AMBO-104

AMBO-104
ACCOUNTING FOR MANAGERS
AUO
AMITY UNIVERSITY
Accounting is an ancient art as old as money itself. Luca Pacioli is widely regarded as Father of Accounting. He developed the double entry bookkeeping system.Double-entry is defined as any bookkeeping system in which there is a debit and credit entry for each transaction, or for which the majority of transactions are intended to be of this form. In India, Chanakya clearly indicates, in his Arthshastra, the existence and need of proper accounting and audit.
Preface
As we read the term accounts or accountancy a curiosity arises as to what it is? Our brain starts working and we feel that it is something related to figures and business. Similar is the scenario when we say finance. As the management students we are expected to have good knowledge of these topics. Hence before going into the technical knowledge of these topics lets understand the basic meaning of the terms accounting & finance. Accounting or accountancy is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof. Finance refers to the concept of time, money and risk and how they are interrelated. Now, after having the working knowledge of these terms, lets proceed to the chapters for better and through understanding of the subject. This e-learning syllabus for Accounting and Finance is thus generated to help you understand the concepts and principles of Accounting and Finance. The entire syllabus is divided into eight chapters. Each chapter is comprehended with multiple choices questions. Further there are three types of assignments Assignment A Assignment B - Five Analytical Questions (to cover the first half of the syllabus) - Three Analytical Questions (Questions covering second half of the syllabus) and a Case Study. Assignment C - 40 multiple choice Objective Questions . Answers can be in the form of tick marking the most appropriate answer.
Table of Contents
Preface............................................................................................................................................. 2 Chapter-1: Introduction to the Basics of Accounting ..................................................................... 9 1.1 Introduction ........................................................................................................................... 9 1.2 Concepts of Accounting ........................................................................................................ 9 1.3 Conventions regarding Financial Statements...................................................................... 10 1.4 Users of Accounting Information ....................................................................................... 10 1.5 Scope of and inter-relationship between financial, cost and management accounting. ...... 11 1.6 Meaning of HR Accounting ................................................................................................ 12 Multiple Choice Questions ....................................................................................................... 14 Chapter- 2: Accounting Equation ................................................................................................. 16 2.1 Basic Accounting Terminology .......................................................................................... 16 2.2 Accounting Equation .......................................................................................................... 19 Multiple Choice Questions ....................................................................................................... 21 Chapter-3: Journalizing, Posting & Balancing ............................................................................. 24 3.1Types of Books .................................................................................................................... 25 3.1.1 Double-Entry Accounting ............................................................................................ 25 3.2 Accounts ............................................................................................................................. 26 3.2.1 Classification of Accounts ........................................................................................... 26 3.2.2 Format for Accounts .................................................................................................... 26 3.2.3 The Ledger ................................................................................................................... 27 3.3 Journalizing ......................................................................................................................... 27 3.3.1 Journal Entries ............................................................................................................. 27 3.3.2 Debits and Credits of Accounts ................................................................................... 30 3.3.3 Normal Balances of Accounts ..................................................................................... 30
3.4 Trial Balance ....................................................................................................................... 37 3.4.1 What is the difference between a trial balance and a balance sheet? ........................... 38 3.4.2 Methods of preparing trial Balance.............................................................................. 38 3.4.3 Format of trial balance ................................................................................................. 38 3.4.4 Preparation of Trial Balance Methods ...................................................................... 45 3.4.5 Errors in the trial balance ............................................................................................. 47 Multiple Choice Questions ....................................................................................................... 49 Chapter-4: Financial Statements ................................................................................................... 52 4.1 Preparation of Profit & Loss Account ................................................................................ 53 4.1.1 Introduction to the profit and loss account .................................................................. 53 4.1.2 Preparation of Balance sheet ........................................................................................ 67 4.1.3 Sample balance sheet structure .................................................................................... 70 4.2 Inventory Valuation and the matching of revenue and expenses ....................................... 73 4.2.1. Inventory and financial statements ............................................................................. 73 4.2.2. Methods of Inventory Valuation ................................................................................. 74 4.2.3 Using non-cost methods to value inventory................................................................. 74 4.2.4 Methods used to estimate inventory cost ..................................................................... 75 4.3 Fixed Assets and Depreciation............................................................................................ 75 4.4 Depreciation ........................................................................................................................ 76 4.1.1 Meaning of Depreciation ............................................................................................. 76 4.4.2 Special Features of Depreciation ................................................................................. 77 4.4.3 Causes of Depreciation ................................................................................................ 77 4.4.4 Importance or need for providing depreciation ........................................................... 78 4.4.5 Factors affecting the amount of depreciation............................................................... 79 Multiple Choice Questions ....................................................................................................... 81
Chapter 5: Analysis of Financial Statements ................................................................................ 84 5.1 Meaning of Ratio Analysis ................................................................................................. 84 5.1.1 Sources of data for financial ratios .............................................................................. 85 5.1.2 Purpose and types of ratios .......................................................................................... 85 5.1.3 Financial ratios allow for comparisons ........................................................................ 85 5.1.4 Accounting methods and principles ............................................................................. 86 5.1.5 Abbreviations and terminology.................................................................................... 86 5.2 Classification of Ratios ....................................................................................................... 88 5.2.1. Profitability ratios ....................................................................................................... 88 5.2.2. Liquidity ratios ............................................................................................................ 92 5.2.3. Activity ratios.............................................................................................................. 93 5.2.4. Debt ratios (leveraging ratios) .................................................................................... 96 5.2.5. Market ratios ............................................................................................................... 97 5.2.6. Capital Budgeting Ratios .......................................................................................... 100 Multiple Choice Questions ..................................................................................................... 102 Chapter-6: Company Accounts ................................................................................................... 105 6.1 Introduction ....................................................................................................................... 106 6.1.1 Meaning of Company ................................................................................................ 106 6.1.2 Characteristics ............................................................................................................ 106 6.1.3 Kinds of Companies ................................................................................................... 106 6.1.4 Formation of Company .............................................................................................. 107 6.2 Shares and Share Capital .................................................................................................. 108 6.2.1 Meaning and Types of Shares .................................................................................... 108 6.2.2 Share Capital .............................................................................................................. 108 6.2.3 Classification of Share Capital................................................................................... 109
6.2.4 Issue of Shares ........................................................................................................... 109 6.2.5 Forfeiture of Shares.................................................................................................... 113 6.2.6 Reissue of Forfeited Shares ....................................................................................... 115 6.3 Debentures ........................................................................................................................ 115 6.3.1 Meaning of Debentures .............................................................................................. 115 6.3.2 Types of Debentures .................................................................................................. 116 6.4 Liquidation ........................................................................................................................ 116 6.4.1 Meaning of liquidation ............................................................................................... 116 6.4.2 Types of Liquidation .................................................................................................. 116 Multiple Choice Questions ..................................................................................................... 118 Chapter-7: Cost & Management Accounting ............................................................................. 121 7.1 Introduction to Cost and Management Accounting .......................................................... 122 7.1.1 Management Accounting ........................................................................................... 122 7.1.2 Cost Accounting......................................................................................................... 124 7.2 Concept of Cost................................................................................................................. 127 7.3 Elements of Cost ............................................................................................................... 127 7.4 Cost Sheet ......................................................................................................................... 132 7.4.1 Components of Total Cost ......................................................................................... 132 7.4.2 Structure of Cost Sheet .............................................................................................. 133 7.5 Classification of Cost ........................................................................................................ 137 7.5.1. Fixed, Variable and Semi-Variable Costs ................................................................. 137 7.5.4. Decision-Making Costs and Accounting Costs ........................................................ 140 7.5.5. Relevant and Irrelevant Costs ................................................................................... 140 7.5.6. Shutdown and Sunk Costs ........................................................................................ 141 7.5.7. Controllable and Uncontrollable Costs ..................................................................... 141
7.5.8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs .................... 141 7.5.9. Imputed or Hypothetical Costs ................................................................................. 142 7.5.10. Differentials, Incremental or Decrement Cost ........................................................ 142 7.5.11. Out-of-Pocket Costs ................................................................................................ 144 7.5.12. Opportunity Cost ..................................................................................................... 144 7.5.13. Traceable, Untraceable or Common Costs ............................................................. 144 7.5.14. Production, Administration and Selling and Distribution Costs ............................. 145 7.5.15. Conversion Cost ...................................................................................................... 146 7.6 Cost Unit and Cost Center ................................................................................................ 147 7.6.1 Cost Unit .................................................................................................................... 147 7.6.2 Cost Center................................................................................................................. 147 7.7 Cost Estimation and Cost Ascertainment ......................................................................... 148 7.8 Cost Allocation and Cost Apportionment ......................................................................... 149 7.9 Cost Reduction and Cost Control ..................................................................................... 149 7.10 Methods of Costing ......................................................................................................... 149 7.11 Techniques of Costing .................................................................................................... 152 Multiple Choice Questions ..................................................................................................... 154 Chapter 8: Process Costing ......................................................................................................... 157 8.1 Features/Characteristics of Process Costing ..................................................................... 157 8.2 Elements/Components of Process Cost ............................................................................ 159 8.3 Methodology of Recording/Accounting Costs ................................................................. 160 8.3.1 Process Accounts ....................................................................................................... 160 8.3.2 Process Stock Accounts ............................................................................................. 161 8.4 Process Losses & Gains .................................................................................................... 161 8.4.1 Process Losses ........................................................................................................... 161
8.4.2 Abnormal Effectives/Gain ......................................................................................... 163 Multiple Choice Questions ..................................................................................................... 166 Chapter-9: Marginal Costing & Break Even Analysis ............................................................... 169 9.1 Marginal Costing .............................................................................................................. 170 9.1.1 Introduction ................................................................................................................ 170 9.1.2. Theory of Marginal Costing...................................................................................... 171 9.1.3 The principles of marginal costing ............................................................................ 173 9.1.4 Features of Marginal Costing..................................................................................... 174 9.1.5 Advantages and Disadvantages of Marginal Costing Technique .............................. 174 9.2 Marginal Costing Pro-Forma ............................................................................................ 176 9.3 Breakeven Analysis .......................................................................................................... 177 9.3.1 Introduction ................................................................................................................ 177 9.3.2 Cost-Volume-Profit (C-V-P) Relationship ................................................................ 178 9.3.3 Objectives of Cost-Volume-Profit Analysis .............................................................. 180 9.3.4 Assumptions and Terminology .................................................................................. 180 9.3.5 Limitations of Cost-Volume Profit Analysis ............................................................. 182 9.4 Marginal Cost Equations and Breakeven Analysis ........................................................... 183 Key to Multiple Choice Questions .............................................................................................. 197 Bibliography ............................................................................................................................... 198
Chapter-1: Introduction to the Basics of Accounting

Contents: 1.1 Introduction 1.2 Concepts of accounting, 1.3 Conventions regarding financial statements, 1.4 Users of accounting information, 1.5 Scope of and inter-relationship between financial, cost and management accounting, 1.6 HR Accounting
1.1 Introduction
Accounting is an ancient art as old as money itself. Luca Pacioli is widely regarded as Father of Accounting. He developed the double entry bookkeeping system.Double-entry is defined as any bookkeeping system in which there is a debit and credit entry for each transaction, or for which the majority of transactions are intended to be of this form. In India, Chanakya clearly indicates, in his Arthshastra, the existence and need of proper accounting and audit. Accounting is an actual process of preparing and presenting the accounts. An account is a British term for Financial Statements.
1.2 Concepts of Accounting

The various concepts of accounting are: 1. Business Entity Concept: According to it the business & the person owing it are different entities.
2. Money Measurement Concept: Accounting records only those transactions which are expressed in monetary terms, though quantitative records are also recorded. 3. Cost Concept: Transactions are entered in the books of accounts at the amounts actually involved. 4. Going Concern Concept: It is assumed that the business will continue for long period. 5. Dual-Aspect Concept: For each and every transaction there is an effect on both sides of Balance Sheet i.e. Assets and Liabilities. 6. Realization Concept: According to it the transaction is recorded only when the money is realized. 7. Accrual Concept: According to it the transaction must be recorded when it occurs, it may or may not be settled at the time of recording.
1.3 Conventions regarding Financial Statements

For the proper interpretation of the Financial Statements the following are the conventions: 1. Consistency: There must be consistency in the accounting practices followed from year to year. If a change becomes necessary, the change and its effect must be stated clearly. 2. Disclosure: Good accounting practice demands that all significant information must be disclosed. 3. Conservatism: It means that Financial Statements must not disclose any illusionary data. It must not be window dressed.
1.4 Users of Accounting Information

Besides the persons at the helm of affairs of the concerned firm or institution, there are numerous other parties interested in the financial statements. These are:
1. Shareholders: Get the knowledge of the performance of the company through the help of financial statements. 2. Investors: Who are interested in buying the shares of the firm need Financial Statements to determine the credentials, returns and overall performance of the firm. 3. Creditors: The Financial Statements greatly help them in properly assessing the capability of the firm to pay back their money in time. 4. Labor: They need Financial Statements for conducting the wage negotiations. 5. Government: Need Financial Statements for compiling the statistics of the concerning business which, in turn, help in compiling national accounts. 6. Researchers: The Financial Statements, being the mirror of business conditions, are of inestimable value to research in to business affairs. 7. Public: Financial Statements may assist the public by providing information about trends and recent developments in the prosperity of the enterprise and the range of its activities.
1.5 Scope of and inter-relationship between financial, cost and management accounting.
Economic development and technological improvements have resulted in an increase in the scale of business operations. This leads to the specialized branches of accounting such as Financial Accounting, Cost accounting, Management Accounting & Social Responsibility Accounting.
Branches of Accounting Social Responsibility Accounting
Financial Accounting
Cost Accounting
Management Accounting
Lets understand these branches of accounting: 1. Financial Accounting: It is the process of identifying, measuring, recording, classifying, summarizing, analyzing, interpreting and communicating the financial transactions and events. The purpose of this branch is to keep the systematic records to ascertain financial position and performance of the enterprise. 2. Cost Accounting: It is the process of accounting and controlling the cost of a product, operation or function. The purpose of this branch is to ascertain the cost, to control the cost and to communicate information for decision making. 3. Management Accounting: It is the application of accounting techniques for providing information designed to help all levels of management in planning and controlling the activities of business enterprise and in decision making. The purpose of this branch is to supply any and all information that management may need in taking the decisions. 4. Social Responsibility Accounting: It is the process of identifying, measuring and communicating the social effects of business decisions to permit informed judgement and decisions by the users of information.
1.6 Meaning of HR Accounting

Human Resource Accounting is the offshoot of various research studies conducted in the areas of accounting and finance. Human resource is an asset whose value gets appreciated over the period of time provided placed, applied and developed in the right direction. To ensure growth and development of any organization, the efficiency of people must be augmented in the right perspective. Without human resources, the other resources cannot be operationally effective. The original health of the organization is indicated by the human behavior variables, like group loyalty, skill, motivation and capacity for effective interaction, communication and decision making.
Men, materials, machines, money and methods are the resources required for an organization. These resources are broadly classified into two categories Animate Inanimate (human and physical) resources. Men, otherwise known as the human resources, are considered to be animate resources. Others, namely, materials, machines, money and methods are considered to inanimate or physical resources. Till the recent past, organizations took few efforts to assign monetary value to human resource in its accounting practice. Presently the behavioral scientists initiated efforts to develop appropriate methodology for finding out the value of human resource to the organization. They were against the conventional accounting practice for its failure to value the human resource of an organization along with physical resources. As a result the HR Accounting comes into the scenario. The various approaches towards it are: 1. Historical Cost Approach. 2. Replacement Approach. 3. Present value of future earnings. 4. Value of the organization. 5. Expense Model.
Multiple Choice Questions
1). Accounting is an art of: a) Recording b) Classifying c) Interpretating d) All of above
2). For each & every transaction there is an effect on both Assets & Liabilities: a) Business Entity Concept b) Money Measurement Concept. c) Cost Concept. d) Dual-Aspect Concept.
3). Consistency in Financial Statements means: a) Same accounting practices must be followed in years to come. b) All significant information must be disclosed. c) It must not be window dressed. d) None of above.
4). According to HR Accounting the resources are: a) Men b) Material c) Money d) Machine e) All of above
5). The purpose of this branch is to supply any and all information that management may need in taking the decisions: a) Financial Accounting b) Management Accounting c) Cost Accounting d) HR Accounting
Chapter- 2: Accounting Equation

Contents: 2.1 2.2 Basic Accounting Terminology Accounting Equation
In order to understand the Accounting concepts its necessary to have the basic understanding of accounting terminology.
2.1 Basic Accounting Terminology

