MB0025 - Financial and Management Accounting

Reference Books:
1. Accounting for managers by Jawahara Lal.
2. Financial Accounting by S.N.Maheswari.
3. Financial Accounting for Managers by R.Narayana Swamy.
4. Introduction to Management by Anthony Reece.
5. Management Accounting by Manmohan and Goel.
6. Cost and Management Accounting to Horugren etal.
Financial and Management Accounting
MB 0025
Contents
Unit 1
Financial Accounting – An Introduction 1
Unit 2
Accounting Concepts, Principles, Bases and Policies 14
Unit 3
Double Entry Accounting 29
Unit 4
Primary Books 48
Unit 5
Secondary Books 71
Unit 6
Trial Balance 86
Unit 7
Final Accounts 105
Unit 8
Introduction to Management Accounting 140
Unit 9
Financial Statement Analysis 149
Edition: Fall 2008
Contents
Unit 10
Funds Flow Analysis 184
Unit 11
Cash Flow Analysis 229
Unit 12
Understanding Cost 243
Unit 13
Marginal Costing and Break Even Analysis 264
Unit 14
Budgetary Control 281
Unit 15
Standard Costing 300
Edition: Fall 2008
BKID – B0668
Dr. K. Jayakumar
Vice Chancellor
Sikkim Manipal University of Health, Medical, and Technological studies
Prof. Nandagopal V. B.
Director and Dean
Sikkim Manipal University of Health, Medical, and Technological studies.
Board of Studies
Dr. T. V. Narasimha Rao Prof. K. V. Varambally
Professor, Manipal Universal Learning Director, Manipal Institute of Management, Manipal
Ms. Vimala Parthasarathy Mr. Shankar Jagannathan
Asst. Professor, Sikkim Manipal University of Former Group Treasurer
Health, Medical and Technological studies. Wipro Technologies Limited, Bangalore
Ms. Sadhana Dash Mr. Abraham Mathews
Senor Manager HR Chief Financial Officer
Microsoft India corporation ( Pvt) limited Infosys BPO, Bangalore
Mr. Pankaj Khanna
Director, HR, Fidelity Mutual Fund
Content Preparation Team Peer Review By
1. Dr. Y. Rajaram Dr. Nagesh Malavalli
Adjunct Faculty, Manipal Universal Learning Principal & Professor of Finance & Accounting
M.P. Birla Institute of Management, Bangalore
2. Mr. S. N. Dorai Raj
Retd Principal & Professor of commerce,
Seshadripuram College, Bangalore.
Edition: Fall 2008
This book is a distance education module comprising of collection of learning material for our students.
All rights reserved. No part of this work may be reproduced in any form by any means without permission in
writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim.
Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological Sciences,
Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd., Manipal – 576 104.
Printed at Manipal Press Limited, Manipal.
INTRODUCTION
Accounting is a systematic effect of collecting. Classifying and analyzing financial information for
effective use in decision making activities. There are two facts of accounting namely Financial
Accounting and Management Accounting. While financial accounting is concerned with recording and
preparation of financial statements, management accounting focuses on using the information for
planning, decision making and controlling the financial activities of business enterprise. In view of the
fast changing scenario world over, MBA students should acquaint themselves with rudiments of the
subject. This book contains 15 Units.
Unit 1: Financial Accounting – An Introduction
Presents an overview of meaning, purpose and evolution of accounting and introduces
basic terminology.
Unit 2: Accounting Concepts, Principles, Bases and Policies
Briefly describes the accounting concepts and assumption in financial accounting.
Unit 3: Double Entry Accounting
Deals with basic accounting principles of Double – entry system.
Unit 4: Primary Books
Contains details of primary books General journal and subsidiary books.
Unit 5: Secondary Books
Covers the process of posting from primary books to ledger, which is called secondary
book.
Unit 6: Trial Balance
Deals with the process of preparing trial balance, errors and rectification.
Unit 7: Final Accounts
Describes the Preparation of final accounts – Trading A/c, P & L A/c and Balance sheet.
Unit 8: Introduction to Management Accounting
Presents the meaning and scope of Management Accounting.
Unit 9: Financial Statement Analysis
Deals with ratio analysis as a part of analysis of financial statements.
Unit 10: Funds Flow Analysis
Focuses on fund flow analysis.
Unit 11: Cash Flow Analysis
Gives a brief sketch of cash analysis.
Unit 12: Understanding Cost
Throws light on meaning and role of cost accounting.
Unit 13: Marginal Costing and Break Even Analysis
Introduces the tool of marginal costing and its usage.
Unit 14: Budgetary Control
Provides an insight of budgets – as a means of control.
Unit 15: Standard Costing
Introduces the technique of standard costing as an effective controlling system.
Financial and Management Accounting Unit 1
Unit 1 Financial Accounting – An Introduction
Structure:
1.1 Introductions
Objectives
1.2 Evolution
Self Assessment Questions 1
1.3 Need
1.4 Meaning of Accountancy, book – keeping and Accounting
1.5 Characteristics
1.6 Functions and objectives of accounting
1.7 Difference between book – keeping and accounting, accountancy
1.8 Financial accounting and management accounting
1.9 Basic terms
Self Assessment Question 8
1.10 Summary
Terminal Questions
Answer to SAQs and TQs
1.1 Introduction
Accounting is a branch of knowledge, concerned with recording classifying, analyzing and
reporting financial information to owners, bankers, creditors, government and host of
stakeholders regarding the financial performance of organizations - business or bon-business
entities. Over a period of time, accounting has assumed a status of a science and an art. In order
to achieve uniformity globally, international standards have also emerged in accounting. In this
Unit, the historical perspective of Accounting, its meaning, functions and basic terms used in the
subject are discussed.
Sikkim Manipal University 1

Learning Objectives:
After studying this unit, you should be able to understand the following
1. To expose the students with meaning, need and purpose of accounting.
2. To know the functions Accounting.
3. To understand the difference between Financial Accounting and Management Accounting.
4. To acquaint with the basic terminology used in the subject.
1.2 Evolution of Financial Accounting

Any branch of knowledge does not emerge all of a sudden. Knowledge is a product of continuous
intellectual exercise and the changes in the environmental and social demands. Accounting is an
ancient art. Michael Russel in his article ‘Evolution of Accounting’ points out that as early as 8500
B.C, accounting was existing. Archeologists have found clay tokens as old as 8500 BC in
Mesopotamia which were usually cones, disks, spheres and pellets. These tokens correspond to
such commodities like sheep, clothing or bread. They were used in the Middle West in keeping
records. Similarly in ancient civilizations like China, Babylonia, Greece and Egypt, record keeping
was in practice in the same manner as stated above. During 3600 BC in Babylonia payment of
salaries was recorded in clay tablets. The rulers of these civilizations kept track of labour and
material costs by using accounting methods.
In an article published by John R. Alexander on ‘History of Accounting’, he stated that an

improved system of book keeping known as double entry book keeping was introduced in 14th
century and the following seven key ingredients were responsible for the creation of double entry
book keeping.
• Private property: The power to change ownership, because book keeping is concerned with
recording the facts about property and property rights
• Capital: Wealth productively employed, because otherwise commerce would be trivial and
credit would not exist
• Commerce: The interchange of goods on a widespread level, because purely local trading in
small volume would not create the sort of press of business needed to spur the creation of an
organized system to replace the existing hodgepodge of record keeping
• Credit: The present use of future goods, because there would have been little impetus to
record transactions completed on the spot.

• Writing: A mechanism for making a permanent record in a common language given the limits
of human memory.
• Money: The common denominator for exchange, since there is no need for book keeping
except as it reduces transactions to a set of monetary values.
• Arithmetic: A means of computing the monetary details of the deal.
Double entry records first came out during 1340 A.D. in Genoa. In 1494, the first systematic
record keeping was formulated by Fra Luca Pacioli a Franciscan monk and one of the most
celebrated mathematicians to this day. Pacioli is considered as the father of accounting.
Michael Russel, in his article states that industrial revolution, which brought paradigm changes in
the working and business transactions paved way to the specialized field of accounting called
‘cost accounting’ in order to meet the need for the analysis of various costs. Mean while,
corporate form of organisation came into being which made it necessary to report financial
information to the owners (shareholders) by the management. Virtually management and
ownership got separated and to instill confidence of the shareholders, managers had to submit
reports, as prepared on the basis of accounting information.
Welsch and Anthony, in their book’ Fundamentals of Financial Accounting’, comment that the
growth of business organizations in size, particularly publicly held corporations, has brought
pressure from stock holders, potential investors, creditors, government agencies, and the public
at large, for increased financial disclosure. The public’s right to know more about organizations
that directly or indirectly affect them (whether or not they are shareholders) is being increasingly,
recognized as essential. An open society is one that has a high degree of freedom at the
individual level and typically evidences an effective commitment to measuring the quality of life
attained. These characteristics make it essential that the members of the society be provided
adequate, understandable, and dependable financial information from the major institutions that
comprise it. So accountants have a greater responsibility of not only being accurate but also
transparent to the possible extent.
At present, there have been tremendous advancements in accounting to meet the needs brought
about by information technology. Work is done faster, more accurate, and more dependable by
using computers. Business can be transacted without even facing one another and accounting
has become so customer friendly that records and reports are generated instantaneously to all
parties concerned.
Self Assessment Questions 1:

1. __________ is the father of Accounting.

2. A new accounting system called _______ emerged during industrial revolution.
3. Double Entry book keeping was introduced during ___________ century.
1.3 Need
Economic activities are carried on by trading and non-trading organizations, the former with profit
motive and the latter with a focus on service. Business is prominently carried on under different
forms of organizations, namely sole trading, partnership, Hindu undivided family firms (HUF),
cooperative societies and companies. Having invested capital in the business, one has to find out
at the end of a particular period whether the business has yielded any profit or loss; any assets
are created; the liabilities payable; total expenses incurred; total revenues generated and so on
and so forth. Innumerable business transactions might have taken place during the period and
remembering all transactions is humanly impossible, let alone finding the results of the
transactions. Even to put them in a computer, it requires a systematic approach to record,
classify, analyse and report the financial data to the stake holders of a business enterprise.
Precisely for this purpose, financial accounting is needed.
Proprietor/s in case of sole trading and partnership firms, members in case of cooperative
institutions, shareholders in case of companies, suppliers, customers, tax authorities, banking
institutions, lenders, borrowers, employees, government agencies and general public are the
various parties interested in the financial information of a business enterprise and each one them
is interested in different aspects of the business. Accounting information has to be supplied in a
prescribed manner to these parties and this information is contained in the form of different
statements such as trading account, profit and loss account, balance sheet, cash flow statement,
fund flow statement, statement of investments and so on. While a proprietor/
partner/member/shareholder is interested in profit and loss account and balance sheet, bankers
are interested in cash and fund flow statements in addition to P&L account and balance sheet,
government is interested in the amount of tax collections, employees are interested in P&L
account, customers, in total sales, suppliers in cash statements, security analysts in the ratio
analysis of various financial parameters of the business organization. Financial accounting fulfills
the aspirations of the above parties regarding the enterprise. Thus Accounting has emerged for
two purposes, namely to record all business transactions since one can not remember them and
communicate the results of financial data to all interested parties.


1. What are the two purposes of accounting?
2. Shareholders of a company are interested in ______ and _______ of a business.
3. Bankers are interested in _________ and _______ besides P&L A/C and balance sheet.
1.4 Meaning of Accountancy, Book-keeping and Accounting

Book-keeping, accounting and accountancy are the terms used in the science of financial
accounting. Book-keeping means recording of business transactions in the books of accounts in
accordance with the principles of accounting. Book keeping is an adjunct for accounting. Day to
day transactions are entered in a systematic manner to facilitate the preparation of profit and loss
account, balance sheet and other statements containing information about debtors, creditors, tax
payment etc., For the purpose of recording the financial data, debit and credit principles are
adopted so that cross checking is made possible, summary of each account is known at the end
of an accounting period.
Accounting on the other hand is the discipline of measuring, communicating and interpreting
financial activities and it is widely referred to as language of business.
Way back in 1941, the definition for the word Accounting was given by the Committee on
Terminology of the American Institute of Chartered Public Accountants, (AICPA)thus, ‘accounting
is an art of recording, classifying and summarizing in a significant manner and terms of money
transactions and events which are, in part at least, of a financial character, and interpreting the
results thereof.’
The American Accounting Association (AAA) in 1966 provided the following definition:
“Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information”
In 1970, the AICPA emphasized accounting with reference to the concept of information..
Accounting is treated as a service activity. The function of accounting is to provide quantitative
information, primarily financial in nature, and about economic activities, that is intended to be
useful in making economic decisions.
Accountancy is the profession and the practitioners of accountancy are called accountants.
Therefore book keeping is the basic activity of recording, accounting is the analysis and reporting
function and accountancy is the profession of carrying the above activities.

1. What is book keeping?

2. Define Accounting.
3. Accountancy is a __________ and the practitioners of accountancy are __________ .
1.5 Characteristics of Accounting

From the above definitions of Accounting, one can list out the characteristics of accounting:
1. Accounting is an art and science: Recording and maintenance of accounts of various
transactions needs special skill and knowledge. Reading and interpreting the results, obtained
by the accounting system requires experience. From this angle, accounting is an art.
Accountants are endowed with this special skill and aptitude and it is difficult to acquire
proficiency in this art. It is like a doctor who diagnoses and prescribes medicines just by
looking to the medical reports, an accountant on a gaze of the financial reports can find out
the financial health of an enterprise and suggests measures to improve the financial position.
Accounting is also a science, not like physics or chemistry, but it is an exacting science.
Accounting is governed by definite principles, rules, concepts, conventions and policies. A
systematic and scientific approach is adopted to classify, record, analyse and interpret the
accounting information.
2. Accounting involves a process of identifying, classifying and recording financial information,
expressed in terms of money. All financial transactions are expressed in terms of money.
Incomes, expenses, acquisition of assets, payment of liabilities, capital of shareholders etc.,
are stated in money terms and all transactions are broadly classified as related to definite
heads of account, namely – personal, real and nominal. After classification, they are recorded
in the books of original entry as per the accounting principles. The book of original entry is
called Journal. From Journal, the transactions are summarized under each head of relevant
account and posting takes place to a book called ledger. At the end of a particular accounting
period, the gist or the net balance of all ledger accounts is aggregated to prepare a trail
balance. From trial balance, it is possible to prepare trading, profit and loss accounts and
balance sheet.
3. Events of non financial nature can not be recorded, even though such events may have an
impact on the operational results of the enterprise. For instance financial manager and
production manager of a concern do not have good relationship and owing to this the
production process is affected and subsequently the profitability. This event of non financial
nature can not be reflected in accounts.

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

communicated to the management and other interested parties. Internal control is effectively
exercised and accountability is ensured through accounting information.
5. It helps in taking managerial decisions.

1. The book of original entry is called __________ .
2. Profitability of an enterprise is affected if the finance manager and production manager do not
agree each other. Does this picture in accounts?
1.6 Functions and Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves the following functions
and objectives.
a) Systematic recording of all business events or transactions and subsequent posting to ledger
to finally prepare financial statements – profit and loss account and balance sheet.
b) Reporting the results to management, shareholders, creditors, bankers, investors, stock
brokers, stock exchanges, employees, governments etc.,
c) Satisfying the statutory requirements, especially of Registrar of Companies, SEBI (Securities
Exchange Board of India) in case the company is listed, tax authorities (sales tax, excise,
customs, income tax) and government in order to protect the interest of general public.
d) Protecting the properties of business by recording them on the date of acquisition and
showing their accounts in the balance sheet.
e) It helps for internal control by holding the concerned persons responsible for any errors,
lapses or under performance. Equally it helps to identify the strong areas of excellent
performance and subsequently pin point the individuals or departments to be rewarded or
appreciated.
f) Accounting is a tool for effective planning. Current year’s financial performance becomes the
basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for
controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the
functions of accounting.

1. State any two functions of accounting.
2. Name the different parties to whom accounting information has to be reported?

1.7 Differences between Book Keeping and Accounting

As already said, book keeping is a system of recording the day to day transactions in the books of
enterprise. Accounting enjoys wider scope and includes not only book keeping but also analysis,
interpretation and reporting of financial information. The later part of accounting is the core
function of accounting. Now - a-days, owing to information technology, ready made packages like
Tally are available, which facilitate entry of transactions and preparation of ledger accounts are
made easy. In case of large industrial enterprises and multi national corporations, regular journal
entries are not recorded owing to very large number of transactions taking place day in and day
out. On the other hand subsidiary books such as cash book, sales book, purchases book, bills
receivable book are prepared and ledger accounts are drawn from them. The differences
between book keeping and accounting are as under:
Book keeping Accounting

• It is a process of recording the • It includes recording, analyzing and
transactions in books of accounts communicating
• Adopt principles of accounting for • Analysing and interpreting requires skill,
recording knowledge and experience
• Book keeping is an adjunct to • Accounting starts when book keeping ends
accounting
• The objective is to prepare final • The objective is to inquire and find out the
accounts and balance sheet at the reasons for financial results and
end of accounting period communicate the results to all stakeholders
in a manner they understand.

1. When book keeping ends, ________________ commences.
2. State two differences between book keeping and accounting.
1.8 Financial Accounting and Management Accounting

Financial accounting is the preparation and communication of financial information to outsiders
such as creditors, bankers, government, customers and so on. Another objective of financial
accounting is to give complete picture of the enterprise to shareholders. Management accounting
on the other hand aims at preparing and reporting the financial data to the management on
regular basis. Management is entrusted with the responsibility of taking appropriate decisions,
planning, performance evaluation, control, management of costs, cost determination etc., For

both financial accounting and management accounting the financial data is the same and the
reports prepared in financial accounting are also used in management accounting But the
following are major differences between Financial accounting and Management accounting.
Financial accounting Management accounting

• The primary users of financial • Top, middle and lower level managers use
accounting information are the information for planning and decision
shareholders, creditors, government making
authorities, employees etc.,
• Accounting information is always • Management accounting may adopt any
expressed in terms of money measurement unit like labour hours, machine
hours or product units for the purpose of
analysis
• Financial data is presented for a • Reports are prepared on continuous basis,
definite period, say one year or a monthly or weekly or even daily
quarter
• Financial accounting focuses on • Management accounting is oriented towards
historical data future
• Financial accounting is a discipline by • Management accounting makes use of other
itself and has its own principles, disciplines like economics, management,
policies and conventions information system, operation research etc.,
1. Management accounting is concerned with _____________.
2. State any two differences between Financial accounting and Management accounting.
1.9 Basic Terms

To understand the subject, proper understanding of the following terms is essential.
1. Transaction: It is transfer of money or goods or service from one person or account to
another person or account. For example, purchase of goods, sale of goods, payment of cash
towards rent, receipt of cash towards interest on loans given, cash brought in as capital
dividend paid to share holders etc are all transactions. There are cash transactions, credit
transactions and paper transactions. In all cash transactions, cash is paid or received
immediately. Ex: Rama paid cash Rs.10000 for purchase of goods. Krishna sells goods for
cash Rs1000.Credit transaction is one where there is a promise to pay/receive cash at a
future date. EX: Rama purchases goods from Gopal and promises to pay cash one month
after the date. Paper transaction is one where there is no cash inflow or outflow but

adjustment is made in the records only. Bad debts of previous year are written off;
depreciation provided on fixed assets etc.,
2. Capital: Funds brought in to start business, by the owner/s. In the case of a company,
capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed
capital and that capital used for day to day affairs of business is known as working capital.
From business point of view, Capital is a liability.
3. Assets: Every enterprise has assets. Land and buildings, plant and machinery, furniture and
fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, by the
use of which business is carried on. Assets may be fixed, current, liquid or fictitious. Fixed
assets are those which are held for use in the production or supply of goods and services.
Ex: plant and machinery, which is used fairly for long period. Current assets are those which
are held or receivable within a year or within the operating cycle of the business. They are
intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors,
bills receivable, cash at bank etc., Liquid assets are those which can be easily converted
into cash and for instance, cash in hand, cash at bank, marketable investments etc.,
Fictitious assets are in the form of such expenses which could not be written off during the
period of their incidence. For example, promotional expenses of a company which could not
be treated as expenditure in the year of incidence are shown as fictitious asset.
4. Liability: Obligation to be fulfilled in future with respect to payment towards acquisition of an
asset or performance of a service. Current liability is that obligation which has to be satisfied
within a year. For example, payment to be made sundry creditors for the goods supplied by
them on credit; bills payable accepted by the businessman; overdraft raised by the
businessman in a bank etc.
5. Goods: Commodities or articles purchased for resale are called goods. Furniture items
dealt by a furniture dealer constitute goods for that business. If rice dealer purchases
furniture, not for resale but for use, it is called purchase of asset and the same furniture
becomes asset. Rice for rice dealer is goods, because he purchases only for resale.
6. Trade: Purchase and sale of goods is called trade.
7. Purchases: It refers to goods bought in exchange for cash or credit. In case of credit
purchase, goods are received against a promise to pay the price for the same at a future
date.

8. Sales: Goods sold to customers either for cash or for credit are regarded as sales. In case
of cash sales, cash is received immediately and in case of credit sales, cash will be received
at a future date.
9. Sole trader: A single individual carrying on business with or without the help of his kith and
kin is called sole trader.
10. Partnership: It is a relationship between partners to contribute capital to start business,
agree to distribute profits and losses in an agreed proportion and the business being carried
on by all or any one acting for all. Partnership firm refers to business where as the
partnership refers to relationship caused by agreement.
11. Joint Stock Company: It is an organization, for which the capital is contributed by
shareholders to carry on business and it is registered under Companies Act and it has a
legal entity, having perpetual existence and a common seal.
12. Debtor: Debtor is a person who owes some thing to business. A person to whom goods are
sold on credit becomes a trade debtor to the business.
13. Creditor: A creditor is a person to whom the business owes some thing. For example, a
person from whom goods are purchased on credit and amount is yet to be paid is called a
trade creditor.
14. Stock: Total goods kept on hand by a trader or industrial enterprise on a given date. It
represents unsold part of goods.

1. A company is registered under ___________ .
2. A partnership is ___________ among partners.
3. Rama & Co., owned by Govind. Is it a firm or sole trader?
4. If A purchases goods from B, A is ___________ to B and B is _________ to A.
5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable after one month. Is it a
cash sale or credit sale?
6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000 into his business. Is it
capital?
Terminal Questions
1. Briefly describe the meaning of accountancy, book-keeping and accounting.
2. Write the differences between accounting and book-keeping.

3. Brief describe the need and evolution of accounting.

4. State the meaning of the folling terms
a. Transaction
b. Assets
c. Joint stock company
d. Goods
e. Trade.
Answer for Self Assessment Questions

1. Fra Luca Pacioli
2. Cost Accounting
3. 14th Century

1. Record all business transactions and communicate the results to interested parties.
2. Profit and loss and balance sheet
3. Cash flow and fund flow statements

1. Recording business transactions as per accounting principles
2. Accounting is the discipline of measuring, communicating and interpreting financial
activities.
3. Profession, accountants.

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

1. Systematic recording, reporting, Satisfying statutory requirements, protecting the properties,
internal control, tool for effective planning (Any two).
2. Shareholders, creditors, bankers, brokers, debtors, customers, suppliers, Government etc.

1. Accounting

2. Book keeping is a process of recording but accounting is not only recording but also analyzing
and communicating; book keeping requires the knowledge of accounting principles but
accounting requires not only knowledge but also skill and experience.

1. Taking decisions, planning, evaluating and controlling
2. FA considers historical data and MA focuses on future; FA is a discipline by itself but
MA makes use of other disciplines like economics, information system etc.

1. Companies Act,
2. An agreement
3. Sole Trading concern
4. Debtor, Creditor
5. Credit sale
6. Yes, it is capital.
Answer for Terminal Questions:

1. Refer to unit 1.2

Unit 2 Accounting Concepts, Principles, Bases and Policies
Structure
2.1 Introductions
Objectives
2.2 Accounting concepts, principles, bases and policies – meaning
2.3 Types of accounting concepts
2.3.1 Business entity concept
2.3.2 Going concern concept
2.3.3 Money measurement concept
2.3.4 Periodicity concept
2.3.5 Accrual concept
2.4 Basic Principles
2.4.1 Principle of Income recognition
2.4.2 Principle of expense
2.4.3 Principle of matching cost and revenue
2.4.4 Principle of Historical cost
2.4.5 Principle of full disclosure
2.4.6 Double aspect principle

2.4.7 Modifying Principle

2.4.8 Principle of materiality
2.4.9 Principle of consistency
2.4.10 Principle of conservatism or prudence
Terminal Questions
2.1 Introduction:
Any subject for that matter, is based on certain postulates, concepts and policies. Before
understanding the subject, one has to go through the basic assumptions on which the subject is
built upon. Accounting is a reflection of all business transactions expressed in terms of money
relating to a definite period of time and the object of accounting being finding out profit or loss
arising out of transactions and finally to judge the financial position of the business organization.
In this Unit, the concepts, the basic principles and policies of accounting are briefly described.
1. To know the meaning of concepts, principles and policies basing on which Accounting
science has emerged.
2. To expose the students to different concepts of accounting.
3. To have an insight into the basic principles of accounting.
2.2 Accounting concepts, principles, bases and policies

As we have understood in the Unit 1, accounting is the language of business and it is concerned
with measurement of financial performance of a business by recording, analyzing and reporting
the business results for the sake of stakeholders. Since all stakeholders should understand the
accounting language in the same sense, certain principles, concepts and policies of accounting
have been laid down. Principles are basically the rules of action adopted by the accountants
universally while recording accounting transactions. The principles are doctrines associated with

theory and procedures and current practices of accounting. These principles may be classified as
concepts and conventions. While concepts are in the form of assumptions or conditions,
conventions are those customs and traditions which guide the accountants while preparing
accounting statements. For instance business is started with an assumption that it shall be
continued for a long period of time and no body promotes a business organization to close it
down within a short period. Basing on this assumption, business man purchases fixed assets,
uses them and values them from time to time. This is a strong assumption that any businessman
approaches with. Such assumption is called a concept. To give an example for convention,
inventory (stock) in a business is valued at the end of an accounting period, at cost or market
price which ever is lower. This is an accepted convention or a practice or a principle in
accounting. On the other hand, an accounting policy is one which is adopted by management,
relevant to the situations. For example, every asset should be depreciated (this is a concept) at
the end of an accounting period. The practice is to adopt fixed installment or diminishing balance
method or any other method of depreciation.(this is a convention). The policy of the management
may be to adhere to fixed installment method of depreciation and it is their choice. Therefore no
management can exercise discretion regarding fundamental presumptions of accounting. But
every management has a choice of making an accounting policy.
It is not out of place to mention that in order to bring uniformity in terminology, accounting
concepts, conventions, and assumptions, the Institute of Chartered Accountants of India (ICAI)
established Accounting Standards Board (ASB) in 1977. The principal objective of ASB is to
formulate accounting standards so that such standards will be established by the council of ICAI.
While formulating the accounting standards, ASB will give due consideration to the International
Accounting Standards and try to integrate them to the extent possible. It also considers the
customs, practices, laws and usages prevailing in Indian business. There are altogether 30
accounting standards issued by ASB which have to be adopted by management of different
enterprises to improve the quality of presentation of financial statements in our country.

1. Accounting principles are _______ , associated with theory and practice of accountings.
2. Principles are classified as ________ and ________.
3. Assets may be depreciated on fixed installment method or reducing balance method. Is this a
concept or convention?
4. A business is started with an assumption of making profit. Is this assumption, a concept or
convention?

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

6. How many accounting standards are issued by ASB so far?
2. 3 Types of Accounting concepts

As said earlier, concepts are the basic assumptions or conditions upon which the science of
accounting is based. There are five basic concepts of accounting, namely – business entity
concept, which is also termed as separate entity concept, going concern concept, money
measurement concept, periodicity concept and accrual concept. Each concept is discussed
below.

1. What are the different types of accounting concepts?
2.3.1 Business Entity Concept

The essence of this concept is that business is a separate entity and it is different from the owner
or the proprietor. This is true in the case all forms of organization. If X starts business, he should
not mix up his personal properties with that of the business. When he invests his funds into the
business, it is regarded as capital to the business and capital is a liability from the business point
of view. If X withdraws any money from the business, it is deductable from the capital and to that
extent the liability of the business towards the owner is reduced. On the other hand, if the
proprietor withdraws money from the business for business purposes, then it is treated as
expenditure to the business.This legal separation between business and ownership is kept in
mind while recording the transactions in the books of business.

1. Business entity concept is also termed as __________.
2. Business and its owner are _______________ entities .
3. Can personal properties of owner be mixed with the properties of business properties?
4. Capital brought in by proprietor to the business is _______ to the business.
5. Profits earned in business form an addition to _____________ of the owner.
2.3.2 Going concern concept

The fundamental assumption is that the business entity will continue fairly for a long time to
come. There is no reason why an enterprise should be promoted for a short period only to
liquidate the business in the foreseeable future. This assumption is called “going concern
concept”. For this reason accountants value fixed assets on historical cost method. Had the

business been set up to last for a short period, fixed assets should have been valued at a market
price. Besides, going concern concept provides for amortization of the cost of fixed assets over
the life time of the assets. For example, an entrepreneur purchases a plant for Rs. One crore and
it has a life of 10 years. During this period, he sets aside every year certain funds from the
income of the business so that it would help him for replacement of the asset at the end of ten
years. This process of amortization presupposes that the enterprise will continue to do business
fairly for long time.

1. Can a company be promoted to last only for a month?
2. A business concern continues to function for ________. This is the essence of going concern
concept.
3. Do you purchase a building for your business to last for a short period or long period?
4. What is the underlying intention in making a provision every year when an asset is
purchased?
2.3.3 Money Measurement Concept

All transactions of a business are recorded in terms of money. An event or a transaction that can
not be expressed in money terms, can not find place in the books of account. The honesty of the
employees, dynamism of the selling agents, promptness and integrity of the cashier, even though
influence the business results, can not be brought to the books of accounts. Besides it makes no
sense if a business has 10 tons of raw material, five vehicles, one premises and a few items of
furniture, unless all these assets are expressed in terms of some monetary value. If it is said that
the value of these assets is Rs. two crores, it makes a lot of sense. Money is the common
denominator in which the business transactions should be expressed.

1. Can honesty of an employee be expressed in terms of money?
2. Transactions should be stated in terms of _______________.
3. We have in a business 5 chairs, one godown, 2 tons of cement. What does it mean?
4. Money is common _______ in which the business transactions should be expressed.
2.3.4 Periodicity Concept

The time interval for which accounts are prepared is an important factor, even though we assume
long life for a business. The time interval is usually one year and this period is called accounting
year. Often the accounting period could be half year or even a quarter. The financial statements

should be prepared at the end of each accounting period so that income statement shows profit
or loss for the accounting period. So also a balance sheet is prepared to depict the financial
position of the business.

1. The time interval for which accounts are prepared is called ____________.
2. What is the usual accounting period?
3. The expenses of a business are Rs.500000. Why does this statement not make any sense?
2.3.5 Accrual Concept

Profit earned or loss suffered for an accounting period is the result of both cash and credit
transactions. It is possible that certain incomes are earned but not received and similarly
expenses incurred but not yet paid during an accounting period. But it is relevant to consider
them while computing the financial results just because they are related to the specific accounting
period. For example, interest receivable on Fixed deposit for the year ending 31-12-2006 is Rs.
12000 but it is actually credited to the bank account only in February 2007. For calculating the
income from interest, the amount Rs.12000 is considered even though it is not received before
31-12-2006. This amount is called accrued interest. Similarly the expenses which are incurred for
the accounting period, might be paid only after the accounting period. Such accrued expenses
are deducted while calculating the profit for the accounting period. This is the accrual concept.

1. Interest earned but not received within an accounting period is called _______.
2. Salary payable for December, 2004 but paid in January, 2005 is known as
_________________ for 2004.
3. Accrued items should be _________ to compute profit or los for the said period.
4. Accrual concept considers not only cash transactions but also ______ transactions.
2.4 Basic principles

As stated above basic principles are the rules basing on which accounting takes place and these
rules are universally accepted. There are ten such basic principles, namely principle of income
recognition, principle of expense, principle of matching cost and revenue, historical cost principle,
principle of full disclosure, double aspect principle, modifying principle, principle of materiality,
principle of consistency and principle of conservatism. A brief description is in the following
paragraphs.


1. Basic principles of Accountancy are _____________ accepted.
2. How many basic principles of accountancy are there?
2.4.1 Principle of Income Recognition

According to this concept, revenue is considered as being earned on the date on which it is
realized., i.e., the date on which goods and services are transferred to customers for cash or for
promise. It should further be noted that it is the amount which the customers are expected to pay
which shall be recorded. In effect, only revenue which is actually realized should be taken to profit
and loss account. Unreaslised revenue should not be taken into consideration for determining the
profit. For example, a sale is considered to be made when the property in goods (ownership) is
transferred from the seller to buyer. Similarly, when a businessman receives an order for the sale
of such products, yet to be manufactured, then revenue is said to have been generated when the
products are ready and physically present in deliverable state and payment is received or
promised to be received but not when the order is received.

1. Income is considered as earned only when it is ____________.
2. Income is realized whether it is actually received in cash or promised to be received . Is it
True or False?
3. Income realized is different from cash received. Is it true or false?
4. A sale is made on credit. Does it constitute income realization?
5. An order is received for sale of goods. Is it realisation of income?
6. An order is received with an advance of Rs.100000 cash. Can this be called income?
2.4.2 Principle of Expense

Expenses are different from payments. A payment becomes expenditure or an expense only
when such payment is revenue in nature and made for consideration. Salaries are paid for having
received the services of the employees and so it is an expense. If furniture is bought, it is not
expenditure because it is a capital payment. Therefore all revenue expenses are transferred to
profit and loss account to ascertain profit or loss of the business undertaking. In other words,
there are revenue expenses and capital expenses. While revenue expenses are charged against
profit, capital expenses are shown in the balance sheet as assets.

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

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

3. Plant is purchased and payment is made. Is it an expenditure or acquisition of asset?
4. All revenue expenses are charged against ––––––––––––– .
5. Capital payments resulting in acquisition of assets appear in the balance sheet. True or
False?
2.4.3 Principle of Matching Cost and Revenue

Revenue earned during a period is compared with the expenditure incurred to earn that income,
whether the expenditure is paid during that period or not. This is matching cost and revenue
principle, which is important to find out the profit earned for that period. Here costs are reported
as expenses in the accounting period in which the revenue associated with those costs is
reported. For example, sales revenue reported in 2005 is Rs 50 lakh. The expenses to earn this
revenue, comprising purchases, wages, salaries, sales commission and so on amount to Rs. 30
Lakh. It is possible that some of these costs might be payable actually in 2006. Even then, they
are considered only for the period 2005, when the sales revenue was earned. Adjustments are
made for outstanding and prepaid expenses as well as outstanding and pre received incomes
while preparing the final accounts for the accounting period.

1. Matching concept of accounting considers only revenue incomes and expenses relating to a
particular accounting period. True or False?
2. Incomes and expenses for an accounting period are considered to compute _____ .
3. Expenditure paid or payable and revenue earned whether realised or not in cash are taken
into account to find out profit or loss. True or False?
4. For the actual revenue received, outstanding incomes are ________ and pre-received
incomes are_________________ to find out the revenue income for the given period.
5. For the actual revenue expenses (costs) paid during the accounting period, outstanding
expenses are _____ and prepaid expenses are _____ to find out expenses for the accounting
period.
2.4.4 Principle of Historical Costs

This is called ‘cost’ principle. All assets are recoded at the cost of acquisition and this cost is the
basis for all subsequent accounting for the assets. The expenses and the goods purchased are
all shown at the value at which they are incurred. The assets are constantly reduced in their value
by charging depreciation against their cost to present their book value in the balance sheet. For

example, land bought for Rs.5,00,000 will be shown at that price only and market value will not
be considered. In financial statements, historical cost is considered but not market value for the
purpose of consistency. However, on account of inflationary situations, this cost concept does not
portray correct picture of the business and so inflation accounting has emerged.

1. All assets are shown at historical cost in balance sheet. True or False?
2. Depreciation is charged against the historical cost of assets. True or False?
3. Historical cost is the cost at which an asset is actually purchased. True or False?
4. A machinery is bought for Rs.200000 and its market value is Rs.80000. Which of these
values, do you consider reasonable to mention in the balance sheet?
5. Inflation accounting has emerged as a result of limitation of historical cost concept. True or
False?
2.4.5 Principle of Full Disclosure

The business enterprise should disclose relevant information to all the parties concerned with the
organization. It means that any information of substance or of interest to the average investors
will have to be disclosed in the financial statements. For example, the liabilities of the business
should be stated along with assets. If only assets are exhibited without disclosing liabilities, it
amounts to fraud. The Companies Act, 1956 requires that income statement and balance sheet
of a company must give a fair and true view of the state of affairs of the company.

1. The principle of full disclosure implies that information which is of ___________ should be
stated in financial statements.
2. The material information that is disclosed should be of great interest to the average investors.
True or False?
3. Non-disclosure of material information amounts to ___________.
4. Disclosing about assets without disclosing about liabilities is against to the principle of full
disclosure. True or False?
2.4.6 Double Aspect Principle

This concept is the most fundamental one for accounting. A business entity is an independent
unit and it receives benefits from some and gives benefits to some other. Benefit received and
benefit given should always match and balance. For instance capital, say Rs.20000 provided by

the proprietor is a liability to the business and it is used for purchasing goods Rs.10000, kept in
bank account of the business Rs.8000 and the balance held in cash.Rs.2000. The goods, cash at
bank and cash in hand (10000 + 8000 + 2000) are regarded as assets. The total liabilities
balance with total of assets. This is dual aspect of accounting. The established principle of
accounting is that for every debit there is an equivalent credit and this is called double entry
principle of accounting.

1. Under dual aspect principle, total benefits received by business should match with total
benefits given. True or False?
2. Total liabilities should be equal to ___________ as per dual aspect principle.
3. For every debit, there should be an equivalent credit. This is called _________ of accounting.
2.4.7 Modifying Principle

The modifying principle states that the cost of applying a principle should not be more than the
benefit derived from. If the cost is more than the benefit, then that principle should be modified.
This is called cost-benefit principle. There should be flexibility in adopting a principle and the
advantage out of the principle should over weigh the cost of implementing the principle.

1. Modifying principle is also known as _____________.
2. The advantage out of the Principle should over weigh the cost of implementing the principle
itself. True or False?
3. If the establishment of costing department is too high that the cost of the products produced in
the organisation is going to overshoot by50%., far more than the market price. Is it advisable
to have cost-department?
2.4.8 Principle of Materiality

While important details of financial status must be informed to all relevant parties, insignificant
facts, which do not influence any decisions of the investors or any interested group, need not be
communicated. Such less significant facts are not regarded as material facts. What is material
and what is not material depends upon the nature of information and the party to whom the
information is provided. While income has to be shown for income tax purposes, the amount can
be rounded off to the nearest ten. And fraction does not matter. When we send statement to a

debtor, all details have to be presented. The same information about the debtors need not be
given in great detail, while sending the information to the Registrar of companies.

1. Principle of materiality states that relevant information should be given to relevant parties.
True or False?
2. Details of debtors should be given to creditors. True or False?
3. What is material information to one party may not be so for another party. True or False?
4. The method of depreciation adopted should be disclosed to Income Tax Authorities. True or
False?
2.4.9 Principle of Consistency

Consistency is required to help comparison of financial data from one period to another. Once a
method of accounting is adopted, it should not be changed. For instance, stock is valued under
FIFO method in an year and it should not be valued under LIFO method in another year. If assets
are depreciated under diminishing balance method, it should be continued for ever. It should not
be changed.
Self Assessment Questions 17 :

1. The purpose of principle of consistency is to help for ______ from one period to another
period.
2. Consistency principle helps for proper assessment of profit or loss. True or False?
2.4.10 Principle of Conservatism or Prudence

Accountant follow the rule “anticipate no profit but provide for all anticipated losses “Whenever
risk is expected, provision should be made. The value of investments is normally taken at cost,
even if the market value is higher than the cost. If the market value expected is lower than the
cost, then provision should be made by charging profit and creating investment fluctuation fund.
This is the principle of conservatism and it does not mean that the income or the value of assets
should be intentionally under stated.

1. Provision should be made whenever _____________ is expected.
2. The underlying spirit of principle of conservatism is __________ .
3. The prices of shares in which the business has invested are going up. Do you consider
advisable to provide any provision for that?

Terminal Questions:
1. What are the basic principles of Accountancy?
2. The salaries paid in 2004 Rs.500000; Salaries outstanding Rs.20000; Salaries paid in
advance for 2005 Rs.30000; What is the actual salary expenditure for 2004? What is the
accounting principle involved in this?
3. What is wrong if assets like buildings are shown at market value in the balance sheet?
4. A business receives capital of Rs.100000 and a loan is raised for Rs.50000. This is
represented by cash Rs.15000; Machinery Rs.85000; Furniture Rs.20000 and goods
Rs30000. Find the total debits and credits from business point of view. What principle of
accounting is underlying in this case?

1. Doctrines
2. Concepts, conventions
3. Convention
4. Concept
5. Bringing uniformity in accounting terminology and principles
6. 30

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

1. Separate entity concept
2. separate
3. No
4. Liability
5. capital

1. No
2. Long time
3. Long period
4. To replace it after a certain period.


1. No
2. Money value
3. It makes no sense unless expressed in terms of money value
4. Denominator

1. Accounting period
2. Year
3. It is because it does not indicate for what period the expenditure is.

1. Accrued interest
2. Accrued salary
3. Added
4. Credit

1. Universally
2. Ten

1. Realised
2. True
3. True
4. Yes
5. No
6. No

1. True
2. True
3. Asset Acquisition
4. Profit
5. True


1. True
2. Profit or loss
3. True
4. Added, Deducted
5. Added, Deducted

1. True
2. True
3. True
4. Rs.200000
5. True

1. Substance
2. True
3. Fraud
4. True

1. True
2. b) Total Assets
3. c) Double entry principle

1. Cost-benefit principle
2. True
3. No

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


1. Comparison
2. True

1. Risk
2. Anticipate no profit but provide for all anticipated losses
3. No.
Answers for Terminal Question:

1. Income recognition, principle of expense, matching of cost and revenue, historical cost
principle, full disclosure principle, double aspect principle, modifying principle, materiality
principle, consistency principle and conservatism principle.
2. Rs.490000 (500000 + 20000 – 30000); Matching cost and revenue principle.
3. If assets like building are shown at market value instead of historical cost in the balance
sheet, the profit or loss arising out of such valuation is against to the principle of income
recognition. The profit or loss is said to arise only when the asset is sold or revalued for a
specific purpose. The day when the assets are valued, the market value may be high and
later the prices may fall. Therefore it is wrong to consider the unrealized or anticipated profit.
Hence the assets should be shown at historical cost in the balance sheet.
4. Benefits received Rs.150000 (Capital Rs.100000 + Loan Rs.50000); Benefit given Rs.150000
(Cash Rs.15000 + Machinery Rs.85000 + Furniture Rs.20000 + Goods Rs.30000). It is as per
double aspect principle.

Unit 3 Double Entry Accounting
Structure
3.1 Introduction
Objectives
3.2 Meaning of double entry accounting
3.3 Cash and mercantile system of double entry system
3.4 Accounting trail
3.5 Transactions and events
3.6 Preparation of vouchers
3.7 Financial statements and their nature
3.8 Accounting equation
3.9 Effect of transactions on accounting equation
3.10 Meaning and rules of debit and credit Short Answer Questions
Terminal Questions
3.1 Introduction:
The dual aspect concept of accounting is a fullproof system of recording, having the advantage
of internal checking. The very fact that every transaction is recorded of its debit and credit
aspects indicates that the final accounts of an organization takes into consideration every small or
big transaction and the impact is every account is absorbed in the preparation of final financial
statements. Double entry book keeping is definitely an improvement and more systematically
designed than single entry system, where only a few personal and real accounts are considered.
In this unit, the process of accounting – recording, journalizing, posting, ledger balancing,
preparation of trial balance, preparation of final statements of accounts – is described along with
the effect of every transaction on accounting equation. The rules of debit and credit as applicable
to various types of accounts are also discussed.
1. To know what double entry book keeping means.
2. To understand the process of accounting, known as accounting trail.
3. To know the nature of financial statements.
4. To formulate an Accounting equation basing on debits and credits.
5. To know practically the impact of each transaction on the Accounting Equation.
6. To summarize the rules of debit and credit as applicable to different types of accounts.
The students should be able to appreciate the double entry system and know the accounting
process.
3.2 Meaning of Double Entry Accounting
We have learnt that the dual aspect recording is the most important accounting concept.
According to the concept, every business transaction involves receiving aspect and giving aspect.
If capital is brought in by the owner of the business unit, the owner is the giver of the benefit and
the business unit is the receiver of the benefit. It is a liability to the business unit and it is equally
balanced by an asset in the business unit, in the form of cash received towards capital. Therefore
every liability is represented by an asset. This is also expressed as every debit has an equivalent
credit.
The logic adopted in double entry accounting can well be understood by an illustration. We shall
consider five transactions and show how they are accounted for in the books of the business.
a. Mr. Abhi brings Rs.100000 cash as capital into his business.
b. He purchases furniture to his shop Rs.10000
c. He buys goods for cash Rs.50000
d. He sells goods worth Rs.30000 for Rs.40000 on credit to Arjun
e. He pays wages to servants Rs.1000
In the first transaction, the business receives capital in cash and so capital account and cash
account are affected. Capital is a liability and cash is an asset to the business.
Capital Rs.100000 (Liability) = Cash Rs.100000 (Asset)
In the second transaction, Furniture is purchased for cash and so furniture account and cash
account are affected. This transaction can be reflected as under
Capital Rs.100000 Cash Rs. (100000 10000) 90000

Furniture 10000
100000 100000
The third transaction is buying goods for cash, which means that stock of goods are received and
cash balance is reduced and this can be reflected in the statement as under.
Capital Rs.100000 Cash Rs (90000 – 50000) 40000
Furniture 10000
Stock of goods 50000
100000 100000
The fourth transaction is a credit transaction of selling goods for Rs40000, the cost of which is

only Rs. 30000 to Arjun. So the accounts affected are goods account, Arjun account and profit
account. Since the profit belongs to the owner and it is fair to add it to the owner’s capital. The
effect of this transaction can appear on the statement as shown below:
Capital Rs. 100000 Cash 40000

Profit 10000 Furniture 10000
Stock of goods(5000030000) 20000
Arjun (Debtor) 40000
110000 110000
The fifth transaction is payment of wages, which means that cash account is affected and profit is
reduced as a result of the expenditure(wages account). This changes the statement as shown
below:
Capital Rs. 100000 Cash (40000 – 1000) 39000

Profit (100001000) Furniture 10000
9000 Stock of goods 20000
Arjun 40000
109000 109000
From the above illustration, it is clear that every transaction has dual effect and recording these
two aspects which are known as debit and credit aspects is the fundamental idea behind double
entry system of book keeping. So the meaning of double entry system is that every transaction is
recorded by identifying the two or more accounts affected therein and suitably reflect them in the
financial statements. This is a system where internal cross checking is ensured.
1. The system of recording transactions based on dual aspect concept is called
i) Double account system
ii) Double entry system
iii) Single entry system
2. Show the dual aspect effect of the following transactions on the assets and liabilities of
business.
a. Purchased goods for cash Rs.80000
b. Purchased delivery van on credit for Rs.400000
c. Paid Rs.5000 to a supplier of goods on credit
d. The proprietor withdrew Rs.20000 from the bank account of business for Personal
expenses.
3.3 Cash and mercantile system of double entry system
There are two systems of double entry book keeping namely cash system and mercantile system.
In case of cash system, transactions are recorded only if cash is received or paid. Government
accounting is done basing on this system. On the other hand, mercantile system is one where
both cash and credit transactions are recorded. Besides, outstanding expenses or incomes also
find place in the mercantile system. It is fair enough to adopt mercantile system because when an
event takes place, it gets recorded irrespective of its immediate impact on the cash position. In
case of credit transactions, cash does not flow immediately but it takes place at a future point of
time. Transactions like sales or purchases on credit, salary payable, rent receivable, interest
accrued but not received, depreciation provided etc., influence on the financial position of the
business unit and therefore they should be recorded. Mercantile system facilitates this. Hence
double entry recognizes the fact that every transaction, whether cash or credit, influences at least
two accounts – one representing debit aspect and another credit aspect.
1. The two systems of double entry book keeping are ________ and __________ .
2. Government accounting is based on mercantile system. True or false?
3. All credit transactions come under mercantile system. True or False?
4. Interest receivable, rent receivable, dividend receivable are recorded in cash system of book
keeping. True or False?
5. Profit as per cash system and mercantile system of double entry show different figures. True
or False
3.4 Accounting Trail
Accounting trail is the process of identifying the transactions or events, preparation of vouchers,
recording them as journal entries, preparation of ledger accounts, balancing the ledger accounts,
incorporating all adjustments, preparation of a trail balance and finally preparing the financial
statements and balance sheet. It is a sequential order in which the accounting process flows. All
transactions are recorded first in a book called journal. The transactions are posted to the
respective accounts, maintained in a separate book called ledger. Later, all adjustments such as
opening entries, closing entries, adjusting entries are made in a book called journal proper and
there from, the ledger balances are summarized to form a trial balance. From trial balance,
trading account, profit and loss account and balance sheet are prepared.
The identification of the accounts affected in the transactions is a major task. There are three
types of accounts, namely personal accounts, real accounts and nominal accounts. An account is
a summary of transactions pertaining to a particular head.
Personal accounts include accounts of natural persons, such as Abhi account, Mohan’s account,
Sonali account etc; artificial personal accounts such as Syndicate Bank account, X Co. Ltd
account, a club account etc; representative personal account like outstanding rent account,
salaries payable account etc.
Real accounts are those which may be tangible real accounts and intangible real accounts.
Tangible real accounts relate to things that can be touched, felt, physically measurable. Building
account, furniture account, stock account, cash account etc are tangible real accounts. Intangible
real accounts are such that they can not be seen or touched. They can be measured in terms of
money such as goodwill, patent rights etc.
Nominal accounts are also known as impersonal accounts. They are in the form of expenses or
losses, incomes or gains. They do not really exist in physical form, but behind every nominal
account cash is involved. For example, salary account is a nominal account and when salary is
paid, the reality is the cash goes out and there is nothing salary in physical form. Therefore salary
account is regarded as nominal account. Similarly all expenses and losses and all incomes and
gains accounts are regarded as nominal accounts.
1. Accounting trial is a process starting from identifying the transactions or events to preparation
of final statement of accounts. True or False
2. There are three types of accounts namely ____________ and ________________.
3. A trial balance is the summarized form of ledger balances. True or False
4. Classify the following accounts into personal, real and nominal
i) Bank of Baroda Account ii) Printing and stationery expenses Machinery Outstanding salary
iii) Copy Rights iv) Sock of goods v) Loan given to Krishna vi) Loan from Bank
vii) Dividend received viii) Discount Account
3.5 Transactions and Events
A transaction is a business activity involving transfer of money or money’s worth. It may be cash
transaction or credit transaction. In cash transaction cash flows immediately where as in credit
transaction cash will be paid or received at future date. Assets acquired or sold, liabilities incurred
or paid, expenses paid or payable, incomes received or receivable – are all business
transactions. But there are events which are neither cash nor credit transactions but it has an
impact on the financial position of a business. These events may include provision for bad debts,
provision for repairs, depreciation, taxation, transfer of profit towards reserve fund or sinking fund
or investment fluctuation fund, etc., Events happen as a result of internal policies or external
needs. In accounting, transactions and events have equal relevance and they must be recorded
to arrive at the financial results of the business concern.
1. A transaction is a business activity where there is transfer of money or money’s worth.
True or False
2. An event happens as a result of internal policy of an organization. True or False
3. Business transactions and events have equal importance in finding the financial results of the
business concern. True or False?
4. Identify the following as transactions or events as the case may be.
i) Depreciation of assets ii) Tax rates iii) Acquisition of assets iv) Selling an asset v) Transfer
of profits to Reserve Fund
3.6 Preparation of Vouchers
A voucher is a document in support of a business transaction. It may be a receipt, a counterfoil of
a receipt, an invoice or even correspondence with the concerned parties. Usually in large
organizations, voucher system is adopted to record payments. Some organizations will have
printed voucher book and each voucher contains the number of voucher, date, the name of
payee to whom the payment is made, the amount, the purpose for which payment is made,
signature of the person authorized to pay and the person who receives the payment. For
instance, Ram has supplied to us goods worth Rs5000, for which he has given an invoice. This
invoice itself can be regarded as voucher, against which the payment is made. If carriage charges
of Rs100 are paid, we prepare a voucher and take the signature of the person who receives it.
When we pay cash, the receiver will give us a receipt, that itself becomes a voucher. Vouchers
are often prepared basing on the invoices received or goods received returns. The actual
payment may be made partially or completely and it may be made in course of time. In such
cases, they are entered in Voucher register. The payment of a voucher is recorded in cheque
register. The system has the following advantages:
1. It safeguards all cash disbursements
2. Total amount payable to creditors can be found out with the help of unpaid
3. vouchers.
4. Internal check is ensured
5. Information about future cash requirements can be found out.
However, the system is not suitable for small organizations because it involves personnel and the
cost of maintenance.
1. Voucher system is adopted to record payments. True or False?
2. Voucher system is suitable for small organizations. True or False?
3. Voucher is a document showing the__________for which payment is made.
4. Voucher system ensures internal check . True or False?
3.7 Financial statements and their nature
Financial statements are prepared to find out the profit or loss at the end of an accounting period.
In a trading concern, trading account and profit and loss account are prepared. The purpose of
preparing trading account is to find out the gross profit / loss. Similarly, profit and loss account is
prepared to find out net profit / loss. Both these accounts are revenue accounts. In other words,
all revenue receipts and revenue payments are considered. Revenue expenses are those which
are incurred in day to day business activities. Examples may include wages, carriage expenses,
insurance premium paid on stocks, salaries, printing, stationary, administrative expenses, selling
expenses and so on. Revenue receipts are called incomes and the examples include rent
received, sales made, interest received, dividend received, discount received, royalty received,
compensation received etc. More details about trading and profit and loss account are given in
Unit 7.
After preparing final accounts, a balance sheet is prepared containing capital and liabilities on
one side and assets on the other side of a statement. Balance sheet is a statement of affairs and
not an account. Liabilities of a business include trade creditors, bills payable, bank over draft,
loans payable, outstanding expenses, prereceived incomes etc. Capital of the owner, which is
called equity, is added with liabilities on the left side of the balance sheet. Assets of a business
include fixed assets like buildings, plant, machinery, furniture etc; current assets like sundry
debtors, bills receivable, closing stock of materials, outstanding incomes, prepaid expenses, cash
in hand, cash at bank etc., Trading account or profit and loss account and balance sheet are
prepared at the end of a particular accounting period, say one year. In Unit 7, details about
balance sheet preparation are given.
1. Trading account and Profit and loss account are revenue accounts. True or False?
2. What is the purpose of preparing Trading Account?
3. What is the end result of preparing profit and loss account?
4. Is balance sheet an account? What is it otherwise?
5. What items are shown on the left hand side of balance sheet?
6. Assets are shown on which side of balance sheet?
7. What is the purpose of preparing a balance sheet?
3.8 Accounting equation
The preparation of balance sheet is the final step in accounting process. The accounting equation
indicates that the sources of funds should be equal to uses of funds. In other words, proprietor’s
equity and liabilities to outsiders should be equal to assets.
Sources of Funds = Application of funds OR
Owner’s equity = Asset OR
Owner’s equity + outside liabilities = Assets OR
L + P = A, where L is liabilities, P is proprietor’ equity and A
means assets. From this equation, the following expressions can be obtained
L = A – P
P = A – L
A – L – P = Zero
1. Liabilities plus Equity is equal to ____________________________.
2. Assets minus liabilities to outsiders is equal to __________________.
3. If assets are Rs.5 lakhs, liabilities are Rs.3 lakhs, find out equity.
4. If Owner’s equity is Rs3 lakhs, Outsider liabilities are Rs.2 lakhs, Owner’s share of profit is
Rs.1 lakhs, find out the total value of assets.
5. Every transaction influences balance sheet and it is shown by accounting equation True or
False?
3.9 Effect of Transactions on Accounting Equation
As said earlier, every transaction has its effect on the balance sheet equation. This has been
amply illustrated while discussing the meaning of double entry. The dual aspect of a transaction
is reflected on the balance sheet, ultimately making liabilities side equal to asset side of a
balance sheet. The following are the possible sets of transactions that can change the values of
assets and liabilities but the changes are equal on both sides of balance sheet.
1. Increase in one asset with a decrease in another asset. For example, goods are purchased
for cash. It affects cash balance to come down and stock balance increases and both of
them are assets.
2. An increase in one asset with an equal amount of increase in liability. For example, a
building is purchased for business for Rs500000 by raising a loan from bank. Here an asset
is created and a loan is also raised and the balance sheet tallies.
3. An increase in asset with an equivalent rise in the proprietor’s equity. When an additional
capital is obtained in cash, Cash account on the asset side increases and capital account on
the liabilities side also increases with the same amount.
4. An increase in a liability causing an equal amount of decrease in another liability. Ex: A
bank’s overdraft is paid out of debenture amount collected. Here debenture liability
increases with an equal amount of decrease in bank’s overdraft.
5. Increase in a liability, followed by decrease in proprietor’s equity. If debentures are issued for
the purpose of paying redeemable preference shares, the owner’s equity gets reduced and
an additional liability of debentures is added up.
6. Decrease in an asset and equivalent decrease in a liability. For instance, bills payable are
paid out by cheque. The bank balance which is an asset is decreased and correspondingly
the liability of bills payable is also decreased.
7. Decrease in an asset and corresponding decrease in owner’s equity. If capital is paid out for
any reason, cash to that extent is decreased on the asset side and the capital is reduced to
that extent on the liabilities side.
1. The principle of accounting equation is that the total of assets should be equal to total of
liabilities side. True or False.
2. Show how the accounting equation is affected in the following transactions
a. Lal started business with Rs20000 cash
b. He purchased goods on credit Rs.80000
c. He sold goods costing Rs.25000 for Rs.30000 on cash.
d. He purchased furniture for cash Rs14000
e. He sold goods to Hari costing Rs500 for Rs.800
f. He received dividend on securities Rs.2000
3.10 Meaning and rules of debit and credit
Debit and credit are the two words basic for accounting. Debit represents receiving aspect and
credit represents giving aspect. However the meaning of debit and credit depends upon the
classification of accounts. An account, as we have understood is a summary of transactions
pertaining to a particular head. The account may be personal, real and nominal. Before grasping
the rules of debit and credit as applicable to various classes of accounts, it is necessary to know
how an account appears in the books of accounts. An account is recorded in a ‘ T ‘ form, the left
side indicating the debit of the account and the right side representing the credit of the account.
On the left side of an account the columns are date, particulars, ledger folio and amount and
similarly on the right side (credit side), the columns are date, particulars, ledger folio and amount.
The following illustration may be observed:
CASH ACCOUNT
Debit Side Credit Side
Date particulars Ledger Amount Date Particulars Ledger Amount
Folio (Rs) Folio (Rs)
2005 2005
Jan. 1 To Balance brought down 20000 Jan 05 By salaries 10900
Jan15 To Joseph 35 10900 Jan 25 By Furniture 123 6000
Jan 28 To Sales 18 108900 Jan 30 By purchases 19 58800
Jan 31 By Rent 298 7500
By balance c/d 56600
139800 139800
Feb 1 To balance b / d 56600
Observe from the above form of an account the following:
1. The balance brought down is the closing balance of the last month, December,2004
2. The amount received from Joseph is Rs.10900 and his account is prepared in the in the page
number 35 of the ledger. Similarly from sales and its account is found in the ledger folio
(page) 18.
3. The credit side contains payment of cash towards salary, furniture, purchase of goods and
rent respectively on different dates.
4. The balance carried down is the closing balance on the last day of January, 2005 and it is
brought down as opening balance on Feb,1
5. On the debit side, ‘To’ and credit side ‘By’ are the prefix used for every entry as a matter of
convention.
There is a standard form of drawing a ledger account. It is similar to that of a pass book issued by
a bank. The above illustration is shown in the standard form.
CASH ACCOUNT
Date Particulars Post. Ref. Debit Credit Balance
2005 LF Rs Rs Rs

