FINANCIAL AND MANAGEMENT ACCOUNTING

Unit - 1
Accounting – Defination – According for historical function and
managerial function – Scope of accounting – Financial accounting and
Management accounting – Managerial uses – Differences.

Financial Accounting: Accounting concepts – Convections –

Principles – Accounting standards – International Accounting
standards.

Unit-2
Double entry system of accounting - Accounting books –
Preapartion of journal and ledger, subsidiary books - Errors and
rectification – Preparation of trial balance and final accounts.

Accounting from incomplete records - Statements of affairs

methods -Conversion method - Preparation of Trading, Profit & Loss
Account and Balance Sheet from incomplete records.

Unit - 3
Financial Statement Analysis - Financial statements - Nature of
financial statements - Limitations of financial statements - Analysis of
interpretation -Types of analysis -- External vs Internal analysis -
Horizontal vs Vertical analysis - Tools of analysis - Trend analysis -
Common size statements -Comparative statements.

Ratio Analysis - Types - Profitability ratios - Turnover ratios -

Liquidity ratios - Proprietary ratios - Market earnings ratios - Factors
affecting efficiency of ratios - How to make effective use of ratio
analysis - Uses and limitation of ratios - Construction of Profit and
Loss Account and Balance Sheet with ratios and relevant figures -
Inter-firm, Intra-firm comparisons.
Unit -4
Fund Flow Statements - Need and meaning - Preparation of
schedule of changes in working capital and the fund flow statement -
Managerial uses and limitation of fund flow statement.

Cash Flow Statement - Need - Meaning - Preparation of cash

flow statement - Managerial uses of cash flow statement - Limitations
– Differences between fund How and cash tlow analysis.

Unit-5
Budgeting and Budgetary Control: Preparation of various types
of budgets - Classification of budgets - Budgetary control system -
Mechanism -Master budget.

Unit-6
Capital Budgeting System - Importance - Methods of capital
expenditure appraisal - Payback period method - ARR method - DCF
methods - NPV and
IRR methods - Their rationale - Capital rationing.
 FINANCIAL AND MANAGEMENT ACCOUNTING

LESSON TITLE
1. Accounting an Introduction
2. Management Accounting
3. Theory Base of Accounting - Accounting Standards
4. Practical Base of Accounting - Origin and Analysis of
Business Transactions
5. Financial Statements of Profit-making Entities
Manufacturing-cum-Trading Organisations
6. Financial Statements of Non-Profit-making Entities
7. Errors Management
8. Accounts from Incomplete Records - Single Entry System
9. Financial Statement Analysis
10. Ratio Analysis
11. Fund Flow Analysis
12. Cash Flow Analysis
13. Budgeting and Budgetary Control
14. Capital Budgeting
15. Case Study
 LESSON - 1

ACCOUNTING: AN INTRODUCTION

Learning outcomes; on completion of this chapter, you should be able

to:

 Explain the nature of accounting.

 Identify the various branches of accounting.
 Explain the process of creation of financial statements and their
interpolation.
 Explain the various objectives of financial statements.
 Identify the various uses of accounting information.

INTRODUCTION
Accounting discipline deals with measurement of economic
activities affecting inflow and outflow of economic resources to develop
useful information for decision making. At household level information
about outflow and inflow of cash resources helps -.0 assess financial
position and plan household activities. At Government level,
information about inflow from taxes (direct as well as indirect) and
expenditure on various activities (developmental and non
developmental) is needed for planning and budgeting. Although
accounting can be discipline has universal applicability, but its
growth is closely associated with the developments in the business
world. Thus to understand accounting as a field of study for universal
application, it is best identified with recording of business transaction
and thereby creating economic information about business enterprises
to facilitate decision making.

NATURE OF ACCOUNTING:

1.2 Accounting
i. is man-made;
ii. has evolved over a period of time;
 iii. is practiced in a social system;
iv. is a systematic exercise;
v. is judgmentat at times;
vi. follows flexible, not a rigid approach;
vii.is essentially a language;
viii. as a language, has a very well defined syntax of its own; and
ix. Communicates financial information for decision making.

Accounting being a man-made system has evolved over a period

of time to provide financial information of business enterprises to
users of accounting information. A large number of groups with varied
interests in affairs of a business enterprise have emerged over a period
of time, especially after emergence of corporate forms of organization
involving separation of ownership management. These user groups
include those who;
 manage the activities of the
enterprise( management)
 own the enterprise( owners/ shareholders)
 extend credit for supply of goods to the enterprises
(creditors)
 buy goods from the enterprises( customers)
 lend money to the enterprises( banks and
financial information)
 are employed in the enterprises (employees)
 intend to make investment in the
enterprises(mvestors)
 are doing research(researchers)
 are engaged in collection of taxes ( sales tax and
income tax
 authorities)
 formulate fiscal and monetary policies
(other Government
 department)
  are members of the public at large(general public)
Internal users of accounting information are inside the
enterprise and need information to control and plan the activities of
the business to manage it effectively. These include Owners in case of
non corporate enterprises and managers and directors in case of
corporate business. Their information needs are satined through
various reports which are generally prepared internal use and remain
unpublished. External users of accounting information are outside the
enterprise. The information need of these user groups are met by
measuring the desired information by following a systematic process.
It results in creation of financial statements which are generally
published to make the information available to external user group for
decision making. The need for communicating relevant and useful
information to that potential internal and external users is always
there and accounting is intended to perform that role.
Thus, accounting may be defined as:

"the process of identifying, measuring and communicating

information to permit judgement and decision by the users"
( American Accounting Association)

BRANCHES OF ACCOUNTING

Financial Accounting:

It primarily concentrates on creation of financial

information for external user groups such as creditors, investors,
lenders and so on. It deals with business events which have already
occurred and is, therefore, historical in nature. Traditionally, the aim
was to develop information about income and financial position on the
basis of events which had taken place during a period of time. Recent
trend in corporate form of organization is to provide information about
cash flows and earnings per sh^e also as part of published financial
statements.

Management Accounting - The information provided by

the financial accounting system is significant but not sufficient for
smooth orderly and efficient conduct of business. Management needs
more information to discharge its function of stewardship, planning,
control and decision-making. As information needs of management
vary from enterprise to enterprise, the grouping and reporting of
information takes different forms. Trie different ways of grouping
information and preparing reports as desired by managers for
discharging their functions are referred to a management accounting.
Management accounting provides information to the management not
only about cost but also revenue, profit, investment etc., for managing
business more efficiently and effectively. A very important component
of management accounting is cost accounting which deals with cost
ascertainment and cost control.

Few other branches of accounting which are of recent

origin are social responsibility accounting and human resources
accounting. The first one involves accounting for social costs incurred
by the enterprise and social benefits created by it while the second
deals with accounting for human resources.

In the present book, we are concerned with financial

accounting only. The word accounting and financial accounting are
used interchangeably.

Financial accounting provides information to external

user groups in the form of published financial statements. As these
users are involved in preparation of financial statements, it is very
essential that the published statements have credibility and regarded
as reliable by external users. Therefore, accounting, as a language for
communicating information, needs to have a strong syntax of its own
for preparing credible financial statements.

The syntax of accounting language comprises of analysis

and recording of business transactions on the basis of double Entry
system of book keeping and the basic principles on which the
practical system is based. The theory base; of accounting consists of
Generally Accepted Accounting Principles (GAAP), Conceptual
framework and Accounting Standards (AS) issued by the professional
accounting bodies all over the world,

The credibility of the financial statements is established

through analysis independent examinations by a chattered
accountant who certifies that the information provided therein gives
true and fair view of the activities of tM business in conformity with
accepted principles and practices. This process of attestation of
account is known as auditing of accounts.

MEANING OF FINANCIAL ACCOUNTING

Measurement of accounting information involves three

basic steps as per the traditional definition of accounting by the
American Institute of Certified Public Accounts (AICPA) which defines
accounting as "the are of recording, classifying and summarizing in a
significant manner and in terms of money, transaction- and events
which are negative part atleast of financial character and interpreting
the results thereof.
On this basis of above information, Accounting or more
precise financial accounting can be basically divided into two parts",
A. Creation of financial information.
B. Use of financial information.

A. Creation of financial information:

Creation of financial information involves three steps:
1. Recording:

The process of creation of financial information starts with the

occurrence of a business transaction which can be Qualified. The
transaction is evidenced by some document such as Sales bill, Pass
book, Salaries slip etc., The systematic record of those transactions is
chronological order (i.e. the order in which they occur ) is made in a
book called JOURNAL BOOK. The four basic questions need to be
addressed while recording namely, what to record, when to record,
how to record and at what value to record?

What to record? Since-accounting is regarded as language of the

business, it should systematically record all the transaction and
events which affect the results of business and ignore the person
transaction of the proprietor. Before recording in the journal book, all
business transaction expressed in terms of money. Consequently
business activities which cannot be expressed in terms of money such
as strikes, changes in the composition of board of directors etc., are
not recorded. Thud decision makers will get informa^on only about
money aspects of the business enterprise from a accounting records.

When to record? Usually business transaction is recorded only when

it has occurred. Thus accounting is basically historical in nature.

How to record? Usually business transaction has two aspects and

both these are recorded by passing analysts entry in an journal book.
This system of recording is called double entry book keeping system.

At what value to record? To record occurrence of an event in journal

book, decision about the value of the transaction is needed.
A number of different valuation bases are used in
accounting in varying degrees and include historical cost, current
cost, realizable value and present value. These valuation based
generally assume significance in case of valuation of assets. Historical
cost refers to amount paid / payable to acquire an asset. The current
cost means the amount that would have to be paid, if the asset is to
be acquired currently. The realizable value refers to the net realizable
value of the assets if it is to be disposed. The present value of an asset
is the present discounted value of the future inflows that analysis item
is expected to generate in the normal course of business.

2. Classifying:

After recording monetary transactions in the journal

book, next step is to classify the recorded information into related
groups to put information in compact and usable forms. For e.g., all
transactions involving cash inflows (receipts) and cash outflows
(payments) can be grouped to develop useful information is called
ledger book. Mechanism used for classification of recorded
information is to open accounts which are called ledger accounts.

3. Summarizing:

Basic aim of accounting is to create financial information in a

form which will be useful to the decision makers. To achieve this end,
accounts containing classified information in the ledger book are
balanced. After balancing of the ledger book, account balances are
listed statement giving names of theses accounts and their balance is
called " TRIAL BALANCE " on the basts of trail balance, summaries
are prepared to give useful information about the financial results
during a time period and the financial position at a point of time.
Reporting of summarizes of the business transaction is done in the
form of financial statements which are known as FINAL ACCOUNTS.
According to international Accounting standard - 1 the term financial
statements covers balance sheet, income statements or profit and loss
accounts, notes and other statements and explanatory material which
are identified as being part of the financial statements. The process of
creation of financial information can be summarized as follows:
 Analysis of Recording Classificati Summariza
business Journal on in ledger tion first in
transaction Book book trial
evidenced balance
by source and then in
document financial
statements

Thus recording, classifying and summarizing are three basic

steps involved in creation of financial statement which ascertain and
communicate result of business entity. For this is assumed that
business and its owner have separate existence. For accounting
purpose, even a division of the business or a branch of it may be
treated as an accounting entity.

B. Use of Financial Information / Statements:

Financial statements prepared by a business enterprise

are published and are available to the decision makers. Sound
division making requires analysis and interpretation of these financial
statements. A very commonly used tool for financial analysis is ratio
analysis. However, there are other tools which are used by the
decision makers to undertake analysis. The widely used tools for
carrying out analysis are :
 Cash flow statement
 Fund flow statement Ratio analysis
 Comparative statement
 Common size statement

However to analyze and interpret these financial

statements, the user shou/d be aware of purpose and nature of these
statements can be described as follows :
"Financial statements are prepared for the purpose of
presenting a periodical review or report on progress by management
and deal with the status of investment in the business and the results
achieved during the period under review. They reflect a combination of
recorded facts, accounting, conventions and personal judgements and
judgements and conventions applied after them materially. The
soundness of the judgement necessarily depends on the competence
and integrity of those who make them and on their adherence to
Generally Accepted Accounting Principles and Conventions. (Bombay
Stock Exchange Official Directory).

OBJECTIVES OF ACCOUNTING

The main objective of accounting are as follows:

 The main records of business: In accounting, systematic record
of monetary aspects of business events are maintained. The first
step in preparation of financial statements. This is referred to as
book-keeping.
 Calculation of profit or loss: To calculate profit earned or losses
suffered during a period of time, a business enterprise prepares
an Income Statement. It is also referred to a trading and profit
and loss account.
 Depiction of financial position: In addition to profit (or loss),
sound decision-making requires information about the financial
position of a busiriess enterprises. To depict financial position of
a business, financial position statement is prepared. On the one
hand, it gives details of resources owned by the business
enterprise. Resource owned are termed as assets. On the other
hand it contains the information about obligations of business.
Obligation of the business towards outsiders and owner are
referred to as liabilities and capital respectively. Financial
position statement is also termed as balance sheet which
provide information about sources of finance (e.g. outside
liability and owners equity) and the resources (eg. assets) of the
business.
  To portiay the liquidity position: Financial reporting should
provide information about how an enterprise obtains and
spends cash, about its borrowing and repayment of borrowing
about its capital transactions, cash dividends and other
distribution of resources by the enterprise to owners and about
other factors that may affect an enterprise's liquidity and
solvency.
 Control over the property and asset of the firm: Accounting
provides up-to-date information about the various assets that
the firm possess and the liabilities the firm owes so that nobody
can claim a payment which is not due to him.
 To file tax returns: This is the objective which really hardly
needs emphasis. The credible accounting records provide the
best bases for filing returns of both, direct as well as indirect
taxes.
 To make financial information available to various groups and
users: Accounting is called the language of business. It aims to
communicate information about financial results and financial
position of a business enterprise to decision makers,

USERS OF ACCOUNTING INFORMATION

Users of accounting information can be grouped as
follows
Owners: Owners refers to a person or group of persons who have
supplied capital for running the business. It refers to individual in
case of joint stock companies. Information needs of shareholders have
assumed great significance in the corporate business world because of
separation of ownership and management in case of joint stock
companies owners are interested in the financial information, to
know"about safety of amount invested and return on amount
invested.
Managers: For managing business profitably information
aboutHnancial result and financial position is needed by management
By providing this information, accounting helps managers in efficient
and smooth running of a business enterprise.

Investors: Prospective investors would like to know about the past

performance of the business enterprise before making investment in
that concern. By analyzingihistorical information provided by
accounting records, they can arrive at a decision about the expected
return and risk involved in investing in particular business enterprise.

Creditors and Financial Institutions: Whosoever is extending credit

or loan to a business'enterprise, would like to have information about
its repaying capacity, creditworthiness etc., The required information
can be obtained by analyzing and interpreting the financial
statements of the business enterprise.

Employees: Employees are concerned about job security and future

prospectus. Both of thpse are intimately related with the performance
of the business enterprise, Thus by analyzing financial statements
they can draw conclusions about their job security and future
prospectus.

Government: Government policies relating to taxation, providing

subsidies etc., are guided by the relevance of the industry in the
economic development of the country and the past performance of the
industry. Information about the past performance is provided by the
accounting system, collection of taxes is also based on accounting
records.

Researchers: Researchers need financial information for testing

hypothesis and development of theories and models. The financial
statement provides the recorded information.
Customers: (Customers who have developed loyalties to a business
are ceitainly interested in the continuance of the business. They
certainly want to know about the future directions of the enterprise
with which they are associating themselves. The way to information
about the enterprise is through their financial statements.

Public: An enterprise affects the public at large in many ways such as

provider of the employment to a number of persons being a customer
to many supplier a provider of amenities on the locality, a cause of
concern to the public due to pollution etc., Hence public at large is
interested in knowing the future directions of the enterprise and the
only window to peep inside the enterprise is their financial
statements.

ACCOUNTING AND THEIR DISCIPLINES:

Accounting is the best understood when the other related
disciplines are conceptually clear to the user. For e.g., a user can
hardly understand financial statements with lots of tables and graphs
in it. He is not comfortable with the basics of mathematics and
statistics. Accounting is very intimately connected with many
disciplines more important of which are economics, law, management,
statistics and mathematics.

Linkage with Economics:

Accounting has strong linkages with economics. It has acquired

its most important concepts of income and capital from economics.
The accountant as well as economist agree that capital should be
maintained intact while calculating income and this income can be
distributed without affecting capital. However, the interpretation of
the two concepts by accountant and economist differ a great deal
despite similarities. The capital to an economist is like a tree and
income is like a fruit on that tree. In technical terms, a stock of wealth
(Tree) or assets existing at a point of time is called capital whereas
flow of benefits from the wealth through a given periodvs called
income. Hence capital and wealth are synonyms for the economist.
The methodology adopted by economist is finding income is to find out
the excess of capital at the end of the year over the beginning of the
year. If the capital increases, it is more income. However as the capital
decreases it is called loss. To arrive at the value of the capital or
wealth, the present value of the future benefits is calculated by
discounting expected benefits at the required rate of return. Hence to
find out the worth of an asset, the economist will have to estimate the
life of the asset and the likely benefits to be desired from it. The
benefits will be discounted at the requires rate of return of the asset
has an exceptionally long life. Hence economists valuation of capital
and income are highly subjective.