1. Entity: An entity is something that has a distinct, separate existence, that performs economic activities. 2. Event: It is the happening of consequence to an entity. 3. Transaction: A transaction is an agreement, communication, or movement carried out between separate entities or objects, often involving the exchange of items of value, such as information, goods, services and money. 4. Voucher: It is the document which serves as an evidence for transaction. 5. Entry: It is the record made in the books of accounts in respect of a transaction or event. 6. Assets: In business and accounting, assets are everything of value that is owned by a person or company. The two major asset classes are: a. Tangible assets: Tangible assets contain various subclasses, including current assets and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.
b. Intangible assets: Intangible assets are nonphysical resources and rights that have a value to the firm because they give the firm some kind of advantage in the market place. Examples of intangible assets are goodwill, copyright, trademarks, patents and computer programs and financial assets, including such items as accounts receivable, bonds and stocks. 7. Liabilities: In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Liabilities are reported on a balance sheet and are usually divided into two categories: a. Current liabilities these liabilities are reasonably expected to be liquidated within a year. They usually include payables such as wages, accounts, taxes, and accounts payables, unearned revenue when adjusting entries, portions of longterm bonds to be paid this year, short-term obligations (e.g. from purchase of equipment), and others. b. Long term liabilities these liabilities are reasonably expected not to be liquidated within a year. They usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties. 8. Capital: It is the excess of assets over external liabilities. 9. Drawings are the total amount of cash or goods or any other asset withdrawn by the proprietor or the partner of the partnership enterprise for personal use. 10. Purchases refer to the total amount of goods obtained by an enterprise for resale or for use in the production of goods or rendering of services in the normal course of business. It may be for cash or credit. 11. Sales refer to the amount for which goods are sold or services are rendered. It may be for cash or credit. 12. Stock refers to the tangible property held for sale in the ordinary course of business or for consumption in the production of the goods or services.
13. Trade creditors refer to the person to whom the amounts are due for goods purchased or services rendered on credit basis. 14. Trade debtors refer to the person from whom the amounts are due for goods purchased or services rendered on credit basis. 15. Receivables: includes both trade debtors and bills receivable. 16. Payables: includes both trade creditors and bills payable. 17. Expenditure is the costs incurred in acquiring an asset or service in the form of outflow or depletion of assets or incurrence of liability. 18. Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. 19. Expenses decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants 20. Gains are increase in equity (not assets)from incidental transaction of an entity and from all other transaction and other events and circumstances affecting the entity during the accounting period except that result from revenues or investment by equity participants. 21. Losses are decrease inequity (not assets)from incidental transaction of an entity and from all other transaction and other events and circumstances affecting the entity during the accounting period except that result from revenues or investment by equity participants. 22. Revenue refers to the amount charged for the goods sold or services rendered or permitting others to use enterprises resources yielding interest, royalty and dividend. 23. Net Profit is the excess of revenue over expenses 24. Net Loss is the excess of expenses over revenue.
2.2 Accounting Equation

The basic accounting equation is the foundation for the double entry book keeping system. It shows how assets were financed: Either by borrowing money from someone (liability) or By paying your own money (shareholders equity). Assets = Liabilities + (Shareholders or Owners equity) For example: A student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445. The formula can be rewritten:
Assets Liabilities = (Shareholders or Owners equity)
Now it shows owners interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owners interest is called shareholders equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include. Transaction Number 1 Shareholders Equity + 6,000
Assets
Liabilities
Explanation
+ 6,000
Issuing stocks for cash or other assets Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
+ 10,000 + 10,000
- 900
- 900
Selling assets for cash to pay off liabilities:
both assets and liabilities are reduced Buying 4 + 1,000 + 400 + 600 assets by paying cash by
shareholders money (600) and by borrowing money (400)
+ 700
700
Earning revenues Paying expenses (e.g. rent or professional fees) or dividends Recording expenses, but not paying them at the moment Paying a debt that you owe Receiving cash for sale of an asset: one asset
- 200
200
+ 100
100
- 500
- 500
is exchanged for another; no change in assets or liabilities
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries. Also, the equation can be rewritten as: Assets = Liabilities + Owners equity + (Revenue Expenses) OR Assets + Expenses = Liabilities + Owners equity + Revenue This is often referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation
1). It is the document which serves as an evidence for transaction a) Transaction b) Voucher c) Journal d) Ledger
2). The tangible property held for sale in the ordinary course of business or for consumption in the production of the goods or services. a) Stock b) Plant c) Machine d) Furniture
3). Which of the following is correct? a) Assets = Liabilities Capital b) Assets = Capital Liabilities c) Assets = Liabilities + Capital d) Assets = External Equities
4). Which of the following is correct? a) Profit/loss = Closing Capital + Additional Capital Drawings made Opening Capital b) Profit/loss = Closing Capital Additional Capital Drawings made Opening Capital c) Profit/loss = Opening Capital + Drawings made Additional Capital Closing Capital. d) Profit/loss = Closing Capital Additional Capital + Drawings made Opening Capital
5). Which of the following is correct? a) Opening Capital = Closing Capital + Additional Capital Drawings Profits b) Opening Capital = Closing Capital + Drawings Additional Capital Losses c) Opening Capital = Closing Capital + Drawings Additional Capital Profits
6). Which of the following is correct? a) Closing Capital = Opening Capital + Additional Capital Profit Drawings. b) Closing Capital = Opening Capital + Additional Capital Drawings + Profit c) Closing Capital = Opening Capital Additional Capital Losses Drawings.
7). The liabilities of a firm are Rs.6000 and the capital of the proprietor is Rs.4000. The total assets are: a) Rs.6000 b) Rs.10000 c) Rs.2000
8). If a firm borrows a sum of money, there will be: a) Increase in capital b) Decrease in capital c) No effect on capital.
9). The assets on 31/12/2008 $60,000 and capital is $45,000. Its liabilities on that date shall be: a) $60,000 b) $105,000 c) $15,000
10). Harry has assets of $10,000 and liabilities of $2,000. His capital would be: a) $10,000 b) $8,000 c) $2,000
Chapter-3: Journalizing, Posting & Balancing
Contents: 3.1 Types of Books 3.1.1 Double Entry Accounting 3.2 Accounts 3.2.1 Classification of Accounts 3.2.2 Format of Accounts 3.2.3 The Ledger 3.3 Journalizing 3.3.1 Journal Entries 3.3.2 Debits and Credits of Accounts 3.3.3 Normal Balances of Accounts 3.4 Trial Balance 3.4.1 What is the difference between a trial balance and a balance sheet? 3.4.2 Methods of preparing trial Balance 3.4.3 Format of trial balance 3.4.4 Preparation of Trial Balance 3.4.5 Errors in the trial balance
Transactions are either written, as they occur, in a waste book or the various documents or papers. This is recording of accounts and the documents are called vouchers. The steps for the recording of transactions are: 1. Recording of transactions in Vouchers. 2. Recording of vouchers to Journal Entries. 3. Posting of journal entries to ledgers. 4. Preparation of Profit & Loss Statement by the help of ledgers. 5. Preparation of Balance Sheet.
3.1Types of Books
There are basically two types of books: 1. Principal Books: 2. Subsidiary Books:
3.1.1 Double-Entry Accounting

To record transactions, accounting system uses double-entry accounting. Double-entry implies that transactions are always recorded using two sides, debit and credit. Debit refers to the left-hand side and credit refers to the right-hand side of the journal entry or account. The sum of debit side amounts should equal to the sum of credit side amounts.
3.2 Accounts
A record is the general ledger that is used to collect and store similar information. For example, a company will have a Cash account in which every transaction involving cash is recorded. Company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.
3.2.1 Classification of Accounts

(a). Personal Accounts, i.e., accounts of persons (creditors, customers, etc) (b). Impersonal accounts: 1. Real Accounts, i.e., accounts of properties and assets; & 2. Nominal Accounts, i.e., accounts of incomes, expenses and losses.
3.2.2 Format for Accounts
Dr. Cr. Date Particulars Folio Amount Rs. P. April 1 To Balance b/d Date Particulars Amount Rs. P.
10,000 00 April 30 By Balance b/d 10,000 00
10,000 00
10,000 00
3.2.3 The Ledger

The book which contains accounts is known as the ledger. Since final information pertaining to the financial position of a business emerges only from accounts, the ledger is also called the Principal Book. Other books like Purchase Books or Sales Book or Journal merely facilitate the preparation of accounts or the ledgers and hence are called as Subsidiary Books or the Books of Original Entries.
3.3 Journalizing
3.3.1 Journal Entries

Journal entry is an entry to the journal. Journal is a record that keeps accounting transactions in chronological order, i.e. as they occur. Account is a unit to record and summarize accounting transactions. All accounting transactions are recorded through journal entries that show account names, amounts, and whether those accounts are recorded in debit or credit side of accounts. A journal entry is called "balanced" when the sum of debit side amounts equals to the sum of credit side amounts. Transaction 1: Company A sold its products at $120 and received the full amount in cash. Steps Self-Questions Answers
What did Company A receive?
Cash.
If Company A received cash, how would this affect Receiving cash increases the cash balance of the
the cash balance?
company.
Which side of cash account represents the increase in Debit side (Left side). cash?
What is the account name to record the sales of Sales. products?
Which side of sales account represents the increase in Credit side (Right side). sales?
Does the sum of debit side amounts equal to the sum Yes. of credit side amounts? In other words, does this $120 = $120 journal entry balance?
[Journal entry to record transaction 1] Debit Cash Sales 120 120 Credit
Transaction
2:
Company
purchased
supplies
and
paid
$50
in
cash.
Steps
Self-Questions
Answers
What did Company A receive?
Supplies.
If Company A received supplies, how would this It affect the supplies balance?
increases
supplies
balance.
Which side of supplies account represents the increase Debit side (Left side). in cash?
What did Company A pay?
Cash.
Which side of cash account represents the decrease in Credit side (Right side). cash?
Does the sum of debit side amounts equal to the sum Yes. of credit side amounts? In other words, does this journal entry balance? $50 = $50
[Journal entry to record transaction 2] Debit Supplies Cash 50 50 Credit
3.3.2 Debits and Credits of Accounts

Debit Increase in asset accounts Increase in expense accounts Credit Decrease in asset accounts Decrease in expense accounts
Decrease in liability accounts Decrease in equity accounts Decrease in revenue accounts
Increase in liability accounts Increase in equity accounts Increase in revenue accounts
3.3.3 Normal Balances of Accounts

Accounts have normal balances on the side where the increases in such accounts are recorded. Asset accounts have normal balances on debit side. Expense accounts have normal balances on debit side. Liability accounts have normal balances on credit side. Equity accounts have normal balances on credit side. Revenue accounts have normal balances on credit side. On the financial statements, accounts are reported on the sides where they have normal balances. Liability accounts have normal balances on credit side. Equity accounts have normal balances on credit side.
Example 1: Financing Activities Owner invested $10,000 in the company.
Analysis of Transaction Steps 1 2 Debit or Credit? Increase in Assets (Cash) by $10,000 Debit Increase in Owner's Equity by $10,000 Credit
Journal Entry Debit Cash Owner's Equity 10,000 10,000 Credit
Description of Journal Entry Owner invested $10,000 in the company. Results of Journal Entry Cash balance increases by $10,000. --> Increase in Assets Owner's Equity balance increases by $10,000. --> Increase in Owner's Equity Example 2: Financing Activities The company borrowed $20,000 from a bank.
Analysis of Transaction Steps 1 2 Debit or Credit? Increase in Assets (Cash) by $20,000 Debit Increase in Liabilities (Borrowings) by $20,000 Credit
Journal Entry Debit Cash Borrowings 20,000 20,000 Description of Journal Entry Credit
Borrowed $20,000. Results of Journal Entry Cash balance increases by $20,000. --> Increase in Assets Borrowings balance increases by $20,000. --> Increase in Liabilities
Example 3: Investing Activities The company purchased $12,000 equipment and paid in cash. Analysis of Transaction Steps 1 2 Debit or Credit? Increase in Assets (Equipment) by $12,000 Debit Decrease in Assets (Cash) by $12,000 Credit
Journal Entry Debit Equipment Cash 12,000 12,000 Credit
Description of Journal Entry Purchased $12,000 equipment in cash. Results of Journal Entry Equipment balance increases by $12,000. --> Increase in Assets Cash balance decreases by $12,000. --> Decrease in Assets
Example 4: Operating Activities The company purchased $6,000 merchandise (600 units) on credit. Analysis of Transaction Steps Debit or Credit? 1. Increase in Assets (Merchandise) by $6,000 Debit 2. Increase in Liabilities (Accounts Payable) by $6,000 Credit Journal Entry Debit Merchandise Accounts Payable 6,000 6,000 Credit
Description of Journal Entry Purchased $6,000 merchandise on credit. Results of Journal Entry Merchandise balance increases by $6,000. --> Increase in Assets Accounts Payable balance increases by $6,000. --> Increase in Liabilities
Example : 5 Operating Activities The company sold 500 units of merchandise at the price of $11,000. Customer paid $9,000 in cash at the time of sale.
Analysis of Transaction Note: This transaction includes both "REVENUE" and "EXPENSE" components. (1) REVENUE side Steps Debit or Credit ?
1. Increase in Assets (Cash) by $9,000 Debit 2. Increase in Assets (Accounts Receivable) by $2,000 Debit 3. Increase in Revenue (Sales) by $11,000 Credit
(2) EXPENSE side Steps Debit or Credit ? 1 Increase in Expenses (Cost of Merchandise Sold) by $5,000
($6,000 / 600 units = $10 per unit) ($10 per unit X 500 units sold = $5,000 cost) Debit
Decrease in Assets (Merchandise) by $5,000 Debit
(1) REVENUE Journal Entry Debit Cash Accounts Receivable Sales Revenue 9,000 2,000 11,000 Credit
Description of Journal Entry Sold merchandise at $11,000 price and received $9,000 in cash. Results of Journal Entry Cash balance increases by $9,000. --> Increase in Assets Accounts Receivable balance increases by $2,000. --> Increase in Assets Sales Revenue account balance increases by $11,000. --> Increase in Revenue
(2) EXPENSE Journal Entry Debit Cost of Merchandise Sold Merchandise 5,000 5,000 Credit
Description of Journal Entry To record the cost of merchandise sold.
Results of Journal Entry Merchandise balance decreases by $5,000. --> Decrease in Assets Cost of Merchandise Sold account balance increases by $5,000. --> Increase in Expense
Example 6: Operating Activities The company paid $3,500 salaries. Analysis of Transaction Steps Debit or Credit ?
1. Increase in Expenses (Salaries Expense) by $3,500 Debit 2. Decrease in Assets (Cash) by $3,500 Credit
Journal Entry Debit Salaries Expense Cash 3,500 3,500 Credit
Description of Journal Entry Results of Journal Entry
Paid $3,500 salaries.
Cash balance decreases by $3,500. --> Decrease in Assets Salaries Expense account balance increases by $3,500. --> Increase in Expenses
Example 7: Operating Activities The company paid $1,500 rent. Analysis of Transaction Steps Debit or Credit ? Debit
1. Increase in Expenses (Rent Expense) by $1,500 2. Decrease in Assets (Cash) by $1,500 Credit
Journal Entry Debit Rent Expense Cash 1,500 1,500 Credit
Description of Journal Entry Paid $1,500 rent. Results of Journal Entry Cash balance decreases by $1,500. --> Decrease in Assets Rent Expense account balance increases by $1,500. --> Increase in Expenses
3.4 Trial Balance

In accounting, the trial balance is a worksheet listing the balance at a certain date, of each ledger account in two columns, namely debit and credit. Under the double-entry system, in any transaction the total of any debits must equal the total of any credits, so in a Trial Balance the
total of the debit side should always be equal to the total of the credit side. The trial balance thus serves as a tool to detect errors, which can result in the totals not being equal. Often credits will be represented as a negative, in which case the total of the trial balance should be 0.
3.4.1 What is the difference between a trial balance and a balance sheet?
The trial balance is an internal documentit stays in the accounting department. It is a listing of all of the accounts in the general ledger (balance sheet accounts and income statement accounts) and their respective balances as of a specified point in time, such as March 31, 2009. The purpose of the trial balance is to document that the total amount of account balances with debit balances is equal to the total of amount of account balances with credit balances. The balance sheet is a financial statement that reports the currency amounts of assets, liabilities, and stockholders equity at a specified point, such as March 31, 2009. Since it is a financial statement, it will be distributed outside of the accounting department. As a result, it should be prepared in accordance with generally accepted accounting principles. (Often the balance sheet accounts in the general ledger are summarized and combined so that the resulting balance sheet is only 20 - 30 lines in length.)
3.4.2 Methods of preparing trial Balance

Totals method: In this method, the totals of debit and credit sides of the ledger accounts, excluding the closing balances, are shown in the trial balance. Balances method: Only the closing balances of the ledger accounts are shown in the trial balance.
3.4.3 Format of trial balance