Jan 1 Opening balance b /d 20000 20000
Jan 5 Salaries 10900 9100
Jan 15 Joseph 35 10900 20000
Jan 25 Furniture 123 6000 14000
Jan 28 Sales 18 108900 122900
Jan 30 Purchases 19 58800 64100
Jan 31 Rent 298 7500 56600
The rules of debit and credit for different classes of accounts are the following
1. In respect of personal accounts : Debit the receiver and credit the giver
2. In respect of real accounts : Debit what comes in and credit what goes out
3. In respect of nominal accounts : Debit all expenses and losses and credit all incomes
and gains.
The following steps should be remembered to apply debit and credit principles
a) Identify the accounts affected in a transaction from business point of view
b) If a personal account is involved, find whether the person is receiver or giver of benefit
c) If the real account is affected, find whether it is coming in or going out
d) If the account is nominal account, find out if it is expenditure or income or loss or gain.
e) Apply the suitable principle to debit or credit the respective affected account.
Illustration: Show what accounts are affected in the following transactions.
Also show the accounting equation for the transactions
1. Madan commenced business with cash Rs. 70000
2. Purchased goods on credit 14000
3. Withdrew for private use 3000
4. Goods purchased for cash 12000
5. Paid wages 5000
6. Paid to creditors 10000
7. Sold goods on credit (cost price Rs18000) 22000
8. Sold goods for cash (Cost price Rs.3000) 6000
9. Purchased furniture for cash 5000
10. Received from debtors 11000
Solution:
Transaction Accounts affected in the Account to be debited and account to be

No books of the business credited
01 Capital account and cash Cash account being real account is debited
account and Capital account being personal account
is credited
02 Goods account and creditors Goods account being real account is debited

account and creditor’s account being personal
account is credited
03 Personal drawings account and Drawings account being personal account is

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

account and cash account being real account is
credited
05 Wages account and cash Wages account being nominal account is
account debited and cash account being real account
is credited
06 Cash account and creditors Creditor’s account being personal account
account is debited and cash account being real
account is credited
07 Goods account, Debtor’s Debtor’s account being personal account is

account and profit account debited, profit transferred to capital account
being personal account is credited and
goods account being real account is also
credited
09 Furniture account and Cash Furniture account being real account is
account debited and cash account being real account
is credited
10 Cash account and debtor’s Cash account being real account is debited
account and debtor’s account being personal
account is credited.
Accounting equations for the transactions
Transaction Assets = Liabilities + Owners

Equity
Cash + Goods + Debtors + Furniture + Creditors Madan’s
= + capital
01 70000 70000
02 14000 14000
03 3000 3000
04 12000 +12000
05 5000 5000
06 10000 10000
07 18000 22000 +4000
08 +6000 3000 +3000
09 5000 5000
10 +11000 11000
End equation 52000 + 5000 + 11000 + 5000 + 4000 + 69000
73000 73000
1. Rules of debit and credit are different for different types of accounts. True or False?
2. Debit the receiver and _______________ the giver.
3. Debit all assets and credit all ________________.
4. Debit _____________________ and credit what goes out.
5. All expenses are ___________________ type of accounts.
6. Incomes and gains are always _________ as per principle of debit and credit for nominal
accounts.
7. Capital is ____________________ when it is withdrawn.
8. When cash is received from debtors, debtor’s account is ______ .
Terminal Questions
1. The accounting equation is Assets = _______________ + _______________.
2. State the meaning of double entry book keeping.
3. State the remarkable difference between cash system and mercantile system of double
entry.
4. State the important accounting trail.
5. Classify the following accounts as personal, real and nominal
a. Land account b. outstanding expenses account c. capital account
d. ABC co Ltd., account e. Discount received account f. salaries account
6. A voucher is a document which _______________ cash disbursement.
7. What is a trading account?
8. The result of a trading account is ____________ or _______________.
9. Net profit or net loss is the result of ____________________account.
10. Give a list of any four items of assets.
11. Name any four items that appear on the liabilities side of balance sheet.
12. Balance sheet is a ________________________ of affairs of a business.
13. Find the value of the following:
a. If the total assets are Rs87000 and the liabilities are Rs47000, find out the amount of
capital.
b. If the capital of proprietor is Rs400000 and the total assets are Rs600000, what is the
amount of liabilities to outsiders?
c. If creditors are Rs56000, bank overdraft is Rs100000 and outstanding expenses are
Rs.8000, what is the total amount of assets?
d. Fixed assets are Rs.70000 and current assets are Rs.100000 and the creditors are
Rs.30000. What is capital?
14. Show the effect of the following transactions on assets, liabilities and owner’s
Equity of the business:
i. Ganesh started business with a capital of Rs.40000
9. He purchased stock of goods Rs.30000
10. Sold goods on cash Rs.40000, cost of which is Rs25000
11. Bought goods on credit Rs.10000
12. Sold goods on credit for Rs18000, the cost of which being Rs10000
13. Paid Sales commission Rs.5000
14. Received cash discount Rs3000
15. Purchased furniture Rs.10000.
16. Received cash from debtors Rs.15000
17. Paid cash to creditors Rs.6000.
1. Double entry system
2. a. Stock of goods increases and cash balance is reduced
b. Delivery Van is an asset and the supplier of the delivery van becomes a creditor and it
appears as liability
c. Creditor’s balance is reduced on liabilities side and cash paid brings down the cash
balance on the asset side
d. The bank balance comes down on asset side and capital account is reduced by the
amount of drawings on the liabilities side.
1. Cash system, Mercantile system
2. False
3. True
4. False
5. True.
1. True
2. Personal, real and nominal
3. True
i. Personal
ii. Nominal
iii. Real
iv. Personal
v. Real
vi. Real
vii. Personal
viii. Personal
ix. Nominal
x. Nominal
1. True
2. True
3. True
4. i) Event ii) Event iii) Transaction iv) Transaction v) Event
1. True
2. False
3. Purpose
4. True
1. True
2. To find out gross profit or gross loss
3. To find out net profit or loss
4. No. It is a statement of assets and liabilities
5. Capital, liabilities are shown on the left hand side of Balance Sheet
6. On right hand side
7. To know the financial position of the business.
1. Assets
2. Equity
3. Rs.2 lakh
4. Assets are Rs.6 lakh
5. True
a) True
b)
i. Lal’s capital increases on liabilities side and Cash balance increases on the asset side by
Rs.20000
ii. Creditors on liabilities side and stock of goods on the asset side increase by Rs.80000
iii. Profit of Rs.5000 is added to capital on the liabilities side, stock of goods is reduced by
Rs.25000 and Cash balance increases by Rs.30000
iv. Furniture value increases by Rs.14000 on the asset side, Cash balance is reduced by
Rs.14,000, thus making no effect on liabilities side.
v. Hari appears as debtor on the asset side for Rs.800, Stock of goods gets reduced by
Rs.500 on the asset side but on liability side the profit of Rs.300 is added to capital.
vi. Cash balance on asset side increases by Rs2000, dividend being income results in profit
of Rs.2000 and so added to capital on liability side.
1. True
2. Credit
3. Liabilities
4. What comes in
5. Nominal
6. Credited
7. Debited
8. Credited.
Answers for Terminal Questions:
1. Liabilities + Owner’s capital
2. Every transaction has two aspects, debit and credit and for every debit, there is equivalent
credit.
3. 3.All cash transactions are recorded in cash system, while both cash and credit transactions
are recorded in mercantile system
4. Identification of accounts affected in transactions, recording them in Journal, post them to
ledger, balance the ledger accounts, prepare trial balance, finally prepare final accounts.
5. a) Real b) Personal c) personal d) Personal e) Nominal f) Nominal
6. Records
7. Account showing the result of trading activities (Purchase and sale of goods)
8. Gross profit or gross loss
9. Profit and Loss Account
10. Land and Buildings, Plant and Machinery, Furniture and Fixtures, Debtors, Cash in hand,
and Bank, Closing stock etc.
11. Bills Payable, creditors, Bank overdraft, Capital etc.,
12. Statement
13. a) Rs.40000 b) Rs.200000 c) Rs.164000 d) Rs.140000
14. Refer to Illustration under sub head 9.
Unit 4 Primary Books
Structure:
4.1 Introduction
Objectives
4.2 Introduction to Primary books
4.3 Journal
4.4 Ground rules of journal entry
4.5 Types of journal
4.6 Purchases Day book
4.7 Sales day book
4.8 Return Outward book
4.9 Return inward book
4.10 Bills receivable book
4.11 Bills payable book
4.12 Cash book
Terminal Questions

4.1 Introduction
The accounting process actually begins with recording the transactions in an accounting book.
This book of original recording is called primary book and of course all transactions are recorded
basing on certain documents like invoices, vouchers or receipts etc., All transactions should
invariably be entered through the primary accounting books. Other wise, the final results of the
business concern project a distorted position or end up in preparing unreliable statements. So
making entries in the primary books is the basis for further accounting treatment such as posting
to ledger, preparation of trial balance etc.,
1. To know the various primary books, containing original entries.
2. To record transactions in General Journal adopting debit and credit principles.
3. To know in brief about subsidiary books
4. To open purchases day book and Purchase Returns Book.
5. To open Sales day book and Sales Returns Book.
6. To know about Bill Transactions.
7. To prepare Bills Receivable Book and Bills Payable Book.
8. To open Cash Book with Cash column only.
9. To understand the preparation of Cash Book with Cash and Bank Columns.
10. To understand the preparation of Cash Book with cash, bank and discount columns.
11. To know the preparation of Petty Cash Book.
12. To know how to prepare ledger accounts from individual subsidiary books.
4.2 Introduction to Primary Books

Journal is a book of original entry. In French, ‘jour’ means ‘a day’. Therefore journal is basically a
day book in which transactions are first entered in a systematic manner adopting the principles of
debit and credit. If a business organization is very small and the number of transactions taking
place each day are limited, then all the transactions can easily be recorded in the journal. But it is
not so, in case of organizations of large scale, where hundreds of transactions take place. To
facilitate convenient way of entering transactions, journal is subdivided into several books of
original entry, namely purchases, sales, cash, bills receivable, bills payable, returns inwards,
returns outwards books. They are also regarded as primary books or subsidiary books. When

once the transactions are recorded in the journal or other subsidiary books, posting is made to
ledger. It is also possible that entries are made directly to ledger accounts without bringing them
to journal at all. However, to help in cross checking, both journal and ledger accounts are
prepared.

1. Book of original entry is called ______________________________.
2. Do you regard subsidiary books as primary books of original entry?
3. Transactions are first recorded in the journal and later posted to ____________________.
4.3 Journal
It is a book containing systematic recording of transactions. The entry made is known as journal
entry and the process of writing the journal entry is called journalizing. Each page of the journal is
numbered and it is called journal folio (JF). Entries are made date wise and they reflect what
account is debited and what account is credited. The form of a journal is given below.
JOURNAL
Ledger Debit Credit
Date Particulars
Folio Rs. Rs.
2-4-2005 Cash A/c Dr 100000
To Capital A/c 100000
(Being capital brought in cash)
3-4-2005 Furniture A/c Dr 20000
To cash A/c 20000
(Being furniture purchased for cash)
The ledger folio mentioned in the third column indicates the number of page in the ledger book
where the respective account summary is stated. For instance, the cash account is separately
mentioned in page number 120 of the ledger book, then the ledger folio is 120. Similarly the folio
number is given to other accounts. Usually the entry is read as ‘cash account debtor to capital
account’ and so on. For every journal entry, narration is given to briefly describe the transaction.

1. What is journal?
2. What does a Ledger folio indicate ?

4.4 Ground rules of journal entry

As discussed earlier, a transaction affects at least two accounts and the accounts may be
personal or real or nominal. For each class of accounts, the rules of debit and credit are also
discussed. ‘Debit the receiver and credit the giver’ is the principle for personal accounts; ‘debit
what comes in and credit what goes out’ is the rule for real accounts and ‘debit all expenses and
losses and credit all incomes and gains’ is the rule for nominal accounts. To draw journal entries,
the following steps be followed:
a) Identify the accounts affected in the given transaction
b) Classify the accounts as personal, real or nominal
c) Apply the relevant rule for debit and credit to determine what account to debit and what
account to credit
d) Write the journal entry as described above.
e) Give the narration for the transaction.
Illustration 1
Enter the following transactions in the books of Gopichand
1. 10-5-2004 Started business with capital of Rs.50000
2. 12-5-2004 Bought goods worth Rs.30000
3. 14-5-2004 Sold goods to Ram Charan for Rs.5000 for cash
4. 15-5-2004 Sold goods to Kanthilal Rs.12000 on credit
5. 20-5-2004 Paid wages to daily workers Rs.300
Answer
Journal Entries in the books of Gopichand
Date Particulars LF Debit (Rs.) Credit (Rs.)
10-5-04 Cash A/c Dr 50000
To Capital A/c 50000
(Being capital brought in cash)
12-5-04 Goods A/c Dr 30000
To Cash A/c 30000
(Being Goods purchased for cash)
14-5-04 Cash A/c Dr 5000
To Goods A/c 5000
(Being goods sold on cash to Ram Charan)
15-5-04 Kanthilal A/c Dr 12000
To Goods a/c 12000
(Being goods sold on credit to Kanthilal)
20-5-04 Wages A/c Dr 300

To Cash A/c 300

(Being wages paid to daily workers)
97300 97300
Note:
1. The fourth transaction is a credit transaction and so the name of the debtor, Kanthilal is
debited and the goods account is credited because goods are going out and it is real account
2. The fifth transaction involves an expense and wages account is a nominal account. It is thus
debited and since cash account is real account and it is going out and therefore it is credited.
3. At the end of accounting period, the total of debits should be equal to total of credits.

1. All assets should be debited and all liabilities should be ___________________.
2. When interest is received in cash, Cash account is debited and _____ account is credited
3. If bank overdraft is raised, the overdraft account is ________ and cash account is _____.
4. When creditors are paid out, ______is debited and _____________ account is credited.
5. If furniture is bought for cash from X Co Ltd., the company account is not credited. Why?
6. If wages are paid for construction of business premises, ___________ A/c is debited and
_____________ A/c is credited.
7. Write the journal entries for the following transactions in the books of Y Co Ltd.,
i) Advance of Rs. 500000 received from Damodar & Bros for the supply of goods.
ii) Sales tax paid Rs. 40000
iii) Amount drawn from Bank of Baroda for miscellaneous expenses Rs. 5000.
4.5 Types of Journal

Journal is a book of original entry and only one journal is maintained if the business is very small
in size and the transactions are limited. However, if the transactions are multifarious, then
subsidiary books which are known as books of original entry are prepared. The types of journal
include purchases book, sales book, purchase returns book, sales returns book, bills receivable
book, bills payable book, cash book and journal proper. The entries are made in these books
straight without recording in usual journal. From the respective books, posting is made to ledger.
In fact, from the entries made in the subsidiary books, journalizing can be done. A detailed note is
given in the following paragraphs on each of the subsidiary books.
Self Assessment Questions 4: State True or False

1. All subsidiary books are also journal because they are books of original entry.

2. All such transaction which cannot be included under different subsidiary books are entered in
journal proper.
3. Can we post the transactions to ledger accounts from the entries made in subsidiary books ?
4. The purpose of subsidiary books is to classify enumerable transactions into various functional
activities.
4.5 Purchases Book/purchases day book

Purchases book is also called purchases journal. Only credit purchases of goods are recorded in
this journal. ‘Goods’ mean items or commodities procured for resale. Cash purchases are
recorded in cash book and credit purchases are recorded in purchases book. The form of a
purchases book is given below.
Purchases Book of Johnson and Johnson Co
Inward Amount
Date Name of Supplier Ledger Folio
Invoice No Rs.
2006
August 5 Rao Bros, Bangalore 567 36,000
8 Snow white Co, 87 45,000
16 Best & Company 146 29,000
Total 1,10,000
Inward invoice is the document sent by the supplier while selling the goods. Every invoice
received is numbered and this number is stated in the purchases book for reference. From the
above entries made in the purchases book, it is possible to record journal entries. Whenever,
purchases are made, goods account is debited because it is real account and the supplier’s
account is credited because the supplier is the giver and it is personal account. The journal
entries for the above transactions appear as under:
Journal entries in the books Johnson and Johnson Co.,

Debit Credit
Date Particulars LF
Rs. Rs.
5-8-06 Goods A/c Dr 36,000
Rao Bros A/c 36,000
(Being goods purchased on credit)
8-8-06 Goods A/c Dr 45,000
Snow White Co A/c 45,000
(Being Goods purchased on Credit)
16-8-06 Goods A/c Dr 29,000

To Best & Co A/c 29,000

Total 1,10,000 1,10,000
Observe that in every case of credit purchase, the supplier’s account is credited and goods
account is debited.
At the end of the day or week or month, the total of purchases is transferred to one ledger
account known as Purchases account in the ledger.

State True or False
1. All purchases cash or credit are entered into purchases day book.
2. Purchases of goods and other assets can also be recorded in purchase book.
3. Inwards Invoice is a document to verify the quantity, price and other details of goods
purchased.
4. Purchases made from Mr. Ganesh an credit Rs 6000, entered in the purchases book. What is
the journal entry ?
4.7 Sales book or Sales Day book

Sales book or sales day book contains the details of credit sales of goods made during a
particular period. The total of the sales book is transferred to ledger to an account called sales
account. The parties to whom credit sales are made are known as trade debtors. All debtors are
classified as personal accounts and for each party, ledger account is prepared in the ledger.
Sales account shows credit balance and debtor’s account shows debit balance. A pro forma of
sales book is as given under.
Sales book of Raghu Medicals
Ledger Outward Amount

Date Name of customer/debtor
Folio Invoice No. Rs.
4-3-05 French Medicals 476 6,800
18-3-05 Mandara stores 477 19,200
28-3-05 Shaw Medical and General 478 85,000
Stores
Total 1,11,000
Outward Invoice number is the number of the invoice issued by the businessman to the customer.
The total of Rs. 1,11,000 will be transferred to sales account in the ledger. Similarly the
respective ledger accounts of the customers will be prepared in the ledger.


1. Sales day book contains only credit sales of goods made.
2. Sale of any other asset other than goods is also recorded in sales day book.
3. Persons to whom sales are made on credit are called ________.
4. Outward invoice is a document issued to customer, when the goods are sold on credit.
4.8 Purchase Returns Book

When the businessman purchases the goods and finds that the goods are not as per the
specifications or the goods are damaged or for any other valid reason, he may decide to return
the goods to the supplier from whom the goods were purchased. All such purchase returns are
recorded in a journal called purchase returns book. Normally the supplier’s account is credited
when the purchases are made. If the goods are returned, then a debit note will be sent and the
number of debit note is recorded in the purchase returns book.
Purchase Returns Book of Johnson and Johnson Co.,
Debit Amount
Date Name of supplier Ledger folio
note No. Rs.
2006 August, 12 Snow White Co 25 5000
24 Best & Co 26 7000
Total 12,000
The total of the book is transferred to ledger to an account called purchase returns account,
which shows credit balance. The respective personal accounts of the suppliers/creditors are
debited in their respective ledger accounts.

1. Purchase returns are also called returns outwards.
2. Purchase returns take place when the goods bought are not as for the specification.
3. When goods, bought, are returned, suppliers account is _________ and purchase return
account is _____________.
4. Debit note is a document to slow the supplies account being debited.
4.9 Sales Returns Book

Just as goods which do not conform with specifications are sent back to suppliers, our customers
may also send the goods sold to them back to us owing to similar reasons. Then a credit note is
prepared to show that the customer’s/debtor’s account is credited to the extent of the value of the
goods returned by them to us. Goods are received from the customers and a credit note is sent to
them.

Sales Returns Book of Raghu Medicals
Credit Note Amount

Date Name of customer/debtor LF
No. Rs.
10-3-05 French Medicals 56 2,000
30-3-05 Shaw Medicals and Gen. Stores 57 4,000
Total 6,000
As usual the total of the book is transferred to an account called sales returns account in the
ledger and this account shows debit balance. The respective personal accounts of the customers
are credited with the value of the goods returned by them.

1. Sales return are also called returns inwards.
2. Credit not is a document to indicate that the goods are recived as returned by customers.
3. Credit noted is sent by _____________ to __________.
4.10 Bills Receivable Book

When a businessman sells goods on credit, he does not receive cash immediately. But the
businessman requires cash for which he draws a bill of exchange against the customer and the
customer accepts it. Such a bill of exchange can be discounted with a banker for commission.
The businessman who draws the bill is called drawer and the customer on whom it is drawn is
drawee or acceptor. So bill of exchange is a document in writing, promising to pay a certain sum
of money or money’s worth to the drawer at a certain date for value received. The businessman
maintains a journal/ subsidiary book containing the details of the bills receivable. The bills
receivable account shows debit balance and the amount receivable against them is an asset.
Bills Receivable Book of Sham Sundar & Co.,

From Amount
No. of Date of Date of Where Term of
Whom Acceptor Due Date LF Remarks
the bill Receipt the bill payable the bill Rs.
received
1 04-7-04 04-7-04 Mr.X Mr. X Delhi 3 mths 7-10-04 7,000
2 1-8-04 01-8-04 Mr. Y Mr. Y Noida 4 mths 4-12-04 9,000
3 9-9-04 09-9-04 Mr. A Mr. A Agra 3 mths 12-12-04 12,000
4 10-9-04 10-9-04 Mr. B Mr. B Delhi 4 mnth 13-1-05 10,000
38,000
For every bill the due date is calculated after adding three days of grace. The person from whom
the bill is received and the person who accepted the bill could be the same person or different
persons. The total of the bill receivable is transferred to bills receivable account in the ledger.


1. A bill is an instrument in writing similar to that of a promissory note.
2. Who is a drawer of a bill of exchange in a business ?
3. Who is the acceptor of a bill of exchange in a business ?
4. Bills Receivable account shows _____________- balance.
5. Can bills receivable be discounted ?
4.11 Bills Payable Book

What is bills receivable for a drawer, is bills payable to the drawee. In a business concern,
proprietor draws bills on debtors and accepts bills drawn by trade creditors. All such bills
accepted by the proprietor are recorded in a separate book called bills payable book. The sum of
the value of bills payable for a period ending will be transferred to the ledger. Usually bills
payable account shows credit balance and hence is a liability. The form of bills payable book is
given here under.
Bills Payable Book of Sun Shine Co.,

No. of Amount
Date of the To whom Where Term of Due Date Re-
the Drawer Payee LF
bill given payable the bill date Rs paid marks
bill
1 2000 Ram & Co Ram & Co Ram & Co. Agra 3 months 2000 56,000
June 07 Sept 10
2 June 12 Sundaram Sundaram Sundaram Delhi 4 months Oct 15 72,000
3 June 20 KV & Co KV & Co KV & Co Chennai 5 months Nov 23 50,000
Total 1,78,000

1. Bills accepted by the proprietor of the business and drawn by supplies are called _________.
2. Every bill has ________ number of grace days .
3. Bill payable account shows _________ balance.
4. Bill payable represent ________.
5. when bills payable account is credited ________ account is debited.
4. 12 Cash Book
Cash book is an important subsidiary book and a book of original entry. It is a record of cash
receipts and cash payments made during a particular period. On the right hand side, receipts are
recorded and on the left hand side, payments are recorded. A simple cash book has two sides,
receipts side and payment side. The receipts are on debit side and the payments are on credit

side. Just as a ledger account, the words ‘To’ and ‘By’ are used. Cash book may also contain
cash column and bank column. Cash column represents cash in the business and bank column
represents cash kept in the bank. Bank column of cash book is a reflection of bank pass book.
In this connection, it is important to note that in a few transactions, affecting both cash and bank
accounts, contra entries are drawn. For example, cash is deposited in the bank is a transaction in
which cash goes out and bank is the receiver. In cash account, it is recorded as payment and in
bank account it is treated as a receipt. Similarly when cash is withdrawn from bank for office
purpose, contra entry is drawn, debiting cash account and crediting bank account.
Cash book containing cash and bank columns is known as two column cash book. In the case of
three column cash book, on the receipt side, cash, bank and discount allowed columns are
stated. On the credit side, cash, bank and discount received columns are mentioned.
Single column Cash Book of Rekha & Bros

Date Receipts Cash Date Payments Cash
Rs. Rs.
2003 2003
July 1 To Balance b/d 4,500 July 1 By Rent of shop 500
4 To Sales 8,050 3 By Postage 50
10 To Interest on FD 2,000 14 By Purchases 7,000
20 To Commission 4,000 20 By Stationery 800
28 To Sale of goods 10,000 28 By wages 2,000
30 To Balagopalan 5,000 31 By Narasimhan 9,000
By balance c/d 13,800
33,550 33,550
Two-Column Cash Book of Sampson Co.,

Cash Bank Cash Bank
Date Receipts Date Payments
(Rs.) (Rs.) (Rs) (Rs)
2003 2003
Apr 5 To Balance b/d 1,500 13,000 April 2 By Wages 50
6 To Sales 900 5 By Electricity 400
7 To Ashok Co 2,000 8 By repairs 400
11 To Beta Co 2,350 15 By Yenki Ltd 10,800
20 To Sales 500 30 By Balance c/d 2,350 6,150
2,800 17,350 2,800 17,350

Three-Column Cash Book of Janardhan Works

Discoun Discoun
Cash Bank Cash Bank
Date Receipts t Date Payments t
Rs Rs Rs Rs
Rs Rs
2002 2002
Jan 2 3,700 4,500 Jan 6 By wages 1,550
5 To balance b/d 100 2,400 3 By Agarwal 50 950
10 To Patel 6,000 15 By Cash C 3,000
15 To Neelima 3,000 22 By drawings 2,000
30 To Bank C 1,000 30 By Bank C 1,000
31 To Cash C 31 By rent 1,500
To Dividend from X Co 2,000 31 By bal c/d 5,600 7,000
100 9,100 13,500 50 9,100 13,500
Note the following points from the above illustration:

a) Discount column on the debit side represents discount allowed and on the credit side, it
represents discount received. Balancing is not done for these columns for a simple reason to
find out separately the discount allowed and received.
b) There are two contra entries each on 15th and 30th. On 15th the transaction is cash withdrawn
from bank Rs. 3,000. It is a payment from bank and it is receipt to business cash. Similarly on
30th Cash is deposited to bank Rs.1000. It is a receipt to the bank account and payment from
cash account.
c) To indicate contra entry, ‘C’ is mentioned against the entry.
d) Drawings represent the amount withdrawn from bank for business purposes.
e) Dividend from X Co is received by cheque and the company should have remitted the
dividend directly to the bank account of the businessman.
f) The balance c/d is the closing balance for the month of January 2002 and this becomes
opening balance for February, 2002.

State True or False
1. Cash book and cash account are one and the same.
2. Cash book may be single column, two column or three column are.
3. Trade discount allowed to customers or received from suppliers are not recorded in cash
book.

4. cash discount allowed to customers appears an ____ side of cash book. Cash discount
received appears are ____ side of cash book.
5. discount columns are independently totaled and not balanced.
6. Bank columns of cash book indicates Bank transations made by business man.
7. contra entry is an entry where both cash account and bank account are affected.
4.12 (a) Petty Cash Book

In large organizations, petty expenses like stationery, postage, stamps, refreshments, carriage,
cartage, daily wages etc are incurred day in and day out. All these expenses are more in number
and very insignificant in value. To look after payment of such expenses, a separate petty cashier
is appointed, who obtains a definite sum of money at the beginning of a month and gives a
statement of account at the end of the period to the chief cashier. To record such payments, a
separate book, known as petty cash book is maintained.
There is a distinct method, namely imprest system which is adopted in maintaining such petty
cash book. Under this system, at the beginning of a month, a definite sum of money is given by
chief cashier to petty cashier for petty expenses. At the commencement of the next period, the
petty cashier receives money equal to what is spent during the earlier period. For instance, in the
beginning of January, 2004, a sum of Rs.10000 is given to petty cashier assuming that such
miscellaneous expenses may be to the order of Rs.10000. By the end of January, it may be
found that the actual expenses are only Rs.9000. Then the chief cashier will reimburse Rs.9000
so that the opening balance for the month of February will be Rs.10000. This is also called
analytical petty cash book.

State True or False
1. Petty cash book is maintained in case of petty organization.
2. Imprest system of cash book is a system where the expenses paid are reimbursed.
3. The closing balance in case of imprest system of petty cash book always remains the same .
4. Imprest system of cash book is also called analytical cash book.
Illustration:
Enter the following transactions in an analytical petty cash book.
2005
November 1st . Received a cheque for petty cash Rs.1000
2nd . Paid bus fare to messengers Rs50

4th . Paid auto fare Rs.70

10th . Postal stamps purchased Rs.80
12th . Paid for stationery Rs90
15th . Paid for carriage Rs.60
16th . Purchased envelopes Rs.50
20th . Wages paid Rs 100 .
25th . Tips given to driver Rs.50
30th . Telephone calls paid Rs. 20
Total
Amt
V Payme Ledger
Recd CBF Date Particulars Analysis of payments LF
No nts A/cs
Rs
Rs
Tra Post Carr P&S Wages Sundry
Rs Rs Rs Rs Rs Exps
Rs
1,000 Nov To Bank
st 50
1 By bus fare 50
nd
70
2 ByAutofare 70
th
80
4 By postal 80
10th
By Stationery 90
12th
By Carriage 60
15th
By Envelopes 50
16th
By Wages 100
20th
90
By tips 50
25th
By Telegram 20
30th
By Balance C/d 570
Nov 60
30th ____ 50
Dec 1st 80 100
___120 50
430
20 ____ _____
80 140 100 50
1,000
Note:
1. CBF stands for cash book folio
2. V.No stands for Voucher No
3. Tra stands for Travelling expenses
4. Carr indicates Carriage expenses

5. P & S stands for printing and stationery
Terminal Question
1. Purchases book records___________________ purchases.
2. Cash purchases are recorded on-_____________ side of cash book..
3. Credit sales are entered in ____________________________ book.
4. Record a journal entry for drawings made for personal purposes of the businessman.
5. If drawings are made from bank for office purpose, what is the entry?
6. During the year, if the total owner’s equity of Beta Co increased from Rs50,000 to Rs60000, it
is because of earnings made during the year. Is this statement necessarily true?
7. Complete the following matrix by entering either debit or credit in each cell.
Item Increases Decreases
Assets
Liabilities
Owner’s equity
Income
Expenses
8. Listed below a number of transactions. Identify which account to be debited and which
account to be credited, as shown for the first transaction.
Transaction Debit Credit
Paid to Gopal, a creditor Gopal account Cash account
Paid rent in advance for the next year
Purchased stationery
Paid rent for the proprietor’s house
Purchases machinery on part payment
Charged customers for services provided
Collected cash for the services provided
Received a cheque from customer on account
Paid dividend
Paid wages for construction of business premises
Paid interest charges on loan
Electricity bill paid
Salaries paid

9. Journalise the following transactions in the books of Harinam Singh for the month of April,
2005.
Rs.
st
1 Harinam Singh started business with cash 60,000
nd
2 Purchased furniture for cash 10,000
th
4 Purchased goods for cash 25,000
th
5 Bought goods from Karmesh 25,000
th
7 Sold goods for cash 44,000
th
9 Sold goods to Ramesh 30,000
th
10 Paid cash Kamalnath 15,000
th
11 Received cash from Ramanath 10,000
th
18 Purchased goods from Sohan Kumar 12,000
th
25 Purchased computers on credit from Shivshankar 28,000
29th Paid salaries 7,000
th
30 Withdrew cash for personal use from the office 10,000
th
30 Paid wages 5,500
10. Record the following transactions in the subsidiary books of Ramachandra and Sons of
Chennai and show the totals of each book for the month of January, 2000.
Date Transaction Amount (Rs.)
Jan 1 Bought goods from Das Gupta 20,000
2 Sold to Sen Gupta 12,500
3 Sold goods to Ramesh 30,000
5 Bought goods from Suresh 15,000
7 Sold goods to Anand 13,000
8 Received goods returned by Sen Gupta 5,500
9 Purchased goods from Shyam Sundar 16,000
10 Roy bought goods from us 25,000
11 Roy returned goods to us 3,000
14 Sold goods to Ram 45,000
16 Bought goods from Naresh 20,000
20 Returned goods to Naresh 4,000
22 Purchased furniture from Vibhu 10,000
30 Sold goods on cash to Khadju 9,000
30 Paid cash to Suresh 10,000

11. Enter the following transactions in the single column cash book of Gopichand.
March, 2003
1st .Commenced business with cash 20000
2nd Bought goods for cash 5000
rd
3 . Sold goods for cash 4000
4th . Goods purchased from Ravi Kumar 10000
th
10 .Paid to Ravi Kumar 7000
14th . Cash sales 8000
th
18 . Purchased furniture for office 4000
nd
22 . Paid wages 500
th
25 . Paid rent 600
th
30 . Received Commission 4000
th
30 . Withdrew for personal purpose 1000
st
31 . Paid salary 900
12. Record the following transactions in two column cash book(Cash and Bank)in the books of
Soft Silk Co., for the month of July, 2004.Find out the closing balances.
July, 2004 Rs.
st
01 . Opening balance b/d(Cash) 14,500
(Bank) 7,000
th
04 . Cash purchases 6,700
th
05 . Rent for June month paid by cheque 2,500
th
09 . Cash sales 15,200
th
12 . Dividend received from X Co and paid it into bank 4,350
th
15 . Cash deposited into bank 5,000
th
18 . cash paid to Rahim Bros to settle his account 10,000
th
20 . Repairs paid 1,000
nd
22 . Commission paid by cheque 2,000
rd
23 . Customer, Deepak remitted to our bank account 20,000
th
25 . Cash withdrawn from bank for office use 5,000
th
27 . Drawings made from business cash for personal purposes 2,000
th
28 . Purchased stationery by cash 3,000
th
30 . Cash withdrawn for personel use from bank 1,400

13. Enter the following transactions in the cash book with discount, cash and bank columns
May 1st . Balance of cash in hand Rs. 14000; bank overdraft at bank Rs.5000
4th Invested further capital Rs. 10000 out of which Rs.6000 was deposited in the bank.
6th . Sold goods for cash Rs. 30000
6th Collected from debtors of last year Rs. 80000; Discount allowed to them Rs. 2000.
10th . Purchased goods for cash Rs. 55,000
11th . Paid Ram Vilas, our creditor Rs. 25,000; discount allowed by him Rs.650
13th . Commission paid to our agent Rs. 5,300
14th . Office furniture purchased for cash Rs. 2,000
14th . Rent paid Rs 400; electricity charges paid Rs. 1,000
14th . Drew cheque for personal use Rs. 7,000
17th . Cash sales Rs. 25,000
18th . Collection from Atal Bihari Rs.40,000, deposited in the bank on 19th April.
19th . Drew from the bank for office use Rs.5,000
22nd . Drew cheque for petty expenses Rs.1,500
24th . Dividend received by cheque Rs.500, deposited in the bank on the same day.
25th . Commission received by cheque Rs.2,300, de[posited in the bank on 28th April
29th . Drew from the bank for salary of the office staff Rs15,000
30th . Deposited cash in the bank Rs.10,000.

1. Journal
2. Yes
3. Ledger

1. It is a book containing the entry of transactions
2. It indicates the pages number in which the summary of respective account is found in ledger.

1. credited
2. Interest
3. Credited, debited
4. Creditor’s account, cash
5. Because it is cash transaction and X co is insignificant.
6. Business premises, cash
7. i. Cash A/c Dr 5,00,000 to damodar & Bros 5,00,000 ( Being advance received )

ii. Sales Tax A/c 40,000, To cash A/c 40,000 ( sales Tax paid )
iii. Cash A/c the 5000 To BOB A/c 5000 ( cash drawn for mis.expenses )

1. True
2. True
3. Yes
4. True

1. False
2. False
3. True
4. Purchases A/c Dr To Ganesh account ( Being purchases made )

1. True
2. False
3. Debtors
4. True
1. True
2. True
3. Debited, Credited
4. True

1. True
2. True
3. Business, Customer.

1. True
2. Owner of the business who is the seller
3. Customer / debtor
4. Debit
5. Yes


1. Bills payable
2. Three
3. Credit
4. Liability
5. Supplier’s account / Creditors account

1. True
2. True
3. True
4. Debit, Credit
5. True
6. True
7. True.

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

Answer
1. Credit
2. Credit
3. Sales Day
4. Drawing are A/c , Dr To Cash a/c
5. Cash account Dr To bank account.
6. The statement is true if additional capital is not brought in during the year. Owner’s equity
increases if profits are added or additional capital is brought in.
7.
Debit Credit
Credit Debit
Credit Debit
Credit Debit
Debit Credit

8. Prepaid Expenses Cash

Stationery Cash
Drawings Cash
Machinery Supplier
Customers Services
Cash Customers
Cash Customers
Dividend Cash
Business Premises Cash
Interest on loan Cash
Electricity Cash
Salaries Cash
9.
st
1 1 Cash a/c Debited Capital a/c Credited
nd
2 2 Furniture a/c Debited Cash a/c Credited
th
3 4 Goods a/c Debited Cash a/c Credited
th
4 5 Purchases a/c Debited Kamalesh a/c Credited
th
5 7 Cash a/c Debited Goods a/c Credited
th
6 9 Ramesh a/c Debited Sales a/c Credited
th
7 10 Kamel nath a/c Debited Cash a/c Credited
th
8 11 Cash a/c Debited Kamanath a/c Credited
th
9 18 Purchases a/c Debited Sohan Kuma Credited
th
10 25 Computers a/c Debited Shiva Shankar Credited
th
11 29 Salaries a/c Debited Cash a/c Credited
th
12 30 Drawings a/c Debited Cash a/c Credited
10.
Total of Purchases Day book:
Das Gupta Rs. 20,000
Suresh Rs. 15,000
Shyan sunda Rs. 16,000
Naresh Rs. 4,000
Rs. 55,000
Purchase Returns Book

Naresh Rs. 4,000
Sales Returns Book

Sen Gupta Rs. 5,500
Roy Rs. 3000
Rs. 8,500
Total sales Day book

Sen Gupts Rs. 12,500
Ramesh Rs. 30,000
Anand Rs. 13,000
Ray Rs. 25,000
Ram Rs. 45,000
Rs. 1,25,500
11. Cash Book
To Capital 20,000 By Goods 5000
To Sales 4,000 By Ravi Kumar 7000
To Sales 8,000 By office furniture 4000
To Commission 4,000 By wages 500
By rent 600
By drawings 1000
By salary 900
By bal c/d 17,000
36,000 36,000
Hint: Goods Purchased from Ravi Kumar is a credit purchase.
12.
Cash Bank Cash Bank
To Opening bal b/d 14,500 7000 By Purchases 6700
To Sales 15,200 By Rent 2500
To Cash 5000 By dividend 4350
To Deepak 20,000 By bank 5000
To Bank ( c ) By Rahim & Bus 10,000
By repairs 1000
By commission paid 2000
By cash ( c ) 5000
By drawings 2000
By stationery 3000
By drawings 1400

By bal c/o 7000 16750

24,700 32,000 24,700 32,000
To Bal b/d 7,000 16,750
13. Cash Book

Discount Cash Bank Discount Cash Bank
Rs Rs Rs Rs Rs Rs
To bal b/d 14,000 By purchase 55,000
To bal b/d ( OD) 5000 By Ram vilas 650 25,000
To Capital 4000 6000 By commission 5,300
To Sales 30,000 By office furniture 2000
To Debtors 2000 80,000 By rent 400
To Sales 25,000 By electricity 1000
To Atal Bihari 40,000 By drawings 7000
To Cash ( c) 4,000 By banks ( c) 40,000
To Bank 5,000 By cash ( c) 5,000
To Dividend 500 By petty expenses 1,500
To Commission 2300 By bank ( c) 2,300
To Cash ( c) 2300 By salary 15,000
To Cash ( c) 15,000 By bank ( c) 15,000
By c/d 54,300 40,300
Total 2000 2,00,300 68,800 Total 650 2,00,300 68,800

Unit 5 Secondary Books
Structure
5.1 Introduction
Objectives
5.2 Types
Self Assessment Questions 1 to 7
5.3 Posting technique in the ledger
Terminal Questions
5.1 Introduction
Journal is the book of original entry and all transactions are recorded first in that book. We have
also learnt that there are subsidiary books, which are different types of journal and in large
organizations, these subsidiary books are maintained as books of original entry. However there is
a book called Journal Proper, which is also a type of journal in which transactions which can not
be entered in any other subsidiary books, shall be recorded. For instance, a loan is declared as
bad and it should be written off. This is not a cash transaction non the less a credit transaction.
But it should be recorded in some book. Similarly depreciation on assets has to be provided; rent
paid in advance ; taxes paid in advance, outstanding expenses payable and so many such
transactions have to be recorded for a fair calculation of profit or loss. To facilitate recording of
such transactions, a separate book called journal proper is maintained. It is only after all
transactions are entered into various books, ledger accounts are prepared entirely in a different
book namely ledger. The process of recording the transactions in the ledger is known as posting.
Since ledger is prepared basing on journal, it is known as secondary book.
1. To know what secondary books are.
2. To know what Journal proper is and its purpose.
3. To know what a ledger and ledger account mean.
4. To understand the posting of transactions from General Journal
5. To know the technique of posting transactions from subsidiary books
5.2 Types
There are three types of ledger, namely debtors ledger, creditors ledger and general ledger.
Debtors ledger contains accounts of debtors to whom goods are sold on credit. Creditors ledger
contains accounts of creditors from whom goods are purchased on credit. General ledger
contains real accounts, nominal accounts and all personal accounts, other than debtors and
creditors accounts. Before understanding about posting transactions to ledger, it is useful to
understand about journal proper.
Journal proper contains the following aspects:
a) Opening journal entries
b) Closing journal entries
c) Adjusting entries
d) Rectification entries
e) Transferring entries
f) Credit purchase of assets and sale of assets
g) Withdrawal of goods by the proprietor for his personal use
h) Loss of goods due to natural causes
1. Ledger is also known as _____________.
2. Journal proper contains ______________.
3. Is Ledger an account or a book ?
4. The three types of secondary books are _____,______ and ______________.
5. Furniture of the office used by the proprietor in his house. where do you find an entry for
this transaction in business books?
6. What ever is recorded in journal proper is also posted to ledger.(state whether it is True /
False).
5.2 a. Opening Journal entries:
In the case of running business, all the assets and liabilities of the previous year should be
brought down to the current year and therefore an entry is drawn debiting all assets account and
crediting liabilities account and the difference being credited to capital account. In a business on
31 st Dec, 2004, the following assets and liabilities were there: Cash at bank Rs50000; Furniture
Rs.48000; Plant and machinery Rs200000; Debtors Rs.100000; Stock in trade Rs.20000;
Creditors Rs.50000; Bank loan Rs.45000. On 1 st of January, 2005the assets and liabilities have
to be brought in and so in Journal Proper the following entry is recorded.
Date Particulars Ledger Folio Debit Rs Credit Rs

1105 Cash at Bank A/c Dr 50000
Furniture A/c Dr 48000
P and M A/c Dr 200000
Debtor’s A/c Dr 100000
Stock In trade A/c Dr 20000
To Creditors A/c 50000
To Bank Loan A/c 45000
To Capital A/c (Diff) 323000
(Being assets and liabilities of the
previous year brought in)
Similarly, a newly set up business may commence its activities with some assets and liabilities.
Then the assets are debited and liabilities are credited and the difference is transferred to capital
account.
1. Opening journal entries are drawn at the commencement of accounting period. (state whether
it is True / False).
2. When all assets are debited and all liabilities are credited, the difference is transferred to
___________ account.
3. If opening liabilities including capital are more than assets, to what account the difference is
transferred ?
5.2 b. Closing entries
Closing entries are drawn at the end of accounting period and the purpose is to close down
several account balances for the current period. The accounts of assets and liabilities will not be
closed because they continue to exist further. All expenses and income accounts are closed by
transferring them to the respective revenue accounts such as Trading account and Profit and
Loss account. For example, salaries paid during the year are closed by transferring to P & L
account, debiting P & L account and crediting Salaries account, so that the salaries account of
the current year does not again appear in the next year. More details about closing entries will be
dealt with in Unit 7.
1. All revenue accounts are closed at the end accounting period. ( state whether it is True /
False).
2. All trade expenses are closed by debiting trading account and crediting _____ accounts.
3. _______ account are closed by transferring them to P & L account.
4. Are assets and liabilities accounts closed at the end of the accounting year ? (state whether it
is Yes / No).
5.2 c. Adjusting entries
After the closure of accounting year, there might be a few more transactions left over and which
are not incorporated into journal or ledger, owing to omission and practical difficulties. For
example, closing stock should be valued on the last day of the accounting period. If the stock is
so large containing several items, it is possible that the calculation is not made along with
physical verification. In such a case, an adjusting entry is made to bring that item into account.
Similarly, with regard to rent paid in advance, expenses outstanding, incomes received in
advance etc adjusting entries are made in Journal proper. If they are not considered, the profit or
loss reflected by the final accounts will not give the correct picture for the accounting period. More
details about adjusting entries will be discussed in Unit 7.
1. Transaction which are out of trial balance have to be adjusted for proper calculation of profit /
loss.( state whether it is True / False ).
2. What is the adjusting entry in the following cases
a. Depreciation of Building
b. Closing stock
c. Prepaid Insurance
d. Outstanding salaries
e. Stock used for personal purposes
5.2 d. Rectification entries
Errors are natural and rectification is a must to arrive at exact position of profit or loss and
balance sheet. These errors may or may not be disclosed by trail balance. Casting errors,
omissions, commissions, principle errors, compensatory errors etc can occur in the process of
accounting. They have to be identified and rectification entries have to be recorded. For example,
wages which are paid for construction of a building are wrongly debited to wages account. By
doing so, the expenses are increased and the resultant profit is reduced. Really speaking, the
wages paid for construction, being a part and parcel of building account, should have been
debited to building account. Therefore to rectify this error, building account should be debited and
wages account should be credited so that building account gets enhanced and wages account
gets reduced. Such rectification entries are drawn in Journal proper. More details are available in
Unit 6.
1. Errors occur in the course of accounting and they influence the profit calculation of the
business concern ( State whether it is True or False ).
2. What are the broad categories of errors ?
3. Rectification entries are drawn in _____________.
5.2 e. Transferring entries
When the balance of one account is transferred to another account, transferring entry is made.
For instance, drawings made by proprietor should be reduced from his capital account. To
facilitate this, drawings account, which shows debit balance, is credited and capital account is
debited (because capital is reduced as a result of drawings). This is a transferring entry and it is
recorded in Journal proper.
1. When an account showing debit balance, when transferred, should be _______ and vice
versa.
2. The cost of stock destroy in fire should be transferred to which account? what is the entry for
that ?
3. When drawing are transferred to capital. What is the entry?
5.2 f. Credit purchase of assets and sale of assets
Normally, purchase of goods either on cash or credit, get recorded in cash account or purchases
account respectively. Cash purchase of assets, like furniture or plant or machinery also get
recorded in cash account. But credit purchase of assets, as mentioned above, can not be entered
in purchase account or cash account because they are not goods. Hence such entries are
recorded in Journal proper, by debiting asset account and crediting the personal account of the
supplier of the assets. Similarly, when these assets are sold, an entry is made debiting cash
account or personal account of the buyer as the case may be and crediting the concerned asset
account. For example, an asset of Rs.5000 is sold for Rs.3000 to Shaym & Bros, who promised
to pay the amount later. Then Shyam & Bros account is debited with Rs3000, Loss on sale of
asset account is also debited by Rs.2000 and the concerned asset account is credited with the
book value Rs5000. The loss sustained in the process is transferred to Profit and Loss account
later.
5.2 g. Withdrawal of goods by proprietor for his personal purpose
If a proprietor uses the goods of his business for his personal purpose, this should also be
recorded. Since this transaction is not a sale, it can not be transferred to sales account. But it
should be regarded as drawings account and it should be debited and the goods which are going
out of business should be credited.
5.2 h. Loss of goods and assets due to natural causes
Goods may be lost on fire or as a result of any natural calamity. The cost of such goods should
be reduced out of the stock of goods. Goods which insured may also be lost. A part of the value
of the cost may be recovered. The part not recovered is transferred to P & L A/c. The cost of
goods lost is debited and the stock account is credited. Owing to natural causes, wear and tear is
caused to assets. Even if the assets are not used, there is obsolescence and as a result,
depreciation has to be provided. This is a loss and therefore depreciation is debited and the
concerned asset account is credited. Such implied loses are recorded in journal proper.
1. Credit purchase of assets is not included in purchases account because assets are not
goods. ( state whether it is True or False ).
2. The profit or loss in the sale of assets should be transferred to ________account.
3. Office cash if used by the proprietor is treated as personal drawings ( state whether it is True /
False )
4. A part of the business premises being used by the proprietor for his residence. The rent
payable for that portion is drawings. ( state whether it is Yes / No ).
5. Loss of asset as a result of wear and tear is called _______.
6. Loss of goods as a result of fire accident is transferred to ____ account.
5.3 Posting Technique to Ledger – Form of a ledger account
Having understood the journal and journal proper, the next important stage of accounting is
preparation of ledger accounts in a book called ledger. The book contains the summary of
transactions concerning to various heads of accounts for a given period. Posting is made to
ledger accounts from journal entries and at the end of the accounting period, each ledger account
is balanced. For each ledger account, a few items appear on the debit side and a few on the
credit side. While balancing the account, amount on the debit side may be more than that of
credit side, and vice versa. The excess of debit over credit is called debit balance carried down to
credit side of the account. Similarly, excess of credit over debit is known as credit balance
brought down to debit side of the account. For example, observe the following account of Rama,
a customer.
Debit Rama’s Account Credit

