through this techniques.

6.Budgtary Control

It is concern with the preparation of different types of budgets like cash,

sales, production, maintenance etc. it is possible to compare the actual values with
budget value and to take necessary action for correction.

7.Revaluation Accounting

Is concerned with the effective representation of capital in fixed assets .

the fixed assets should be revalued to represent the real worth in order to ascertain the
correct measurement of the return on capital employed.

8.Management Information System

Information system adopted by the management to provide information

to management in a meaningful manner. The information prepared by applying the
computer skill so that the management can easy understand the information. The
information is required for taking management decision making.

26
9. Management Reporting

Reporting to management is an important technique in management

accounting. Management accounting analysis the profit and loss account and balance
sheet by adopting different methods and explore the strength and weakness in
different areas of operating activities and financial activities. This identification is
properly reported to the management for managerial planning, control and decision
making.

ADVANTAGES OF MANAGEMENT ACCOUNTING:

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

LIMITATIONS OF MANAGEMENT ACCOUNTING:

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

27
 Two Marks:

1. Define Accounting? (May/June 2011)

2. Write Short note on Cost Accounting? (May/June 2011) (Jan 2013)
3. What is the Position of Ledger in Book Keeping? (May/June 2012)
4. What are the Functions of Accounting? (Apr/May 2011)
5. What is Provision for Doubtful Debts? (Apr/May 2011)
6. What is Money Measurement Concept? (Jan/2012)
7. Explain Management Accounting Information? (Jan/2012)
8. What is Profit and Loss Account? (Jan/2012)
9. What do you mean by GAAP? (Jan/2013)
10. What are the functions of Accounting? (NOV/DEC2013)
11. What is financial accounting? (JAN 2014)
12. What are personal accounts? (JAN 2014)
13. What is GAAP? (MAY/JUNE 2014)
14.Mention the objectives of accounting. (JAN 2015)
15.Define management accounting. (APR/MA 2015)
16.What is GAAP? (APR/MA 2015)
16 Marks:
1. Explain the difference branches of Accounting with their Significances? (May/June
2011)
2. Evaluate the Generally Accepted Accounting Conventions? (May/June
2011),(Jan/2013)
3. What is Nature of Accounting? In What ways accounting information is Useful to
creditors, Investors and Employees of a business Enterprise? (May/June 2012),
(Jan/2012)
4. Explain the Importance of Various Accounting Concepts & Conventions?
(May/June 2012), (Jan2013)
5. Mention the Accounting Conventions and Explain? (Nov/Dec 2011)
6. “Management Accounting is the best tool for the Management to achieve higher
profits and Efficient Operations” Discuss. (Apr/May 2011)
7. Discuss the Brief about Accounting Concepts. (NOV/DEC2013)
8. Distinguish between profit and loss account and balance sheet using an Illustration.
(JAN 2014)

28
 UNIT II

ANALYSIS OF FINANCIAL STATEMENTS

Analysis of financial statements

INTRODUCTION

Presentation of financial statements is the important part of accounting process.

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

MEANING OF ANALYSIS AND INTERPRETATIONS

The term "Analysis" refers to rearrangement of the data given in the financial
statements. In other words, simplification of data by methodical classification of the data
given in the financial statements.

The term "interpretation" refers to "explaining the meaning and significance of

the data so simplified.

“Both analysis and interpretations are closely connected and inter related. They
are complementary to each other. Therefore presentation of information becomes more
purposeful and meaningful-both analysis and interpretations are to be considered.

Metcalf and Tigard have defined financial statement analysis and interpretations
as a process of evaluating the relationship between component parts of a financial
statement to obtain a better understanding of a firm's position and performance.

The facts and figures in the financial statements can be transformed into
meaningful and useful figures through a process called "Analysis and Interpretations."

In other words, financial statement analysis and interpretation refer to the process of
establishing the meaningful relationship between the items of the two financial
statements with the objective of identifying the financial and operational strengths and
weaknesses.

Objectives of Financial Statement Analysis

To help in making future plan.
To estimate the earning capacity of the firm.
To assess the financial position and performance of the firm.
To know the progress of the firm.
To judge the solvency of the firm.
To estimate the debt capacity of the firm.
To determine the legality of dividends.
 What are the uses and importance of financial statement to different parties?
 They are useful to the shareholders to judge the prospects of their investments and to sell or
continue ownership.
 They are useful for assessing the efficiency for different cost centers.
 They are useful to the creditors to assess the current financial position of the concern in relation
to their debts.
 They can be used as informative for prospectus investors in an enterprises and a guide to the
value of the investment already made.

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

The mainobjectives of ratio analysis are:

1. Measuring the profitability

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

2. Indicating the trend of Achievements

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

The purpose of financial statements analysis is to help the management to make a

comparative study of the profitability of various firms engaged in similar businesses.
Such comparison also helps the management to study the position of their firm in respect
of sales, expenses, profitability and utilizing capital, etc.

3. Assess overall financial strength

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

4. Assess solvency of the firm

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

5.Parties Interested

Analysis of financial statements has become very significant due to widespread

interest of various parties in the financial results of a business unit. The various parties
interested in the analysis of financial statements are:

(i) Investors :

Shareholders or proprietors of the business are interested in the wellbeing of the

business. They like to know the earning capacity of the business and its prospects of
future growth.

(ii) Management:

The management is interested in the financial position and performance of the enterprise
as a whole and of its various divisions. It helps them in preparing budgets and assessing
the performance of various departmental heads.

(iii) Trade unions:

They are interested in financial statements for negotiating the wages or salaries or bonus
agreement with the management.

(iv) Lenders :

Lenders to the business like debenture holders, suppliers of loans and lease are interested
to know short term as well as long term solvency position of the entity.

(v) Suppliers and trade creditors:

The suppliers and other creditors are interested to know about the solvency of the
business i.e. the ability of the company to meet the debts as and when they fall due.

(vi) Tax authorities :

Tax authorities are interested in financial statements for determining the tax liability.

(vii) Researchers:

They are interested in financial statements in undertaking research work in business

affairs and practices.

(viii) Employees:

They are interested to know the growth of profit. As a result of which they can
demand better remuneration and congenial working environment.

(ix) Government and their agencies:

Government and their agencies need financial information to regulate the activities
of the enterprises/ industries and determine taxation policy. They suggest measures to
formulate policies and regulations.

(x) Stock exchange:

The stock exchange members take interest in financial statements for the purpose
of analysis because they provide useful financial information about companies. Thus,
we find that different parties have interest in financial statements for different reasons

NATURE OF FINANCIAL ANALYSIS

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

TYPES OF FINANCIAL ANALYSIS

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

External Analysis:
When the parties external to the business like creditors, investors, etc. Do the
analysis, the analysis is known as external analysis. This analysis is done by them to
know the credit-worthiness of the concern, its financial viability, its profitability, etc.
Internal Analysis:
This analysis is done by persons who have control over the books of accounts
and other information of the concern. Normally this analysis is done by management
people to enable them to get relevant information to take vital business decision.

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

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

Vertical Analysis:
This type of analysis establishes a quantitative relationship of the various items
in the financial statements on a particular date. For e.g. the ratios of various expenditure
items in terms of sales for a particular year can be calculated. The other name for this
analysis is `static analysis’ as it relies upon one year figures only.
 CLASSIFICATION OF RATIOS
Financial ratios may be categorized in various ways. Van Horne has divided
financial ratios into four categories, viz., liquidity, debt, profitability and coverage ratios.
The first two types of ratios are computed from the balance sheet. The last two are
computed from the income statement and sometimes, from both the statements. For the
purpose of analysis, the present lesson gives a detailed description of ratios, the formula
used for their computation and their significance.