The most common format in which we find a trial balance is as below.
Trial Balance of M/s _____ as on _____ Debit Amount Credit Amount (in Rs) (in Rs)
Particulars
L/F
Account Head 1 Account Head 2 Account Head 3 Total Header Row
xxxx
xxxx
The heading row contains the heading for the trial balance. It consists of the details relating to name of the organization and the instance to which the ledger account balances pertain. Particulars Each row in the trial balance pertains to the information relating to an account. The name of the Account head is written in the particulars column. L/F Ledger Folio Ledger Folio gives the information relating to the page number in the ledger from which the information relating to the ledger is being extracted. Debit amount This is the amount whose information is extracted from the ledger account. What the debit amount actually means is dependent on the method used for constructing the trial balance. Credit amount
This is the amount whose information is extracted from the ledger account. What the credit amount actually means is dependent on the method used for constructing the trial balance.
Illustration General Ledger
The following is the General Ledger of Mr. Ibrahim, containing all the Ledger accounts within the accounting system. General [Books of Mr. Ibrahim] Dr Cash a/c Cr Amount (in Rs) Amount (in Rs) 20,000 5,000 1,50,000 10,000 5,000 1,90,000 24,500 2,14,500 Ledger
Date
Particulars
J/F
Date
Particulars
J/F
15/06/05 To
Capital
a/c
2,00,000 17/06/05 By Furniture a/c 12,000 2,000 17/06/05 By Rent Paid a/c 18/06/05 By Bank a/c 18/06/05 By Goods/Stock a/c
19/06/05 To Goods/Stock a/c 24/06/05 To Mr. Natekar a/c 24/06/05 To Commission Received a/c sub-total
500 2,14,500
21/06/05 By Wages Paid a/c sub-total 25/06/05 By Balance c/d
Total 25/06/05 To Balance b/d
2,14,500 24,500 Dr Capital a/c Cr
Total
Date
Particulars
J/F
Amount (in Rs)
Date
Particulars
J/F
Amount (in Rs) 2,00,000 2,00,000
15/06/05 By Cash a/c sub-total 25/06/05 To Balance c/d Total 0 2,00,000 2,00,000 Total sub-total
2,00,000 2,00,000
25/06/05 By Balance b/d Dr Furniture a/c Cr Amount (in Rs) 20,000 20,000 sub-total 25/06/05 By Balance c/d Total 25/06/05 To Balance b/d 20,000 20,000 Dr Rent Paid a/c Cr Amount (in Rs) 5,000 5,000 sub-total Total
Date
Particulars
J/F
Date
Particulars
J/F
Amount (in Rs)
17/06/05 To Cash a/c sub-total
0 20,000 20,000
Date
Particulars
J/F
Date
Particulars
J/F
Amount (in Rs)
25/06/05 By Balance c/d Total 25/06/05 To Balance b/d 5,000 5,000 Dr Bank a/c Cr Amount (in Rs) Total
5,000 5,000
Date
Particulars
J/F
Date
Particulars
J/F
Amount (in Rs) 25,000
18/06/05 To Cash a/c
1,50,000 20/06/05 By Machinery a/c 24/06/05 By M/s Ramdas & Bros. a/c
5,000 30,000
sub-total
1,50,000
sub-total 25/06/05 By Balance c/d
1,20,000 1,50,000
Total 25/06/05 To Balance b/d
1,50,000 1,20,000
Total
Dr Goods/Stock a/c Cr Amount (in Rs) 10,000 Amount (in Rs) 12,000 8,000
Date
Particulars
J/F
Date
Particulars
J/F
18/06/05 To
Cash
a/c
19/06/05 By
Cash
a/c
18/06/05 To M/s Ramdas & Bros. a/c sub-total Total 10,000 20,000 20,000
21/06/05 By Mr. Natekar a/c
sub-total Total
20,000 20,000
Dr M/s Ramdas & Bros. a/c Cr Amount (in Rs) 5,000 5,000 5,000 10,000 Total 25/06/05 By Balance b/d Dr Machinery a/c Cr Amount (in Rs) 25,000 25,000 sub-total 25/06/05 By Balance c/d Total 25/06/05 To Balance b/d 25,000 25,000 Dr Mr. Natekar a/c Cr Amount (in Rs) Amount (in Rs) Total 0 25,000 25,000 Amount (in Rs) 10,000 5,000 Amount (in Rs) 10,000 10,000
Date
Particulars
J/F
Date
Particulars
J/F
24/06/05 To Bank a/c sub-total
18/06/05 By Goods/Stock a/c sub-total
25/06/05 To Balance c/d Total
Date
Particulars
J/F
Date
Particulars
J/F
20/06/05 To Bank a/c sub-total
Date
Particulars
J/F
Date
Particulars
J/F
21/06/05 To Goods/Stock a/c sub-total
8,000 8,000
24/06/05 By Cash a/c sub-total
2,000 2,000 6,000 8,000
25/06/05 By Balance c/d Total 25/06/05 To Balance b/d 8,000 6,000 Total
Dr Wages Paid a/c Cr Amount (in Rs) 5,000 5,000 sub-total 25/06/05 By Balance c/d Total 25/06/05 To Balance b/d 5,000 5,000 Total 0 5,000 5,000 Amount (in Rs)
Date
Particulars
J/F
Date
Particulars
J/F
Dr Commission Received a/c Cr Amount (in Rs) Amount (in Rs) 500 500
Date
Particulars
J/F
Date
Particulars
J/F
24/06/05 By Cash a/c sub-total 25/06/05 To Balance c/d 0 500 sub-total
Total
500
Total 25/06/05 By Balance b/d
500 500
3.4.4 Preparation of Trial Balance Methods

There are two methods for preparing a trial balance (1) Traditional Method and (2) Modern Method. Both serve the same purpose. The modern method is a derivative of the traditional method. Traditional Method The traditional method considers the sub-totals of each ledger account. It is prepared by presenting the sub-totals relating to each ledger account in the relevant columns in the trial balance. "Trial [Traditional Method] Trial Balance of M/s _____ as on _____ Debit Amount Credit Amount (in Rs) 214,500 0 20,000 5,000 1,50,000 20,000 5,000 (in Rs) 1,90,000 2,00,000 0 0 30,000 20,000 10,000 Balance"
Particulars
L/F
Cash Capital Furniture Rent Bank Goods/Stock Paid
a/c a/c a/c a/c a/c a/c
M/s Ramdas & Bros. a/c
Machinery Mr. Wages Natekar Paid
a/c a/c a/c
25,000 8,000 5,000 0 4,52,500
0 2,000 0 500 4,52,500
Commission Received a/c Total Debit amount
Debit amount is the sub-total of the debit column in the Ledger Account. Credit amount Credit amount is the sub-total of the credit column in the Ledger Account. Modern Method The modern method considers only the balances of the ledger accounts. It is prepared by presenting the balance relating to each ledger account in the relevant column in the trial balance.
"Trial [Modern Method] Trial Balance of M/s _____ as on _____ Debit Amount Credit Amount (in Rs) 24,500 2,00,000 (in Rs)
Balance"
Particulars
L/F
Cash Capital
a/c a/c
Furniture Rent Bank Goods/Stock Paid
a/c a/c a/c a/c
20,000 5,000 1,20,000
M/s Ramdas & Bros. a/c Machinery Mr. Wages Natekar Paid a/c a/c a/c 25,000 6,000 5,000
5,000
Commission Received a/c Total 2,05,500
500 2,05,500
3.4.5 Errors in the trial balance

A balanced trial balance does not guarantee that there is no error. The following are the main classes of error that are not detected by the trial balance: An error of original entry is when both sides of a transaction include the wrong amount. For example, if a purchase invoice for 21 is entered as 12, this will result in an incorrect debit entry (to purchases), and an incorrect credit entry (to the relevant creditor account), both for 9 less, so the total of both columns will be 9 less, and will thus balance. An error of omission is when a transaction is completely omitted from the accounting records. As the debits and credits for the transaction would balance, omitting it would still leave the totals balanced. An error of reversal is when entries are made to the correct amount, but with debits instead of credits, and vice versa. For example, if a cash sale for 100 is debited to the Sales account, and credited to the Cash account. Such an error will not affect the totals.
An error of commission is when the entries are made at the correct amount, and the appropriate side (debit or credit), but one or more entries are made to the wrong account of the correct type. For example, if fuel costs are incorrectly debited to the postage account (both expense accounts). This will not affect the totals. An error of principle is when the entries are made to the correct amount, and the appropriate side (debit or credit), as with an error of commission, but the wrong type of account is used. For example, if fuel costs (an expense account), are debited to stock (an asset account). This will not affect the totals. Compensating errors are multiple unrelated errors that would individually lead to an imbalance, but together cancel each other out. A Transposition Error is a Computing error caused by switching the position of two adjacent digits. Since the resulting error is always divisible by 9, accountants use this fact to locate the misentered number. For example, a total is off by 72, dividing it by 9 gives 8 which indicates that one of the switched digits is either more, or less, by 8 than the other digit. Hence the error was caused by switching the digits 8 and 0 or 1 and 9. This will also not affect the totals.
1). The information provided in the annual financial statements of an enterprise pertains to: a) Individual business enterprise b) Business enterprise c) The economy as a whole d) None of the above.
2). Journal is a book of: a) Original entry b) Secondary entry c) All cash transactions d) All non cash transactions.
3). Ledger is a book of: a) Original entry b) Secondary entry c) All cash transactions d) All non cash transactions
4). If a firm borrows a sum of money, there will be: a) Increase in capital b) Decrease in capital c) No effect on capital.
5). Debit means: a) An increase in assets b) An increase in liability c) A decrease in asset d) An increase in proprietors equity.
6). Which of the following is a cash transaction: a) Sold goods b) Sold goods to Ram c) Sold goods to Ram on credit d) Sold goods to Ram on account.
7). Patent right is: a) Personal account b) Real account c) Nominal account d) Expense account.
8). Drawings are deducted from: a) Sales b) Purchases c) Returns outward d) Capital
9). Purchase of an asset is: a) An expense b) A loss c) An asset d) None of these
10). The following account has a credit balance: a) Carriage inward b) Carriage outward c) Return inward d) Returns outward
Chapter-4: Financial Statements

Contents: 4.1 Preparation of Profit and Loss account and Balance Sheet 4.1.1 Introduction to the profit and loss account 4.1.2 Preparation of Balance sheet 4.1.3 Sample balance sheet structure 4.2 Inventory valuation and the matching of revenue and expenses 4.2.1 Inventory and financial statements 4.2.2 Methods of Inventory Valuation 4.2.3 Using non-cost methods to value inventory 4.2.4 Methods used to estimate inventory cost 4.3 Fixed assets and depreciation, 4.4 Depreciating a Fixed Asset 4.4.1 Meaning of Depreciation 4.4.2 Special Features of Depreciation 4.4.3 Causes of Depreciation 4.4.4 Importance or need for providing depreciation 4.4.5 Factors affecting the amount of depreciation
Once the trial balance is prepared the next step is to prepare the trading and profit and loss account. There after the balance sheet is drafted on this basis.
4.1 Preparation of Profit & Loss Account

Income statement, also called profit and loss statement (P&L) and Statement of Operations, is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out) is transformed into the net income (the result after all revenues and expenses have been accounted for). The basic purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
4.1.1 Introduction to the profit and loss account