Date Particulars JF Amount Date Particulars JF Amount
2202 To balance b/d 5,000 8202 By Cash 6,000
4202 To sales 27,000 9202 By Sales returns 4,000
12202 To Sales 30,000 15202 By Bank 25,000
25202 To Sales 6,000 28202 By Cash 20,000
26202 To Sales 4,000 28202 By Discount 2,000
28202 To Sales 13,000 28202 By balance c/d 28,000
85,000 85,000
1302 To balance b/d
28,000
Note:
1. Every account has four columns on debit side and four columns on the credit side.
2. At the end of period, total of debit side is Rs.85000 and the credit amount is Rs.57000. The
balance of Rs.28000 is in excess of debit over credit and is stated on credit side in order to
balance the account to an equal amount of Rs85000
3. The closing balance of the account for February month becomes opening balance for the
month of March.
4. JF stands for journal folio, where from the transaction is obtained.
5. For closing balance, it is called balance carried down and for opening balance, it is balance
brought down.
Posting technique
Posting is done either from journal or any subsidiary book.
For example, there is a transaction that goods are sold to Krishna for cash Rs5,000. The journal
entry in the journal is Cash account is debited and goods account is credited with an equal
amount. In the ledger, on the debit side of cash account, we write ‘To goods’ Rs.5000 and in the
goods account, we write ‘By cash Rs.5000. It is shown here below:
Journal entry Cash account Dr Rs. 5000
To Goods account Rs. 5000
(Being goods sold to Krishna on cash)
Ledger in the books of business
CASH ACCOUNT
Particulars Amount (Rs) Particulars Amount (Rs)
To goods 5,000
GOODS ACCOUNT
By cash 5,000
From the entries in the subsidiary book also, ledger accounts can be prepared. For example, the
total of purchases book for the month of January 2004 is Rs.56000. The purchases are made
from supplier ‘A’ Rs.26,000; ‘B’ 20000 and from ‘C’ Rs.10000.We can find the entries in the
ledger as shown below.
A’s Account
January 2004 January 2004
26,000 26,000
To balance c/d By Purchases
February 2004
26,000
By bal b/d
B’s Account
20,0000 20,000
Feb, 2004
20,000
By balance b/d
C’s Account
10,000
!0,000
Feb, 2004
By bal b/d
10,000
Purchases Account
To Sundries 56,000 By balance c/d 56,000
Feb, 2004
To balance b/d 56,000
1. Ledger is regarded as _______________________ book.
2. Transactions that are not recorded in other journals, are incorporated in _______
3. What is a closing entry?
4. Rent account is closed by debiting P & L account and crediting ________account.
5. If assets brought in by proprietor are Rs400000 and liabilities are Rs150000, what opening
entry, do you draw in journal proper?
6. Out of salaries paid for the year 2005, Rs.6000 is related to the year 2006. How do you
adjust this gap? And what entry do you pass?
7. What is balancing of ledger account?
8. Can we draw journal entries from ledger?
9. If Rama has sold goods to Krishna Rs4000 on credit, draw journal entries in the books of
Rama and Krishna.
10. State any two differences between journal and ledger.
11. Cash account and cash book look alike. Is it a ledger account or mere subsidiary book?
Illustration
Journalise the following transactions and open only the personal accounts in the ledger.
2001 Govind Singh started business with the following Amount

July 1 assets: Rs.
Cash 20,000
Goods 10,000
Furniture 5,000
July 5 Sold goods to Raghavan 5,000

Sold goods for cash 3,000
July 9 Received from Raghavan on account 3,000
July 12 Purchased goods from Mukundan 9,000
July 15 Paid Mukundan 5,000
July 20 Paid interest to Mukundan 100
July 30 Paid stationery charges 600

Paid Salaries 250
Paid rent 160
Solution
Journal entries in the books of Govind Singh
Date Particulars LF Debit (Rs) Credit (Rs)
2001 July 1 Cash account Dr 20,000

Stock account Dr 10,000
Furniture account Dr 5,000
To Capital account 35,000
(Being assets brought in as capital)
July 5 Raghavan account Dr 5,000
Cash account Dr 3,000
To Sales account 8,000
(Being sales made in cash and on credit

to Raghavan)
July 9 Cash account Dr 3,000
To Raghavan account 3,000
(Being cash received from Raghavan)
July 12 Purchases account Dr 9,000
To Mukundan’s account 9,000
(Being goods purchased on credit from
Mukundan)
July 15 Mukundan’s account Dr 5,000
To Cash account 5,000
(Being cash paid to Mukundan on
account)
July 20 Interest account Dr 100
To Cash account 100
(Being interest paid to Mukundan)
July 30 Stationery account Dr 600
Salaries account Dr 250
Rent account Dr 160
To cash account 1,010
(Being the above expenses paid out)
In this problem, there are 12 ledger accounts affected, namely Cash, furniture, stock, Raghavan,
sales, purchases, Mukundan, interest, stationery, salaries, rent accounts. However, the personal
accounts are Raghvan’s account and Mukundan’s account. These ledger accounts appear in the
following manner in the ledger.
Dr Raghavan’s Account in the books of Govind Singh Cr
Particulars Amount Particulars Amount

(Rs) ( Rs)
July, 5 To Sales 5,000 July 9 By Cash 3,000

July 31 By Balance c/d 2,000
5,000 5,000
August, 1 To balance b/d 2,000
The above account shows that Raghavan is owing to Govind Singh Rs.2000 as on 31 st July and
this is the opening balance for August.
Dr Mukundan’s Account in the books of Govind Singh Cr
Particulars Amount Particulars Amount

(Rs) (Rs)
July 15 To cash 5,000 July 12 By purchases 9,000

July 31 To balance c/d 4,000
9,000 9,000
August 1 st By balance b/d 4,000
This means that Mukundan is owing to Govind Singh Rs.4000 as on 31 st July and this is the
opening balance for August 1 st .
Summary
Ledger accounts are prepared from General journal and other subsidiary books including Journal
proper. All transactions are posted to ledger accounts and some of them show debit balance and
some other credit balance. For convenience of the students, the following table gives a fair idea
of what account usually shows what balance.
Name of the account Debit / credit balance
Capital Credit
Personal Drawings Debit
Creditors Credit
Bills Payable Credit
Bank overdraft Credit
Loans from others Credit
Outstanding expenses Credit
Pre received incomes Credit
Reserves for future expenses or losses Credit
All items of incomes Credit
Cash in hand or at bank Debit
Assets such as furniture, buildings, plant, machinery, tools, stock
of goods, etc Debit
Debtors, Bills receivable Debit
Loans given to others Debit
Investments made Debit
All expenses such as wages, carriage, insurance, salaries,

printing and stationery, advertising, commission paid, interest Debit
paid, etc
Prepaid insurance, rent or any prepaid expenses Debit
Outstanding incomes Debit
Losses like depreciation, loss in the revaluation of assets or sale Debit
of assets,
Any other asset Debit
Terminal Questions
1. A company is engaged in the following transactions in June. You are required to record
transactions in general journal.
1. Received cash from customers Rs.14000
2. Returned goods to suppliers Rs.4000
6. Paid for type writer purchased on credit on May 4, Rs.6000
10. Received cash for services provided Rs.Rs.2300
13. Paid for supplies purchased Rs5600
18. Paid telephone bill for the month Rs.8400
20. Provided professional services for Rs.9000 to the customer who paid advance
Of Rs2000
30. Paid salaries for the month of June Rs3400
2. Mr. Lakshminarayana set up a finance company. The following transactions took place in the
month of January. Draw the journal entries
a) Began business by depositing Rs60000 in bank in the name of the company.
b) Paid office rent for two months in advance Rs.6000
c) Purchased office supplies on credit from ‘C’ Rs.3000
d) Purchased office equipment for cash Rs.5000
e) Received cash for the services rendered Rs.10000
f) Paid security guard salary Rs.3000
g) Paid to a creditor ‘C’ on his account Rs.1200
h) Billed customers for services provided Rs.9500
i) Paid insurance premium for the month Rs.500
j) Paid advertisement charges Rs. 2000
k) Collected amounts due from customers Rs.5000
l) Purchased office supplies for cash Rs.800
m) Paid telephone expenses Rs.700
n) Paid electricity expenses Rs.200
3. Prepare ledger accounts for the journal entries recorded for the transactions as given in the
exercise 2.
4. Record the following transactions in the personal account of Mr. Ravindranath and balance
the account at the end of each month. Find out the closing balance for each month.
Date Particulars Amount

Rs.
1998
September 1 Sold goods to Ravindranath 54250
4 Received from Ravindranath 51538
4 Allowed him a discount 2712
15 Ravindranath bought goods 60000
18 Received from Ravindranath cash on account 20000
October 1 Balance from last month ?
3 Sold goods to Ravindranath 10000
21 Received from Ravindranath cash 3960
Allowed him discount 40
31 Received cash in full settlement of account ?
1. Secondary book
2. All such transactions which are not entered in any other journal
3. Book.
4. Journal proper and Ledger.
2. Journal proper
3. True.
1. True
2. Capital
3. Goodwill
1. True
2. Trade expenses
3. All expenses other than trade expenses
4. No.
1. True
2. a. Depreciation is debited & building account is credited
b. Closing stock A/c is debited and trading A/c is credited
c. Prepaid expenses account is debited and insurance A/c is credited
d. Salaries A/c is debited and outstanding expenses account is credited.
e. Drawings A/c is debited and stock account is credited.
1. True
2. Errors that can be disclosed by trial balance and errors that cannot be disclosed by trial
balance
3. Journal proper.
1. Credited
2. Trading account, stock destroy of account is debited and stock account is credited.
3. Account is debited and drawings account is credited.
1. True
2. P & L
3. True
4. Yes
5. Depreciation
6. P & L
1. Secondary
2. Journal proper
3. Closing entry is an entry to close expenses, incomes (revenue items ) to the respective
revenue accounts( Trading and P & L A/c ).
4. Rent
5. Assets account Dr 4,00,000
To Liabilities account 1,50,000
To Capital account 2,50,000( Difference)
6. The salary paid in advance is Rs 6,000. It should be deducted out of salaries paid in 2005.
The entry is : Prepaid salaries A/c 6000
To Salaries A/c 6000
( Being salary paid in advance adjusted ).
7. Balancing of a ledger account means finding out excess of debit over credit or vice versa
and equating both debit and credit sides of account.
8. Yes
9. Books of Rama: Krishna’s A/c Dr
To sales account.
Books of Krishna : Purchases A/c Dr
To Rama’s account.
10. a. Journal is a book of original entry where as ledger is a secondary book.
b. Journal includes General journal and subsidiary books. But ledger does not.
11. cash account is both a subsidiary book and a ledger account.
1. Refer to unit 5.3 illustration.
2. Refer to unit 5.3 illustration.
3. Refer to unit 5.3 illustration
4. Closing balance Sept 30 Debit balance b/d 40,000.
Closing balance Oct 31 Balance Nil.
Amount paid in full settlement is Rs 46,000.
Unit 6 Trial Balance
Structure
6.1 Introduction
Objectives
6.2 Meaning
6.3 Objectives
6.4 Methods of preparing trial balance: Total Method and Balance Method
6.5 Preparation op Trial balance
6.6 Errors and their rectification
6.7 Errors disclosed by a Trial Balance
6.8 Errors not disclosed by Trial Balance
6.9 Steps to locate the errors
6.10 Trial Balance and adjustments
Terminal Questions
6.1 Introduction
Journal and ledger are the books containing the details of business transactions which have
taken place during a particular period. The purpose of these records is preparation of final
accounts – trading account, profit and loss account and balance sheet. Before attempting to
prepare final accounts, a summary of the transactions, as depicted by ledger should be available
in a form that is easy to classify the assets, liabilities, expenses and incomes. While expenses
and incomes are used to prepare trading and profit and loss accounts, assets and liabilities are
presented in the balance sheet. Trial Balance stands as a bridge between primary and secondary
books on one hand and final statements of accounts on the other hand.
1. To know the meaning and format of trial balance.
2. To understand the objectives of preparing a trial balance
3. To know the guidelines to prepare a trial balance.
4. To identify and rectify the errors that can be disclosed by trial balance
5. To identify and rectify the errors that can not be disclosed by trial balance
6. To know the steps to locate the errors.
7. To prepare trial balance after incorporating adjustments.
6.2 Meaning
Trial Balance is a statement containing the various ledger balances on a particular date. It is used
to verify the equality of debits and credits in the ledger. When the total of debit balances equals
the total of credit balances, the ledger is said to be in balance. A trial balance is prepared as
follows:
TRIAL BALANCE AS ON 31 ST MARCH,
Debit Credit
Particulars
Rs. Rs.
Cash account 1,20,000
Capital account 1,00,000
Purchases account 40,000
Mohan account (creditor) 20,000
Sales account 40,000
Total 1,60,000 1,60,000
1. The purpose of preparing journal and ledger accounts is to prepare __________.
2. The final accounts include _________, ____________ and ________.
3. Trial balance is regarded as a bridge between primary and secondary books and
preparation of final accounts (True / False ).
4. Trial balance contains debit balances and credit balances. (True / False )
5. If trial balance tallies, balance sheet also tallies. (True / false )
6.3 Objectives
There are three objectives of preparing a trial balance.
a) To check the arithmetic accuracy of entries made. In double entry, every debit has an
equivalent credit. Even in General Journal, we have seen that the total of debits equals the
total of credits. Similarly, if the debits and credits tally in a trial balance, it indicates that the
books of account are arithmetically accurate. If the two sides do not tally, it is sure that errors
have crept in.
b) Basis for financial statements. As stated earlier, trial balance is a bridge between ledger and
final statements. It is only through trial balance, trading account, profit and loss account and
balance sheet are prepared. If trial balance tallies, it means that the final statements should
invariably tally.
c) It is a summarised ledger. The position of a ledger account be judged simply by looking at the
trial balance. It is because, all ledger accounts, after being balanced, are grouped as those
showing debit and those showing credit balances. They must be equal in value.
1. Trial balance checks the arithmetic accuracy of debits and credits ( True / False)
2. Trial balance is a summary of ledger accounts. So, if ledger accounts are properly prepared
and balanced, trial balance tallies ( True / False).
6.4 Methods of preparing Trial Balance
Totals method and Balance method are the two techniques of preparing trial balance. In the first
method, the totals of debits and credits of every account are shown in the trial balance. For
instance, a cash account shows Rs.45000 as debit total (Receipts) and Rs35000 as credit total
(Payments). Both these totals are carried to trial balance. The same logic is applied for all other
accounts. Then also the trial balance tallies In the second method, instead of transferring the
totals of both debit and credit, the net balance Rs.10000 (45000 – 35000) is shown on the debit
side of trial balance. Same principle is adopted for all other accounts. The trial balance tallies. In
the former method, more details can be understood but it is cumbersome. The second method
gives the gist of the account and second method is popular.
1. Trial Balance is prepared either under total method or balance method ( True / False).
2. Which method is popular ?
3. What ever be the method of preparing trial balance, debit total should be equal to total of
credit (True / False ).
6.5 Preparation of Trial Balance
A trial balance can be prepared just as an account having debit side and credit side. It can also
be prepared by enlisting all ledger accounts one below the other and showing their respective
debit or credit balances on separate columns. Both methods are equally prevalent.
However, the following steps should be followed to prepare a Trial Balance.
a) Prepare the ledger accounts
b) Balance them at the end of accounting period
c) Group all accounts showing debit balance and show them of left hand side of trial balance
d) Group all those accounts showing credit balance and show them on the right hand side of trial
balance.
e) Total the debits and credits and they must be equal, what ever be the method of preparing the
trial balance.
1. How do you prepare trial balance ?
2. If total of debits and credits do not tally, do you suspect any errors ?
Illustration:
The following are the ledger accounts of Mr. X as on 31 st December, 1998. Prepare a trial
balance.
Dr. Cash Account Cr.
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
1404 To balance b/d 50,000 6404 By Cash 5,000
24—04 To Sales 45,000 10404 By Kumar 29,000
16404 To Mohan 35,000 14404 By Purchases 50,000
26404 To Sales 10,000 18404 By creditors 20,000
20404 By Furniture 5,000
22404 By Wages 500
By Printing 1,000
By Comm 2,000
30404 By Electricity 500
By Telephone 1,000
By salaries 4,000
By balance c/d 22,000
1,40,000 1,40,000
1504 To balance b/d 22,000
Building Account
Amount Amount
Rs. Rs.
1404 To balance b/d 2,00,000 30404 By balance c/d 2,00,000
1504 To balance b/d 2,00,000
Furniture Account
Date Particulars Amount Date Particulars Amount
Rs. Rs.
20404 To Cash 5,000 30404 By balance c/d 15,000
15,000 15,000
Bank Fixed Deposit Account
Amount Amount
Rs. Rs.
1404 To balance b/d 1,00,000
12404 To Interest 7,000 30404 By balance c/d 1,07,000
1,07,000 1,07,000
1504 To balance b/d 1,07,000
Stock Account
Amount Amount
Rs. Rs.
1404 To balance b/d 25,000 30404 By balance c/d 25,000
Creditor’s Account
Amount Amount
Rs. Rs.
18404 To Cash 20,000 1404 By balance b/d 35,000
30404 To balance c/d 15,000
35,000 35,000
1504 By balance b/d 15,000
Capital Account
Amount Amount
Rs. Rs.
30404 To balance c/d 3,50,000 1404 By balance b/d 3,50,000
35,000 3,50,000
1504 By balance b/d 3,50,000
Purchases Account
Amount Amount
Rs, Rs.
4404 To Kumar 30,000 30404 By balance c/d 95,000
14404 To Cash 50,000
To Sarin 15,000
95,000 95,000
Sales Account
Amount Amount
Rs. Rs.
30404 To balance c/d 95,000 2404 By Cash 45,000
8404 By Mohan 40,000
26404 By Cash 10,000
95,000 95,000
Kumar Account
Amount Amount
Rs. Rs.
10404 To Cash 29,000 4404 By Purchases 30,000
To discount 1,000
30,000 30,000
Repairs Account
Amount Amount
Rs. Rs.
5,000 5,000
Mohan Account
Amount Amount
Rs. Rs.
8404 To sales 40,000 16404 By Cash 35,000
30404 By balance c/d 5,000
40,000 40,000
Discount Received Account
Amount Amount
Rs. Rs.
30404 To balance c/d 1,000 10404 By Kumar 1,000
1,000 1,000
Interest on Fixed Deposit Account
Amount Amount
Rs. Rs.
30404 To balance c/d 7,000 12404 By Bank FD 7,000
7,000 7,000
Wages Account
Amount Amount
Rs. Rs.
22404 To Cash 500 30404 By balance c/d 500
500 500
1504 To balance b/d 500
Printing Account
Rs. Rs.
1,000 1,000
Commission Account
Amount Amount
Rs. Rs.
2,000 2,000
Electricity Account
Rs. Rs.
30404 To Cash 500 30404 By balance c/d 500
500 500
Telephone Account
Amount Amount
Rs. Rs.
1,000 1,000
Salaries Account
Amount Amount
Rs. Rs.
4,000 4,000
Sarin’s Account
Amount Amount
Rs. Rs.
30404 To balance c/d 15,000 28404 By Purchases 15,000
15,000 15,000
Solution
TRIAL BALANCE AS ON 30 TH APRIL, 2004
Debit balances Amount Rs. Credit balances Amount
Rs.
Cash 22,000 Creditors 15,000
Building 2,00,000 Capital 3,50,000
Furniture 15,000 Sales 95,000
Bank FD 1,07,000 Discount received 1,000
Stock 25,000 Interest on FD 7,000
Purchases 95,000 Sarin 15,000
Repairs 5,000
Mohan 5,000
Wages 500
Printing 1,000
Commission 2,000
Salaries 4,000
Telephone 1,000
Electricity 500
Total 4,83,000 Total 4,83,000
6.6 Errors and their rectification
An error is unintentionally committed mistake. Trial Balance, if does not tally, is a clear indication
that there are some errors committed. The errors may be committed at various stages –
journalizing, posting, casting (totaling), balancing, transferring to trial balance and so on. Mere
tallying the trial balance does not ensure error free statement. For example, if a transaction is
completely omitted, the trial balance still tallies. But there is inherent error. Errors whether
disclosed or not disclosed by trial balance, have to be corrected or rectified in order to obtain the
correct picture of profit or loss. It should be remembered that errors will have their impact not only
on profit but also on the asset and liability position of the business organization.
1. Errors can be committed at all stages, commencing from journalizing, posting, costing,
balancing, transferring the closing balances, etc. (True / False).
2. Errors of omission, error of principle and compensating errors are not disclosed by trial
balance (True / False).
3. Errors of costing, posting to wrong side of an account, wrong amount etc can be detected by
trial balance (True / False).
6.7 Errors disclosed by Trial Balance
Those errors that can be disclosed by trial balance can easily be located. As soon as the trial
balance does not tally, the accountant can proceed to find out the spots where the errors might
have been committed. The total amount of difference in the trial balance is temporarily transferred
to a ‘Suspense Account’ so that it can be mitigated as and when the errors get rectified.
Therefore the suspense account gets debited or credited as the case may be for rectification of
this type of errors. The following are the errors which are disclosed by trial balance:
a) Posting a wrong amount: While posting an entry from subsidiary book to ledger,
b) this mistake may happen. For example, Cash received from Rama Rs1150 is posted to
Rama’s ledger account as Rs.1500, while it is correctly recorded in cash account. As a result
of this error, trial balance does not tally. To rectify this Rama’s account should be debited by
Rs350 (1500 – 1150) and credit should be given to suspense account.
c) Posting to the wrong side of an account: This error is committed while posting entries from
subsidiary books to ledger. For instance, Sales made to Krishna Rs5000 is transferred to
credit side of Krishna’s account in the ledger. This error can be rectified by debiting Krishna’s
account by Rs1000 and crediting suspense account. Note that the amount debited is double
the actual amount.
d) Wrong totaling: Both under casting and over casting are detected by trial balance. If any
account is wrongly totaled, it gets reflected in the trial balance. To illustrate, purchases book
total is Rs.5800. If it totaled as Rs.5700 or 5900, the difference will be shown in the trial
balance. To rectify this, first find out what is the normal balance shown by the account
wrongly totaled. If it is debit balance and it is under cast, the same account can be debited
and credit is given to suspense account. If it is over cast, the respective account should be
credited by the amount of difference and debit is given to suspense account. It is quite
opposite in case the respective account is one which normally shows credit balance.
e) Omitting to post an entry from subsidiary book to ledger: If an entry made in the
subsidiary book does not get posted to ledger, the trial balance does not tally. For instance,
rent paid Rs2000 recorded in cash account but is not posted to rent account at all. To rectify
such error, the respective account should be debited or credited as the case may be and
suspense account is credited or debited as the case may be.
f) Omission of an account altogether from being shown in trial balance: For instance,
advertisement account which shows a debit balance is completely omitted from trial balance.
This can be rectified by bringing it to trial balance and suspense account can be credited and
advertisement account is debited.
g) Posting an amount to a correct account more than once: This results in imbalance in the
trial balance. The concerned account which is posted twice should be cancelled and
suspense account to be suitably debited or credited as the case may be.
h) Posting an item to the same side of two different ledger accounts: If two accounts are
debited /credited for the same transaction, this type of error occurs. For example, Furniture
purchased should be debited to furniture account only. If it is posted to furniture account and
purchases account, then the difference arises in the trial balance. To rectify this, the ledger
account to which it is debited wrongly should be credited and suitably suspense account is
debited.
1. Suspense account is the difference between debit total and credit total of a trial balance.
( True / false ).
2. Suspense account is created temporarily and later, it is removed as and when errors are
detected and suitable rectified ( True / False ).
3. if amount paid to Rama Rs 500 is credited to Ramanan accounts, what rectification entry
should be made ?
4. Instead of putting Rs. 1500 to debit of wages account, Rs 15000 is recorded. What impact, it
has an profit ?
5. How do you rectify the above error ?
6. Telephone expenses of Rs 2500 is entered in cost account but not posted to ledger. How do
your rectify ?
7. Rs. 2116 interest paid an loan is posted to interest accounts once as Rs 2611 and second
time as Rs. 2161. How do you rectify?
6.8 Errors not disclosed by Trial Balance
There are four errors regarded as those which do not affect trial balance and it is difficult to locate
them. A brief description of the four errors is offered in the following paragraphs:
a) Error of omission: Error of omission occurs when a transaction is completely omitted from
the books of accounts. If purchase of goods from Jairam on credit is not recorded at all either
in the general journal or in the purchases book, it is termed as error of omission. Since both
aspects – debit and credit – of the transaction are missing, the trial balance is not affected at
all. To rectify such errors, the transaction should be recorded when it is traced.
b) Error of commission: If the error of wrong posting, wrong casting, wrong calculation etc.,
committed in the books of original entry or ledger, it is said to be error commission. For
instance, purchase invoice of Rs.1730 may have been entered as Rs.1370 in the purchases
book itself, then in the subsequent ledger accounts, the same mistake continues and thereby
can not be disclosed by trial balance. The difference of Rs.360 (17301370) should be added
to purchases account and to the respective supplier’s account. The error can be detected only
when the original invoice is referred to after getting the complaint from the supplier. In the
above example, purchases account is debited and the concerned supplier’s account is
credited to rectify the error. Such errors have repercussion on the profit or loss of the
organization. From the above example, additional purchases will have to be incorporated and
to that extent the expenses will be increased or profit will be affected.
c) Error of principle: While drawing journal entries, often error of principle is committed and this
goes un noticed because it does not affect the total of trial balance. For instance, ‘wages’ paid
to workers engaged in the construction of building of the organization, constitutes part of the
cost of the building. So the wages paid should be debited to building account but not wages
account. If the building account is debited, the value of the asset appears in the balance sheet
and the expenditure is actually capitalized. In case the wages are treated as usual revenue
expenditure, they are deducted from profit. The error here is wages account is debited and
not building account. Therefore to rectify this, building account should be debited and wages
account should be credited to erase. Similarly, treating incomes as liabilities, providing
insufficient provision for bad and doubtful debts, inadequate depreciation against assets etc.,
come under errors of principle. They must be rectified by applying the correct principles of
accountancy.
d) Compensating errors: It is also called offsetting error. Compensating error is one which is
counter balanced by another error. If the account of Mr. X is to be debited for Rs1000, but it is
debited for Rs100 while the account of Mrs X account is to be debited Rs.100 but it is debited
by Rs.1000, the first error is compensated by the second error and therefore the trial balance
is not affected. This comes to light only at a later stage. To rectify the error, Mr. X account
should be debited by Rs.900 where as Mrs. X account should be credited by Rs.900.
1. If error of wrong posting, wrong costing, wrong calculation are committed in the books of
original entry or secondary books, such errors are called ________.
2. Error of commission affects trial balance (True / False).
3. Furniture purchased for cash Rs 5000/ is to recorded in journal. What type of error is this ?
4. Error of omission can be detected only after a careful review of ledger balances of previous
years (True / False).
5. Error of principle affects the value of revenue and capital items (True / False).
6. It is very difficult to find out the compensating errors. (True / False).
6.9 Steps to locate the Errors
The following steps help to locate the errors. In spite of the efforts, if the difference in the trial
balance persists, a suspense account may be created and subsequently the suspense account
can be eliminated as and when the errors are located and rectification is made.
i) Check both sides of the trial balance to ensure that mistake of totaling is not there.
ii) Check the totals of debtors and creditors accounts
iii) Find out whether all ledger balances are carried to trial balance
iv) Verify the totals of all ledger accounts
v) Divide the amount of difference in the trial balance by 2 and see if any item of the debit or
credit side, equal to that amount has been posted to the opposite side.
vi) Check whether the opening balances are brought down correctly from the previous
accounting period
vii) Make a comparison with trial balance of the previous year to find out if there are any items
missing.
viii) Where the difference in the trial balance is divisible by 9 then the difference is likely to be
due to misplacement of figures like 12 for 21; 24 for 42;36 for 63 and so on.
6.10 Trial Balance and adjustments
When errors are located, they should be rectified. It is not a good practice nor does it have any
legal sanction to erase the mistakes and re write the correct ones. Rectification entries are
recorded in General journal or journal proper. The following illustrations are given to show how to
rectify the different types of errors.
1. Summary of all ledger balances is called ______________________ .
2. Trial balance is necessary to prepare _________________________ .
3. The broad two categories of errors are a)________________ b) ____________.
4. Is casting error of principle or error of commission?
5. Purchase of machinery is included in the purchases book. What type of error is it?
6. What is error of omission? Illustrate.
7. What are the errors that can not be disclosed by trial balance?
8. The sum of errors in accounting is transferred temporarily to _________ account.
9. In which journal do you make rectification entries?
10. State any four steps to locate errors.
11. If sales account is under cast by Rs.45, what is the rectification entry?
12. Returns inwards book is over cast by Rs9, write rectification entry.
13. salary paid to Gopal is debited to his personal account. What is the rectification entry to
correct the error?
14. Discount received Rs50 is transferred to the debit side of discount account. Write the
rectification entry.
15. An invoice of purchase for Rs.760 is entered as Rs.670. What type of error is this? How to
rectify this error?
Illustration 1
An accountant finds that the trial balance of his client did not tally and it showed an excess credit
of Rs.69.74. He transferred it to a suspense account and later discovered the following errors.
a) Rs.44.37 paid to Anand has been credited to his account as Rs34.37.
b) A purchase of Rs.145.50 has been posted as Rs154.50 to the purchases account
c) An expenditure of Rs.158 on repairs has been debited to the Buildings account
d) Rs.80 was allowed by B as discount which has not been entered in the books.
e) A sum of Rs.125.05 realized on the sale of old furniture has been posted to the sales account.
Give journal entries to rectify the errors and show the suspense account as it would appear after
adjustments.
Solution
Date Particulars LF Debit (Rs.) Credit (Rs.)
1 Anand’s account Dr 78.74
To suspense account 78.74
(Being wrong amount, wrong
ly credited to Anand’s a/c
rectified)
2 Suspense account Dr 9.00
To Purchases account 9.00
(Being over debit of
purchase account rectified)
Repairs account Dr
3 158.00
To Buildings account
158.00
(Being wrong debit given to
building account rectified)
80.00
B’s account Dr
4 80.00
To Discount received a/c
(Being discount received
from B, omitted earlier,
brought to account)
Sales account Dr 125.05
5. To old furniture account 125.05
(Being sale of old furniture
wrongly transferred to sales
account rectified)
Suspense Account
Amount Amount
Rs. Rs.
To Difference in trial balance 69.74 By Anand’s a/c 78.74
To Purchases a/c 9.00
78.74 78.74
Note:
1. The excess of credit balance of trial balance means that the total of credit is more than debit
by Rs69.74 and so the difference is shown on the debit side of suspense account.
2. When amount is paid to Anand, his account should have been debited. On the other hand, his
account was credited and that too with a wrong figures. To rectify this double error, Anand’s
account has to be debited with Rs.78.74 (Rs.44.37 + 34.37) and the suspense account is
credited.
3. Purchases account was over debited by Rs9 and so Purchases account is credited to nullify
the effect and suspense account is debited.
4. Repairs spent on building are, by mistake, debited to buildings account. This is error of
principle. So repairs account is debited and buildings account is credited to rectify the
mistake.
5. Discount received from B has not been taken to records. This is an error of omission.
Therefore, it is now brought to accounts. This has not affected the trial balance.
6. When old furniture is sold, the furniture account should have been credited. On the other
hand, sales account was credited against to the principle of accounting. To rectify the error,
sales account is debited and old furniture account is credited.
Illustration 2
The trial balance of Evergreen Co Ltd., taken out as on 31 st December, 2002 did not tally and the
difference was carried to suspense account. The following errors were detected subsequently.
a) Sales book total for November was under cast by Rs1200.
b) Purchase of new equipment costing Rs.9475 has been posted to Purchases A/c.
c) Discount received Rs1250 and discount allowed Rs850 in September 2002 have been posted
to wrong sides of discount account
d) A cheque received from Mr Longford for Rs.1500 for goods sold to him on credit earlier,
though entered correctly in the cash book has been posted in his account as Rs.1050
e) Stocks worth Rs.255 taken for use of Mr Dayananda, the Managing Director, has been
entered in sales day book.
f) While carrying forward, the total in Returns Inwards Book has been taken as Rs.674 instead
of Rs.647.
g) An amount paid to cashier, Mr. Ramachandra, Rs.775 as salary for November month has
been debited to his personal account as Rs757.
Pass journal entries and draw up the suspense account.
Solution
Journal Proper of Evergreen Co Ltd.,
Date Particulars L F Debit Credit
Rs. Rs.
31122002 Suspense account Dr 1,200
To Sales account 1,200
(Being under casting of sales book rectified)
31122002 New Equipment account Dr 9,475
To Purchases account 9,475
(Being wrong debit given to purchases account rectified)
31122002 Discount allowed account Dr 1,700
Suspense account Dr 800
To Discount received a/c 2,500
(Being discount received and discount allowed posted to
wrong sides of discount account rectified)
31122002 Suspense account Dr 450
To Longford account 450
(Being short credit given to Longford rectified)
31122002 Sales account Dr 255
To suspense account 255
(Being stock used for personal purpose wrongly credited
to sales account rectified)
31122002 Suspense account Dr 27
To Returns Inwards account 27
(Being excess debit given to returns inwards account to
the extent of Rs27, now rectified)
31122002 Salary account Dr 775
To Ramachandra ‘s a/c 757
To Suspense a/c 18
(Being the wrong debit of salary to the personal account
of Ramachandra now rectified)
Dr SUSPENSE ACCOUNT Cr
Amount Amount
Particulars Particulars
Rs. Rs.
To sales account 1,200 By Sales 255
To Discount received a/c 800 By Salary 18
To Longford 450 By balance c/d 2,204
To Returns Inwards a/c 27
Total 2,477 Total 2,477
Terminal Questions
1. Prepare a trial balance from the following
Amount Amount
Particulars Particulars
Rs. Rs.
Purchases 8,225 Premium on lease 1,200
Wages 1,025 Loan on mortgage 2,500
Sales 12,450 Plant and machinery 2,000
Arun’s capital 13,500 Provision for doubtful debts 300
Stock on 1198 1,500 Sundry debtors 16,550

Salary 410 Trade charges 200
Rent and taxes 162 Bad debts 200
Sundry creditors 2,572
(Ans: Rs .31322).
2. The following Trial balance was extracted from the books Chetan, a small businessman. Do
you think that it is correct? If not, rewrite it in the correct form.
Debits Rs. Credits Rs.

Stock 8250 Capital 10000
Purchases 12750 Sales 15900
Returns outwards 700 Returns inwards 1590
Discount received 800 Discount allowed 800
Wages and salaries 2500 Scooty 1750
Rent and rates 1850 Carriage charges 700
Sundry debtors 7600 Sundry Creditors 7250
Bank Overdraft 2450 Bills payable 690
(Ans: Rs. 37,790).
3. Mr. Abhijit was unable to tally Trial balance last year and wrote off the difference to the
Suspense account. He appointed a chartered accountant who examined the old books and
found the following mistakes.
a) Purchase of a cycle was debited to conveyance account Rs.3000
b) Purchase account was over cast by Rs.10000
c) A credit purchase of goods from Padam for Rs4000 was entered as sale.
d) Receipt of cash from Allum was posted to the account of Arun Rs.3000
e) Receipt of cash from Cherag was posted to the debit side of his account Rs.6000
f) Rs.1000 due by Mr. Zavahir was omitted to be taken to trial balance.
g) Sales of goods to Mr. Rajaram for Rs6000 was omitted to be recorded.
h) Payment of Rs.5050 for purchase was wrongly posted as Rs.5500 in purchases account..
Suggest the necessary rectification entries. Prepare suspense account.
1. Final Accounts
2. Trading A/c, P & L A/c, Balance sheet.
3. True
4. True
5. False
1. True
2. True
1. True
2. Balance method
3. True
1. Group all ledger accounts showing debit balance and group all accounts showing credit
balance. summaries them total of debit is equal to total of credit.
2. Yes
1. True
2. True
3. True
1. True
2. True
3. Rama account should be Debited by Rs 500, Ramanan’s account should be debited by Rs
500 and credit should be given suspense account Rs 1000.
4. Profit – (gross ) is Reduced by Rs 13500.
5. Wages account is credited by Rs 13500 and debit is given to suspense A/c.
6. Telephone expenses account is debited and suspense account is credited
7. Total amount debited to interest account is Rs 2611 + 2161 = 4772.
The correct amount by crediting interest account and debiting suspense account with similar
amount.
1. Error of commission
2. False
3. Error of omission
4. True
5. True
6. True
1. Trial balance.
2. final accounts
3. Error that are disclosed by trial balance and those which cannot be disclosed by trial
balance.
4. Error of commission.
5. Error of principle.
6. Omitting completely a transaction from books of original entry. Sales made to Raghu Rs
120 completely ignored.
7. Error of omission, commission, principle, compendating error.
8. suspense account.
9. Journal proper
10. check the total of both sides of trial balance, total debtors & creditors, verify whether
balancing is done correctly, check the totals of ledger balances etc.
11. suspense account is debited and sales account is credited.
12. suspense a/c is debited and sales returns a/c is credited.
13. Salary a/c is debited and Gopal a/c is credited.
14. Discount a/c is credited by Rs 100 and suspense a/c is debited
15. This is an error of omission. By checking the original invoice document, it can be rectified.
Debit purchases account and credit the creditor’s account.
Terminal Question Answers :
1. Refer to unit 6.5 Ans – Rs 31322
2. Refer to Unit 6.5 Ans – Rs 37790
3. Refer to unit 6.10 Ans Suspense A/c Excess debit over Credit is Rs 5450.
Unit 7 Final Accounts

Structure:
7.1 Final Accounts – Introduction
Objectives
7.2 Adjustments before preparing final accounts
7.2.1 Outstanding expenses

7.2.2 Prepaid Expenses
7.2.3 Accrued Income
7.2.4 Income received in advance
7.2.5 Depreciation
7.2.6 Bad Debts
7.2.7 Provision for Doubtful Debts
7.2.8 Reserve for Discount on debtors:
7.2.9 Reserve for discount on creditors
7.2.10 Closing stock

7.3 Trading Account

7.4 Preparation of Trading Account
7.5 Profit and Loss Account
7.6 Preparation of Profit and Loss Account
7.7 Balance Sheet – Meaning
7.8 Preparation of Balance Sheet
Terminal Questions
7.1 Final Accounts – Introduction

The last step of accounting process is preparation of final accounts. Final accounts are Trading
account and Profit and Loss Account with respect to any trading organization. If it is non trading
organization like a club or an Educational Institution, Receipt and Payment Account and Income
and Expenditure Account are the final accounts. In case of a manufacturing unit, a Manufacturing
account is prepared in addition to Trading Account. Profit and Loss Account is prepared by all
trading and manufacturing units. Balance Sheet is closely associated with these final accounts.
But Balance Sheet is not an account. It is a statement of assets and liabilities of business
organization prepared at the final stage of the accounting process. Therefore balance sheet is
regarded as a part of final accounts. The purpose of preparing final accounts is to find out the end
result of business at the end of an accounting period, may it be profit or loss.
The basis for preparing final accounts is the Trial Balance. For Trial Balance, the ledger balances
are the root. For ledger accounts, the journal entries or entries in the subsidiary books (Books of
original entry) are the roots. Hence the final accounts reflect the original business transactions,
which are systematically and scientifically recorded, classified, and analyzed. Final accounts
provide bundle of information for decision making activities.
1. To know the meaning and purpose of final accounts
2. To identify the items of Trading Account

3. To identify the items of Profit and Loss Account

4. To identify the items of assets and liabilities of a Balance Sheet and modes of preparing it.
5. To know the adjustments such as Reserve for bad debts, Reserve for discounts on Debtors,
Reserve for discount on Creditors, bad debts out side the trial balance.
6. To understand the adjustments like depreciation on assets, closing stock, stock lost in fire,
goods given as samples, goods used for personal purpose etc.,
7. To know the adjustments of prepaid expenses, outstanding expenses, pre-received incomes,
outstand incomes etc.
8. To prepare Balance Sheet without any adjustments from trial balance.
9. To prepare Balance Sheet with adjustments.
7.2 Adjustments before preparing final accounts

The Generally Accepted Accounting Principles (GAAP) supports the accrual basis of accounting,
according to which revenue is recognized when it is earned and expenses are recognized when
they are incurred, irrespective of their actual receipt or actual payment.
If the accrual basis of accounting is used, adjusting entries are required at the end of the period
to record any changes in assets, liabilities, revenue incomes, revenue expenses, previously
unrecognized. Adjusting entries are regarded as internal transactions. For instance, salaries are
paid in advance to a few employees and the excess paid in the current period, should be
adjusted to the coming period and what is paid in advance now should not be charged against
the revenues relating to the current period. Similarly, insurance paid in advance, rent paid in
advance etc., Like wise incomes received in advance should not be considered for the current
period. On the other hand, expenses yet to be paid for the current period should be charged
against the current period’s income. On the same lines, incomes yet to be received for the current
period should be considered as incomes for the current period whether actually received in cash
or not. Every asset is subject to wear and tear and the value of the asset gets reduced even if the
loss on account of this is not recorded by means of a journal entry. Some stock of goods at the
end of the period is left over and it has to be valued and be taken to accounts for fair computation
of profit. Such internal adjustments have to be made and recorded before preparing Trading
Account, Profit and Loss Account and Balance Sheet. The adjustments to be incorporated are
briefly described in the following paragraphs.


1. Final account are prepared from trial balance, trial balance from ledger accounts and ledger
account from books of original entry. So final accounts are reflection of original transaction
(state True / False ).
2. Final accounts speak about profit or loss as on a particular day ( state True and False )
3. Balance sheet tells the value of assets and liability as standing an a the last day of
accounting period ? ( True / False )

4. Adjustment in final accounts is necessitated because of accrual basis of accounting (state
True / False ).
5. Adjusting entries are also regarded as ______ .
6. Adjustments such as outstanding and prepaid / received items are needed to find out
_____________.
7. Adjustment entries are made before preparing tracking and P & L and balance sheet
(True/False ).
7.2.1 Outstanding expenses

Expenses due but not yet paid are known as outstanding expenses. Wages, salaries, rent,
commission etc payable in the current month are paid in the following month. If final accounts are
prepared for year ending 31st December, then the expenses payable for December will be paid in
January of next year. The extent to which the amount belongs to the current year but payable in
the next year is called outstanding expenses. To record that aspect, the journal entry drawn in the
Journal proper is:
Concerned Expenses account Dr

To outstanding Expenses account.
Outstanding expenses account indicates liability for the current year and it will appear in the
balance sheet.
Example: Advertisement expenses for year 31-12-2003 outstanding is Rs.5000. The journal
entry is
Advertisement expenses account Dr 5000
To Outstanding expenses account 5000

1. Expenses due but not yet paid are known as ___________.
2. What is the entry if salaries are outstanding ?

3. If ‘outstanding expenses’ appear in trial balance, what does it mean ?

4. Outstanding expenses appear an assets side of balance sheet ( state True / False ).
7.2.2 Prepaid Expenses
Expenses paid in advance are regarded as prepaid expenses. Prepaid expenses form an asset
and therefore prepaid expenses account is debited. For example, insurance premium is paid
from April, 2004 to March, 2005 and the amount is Rs.3600. The financial year ends by 31st
December, 2004. Therefore the premium relating to Jan, Feb and Mar of 2005 Rs.900 is said to
have been paid in advance. To record this internal adjustment, the entry is
Prepaid Expenses account Dr 900
To Insurance account 900
Note that outstanding or prepaid expenses accounts are regarded as personal accounts.

1. Expenses paid even before incurred. They are know as _____.
2. Prepaid expenses appear on the asset side of balance sheet. ( state True / False).
3. Opening balance of prepaid insurance is Rs 1000; insurance paid during the year Rs. 5600;
Insurance paid in advance include in the above is Rs 800: Find out actual expenditure for
insurance for the current year.
4. Prepaid expenses account is a personal account ( True / False).
7.2.3 Accrued Income

Accrued income is also called outstanding income. Outstanding income account is a personal
account and it represents an asset. This account is credited and the concerned income account
is debited in the journal proper as an adjusting entry. The entry is
Outstanding incomes account Dr

To Concerned income account
Example
Interest accrued on Fixed Deposit of Rs 200000 at 12% simple interest on 31-12-2006, not yet
received. The entry is
Outstanding incomes account Dr 24,000
To interest on FD account 24,000
Outstanding Income account appears as an asset in the balance sheet.

1. Income earned but not received is called ____________.

2. Outstanding income is an asset ( state True / False ).

3. Outstanding income is a personal account. (True / False ).
7.2.4 Income received in advance

Just as income is accrued, there are instances where income is received in advance. The amount
is shown as liability in the balance sheet and it shows a credit balance. The adjusting entry to
record the income received in advance is
Concerned item of income account Dr

To Income received in advance account
Example
Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts are finalized on 31-
12-2005. Therefore rent received for January, February and March of 2006 is said to have been
received in advance Rs.12000. The entry is
Rent received account Dr 12000

To Income received in advance a/c 12000

1. Any income received in advance is a liability (state True / False ).
2. What is the adjusting entry for rent received in advance ?
3. Income received in advance in the current year is ________ from the unearned item of
income received.
7.2.5 Depreciation
Depreciation is reduction in the value of an asset due to constant use of the same, which is called
wear and tear. Fixed assets like, buildings, plant, machinery, furniture etc., are subject to
depreciation. Whenever, an asset is depreciated, its value goes down and therefore it is a loss to
the organization. Depreciation account is debited and the concerned asset account is credited.
The item of depreciation may appear in the trial balance, which means that already the
concerned asset is reduced by the amount of depreciation. If depreciation is given as an
additional adjustment, then the depreciation amount should be charged against profit and loss
account on one hand and the concerned asset account is reduced on the other hand in the
balance sheet.
There are two popular methods of depreciation, namely fixed installment method and reducing
balance method. In fixed installment method, depreciation is calculated on cost of the asset. In
case of reducing balance method (Diminishing balance method), the depreciation is charged on

the reducing balance of the book value of the asset. Reducing balance method is more popular
and well recognized.
Example
Building is of the book value of Rs.400000. It is depreciated at 10% on fixed installment method.
Show the journal entry and how does it appear in the balance sheet?
Solution
The entry for depreciation is
Depreciation account Dr 40,000

To Building account 40,000
Depreciation being a loss is transferred to profit and loss account and in the balance
sheet, the value of Building is shown as Rs.400000 – 40000 = 360000.
Note: For the second year the depreciation will be Rs.40000 if the asset is depreciated under
fixed installment method. If it is depreciated under reducing balance method, the depreciation for
the second year is Rs.36000 (10% of 360000).

1. Depreciation is for __________ of an asset.
2. What entry is drawn if depreciation is provided ?
3. When depreciation account is transferred to P & L A/c , what entry do you draw ?
4. If depreciation to be provided in the adjustments, what do you understand by this ?
5. What is the method of depreciation recognized by Indian Income Tax Act?
6. If depreciation appears in the trial balance, what does it indicate ?
7.2.6 Bad Debts

Bad debts are those debts which are not recovered. Bad debts form loss to the business and
reduce the amount of debtors. Since bad debts are losses, they are debited and the debtor’s
account is credited because the outstanding amount of debtors comes down.
If bad debts are identified well before preparing trial balance, then bad debts appear in the trial
balance and they should be taken to the debit side of profit and loss account. Since debtors
account is already reduced by the amount of bad debts, it does not require any further adjustment
in the balance sheet.
If bad debts are shown outside the trial balance, which means that they are identified after the
preparation of Trial Balance, then two adjustments should be incorporated. One – bad debts

should be charged against profits in P & L A/C and the second – the debtor’s account should be
reduced by the amount of bad debts in the balance sheet on the asset side.
Example
The sundry debtors for the year 2005 are Rs.50000. The bad debts amounted to Rs.4000 as on
31-12-2005 already shown in the trail balance. Write off further bad debts Rs5000. Show how
the above internal adjustments appear in the final accounts.
Solution
• There are bad debts shown in the trial balance Rs4000 and not shown in the trial balance
Rs.5000. To incorporate those bad debts not yet shown in the trial balance, the adjusting
entry is
Bad debts account Dr 5000
To Debtor’s account 5000
• In the profit and loss account of 2005, the total bad debts appearing on the debit side are Rs.
9000(4000 + 5000)
• In the balance sheet, on the asset side, the amount of debtors is Rs45000(50000 -5000).

1. Unrecovered debts are called ______.
2. Bad debts are not expenses but they form losses. (state True / false )
3. What is the entry made in journal proper, if bad debts are recorded.
4. What entry do you make to close the bad debts ?
5. What impact bad debts have on profits ?
6. If bad debts are recovered, what entry can be drawn ?
7.2.7 Provision for Doubtful Debts

Debts that can not be recovered are called bad debts but debts, the recovery of which is doubtful,
are called doubtful debts. From the past experience of the business proprietor, what percentage
of good debts may become bad in future, can be estimated and in the current year itself an equal
amount of profit be set aside. This provision is known as Reserve for Bad Debts or Provision for
Doubtful Debts or Reserve for Doubtful Debts.
Since the provision for bad debts is a charge against current year profit, the adjusting entry is to
debit P & L A/C and credit Provision for Bad Debts Account.
Profit and Loss Account Dr
To Provision for bad debts account

Provision for bad debts is a liability to be incurred in future and so it should appear on the liability
side of balance sheet. However, the convention is - RBD (Reserve for Bad and Doubtful Debts) is
deducted from the amount of good debtors. The important note here is that RBD is computed as
a percentage of good debts, which means total debtors minus bad debts unadjusted.
Provision for bad and doubtful debts is a running account and every year the amount keeps on
changing because from the provision made in the current year, bad debts occurring in the
following year have to be adjusted and additional amount of provision to be made is calculated.
Every year, the amount transferred to P & L A/C is B + N – O, where B stands for bad debts; N
stands for new provision and O stands for old reserve. For example, the old reserve stands at
Rs.15000 and bad debts to be adjusted is Rs4000 and new reserve to be maintained is Rs18000.
The amount to be charged against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The
formula can also be shown as
N - O + B = 18000 – 15000 + 4000 = 7000

1. What is the difference between Bad debts and doubtful debts?
2. Provision is made for Debts which have become bad (state True / False ).
3. Provision for Doubtful debts is a change against the profits of the firm (state True / False )
4. Bad debts incurred in the subsequent period are written off against reserve for bad debts
(state True / False ).
5. What is the entry for writing off of bad debts against RBD?
6. If RBD is fresly to be provided, what entry can be draw?
7. RBD is calculated on debtors which are good and so any bad debts out side trial balance
should be deducted out of total debtors (state True / False ).
Illustration:
On 1st January 2006, the RBD account stood at Rs.9000 in the books of a merchant. The bad
debts written off during the year ended 31st December, 2006 amounted to Rs.4800 and Sundry
Debtors stood at Rs.480000. It was desired to maintain the reserve for bad debts at 5% on
Debtors. During the year 2007 bad debts written off amounted to Rs.12000 and sundry debtors
on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was required. Show the
journal entries for recording the above transactions and write up the bad debts reserve account.

Solution
Journal Entries
Debit Credit
Date Particulars LF
Rs. Rs.
2006 Bad debts account Dr 4800
st 4800
Dec, 31 To Sundry Debtors Account
(Being the bad debts written off)
Dec, 31st Bad Debts Reserve account Dr 4800

4800
To Bad Debts account
(Being bad debts set off against RBD)
st
Dec 31 Profit and Loss Account Dr 19800
19800
To Bad Debts Reserve account
(Being additional RBD made to bring the
reserve to 5% of 480000)
Bad debts account Dr 12000
12000
2007 To Sundry Debtors account
Dec, 31st (Being bad debts written off )
Bad debts Reserve account Dr 12000
st 12000
Dec 31 To bad debts account
(Being bad debts written off against RBD)
Profit and loss Account Dr
7000
To Bad debts reserve account 7000
Dec 31st
(Being additional RBD made to bring the
reserve to 5% of 380000)
NOTE:
On January 1st 2006, the RBD account stands at Rs9000 and during the year the actual bad
debts are Rs4800 and so there is unused balance of Rs.4200 (9000 -4800). It is desirable to
have reserve of 5% of 480000 – Rs24000. Therefore additional reserve required to be provided in
P & L A/C is Rs19800 (24000 – 4200).
Similarly during 2007 the actual bad debts are Rs.12000 and the available reserve is used for
writing it off. Still there is a balance left over is Rs.12000 (24000 – 12000). The additional reserve
to be maintained is 5% of 380000, that comes to Rs19000. So the additional amount to be
provided in P & L A/C in 2007 is Rs.7000 (19000 – 12000).