Short term solvency ratios

Liquidity ratio indicates that the firm has sufficient liquid resources to meet their short term liabilities.
It is also known as short term solvency ratio.

Current Ratio:
Current ratio is the most common ratio for measuring the liquidity. Current ratio is te ratio of
total current assets to current liabilities.

Current assets are easily converted into cash within a period of one year. They are cash, bank,
debtors, bills receivable, stock, prepaid expenses and amounts receivable within a year.

Current liabilities are payable within a period of one year. They are creditors, bills payable,
bank overdraft, outstanding expenses.

Liquid Ratio
It is also known as quick ratio or acid test ratio. It shows the relationship between liquid
assets and liquid liabilities. Liquid assets are easily converted into cash immediately without any
diminishing value. liquid ratio is the true test of the business solvency.

Long term Solvency Ratios

Financial strength indicates the soundness of the financial resources of an
organization to perform its operations in the long run. The parties associated with the
organization are interested in knowing the financial strength of the organization.
Financial strength is directly associated with the operational ability of the organization
and its efficient management of resources.
Debt-Equity Ratio:
The debt-equity ratio is determined to ascertain the soundness of the long-term
financial policies of the company. This ratio indicates the proportion between the
shareholders’ funds (i.e. Tangible net worth) and the total borrowed funds. Ideal ratio is
1. In other words, the investor may take debt equity ratio as quite satisfactory if
shareholders’ funds are equal to borrowed funds. However, creditors would prefer a low
debt-equity ratio as they are much concerned about the security of their investment. This
ratio can be calculated by dividing the total debt by shareholders’ equity. For the purpose
of calculation of this ratio, the term shareholders’ equity includes share capital, reserves
 and surplus and borrowed funds which includes both long-term funds and short-term
funds.
Capital Gearing Ratio
This ratio establishes the relationship between the fixed interest-bearing
securities and equity shares of a company. Fixed-interest bearing securities carry with
them the fixed rate of dividend or interest and include preference share capital and
debentures. A firm is said to be highly geared if the lion’s share of the total capital is in
the form of fixed interest-bearing securities orthis ratio is more than one. If this ratio is
less than one, it is said to be low geared. If it is exactly one, it is evenly geared. This
ratio must be carefully planned as it affects the firm’s capacity to maintain a uniform
dividend policy during difficult trading periods that may occur. Too much capital
should not be raised by way of debentures, because debentures do not share in business
losses.

FINANCIAL LEVERAGE RATIO:

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

Proprietary Ratio:
This ratio establishes the relationship between the proprietors’ funds and the total
tangible assets. The general financial strength of a firm can be understood from this ratio.
The ratio is of particular importance to the creditors who can find out the proportion of
shareholders’ funds in the capital assets employed in the business. A high ratio shows
that a concern is less dependent on outside funds for capital. A high ratio suggests sound
financial strength of a firm due to greater margin of owners’ funds against outside
sources of finance and a greater margin of safety for the creditors. A low ratio indicates a
small amount of owners’ funds to finance total assets and more dependence on outside
funds for working capital.
Profitability Ratios
Profitability refers to the ability to earn profit. It is a measure of efficiency and control. It is the
main base for liquidity and solvency. Creditors and financial institutions are interested in
profitability because it indicates the capacity of the business.

Gross Profit Ratio:

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

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

Net Profit Ratio:

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

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

Return On Capital Employed:

The prime objective of making investments in any business is to obtain
satisfactory return on capital invested. Hence, the return on capital employed is used as
a measure of success of a business in realizing this objective. Otherwise known as return
on investments, this is the overall profitability ratio. It indicates the percentage of return
on capital employed in the business and it can be used to show the efficiency of the
business as a whole. The term “capital employed” means [share capital + reserves and
surplus + long term loans] minus [non-business assets + fictitious assets] and the term
“operating profit” means profit before interest and tax. The term `interest’ means
interest on long- term borrowings. Non-trading income should be excluded for the
above purpose. A higher ratio indicates that the funds are invested profitably.

Operating Ratio:
This ratio establishes the relationship between total operating expenses and
sales. Total operating expenses includes cost of goods sold plus other operating
expenses. A higher ratio indicates that operating expenses are high and the profit margin
is less and therefore lower the ratio, better is the position. The operating ratio is an index
of the efficiency of the conduct of business operations. Operating profit ratio helps in
determining the efficiency with which affairs of the business are being managed. An
increase in the ratio over the previous period indicates improvement in the operational
efficiency of the business provided the gross profit ratio is constant. Operating profit is
estimated without considering non-operating income such as profit on sale of fixed
assets, interest on investments and non-operating expenses such as loss on sale of fixed
assets. This is thus, an effective tool to measure the profitability of a business concern.

Return On Owners’ Equity (Or) Shareholders’ Fund (Or) The NetWorth:

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

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

ANALYSIS OF TURNOVER (OR) ANALYSIS OF EFFICIENCY

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

Current Assets Turnover Ratio

Working Assets Turnover Ratio

Inventory (Or Stock) Turnover

Ratio Debtors Turnover Ratio

Creditors Turnover Ratio

FIXED ASSETS TURNOVER RATIO:

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

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

CURRENT ASSETS TURNOVER RATIO:

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

Working Capital Turnover Ratio: this ratio shows the number of times working
capital is turned-over in a stated period. Working capital turnover ratio reflects the extent
to which a business is operating on a small amount of working capital in relation to sales.

The higher the ratio, the lower is the investment in working capital and greater
are the profits. However, a very high turnover of working capital is a sign of over trading
and may put the firm into financial difficulties. On the other hand, a low working capital
turnover ratio indicates that working capital is not efficiently utilized.
INVENTORY TURNOVER RATIO:
The inventory turnover ratio, also known as stock turnover ratio normally
establishes the relationship between costs of goods sold and average inventory. This ratio
indicates whether investment in inventory is within proper limit or not. In the words of
S.C.Kuchal, “this relationship expresses the frequency with which average level of
inventory investment is turned over through operations”.
In general, a high inventory turnover ratio is better than a low ratio. A high ratio
implies good inventory management. A very high ratio indicates under-investment in,
or very low level of inventory which results in the firm being out of stock and incurring
high stock-out cost. A very low inventory turnover ratio is dangerous. It signifies
excessive inventory or over-investment in inventory. A very low ratio may be the results
of inferior quality goods, over-valuation of closing inventory, and stock of
unsalable/obsolete goods.

DEBTORS TURNOVER RATIO AND COLLECTION PERIOD:

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

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

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

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

Creditors’ Turnover Ratio and Debt Payment Period:

Creditors’ turnover ratio indicates the speed with which the payments for credit
purchases are made to the creditors. The term accounts payable include trade creditors
and bills payable. A high ratio indicates that creditors are not paid in time while a low
ratio gives an idea that the business is not taking full advantage of credit period
allowed by the creditors.
 ANALYSIS OF LIQUIDITY POSITION

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

current ratio

liquid (or) quick ratio

cash to current assets ratio

cash to working capital ratio

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

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

“current ratio is a tool for measuring the short-term stability or ability of the company
to carry on its day-to-day work and meet the short-term commitments earlier”.
Generally 2:1 is considered ideal for a concern i.e., current assets should be twice of the
current liabilities. If the current assets are two times of the current liabilities, there will
be no adverse effect on business operations when the payment of current liabilities is
made. If the ratio is less than 2, difficulty may be experienced in the payment of current
liabilities and day-to-day operations of the business may suffer. If the ratio is higher than
2, it is very comfortable for the creditors but, for the concern, it indicates idle funds and
lack of enthusiasm for work.
Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a firm’s ability to
convert its current assets quickly into cash in order to meet its current liabilities. It is a
measure of judging the immediate ability of the firm to pay-off its current obligations. It
is calculated by dividing the quick assets by current liabilities:The term quick assets
refers to current assets which can be converted into cash immediately or at a short
notice without diminution of value. Thus quick assets consists of cash, marketable
securities and accounts receivable. Inventories are excluded from quick assets because
they are slower to convert into cash and generally exhibit more uncertainty as to the
conversion price.