Accountant tries to impart practicability to the concept of

capital and income. Recognizing that future benefits of an asset with
long life of say 100 years are difficult to estimate, the accountant puts
a value of the asset at which it was acquired. However, his attitude is
quite flexible and makes use of other bases of measurement wherever
the need arises. The income of business belongs to a owner. The
accountant finds income as a direct result of matching of revenue and
expense of the same period. It is always calculated at the end of a
period. The matching of revenues and expense can be done on
different basis viz accrual, cash and hybrid bases. The bases are
discussed in detail later:

Linkage with Mathematics:

Accounting is all about figures and operations on these

figures. The basic system of accounting can be very conveniently
converted in the mathematical form in the form of an accounting
equation. Simple mathematical operations involved in accounting are
addition, subtraction, multiplication and division. Besides many
aspects of accounting involve calculations which involve strong
knowledge of mathematics. For e.g., calculation of interest, calculation
of the annuity needed to depreciate an asset with a defined rate of
interest over its estimated useful life, bifurcation of a hire purchase
instalment in cash price component and interest component etc.,

Linkages with Statistics:

Accounting is not only about the preparation of accounting

information, it also involves the presentation and interpretation of
accounting information. The presentation aspects involved creation of
tables and graphs etc., the knowledge of which essentially lies in the
discipline of statistics. One of the most debated topic of accounting
namely inflation accounting involves extensive conversation of
historical accounting information with the help of price indices, 'an
important constituent of the discipline of statistics. The interpretation
of accounting information involves making absolute and relative
comparison with the help of ratio analysis. The knowledge of statistics
is needed for the purpose. An important way of calculating interest is
through the concept of average due date, which is based on the
knowledge of averages.

Linkages with Law:

Accounting essentially operates within a legal

environment. Many business organizations are governed by their
respective statues which prescribe the many aspects of their
accounting information including the presentation of information. For
e.g., the Indian Companies Activities, 1956 prescribes the rules for
managerial remuneration. It also prescribes the format of balance
sheet as well as profit and loss account, The banking, insurance and
electricity companies have also to prepare their accounts as per the
requirement of the respective statutes governing them.
 LESSON - 2

MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ACCOUNTING

The accounting activity can be classified into two parts.
Financial Accounting and Management Accounting. Though both of
them are interlinked, Management accounting is future oriented,
dynamic and is made to be decisive and control relevant.
International Federation of Accountants (IFAC) defined
Management Accounting process as "the process of identification,
measurement, accumulation, analysis, preparation, interpretation and
communication of information both financial and operating used by
management to plan, evaluate and controJ within an organisation and
to assure use of and accountability for its resources".
ICWAI published Glossary of Management Accounting terms
defining Management Accounting as "a system of collection and
presentation of relevant economic information relating to an enterprise
for planning, coordinating and decision making",
Management Accounting : Official Terminology of CIMA is defined
Management Accounting as "the provision of information required by
management for such purposes as:
1. Formulation of policies
2. Planning and controlling the activities of the enterprise
3. Decision taking on alternative course of action
4. Disc losure to those external to the entity (shareholders and
others)
5. Disclosure to employees
6. Safeguarding assets

The assets involves participation in management to ensure that there

is effective:
  Formulation of plans to meet objectives (long-term
planning)
 Formulation of short-term operation plans
(budgeting/ profit making)".

American Accounting Association defines Management

Accounting as "the application of appropriate techniques and concepts
in processing historical and projected economic data of an entity to
assist management in establishing plans for reasonable economic
objectives and in the making of rational decisions with a view towards
these objectives".
Richard M.S. Wilson and Wai Fong Chua define Managerial
Accounting as "Managerial Accounting encompasses techniques and
processes that are intended to provide financial and non-financial
information to people within an organisation to make better decisions
and thereby achieve organisational control and enhance
organisational effectiveness"

The Management Accounting is used by management to plan

the activity, evaluate performance, ensure integrity of financial
information and to irnplement the system of reporting that is linked to
organisational responsibilities and contributes to the effective
performance measurement. The definition of Management Accounting
embraces all functions undertaken by accountants in an organisation.
Management Accounting needs to be dynamic and forward looking. It
also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory
agencies and tax authorities. The role of Management Accountant is
not determined by an isolated concept. It is determined by the
requirements of business as Expressed in its structures.
SCOPE OF MANAGEMENT ACCOUNTING
Management Accounting includes Financial Accounting and
extends to the operation of a system of cost accounting and financial
management. While meeting the legal and conventional requirements
regarding the presentation of financial statements (profit and loss
account, balance sheet and funds flow statements) it stresses upon
the establishment and operation of internal controls. The scope of
Management Accounting, inter alia, includes:
 Formation, installation and operation of accounting, cost
accounting, tax accounting and information systems.
Management Accountant has to
 construct and re-construct these systems to meet the changing
needs of management functions
 The compilation and preservation of vital data for management
planning. The account and document files are respository of
vast quantities of details about the past progress of the
enterprise, without which forecasts of the future is very difficult
for the enterprise. The Management Accountant presents the
past data in such a way as to reflect the trends of evbnts to the
management.

 Providing means of communicating management plans to the

various levels of organisation. This, on the one hand, ensures
the coordination of various segments of the enterprise plans and
on the other defines the role of individual segments in the whole
plan and assists the management in directing their activities.

 Providing and installing an effective system of feedback reports.

This would enable the management in its controlling function.
By pinpointing the significant deviations between actual and
expected activities, and by adhering to the principles of
selectivity and relevance, such reports help in jthe installation
and operation of the system of 'Management by Exception'. The
 Management Accounting is expected to analyse the deviation by
reasons and responsibility and to suggest appropriate corrective
measures in deserving cases.

 Analysing and interpreting accounting and other data to make it

understandable and usable to the management. It is only
through such analysis and clarification that the management is
enabled to place the various data and figures in proper
perspective in the performance of its functions. Such analysis
assists management- in the location of responsibilities and to
effect necessary changes in the organisational setup to achieve
the objectives of the enterprise in a more efficient manner.

 Assisting management in decision making by (i) providing

relevant accounting and other data and (ii) analysing the effect
of alternative proposals on the profits and position of the
enterprise. Management Accountant helps the management in
proper understanding and analysis of the problem in hand and
presentation of factual information obviously in financial terms.

 Providing methods and techniques for evaluating the

performance of the management in the light of the objectives of
the enterprise, thus assisting in the jrnpiementation of the
principle 'Management by Objectives'.

 Improving, modifying and sharpening the effectiveness of the

existing techniques of analysis. The Management Accountant
would always think of increasing the practicability of existing
techniques. He should be on the look-out of the development of
new techniques as well.

Thus, Management Accounting serves not only as a tool in the

hands of management, but also provides for a technique evaluating
the performance of its functions of planning/decision making and
control, and at the same time, enabling the owners and other
interested parties to evaluate and appraise the management of the
enterprise.

FUNCTIONS OF MANAGEMENT ACCOUNTING

Management Accountant is one of the best assets for

management. His contribution has been growing with passage of time.
He will continue to deliver the goods in a magnificent manner in
future with varied experiences. Scope is expanding and managements
of various sectors are benefiting. Excerpts from the "Preface to
Statements on International Management Accounting" issued oy the
international Federation of Accountants in February 1987 are
reproduced below:
"Management Accounting is used by management to;
Plan - to gain an understanding, to expected business
transactions and other economic events and their impact on the
organisation, and to use this understanding as a basis for a
course of action to be followed by the organisation in the future;

Evaluate - to judge the implications of various past and/or

future events;

Control - to ensure the integrity of financial information

concerning an organisation's activities or its resources;

Assure accountability - to implement the system of reporting

that is closely aligned to organisational responsibilities and that
contributes to the effective measurement of management
performance"
The functions of Management Accounting can be broadly classified
into;
(a) Periodic interval accounting reports, and
(b) Ad hoc analysis of data decision making.

It is increasingly felt that Management Accountants should

involve themselves more and more in decision making and problem
solving of organisations. The areas of decision making and problem
solving are dealt in the following paras:
 Strategic Management Accounting: This function helps the
organisation prepare long-term plans, formulate corporate
strategy and forecast and evaluate the competitors.
 Investment Appraisal: This activity includes the (i) appraisal of
long-term investment (ii) funding of accepted programmes
projects, and (iii) post-audit of accepted programmes.
 Financial Management: It deals with raising of funds for
investment, managing surplus funds, controlling working
capital etc,
 Short-term ad hoc decisions: This includes analysing data for
taking decisions c i pricing, product introduction, acceptance of
special orders etc.
 Managing the organisation of information system: This includes
not only organising the enterprise's financial data but fulfilling
the information needs of all the segments of the organisation.

FUNCTIONS OF MANAGEMENT ACCOUNTANT

The term 'Management Accountant' has many Director,
Financial Director, Financial Controller, Finance Comptroller etc., are
some of the terms used to designate with the work Management
Accounting. Depending situation, size, nature arid organisational
setup and his position in the company, the Management Accountant
may be required to perform various and varied functions. The
importance and effectiveness of his function would also depend upon
the confidence reposed in him by the top management and the
functional managers. His functions generally embrace each and every
activity of the management. The essence of Management Accountant's
functions are as follows:

 The Management Accountant will establish, coordinate and :

administer plans to facilitate the forecasting of sales, expense
budgets and cost standards that will permit profit planning,
capital budgeting and financing.
 The Management Accountant will formulate accounting policy
and procedures. Operating data and special reports must be
prepared so that the performance can be compared with plans
and standards, and any variance between actual operations and
pre-determined standards can be analysed for corrective actions
by management Such comparisons between actual and
expected activities should help the management in proper
fixation of responsibility and also in evaluation of various
functional and divisional heads.
 The Management Accountant will be responsible for the
protection of business assets to the extent possible by external
controls and internal auditing and insurance coverage.
 The Management Accountant will be responsible for tax policies
and procedures and will supervise and coordinate the reports
required by various authorities. ;
 The Management Accountant must continually £e aware of
economic and social forces as well as the effect of the
Government policies and actions on business activities.

An analysis of the above list (obviously not exhaustive) o

functions, reflects the status of a Management Accountant. He is the
principal office in-charge of the accounts of the company. He shall be
responsible to the Board of Directors for the maintenance of adequate
accounting procedures and records on the operation of business. He
shall be responsible to the President or the Chairman of the Board or
the Board of Directors. Thus, in his broad functional activities, the
Management Accountant is responsible to the policy making group of
top management, whereas, in his administrative activities he ss
responsible to the top executive offer.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING

The financial accounting classifies and records an entity's

transactions normally in money terms, in accordance with established
concepts, principles, accounting standards and legal requirements. It
aims to present a 'true and fair view' jof the overall results of those
transactions. Management Accounting has been described as a
continuous process of analysis, planning and control in the context of
providing decision support for decision makers. Management
Accounting is more concerned with decision making and a key role for
Management Accountant is acting as a provider of financial
information to support these decisions, There are several differences
between Financial Accounting and Management Accounting as are set
out in Table 1.1.

Financial Accounting and Management Accounting both appear to be

similar inasmdch as both study the impact of business transactions
and events of the enterprise, reports and interpret the results thereof.
Both provide information for internals as well as external use. But
Management Accounting although having its roots in Financial
Accounting differs from the latter in following respects:

 Financial Accounting studies the business transactions and

events for the enterprise as a whole. It does not trace the path of
events with in the enterprise. Management Accounting, in
additions to the study of the events in relation to the enterprise
as a whole, takes organisation in its various units and segments
 and attempts to trace the impact and effect of the business
transactions and events through these various divisions and
sub-divisions. Thus, while the financial statements -profit and
loss account, balance sheet and flow statements reveal the
overall performance and position of the enterprise. Management
Accounting reports emphasis on the details of operational costs,
inventories, products, processes and jobs. It traces the effect
and impact of the business transactions and events on costs,
inventories, processes, jobs and products.
 Financial Accounting is more attached with reporting the
results and positions of business to persons and authorities
other than management-Government, Creditors, Investors,
Owners, etc. At times, Financial Accounting follows window-
dressing tactics in order to project a better than actual image of
the enterprise. Management Accounting is concerned more with
generating information for the use of internal management and
hence the information reflects the real or really expected
position.

 Financial Accounting is necessarily historical. It records and

analyses business events long after they have taken place.
Management Accounting analyses the events as they take place
and also anticipates such events for the future. Thus, it uses
data which generally has relevance to the future.

 Since Financial Accounting data is historical in nature, it is

more precise than the Management Accounting data, which
generally reflects Ihe expected future, and hence could only be
an estimation. This provides the necessary rapidly to
Management Accounting information.

 The periodicity in reporting financial accounts is much wider

than in case of Management Accounting. In Financial
 Accounting, generally, results are reported on year to year basis.
In Management Accounting is free to formulate its own rules,
procedures and forms because the information generates is
solely for internal consumption.

 Financial Accounting has to governed by the 'generally accepted

principles'. This is so because, it has to cater for the
informational needs of the outsiders and legal provisions.
Management Accounting is free to formulate its own rules,
procedures and forms because the information it generates is
solely for internal consumption.

 Financial Statements prepared under Financial Accounting

consists 'of monetary information only. Management Accounting
statements, in addition to monetary information, also consists
non-monetary information viz., quantities of materials
consumed, number of workers, quantities produced and sold
and so on.

TABLE 1.1: MANAGEMENT ACCOUNTING vs. FINANCIAL

ACCOUNTING
Nature Fianacial Accounting Management
Accoutning
1. Governed by Company law etc. Needs of managers

2. Basic functions Transaction Decision support

recording, Provision of
Publication of Management
3. Users external financial information
statements Internal
External
4. Availibility Publicly available Confidential
5. Time focus Past and present Present and future
6. Period Usually one year As appropriate
7. Main emphasis Explanation Planning and control
8. Speed of Slow but detailed and Fast but approximate
prepartion
accurate
9. Form of whole of entity Segmented to control
presentations
units
10. Style and Standardized Tailored to
details
requirement and
Objective, verifiable summarized
11. Criteria
and consistent Relevant, useful and
Money understandable
12. Unit of
Somewhat technical Money physical units
account
For use by non-
13. Nature of
accountants
data
 LESSON - 3
THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS

Accounting is "the process of identifying, measuring and

communicating information to permit judgement and decisions by the
users of accounts" -American Accounting Association. It is absolutely
necessary that accounting information contained in financial
statements are credible and are regarded as reliable by the different
user groups to be consistent. Preparation of financial statements on
uniform and consistent basis improves their comparability and
credibility. It has two aspects, namely,
 The financial statements of an enterprise for different
accounting years are based on similar accounting procedures
and policies so that meaningful comparisons over a period of
time can be made1 about he progress of the enterprise. This is
commonly referred to as 'Time series analysis’.

 The financial statements of many enterprises at a point of

time are based on similar accounting procedures and policies
so that conclusions can be drawn about their relative
performance at a point of time. It is known as 'Cross-sectional
analysis'. ,

It is the function of 'Accounting Standards' -to provide a rational

structural framework so that credible financial statements of the
highest quality can be produced. According to T.P. Ghosh accounting
standards are defined as under’.

“Accounting standards are the policy documents issued by the

recognised
expert accountancy body relating to various aspects of
measurement,
 treatment and disclosure of accounting transactions and
events”

It is clear from the above definition that accounting standards

provide a
framework for the preparation of the financial statements. They also
draw the boundaries within which acceptable conduct lies. In the
absence of accounting standards, many alternatives will exist and will
give the accountant the| leverage to colour'his accounting records the
way he likes. Such 'Creative Accounting Practices’ will certainly
create financial statements which are unreliable and lower the
confidence of user in the reported results. Hence the need for a
coherent pet of accounting standards is imperative. The efficient
functioning of the financial system depends upon the confidence that
user groups have in the fairness and reliability of the financial
statements of the businesses ana it is the function of accounting
standards to create this genera) sense of confidence by providing; a
structural framework within which credible financial statements can
be produced. The whole idea of ‘Accounting Standards’ is centred
around harmonisation in the accounting policies and practices
followed by businesses. The basic purpose of 'Accounting Standards'
is to standardize the diverse accounting practices followed for
many aspects of accounting. The harmonisation of accounting
policies and practices is needed at national level as well as
international level. To tackle the problem at national level, the
Institute of Chartered Accountants of" India issues accounting
standards (called AS's) formulated by the Accounting Standards Board
(ASB). At international level, International Accounting Standards
Committee (IASC) issues International Accounting Standards (called
lAS's). The objective of the IASC in terms of standard setting is "to
work generally for the improvement and harmonisation of regulations,
accounting standards and procedures relating to the presentation of
financial statements'. The Institute of Chartered Accountants of India
is a member of IASC and has a tacit understanding with the IASC that
it would adopt the accounting standards issued by IASC after due
recognition of the conditions and practices prevailing in India. At the
international level, IASC has issued 32 international accounting
standards. At the national level, ICAI has issued 15 accounting
standards on various issues of accounting and a preliminary draft
of a proposed accounting standard on borrowing costs is being made
by the ASB in addition to the revision contemplated in existing
standards on valuation of inventories and accounting for construction
contracts.

ACCOUNTING STANDARDS (N INDIA

The Institute of Chartered Accountants of India, fully
recognising the need cf harmonizing the diverse accounting policies
and practices established 'Accounting Standards Board' on 21 st April,
1977 so that accounting as a language could develop along the right
lines. Accounting Standard Board's (ASB) main function is to
formulate accounting standards to be issued under the authority of
the council of the institute. Accounting standards provide rules and
criteria of accounting measurement. However the rules' criteria are
intended lo be used if: a sociai system and hence are never intended lo
be rigid as in case of physical sciences.

Constitution of ASB :
The consistitution of ASB gives adequate representation to all
interested parties and, at present, it consists of members of the
council and representatives to industry, banks, Company Law Board,
Central Board of Direct Taxes and the Comptroller and Auditor
General of India, Security Exchange Board of India etc,

Functions of ASB :
The main function of ASB is to fomralate accounting standards. While
formulating accounting standards, ASB takes into consideration the
applicable laws, customs, usage and business environment. The
Institute is the member of International Accounting Standards
Committee (IASC) and has agreed to support the objectives of IASC.
While formulating standards, it gives due consideration to the
International Accounting Standards (IAS) issued by IASC and tries to
integrate them, to the extent possible, in the light of conditions and
practices prevailing in India. It also reviews the accounting standards
at periodical intervals.