Richard Bowett introduces the important concept of the profit and loss account
(a). Introduction - the Meaning of Profit: The starting point in understanding the profit and loss account is to be clear about the meaning of "profit". Profit is the incentive for business. It is the reward for taking risk; generally speaking high risk = high reward (or loss if it goes wrong) and low risk = low reward. People wont take risks without reward. All business is risky (some more than others) so no reward means no business. No business means no jobs, no salaries and no goods and services. Profit also has an important role in allocating resources (land, labor, capital and enterprise). Put simply, falling profits (as in a business coming to an end e.g. black-and-white TVs) signal that resources should be taken out of that business and put into another one; rising profits signal that resources should be moved into this business. Without these signals we are left to guess as to what is the best use of societys scarce resources.
(b). The Task of Accounting - Measuring Profit The main task of accounts is to monitor and measure profits. Profit = Revenue less Costs Thus monitoring profit is monitoring and measuring revenue and costs. There are two parts to this:1. Recording financial data. This is the book-keeping part of accounting. 2. Measuring the result. This is the financial part of accounting. It is studied in detail in Ratio Analysis.
(c). Profits are spent in three ways. 1. Retained for future investment and growth. 2. Returned to owners eg a dividend. 3. Paid as tax.
(d). Parts of the Profit and Loss Account The Profit & Loss Account aims to monitor profit. It has three parts. 1) The Trading Account. This records the money in (revenue) and out (costs) of the business as a result of the business trading i.e. buying and selling. This might be buying raw materials and selling finished goods; it might be buying goods wholesale and selling them retail. The figure at the end of this section is the Gross Profit.
2) The Profit and Loss Account proper This starts with the Gross Profit and adds to it any further costs and revenues, including overheads. These further costs and revenues are from any other activities not directly related to trading. An example is income received from investments.
3) The Appropriation Account. This shows how the profit is appropriated or divided between the three uses mentioned above.
(e). Uses of the Profit and Loss Account. 1. The main use is to monitor and measure profit, as discussed above. This assumes that the information recording is accurate. Significant problems can arise if the information is inaccurate, either through incompetence or deliberate fraud. 2. Once the profit(loss) has been accurately calculated, this can then be used for comparison ie judging how well the business is doing compared to itself in the past, compared to the managers plans and compared to other businesses. 3. There are ways to fix accounts. Internal accounts are rarely fixed, because there is little point in the managers fooling themselves (unless fraud is going on) but public accounts are routinely fixed to create a good impression out to the outside world. If you understand accounts, you can usually (not always) spot these fixes and take them out to get a true picture.
(f). Example Profit and Loss Account: An example profit and loss account is provided below:
Illustration: 1 To get an understanding and feel of the process of final accounting, let us go through an example of an organizations accounting consisting of a few transactions during an accounting period. Following are the transactions relating to M/s Trinity Foods, over an accounting period from 1st June 2005 to 30th June 2006. Started business with Capital Rs. 1,00,000
Paid into Bank Rs. 10,000 Bought Furniture and paid cash Rs. 25,000 Bought goods for cash Rs. 50,000 Bought goods from Ram on Credit Rs. 15,000 Sold a part of the goods for Rs. 75,000 and paid the proceeds into bank directly Sold the remaining goods on credit for Rs. 50,000 to Rahim Paid Salaries and Wages Rs. 5,000 Paid rent by cheque Rs. 8,000
Illustration: 1 Solution [Journal and Ledger]:
Journal Entries Journal in the books of M/s Trinity Foods for the period from 1st June 2005 to 30th June 2005 Debit Particulars L/F Amount (in Rs) Cash To Capital a/c [For the amount brought in by the proprietor towards his capital contribution.] 1st 30th to Bank To Cash a/c [For the amount paid into bank.] a/c Dr 10,000 10,000 a/c Dr 1,00,000 1,00,000 Credit Amount (in Rs)
Date
V/R No. to
1st 30th
1st 30th
to
Furniture To Cash a/c
a/c Dr
25,000 25,000
[For the amount paid towards purchase of Furniture.] 1st 30th to Purchases To Cash a/c [For the amount paid towards purchase of goods/stock.] 1st 30th to Purchases To Ram a/c [For the value of goods bought from Ram on credit.] 1st 30th to Bank To Sales a/c [For the sales made for cash and the proceeds paid into bank directly.] 1st 30th to Rahim To Sales a/c [For the value of goods sold on credit to Rahim.] 1st 30th to Salaries and Wages a/c Dr 5,000 5,000 a/c Dr 50,000 50,000 a/c Dr 75,000 75,000 a/c Dr 15,000 15,000 a/c Dr 50,000 50,000
To Cash a/c [For the amount paid in cash towards salaries and wages.]
1st 30th
to
Rent To Bank a/c
Paid
a/c Dr
8,000 8,000
[For the amount paid towards rent by cheque.]
Ledger Accounts:
Dr Cash a/c Amount (in Rs) Cr Amount (in Rs) 10,000 25,000 50,000 5,000
Date
Particulars
J/F
Date
Particulars
J/F
1st-30th To Capital a/c
1,00,000 1st-30th By " " " By
Bank Furniture
a/c a/c
By Purchases a/c By Sal. & Wages a/c
30/06/05 By Balance c/d Total 30/06/05 To Balance b/d Dr 1,00,000 10,000 Capital a/c Amount (in Rs) Cr Total
10,000 1,00,000
Date
Particulars J/F
Date
Particulars
J/F
Amount (in Rs)
30/06/05 To Bal c/d Total
1,00,000 01/06/05 By Cash a/c 1,00,000 Total
1,00,000 1,00,000
30/06/05 By Balance b/d 1,00,000
Dr
Bank a/c Amount (in Rs)
Cr Amount (in Rs) 8,000
Date
Particulars
J/F
Date
Particulars
J/F
1st-30th To Cash a/c To Sales a/c
10,000 1st-30th By Rent Paid a/c 75,000 30/06/05 By Bal c/d
77,000 85,000
Total 30/06/05 To Balance b/d Dr
85,000 77,000 Furniture a/c Amount (in Rs)
Total
Cr Amount (in Rs) 25,000 25,000
Date
Particulars
J/F
Date
Particulars J/F
1st-30th To Cashl a/c Total
25,000 30/06/05 By Bal c/d 25,000 25,000 Purchases a/c Amount (in Rs) Cr Total
30/06/05 To Balance b/d Dr
Date
Particulars
J/F
Date
Particulars J/F
Amount (in Rs) 65,000
1st-30th To Cash a/c " To Ram a/c Total 30/06/05 To Balance b/d Dr
50,000 30/06/05 By Bal c/d 15,000 65,000 65,000 Ram a/c Cr Total
65,000
Date
Particulars J/F
Amount (in Rs)
Date
Particulars
J/F
Amount (in Rs) 15,000 15,000
30/06/05 To Bal c/d Total
15,000 1st-30th By Purchases a/c 15,000 Total 30/06/05 By Balance b/d
15,000
Dr
Sales a/c Amount (in Rs)
Cr Amount (in Rs) 75,000 50,000 1,25,000
Date
Particulars J/F
Date
Particulars
J/F
30/06/05 To Bal c/d
1,25,000 1st-30th By Bank a/c " 1,25,000 By Rahim a/c Total
Total
30/06/05 By Balance b/d 1,25,000 Dr Rahim a/c Amount (in Rs) Cr Amount (in Rs) 50,000 50,000
Date
Particulars
J/F
Date
Particulars J/F
1st-30th To Sales a/c Total
50,000 30/06/05 By Bal c/d 50,000 50,000 Total
30/06/05 To Balance b/d Dr
Salaries and Wages a/c Amount (in Rs)
Cr Amount (in Rs) 5,000
Date
Particulars
J/F
Date
Particulars J/F
1st-30th To Cash a/c
5,000 30/06/05 By Bal c/d
Total 30/06/05 To Balance b/d Dr
5,000 5,000 Rent Paid a/c Amount (in Rs)
Total
5,000
Cr Amount (in Rs) 8,000 8,000
Date
Particulars
J/F
Date
Particulars J/F
1st-30th To Bank a/c Total
8,000 30/06/05 By Bal c/d 8,000 8,000 Total
30/06/05 To Balance b/d
Illustration: 1 Solution [Trial Balance] The trial balance is nothing but a statement of ledger account balance as on a particular instance.
Trial Balance of M/s Trinity Foods" as on 30th June 2005
Particulars
L/F
Debit Amount Credit Amount (in Rs) (in Rs)
Cash Capital Bank Furniture Purchases Ram Sales Rahim
a/c a/c a/c a/c a/c a/c a/c a/c
10,000 1,00,000
77,000 25,000 65,000
15,000 50,000 5,000 8,000 1,25,000
Salaries and Wages a/c Rent Paid a/c
Total
2,40,000
2,40,000
Preparing Trading and Profit and Loss Account: Journal & Ledger Consider the above Trial Balance. There are a total of 4 nominal accounts with either debit or credit balances Purchases a/c [Debit Balance] Sales a/c [Credit Balance] Salaries and Wages a/c [Debit Balance] Rent Paid a/c [Debit Balance] To ascertain the profit or loss made by the organization, the balance in these accounts should be transferred to the "Trading and Profit & Loss a/c". The journal entries for these transfers would be: Journal Entries
Journal in the books of M/s Trinity Foods for the period from 1st June 2005 to 30th June 2005 Debit Particulars L/F Amount (in Rs) and Profit To To To Rent Paid a/c [For the transfer of debit balances in nominal accounts at the end of the accounting period to the Trading and Profit & Loss a/c for the purpose of ascertaining profits.] Salaries & Loss a/c Dr a/c a/c 78,000 65,000 5,000 8,000 Credit Amount (in Rs)
Date
V/R No.
June 30th
Trading
Purchases & Wages
June 30th
Sales To Trading and Profit & Loss a/c
a/c Dr
1,25,000 1,25,000
[For the transfer of credit balances in nominal accounts at the end of the accounting period to the Trading and Profit & Loss a/c for the purpose of ascertaining profits.]
Trading and Profit & Loss a/c The "Trading and Profit & Loss a/c" would be
Dr Trading and Profit & Loss a/c Amount (in Rs) Cr Amount (in Rs) 1,25,000
Date
Particulars
J/F
Date
Particulars J/F
30/06/05 To " "
Purchases
a/c
65,000 30/06/05 By Sales a/c 5,000 8,000 78,000 Sub-total
To Salaries & Wages a/c To Rent Paid a/c sub-total
1,25,000
30/06/05 To Bal (Profit) Total
47,000 1,25,000 Total 1,25,000
Since the credit side total is greater, the account has a credit balance. Since a credit balance in a nominal account indicates a gain, we can say that there is a profit. Other Ledger Accounts Affected
Dr Date Particulars Purchases a/c J/F Amount Date Cr Particulars J/F Amount
(in Rs) 1st-30th To Cash a/c " To Ram a/c Total 30/06/05 To Balance b/d Total 50,000 30/06/05 By Bal c/d 15,000 65,000 Total
(in Rs) 65,000
65,000 65,000 65,000
65,000 30/06/05 By Trdg. P/L a/c 65,000 Total
Dr
Sales a/c Amount (in Rs)
Cr Amount (in Rs) 75,000 50,000 1,25,000
Date
Particulars J/F
Date
Particulars
J/F
30/06/05
To Bal c/d
1,25,000 1st-30th By Bank a/c " 1,25,000 By Rahim a/c Total
Total To Trdg, & P/L a/c Total
1,25,000 30/06/05 By Balance b/d 1,25,000 1,25,000 Total 1,25,000
Dr
Salaries and Wages a/c Amount (in Rs)
Cr Amount (in Rs) 5,000 5,000
Date
Particulars
J/F
Date
Particulars
J/F
1st-30th To Cash a/c Total
5,000 30/06/05 By Bal c/d 5,000 Total
30/06/05 To Balance b/d Total
5,000 5,000
Dr
Rent Paid a/c Amount (in Rs)
Cr Amount (in Rs) 8,000 8,000 8,000 8,000
Date
Particulars
J/F
Date
Particulars
J/F
1st-30th To Bank a/c Total
8,000 30/06/05 By Bal c/d 8,000 Total
30/06/05 To Balance b/d Total
The balance in these nominal accounts becomes zero after the balances are transferred to the "Trading and Profit & Loss a/c". Thus, nominal accounts are closed at the end of the accounting period by transfer to the "Trading and Profit & Loss a/c". In the subsequent accounting period, if the same nominal account heads are used, they are opened anew. Thus these accounts pertaining to the current accounting period are independent of the nominal accounts with the same name in any other accounting period.
Trial Balance Redrawn/Remade
The trial balance is a list of ledger account balances at an instance when it is drawn. If we consider the instance after having prepared the "Trading and Profit & Loss a/c", we do not find a balance in any nominal account. All the nominal accounts are closed by transfer to the "Trading and Profit & Loss a/c", thereby leaving a nil balance in all of them. The "Trading and Profit & Loss a/c" is also a nominal account and has a credit balance if there is
a profit and a debit balance if there is a loss. If we make a trial balance after having prepared the "Trading and Profit & Loss a/c" we will find only real and personal accounts in it apart from the nominal account "Trading and Profit & Loss a/c".
Trial Balance of M/s Trinity Foods" as on 30th June 2005 [After closing Nominal accounts]
Particulars
L/F
Debit Amount (in Rs)
Credit Amount (in Rs)
Cash Capital Bank Furniture Ram Rahim
a/c a/c a/c a/c a/c a/c
10,000 1,00,000 77,000 25,000 15,000 50,000 47,000
Trading and Profit & Loss a/c
Total
1,62,000
1,62,000
4.1.2 Preparation of Balance sheet

In financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a company's financial condition. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time. A company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first and are followed by the liabilities. The difference
between the assets and the liabilities is known as equity or the net assets or the net worth of the company and according to the accounting equation, net worth must equal assets minus liabilities. Assets Current assets Cash and cash equivalents Inventories Accounts receivable Prepaid expenses
Long-term assets Property, plant and equipment Investment property, such as real estate held for investment purposes Intangible assets Financial assets (excluding investments accounted for using the equity method, accounts receivables, and cash and cash equivalents) Investments accounted for using the equity method Biological assets, which are living plants or animals. Bearer biological assets are plants or animals which bear agricultural produce for harvest, such as apple trees grown to produce apples and sheep raised to produce wool.
Liabilities Accounts payable
Provisions for warranties or court decisions Financial liabilities (excluding provisions and accounts payable), such as promissory notes and corporate bonds Liabilities and assets for current tax Deferred tax liabilities and deferred tax assets Minority interest in equity Issued capital and reserves attributable to equity holders of the Parent company Unearned revenue
Equity The net assets shown by the balance sheet equals the third part of the balance sheet, which is known as the shareholders' equity. Formally, shareholders' equity is part of the company's liabilities: they are funds "owing" to shareholders (after payment of all other liabilities); usually, however, "liabilities" is used in the more restrictive sense of liabilities excluding shareholders' equity. The balance of assets and liabilities (including shareholders' equity) is not a coincidence. Records of the values of each account in the balance sheet are maintained using a system of accounting known as double-entry bookkeeping. In this sense, shareholders' equity by construction must equal assets minus liabilities, and are a residual.
Numbers of shares authorized, issued and fully paid, and issued but not fully paid Par value of shares Reconciliation of shares outstanding at the beginning and the end of the period Description of rights, preferences, and restrictions of shares Treasury shares, including shares held by subsidiaries and associates
Shares reserved for issuance under options and contracts A description of the nature and purpose of each reserve within owners' equity
4.1.3 Sample balance sheet structure

The following balance sheet structure is just an example. It does not show all possible kinds of assets, equity and liabilities, but it shows the most usual ones. Because it shows goodwill, it could be a consolidated balance sheet. Monetary values are not shown; summary (total) rows are missing as well.
Balance Sheet of XYZ, Ltd. as of 31 December 2006
As
on
31 As
on
31
Dec, 2005 Particulars Schedule Rs.'000
Dec, 2006 Rs.'000
ASSETS
Current Assets Cash and cash equivalents Accounts receivable (debtors) Inventories Prepaid Expenses
Investments held for trading Other current assets
Total Current Assets
xxxx
xxxx
Fixed Assets (Non-Current Assets) Property, plant and equipment Less : Accumulated Depreciation Goodwill Other intangible fixed assets Investments in associates Deferred tax assets
Total Fixed Assets
xxxx
xxxx
Total Assets
xxxx
xxxx
LIABILITIES and EQUITY
Liabilities Current Liabilities Creditors: amounts falling due within one year Accounts payable Current income tax liabilities Current portion of bank loans payable Short-term provisions Other current liabilities
Long-Term Liabilities Creditors: amounts falling due after more than one year Bank loans Issued debt securities Deferred tax liability Provisions Minority interest
Total Liabilities
xxxx
xxxx
Equity
Share capital Capital reserves Revaluation reserve Translation reserve Retained earnings
Total of Liabilities and Equity
xxxx
xxxx
4.2 Inventory Valuation and the matching of revenue and expenses

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.
4.2.1. Inventory and financial statements

When ending inventory is incorrect, the following balances of the balance sheet will also be incorrect as a result: merchandise inventory, total assets, and owner's equity. When ending inventory is incorrect, the cost of merchandise sold and net income will also be incorrect on the income statement. The inventory accounting involves two major aspects: a) The cost of the purchased or manufactured inventory has to be determined and
b) Such cost is retained in the inventory accounts of the company until the product is sold
4.2.2. Methods of Inventory Valuation

The following methods are the most commonly used for inventory valuation by companies: 1. First-in First-Out (FIFO): the first goods to be sold (cost of sales) are the first goods that were purchased or consumed (cost of production). The ending inventory is formed by the last goods that were purchased and came in at the end to the inventory. 2. Last-in First-out (LIFO): the first goods to be sold (cost of sales) are the last goods that were purchased or consumed (cost of production). The ending inventory is formed by the first goods that were purchased and came in at the beginning to the inventory. 3. Average Cost: this method requires to calculate the average unit cost of the goods in the beginning inventory plus the purchases made in the period. Based on this average unit cost the cost of sales (production) and the ending inventory of the period are determined. 4. Specific Identification: each article sold and each unit that remains in the inventory are individually identified.
4.2.3 Using non-cost methods to value inventory

Under certain circumstances, valuation of inventory based on cost is impractical. If the market price of a good drops below the purchase price, the lower of cost or market method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The net realizable value is the estimated selling price less any expense incurred to dispose of the good.
4.2.4 Methods used to estimate inventory cost

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost.
Two very popular methods are 1. retail inventory method: The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. 2. gross profit (or gross margin) method: The gross profit method uses the previous years average gross profit margin (i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.
4.3 Fixed Assets and Depreciation

Fixed asset, also known as property, plant, and equipment (PP&E), is a term used in accountancy for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed. These are items of value which the organization has bought and will use for an extended period of time; fixed assets normally include items such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets. According to International Accounting Standard (IAS) 16, Fixed Assets are assets whose future economic benefit is probable to flow into the entity, whose cost can be measured reliably.
It is pertinent to note that the cost of a fixed asset is its purchase price, including import duties and other deductible trade discounts and rebates. In addition, cost attributable to bringing and installing the asset in its needed location and the initial estimate of dismantling and removing the item if they are eventually no longer needed on the location. The use of assets in the generation of revenue is usually more than a year- that is long term. It is therefore obligatory that in order to accurately determine the net income or profit for a period depreciation is charged on the total value of asset that contributed to the revenue for the period in consideration and charge against the same revenue of the same period. This is essential in the prudent reporting of the net revenue for the entity in the period. Net book value of an asset is basically the difference between the historical cost of that asset and it associated depreciation. From the foregoing, it is apparent that in order to report a true and fair position of the financial jurisprudence of an entity it is relatable to record and report the value of fixed assets at its net book value. Apart from the fact that it is enshrined in Standard Accounting Statement (SAS) 3 and IAS 16 that value of asset should be carry at the net book value, it is the best way of consciously presenting the value of assets to the owners of the business and potential investor.
4.4 Depreciation
4.1.1 Meaning of Depreciation
Depreciation is, simply put, the expense generated by the use of an asset. It is the wear and tear of an asset or diminution in the historical value owing to usage. Further to this; it is the cost of the asset less any salvage value over its estimated useful life. It is an expense because it is matched against the revenue generated through the use of the same asset. Depreciation is usually spread over the economic useful life of an asset because it is regarded as the cost of an asset absorbed over its useful life. Invariably the depreciation expense is charged against the revenue generated through the use of the asset. The method of depreciation to be adopted is best left for the management to decide in consideration to the peculiarity of the business, prevailing
economic condition of the assets and existing accounting guideline and principles as implied in the organizational policies. It is worth noting that not all fixed assets depreciate in value year-over-year. Land and buildings, for example, may often increase in value depending on local real-estate conditions
According to R.N. Carter, "Depreciation is gradual and permanent decrease in the value of an asset from any cause".
4.4.2 Special Features of Depreciation

1. Depreciation is loss in the value of assets. 2. Loss should be gradual and constant. 3. Depreciation is the exhaustion of the effective life of business. 4. Depreciation is the normal feature. 5. Maintenance of assets is not depreciation. 6. It is continuing decrease in the value of assets. 7. It is the allocation of cost of assets to the period of its life.
4.4.3 Causes of Depreciation

1. By constant use. The loss in the value, efficiency and utility of fixed assets due to its constant use is termed as depreciation. 2. By expiry of time. The effective life of assets goes on decreasing with the passage of time. If certain lease has been obtained for 20 years for Rs. 1,00,000, it will lose its 1/20 th i.e (1/ 20 X 1,00,000) = 5,000 value at the end of the first year and so on. At the end of 20th year it will become valueless. 3. By obsolescence. The old assets will become obsolete due to new inventions and improved techniques.
4. By depletion. Loss of mineral wealth due to constant working of mines is also depreciation, but specifically known or as 'depletion'. Suppose a particular mine has got 1,00,000 ton of coal during 1 st year, coal with 5,000 tons have been extracted. The loss of 5,000 tons of coal from mines is loss due to depletion. This is why, we charge depreciation on these mineral wealth according to depletion method. 5. Permanent fall in price. Though fluctuations in the market value of fixed assets are not recorded in the books yet sometimes we have to account for this loss such as permanent fall in the value of investments. 6. By accidents. Depreciation may also be due to the loss in the value of assets by accidents and damage.
Depreciation in the value of assets in all the above cases is accounted for in the books of accounts.
4.4.4 Importance or need for providing depreciation