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

CASH TO CURRENT ASSETS RATIO:

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

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

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

An appraisal of the financial position of any enterprise is incomplete unless its

overall profitability is measured in relation to the sales, assets, capital employed, net
worth and earnings per share. The following ratios are used to measure the profitability
position from various angles:

Gross Profit Ratio

Net Profit Ratio
Return On Capital Employed
Operating Ratio
Operating Profit Ratio
Return On Owners’ Equity
Dividend Pay Out Ratio

ANALYSIS OF OPERATIONAL EFFICIENCY

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

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

2. Financial operations ratio

TURNOVER TO CAPITAL EMPLOYED:

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

Operating Revenue / Capital Employed * 100

The higher the ratio, the better is the position.
FINANCIAL OPERATIONS RATIO:
The efficiency of the financial management of a firm is calculated through
financial operations ratio. This ratio is a calculating device of the cost and the return of
financial charges. This ratio signifies a relationship between net profit after tax and
operating profit. The formula for the computation of this ratio is:
Here, the term “operating profit” means sales minus operating expenses. A higher ratio
indicates the better financial performance of the firm.

RATIOS FROM SHAREHOLDERS’ POINT OF VIEW

1. Preference dividend cover: this ratio expresses net profit after tax as so many times
of preference dividend payable.
 2. Equity Dividend Cover: this ratio gives information about netprofit available to
equity shareholders. This ratio expresses profit as number of times ofequity
dividend payable.
3. Dividend Yield on Equity Shares or Yield Ratio: this ratio interprets dividend as a
percentage of market price per share.
4. Price Earnings Ratio: this ratio tells how many times of earnings per share is the
market price of the share of a company.

DU PONT RATIOS

This Ratios was first prepared by DU Pont Company of USA. It is used as a tool for
financial analysis. It shows the return on investment. Which represents the earning power of the
firm? Return on Investment depends on two ratios namely Net Profit ratio and capital turnover
ratio. These ratio are affected by many factors. Any change in these factors will affect the two
ratios and the earning power of the firm.

The DU Point ratios shows that Return on capital employed is affected by a number of factors.
Any change in these factors will affect the ROI. For example increase in cost of goods sold
without increase in selling price, reduce the net profit and ROI. This ratio helps the
management to identify the factors which have a bearing on profitability.

TYPES OF ANALYSIS AND INTERPRETATIONS

The analysis and interpretation of financial statements can be classified into

different categories depending upon:

I. The Materials Used

II. Modus Operandi (Methods of Operations to be followed)

1. On the basis of Materials Used:

(a) External Analysis.

(b) Internal Analysis.

II. On the basis of Modus Operandi

(a) Vertical Analysis.

(b) Horizontal Analysis.

The following chart shows the classification of financial analysis:

I. On the Basis of Materials Used

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

(a) External Analysis and

(b) Internal Analysis.
(c)

(a) External Analysis

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

(b) Internal Analysis

Internal analysis performed by the persons who are internal to the organization.
These internal people who have access to the books of accounts and other information
related to the business. Such analysis can be done for the purpose of assisting managerial
personnel to take corrective action and appropriate decisions.

II. On the basis of Modus Operandi

On the basis of Modus operandi, the analysis and interpretation of financial
statements may be classified into: (a) Horizontal Analysis and (b) Vertical Analysis.

(a) Horizontal Analysis

lysis is also termed as Dynamic Analysis. Under this type of analysis,
comparison of the trend of each item in the financial statements over the number of years
are reviewed or analyzed. This type of comparison helps to identify the trend in age 59
various indicators of performance. In this type of analysis, current year figures are
compared with base year for figures are presented horizontally over a number of
columns.
(b) Vertical Analysis
Vertical Analysis is also termed as Static Analysis. Under this type of analysis,
a number of ratios used for measuring the meaningful quantitative relationship between
the items of financial statements during the particular period. This type of analysis is
useful in comparing the performance, efficiency and profitability of several companies
in the same group or divisions in the same company.
Rearrangement of Income Statements
Financial statements should be rearranged for proper analysis and interpretations
of these statements. It enables to measure the performance of operational efficiency and
profitability of a concern during particular period.

METHODS OF FINANCIAL STATEMENT ANALYSIS

Comparative Financial Statement Analysis

This is a major tool for making horizontal analysis. Under this technique, statements
(either Balance Sheets or Profit & Loss accounts) for two years or more are analyzed.
The data is arranged side by side. And the changes from one period to another period are
calculated and analyzed as to the reasons and suitable inferences are drawn from them.

Comparative Financial Statement analysis provides information to assess the

direction of change in the business. Financial statements are presented as on a particular
Date for a particular period. The financial statement Balance Sheet indicates the
financial position as at the end of an accounting period and the financial statement
Income Statement shows the operating and non-operating results for a period. But
financial managers and top management are also interested in knowing whether the
business is moving in a favorable or an unfavorable direction. For this purpose, figures
of current year have to be compared with those of the previous years. In analyzing this
way, comparative financial statements are prepared.

Comparative Financial Statement Analysis is also called as Horizontal analysis. The

Comparative Financial Statement provides information about two or more years' figures
as well as any increase or decrease from the previous year's figure and it's percentage of
increase or decrease. This kind of analysis helps in identifying the major improvements
and weaknesses

Comparative statements are financial statements that cover a different time

frame, but are formatted in a manner that makes comparing line items from one period
to those of a different period an easy process. This quality means that the comparative
statement is a financial statement that lends itself well to the process of comparative
analysis. Many companies make use of standardized formats in accounting functions
that make the generation of a comparative statement quick and easy.

FEATURES OF COMPARITIVE STATEMENTS:-

A comparative statement adds meaning to the financial data.

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

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

companies or of the same company over different periods. By expressing the items in
proportion to some size-related measure, standardized financial statements can be
created, revealing trends and providing insight into how the different companies
compare. Total Assets.

The ratios often are expressed as percentages of the reference amount. Common size
statements usually are prepared for the income statement and balance sheet, expressing
information as follows:

Income statement items - expressed as a percentage of total revenue

Balance sheet items - expressed as a percentage of total assets

The following example income statement shows both the rupee amounts and the
common size ratios:

FEATURES OF COMMON SIZE STATEMENT

A common size statement analysis indicates the relation of each component to the
whole.

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

Limitations

As with financial statements in general, the interpretation of common size statements is

subject to many of the limitations in the accounting data used to construct them. For
example:

1. Different accounting policies may be used by different firms or within the same firm
at different points in time. Adjustments should be made for such differences.
2. Different firms may use different accounting calendars, so the accounting periods
may not be directly comparable.
TREND STATEMENT

Trend analysis calculates the percentage change for one account over a period of time of
two years or more.

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

Percentage change

To calculate to percentage change between two periods:

Calculate the amount of the increase/ (decrease) for the period by subtracting the earlier
year from the later year. If the difference is negative, the change is a decrease and if the
difference is positive, it is an increase..

FEATURES OF TREND ANALYSIS

In case of a trend analysis all the given years are arranged in an ascending order.