FORMULATION OF ACCOUNTING STANDARDS

The following points need to be kept in mind while drafting accounting
standards, namely -
 The accounting standards issued are in conformity with the
provisions of the applicable laws, customs, usage and business
environment of our country;

 The accounting standards are in the nature of laws but not

laws. Though every possible care is taken while drafting
standards that they are in conformity with eh applicable laws,
still the conflict between the law and an accounting standard
might arise due to amendments in the law subsequent to the
issuance of the accounting standard. As clarified in the
'Statements of Accounting Standards', accounting standards
cannot and do not override the statute and in all such cases of
conflicts, the provisions of the law will prevail and the financial
statements should be prepared in conformity with the relevant
laws Obviously, to that extent, the accounting standards shall
not be applicable. However, "the institute will determine the
extenl of disclosure to be made in financial statements and the
related auditor's reports. Such disclosure may be by way of
appropriate notes explaining the treatment of particular items.
Such explanatory notes will be only in the nature of clarification
 and therefore, need not be treated as adverse comments on the
related financial statements"

 The accounting standards are intended to apply only to items

which are material and become applicable from the date as
specified by the institute. They are applicable to all classes of
enterprise unless otherwise stated. No standard is applicable
retroactively, unless otherwise stated;

 The accounting standards are to address the basic mattes, to

the extent possible. The idea is to confine them to essentials
only and not to make them complex.

The ASB has drawn an elaborate procedure for formulating

accounting standards. However, it needs to be emphasised that the
standards are issued under the authority of the council of the
institute. The procedure involves the following steps:

a) Firstly, the ASB determines the broad areas in which

accounting standards need to be formulated;

b) Secondly, the ASB takes the assistance of the various study

groups to formulate standards The preliminary drafts of the
standards are prepared by the Study groups which take 'up
the specific subjects assigned to them. The draft prepared
by a Study Group is considered by ASB and sent to various
outside bodies like FICCI, ASSOCHAM, SCOPE, CLB, C&AG,
ICWAI, ICSI, CBDT etc. and the representative of these bodies
are also invited at a meeting of ASB for discussion.

c) Thirdly, after taking into consideration their views, the draft of

the standard is issued as exposure draft for soliciting
comments from members of the institute and public at large.
 The draft is issued to a large number of institutions and is
published in the journal of the institute. The exposure draft
includes the following basic points:

 A statement of concepts and fundamental accounting

principles relating to the standard;
 Definitions of the terms used in the standard;
 The manner in which the accounting principles have been
applied for formulating the standard;
 The presentation and disclosure requirements in
complying with the standard;
 Class of enterprises to which the standard will apply,
 Date from which the standard will be effective.

d) Fourthly, the comments on the exposure draft are then

considered by the ASB and a final draft is prepared and
submitted to the council of the institute;

e) Lastly, the council of the institute considers the final draft of the
proposed standard, and if found necessary, modifies the same
in consultation with ASB. The accounting standard on the
relevant subject is then issued under the authority of the
council.

NATURE OF ACCOUNTING STANDARDS

The accounting standards issued by the ICAI-are

recommendatory in nature in the initial years. During the period a
standard is recommendatory, it is expected that the accounting
practices shall be brought in line with the standard. In other words,
the recommendatory period is allowed to smoothen the process of
transition so that no enterprise should have difficulty in conforming to
the accounting standards once they are made mandatory. Once an
accounting standard is made mandatory, it is applicable to all
enterprises whose accounts are audited by the members.
During the period an accounting standard is recommendatory,
tne auditors of companies are required to recommend and persuade
their cfients to comply with the requirements of the accounting
standard even though it is recommendatory in nature. Regarding the
mandatory standards, it is the duty of the auditors to ensure that the
accounting standards are followed in the preparation and presentation
of the financial statements. If the mandatory accounting standards
have not beer, complied with, the auditor is required to make
adequate disclosure in his report so that the users of financial
statements are aware of the non-compliance on the part of the
enterprise. If a member fails to do so, the Chartered Accountants Act
explicitly provides that “a chartered accountant in practice will be
deemed to be guilty of professional misconduct if he ails to invite
attention to any material departure from the generally accepted
procedure of audit applicable to the circumstances”

It is amply clear that standards on their own have no legal

backing and hence, are not enforceable on the public at large. Hence
the institute depends on is members for implementation of accounting
standards issued by it through their attest function. To make it
effective, following steps are needed:

 Self-regulation on the part of the business organisation so that I

hey adhere to these standards while finalising their accounts;

 Legal backing to the accounting standards. The standards as

they are issued not have no legal backing and institute depends
on its memters for their implementation through their attest
function;
  Publicising the use of accounting standards and making the
user: of accounting information more informed about their right
of getting a more true and fair picture of the results of business
based on these accounting standards;

 To avoid duplication of authority. If more than one authority

issues standards, it is bound to create a confusion in the mind
of the user as to which standard needs to be followed. A recent
development, worthy of attention, is the establishment of two
accounting standards by the government under the Income Tax
Act, 1961 which are to be followed in the preparation of
financial statements in case the assessee prefers mercantile
basis accounting, (Accounting Standard I 'relating to disclosure
of accounting policies and Accounting Standard II relating to
disclosure of prior period and extraordinary items and changes
in accounting policies).

To conclude, the Institute and its members are duty bound to

formulate and implement accounting standards to provide objective
and reliable accounting data that would satisfy the information
requirements of the users To achieve this, problem of duality of
authority should be tackled and the system of dual accounting
standards in view of its expertise in the field. To improve their
effectiveness, it is also suggested that the standards should be given a
legal backing with strong punishment for the erring business
organisations. At the same time, to make a genuine case for
recognition of accounting standards and to prevent abuse of financial
statements, more credibility should be provided to the process of
standard setting.

ACCOUNTING STANDARDS ISSUED BY THE INSTITUTE

AS-1 Disclosure of Accounting Policies :
 The standard defines 'Accounting Policies' as referring to the
specific accounting principles and the methods of applying those
principles adopted by the enterprise in the preparation and
presentation of financial statements. It recommends the disclosure of
significant accounting policies adopted in the preparation and
presentation of financial statements in a manner that should form
part of the financial statements. It also recommends that he
disclosure should normally be at one place. Any change in the
accounting policies which has a material effect in the current period
or which is reasonably expected to have material effect in later pe\jods
should be disclosed. It also emphasises that the disclosure of
compliance with fundamental accounting assumption of Going
Concern, Consistency and Accrual is not needed. However, if they are
not followed, the fact must be disclosed.

AS-2 Valuation of Inventories :

The inventories should be normally valued at 'Lower of Cost or

Market' where market value means net realizable value. The historical
cost of inventory can be ascertained by use of 'FIFO', 'Average Cost', of
'LIFO' formulae. When organization have different items in inventory,
each item may be dealt with separately, or similar items may be dealt
with as a group.

The historical cost of manufactured inventories may be arrived

on the basis of either direct costing or absorption costing. Where
absorption costing is used, the fixed costs should be based on the
normal level of production. Overheads other than production
overheads should be included as part of the inventory' cost only 10
the extent that they clearly relate to putting the inventories in their
present location and condition.

The accounting policy in respect of inventories should be

properly disclosed and any change in it which has a material effect in
the current accounting period or which is reasonably expected to have
material effect in later periods should be disclosed. The amount by
which an item in the financial statements is affected by such change
should also be disclosed to the extent ascertainabfe. Where such
amount is not ascertainable, wholly or in part, the fact should be
indicated.

The 'Specific Identification Method', 'Adjusted Selling Price

Method', 'Standard Cost Method' and 'Base Stock Method' are to be
used in specific circumstances. However, if base stock method is
used, the difference between the value at which it is carried and the
value by applying the method at which stock in excess of the base
stock is valued should be disclosed.

AS-3 Changes in Financial Position :

A statement of changes in financial position should be

published along with its published accounts. Such a statement should
be prepared and presented for the period covered by the profit and
loss account and for the corresponding period. It may be prepare on
working capital basis or cash basis. It emphasises that the funds
provided from operation and used in the operation be shown
separately and the form of statement should be most informative in
the circumstances. However, the standard is no longer vaJid as it has
been superseded by new standard AS-3 (Revised) ‘Cash Flow
Statement’ issued in March, 1997.
AS-3 (Revised) Cash Flow Statement:

The cash flow statement should report cash flows coring the
period classified by operating, investing and financing activities. An
enterprise should report cash Hows from operating activities using
either (a) direct method; or (b) indirect method. The inflow and outflow
from the investing and financing activities should be shown
separately. Investing and financing transactions that do not require
the use of the cash or cash equivalents and should present a
reconciliation of the amounts in its cash flow statement with the
equivalent items reported in the balance sheet. The enterprise should
also disclose the amount of significant cash and cash equivalents
balances that are not available for use by it.

AS-4 (Revised) Contingencies and Events Occurring after the

Balance Sheet Date :
A contingency is a condition or situation, the ultimate outcome
of which, gam or loss, will be known or determined only on the
occurrence, or non-occurrence, of one or more uncertain events. A
contingent loss should be recognised if (a) it is probable that future
events will confirm that ari asset has been impaired or a liability has
been incurred on the balance sheet date^ and (b) a reasonable
estimate of the amount of the resulting loss can be made. A
contingent gain should not be recognised. If either of the two
conditions mentioned above are not met, a disclosure should be made
of the existence of the contingency specifying:
 the nature of the contingency;
 the uncertainties which may affect the future outcome; :
 an estimate of the financial effect, or a statement that such ail
estimate cannot be made.
 Assets and liabilities should be adjusted for events occurring
after balance sheet date that provide additional evidence to assist the
estimation of the amounts relating to conditions existing at the
balance sheet date (for: example, insolvency of a debtor subsequent to
finalisation of financial statements) or that indicate that the
fundamental accounting assumption of going concern is not
appropriate. Dividends, proposed (or declared) by the enterprise: after
the balance sheet date but before approval of the financial statements,
and pertaining to the period covered by financial statement, should be
adjusted. Adjustments to assets and liabilities are not appropriate for
events occurring after the balance sheet date, if such events do not
relate to conditions existing at the balance sheet date (for example,
decline in market value of the investment). Disclosure should be made
in the report of the approving authority of those events occurring after
the balance sheet date that represent material changes and
commitments affecting the financial position of the enterprise
specifying:

 the nature of the event; I

 an estimate of the financial effect, or a statement that such an
estimate cannot be made.

AS-5 (Revised) Net Profit or Loss for the Period, Prior hems and
Changes in Accounting Policies :

The objective of this standard is to prescribe the classification and

disclosure of certain items in the statement of profit and loss so that
all enterprises prepare and present their financial statements on a
uniform basis to improve 'their comparability. It explains that profit or
loss of a period comprises of ordinary activities, extraordinary
activities and prior period items and all three need to be disclosed
separately. It also includes the impact of change in accounting
estimates and change in accounting policies.

Ordinary activities are any activities which are undertaken by

an enterprise as part of its business and such related activities in
which the enterprise engages in furtherance of, incidental to, or
arising from, these activities. Extraordinary items are incomes or
expenses that arise from events or transactions that are clearly
distinct from the ordinary activities of the enterprise and, therefore,
are not expected to recur frequently or regularly. Prior period items
are'income or expenses which arise in the current period as a result of
errors or omissions in the preparation of the financial statements of
the one or more prior periods. The net profit or loss for the period
comprises the following components, each of which should be
disclosed on the face of the statement of profit and loss;
 profit or loss from ordinary activities; and
 extraordinary items.

Prior period items are normally included in the determination of

net profit or loss for the current period. An alternative approach is to
how such items in the statement of profit and loss after determination
of current net profit or loss. The second approach seems better
because that will help ascertain the result of current period unaffected
by the mistakes of the past, in either case, the objective is to indicate
the effect of such items on the current profit or loss.

Change in Accounting Estimates Vs. Change in Accounting

Policies:
A distinction should always be made between change in accounting
estimates and changes in accounting policies. When it is difficult to
distinguish between the change in accounting estimate and change in
accounting policies, it should be regarded as change in accounting
estimate, with appropriate disclosure in the periods of change, which
may be current period only or current period as well as future periods.
The effect of change in an accounting estimate should be classified as
ordinary or extraordinary depending upon whether the original
estimate was regarded as ordinary or extraordinary item. However, the
revision of estimate, by its nature, cannot be called extraordinary or
prior period item. When change in accounting estimate/ change in
accounting policy takes place which has a material effect, its nature
and amount should be disclosed. If the effect is not ascertainable, the
fact should be disclosed in the financial statement.

AS-6 (Revised) Depreciation Accounting :

The depreciable amount of an asset comprising of its historical

cost, or other amount substituted for historical cost in the financial
statements, less the estimated realizable value should be allocated on
a systematic basis to each accounting period during the useful life of
the asset. The historical cost may undergo revision arising as a result
of increase or decrease in long term liability on account of exchange
rate fluctuations, price adjustments, changes in duties or similar
factors. The useful life of the asset may itself be subjected to revision,
in which case, the unamortised balance of the asset be depreciated
over its remaining life. Any addition or extension to an existing asset
should be depreciated along with the original asset, unless the
extension has a separate identity, in which case it should be
depreciated on the basis of an estimate of its own life. Where
depreciable asses are disposed of, discarded, demolished or destroyed,
the net surplus or deficiency, if material, is disclosed separately. The
change of method, if warranted, should be done with retrospective
effect from the date of asset coming to use. In case of revaluation of
asset, the revalued amount should be amortised over the remaining
useful life of the asset. The information to be included in the financial
statements should comprise of historical cost or any substituted
amount, total depreciation for the period in respect of each class of
asset and related accumulated depreciation. The following information
should be disclosed in the financial statements along with disclosure
of other accounting policies:

 depreciation methods used; and

 depreciation rates or the useful lives of the asset, if they are
different from the principal rates specified in the statute
governing the enterprise.

AS-7 Accounting for Construction Contracts :

The standard deals with the problem of allocation of revenues

and related costs to the accounting periods over the duration of the
contract. The long term construction contracts could be fixed price
contracts where contractor agrees to a fixed contract price or cost plus
contracts where the contractor is reimbursed for allowable or
otherwise defined costs, and is also allowed a percentage of these
costs or a fixed fees. Both these contracts can be accounted by either
percentage of completion method or completed contract method.
Under percentage of completion method, the amount of revenue
recognised is determined with reference to the stage of completion of
the contract activity at the end of each accounting period. The
completed contract method is based on results as determined when
the contract is completed or substantially completed.

Profit in the case of fixed price contract should be recognised

when the work has progressed to a reasonable extent- say 25 or 30%.
While recognising profit under percentage of completion method, the
appropriate allowance for future unforeseeable facts should be made
on either a specific or percentage basis. A foreseeable loss on entire
contract should always be provided for in the financial statements
irrespective of the amount of work done and the method of accounting
followed. Disclosure of changes in accounting policy used for
construction contracts should be made in the financial statements
giving the effect of the change and its amount.

AS-8 Accounting for Research and Development:

The prescribed research and development costs outlined in para

7 of Hie standard relating to a business should be charged to the
revenues of the period in which they are incurred unless the criteria
mentioned in para 9 of the standard are met, in which case, the
charging of these expenses can be deferred to future accounting
periods. The research and development costs, once written off, arc
never reinstated in accounts. The deferred research and development
cost should be allocated on a systematic basis to future accounting
periods by reference to either to the sale or use of the product or
process or to the time period over which the product or process is
expected to be sold or unused. If at any point of time, criteria for
deferral as detailed in para 9 are not met, the unamortised balance of
research and development expenditure should be charged to the profit
and loss account. When the criteria for deferral continue to be met but
the amount of the deferred research and development costs and other
relevant costs exceed the expected filture revenues/ benefits related
thereto, such expenses should be charged as an expense immediately.
The amount charged to profit and loss account should be explicitly
disclosed and unamortised research and development costs should be
shown in the balance sheet under the head "Miscellaneous
Expenditure". ,

AS-9 Revenue Recognition :

The standard mainly deals with the timing of revenue. Revenue

is defined as "gross inflow of cash, receivable or other consideration
arising in the course of ordinary activities of an enterprise from the
sale of goods, from the rendering of services, and from the use by
others of enterprise resources yielding interest, royalties and
dividends. The revenue is recognised in case of sale when:


the seller of goods has transferred the property in goods tci the
buyer along with significant risks and rewards of the ownership
;
and seller has no effective control over goods transferred;


no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale.

The revenue from rendering of services is recognised either

under completed service method or proportionate completion method.
Completed service method is a method of accounting which recognises
revenue in the statement of profit and loss only when the rendering of
services under a contract is completed or substantially completed.
Proportionate completion method is a method of accounting which
recognises revenues in the statement of profit and loss proportionately
with the degree of completion of services under a pontract.
Revenue arising from interest is recognised on a time proportion
basis, royalties on an accrual basis and dividends from investments in
shares when the owner's right to receive payment is established.