Reserve for Bad Debts Account
Dr Cr
Amount Amount
Date Particulars JF Date Particulars JF
Rs. Rs.
2006 2006
st
Dec, 31 To bad debts 4800 Jan, 1st By Balance b/d 9000
To balance c/d 24000 Dec 31st By P&L A/C 19800
Total 28800 Total 28800
2007 2007 By balance b/d 24000
st
Dec,31st To bad debts 12000 Jan 1
7.2.8 Reserve for Discount on debtors:

There are two types of discounts allowed to customers in a business. One is trade discount and
another is cash discount. Trade discount is given to customers to retain the customers and it is
shown in the invoice itself. It means that trade discount does not come to accounting records at
all. But cash discount is allowed to customers to encourage them to pay cash promptly at the
earliest. Normally cash discount gets recorded in cash account. Out of experience, a
businessman can guess how much of cash discount he may have to give on customer’s
accounts. Cash discount given to debtors is always a loss and is shown as expenditure in the
Profit and Loss Account. After anticipating the amount of cash discount allowable, a provision is
made in the current year itself. In the subsequent years, the actual discount allowed is set off
against the provision for discount on debtors. Every year, the amount of provision for discount on
debtors is deducted from the profits. The entry for making the provision is
Profit and Loss Account Dr
To Provision for discount on debtors account
Just as in the case of provision for bad and doubtful debts, the bad debts are first written off
against provision for bad debts and later the required amount of provision is provided in the P&L
A/c, similar procedure takes place in the case of provision for discount on debtors. The following
guide lines may be kept in mind while dealing with the reserve for discount on debtors
1. If a reserve for discount on debtors is not existing and cash discount is allowed, then transfer
the discount to P&L account.
2. Any fresh reserve for discount on debtors is to be made, debit the P&L A ccount with the
amount of reserve.

3. If provision for discount on debtors exists at the time of providing discount, then write off the
discount from the provision already made for the purpose.
4. New provision should then be calculated and only as much as required to bring the existing
provision to the new figure should be debited to P&L Account.
5. If the new provision required is lower than the provision already existing (old), then the
difference shows profit and transfer the same to P&L Account.

1. what is the aim of giving cash discount ?
2. If discount is allowed against receivables, what entry do you draw in journal proper?
3. Provision for Discount on debtors is a charge against P & L a/c. (state True / False).
4. Provision for discount on debtors appears as a liablility in the balance sheet ( state True /
False )
5. What is the basis for calculating provision for discount an debtors?
Illustration
The following items are found in the trial balance of Praksh on 31st December 2000.
Sundry Debtors Rs. 160000
Bad Debts written off 9000
Discount allowed to Debtors 1800
Reserve for Bad and doubtful Debts 31-12-1999 16500
Reserve for discount on Debtors 31-12-1999 3200
You are required to provide for the bad and doubtful debts at 5% and for discount on debtors at
2%. Give necessary journal entries and show bad debts account, bad debts reserve account,
discount account and provision for discount on debtors account.
Solution
Debit Credit
Date Particulars LF
Rs. Rs.
2000 Dec, RBD account Dr
31st To Bad Debts account 9000
(Being bad debts written off against existing RBD) 9000
P & L Account Dr
To RBD account
Dec 31st
(Being addition to RBD to make the new RBD
500
equal to 5% of 160000)

500
Reserve for discount on debtors account Dr
To Discount on Drs A/c
Dec 31 st
(Being discount on debtors written off against 1800 1800
Reserve for discount on Debtors)
P & L Account Dr
To Reserve for discount
On debtors account
Dec 31st ( Being additional reserve made to make the new
reserve for discount on debtors to 2% of 152000) 1640
1640
NOTE:
1. The amount debited to P&L Account towards RBD is computed as follows
Old RBD = Rs. 16500
Less Bad debts = 9000
Balance = 7500
New RBD @5% on160000 = 8000
RBD to be provided = 500 (8000-7500)
2. The amount debited to P&L Account towards Reserve for Discount on Debtors is computed
as follows:
Good Debtors = 160000 – 8000 (New RBD)=152000
Old Res for Dis On Drs = Rs. 3200
Less Discount on Drs = 1800
Balance Reserve = 1400
New Res for Disc at 2%
On good drs 152000 = 3040
Res for Discount to be
Provided now = 1640 (3040 -1400)
Bad Debts Account

Dr Cr
Amount Amount
Rs. Rs.
2000 2000
st
Dec, 31 To Sundry debtors Dec 31st By RBD account
account 9000 9000

Reserve for Bad Debts Account

Dr Cr
Date Particulars JF Amount Date Particulars JF Amount
Rs. Rs.
2000 2000
st
Dec, 31 To bad debts 9000 Jan, 1st By Balance b/d 16500
Discount on Debtors Account

Dr Cr
Amount Amount
Rs. Rs.
2000 2000
st
Dec, 31 To Sundry Dec 31st By Reserve for Discount
debtors account 1800 on Debtors A/C 1800
Reserve for Discount on Debtors Account

Dr Cr
Amount Amount
Rs. Rs.
2000 2000
Dec, 31st To Discount on Debtors 1800 Jan, 1st By Balance b/d 3200
In the balance sheet, the Sundry debtors are reduced by bad debts shown out side the trial
balance, the new RBD, discount on debtors shown out side the trial balance and the new
Reserve for discount on debtors.
7.2.9 Reserve for discount on creditors

Just as reserve is for discount on debtors is created, reserve for discount on creditors is also
created. Businessman expects that he would receive discounts from suppliers (creditors), when
the businessman remits cash to them. Anticipating some percentage of creditors being received
as discount in the coming year, the business proprietor makes a provision for the expected
income in the current year itself. Discount on creditors is an income and therefore reserve for

discount on creditors is debited and profit and loss account is credited to show it as anticipated
profit. In the subsequent year, when discount on creditors is actually received, it is first set of
against provision for discount on creditors and the difference between the new provision for
discount on creditors and the balance of old provision left over is carried to P&L Account.
Discount on creditors is income and to that extent the creditors due is reduced. So the journal
entry to record them is
Creditor’s account Dr
To discount on creditors account
Later if the discount received is adjusted against reserve for discount on creditors, the entry will
be
Discount on creditor’s account Dr
To Reserve for discount on creditors
When provision for discount on creditors is made in P&L Account, the entry will be
Reserve for discount on creditors account Dr
To Profit and loss account
The amount of provision for discount on creditors is calculated at a percentage on creditors. In

the balance sheet, creditors are shown after deducting reserve for discount on creditors.

1. Discount on creditors is an item of income (state True / false ).
2. Provision for discount on creditors is shown as an anticipated income (State True/False ).
3. How do you treat provision for discount an creditors in balance sheet ?
4. Discount received from creditors subsequently is changed against provision for discount on
creditors. (state True / False ).
7.2.10 Closing stock

Stock of goods – raw materials, semi finished goods, finished goods – at the end of the
accounting year should be considered for preparing trading account and balance sheet. It is an
internal adjustment. Closing stock is normally valued at cost or market price which ever is lower,
even though there are several other methods to value stock. Closing stock does not appear in the
trial balance because the value of it is ascertained only after the preparation of trial balance. To
bring to the records, a journal entry is passed in journal proper by debiting closing stock account
and crediting trading account. In the balance sheet, closing stock appears as an asset.


6. what is the popular valuation method of closing stock ?
7. what is the entry for adjusting the closing stock ?
8. what does happen in case closing stock is not considered for computing gross profit ?
9. Closing stock always appears as an asset in balance sheet. (state True / false).
7.3 Trading Account

Trading account shows gross profit or gross loss arising out of trading activities. Trade means
buying and selling. The account mainly focuses on finding the result of goods bought and goods
sold. Interestingly, goods are bought for a cost and the proprietor incurs a few items of purchase
expenses and the goods are sold at a price higher or lower than the cost incurred. At the end of
accounting period, some stock is left over and it should be valued so as to calculate the profit or
loss from the cost of goods sold. Therefore, opening stock of goods, cost of purchases made,
expenses on purchases are taken on debit side of the trading account. On the credit side of the
account, the sales of goods and the value of closing stock are shown. The excess of credit over
debit is gross profit and vice versa. The gross profit or gross loss is transferred to Profit and Loss
Account. The format of a Trading Account is given below:
Dr Trading Account for the year ending- - - - Cr

Particulars Rs. Particulars Rs.
To opening stock By sales
To Purchases Less returns inwards/sales returns
Less Purchase returns/returns outwards By Closing stock
To Carriage inwards
To freight and octroi
To wages
Add outstanding wages
Less prepaid wages
To fuel and power
To Gas, coal, electricity for production
To Import duty and clearing charges
To stores consumed
To factory rent, insurance, factory expenses
To other direct expenses
To Royalty paid
To Profit and Loss A/c (Gross Profit)
Note: For every expenditure, outstanding and prepaid aspects must be considered.

From the above account, it is easy to learn the transferring entries made to close the accounts of
expenses and incomes. The transferring entries are
1. Trading account Dr
To opening stock a/c
To purchases a/c/
To Wages a/c
To Royalty paid a/c etc
(Being all expenses of trading transferred to trading account)
2. Sales account Dr
Closing stock account Dr
To Trading account
(Being sales and closing stock transferred to trading account)
3. Trading account Dr
To Profit and Loss Account
(Being gross profit carried forward to P&L A/C)
4. Profit and Loss Account Dr

To Trading account
(Being gross loss transferred to P&L Account)

1. Trading account is an account showing profit on cost of goods sold.( state True / False).
2. Cost of goods sold include opening stock + Purchase expenses – closing stock. (state True/
False ).
3. Gross profit is ______minus cost of goods sold.
4. Gross profit or loss is transferred to ___________ account.
7.4 Preparation of Trading Account
To prepare Trading Account, the following steps may be followed:

a) Identify the items of expenses relating to trading and show them on the debit side of Trading
Account.
b) Effect the adjustments such as outstanding or prepaid to the relevant items of expenses
c) Show the sales less returns and closing stock on the credit side of trading account

d) The difference is gross profit if credit total is more than debit and gross loss if debit total is
more than credit.
e) Transfer the gross profit or gross los to Profit and Loss Account as the case may be.

1. Do you consider gross purchases or net purchases while preparing trading account ?
2. Do trading concerns prepare manufacturing account ?
Illustration
From the following balances extracted from Trial balance, prepare Trading Account. The closing
stock at the end of the period is Rs56000
Amount in
Particulars
Rs.
Stock on 1-1-2004 70700
Returns inwards 2000
Returns outwards 3000
Purchases 102000
Debtors 56000
Creditors 45000
Carriage inwards 5000
Carriage outwards 4000
Import duty on materials received from abroad 6000
Clearing charges 7000
Rent of business shop 12000
Royalty paid to extract materials 10000
Fire insurance on stock 2000
Wages paid to workers 8000
Office salaries 10000
Cash discount 1000
Gas, electricity and water 4000
Sales 250000

Dr TRADING ACCOUNT FOR THE YEAR ENDING - - - - Cr
Particulars Rs Particulars Rs
70700
To stock on 1-1-2004 By sales 250000
To Purchases 102000 Less Returns
247000
Less Returns Inwards 3000
99000 56000
Outwards 3000 By Closing stock
5000
To Carriage inwards
6000
To import duty
7000
To Clearing charges
10000
To Royalty
2000
To Fire Insurance
8000
To Wages
4000
To Gas, electricity, water
91300
To P & L Account (GP)
303000 303000
7.5 Profit and Loss Account

Profit and los account is an important final account in the sense that the net result of the business
in the form of net profit or net loss is disclosed by preparing the same. All business expenses like
administrative expenses, office expenses, selling and distribution expenses are shown on the
debit side of the account. Besides, all provisions made for different purposes such as reserve for
bad debts, reserve for discount on debtors, reserve for repairs, depreciation etc., also picture on
the debit side of the account. On the credit side of the account, all incomes of revenue in nature,
reserve for discount on creditors and gross profit carried from trading account are mentioned.
In this connection, it is important to note that Trading and Profit and Loss Account are regarded
as revenue accounts. Any capital receipts or capital payments are not considered while preparing
them. In brief, revenue receipts are those which are received regularly arising out of day to day
activities of the business and similarly revenue payments, which are known as expenses are
incurred regularly and for every day functions of the business. Capital receipts are in the form of

sources of funds such as capital received, sale of capital asset like building etc., Capital
payments are those spent for acquisition of capital assets, incurring capital expenditure etc.,
The transferring entries are drawn to prepare Profit and loss account. They are

To all expenses account To Transfer all expenses
2. All Incomes account Dr

To Profit and Loss Account To Transfer all incomes

To Capital account To Transfer Net Profit to Capital
4. Capital account Dr
To Profit and Loss Account To Transfer Net loss to Capital
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING ---
Dr Cr
To Trading Account (GL) By Trading account (GP)
To Salaries + Out standing By Interest earned +
–Prepaid salaries as per Accrued interest as per
adjustments adjustments
To Rent of the premises By Commission earned
To Travelling expenses By discount earned
To Rates and Taxes By Rent received
To Printing and stationery By Bad debts recovered
To Postage and Telegram By Interest on drawings
To Telephone charges By Reserve for discount on
To Insurance –Prepaid Creditors
amount as per adjustment By Dividends received
To Interest paid By Royalty Received
To Discount allowed By Capital Account( Net
To Sundry expenses Loss)
To Advertisement

To Commission
To Carriage outwards
To Bad Debts
To Reserve for Bad debts
To Reserve for discount on
Debtors
To Depreciation
To Legal charges
To Audit fee
To Interest on Capital
To Capital Account (Net
Profit)
7.6 Preparation of Profit and Loss Account

The following steps may help to prepare Profit and Loss Account
1. Identify the expenses and bring them to debit side of P&L Account
2. Identify the revenue incomes and put them on the credit side of P&L Account
3. Check whether all adjustments like outstanding, prepaid, pre received expenses and incomes
as the case may be are brought to the account
4. Check the transfer of reserves to the relevant sides of the account
5. Transfer the net profit / net loss to the capital account

1. What types of expenses are shown on the debit side of P & L account ?
2. P & L account is revenue account showing the revenue net profit or loss for the accounting
period(state True / False ).
3. Painting for a new building, Installation expenses paid to install a plant, amount spent for
advertising for promotion of sale of a product are revenue expenses (state True / False ).
4. Net profit / loss is carried to owners equity / capital (state True / False )

Illustration
The following Trial Balance is extracted from the books of a merchant on 31-12-2004.
Rs
Particulars
Furniture and fittings 640
Motor Vehicles 6250
Buildings 7500
Capital Account 12500
Bad Debts 125
Provision for Bad debts 200
Sundry Debtors 3800
Sundry Creditors 2500
Stock on 1-1-2004 3460
Purchases 5475
Sales 15450
Bank Over Draft 2850
Sales Returns 200
Purchase Returns 125
Advertising 450
Interest on Bank Over Draft 118
Commission 375
Cash 650
Taxes and Insurance 1250
General Expenses 782
3300
Salaries
The following adjustments are to be made.

1. Stock in hand on 31-12-2004 was Rs3250
2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and Motor Vehicles @
20%.
3. Rs.85 is due for interest on bank overdraft.
4. Salaries of Rs300 and taxes Rs.120 are outstanding.
5. Insurance amounting to Rs.100 is prepaid
6. One-third of the commission received is in respect of work to be done next year

7. Write off a further sum of Rs.100 as bad debts and provision for bad and doubtful debts to be
made equal to 10% on sundry debtors.
8. Prepare Trading Account and Profit and Loss Account.
9. Dr Trading Account for the year ending 31-12-2004 Cr
To Stock on1-1-2004 3460 By Sales 15450

15250
To Purchases 5475 Les Returns 200
3250
Less returns 125 5350 By Closing Stock
To P & L A/C (GP) 9690
Profit and Loss Account for the year ending 31-12-2004
Dr Cr
To Salaries 3300 By Trading Account (GP)
Add Outstanding 300 3600 By Commission 375 9690
To Advertising 450 Less Pre-received 125
To Interest on OD 118 250
Add Outstanding Int 85 203
To Taxes and Insurance 1250
Add Out standing tax 120
1370
Less Prepaid Insurance 100 1270
To General expenses 782
To bad debts 125
To RBD(New) 370
Less old RBD balance 100 270
To Depreciation:
On Bldgs @ 5% 375
On FF @ 10% 64
On M Vehicles @20% 1250 1689
To Capital Account (NP) 1551

Note:
Sundry Debtors are Rs.3800 and there have been bad debts outside TB Rs100. The good
debtors are Rs.3700. The new RBD is 10% of 3700, i.e.Rs370. The old RBD unspent is Rs100
(200 -100). Therefore RBD to be charged against profit is Rs270
7.7 Balance Sheet

Balance Sheet is the sum and substance of financial performance a business undertaking. It
shows the assets and liabilities of business on a particular day. It is not an account but is a
statement of affairs. The statement of assets and liabilities is prepared, having two sides, left
side containing capital and liabilities and on the right side, containing assets and properties. Often
the statement is prepared vertically, mentioning sources of funds first and later application of
funds. Sources of funds indicate capital and liabilities and application of funds indicate assets.
Balance Sheet is prepared from Trial Balance. In case of sole trader organization and Partnership
organization, the format of preparing Balance Sheet is arranged basing on liquidity of the assets.
In case of Companies, the Companies Act, 1956 has specified a definite pattern of preparing
Balance Sheet. Both the models of preparing Balance Sheet are stated here under.
BALANCE SHEET FOR THE YEAR ENDING 31-12-2003 OF Mr. X

Capital and Liabilities Rs Assets Rs
Sundry Creditors Cash in hand
Less Reserve for Discount on Cash at Bank
Creditors Land and Building
Add Additions if any
Bills Payable Less depreciation
Plant and Machinery less
Bank Over Draft depreciation
Furniture and Fixtures less
Loans Borrowed depreciation
Sundry debtors
Outstanding Expenses Less Bad debts out side Trial
Balance
Pre-received Incomes Less Reserve for Bad Debts
Less Reserve for discount on
Capital (Opening) Debtors
Add Additions to capital Bills Receivable
Add interest on capital if any Loans and advances given to others
Add Net profit as per P&L a/c + Interest outstanding
Less personal drawings Investments + outstanding income
Less Net loss as per P&L A/C on investments
Other outstanding incomes
Pre-paid expenses
Closing stock
Total Total

The Format of Balance Sheet of a Company

Capital: Fixed Assets:
Authorised, Issued, Goodwill, Land
Subscribed,Called up, Buildings,Furniture, Fixtures,
Paid-Up capital with Equipment, Plant, Machinery,
adjustments Copy Rights, Patents
Reserves and Surplus Investments
Loans and Borrowings Loans and Advances
Long Term Loans Current Assets:
Short Term Loans Debtors, B/R, Inventory,
Current Liabilities: Cash, Bank, Outstanding
Sundry Creditors, B/P, incomes, Prepaid expenses
Outstanding expenses, pre- etc
received incomes, dividends
payable, etc.,
Total Total

1. The two sides of a balance sheets are ____ and ___________.
2. balance sheet is prepared on the bases of trial balance. (state True / False ).
3. balance sheet portrays the financial soundness of a concern (state True / False).
7.8 Preparation of Balance Sheet:

A few guide lines are given here under to prepare balance Sheet of a business concern. Balance
Sheet is not an account and there is nothing like debit side and credit side. If Trial Balance tallies,
naturally Balance Sheet also tallies:
1. Identify all assets from the trial balance. Assets are shown on the debit side of T.B
2. Identify all liabilities from the Trial Balance and they are on the credit side of TB.
3. Make a mark of items with respect to which adjustments are given out side the TB
4. All adjustments should find place in two places, one either in Trading account or in Profit and
Loss Account and another invariably Balance Sheet. For example, closing Stock given
outside TB is first shown on the credit side of Trading Account and it is shown as an asset in

the Balance Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and later
shown as a deduction from Sundry Debtors in the Balance Sheet. Similarly depreciation is
charged against profits first and later deducted from the book value of concerned asset in the
balance sheet.
Illustration 1
From the Trial Balance given in para 6, prepare Balance Sheet of the merchant as on 31-12-
2004.
Solution
Balance Sheet as on 31-12-2004

Sundry Creditors 2500 Cash 650
Bank Over Draft 2850 Building 7500
Add interest due 85 2935 Less Depreciation 375 7125
Commission received in Furniture and Fixtures 640
advance 125 Less Depreciation 64 576
Outstanding Taxes 120 Motor Vehicle 6250
Outstanding Salaries 300 Less Depreciation 1250 5000
Capital 12500 Sundry Debtors 3800
Add Net Profit 1551 14051 Less bad debts as per
Adjustments 100
Balance 3700
Less Reserve for Bad
Debts(New) 370 3330
Closing Stock 3250
Pre-Paid Insurance 100
NOTE: Every adjustment given outside Trial Balance finds place in two accounts –Trading
account / Profit and Loss Account and invariably in Balance Sheet.


1. What is the purpose of creating Reserve for Bad debts?
2. State the purpose of creating reserve for discount on creditors.
3. Insurance paid on 1-1-2000 up to 31-12-2000 Rs.4800. If the books are closed on 31-7-2000,
what is the amount of prepaid insurance?
4. Select the most appropriate answer.
i) Sales are equal to a) Cost of goods sold + Profit b) Cost of goods Sold – Gross
Profit c) Gross Profit – Cost of Goods sold
ii) Interest on Drawings is a) Expenditure for the business b) Expense for the business
c) Gain for the business
iii) Goods given as samples should be credited to a) Advertisement account
b) Sales account c) Purchases account
iv) Out standing salaries are shown as a) an expense b) a liability c) an asset
v) Income tax paid by a sole trader on his business income should be
a) debited to the Trading Account b) debited to P&L Account c) deducted from
capital account in the Balance Sheet
5. Stock at the end, if appears in the Trial Balance is taken only to the Balance Sheet – Yes or
No?
6. Goods taken by the proprietor for personal use are credited to sales account – Yes or No?
7. Salary paid in advance is not an expense because it neither reduces assets nor increases
liabilities. – Yes or No?
8. Balance Sheet is an account because it is included in the scope of final accounts – Yes or No
Terminal Questions.
1. In taking out a Trial Balance, a Book keeper finds that debit total exceeds the credit total by
Rs.611. The amount is placed to the credit of a newly opened Suspense Account.
Subsequently the following mistakes were discovered. You are required to pass the
necessary entries for rectifying the mistakes, and show how Suspense account.
(a) Sales day book was over cast by Rs.1000
(b) A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna
(c) General expenses Rs.180 were posted as 801
(d) Cash received from Bhatt was debited to his account RS.450
(e) While carrying forward the total from one page of the Purchases book to the next, the
amount of Rs.1235 was entered as Rs.1325.

2. Rectify the following errors:

(i) Furniture purchases for Rs.2500 was debited to Purchases account
(ii) A sum of Rs.500 paid to Lalitha was debited to Shantha
(iii) A bill receivable for Rs.1000 received from Kumar has been omitted to be entered.
(iv) Goods worth Rs2040 taken away by the proprietor were debited to Bharath
(v) An engine purchased for Rs.12500 had been posted to Purchases account
3. An accountant could not tally the Trial Balance. The difference was temporarily transferred to
Suspense account for preparing the final accounts. The following errors were later
discovered.
(a) The sales book was under cast by Rs.500
(b) Entertainment expenses Rs.950 though entered in the cash book were omitted to be
posted in the ledger.
(c) Discount column of the receipt side of cash book was wrongly added as Rs114 instead of
Rs.144.
(d) Commission of Rs.250 paid, was posted twice, once to discount account and once to
Commission account.
(e) A sale of Rs.169 to Rama Murthy though correctly entered in sales book, was posted
wrongly to his account as Rs.196.
(f) A purchase from Neeraj of Rs.290 though correctly entered in purchases book was
wrongly debited to his personal account.
You are required to
1. Pass the necessary rectifying entries
2. Prepare Suspense account
3. State the effect of each of the rectification on the profit.
What would be the correct profit originally arrived at was Rs.10000?
4. The trial balance of Raj Bahadur of Vijayanagaram as on 31-12-2005 is given below.Prepare

Trading Account, Profit and Loss Account and Balance Sheet for year ending 31-12-2005
after taking into consideration the following adjustments.
(a) Stock on 31-12-2005 was 15000
(b) Debts worth Rs.2000 should be written off as bad
(c) Depreciate Machinery by 5% and Motor Van by 15%
(d) Reserve for bad and doubtful debts should be increased by Rs.600
(e) Commission accrued and not received Rs.500

(f) Goods worthRs.500 were used by the proprietor for his personal use
(g) On September,2005, a fire broke out in the shop and goods worth Rs.2000 were
completely destroyed. The insurance company accepted a claim of Rs.1500 only and paid
the amount on January 1st 2006.
TRIAL BALANCE AS ON 31-12-2005

Particulars Debit in Rs Credit in Rs
Capital 85000
Drawings 7500
Opening Stock 12000
Purchases and Sales 86000 170000
Returns 2000 1000
Discounts 500 700
Commission 1000
Income Tax paid 700
Office Salaries 17300
Advertising 2000
Sundry Debtors and creditors 1700
Reserve for Doubtful Debts 85000 30000
Manufacturing Wages 8600 3000
Bills Receivable and Payable 5000
Carriage 600 5000
Machinery 40000
Motor Vans 7000
Land and Buildings 10000
Office Expenses 1500
Cash at Bank 6000
Cash in Hand 2300
295700 295700
Ans: Gross Profit Rs.79300; Net Profit: 52350; BS163650

5. On 31st December,2003 the following trial balance has been extracted.
Rs Rs
Drawings 4000 Establishment 9100
Sundry Debtors 20500 Rent, rates and insurance 5000
Interest on loan 300 Advertisement 4160
Cash in hand 4000 Credit Balances
Stock (1-1-2003) 6050 Capital account 50000
Motor Vehicles 10000 Sundry creditors 12000
Cash at Bank 5600 Loan on mortgage 15700
Land and buildings 62000 Bad debts Provision 2000
Purchases 97500 Sales 170000
Salaries 8600 Purchase returns 1460
Carriage in 4100 Discounts 500
Carriage out 2200 Bills payable 3000
General Expenses 5100 Rent received 600
Bills receivable 7050
Adjustments
1. Depreciate land and buildings at 5% and Motor Vehicles at 15%
2. Interest on loan is at 5% taken on 1st January,2003
3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due.
4. There has been a fire on 1st January, 2003 destroying goods worth Rs.200
5. The bad debts provision is to be brought up to 5% on Sundry debtors
6. The stock in hand on 31-12-2003 was valued at Rs16000
7. Goods costing Rs.1000 were taken away by the proprietor for his personal use, but no entry
has been made in the books of accounts
8. Prepaid insurance amounted to Rs.500
9. Provide for Manager’s commission at 5% on net profit after charging such commission.
Prepare Trading & P&L a/c and balance sheet.

6. A firm had the following Balances on 1st January 2000

(a) Provision for bad debts Rs7500
(b) Provision for discount on debtors 3600
(c) Provision for discount on creditors 3000
During the year Bad debts amounted to Rs.6000, Discounts allowed were Rs300 and
discounts received were Rs.600. During 2001, bad debts amounted to Rs.5000 and discounts
allowed and received were respectively Rs.6000 and Rs1500.
Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off of bad debts, but
after allowing discounts. On December 31st, 2000, the amount of debtors was Rs.57000 after
writing off the bad debts but before allowing discounts. Total creditors on these two dates
were Rs.60000 and Rs.75000 respectively.
It is the firm’s policy to maintain a provision of 5% against bad and doubtful debts and 3 % for
discount on debtors and a provision of 3% for discount on creditors.
Show the accounts relating to provision on Debtors and provision on creditors for the year
2000 and 2001 (Ans: Provision for bad debts-2000 Rs.6900 and 2001 Rs.2850; Provision for
discount on debtors – 2000 Rs.3933, 2001 Rs.1530; Provision for discount on creditors –
2000 Rs.1800, 2001 Rs2250)
7. In a business, Sundry debtors were Rs.40000 at the beginning of the year and there was 5%
Reserve for Doubtful Debts and also 5%Rreserve for Discount on Debtors. During the year
the actual bad debts amounted to Rs.1600 and the discount allowed were Rs.1700. At the
close of the year, the debtors were Rs.50000; and the percentage of the two reserves have to
be maintained as at beginning. Show ledger accounts.
Answer for Self Assessment Questions.

1. True
2. False
3. True.
4. True
5. Internal transactions
6. profit / loss for the accounting period
7. Time.


1. Outstanding expenses
2. Salaries account Dr To outstanding expenses account
3. It means t hat they are already considered.
4. False.

1. Prepaid expenses
2. True
3. 1000 + 5600 – 800 = 5800
4. True.

1. Accrued or outstanding income
2. True
3. True

1. True
2. Rent account Dr
To Income received in advance account
3. Deducted.

1. Wear & tear / usage
2. Depreciation a/c Dr
To asset account
3. P & L a/c Dr
To Depreciation a/c
4. It means that the concerned asset is get to be depreciated
5. Diminishing(Reducing) balance method.
6. It indicates that the asset is already depreciated and depreciation should be transferred only
to P & L a/c.


1. Bad debts
2. True
3. Bad debts a/c Dr
To Debtor a/c
4. P & L a/c Dr
To Bad debts a/c
5. Profits are reduced.
6. Cash a/c Dr.
To Bad-debts recovered a/c.

1. Bad debts are totally not recoverable, doubtful debts may be recovered.
2. False
3. True
4. True
5. R.B.D a/c Dr
To bad debts account.
6. P & L a/c Dr
To R BD a/c
7. True

1. To encourage customers to make quisk & prompt payment.
2. Cash discount a/c Dr
To Debtors a/c
3. True
4. True
5. Good debtors (Meaning total debtors- Bad debts outside trial balance-RBD )

1. True
2. True
3. Deduct the provision from the amount of creditors
4. True.


1. Cost on market price which ever is lower
2. Closing stock is debited and trading account is credited
3. Gross profit is reduced by not considering unsold stock
4. True.

1. True
2. True
3. Sales
4. P & L

1. Net purchases meaning (Total purchases – purchase returns – stock destroyed – stock used
for personal use ).
2. No, because they do not manufacture any product.

1. Indirect expenses office & administrative expenses, selling & distribution expenses etc.
2. True
3. False
4. True

1. Assets, liablities
2. True
3. True

1. To write off bad debts against the reserve and reduce the pressure on cuurent profits.
2. to provide for anticipated profits.
3. Rs 2000 relating to 5 months ( 1.8.2000 to 31.12.2000)
4. i) a ii) c iii) c iv) b v) c
5. Yes

6. No
7. Yes
8. No
Answer for Terminal Question:

1. Refer to unit 6.10.
4. Refer to unit 7.4, 7.6, 7.8.
Ans: Gross profit Rs 79300, Net profit Rs 52350
Balance sheet Rs 163650.
5. Refer to unit 7.4, 7.6 & 7.8
Gross Profit Rs 81010; Net Profit Rs 40706; Commission Rs 2034;
Balance Sheet Total Rs 1,20,025
6. Refer to unit 7.2.7, 7.2.8, 7.2.9

Answer : Provision for Bad debts 2000 – Rs 6900 ; 2001 – Rs 2850.
Provision for discount on debtors 2000 – Rs 3933; 2001- Rs 1530
Provision for discount on creditors 2000 – Rs 1800; 2001 – Rs 2,250.
7. Refer to unit 7.2.7, 7.2.8
Closing Balance of RBD Rs 2,500
Closing Balance of Reserve for Discount on Debtors Rs 2,375.
RBD Transferred to P & L account Rs 2,100
Reserve for Discount Transferred to P & L account Rs 2,175

Unit 8 Introduction to Management Accounting
Structure:
8.1 Introduction
Objectives
8.2 Decision Making
8.3 Meaning and scope
8.4 Cost analysis
8.5 Budgetary control
8.6 Standard costing
8.7 Financial analysis
8.8 Relevant cost
8.9 Management accounting framework
8.10 Function of management accounting
8.11 Special features
8.12 Merits and Demerits
8.13 Distinction between M.A and F.A
Terminal Questions
8.1 Introduction
Management accounting is an accounting service to the management. It assists the managers in
the formulation of policy, taking a decision, control of execution. It focuses in increasing the
managerial efficiency. Hence management accounting is also called as “Accounting for
Management”.
1. Spell out the meaning, scope, functions, special features, role of Management accounting,
2. Expose the cost analysis,
3. Appreciate the budgetary control,
4. Deal with standard costing,
5. Recognize the merits and demerits of management accounting,
6. Identify the differences between management accounting and financial accounting,
7. Perform some basic financial analysis.
8.2 Decision Making as a Nucleus of Management
Decisionmaking in any business organization( individuals or groups of individuals) is primarily a
function of management. Decisions are normally taken under uncertainty. Decision under trial
and error or intuition will not end in good results. Scientific decision need to be made from time to
time. For this, the management has to rely on the information supplied by professionals and
specialized agencies. One of the important components in information collection is in the field of
internal financial information. Accounting acts as a basis upon which crucial decisions can be
made. The financial statements prepared in its traditional form may not convey the required
information for taking decisions. The financial information need to be finetuned for use by the
busy management. This function is being performed by the management accounting.
1. Decision making is a painful game (True or false).
2. Decision based on trial and error method bring in good results (true/false).
3. Decisions are normally based on financial statements (true or false) .
4. Financial information need to be ________ For use by management.
8.3 Meaning And Scope
Management accounting is an accounting service to the management. It covers all those services
by which the accounting department can assist the managers in the formulation of policy, taking a
decision, the control of its execution and the appreciation of effectiveness.
As regards the scope of management accounting, it is very wide. It is based on historical
financial data. It is concerned with future. It uses the information available from different walks of
life like Political Science, Statistics, Mathematics, Economics, Cost Accounting and Financial
Accounting. The main purpose of management accounting is to utilize information in solving the
business problems and taking scientific decisions. Hence, it is difficult to pinpoint the exact scope.
The Management Accountant seek to support management decision making by the provision of
information and the analysis of financial performance. As the data is required for internal
purposes, the management accountant is not constrained by the need to comply with regulations
of the format for presentations. The main scope is :
1. To identify and calculate costs of production. This is known as Cost Accounting
2. To provide estimates for future expenses and revenues. This is known as Budgeting
3. To identify inefficiencies within the organization
4. To control costs and manage the flow of cash
5. To seek opportunities e.g. to identify “tax breaks”, possible cost savings and movements in
foreign exchange rates which could be exploited by the organization.
The main management accounting techniques are:
1. Breakeven analysis
2. Costing
3. Budgeting
4. Ratio Analysis
5. Variance analysis
1. Function of accounting department is _______, ________, _______, ______ .
2. Main purpose of Management accounting is _______ and ______________ .
8.4 Cost Analysis
M.A take into account some of the concept of cost accounting technique. The cost analysis is an
important aspect. A management accountant has to face questions such as “what will our cost be
next year”. This deceptively simple boundary question.
Such question can occur in virtually every aspect of work and knowledge of the patterns of cost
behavior and ways that future cost can be predicted is fundamental requirement when concerns
with decision makers.
8.5 Budgetary Control
Modern business world is full of competition, uncertainty and exposed to different types of risks.
The complexity of managerial problems has led to development of various managerial tools,
techniques and procedures useful for the management in managing the business successfully. In
this direction, planning and control plays an important role. Budgeting is the most common and
powerful standard device of palling and control.
Budgetary control is a technique of managerial control through budgets.. A budget is a
quantitative expression of plan of action. . It is a predetermined detailed plan of action
developed as a guide for future operation. According to Wheldon “Budgetary control is the
planning in advance of the various functions of business so that the business as a whole can be
controlled”. Budgetary controls deals with planning, coordination, recording appraisal and follow
up of actions.
1. Budget is ____________ _________________ Plan of action
2. Budgetary controls deals with _______, ________, _______, _____, _____ .
8.6 Standard Costing and Variance Analysis
Businesses need to plan and budget for their future activities if their objecti are to be achieved.
Planning and budgeting are not enough. It is necessary to monitor progress against the planned
outcomes to establish significant differences and to permit corrective action to take place. This
means that performance must be regularly assessed, differences identified and plans revised..
Although the ultimate objectives may not change, the way in which they are to be achieved may
be very different and might make additional demands on resources than originally anticipated.
A standard is a specified quantity or money amount that has been estimated with reference to
past experience and the future expectations of efficiency levels, productivity and prices. Product
or service costs can be estimated by ascertaining amount of material if applicable, and direct
labour spent on each unit. This might be determined by observing what quantity of material is
used in a product and at which price it may be purchased. It will also involve estimating how long
a particular type of direct employees spend on various aspects of making the product or
providing the service and what the various wage rates are for each type of labour involved.
Therefore, the setting of these standards is a subjective process. The acceptable or desired
standards may vary from manager to subordinate, from individual to individual. Standard costing
makes the planning and budgeting easier and avoids the problem of completely reformulating
budgets every period. Standards also provide a controlling mechanism where behavior is
modified through motivation and appraisal. Standard costing allows management to locate
operational problems. Standard costing is best applied to manufacturing concerns where many
products are produced and their components numerous.
Deviation from standards is called variance. In budgeting language, a difference is known as
variance. Differences between budgeted and actual performance will be referred to as variances.
8.7 Financial Analysis
It is the process of determining the significant operating and financial characteristics of a firm from
accounting data. An organization has to deal with three areas viz. financial records and external
reports, accounting for management decisions and internal reports and finally financial
assessment and analysis. Financial statement analysis is therefore largely a study of relationship
among the various financial factors in a business . It is the process of selection, relation and
evaluation. The focus of financial analysis is on key figures in financial statements and the
significant relationship that exists between them. The technique of financial analysis is typically
devoted to evaluate the past, present and projected performance of a business firm. Financial
analysis is commonly called “the analysis and interpretation of financial statements”.
1. An organization has to deal with three areas _______, _______ and ______ .
2. Financial analysis is also known as _______________________________ .
8.8 Relevant Cost
Management decision is based on relevant costs. Costs incurred in the past is sunk cost.
Whether to replace a machine or a not is a decision not based on how much was invested to buy
that machine. This is based on comparative cash inflows from replacements and additional
investments necessary net of realization of the old asset. Thus, sunk costs are not relevant
costs.
Thus management accounting accumulates cost data but classifies them into relevant costs to
aid management decisionmaking. Discretionary costs are incurred at the discretion of the
management. A percentage of profit may be used for research and development. Unless
discretions are compulsions, these should not be treated as relevant costs.
1. Sunk cost is ________________________.
2. Sunk costs are not __________________ Costs.
3. A _______________________ is used for research and development.
8.9 Management Accounting Framework
For offering accounting and financial advice as well as for capitalizing the available opportunities
for future development, it is necessary that an effective development, it is necessary that an
effective frame must should be designed. The management accountant must organize the whose
accounting division in such a way that there is prompt and immediate recording of the entire
information flow into the department from functional and service department. The frame must
concentrate on.
· Getting rid of routine work
· Reporting actual and planned performance
· Fixing organizational responsibilities
· Application of new modern and modified practices of analyzing and interpreting results.
· Designing of sound and efficient organization taking into account the native and size of the
business unit.
8.10 Functions of Management Accounting
Management Accounting functions nay be said to include all activities with collecting, processing ,
interpreting and presenting information to management. More specifically, the functions are as
follows:
Forecasting and Planning: Short and long term forecasts are very essential. Planning the
future operations of a business is crucial. Necessary information and data for forecasting should
be provided from time to time. Various tools and techniques should be made use of.
Organizing: Organizing of finance and accounting functions is an important function of
management accounting.
Coordinating: Coordination increases the efficiency of an organization and maximizes its profits.
Controlling performance: The management accounting is very helpful in controlling the financial
performance of the organization through financial reporting, budgeting, financial analysis .
Communication: It is an important medium of communication. The management reporting
mechanism is a typical example of communicating the results to the superiors.
Other functions: Management accounting serves in a number of other ways. It supplies useful
information to different functional authorities. It provides accounting information and advice for
price determination and pricing decisions. It also helps in making certain strategic decisions,
decisions regarding seasonal or temporary suspension of production, make or buy decisions,
replacement decisions.
1. Management functions include ________, ________, ________, _________ .
2. Controlling performance is done through _______,__________,________ .
8.11 Special Features Of Management Accounting
Accounting principles are manmade. Unlike the principle of natural science, accounting
principles were not deducted from axioms, nor is their validity verifiable by observation and
experiment. They have been evolved as “ necessity is the mother of invention” Based on this the
special features are:
1. Selective in Nature : It is technique of selective nature. It picks up only those data which
are relevant for decision making.
2. Provides Data : The function is to provide data and not the decision. It can inform but it
cannot prescribe.
3. Future oriented: It helps in planning for the future decision and hence future oriented.
4. Cause and effect relationship : M.A studies the causes of profits or losses since the
profit and loss account does not tell the reasons for profit or losses. M.A analyses the
results of different variables on the profits and the profitability.
5. NonAdherence of rules : M.A does not follows set rules and formats like financial
accounting. The basic task is to motivate management action. Hence M.A is on the utility
of information and not on formats and legal presentation.
6. Economic Reality : Accounting data and information represents the economic activities
but M.A is used to guide future planning and decision making thereby representing the
underling economic realities in a clear and unambiguous manner.
7. Goal congruence : M.A normally encourages all employees to act in a fashion which
contributes to the overall objectives.
8. Information system : An organization comprises a number of information system or
networks. In other accounting system the information system are rarely integrated. But in
M.A these are designed in accordance with the principle of system theory to make it more
efficient.
9. Quantitative Techniques : Certain aspects of management accounting particularly in the
area of planning and decision making, statistical and operational research techniques are
used extensively, By use of it, a particular solution is being refined for cost effectiveness.
10. Uncertainty : Conditions of certainty are said to exist when a single point estimate can be
made which will be exactly archived. Conversely, Uncertainty exists where there are
various possible outcomes or results or values.
8.12 Merits and Demerits of Management Accounting
Merits
1. Efficient palling and effective organization which are the end product of the system of
management accounting bring systematic regularity in the business activities.
2. Maximum return on capital employed is ensured by the use of management accounting
because it helps in the functions of planning, coordination and control
3. Better and improved services by management to customers are assured by this system.
4. Management accounting removes unacceptable standards or substandards.
5. Industrial relations may be improved by adoption of management accounting principles.
6. Eliminations of various types of wastages, production defectives and other related work
deficiencies are removed with the help of management accounting.
7. Economic uplift of community and development of nation’s economy can be achieved by the
use of management accounting.
Demerits
1. Most of the information used in Management accounting are derived from financial accounting
records or cost accounting records other records. As such fairness and accuracy of decisions
deduced depends to a greater extent upon fairness and accuracy of these original records.
2. Decisions or conclusions derived are insignificant unless properly executed at all levels of
business operations.
3. Management accounting is a mere tool for management. It cannot substitute for
management.
4. The evolution has been on account of interalia development of new theories in other
sciences. Hence there is a need to have a comprehensive knowledge and understanding of
all these related disciplines to derive the full advantage.
5. Management accounting is still in its evolutionary stage. Hence, there is an uncertainty in its
use.
6. The installation of management accounting is a costly affair and as such it has very limited
scope for its use.
8.13 Distinction Between Management Accounting And Financial Accounting
Management accounting initially is said to emanate from financial accounting in the sense that
financial accounting in the beginning designed to supply information in the form of statements for
management use. In fact, both management accounting and financial accounting are
complementary in nature to each other. But they are distinguished in terms of kind and relative
importance of the problems involved
Area Financial Accounting Management Accounting

Objective Limited to the preparation Information is collected for internal
for external use communication and use.
Process Recoding of financial Data is collected for internal use
transactions
Nature It is objective It is Subjective
Flexibility It is rigid It is flexible
Data Emphasis on Past data It lays stress on future
Precision It is precise It is approximation
Legality It is a legal Document It is voluntary
Unitization It covers entire It is based on activity, Department,
organization Division
Audit Compulsory Voluntary
Publication Mandatory Voluntary
Terminal Questions
1. Briefly explain the merits and demerits of Management Accounting.
2. Distinguish between Management Accounting and Financial Accounting
3. Describe briefly the scope of Management Accounting.
4. Describe the functions of Management Accounting.
5. Define Standard Costing and Variance Analysis.
1. False
2. True
3. False
4. Finetuned
1. To prepare financial statements
2. Formulation of policy and taking decision.
3. Breakeven analysis, Costing, Budgeting, Ratio analysis, Variance analysis.
1. Most powerful.
2. Planning and appraisal
1. Financial ,external reports, Accounting.
2. Analysis and interpretation of financial statements
1. Past cost
2. Relevant.
3. Percentage of profit.
1. All functional Activities
2. Financial documents.
Unit 9 Financial Statement Analysis
Structure
9.1 Introduction
Objectives
9.2 Meaning of Ratio
9.3 Meaning of ratio analysis
9.4 Scope
9.5 Advantages
9.6 Classification
9.7 Liquidity
9.8 Solvency
9.9 Profitability
9.10 Activity
9.11 Leverage
9.12 Limitation
9.13 Computation
Terminal Questions
9.1 Introduction
“Every fact that is learned becomes a key to other facts” – E.Y. Youmans. Based on this, this
Unit deals with analysis of financial statements, the functions of which is to identify and highlight
the firm’s strengths and weaknesses. The objective of ratio analysis is to provide with the
financial information necessary to make financial decisions.
1. Understand the concept of ratio analysis and its role in comparative analysis
2. Explain the fundamental relationship between the gross profit ratio, the expenses to sales
ratio and the net profit margin ratio.
3. Define and calculate the three primary ratios which explain how well a business is utilizing
the resources to generate revenue and profit.
Ratio analysis can provide you with this information in three steps:
1. Calculate the firm’s ratios for the current or recent period . Ratios are calculated from the
firm’s income statement or balance sheet It is helpful and sometimes necessary to have the
financial statement independently audited.
2. Compare these ratios to those calculated in past records. The purpose of this
comparison is to identify tendencies in the firm’s ratios. This is known as trend analysis.
3. Compare the ratios to industry averages to show how the company compares to firms of the
same size in its industry. This process is known as Cross sectional analysis.
After completing the analysis, one can have a great deal of information on how the company is
doing both over a period of time and compared to other firms in its industry.
1. Ratios are calculated from _____________ Statement and _____________.
2. Identifying tendencies in the firm’s ratio is known as ___________ analysis.
3. Comparing firm’s ratio with industry ratios is known as __________ analysis.
4. Ratios enable a company to have _______________ data.
9.2 Meaning of Ratio
Absolute numbers tell very little. Assume that two companies A and B, operating within the same
industry supply the information:
Company
A B
NET PROFIT in Rs. 10,000 1,00,000
One can easily say that Company B makes the most profit. But which company is most
profitable? The answer for this will naturally call for further additional information relating to profit
such as size of the company, the total sales it generates or to how much capital is invested in it.
Hence, an assessment or a judgment is made based on making some sort of comparison.
Extending the example,
A B
Net Profit 10,000 1,00,000
Sales 2,00,000 5,00,000
Net worth (Capital and Reserves) 1,00,000 2,00,000
If net profit is compared with Sales, an assessment can be made on which company generates
the most net profit per Re.1 received from customers. Company A : Net Profit/ sales * 100 i.e. 5
percent and Company B it is 20 percent. If the net profit is expressed in terms of investments
made by the owners in each company, it is Net Profit / Net worth *100. For Company A, it is
10% and for it is 25%. It is also known as Return on Capital Employed. ROCE. Ratios are useful
in two ways:
1. To make interbusiness comparisons
2. To make comparisons across financial periods
A ratio is simply one number expressed in terms of another. It is a means of highlighting in
arithmetical terms the relationship between figures drawn from various financial statements.
Therefore, it refers to the numerical or quantitative relationship between two variables or items. A
ratio expresses simply in one number the result of comparison between two figures. It is
calculated by dividing one figure by the other. The quotient so obtained is the ratio of the figures.
Ratio can be expressed in the following three forms:
1. As proportion
2. As percentage
3. As turnover or rate
The Dictionary meaning of Analysis is “separation or breaking up of anything into its elements or
component parts”. Ratio Analysis is, therefore, a technique of analysis and interpretation of
financial statements. Ratio analysis is the process of establishing and interpreting various ratios
for helping in making certain decisions. It involves the methods of calculating and interpreting
financial ratios to assess the firm’s performance and status.
1. a) Ratios are useful to make ____________ and _________________.
2. Ratio is __________________________________________.
3. Ratio refers to ________________________________ relationship.
4. The answer for a division is known as _______________________.
5. Ratio can be expressed in three ways _________,_______,___________.
6. Ratio analysis is ____________________________________.
9.3 Meaning Of Ratio Analysis
The Dictionary meaning of Analysis is “ separation or breaking up of anything into its elements or
component parts”. Ratio analysis is therefore a technique of analysis and interpreting various
ratios for helping in making certain decisions. It involves the methods of calculating and
interpreting financial ratios to assess the firm’s performance and status
9.4 Scope
The ratio analysis is one of the most powerful tools of financial analysis. The firm is answerable
to the owners, the creditors and employees. The firm can reach a number of parties. On the
other hand, parties interested in the business can compute ratios based on the financial
statements of the firm. The analysis is not restricted to any one aspect but takes into account all
aspects such as earning capacity of the firm, financial obligation, liquidity and solvency aspects,
liquidity and profitability concepts.
1. Ratio analysis is power tool _______________________.
2. ratios are based on _______________________.
3. Ratio indicates ___________________________.
9.5 Advantages
The various advantages of ratio analysis are as follows:
a) Financial Forecasting and Planning
Ratio analysis helps in the financial forecasting and planning activities. Ratios based on the past
sales are useful in planning the financial position . Based on this, future trends are set.
b) Decision Making
Ratio analysis throws light on the degree of efficiency. It is also concerned with the management
and utilization of the assets. Thus, it enables for making strategic decisions.
c) Comparison
With the help of ratio analysis, ideal ratios can be composed. These can be used for comparison
in respect of the firm’s progress and performance, interfirm comparison with industry average.
d) Financial Solvency
Ratios are useful tools. It indicates the trends in the financial solvency of the firm. Long term
solvency refers to the financial liability of a firm. It can also evaluate the short term liquidity
position of the firm. .
e) Communication
The financial strength and weaknesses of a firm are communicated in a more easy and
understandable manner by the use of ratios. The information contained in the financial
statements is conveyed in a meaningful manner. It, thus, helps in the communication and
enhance the value of the financial statements.
f) Efficiency Evaluation
It evaluates the overall efficiency of the business entity. Ratio analysis is an effective instrument
which, when properly used, is useful to assess important characteristics of business liquidity,
solvency, profitability. A critical study of these aspects may enable conclusions relating to
capabilities of business.
g) Control
It helps in making effective control of the business. Actual results can be compared with the
established standard and to take corrective action at the right time.
h) Other uses
Financial ratios are very helpful in the early and proper diagnosis and financial health of the firm.
1. There are major ______________________ advantages.
2. Financial forecasting is useful for ___________________.
3. Decision making concerned with ______________________.
4. Comparison is for ________________________________.
5. Financial solvency includes ________________________.
6. Communication enhances _________________ statements.
7. Evaluation done for ______________________________.
8. Through control,________________________________.
9.6 Classifications Of Ratios
The diagrammatic representation of ratios are as follows :
TYPE OF RATIO
LIQUIDITY SOLVENCY PROFITABLITY ACTIVITY LEVERAGE
Current Debt Gross Profit STO Gearing