The first year is termed as the “Base year” and all figures of the base year are taken
as 100%.
Item in the subsequent years are compared with that of the base year.
If the percentages in the following years is above 100% it indicates an increase over
the base year and if the percentages are below 100% it indicates a decrease over
thebase year.
A trend analysis gives a better picture of the overall performance of the business.
A trend analysis helps in analyzing the financial performance over a period of time.
A trend analysis indicates in which direction a business is moving i.e. upward or
downwards.
A trend analysis facilitates effective comparative study of the financial performance
over a period of time.
For trend analysis at least three years financial data is essential. Broader the base the
more reliable is the data and analysis.
 FUND FLOW STATEMENT

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

Definition

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

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

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

Uses of Fund Flow Statement

 It shows how the funds were raised and disbursed during a period.
 It helps to formulate financial policies like dividend declaration, creating reserve
etc.
 It points out the reasons for changes in working capital.
 It shows the financial strength and weakness of the firm.
 It helps to assess the creditworthiness and repaying capacity of the firm.
 It lays down the plan for efficient use of scare resources in future.

Limitations of Fund Flow Statement

 It is not an original statement. It is only a rearrangement of financial data.

 It shows only the past position and not future.
 When both the aspects of a transaction are current and noncurrent, they are not included
in this statement.
 It is not an ideal tool for financial analysis.

Procedure for Preparing a Fund Flow Statement

Funds flow statement is a method by which we study changes in the financial

position of a business enterprise between beginning and ending financial statements
dates. so, funds flow statement is prepared by comparing two balance sheets and with
the help of such other information derived from the accounts as may be needed. The
preparation of a fund flow statement consists of three parts:

1. Statement or schedule of changes in working capital

A statement shows the changes in current assets and current liabilities of two periods are
known as schedule of changes in working capital. This statement is prepared with current
assets and current liabilities as appeared in the balance sheet. The net increase or decrease of
working capital is arrived at the end.

Rules of Preparing the Schedule

Increase in Current Asset: Increase in working capital
Decrease in Current Asset: Decrease in working capital
Increase in current liabilities: decrease in working capital
Decrease in current liabilities: Increase in working capital
 2. Statement of fund from operation
Funds from operation are the only internal source of funds. To find out the real funds
from operations the non operating incomes and expenditures are adjusted with the net profit
because non operating items do not affect the working capital.

3. Statement of sources and application of funds.

While preparing fund flow statement, it is necessary to findout the source and
applications of funds. The sources of funds can be both internal and external sources.
Internal source is funds from operations. External sources are issue of shares and debentures,
long term borrowings, sale of fixed assets, income from investment. The application of funds
means disbursement or payment of funds. They are purchase of fixed assets, repayment of
loan, and payment of dividend.

CASH FLOW STATEMENTS

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

DEFINITIONS OF CASH FLOW STATEMENT

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

SCOPE CASH FLOW STATEMENT

✓
An enterprise should prepare a cash flow statement and should present it for each
period for which financial statements are presented.
✓
Cash flow statements are interested in how the enterprise generates and uses cash and
cash equivalents.
✓
Enterprise needs cash for essentially the same reasons, however different their
principal revenue producing activities might be.
✓
Enterprise needs cash to conduct their operations, to pay their obligations, and
to provide returns to their investors.
Difference between cash flow statement and fund flow statement:

Cash flow statement Fund flow statement

It start with opening balance and end with No such balances
closing balance
It deals with cash receipts and payments It deals with increase or decrease in working
capital
It shows the changes in cash It shows the changes in working capital
It is useful for short term financial analysis It is useful for long term financial analysis
Cash is a part of working capital Working capital may not necessarily mean
cash
Flow of cash means definitely be flow of funds Flow of funds does not mean flow of cash

1) State the limitations of ratio analysis. June 2010

2) What are the objectives of financial statements? Jan 2012
3) Write the importance of Analysis and Interpretation of Financial Statements?
4) What are financial statements? May 2013
5) What are the sources of cash inflow? May 2013
6) Write the formula for debt-equity ratio? Dec 2011
7) What is a fund flow statement? Dec 2010
8) What do you by ‘flow of funds’? June 2011
9) What are funds from operations? (NOV/DEC2013)
10) What are profitable ratios? (NOV/DEC2013)
11) Write a short note on operating ratio. (JANUARY 2014)
14)Define cash flow statement. (JANUARY 2014)
15) Define the term fund. (MAY/JUNE 2014)
16.What is Du Point Ratio?

.
 UNIT III

COST ACCOUNTING

Cost accounting emerged as a subject in order to provide information to

management to take various managerial decisions, the business at present is highly
competitive , in order to withstand competition, the concerns have to supply goods
at low prices. Low prices may affect the basic concept of the profit maxima ion of
business. To overcome this problem the only alternative for a concern is to reduce
the cost of production.

COSTING

The institute of cost and management accounting, London defined costing as

the ascertainment of costs; it includes the technique and process of ascertainment
of costs. The technique means the principles and rules required for ascertainment
of cost of production of products and services. The process refers to the procedure
for the ascertainment of cost.

Cost accounting

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

Objectives of cost accounting

1. Ascertainment of cost

It enables the management to ascertain the cost of product, job, contract or unit of
production so as to develop cost standard. And once of the important ojectives of
cost accounting is the ascertainment of cost at different stages of production. The
cost incurred for each department and activities are to be calculated. The standard
cost for all types of costs are also to be calculated in order to compare the actual
cost with the standard cost.

2. Fixation of selling Price

Cost data are useful in the determining of selling price. The cost accounting
analysis the total cost into fixed and variable cost. This will help the management
to fix the selling price.

3.Cost Control

Minimizing the cost of manufacturing, comparison of actual cost with standard

reveals the variances. If the variance are adverse the management enters into
investigation so as to adopt corrective action immediately.
4. Matching cost with revenue

The determination of profitability of each product, process, department etc, is the important
object of costing.

5.Special Cost Studies and Investigations

It undertakes special cost studies and investigations and these are the basis for the management
in decision making or policies, this will also include pricing of new products, expansion
programme, closing down or continuing department, product mix, price reduction in depression
etc.

Advantages of Cost Accounting

1.To the Management

 Gide in Reducing Prices

In certain periods it becomes to reduce the price even below the total cost. This will be so when
there is a depression or slump. Costs, properly ascertained, will guide management in this
direction.

 Action Against Unprofitable Activities

It reveals unprofitable activities, inefficiencies such as materials spoilage, leakage, scrap etc and
wastage of resources etc. the management is able to concentrate on profitable jobs and consider
change or closure of the unprofitable jobs.
  Facilitates Decision Making

It provides necessary data along with information to the management to take decision on any
matter, relating to the business.

 Assists in Fixing Prices

The various types of cost accounting are much helpful in fixing the cost and selling price of a
product. Thus the desired volume of production is secured at the minimum possible cost.

 Improves Efficiency

Through the standard cost and budgetary control, remedial action can be chosen in order to
improve the efficiency and implement new principles.

 Inventory Control

An effective system and check are provided on all materials and stores. Interim profit and loss
account, and balance sheet can be prepared without checking the physical inventory.

 Prevent fraud

An effective costing system prevents frauds and manipulation and supplies reliable cost data to
the management.

 Future Prospects

The cost accountant not only provided the present trend, but future prospectus also. On this basis,
bankers, financial agencies etc. form an idea of the soundness of the firm before granting credits.