Recording depreciation in the books of accounts is essential due to the following reasons: 1. For determination of net profit or loss. Loss in the value of assets is undoubtedly a business expense. It must be recorded and shown at the debit side of the profit and loss account for the correct calculation of net profit or net loss. 2. For showing assets at fair and true value in the balance sheet. If depreciation is not charged, the assets will be shown at value more than its actual value. The purpose of recording assets is to show them at their true value. Provision for depreciation reduces the value of assets with the amount of depreciation and assets are shown at their true and fair value. 3. Provision of funds for replacement of assets. The assets acquired and used in the business will become useless after expiry of their estimated life or even before that, we will have to replace the obsolete assets with another fresh asset. The replacement will require funds. Proper method of depreciation will make the funds available for the purchase of fresh assets.
4. Ascertaining accurate cost of production. Depreciation on factory plant and machinery is factory overhead. It will increase the cost of production and the price of the commodity will be fixed at higher rates. In the absence of provision for depreciation, the sales price of the commodity will be fixed at lower rates, because cost of production will also be lower due to ignorance of depreciation. Profit will thus be reduced. 5. Distribution of dividend out of profit only. Depreciation is charged out of Profit and loss account, so the profit after charging depreciation will be lesser. Shareholders will get dividend out this profit. If depreciation is not charged, the profit will be more and the excess dividend will be paid out of capital which should have been paid out of profit. 6. Avoiding over payment of income tax. If depreciation is not charged, profit and loss account will show more profit. We will have to pay income tax on this profit. In this way, the payment of tax will be definitely more than what it should here actually been. The profit will reduce with the amount of depreciation, so lesser or the actual income tax due will be paid. Provision for depreciation in this way avoids over payment of income-tax.
4.4.5 Factors affecting the amount of depreciation

It is quite impossible to calculate the actual and accurate amount of depreciation. It can always be estimated, though we try our best to be more accurate and correct. Following factors have to be considered before estimation of the amount of depreciation. 1. Total cost of assets. Value of assets is determined after adding all expenses of acquiring, installing and constructing the assets. We should take into consideration the total cost of assets for determining the rate and the amount of depreciation. 2. Estimated useful life of assets. The estimated working life of the assets may be measured in terms of years, months, hours, output (units) or kilometers (for trucks). In case of depreciation the value of assets is allocated over the estimated useful life of the asset. If expected life is more, the rate of depreciation will be lesser and vice-versa. 3. Estimated scrap value. It is the residual value, which is expected to be realized even if the asset becomes, obsolete, we shall have to make provision of the amount which is the value of assets less its scrap value. Suppose we purchase a machine for Rs.10,000, whose expected life is ten years. If the scrap value is Rs.1,000., we will have to arrange Rs.9,000
i.e. 10,000-1,000 in ten years. Every year will bear a depreciation of RS.900 i.e. 9,000/10. If the scrap value in the above case is Rs.2,000 , depreciation to be charged will be Rs.800 only 4. Chances of obsolescence. If the asset acquired is expected to be obsolete within 5 years, we will have to split its value over 5 years. If it will be obsolete within four years the value will be split over four years. It shows that the amount of depreciation.
1). Returns outwards appearing in Trial Balance are deducted from: a) Sales b) Purchases c) Returns Inwards d) Closing stock
2). Returns Inwards appearing in Trial Balance are shown: a) Purchases b) Sales c) Returns outwards d) Closing stock
3). Wages and salaries appearing in the Trial Balance are shown: a) On the debit side of Profit & loss Account b) On the debit side of Trading Account c) On the liabilities side of the Balance Sheet.
4). Closing stock appearing in the Trial Balance is shown: a) On the credit side of trading account b) On the credit side of Manufacturing Account. c) On the credit side of Profit and Loss A/c.
5). Goodwill is: a) Current Asset b) Fictitious asset c) Tangible asset d) Intangible asset
6). Drawings are deducted from: a) Sales b) Purchases c) Returns outwards d) Capital
7). As Trial Balance shown the opening stock $20,000, it will be: a) Debited to the Trading Account b) Debited to the profit and Loss Account c) Deducted from the closing stock in the Balance Sheet.
8). Income tax paid by Mr. A amounts to Rs. 3000. The accounting treatment is: a) To be credited to the Profit & Loss Account b) To be ignored altogether c) To be deducted from capital d) To be debited to the Trading Account
9). Prepaid wages Rs 2,500, appear in As Trial Balance. These will appear ina) Trading account b) Profit & Loss Account c) Balance Sheet d) Manufacturing Account
10). Is Trial Balance as at 31st Dec2008, contains the following information: 12% Bank Loan $ 40,000, Interest paid $ 3,800. Interest debited to the Profit & Loss Account is: a) $4,800 b) $5,000 c) $5,500 d) $1,000
Chapter 5: Analysis of Financial Statements

Contents: 5.1 Meaning of Ratio Analysis 5.1.1 Sources of Data for financial Ratios 5.1.2 Purpose and types of ratios 5.1.3 Financial ratios allow for comparisons 5.1.4 Accounting methods and principles 5.1.5 Abbreviations and terminology 5.2 Classification of Ratios 5.2.1 Profitability ratios 5.2.2 Liquidity ratios 5.2.3 Activity ratios 5.2.4 Debt ratios (leveraging ratios) 5.2.5 Market ratios 5.2.6 Capital Budgeting Ratios
5.1 Meaning of Ratio Analysis

In finance, a financial ratio or accounting ratio is a ratio of two selected numerical values taken from an enterprise's financial statements. There are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses
in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
5.1.1 Sources of data for financial ratios

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of retained earnings. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organization.
5.1.2 Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm's ability to repay long-term debt. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.
5.1.3 Financial ratios allow for comparisons

between companies between industries
between different time periods for one company between a single company and its industry average Ratios generally hold no meaning unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.
5.1.4 Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce their financial statements, or they may use the generally accepted accounting principles of their home country. There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.
5.1.5 Abbreviations and terminology

Various abbreviations may be used in financial statements. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below). Companies that are primarily involved in providing services with labour do not generally report "Sales" based on hours. These companies tend to report "revenue" based on the monetary value of income that the services provide.
Note that Shareholder's Equity and Owner's Equity are not the same thing, Shareholder's Equity represents the total number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's book value. It is important to make this distinction when calculating ratios.
Other abbreviations COGS = Cost of goods sold, or cost of sales. EBIT = Earnings before interest and taxes EBITDA = Earnings before interest, taxes, depreciation, and amortization EPS = Earnings per share (Note: Earnings per share is not a ratio, it is a value in currency.)
5.2 Classification of Ratios
Financial Ratios Liquidity Ratios Profitability ratios Activity ratios Debt Ratios Market Ratios
To begin with lets first start with:
5.2.1. Profitability ratios

Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. It can be classified as under:
(1). Gross margin, Gross profit margin or Gross Profit Rate
This ratio gives the percentage of gross profit over sales. It can be stated as:
OR
(2).Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)
Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales)
(3). Profit margin, net margin or net profit margin
(4). Return on equity (ROE)
(5). Return on investment (ROI ratio or Du Pont ratio)
(6). Return on assets (ROA)
(7). Return on net assets (RONA)
(8). Return on capital (ROC)
(9).Risk adjusted return on capital (RAROC)
OR
(10). Return on capital employed (ROCE)
Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity
(11).Cash flow return on investment (CFROI)
(12). Efficiency ratio
5.2.2. Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt. It determines the liquidity of the enterprise i.e. how easily the current assets can be converted in cash.
(1).Current ratio It is the ratio of current assets to current liabilities. Its ideal situation is 1:1.
(2). Acid-test ratio (Quick ratio) This ratio further examines the liquidity of the enterprise & for this purpose it excludes inventories or stock and any advance payments made. Though it excludes inventory but it include debtors.
(3).Operation cash flow ratio It means all the proportion of cash available for the payments of total debts.
5.2.3. Activity ratios

Activity ratios measure the effectiveness of the firms use of resources.
(1). Average collection period
(2). Degree of Operating Leverage (DOL)
(3). DSO Ratio
(4). Average payment period
(5). Asset turnover
(6). Inventory turnover ratio
(7). Receivables Turnover Ratio
(8). Inventory conversion ratio
(9)Inventory conversion period
(10). Receivables conversion period
(11). Payables conversion period
(12). Cash Conversion Cycle
Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period
5.2.4. Debt ratios (leveraging ratios)

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage.
(1).Debt ratio
(2). Debt to equity ratio
(3). Long-term Debt to equity (LT Debt to Equity)
(4). Times interest-earned ratio
OR
(5). Debt service coverage ratio
5.2.5. Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.
(1). Earnings per share (EPS)
(2). Payout ratio
OR
(3). Dividend cover (the inverse of Payout Ratio)
(4). P/E ratio
(5). Dividend yield
(6). Cash flow ratio or Price/cash flow ratio
(7). Price to book value ratio (P/B or PBV)
(8). Price/sales ratio
(9)PEG ratio
Other Market Ratios
(10). EV/EBITDA
(11). EV/Sales
Cost/Income ratio Sector-specific ratios EV/capacity EV/output
5.2.6. Capital Budgeting Ratios

In addition to assisting management and owners in diagnosing the financial health of their company, ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion. Many formal methods are used in capital budgeting, including the techniques such as Net present value Profitability index Internal rate of return Modified Internal Rate of Return
Equivalent annuity All these ratios are specifically studied under the Financial Management. For the detailed study the books that can be referred are: Leo Troy (Author), Almanac of Business and Industrial Financial Ratios (2006) (Paperback)
1). Equity to fixed interest bearing securities is a) Acid test ratio b) Debt equity ratio c) Interest coverage ratio d) Current ratio
2). Debt Equity Ratio is a) Solvency Ratio. b) Activity Ratio c) Profitability Ratio d) Market Ratio
3). Ratio analysis is a technique of: a) Planning and controlling. b) Comparing strengths & weaknesses in various companies. c) Analyzing cost. d) Writing data.
4). A firms ability to meet the interest charge and repayment dues on long-term liabilities is referred to as its a) Solvency b) Consistency c) Prudency d) Integrity.
5). Rate of return on capital employed is a a) Turnover ratio. b) Profitability ratio c) Activity ratio d) Market ratio
6). Acid test denotes a) Liquidity b) Profitability c) Stability d) Solvency
7). For stock turnover ratio, stock to be calculated is a) Opening b) Closing c) Average
8). A decreased Stock turnover Ratio usually indicates a) Expanding business b) Contracting business c) Stagnant business d) Best business situation
9). The ideal current ratio is a) 2:1 b) 1.33:1 c) 1:1 d) 1.5:1
10). Price Sales ratio falls under the category of a) Market ratios. b) Turnover ratio c) Profitability ratios d) Debt ratios
Chapter-6: Company Accounts

Contents: 6.1 Introduction 6.1.1 Meaning of Company 6.1.2 Characteristics: 6.1.3 Kinds of Companies 6.1.4 Formation of Company 6.2 Shares & Share Capital 6.2.1 Meaning and Types of Share Capital 6.2.2 Share Capital 6.2.3 Classification of Share Capital 6.2.4 Issue of shares 6.2.5 Forfeiture of shares 6.2.6 Reissue of Forfeited Shares 6.3 Debentures 6.3.1 Meaning of debentures 6.3.2 Types of debentures 6.4 Liquidation 6.4.1 Meaning of liquidation 6.4.2 Types of Liquidation
6.1 Introduction
6.1.1 Meaning of Company

In common parlance, company means, an association of persons formed for the common object of its members. This common object may be charity, research, economic gain, etc. In the words of Justice Lindley, A Company is an association of many persons who contribute money or moneys worth to a common stock and employs it for a common purpose. The common stock so contributed is denoted in money and is the capital of the company. The persons who contribute it or to whom it belongs are members. However Company does not have physical existence. Its a creation of Law and only law can dissolve it.
6.1.2 Characteristics
1. Voluntary Association 2. Independent legal entity 3. Perpetual existence 4. Common seal 5. Limited liability 6. Transferability of shares.
6.1.3 Kinds of Companies

1. Statutory Companies: Formed by special Act passed either Legislature by Central or State
2. Government Companies: In which at least 51% paid up share capital is held by Government. 3. Foreign Companies: Incorporated outside country but having place of business in the country. 4. Registered Companies: Companies registered under Companies Act. 5. Private and Public Companies:
Private company refers to the ownership of a business company in two different ways: first, referring to ownership by non-governmental organizations; and second, referring to ownership of the company's stock by a relatively small number of holders who do not trade the stock publicly on the stock market. Less ambiguous terms for a privately held company are unquoted company and unlisted company.
Public company refers to a company that is permitted to offer its registered securities (stock, bonds, etc.) for sale to the general public, typically through a stock exchange, or occasionally a company whose stock is traded over the counter (OTC) via market makers who use nonexchange quotation services.
6.1.4 Formation of Company

A company may be formed either to take over the existing business or to carry on anew business. Whatever may be object, the formation involves the following stages: 1.Promotion 2.Incorporation
3.Commencement of business.
6.2 Shares and Share Capital
6.2.1 Meaning and Types of Shares

A share in a company is one of the units into which the total share capital of a company is divided. Shares are of two types: 1. Preference Shares: are those which carry the following preferential rights over other classes of shares: a. Preferential right of fixed dividend b. Preferential right to repayment of capital in the event of companys winding up. 2. Equity Shares: the shares which are not preference are equity shares.
6.2.2 Share Capital

The sum total of the nominal value of shares of a company is called its share capital. The share capital is of two types: Preference share capital: sum total of nominal value of preference shares. Equity share capital: sum total of nominal value of equity shares.
6.2.3 Classification of Share Capital

According to Schedule VI of Companies Act, share capital of the company should be classified in the Balance Sheet as under: Authorized Share Capital: the maximum shares a company can issue. Issued Share Capital: that part of authorized share capital which is issued to public either for cash or for consideration other than cash. Subscribed Share Capital: It represents the paid up value of the issued share capital. It can classified as Called up capital: that portion of share capital which has been called up by the company. Paid up capital: that portion of called up capital against which payment has been received.
6.2.4 Issue of Shares

The shares can be issued for two different considerations: For cash Normal shares: Normally when shares are issued as public offer first of all application is made to public as invitation. For the purpose Share Application Account is created. After the receipt of applications the allotment of shares is done, for this purpose Share Allotment Account is created. Instead of creating two accounts one account called Share Application & Allotment Account can be created. Amount received in respect of applications and allotments is transferred to Share Capital Account. Journal Entry: 1. Bank Account Dr.
To Share Application & Allotment A/c
(For application money received)
2(a). Share Application & Allotment A/c To Share Capital A/c
Dr.
(For transfer of application money & allotment money due)
3. Bank Account
Dr.
To Share Application & Allotment A/c (For allotment money received)
Shares at premium: Above entries remaining the same, sometimes shares may be issued at premium. When the shares are issued at a price higher than the face value, it is called the issue of shares at premium. To record the premium Securities Premium Account is created. The premium is generally received at the time of allotment of shares.
Journal Entry Entry at the time of receiving premium is done
2(b).Share Application & Allotment A/c To Share Capital A/c To Securities Premium A/c (For premium due)
Dr.
3 Bank A/c
Dr.
To Share Application & Allotment A/c (For premium received)
Shares at discount: When the shares are issued at a price lower than the face value of shares they are called to be issued at discount. To record the amount discount on issue of shares account is created. It is a fictitious account and can be written off against Securities Premium Account or Profit & Loss A/c Journal Entry:
2(c). Share Application & Allotment A/c Discount on issue of Shares A/c To Share Capital A/c (for issue of shares on discount)
Dr. Dr.
4. On writing off discount Securities Premium A/c / P&L A/c To Discount on issue of Shares A/c (for writing off discount) [NOTE: The sequence of entries will be: 1, 2(a) / 2(b) / 2(c), 3 & 4(if applicable)] Dr.
For consideration other than cash o To vendors: if shares issued in respect of any purchases made from the vendors: Journal entry:
1. Asset A/c
Dr.
To Vendor A/c (For purchase of Asset)
2 Vendor A/c
Dr.
To Share Capital A/c (For shares issued)
To promoters: they generally incur preliminary expenses for promotion of company and build goodwill for the company. o Journal Entry:
Preliminary Expenses A/c Goodwill A/c To Share Capital A/c
Dr. Dr.
6.2.5 Forfeiture of Shares

At the time of issue of shares the entire amount an be received either at allotment of shares or the amount can be received partly at application, allotment and later on in the form of calls. If a shareholder fails to pay allotment money or a call or a part thereof by the last date fixed for payment, the Board of Directors, if Articles of Association of the company empower to do so, proceed to forfeit the shares on which allotment money or call money has become in arrear.
Entry at the time of call will be: 5 Share Call A/c Dr.
To Share Capital A/c (For the call amount due) 6 Bank A/c Dr.
To Share Call A/c.
Entry when the amount due on allotment or call is not received:
o Bank A/cDr Calls in Arrear A/cDr To Share Application & Allotment A/c / Share Call A/c (For amount not received on______shares)
Forfeiture of Shares: o When shares issued at par
Share Capital A/c..Dr
To Share Application & Allotment A/c To Share Call A/c To Forfeited Shares A/c (Forfeiture of__________shares on which _____amount received at allotment and_____amount due on call.) To Calls in Arrear A/c (forfeited shares account debited with calls in arrear A/c) Forfeited Shares A/c.Dr.
o When shares issued at premium: if shares issued at a premium are forfeited, first we have to find out whether the premium on forfeited shares has been realized or not. If premium received, Securities Premium Account will not be debited to forfeited shares account. But if the premium is made due than the entries has to be reversed to nullify its effect. o When shares issued at discount: the discount on issue of shares account will be credited with the amount of discount.
To Calls in arrear A/c
Share Capital A/c.Dr.
To Discount on Shares A/c To forfeited Shares A/c
6.2.6 Reissue of Forfeited Shares