liquid Equity Net Profit DTO TI to LT
Operating CTO
1. Types of ratios are _____________________________________.
2. Liquidity ratios consist of ______________________________.
3. Solvency ratio consists of ______________________________.
4. Profitability ratio consists of ____________________________ .
5. Activity ratio consists of _______________________________.
9.7 Liquidity Ratio
It means the liquidity of the firm. Liquidity is the ability of the firm to meet its current liabilities as
they fall due. Since the liquidity is basic to continuous operations of the firm, it is necessary to
determine the degree of liquidity of the firm. These are important because liquidity is close to the
heart of the firm. A firm may have a high level of long term assets and substantial net income,
but if they do not have enough cash on hand or assets that can be turned into cash fairly quickly,
they will not be able to operate day to day. The liquidity ratios examine the current portion of the
balance sheet : current assets and current liabilities. The implicit assumption is that current
assets will be used to pay off current liabilities. This makes sense due to the matching principle
(match the maturity of the debt with the duration of the need) e.g. one would not take a five year
bank loan to pay off an account payable due in thirty days.
There are two ratios that determine how liquid a firm is : the current ratio and quick ratio.
1. Liquidity is the ability ________________________.
2. Liquidity ratios deal with ______________________.
3. Liquidity ratios place importance on _____________.
4. Two ratios that determine liquidity _______________.
Current Ratio
It is one of the popular financial ratios. It measures the firm’s ability to meet its short term
obligations. This is achieved by comparing the current assets of a business with its current
liabilities.. The formula for current ratio is :
Current Ratio = Current Assets / Current Liabilities
Example:
A B
Current Assets Rs. Rs.
Stock 3,000 60,000
Debtors 16,000 Nil
Cash 5,000 Nil
Current Liabilities
Creditors 24,000 Nil
Bank Overdraft Nil 10,000
The liquidity of the firms are determined by the amount of working capital available to the
business. This is defined as current assets minus current liabilities. The current ratio is not
expressed as a percentage but as a proportion. The current ratio of the above two firms are: 1 for
A and 5 for B. The ratio reveals a considerable difference between the two companies.
Company B is five times more liquid than company A. Company A can only just cover its
obligations to creditors in the short term, yet Company B can cover its obligation to the bank five
times over.
Although company A would be less vulnerable if its ratio was higher, it can be argued that to have
a ratio that is too high indicates inefficiency, in that too much working capital is available, which
might be better invested in fixed assets. However, it is important to identify the specific types of
current assets that are excessive such as
1. Excessive stock levels, indicating poor stock control or a decline in sales volume
2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts
3. Excessive cash or near cash equivalents, indicating a lack of suitable investment
opportunities in capital projects.
A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is
acceptable. However, the current ratio may vary from less than one in such industries as fast
foods to more than two in the telephone apparatus manufacturing industry. Consequently, it is
important too utilize the industry averages.
A ratio that is much higher than the industry average indicates that the firm may have excessive
current assets. Further investigation may demonstrate the cause of the excess. One reason may
be that the firm is having trouble in the collection of its debtors or has high inventory, both of
which will be identified through the use of other ratios. Another reason may be that the firm is
holding too much cash or short term investments which could be earning more money if they
were invested in long term instruments. Still another reason for a high ratio is that the firm may
be at a specific point in its business cycle. The company that sells woolen goods in winter is
expected to have high inventory in November, December, January and high debtors in February.
A ratio which is much lower than the industry average indicates that the firm is having liquidity
problems, meaning that it may not be able to meet its short term obligations. Accordingly, an
extremely low current ratio should be a red flag to the company being analyzed.
The components of current assets and current liabilities are:
Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock, prepaid
expenses, trade investments, marketable securities
Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or accrued
expenses, tax payable, provision for tax, dividends payable.
Example: Given: Current Ratio is 2.5 and working capital is Rs.1,80,000. Calculate the Current
Assets and current liabilities.
Solution: Given data is working capital, hence :
Working capital = Current assets minus current liabilities
Current Ratio = CA / CL
In the absence of any value, the current liability is always taken as 1 unit
2.5 = CA / 1 and cross multiplying , CA is 2.5
Working capital ratio is 2.5, then substituting the values,
2.5 = 2.5 minus 1 or WC = 1.5
For 1.5 WCR = Working capital value is Rs1,80,000
For 2.5 CAR, the current asset is Rs.1,80,000 x 2.5 / 1.5 = Rs.3,00,000
For 1 CLR, the current liability is 1,80,000 x 2.5 / 1 = Rs.1,20,000
1. Current Ratio is___________________________________ ratio.
2. Current ratio measures ____________________________.
3. Current ratio compares ___________________________.
4. The formula for current ratio is _____________________.
5. Current ratio is expressed in _______________________.
6. The rule of thumb in Current ratio is ___________________.
7. Working capital is the result of _______________________.
8. The working capital is Rs.80,000 and its current ratio is 5. What are the
9. current assets and current liabilities.
Liquid Ratio
It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except that it
excludes inventory which is generally the least liquid current asset. The reason for eliminating
inventory may be due to two primary factors
a. Many types of inventory cannot be easily sold because they are partially completed items,
obsolete items, special purpose items.
b. The items are typically sold on credit. This results in the creation of
trade debtors or bills receivables before being converted into cash.
Citing the example, in the case of company B, the only current asset that it carries is stock. The
question must be asked : is this level of stock too high or might it be essential to this type of
business ?
As stock is the least liquid of the current assets, prudence requires that liquidity be looked at in
another way. If current assets excluding stock are compared with current liabilities, a more
cautious assessment of the liquidity of the two companies is given.. This ratio is calculated as
follows:
Acid Test Ratio = Current assets less Stock / current liabilities
The quick ratios for companies A and B are as follows :
A = 24,000 3,000 / 24,000 = 0.875
B = 50,000 50,000 / 10,000 = 0
This time the quick ratio indicates that company A has a considerably better liquidity from this
point of view and company B is dangerously insolvent.
Illustration:
Given that Current ratio is 3.5, acid test ratio is 1.5 and working capital is Rs.6,50,000. Compute
current assets, current liabilities, liquid assets
Solution:
Given data, Working capital = Current Assets minus current liabilities
Where current liability is taken as 1
CR = CA /.CL = 3.5 = CA / CL
Crossmultiply = 3.5 x 1 = Current Assets
Working Capital Ratio is therefore : CAR – CLR or 3.5 minus 1 or 2.5
For 2.5 WCR, the amount is Rs.6,50,000
For 3.5, CAR, the current asset is 6,50,000 x 3.5 / 2.5 or Rs.9,10,000
For 1, CLR, the current liability is 6,50,000 x 1 /2.5 or Rs.2,60,000
Liquid asset is based on Acid Test Ratio where, 1.5 = LA / CL
Liquid asset, therefore, are = 2,60,000 x 1.5 or Rs.3,90,000
Problem: Given Current ratio 1.5 :1; Quick ratio 1 : 1 and Current liabilities Rs.50,000. Calculate
current assets, quick assets and inventory.
Solution: Given Current ratio : 1. 5 : 1 and value of current liabilities Rs.50,000
Current assets : CR = CA /e 1.5 = CA / 50,000 or CA = Rs.75,000
Quick Asset : QR = QA / 1 or 1 = QA / 50,000 or Rs.50,000
Inventory = CA – QA or 75,000 – 50,000 or Rs.25,000
Problem: Assuming the Current ratio of DR Ltd is 2, state in each of the following cases whether
the ratio will improve or decline or will have no change.
(a) payment of current liability (b) purchase of fixed assets (c) cash collected from customers
(d) Bills receivable dishonored and (e) issue of new shares.
Solution: CR = CA / CL where 2 = CA / 1 or CA = 2 and CL = 1
a) Payment of current liability : Current ratio will improve. The reason is that when current ratio
is 2:1, payment of current liability will reduce the same amount in the numerator and
denominator. Hence, the ratio will improve.
b) Purchase of fixed assets : here, the current ratio will decline.
c) Cash collection : Current ratio will not be changed because cash will increase and debtors

will decrease
d) BR dishonored : Current ratio will not change. Reason is that BR will decrease and debtors
will increase
e) Issue of new shares : Current ratio will improve because cash balance will increase.
1. Liquid Ratio is also known as ________________________.
2. Liquid ratio excludes _______________________________.
3. The reason for exclusion is __________________________.
4. The formula to calculate the liquid ratio is ______________.
5. Payment to current liability will improve _______________.
6. For Bills dishonored, Current ratio _____________________.
7. For issue of new share, current ratio ____________________.
8. For purchase of fixed assets ___________________________.
9. For cash collection, __________________________________.
10. Given CR is 1.75. Liquid ratio is 1.25.. Net working capital is Rs.1,50,000. Calculate (a)
current assets (b) current liabilities and (c) liquid assets and stock.
11. DR’s current ratio is 5.5 : 1 . Quick ratio is 4 to 1. Inventory is Rs.30,000.find out the current
liabilities.
12. Given CR is 2.5. Liquid ratio 1.5 working capital Rs.6,00,000, Bank overdraft Rs.10,000.
Calculate Current assets, current liabilities. Stock and liquid assets.
9.8 Solvency Ratios
The ratios are analyzed on the basis of long term financial position of a firm. It is also known as
test of solvency or analyzing the debt. Many financial analysts are interested in the relative use
of debt and equity in the firm. Debt refers to outside borrowings by the firm.
The debt position of a firm indicates the amount of other people’s money being used in
attempting to generate profits. The long term debts are of much importance to the firm since a
firm is expected to commit the payment of periodic interest over the long run. In addition,
repayment of loan after the expiry of maturity date has to be planned.
Since the creditor’s claims must be satisfied before the distribution of earnings to shareholders,
present and prospective shareholders pay close attention to the degree of indebtedness and
ability to repay the debts. Lenders are also equally concerned about the indebtedness and the
repayment modes. Hence, the solvency of the firm in particular needs consideration.
1. Solvency ratio are analyzed on __________________________basis.
2. Solvency ratio is also known as ______________________.
3. Solvency ratio is combination of ____________________.
4. Debt refers to ____________________________________.
5. Lenders are concerned about ________ and ____________.
Debt Ratio
Debt ratios are important because debt is widely considered to be a measure of the health of the
firm and the risk associated with it. If a firm has high debt, they have fixed payments which must
be made. This means that limited funds may be directed to debt payment (either principal or
interest or both) instead of investments. .
The debt ratio is :
Total Liabilities / total assets
This ratio tells you how much of the firm’s assets are financed with debt. A high debt ratio
indicates that the firm may be carrying too much debt. This is of concern to the firm because it
may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a
firm in this situation is considered risky because short term financing is limited and may not be
available in an emergency.
A low debt means that the firm has a low level of liabilities compared to its total assets. Such a
ratio indicates that the firm is not risky because it has plenty of financing available when
compared to its need. However, a low ratio may also indicate that the firm should take on more
debt. The reason for this is that the ability to borrow is considered a resource and a firm with low
debt may not be taking advantage of this resource.
1. Debt is considered as _________ Of the firm and ________ Associated ________.
2. The formula is __________________________.
3. High debt ratio indicates __________________.
4. The result of high debt ___________________.
5. Short term financing is ____________________.
6. A low debt ratio indicates __________________.
Debt : Equity Ratio
The debt : equity ratio is :
Long term Debt / Shareholder’s equity
The debtequity ratio deals with the long term liabilities and equity portion of the balance sheet.
Note that shareholders’ equity includes retained earning (Equity may also be known as net
worth). The debtequity ratio provides information on the capital structure (relationship between
debt and equity) of the firm. Such information is important because it affects the value of the firm.
The value of the firm is important because it has an impact on the ability to raise funds., either
through increased borrowing or the sale of shares or both.
A high debtequity ratio indicates a poor capital structure because it signifies that the firm has
high debt in comparison to its level of shareholders’ equity. This means that the firm’s creditors
may be concerned about the repayment of debt, which in turn leads to high interest rates, which
in turn leads to higher required returns on the firm’s potential investments..
A low debt equity ratio is an indication that the firm is in sound financial position and therefore is
not considered risky. Normally, the debt equity ratio vary tremendously from industry to industry.
Problem: The Balance Sheet of DR Ltd is as follows :
Assets: Fixed Assets 10,00,000
Current Assets 5,00,000
Represented by:
Current Liabilities 1,00,000
Reserves and surplus 1,00,000
10 % Debentures 2,00,000
6 % Preference Share capital 3,00,000
Equity Share capital 8,00,000
Calculate the Debt Ratio and Debtequity ratio.
Solution: Debt Ratio : Total Liabilities to outsiders / total assets
: Debentures + Trade creditors / Fixed + current assets
3,00,000 / 15,00,000 or 1 : 5
Debt – equity ratio : Outsiders’ funds / shareholders’ equity
Outsiders’ funds 10 % Debentures only + Sundry Creditors
Shareholders’ funds Equity Share capital + Preference share capital + Reserves
3,00,000 / 12,00,000 or 1 : 4
1. Debt equity deals with ____________________________.
2. Shareholders equity is ____________________________.
3. The formula is __________________________________.
4. Debt equity provides information on_________________.
5. Capital structure refers to _________________________.
6. Capital structure affects ___________________________.
7. value is important to raise _________________________.
8. Raising of funds is done through ____________________.
9. High debt indicates _______________________________.
10. Creditors may get upset over _______________________.
11. Low debt indicates ______________________________
12. Low debt is not __________________________________ .
13. Debt equity ratio _____________ from industry to industry.
9.9 Profitability Ratios
A firm’s profitability can be assessed relative to sales, assets, equity or share value. The
profitability ratios are important because they indicate whether the firm is doing what it set out to
do : make a profit and provide a return to its investors. There are many measures of profitability.
Each relates the returns of the firm with regard to the sales, assets, equity or share value. As a
group, these measures enable to evaluate the firm’s earnings. The criteria for earnings can be
related to a given level of sales,. A certain level of assets, the owner’s investment or share value.
Earnings result in profits. Without profits, a firm may be handicapped to attract outside capital.
The income statement of the firm shows the total profits earned by the firm during the preceding
fiscal period. The important ratios which highlight the profitability of a firm would be as follows:
1. Profitability ratio is important as ______________________.
2. Profitability can be assed to ___________________________.
3. Profitability ratio evaluates firm’s _____________________.
4. Earnings result in ___________________________________.
5. Without profit, ______________________Cannot be attracted.
Gross Profit Ratio
It measures the percentage of each sales value remaining after the firm has paid for its goods.
The higher the gross profit margin, the better and lower the relative cost of merchandise sold.
Thus, it serves an important tool in shaping the pricing policy of the firm. The formula is :
Gross Profit = ( Gross Profit / Sales ) x 100
Where Gross profit = Sales minus Cost of goods sold (COGS)
Net Sales = Cash Sales + Credit Sales minus Sales Returns
It is normally expressed as a percentage. If we deduct gross profit ratio from 100, the ratio of
COGS is obtained..
Problem
DR Ltd provides the following information.
Cash Sales Rs.8,00,000; Credit Sales Rs.10,000; COGS Rs.15,80,000 and Return Inwards
Rs.20,000. Calculate Gross Profit Ratio and ratio of COGS.
Solution
GPR: GP / Net Sales x 100 : Gross Profit : Net Sales minus COGS
Net Sales : Gross Sales minus Return Inwards
Gross Sales : Cash + Credit Sales
8,00,000+10,00,000 minus 20,000 or Rs.17,80,000
Gross Profit : 17,80,000 minus 15,80,000 or Rs.2,00,000
GPR 2,00,000 /17,80,000 x 100 or 11.2 %
Ratio of COGS : 100 – GP Ratio or 100 – 11.2 or 88.76 %
1. Gross profit measures __________________ of each sales value.
2. Gross profit measures __________________.
3. The formula is _________________________.
4. Gross profit is _________________________.
5. Net sales is ____________________________.
6. Gross Profit ratio is expressed as ___________.
Expenses Ratio
These ratios indicate the relationship of various expenses to net sales. Individual expenses are
calculated based on the net sales and indicated as a percentage to net sales.
1. Expense ratio indicate ____________________of expenses to net sales.
2. Individual expenses are calculated on ___________________.
Net Profit Ratio
It is also known as Net Profit Margin. It measures the percentage of each sales in rupee after all
expenses including taxes have been deducted This ratio provides considerable insight into the
overall efficiency of the business. A higher ratio speaks about the overall efficiency of the
business. It also focuses the attention of the better utilization of total resources. A lower ratio
would mean a poor financial planning and low efficiency. A net profit margin of 1 percent or less
would be unusual for a grocery store which a net profit margin of 10 percent would be low for a
retail stores. It is divided by net income by net sales. The formula is :
Net Profit Ratio = (Net Profit after taxes / Net Sales ) x 100
The net profits are calculated after excluding the income tax, the nonoperating incomes and
nonoperating expenses. It is expressed as a percentage on net sales..
Example: The income statement of DR Ltd is as follows:
To Opening Stock 2,00,000 By Sales 12,00,000
Purchases 8,00,000 Closing Stock 1,00,000
Direct Expenses 1,00,000
Gross Profit 2,00,000
13,00,000 13,00,000
To Admn Expenses 1,00,000 By Gross Profit 2,00,000
Selling Expenses 80,000 Profit on sale of
Investments 60,000
NonOperating exp 40,000 Dividends received 40,000
Net Profit 80,000
3,00,000 3,00,000
Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and
Expense Ratio.
Solution
Gross Profit Ratio = GP / New Sales x 100 or 2,00,000 / 12,00,000 x 100 or 16.61 %
Net Profit ratio = NP after tax / Net Sales x 100 or 80,000 / 12,00,000 x 100 or 6.67 %
Operating Ratio = COGS + operating expenses / Net Sales x 100
Sales minus Gross profit = COGS
10,00,000+1,00,000+80,000 / 12,00,000 x 100 or 98.33 %
Operating Profit = 100 – 98.33 or 16.67 % Ratio
Admn Expenses Ratio = Admn Expenses/Net sales x 100 or 1,00,000/12,00,000 x 100 8.33 %
Selling Expense Ratio = Selling Expenses/Net Sales x 100 or 80,000/12,00,000 x 100 or 6.67 %
1. Net profit is known as __________________________.
2. Net profit measures percentage of each _________________ after ___________.
3. Net profit provides _________________________ of business.
4. Net profit focuses on ________________________.
5. Low ratio refers to __________________________.
6. The formula is _____________________________.
7. Calculation is based on ______________________.
9.10 Activity Ratios
These are used to measure the speed with which various accounts are converted into sales or
cash. Measures of liquidity are generally inadequate due to the composition of the firm’s current
assets and current liabilities. The activity ratios are also known as turnover ratios. Some of the
turnover ratios are as follows :
Stock Turnover Ratio : STO
Debtors Turnover Ratio : DTO
Creditors Turnover Ratio : CTO
1. Activity ratios measure __________________________________.
2. Measures of liquidity is inadequate due to __________________.
3. STO, DTO, CTO are also known as ________________________________.
Stock Turnover Ratio
I t commonly measures the activity or liquidity of the firm’s stock.. The STO is also known as
stock velocity. Velocity refers to “speed” with which an object travel. Here, it is the speed on
converting the stock into sales then to cash. It indicates the number of times the stock has been
turned over as cash during a given period of time. It evaluates the efficiency with which a firm is
able to manage its stock.
If the cost of goods sold )COGS) is known, the STO can be calculated as follows:
STO = COGS / Average stock at cost
Where COGS = Net Sales – Gross Profit
Average Stock = Opening + Closing Stock / 2
If COGS is not known, it can be computed as follows:
STO = Net Sales / Stock
Example: DR Ltd provides the following
Stock: Opening Rs.75,000; Closing Rs.1,00,000. Credit Sales Rs.2,00,000. Cash sales
Rs. 50,000. Gross Profit 25 %. Calculate the Stock Turnover Ratio
Solution:
STO = COGS / Average stock
COGS = Net Sales – Gross Profit
Net Sales = Cash Sales + Credit Sales or 2,00,000 + 50,000 or 2,50,000
Average stock = Opening + closing stock / 2 or 75,000 + 1,00,000 / 2 or 87,500
Gross Profit = 25 % on Rs.2,50,000 or 62,500
COGS = 2,50,000 – 62,500 or 1,87,500
STO = 187,500 / 87,500 or 2.14 times.
1. STR measures ______________________________.
2. STR is also known as _______________________.
3. Velocity refers to ___________________________.
4. STR commonly refers to _____________________.
5. STR evaluates the ___________________________.
6. The formula for STR is ______________________.
7. COGS is __________________________________.
8. Average Stock is ____________________________.
9. If COGS not given, the formula is _______________.
Debtors Turnover Ratio : DTO
It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors
include the Bills Receivable also. The Bills receivables are written promise of trade debtors.
Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay
cash. Thus, debtors are expected to be converted into cash within a short period. Therefore, it is
included in the current assets. It is calculated as follows :
DTO = ( Debtors + BR / Net credit sales) x Number of working days
DTO indicates the velocity of debt collection of firm. It indicates the number of times average
debtors convert themselves over into cash during a year. Debtors care should always be taken
on gross value/ Do not deduct the bad debts or provision for doubtful debts. It is expressed as the
number of times.
If DTO is given in months, convert it into a common base period. If it is given as a number
of times, do not reduce it to a base period.
Example: Total sales of a firm Rs.5,00,000, of which the credit sales are Rs.3,65,000.Sundry
Debtors and Bills receivable are Rs.50,000 and Rs.2,000 respectively
Calculate the DTO.
Solution: DTO = Debtors + BR / Net credit sales x 365
50,000 + 2,000 / 3,65,000 x 365 or 52 days
1. DTO is also known as ___________________________.
2. Birth of debtors is from _________________________.
3. Debtors are based on ____________________________.
4. Debtors include ________________________________.
5. Total debts include _____________________________.
6. Bills receivable is _______________________________.
7. Trade debtors are provided with ___________________ credit time .
8. Debtors are included in ___________________________.
9. Formula for DTO ________________________________.
10. Net credit sales include ___________________________.
11. DTO involves in _________________________________.
12. Total sales R.1,00,000. Cash sales Rs.20,000. Opening Debtors Rs.10,000,
13. Debtors at close Rs.15,000. BR opening Rs.7,500 and at close Rs.12,500.
14. Calculate DTO.
15. Total annual sales Rs.10,00,000 and BR or Rs.1,60,000. How rapidly must BR
16. be collected if the management wants to reduce the BR to Rs.1,20,000?
Creditors Turnover Ratio : CTO
Creditors come into being out of credit purchases. Creditors include both trade creditors and bills
payables. It is included in the current liability since the payment has to be made within three
months normally. The formula is as follows :
CTO = ( Creditors + Bills Payable / Credit purchases ) x 100
Where credit purchases = Total purchases minus cash purchases
Example: Total purchases Rs.1,00,000. Cash purchases Rs.20,000. Discount Provision on
creditors Rs.1,000. Purchase returns Rs.2,000. Creditors at close Rs.30,000. Bills payable at
close Rs.25,000. Calculate CTO.
Solution: Credit purchases = Total purchase – cash purchase – purchase return
1,00,000 – 20,000 – 2,000 or Rs.78,000
CTO = 30,000 + 25,000 / 78,000 x 365 or 257 days
The Reserve for discount on creditors should not be considered for calculating the net credit
sales.
1. The birth of creditors __________________________ .
2. Creditors include ___________________________ .
3. Creditors are ______________________________ .
4. The formula is ____________________________ .
5. Credit purchases ____________________________ .
9.11 Leverage Ratio
A firm’s capital structure is the relation of debt to equity as sources of the firm’s assets.. Normally
both the owners and the creditors of the business will be interested in analyzing its capital
structure. The ratios that deal with the leverage are as follows :
1. Leverage ratio refers to _____________________________ .
2. It is based on ____________________________________ .
Capital Gearing Ratio: :
It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the
preference share capital and the debentures as against the equity funds provided by the equity
shareholders. The ratio is calculated as:
Capital Gearing Ratio : Fixed cost bearing capital / variable cost bearing capital
Where fixed cost bearing capital = preference share capital, debentures , long term bank
borrowings.
Variable cost bearing capital = equity share capital, reserves and surplus.
If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm
is said to be highly geared. On the reverse, it is low geared.
Example: The capital structure of two companies, Neverdowell and Goodfornothing Ltd are
as follows:
NDW GDF
Equity Share Capital (Rs.) 10,00,000 6,00,000
6 % Preference Share Capital 3,00,000 4,00,000
Reserves and Surplus 2,00,000 2,00,000
Solution:
Capital Gearing Ratio : NDW : 3,00,000 / 12,00,000 or 0.25:1
GDF : 6,00000 / 8,00,000 or 0.75 : 1
The capital of NDW is low geared when compared to GDF.
1. CGR relies on ______________________________ .
2. Fixed cost securities include _________________ .
3. The ratio is _______________________________ .
4. Variable cost bearing capital include ___________ .
Debtequity Ratio:
The ratio compares the debt with equity. Debt refers to long term loans and liabilities.
Redeemable Preference shares are also considered as debt. This measure is helpful to assess
the soundness of the longterm financial policies. It determines the relative stake of outsiders and
shareholders in the company . Lower the ratio, it is considered more comfortable for the creditors
financial position. 2 : 1 is taken as a satisfactory debt – equity ratio. However, it is not a very
satisfactory measure. since the nominal values may bear very little relationship to their current
market values. The calculation is as follows:
Debt – equity Ratio = Long term debts / Shareholders’ funds + Long term debts
1. DER compares ______________ with _____________________ .
2. Debt refers to _______________________________________ .
3. Redeemable Preference shares are taken as _______________ .
4. DER determines ________________________________ stake.
5. Lower ratio indicates __________________________________ .
6. ________________________________________ Rule of thumb.
7. Formula _____________________________________________ .
Example: The capital structure of DR Ltd is as follows :
Equity Share Capital : 10,00,000
Redeemable Preference Capital 5,00,000
Long term liabilities 2,00,000
Reserves and surplus 2,00,000
Calculate the Capital Gearing Ratio and Ratio of Total Investment to Longterm liabilities
Solution:
CGR : Fixed Cost bearing capital / variable cost bearing capital
10,00,000 / 12,00,000 or 0.83 : 1
TI to LTL : Equity Share capital + Reserves and surplus + Long term
Liabilities / Long term liabilities
22,00,000 / 10,00,000 or 2.2 : 1
9.12 Limitations Of Ratio Analysis
Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance comes
from proper use of these ratios. Misuse or mishandling of these ratios and using them without
proper context may lead the analyst or management to a wrong direction. The person who uses
these ratios should be well versed and should possess expertise knowledge about making proper
use of these ratios. Like all tools, ratios also suffer from several ‘ifs’ and ‘buts’ and for a thorough
understanding of proper use of these ratios. There are certain limiting factors in the case of ratio
analysis. These limiting factors are :
1. The user should possess the practical knowledge about the concerns and the industry in
general.
2. Ratios are not an end. They are only means to an end.
3. A single ratio in itself is not important. The trend is more significant in the analysis.
Comparison of ratios should be made.
4. For comparative purposes, there should be a standard ratio. There is no such standards
prescribed for the ratios.
5. The accuracy and correctness of ratios are totally dependent upon the reliability of the data
contained in the financial statement on the basis of which ratios are calculated.
6. To use ratios, first of all there should be uniformity in the accounting plan used by both the
firms. In addition. There must be consistency in the preparation of financial statement and
recording the transactions from year to year within that concern.
7. Ratios become meaningless if detached from the details from which they are derived. The
should be used as supplementary and not substitution of the original absolute figures.
8. Time lag in calculation and communicating the same should not be unnecessarily too
much.
9. The method of presentation should be precise and without any ambiguity.
10. Price level changes make the ratio analysis meaningless.
11. Interfirm comparison should never be undertaken iin the case of concerns which are not
associated or comparable.
12. All techniques concerning the ratio analysis should be taken into account.
1. One should possess ___________________ about the concern.
2. Ratios are not _______________ But ______________________.
3. Ratio should be studied ________________________________ .
4. Comparison of ratios is done with the help of _______________ .
5. _________________________ Make ratio analysis meaningless.
9.13 Computation of Ratios
Problem 1:
Extracts from financial account of DR ltd are given below
Year 2006 Year 2007
Assets
Stock 10,000 20,000
Debtors 30,000 30,000
Payment in advance 2,000
Cash in hand 20,000 15,000
Liabilities
Sundry creditors 25,000 30,000
Bills payable 15,000 12,000
Bank Overdraft 5,000
Sales amounted to Rs.3,50,000 2006 an Rs.3,00,000 in 2008. Compute the solvency position of
DR.
Solution: Shortterm solvency analysis
Current Ratio : CA / CL or Year 2006 : 62,000 / 40,000 or 1.55 : 1
2007 : 65,000 / 47,000 or 1.38 : 1
Liquid Ratio : LA / Liquid liabilities
For 2006 : 52,000 / 40,000 or 1.30 : 1
2007 : 45,000 / 42,000 or 1.07 : 1
Bank overdraft is not included in liquid liabilities as it tends to become some sort of a permanent
mode of financing.
Inventory turnover ratio : Net sales / average inventory
For 2006 : 3,50,000 / 10,000 or 35 : 1
2007 : 3,00,000 / 15,000 or 20 : 1
The liquid position is not sound. The current ratio I the year 2006 does not appear to be good
enough as it is below the rule of thumb i.e. 2 : 1 . In the year 2007, the position has further
deteriorated to 1.38: 1. The later ratio shows a definite weakening in the solvency position of the
company. As regards the acid test ratio, it is satisfactory in the year 2006 and not alarming in the
year 2007. However, the fall in the cash balance and appearance of bank overdraft in the year
shows a definite deterioration in the financial position. Moreover, because of factors concerning
sales, stock and debtors, the quick ratio is likely to soon deteriorate.
As regards inventory turnover ratio, it indicates an alarming deterioration in the year 2007. The
disproportionate rise in the percentage of stock to total current assets from 16% in the year 2006
to 31 % in the year 2007 is also a matter of concern. This shows over purchase of materials
which needs through investigation.
A comparison of debtors turnover ratios of the two years indicates worsening of the company’s

liquid position. There will be much cause of worry if the sales is only to a few customers.
LONG TERM RATIOS
Debt to equity ratio : External equities / Internal equities
For 2006 : 40,000 / 22,000 or 1.82 : 1
2007 : 47,000 / 18,000 or 2.61 : 1
Proprietary Ratio : Shareholders’ Equities / Total Equities
For 2006 : 22,000 / 62,000 or 0.35 : 1
2007 : 18,000 / 65,000 or 0.28 : 1
From the long term point of view, the financial position of DR is very unsatisfactory as the debt to
equity ratio and proprietary ratio are far off the norm in both years. The situation has worsened
in the year 2007 resulting in a serious decline in the shareholders’ equity. The company seems
to be heavily banking upon the creditors’ funds.
The overall conclusion of the above analysis is that the solvency position of DR is not
satisfactory and needs careful planning.
Problem 1
A manufacturer of stoves sells to retailers on terms 2 .5 % discount in 30 days, 60 days net. The
debtors and receivables at the end of December of past three years and net sales for all these
three years are as under.
Year
2005 2006 2007
Debtors 54,842 33,932 85,582
Bills Receivable 4,212 3,686 9,242
Net Sales 2 ,68,466 3,47,392 4,43,126
Determine the average collection period for each of these three years and comment.
Solution: Collection period : Trade receivables / Net credit sales x Number of working days
Year 2005 : 59,054 / 2,68,466 x 365 = 80 days
2006 37,618 / 3,37,392 x 365 = 41 days
2007 94,824 / 4,43,126 x 365 = 78 days
The average collection period in all the three years has been within standard period 80 days, i.e.
60 + 1/3 of 60 days . Hence, it is good.
Problem 2: DR purchases goods both on cash and credit terms. The following particulars are
obtained from the books:
Total purchases Rs.2,00,000. Cash purchases Rs.20,000. Purchase returns Rs.34,000. Creditors
at the end Rs.70,000. Bills payable at the end Rs.40,000. Reserve for discount on creditors
Rs.5,000. Calculate average payment period.
Solution:
Calculation of net credit purchases : Total purchases minus cash purchases minus purchase
returns or Rs.3,00,000 – 20,000 – 34,000 or Rs.1,46,000.
Average payment period : Creditors + Bills payable / Net credit purchases x 365 days
70,000 + 40,000 / 1,46,000 x 365 days or 275 days.
Problem 3 : From the following Balance sheet , compute the Balance Sheet ratios
Assets: Plant and Machinery Rs.2,00,000. Land and Building Rs.2,00,000. Stock Rs.1,50,000.
Debtors Rs.50,000 and Cash balances Rs.1,00,000 = Rs.7,00,000
Liabilities: Equity Share capital Rs.2,00,000. 6 % Preference Share capital Rs.1,00,000. 8 %
Debentures Rs.1,00,000. Reserves and surplus Rs.1,00,000. Long term loan Rs.50,000.
Creditors Rs.1,00,000. Bank overdraft Rs.50,000 = Rs.7,00,000.
Solution:
Current Ratio: CA / CL or 3,00,000 / 1,50,000 or 2: 1
Liquid Ratio: LA / CL or 1,50,000 / 150,000 or 1 : 1
Absolute Liquid Ratio: Absolute liquid assets / current liabilities or 1,00,000 / 1,50,000
Or 1 ; 0.67
Proprietary Ratio: Proprietors’ equity /current liabilities or 4,00,000 / 7,00,000 or 0.57 : 1
Assets Proprietary Ratio: Fixed assets / Proprietors’ equity or 4,00,000 / 4,00,000 or 1:1
Current assets to proprietors’ equity: Current assets/ Proprietors’ equity or 4,00,000 / 4,00,000 or
1 : 1
Debt Equity Ratio: Total debts / Proprietors’ equity or 3,00,000 / 4,00,000 or 0.75 : 1
Stock to Current asset Ratio: Stock / Current assets or 1,50,000 / 3,00,000 or 0.50:1
Stock to working capital ratio: Stock/working capital or 1,50,000 / 1,50,000 or 1:1
Current assets to working capital ratio: CA / WC or 3,00,000 / 1,50,000 or 2:1
Current assets to Liquid assets ratio: CA / LA or 3,00,000 / 1,50,000 or 2:1
Long term funds to working capital ratio: All long term funds / working capital or 2,50,000 /
1,50,000 or 1.67 : 1
Tangible assets to working capital ratio: Tangible assets / current liabilities or 4,00,000 / 1,50,000
or 2.67 : 1
Tangible assets to current liabilities ratio: Tangible assets / current liabilitieisi or 4,00,000 /
1,50,000 or 2.67 : 1
Capital Gearing Ratio: Equity share capital / Preference shares + Debentures or 2,00,000 /
2,00,000 or 1:1
Problem 4: A factory engaged in an industry which is capital intensive has been in operation for
ten years. The capital employed is Rs.17,00,000, out of which Rs.10,00,000 represent equity
capital and reserves, Rs.5,00,,, long term borrowings on Debentures and Rs.2,00,000 cash credit
from banks. The working capital of the company is Rs.8,50,000 made up of stocks Rs.3,00,000,
Stores Rs.1,40,000, Debtors Rs.3,50,000, Advances and deposits Rs.60,000. Annual Sales
Rs.8,00,000. Calculate current ratio, liquidity ratio, debt equity ratio, proprietary ratio, Fixed
assets to proprietors’ funds, Fixed asset ratio.
Solution: Current Ratio : 8,50,000 / 2,00,000 or 4.25 : 1
Liquidity Ratio = 4,10,000 / 2,00,000 or 2.05 : 1
Debt equity ratio : 7,00,000 / 10,00,000 or 0.7 : 1
Proprietary ratio : 10,00,000 / 17,00,000 or 0.59 : 1
FA to Proprietors’ fund or 8,50,000 / 10,000 or 0.85 : 1
Fixed assets ratio or 8,50,000 / 15,00,000 or 0.57 : 1
Problem 5: The ratios relating to DR Ltd are given below
Gross profit ratio 15 %. Stock velocity : 6 months. Debtors velocity 3 months. Creditors velocity 3
months. The gross profit for the year amounts Rs.60,000. Closing stock is equal to opening stock.
Find sales, closing stock, sundry debtors and sundry creditors.
Solution:
Gross Profit Ratio = Gross Profit / sales and 100 or 15 % = 60,000 / sales x 100 or Sales is
Rs. 4,00,000.
Closing stock = Basis stock velocity or Cost of goods sold / average stock where
COGS = Sales – Gross profit or Rs.4,00,000 – Rs.60,000 or Rs.3,40,000
6 months = 3,40,000 / Average stock of Average stock is Rs.6,80,000.
Since opening and closing stocks are the same, the closing stock is Rs.6,80,000
Sundry Debtors : Basis Debtors velocity = Total debtors / sales x Number of months
Total Debtors is 4,00,000 x 3 /12 or Rs.1,00,000
Sundry Creditors : Total creditors / purchases x Number of months
Where Purchases = Opening stock + purchases closing stock or Rs.3,40,000
Creditors = 3,40,000 x 3/12 or Rs.85,000
Problem 6: Prepare a Balance sheet from the following
Current Ratio 1.4. Liquid Ratio 1. Stock turnover Ratio 8. GP Ratio 20 %. Debt collection period
1.5 months. Reserves and surplus to capital 0.6. Turnover to fixed assets 1.6. Capital Gearing
Ratio 0.5. Fixed assets to net worth 1.25. Sales Rs.10,00,000.
Solution: Calculation of cost of Sales : Sales – Gross profit 10,00,000 minus 2,00,000 (20 %
of 10,00,000) Rs. 8,00,000.
Closing Stock: Cost of sales / Stock Turn over Ratio or 8,00,000 / 8 or Rs.1,00,000
Fixed Assets: Cost Sales / FA turnover or 8,00,000 / 1.6 or Rs.5,00,000
Debtors: Total sales x Debt collection period of 10,00,000 x 1.5 / 12 or Rs.1,25,000
Current assets based on liquid ratio: Current Ratio is 1.4. Therefore Stock is Current Ratio
minus Liquid Ratio of 1.4 minus 1.0 or o.4 or Value of stock x current ratio / stock ratio o 1,00,000
x 1.4 /4 or Rs.3,50,000
Liquid assets = Current assets minus stock or 2,50,000 minus 1.25,000 or Rs.1,25,000
Cash balances : Liquid assets minus Debtors or 2,50,000 minus 1,25,000 or Rs.1,25,000
Current Liabilities : Current Ratio is 1.4
Therefore, current liabilities is Current assets / current ratio or 3,50,000 / 1.4 or Rs.2,50,000
Net Worth : Fixed Assets / FA to net worth or 5,00,000 / 1.25 or Rs.4,00,000
Reserves and Surplus : Ratio 0.6
Let the Capital be 1
Add: Reserves and surplus which is 0.6, hence it is 1.6
Reserves and surplus will be : Shareholders funds x Reserves / Total ratio or 4,000 x 0.6 / 1.6 or
Rs. 1,50,000
Share Capital : Shareholders funds minus Reserves or 4,00,000 minus 1,50,000 or Rs.2,50,000
Long term Liabilities : Capital Gearing ratio is 0.5
Share capital x Gearing ratio or 4,00,000 x 0.5 or Rs.2,00,000
BALANCE SHEET
Liabilities Assets
Share capital 2,50,000 Fixed Assets 5,00,000
Reserves and Surplus 1,50,000 Stock 1,00,000
Long term Liabilities 2,00,000 Debtors 1,20,000
Current Liabilities 2,50,000 Cash balances 1,25,000
8,50,000 8,50,000
Terminal Questions:
Problem 1:
Calculate Current ratio, acid test ratio.: Cash in hand Rs.3,000. Cash at Bank Rs.65,000. Bills
receivable Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses Rs.2,000.
Creditors Rs.1,20,000. Bills payable Rs.20,000.
Problem 2:
Calculate : Debts to equity Ratio and Proprietary ratio : Equity share capital Rs.5,00,000.
Preference share capital Rs.3,00,000. Reserves Rs.2,00,000. Current liabilities Rs.1,00,000. 8 %
Debentures Rs.3,00,000. Fixed assets Rs.10,00,000. Current assets Rs.4,00,000
Problem 3:
The current assets and current liabilities were Rs.16,00,000 and Rs.8,00,000 respectively. What
is the effect of each of the following transactions individually and totally on the current ratio :
1. Purchase of new machinery for Rs.5,00,000
2. Purchase of new machinery for Rs.10,00,000 on a medium term loan from a bank with 20 %
margin.
3. Payment of a dividend of Rs.2,00,000 of which Rs.0.47 lakh was tax deducted at source.
4. Materials purchased costing Rs.5,00,000 in respect of which bank financed Rs.3,00,000.
Problem 4:
The current ratio is 2 : 1. Which of the following suggestions would improve the ratio, which
would reduce it and which would not change it.
a) to pay a current liability
b) to sell a motor car for cash at a slight loss
c) to borrow money for short time on an interest bearing ;promissory note
d) to purchase stock for cash
e) to give an interest bearing promissory note to a creditor to whom money was to be paid.
1. Income and balance sheet
2. Trend
3. Cross sectional
4. Comparative
1. Interbusiness comparison and across financial period
2. One number expressed in terms of another
3. Numerical or quantitative
4. Quotient
5. Proportion, percentage and turnover
6. Process of establishing and interpreting ratios for decision making
1. Financial analysis
2. Financial statements
3. Liquidity, solvency and profitability aspects
1. Eight
2. For forecasting and planning activities
3. Management and utilization of asset
4. Firm’s progress and performance
5. Short term and long term liquidity position
6. Value of the financial statements
7. Overall efficiency of the business entity
8. Actual results can be compared with established standards
1. Current and liquid
2. Debt and equity
3. GP, NP, and operating
4. STO,DTO and CTO
5. Gearing.
1. To meet current liability
2. Current assets and current liabilities
3. Matching principle
4. Current ratio and quick ratio.
1. Financial
2. Short term obligations
3. Current and current liabilities
4. Current assets : current liabilities or current assets / current liabilities
5. Proportion
6. 2 : 1
7. Current assets minus current liabilities.
8. CA 1,00,000 and CL 20,000
1. Quick, acid test
2. Stock
3. Stock cannot b e sold easily and stock typically sold on credit
4. Current stock minus stock / current liabilities
5. Will not change
6. Will improve
7. CR will decline
8. CR will not change.
9. 3,50,000; 2,00,000, 2,50,000 and Rs.1,00,000.
10. Rs.20,000
11. CA Rs.1,00,000, CL Rs.40,000, Stock Rs.40,000 and LA Rs.60,000.
1. Long term financial position
2. Test of solvency
3. Debt and equity
4. Outside borrowings
5. Indebtedness and repayment
1. Health and risk
2. Total liabilities / total assets.
3. Too much of debt
4. Inability to repay debt
5. Limited
6. Non risky situations.
1. Long term liabilities and equity portion in Balance sheet
2. Equity share capital + Reserves and surplus
3. Long term debt / shareholders’ equity
4. Capital structure
5. Relationship between debt and equity
6. Value of the firm
7. Funds
8. Increased borrowings or sale of shares or both
9. Poor capital structure.
10. Repayment of debt
11. Sound financial position
12. Risky
13. Vary
1. Tells the status
2. Sales, assets, equity or share value
3. Earnings
4. Profits
5. Capital.
1. Percentage
2. Pricing policy
3. Gross profit / sales x 100
4. Sales minus Cost of goods sold
5. Cash + credit sales minus returns
6. Percentage.
1. Relationship
2. Net sales
1. NP margin
2. Sales in rupee, expenses and taxes
3. Overall efficiency
4. Overall efficiency
5. Poor financing planning and low efficiencies
6. f ) Net profit after taxes / net sales x 100
7. Income statement
1. Speed
2. Composition of Current assets and current liabilities
3. Turnover.
1. Firm’s stock
2. Inventory turnover, stock velocity
3. Speed of converting stock into sales to cash
4. Number of times turnover
5. Efficiency to manage stock
6. Cost of Goods Sold (COGS) / Average stock
7. Net sales minus gross profit.
8. Opening + Closing stock / 2
9. Net sales / Stock
1. Debtors velocity
2. credit sales
3. Gross value
4. Bad debts and reserve e for doubtful debts
5. Trade debtors and Bill receivable
6. Written
7. Three months
8. Current assets
9. Debtors + Bills receivable / net credit sales x number of working days.
10. Sales minus return inwards
11. Velocity of debt collection
12. DTO 3.56
13. Collection period 43 days.
1. Credit purchases
2. Trade creditors + bills payable
3. Current liabilities
4. Creditors + BP / credit purchases x Number of days.
5. Credit purchases minus return outwards.
1. Relation of debt and equity
2. Capital structure.
1. Fixed cost bearing securities.
2. Preference share capital + debentures.
3. Fixed cost bearing securities / variable cost bearing capital .
4. Equity share capital + reserves and surplus.
1. debt, equity
2. Long term loans and liabilities
3. Long term debt
4. relative
5. comfort zone
6. 2 : 1
7. Long term debts / Shareholders’ funds + long term debt
1. Comprehensive and practical knowledge
2. Ends but means
3. In totality
4. Standards
5. Price level changes
1. Refer to units 9.7
2. Refer to units 9.8 & 9.13
3. (1) Decrease (2) decrease (3) decrease (4) increase
4. (a) increase (b) increase (c) decrease (d) no change (e) no change
Unit 10 Funds Flow Analysis
Structure:
10.1 Introduction
Objectives
10.2 Meaning
10.3 Concept
10.4 Technique
10.5 Sources
10.6 Increase in funds
10.7 Decrease in Assets
10.8 Increase in Liabilities
10.9 Increase in Networth
10.10 Sources
10.11 Increase in Assets
Self Assessment Questions10
10.12 Decrease in Liabilities
10.13 Networth
10.14 Flow of funds
10.15 Transaction not affecting flow
10.16 Steps in preparation of funds flow statements
10.17 Computation of changes in working capital
10.18 Layout
10.19 Treatment of certain items
Terminal Questions
10.1 Introduction
The usefulness of developing certain financial statements as an aid to evaluate past and / or
present performance of a business concern is unquestionable and beyond any dispute. The
Income Statement reports the revenues earned and expenses incurred or outstanding. The
Balance Sheet conveys about the deployment of funds in various assets and equities The Fund
Flow analysis is a modern technique of analyzing the movement of “funds” of a concern. The
Fund Flow statement shows the movement of funds between two balance sheet dates. As per
Robert N. Anthony “the Funds Flow statement describes the sources from which additional funds
were derived and the use to which these funds were put”. Such a statement is becoming more
and more popular and is being increasingly published as part of the annual accounts. Para 20 of
International Accounting Standards 7 reads as follows :
“A statement of changes in financial position should be included as an integral part of financial
statements. The statement of changes in financial position should be presented for each period
for which the income statement is prepared”.
The inclusion of such a statement, therefore, is very helpful to improve the understanding of the
operations and activities of an enterprise for the reporting period.
1. Understand the meaning and the concepts of funds flow statement.
2. Familiar with techniques of fund flow statement.
3. Preparation of fund flow statement.
10.2 Meaning of Fund Flow Statement
Statement of Sources and Uses of Funds is a statement which depicts the sources from which
funds are obtained and the uses to which they are being put. It is essentially derived from the
analysis of changes which have occurred in assets and equities between two Balance Sheets
periods. It is not the endproduct of accounting records. The statement speaks about the
changes in financial items of Balance Sheets prepared at two different dates. Therefore, the
funds flow indicates the inflows and outflows of funds during a particular accounting period
generally a year. The flow exhibits the movements of funds in both the directions – inside and
outside the business. As such, the term ‘flow’ in the context of funds indicates the transfer of
cash or cash equivalent from asset to equity or one equity to another equity or from one asset to
another asset.
1. Fund flow statement is _________ From _________ Changes in _____ and ____.
2. FFS speaks about changes in _______________________ Balance Sheets.
3. Flow exhibits the flows _______________ And ________________ business.
4. Flow refers to transfer of ___________________ And __________________.
10.3 Concept of Fund
The term “funds” has been defined in a number of ways in financial circles. The three common
usages of the term are cash , working capita and total financial resources..
Cash: Under this concept, the term “funds” is used only in the sense of cash. Here, only the
changes in cash are considered. Hence, the statement is called “Cash Flow statement. This
statement aims at listing the various items which bring about changes in the cash balance
between two balance sheet dates. Cash planning becomes useful for control purposes.
Using this method has certain disadvantages. Since cash is considered as short term assets,
they are subjected to short term fluctuations. A delay in making payment to suppliers and a
provision of one month’s credit for making a payment of land purchases may show sufficient cash
flow . They may reflect a satisfactory position. But it is not a reality. Therefore, cash equivalent
concept of fund is useful only for short term financial planning and not for long term or
general financial position assessment.
Working Capital: Working capital is Current asserts minus current liabilities. It is an
alternative measure of the changes in the financial position. All those transactions which increase
or decrease working capital are included in this statement. It excludes all such items which do
not affect the working capital. The working capital concept of funds is in conformity with normal
accounting procedures. Hence, a funds flow statement based on this concept fits well with the
other statements. Moreover, working capital is also a measure of short term liquidity of the firm.
Therefore, an analysis of factors bringing about a change in the amount of net working capital is
useful for decision making by shareholders, creditors and management. Due to these reasons,
the working capital approach to funds is more useful than the cash approach.
Total Financial Resources : The term “funds” is very often used in the sense of useful financial
resources also. Cash approach and working capital approach both are incomplete and
inadequate to the extent that they omit a few major financial and investment transactions. Such
items do not affect net working capital. But, if they are included, they would certainly provide
qualitative information for the decision making.,
For example issuing equity shares and debentures for purchase of buildings or assets shall not
have any effect on the working capital. But it is a significant financial transaction that should be
disclosed. Therefore, this concept seems to be the best approach to disclose the changes in the
financial position as compared to other concepts. It is in conformity with the statutory regulations
and legal requirements.
1. The three common funds are __________________________.
2. Cash planning is used for ____________________________.
3. Cash equivalent is used for ___________________________.
4. Working capital is __________________________________.
5. Non working capital items are ________________________.
6. Working capital means ______________________________.
7. Total financial resources considers _____________________.
8. Total financial resources provide _______________________.
Objectives:
The main objectives of the funds flow statement is normally based on the purpose its going to be
served. These are :
a) to help in understanding the changes that are likely to take place in the assets and liabilities
portfolio. These may not be readily available from the income statement.
b) To inform the stakeholders as to how a firm can use the funds which are available at its
disposal.
c) To bring out the financial strengths and weaknesses of the business.
1. The objectives of FFS is to identify ______________ in ______. and ____.
2. FFS is to bring out _______________________.
10.4 Techniques Of Preparing A Funds Flow Statement
Like other accounting statements, the structure of Fund Flow Statement is based on the equality
of financial assets and liabilities including capital. The basic understanding is that the funds are
obtained through profit, external borrowings or by issue of shares. If funds are not available
readily from these sources, the other alternative available is to sell the fixed assets and
investments. . The preparation of Funds Flow Statement is normally based on the following to
bring to scientific method of preparation.
a) Schedule of working capital changes
b) Statement of Sources and Uses of Fund.
Schedule of Working Capital Changes : It is also known as “Comparative change in Working
Capital Statement” or “Working Capital Variation Statement”. The net change in working capital
is projected here in the place of individual changes in all the current assets and current liabilities
in the Funds Flow Statement. The statement indicates the amount of working capital at the end of
two years. It shows the increase or decrease in the individual items of current assets and current
liabilities. The effect of the changes in the individual items of the current assets and current
liabilities on working capital is also presented clearly and precisely. The difference in the amount
of working capital at the end of two years will depict either the increase or decease in working
capital. While ascertaining the increase or decrease in individual items of current assets and
current liabilities and its impact on working capital, the following Rules should be taken into
account.
i) increase in Current Assets will increase the Working Capital
ii) Decrease in Current Assets will decrease the Working Capital
iii) Increase of Current Liabilities will decrease the Working Capital
iv) Decrease in Current Liabilities will increase the Working Capital
It is, therefore, noted that the changes in the items of current assets are positively correlated to
the changes in the working capital. On the other hand, changes in current liabilities are inversely
related to the changes in the working capital.
1. FFS is based on ___________________________.
2. FFS is prepared based on ___________________.
3. Working capital schedule indicates the ______________________.
4. Increase in current assets ___________________ the Working capital.
5. Decrease in CA _____________________________________ the WC.
6. Increase in CL ______________________________________ the WC.
7. Decrease in CL ______________________________________ the WC.
8. Changes in CA ________________________________ changes in WC.
9. Changes in CL ________________________________ changes in WC.
10.5 Sources of Funds
The transactions that increase the working capital are sources of funds. Following may the
sources of funds in a concern.
Funds from operations : Profit earned by the concern during the current year is deemed to be
the source of funds. It is very important source of funds inflow. Net profit is arrived at by
deducting cost of goods sold and other expenses from total sales revenue. However, the profit so
calculated is seldom equal to the funds from operations because there are many items which are
debited or credited in the Profit and Loss Account which do not affect working capital. Therefore,
in calculating the funds from operations, the following adjustments must be kept in mind:
Items to be added back to net profit :
a. Nonfund revenue deductions: These are items which are debited to Profit and Loss
account. These do not cause outflow of funds such as depreciation and depletion on non
current assets, amortization of fictitious and intangible assets, preliminary expenses,
redemption of preference shares or debentures, deferred charges, advertising suspense
account written off. If non fund expenditures does not affect the current assets such as
unexpired insurance, do not add back. So also, all allowances for income tax payable in
future years are excluded.
b. Nontrading charges or losses : These items which were debited to Profit and Loss account
reduce the profits but they do not cause any outflow of funds. Hence, profit should be
corrected by adding back all such charges and losses. These include appropriation of
retained earnings such as general reserve, dividend equalization fund, reserve for
contingencies, sinking fund. In addition the dividend on shares must be added back since it
is an appropriation and not trading charge. The losses arising out of sale of land, buildings,
machinery, long term investments which were written off to the profit and loss account must
be added back. Do not add the loss arising out of sale of a current asset such short term
investments. It is a trading loss and hence it will not require any adjustment. The amount set
aside as provision for current taxation will also be added back. This will be considered only
when the provision for taxation is treated as a charge on profits.
Items to be deducted from Net Profit.
The non fund and non trading revenue receipts or incomes must be deducted
Net profit in order to compute funds from operations. The items are:
(a) Dividend received or receivable: Although this transaction increases the current assets
such as cash and debtors, it is not a trading income. Hence, it should be deducted from the
net profits to determine the funds from operations.
(b) Retransfer of excess provisions: Where the provisions made for taxation, depreciation,
doubtful debts exceed the genuine requirements, the excess amount is transferred back to
the Profit and loss account. It does not create any inflow of funds since it is an accounting
entry. Hence, deduct it.
(c) Profit on sale of non current assets: It is a non trading income. Hence it must be
eliminated from the amount of profit.
(d) Appreciation in fixed assets: The amount of appreciation on revaluation of fixed assets is
normally credited to the profit and loss account. If it is so, deduct it from the profit to compute
the funds from operations.
1. Increase in working capital ____________________.
2. Decrease in WC _____________________________.
3. Net profit is ________________________________.
4. Items to be added back to net profit are __________.
5. Some of nonfund revenue items _______________.
6. Non trading losses include ___________________.
10.6 Increse in Funds
In a nutshell, the sources of funds can be observed as follows :
a) increase of fresh shares derived from increase in share capital.
b) Issue of debentures derived from increase in debentures.
c) Raising of new loan derived from increase in long term loans
d) Sale of fixed assets for cash or for other current assets derived from decrease in fixed assets
and additional information.
e) Non trading income
f) Profit from operations before deducting non cash items of expenses and losses and before
additional non cash, non trading incomes.
g) Decrease in working capital derived from the Schedule of Working capital changes.
1. Increase in share capital is ___________________________ of cash.
2. Increase in debentures _______________________________ of cash.
3. Increase in raising loans ______________________________.
4. sale of fixed assets __________________________________.
5. Non trading income is _______________________________.
6. Profit from operations is _____________________________.
7. Decrease in working capital is ________________________.
10.7 Decrease in Assets
Decrease in assets is always a source of funds for the business. Decrease may be in many
ways: such as cash received from debtors, sale of goods for cash, Bills realized, sale of assets,
fixed assets through provision for depreciation or amortization of fictitious assets. Decrease in an
item of assets results in either a parallel decrease in some other liabilities or a parallel increase in
some other item of assets example repayment of bank loan.. It should be remembered at the
very outset that the decrease is ascertained by comparing the cost of fixed assets and not by
comparing the written down value i.e cost less depreciation. If fixed assets have been shown not
at cost but at written down value, then cost may be ascertained by adding total depreciation
written off todate (generally known as accumulated depreciation) to the written down value The
decrease in fixed assets results in sale of fixed assets. Specific information is generally given in
the problem about this. The decrease in fixed assets not on account of depreciation or writing off
is known as sale of fixed assets. It must be noticed that the total sale proceeds and not the cost
of fixed assets sold are shown as source of fund. If the information in respect of sale of fixed
assets is not clearly given, the following steps should be taken to find out the value of sale
proceeds.
Cost of Fixed Assets (Previous Year) ………………
Less: Cost of Fixed Assets of Current year ( ………………)
Cost of Fixed Assets x x x x x x x x
ADD : Profit or DEDUCT loss on sale ………………………
Sale Proceeds to be treated as source XXXXXXXXXXXXXX
The amount of profit or loss on sale of fixed assets for the above purpose derived from profit and
loss account or from capital reserve or from any specific reserve. This is based on the fact that
such profit or loss are credited or debited or transferred to these accounts in accordance with the
accounting principles. It must be remembered that profit or loss on sale of fixed assets are not
included in profit from operation for the purpose of this Fund Flow Statement.
If such profit or loss has been included in Profit and Loss Account , adjustment has to be made.
If there is profit on sale of assets, the net profit disclosed by Profit and Loss Account is reduced
by the amount of profit earned on the sale of fixed assets. On the other hand, the net profit
shown by Profit and Loss Account is increased by the amount of loss incurred on the sale of fixed
assets.
Example:
The land and buildings account had a balance of Rs.5,00,000on Jan 2007. A piece of land has
been sold . There is no purchase. Rs.30,000 depreciation has been charged in 2007. The profit
on sale has been credited to Capital Reserve Account . The balance stood on January 1, 2007
was Rs.20,000 and Rs.50,000 on December 31. The balance of land and building account as on
December 31 is Rs.4,50,000. Find the sale proceeds.
Solution
Balance of land and building on Jan 1, 2007 5,00,000
LESS : Depreciation charged (30,000)
4,70,000
LESS: Balance of Land and Building on Dec 31 ( 4,50,000)
Cost of Land sold 20,000
ADD : Profit on sale (derived from capital reserve) 30,000
(closing minus opening balance
Rs.50,000 minus Rs.20,000)
Sale Proceeds 50,000
1. Decrease in assets is _________________________________.
2. Profit or loss on sale of fixed assets ____________________.
10.8 Increase In Liabilities
The increase in liabilities is always a source of funds for the business. It may occur as a result of
many transactions such as equity share capital or / and debentures to the public., purchase of
goods on credit. Outstanding expenses are also considered as source of funds since payments
are postponed and cash saved is parked in the business. A comparison of the amount of the
items of long term liabilities i.e debentures and mortgage and other loans for the current year and
previous year will disclose the increase or decrease in the long term liabilities. Additional
information should also be taken into account for determining the correct amount of increase or
decrease for the purpose of this statement.
Any increase on account of the issue of debentures for consideration other than cash or current
assets for the purchase of fixed assets or redeeming other debentures or preference shares
would not at all be shown in the statement because in such a case there is no flow of fund.
1. Increase in liability is ______________________ .
2. Outstanding expenses is __________________ .
10.9 Increase In NetWorth
There can be only two main channels of increase in networth or equity :
a) procurement of more funds by issue of additional shares
b) through accumulation of retained earnings or profits in business
As the increased in owned funds is concerned, it happens only when the business has plans for
expansion, diversification, modernization. The increase in paidup equity
Share capital is not a regular feature. Its occurrence is only sporadic. But profit generated from
operations is a normal feature and is virtually a continuous process from year to year. Profit
earned during an operating period increases the new worth of the business and hence it is
always considered as a source of funds. Sometimes, the premium received on sale of equity
shares and credited to share premium account is also a source of funds as it adds to the size of
net worth .
Share capital consists of equity share capital and preference share capital. The change in equity
share capital is always in the form of increase; it can never be in the form of decrease. The
increase in equity share capital as per Balance Sheet values must be adjusted in terms of
additional information. If the increase has taken place on account of the issue of fresh shares,
only that portion of increase should be treated as sources which is due to the issue of fresh
shares for cash and other current assets. Increase on account of share issues for consideration
involving the purchase of fixed assets or redemption of preference shares or debentures shall
not partake the character of inflow of funds and hence should not be shown in the statement. If
fresh shares have been issued at premium, the amount of premium must be added to the
increase in share capital for the purpose of showing it as source of fund. If the fresh shares
have been issued at discount, the amount of discount must be deducted from the increase in
share capital because it does not involve inflow of fund.
Example:
The opening and closing balance of Share capital are Rs.6,00,000 and Rs.9,50,000 respectively.
The Preference Share capital included in opening balance is Rs.1,00,000. During the year,
Rs.75,000 worth of Preference shares were redeemed at 8 % premium. Bonus shares at Re.1
for every five equity shares held . In addition, a business was purchased by issue of Rs.90,000
shares at a premium of 10 %. The opening and closing balance in the Premium Account is
Rs.8,00,000 and Rs.14,000 respectively. Calculate the further fresh issue.
Solution:
Share capital at close 9,50,000
DEDUCT : Share capital opening 6,00,000
Less: Redemption of Preference
Shares ( 75,000)
( 5,25,000)
4,25,000
Deduct: Shares issued for noncash items (90,000)
3,35,000
DEDUCT : Bonus shares ( 1 / 5 x 5,00,000) (1,00,000)
(1/5 of 6,00,000)
2,25,000
ADD: Share premium. (14,000 + 6,000 minus
8,000 minus 9,000) 3,000
Fresh issue of Shares 2,28,000
1. Decrease in net worth is through __________________________.
2. Increase in net worth is needed for ________________________.
3. Profit earned _________________________________ net worth.
4. Premium on shares is __________________________.
5. Change in equity shares is always ________________.
6. Decrease in preference share capital is ____________.
10.10 Sources Of Funds
The use of funds results in cash outflows. The outflows are known as :application” of funds. The
uses of funds are mainly concerned with.
a) Redemption of Preference shares in cash derived from decrease in share capital.
b) Redemption of debentures in cash derived from decrease in debentures
c) Repayment of loan derived from decrease in long term loans
d) Purchase of fixed assets for consideration other than shares, debentures or long term debt
derived from increase in fixed assets and additional information.
e) Loss from operations
f) Payment of dividend in cash
1. Use of funds result in ________________________.
2. Redemption of Preference shares is _____________.
3. Redemption of debentures is __________________.
4. Redemption of long term loan is _______________.
5. Purchase of fixed asset is _____________________.
6. Loss from operations is ______________________.
7. Payment of dividend is ______________________.
10. 11 Increase In Assets
The increase in fixed assets is known in the accounting language as “Purchase of fixed assets”.
In order to find out the increase in fixed assets, cost of fixed assets of previous year as reduced
by the cost of fixed assets sold during the current year is deducted from the cost of fixed assets of
the current year. In other words, the increase in fixed assets is calculated as under :
Cost of Current year fixed assets ………………
DEDUCT ; Cost of previous fixed assets ………..
LESS: Cost of fixed assets sold or
Written off during the
Current year (……….) (………………..)
INCREASE in fixed assets x x x x x x x
Example: The opening and closing written down balances of an asset are Rs.5,00,000 and
Rs.5,50,000. The accumulated depreciation has been Rs.1,50,000 at the beginning and
Rs.1,90,000 at the close. A machine costing Rs.30,000 (accumulated depreciation Rs.18,000)
was sold during the year for Rs.9,500. Calculate the purchase price of the fixed assets.
Solution
Closing cost of asset (closing value + closing accumulated
Depreciation : 5,50,000 + 1,90,000 7,40,000
DEDUCT : Opening cost of Asset (opening
Value + opening accumulated Depreciation
5,00,000 + 1,50,000 6,50,000
Less : Cost of asset sold (30,000)
(6,20,000)
1,20,000
Sometimes, it may happen that the cost figures cannot be ascertained on the basis of information
available. Increase in fixed assets, in this case, has to be found out with reference to the written
down value along with annual depreciation. If no purchase of fixed assets were made during
the current year, then the value of fixed assets shown in the Balance Sheet of the current year
should be equal to the values of the previous year minus annual depreciation for current year.
The excess of current year’s value over previous year’s value minus annual depreciation will be
treated as increase. This will represent the purchase of fixed assets.
Current year written down value of Asset ……………..
DEDUCT ; Previous year WDV
of Asset ……………
Less: Current year Depreciation (…………) ( ……………..)
_______________
Increase in Fixed Asset being Purchases x x x x x x
Example: The written down value of a Machinery at the beginning and at close were Rs.2,00,000
and 1,75,000. An old machine whose written down value was Rs.12,000 was sold for Rs.6,500.
Rs.32,000 depreciation was charged during the current year. Calculate the purchase price.
Solution:
Current year written down value of Machinery 1,75,000
DEDUCT : Previous year written down
Value of Machinery 2,00,000
Less : Current year depreciation ( 32,000)
1,68,000
Less: written down value of machine Sold ( 12,000)
(1,56,000)
Purchase price 19,000
1. Increase in fixed asset is known as _____________________.
2. Purchase is _______________________________________.
3. The excess of current year –minus (previous year + Depreciation) is treated as
________________.
10.12 Decrease In Liabilities
It implies application which is the flow of funds out of business. Decrease in liability may be done
due increase in one or more liability items or due to decrease in one or more asset items. It may
also be partly due to increase in liability and partly due to decrease in assets. . Any amount of
premium on the redemption of debentures should be adjusted as deduction . Any decrease on
account of redemption of debentures through the issue of another debentures or preference
shares should also not be shown in the statement.
Example:
On January 1, 2007, the balance of 8 % Debentures Account stood at Rs.5,00,000. Rs.60,000
debentures were repaid at 5 percent premium. Rs.75,000 debentures were purchased at Rs.95
from the market and cancelled. The closing balance of debentures was Rs. 2,00,000. Calculate
the outflow of funds.
Solution:
Opening balance of Debenture Account 5,00,000
LESS: Closing balance of Debenture Account ( 2,00,000)
Decrease 3,00,000
LESS : Discount on cancellation (Rs.75,000 / Face
Value of Rs.100 each or 750 debentures x
Rs.5 each (Rs.100 minus Rs.95) ( 1,250)
2,98,750
ADD: Premium (Rs.60,000 x 5 / 100) 3,000
Outflow of funds 3,01,750
1. Decrease in fixed liabilities ________________________ funds.
2. Premium on redemption of debentures is _____________ .
10.13 Net Worth
It may be used due to (a) loss from operations (b) payment of cash dividend out of accumulated
reserves and (c) return of a part of paid up share capital to shareholders implying reduction of
share capital – a rare occurrence. If there is decrease in preference share capital and this
decrease is on account of redemption of these shares in cash or other current assets, such
decrease should be shown as use of fund. But the decrease on account of redemption by the
issue of another preference shares or equity shares or debentures, shall never be shown in the
statement because it will not involve outflow of fund. If the preference shares have been
redeemed at a premium, necessary adjustments should be made
1. New worth is due to _______________________.
2. Net worth is also due to ___________________.
3. Net worth can be ________________________.
10.14 Flow of Funds
It refers to change in fund. Increase of funds of any transaction is a source and decrease of
funds in any transaction is application or uses of funds. But the transactions which do not result
in any change in the funds is called “Nonfund”. Flow of fund takes place when a business
transaction brings a change in the working capital. Such change may be increase or decrease.
The increase is a positive change and the decrease being the negative. These directions in
change are known as fund elements or fund factors. They are commonly known as “inflows” and
“outflows”. The basic rule is :
Flow of fund if a transaction involves :
a) Current assets and fixed assets that is machine sold for cash
b) Current assets and fixed liabilities that is issue of debentures to the public
c) Current assets and owner equity that is issue of shares for cash
d) Current liabilities and fixed assets that is transfer of assets to discharge a claim
e) Current liabilities and fixed liabilities that is conversion of creditors due by issue of
debentures.
f) Current liabilities and capital that is conversion of creditors into owner’s equity by issue of
equity shares.
1. Flow refers to __________________________.
2. Increase in funds _______________________.
3. Decrease in funds ______________________.
4. Non change is known as _________________.
5. Flow takes place due to __________________ working capital.
6. The increase in fund is a __________________ change.
7. The decrease in fund is a __________________ change.
10.15 Transactions that do not affect the flow of Funds
a) Current assets and current liabilities creditors paid
b) Fixed assets and fixed liabilities purchase of assets for debentures
c) Fixed assets and capital purchase of assets by issue of equity shares.
1. Transactions not affecting flow are _______________________.
10.16 Steps In Preparation Of Funds Flow Statement
There are three steps involved in the preparation of a Fund Flow Statement (FFS). They are as
follows:
a) Preparation of Statement of changes in working capital or Schedule of changes in working
capital.
b) Preparation of Adjusted Profit and Loss Account (APL)
c) Statement of changes in Financial position as per AS – 7
1. First step in preparation of FFS is __________________.
2. Second step in the preparation of FFS is _____________.
3. Third step in the preparation of FFS is _______________.
10. 17 Computation of Changes in Working Capital and Funds from Operations
It is a customary practice that only the net changes in working capital should be shown in the
Fund Flow Statement instead of individual changes. Here, the current assets and current
liabilities are considered. For this purpose, a separate statement or schedule is being prepared.
Individual items are entered here. The opening and closing balances are entered one after the
other. The corresponding increase or decrease are entered based on the following rules :
a) Increase in a current asset item increases working capital.
b) Decrease in a current asset item decreases working capital.
c) Increase in a current liability item decreases working capital.
d) Decrease in a current liability item increases working capital .
Insert the total of current asset and current liabilities of both opening and closing periods. Say,
the total of current assets as A and that of total of current liabilities as B. Deduct A minus B. The
answer is known as net Working capital. If the working capital at the end of the current year is
more than the working capital at the end of previous year, the excess is called as “increase in
working capital”. Otherwise, if previous year’s working capital is more than the current year’s
working capital, the difference is called as “Decrease in working capital”. Increase in working
capital is shown as application of funds and decrease in working capital as source of funds in the
Funds Flow Statement.
The funds from operation can be found with the help of preparing an Adjusted Profit and Loss
Account.
1. Individual items are projected in ___________________.
2. Working capital equation is _______________________.
3. A is total _____________________________________.
4. B is total ____________________________________.
5. Working capital is _____________________________.
6. Net increase or decrease is ______________________.
10.18 Layout
The layout for schedule of changes in Working Capital is as follows
Balances as on Effect on
Details Last Current Increase Decrease
Year Year
CURRENT ASSETS
Cash in hand
Cash at Bank
Sundry Debtors
Bills Receivable
Stock or Inventory
Prepaid expenses
Total Current Assets, Say A
CURRENT LIABILITIES
Sundry Creditors
Bills Payable
Bank Overdraft
Outstanding expenses
Total Current Liabilities, Say B
NET WORKING CAPITAL
A minus B
Increase or Decrease in Working
Capital (Balancing figure)