2.To the Employee

 Sound Wage Policy

Cost accounting introduces incentive wage schemes, bonus plan etc. which bring better reward to
sincere and efficient workers. Cost data aid the management in devising a suitable wage policy
for the workers. Time wage system and piece rate system can be blended to provide higher
wages and at the same time increasing productivity rate.

 Higher Bounus Plan

Cost accounting leads to an increase in productivity, lowering of costs and increase in

profitability. Worker get their share I profits in the form of bonus.
  Security of Job

Employees get better remuneration, security of job etc. due to the increasing prosperity of the
industries. Monetary appreciation of the efficiency of a worker is a good tonic which leads to
higher rate of productivity.

3.To the Creditors

Bankers,creditors,investors etc. can have a better understanding of the firm, as regards the
progress and prosperity, before offer financial lendings.

4.To the Government

 The Proper Systems Of Cost Accounting Are Of Great Use In Preparation Of National
plans, economic developments.
 Costing system has stability and cost reduction in industries, cost audit is important and
industries have to keep books of accounts to show the utilization of materials,labour and
other costs.

5.To the Public

 Cost accounting removes all types of wastages and inefficiencies. These will enable the
consumers to get goods at better quality and cheaper rates.
 Development and prosperity of industries will create employment opportunities
 Cost reduction will help in curbing inflationary trends in economy.
Essentials of Good Costing System

1.Simplicity

It must be simple and it must be easily understandable to the personnel. The information
provided must be in the proper order, in right time and to the right persons so as to be utilized
fully.

2.Flexibility

Costing system must be flexible to accommodate the changing conditions and circumstances.

3.Comparability

Management must be able to make comparison of the facts and figures with the past figures or
department.

4.Suitability to the firms

Before accepting a costing system, the nature, requirements ,size and conditions of the business.

5.Uniformity of forms

Forms of different colours can be used to distinguish them, forms must be uniform in size and
quality, forms should contain instruction to fill.

6.Less clerical work

Printed forms will involve less labour to fill in, as the workers may be a little educated.

Cost Centre

Cost centre is location, person,item of equipment for which cost may be ascertained and
used for the purpose of cost control.

1.Personal Cost Centre

It consist of a person or group of person, costs like work manager,store keeper,sales manager
may be accumulated .

2.Impersonal Cost Centre

It consist of a location or items of equipments.

3.Operation Cost centre

It consist of machineries and person carrying out similar operations.

4.Process Cost centre

It consist of specific process or continuous sequence of operations.

Methods of Cost

 Job Costing
The costing adopted by concerns which produce goods according to the specific order of
the customer is called job costing.
Eg.Printing,Repair Shops

 Batch Costing
Which produces group of similar product in large unit.
Eg.Medicines,Readymade garments

 Contract costing
Which produces product of constructions type. It is just like Job costing, but the period of
completion of the work is long when compared to the job costing.
Eg.construction of building

 Process costing
Which produce products of mass scale with two or more process.
Eg.Cement Industries

 Operation costing
 Producing products with number of operations where cost are collected accumulated and
ascertained for each operation separately.
Eg.Engineering,Toy making


Techniques or Types of costing

 Historical Costing
The dertermination of cost after the costs have been incurred is called historical costing.
 Standard Costing
The determination of cost before the costs are incurred for the production is called
standard costing. In standard costing the cost of each stages of production are determined
well in advance. It helps the management to control the cost in all stages of production.

 Absorption Costing
Difference cost incurred for manufacturing a product are charged to the product.

 Marginal Costing
It is also known as variable cost. Aggregate cost are changed if the colume of out
increased or decreased in one unit.

 Production cost
Production cost includes all expenses incurred in producing an item and keeping it in a
saleable condition.

 Replacement cost
It is a cost of Replacement of Materials. Eg.Material A was originally purchased at
Rs.100 and same Material B is now purchased at Rs.130. the Replacement cost is Rs.130.

 Sunk cost
Plant purchased for Rs.5000 appears in balancesheet at the depreciated value of Rs.2000
and if it is sold for Rs.1500, the sunk cost is Rs.500 the difference between the
depreciated value and selling price.

 Development cost
When new product have to be manufactured method is to be adopted. The cost are
expected to be higher, the extra cost incurred in the initial stages is segregated.

 Research Cost
It is the cost of searching for new products. Such costs are to be incurred in order to
improve the products.
Classification of cost

1.Element wise Classification

The primary classification of costs accounting to the factors upon which expenditure is incurred,
Material cost,labour cost and expenses. According to this classification the cost are divided into
three categories materials, labour and expenses.

Material cost: Material cost means the cost of commodities supplied to an undertaking.
Labour Cost: Labour cost means cost of remuneration, such as wages, salaries, bonses etc. of
the employees of the undertaking.
Expenses: Expenses means cost of services provided to an undertaking and notional cost of the
use of owned asset., depreciation etc.

2.Functional wise Classification

 1.Production cost
All indirect expenses incurred on processes and operations, which commence from the
receipt of work order till its completion, ready for delivery to customer or to the finished
goods store.

 2.Administration cost
It consist of all expenses incurred in formulating the policies, directing the organization
and controlling the operations of an undertaking, which are not directly connected to
production.

 3.Selling and Distribution cost

It is the cost of seeking to create and stimulate demand and of securing orders. In oter
words all expenses in securing and retaning customers for the products are selling
expenses, since they have been spent on creating and manintaining demands for the
products.

Distribution cost, these are the expenses concerned with the delivery and dispatch of
finished goods to customers.

3.Behaviour wise classification

1.Fixed Cost
 The costs tends to be unaffected with the volume of output.fixed cost depends upon the
passage of time and does not vary directly with the volume of output. It is also known as
period of cost. Eg.rent and rate of factory buildings,depreciations of buildings.
 2Variable cost
Variable cost tends to vary directly with the volume of output. It varies almost in direct
proportion to the volume of production, the examples such as expenses are the cost of
direct materials,direct labour,direct expenses such as power,repair etc.

3.Semi variable cost

 Are those which are partly fixed and partly variable. In other words, both fixed and
variable elements are present in these costs they are also known as semi fixed costs.

4.On the basis of Controllability

Controllable cost

 A cost which can be influvenced by the action of a specified number of an undertaking is

known as controllable cost.

Uncontrollable cost

 A cost which canot be influvenced by the action of a specified number of an undertaking

is known as uncontrollable cost.

5. Classification into Direct and Indirect Costs

Direct costs are those which can be identified with the cost centre or cost unit, and
can conveniently be wholly connected with any cot unit, whereas indirect costs can
not be identified with, but can be apportioned to or absorbed by cost centers or cost
unit.

6.Classification According to Normality Costs

Normal cost is a cost which is normally incurred at a given level of output in the
conditions in which that level of output is normally attained. Abnormal costs are
not normally incurred at a given level of output in the conditions in which that
level of output is normal. Normal cost is taken as an item of cost of production but
it excluded abnormal cost from cost of production.
Job Cost Sheet and Job Order costing

The system of costing adopted for the production of goods according to the
specification of customer is called Job Order costing. Through the treatment of
costs and the nature of the terms and conditions of the work are same in job
costing.

Job costing is a method of costing in the category of specific order costing. In job
costing size of the job is relatively small. It requires very short period for
completing the work.

Objectives

In Job costing profit or loss of each job can be ascertained. if facilitates the
management to known the different types of cost incurred for different jobs to take
appropriate actions for the future period.

It facilitate the management to estimate the costs for the future period for the
similar jobs, hence it would be easy for the management to quote prices for orders.

It helps for cost control techniques to be adopted by comparing the actual costs
with the estimated costs.

Ascertainment of Job Costs

The cost of a job is determined on the basis of the requirements of direct

material,direct labor, direct expenses and overheads.