AS-10 Recounting for Fixed Assets :

Fixed asset is an asset held with the intention of being used for
the purpose of producing or providing goods or services and is not he!
d for :he sais in the notarial course of business. The gross book vaiue
of a fixed asset shoulo be either historical cost or a revalued amount.
The cost of a fixed asset should normally comprise of its purchase
price and other attributable cost of bringing the asset to its working
condition for its intended use. Financing costs relating to deferred
credits or to borrowed funds attributable to construction or
acquisition of fixed assets for the period up to the completion of
construction or acquisition of fixed assets should also be included in
the gross book value of the asset to which it relates. When a fixed
asset is acquired in exchange or in part exchange for another asset,
the cost of the asset required should be recorded either at fair market
value or at the net book value of the asset given up, adjusted for any
balancing; payment or receipt of cash or other consideration.
Subsequent expenditures related to an item of fixed asset should be
added to its book value only if they increase the future benefits from
the existing asset beyond its previously assessed standards of
performance. Material items retired from active use and held for
disposal should be stated at the lower of their net book value and; net
49haracteri value. Losses arising from the disposal of fixed asset
carried at cost should be 49haracteri in the profit and loss account.

Normally the entire class of asset should be revalued and

revaluation should never result in the net book value of the class of
asset being greater than the recoverable amount of assets of that
class. Gain on revaluation should normally be taken to the owner’s
interest in the form of ‘Revaluation Reserve’ Alternatively it could be
taken to profit and loss account. Loss on revaluation should normally
be taken to profit and loss account except that such a decrease is
related to; an increase which was previously recorded as a credit to
the revaluation reserve and which has not been subsequently reversed
or 49haracte, it may be charged directly to that account. On disposal
of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value should be charged or
credited to the profit and loss statement except that to the extent that
such a loss is related to an increase which was previously recorded as
a credit to revaluation reserve and which has not been subsequently
reversed or 49haracte, it may be charged directly to that account.
Goodwill should he recorded in the books only when some
consideration in money or money’s worth has been paid for it. A proper
disclosure of the gross and net book value of the asset as well as
relevant amount, if the assets are stated at revalued amounts should
be made.

AS-H (Revised) Accounting for tbc Effects of Changes in Foreign

Exchange Rates :

The standard deais with (a) accounting for transactions in

foreign currencies; and (b) translating the financial statements of
foreign branches for inclusion in the financial statements of the
enterprise. The standard details the methods to be adopted for
converting foreign transactions denominated in foreign currency in
the reporting currency defined as currency used in presenting the
financial statements of the enterprise. The standard recommends
proper disclosure of the exchange differences arising on foreign
currency transaction. Disclosure is also encouraged of an enterprise’s
foreign currency risk management policy.

AS-12 Accounting for Government Grants :

Government grants are assistance by government in cash or

kind to an enterprise for past or future compliance with certain
conditions. Government grants can be 50haracteri in accounts on the
basis of capital approach or Income approach, based on nature of
relevant grant. However, the government grant should not be
50haracteri until there is reasonable assurance that (i) the enterprise
will comply with the conditions attached to them; and (ii) the grant
will be received. A proper disclosure should be made of the accounting
policy adopted for government grants, including the methods of
presentation in the financial statements including the nature and
extent of government grant 50haracteri in the financial statements,
including grants of non-monetary assets given at a concessional rate
or free of cost.
AS-13 Accounting for Investments :

The standard deals with accounting for investment in financial

statements of enterprises and related disclosure requirements. An
enterprise should disclose current investments and long-term
investments distinctly in the financial statements. A current
investment is an investment that by its nature readily realizable and
is intended to be used for not more than one year from the date on
which such investment is made. A long-tern investment is an
investment other than a current investment. The cost of acquisition
should include charges such as brokerage, fees and duties. If an
investment is acquired by issue of share or other security, the
acquisition cost should be fair value of the security issued. IF an
investment is acquired in exchange for another asset, the acquisition
cost should be the determined cost with reference to the fair value of
the asset given up. Investment properties should be treated as long-
term investments.

Current investments should be carried in the financial

statements at the lower of cost and fair market value determined
either on an individual investment basis or by category of
investments, but not on an overall (or global) basis. Long-term
investments should be carried at their cost, although a provision for
diminution in their value, other than temporary, should be made. Any
change in the carried value of the investment should be carried to the
profit and loss account. Profit or loss on disposal of investments
should be 51haracteri and shown in the profit and loss account.
Significant disclosure requirements are also inserted in the standard
and include among other things, the disclosure of accounting policy
for determination of carrying amount of investments, classification of
investments, profit and loss on disposal of investments and changes
in carrying amounts of these investments, for current and long-term
investment separately and aggregate amount of quoted and unquoted
investments.

AS-14 Accounting for Amalgamation :

The standard deals with the accounting for amalgamation and

the treatment of any resultant goodwill or reserves. Amalgamation is
52haracterized as either in the nature of merger or purchase
depending upon five conditions enumerated. Amalgamation in the
nature of merger is accounted for by ‘Pooling of interest method’ and
amalgamation in the nature of purchase is accounted by ‘Purchase
method’. The consideration for the amalgamation means ihe aggregate
of the shares and other securities issued and the payment made in
the form of cash or other assets by the transferee company to the
shareholders of the transferor company.

The identity of all the reserves in amalgamation in the nature of

merger is preserved. However, in the case of amalgamation in the
nature of purchase, only statutory reserves are preserved by giving
debit to a new account called ‘Amalgamation Adjustment Account’.
Goodwill only arise in case of ‘Purchase method’. Goodwill arising on
amalgamation is amortised over a period not exceeding five years
unless a somewhat longer period can be justified. When an
amalgamation is effected after the balance sheet date but before the
issuance of the financial statements of either party to the
amalgamation, disclosure should be made in accordance with AS-4
but the amalgamation should not be incorporated in the financial
statements.

AS-15 Accounting for Retirement Benefits in the Financial

Statements of Employers:
 The standard deals with the accounting of retirement benefits
consisting of (a) Provident funds; (b) Superannuation/ pension; (c)
Gratuity; (d) Leave encashment benefit on retirement; (e) Post
retirement health and welfare schemes; and (f) Other retirement
benefits in the financial statements of employers. The contribution of
the employer towards the provident fund and other contribution
schemes should be charged to the statement of profit and loss for the
period. The accounting treatment of gratuity and other benefit
schemes will depend on the type of arrangement which the employer
has chosen to make. Any alterations in the retirement benefit costs
should be charged or credited to the statement of profit and loss as
they arise in accordance with AS-5.
 LESSON-4
PRACTICAL BASE OF ACCOUNTING – ORIGIN AND ANALYSIS OF
BUSINESS TRANSACTIONS

Accounting process begins with the origin of business

transactions and is followed by analyses of these transactions. After
origin and analysis of transactions comes recording, classification and
summarization of business transactions culminating in preparation of
financial statements,

Origin of Business Transactions

Accounting deals with business transactions which have

already taken place, As financial accounting concentrates on monetary
transactions of the past it is basically historical in nature. Since it
amounts to making recording and analysis of historical information
only, it is also known as post-mortem accounting. For recording
business transactions, it is necessary that these transactions are
evidenced by an appropriate document such as cash memo
purchase bill, sales bill, cheque book, pass book, salary slip, etc.,
Document
which provides evide nce cf the transaction is called the Source
Document.

Analysis of Business Transactions

In accounting record is made of monetary transactions which

are evidenced by a source document and double entry system is
applied for recording. According to J.R Batliboi “every business
transaction has a two-foid effect and that it affects two accounts in
opposite directions and if a complete record were to be made of such
transaction, it would be necessary to debit one account and credit
another account. It is this recording of the two-fold effect of every
transaction that has given rise to the term Double Entry System”

To analyze the dual aspect of each transactions and to find out

the accounts to be debited and credited following two approached can
be followed.
7. Accounting Equation Approach
8. Traditional Approach.

9. Accounting Equation Approach:

Equality of assets on one hand and liabilities and capital on the

other hand is called basic accounting equation and is written as

ASSETS = LIABILITIES + CAPITAL

expected Where assets refer to resources which are owned by

business enterprise and are to benefit future operations, liabilities are
debts payable to parties external to business and capital means the
amount payable to owners of the business enterprise (also called
owner’s equity )

The dual aspect of some business transactions is analyzed as

follows:
10. Introduction of resources by the owner:

Rs. 5,00,000 cash and furniture worth Rs. 20, 000 invested by
the owner in the business.
Introduction of Rs.5,00,000 cash increases business cash by
Rs. 5,00,000 and it creates analysis obligation to pay Rs. 5,00,000 to
the owner which is recorded as capital. In terms of accounting
equation its effect is as
follows:
 ASSETS = LIABILITIES + CAPITAL
Cash (Rs.5,00,000) =__ + capital (Rs.5,00,000)
Further, if furniture worth Rs.20,000 is provided by the
proprietor, the accounting equation appears as under:
Cash + Furniture = Capital
(Rs.5,00,000) (Rs.20,000) - +(5,00,000 + 20,000
)
Rs. 5,20,000 Rs.5,20,000

11. Purchase of assets for cash and / or credit :

Purchased building for Rs,2,00,000 and paid Rs. 10,000 cash

immediately. It increases business assets or resources by Rs,
1,90,000 as cash decreases by Rs. 10,000 and building increases by
Rs.2,00,000. It also creates an obligation to pay Rs. 1,90,000 in
future. The accounting equation now appears as follows;
Cash + Furniture = Creditors for building + Capital
(Rs.5,00,000 (Rs.20,000) (Rs.1,90,000)
(Rs.5,20,000) –
Rs. 10,000)
+ Building
(Rs. 2,00,000)
-7,10,000 = Rs.7,10,000

12. Paid into bank Rs.3,00,000

It decreases cash balance and increase bank balance and thus,

have no net effect on total assets as shown below:

Cash + Bank = Creditors for building + Capital

(Rs.4,90,000 (Rs.1,90,000) (Rs.5,20,000)
13. (Rs. 3,00,000)
+ Furniture + Building
(Rs. 20,000) (Rs. 2,00,000)

-7,10,000 = Rs.7,10,000

14. Payment of Rs. 1,90,000 by cheque to creditors for

building :

It decreases bank balance by Rs.1,90,000 and creditors for

building by Rs. 1,90,000 as shown below:

Cash + Bank = Creditors for building +

Capital
(Rs.1,90,000 (Rs. 3,00,000) (Rs.1,90,000)
(Rs.5,20,000)
- Rs. 1,90,000) - Rs. 1,90,000)
+ Furniture + Building
(Rs. 20,000) (Rs. 2,00,000)

Rs. 5,20,000 = Rs. 5,20,000

15. Purchase of goods for Cash/Credit:

Business enterprise purchase goods worth Rs. 50,000 for cash

and Rs.20,000 on credit.

It increases stock of goods by Rs. 70,000, decreases cash by

Rs.50,000 and creates analysis obligation to pay. Rs.20,000 to the
supplier of goods. After this accounting equation appears as follows:

Cash + Bank + Stock of goods = Creditors + Capital

(Rs.1,90,000 (Rs. 1,10,000) (Rs.70,000) (Rs.20,000)
(Rs.5,20,000)
16. 50,000)
+ Furniture + Building
(Rs. 20,000) (Rs.2,00,000)
Rs. 5,40,000 =
Rs.5,40,000

17. Rs. 40,000 cash and Rs.20,000 goods withdrawn for

personal use:
It decreases cash by Rs.40,000 and goods by Rs.20,000. At the same
time, it decreases capital by Rs.60,000 as shown below:

Cash + Bank + Stock of goods = Creditors +

Capital
(Rs. 1,40,000 (Rs. 1,10,000) (Rs.70,000 (Rs.20,000)
(Rs.5,20,000
- 50,000) -Rs,20,000) -
Rs.60,000) + Furniture + Building
(Rs. 20,000) (Rs.2,00,000)

Rs. 4,80,000 = Rs.4,80,000

if accounting equation after above transactions is to be presented in

the form of balance sheet, it will appear as follows :
 Balance Sheet
Liabilities Amount Assets amount
Capital 4,65,000 Cash 1,25,000
Creditors 20,000 Bank 1,10,000
Stock 30,000
Furniture 20,000
Building 2,00,000
4,85,000 4,85,000

Classification of Accounts and rules for Recording Transactions :

For recording business transaction all accounts are divided into
three categories,

1) Assets Account
2) Liability Account
3) Capital Account

For recording changes in assets, liabilities and capital two

basic rules are followed :

Rule No. 1 for recording changes in assets :

Increase in asset is debited and decrease in asset in credited.

Rule No. 2 for recording changes in liabilities and capital :

Increase in liabilities and capital are credited and decrease in
liabilities and capital are debited.
Transaction
Assets =
No.
Creditors
Trade
for
Cash + Bank + Stock+ Furniture+ Building = Creditors Capital
Building
+
+
1. 5,00,000 - - 20,000 - = - - 5,20,000
2. 5,00,000 - - 20,000 - = - - 5,20,000

- 10,000 - - - +2,00,000 + - -

1,90,000
3. 4,90,000 - - 20,000 2,00,000 = 1,90,000 - 5,20,000

- +3,00,000 - - - - - -

3,00,000
4. 1,90,000 3,00,000 - 20,000 20,000 = 1,90,000 - 5,20,000

- -1,90,000 - - - - - -

1,90,000
5. 1,90,000 1,10,000 - 20,000 20,000 = - - 5,20,000

- 50,000 - +70,000 - - - + 20,000 -

6. 1,40,000 1,10,000 70,000 20,000 20,000 = - 20,000 5,20,000

- 40,000 - -20,000 - - - - - 60,000

7. 1,00,000 1,10,000 50,000 20,000 20,000 = - 20,000 4,60,000

+ 25,000 - -20,000 - - - - + 50,000

8. 1,25,000 1,10,000 30,000 20,000 20,000 = - 20,000 4,65,000

Analysis of Changes in Capital Account

Increases and decreases in capital account can take place

due to introduction of capital, withdrawal of cash, goods and other
assets for personal use ( called drawings ), revenue and income earned
( resulting in increase in capital) and expenses incurred ( resulting in
decrease in capital). Recording the effect of all these transactions
directly in the capital account will make it unwieldy. In actual
practice, net effect of revenue and expense transaction during an
accounting period as shown by profit and loss account is transferred
to capital account. Similarly cumulative effect of drawings during an
accounting period is recorded in the capital account at the end of the
accounting period. For this purpose, temporary capital accounts are
opened. These are called temporary accounts because these accounts
start with zero balance in the beginning of the accounting period and
at the end of the accounting period, these account are closed and
their net effect it transferred to capital account. These include:

a) Revenue Account(mcluding other incomes and gains)

b) Expense Account(mcludmg losses)
c) Drawing Account.

As these accounts record changes which affect capital account only,

no separate rule is required for recording changes in temporary
accounts. For example:
i. Revenue increases capital and decrease in capital is credited,
therefore revenue earned is credited to revenue account.

ii. Expense decreases capital and decrease in capital is debited,

therefore, expenses are debited to expense account.

iii. Drawings decrease capital and decrease in 'capital is debited,

therefore, the value of assets withdrawn for personal use is
debited to drawings account.

Thus capital at the end of the period may be calculated as

follows:
Closing capital = Opening capital + Additional capital
- Drawings
+Revenue and Gains
- Expenses

To sum up, under accounting equation approach all

accounts are divided into three, categories namely, assets, liabilities
and capital. Capital account is further sub-divided into permanent
and temporary account For recording changes in assets Rule NO. 1 is
applied and to record increases and decreases in liabilities and capital
Rule N0.2 is followed.

Illustration:
Prepare a statement showing analysis of transactions,
title and nature of affected accounts, relevant rule of recording and
the account to be debited and credited on the basis of transactions of
Mr. X for the month of December,1998. Transactions for the month of
December, 1998, were as
follows
Rs.
1. Received cash form debtors 20,000
2. Deposited cash in bank 4,000
3. Payment to creditors by 4,000

cheque
4. Machine purchased for 10,000
5. Traveling Expenses 5,000

Statement Showing Analysis of Transactions

Transactions Analysis Title and Rule Entry
Nature of
Account
Received cash Increase Cash – Debit Debit cash

from debtors cash Asset increase in

Rs. 20,000 Decrease Debtor– assets Credit

the amount Asset Credit Debtors

due from decrease in

debtors asset
Deposited Increase Bank – Debit Debit bank

cash in bank bank asset increase in

Rs. 4000 balance asset Credit cash

Decreases Cash - asset Credit

 cash in decrease

hand increase

asset
Payment to Decreases Debit Debit

creditors by amount Creditors – decrease in creditors

cheque payable to Liability liability

Rs.4,000 creditors

decreases Bank – Credit

bank Asset decrease in Credit Bank

balance asset

Increases Machinery – Debit Debit

Machinery machinery asset increase in machinery

purchased asset

Rs.10,000 Decreases Cash - asset Credit cash

cash in Credit

hand decrease in

asset
Expenses Traveling Debit

Traveling incurred on expense- Debit traveling

expenses travel Temporary increase in Expenses

Rs.5000 increases capital expenses

cash in (Expense)

hand Cash - Asset Credit Credit cash

decreases decrease in

asset
Analysis of Valuation of Assets and Liabilities
Financial accounting is basically historical in nature and
business transactions are accounted at their value on the date of the
transactions. As a result asset and liabilities also appear at historical
value. To portray true and fair fianancial position in balance sheet
some of the assets and liabilities need revaluation to show these items
at realistic, and not historical, level in the balance sheet. To achieve
this objective without changing asset and liabilities balances in
accounting records, valuation records, valuation accounts are opened
to account for increase or decrease in historical value of these items.

Rules relating to analyze to assets and liabilities can be

extended to accommodate analysis of valuation accounts as follows:
1. Valuation of Assets :

Various valuation accounts generally opened to account for

decreae in the value of assets are ‘provision for discount on debtors
account’, ‘provision for doubtful debts account’, ‘stock reserve
account’, ‘investment fluctuation reserve account, provision for (or
accumulated) depreciation account ‘and so on. The accounts are
opened to bring and report assets at their reduced level.