Example: DR Ltd provides the following information
Jan 1 Dec 31
In Rupees
Sundry Debtors 65,000 1,05,000
Cash in hand 13,000 20,000
Cash at Bank 15,000 20,000
Bills Receivable 16,000 30,000
Inventory 90,000 84,000
Bills Payables 12,000 8,000
Outstanding expenses 6,000 5,000
Sundry Creditors 30,000 58,000
Bank Overdraft 30,000 42,000
Short term Loans 32,000 36,000
Prepare a schedule of changes in working capital
Solution
Schedule of changes in Working Capital
Balances as on Effect of WC
Details Jan 1 Dec 31 Increase Decrease
Current Assets
Cash in hand 13,000 20,000 7,000
Cash at Bank 15,000 20,000 5,000
Sundry Debtors 65,000 1,05,000 40,000
Bills Receivable 16,000 30,000 14,000
Inventory 90,000 84,000 – 6,000
Total Current Assets, A 1,99,000 2,59,000
Current Liabilities
Sundry Creditors 30,000 58,000 – 28,000
Bills Payables 12,000 8,000 4,000
Outstanding expenses 6,000 5,000 1,000
Bank Overdraft 30,000 42,000 – 12,000
Short term loans 32,000 36,000 – 4,000
Total Current Liabilities, B 1,10,000 1,49,000
Working Capital A minus B 89,000 1,10,000
Net Increase in working capital
(balancing figure) 21,000 21,000
TOTAL 1,10,000 1,10,000 71,000 71,000
Example :
Prepare a statement of changes in working capital from the following information.
Jan 1 Dec 31
In Rupees
Share Capital 50,000 50,000
Retained earnings 14,000 40,000
Fixed Assets at cost 80,000 90,000
Provision for Depreciation on Fixed Assets 22,000 27,000
Investments in shares of subsidiaries 15,000 15,000
8% Debentures (redeemable in 5 equal
annual instalment of Rs.20,000 each,
from the current year) 20,000 –
Prepaid expenses 21,000 14,000
Creditors and Bills Payables 30,000 25,000
Debtors and Bills Receivables 18,000 20,000
Cash and Bank balances 5,000 13,000
Provision for Doubtful Debts 4,000 2,000
Solution
Statement of changes in working capital during the year
Balances as on Effect on WC
Details
Jan 1 Dec 31 Increase Decrease
Current Assets
Cash and bank balances 5,000 13,000 8,000
Debtors and B.R. 18,000 20,000 2,000
Government Securities 6,000 12,000 6,000
Prepaid expenses 21,000 14,000 – 7,000
Total, say A 50,000 59,000
Current Liabilities
8% Debentures 20,000 20,000 – 20,000
Outstanding expenses 5,000 12,000 – 7,000
Creditors and B.P. 30,000 25,000 5,000
Provision for Doubtful Debts 4,000 2,000
Total, say B 59,000 39,000 3,000

Working Capital : A minus B ( 9,000 ) 20,000
Net increase in working capital 29,000
29,000
20,000 20,000 43,000 43,000
Adjusted Profit and Loss Account
The Layout is as follows:
Dr. Cr.
To By
Depreciation written off Profit and Loss account
Depreciation Provision last year from Balance
Preliminary expenses written Sheet
Off Profit on sale of investments
Goodwill written off Profit on sale of Fixed assets
Discount on issue of shares and Dividend and interest received
Debentures written off from trade investments
Fixed assets discarded or
Written off
Loss on sale of fixed assets FUNDS GENERATED FROM
Loss on sale of trade investments TRADING OPERATIONS
Transfer to General Reserve, (balancing figure) transferred
to Funds Flow Statement as
Sinking Funds, Reserve Funds application of funds
Transfer to other Reserves
Premium on redemption of
Preference Shares
Provision for Tax
Provision for Final or
Proposed Dividend
Interim Dividends
Net Profit as per closing current
Year Profit and Loss Account
TOTAL
NOTE : If debit total of APL is more than the credit total, the difference is Funds generated from
Operation : Record on the credit side of Adjusted Profit and Loss Account.
If credit total of APL is more than the debit total, the difference is funds lost in operations. Record
on the debit side of Adjusted Profit and Loss Account
The balancing figures should be transferred in opposite direction to Funds Flow statement..
Example 3: Calculate funds from operations from the following Profit and Loss Account
To By
Expenses paid and 3,00,000 Gross Profit 4,50,000
Outstanding
Depreciation 70,000 Gain on sale of land 60,000
Loss on sale of machine 4,000
Discount 200
Goodwill 20,000
Net Profit 1,15,800
5,10,000 5,10,000
Solution:
ADJUSTED PROFIT AND LOSS ACCOUNT
To Rs. By Rs.
Goodwill written off 20,000 Funds from operations 1,50,000
Discount written off 200 (balancing figure)
Loss on sale of machines 4,000
Net Profit 1,15,800
2,10,000 2,10,000
Example 4: Following are the extracts from the Balance sheets of DR Lt.
3132007 3132008
Rs. Rs.
Profit and Loss account 11,100 14,800
General Reserve 7,400 9,250
Goodwill 3,700 1,850
Provision for depreciation on asset 3,700 4,400
Preliminary expenses 2,200 1,500
During the year, the company sold land whose book value was Rs.50,000 for Rs.54,000 and paid
an interim dividend of Rs.2,000
Calculate funds from operations.
Solution
ADJUSTED PROFIT AND LOSS ACCOUNT
To Rs By Rs.
General Reserve Balance brought down 11,100
(9,250 minus 7,400) 1,850 being opening balance
Goodwill written off Profit on sale of land 4,000
(3,700 minus 1.850) 1,850
Preliminary expenses
Written off 700 Funds generated from
Depreciation written operations (balancing
Off 700 figure) 6,800
Interim dividend paid 2,000
Closing balance of Profit
And Loss account 14,800
21,900 21,900
NOTES:
1. There is an increase in the balance in General Reserve. It implies that some amount has
been transferred to the account from the Profit and Loss account. This is an appropriation of
profit which does not result in any outflow of funds.
2. The balance in Goodwill Account and preliminary expenses account has come down which
indicates tht the difference has been written. This also does not result in an outflow of funds.
3. The increase in provision for depreciation is on account of current year’s depreciation which
does not result in any outflow of funds.
4. Profit on sale of land and interim dividend being nonoperating items are to be separately
shown as source and application of funds in the Funds Flow Statement.
Example 5: The following information is provided :
Opening balance of Plant Rs.1,32,500. Closing balance of Plant Rs.1,97,500. Provision for
Depreciation in Plant at the beginning 45,000; and at close Rs.61,000. During the year
Rs.65,000 worth of Plant was purchased in exchange for fully paid debentures and old Plant
costing Rs.40,000 was sold for Rs.34,000. Depreciation provided Rs.18,000. Calculate the flow
of funds.
Solution:
Plant Account
To By
Opening Balance 1,32,500 Bank : Sale of Plant 34,000
Debenture Account 65,000 Provision for Depreciation
(Plant purchased) Account : Depreciation on
sold 18,000
Adjusted P&L Account
Profit on sale 12,000* Closing balance 1,97,500
Bank Account : Plant
Purchased (balancing
Figure) 40,000
2,49,500 2,49,500
Calculation of Profit on sale : 34,000 minus (40,000 – 18,000) = 12,000
Provision for Depreciation on Plant Account
To By
Plant Account
:Depreciation Opening Balance 45,000
On plant sold 18,000 APL : Current year
Closing Balance 61,000 Depreciation (bal.figure 34,000
79,000 79,000
Note: For all Asset Account, record the opening balance on the debit side and closing balance on
the credit side of the concerned Asset Account. For all liabilities , record the opening balance on
the credit side and the closing balance on the debit side.
10.19 TREATMENT OF CERTAIN ITEMS
There are certain items whose treatment is not uniform. Different authors differ differently. But,
in this study material, an uniformity is maintained. The likely arguments have been provided for
treating items on a particular principle. The items are :
Provision for Bad Debts
Sometimes, it is shown as reserve for bad / doubtful debts. Actually, this item is shown as
deduction from total book debts to the asset side of the Balance Sheet. Therefore, this item
should be deducted from the amount of debtors shown in the schedule of working capital
changes. Since such treatment may complicate the calculation work, it is suggested that it should
be shown along with current liabilities, although, it does not belong to that category.
Provision for Tax:
DO not treat this item as a current liability. The Provision has to be made to meet the tax liability
of current year. If there is a Provision for last year, it has to be paid this year. Hence, the last
year Provision actually becomes the current year cash outflow. Hence record it in the Funds flow
statement.
Proposed Dividend
Normally, the proposed dividends are given as Balance Sheet item on the liability side. The
Directors propose the final dividend which needs to be approved by the General Meeting. Hence,
it is fair to assume that the proposed dividend is not a current liability. Do not show in the
schedule of working capital changes. The last year proposed dividend should be paid during the
current year, hence a cash outflow
Investments
It poses problems in its treatment. The Rule is :
a) if the investments are in the form of Government or other marketable securities, treat it as
current assets.
b) If it is mentioned as trade investments, that is investments in shares and debentures of
another companies, treat it as fixed assets.
c) If nothing is mentioned specifically, the treatment is :
: if investments have been sold simultaneously, treat it as current assets
: in other cases, treat it as Fixed Assets.
Depreciation
Normally, the value of deprecation will be provided in the problem as an adjustment items.
Depreciation is a non cash item. It is, therefore, charged to Profit and Loss and recorded in the
concerned Fixed Assets Account. If the depreciation is given as a percentage, calculate the
value on the opening balance of the concerned account.. If the value of depreciation is not
given, it has to be found out as follows :
Opening balance of Fixed Assets ……..
ADD: Purchases …….
LESS : Fixed assets sold (…….)
LESS : Closing balance of fixed assets (…….)
Depreciation charges x x x
If a concern intends to show its fixed assets at its cost price, the periodic annual depreciation is
shown under “liabilities” side as Provision for Depreciation commonly known as Accumulated
Depreciation Fund Account. If there were to be an Accumulated Depreciation Fund Account in
already in operation, the current year depreciation is charged against this Provision for
accumulated Depreciation Account and not recorded directly into Adjusted Profit and Loss
Account . In other words, the current year depreciation is routed through the Provision Account.
Increase / Decrease in Fixed Assets
The increase or decrease by means of cash is recorded in the FFS. Increase or decrease due to
purchase consideration through shares and debentures are not recorded.
Increase / Decrease in longterm liabilities
Compare debentures and mortgages as per the Balance Sheet figures. Only consider if cash is
the main striker to cause the increase or decrease. If the changes were to be due to
consideration other than cash or current assets, do not record it in the FFS..
Hidden Items
Prepare the necessary ledger accounts concerned in the fixed assets, fixed liabilities and share
capital and carry out all the necessary adjustments. The balancing figure, if any, would be the
cash transactions. For all non, cash transactions, concentrate on the Adjusted Profit and Loss
Account.
1. Provision is shown as _______________________
2. Provision for doubtful debts is _______________ from gross debtors
3. Provision is shown in _______________________
4. Provision for tax may be _____________________
5. If Provision for Tax is maintained , treat it in _________________
6. Proposed dividend is shown on ________________ of Balance sheet
7. Proposed dividends are to be approved by _____________________
8. Proposed divided. Is not considered as ________________________
9. Last year proposed dividend is cash __________________________
10. Government investments are _______________________________
11. Investments in shares and debentures are ______________________
12. Depreciation is _____________________
13. Depreciation is a ___________________
14. If Depreciation is given as a percentage, calculate on _____________
15. If Provision for depreciation account is maintained, charge the current depreciation to
_____________ and not to _______________________
16. Depreciation is charged only on _______________________________
Problem 6: The Balance Sheets are given below :
Year (Rs.in lakhs)
2006 2007
Fixed Assets 50 60
Investments 10 20
Current Assets 140 150
Share Capital 100 160
Profit and Loss Account 30 30
Debentures 10
Current Liabilities 60 40
Depreciation charges was Rs.6 lakhs. Prepare Fund Flow statement.
Solution:
Schedule of changes in working capital
2006 2007
Current Assets 140 150
LESS: Current liabilities ( 60 ) (40)
Working Capital : CA minus CL 80 110
Net Increase in working capital transferred to 30
FFS (application)
110 110
To By
Depreciation 6 Opening Balance 30
Closing Balance 30 Funds from Operations 6
36 36
Funds Flow Statement
Sources Applications
Issue of Equity shares 60 Purchase of Fixed Assets 16
Funds from operation 6 Purchase of investment 10
Redemption of debenture 10
Increase in working capital 30
66 66
Problem 7 : From the following extracts, calculate funds from operations
Year
2006 2007
Profit and Loss account 50,000 80,000
Provision for taxation on 10,000 15,000
Proposed dividends 5,000 10,000
Additional information: Tax paid Rs.2,500. Dividends paid Rs.1,000.. Calculate funds from
operation taking provision for tax and provision for tax and proposed dividend as (a) non current
liabilities and (b) current liabilities.
Solution:
Provision for tax and proposed dividend are taken as noncurrent liabilities
To By
Income tax account 2,500 Opening balance 10,000
Tax paid Profit and loss account 7,500
Closing balance 15,000 provision made (balance
Figure)
17,500 17,500
Proposed Dividend Account
To By
Dividend account being Opening balance 5000
Dividend paid during the Profit and loss account
Year 1,000 proposed dividend 6,000
Closing balance 10,000
11,000 11,000
To By
Provision for Tax 7,500 Opening balance 50,000
Proposed Dividend 6,000 Funds from operations
Closing balance 80,000 (balancing figure) 43,500
93,500 93,500
c) If Provision of tax and proposed dividend are taken as a current liability, funds from
operations will be the difference in Profit and Loss account at the beginning and the end of
the year.
NOTES
1. In case a) Income tax paid Rs.2,500 and Dividend paid Rs.1,000 are shown as application of
funds in the FFS.
2. In case (b), there is no need to prepare proposed dividend account and provision for tax
account,. However, the opening and closing balances of the two accounts are shown as
current liabilities in the statement of changes in working capital
Problem 8: The book value of trade investments of DR Ltd as on March 1, 2006 and March 31,
2007 was Rs.50,000 and Rs.70,000 respectively. During the year, Rs.5,000 was received as
dividends, of which Rs.2,000 pertained to preacquisition profits which have been credited to
Investments Account. Investments costing Rs.10,000 have been sold during the year for
Rs.10,000. Find the flow of funds on account of investments.
Solution:
Investments Account
To By
Opening balance 50,000 Dividend Account : Pre
Bank Account : purchase acquisition profit 2,000
Of investments (balance 32,000 Bank : sale of investments 10,000
82,000 82,000
Notes:
1) The investments purchased were valued cumdividend. Hence, on receipt of dividends, they
were rightly credited to Investments. Hence there is no need for any further adjustment.
2) The investments sold has been at the book value. There is no profit or loss on account of the
transactions. If the transaction had resulted in profit, it will have to be deducted from net profit
to calculate funds from operations. In case of loss, it would be added to net profit to calculate
funds from operations.
Problem 9: Prepare a fun d flow statement of DR Ltd.
Year
2007 2008
Equity share capital 10,00,000 15,00,000
10 % Preference Share Capital 3,00,000
11 % debentures 8,00,000 6,00,000
Share Premium Account 1,00,000 95,000
Additional information (a) 10 % Preference shares have been redeemed at a premium of 10%,
the premium amount was charged to the share premium account (b) There has been a profit of
Rs.1,000 on the redemption of debentures.
Solution:
Equity Share Capital
To By
Closing Balance 15,00,000 Opening balance 10,00,000
Bank (Fresh issue) 5,00,000
Balancing figure
15,00,000 15,00,000
Preference Share Capital Account
To By
Bank (Redemption) 3,30,000 Opening balance 3,00,000
Premium on redemption 30,000
3,30,000 3,30,000
Debentures Account
To By
Bank (redemption) 1,99,000 Opening balance 8,00,000
Profit on redemption 1,000
Closing balance 6,00,000
8,00,000 8,00,000
Share Premium Account
To By
Preference share 30,000 Opening balance 1,00,000
capital
Closing balance 95,000 Equity share capital * 25,000
1,25,000 1,25,000
STATEMENT SHOWING SOURCES AND APPLICATION OF FUNDS
Equity share capital 5,00,000 Redemption of Preference shares 3,30,000
Share Premium 25,000 Redemption of Debentures 1,99,000
Decrease in working capital 4,000
5,29,000 5,29,000
Problem 10: The following are the summarized Balance Sheets of DR Ltd.
Liabilities 2006 2007
Share Capital 5,00,000 6,00,000
Reserves 1,50,000 1,80,000
Profit and Loss Account 40,000 65,000
Debentures 3,00,000 2,50,000
Creditors for goods 1,70,000 1,60,000
Provision for Income tax 60,000 80,000
12,20,000 12,20,000
Assets
Fixed Assets 10,00,000 11,20,000
Less : Depreciation (3,70,000) (4,60,000)
Stock 2,40,000 3,70,000
Book Debts 2,50,000 2,30,000
Cash 1,00,000 75,000
12,20,000 12,20,000
Prepare a Funds Flow statement
Solution:
Statement of changes in working capital
Balances as on Effect on W.C
2006 2007 Increase Decrease
Current Assets
Stock 2,40,000 3,70,000 1,30,000
Book Debts 2,50,000 2,30,000 20,000
Cash 1,00,000 75,000 25,000 .
Total CA say A 5,90,000 6,75,000
Current Liabilities
Creditors for goods 1,70,000 1,60,000 10,000
Provision for income tax 60,000 80,000 20,000
Total CL, say B 2,30,000 2,40,000
Working Capital, A – B 3,60,000 4,35,000
Increase in Working capital 75,000 75,000
Total 4,35,000 4,35,000 1,40,000 1,40,000
To By
Reserve 30,000 Opening balance 40,000
Depreciation 90,000 Funds from Operation 1.45,000
Closing balance 65,000 transferred to source
1,85,000 1,85,000
Statement showing Sources and Application of Funds
Sources Application
Issue of Share capital 1,00,000 Redemption of debentures 50,000
Funds from operation 1,45,000 Purchase of Fixed Assets 1,20,000
Increase in working capital 75,000
2,45,000 2,45,000
Notes:
1) The increase in General Reserve is due to transfer a part of profit of the current year and
hence the difference is transferred to APL since it’s a noncash item
2) The difference in depreciation is charged to APL, since it’s a noncash item.
3) Increase in Equity Share capital is assumed to be the fresh issue which is a cash item. It is
recoreded in FFS.
4) The difference is debentures is the redemption. It’s a cash item. Hence taken to FFS
5) Purchase of fixed asset is difference between the opening and closing balance of fixed
assets. It’s a cash item. Hence taken to FFS .
Problem 11
Prepare a Fund Flow Statement
Balance Sheets
2006 2007 2006 2007
Equity Share capital 50,000 65,000 Cash balances 15,000 9,000
Profit & Loss 14,750 17,000 Debtors 25,000 27,000
Trade Creditors 31,000 29,000 Investment 5,000
Mortgage 10,000 15,000 Fixed Assets 70,000 80,000
Short term loans 16,500 15,000 Less: Depreciation (25,250) (7,000)
Accrued expenses 7,500 8,000 Goodwill 5,000
1,29,750 1,49,000 1,29,750 1,49,000
Depreciation provided is Rs.4,750. Write off goodwill. Dividend paid Rs.3,500.
Solution:
Schedule of changes in working capital
Balances as on
2006 2007
Current Assets
Cash 10,000 13,000
Debtors 25,000 27,000
Stock 40,000 35,000
Total current assets, say A 75,000 75,000
Current Liabilities
Trade Creditors 29,000 31,000
Short term loans 15,000 16,500
Accrued expenses 8,000 7,500
Total current liabilities, say B 52,000 55,000
Working capital, A – B 20,000 24,000
Net increase in Working capital 4,000
Total 24,000 24,000
To By
Depreciation 1,750 Opening balance 30,000
Goodwill 5,000 Funds generated from
Dividend 3,500 operations 12,500
27,250 27,250
Funds Flow statement
Issue of fresh equity 15,000 Purchase of fixed assets 30,000
Sale of investment 5,000 Payments of dividends 3,500
Loan on mortgage 5,000 Increase in working capital 4,000
Funds from operations 12,500
37,500 37,500
Problem 12
The Balance Sheets of DR Ltd
Rupees in 000s
2006 2007 2006 20078
Share capital 50 100 Goodwill 15 25
Debenture 25 Plant 18 96
Profit and Loss 15 25 Stock 40 35
Proposed Dividend 5 6 Debtors 15 32.5
Creditors 20 30 Cash 8 9
Liabilities for expenses 5 3.5 Preliminary exp 4 2.5
100 200 100 200
A business was purchased during the year by the issue of 25,000 shares and 25,000 debentures.
Depreciation Rs.6,000 has been provided in the year. A machine has been sold for Rs.1,50,000,
the written down value being Rs.1,000. The business purchased had the following assets and
liabilities : Machine Rs.20,000, Stock Rs.5,000, Debtors Rs.15,000, Creditors Rs.5,000. Prepare
the Funds Flow Statement.
Solution
In this problem, another business concern was purchased whereby the assets and liabilities come
into business. For this purchase, the payment is through the issue of shares and debentures. If
the payment were to be in excess of assets and liabilities taken over, the excess payment is
known as “Goodwill”.
Assets taken over : Machine 20,000
Stock 5,000
Debtors 15,000
40,000
Less Creditors taken over ( 5,000 )
Net assets taken over 35,000
Total payments made : Share capital + Debentures 50,000
Excess payment being treated as Goodwill (50,00035,000) 15,000
Statement showing changes in working capital:
Balances as on
2006 2007
Current Assets
Stock 40,000 35,000
Debtors 15,000 32,500
Cash 8,000 9,000
Total current assets, say A 63,000 76,500
Current Liabilities
Sundry Creditors 20,000 30,000
Liabilities for expenses 5,000 3,500
Overdraft 5,000 10,500
Total current liabilities, say B 30,000 44,000
Working capital A – B 33,000 32,500
Decrease in working capital (source) 500
33,000 33,000
To By
Goodwill 5,000 Opening balance 15,000
Preliminary expenses 1,500 Profit on sale of Plant 500
Depreciation 6,000 Funds from operations 28,000
Proposed dividend 6,000
43,500 43,500
Funds Flow Statement
Issue of fresh shares for :
cash for current assets
Stock 5,000
Debtors 15,000
Less: Creditors (5,000) 15,000 Purchase of Plant 65,000
Sale of Plant 1,500 Payment of dividend 5,000
Funds from operations 28,000
Decrease in working
Capital 500
70,000 70,000
Terminal Question
Problem 1: The balance in the Provision for taxation : opening Rs.30,000 and closing
Rs.40,000. Taxes paid during the year was Rs.25,000. Calculate Funds from operation. (b) What
is the provision made during the year?
Problem 2: Extracts of Balance Sheets are given below :
2006 2007
Profit and Loss appropriation account 30,000 40,000
General Reserve 20,000 25,000
Goodwill 10,000 5,000
Preliminary expenses 6,000 4,000
Provision for Depreciation on Machinery 10,000 12,000
Calculate funds from operation
Problem 3: Calculate funds from operations:
Profit and Loss Account
To By
Expenses 3,00,000 Gross profit 4,50,000
Loss on sale of plant 4,000
Discount on Debenture 200
Goodwill 20,000
Net profit 1,15,800
5,10,000 5,10,000
Problem 4: Calculate funds from sale of Plant
Plant (gross) 1,00,000 1,25,000
Additional information:
a) Loss on sale 1,000
b) Depreciation charged 14,000
c) Purchase of Plant 35,000
Problem: 5. The Balance Sheets are as follows
Capital 25,000 20,000 Cash 4,700 3,000
Profit and Loss 2,300 1,000 Debtors 11,500 12,000
Bills Payable 4,500 7,000 Land 6,600 5,000
Stock 9,000 8,000
31,800 28,000 31,800 28,000
Prepare a statement of Sources and uses of funds.
Answer Self Assessment Questions
1. Derived, changes, assets, equities
2. Two
3. Inside and outside
4. Cash and cash equivalents
1. Cash, working capital, total financial resources
2. Control
3. Short term financial planning
4. Current assets minus current liabilities
5. Excluded
6. Short term liquidity
7. Both financial and investment transaction
8. Qualitative information
1. Changes, assets and liabilities
2. Financial strengths and weaknesses
1. Financial assets and liabilities including capital
2. Statement of changes in working capital, statement of sources and uses of funds
3. Net increase or decrease in individual items
4. Increases
5. Decreases
6. Decreases
7. Increases
8. Positively corelated
9. Inversely related
1. Application
2. Source
3. Gross profit – Cost of goods sold + expenses
4. Non fund revenue, non trading changes or losses
5. intangible assets and revenue items
6. Appropriation of retained earnings.
1. Inflow
2. Inflow
3. Inflow
4. Inflow
5. Inflow
6. Inflow
7. Inflow
1. Source
2. Excluded from fund flow statement.
1. Source of funds
2. Source of funds
1. Addition of shares, accumulated retained earnings
2. Expansion, diversification and modernization
3. Increases
4. Source
5. Increases and never decreases
6. Redemption
1. Outflow of cash
2. Outflow of cash
3. Outflow of cash
4. Outflow of cash
5. Outflow of cash
6. Outflow of cash
7. Outflow of cash.
1. Purchase
2. Current year minus previous year
3. Increase in fixed assets
1. Outflow
2. Deduction.
1. Loss of operation
2. Payment of cash dividend out of accumulated reserves
3. Part of paid up capital + reserves and surplus.
1. Change of fund
2. Source
3. Application
4. Non fund
5. Change.
6. Positive
7. Negative.
1. Current assets and Current liabilities.
1. Schedule of changes in working capital
2. Adjusted Profit and Loss account
3. Funds flow statement
1. Two Balance sheet dates
2. (b) A minus B
3. (c) Current assets
4. Current liabilities
5. A minus B
6. Balancing figure.
1. Reserve
2. Deduction
3. Working capital changes
4. Considered as current liabilities
5. In Provision account
6. Liability
7. General Body Meeting
8. Current liability
9. Outflow
10. Current assets
11. Fixed assets
12. Fall in value
13. Non cash item
14. Opening balance
15. Provision account and not to Profit and Loss account
16. Fixed assets
Answer for Terminal Questions
1: 35,000, (b) Taxes paid is an application of funds.
2. Rs.24,000
3. Rs.1,50,000
4. Fund Rs.45,000; Accumulated Depreciation on plant sold Rs.9,000
5. Funds lost from operations. Rs.1,300, Decrease in WC Rs.4,700)
Unit 11 Cash Flow Analysis
Structure:
11.1 Introduction
Objectives
11.2 Meaning
11.3 Objective
11.4 Uses
11.5 Steps in preparation
11.6 Difference between CFS and FFS
11.7 Computation
Terminal Questions
11.1 Introduction
The funds flow analysis deal with the flow of funds within and outside the organization. The main
focus of funds flow statement is to explain the changes which have taken place in net working
capital during the period under consideration. Funds flow statement normally fails to explain the
changes in cash balance. The movement of cash is of vital importance to the management. The
organization may become directionless if the cash inflows are not sufficient to meet the cash
outflows. Many a time, a management is posed with the paradox of huge profits and yet
impossible to pay dividends or even taxes. This is due to the ground realities that cash is either
not received or the cash received is drained out in other items. Hence, it has become a
necessity to have a cash flow analysis on a day to day basis. The statement shows the items
resulting in cash inflows and cash outflows.
1. Understand the meaning of cash flow statement.
2. Appreciate the uses of cash flow statement.
3. Acquaint with steps in preparation of CFS.
4. Distinguish between FFS and CFS.
5. Compute the CFS.
11.2 Meaning of Cash Flow Statement
Cash flow statement, also known as “Statement Accounting for variations in cash” shows the
movement of cash and their causes during the period under consideration. The statement is
mainly prepared to show the impact of financial policies and procedures on the cash position. It
takes into account all the transactions that have a direct impact upon cash.
1. CFS is also known as __________________.
2. CFS is prepared to Know ______________.
11.3 Objectives
The main objective of cash flow analysis is to show the causes of changes in cash balances
during the period under consideration. The necessary information required to keep the
management of the real cash position, this statement is comes handy. It bring in the liquidity
position of the firm. It is of particular importance in short range planning. It enables a
management to take a strong short term financial decision relating to liquidity and ways and
means to achieve it.
1. Main objective of CFS is _______________.
2. CFS brings in ___________________ position.
3. CFS is ________________ of importance in ________ planning.
11.4 Uses of Cash Flow Statement
The cash flow statement, being one of the important financial documents a firm has to possess ,
reveals the effective uses. First of all, it explains in depth the reasons for the low cash balance
available at a particular time. Based on this, it is possible to find the reasons for such a situation.
It also shows the major sources and uses of cash. By effectively maintaining the cash and
controlling the outflow of cash, it is possible to set in motion the smooth functioning of the
organization. It helps the financial decisions more effectively with regard to short term liquidity
position of an organization. Projections of cash inflows and outflows can be regulated based on
the records available in the past. Proper projections can be made once the reasons are
analyzed. Based on this, it is possible to liquidate the short term obligations without much fun
fare. Short term obligations need to be serviced so that the credit worthiness of an organization
can be carried on unabated.
1. CFS explain _______________ low cash balance.
2. CFS shows _________ flows.
3. CFS helps ________decision ______________ position.
11.5 Steps In Preparation Of Cash Flow Statement
The Cash Flow Statement (CFS) is prepared with the help of Balance Sheet. , income statement.
The measurement of cash flow is primarily based on income statement. Under the CFS, the cash
basis technique is adopted. The measurement of cash flow is not measurement of net income.
The CFS depends primarily on determining cash receipts and disbursements over a given period.
The CFS is concerned with cash inflows sources of cash_ and cash outflows (application of
cash).The sources and application of cash are computed separately.
The various sources for cash inflows are :
Cash Sales : When a concern is doing its business on cash basis, the cash flows in out of sales
effected. When the cash sales are in vogue, it is quite natural that the business also effects its
purchases on cash basis. In addition, the operating expenses should be payable in cash.
Therefore the cash inflow should be as follows :
Cash inflow from cash sales = Cash sales – cash purchases – operating expenses.
In addition, if the business is conducted both on cash and credit basis, then from the total sales
effected, deduct the credit sales. Therefore the cash sales is :
Total sales – credit sales
OR
Total sales – increase in debtors and Bills receivable.
So also, the cash purchases are also dealt with in the same manner as discussed with cash
sales.
Net Profit method : Cash from operations can be determined with the net profits figure also.
This method is handy when the amount of sales is not known In this case, non cash and non
trading expenses and losses are added back to net profit. From this, the income from
investments, increase in Accounts Receivable, increase in prepaid expenses, decrease in
outstanding expenses are deducted.
In addition to the above, operating profits are also considered as cash from operations, such as
increase in share capital, debentures, loans, other receipts such as dividends, interest on
investment, and reduction in or sale in assets.
Cash outflows : These refers to uses or application of cash. These arises due to operating loss,
redemption or repayment of redeemable preference shares or debentures, repayment of loans,
purchase of assets, other revenue payments such as dividend, income tax , interest,
compensation.
1. CFS is prepared with the help of ____________.
2. CFS is based on _________ technique.
3. CFS is ____________________.
4. Cash sales refers_________________.
5. Cash flow _______________________.
6. For credit transaction the equation is cash flow = total sales______________.
7. Cash outflow = total purchase ____________________.
8. Net profit method is used when __________ not known.
9. ______ and ______ added back to net profit.
10. Cash outflow refers to________________.
11.6 Difference Between Cash Flow And Funds Flow Statement
The major differences between the two are :
1. FFS is related with accrual basis whereas CFS is on cash basis. For this the, it is
necessary to convert the accrual to cash basis.
2. In FFS, a Schedule of changes in working capital delinking the current assets and current
liabilities are made. But in FFS, no schedule is prepared.
3. FFS shows the causes of the changes in net working capital. CFS shows the causes for
the change in cash
4. In FFS, no opening or closing balances are recorded. But in CFS both are incorporated
5. FFS is not based on the Ledger mode. But CFS is prepared on the basis of Ledger
principles.
6. In FFS, “To” and “By” are indicated. In CFS, these are indicated.
7. In FFS, net effect of receipts and disbursements are recorded. In CFS only cash receipts
and payments are recorded.
8. FFS is concerned with the total provision of funds. CFS is concerned with only cash.
9. FFS is flexible but CFS is rigid
10. FFS is more relevant for long range financial strategy. CFS concentrates on short term
aspects mostly affecting the liquidity of the business.
1. FFS is __________ basis CFS is __________.
2. Statement of working capital is the _____________. And not the ______________.
3. In FFS __________ balance not recorded but CFS _____________.
4. CFS is ____________ mode but FFS_______
5. FFS ________ receipts are recorded in CFS________
6. FFS is _________ CFS ___________.
11.7 Computation Of Cash From Operations
The Cash Flow Statement should be prepared as per the revised Accounting Standard issued by
the ICAI . Accounting Standards 3 specifies : “The cash flow statement should report cash flows
during the period classified by operating, investing and financing activities”. As per the revised
standard, there are two methods of preparing cash flow statement namely Direct method and
Indirect method. In this Study material, indirect method is adopted throughout.
Format
CASH FLOW STATEMENT AS PER AS 3
For the year ended ………..
A Cash flow from operating activities :
Net profit before taxes and extraordinary items
ADJUSTMENTS FOR ;
1, Depreciation
2. Miscellaneous expenses written off
3. Loss on sale of fixed assets
4. interest expenses
5. Dividend income
Operating profit before working capital changes
ADD : Decrease in current assets
Increase in current liabilities
Deduct : Increase in current assets
Decrease in current liabilities
Cash Generated from operating activities
B. CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of fixed assets
Sale of fixed assets
Purchase of long term investment
Sale of long term investment
Interest received
Dividend received
Capital gain tax on income from sale of long term investment
Net cash from investing activities
C. CASH FLOWOS FROM FINANCING ACTIVITIES
Proceeds from issue of share capital
Proceeds from long term borrowing
Repayment of long term borrowings
Interest paid
Dividend paid
Tax on distributed profit
Net cash from Financing Activities
Total of A + B +C
Net Increase or Decrease in cash and cash equivalents
Add : Cash and cash equivalents opening balance
Cash and cash equivalents : closing balance
Classification of cash flows :
Cash flow statement has been divided into three parts namely:
1. Cash flows from Operating Activities
2. Cash flows from Investing Activities
3. Cash flows from Financing Activities
CASH FLOWS FROM OPEPRATING ACTIVITIES
Meaning : Operating activities are the principal revenue producing activities of the enterprise
and other activities that are not investing or financing activities.,. Therefore, they generally result
from the transactions and other events that enter into the determination of net profit or loss.
Object : The amount of cash flows arising from operating activities is a key indicator of the
extent to which the operations of the enterprise have generated sufficient cash flows to maintain
the operating capability of the enterprise, pay dividends, repay loans and make new investments
without recourse to external source of financing. Information about the specific components of
future operating cash flows is useful in conjunction with other information in forecasting future
operating cash flows.
1. CFS is prepared as a per _________.
2. CFS deals with ____, __________, _____________activities .
3. CFS is based on 2 methods _____________ and _______________.
4. Operating Activity is based on __________.
Problem 1: Compute the cash flow from operating activities
Profit and Loss Account
To By
Cost of goods sold 4,00,000 Sales including cash sales 5,00,000
1,00,000
Office expenses 12,000 Profit on sale of land 30,000
Selling expenses 8,000 Interest on investment 20,000
Depreciation 6,000
Loss on sale of plant 4,000
Goodwill written off 3,000
Income tax 7,000
Net Profit 1,10,000
__________ _________
5,50,000 5,50,000
Position of current assets and current liabilities are as follows :
MARCH 31
2006 2007
Stock 30,000 28,000
Debtors 15,000 12,000
Creditors 10,000 12,000
Bills Payable 8,000 5,000
Solution
Statement showing cash flows from operating activities
Net Profit before tax and extraordinary items 1,10,000
ADD : income tax 7,000
Adjustments for Depreciation 6,000
Goodwill written off 3,000
:Loss on sale of plant 4,000
1,30,000
Less: Profit on sale of land 30,000
Interest received 20,000
( 50,000 )
Operating profit before working capital changes 80,000
Stock 2,000
Debtors 3,000
Increase in current liabilities : Creditors 2,000
Outstanding expenses 1,000
8,000
88,000
Less Increase in current assets : Bills Receivable 2,000
Decrease in current liabilities : Bills payable 3,000
( 5,000)
Cash generated from operating activities 83,000
Less : Payment of income tax ( 7,000 )
Net Cash from operating Activities 76,000
As per AS – 3, Net profit before taxation must be shown here.
Problem 2 : Calculate cash flow from operating activities
MARCH 31
2006 2007
Debtors 1,00,000 80,000
Creditors 30,000 40,000
Income received in advance 1,000 800
Prepaid expenses 600 500

Accrued income 300 450
Operating profit before working capital changes Rs.3,80,000
Solution
Statement showing cash flow from operating activities
Operating profit before working capital changes 3,80,000
Debtors 20,000
Prepaid expenses 100
Creditors 10,000
Outstanding expenses 2,000
32,100
4,12,100
Less : Increase in current assets
Bills receivable 5,000
Accrued income 150
Decrease in current liabilities
Bills payable 8,000
Income receivable in advance 200
(13,350)
Net cash from operating activities 3,98,750
Problem 3: The following is the position of current assets and current liabilities
March 31
2006 2007
Short term loan 15,000 18,000
Creditors 30,000 8,000
Provision for Doubtful debts 1,200
Bills Payable 18,000 20,000
Stock in trade 15,000 13,000

Prepaid expenses 800 600
Outstanding expenses 300 500
Current year net loss is Rs.38,000. Calculate the cash flows
Solution
Net Loss ( 38,000 )
ADD: Decrease in Current Assets
Provision for doubtful debts 1,200
Stock 2,000
Outstanding expenses 200
Bills payable 2,000
+ 5,600
__________
32,400 )
DEDUCT ; Increase in current assets
Short term loan 3,000
Bills receivable 10,000
Creditors 22,000
+ 35,000
Net cash loan in operating activities ( 67,400 )
Problem 4:
Following extracts are in respect of a company.
MARCH
2006 2007
Debtors 30,000 10,000
Stock 25,000 28,000
B.R. 40,000 8,000
Short term loan 10,000 11,000
Creditors 10,000 20,000

B.P. 6,000 2,000
Outstanding expenses 600 300
The current year net loss is Rs.50,000. Calculate the cash flows.
Solution :
Net Loss ( 50,000 )
Add: Decrease in current assets
Debtors 20,000
B.R. 32,000
Creditors 10,000
+ 62,000
+ 12,000
DEDUCT : Increase in current assets
Stock 3,000
B.P. 4,000
Outstanding expenses 400
(8,500)
Net cash from operating activities + 3,500
Terminal Questions
1. What are the objectives of cash flow statements ?
2. Mention the steps involved in the preparation of CFS ?
3. Distinguish between cash flow and fund flow statements.
4. Compute cash flows from operating activities
March
2006 2007
Profit and loss account 1,00,000 80,000
Debtors 90,000 72,000
Bills receivable 50,000 48,000