Process Costing

Process costing is a method of costing to find out the cost of production when the
product undergoes different stages of production. The characteristic of process
costing is that the finished product of one process is used as the raw material of
another process. Apart from this each process has its own expenses like material
cost, labour cost and other expenses.this costing method helps to ascertain the cost
of production and the cost per unit in each stages of production. process costing
can be prepared for any span of time, say one month or three months or one year. It
depends upon the nature of the product and policy of the management. The product
to which process costing is applied is of uniform and standised one. It should be
produced with large volume with continuous production flow.

By Products and Joint Products

Sometimes tow or more products are produced simultaneously from a common

process. If a manufacturing process using the same inputs produces two or more
products they can be either by products, or joint products and also major products
abd by products, the classification of products into joint products by products
depends upon relative importance of the products, objectives and policies of the
management. When two or more products of equal importance are simultaneously
produced from the same raw materials, such products are generally known as joint
products.

Joint Product

Joint products are the products which are jointly produced having equal economic
importance from the same or basic raw materials possessing comparable value.

The joint products having the following characteristics

The products are the simultaneous outcome of the joint process and from the same
raw materials.

The products have equal commercial value

The joint product cannot be identified as separate products upto a certain stage in
manufacturing this stages is known as split off point.

Average unit cost method

It is assumed that the total cost of the process is borne by all units equally. The
total process cost of pre separation is divided by the total units produced to get the
average cost per unit of production.
Physical Units Methods

In this methods the joint cost are apportioned on the basis of some physical units.
Physical units are the units in which the basic raw materials are measured and are
determinable at the point of separation of the joint products.

Survey Method

This method adopted after a technical survey of all factors involved in the
production and distribution of products.

Market value method

The joint costs are apportioned on the basis of the proposition of market price of
the products. Thus products having higher price are charged with higher portion of
the joint costs and products having lesser get lesser share of the joint costs.

By Product Costing can be two types

Non Cost Methods (sales value method)\

1.other income methods

The value realized by the sale of by products is treated as other or miscellaneous

income because of negligible value. The stock of by products is valued at zero
value for balance sheet purposes.

2.Credit sales value to the process account

The value of by product is credited to the process account. So that the cost of the
main product is reduced for balance sheet purposes, the unsold stock of by product
carries zero value.

3.credit to sales value less selling and distribution expenses

By product need selling and distribution expenses, and these expenses are deducted
from the sale value. The net amount is credited to the process account.

4. Crediting actual cost to the process

By product need further processing before sale, the amount is ascertained and
deducted from the sale value. The net amount is credited to the process account.
Cost Method

1.Replacement cost

By products are utilized in the same industry as raw materials and valued at the
market price, the process account is credited to the value.

2. standard price

By products are prominent they will be and credit is given to the process account.

Apportionment on suitable basis

By products are prominent, they will be treated as joint products and as such joint
costs is to be apportioned.

Activity based costing (ABC)

• Activity based costing (ABC) is an accounting methodology that assigns
costs to activities rather than products or services.

• This enables resources and overhead costs to be more accurately assigned to

the products and the services that consume them.

• ABC is a systematic, cause-and-effect method of assigning the cost of

activities of products, services, customers, or any cost object.

Definitions

• CIMA defines ABC as, “Cost attribution to cost units on the basis of benefit
received from indirect activities”.

• Example – Ordering, handling, quality assurance etc.

• It can also be defined as “the collection of financial and operational

performance information tracing the significant activities of the firm to
product costs”.
Objectives

• As some products are produced in large batches and some in small batches.

• As manufacturing overhead costs have increased significantly and they no

longer correlate with the productive machine hours or direct

• To understand product and customer cost

• To understand profitability based on the production or performing processes

• To have a structured analysis in respect of complex processes

• To provide wealth of information to the management in order to help in

decision making

Advantages

• Focus on where the cost originates, i.e., the causes of the cost.

• Accurate product cost due to understanding of the cost behaviour.

• Identifies source of non-value added activity or wasted efforts.

• Strategic cost information of which long-term profitability decision for a

product can be taken.

• Non-financial information regarding quality flexibility and value to the

customer can be received.

• Improved cost-basis available both at head office and plant level for better
decision making.

Target Costing

• Target costing is a cost management technique. Target cost is the difference

between target sales minus target margin.

• It is, thus, the difference between estimated selling price of a proposed

product with specified functionality and quality and the target margin.
 • Target cost is the estimated cost of a product that enables a company to
remain and complete in the market in the long run.

Definitions

• Target costing “ as a cost management tool for reducing the overall cost of a
product over its entire life cycle with the help of the production, engineering,
R & D.”

• CIMA – “Target cost is a product cost estimate derived from a competitive

market price”.

Objectives of Target costing

• To lower the costs of new products so that the required profit level can be
ensured.

• The new products meet the levels of quality, delivery timing and price
required by the market.

• To motivate all company employees to achieve the target profit during new
product development by making target costing a company wide profit
management activity.

Features of Target Costing

• It is viewed as an integral part of the design and introduction of new

products.

• A target selling price is determined using various sales forecasting

techniques.

• The target selling price is the establishment of target production volumes,

given the relationship between price and volume.

• Target costing process is to determine, cost reduction targets.

Characteristics of target costing

• Target cost is decided by deducting target income from the target price.

• Target costing is known as an integral part of the design and introduction of

new products.

• It is the estimated market price of the product

• Cost reduction target is fixed, which requires estimation of current cost of

the new product

Advantages

• It reinforces top to bottom commitment to process and product innovation to

achieve some competitive advantages.

• It helps to create a company’s market-driven management for designing and

manufacturing products that meet the price required for the market success.

• Reduces the development cycle of a product.

• Reduces the costs of products significantly.

 UNIT IV & V

MARGINAL COSTING, STANDARD COST, VARIANCE ANALYSIS, BUDGET

Marginal cost is nothing but variable cost, comprising prime cost and variable overheads.
Cost which varies in direct proportion to any change in the volume of output is known as
marginal cost.

Marginal costing is a technique where by only the variable cost is considered while
computing the cost of the product. The fixed cost, are written off against profits in the period
in which they arise.

The charted institute of management account, London defined marginal cost as 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.

Objectives of marginal cost

 It is used in conjunction with other methods of costing.

 Cost elements are divided into fixed and variable costs.
 Semi variable costs are segregated into fixed and variable costs.
 Variable costs are considered for cost of production.
 Fixed cost is excluded from cost of production, which will be charged to costing
profit and loss account.
 Stock of work in progress and finished goods are valued at marginal costs.
 Selling price is based on variable costs plus contribution.
 The profitability of the products/ departments are determined by studying the
contribution only.

Advantages of Marginal cost

 It enables effective cost control by dividing costs into fixed and variable.
 It reduces the degree of over or under recovery of overheads.
 It becomes realistic in the valuation of work in progress and finished goods, which
gives uniformity.
 It is helpful in taking decisions regarding pricing and tendering.
 It gives better results when combing with standard costing.
 It enables to take a decision on making or buying a product or components.
Cost Volume Profit Analysis

CVP analysis helps the management in profit planning. It analysis the relationship between
cost of production, volume of production and the sales value. It is a managerial tool which
shows the relationship between various ingredients of profit planning such as cost selling
price and volume of activity and so on. The three factor cost, volume and profit are
interconnected and dependent on one another. For example profit depends upon sales, selling
price depends upon cost, and volume of sales depends upon volume of production, which in
turn related to cost. In cost with variations in volume. The cost volume profit analysis shows
which Product mix is most profitable and the effect of changes in the volume of output with
cost and profit. Both are very useful for the management for planning and control.