As decrease in assets are credited, therefore valuation accounts

resulting in decrease in assets are credited.

For example, assets machine of Rs. 2,00,000 is depreciated by

Rs. 20,000 at the end of accounting year 1998, the depreciation
reduces (or decreases) the value of asset and it is calculated to the
assets account with the help of the following entry.

Debit Depreciation account (Being and expenses account and

hence debited) Credit Machinery account.

Alternatively, with the help of a valuation account called provision for

depreciation account, decrease in asset account can be recorded using
the following entry:

Debit Depreciation Account

Credit provision for depreciation account (or accumulated
depreciation)

The provision for depreciation is shown as assets

deduction from the machinery account (because it has assets credit
balance and machinery account has a debit balance) and the same
impact is achieved.
 Conversely, if revaluation result in increase in value of
assets, the f valuation accounts are debited.

Thus rule is as follows:

Credit valuation account if asset account is to be decreased.

Debit valuation account if asset account is to be increased

2. Valuation of Liabilities:
Like provision for discount on debtors, Provision for
discount on creditors account is created. As per conservation
principle, it should not be provided because anticipated gains are not
taken into account. But it is analysts accepted accounting practice to
make provision for discount on creditors. It results in decrease in
liabilities. As decrease in liabilities are debited, valuation accounts
recording decrease in liabilities are debited. Conversely, valuation
account recording in increase in liabilities are credited. This rule is as
follows:

Debit valuation account if liability account is to be decreased.

Credit valuation account if liability account is to be increased.

Second aspect of valuation accounts generally appears in

temporary capital accounts and ultimately affects capital account.

Thus, an entry on debit side of an account means either

Increase in asset or
Decrease in liabilities or
Decrease in capital or
Increase in Drawings or
Increase in expense

and analysis entry on credit side of an account indicates either

Increase in liabilities or
Increase in capital or
Decrease in asset or
Increase in revenue

Traditional Approach
Both accounting equation approach and traditional
approach record dual aspect of business transactions. But in
accounting literature, generally, traditional approach is referred to as
double entry system. For analysis and recording of transactions,
traditionally all ledger accounts are divided as follows.

Personal Accounts:

Accounts recording transactions with a person or group of

persons are called personal accounts. These accounts are necessary,
in particular, to record credit transactions. Personal accounts are of
following types.
1. Natural person(s)

Accounts are accounts of individual living beings and

include accounts ;of individuals such as Ramesh capital account. Ram
account, Neha account and so on.

2. Artificial or legal person(s)

Accounts include accounts of legal entities such as

Reliance Industries Limited Account, Delhi Corporation Account,
Goodwill Co-operative society Account, Punjab National Bank Account
and so on.

3. Group / representative personal account:

group personal accounts are accounts of natural and legal

persons grouped together such as debtors account, creditors account,
share capital account etc. commission outstanding account, salaries
outstanding account etc., represent the person to whom commission
or salary is payable and are called representative personal accounts.

Accounts which are not personal are termed as

impersonal accounts and are divided into real and nominal accounts.

Real Accounts:
Real Accounts relate to properties of a business enterprise
which can be tangible or intangible.
1. Tangible real accounts:

Accounts of properties having physical existence like

cash, building, stock of goods, furniture etc., are called tangible real
accounts.

2. Intangible real accounts:

Include account of things which cannot be physically felt

or touched but are capable or monetary measurement such as
accounts of goodwill, patents rights, trade-marks rights, copy rights
etc.,

Nominal Accounts:

Accounts relating to income, revenue, gain, expenses and

losses are termed as nominal accounts. Example of nominal accounts
are salaries, rent, commission, discount allowed, rent received, sales
interest received etc. For recording changes in personal, real and
'nominal accounts, following rules are followed.

Rule No.I - for personal accounts.

Debit the receiver and credit the giver
Rule No.II - for real accounts
Debit what comes in and credit what goes out.
Rule No.Ill - for nominal accounts
Debit all expenses and losses and credit all revenue, gains
and
incomes.

Dual aspect of some business transactions is analyzed by applying

traditional rules as follows.

Transactions Analysis Title and Rule Entry

 Nature of
Account
Introduction Business Cash-Real Debit what Debit cash

of cash by gets cash Capital comes in.

owners owner is personal Credit the Credit

the giver giver Capital

cash Bank Bank-Personal Debit the Debit bank

deposited in receives receiver

bank cash

Business Cash – Real Credit what Credit cash

gives goes out

cash
Building Building Building – Real Debit what Debit

purchased comes in comes in Building

from Mr. X on X is the X – Personal Credit the

credit giver giver Credit X

Purchase of Goods Goods – Real Debit what Debit Goods

goods for are comes in

cash received Cash – Real Credit what Credit cash

Cash in goes out

paid
Payment of Service of Salary – Debit all Debit salary

salary to an the Nominal expenses

employee employee

utilized Credit cash

Business Credit what

pays Cash – Real goes out

 cash for

service

utilized
Rent of Building Rent – Nominal Debit all Debit Rent

building due is used Rent expenses Credit rent

but not paid by outstanding – Credit the outstanding

business personal giver

rent for (representative)

the

period is

payable

Note: Rent payable or outstanding is a personal account and shows he

amount payable to the owner of the building.

Advantages of Double Entry System

1. Scientific System:
Double entry system records, classifies and summarizes
business transactions in a systematic manner and thus, produce
useful information for decision-makers. It is more scientific as
compared to single entry system of book-keeping.
2. Complete record of business transactions:
It maintains complete record of a business transaction. It
records both debit and credit aspect with explanation for the
transactions.

3. Arithmetical accuracy of records:

Under double entry system arithmetical accuracy of
records can be checked by preparing a trial balance. However, some
errors cannot be deducted by preparing assets trial balance. ,

4. Ascertainment of profit of loss:

Profit or loss due to operation of business can be known
by preparing profit and loss account.

5. Information about financial position of the business enterprise:

It can be obtained by preparing balance sheet .at a point
of time.

6. Lesser possibility of fraud:

Possibility of frauds and misappropriation is minimized as
complete information is recorded under this system.

7. Helps users of accounting information:

Double entry system is most scientific and extensively
used system of book-keeping all over the world. This system provides
systematic and reliable information, it meets the needs the users of
accounting information, and assist them in sound decision making.

Analysis of Purchases and Sales of Goods

Following transactions relating to sale and purchase of

goods need careful analysis.
1. Purchases and sales,
 2. Discount received and discount allowed,
3. Sales tax
4. Cheques issued and cheques received.
5. Bad debts (applicable in case of credit transactions only).

1. Analysis of Purchases and Sales:

In accounting vocabulary, purchases and sales refer to
purchase and sale of items in which the business is dealing in the
normal course of business. For example, purchase of car by assets car
dealer for resale is purchase of goods but purchase of car by a
manufacturing concern for official use is recorded as an asset.
Purchases includes items acquired for resale, and not for utilization
during business operations.

Purchase of goods increases goods held for resale and sale of goods
decreases goods. Goods in hand are called Stock or Inventory.
Suppose goods costing Rs.5,000 are purchased and goods costing
Rs.4,000 are sold for Rs.6,500. theoretically effect of these
transactions can be analyzed as follows:

Goods purchased increases stock (Asset /Real account)

by Rs.5,000 and decreases cash (Asset / Real account) Rs.5,000.
Therefore, the entry is as follows:
Rs.
Debit stock 5,000
Credit stock 5,000

At the time of sale of goods costing Rs.4,000 for Rs.6,500

cash (Asset / Real account) increases by Rs.6,500 stock (Asset / Real
account) decreases by Rs.4,000 and profit on sale ( Gain / Temporary
capital account ) increases by Rs.2,500

Therefore, the entry is as follows.

 Rs.
Debit cash 6,500
Credit stock 4,000
Credit profit on sale 2,500

Theoretically, it is possible to find out the stock in hand

after each purchase transaction and to calculate stock of goods and
profit ( or loss ) on sale of goods at the time of sale and record this in
accounting records.

But it is impracticable or not feasible to record Sale and

purchase transactions in this manner.

Purchase of goods are recorded in purchase account.

Sales are recorded in sales account and no attempt is made to
calculate profit (or loss) on sale at the time of sale.
At the time of cash purchase of goods
Rs.
Debit purchases (Asset / Real account) 5,000
Credit cash (Asset / Real account) 5,000

At the time of cash sale of goods:

Debit cash (Asset J Real account) 6,500

Credit sales (Revenue / Temporary

Capital account (Revenue)) 6,500

At the end of the accounting period:

Cost of goods remaining unsold is determined on the

basis of physical stock-taking. Goods in hand are listed and generally
prices at its historical cost. In this case physical stock taking will
reveal stock in hand worth Rs. 1,000 i.e. cost of goods purchased
(Rs.5,000) minus the cost of goods sold (Rs.4,000). Value of stock in
hand at the end of the account in g^ period is recorded as follows.
Rs.
Debit closing stock (Asset / Real 1,000
 account)
Credit purchases (Asset / Real account) 1,000

In case of purchases and opening stock are transferred ni

trading account and to record the amount of closing stock following
procedure is
followed,

Debit closing stock

Credit Trading Account

The gross profit along with other incomes is compared with indirect
expenses to find out net profit ( or loss) during an accounting period.
Then net profit ( or loss) is transferred to capital account Assuming
there are no expenses, net profit is equal to Rs.2,500. ( i.e. sales
(6500) - cost of sales (4000)). The entry for transfer of net profit to
capital account is as follows:
Rs.
Debit profit and loss (nominal 2,500

Account)
Credit capital (capital Account) 2,500

2. Analysis of Commission, Rebate and Discount:,

Commission is the amount payable to analysis agent,

broker, employee etc., for services rendered by him in transacting the
business. It is generally calculated as a percentage of the value of the
business transacted.

Rebate is a reduction granted on the amount chargeable

for goods sold and services rendered. It is given under specified
conditions such as rebate in airfare to senior citizens, rebate in rail
fares to the handicapped persons, rebate to the senior citizens under
the Income Tax Activities etc..
 Discount is a reduction from a states amount such as
discount allowed to debtors to encourage prompt payment, issue of
securities ata price below their nominal value to attract subscribers,
amount charged by assets bank
at the time of discounting of a bill of exchange for discounting future
cash flow to its present value etc.,

Suppose a dealer in Vimal Fabrics purchases cloth from

Reliance Industries Limited at assets list price of Rs.300 per metre
less 35% discount Company allows additional discount @5% of list
price if payment is made immediately.
Now the cost of purchases of M/Statements, Vimal Fabrics and sales
revenue of M/Statements Reliaance Indusries Limites for accounting
purposes is Rs.195 per metre (i.e. Rs.300 - 35 % of Rs. 300). If
M/Statements Vimal Fabrics makes cash payment, the entry is
Book of M/Statements Reliance Book of M/S Vimal Fabrics

Industries Ltd
Rs. Rs.
Debit Cash 180 (Real A/C) Debit purchases 195 (Revenue A/C)
Debit 15 (Expenses Credit cash 180

Discount A/C)

Allowed
Credit sales 195 (Revenue Credit Discount 15

A/C) Received

3. Analysis of Sales Tax:

From purchaser's point of view sales tax forms part of the

cost of purchases. But from seller's point of view, sales tax charged
shows-the-amount collected on behalf of and payable to the sales Tax
Department of the Government. It is recorded in a separate account
named ‘Sales Tax payable Account’, Suppose an item is sold for
Rs.1,100 including sales tex Rs.100. the entry is as follows

Books of Seller Books of Purchaser

Debit Cash 1,100 (Real A/C) Debit Purchaser 1,100 (Real A/C)
Credit Sales 1,100 (Revenue A/C) Credit Cash 1,100 (Real A/C)
Credit Sales tax payable 100

(Represtative personal A/C)

4. Analysis of cheques issued and cheques received:

In case of payments made by issue of cheque, it is

recorded in
bank account straightway. But in case of cheques received, it is
recorded in bank account only when the cheque is deposited in bank
on the same day. If the cheque received is not deposited on the same
day, it is treated as cash on the day of receipt of cheque and when it is
deposited in bank, it is treated as cash deposited in bank.

For example, if Rs.5,000 cheque received from Mr. P on 31.1.1999 is

deposited in bank on 31.1.1999 itself, the entry on 31.1.1999 is as
follows

Rs.
Debit bank 5,000 (Personal Account)
Credit P 5,000 (Personal Account)

But if cheque is deposited on, say 5.2,1999, the entries are as follows:
On 31.1.1999
Debit bank (Real Account)
Credit P (Account)

On 5.2.1999
Debit bank (Personal Account)
Credit cash (Real Account)
 Above mentioned traditional approach for cheques received is
followed when:
1. Cheques received are currently due. Post - dated cheques should
not be recorded in cash book.
2. Cheques received are not crossed 'Account Payee '. Crossed
cheques are recorded in bank column directly.

A better way of recording cheques received is to record

these as ' cheques in Hand', and to transfer it to bank account at the
time cheque is deposited in bank.

5. Bad debts:
Bad debts refer to the amount of debt that cannot be
recovered form the credit customers. At the time when business
enterprise becomes definite about the non-recovery of assets certain
sum from debts, the amount receivable is reduced by crediting
debtors account. As the amount non-recoverable is a loss, it is debited
to a new account, called bad debts account and, at the end of the
accounting period, it is transferred to profit and loss account. Thus,
entry for recording bad debts is as under.
Debit Bad debts (Nominal / Temporary Capital A/C)
Credit Debtors(Group personal / Asset A/C)
 LESSON - 5
FINANCIAL STATEMENTS OF PROFIT-MAKING ENTITIES
MANUFACTURING-CUM-TRADING ORGANISATIONS

The basic operation of a trading organisation involves purchase

of, finished goods and their subsequent sale to final customers
without any,, substantial modification. At any point of time, a trader
has to manage only one, kind of inventory, namely that of the
'Finished Goods' and it is adjusted.in? Trading account.
In contrast, a Manufacture-cum-Trader's basic operation
involves purchase of raw material and its subsequent conversion into
finished product; followed by their trading. At any point of time, he
has to manage three kinds of inventories, namely, those of 'Raw
Materials’ 'Finished Goods', and Unfinished Goods' (popularly called
Work-in-process). He like a trader^' ascertains his gross results of
operation with the help of following equation:

Gross Profit = Net Sales - Cost of Goods Sold

where Cost of Goods Sold = Opening Stock of Finished Goods + Cost

of Finished Goods manufactured during the period - Closing Stock of
Finished. Goods + Direct Expenses related with Trading.

Note the contrast in the determination of the Gross Profit of a

Manufacturer with that of a Trader. The new aspect is the 'Cost of
Finished Goods manufactured during the year as compared to
'Purchase (less returns) of Finished Goods during the period' of a
trading organisation. The cost of finished goods manufactured during
a periods is computed is a new account called 'Manufacturing
Account' which precedes the trading and profit and loss account of
manufacturer-cum-trader. In fact the "Income statement of a
manufacturer-cum-trader is made in three stages and is called
'Manufacturing, Trading and Profit and Loss /recount for the period
ending . . .*.

To prepare the manufacturing account, a manufacturer divides

his expenditures in three parts, namely, Material cost, Labour Cost
and Other costs. These three categories are further subdivided in two
more categories, namely, 'Direct and Indirect'.

The 'Direct Costs' are those which do not lose their existence in
the final product. Indirect costs are those which are not direct costs.
Hence, for the manufacture of furniture, cost in incurred on wood is a
'Direct Material Cost' whereas cost incurred on nails and fevicol used
is a 'indirect Material cost'. The reason is that whereas wood has not
lost its existence in the final furniture made,
nails and fevicol have lost it. Similarly, the cost paid to person who is
actually making the furniture (also called carpenter) is called 'Direct
labour Cost' whereas cost paid to a person who is supervising many
carpenters Is an example of Indirect Labour Cost'. '

The 'Indirect Costs' comprising of indirect material costs,

indirect labour costs and indirect other costs are collectively called
'Overheads'. Overheads are further subdivided in three categories
namely, Factory; Office and Administration and Selling and
Distribution. Hence, a manufacturer views his total cost in six ways,
namely,
(a) Direct Material Cost;
(b) Direct Labour Cost;
(c) Other Direct Cost;
(d) Factory Overheads;
(e) Office & Administration Overheads;
(f) Selling & Distribution Overheads;
 The cost of manufactured goods will include the first four
components of the cost of a manufacturer and the last two aspects are
shown in the profit and loss account. The cost is computed in
statement form" as below:

Computation of cost of finished goods manufactured during the

period.
Direct Material consumed*
+ Direct Labour
+ Direct Other Costs
Prime Cost
+ factory Overhead (net of Scrap value realised**)
Gross Works (Manufacturing) Cost
+ Opening Stock of Work-in-Process
_ Closing Stock of Work-in-Process
Cost of goods manufactured

Opening stock of Raw Material + Purchase of Raw Material

during the. period + Closing stock of Raw Material + Freight inward +
Duties+ Subsidies + Duty Drawbacks - Return Outward. ** Scrap is
the incidental residue arisin; from a process of manufacture having
very low sales value. This is shown as a deduction from the factory
overheads. Alternatively, it can be shown as a deduction from the total
works (manufacturing) cost. ;
The information, when contained in the account form, appears as
below:

Dr. Manufacturing Account Cr.