Stock 60,000 42,000
Goodwill 20,000 8,000
Creditors 26,000 38,000
5. Cash transactions in respect of DR Ltd are as follows :
Balance of cash on hand 70,000 Payment to creditors 25,00,000
Receipts from Debtors 30,00,000 Purchase of fixed assets 2,50,000
Issue of shares 8,00,000 Payment for overheads 1,50,000
Sale of fixed assets 2,00,000 Salaries 70,000
Income tax 1,00,000
Dividend paid 80,000
Repayment of loan 1,50,000
Closing balance of cash 7,70,000
40,70,000 40,70,000
Prepare a cash flow statement
Answer Self Assessment Questions:
1. Statement Accounting for variation in cash
2. Financial polices and procedures
1. show causes of changes.
2. Liquidity
3. short term.
1. reasons.
2. major
3. financial, short term liquidity
1. B.S. income statement.
2. cash basis
3. measurement of net income
4. sale through case only
5. cash sales – cash purchase – operating expenses.
6. credit sales
7. minus credit purchases
8. sales
9. cash and non trading expenses and losses.
10. application of cash.
1. accrual, cash
2. FFS , CFS
3. opening and closing, recorded.
4. ledger, not
5. net effect, cash receipts.
6. flexible, rigid.
1. AS 3
2. operating, investing and financing.
3. Direct, Indirect.
4. profit and loss account
1. Refer to unit 11.2 and 11.3
4. Net cash from operating activities Rs 13,000
5. Net cash from operating activities Rs 1,80,000
Cash flows from investing activities Rs 50,000
Cash flows from financing activities Rs 5,70,000
Unit 12 Understanding Cost
Structure:
12.1 Introduction
Objectives
12.2 Meaning
12.3 Concepts
Self Assessment Question 2
12.4 Components
12.5 Total cost
12.6 Cost sheet
12.7 Format
12.8 Valuation of WIP
Terminal Questions
12.1 Introduction
The need for accounting arose because of limitations of human memory. To preserve the
knowledge, various steps are taken both in the past and in future. It is necessary to record all the
business purposes. Accounting is a science as well ass an art of recording the business
transactions in the books of accounts systematically and scientifically.
Until the1980s, the Cost Accounting was in the domain of the Engineer. Its integration with
financial accounting started when Accountants started to audit the cost records. The costing
technique play a vital role in gathering and analyzing revenue and cost data to assist
management in decision making. The point of emphasis has logically shifted from cost
accumulation to cost analysis, a change from a limited cost finding function on to a broader
managerial function. All managerial policies and decisions permeate all phases of cost
accounting and cost information helps in :
Acquiring plant and machinery
Adding or reducing a product
Buying or making parts
Special pricing of products
Replacement of equipments.
1. Explain the meaning of cost.
2. Analyse the cost concepts.
3. Understand the element of cost.
4. Familiarize with components of total cost.
5. Prepare the statement of cost.
6. Understand the valuation procedure of work in progress.
12.2 Meaning Of Cost
Cost is the amount of resources given up in exchange of some goods and services. The
resources are expressed in money or money’s equivalent. CIMA defines the term Cost as “ the
amount of expenditure (actual or notional) incurred on or attributable to a given thing.”. The given
thing may be taken as a product, service or any other activity. While the actual expenditure refers
to the amount spent , the notional expenditure does not involve in any cash outlay. It does not
reflect itself in the accounting records. But, it is important for the purpose of comparison of cost
and in decision making.
1. CA ___________ resources scarified .
2. Resource are in _________________.
12.3 Cost Concepts
Cost represents expenses. It is a sacrifice in advance. It concerns with a release of something of
value. The cost is used :
The expected cost of a particular action. It is what the cost is expected to be in
choosing a course of action.
The cost of something purchase i.e. the price actually paid for it. It is the price paid or payable,
time of purchase of goods or services. The price paid is the amount of money, the holding of
which is foregone.
The cost of attaining some end – the sacrifices actually made to attain it experienced costs.
1. Cost is ________________.
2. cost __________ advance.
12.4 Component Or Element Of Cost
Any product that is manufactured, whether a pin or a computer calls for consumption of some
resources. The management, for its planning and control function must know the cost of using
their resources. Therefore, the elements of costs are classified as materials, labor and
expenses. These three elements of cost would be grouped in to direct and indirect categories
Cost
Direct Indirect
Raw Labor Chargeable Material Labor Overheads

Material Expenses
Following are the three broad elements of cost
Materials
Labor
Expenses
Materials: The term materials may be defined as the substances from which products are
manufactured. These materials may be in a raw or a manufactured state. Materials may be
direct or indirect.
It is an accepted fact, based on statistics, that 75% of the total cost is in the form of raw materials.
These are the physical; items used in manufacturing. These are the physical items used in
manufacturing. These can be traced precisely and convincingly to the unit of product. It refers to
all materials brought for being converted into finished product example log of wood awaiting to be
converted into doors and windows. Therefore, the term “raw” indicates that the firm using the
materials has not yet processed them. But what is raw material for one manufacturer might be a
finished product for another : for example bricks, cement, steel is a raw material for a
construction company where for a steel producing firm it is the final product. For admission to I
MBA, the raw materials are the graduates.
Indirect materials: These are materials which do ot become part of the product. These
materials are consumed in the course of production. These materials cannot be conveniently
assigned to specific physical units. Some of the indirect materials are consumable stores, oil,
lubricants, cotton wastes, printing and stationers. Indirect materials may relate to the factory, the
office and administration and the selling and distribution divisions.
Direct Labor: It represents wages payable / paid to those employees who directly engaged in the
conversion of raw materials into final product. They operate in the manufacturing machinery and
equipment. They directly handle the raw materials, work in process and the finished goods on
the production line. They account is to see whether the work done on a particular product or a
specific group of products.
Examples: In a furniture mart, the carpenters engaged in conversion of raw wood with sofa set,
computer tables, windows, doors , benches are said to be the direct workers. In an engineering
workshop, the wages paid to the operators working with laths, drilling, cutting, shaping machines
can be specifically assigned to the products concerned. Therefore, the direct labor costs can be
traceable to individual products.
Indirect Labor: Indirect labor is the labor which is not directly engaged in the production
operations. They are, however, engage themselves to help in the production operations. Such
labor does not alter the construction, composition or conditions of the product. Example
foreman’s salary, storekeepers salary, Factory manager’s salary etc. The indirect labor may
relate to the factory, office and administration and selling and distribution divisions.
Chargeable Expenses : The items are of expenses which may be allocated to a specific job,
process or operation. The utility of expenses is exhausted on completion of the job concerned.
Therefore, logically, they are treated as direct expenses. The chargeable expenses are usually
incurred when the business concern undertakes some outside constructional work far away from
the principal premises, example widening of road by L & T construction company for the new
International Airport. The popular items fall under this category are:
a) cost of pattern, designs, drawings specifically prepared for a particular job
b) hire charges of special machinery, plant or equipment
c) architects and surveyors fees in connection with particular job or contracts.
d) Cost of any experimental work carried out for a particular job
Indirect expenses: These are those expenses which cannot be directly and conveniently
allocated to specific cost units / cost centers.. They are apportioned. Examples are rent, rates
and insurance. They may relate to the factory, the office and administration and selling and
distribution divisions. These are now popularly known as “overheads”. These costs arise as a
result of overall operations of a business. These costs are shared by all the products. It includes
all manufacturing and nonmanufacturing suppliers and services. These costs cannot be
associated withy a particular product or unit. Overheads remain relatively constant from period to
period. At least they do not fluctuate in amount in relations to changing levels of factor
production. Overhead costs are classified by functions of an organization into :
Factory, works or manufacturing overheads
Administration, office, establishment or general overheads
Selling and distribution overheads.
1. Cost compose ________________
2. Direct cost include__________.
3. Indirect cost are know as ___________.
4. Raw refers to ______________.
5. Indirect materials cannot be _____________.
6. Direct labor is ____ for __________.
7. Indirect labor is engaged for ________.
8. Chargeable expenses are ____________
9. Chargeable expenses are______________________ expand.
10. Indirect expenses are ________________.
11. IDE are known as _________________.
12.5 Components Of Total Cost
The components of total costs are based on functional classification. The various stages through
which the costs flow are:
Prime cost : It is the total of direct materials cost, direct labor cost and chargeable expenses/
Factory Cost : It consists of prime cost and factory overheads/
Office cost or Cost of Production: It comprises of factory cost and office and administration
overheads.
Total Cost : By adding selling and distribution expenses to cost of production, one can get the
total cost or cost of sales.
1. Prime cost is _______________.
2. Factory cost is _____________.
3. Cost of production is _____________.
4. Total cost is ___________________.
5. Sales is _________________.
6. Profit is __________________.
12.5 Statement Of Cost Sheet
Cost sheet is a statement prepared to show the different components of the total cost. It
generally shows the total cost and sales as well as cost and selling price per unit. It is generally
presented in a tabular form.
1. Cost sheet shows ___________ cost.
2. It is prepared _________ form.
12.5 Format Specimen Of Cost Sheet
Name of Company _______________________________
Cost sheet for the product __________________________
For the year ending _______________________________
Output in units
Particulars Total Per unit
Rs. Rs.
Raw Materials consumed:
Opening Stock of Raw Material
ADD: Purchases of Raw materials
Add: Carriage on purchases
LESS: Closing stock of Raw material
Raw Material Consumed (RMC) x x x
Director Labor x x x
Chargeable Expenses x x x
Prime Cost XXX
Factory overheads x x x
Factory Cost XXX
Office and Administration Overheads x x x
Cost of Production XXX
Inventory valuation
Opening stock of finished goods xxx
Less: closing stock of finished goods : always
To be valued at cost of production ( xxx )
Cost of Goods Sold (COGS) XXX
Selling and Distribution Overheads x x x
Total Cost of Cost of Sales XXX
Profit (balancing figure) x x x
Sales Revenue or Sales XXX
Example:
Prepare a cost sheet Raw materials consumed Rs.1,60,000. Direct wages Rs.80,000. Factory
overheads Rs.16,000. Office overheads 10% of factory cost. Selling overheads Rs.12,000. Units
produced 4,000.Selling price per unit Rs.100.
Solution: Cost Sheet
Raw materials 1,60,000
Direct wages 80,000
Prime cost 2,40,000
Factory overheads 16,000
Factory Cost 2,56,000
Office overheads (10 % of factory cost) 25,600
Cost of Production 2,81,600
Less : Closing stock of finished goods to be valued at
Cost of production : 2,81,600 x 400 */ 4000** ( 28,160)
Cost of Goods Sold 2,53,440
Selling overheads 12,000
Cost of Sales / Total Cost 2,65,440
PROFIT (balancing figure) 94,560
Sales (3600 x Rs.100) 3,60,000
*Closing stock in units : Units produced minus units sold
**Denominator should be the current year production in units.
Items not included in Cost Sheet:
a) Income tax
b) Dividends to shareholders
c) Commission to managing directors
d) Capital losses i.e. loss out of sales
e) Interest on loan or debentures or bank interest
f) Donations
g) Capital expenditure
h) Discounts on shares and debentures
i) Premium on redemption of shares and debentures
j) Underwriting commission
k) Writing of goodwill, preliminary expenses
l) Reserve for bad debts
m) Transfer to all reserves or appropriation of profits
n) Share premium
o) Interest on capital
p) Drawing of proprietors
q) All personal expenses of owner
1. RMC is ___________.
2. COGS is _____________.
3. Closing inventory is valued _____________________.
4. Profit ______________ figure.
12.6 Valuation Of WorkinProgress
In a manufacturing enterprise, there may be certain amount of goods in a partly manufactured
state at the end of a particular period. These are called as “semi manufactured goods” or “work
in progress”. The WIP is valued according to the value of raw material, labor and expenses
which has so far incurred to the date of closing of financial period. The work in progress has
usually three components:
Material work in progress cost to date
Labor to date
Manufacturing expenses incurred to date
The treatment of work in progress is to add the opening work in progress to the concerned cost
and deduct the closing work in progress against it.
1. WIP is nether ____________ nor __________.
2. WIP is treated as ________________.
3. Profit margin as total cost is _____________.
4. Profit margin as selling price is ___________.
5. 25% profit on SP is ______________.
6. 25% on TC is ___________.
Example:
DR Ltd manufactures Electronic components. The following figures are supplied Rs.
Purchase of Raw Material 2,00,000. Direct labor 1,20,000. Carriage inwards 20,000
Manufacturing expenses 10,000. Stock of raw materials : opening 25,000, closing 75,000. Work
in progress on 1:4:2006 : Materials 2,000 Labor 5,000 Expenses 1,000. Calculate the Factory
cost..
Solution:
COST OF PRODUCTION FOR THE YEAR ENDED 31 st March 2008
Direct Raw materials consumed:
Opening stock of raw material 25,000
Add: Purchase of raw materials 2,00,000
Add: carriage inwards 20,000
Less: Closing stock of raw materials (75,000)
Add: Opening Work in progress of materials 5,000
Less: Closing work in progress of materials (2,000)
Raw materials consumed 1,73,000
Director Labor 1,20,000
Add: Opening WIP of labor 8,000
Less: Closing WIP of labor (5,000)
_________ 1,.23,000
___________
PRIME COST 2,96,000
FACTORY OVERHEADS
Manufacturing expenses 10,000
Add:: opening WIP of expenses 2,000
Less : Closing WIP of expenses ( 1,000)
___________ 11,000
____________
Problem 1:
Calculate the cost of raw materials purchased: Opening stock of raw materials Rs.10,000.
Closing stock of raw materials Rs.15,000. Expenses on purchases Rs.5,000. Direct wages
Rs.50,000 Prime cost s Rs.1,00,000.
Solution:
Computation of cost of raw materials purchased
Opening Stock of raw materials 10,000
Add Purchases X
Expenses on purchases 5,000
___________
15,000 + X
Less closing stock of raw materials (15,000)
____________
Raw materials consumed X
Direct wages 50,000
_____________
Prime Cost 50,000 + X
Prime cost given in the problem is Rs.1,00,000
Hence substituting , 1,00,000 = 50,000 + X; Therefore X = Rs.50,000
Cost of Raw Materials is Rs.50,000
Problem 2:
Prepare a cost sheet:
Direct materials Rs.2,00,000. Factory expenses Rs.1,20,000. Office expenses Rs.90,000
Total sales Rs.6,50,000. Prime cost Rs.4,10,000 . 10 % of the output is in stock.
Solution: Cost Sheet
Direct materials 2,00,000
Direct wages (Prime cost minus Direct materials 2,10,000
_____________
Prime Cost 4,10,000
Factory expenses 1,20,000
_____________
Office expenses 90,000
_____________
Less: closing stock of finished goods 10 % of 6.20,000 ( 62,000.)
_____________
Cost of Sales 5,58,000
Profit (balancing figure) 92,000
_____________
SALES 6,50,000
Problem 3 :
The following information is obtained:
Stock on Jan 1, 2007 : Raw materials 40,000; Finished goods 30, 000. Purchases of Raw
materials 2,40,000. Direct wages 1,36,000. Works expenses 70,400. Dividends paid 40,000.
Office expenses 24,000. Depreciation 10,000. Selling and Distribution expenses 32,000. Work in
progress : 1.1.2007 64,000. 31:.12.:2007 72,000. Goodwill written off 40,000. Stock on
31.12.2007 Raw materials 42,000 Finished goods 32,000. Sale of finished goods 5,50,000.
Payment of sales tax 16,000. Prepare a cost sheet.
Solution Cost Sheet
Opening stock of Raw materials 40,000
Add: Purchases of raw materials 2,40,000
Less: Closing stock of raw materials ( 42,000)
___________
Direct wages 1,36,000
____________
Prime Cost 3,74,000
Works Overheads
Works expenses 70,400
Depreciation 10,000
____________
4,54,400
Add : opening stock of WIP 64,000
Less: Closing stock of WIP ( 72,000)
____________
Works Cost 4,46,400
Office and Administration overheads
Office expenses 24,000
____________
Add : opening stock of finished goods 30,000
Less : Closing stock of finished goods ( 32,000)
____________
Cost of Goods sold 4,68,400
Selling and Distribution expenses 32,000
_____________
Cost of Sales 5,00,400
Sales Tax 16,000
_____________
Total Cost
5,16,400
Profit 33,600
_____________
Sales 5,50,000
Problem 4:
Prepare a cost sheet
Raw materials Rs.33,000. Unproductive wages Rs.10,500. Factory lighting Rs.2,200. Motive
power Rs.4,400. Director’s fees (Works) Rs.1,000. Factory cleaning Rs.500. Factory stationery
Rs.750. Loose tools written off Rs.600. Water supply Rs.1,200. Office insurance Rs.500.
Chargeable expenses Rs.3,000. Depreciation: Plant and machinery Rs.2,000. Office Building
Rs.1,000. Delivery vans Rs.200. Upkeep of Delivery van Rs.700. Commission on sales Rs.1,500.
Productive wages Rs.35,000. Factory rent and taxes Rs.7,500. Factory heating Rs.1,500.
Haulage Rs.3,000. Director’s fees (office) Rs.2,000. Sundry office expenses Rs.200. Office
stationery Rs.900. Rent and taxes (office) Rs.500. Factory insurance Rs.1,100. Legal expenses
Rs.400. rent of warehouse Rs.300. Bad debts Rs.100. Advertising Rs.300. Sales Department
salaries Rs.1,500. Bank charges Rs.50, Reserve for Doubtful debts Rs.100..Debenture interest
Rs.20,000. Income tax Rs.22,500. Total output 20,000 tons.
Solution
Statement of Cost (Production 20,000 tons)
Direct materials consumed 33,000
Productive wages 35,000
Chargeable expenses 3,000
____________
Prime Cost 71,000
Works Expenses
Unproductive wages 10,500
Factory rent and taxes 7,500
Factory lighting 2,200
Factory heating 1,500
Motive power 4,400
Haulage 3,000
Director’s fees 1,000
Factory cleaning 500
Factory stationery 750
Loose tools written off 600
Water supply 1,200
Factory insurance 1,100
Depreciation of Plant and machinery 2,000
__________ 36,250
____________
Factory / Works cost 1,07,250
Office and Administration expenses
Director’s fees 2,000
Sundry expenses 200
Office stationery 900
Rent and taxes 500
Office insurance 500
Legal expenses 400
Bank charges 50
Depreciation of office building 1,000
_____________ 5,550
__________
Selling and Distribution Expenses
Rent of warehouse 300
Depreciation of Delivery vans 200
Bad debts 100
Advertising 300
Sales Department salaries 1,500
Upkeep of Delivery van 700
Commission on sales 1,500
4,600
Total Cost / Cost of Sales 1,17,400
Cost Per unit : Total Cost / No of Units produced : 117400 / 20,000 Rs.5.87
Note: Ignore reserve for doubtful debts.
Ignore Income tax
Ignore Debenture interest
Problem 5:
The following extract refers to a commodity for the half year ending 31 st March 2008. Prepare a
cost statement.
Purchase of raw materials Rs.1,20,000. Rent, rate, insurance and works expenses Rs.40,000.
Direct wages Rs.1,00,000. Carriage inwards Rs.1,440. Opening stock Raw materials Rs.20,000,
Finished goods (1000 units) Rs.16,000. Closi9ng stock : raw material Rs.22,240 Finished Goods
(2,000 tons). Work in progress : opening Rs.4,800 and closing Rs.16,000. Sale of finished goods
Rs.3,00,000. Cost of factory Rs.8,000.
Advertising, discounts allowed and selling costs Re.1 per ton sold. Production during the year is
16,000 tons. Prepare a cost sheet.
Solution
Statement of Cost
Direct materials
Opening stock or raw materials 20,000
Add: Purchases of raw materials 1,20,000
Add : carriage inwards 1,440
Less: Closing stock of raw materials (22,240)
____________
Direct Wages 1,00,000
__________
Prime Cost 2,19,200
Works Expenses
Cost of factory 8,000
Rent, rate and insurance 40,000
Add: opening WIP 4,800
Less: Closing WIP (16,000)
__________
Factory / Works cost 2,56,000
Office and administration expenses Nil
__________
Cost of production 2,56,000
Inventory valuation
Opening stock of finished goods 16,000
Less : Closing stock of finished goods to be valued at cost of
Production (32,000)
__________
Cost of Good Sold 2,40,000
Selling and Distribution Expenses *
Advertisement and discount allowed 15,000
__________
Total Cost or cost of sales 2,55,000
Profit 45,000
__________
Sales** 3,00,000
*To be valued only at number of units sold. Opening stock of finished goods + production minus
closing stock = Number of units sold.
** Always to be valued at number of units sold. Number of units sold x Selling price per unit.
Tender Cost Sheet or Quotations
Frequently, a manufacturer of capital goods and consumer durable goods is required to quote the
price at which he can supply a particular article. Moreover, demand for certain seasonal articles
need to be taken into account. The manufacturer has to fix a competitive price to take care of
inflationary trends on the input. These aspects need an estimation at the production level itself.
For this purpose, consider the following principle:
Works expenses are based on direct wages
Office expenses are based on works / factory cost.
Finally, since the costs are estimated, the profits can be related either to cost or to the selling
price. The formula is :
If profit percentage is given on Profit = Total Cost x given percentage ex.
Cost price ie. On Total cost for 20 %, TC x 20/100 or 25%, it is TC x 25 /
If profit percentage is given on Profit = Total cost x given percentage / 100
Selling price, bring the percentage minus same given percentage eg. For 20 %
to cost price TC x 20 / 100 minus 20for 25%, it is
TC x 25 / 100 minus 25 %
Problem 6:
The cost data is as follows:
Raw materials consumed Rs.1,82,000. Direct wages Rs.40,000. Chargeable expenses

Rs.20,000. Opening stock of finished goods (1,000 units) Rs.32,000. Closing stock 2,000 units.
Factory overheads 100 % of direct labor. Office overheads 10% of works cost. Selling of
Distribution expenses Rs.4 per unit sold. Units produced 10,000. Profit markup 20% on selling
price. Prepare a cost sheet.
Solution
STATEMENT OF COST
Direct wages 40,000
Chargeable expenses 20,000
_____________
Prime Cost 2,42,000
Factory expenses at 100 % on direct wages 40,000
_____________
Works cost 2,82,000
Office and administrative expenses 10 % of works cost 28,200
_____________
Inventory valuation
Opening stock of finished goods 32,000
Less : Closing stock of finished goods at COP (62,040)
_____________
Cost of Goods sold 2,80,160
Selling and Distribution overheads at Rs.4 per unit sold 36,000
_____________
Cost of Sales or Total sales 3,16,160
Profit 20 % on Selling Price : TC x 20 / 100 – 20 or .
3,16,160 x 20/100 – 80 79,040
Tender Price being sales 3,95,200
Terminal Questions:
1. The costing records show the following
Raw materials consumed Rs.3,30,400. Direct wages Rs.3,80,000. Closing stock of finished
goods Rs.1`,60,000. Administrative expenses Rs.40,000. Factory expenses Rs.70,000.
Sales Rs.7,56,000 Units produced and sold 4,000. The firm received a quotation for supply
of 1,000 units. Prepare a quotation based on the above data.
2. Costing Department provides the following information:
Total production 5,000 tons. Cost of raw materials consumed Rs.22,00,000. Direct wages
Rs.20,00,000. In direct factory wages Rs.1,00,000. Office expenses Rs.10,00,000. Public
Relations expenses Rs,.50,000. Expenses on testing laboratory Rs.60,000. Selling overheads
Rs.10,00,000. Salary of Managing Director Rs.50,000. Payment of income tax Rs.3,00,000.
Dividends paid Rs.5,00,000. A profit margin of 50 % on cost is provided. The Government
grants a special export subsidy of Rs.1,000 per ton. Prepare a cost sheet.
3. The Trading, profit and loss account of DR is given below
To Cost of materials
Consumed 2,00,000 By Sales 8,00,000
To Direct wages 2,00,000
To Works expenses 1,00,000
To Gross Profit 3,00,000
8,00,000 8,00,000
To Selling expenses 1,00,000 By Gross Profit 3,00,000
To Net Profit 2,00,000
3,00,000 3,00,000
The management estimates the following for the year ending 31 st March :
a) output and sales will be 2000 units.
b) Prices of materials and wages will go up by 25 % of previous year.
c) Works expenses will rise in proportion to the combined cost of materials and wages
d) Selling expenses per unit are estimated at Rs.50
Prepare a cost statement for quotation purposes so as too yield a profit of 10 % on selling price.
1. Amount of
2. Monetary term
1. Expense
2. Sacrifice in
1. Direct and Indirect
2. Raw material, labor, direct expenses
3. Overheads
4. Crude form of a substance.
5. Charged to product
6. Conversion of materials to finished products
7. Production operations
8. Allocated
9. Direct
10. Apportioned
11. Overheads
1. Aggregation of DM, DL and DE.
2. PC + FOHS
3. FC + AOSH
4. COP + DOSH
5. TC + profit
6. Sales – total cost.
1. Components
2. Tabular
1. Opening stock + purchase – closing stock.
2. COP + Inventory valuation.
3. At current year COP
4. Balancing figure between SP and TC.
1. Raw material, finished product.
2. Add opening WIP and deduct closing WIP
3. TC x given percentage.
4. (TC x given percentage) – 100 – given Percentage.
5. TC x 25 / 100 – 25.
6. TC x 25 / 100.
1. Cost of production for 4000 units Rs 8,20, 400; cost of production for 1000 units Rs 2,26,990.
Total cost (4000 units ) Rs 6,80,400 ; (1000 units) Rs 2,26,990; profit for quotation of 1000
units Rs 25,221.
2. Cost of production Rs 54, 60,000 per ton Rs 1092; Total cost Rs 64,60,000 ; per unit Rs
1,292.
3. Total cost of the tender Rs 13,50,000 ; Sales Rs 15,00,000
Unit 13 Marginal Costing and Break Even Analysis
Structure
13.1 Introduction
Objectives
13.2 Concept
13.3 Fixed cost
13.4 Variable Cost
13.5 Marginal cost
13.6 CVP analysis
13.7 Break Even Chart
13.8 Break Even Analysis
13.9 Break Even Point
13.10 Contribution margin
13.11 Equation approach
13.12 Target profit
13.13 Margin of safety
13.14 Application
13.15 Limitation
13.16 Useful equation
Terminal Questions
13.1 Introduction
Information is a commodity. It can be purchased, produced and consumed. It can be of high or
low quality, timely or late, appropriate for its intended use or utterly irrelevant like all other goods
and services. Information entails both costs and benefits. While costs refer to other cost of
purchase, cost of compensation, cost of operating computers, cost of time spent by the
information users to read, understand and utilize the information, the benefits include improved
decisions, more effective planning, and greater efficiency of operations at lower costs and better
direction and control of operations.
1. Understand the concept of marginal cost.
2. Distinguish between fixed cost, Variable cost and Marginal Cost.
3. Familiarize with break even chart, break even analysis and break even point.
4. Understand the contribution marginal approach, equation approach, target profit
and margin of safety.
5. Practice the concepts in real life situations.
13.2. Concept Of Marginal Cost
According to C.I.M.A. London, “Marginal Cost means the amount at any given volume of output
by which aggregate costs are changed if the volume of output is increased or decreased by one
unit”. Thus, marginal cost is the amount by which total cost changes when there is a change in
output by one unit. Marginal cost per unit remains unchanged irrespective of the level of activity
or output. It is also known as Variable Cost. Marginal cost is the sum total of direct material cost,
direct labor cost, variable direct expenses and all variable overheads. The marginal cost is the
same as the variable cost.
1. Marginal cost is sum total of ________.
13.3 Fixed Cost
It involves the way a cost changes in relation to changes in the activity of an organization. The
activity refers to a measure of the organization’s output of products and services example number
of contact classes conducted, number of students passed in MBA, number of cars manufactured
by an Automobile industry, number of meals served by a hotel. The activities that cause costs to
be incurred are called “Cost Drivers”. A fixed cost remains unchanged in total as the level of
activity (cost drivers) varies. If activity increases or decreases say by 20 %, the total fixed costs
remain the same e.g. depreciation, property tax, rent to landlord. But fixed costs per unit will
change.
1. Fixed cost remains constant _________.
2. Fixed cost varies with ______________.
3. Variable cost remains constant with ____________.
13.4 Variable Cost
A variable cost changes in total in direct proportion to a change in the level of activity or cost
driver. If activity increases, say by 20%, total variable cost also increases by 20 %. The total
variable cost increases proportionately with activity. Variable cost fixed per unit but varies in total.
1. Variable cost varies with _______________.
2. MC is extra cost incurred ________________.
13.5 Marginal Cost
It is extra cost incurrent when one more unit is produced. It typically differs across different
ranges of production quantities because the efficiency of the production process changes. The
marginal cost of producing a unit declines as output increases. It is much more efficient to
produce more than to make only one.
13.6 Cost Volume Profit (CVP) Analysis
This technique summarizes the effects of changes in an organization’s volume of activity on its
costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of
changes in selling prices, service fees, costs, incometax rates and the organization’s mix of
products or services. It provides management with a comprehensive over view of the effects on
revenue and costs of all kinds of short run financial changes
Although, the word “profit” appears in the term, CVP analysis is not confined to profit seeking
enterprises. Managers in non profit organizations also routinely use CVP analysis to examine the
effects of activity and other short run changes on revenue and costs. It is being used as a regular
organizational tool. . In CVP analysis, it is necessary that expenses should be categorized
according to their cost behavior that is fixed or variable.
1. CVP refers to change in ________________.
2. CVP provides _________________.
3. CVP is not ______________ concept.
4. CVP focuses on ________________ cost.
13.7 Break Even Chart
It is a graphic or visual presentation of the relationship between costs, volume and profit. It
indicates the point of production at which there is neither profit nor loss. It also indicates the
estimated profit or loss at different levels of production. While constructing the chart, the
following assumption is normally considered.
a) Costs are classified into fixed and variable costs
b) Fixed costs shall remain fixed during the relevant volume range of graph.
c) Variable cost per unit will remain constant during the relevant volume range of graph
d) Selling price per unit will remain constant
e) Sales mix remains constant.
f) Production and sales volume are equal
g) There exists a linear relationship between costs and revenue.
h) Linear relationship is indicated by way of straight line.
1. BEP chart is ______________.
2. Its relation is between ________________.
3. It indicates the estimated ____________.
13.8 Break Even Analysis
It is an extension of or even part of marginal costing. It is a technique of studying cost volume
profit relationship. Basically, the break even analysis is aimed at measuring the variations of cost
with volume. It is a simple method of presenting the effect of changes in volume on profits. It is
also known as CVP analysis. The various assumptions are:
a) All costs can be classified into fixed and variable
b) Sales mix will remain constant.
c) There will be no change in general price level
d) The state of technology, Methods of production and efficiency remain unchanged.
e) Costs and revenues are influenced only by volume
f) Cost and revenues are linear.
g) Stocks are valued at marginal cost
h) Unit produced and sold are same.
1. BEP studies ____________________ relationship.
13.9 Break Even Point
BEP is the volume of activity where the organization’s revenues and expenses are equal. At a
particular amount of sales, the organizations have no profit or loss: it normally breaks even.
1. BEP is a ______________________.
Example
DR sells 8,000 pens at Rs.16 per pen. The variable expenses amount to Rs.10 per pen. The
total fixed expenses are Rs.48, 000. Prepare an Income statement.
Solution
No. of pens produced 8,000
No. of pens sold 8,000
Unit selling price per pen Rs.16
Unit variable cost per pen Rs.10
Sales Revenue (Quantity sold x unit selling price)
8000 x Rs.16 1, 28,000
Less Variable Cost (8000x Rs.10) (80,000)
Less: Fixed expenses (48,000)
Profit or Loss Zero
Note that the income statement highlights the distinction between variable and fixed expenses.
13.10 Contribution Margin Approach
The contribution margin approach refers to the total sales revenue minus the total variable
expenses. This is the amount of revenue that is available to contribute to covering fixed
expenses after all variable expenses have been covered or recovered.
DR’s firm will break even when the organization’s revenue from pen sales is equal to its
expenses. How many pens must be sold during one month for DR to breakeven?
Each pen sells for Rs.16, but Rs.10 of this is used to cover the variable expense per pen. This
leave Rs...6 per pen to contribute to covering the fixed expenses of Rs.48, 000. When enough
pens have been sold in one month so that these Rs.6 contributions per pen add up to Rs.48, 000,
the organization will break even for the month. The break even can be computed as follows:
Breakeven in Fixed Expenses
Units = __________________________________________________
Contribution of each pen towards covering fixed expenses
Rs.48, 000 / Rs.6 or 8,000 pens
The Rs.6 amount that remains of each pen’s price after the variable expenses are covered is
called the “Unit contribution margin”. The general formula for computing the break even sales
volume in units is:
BEP (in units) : Fixed expenses / unit contribution margin
Sometimes, the management prefers that the BEP be expressed in sales rupees rather than unit.
The formula is:
BEP in Rupees: Fixed expenses / Contribution sales ratio
The Contribution Sales Ratio is popularly known as “Marginal Contribution Sales Ratio – MCSR “.
Its traditional name is: ‘P/V Ratio. ’
Note: Kindly avoid using the term P / V Ratio and only use the modern concept “MCSR”
MCSR = Contribution / Sales x 100
Where Contribution = Sales value minus variable expenses
1. Contribution margin is _______________.
2. BEP in units is _________________.
3. BEP in rupees is ___________________.
4. Contribution is ___________.
13.11 Equation Approach
This approach is based on the profit equation. Income or profit is equal to sales revenue minus
expenses. If expenses are separated into variable and fixed expenses, the essence of income or
profit statement is captured by the following equation:
Sales minus Variable Cost = Fixed Cost + Profit
S – V = F + P
The contribution margin and equation approaches are two equivalent techniques are two
equivalent techniques for finding g the BEP. Both the methods reach the same conclusion,
hence personal preference dictates which approach should be used.
1. Equation approach is based on ____________.
2. Sales – VC = _______________
3. SV = _________
4. SV = C _________________.
5. C = _______________.
6. C _______ = P.
13.12 Target Profit
Based on the experiences gained, an organization may intend to increase the production and
sales. When an organization was to be on its optimum level, a direction will be provided to
achieve the maximum level. In this connection, if one intends to increase the current year
production to higher levels, no variable expenses would be incurred. A target net profit or income
may be decided in advance. To achieve this profit, efforts will be made to effect sales. The
problem of computing the volume of sales required to earn a particular target net profit is very
similar to the problem of finding the break even point. After all, the break even point is the
number of unit sales required to earn a target net profit of zero. The target net profit is known as
“desired profit”. The formula is:
Number of units to be sold: Fixed expenses + Desired or Target profit / Contribution per
unit
Example: Calculate sales in units and in rupees: Units produced 60,000. Selling price per unit
Rs.15. Profits to be earned is Rs.87, 500.
Solution: Sales required in units : Fixed expenses + target profit / contribution per unit or
1,50,000 + 87,500 / 15 10 or 47,500 units or Rs.47,500 x Rs.15 or Rs.7,12,500.
1. Number of units to be sold is _________.
2. Desired profit is also known as ____________.
3. A target profit is set ____________.
13.13 Margin Of Safety
The safety margin of an enterprise is the /difference between the budgeted sales revenue and the
break even sales revenue. The safety margin gives management a feel for how close projected
operations are to the organization’s break even point. The formula is:
MOS = Profit / MCSR
Example: Calculate BEP and MOS:
Sales at present 50,000 units per annum. Selling price Rs.6 per unit, Prime cost Rs.3 per unit.
Variable overheads Re.1 per unit. Fixed cost Rs.75, 000 per annum.
Solution: BEP = Fixed cost / (SP VC) per unit or 75,000 / 6 4 or 75,000 / 2 or 37,500 units.
BEP in rupees: BEP in units x selling price per unit or 37,500 x Rs.6 or Rs.2, 25,000
MOS: Actual Sales – BEP Sales or (50,000 x 6) – 2, 25,000 or Rs.75, 000
1. MOS is ________________
2. MOS is calculated as _______________.
13.14 Applications Of Marginal Costs
The marginal costing helps the management in taking many policy decisions. The vital areas
where these concepts are applied directly are as follows:
Level of activity planning: Normally, the managements will consider different levels of
production or selling activities to decide optimum level of activity. Such periodic exercise shall put
the organization in the right tract to achieve its goal. Since the optimum level of activity results in
the maximum contribution per unit, the planning can become a perfect execution tool.
Alternative methods of production: With the help of marginal costing techniques, it’s possible
to undertake decision about the alternate methods of production. All the decisions should be
focused at the greater contribution so that profit can be maintained at a balanced level.
Make or buy decision: Depending upon the situational ambience, the management can have a
blue print on a vital decision. Management can think of outsourcing the production activities or to
undertake it within its purview. Based on the comparative statement of cost of manufacture with
the purchase price, decisions can be taken.
Fixation of Selling Price: While pricing a product, the marginal costing techniques can come

handy. While fixing a price for a product, it is prudent to take into account the recovery of
marginal cost in addition to get a reasonable contribution to cover fixed overheads. Pricing will be
at ease once the marginal cost and overall profitability of the concern are known.
Selection of optimum sales mix: The product mix plays an important role when a firm produces
more than one product. The main focus will on profit maximization. With the help of marginal
costing techniques, it is possible to decide the best product mix which will result in maximum
profits to the firm.
New Product introduction: When a firm intends to diversify its activities or to expand its
existing markets, with the help of marginal costing techniques. By fixing the time horizon to
recover the fixed costs and profit, decisions can be taken for the introduction of new products.
Balancing of profits: As the economic trends gets changed on account of government fiscal
policies and regulations, competition at the regional, national, and international levels, marginal
costing techniques can aid to bring out facts with regard to maintaining a desired level of profits.
Final balancing decisions: If the sales of the product were not encouraging to cover the fixed
costs, it is quite natural that the firm may decide about its continuance. This may lead to
dovetailing or completely closing down the operations. Marginal costing helps the management
to take a sound decision.
1. The application is as _______________.
13.15 Limitations Of Marginal Costing
There are certain limitations which can be described as follows:
Suitability: The techniques of marginal costing cannot be applied to all the concerns. When a
concern needs to carry large stocks by way of workinprogress, the technique becomes
redundant In addition; the marginal costing techniques are not suitable to industries working on
contract basis.
Inventory valuation difficulties: Since the work in progress and the closing inventories are
valued at marginal cost basis, it will not be a sound decision from the Balance Sheet point of
view. The main focus on the ‘true and fair value’ concept gets diluted and the very purpose of
exhibiting the financial position will get defeated.
Segregation of costs: Though the marginal costing principles call for the differentiation of costs
into fixed and variable, in actual practice it becomes difficult to classify them precisely. Many
overheads which are appear to be fixed and variable may not exactly align at various levels of
production. There is no logical method to segregate semivariable expenses into fixed and
variable.
Time factor: The marginal costing ignores the time factor which is very important for any costing
purposes. Ignoring the time would naturally relate to unreliable and incomplete basis for
comparing two alternative jobs.
Sales emphasis: Marginal costing principles are basically a salesoriented concept. While the
selling function gets the prominence, other functions are not given equal weight age. This would
be a major set back.
1. Limitation include ________________.
13.16 Useful Equations Of Marginal Costing
Some of the useful equation of marginal costing are as follows :
Basic equation : Sales Revenue – Variable Expenses = Fixed Expenses + Profit
Other derivations are as follows
Sales Revenue – Variable Expenses – Fixed Expenses = Profit
Sales – Variable cost s = Contribution
Contribution – Fixed costs = Profit
Sales – Contribution = Variable costs
Marginal Contribution Sales Ratio (MCSR) = Contribution / Sales x 100
MCSR also can be found out : Change in profit / change in sales x 100
MCSR x Sales = Contribution
Sales = Contribution / MCSR
Number of units to be sold = Fixed expenses + Desired Profit / Contribution per unit
Sales required to earn target net profit in Rupees : Fixed expenses + Profit / Marginal
contribution
BEP in units = Fixed expenses / MCSR contribution per unit
BEP in Rupees : BEP in units x Selling price per unit or
Fixed costs x Total sales / Total Sales Variable costs
Margin of Safety : Total Sales – Break Even sales OR
Profit / MCSR where Profit = Sales – Total Costs
1. Basic equation of M.C is __________.
2. Profit is __________.
Problem 1: Find the contribution and profit earned. Selling price per unit Rs.25. Variable cost
per unit Rs.20. Fixed Cost Rs.3,,05,000. Output 80,000 units.
Solution: Contribution = Sales – variable cost . Rs.25 – Rs.20 or Rs.5 or 80,000 x 5 =
Rs.4,00,000
Profit =Contribution – Fixed Cost or 4,00,000 – 3,05,000 = Rs.95,000
Problem 2: Calculate the profit earned. Fixed cost Rs.5,00,000. Variable cost R.10 per unit.
Selling price Rs.15 per unit. Output 150,000 units
Solution : S – V = F + P or ( 1,50,000 x 15) – (1,50,000 x 20 ) = 5,00,000 + Profit
Profit = 22,50,000 – 15,00,000 – 5,00,000 = Rs.2,50,000
Problem 3: Find the fixed costs : Sales Rs.2,00,000. Variable Cost Rs.40,000. Profit Rs.30,000
Solution : S – V = F + P or 2,00,000 – 40,000 = Fixed Cost + 30,000
Fixed Cost = 2,00,000 – 40,000 – 30,000 = Rs.1,30,000
Problem 4: Calculate the variable cost : Sales Rs.1,50,000. Profit Rs.40,000. Fixed cost
Rs.30,000. Find the amount of variable cost.
Solution : S – V = F + P or 1,50,000 – V = 30,000 + 40,000 or 1,50,000 – 30,000 – 40,000 =
Rs.80,000
Problem 5: Calculate MCSR or P / V Ratio : Marginal cost Rs.24,000. Sales Rs.60,000
Solution: Contribution : Sales – Marginal Cost or 60,000 – 24,000 or 36,000
MCSR = Contribution / Sales x 100 or 36,000 / 60,000 x 100 or 60 %
Problem 6: The sales turn over and profit during two periods are as under:
Period 1 Period 2
Sales Rs.20,000 Rs.30,000
Profit Rs.2,000 Rs.4,000
Calculate the MCSR.
Solution : MCSR = Change in Profit / Change in Sales x 100 or 4,000 2,00,000 / 30,000

20,000 x 100
2,000 / 4,000 x 100 or 20 %
Problem 7 : Calculate : MCSR. Total Sales Total Costs
Year ending 31 st December 2006 22,23,000 19,83,600
Year ending 31 st December 2007 24,51,000 21,43,200
Solution: Profit = Total Sales – Total Costs or For the year 2006 = 22,23,000 – 19,83,600 =
2,39,400
For the year 2007 = 24,51,000 – 21,43,200 = 3,07,800
MCSR = Change in profit / change in sales x 100 or 68,400 / 2,28,000 x 100 or 30 %
Problem: 8 : Calculate the selling price if marginal cost is Rs.2,400 and MCSR is 20 %.
Solution: MCSR = 20%, therefore the variable cost is 100 – 20 = 80 %
Variable cost given is Rs.2,400 : Therefore, Selling price is 24000 / 80 %
Or Rs.3,000.
Problem 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40. Selling price per unit

Rs.80. Fixed expenses Rs.2,00,000. Output 10,000 units.
Solution: Contribution : Sales – variable costs or (10,000 x Rs.80) – (10,000 x Rs.40)
8,00,000 – 4,00,000 or Rs.4,00,000.
MCSR = Contribution / MCSR or 4,00,000 / 8,00,000 x 100 or 50 %
Problem 10. Calculate Break even point. Fixed costs Rs.80,000. Variable cost per unit Rs.4.
Sales Rs.2,00,000. The number of units involved coincides with expected volume of output.
Each unit sells at Rs.20.
Solution: BEP in units : Fixed expenses / contribution per unit
Contribution = S – V or Rs.20 – Rs.4 or Rs.16
Rs.80,000 / Rs.16 or 5,000 units.
Problem 11: Calculate the Break even point : Sales Rs.2,00,000. Fixed expenses Rs.50,000.
Variable expenses.Rs.1,00,000.
Solution: Since no information about the number of units produced and costs per unit is given,
only Break even point in value can be ascertained.
BEP in Rs. = Fixed costs x Total sales / Total Sales – Variable costs
50,000 x 2,00,000 / 2,00,000 – 1,00,000 or Rs.1,00,000
Problem 12: Calculate MCSR and Break Even Point : Sales Rs.5,00,000. Fixed Costs
Rs.1,00,000. Profit Rs.1,50,000.
Solution: MCSR = Contribution / Sales
Contribution = Fixed Costs + Profit or Rs.1,00,000 + Rs.1,50,000 = Rs.2,50,000
MCSR = 2,50,000 / 5,00,000 = 50%
BEP in Rs. = Fixed Costs / MCSR or 1,00,000 / 50 % or Rs.2,00,000.
Problem 13: Find BEP. Variable cost per unit Rs.12. Selling price per unit Rs.20. Fixed expenses
Rs.60,000. What will be the selling price per unit if the BEP is brought down to 6000 units?
Solution: BEP in units : FC / CPU where CPU S V 20 – 12 or Rs.8, 60,000/8 or 7,500 units
7,500 units x Rs.20 = Rs.1,50,000.
Selling price if BEP is 6000 units : FC / CPU or FC / (SP – VP) per unit or 60,000 / (x – 12)
Let selling price be Rs .x
6,000 = 60,000 / x – 12 or 6000 (x – 12) = 60,000 or x = Rs.22 on simplification.
Problem 14: Calculate MCSR. (2) Profit when sales are Rs.20,000 (3) New BEP if selling price
is reduced by 20 %. Given Fixed expenses Rs.4,000 and Break even point Rs.10,000.
Solution: Basis BEP sales : BEP in volume : FC / MCSR
Cross multiplying, MCSR = FC / BEP Sales or 40,000 / 10,000 x 100 or 40 %.
Profit Calculate the contribution first; where MCSR = C/Sales
40 % x 20,000 = Contribution or Rs8,000
C = F + P or 8,000 = 4,000 + P or Profit = Rs.4,000.
New BEP is SP is reduced by 20 % : Let the original SP be Rs.x. Therefore, at 20 % reduction,
the Revised SP would become 20 % of x or .2x. Hence the revised SP would be x – 0.2x or 0.8x
New contribution is S – V or x – (60 % of x ) = C or 0.8x – 0.6x = 0.2x. SR = 0.2x / 0.8x or 0.25
BEP in volume = 4,000 / o.25 or Rs.16,000
Problem 15: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP sales Rs.40,000.
Find the actual sales.
Solution: MCSR is based on BEP sales : BEP sales = FC / MCSR = FC / BEP sales or 8,000 /
40,000 = 0.2
Actual sales = FC + desired profit / MCSR or 8,000 + 2,000 /0.2 or Rs.50,000
Terminal Questions:
1. A factory is manufacturing sewing machines. The variable cost of each machine is Rs.200
and each machine is sold for Rs.250. Fixed costs are Rs.12,000. Calculate the BEP for
output.
2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000. Variable cost per
unit Rs.2 and Selling price per unit Rs.18. Also compute the margin of safety if the company
is earning a profit of Rs.36,000.
3. Calculate the breakeven point and turnover required to earn a profit of Rs.3,600. Fixed
overheads Rs.1,80,000. Variable cost per unit Rs. Selling price Rs.20. If the company is
earning a profit of Rs.36,000, express the margin of safety available to it.
4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit Rs.1,00,000. Sales
Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit when sales amounted Rs.12,00,000 (d)
sales required to earn a profit of Rs.2,00,000.
5. Given : Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit Rs.1,000. Selling price per
unit Rs.20. Calculate (a) sales and marginal cost of sales (b) new break even point if selling
price is reduced by 10 %.
6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %.
7. Calculate Break even sales and margin of safety. Given Sales Rs.10,00,000.Fixed costs
Rs.3,00,000 and Profit Rs.2,00,000.
8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs Rs.12,000. Compute
Break even sales, Margin of safety and sales to earn a profit of Rs.4,000.
1. DMC, DLC, variable overheads
1. In total.
2. Per unit.
3. Per unit
1. Total
2. With one more unit of production.
1. Cost, revenue and profits.
2. Comprehensive
3. Profit seeking
4. Categorization of
1. A visual presentation
2. Cost, volume and profit.
3. Profit or loss
1. Cost, volume, profits.
1. No profit, no loss
1. Sales – TVC
2. FC / unit contribution margin
3. FC / MCSR
4. Sales – VC
1. Profit equation
2. FC + profit
3. F + P
4. Contribution
5. F + P
6. FC
1. FC + DP / MCSR
2. Target profit in advance.
1. Difference between Budget – BEP sales.
2. Profit / MCSR.
1. Activity planning.
1. Suitability, segregation of cost.
1. S – V = F + P
2. S – V – F
1. Contribution = S –V or 250 – 200 or Rs.50 : Therefore BEP = FC / Contribution or 12,000 /
500 or 240 units.
2. Contribution = S – V = 18 – 2 = 16. BEP in units = Fixed costs / contribution per unit or
1,60,000 / 16 or 10,000 units.
Margin of safety = Actual Sales less Breakeven sales :
The formula for actual sales is : fixed Cost + Desired profit / contribution per unit or 1,60,000
+ 36,000 / 16 or 12,250 units.
Therefore, margin of safety is 12,250 10,000 units or 2,250 units.
3. Contribution per unit = S – V or 20 – 2 = 18. BEP in Units : FC / CPU or
1,80,000 / 18 = 10,000 units.
Break even sales : BEP in units x Selling price = 10,000 x Rs.20 = Rs.2,00,000
Turnover required to earn a profit of Rs.36,000
Total Fixed overheads + Profit desired / CPU = 1,80,000 + 36,000 / 18 = 12,000 units or in
terms of rupees units x selling [rice = 12,000 x Rs.20 = Rs.2,40,000.
Margin of safety = Actual sales – Break even sales = Rs. 2,40,000 – Rs.2,00,000 =
Rs.40,000 or in terms of units 12,000 – 10,000 units = 2,000 units.
4. MCSR = Contribution / Sales x 100 = Contribution = S – V or Rs.4,00,000.
4,00,000 / 10,00,000 x 100 or 40%
Break even point = FC / MCSR = 3,00,000 / 0.4 = Rs.7,50,000
Profit when sales amounted to Rs.12,00,000 . Contribution 40 % Therefore total contribution
12,00,000 x 40 % = Rs.4,80,000 Less fixed costs Rs.3,00,000 = Rs.1,80,000, being profit.
Sales to earn a profit of Rs.2,00,000 = FC + Desired profit / MCSR or 3,00,000 + 2,00,000 /
40 % = Rs.12,50,000.
5. BEP = Fixed costs / MCSR = 20,000 = 4,000 / MCSR or MCSR = 4,000 / 20,000 x 100 =