Forfeited Shares A/c..Dr.( Amount forfeited) Discount on Issue of Shares A/c..Dr. (if issued at discount) To Share Capital A/c (with the amount of reissue) To Securities Premium A/c (if issued at premium) To Capital Reserve A/c (difference of above entries)
6.3 Debentures
6.3.1 Meaning of Debentures

A debenture is defined as a certificate of agreement of loans which is given under the company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures. In law, a debenture is a document which either creates a debt or acknowledges it. It is a medium to long-term borrowing facility created by a company. Where repayment is secured by a charge over land, the document is called a 'mortgage'. Where repayment is secured by a charge other assets of the company, the document is called a 'debenture'. Where no security is involved, the document is called a note or 'unsecured deposit note' In finance, a debenture is a long-term debt instrument used by governments and large companies to obtain funds. It is defined as "any form of borrowing that commits a firm to pay interest and repay capital. In practice, these are applied to long term loans that are secured on a firm's assets. Where securities are offered, loan stocks or bonds are termed 'debentures' in the UK or 'mortgage bonds' in the US. The advantage of debentures to the issuer is they leave specific assets burden free, and thereby leave them open for subsequent financing. Debentures are generally freely transferable by the
debenture holder. Debenture holders have no voting rights and the interest given to them is a charge against profit.
6.3.2 Types of Debentures

There are two types of debentures: 1. Convertible Debentures, which can be converted into equity shares of the issuing company after a predetermined period of time. 2. Non-Convertible Debentures, which cannot be converted into equity shares of the liable company. They usually carry higher interest rates than the convertible ones.
6.4 Liquidation
6.4.1 Meaning of liquidation

In law, liquidation refers to the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed. Liquidation can also be referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation. The process of liquidation also arises when customs, an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation or ascertainment of the duties or drawback accruing on an entry.
6.4.2 Types of Liquidation

Liquidation may either be compulsory (sometimes referred to as a creditors' liquidation) or voluntary (sometimes referred to as a shareholders' liquidation, although some voluntary liquidations are controlled by the creditors, see below).
Compulsory liquidation The parties who are entitled by law to petition for the compulsory liquidation of a company vary from jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the compulsory liquidation of a company by: 1. the company itself 2. any creditor who establishes a prima facie case 3. contributories 4. the Secretary of State (or equivalent) 5. the Official Receiver
Voluntary liquidation Voluntary liquidation occurs when the members of the company resolve to voluntarily wind-up the affairs of the company and dissolve. Voluntary liquidation begins when the company passes the resolution, and the company will generally cease to carry on business at that time (if it has not done so already). If the company is solvent, and the members have made a statutory declaration of solvency, the liquidation will proceed as a members' voluntary winding-up. In such case, the general meeting will appoint the liquidator(s). If not, the liquidation will proceed as a creditor's voluntary winding-up, and a meeting of creditors will be called, to which the directors must report on the company's affairs. Where a voluntary liquidation proceeds by way of creditor's voluntary liquidation, a liquidation committee may be appointed.
1. Company is a) an association of persons b) formed for common object c) does not have physical existence d) all of above
2. Statutory Company is a company: a) Formed by special Act b) In which at least 51% paid up share capital is held by Government c) Registered under Companies Act.
3. Share Capital consists of: a) Equity shares b) Preference Shares c) Shares & Debentures d) Equity shares & Preference shares
4. Preference Shares have: a) Preferential right of fixed dividend b) Preferential right to repayment of capital in the event of companys winding up. c) Above all.
5. Share Capital can be classified as: a) Equity share & preference share b) Authorized, issued & subscribed c) Equity share, preference share, debentures d) None of above
6. Premium received on issue of shares is recorded in: a) Securities premium account b) Capital reserve account c) Profit & loss Account d) Share Application & Allotment account
7. Profit on reissue of forfeited shares is recorded in: a) Securities premium account b) Capital reserve account c) Profit & loss Account d) Share Application & Allotment account
8. Debenture is a document which: a) Creates a debt or acknowledges it b) Form the capital of the company. c) Cannot be transferred d) Does not have first right to be repaid at the time of liquidation of company.
9. Process of winding up of company is: a) Promotion b) Incorporation c) Commencement of business. d) Liquidation
10. A petition may be lodged with the court for the compulsory liquidation of a company by: a) the company itself b) any creditor who establishes a prima facie case c) contributories d) any of above e) none of above
Chapter-7: Cost & Management Accounting
Contents: 7.1 Introduction to cost and management accounting 7.1.1 Management Accounting 7.1.2 Cost Accounting 7.2 Concept of Cost 7.3 Elements of Cost 7.4 Cost Sheet 7.4.1 Components of Total Cost 7.4.2 Structure of Cost Sheet 7.5 Classification of Cost 7.5.1 Fixed, Variable and Semi-Variable Costs 7.5.2. Product Costs and Period Costs 7.5.3. Direct and Indirect Costs 7.5.4. Decision-Making Costs and Accounting Costs 7.5.5. Relevant and Irrelevant Costs 7.5.6. Shutdown and Sunk Costs 7.5.7. Controllable and Uncontrollable Costs 7.5.8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs
7.5.9. Imputed or Hypothetical Costs 7.5.10. Differentials, Incremental or Decrement Cost 7.5.11. Out-of-Pocket Costs 7.5.12. Opportunity Cost 7.5.13. Traceable, Untraceable or Common Costs 7.5.14. Production, Administration and Selling and Distribution Costs 7.5.15. Conversion Cost 7.6 Cost Unit and Cost Center 7.6.1 Cost Unit 7.6.2 Cost Center 7.7 Cost Estimation and Cost Ascertainment 7.8 Cost Allocation and Cost Apportionment 7.9 Cost Reduction and Cost Control 7.10 Methods of Costing 7.11 Techniques of Costing
7.1 Introduction to Cost and Management Accounting
7.1.1 Management Accounting
Management accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions.
In contrast to financial accountancy information, management accounting information is: usually confidential and used by management, instead of publicly reported; forward-looking, instead of historical; Pragmatically computed using extensive management information systems and internal controls, instead of complying with accounting standards. This is because of the different emphasis: management accounting information is used within an organization, typically for decision-making.
The Institute of Certified Management Accountants (ICMA), states A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking.
Management Accountants therefore are seen as the "value-creators" amongst the accountants. They are much more interested in forward looking and taking decisions that will affect the future of the organization, than in the historical recording and compliance (scorekeeping) aspects of the profession. Management accounting knowledge and experience can therefore be obtained from varied fields and functions within an organization, such as information management, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc.
Aims: 1. Formulating strategy / strategies 2. Planning and constructing business activities 3. Helps in making decision 4. Optimal use of Resource (economics) 5. Supporting financial reports preparation 6. Safeguarding asset
Approaches: The various managerial accounting approaches are: 1. Standardized or Standard Cost Accounting 2. Activity-based Costing 3. Resource Consumption Accounting 4. Throughput Accounting 5. Marginal Costing / Cost-Volume-Profit Analysis
7.1.2 Cost Accounting

Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature of the market, it was realized that ascertaining of cost is not as important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to the technological developments in all fields, cost reduction has also come within the ambit of cost accounting.
Cost accounting is, thus, concerned with recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making. According to Charles T. Horngren, cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes: 1. Operational planning and control 2. Special decisions 3. Product decisions According to the Chartered Institute of Management Accountants, London, Cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned.
Objectives of Cost Accounting The main objectives of cost accounting can be summarized as follows:
1.Helps in Determination of Selling Price Business enterprises run on a profit-making basis. It is, thus, necessary that revenue should be greater than expenditure incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides various information regarding the cost so that the selling price and profit can be estimated in advance.
2. Determining and Controlling Efficiency Cost accounting involves a study of various operations used in manufacturing a product or providing a service and uses a number of methods, e.g., budgetary control, standard costing etc. for controlling costs. The study facilitates measuring the efficiency of an organization as a whole or department-wise as well as devising means of increasing efficiency.
3. Facilitating Preparation of Financial and Other Statements The financial statements are generally prepared once a year or half-year and are spaced too far with respect to time to meet the needs of management. In order to operate a business at a high level of efficiency, it is essential for management to have a frequent review of production, sales and operating results. Cost accounting provides daily, weekly or monthly volumes of units produced and accumulated costs with appropriate analysis. A developed cost accounting system provides immediate information regarding stock of raw materials, work-in-progress and finished goods. This helps in speedy preparation of financial statements.
4. Providing Basis for Operating Policy Cost accounting helps management to formulate operating policies. These policies may relate to any of the following matters: Determination of a cost-volume-profit relationship Shutting down or operating at a loss Making for or buying from outside suppliers Continuing with the existing plant and machinery or replacing them by improved and economic ones
7.2 Concept of Cost

Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective. In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing. However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors: The nature of business or industry The context in which it is used In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading.
7.3 Elements of Cost

Elements of Costs Material Labor Expenses Overheads
Following are the three broad elements of cost: 1. Material The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.
1) Direct Material The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material: All material or components specifically purchased, produced or requisitioned from stores Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.) Purchased or partly produced components Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc.
2) Indirect Material The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Some of the examples of indirect material are. Consumable stores, oil and waste, printing and stationery material etc
Indirect material may be used in the factory, office or the selling and distribution divisions.
2. Labor For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.
1) Direct Labor The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products. Direct labor can also be described as process labor, productive labor, operating labor, etc.
2) Indirect Labor The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors fees, salaries of salesmen etc, are examples of indirect labor costs. Indirect labor may relate to the factory, the office or the selling and distribution divisions.
3. Expenses Expenses may be direct or indirect.
1) Direct Expenses These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows: Hire of some special machinery required for a particular contract Cost of defective work incurred in connection with a particular job or contract etc. Direct expenses are sometimes also described as chargeable expenses.
2) Indirect Expenses These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc.
4. Overhead The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads. A manufacturing organization can broadly be divided into the following three divisions: Factory or works, where production is done (Factory overheads) Office and administration, where routine as well as policy matters are decided (Office and administration overheads) Selling and distribution, where products are sold and finally dispatched to customers (Selling and distribution overheads)
Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types:
1. Factory Overheads They include the following things: Indirect material used in a factory such as lubricants, oil, consumable stores etc. Indirect labor such as gatekeeper, timekeeper, works managers salary etc. Indirect expenses such as factory rent, factory insurance, factory lighting etc.
2. Office and Administration Overheads They include the following things: Indirect materials used in an office such as printing and stationery material, brooms and dusters etc. Indirect labor such as salaries payable to office manager, office accountant, clerks, etc. Indirect expenses such as rent, insurance, lighting of the office
3. Selling and Distribution Overheads They include the following things: Indirect materials used such as packing material, printing and stationery material etc. Indirect labor such as salaries of salesmen and sales manager etc. Indirect expenses such as rent, insurance, advertising expenses etc.
7.4 Cost Sheet

7.4.1 Components of Total Cost
1. Prime Cost Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost. 2. Factory Cost Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost. 3. Office Cost Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production. 4. Total Cost Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales. Various components of total cost can be depicted with the help of the table below: Components of total cost Direct Direct Direct expenses material labor
Prime cost or direct cost or first cost
Works Prime cost plus works overheads
or
factory
cost
or
production cost or manufacturing cost
Works cost plus office and Office cost or total cost of administration overheads Office cost plus selling and distribution overheads production
Cost of sales or total cost
7.4.2 Structure of Cost Sheet

Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on different items for a particular period. Additional columns may also be provided to show the cost of a particular unit pertaining to each item of expenditure and the total per unit cost. Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated data (estimated cost sheet), depending on the technique employed and the purpose to be achieved. The techniques of preparing a cost sheet can be understood with the help of the following examples. Example 1 Following information has been obtained from the records of left center corporation for the period from June 1 to June 30, 1998. Cost of raw materials on June 1,1998 Purchase of raw materials during the month Wages paid Factory overheads 30,000 4,50,000 2,30,000 92,000
Cost of work in progress on June 1, 1998 Cost of raw materials on June 30, 1998 Cost of stock of finished goods on June 1, 1998
12,000 15,000 60,000
Cost of stock of finished goods on June 30, 1998 55,000 Selling and distribution overheads Sales Administration overheads Prepare a statement of cost. Solution Statement of cost of production of goods manufactured for the period ending on June 30, 1998. 30,000 Opening stock of raw materials 4,50,000 -----------4,80,000 15,000 Less-- closing stock of raw material Value Wages Prime Factory cost overheads of raw materials consumed 4,65,000 2,30,000 6,59,000 92,000 7,87,000 12,000 Add-- opening stock of work in progress 7,99,000 20,000 9,00,000 30,000
Add-- purchase
Less-- closing stock of work in progress Factory Add-Administration cost overhead
--7,99,000 30,000 8,29,000 60,000 8,89,000
Cost of production of goods manufactured Add--opening stock of finished goods
Less-- closing stock of finished goods Cost of production of goods sold Add-- selling and distribution overheads Cost Profit Sales Example 2 of sales
55,000 8,34,000 20,000 8,54,000 46,000 9,00,000
From the following information, prepare a cost sheet showing the total cost per ton for the period ended on December 31, 1998. Raw Productive Direct Unproductive materials 33,000 Rent and taxes (office) 500 wages 35,000 Water expenses 3,000 Factory supply 1,200 insurance 1,100 insurance 500 expenses 400 of warehouse 300
wages 10,500 Office Legal Rent
Factory rent and taxes 2,200 Factory Factory lighting 1,500 heating 4,400
Depreciation-Plant Office Delivery Bad Advertising and machinery 2,000 building 1,000 vans 200 debt 100 300
Motive power Haulage 3,000 Directors fees (works) 1,000 Directors fees (office) 2,000 Factory cleaning 500
Sundry office expenses 200 Expenses 800
Sales department salaries 1,500
Factory Office
stationery 750 stationery 900
Up keeping of delivery vans 700 Bank charges 50 1,500
Loose tools written off 600
Commission on sales
The total output for the period has been 10000 tons. Solution Cost sheet for the period ended on December 31, 1998 $. Raw Production Direct Prime materials 33,000 wages 35,000 expenses 3,000 cost 71,000 wages 10,500
Add--works overheads: Unproductive
Factory rent and taxes 7,500 Factory Factory heating lighting 2,200 1,500 4,400 Motive Haulage Directors Factory Estimating Factory Loses Water Factory tools written fees (works) cleaning expenses stationery off supply insurance power 37,050
3,000 1,000 500 800 750 600 1,200
1,08,050 5,550
1,100 1,13,600 2,000 4,600
Depreciation of plant and machinery
Works Add-Directors Sundry Office Rent Office Legal Depreciation Bank charges Office of office and taxes office fees office
cost overhead (office) expenses stationery (office) insurance expenses building 2,000 1,18,200 200 900 500 500 400 1,000 50
cost warehouse 200 delivery vans 100 debts 300 1,500 department on of delivery salaries 1,500 sales 700 vans cost
Add-- selling and distribution overheads 300 Rent Depreciation Bad Advertising Sales Commission Upkeep Total of on
Cost per ton $. 1,18,200/10,000 = $. 11.82
7.5 Classification of Cost

Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows:
7.5.1. Fixed, Variable and Semi-Variable Costs

1. Fixed Costs:
The cost which does not vary but remains constant within a given period of time and a range of activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are as follows: Rent or rates Insurance charges Management salary
Fixed costs can be further classified into: 1. Committed fixed costs Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organizations competence to meet the long-term goals.
2. Discretionary fixed costs Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development
2. Variable cost: The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows:
Wages of laborers Cost of direct material Power In some circumstances, variable costs are classified into the following: 1. Discretionary cost 2. Engineered cost
3. Semi-variable cost: The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows: Depreciation Repairs Fixed costs are sometimes referred to as period costs and variable costs as direct costs in system of direct costing. The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred are called as product costs. They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc. The costs which are not associated with production are called period costs. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of
production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs. The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs.
7.5.4. Decision-Making Costs and Accounting Costs

Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routinefinancial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover, they are historical costs and show what has happened under an existing set of circumstances. Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example, accounting costs may show the cost of a product when the operations are manual whereas decision-making cost might be calculated to show the costs when the operations are mechanized.
7.5.5. Relevant and Irrelevant Costs

Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.
7.5.6. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs. Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decisionmaking.
7.5.7. Controllable and Uncontrollable Costs

Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.
7.5.8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs

Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination.
It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business.
7.5.9. Imputed or Hypothetical Costs

These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. For example, interest on capital is ignored in cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash, the management should take into consideration the capital to judge the relative profitability of the projects.
7.5.10. Differentials, Incremental or Decrement Cost

The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenue. This is explained with the following example: Example A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows: Selling price per unit Variable cost per unit Fixed costs $. 10 $. 5 $. 4,000
The management is considering the following two alternatives: i. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500.
ii.
To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000.
Which alternative the management should accept? Solution Statement showing profitability under different alternatives is as follows: Present situation $. $. 10,000 5,000 9,000
Particulars
Proposed situations
Sales. Less:
11,600
10,000
6,000 10,500 5,400 8,400 4,500 3,000
Variable purchase costs 4,000 Fixed costs Profit 1,000 1,100 1,600
Observations i. ii. In the present situation, the company is making a profit of $. 1,000. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation. iii. In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation. Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii).
The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative. In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs.
7.5.11. Out-of-Pocket Costs

Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as outof-pocket costs.
7.5.12. Opportunity Cost

Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. For example, if a building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profitability of the project.
7.5.13. Traceable, Untraceable or Common Costs

The costs that can be easily identified with a department, process or product are termed as traceable costs. For example, the cost of direct material, direct labor etc. The costs that cannot be identified so are termed as untraceable or common costs. In other words, common costs are the costs incurred collectively for a number of cost centers and are to be suitably apportioned for
determining the cost of individual cost centers. For example, overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment etc. Joint cost is a kind of common cost. When two or more products are produced out of one material or process, the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are produced from the same material, the cost incurred till the splitoff or separation point will be joint costs.
7.5.14. Production, Administration and Selling and Distribution Costs

A business organization performs a number of functions, e.g., production, illustration, selling and distribution, research and development. The Chartered Institute of Management Accountants, London, have defined each of the above costs as follows: Production Cost The cost of sequence of operations which begins with supplying materials, labor and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and factory overheads.
Administration Cost The cost of formulating the policy, directing the organization and controlling the operations of an undertaking which is not related directly to a production, selling, distribution, research or development activity or function.
Selling Cost It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.
Distribution Cost It is the cost of sequence of operations beginning with making the packed product available for dispatch and ending with making the reconditioned returned empty package, if any, available for reuse.
Research Cost It is the cost of searching for new or improved products, new application of materials, or new or improved methods.
Development Cost The cost of process which begins with the implementation of the decision to produce a new or improved product or employ a new or improved method and ends with the commencement of formal production of that product or by the method.
Pre-Production Cost The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost.
7.5.15. Conversion Cost

The cost of transforming direct materials into finished products excluding direct material cost is known as conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory overheads.
7.6 Cost Unit and Cost Center

The technique of costing involves the following: Collection and classification of expenditure according to cost elements Allocation and apportionment of the expenditure to the cost centers or cost units or both
7.6.1 Cost Unit

While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed. Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost: (i) Brick works (ii) Collieries (iii) Textile mills (iv) Electrical companies (v) Transport companies (vi) Steel mills per 1000 bricks made per ton of coal raised per yard or per lb. of cloth manufactured or yarn spun per unit of electricity generated per passenger km. per ton of steel made
7.6.2 Cost Center

According to the Chartered Institute of Management Accountants, London, cost center means a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control. Thus, cost center refers to one of the convenient units into
which the whole factory or an organization has been appropriately divided for costing purposes. Each such unit consists of a department, a sub-department or an item or equipment or machinery and a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purposes. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost center and all costs relating to a particular cost center may be found out separately. Cost centers may be classified as follows: Productive, unproductive and mixed cost centers Personal and impersonal cost centers Operation and process cost centers
7.7 Cost Estimation and Cost Ascertainment

Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-determination may be required for several purposes. Some of the purposes are as follows: Budgeting Measurement of performance efficiency Preparation of financial statements (valuation of stocks etc.) Make or buy decisions Fixation of the sale prices of products Cost ascertainment is the process of determining costs on the basis of actual data. Hence, the computation of historical cost is cost ascertainment while the computation of future costs is cost estimation.
7.8 Cost Allocation and Cost Apportionment

Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units Thus, the former involves the process of charging direct expenditure to cost centers or cost units whereas the latter involves the process of charging indirect expenditure to cost centers or cost units. For example, the cost of labor engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share will have to be found out. Charging of costs in the former case will be termed as allocation of costs whereas in the latter, it will be termed as apportionment of costs.
7.9 Cost Reduction and Cost Control

Cost reduction and cost control are two different concepts. Cost control is achieving the cost target as its objective whereas cost reduction is directed to explore the possibilities of improving the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is a continuous process.
7.10 Methods of Costing

Costing can be defined as the technique and process of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of job costing are as follows: 1. Job Costing The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labor costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in
plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto. 2. Contract Costing Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract. The term is usually applied where large-scale contracts are carried out. In case of ship-builders, printers, building contractors etc., this system of costing is used. Job or contract is also termed as terminal costing. 3. Cost Plus Costing In contracts where in addition to cost, an agreed sum or percentage to cover overheads and fit is paid to a contractor, the system is termed as cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the process of production. The system is used generally in cases where government happens to be the party to give contract. 4. Batch Costing This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries. 5. Process Costing If a product passes through different stages, each distinct and well defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which a separate account is opened for each process. This system of costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc.
6. Operation Costing Operation costing is a further refinement of process costing. The system is employed in the industries of the following types: 1. The industry in which mass or repetitive production is carried out 2. The industry in which articles or components have to be stocked in semi-finished stage to facilitate the execution of special orders, or for the convenience of issue for later operations The procedure of costing is broadly the same as process costing except that in this case, cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips molding, machining and finally polishing. The cost to complete these operations may be found out separately. 7. Unit Costing (Output Costing or Single Costing) In this method, cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. In case where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared in which various items of expense are classified and the total expenditure is divided by the total quantity produced in order to arrive at per unit cost of production. The method is suitable in industries like brick making, collieries, flour mills, paper mills, cement manufacturing etc. 8. Operating Costing This system is employed where expenses are incurred for provision of services such as those tendered by bus companies, electricity companies, or railway companies. The total expenses regarding operation are divided by the appropriate units (e.g., in case of bus company, total number of passenger/kms.) and cost per unit of service is calculated. 9. Departmental Costing
The ascertainment of the cost of output of each department separately is the objective of departmental costing. In case where a factory is divided into a number of departments, this method is adopted. 10. Multiple Costing (Composite Costing) Under this system, the costs of different sections of production are combined after finding out the cost of each and every part manufactured. The system of ascertaining cost in this way is applicable where a product comprises many assailable parts, e.g., motor cars, engines or machine tools, typewrite$, radios, cycles etc. As various components differ from each other in a variety of ways such as price, materials used and manufacturing processes, a separate method of costing is employed in respect of each component. The type of costing where more than one method of costing is employed is called multiple costing.
7.11 Techniques of Costing

Besides the above methods of costing, following are the types of costing techniques which are used by management only for controlling costs and making some important managerial decisions. As a matter of fact, they are not independent methods of cost finding such as job or process costing but are basically costing techniques which can be used as an advantage with any of the methods discussed above. 1. Marginal Costing Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. Fixed overheads are excluded in cases where production varies because it may give misleading results. The technique is useful in manufacturing industries with varying levels of output. 2. Direct Costing
The practice of charging all direct costs to operations, processes or products and leaving all indirect costs to be written off against profits in the period in which they arise is termed as direct costing. The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances. 3. Absorption or Full Costing The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing. 4. Uniform Costing A technique where standardized principles and methods of cost accounting are employed by a number of different companies and firms is termed as uniform costing.
1. Management accounting is concerned with a) the provisions and use of accounting information to managers within organizations b) to provide them with the basis to make informed business decisions c) allow them to be better equipped in their management and control functions d) all of above
2. The technique of ascertaining cost is: a) Cost Accounting b) Cost control c) Cost Reduction d) Cost appropriation
3. Elements of cost are a) Material b) Labor c) Expenses d) Overheads e) All of above
4. Indirect materials used such as packing material, printing and stationery material etc a) Factory overheads b) Office overheads c) Selling & distribution overheads d) None of above.
5. Cost sheet consists of a) Prime cost b) Factory cost c) Office cost d) All of above
6. Fixed costs which are set at fixed amount for specific time periods by the management in budgeting process. a) Fixed costs b) Committed fixed costs c) Discretionary fixed costs d) None of above
7. Cost that are compiled primarily from financial statements a) Accounting costs b) Decision-making costs c) Relevant costs d) None of above
8. Those costs which can be influenced by the ratio or a specified member of the undertaking. a) Controllable costs b) Uncontrollable costs. c) Avoidable costs d) Unavoidable costs
9. The costs that can be easily identified with a department, process or product a) Traceable costs b) Untraceable costs c) Common Costs d) None of above
10. technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. a) Direct Costing b) Marginal Costing c) Uniform Costing d) Absorption Costing
Chapter 8: Process Costing
Contents: 8.1 Features of Process Costing 8.2 Elements & Components of Process Costs 8.3 Methodology of Recording / Accounting Costs 8.3.1 Process Accounts 8.3.2 Process Stock Accounts 8.4 Process Losses & Gains 8.4.1 Process losses 8.4.2 Abnormal Effectives/Gain
Process costing is an accounting methodology that traces and accumulates direct cost, and allocates indirect costs of a manufacturing process. Process Costing is a technique of costing and it may be adopted using any of the techniques of costing. The technique adopted would decide the procedure adopted in relation to various accounting aspects. For example, for the purpose of valuation of stocks Fixed costs will be considered along with Variable costs, if "Absorption Costing" is adopted as the technique. Only variable costs will be considered, if "marginal costing" is adopted as the technique.
8.1 Features/Characteristics of Process Costing
Process Costing Method is applicable where the output results from a sequence of continuous or repetitive operations or processes and products are identical and cannot be segregated. It enables the ascertainment of cost of the product at each process or stage of manufacture.
The following features may be identified with process costing: The output consists of products which are homogenous. Production is carried on in different stages (each of which is called a process) having a continuous flow. Production takes place continuously except in cases where the plant and machinery are shut down for maintenance etc. Output is uniform and all units are identical during each process. It would not be possible to trace the identity of any particular lot of output to any lot of input. The input will pass through two or more processes before it takes the shape of the output. The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product. The output of a process (except the last) may also be saleable in which case the process may generate some profit. The input of a process (except the first) may be capable of being acquired from the outside sources. The output of a process is transferred to the next process generally at cost to the process. It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions. Normal and abnormal losses may arise in the processes There are a number of industries in which process costing can be applied. o Manufacturing industries. Iron & Steel, paints, rubber etc. o Chemical industries. Chemicals, oils, medicines etc. o Mining. Mineral oil, gold, iron, zinc etc.
o Public Utility Works. Electricity generation and distribution, water supply etc.
8.2 Elements/Components of Process Cost
For the purpose of cost accounting, the process industry is divided into separate departments with each department representing a specific process. The Direct Material and Direct Labour/Labor Costs are collected for each department separately and the overheads which are collected over all the departments/processes are apportioned over the various departments/processes on some rational basis.
The following are the main elements/components of costs involved in the manufacturing process where process costing method is adopted.
1. Direct Materials There are two types of materials that we come across in process costing. Primary Material Materials which are introduced in the initial process and passed on to the next process as a part of output after completion of processing. Secondary Material Materials which are introduced in the first or subsequent processes in addition to the main material introduced in the initial process. This gets mixed up with the main material and is passed on to the subsequent processes as a part of the output.
2. Direct Labour/Labor The direct labour/labor cost is generally incurred in every process. Identification of direct labour cost is also relatively easy in process costing industry
3. Direct Expenses Expenses in addition to Direct Material and Labor which can be directly attributable to a particular process. These are costs relevant to specific processes.
4. Production Overheads The overhead expenses are generally expended over all the processes involved in production. These are to be apportioned over the various processes in an amicable manner.
8.3 Methodology of Recording/Accounting Costs
Financial Accounting Methodology is adopted for recording costs involved.
8.3.1 Process Accounts

A nominal account for each process is used to record all the costs relevant to a process. Each process account is Debited with o The Primary Direct Material Cost o Secondary Direct Material Cost o Direct Labor Cost o Direct Expenses and o Production Overheads allocated and/or apportioned to the process.
Credited with o The value of output transferred to the subsequent process or finished stocks.
Numbers, Alphabets or any word or phrase representing the process are used as suffixes/prefixes in the names ("Process I a/c", "Process A a/c", "Refining Process A a/c", etc.,.) to distinctly identify the processes accounts.
8.3.2 Process Stock Accounts

Stocks relevant to a process are maintained in a separate stock account. Stock accounts for input may be maintained where all the input acquired/received for a process during a period is not used up. Stock accounts for output may be maintained where all the output produced/completed in a process during a period is not disposed off either by transfer to the next process or by sale.
Where the output relevant to a process is sold apart from being transferred to the next process, it generates revenue. These revenues relevant to a process, are generally recorded using the process account or the stock account.
8.4 Process Losses & Gains

8.4.1 Process Losses
It may be defined as the loss of material arising during the course of a processing operation and is equal to the difference between the input quantity of the materials and its output. It may take the form of: 1. Waste is a discarded substance having no value. 2. Scrap is a discarded substance having some recovery value which is usually disposed of without further treatment. The cost of the process is reduced by the amount for which scrap is sold.
Material Loss in the process costing may be classified as: 1. Normal loss: it is one which is incidental to the production and within standard limit. It is unavoidable and arises from the nature of the production process.
Accounting treatment: The cost per unit is calculated by dividing the normal cost by normal output. Normal Cost = Cost of input Saleable Value of Normal Wastage/scrap Normal Output = Units produced Units of Normal Loss Journal Entries: 1. Normal Loss A/c To Process A/c. 2. Cash A/c To Normal Loss A/c. Dr. Dr.
2. Abnormal loss: Any loss in excess of predetermined loss is known as abnormal loss. It arises owing to the operational inefficiencies.
Accounting Treatment: The cost of abnormal loss is not allowed to influence the cost of good units. Cost of Abnormal Loss = Normal Cost/Normal Output * Units of Abnormal Loss The loss on account of abnormal wastage is not borne by production but by Costing Profit & Loss Account. Journal Entries: 1. Abnormal Loss A/c To Process A/c 2. Cash A/c Dr. Dr.
To Abnormal Loss A/c. (Scrap value of units of abnormal loss)
3. Costing Profit & Loss A/c. To Abnormal Loss A/c (Balance of Abnormal Loss Account)
Dr.
8.4.2 Abnormal Effectives/Gain

If the actual loss is more than the normal, it is known as the abnormal loss, but if the actual loss is less than the normal loss, it is known as the Abnormal Effectives/Gain Accounting treatment: The abnormal gain is calculated in the same way as the abnormal loss except that its value is debited to the related process account and credited to Abnormal Gain Account. Journal Entries: 1. Process A/c Dr.
To Abnormal Gain A/c. 2. Abnormal Gain A/c Dr.
To Normal Loss A/c. 3. Abnormal Gain A/c Dr.
To Costing Profit & Loss A/c,
Value of Abnormal Gain = Normal Cost /Normal Output * Units of Abnormal Gain. Illustration 1: Normal Wastage: The product of a manufacturing company passes through two processes A & B & then to finished stock. It is ascertained that in each process 5% of the total weight put is lost & 10% is scrap which from processes A & B realize Rs. 80 per tonne & Rs. 200 per tonne respectively.
The process figures are as follows: Process A Material consumed in tonnes Cost of materials / tonne in Rs. Wages in Rs. Manufacturing expenses in Rs. 1,000 125 18,000 6,000 Process B 70 200 12,000 6,000
Prepare process cost accounts, showing the cost of the output of each process and cost per tonne.
Solution: Process A Account Particulars Tonnes Amount (Rs.) To Materials To Wages To Manufacturing Exp. 1,000 1,25,000 18,000 6,000 By Normal Wastage (5% of 1,000) By Normal Scrap (10% 0f 1,000) By Transfer Process to 850 1,41,000 100 8,000 50 Particulars Tonnes Amount (Rs.) --------
B A/c @ Rs. 165.88 1,000 1,49,000 1,000 1,49,000
Process B Account Particulars Tonnes Amount (Rs.) To Transfer from 850 1,41,000 By Normal Wastage 46 Particulars Tonnes Amount (Rs.) ------
Process A A/c. To Materials To Wages To Manufacturing Exp. 70 14,000 12,000 6,000
(5% of 920) By Normal Scrap (10% of 920) By Transfer to 782 Finished Stock A/c @ Rs. 197.70 1,54,600 92 18,400
920
1,73,000
920
1,73,000
1. Process costing is a) a technique of costing b) a method of costing c) type of costing d) none of above
2. Normal Loss is a) same as abnormal loss b) charged to cost of product c) charged to profit & loss account d) none of above
3. Abnormal loss is charged to a) Costing profit & loss account. b) Cost of production of good units c) None of above
4. Abnormal loss is due to a) carelessness, b) bad plant design, c) sabotage, d) all of above
5. Abnormal gain affects a) The cost of good units b) Cost of scrap c) Cost of wastage d) None of above.
6. Good units do not bear the a) Abnormal loss arising in process costing. b) Normal loss arising in process costing c) Wastage arising in process costing. d) None of above
7. Process costing is used in a) Paper industries. b) Sugarcane industries c) None of above
8. In the process account the Abnormal gain is written on the a) Debit side b) Credit side c) None of above
9. Discarded substance having some recovery value which is usually disposed of without further treatment a) Scrap b) Waste c) Abnormal loss d) None of above
10. If the actual loss is greater then the normal loss a) Abnormal gain b) Abnormal loss c) None of the two.
Chapter-9: Marginal Costing & Break Even Analysis