To Opening Stock – Raw xxx By Scrap xxx
Material
To Purchaser of Raw - By Rebates xxx
Material xxx By Purchases returns xxx
To Freight Inward xxx By Subsidies xxx
To Duties and Taxes xxx By Duty Draw Back xxx
To Fatory Overheads xxx By Closing stock-Raw xxx
 Material
To Opening Stock– Work xxx By Closing stock -
in progress Work in process xxx
By Cost manufactured xxx
Goods transferred to
trading account
xxx xxx

Note that stocks of raw material and work-in-process have been

adjusted in the manufacturing account whereas the stock of finished
goods is adjusted in the trading account. Factory overheads include
indirect material, indirect labour and other indirect costs incurred in
the factory. Hence, expenses like depreciation of plant, repairs of
plant, factory lighting, factory telephone expenses are shown in the
manufacturing account instead of profit and loss account But the
depreciation of office furniture (office& administration overheads) and
depreciation of delivery vans (selling & distribution overheads) are
shown in the profit and loss account.

MANUFACTURING DEPARTMENT AS PROFIT CENTRE

The business organisation, instead of being viewed as a whole,
can be looked up as comprising of various parts where each part is
responsible for the overall results of the business in their own small
measures. These small parts arc called 'Responsibility Centres' of the
business and are categorised as (a) Expense Centres (b) Revenue
Centres (c) Profit Centres and (d) Investment Centres. These centers,
being headed by responsible managers who are subject to internal
evaluation by their seniors at regular intervals, have a strong case for
projecting their division / part of business as a profit-making division.

Hence often the goods are transferred by the manufacturing

department to the trading department at a transfer price which is
made up of its manufacturing cost + mark up or profit In other words,
the manufacturing department is essentially viewed as a 'Profit
centre'. The transfer of goods internally at a profit leads to the profit
being recognised in the manufacturing account which is transferred to
the profit and loss account with the help of the following entry.

Manufacturing A/c Dr.

To Profit and Loss A/c

However, this profit is not realised unless goods are sold to the
ultimate customer by the trading division. Hence if finished goods
remain unsold at the end of the accounting period it leads to valuation
of the finished goods at a price which is more than the cost of these
goods to the business as a whole. The excess represents the
'Unrealised profit' contained in the value of the stock. This valuation
of inventory violates the principle of 'Lower of cost or market value' as
inventory value advocated by AS-2 on valuation of inventories. It also
violates 'Conservatism' principle by recognising a profit which is not
realised (anticipated gains) by transferring goods from one of business
department to another department.

The anomaly is removed by creating a stock reserve for the unrealized

profit contained in the closing stock from the profit and loss account
with the help of the following entry.

Profit and Loss A/c Dr.

To Stock Reserve A/c

The entry reduces the profit to the extent of unrealized profit in

closing f stock. The stock reserve account is shown as a deduction
from the value of;| closing stock in the balance sheet and hence the
closing stock is properly valued at its cost to the business as a whole.
Next year, this becomes the opening stock and is transferred to the
trading account at the transfer value. The stock reserve (on opening
stock of finished goods) is shown on the credit side of the profit loss
account of the next year.
VALUATION OF INVENTORIES IN A MANUFACTURING
DEPARTMENT
The value of inventory is computed by adding cost of purchase,
cost off conversion, and other cost incurred in the normal course of
business in bringing; the inventories up to their present location and
condition. However, as per AS-2, the inventory is valued at lower of
cost or market price characterised by the net realizable value. The
historical cost of inventory is normally determined by using First in
First out (FIFO), Weighted Average or Last in First out (LIFO) formulae
as per recommendation of AS-2. The value of raw material should be
based on cost of purchase and other cost incurred in the normal
course of business in bringing the inventories up to their present
location and condition. The value of finished goods inventory should
be based on cost of manufacture which includes besides direct
material, direct labour and other direct costs, the fair proportion of
factory overheads. The WIP is commonly valued at factory cost.
However, while valuing it, the concepts of Equivalent Unit is used.
According to institute of Cost and Management accountants,
London, 'Equivalent units are a notional- quantity of completed units
substituted for an actual quantity of incomplete physical units in
progress when the aggregate work content of the incomplete units is
deemed to be equivalent to that of substituted quantity .......'. Hence
by using the concept of equivalent units, a 50% complete work in
process of 10,000 units is treated as 5,000 completed units and then
the overall cost can be allocated amongst the completed units as well
as incomplete units, the complete units being taken as 100%
complete.

Illustration 1: From the following particulars, prepare the

manufacturing account of A with units column:

Unit Rs.
Opening Stock - Raw Material 1,000 10,000
Purchase of Raw Material 10,000 1,10,000
Closing Stock 500 ?
Freight – Inward 10,000
Freight – Outward 15,000
Direct Wages 85,000
Indirect Wages
Factory 40,000
Office 50,000
Other Factory Oveheads 30,000
Opening Stock – Work in Purchase (40% complete) 1,500 15,000
Closing Stock – Work in Process (30% complete) 3,000 ?
Dr. Manufacturing Account Cr.
Particulars Unit Amount Particulars Unit Amount
1,000 10,000 By Closing Stock -
Raw Material 500 6,000
To Purchases - By Closing Stock 3,000 27,000
Raw Matertial 10,000 1,10,000 - WIP (3)
To Freight - 10,000 By Trading A/c 9,000 2,67,000
Inward [cost of finished
goods transferred to
trading account (3)
(b.f.)]
To Direct Wages 85,000
To Factory
Overheads (2) 70,000
To Opening Stock 1,500 15,000
- WIP
12,500 3,00,000 12,500 3,00,000

Working Notes:
1. Calculation of closing stock of raw material (based on FIFO)
Cost= of Purchase + Freight (Inward)
Average pncs of Purchase made during the year
No. of units purchase

= (1,10,000 + 10,000)
10,000
= Rs. 12

Value of closing stock of raw material 500

= units x Rs. 12
= Rs. 6,000

2. Factory Overheads
Indirect Factory wages = 40,000
Other Factory overheads = 30,000.
70,000
 3. Calculation of closing stock of work in process and finished
goods transferred to trading department.

Units manufactured during Units % of completion Equivalent units

the year during the year

Opening Stock of work in
process 1,500 60 % 900
Goods started and finished
during the year 7,500 100 % 7,500
Closing Stock of work in
process 3,000 30 % 900
Total 9,300
 Cost incurred during the year
Raw Material Consumed = 1,24,000***
Direct Labour = 85,000
Factory overheads = 70,000

Hence, average cost of equivalent = 2,79,000/9,300

units

Value of closing stock of work in = Rs. 27,000

process
Value of finished goods = [Opening stock of WIP + Cost of

completing opening WIP + Cost

of goods started and finished

during the year]

= Rs. 15,000 + 900 units x Rs. 30

+ 7,500 units x Rs. 30

= Rs. 15,000 +Rs. 27,000 + Rs.

2,25,000
= Rs. 2,67,000

* Opening stock at the beginning of the year was 40% complete and
hence % completed during the year was remaining 60%.
** Total finished goods transferred during the year is 9,000. Since
1,500 units are from the opening stock of WIP, the remaining (7,500
units) must be those which were started and finished during the year
on the basis of cost flow assumption of FIFO.
*** 10,000 (Opening stock +RM) + 1,10,000 (Purchases) - 6,000
(Closing Stock) +1 0,000 (Freight) = Rs. 1,24,000.
 LESSON - 6
FINANCIAL STATEMENTS OF NON-PROFIT-MAKING ENTITIES

On the other hand, primary objective of a non-profit

organisation is to meet some socially desirable goal or to render
services to its members.

Non-profit organisations include hospitals, educational

institutions, clubs, political associations, religious institutions,
charitable societies etc. These organisations survive on donations,
grants, subscription from members, etc. Sometimes trading activities,
such as hospital canteen, club restaurant health club, chemist shop,
barshop etc. also take place in such institutions to provide certain
facilities to members or public in general. Surplus or profijt from such
incidental trading activities is used to fulfil the objectives for which
the organisation was established.

A person familiar with preparation of financial statements of

profit-making organisations should have no difficulty in preparing
financial statements of non-profit organisations for clear and effective
communication, with their users. This is so because the set of rules or
principles followed for preparing financial statements of both profit-
making and non-profit making entities are almost same.

Non-profit organisations do not prepare profit and loss account

because their primary objective is not to earn profit but to serve its
members or society in general. However, these organisations compare
incomes and expenses to check whether the organisation have
sufficient resources to carry out its objectives. To achieve this 'Income
and Expenditure Account* is prepared by: non-profit organisations
and is accompanied by a balance sheet tc show the financial position
of the organisation.

INCOME AND EXPENDITURE ACCOUNT

Income and expenditure account is like profit and loss account of

profit-making organisations. Non-profit organisations follow the same
rules or principles for preparing income and expenditure account
which are followed by commercial organisations for preparing profit
and loss account. Following points should be noted:

a) It is a nominal account. It records all expenses and losses on

debit side and all incomes and gains on credit side of the
account. As it records incomes and expenses, the word
'expenditure' is used here in the sense of an expense.

b) Expenses debited to income and expenditure account include

expenditure' of revenue nature. Similarly, the incomes credited
to income and expenditure account are also of revenue nature.
Items of capital nature are, not included in income and
expenditure account but the portion of capital \ expenditure
which expires during the year is charged to income and
expenditure account as depreciation.

c) It includes incomes and expenses of current year on accrual

basis irrespective of flow of cash. Therefore, adjustment relating
to outstanding expenses, prepaid expenses, accrued income,
unearned income etc. are taken into account.

d) Excess of credit side over debit side is termed as surplus and is

known as excess of income over expenditure. However, if debit
side exceeds credit side, there is a deficit and is termed as
excess of expenditure over income.: Like transfer of profit or loss
 to capital account in case of profit-making entities, surplus or
deficit of non-profit organisations is transferred to capital fund.
Some Peculiar Items: Though the rules for preparing profit and loss
account of' commercial organisations and income and expenditure
account of non-profit. organisations are same, but there are some
items which are peculiar to non-profit organisations. Items peculiar to
non-trading organisations are as follows:

a) Capital Fund : Excess of assets over liabilities is called capital

fund or general fund. It is similar to capital account of
commercial organisations.

b) Annual Subscription : Subscription received from members is a

revenue item and credited to income and expenditure account.
It is primary source of income of a non-profit organisation.

c) Government Grant: Government schools, colleges, public

hospitals etc. depend upon Government grant for their
activities. The recurring grants in the form of maintenance grant
is, by and large, spent in the year of receipt and is treated as
revenue receipt (income) and credited to income and
expenditure account. Other grants such as building grant,
library grant etc., are treated as capital receipt and transferred
to a fund account. Besides Government's contribution to library
fund, building fund etc., additions may take the form of
retention of surplus, amount charged from students,
contribution from trustees etc.

d) Life-Membership Fees: Fees received for life membership is a

capita] receipt, as it is of non-recurring nature. It is directly
added to capital fund or general fund.
e) Entrance Fees : Fees paid by new members at the time of
joining the organisation is called entrance fees. Since, the fees is
paid only once by members, it is clearly of non-recurring nature.
Hence, it should be treated as capital receipt and be shown in
balance sheet as a part of the general fund.
f) Donation : Donations received for specific purposes are
capitalized and recorded on liabilities side of the balance sheet.
These included donation for building, donation for extension of
library hall, donation for library books, donation for seminar
room, donation for sports activities etc. When the donation is
utilised for the purpose, the amount of donation is transferred
to capital fund. When the purpose for which the donation is to
be utilised is not mentioned, It is called general donation and
treated as income.

g) Honorarium : Payment to non-employees for services received

is called honorarium. It is a revenue item and debited to income
and expenditure account.

h) Legacy : Amount received by non-profit organisations as per

Will of a deceased person is called legacy. As this item is of non-
recurring nature, it is treated as capital receipt and recorded on
liabilities side of the balance sheet.
However, if the amount is small it can be credited to income and
expenditure account.

i) Endowment Fund : It refers to a fund from a bequest or gift.

The fund contains assets uonated by the donor with stipulation
that income earned by these assets but not the gift itself can be
used for principal activities of the organisation. Sometimes,
income may also be restricted. These kind of restrictions must
properly be reflected in the financial statements. The fund is
treated as capital receipt and recorded on the liability side.
j) Subscription for Periodicals : Subscription for newspapers,
magazines etc. is treated as income and credited to income and
expenditure account.

k) Sale of Old Periodicals : Sale of old newspapers, magazines

etc. is treated as income and credited to income and
expenditure account.

l) Sale of Assets : Sale price of old asset is a capital receipt and

not recorded in income and expenditure account. However,
profit or loss on sale of asset is transferred to income and
expenditure account. To recapitulate profit (or loss) on sale of
fixed asset is calculated by comparing sale price with book value
of asset sold on the date of sale.

m) Income from specific fund and expenses related to specific

fund : Generally, incomes and expenses are recorded in income
and expenditure account. But if expenses arc incurred on
certain items for which a fund exists, then expenses are not
debited to income and expenditure account but deducted from
specific fund account. Similarly, income from investment of
specific fund is added directly to fund is added directly to fund
and not credited to income and expenditure account For
example, match fund balance of Rs. 10,000 income from
matches Rs. 5,000 and match expenses Rs. 12,000 ure shown
on liabilities side of balance sheet -as foolows;

Match Fund 10,000

Add income from 5,000
matches 15,000
Less Mtch Expenses 12,000 3,000
 However, if after adjustment of income and expenses related to
a specific fund, fund balance is negative, it is transferred to debit side
of income and expenditure account

n) Outstanding expenses & prepaid expenses : To recapitulate,

the expenses of current year are to be taken on accrual basis
while making income and expenditure account. Hence, the
payment on account of expenses need to be adjusted for
outstanding expenses and prepaid expenses. The entries for the
two aspects may be recalled from the chapter on final accounts,
namely:-

for outstanding expenses.

Expenses A/c Dr.
To Outstanding Expenses A/c
For prepaid expenses
Prepaid Expenses A/c Dr.
To Expense A/c

Outstanding expenses account is shown in the balance sheet on

liability side and prepaid expenses account on the asset side. Both
accounts are transferred to their respective expense accounts of the
next year to find out its amount correctly.

o) Accrued income (or income outstanding) and unearned income

(or income received in advance):

The same treatment is accorded to the income to be shown in income

and expenditure account The entries passed are:

For income outstanding

Income Outstanding A/c Dr.

To Income A/c
For income received in advance
Income A/c Dr.
To Income Received in Advance A/c

Income outstanding account is shown in the balance sheet on the

asset side and income received in advance on the liability side of the
balance sheet. Both accounts are transferred to their respective
income accounts of the next year to find out its amount correctly.

p) Life membership fund : Sometimes, member of a non

organisation pay their membership fees at die time of admission
only. The fees received is clearly of non-recurring nature and is
given in lieu of subscriptions to be paid every year which are of
recurring nature. If nothing is specified in the question, assume
that life membership fund to be capital nature and add it to be
capital fund. However, if some kind of amortisation schedule is
given, than a suitable part out of capital fund should be
transferred to income and expenditure denoting the income of
that year.

Illustration I: From the trial balance and the additional

information of a public school, prepare Income and Expenditure
Account for the year ending December 31,1998 and the Balance
Sheet as at that date.

Trial Balance as at Decembr 31, 1998

Amount (Dr.) Amount (Cr.)

Building 2,50,000 Admission Fees 5,000
Fruniture 40,000 Tution Fees 2,00,000
Library Books 60,000 Rent of Hall 4,000
16% Investmetns (1-1- 2,00,000 Creditors for Books 6,000

98) Supplied
Salaries 2,00,000 Miscllanoues 12,000
 Receipts
Stationery 15,000 Annual Government 1,40,000

Grant
General Expenses 8,000 Donations Received 25,000

for library books

Annual Sports Expense 6,000 Capital Fund 4,00,000
Cash 1,000
Bank 20,000 Interest on 8,000

Investments
8,00,000 8,00,000

Additional Information;
1) Tuition fees receivable for the year 1998 amounted to Rs.
10,000.
2) Salaries payable for the year 1998 amounted to Rs. 12,000
3) Furniture costing Rs. 10,000 was purchased on 1 -7-1998.
depreciation on furniture @ 10% p. a.
4) Depreciate building by 5% and library books by 20%.
Dr. Income and Expenditure Account for the year ending December 31, 1998 Cr.
To Salaries 2,00,000 By Tution Fees 2,00,000
Add 12,000 2,12,000 Add 10,000 2,10,000

Outstanding Outstanding
To Stationery 15,000 By Annual 1,40,000

Goverenment

Grant
To Annual 6,000

Sports Expenses
To General 8,000 By Admission 5,000

Expenses Fees
To Depreciation By Rent of Hall 4,000

on Furniture
On 10,000 (for 500 By 12,000

½ year) Miscellanoues

Receipts
On 30,000 (for 1 3,000 3,500 By Interest on 8,000

year) Investment
To Deprecitation 12,500

on Building
To Depreciation 12,000 Add Accured 24,000 32,000

on Library Interest

Books
To Excess of 1,34,000

Income over

Expenditure
4,03,000 4,03,000

Balance Sheet as at December 31, 1998

 Liabilities Amount Assets Amount
Outstanding 12,000 Cash 1,000

Salary
Creditors for 6,000 Bank 20,000

Books

Supplied
Donation for 25,000 Tution Fees 10,000

Library Books Receivable

Capital Fund Accounted 24,000

Interest on

Investment
On 1-1-98 4,00,000 Investments 20,000
Add Surplus 1,34,000 5,34,000 Furniture on 1- 30,000

1-98
Add purchased 10,000

on 1-7-1998
40,000
Less 3,500 36,500

Depreciation
Library Books 60,000
Less 12,000 48,000

Deprcaition
Building 2,50,000
Less 12,500 2,37,500

Depreciation
5,77,000 5,77,000

RECEIPT AND PAYMENT ACCOUNT

Besides income and expenditure account and the balance sheet,

financial statements of non-profit organisations invariably include
'Receipts and Payment Account'. It is nothing but a summary of cash
 receipts and cash payments during the relevant period. From
chronological record of cash transactions in the cashbook, summary
of cash transactions is prepared at the end of the period under
consideration. It does not give the date of the transact ion (s). Thus,
both cashbook and 'Receipt and Payment Account' provide the same
information but in a different manner.
a) It is real account. All receipts are recorded on its debit side and
all payments are credited.

b) It starts with balance of cash and bank in the beginning of the

period under consideration.

c) It records all items of revenue and capital nature resulting in'

inflow and outflow of cash. Again the period to which the
transaction relates is not significant. Transactions of previous
year, current year and subsequent years are recorded, provided
they affect flow of cash in the current year.

d) Balance of receipt and payment account shows the balance of

cash and bank at the end of the period under consideration.