20%
Contribution : Fixed cost – Profit = 4,000 + 1,000 = Rs.5,000.
MCSR = Contribution / Sales x 100 or 20 = 5,000 / Sales x 100 = Rs.25,000
Marginal cost of sales = Sales – Contribution or 25,000 – 5,000 = Rs.20,000
(b) If selling price is reduced by 10 % : New selling price = 20 – 2 = Rs.18
Variable cost = Rs.16 (20 – 20% of 20) = Rs.2
New MCSR = 2 /18 x 100. Therefore new break even sales = FC /SR or 4,000 / 100 or
Rs.36,000.
6. Margin of safety = Profit / 40 % = Rs.50,000
7. MCSR = Contribution / sales = 5,00,000 / 10,00,000 = 50 %.
Break even sales : Fixed costs / MCSR = 3,00,000 / 50 % = Rs.6,00,000
Margin of safety = Profit / MCSR = 2,00,000 / 50 % = Rs.4,00,000
8. Sales 20,000, Variable cost Rs.13,000, Total Cost Rs.16,000. Therefore, Fixed cost = Total
cost – variable cost = 16,000 – 12,000 = Rs.4,000. Profit = Contribution – Fixed Cost = 8,000
– 4,000 = 4,000. MCSR = Contribution / sales = 8,000 / 20,000 = 40 %.BEP in units : FC /
MCSR = 4,000 / 40% = 10,000.
Margin of safety = Profit / MCSR = 400 / 40 % = 10,000
Sales to earn a profit of Rs.4,000 = FC + Desired profit / MCSR = 4,000 + 4,000 / 40 % =
Rs.20,000.
Unit 14 Budgetary Control
Structure:
14.1 Introduction
Objectives
14.2 Meaning
14.3 Budgetary control
14.4 Objectives
14.5 Merits
14.6 Essential features
14.7 Steps
14.8 Types
14.9 Cast Budget
14.10 Flexible Budget
14.11 Limitation
Terminal Questions
14.1 Introduction
In a competitive environment, the effective operation of a concern resulting into the excess of
income over expenditure fully depends upon “as to what extent the management follower proper
planning, effective coordination and dynamic control “. For all these aspects, it has become
necessary that management should plan for the future financial and physical requirements.
These are the basic criteria that a firm has to adopt to maintain its profitability and productivity.
The procedure for preparing plan in respect of future financial and physical requirements is
generally called “Budgeting”. It is a forward planning exercise. It involves the preparation inn
advance of the quantitative as well as the financial statements to indicate the intention of the
management in respect of the various aspects of the business. In a broader sense, it is
essentially an economic service. Budgeting requires a deeper understanding of the economic
system of the environment in which the business concern operates.
1. Understand the meaning of budget and budgetary control with its objects.
2. Analyze the merits, demerits, essential features of budgetary control.
3. Note the steps involved in the preparation of budgets.
4. Acquaint with various type of budgets.
5. Prepare cash and flexible budgets.
14.2 Meaning of A Budget
It is a numerical statement expressing the plans, policies and goals of an enterprise for a definite
period in the future. Budgets are not actual but are estimated. It is therefore a financial and / or
quantitative statement prepared and approved prior to a definite period of time, of the policy to be
pursued during that period for the purpose of attaining a given objective. (Definition by Cost and
Management Accountants, England).
1. Budget is ___________ statement.
2. Budget are _____________.
14.3 Budgetary Control
It is applied to a system of management accounting control by which all operations and output
are forecasted far ahead as possible and actual results when known are compared with the
budget estimates.
1. Budgetary control is ___________.
14.4 Objectives
Budgeting is a forward planning. It basically serves as a tool for management control. The
objectives of budgeting may be taken as:
· To forecast and plan for future to avoid losses and to maximize profits.
· To help the concern in planning the activities both physical and financial.
· To bring about coordination between different functions of the enterprise.
· To control; actual actions by ensuring that actual are in tune with targets.
Budgeting and Planning: The planning normally deals with long term and short goals and
operations. The goals can be for the entire organization or departmentwise or group wise or
segment wise to achieve the maximum results and operational efficiency. After setting up
objectives in terms of plans, it becomes imperative to organize the factors of production to
convert into a reality and workable preposition. In budgeting, planning refers to the preparation of
budgets in respect of sales, advertisement, production, inventory, materials cost and
requirements, labor cost and requirements, expenses, research, capital expenditures, financial
plans. Planning through budgets brings together all segments of the concern in a cooperative
way and they are compelled to think seriously about the planning. The views get enlarged than
getting into contraction. Internal refinement, broad indexation of activities, concentrated details is
the essential features in planning. All the staff must be involved in the planning function to make
it more successful and purposeful.
Budgeting and Coordination: It deals with the combined efforts of all the people involved from
the shop floor to the top management. Individual and collective wisdom should be considered in
the preparation of budgets at all levels to make it a workable document for translation into reality.
For this adequate communication at all levels should be established. It is very important that
each member of management is having perfect and clear cut knowledge. There must be
continuity to coordination. Budget may help us to evaluate and examine whether the members of
the management are working in a cooperative way or not
Budgeting and control: When one relates control function to budget, we find a system what is
generally termed as budgetary control. Control signifies such systematic efforts which help the
management to know whether actual performance is in line with predetermined goal, policy and
plans. It is basically a measurement tool. Yardsticks should be laid down. Standards must be
set up.
Therefore, the objectives can be summarized as follows:
· To conform with good business practice by planning for the future.
· To coordinate the various divisions of a business.
· To establish divisional and departmental responsibilities.
· To forecast operating activities and financial position.
· To operate most efficiently the divisions, departments and cost center.
· To avoid waste, to reduce expenses and to obtain the income desired.
· To obtain more economical use of capital available for the efficient operation.
· To provide more definite assurance of earning the proper return on capital employed.
· To centralize management control.
· To show the management where action is needed to remedy a situation.
· To help in controlling cash.
· To help in obtaining better inventory control and turnover.
1. Budgetary is ____________ planning.
2. Planning deals with _________________.
14.5 Merits
In order to help in planning, coordinating and control, budgets need to be prepared for every
organization to get the maximum benefit. Broadly, the merits are as follows:
1. It forces basic policies to initiatives
2. The budgetary control aims at the maximization of profits
3. Budgets fix the goals and targets without which operations lack direction
4. Reduction in cost and elimination of inefficiencies
5. Budgetary control facilitates to make ordered effort and brings about overall efficiency in
results.
6. Budgetary control ensures that the capital employed at a particular level is kept at a
minimum level
7. Budgetary control enables the management to decentralize responsibility without losing
control
8. It is a good guide to the management for making future plans. Based on budgetary control
realistic budgets can be drawn.
9. Budgetary control facilitates an intelligent and planned forecast of the future
10. Budgetary control acts as a safety signal for the management. It prevents wastages of all
types.
11. Budgetary control brings to light the inefficiencies and weakness on comparing actual
performance with budget. Management can take timely remedial measures.
12. Financial crisis can be avoided since budget provides advance information.
13. It is a guide to the management in the field of research and development in future.
1. Major merits are __________.
14.6 Essential Features Of Budgetary Control
An effective budgeting system should have essential features to get best results. In this direction,
the following may be considered as essential features of an effective budgeting.
Business Policies defined: The top management of an organization strives to have an action
plan for every activity and for each department. Every budget should reflect the business policies
formulated from time to time. The policies should be precise and the same must be clearly
defined. No ambiguity should enter the document. Clear knowledge should be provided to all the
personnel concerned who are going to execute the policies. Periodic suggestions should be
called for.
Forecasting: Business forecasts are the foundation of budgets. Time and again discussions
should be arranged to derive the most profitable combinations of forecasts. Better results can be
anticipated based on the sound forecasts. As far as possible, quantitative techniques should be
made use of while forecasting
Formation of Budget Committee: A budget committee is a group of representatives of various
important departments in an organization. The functions of committee should be specified
clearly. The committee plays a vital role in the preparation and execution of budget estimated. It
brings coordination among other departments. It aids in the finalization of policies and programs.
Nonfinancial activities are also considered to make it a wholesome affair.
Accounting System: To make the budget a successful document, there should be proper flow
of accurate and timely information. The accounting adopted by the organization should be proper
and must be finetuned from time to time
Organizational efficiency: To make the budget preparation and its subsequent implementation
a success, an efficient, adequate and best organization is necessary a budgeting system should
always be supported by a sound organizational structure. There must be a clear cut demarcation
of lines of authority and responsibility. There must also be a delegation of authority from top to
bottom line. .
Management Philosophy: Every management should set a healthy philosophy while opting for
the budget. Management must wholehear4tedly support the activities which developing a
budget. Encouragement should flow from top management. All the members must be involved to
make it a workable preposition and a dreamdriven document.
Reporting system: Proper feed back system should be established. Provision should be made
for corrective measures whenever comparative measures are proposed.
Availability of statistical information: Since budgets are always prepared and expressed in
quantitative terms, it is essential that sufficient and accurate relevant data should be made
available to each department.
Motivation: Since budget acts as a mirror, the entire organization should become smart in its
approach. Every employees both executive and nonexecutives should be made part of the
overall exercise. Employees should be persuaded than pressurized to appreciate the benefits of
the budgets so that the fruits can be shared by all the members of the organization.
1. Feature are meant for _________.
2. Forecasting is _______________.
3. Budget committee brings in _________.
14.7 Steps In Budgetary Control
The procedure to be followed in the preparation and control of budget may differ from business to
business. But, a general pattern of outline of budget preparation and control may go a long way
to achieve the end results. The steps are as follows:
Formulation of policies: The business policies are the foundation stone of budget construction.
Function policies should be formulated in advance. Longrange policies with short term
projections should be made for the functional areas such as sales, production, inventory, cash
management, capital expenditure.
Preparation of forecasts: Based on the formulated policies, forecast should be made in respect
of each function. Activity based concepts should be introduced at the micro level for each
function Forecasts should not be considered as a mere estimates. Scientific methods should be
adopted for forecasting. Analysis of various factors based on past, and present, future forecast
should be made.
Preparation of budgets: Forecasts are converted into written codified document. Such written

documents can be used for coordination purposes. Function budgets will act as guidelines for
implementation.
Forecast combinations: While developing the budgets, through a Master Budget various
permutations and combination processes are considered and developed. Based on this,
establishment of the most preferred one which will yield optimum benefits should be considered.
All the factor components should be identified which are likely to cause disturbances while
implementing the budgets
1. Important steps in B.C _________________.
14.8 Types of Budgets
The budgets are normally classified according to their nature. They are: (a) fixed budget. (b)
Flexible Budget. (c) Functional Budget
Fixed Budget: It is also known as static budgets. It is prepared for a fixed or standard volume of
activity. They do not change with change in the volume of activity. They are prepared well in
advance Due to this, there are bound to be variances at the time of comparison. Hence, the
budget targets become unsuitable for the purpose of comparison. Wide deviations are noticed
due to changes in the volume of activity.
Flexible Budget: It is prepared with a view to take into account the periodic changes in the level
of activity attained. In this case, the revenues and costs targets are set in respect of different
levels of activity even from zero to 100 % of product ion volume. Such mechanism helps to
change revenues and cost targets for the actual level of activity and thus makes the comparison
more logical and scientific.
Functional Budget: These are also known as subsidiary budgets. These are prepared on the
basis of approved forecasts for individual department. Since departments are created based on
the functions, they are known as functional budgets. The functional budgets may vary in number
from business to business. The functional budgets include sales budget. Production budget,
selling and distribution overhead budget, plant budget, research and development budget,
overheads budget, financial budget such as cash budget and capital expenditure budget.
1. Classification of budget is based on __________.
2. Types of budgets are _____________.
14.9 Cash Budget
A proper control over cash is very essential. Cash is an important component in any activity. The
control becomes inescapable. If cash is not properly managed or if it is mismanaged, the ultimate
result would be disastrous .In many times and in many business situations, business failures are
noticed due to the lacunae found in the cash management. Hence a cash budgeting occupies a
pivotal place in the study of Financial Management.
Cash budgeting is the process of forecasting the expected receipts known as cash inflows, and
expected payments known as cash outflows to meet the future obligations. The written statement
of receipts and payments form the cash budget. It is a crystal ball which enables one to observe
the future movements in cash position. It is a mere forecast of cash position of an undertaking
for a definite period of time. The period may be daily, weekly, monthly, quarterly, semiannually,
or annually. The major two components of cash budget would be forecast first the cash receipts
and then second forecasting the cash disbursements.
The receipts of cash are formatted as follows :
1. Opening balance of cash in hand and cash at bank
2. Cash sales
3. Collection from debtors to whom sales are effected on credit basis
4. College from Bills received
5. Interest and advances and loans granted
6. Dividends received from investments
7. Sale proceeds from capital assets
8. Proceeds from issue of shares and debentures
9. Other sources.
After determining the various sources, the quantum of receipt should be estimated. Past analysis
will help to identify the problem areas for effecting collection of cash.
1. It is prepared on _______________.
Problem 1: A large retail stores makes 25% of its sales for cash and the remainder on 30 days
net. Due to faulty collection practice, there have been losses from bad debts to the extent of 1 %
of credit sales on average in the past. The experience of the store tells that normally 60 % of
credit sales are collected in the month following the sale, 25% in the second following month and
14 % in the third following month. Sales in the proceeding three months have been January 2007
Rs.80,000, February Rs.1,00,000 and March Rs.1,40,000. Sales for the next three months are
estimated as April Rs.1,50,000, May Rs.1,10,000 and June Rs.1,00,000. Prepare a schedule of
projected cash collection .
Solution:
Statement of expected Cash Receipts
Collection form April May June
Cash sales 37,500 27,500 25,000
Collection from Debtors : January 8,400
February 18,750 10,500
March 63,000 36,350 14,700
April 67,500 28,125
May 49,500
Total 1,27,650 1,31,750 1,17,325
Assume that the credit policy is enforced strictly ,what would be the cash receipts.
Cash sales : Debtors 37,500 27,500 25,000
March 1,05,000
April 1,12,500
May 82,500
Total 1,42,500 1,40,000 1,07,500
Forecasts of cash payments : The items of expenditures differ from business to business. The
normal items which come under the lists are :
1. Cash purchases
2. Payment to creditors or suppliers
3. Payments to Bills payable
4. Payment to employees in the nature of wages, salaries
5. Manufacturing, selling and distribution and administration expenses
6. Repayments of bank load and special obligations such as bonus, donations, advances
7. Interest and dividend payments
8. Capital expenditures for acquiring assets of enduring benefit
9. payment of tax liability
10. other expenses of periodic nature
The quantum of amount likely to be spend on the above each item is generally determined with
reference to functional budgets of the concerns. The policy of the management will also play a
crucial role. It is the policy which determines the ratio of cash purchases and credit purchases.
In many cases, the time lag affects the amount of expenditures to be incurred in a particular
period. The formula adopted for the expenses payable in next month is : month’s amount x time
lag
Problem 2:
The following are the forecasts relating to wages and factory expenses.
July Aug Sept Oct Nov
Wages 32,000 32,000 32,000 40,000 32,000
Factory expenses 5,000 5,000 5,000 5,000 5,000
The lag in payment of wages is 1 / 8 month and that in case of factory expenses 1/ 2 month.
Estimate the amounts of wages and factory expenses payable in each month of September to
November.
Solution
Statement showing the disbursements of cash
Particulars Sept Oct Nov
Wages: Aug 32,000 4,000
Sept 32,000 28,000 4,000
Oct 40,000 35,000 5,000
Nov 32,000 28,000
32,000 39,000 33,000
Factory expenses
Aug 5,000 2,500
Sept 5,000 2,500 2,500
Oct 5,000 2,500 2,500
Nov 5,000 2,500
5,000 5,000 5,000
Problem 3:
The following information is provided in respect o DR Ltd. Prepare a Cash Budget for April, May
and June 2007.
Months Details Sales Purchases Wages Expenses (in Rupees)
Jan Actual 80,000 45,000 20,000 5,000
Feb Actual 80,000 40,000 18,000 6,000
March Actual 75,000 42,000 22,000 6,000
April Budget 90,000 50,000 24,000 7,000
May Budget 85,000 45,000 20,000 6,000
June Budget 80,000 35,000 18,000 5,000
Additional information:
a. 10 % of the purchases and 20 % of sales are for cash
b. The average collection period of the company is 1 / 2 month and the credit purchases are
paid regularly after one month.
c. Wages are paid half monthly and the rent of Rs.500 included in expenses is paid monthly.
Other expenses are paid after one mo nth lag.
d. Cash balance on April 1, 2007 may be assumed to be Rs.15,000.
Solution
DR Limited
CASH BUDGET
For the month ending June 2007
Particulars April May June
RECEIPTS
Opening Balance 15,000 27,200 35,700
Cash Sales 18,000 17,000 16,000
Collection from Debtors 66,000 70,000 66,000
Total , say A 99,000 1,14,200 1,17,700
PAYMENTS
Cash purchases 5,000 4,500 3,500
Payments to creditors 37,800 45,000 40,500
Wages 23,000 22,000 19,000
Rent 500 500 500
Other expenses 5,500 6,500 5,500
Total, say B 71,800 78,500 69,000
CLOSING CASH BALANCE, A – B 27,200 35,700 48,700
Problem 4:
DR is to start production on January 1, 2008. The prime cost of an unit is expected to be Rs.40
(Rs.16 per material and Rs.24 for labor). In addition, variable expenses per unit are expected to
be Rs.8 and fixed expenses per month Rs.30,000. Payment for materials is to be made in the
month following the purchases. Onethird of sales will be for cash and the rest on credit for
settlement in the following month. Expenses are payable in the month in which they are incurred.
The selling price is fixed at Rs.880 per unit. The number of units to be produced and sold are
expected to be : January 900, February 1,200./ March 1,800. April 2,000. May 2,100. June 2,400.
Draw a cash budget indicating cash requirements.
Solution
CASH BUDGET
For six months ending 30 th June
Particulars Jan Feb March April May June
RECEIPTS
Opening balance 34,800 37,600 32,400 5,867 17,600
Cash Sales 24,000 32,000 48,000 53,333 56,000 64,000
Collection from Debtors 48,000 64,000 96,000 1.06.667 1,12,000
Total, say A 24,000 45,200 74,400 1,16,933 1,56,800 1,93,600
PAYMENTS
Creditors 14,400 19,200 28,800 32,000 33,600
Wages 21,600 28,800 43,200 48,000 50,400 57,600
Variable Expenses 7,200 9,600 14,400 16,000 16,800 19,200
Fixed Expenses 30,000 30,000 30,000 30,000 30,000 30,000
Total, Say B 58,800 82,800 1,06,800 1,22,800 1,39,200 1,40,400
Closing balance :
A – B
Debit ( + ) Credit ( ) 34,800 37,600 32,400 5,867 17,600 53,200
Cr Cr. Cr Cr
Problem 5:
DR wish to approach his Bankers for temporary overdraft facility for the period from June 1 to
August 30 th , 2007. During the period of these three months, DR will be manufacturing mostly for
stock. Prepare a cash budget for the above period.
Sales Purchases Wages
April 3.60,000 2,49,600 24,000
May 3,84,000 2,88,000 28,000
June 2,.16,000 4,.86,000 22,000
July 3,.48,000 4,.92,000 20,000
Aug 2,.52,000 5,.36,000 30,000
(a) 50 % of credit sales are realized inn the month following the sales and remaining in the
second following month.
(b) Creditors are paid in the month following the month of purchase
(c) Estimated cash as on June 1 is Rs.50,000
Solution DR
CASH BUDGET
For the period ending 20 th August
Particulars JUNE JULY AUGUST
RECEIPTS
Opening balance 50,000 1,12,000 ( 94,000 )
Collection from Debtors 3,72,000 3,00,000 2.82,000
Total, say A 4,22,000 4,12,000 1,88,000
PAYMENTS
Payments to creditors 2,88,000 4,86,000 4,92,000
Wages 22,000 20,000 30,000
Total, say B 3,10,000 5,06,000 5,22,000
Closing Balance A – B 1,12,000 94,000 3,34,000
Cr Cr
Overdraft needed NIL 94,000 2,40,000
Problem 6:
Prepare a cash budget from January to April
Expected Purchases Expected Sales
Jan 48,000 60,000
Feb 80,000 40,000
Mar 81,000 45,000
April 90,000 40,000
Wages to be paid to workers will be Rs.5,000 per month. Cash balance on January 1 may be
assumed to be Rs.8,000. Management decides that :
a) in case of deficit within the3 limit of Rs.10,000 arrangement can be made with the bank
b) in the case of deficit exceeding Rs.10,000 but within a the limit of Rs.42,000 issue of
debentures is to be preferred.
c) In the case of deficit exceeding Rs.42,000 the issue of equity shares is to be preferred.
Assume that this will be within the Authorized Capital.
Solution
CASH BUDGET
Particulars Jan Feb March April
RECEIPTS
Opening balance 8,000 15,000 30,000 (Cr) 71,000 (Cr)
Cash sales 60,000 40,000 45,000 40,000
Total, say A 68,000 55,000 75,000 31,000
PAYMENTS
Purchases 48,000 80,000 81,000 90,000
Wages 5,000 5,000 5,000 5,000
Total, say B 53,000 85,000 86,000 95,000
Closing Balance A – B 15,000 30,000 71,000 1,26,000
The total deficit of Rs,1,26,000 should be raised from the issue of Equity Shares.
14.10 Flexible Budget
According to I.C.M.A, London, a flexible budget is “a budget which is designed to change in
accordance with the level of activity actually attained”. The basic idea of a flexible budget is that
there shall be some standard of cost and expenditures. Thus, a budget prepared in a manner to
give budgeted costs for any level of activity is, known as flexible budget. Such budget is
prepared after considering the variable and fixed elements of costs and the changes which may
be expected for each item at various levels of operations. .The main focus of flexible budget is to
re cognize the difference in behavior pattern of fixed and variable costs in relation to fluctuations
in production and sales . The flexible budget is, hence, designed to change appropriately with
such fluctuations. In flexible budget, data relating to costs and expenses may progressively be
changed in any month in accordance with actual output achieved. Costs and estimates are made
in advance based on standards. A maximum and a minimum levels of operation is made.
Comparison of budgeted with actual are made. Budgeted activities are taken as basis. The
principles of flexible budgeting concepts are applied to functional budget, master budgets.
Popularly, the flexible budget is adopted for production cost budget. In this area., the costs are
classified. A detailed classification is adopted such as variable, fixed and semivariables..
Adopting microlevel classifications, it is intended to pinpoint the various effects on each class of
overheads.
1. Flexible budget is _______________.
2. Main focus on flexible budget is ___________.
Problem 7:
Draw a flexible budget for the level of operation at 70 %, 80 % and 90 %..
Variable overheads : at 80 % capacity. Indirect labor Rs.12,000. Stores and spares Rs.4,000.
Semivariable overheads at 80% capacity. Power (30 % fixed) Rs.20,000. Repairs and
maintenance at 60 % fixed Rs.2,000.
Fixed overheads : at 80 % : Depreciation Rs.11,000. Insurance Rs.3,000. Salaries Rs.10,000.
The estimated direct labor hours 1,24,000,.
Solution:
FLEXIBLE BUDGET (OVERHEADS)
For the period …………………
Particulars Level of operation
Basis 70 % 80 % 90 %
VARIABLE OVERHEADS
Indirect labor 10,500 12,000 13,500
Spares and 3,500 4,000 4,500
Total, say A 13,500 16,000 18,000
SEMI VARIABLE OVERHEADS
Power ( 30 % fixed ) consider 80 %
Power total 20,000 and segregate between
Variable and fixed . For fixed, maintain
Uniformity for all levels of production
30% x 20,000 6,000 6,000 6,000
Balance 70 % ,
proportionately calculate 12,250 14,000 15,750
Repairs and maintenance
60 % fixed on
Rs.2,000 (i.e. 80 % capacity) 1,200 1.200 1,200
40 % variable 700 800 900
Total, say B 34,150 38,000 41,850
FIXED OVERHEADS
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
Total, say C 24,000 24,000 24,000
Grand Total A + B + C 58,150 62,000 65,850
Estimated labor hours 1,08,500 1,24,000 1,39,500
Standard overhead rate / hour 0.54 0.50 0.48
Divide the grand total by estimated Labor hours.
14.11 Limitations Of Budgeting
The main limitations of budgeting are as under :
Budget plan : Since budget plans are based on estimates, the success or otherwise depends on
the accuracy of basic estimates or forecasts. Due to this while making estimates, judgmental
decision may accrue. The results need to be interpreted very cautiously.
Rigidity: Since the estimates are quantitative expression of all relevant data, there is likely that
finality attachment may become very clear. Such consideration may result in rigidity. Rigidity
may become a set back for the changing business conditions.
Replacement: Budgeting is not a substitute for management. It is essentially a tool of
management. Under no circumstances, it should be concluded that the budgeting is alone
sufficient to ensure success and to guarantee future profits.
Costly: The installation of budgeting system to an organization involve too much of costs. Its
scientific approach will definitely call for huge cost allocation. Small concerns cannot afford to
take over huge costs for the establishment of business systems. Since the costs and revenues
and operational activities do not match in many occasions, the entire exercise will become costly.
The system should be adopted only when benefits exceed the costs.
Terminal Questions
1. What are the merits of budgets ?
2. Describe the essential features of budgetary control.
3. What are the steps in budgetary control ?
4. What are the limitations of budgeting ?
5. DR Ltd provides the following Profit and Loss Account for the year 2007.
Sales Rs.3,55,000 LESS : Expenses : Raw materials Rs.72,200. Expenses Rs.2,04,000.
Stores Rs.48,800. Interest Rs.20,000. Depreciation Rs.20,000. Loss : (Rs.11,200). The
company had been working at 60 % capacity during the year 2007. Of the expenses of
Rs.2,04,00, 25 % is variable. During the year 2008, production / sales volume at 80 % of
capacity is expected to be achieved. Fixed cost is, however, expected to increase by
Rs.12,000. Draw a 2008 Budget.
6. The expenses budget for production of 10,000 units in a factory are furnished below. In
rupees per unit.
Materials 70, Labor 25, Variable overheads 20, Fixed overheads (Rs.1,00,000) 10, variable
expenses (direct) 5, Selling expenses (10 % fixed) 13. Administrative expenses (Rs.50,000)
5. Distribution expenses (20 % fixed) 7. Prepare a budget for the production of (a) 8,000 units
and (b) 6,000 units. Assume that administrative expenses are rigid for all levels of production.
1. Numerical
2. Estimated
1. Corrective action.
1. Forward
2. Long and short term goals
1. Fix financial goals
1. Best result
2. Foundation for business activities
3. Group of representatives
4. Coordination
1. Policy formulation, forecasting
1. Fixed, flexible, function
1. Process of cash flow forecast.
2. Weekly, monthly, quarterly, annually
1. Changes with level of activities
2. Recognize behavior pattern.
Unit 15 Standard Costing
Structure:
15.1 Introduction
Objectives
15.2 Definition
15.3 Meaning
15.4 Standard cost and BC
15.5 Establish or standard
15.6 Variance analysis
15.7 Material variance
15.8 Material price variance
15.9 Material usage
15.10 Material Mix
15.11 Material Yield
15.12 Direct labor variance
15.13 Labor Efficiency Variance
15.14 Labor rate variance
15.15 Labor mix variance
15.16 Labor yield variance
Terminal Questions
15.1 Introduction
Standard costing is a very important system of cost control. It is a system which seeks to control
the cost of each unit or batch through determination before hand of what should be the cost and
then its comparison with actual cost. Through planned accounting procedures, the difference
between the actual and predetermined costs are analyzed and then promptly reported upon to
managers. Based on this, it is possible to take corrective and preventive action as well as employ
the data for planning, coordination and control.
1. Define the standard costing.
2. understand the meaning.
3. Differentiate between standard cost and budgetary control.
4. Acquaint with establishment of standards.
5. Practice the variance analysis.
15.2 Definition Of Standard Costing
Standard costing may be defined as a technique of cost accounting which compares the standard
cost of each product or service with the actual cost to determine the efficiency of the operation so
that any remedial action may be taken immediately: Brown and Howard. According to J. Batty
“standard costing is a system of cost accounting which is designed to show in detail how much
each product should cost to produce and sell when a business is operating at a stated level of
efficiency and for a given volume of output”.
1. Standard cost is defined as ___________.
15.3 Meaning
The meaning of standard costing is focused on the method of financial control. It compares the
predetermined and actual costs. It is normally associated closely with budgetary control;. Many
organizations use both the systems although one can be used without the other. Standard
costing is mainly applied to products and processes. Therefore, it is a technique that is more
commonly used in manufacturing organization, though it may also be useful in service industries.
As in budgetary control, it allows the comparison of predetermined costs and income with the
actual costs and income achieved. Any difference can then be investigated.
1. Standard cost is basically _________.
15.4 Standard Cost And Budgetary Control
Both are closely interrelated. They both aim at the improvement of the system of managerial
control. They both achieve the same objective of maximum efficiency and cost control; by
establishing predetermined standards. They compare actual performance with the
predetermined standard. They take necessary steps to improve the situation wherever
necessary. Both techniques are forward looking. However, the following are some of the
differences identified.
1. The scope of budgetary control is wider. It is integrated plan of action, a coordinated plan in
respect of all functions of an enterprise The scope of standard costing, on the other hand, is
limited to the operating level. Here too, it is further linked to costs. Budgetary control is
extensive whereas standard costing is intensive in its application
2. Budgetary control deals with costs and revenues. But standard costing restricts only with
costs .
3. Budgetary control takes into account all activities such as production, sales, purchase3s,
finance, capital expenditure, personnel whereas standard costing is restricted to deal with
only costs.
4. Budgetary control targets are based on past actual adjusted to future trends. In Standard
costing, standards are based on technical assessment.
5. At the approach level, budgeted targets work as the maximum limit of expenses above which
the actual expenditure should not normally exceed. Under standard costing, standards are
attainable level of performance.
6. Budget are projection of final accounts. Standard costs are projection of only cost accounts.
7. Budgetary control emphasizes the forecasting aspect of the future operations. Standard
8. Costing scope and utility is limited to only operating level of the concern.
9. In budgetary control, the degree of variance analysis tends to be much less and variances are
not revealed through the accounts but are revealed in total. But in standard costing, variances
are analyzed in details according to their originating causes and ar3e revealed through
different accounts.
10. Budgetary control is possible even in parts of expenses according to the attitude of
management. A standard costing system can not be operated in parts. All items of
expenditure included in cost units are to be accounted for.
1. Standard cost and budget control _________.
15.5 Establishment Of Standards
Under standard costing system, there is a need to determine the standard costs for each element
of cost. The standards are fixed for three main elements of cost namely direct material, direct
labor and overhead.
Standards should be fixed for each of them separately.
Direct Material : Standard material cost for each product should be predetermined. This will

require the determination of material quantity standard and material price standard. The standard
quantity of each type of materials is determined by the engineering department on the basis of
past records, experience and chemical and engineering tests. While setting such standards, an
allowance should be made for the normal wastage of materials. The standard price for each item
of material is established after carefully studying the market conditions and forecasting the trend
of prices for a future period. This is done by cost accountant with the help of purchase officer..
Direct labor : The standard labor time and standard labor rate should be established. Standard
time for each grade of labor is fixed by the production engineering department on the basis of
time and motion study. In fixing the standard time due allowance should be made for fatigue,
tool setting, receiving instructions and normal idle time. The standard rates of pay for each
category of labor are fixed by the cost accountant with the help of personnel department.
Overheads : These are aggregate of indirect materials, indirect labor and indirect expenses/
Separate standards must be established for variable and fixed overheads. As variable overheads
per unit or per hour remain constant at each level of output / sales but total amount of variable
overheads tend to vary directly with volume of output / sales . Therefore, it is sufficient to
calculate only a standard variable overhead rate per unit or per hour. This is done by dividing the
total variable overheads for the budget period by the budgeted output. In respect of fixed
overheads standards are set for total fixed overheads for the budget period and the budgeted
output and standard fixed overhead rate is computed by dividing the budgeted fixed overheads
with budgeted output.
1. Standards are established for _____.
15.6 Cost Variance Analysis
The distinctive feature of standard costing system is variance analysis. By definition, the term
“variance” means the variation or deviation of the actual from the standard. In standard costing, it
implies the difference between the actual cost and standard cost. Variances indicate the extent
to which standards set have been achieved. If properly recorded and analyzed , these variances
become very important and useful tool for managerial control.
Variances by themselves are not the end. They are computed to know the reasons and fix the
responsibility for any deviations of actual performances from pre determined targets. Based on
this corrective measures are proposed for adoption in future. Therefore, variance analysis is the
process of analyzing variances by subdividing the total variance in such a way that management
can assign responsibility for off standard performance It is hence a very useful means for
interpreting operating results and spotting situations calling for correction.
Variances are interpreted as favorable and unfavorable variances. Each variance is interpreted.
Interpretation helps in deciding whether a variance is favorable or unfavorable. When the actual
cost is less than the standard cost, the difference is termed as “favorable” or “credit” variance. On
the other hand, when actual cost exceeds the standard cost, the difference is termed as
“unfavorable”, “adverse” or “debit” variance. Ordinarily, a favorable variance is a sign of
efficiency of the organization whereas an unfavorable variance a sign of inefficiency. But in
variance analysis, this general logic may prove to be untrue. Therefore, all variances should be
interpreted in relation to each other and only the net result be reported to the management for
corrective action.
Controllable and Uncontrollable variances : The controllable variance can be identified as the
primary responsibility of a specified person or a department. F a variance is due to the factors
beyond the control of the concerned person or department, it is said to be uncontrollable. No
person or department can be held responsible for uncontrollable variances. Actually revision of
standards is required to remove such variances in future.
1. Variation refers ________.
2. Variances analysis is _________________.
3. Variances are interpreted as _____ and ____.
15.7 Material Variance
It refers to material cost variance. It is the difference between the standard cost of materials
allowed for the actual output and the actual cost of materials used. It may be expressed as :
Material Cost Variance = Standard Cost – Actual Cost
Where standard cost = actual output x standard rate per unit of output
Or standard quantity of material for actual output x standard price per unit of material
Actual cost = actual quantity consumed x actual price per unit of material.
A favorable variance would result if actual cost is less than the standard cost and vice versa.
The material cost variance is the sum total of material price variance and material usage
variance.
1. Material variance is ______________.
Example: DR Ltd has decided to extend its range to include Denim Jackets. One jacket requires
a standard usage of 3 meters of direct material which has been set at a standard price of Rs.2.20
per meter. In the period, 80 jackets were made and 260 meters of material consumed at a cost
of Rs.1.95 per meter. Calculate the direct materials total variance.
Solution: Calculate the standard quantity of materials for the actual level of production
For 1 jacket = standard usage is 3 meters
Therefore for 80 jackets, it is 80 x 3 meters / 1 or 240 meters
Consider the formula, (SQ x SP ) – (AQ x AP)
= (240 x Rs.20 ) = (260 x Rs.1.90 ) or Rs.528 – Rs.507
= Rs.21 (Favorable) variance.
The difference indicates that them company has spent less on materials than planned for the
level of production.
15.8 Material Price Variance
Under Material price variance , the price paid for materials is different from the predetermined
price. It is calculated by multiplying the actual quantity of materials used with the difference
between standard and actual prices. The formula is :
Material Price Variance = (Standard Price – Actual Price ) x Actual quantity used
Shorten = ( SP – AP ) AQ
A favorable variance would result if the actual price is less than the standard price and vice versa.
1. Material price variance is __________.
Example : Calculate the direct material price variance from the data of DR Ltd above.
Solution : Formula : (SP – AP ) AQ or (Rs.2.20 – Rs.1.90) x 260 meters or Rs.78 FAV
It is favorable because the company has paid less for the materials than planned for that level of
production
15. 9 Material Usage Variance
It is also known as material quantity variance or efficiency variance. It is that portion of material
cost variance which measures the difference in material cost arising from higher or lessa
consumption of materials than the standard material consumption for the actual output. It is
calculated by multiplying the standard price with the difference between the standard and actual
quantitities of materials :
Material Usage Variance = (Standard Quantity Actual Quantity ) Standard Price
Shorten = (SQ – AQ) SP
A favorable variance would result if the actual quantity is less than the standard quantity and vice
versa.
1. Material usage is _______.
Example 1: Citing DR’s example : the direct material usage variance is :
(SQ – AQ ) SP or (240 – 260 meters) x Rs.2.20 per unit or Rs.44 (ADV)
It is adverse because the company has used more materials than planned for that level of
production.
Example 2: It is observed that one unit of product X requires 3 kgs of material M at Rs.2 per kg
During January 2008, 200 units of product X were produced consuming 620 kgs of material M,
all of which was purchased at Rs.1.80 per kg. Compute material cost variances.
Solution: Material Price Variance : ( SP – AP ) AQ or (2.00 – 1.80) x 620 o Rs.124 F
Material Usage variance : (SQ – AQ ) SP where SQ for actual consumption is
200 x 3 kg / 1 kg 0r 600 kgs
(600 – 620_ Rs.2 or Rs.40 A
Material Cost Variance : Material Price Variance + Material Usage variance
124 (F) + 40 )A) or Rs.84 (FAV)
Example 3: For producing a commodity, the standard quantity of material was fixed 10 kgs and
standard price was fixed at Rs.2 per kg. The actual quantity was consumed 12 kgs and the
actual price was Rs.1.90 per kg. Calculate the material variances.
Solution: MUV = (SQ – AQ) SP or (10 – 12) 2 or 2 x 2 or 4 ADV
MPV = (SP – AP ) SQ or (2 – 1.90 ) 12 or 1.20 FAV
MCV = (SQ x SR) – (AQ x AP) = (10 x 2 ) – (12 x 1.90) = 2.80 ADV
Example 4: Calculate the material variance.
Standard Actual
Material for 80 kgs Output 1,65,000 kgs
Finished products 100 kgs Material used 2,00,000 kgs
Price per kg Rs.0.80 paid Actual cost Rs.1,70,000
Solution: Calculation of standard quantity
For 80 kgs, finished products needs 100 kgs material
Therefore, for 1,65,000 kgs, it is 1,65,000 x 100 / 80
Or 2,06,250 kgs.
MUV = (SQ – AQ ) SP or (2,06,250 – 2,00,000) Rs.0.80
= Rs.5,000 FAV
MPV = (SP – AP ) AQ or (0.80 – 0.85 ) 2,00,000 or Rs.10,000, ADV
Cost of 2,00,000 kgs is Rs.1,70,000
Therefore, cost of one kg is 0.85
MCV = (SQ x SR) (AQ x AP )
(2,06,250 x 0.80) – (2,00,000 x 0.85)
= Rs.5,000 ADV.
Example 5: It is estimated that in the manufacture of a product, for each ton of materials
consumed 100 units should be produced. The standard price per ton of materials is Rs.10.
During the first week of January, 100 tons of materials were issued to the Production Department.
The purchase price of which was Rs.10.50 per ton. The actual output for the period was 10,250
units. Calculate the cost variances.
Solution: Standard rate of material : Standard cost per ton / standard output per ton or 10,250
units / 100 tons or 102.5 per ton
Material usage (SQ – AQ) Sp where SQ = Actual output / standard quantity or 10,250 / 100 tons
= 102.5 ton (one ton for 100 units Rs.10,250, the standard quantity is 102.5 tons. (102.5 – 100
tons) x Rs.10 or Rs.25 FAV
MPV = (SP – AP ) AQ (10 – 10.50 ) x 100 = Rs.50 ADV
MCV = (SQ x SP ) – (AQ x AP) or 102.5 x 10 – 100 x 10.50 or Rs.25 ADV
Example 6: A factory works on standard costing system. The standard esti8mates of material

for the manufacture of 1000 units of a commodity is 400 kg at Rs.2.50 per kg. When 2000 units
of a commodity are manufactured, it is found that 820 kgs of material is consumed at Rs.2.60 per
kg. Calculate the material variance
Solution : First calculate the standard quantity and standard cost.
Standard quantity : For manufacture of 1000 units, the standard estimates = 400 kgs.
Therefore, for actual manufactured quantity, the standard is 2000 x 400 / 1000 or 800 kgs.
Standard cost = Standard quantity x Standard rate or 800 x Rs.25 or Rs.2,000
Actual Cost = 820 x Rs.2.60 or Rs.2,132
Material cost variance = Standard cost – Actual cost or 2000 – 21312 or 132 ADV.
Material price variance = (SR – AR ) AQ or 2.50 – 2.60 x 820 or Rs.82 ADV
Material usage variance = 800 – 820 x 2.50 or Rs.50 ADV
15.10 Material Mix Variance
This variance arises only when more than one type of materials are used in manufacturing the
product and the quantities of materials issued to production are not in proportion of standard mix.
It is defined as that portion of the direct materials usage variance which is due to difference
between the standard and actual, composition of a mixture. For calculating the mix variance, first
calculate the quantities of revised standard mix. This is calculated by dividing the total
quantities of actual mix in standard mix proportion. In the terminology of standard costing,
quantities of revised standard mix are referred to as “revised standard quantity”. Mix variance is
obtained by multiplying the standard price of materials with the difference between revised
standard quantity and actual quantity for each material. It may be expressed as follows:
Material Mix Variance = Revised standard quantity for each material – actual
MMV Quantity for each material) x standard price.
Where RSQ = standard quantity for each material / total of standard quantity of all types of
materials x actual mix total
RSQ = Total weight of actual mix / total weight of standard mix
X standard quantity.
A favorable variance would result if actual quantity is less than revised standard quantity and vice
versa.
1. Material mix variance to __________.
Example : The following extracts are extracted from the books of DR Ltd.
Standard Mix Actual Mix
Material Qty Rate Total Qty Rate Total
X 300 5 1,500 280 5 1,400
Y 200 10 2,000 220 10 2,200
Total 500 500
Calculate the material mix variance
Solution :
Revised standard quantity = Total weight of actual mix / total weight of standard mix x standard
quantity
For Material X = 500 / 550 x 300 = 300
For Material Y = 500 /500 x 200 = 200
MMV = For X = (300 – 280)_ 5 = 100 FAV
Y = (200 – 220) 10 = 200 ADV
Total Mix variance 100 ADV
15.11 Material Yield Variance
This variance arises only when the rate of output is known. It is that portion of the direct material
usage variance which is due to the difference between standard yield specified and actual yield
obtained. It measures the loss or saving due to wastage of materials. This variance is calculated
as follows :
MYV = (Standard yield – Actual Yield ) x standard rate per unit of output or
( Standard Loss – Actual Loss ) x standard rate per unit of output
where standard rate = standard cost of standard mix / standard output from standard mix
standard yield = standard output from standard mix / standard mix total x actual mix total MYV is
an output variance and hence a favorable variance would result if actual yield is more than
standard yield and vice versa.
1. Material yield variance is __________.
Example 1: The following extracts refer to DR Ltd.
Standard Mix Actual Mix
Material Qty Price Total Qty Price Total
X 60 5 300 56 5 280
Y 40 10 400 44 10 440
100 700 100 720
Loss 30 % 30 Loss 25 % 25
a. 75
Calculate the material yield variance.
Solution:
Material Yield Variance : (Standard yield – Actual yield) Standard rate
Where standard rate = Total cost of standard mix / net standard output or 700 / 70 = Rs.70
MYV = (70 – 75) 10 or Rs.50 ADV.
Example 2: DR manufactures a product X. It is estimated that for each ton of material
consumed, 100 articles should be produced. The standard price per ton of material is Rs.10.
During the first week of January 2008, 100 tons were issued to production, the price of which was
Rs.10.50 per ton. Production during the week was 10,200 articles. Compute the variances
Solution:
Cost variance : Standard cost – Actual Cost or Rs.1,020 – Rs.1,050 = Rs.30 ADV
Working : Actual output x standard rate per unit of output or 10200 x 0.10 orRs.1,020
SR = Actual output / standard output per ton or 10,200 / 1`00 or 102 tons
Price variance : Actual quantity of input (Standard price – Actual Price) or ( 10 – 10.50) x 100 =
Rs.50 ADV
Usage Variance : (Standard quantity – Actual quantity) standard price or (102 – 100) x 10 or
Rs.20 FAV
Yield variance = (Standard yield – Actual yield ) standard rate per unit of output or (10,000 –
10,200 ) 0.10 or Rs.20 FAV
Working : Standard yield = Actual quantity of material x standard rate per ton of output or
100 x 100 = 10,000 articles.
Example 3 : The standard mix of product MS is as follows
Materials Qty in kg Price per kg
A 50 5
B 20 4
C 30 10
The standard loss in production is 10 % of input . There is no scrap value. Actual production for
a month was 7,240 kgs of MS from 80 mixes. Actual purchases and consumption of materials
are :
A 4,160 5.50
B 1,680 3.75
C 2,560 9.50
Solution
Statement showing standard input requirements of 80 mixes of product MS
Material Standard Actual
SQ SR SC AQ AR AC
A 4000 5 20,000 4160 5.50 22,880
B 1600 4 6,400 1680 3.75 6,300
C 2400 10 24,000 2560 9.50 24,320
Total 8000 50,400 8400 53,500
Less Std. Loss 800
Final output 7200 50,400
SC per kg of finished product = 50,400 / 7200 kg = Rs.7 per kg
Cost variance : SC AC or 7 x 7240 53500 or Rs.2,820 ADV
Prince Variance : (SR – AR ) x A Q
A = Rs.2,080 ADV
B = Rs.420 FAV
C = Rs.1,280 FAV
Mix Variance = (RSQ – AQ ) SR
A = (8400 x 50 / 100) Rs.5 = 200 FAV
B = 8400 x 20 / 100 x Rs.4 Nil
C = 8400 x 30 / 100 x Rs.10 = 400 ADV
Total : 200 ADV
Yield variance = (SY – AY ) SR per kg
Standard yield = 8400 kg x 9 / 10 or 7560 klg
(7,560 – 7,240 ) Rs.7 or Rs.2,240 ADV
15.12 Direct Labour Variances
The same principles apply to the calculation of Direct Labor variances as for the direct material
variances. Standards are established for the rate of pay to be paid for the production of particular
products and labor time taken for their production. The standard time taken is expressed in
standard hours or minutes and become the measure of output. By comparing the standard hours
allowed and the actual time taken, labor efficiency can be assessed. In practice, standard times
are established by work, time and method study techniques.
Direct Labor variance : It is the difference between actual labor cost and the standard labor
cost of production achieved. It is calculated as :
Total Labor Cost = Hours worked x Rate per hour
Labor Cost Variance = Standard Cost – Actual Cost
Shorten = SC AC Or (Standard labor hours x standard rate per hour ) – (Actual labor hours
x Actual rate per hour)
1. Direct labor variance is ___________.
Example: The management of DR Ltd decides that it takes 6 standard hours to make one Denim
jacket and the standard rate paid to labor is Rs.8 per hour. The actual production is 900 units
and this took 5,100 hours at a rate of Rs.8.30 per hour. Calculate the direct labor total variance.
Solution : Calculate the standard labor hour for 900 jackets
For one Jacket production, the standard hour is 6
Therefore, for producing 900 units, the standard hour is 900 x 6 / 1 = 5,400 hours
DLV = (5,400 x 8) )5,100 x 8.30 ) = Rs.870 favorable.
A favorable variance would result when actual cost is less than standard cost and vice versa.
Labor cost variance is the sum total of labor rate variance, labor efficiency variance, rate
variance, idle time and labor calendar variance
15.13 Labour Efficiency Variance
It is that portion of labor cost variance which is due to the difference between the standard lab or
hours specified for the activity i.e output achieved and the actual labor hours worked. It is
calculated by multiplying standard rate of wages with the difference between standard hours and
actual hours worked.
LEV = Standard hours – actual hours worked ) x standard rate
Shorten = (SH – AH ) SR
A favorable variance would result when actual hours worked are less than standard hours and
vice versa.
1. Labor efficiency variance to _________________.
Example : From the data above, calculate the labor efficiency variance;
Solution : (5400 standard hours – 5100 actual hours ) x Rs,8 standard rate
Rs.2,400 FAV
15.14 Labor Rate Variance
It is that portion of labor cost variance which is due to the difference between the standard rate
specified and actual rate paid. It is calculated by multiplying the actual hours paid with the
difference between standard rate specified and actual rate paid
Labor Rate variance = (Standard Rate – Actual Rate ) x actual hours paid
Shorten = ( SR – AR) AH
1. Labor rate variance is __________.
Example 1: Citing DR example, calculate the direct labor rate variance
Solution : (Rs.8 – 8.30 ) x 5,100 hours or Rs.1,530 ADV
Example 2: The production of a certain unit is assumed to require 18 hours labor at a rate of

Rs.1.25 per hour. On completion of a unit, it was found that the time taken was 16 hours, the
wage rate being Rs.1.50 per hour. Calculate labor variances.
Solution : Cost variance = Standard cost – actual cost
Rs.22.50 – Rs.24 or Rs.1.50 ADV
Working : SC = Standard hours x standard rate per hour = 18 x Rs.1.25 = Rs.22.50
OR
LCV = LEV + LRV
2.5 FAV + 4 ADV= 1.5 ADV
Efficiency variance = (Standard hours – actual hours worked)standard rate
( 18 – 16) x 1.25 or Rs.2..50 FAV
Rate variance = (Standard rate – actual rate) actual hours paid
(1.25 – 1.50) 16 or Rs.4 ADV
Labor Idle Time variance : It is that portion of labor cost variance which is due to abnormal idle
time of workers. This variance is calculated to show separately the effect of abnormal causes
affecting production such as failure of power supplies, machine break down, waiting for materials,
waiting for instructions, strike, lockouts. It is calculated as:
Labor idle time variance = Idle hours x standard hourly rate
This variance is always an adverse one.
Example 3: In the ma manufacture of a product, 200 employees are engaged at a rate of 50
paise per hour. A five day week of 40 hours is worked and the standard performance is set at
250 units per hour. During the first week in January, six employee were paid at 45 paise an hour
and four at 56 paise an hour, the remaining employees were paid at standard rates. The factory
stopped production for one hour due to power failure. Calculate variances.
Solution : Efficiency variance = (Std hours – actual hours worked ) x std rate
(8000 – 7800) 0.50 or Rs.100 FAV
Rate variance = (SR – AR ) AH
(0.50 – 190 employees x 40 hours = Nil
(0.50 – 0.40 ) x 6 x 40 12 FAV
(0.50 .56 ) 4 x 40 9.60 ADV
Total 2.40 FAV
Idle time variance = Idle hours x std rate per hour
200 hrs and 0.50 or Rs.100 ADV
Labor cost variance = LEV +_ LRV + Idle time variance
100 FAV + 2.40 FAV + 100 ADV = Rs.2.40
15.15 Labour Mix Variance
This variance arises only when different types of workers (women and men workers, trained,
semitrained and untrained workers, are employed in manufacturing. If actual working force of
different grades of workers is not in the predetermined ratio, then the mix variance will occur.
The variance shows to the management as to how much of the labor cost variance is due to the
changes in the composition of labor force. It is calculated as follows :
LMV = (Revised standard hours – actual hours worked) x standard hourly rate
Shorten (RSLH – ALH) x SR
Where revised standard hour = total time of actual worker / total time of standard workers x
standard labor rate.
1. Labor mix variance is _________________.
Example 1: The labor budget for a week is as follows :
40 skilled men at Rs.1.50 per hour for 80 hours
80 unskilled men at Re.1 per hour for 80 hours
Actual labor force was used are given below;
60 unskilled men at Re.1 per hour for 80 hours
Calculate labor mix variance.
Solution : Revised standard labor hours = total time of actual workers / total time of standard
workers x standard labor hours
Skilled worker = 80 / 80 x 80 = 80 hours
Unskilled = 80 / 80 x 80 = 80 hours
LMV = Skilled = (3,200 – 4,800) 1.50 = Rs.2,400 ADV
Unskilled = (6,400 – 4,800) Re.1 = Rs.1,600 FAV
Total labor mix variance Rs.800 ADV.
15.16 Labor Yied Variance.
This is due to the difference in the standard output specified and the actual output obtained. The
formula is as follows :
LYV : (Actual output – Standard output ) x standard cost per unit
1. Labor yield variance ________________.
Example 1: Actual output 460 units. Standard output 500 units. Standard rate of wages Rs.9 per
hour. A Standard time 2 hour per unit.
Solution : Standard cost per unit = Rs.9 x 2 hours = Rs.18
LYV = (AO – SO) SC or (460 – 500 units) x Rs.18 or Rs.720 ADV
Example 2: Calculate (a) Labor rate variance (b) labor efficiency variance (c) labor cost variance
Standard : Labor rate 0.24 paise per hour. Labor hours 3 per unit.
Actual : Units produced 250. Labor rate 0.25 perise per hour. Hours worked 800.
Solution: LRV : (SR = AR) AH or Rs.8 ADV
LEV = (SH – AH ) SR or Rs.12 ADV
LCV = (SLC – ALC) or (SH x SR) – (AH x AR) = Rs.20 ADV
Example 3 : The standard labor force of DR Ltd is as follows :
20 skilled men at Re.0.50 per hour for 40 hrs
40 semi skilled men at 0.35 per hour for 40 hrs.
During a certain week, the actual ,labor force was :
30 semi skilled men at 0.40 per hour
Analyze labor variance for 40 hours.
Solution : Calculation of standard hours
Actual hours : 30 x 40 = 1,200 hours
30 x 40 = 1.200 hours
20 x 40 = 800 hours
40 x 40 = 1,600 hours
Total 2,400 hours
Since standard hours and actual hours are the same in total there would be no labor efficiency
variance.
Labor cost variance : SLC – ALC or Rs.120 ADV
Labor rate variance : Skilled : (SR – AR) AH or Nil
Semi skilled (0.350.40) 1,200 or 60 ADV
Labor mix variance = ( SH – AH ) SR
Skilled (800 – 1200) x 0.50 or 200 ADV
Semi skilled (1,600 – 1,200)Rs.0.35 or 140 FAV
Example 4: A contract job is scheduled to be completed in 20 weeks with a labor force of 10

skilled workers, 4 semi skilled workers and 6 unskilled workers. The standard weekly wages of
each type of workers are : Skilled Rs.50, semi skilled Rs.40 and unskilled Rs.30. The work is
actually completed in 25 weeks with a labor force of 8 skilled, 5 semiskilled and 7 unskilled
workers and the actual weekly wage rates average Rs.55 for skilled, Rs.45 for semi skilled and
Rs.25 for unskilled workers. Analyze the variance.
Solution
Grade Standard Actual
No. Weeks Weekly rate Amount No. Weeks Rate AmountSkilled
10 20 Rs.50 10,000 8 25 Rs.55 11,000 Semiskilled
4 20 Rs.40 3,200 5 25 Rs.45 5,625 Unskilled
6 20 Rs.30 3,600 7 25 Rs.25 4,375
l 20 16,800 20 21,000
Skilled Semiskilled Unskilled
LRV = (SR – AR) AT 1,000 ADV 625 ADV 875 FAV
LEV = (ST – AT ) SR Nil 1,800 ADV 1.650 ADV
LMV (RSLH – ALH) SR 2500 FAV 1,000 ADV 750 ADV
Total 750 FAV
Labor cost variance : LRV + LEV = 750 + 3450 = 4200 ADV
Labor yield variance = (Actual weeks – standard weeks ) Standard rate per hour
(500 – 400 ) Rs.42 = Rs.4,200 ADV (16800 / (20 nos x 20 weeks)
RSLH : Total time of actual workers / total time of standard workers x Standard labor hours
500 / 400 x 200 = 250 = (250 – 200 ) 50 = Rs.2,500 FAV
500 / 400 x 80 = 100 = (100 – 125) 40 = Rs.1,000 ADV
500 / 400 x 120 = 150 = (150 – 175 ) x 30 = Rs.750 ADV
Terminal Questions
1. How is standard costing related to budgetary control ?
2. How do you fix standard for direct material, direct labor and direct overheads ?
3. Write short note on :
a. Material Price Variance
b. Material Mix Variance
c. Material Yield Variance.
4. Briefly describe labor mix variance and yield variance.
5. Compute price, usage, cost and mix variance
Material Standard Actual
Quantity Price Total Qty Price Total
A 6 1.50 9 5 2.40 12
B 2 3.5 7 1 6 6
6. Data given below pertain to DR Ltd
DEPARTMENT
A B
Actual gross wages 2,000 1,800
Standard hours produced 8,000 6,000
Standard rate per hour 0.30 0.35
Actual hours worked 8,000 5,800
Calculate labor variances.
1. Cost of each product
1. Finical control
1. Closely interrelated
1. Direct martial, direct labor, overheads
1. Deviation
2. Process of analysis
3. Favorable and adverse.
1. SC – AC
1. ( SP – AP) x AQ
1. SQ – AQ x SP
1. RSQ – AQ x SP
1. SY – AY x SR
1. SC – AC
1. SH – AH x SR
1. SR – AR x AH
1. RSLH – ALH x SR
1. AO – SO x SC
3. Refer to unit 15.8, 15.10 and15.11
4. Refer to unit 15.15 and15.16
5. Price variance = (SR – AR) AQ for A = Rs.4.50 ADV
For B = Rs.2.50 ADV total Rs.7 ADV
Usage variance : (SQ – AQ ) SP for A = 1.50 FAV
For B = 3.50 FAV Total Rs.5 FAV
Cost Variance = MUV + MPV = 5 – 7 or 2 ADV
Mix variance = (RSQ – AQ ) SP where RSQ = A 6 /8 x 6 or 4.5 kgs
B 6 /8 x 2 or 1.5 kgs
For A (4.5 – 5) x 1.5 or 0.75 ADV
For B (1.5 – 1) x 3.5 or 1.75 FAV Therefore total 1 FAV
6. Standard labor cost ; Dept A 8000 x 0.30 = 2,400
B 6,000 x 0.35 = 2,100
Actual rate A 2000 ./ 8000 = 0..25
B 1800 / 5800 or 900 /29 paise
LRV = (SR – AR ) AH Dept A = (0.30 – 0.25) 8000 = 400 FAV
B = (.35 – 900 /25) x 5800 = 230 ADV
LEV = (SH – AH) SR For A = (8000 – 8000) x0.30 Nil
B = (6000 – 5800)0.35 70 ADV
LCV : (SLC – ALC For A (2400 – 2000) 400 FAV
B (2100 – 1800) 300 ADV

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Reference Books:

Unit 1 Financial Accounting – An Introduction

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1.2 Evolution of Financial Accounting

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

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

Self Assessment Questions 1:

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1. __________ is the father of Accounting.

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Self Assessment Questions 2:

1.4 Meaning of Accountancy, Book-keeping and Accounting

Self Assessment Questions 3:

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1. What is book keeping?

1.5 Characteristics of Accounting

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

Self Assessment Questions 4:

1.6 Functions and Objectives of Accounting

Self Assessment Questions 5:

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1.7 Differences between Book Keeping and Accounting

Book keeping Accounting

Self Assessment Questions 6:

1.8 Financial Accounting and Management Accounting

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Financial accounting Management accounting

1.9 Basic Terms

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Self Assessment Questions 8:

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3. Brief describe the need and evolution of accounting.

Answer for Self Assessment Questions

Self Assessment Questions 2:

Self Assessment Questions 3:

Self Assessment Questions 4:

Self Assessment Questions 5:

Self Assessment Questions 6:

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Self Assessment Questions 7:

Self Assessment Questions 8:

Answer for Terminal Questions:

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Unit 2 Accounting Concepts, Principles, Bases and Policies

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2.4.7 Modifying Principle

2.2 Accounting concepts, principles, bases and policies

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Self Assessment Questions 1:

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

2. 3 Types of Accounting concepts

Self Assessment Questions 2:

2.3.1 Business Entity Concept

Self Assessment Questions 3:

2.3.2 Going concern concept

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Self Assessment Questions 4:

2.3.3 Money Measurement Concept

Self Assessment Questions 5:

2.3.4 Periodicity Concept

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