Contents: 9.1 Marginal Costing 9.1.1 Introduction 9.1.2 Theory of Marginal Costing 9.1.3 The principles of marginal costing 9.1.4 Features of Marginal Costing 9.1.5 Advantages and Disadvantages of Marginal Costing Technique 9.2 Marginal Costing pro-forma 9.3 Breakeven Analysis 9.3.1 Introduction 9.3.2 Cost-Volume-Profit (C-V-P) Relationship 9.3.3 Objectives of Cost-Volume-Profit Analysis 9.3.4 Assumptions and Terminology 9.3.5 Limitations of Cost-Volume Profit Analysis 9.4 Marginal Cost Equations and Breakeven Analysis
9.1 Marginal Costing
9.1.1 Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
Marginal costing - definition Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product is its variable cost. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
Marginal
costing
is
formally
defined
as:
the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making. (Terminology) The term contribution mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus MARGINAL COST = VARIABLE COST DIRECT LABOUR + DIRECTMATERIAL
+ DIRECT + VARIABLE OVERHEADS CONTRIBUTION SALES MARGINAL COST EXPENSE
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Note Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
9.1.2. Theory of Marginal Costing

The theory of marginal costing as set out in A report on Marginal Costing published by CIMA, London is as follows: In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost. The theory of marginal costing may, therefore, by understood in the following two steps: 1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the marginal cost of additional output will be $.2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is $2.25. It can be described as follows: Additional cost = $ 45 = $2.25 Additional units 20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost. Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300280). The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output. There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
9.1.3 The principles of marginal costing

The principles of marginal costing are as follows. a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the relevant range). Therefore, by selling an extra item of product or service the following will happen. Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item. b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
9.1.4 Features of Marginal Costing

The main features of marginal costing are as follows: 1. Cost Classification The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique. 2. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. 3. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
9.1.5 Advantages and Disadvantages of Marginal Costing Technique

Advantages 1. Marginal costing is simple to understand. 2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. 3. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. 5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making. Disadvantages 1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. 4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. 6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.
9.2 Marginal Costing Pro-Forma

Sales Revenue Less Marginal Cost of Sales Opening Stock (Valued @ marginal cost) xxxx xxxxx
Add Production Cost (Valued @ marginal cost) xxxx Total Production Cost Less Closing Stock (Valued @ marginal cost) Marginal Cost of Production Add Selling, Admin & Distribution Cost Marginal Cost of Sales Contribution Less Fixed Cost Marginal Costing Profit xxxx (xxx) xxxx xxxx (xxxx) xxxxx (xxxx) xxxxx
9.3 Breakeven Analysis
9.3.1 Introduction
In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity. To assist planning and decision making, management should know not only the budgeted profit, but also: the output and sales level at which there would neither profit nor loss (break-even point) the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
Marginal Costs, Contribution and Profit A marginal cost is another term for a variable cost. The term marginal cost is usually applied to the variable cost of a unit of product or service, whereas the term variable cost is more commonly applied to resource costs, such as the cost of materials and labour hours. Marginal costing is a form of management accounting based on the distinction between: a. the marginal costs of making selling goods or services, and b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period. Suppose that a firm makes and sells a single product that has a marginal cost of 5 per unit and that sells for 9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of 5 and receive income of 9. The net gain will be 4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning making a contribution towards covering fixed costs and making a profit. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit. C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
9.3.2 Cost-Volume-Profit (C-V-P) Relationship

We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit. Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run. The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in various statement forms. Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors: Volume of production
Product mix Internal efficiency and the productivity of the factors of production Methods of production and technology Size of batches Size of plant Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services. In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volumeprofit analysis can answer a number of analytical questions. Some of the questions are as follows: 1. What is the breakeven revenue of an organization? 2. How much revenue does an organization need to achieve a budgeted profit? 3. What level of price change affects the achievement of budgeted profit? 4. What is the effect of cost changes on the profitability of an operation? Cost-volume-profit analysis can also answer many other what if type of questions. Costvolume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to what if theme by telling the volume required to produce. Following are the three approaches to a CVP analysis: Cost and revenue equations Contribution margin Profit graph
9.3.3 Objectives of Cost-Volume-Profit Analysis

1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other. 2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities. 3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control. 4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit.
9.3.4 Assumptions and Terminology

Following are the assumptions on which the theory of CVP is based: 1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o o o
Direct materials Direct labor Direct chargeable expenses
Variable overheads include the following:

o o
Variable part of factory overheads Administration overheads
Selling and distribution overheads
3. There is linear relationship between revenue and cost. 4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line. 5. The unit selling price, unit variable costs and fixed costs are constant. 6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis. 7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes. 8. All revenue and cost can be added and compared without taking into account the time value of money. 9. The theory of CVP is based on the technology that remains constant. 10. The theory of price elasticity is not taken into consideration. Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas: Strategic and long-range planning decisions Decisions about product features and pricing In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same. For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows: Number of output units
Number of customer visits made for sales Number of advertisements placed Some of the multiple cost drivers are as follows: Number of units produced Number of batches in which units are produced Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
9.3.5 Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis: 1. It is assumed that the production facilities anticipated for the purpose of cost-volumeprofit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place. 2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit. 3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations. 5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant. 6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
9.4 Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following: Sales Marginal cost = Contribution ......(1) Fixed cost + Profit = Contribution ......(2) By combining these two equations, we get the fundamental marginal cost equation as follows: Sales Marginal cost = Fixed cost + Profit ......(3) This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems. The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus, P/V Ratio (or C/S Ratio) = Contribution (c) Sales (s) ......(4)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100. Or, Contribution = Sales x P/V ratio ......(5) Or, Sales = Contribution P/V ratio ......(6)
The above-mentioned marginal cost equations can be applied to the following heads: 1. Contribution Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities: Selecting product mix or sales mix for profit maximization Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc. 2. Profit Volume Ratio (P/V Ratio), its Improvement and Application The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: Sales Marginal cost of P/V ratio = Sales sales = Sales Changes contribution = Changes in sales = Change sales in in Change profit in
Contribution
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following: Breakeven point Profit at any volume of sales Sales volume required to earn a desired quantum of profit Profitability of products Processes or departments The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following: Increasing selling price Reducing marginal costs by effectively utilizing men, machines, materials and other services Selling more profitable products, thereby increasing the overall P/V ratio 3. Breakeven Point Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that: Contribution = Fixed cost Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit. a. Using Marginal Costing Equation S (sales) V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S V = F By multiplying both the sides by S and rearranging them, one gets the following equation: S BEP = F.S/S-V
b. Using P/V Ratio Contribution at BEP Sales S BEP = P/ V ratio = P/ V ratio Fixed cost
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then: 400 x 2000 Breakeven point = 2000 - 1200 P/V ratio Similarly, 800 So, breakeven sales = $. 400 / .4 = $. 1000 c. Using Contribution per unit Fixed cost Breakeven point = Contribution per unit 4. Margin of Safety (MOS) Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production. Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business. Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio. = 100 units or $. 1000 = 2000 1200 = 0.4 or 40% = $. 1000
Profit at selected activity Margin of safety = Sales at selected activity Sales at BEP = P/V ratio Margin of safety (sales) x 100 Margin of safety is also presented in ratio or percentage as % follows: Sales at selected activity The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken. a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold. b. Reducing fixed costs c. Reducing variable costs d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output e. Modernization of production facilities and the introduction of the most cost effective technology Problem 1 A company earned a profit of $. 30,000 during the year 2000-01. Marginal cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the margin of safety. Solution
Profit Margin of safety = P/V ratio Contribution x 100 P/V ratio = Sales Problem 2 A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following: Profits for annual sales of 1 unit, 50 units, 100 units and 400 units P/V ratio Breakeven sales Sales to earn a profit of $. 500 Profit at sales of $. 3,000 New breakeven point if sales price is reduced by 10% Margin of safety at sales of 400 units Solution Marginal Cost Statement Particulars Units produced Sales (units * 10) Variable cost Amount 1 10 6 Amount 50 500 300 200 Amount 100 1000 600 400 Amount 400 4000 2400 1600
Contribution (sales- VC) 4
Fixed cost
400
400 -200
400 0
400 1200
Profit (Contribution FC) -396
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40% Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000 Sales at BEP = Contribution at BEP/ PVR = 100 units Sales at profit $. 500 Contribution at profit $. 500 = Fixed cost + Profit = $. 900 Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units) Profit at sales $. 3,000 Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200 Profit = Contribution Fixed cost = $. 1200 $. 400 = $. 800 New P/V ratio = $. 9 $. 6/$. 9 = 1/3 $. 400 Sales at BEP = Fixed cost/PV ratio = 1/3 Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 % = $. 1,200
(Actual sales BEP sales/Actual sales * 100) Breakeven Analysis-- Graphical Presentation Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship. Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales. Construction of a Breakeven Chart The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows: 1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis. 2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis. 3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line. 4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained. Uses of Breakeven Chart A breakeven chart can be used to show the effect of changes in any of the following profit factors: Volume of sales Variable expenses Fixed expenses Selling price Problem A company produces a single article and sells it at $. 10 each. The marginal cost of production is $. 6 each and total fixed cost of the concern is $. 400 per annum.
Construct a breakeven chart and show the following: Breakeven point Margin of safety at sale of $. 1,500 Angle of incidence Increase in selling price if breakeven point is reduced to 80 units Solution A breakeven chart can be prepared by obtaining the information at these levels: Output units 40 $. Sales 400 Fixed cost 400 800 400 480 880 1,200 400 400 1,120 2,000 400 720 1,600 80 $. 120 $. 200 $.
Variable cost 240 Total cost 640
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein: This chart clearly shows the breakeven point, margin of safety and angle of incidence. a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of $. 1,000 or 100 units. b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of ($. 1,500 - $. 1,000), i.e. $. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence. d. At 80 units, total cost (from the table) = $. 880. Hence, selling price for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of $. 10 per unit.
Limitations and Uses of Breakeven Charts A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these factor may change and the original breakeven chart may give misleading results. But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales. Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each products sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%. The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows: Fixed costs Breakeven point (in units) = Weighted average contribution margin per unit One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity. Breakeven Point in Sales Revenue Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows: Fixed cost B.E. point (in revenue) = Weighted average P/V ratio
Multiple Choice Questions: 1. Marginal costing is a method of a) Ascertaining cost. b) Technique of applying different methods of cost c) Ascertaining BEP
2. Other things remaining the same, BEP increases with a) Increase in fixed assets b) Decrease with fixed assets. c) Remains constant.
3. In marginal costing, costs are classified into a) Variable & fixed b) Variable c) Fixed d) Variable, fixed & semi-variable.
4. A firm incurs a loss when a) Contribution is always equal to fixed cost. b) Contribution is more than fixed costs c) Contribution is less then fixed costs. d) BEP is higher.
5. Margin of safety implies a) Break- Even point b) Sales BEP c) BEP + contribution d) Sales Variable Costs.
6. Sales above BEP indicate a) Profits b) Loss c) MOS d) Fixed Costs
7. BEP Chart is the graphic representation of a) CVP relationship b) MOS c) Angle of Incidence
8. Excess of sales over variable cost is known as a) profits. b) Contribution c) Loss d) Fixed cost
9. If the MOS is high, actual sales are a) Very near to break even sales. b) Represents loss c) Equal to BEP sales. d) None of above
10. In marginal costing, stock is valued a) At variable costs b) Market price or book value which ever is less. c) At fixed costs.
Key to Multiple Choice Questions

Chapter 1 Introduction to Basics of Accounting 1).d, 2).d, 3).a, 4).e, 5).b Chapter 2 Accounting Equation 1).b, 2)a, 3).c, 4).a, 5).a, 6).a, 7).b, 8).c, 9).c, 10).b Chapter 3 Journalizing, Posting & Balancing 1).a, 2).b, 3).a, 4).c, 5).c, 6).a, 7).c, 8).d, 9).d, 10).d Chapter 4 Financial Statements 1).b, 2).b, 3).a, 4).a, 5).b, 6).d, 7).a, 8).a, 9).c, 10).a Chapter 5 Financial Ratios 1).c, 2).a, 3).b, 4).a, 5).b, 6).a, 7).c, 8).b, 9).b, 10).b Chapter 6 Company Accounts 1).d, 2).a, 3).d, 4).c, 5).b, 6).a, 7).b, 8).a, 9).d, 10).d Chapter 7 Cost & Management Accounting 1).d, 2).a, 3).e, 4).c, 5).d, 6).c, 7).a, 8).a, 9).a, 10).b Chapter 8 Process Costing 1).a, 2).b, 3).a, 4).d, 5).a, 6).a, 7).a, 8).b, 9).a, 10).b Chapter 9 Marginal Costing & Break Even Analysis 1).b, 2).b, 3).d, 4).d, 5).b, 6).c, 7).a, 8).b, 9).d, 10).a
Bibliography
Reference: M.C.Shukla, T.S.Grewal, S.C.Gupta (2007) Advanced Accounts, Sultan Chand & Company Ltd. P.C. Tulsian (2007) Financial Accounting, Pearson Education. Tutor2u, http://www.tutor2u.net/, Wikipedia, http://en.wikipedia.org/wiki/Accounting Accountingcoach.com, http://www.accountingcoach.com/terms/A/account.html

AMBO-104 - Accounting For Managers

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ACCOUNTING FOR MANAGERS

Chapter-1: Introduction to the Basics of Accounting

1.2 Concepts of Accounting

1.3 Conventions regarding Financial Statements

1.4 Users of Accounting Information

Branches of Accounting Social Responsibility Accounting

1.6 Meaning of HR Accounting

Multiple Choice Questions

1). Accounting is an art of: a) Recording b) Classifying c) Interpretating d) All of above

Chapter- 2: Accounting Equation

2.1 Basic Accounting Terminology

2.2 Accounting Equation

Assets Liabilities = (Shareholders or Owners equity)

Selling assets for cash to pay off liabilities:

shareholders money (600) and by borrowing money (400)

is exchanged for another; no change in assets or liabilities

Multiple Choice Questions

Chapter-3: Journalizing, Posting & Balancing

3.1.1 Double-Entry Accounting

3.2.1 Classification of Accounts

3.2.2 Format for Accounts

10,000 00 April 30 By Balance b/d 10,000 00

3.2.3 The Ledger

3.3.1 Journal Entries

What did Company A receive?

the cash balance?

What is the account name to record the sales of Sales. products?

What did Company A receive?

What did Company A pay?

[Journal entry to record transaction 2] Debit Supplies Cash 50 50 Credit

3.3.2 Debits and Credits of Accounts

Decrease in liability accounts Decrease in equity accounts Decrease in revenue accounts

Increase in liability accounts Increase in equity accounts Increase in revenue accounts

3.3.3 Normal Balances of Accounts

Example 1: Financing Activities Owner invested $10,000 in the company.

Journal Entry Debit Cash Owner's Equity 10,000 10,000 Credit

Journal Entry Debit Equipment Cash 12,000 12,000 Credit

Decrease in Assets (Merchandise) by $5,000 Debit

Description of Journal Entry To record the cost of merchandise sold.

Journal Entry Debit Salaries Expense Cash 3,500 3,500 Credit

Description of Journal Entry Results of Journal Entry

Paid $3,500 salaries.

Journal Entry Debit Rent Expense Cash 1,500 1,500 Credit

3.4 Trial Balance

3.4.2 Methods of preparing trial Balance

3.4.3 Format of trial balance

Account Head 1 Account Head 2 Account Head 3 Total Header Row

Illustration General Ledger

21/06/05 By Wages Paid a/c sub-total 25/06/05 By Balance c/d

Total 25/06/05 To Balance b/d

2,14,500 24,500 Dr Capital a/c Cr

Amount (in Rs)

Amount (in Rs) 2,00,000 2,00,000

Amount (in Rs)

17/06/05 To Cash a/c sub-total

Amount (in Rs)

17/06/05 To Cash a/c sub-total

Amount (in Rs) 25,000

18/06/05 To Cash a/c

sub-total 25/06/05 By Balance c/d

Total 25/06/05 To Balance b/d