Difference between Income and Expenditure Account and Receipt

and Payment Account:

Income and Expenditure A ccount Receipt and Payment Account

I) It is a nominal account. It is a real account.
2) It is a summary of the working of It is a summary of cash and bank

the organisation. transactions of the organisation.

3) It is based on accrual system. It is based on cash system

4) It records expenses and losses on It records inflow of cash on debit

debit side and incomes and gains on side and outflow of cash on credit

credit side. side

5) It is a temporary account and has It is real account and starts

no opening and closing balance. with opening balance of cash and

bank.
6) Itlis closed at the end of the year It is balanced at the end of the

and balance figure of the account is year and the balance carried

transferred to capital fund. forward shows the cash and bank

balance at the end of the period.

7) It records items of revenue nature It records items both of capital

only irrespective of their effect on flow and revenue nature provided they

of cash. affect flow of cash.

8) It records transactions of current It records transactions of previous

year only. years, current year and

subsequent years provided flow of

cash is affected.

BALANCE SHEET

Like commercial organisations, non-profit organisations prepare

balance sheet to show the financial position of the Organisation. If
trial balance is not given in the question, first of all balance sheet on
the first day of the period under consideration (called Opening
Balance Sheet) is prepared. It records assets and liabilities in the
beginning of the period. Donations to capital fund are added to
balance of capital fund in the beginning of the period and after
adjustment of deficit or surplus as revealed by income and
expenditure account, the balance capita] fund is recorded in the
balance sheer prepared on the last day of the period under
consideration (called Closing Balance Sheet)
 Opening and Closing balance sheet on the basis of information
given in Illustration 2 appear as follows:
Balance Sheet as at December 31. 1997

Liabilities Amount Assets Amount

Salaries 4,000 Cash 1,000

Outstanding
Capital Fund 1,59,000 Bank 40,000
(Balancing figure) Outstanding 2,000

Subscription
Furniture 20,000
Building 1,00,000
1,63,000 1,63,000

Balance Sheet as at December 31, 1998

Liabilities Amount Assets Amount

Salaries 1,000 Cash 900

Outstanding
Capital fund Bank 20,000
On 1-1-98 1,59,000 Outstanding 3,000

Subscription
Add 4,500 1,63,000 Investments 30,000

Surplus
Add Accrued 600 30,600

Interest
Furniture 20,000

on 1-1-98
Less sold 5,000 15,000
Building 1,00,000
Less 5,000 95,000

Depreciation
1,64,500 1,64,500
Hence it is amply clear that the financial statements of a non-profit
institution comprises of four basic statements, namely:-
i) A balance sheet at the start of the period (i.e., opening
balance sheet);

ii) Receipts & Payments Account which is a summary of cash

transactions because most of the transactions of non-profit
organisation are in cash (and/or bank);

In fact, these two statements plus some additional

information (essentially j about the outstanding / prepaid
expenses and accrued / unearned incomes) provide the basic
material which is necessary to compute the deficit / surplus
generated by the non-profit organisation and to find out their
financial position at the end of the period. This is done in the
next two statements, namely,

iii) Income and Expenditure Account showing incomes

generated and expenses incurred during the year to find out
the deficit / surplus;

iv) A balance sheet at the end of the period {i.e., closing balance
sheet)

All these statements are intimately connected. In examination,

normally one or two of these statements are given along with
additional information well, it will be easier to make the statements
required in examination problems. For example,

a) Fixed assets appearing in the opening balance sheet will go to

the closing balance sheet after not sold. If they are sold, the sale
price wi11 increase the receipts of cash during the year in
receipts and payments account and the difference of sale price
 and their value on the date of sale will be charged to income and
expenditure account as loss or gain on sale of fixed asset
b) The receipts in receipts and payment account will be divided in
two parts, namely capital and revenue. Revenue receipts, e.g.,
subscription received will denote (he subscription received
during the year whether pertaining to past / present / future
years. However, it will be adjusted in the light of information
about accrued / unearned subscription given in the opening
balance sheet and additional information and adjusted
subscription,/ representing subscription of the current year
whether received in past / current / future years, will be shown
on the credit side of the income and expenditure account of the
current year. Capital receipts such as Iife membership fees,
legacy etc. will be taken to liability side of the closing balance
sheet under suitable headings.

c) The payments in receipts and payment account will be divided

in two parts, namely, capital and revenue. Revenue payments or
expenses, e.g. salary paid will denote the salary paid during the
year whether pertaining to past / present / future years.
However, it will be adjust in the light of information about
outstanding /prepaid salary and adjusted salary, representing
salary of the expenditure account Capital expenditure, denoting
assets will be taken to asset side of the closing balance sheet
after depreciation which will be shown in the income and
expenditure account on the debit side (expenditure side).

From examination point of view, preparation of financial statements of

no-profit organisations can be studies under the following categories:

1) When Receipts and Payments account along with additional

information is given and rest of the basic statements are to be
prepared;
2) When results of an incidental trading (commercial) activity ofa
non-profit organisation (e.g. Bar activities in a club) are to be
ascertained by preparing (Bar) Trading Account along with
income and expenditure account and balance sheet at the end
of the period;

3) When in receipts and Payments account the balance of bank is

given as per pass book;

4) When trial balance along with additional information is given

and few basic statements are to be prepared;

5) When Income and Expenditure account along with additional

information is given and rest of Ihe basic statements are to be
prepared;

6) When both Receipts and Payments account and Income and

Expenditure account along with additional information are
given, and balance sheet in the beginning and at the end are
required;

7) When balance sheet at the beginning and at the end along with
additional information is given, and Receipts and Payments
account and Income and Expenditure account for the year are
required;

8) When raw information is given, and all the basic statements are
to be prepared;

9) When wrong statements / incomplete statements are given and

corrected accounts of non-profit organisation are to be
prepared;
10) Accounts of hospitals;

11) accounts of educational institution including libraries.

Case I: When Receipt and Payment Account along with additional

information is given, and rest of the basic statements are to be
prepared. '

Generally examination problems require preparation of income and

expenditure account and balance sheet at the end of the period from
the information given. But to complete balance sheet the figure of
capital fund in the beginning is required. To calculate information
about capital fund in the beginning, balance sheet at ithe beginning of
the period should be prepared. Thus, to solve the si examination
problems it is suggested to prepare the following simultaneously;

1) Balance sheet at the beginning of the period.

2) Income and Expenditure Account for the period under

consideration.

3) Balance sheet at the end of the period.

To prepare income and expenditure account from receipt and payment

account, all items appearing in receipts and payment account should
be analysed one by one. AH items of capital nature are directly
recorded in the balance sheet All items of, revenue nature appearing
in receipts and payment account are transferred to income and
expenditure account, it is to be ensured that these represent; incomes
and expenses of the current period only. To achieve this, levenue
items appearing in receipts and payment account are adjusted, to
shift from cash to accrual basis, before transferring these items to
income and expenditure account.
Case II : When results of an incidental trading (commercial) activity of
non-orofit organisation (e.g. Bar activities in a club) are to be
ascertained by preparing Trading Account along with income and
expenditure account and balance sh'eet at the end of the period.

Non profit organisations basically survive on donations, grants

subscriptions from members etc. Sometimes trading activities such as
hospital canteen, bar, club, beauty parlour, health club, restaurant,
chemist shop run by a Govt hospital or co-operative store also take
place in such institutions to provide certain facilities to members or
public in general. As the surplus or profit from such incidental
commercial (trading) activities is used to fulfil the objectives for whicn
the organisation was established, therefore, profit from such activities
is transferred to income and expenditure account. Procedure followed
is as follows:

a) Prepare trading account to calculate profit (or loss) due to

incidental trading activity. All costs and revenues and incomes
directly related with such activity are recorded in trading
account. Balance of trading account showing profit or loss is
transferred to income and expenditure account.

b) Income and Expenditure account records, besides trading profit

(or loss) all other incomes and expenses not directly related with
trading activity. Surplus (or deficit) as revealed by income and
expenditure account is transferred to capital fund as usual.

Case III: When in receipts and Payments account the balance of bank
is given as per pass book.

Sometimes, receipts and payments account given in the question

shows opening and closing bank balance as per pass book. It means
the information about various receipts and payments given in the
receipts and payments account is as per pass book. To solve the
question, first of all given receipts and payments account should be
redrafted and bank balance and various receipts and payments as per
cash book should be recorded.

Case IV: When trial balance along with additional information is given
and few basic statements are to prepared.
It has already been emphasized that accounts of non-profit making
entities are not materially different from the accounts of a profit-
making entity. Hence, if information is given in the form of trial
balance it does not poses a special problem (See Illustration 1), All
account have to be analysed to find out whether they result in
generation of deficit/surplus or are accounts of assets / liabilities. The
statements are prepared in the usual manner.

Case V: When Income and expenditure Account along with Additional

information is given and rest of the basic statements are to be
prepared.

Sometimes examination problem requires receipt and payment

account and balance sheet from the information given in the question.
To prepare receipt and payment account from income and expenditure
account, all items appearing in income and expenditure account
should be analysed one by one to find out their effect on flow of cash.
To recapitulate, income and expenditure account records all incomes
and expenses of the current period on accrual basis. Therefore, the
information appearing in the income and expenditure account is to be
adjusted in the light of additional information given in the question to
find out inflow and outflow of cash on account of incomes and
expenses respectively. Then, information about capital receipts and
capital payments included in additional information is analysed and
recorded in the receipt and payment account After recording all
receipts and payments and opening balance of cash and bank, the
account is balanced. Balancing of receipt and payment account now
reveals the closing balance of cash and bank.

Sometimes, closing balance of cash and bank is given in the question

and opening balance is to be calculated. In such a case closing
balance to be carried forward, along with all receipts and payments, is
recorded and balancing figure reveals balance of cash and bank in the
beginning of the period.

Case VI: When both Receipt and Payment Account and Income and
Expenditure Account along with additional information are given, and
balance sheet in the beginning and at the end are required.

Sometimes both receipts and payment account and .income and

expenditure account are given in the questions along with additional
information about assets and liabilities in the beginning of the year. In
this case balance sheet as at the end of the year is to be prepared- To
prepare balance sheet, items given are compared and information
about prepaid expenses, the amount of salaries shown in receipt and
payment account is less than the amount shown in the income and
expenditure account, the difference is on account of salaries
outstanding at the end of the year. Students have to be very careful
when amount appearing in receipts and payment account is more
than that appearing in income and expenditure account. For Example:

a) Insurance premium amount in receipt and payment account is

Rs. 200 and in income and expenditure account is Rs.120
Excess payment of insurance premium can be either on account
of outstanding amount in the beginning of the year or advance
payment for the next year. Generally insurance premium is paid
in advance, therefore, excess amount is treated as unexpired
insurance and recorded on assets side.
b) Income and Expenditure account shows stationery amount
Rs.500 and the amount recorded in receipts and payment
account is Rs.700. In this case, difference is either treated as
stock of stationery (purchases-consumed) at the end or amount
outstanding in the beginning on account of creditors for
stationery.

c) Interest on investment in income and expenditure account is

Rs.1000 and Rs.1500 is shown in receipt and payment account
on account if interest on investment. In this case difference of
Rs.500 can be treatedi as interest received in advance at the
end of the year and recorded on liabilities side of closing balance
sheet. Alternatively difference of Rs.500 can be assumed on
account of interest earned but not received in the beginning of
the year and recorded on asset side of opening balance sheet ;

d) Salary account recorded in receipt and payment account is Rs.

10,000 and Rs.9,000 is shown in income and expenditure
account In this case, Rs. 1,000 can be shown in closing balance
sheet on asset side as advance salary or it can be treated as
salaries outstanding in the beginning of the year and recorded
on liabilities side of opening balance sheet.

It is clear from above that if amount appearing in receipt and

payment! account is more than that appearing in income and
expenditure account, it ispossible to treat the difference in more than
one way. In such a case, student sfiould make a logical assumption
and write the assumption made as part of working notes,

Case VII: When balance sheet at the beginning and at the end of the
period along with additional information are given, and receipts and
payments account or income and expenditure account for the year are
required:

The information about assets and liabilities is given in the beginning

as well "as the end along with additional information either about
receipts and payments or about incomes and expenditures. The
infonnation can be adjusted to find out the incomes and expenditures
or receipts and payments. For example, opening balance sheet shows
salary outstanding of Rs.IOO and payments show that on account of
salary Rs. 14,100 was paid. It will mean that payment to be shown in
receipts and payments account is Rs. 14,100 but salary of the current
year to be shown in income and expenditure account will be Rs.
14,000 betause the payment includes Rs. 100 on account of last year.

Case VIII: When raw information is given and basic statements are to
be prepared: When raw information is given, it virtually involves the
writing of entire books of accounts of non-profit organisations, Due
care mast be taken In recording transactions in these books. All
receipts and payments should be recorded in the receipts and
payments account. All expenses and incomes should be posted to
income and expenditure account keeping in mind the whole
discussion we had so far. Hence, recurring items will find their way to
income and expenditure account and non-recurring would be taken to
balance sheet., the assets and liabilities at the end of the year are
enumerated in the closing balance sheet. The opening balance sheet is
normally prepared to find out the missing figure of capital fund in the
beginning of the year.

Case IX: When Incomplete / Wrong statements are given and

corrected accounts of non-profit organisation are to be prepared.

Case X: Accounts of Hospital: Hospitals, like other non profit

organisations, are required to prepare financial statements to present
their activities in a meaningful manner. Hospitals generally operate a
number of separate but related activities. Inspite' of the varied
activities undertaken, the procedure of preparation and presentation
of financial statements is similar to the one used by other non profit
organisations.

Case XI: Accounts of educational institutions: like other non-profit

organisations, educational institutions need to report on their
activities and to effectively communicate their financial needs. These
institutions by and large, depend upon 'Government Grants' for their
activities. Unrestricted grants are grants that by their term are fully
expended with in the year or receipt, and are treated as income and
credited to income and expenditure account.
 LESSON - 7
ERRORS MANAGEMENT

Trial balance is prepared to check the arithmetical accuracy or

correctness of recording in journal, posting to ledger and balancing of
ledger accounts In case trial balance agrees, it is assumed that
recording, posting and balancing has been done correctly or
accurately. However, if it does not tally, efforts are made to locate
errors in accounting records. Moreover, agreement of trial balance is
not a conclusive proof of accuracy of records. Even when the trial
balance agrees, some errors may remain in accounting records. For
example, non-recording of credit sale transaction in Sales Book will
not affect (he agreement of trial balance because both (i.e., debit as
well as credit) aspects of the sale transaction are not recorded in this
case. Errors, whether affecting trial balance or not affecting trial
balance, are to be corrected. The procedure followed to remedy the
errors committed and to set right accounting records is called
rectification of errors.

Type of Errors
1. Errors of Omission : It refers to omission of a transaction at
the time of recording in subsidiary books or posting to ledger.
When a transaction is not recorded in the books of original
entry, agreement of trial balance is not affected because both
(debit as well as credit) aspects of a transaction are not
recorded. However, if omission takes place at the time of posting
into ledger accounts, agreement of trial balance is disturbed as
either debit or credit aspect of the transaction is ignored. For
example, omission of credit purchase transaction at the time of
recording in purchases book does not affect the agreement of
trial balance, as posting to purchases book does not affect the
 agreement of trial balance, as posting to purchases amount and
supplier's account is not done. However, omission at the time of
posting to supplier's account affects the agreement of trial
balance as posting to purchases account takes place.

2. Errors of Commission : Besides omission at the time of

recording or posting, business transactions are sometimes
recorded and posted in a wrong manner. Such errors are
referred to as errors of commission. These errors may or may
not affect the agreement of trial balance. For example, 1
recording of wrong amount in subsidiary books, posting an
amount to wrong account, etc. are two sided errors and do mot
affect trial balance; However wrong totaling (or casting) of
subsidiary books, posting on wrong side of an account, posting
of wrong amount, wrong balancing of an account etc, are one
sided errors and affect the agreement of trial balance.

3. Compensating Errors: When two or more one sided errors take

place in such a way that their effect is nullified, these are
referred to as I compensating errors. For example, if Rs. 500
credit sales to Ramesh to ' posted to debit side of Ramesh's
account is omitted at the time of posting and Rs. 500 credit
purchases from Naresh to be posted to credit side of Naresh's
account is not posted to credit side of Naresh's account, these ?'
are termed as compensating errors. First error reduces debit
side total by Rs. 500 and second error reduces credit side total
by Rs. 500. As a result, trial balance agrees. Thus,
compensating errors do not affect the agreement of trial
balance. Errors of omission, commission and compensating
errors are also termed as clerical errors

4. Errors of Principle : Besides clerical errors, sometimes

accounting principles are violated in accounting process. Errors
 involving violation of accounting principles are termed as e.rors
of principle. Generally, these errors relate to distinction between
capital and revenue items. Treatment of capital expenditure as
revenue receipts or vice versa are errors of principle. For
example, debiting purchase of furniture to office expenses
account, crediting rent received from tenant to tenant's account,
crediting sale of furniture sales account, debiting payment of
salaries to employee's account etc. involve errors of principle.
These error do not affect the agreement of trial balance.