Contribution

The difference between sales and variable cost is known as contribution.

Contribution = sales – variable cost

Profit Volume Ratio

It is establishes a relationship between the contribution and sales value. It is expressed in

percentage.

Profit Volume Ration = Contribution / Sales x 100

Break Even Analysis

Break even analysis is a widely used technique to study cost volume, profit relationship. In a
narrow sense, break even analysis concerned with break even point. It refers to a system of
analysis which is used to determine the profit at any level of production.

Break even analysis is a logical extension of marginal costing. It establishes the relationship
of cost, volume and profit, so it is also designated as cost volume profit analysis.

Break Even Point:

It is a point at which the total costs are exactly equal to total revenue. In this point there is no
profit and no loss. At this point, the income of the business equals its expenditure. If sales go
up beyond this point, the firm makes profit, if they come down, loss is incurred.

BEP= Fixed cost/Contribution

Margin of Safety

The difference between the actual sales and sales at break even point is known as the margin
of safety, in other words, sales over and above break even sales are known as margin of
safety, it indicates the soundness of business. If the margin is large, it is a sign of soundness
of the business. Margin of safety can be improved by

 Increase in sales/ selling price without affecting the demand.

 Decrease the fixed and variable cost.
 Change the product mix which gives more profit and volume ratio.

Margin of safety = Profit/ P/V Ratio

Angle of Incidence

The angle is formed, by intersecting the sales line and the total cost line at break even point.
It indicates the profit earning capacity of the firm. Large angle indicates a high rate of profit.
A wider angle of incidence and high margin of safety indicates most favorable situations.
Application of Marginal Cost Technique:

1.Evaluation of Performance:

Marginal costing helps the management to evaluate the performances of departments or

product line or sales division. The department which gives the highest profit volume ratio
will be most profitable and having the highest performance efficiency.

2.Fixation of Selling Price

One of the purposes of cost accounting is the ascertainment of cost for fixation of selling
price. While fixing selling price, the marginal cost should be taken into consideration. If the
selling price should not cover marginal cost, it suffers a cash loss in addition to fixed cost.
Hence it is easily to fix the selling price, when turnover, marginal cost and profitability is
known.

3.Fixing Prices below the total cost.

During the time of trade depression, the price should be fixed even below the total cost. It
will minimize the loss. This decision may be taken

 To popularize new product.

 To eliminate competition.
 To dispose off perishable goods.
 To retain its skilled labour force.
 To prevent the loss of future orders.
 To capture the foreign markets.
 4.Maintaining a desired level of profit

Due to various reasons like competition, government regulation etc. the selling price may be
reduced, which will reduce the contribution and profits. While the firm decided to maintain a
minimum level of its profits. Marginal costing techniques can be used to ascertain the units to
be sold to maintain the profit.

4.Decision Involving alternative choices.

Marginal costing techniques are used in providing assistance to the management in vital
decision making. The following are important areas where managerial problems are analyzed
by using marginal costing.

1.Determination of sales mix

When a factory manufactures more than one product, the management has to fix, which
product/ sales mix will give the maximum profits. The sales mix which gives maximum
contribution is to be retained and their production should be increased. The effect of sales
mix can also be seen by comparing the profit volume ratio and break even point.

2.Exploring New markets

Sometime a bulk order or an additional order may be received from local dealer or foreign
dealers asking for a price which is below the market price, hence a decision can be taken to
accept it or not. Mostly the offer from the local dealer should not be accepted below the
normal price because, it will affect the relationship of other dealers, whereas the foreign offer
can be accepted because, it will earn benefits like import quotas, government subsidy, enter
into international market, additional contribution etc.

3.Discontnuing a product line

The following factors should be considered before taking a decision on discontinuance of a

product line.

 The contribution given by the product.

 The capacity utilized weather it is worked at full capacity or below capacity or is there
any ideal capacity etc.

4.Make or Buy decisions

A firm can utilize its ideal capacity by making components parts instead of buying them from
outside suppliers. While arriving such a decision, the price asked by the outside suppliers
should be compared with the marginal cost incurred for production. If the marginal cost is
less than the price demanded the supplier.

5.Equipment Replacement Decision

While deciding about the replacement of a machinery, the firm should consider the savings in
operating costs and the incremental investment in the new equipment. If saving is more than
the cost of raising additional fund for the new equipment, the proposal may be accepted

The items of cost incurred

 Interest on capital invested

 Loss on sale of old machinery
 Increase in fixed overhead

6.Expand or Contract

It is an ambition of every management to maximize the profit and expansion of business

operations. Expansion requires additional fixed and marginal costs. For which sales volume
will be increased for meeting the additional costs. The management must be ensured that
market will absorb the additional volume of sales. In case the profit is likely to increase,, the
expansion can be undertaken.

Rational Decision Making

1.Defining the problem

The problem must be defined clearly and precisely so that quantitative amounts that are
relevant to its solution can be determined.

2.Identifying alternatives

Decision making involves choosing among alternatives, the different alternatives solutions
should be identified and analyzed. So that there is no confusion as to what the problem rally
is.

3.Determining evaluation criteria

The alternatives are to be evaluated and guiding principles should be formed. If proper
principles should not adopted the decision should be misleading.

4.Eavlauating Quantitative factors

Quantitative factors includes relevant revenues and costs associated with different
alternatives. The analyst should evaluate the cost benefit analysis to determine the maximum
profitability.

5.Evaluating Qualitative Factors

Qualitative factors include non financial considerations. Social cost benefits analysis may be
used for this purpose. Social profitability may be analyzed and the decision taken on that
basis.

6.Appraisal of results

After implementing the decision, the results should be appraised from time to time. This will
help to correct the mistakes, revising the targets and giving better predictions in future.
Budgeting

Budgeting is a forward planning and involves the preparation in advance of the quantitative
as well as financial statements to indicate the intension of the management in respect of the
various aspects of the business.

Budgeting is the process of preparing the budget. It is aid to be the act of building the budget.
It is a planning function and their application is a control function.

Budgeting is a kind of future accounting in which the problems of future are met on the paper
before the transactions actually occur.

Budgeting is the formulation of plans for future activity that seek to substitute carefully
constructed objectives for hit and miss performances and provide yardsticks by which
deviations from planned achievements can be measured.

Objectives

 To combine the ideas of all levels of management in the preparation of budget.

 To create good business practice by planning for future.
 To obtain more economical use of capital.
 To coordinate the activities of various departments.
 To fix responsibilities on different departmental heads.
 To plan and control expenditure on research and development.
 To ensure the availability of working capital.
 To help in controlling cash and other liquid resources.

Advantages

 It helps in maximizing the profit through optimum utilization of the available

resources.
 It gives a concrete shape to the objectives and policies of an organization.
 It results in coordinated effort of all persons involved.
 It helps to identify the variances, thus pinpointing the centers of weakness and
inefficiency, hence the management can take remedial actions.
 It evaluates the performance.
 It can provide suitable basis for establishing incentive system and internal audit.

Types of Budget
Sales Budget
 This is the most important and fundamentals budget on which all the budgets are built
up. Generally sales become a key factor for majority of the business. This budget is
essentially a forecast of sales to be achieved in a budget period. The sales manager
should prepare and execute the budget. The following factors should be taken into
consideration while preparing the sales budget.
 Analysis of the sales of the previous years.
 Estimation of salesman.
 Plant capacity.
 Trade prospectus and potential market.
 Seasonal fluctuations.
 Availability of funds.
 Competition and consumers preference.
 Government restrictions.

Production Budget

This budget provides an estimate of the total volume of production and a forecast of the
closing finished stock for a budget period. It shows the quantity of units to be produced.
Generally it is based on sales, but in case of companies in which the sales could not changed
due to style and fashion, it is based on past experience. The production planning is essential
to maintain sufficient stock for sales to keep the inventories within the reasonable limit.
Manufacture the goods economically and pro rating it throughout the year. The formula for
the calculation of production is

Production=Estimate sales + Estimated closing stock – Estimated opening stock

Flexible Budget

This is a dynamic budget. a budget which is designed to change in accordance with the level
of activity is known as flexible budget. According to ICWA,UK a budget which by
recognizing the difference between fixed, variable and semi variable costs. Is designed to
change in relation to the level of activity. It facilitates price fixation, sending quotation,
finding out profits at different levels of capacities.

A flexible budget can be constructed in three formats

Muti activity method, Formula method, graphic method.

Fixed Budget

A budget which is designed to remain unchanged irrespective of the level of activity actually
attained is known as fixed budget. This budget is not an effective tool for cost control. It has a
very limited use because; in practical life there may be internal and external factors which
force the level of activity to change.
Cash Budget

Cash budget is summary of statement of the firms expected cash inflows and outflows over a
projected period. Cash budget gives an estimate of the anticipated receipts and payments of
cash during the budget period. A cash budget helps the management for determining the cash
needs, planning for financing of those needs and exercising control over cash and liquidity of
the firm. The objectives of cash budget are the proper coordination of total working capital,
sales, investment and credit.

Cash budget can be prepared under three ways.

Receipts and payment methods

Adjusted profit and loss account

Balance sheet method

Master budget

Master budget is also known as summarized budget. It is a summary of all functional budgets
in capsule form and gives overall estimated profit position of the firm for the budget period.
The summary budget incorporating its components functional budgets and which is finally
approved adopted and employed. Master budget is prepared and approved by the budget
committee. It produces a budgeted profit and loss account and a balance sheet as at the end of
budget period. This budget is very useful for the top management because it is usually
interested in the summarized meaningful information provided by this budget.

Zero Base Budgeting

The traditional budgets are prepared by taking previous year’s budget as base. Taking the
previous figures, the required adjustments are made in the light of experience. If the
allocation of the funds is improper, it leads to failure. Hence a new technique called ZBB ie
zero base budgeting.

ZBB based on an idea that, there is no given base year for a budget. A fresh budgeted figures
s to be determined keeping in view the circumstances and requirements. This concept of ZBB
is:

 Every budget start with zero bases.

 No previous figures are to be taken as a base for adjustments.
 Each activity is to be examined a fresh.
 Alternatives are to be given due consideration.
Standard Cost

Standard cost is a predetermined cost. It is calculated in advance to manufacture a single unit

or a number of units of a product during a future period. The aim of standard cost is to
estimate the changes in prices. It is used as a guide for decision making.

Standard cost

A predetermined cost, which is calculated from managements standards of efficient operation

and the relevant necessary expenditure.

Advantages

 It helps the management in formulating price and production policy.

 It compares the actual costs with standard costs to ascertain the efficiency of the
business and effective cost control.
 It reduces the wastages and losses.
 It creates cost consciousness, by fixing responsibility among the personnel for the
performance.
 It is useful in planning and budgeting.
 It is a basis for the implementation of an incentives for the employees.
 It facilitates timely cost reports to management.

Different types of standard

1. Ideal standard: The standard which is set up under ideal working condition, ideal
management, ideal pant capacity is known as ideal standard. It is attainable under
most favorable conditions. It is summed that there is no wastages and inefficiencies in
the manufacturing process. It is a theoretical standard.

2. Expected standard: The standard which gives weight age to all the expected changes
for the future budgeted period is known as expected standard.

3. Basic standard: the standard which is unaltered over a long period is known as basic
standard. It is established for some base year and is not changed for long time as
material prices, labour rates and other expenses change. It is not helpful for cost
control.
4. Normal standard: the standard which is based on past performance is known as
normal standard. They are attainable under normal conditions. When there are wide
fluctuations in the past, this would be misleading; it may not be a useful device for
cost control.
 5. Current standard: it is a short term standard as it is revised at regular intervals. It is
related to current conditions of the budgeted period. It is useful for cost control but it
increases clerical costs. It is not useful, while studying the long term trend.

ACCOUNTING STANDARDS

1.Disclosure of Accounting Policies:

Financial statement must be clear and understandable. They are based on accounting policies
which very from enterprises to enterprises and within a single country and among countries.
Disclosure of the significant accounting policies on which the financial statements are are
based is , therefore, necessary so that they must be properly understood.

Accounting policies encompass the principles, base, conversion, rules and procedures
adopted by management in preparing the presenting financial statements.

2.Valuation of Inventory

Inventories constitute a significant portion of the assets of many enterprises. The valuation
and presentation of inventories, therefore, have a significant effect in determining and
presenting the financial position and results of operations of those enterprises.

3.Consolidate Financial Statement

Presentation of consolidated financial statements for a group of companies under the control
of one parent company. The objectives of the consolidated financial statements is to meet the
need for information concerning the financial position and results of operations of a group of
companies.

4.Contigencies and events occurring after the balance sheet date

The valuation based used for determining the amounts at which depreciable assets are stated
should be included with the disclosure of other accounting policies.

The depreciation method used.

The useful lives or the depreciation rates used.

5.Prior period and extraordinary items and change in accounting policies

This standard deals with information to be disclosed in financial statements which includes a
balance sheet, an income statement, notes and other statement and explanatory material
which are identifies as part of the financial statements.

6.Accounting response to changing prices

This standard was approved for publication in June 1977. However in November 1981, it was
superseded by international accounting standard 15 information reflecting the effects of
changing prices.

7.Accounting for Research and Development activities

The objectives of this standard is to prescribe the accounting treatment for research and
development costs. The basic issue in accounting for the costs of research and development
activities is whether such costs should be recognized as an asset or as on expenses.

8.Accounting for Constriction contracts

The objectives of this standard is to prescribe the accounting treatment for the allocation of
revenue and related costs to accounting period over the duration of the contract.

9.Accounting for Tax and Income

This standard deals with accounting for taxes in financial statements. This standard does not
deal with the methods of accounting for government grants or investment tax credits and the
following taxes are not considered to be within the scope of this standard.
 Steps involved in Budgetary Control

1.Preparation of Organization Chart

The organization chart must show the authority, responsibility of each executives
of the organization. It shows the hierarchy of the firm.
2.Creation of Budget Centre
A budget centre may be a department or a section of the department. Separate
budget are prepared for each department and the department heads should have
effective control over the execution of the budget.
3.Establishment of Budget Committee
In small firms, the chief accountant prepares the budget and coordinate various
activities. In big concerns, a budget committee is set up to formulate for a
preparing the budgets. The committee consists of various sectional heads, the chief
executives and the budget controller.. The budget are prepared by the sectional
heads and submitted to the committee for approval.
4.Preparation of Budget Manual
Is a written document, which specifies the objectives of the budgetary
organization, responsibility of executives and the procedure to be followed for
budgetary control? It also specifies different forms and record to be used for the
purpose of budgetary control
5.Fixation of Budget Period
Budget period depends on the nature of business and the control techniques, most
of the firm one year as the planning period because a budget prepared for a long
duration may not accurate.
6.Locating the key factor
Is also known as limiting factor, critical factor, primary factor. Key factor may be
shortage of raw material, non availability of labour, limited sales, government
restriction, and shortage of power supply.