ERROR MANAGEMENT
The whole idea of error management can be executed in three steps,
namely:-

i. Prevention of errors,

ii. Detection of errors, and

(A) Prevention of Errors

The best way to manage the errors is to prevent them from occurring
in the accounts prepared by the business concern. As is said,
"Prevention is better than cure". It is the responsibility of the
management to prevent errors. The management can prevent the
errors in the nature of fraud by exercising an effective internal control
system. It should also curb its own tendencies to window dress the
accounts in order to present their report card in a colourful manner. It
should not allow the prejudice and bias to enter the accounts where it
is avoidable.

The errors other than fraud are caused by the following reasons:

i) Ignorance on the part of employees of latest accounting

developments, generally accepted accounting principles, appropriate
account classification of the necessary subsidiary ledgers with
controlling accounts and of good accounting practices in general;
ii) Carelessness on the part of those doing the accounting work.

(B) Detection of Errors

Despite the best of the efforts of the management, some errors may
still remain in the accounts. However, the rectification of error is
possible only when an error is detected. From the point of view of
detection of errors, all errors can be broadly classified in two
categories:

i) Errors which do not affect the agreement of the

triafbalance. They are also called two sided errors or
undisclosed errors. These errors take the form of complete
omission, commission, principles or compensating errors.
The errors are called undisclosed because one is net sure
of their presence or absence.

ii) Errors which effect the agreement of trial balance. They

are also caiied ''one-sided errors or disclosed errors. These
errors take the form of partial omission or commission
errors. They are also called disclosed errors because one
is sure of their existence due to disagreement of trial
balance.

Following procedure can be adopted to locate the errors which are

there is the trial balance:

a) Recheck the totals of Dr. and Cr. Side of trial balance to

establish undercasting and overcasrting on either side;
b) Recheck the ledger balances as to their amount and nature
(whether Dr. or Cr.) and ensure that they are posted on the
right side of the trial balance;

c) If still error is not located, divide the difference in trial balance

by 2. If the amount of any account is same as computed
number, recheck the nature of the account (whether Dr. and
Cr.) and ensure it is posted on the right side of the trial balance;

d) Divide the difference by 9. If it is completely divisible, the error

probably may be an outcome of the transposition of the figure
(e.g.. 95 written as 59). Although it may give some idea, the
exercise has to be very thorough;

e) If the difference is very big, the balance in various accounts

should be compared with balances of me last year. If the
difference is material, we have sufficient cause to examine the
account in detail;

f) If still the error is not locatable, recheck the totals of subsidiary

books and ensure they are properly transferred;

g) Recheck the schedules of debtors and creditors;

h) Recomputed the account balances;

i) If stil! the error is not detected, recheck all the entries in the
genera! journal for any possible omission, ' commission,
principle and self compensating errors.
(C) Rectification of Errors

Once error is detected, the need for its rectification arises. The
rectification of error should always be done with the help of a journal
entry and not by cutting, pasting or overwriting at the place of error.
Rectification of error depends upon the type of error and the time of
its rectification. Accordingly, the topic of rectification of error can be
broadly discussed as under;

Rectification of Two Sided Errors

Two sided errors are rectified by passing a journal entry called

rectifying entry. Thus, rectification entries are entries passed to
correct the errors committed and set right the accounting records.

Rectification procedure is explained with the help of few examples as

follows:-
1) Payment of rent of building Rs. 5,000 is debited to landlord's
account.

Entry Passed: Landlord Account Dr.

5,000
To cash Account
5,000

Entry Required: Rent Account Dr.

5,000
To cash Account
5,000

To rectify, credit landlord account which was wrongly debited

and debit rent account which should have been debited. Thus,
rectifying entry, is:
 Rent Account Dr.
5,000
To Landlord Account
5,000

2) Cash purchase of goods worth Rs. 5,000 from M/s Prashant

Furniture is debited to furniture account

Entry Passed: Furniture Account Dr.

5,000
To cash Account
5,000

Entry Required: Purchases Account Dr.

5,000
To cash Account
5,000

To rectify, credit furniture account which was wrongly debited

and debit purchases account which should have been debited. Thus,
rectifying entry is:

Purchase Account Dr. 5,000

To Furniture Account
5,000

3) Rs. 5,000 received from Ramesh is wrongly credited to Naresh

Account.

Entry Passed: Cash Account Dr.

5,000
To Naresh Account
5,000
Entry Required: Cash Account Dr.
5,000
To Ramesh Account
5,000

To rectify, debit Naresh's account which was wrongly credited

and credit Ramesh's account not creditei earlier. Thus, rectifying entry
is:

Naresh Account Dr.

5,000
To Ramesh Account
5,000

4) Rs. 5,000 goods purchased on credit from Mr. Anil wrongly posted
to the debit side of Anil's account and purchases book total Rs.
25,000 posted to debit side of purchases account as Rs. 15,000.

As Anil's account is wrongly debited by Rs. 5,000 instead of crediting

his account by Rs. 5,000 to correct Anil's account Rs. 10,000 should
be credited to Anil's account. Since purchases account is debited by
Rs. 35,000 instead of Rs. 25,000 therefore, purchases account is
debited by Rs. 10,000. Thux. rectifying entry is:
Purchase Account Dr.
10,000
To Anil Account
10,000

5) A sale of Rs. 10,000 to Subash is entered in the sales books as Rs.

1,000. It means sales account is credited by Rs. 9,000 less and
Subhash's account is debited by Rs. 9,000 less. Therefore, reclijying
entry is:
 Subhash Account Dr.
9,000
To Sales Account
9,000

Rectification of One-Sided Errors

Errors which affect the agreement of the trial balance are

termed as onesided errors. Undercasting (totaled less) of subsidiary
books, overcastting (excess total) of subsidiary books, omission of
posting to an account, posting of wrong amount to an account,
posting on wrong side of an account-etc., are some of the errors which
affect the agreement of trial balance. If .one-sided errors are located
before the preparation of trial balance, error is corrected by entering
the amount in affected account. For example, if total credit sales are
Rs. 10,000 but sales book is wrongly totaled as Rs. 9,500 error is
rectified as follows:

Dr. Sales Account Cr.

By sundries as per sales books

9,500

By undercasting of sales book

500

Rectification of One-Sided Errors after the Preparation of Trial

Balance

In case of disagreement of trial balance, efforts are made to

locate errors, and rectify them as discussed above. However, if
reason for disagreement of
trial balance can not be found, a new account called SUSPENSE
ACCOUNT is opened. Difference in trial balance is recorded is
suspense account so that the trial balance agrees and the process of
preparation of financial statement can can start.
In trial balance, if debit total is more than credit total, the
suspense account is credited Similarly, if credit total is more than
debit total, suspense^
account is debited,

Journal entries for one-sided errors through suspense account:

Difference in trial balance which is caused by one-sided errors

is put in suspense account. After opening of suspense account if some
errors are located, a .journal entry is passed to rectify them.
Rectification of one-sided errors involves either debit or credit to the
account to be rectified. To complete the double entry, second aspect is
recorded with the help of suspense account.-Difference in trial
balance transferred to suspense account is recorded as opening
balance of suspense account. After location and rectification of all
errors suspense account is automatically closed.

Journal entries required to rectify the one-sided errors given in

illustration 6 are as follows:

1) Purchases book has been totaled Rs. 500 less (undercasting): It

means at 'he time of posting to purchases account, it has been debited
by Rs. 500 less. To correct it, purchases account should be debited by
Rs. 500 To complete double entry, second aspect is recorded through
suspense account. The rectification entry appears as follows:
Purchase Account Dr.
500
To Suspense Account
500
2) Sales book has been totaled Rs. 1,000 more (ovcrcastting) : It
means ut the time of posting of sales book to sales account. Rs. 1,000
excess amoum has been credited. To correct the records, sales
account should be debited by Rs. 1,000. To complete double entry,
suspense account is credited. The rectification entry is as under:
Sales Account Dr.
1,000
To Suspense Account
1,000

3) Rs. 1,000 cash received from X has not heen posted to his
account : This amount should have been posted to credit side of X
account. To rectify the mistake of non-posting, X's account should be
credited by Rs. 1,000- To complete double entry, suspense account is
debited by the same account. The journal entry required to rectify the
error is as under;

Suspense Account Dr.

1,000
To X
1,000

4) Sales return from V Rs. 700 has been posted to Y's account as
Rs. 70 :

Rs. 700 should have been credited to Y's account. As the amount
actually credited is just Rs. 70, Rs. 630 more should be credited to Y's
account. To complete double entry, suspense accouni is debited by
Rs. 630 as follows:

Suspense Account Dr.

630
To YA/c
630
5) Rs. 4,000 cash paid to a creditor has been posted to the credit side
of creditor's account: Rs. 4,000 cash paid to a creditor should have
been debited To creditor account but ft is actually credited to creditors
account. To have correct balance in creditors account Rs. 8,000
should be debited to creditors accounf. Debiting of double amount i.e.,
Rs. 8,000 nullfiles the effect of wrong credit of Rs. 4,000 and ensures
correct debit of Rs. 4,000. The journal entry' | passed for this is as
follows:

Creditors Account Dr.

3,000

To Suspense Account
8,000
Above entries are posted to suspense account as follows;

Dr Suspense Account
Cr.
To Difference in 7,870 By Purchase A/c 500
trial balance By Sales A/c 1,000
(balancing figure) By Creditors 8,000
To X 1,000
To Y 630

After rectification of all the errors, suspense account must

balance. In this case after posting of rectification entries to suspense
account, one finds the debit side 'is short by Rs 7 870 This balancing
figure m suspense account as taken as the opening balance of
suspense account, being the difference in tnal balance transferred to
suspense account.

Errors and Profit : Errors will effect profit only when nominal
accounts recorded in income statement are affected. Effect of
abovementioned errors and their effect on profit is explained as
follows:
a) Wrong credit to sales account increase reported profit by
Rs. 70,000. Correct profit can be calculated by
rectification of this error. Rectification reduces sales
account balance and thus, profit by Rs. 70,000.

b) Wrong debit to wages account reduces reported profit by

Rs. 1,000. To calculate correct profit rectification entry is
passed. It ^uces wages account balance by Rs. 1,000 and
thus, increases profit by Ri. 1,000.

c) Non-posting of discount received balance reduces

reported; profit by Rs 2,500 and thus, increase profit
figures by Rs. 2,500 to report-correct profit figure, -

d) Non-oostine of totalsales return increases net sales by Rs.

12,000. It by Rs. 12,000. Rectification ;of this error reduces
net sales by Rs. 32,000 and thus profit after rectification is
reduced by Rs 12,000 to report correct profit,

e) It does not affect any nominal account and, thus has no

effect on profit. It has not effect on profit as no nominal
account is affected. :

Effect on profit
Errors (a), (b), (c) and (d) do not affect nominal accounts and
therefore, have no effect on profits.

Error (e) affects nominal accounts. This error increases offices

expenses reduces the amount of purchases. As a result, gross profit is
increased and is nduced by the same amount. Therefore, this error
has no effect on net profit figure. Rectification of this error reduces
gross profit and increases net profit by the same amount.

Error (f) reduces rent account balance by Rs. 2,000 and thus
increases net profit by Rs. 2,000 . Rectification of this error reduces
net profit figure by Rs. 2,000 to report correct net profit figure.

Rectification of Errors after Finalisation of Accounts or in

the next
accounting period

The management should make every conceivable effort to

prevent occurrence of the errors in the accounts. However, if still some
errors creep in the accounts, they should be detected and rectified
before the flnalisation of accounts. But if despite the best of their
efforts the management is not able to trace the errors, the difference
should be put to the Suspense A/c and accounts finalized. The
suspense account should be shown in the balance sheet til! such time
itscauses are ascertained.
In the next accounting period, the rectification should be done
as and when tfye error is detected. However, the method of
rectification will depend upon whether the account affected is a
nominal account or any other account. If the account affected is other
than nominal, the rectification is done in the usual manner,' For
example, the amount received from X inadvertently recorded in Y's
account and left untraced last year will be rectified in the current year
by debiting X and crediting Y. Had this error been traced last year
itself, the same rectification entry would have followed.

However, if the error involves a nominal account having its

impact on the profit, the rectification is done in a different manner.
For example, if last year (he sales be jk was undercast by Rs. 10,000,
it would have led to a suspense account with a credit balance of Rs.
10,000 in the trial balance. If the error was to be detected last year
before the fmalisation of accounts, the rectification entry would have
been ;
Suspense Account Dr.
10,000
To Sales Account
10,000

However if the error is detected in the current year after the

finalisation of accounts, the same rectification entry will ensure that
the current year sales is unnecessarily inflated by Rs. 10,000. The last
year profit was under reported by Rs. 10,000 and the current year
profit will be over reported by the same amount.
The errors of these kind should be correct as "Prior Period Items'' or
through 'Profit and Loss Adjustment Account' and shown in the
current year profit and loss account as prior period items as per the
requirement of AS-5 (Revised). As per AS-5, Prior period items are
income or expenses which arise in the current period as a result of
errors omissions in the preparation of the financial statements of the
one or more prior periods. It is recommended that the impact of the
prior period items be shown separately in the profit and loss account
of the current accounting period.

Hence, the entry for this aspect will be:

Suspense Account Dr
10,000
To Profit & toss Adjustment Account
10,000

The profit and loss adjustment account is closed by transfer to

the current year profit and loss account as a prior period item. Hence,
the profit of current year clearly reflects the effect of the errors of the
past period.
 A close look at the following examples will make more clear the
mechanism of rectification (a) if its is done in the same accounting
period; and (b) if it is done in the next accounting period;

i) Purchase book is undercast by Rs. 5,000:

Rectification entry ij it is done in the accounting period of the error

Purchase Account Dr.
5,000
To Suspense Account
5,000

Rectification entry if it is done in the next accounting period,

Profit & Loss Adjustment Account Dr.
5,000
To Suspense Account
5,000

ii) Rent paid of Rs. 2,000 debited to landlord account and included in
the list of
debtors:
Rectification entry if it is done in the accounting period of the error itself
Rent Account Dr.
2,000
To Debtors Account
2,000

Rectification entry if it is done in the next accounting period

Profit & Loss Adjustment Account Dr.
2,000
To Debtors Account
2,000
iii) Private purchases of Rs. 1,000 passed through purchase account:
Rectification entry if it is done in the accounting period of the error itself
Drawings Account Dr.
1,000
To Purchase Account
1,000

Rectification entry if it is done in the next accounting period.

Drawings Account Dr.
1,000
Profit & Loss Adjustment Account
1,000

iv) Cash received of Rs. 4,000 from X shown on the debit of Y's
account: Rectification entry if if is done in the accounting period of the
error itself.
Suspense Account Dr.
8,000
To X Account
4,000

To Y Account 4,000 Rectification entry if if is done in the next

accounting period.
Suspense Account Dr.
8,000
To X Account
4,000
To V Account
4,600

Note that the entry is same in both the cases. The basic reason is
jthat the account affected is not a nominal account.
Illustration 1;
A book keeper while preparing his trial balance finds that the
debit exceeds by Rs. 7,250. Being required to prepare the final
account he places the difference to a suspense account. In the next
year the following mistakes were discovered:
a) A sale of Rs. 4,000 has been passed through the purchase
day book. The entry in the customer's account has been
correctly recorded;

b) Goods worth Rs. 2,500 taken away by the proprietor for

his use has been debited to repairs account;

c) A bill receivable for Rs. 1,300 received from Krishna

has been dishonoured on maturity but no entry passed; :

d) Salary of Rs. 650 paid to a clerk has been debited to his

personal account;

e) A purchase of Rs. 750 from Raghubir has been debited to

his account. Purchase account has been correctly debited;

f) A sum of Rs. 2,250 written off as depreciation on

furniture has not been debited to depreciation account.

Draft the joyrnal entries for rectifying the above mistakes and prepare
the suspense account and profit and loss adjustment account,
Journal
a) Suspense A/c Dr. 8,000
To Profit & Loss Adjustment A/c 8,000
(Being wrong recording of sales as
purchase last year rectified)
b) Drawings A/c Dr. 2,500
To Profit & Loss Adjustment A/c 2,500
(Being Drawings made last year
inadvertently shown as repairs now
rectified)
c) Krishna A/c Dr. 1,300
To Bills Receivable A/c 1,300
(Being bill dishonoured last year now
recorded in the books)

d) To Profit & Loss Adjustment A/c Dr. 650

To Clerk's Personal A/c 650
(Being salary paid to clerk last year
inadvertently shown in his personal
account now rectified)
e) Suspense A/c Dr. 1,500
To Raghubir A/c 1,500
(Being purchase from Raghubir) shown
on debit side of his account
inadvertently now rectified)
f) Profit & Loss Adjustment A/c Dr. 1,500
To Suspense A/c 1,500
(Being depreciation not shown last
year now rectified)

Dr. Suspense Account

 Cr.
To Profit & Loss 8,000 By balance b/d 7,250
Adjustment A/c
To Raghubir A/c 1,500 By Profit & Loss 2,250
Adjustment A/c
9,500 9,500
Dr. Profit & Loss Adjustment Account
Cr.
To Clerk's Persona] 650 By Suspense A/c 8,000
A/c
To suspense A/c 2,250 By Drawings A/c 2,500
To Profit & Loss 7,600
Adjustment A/c
(Transfer)
10,500 10,500
 LESSON - 8
ACCOUNTS FROM INCOMPLETE RECORDS-SINGLE ENTRY
SYSTEM

SALIENT FEATURES

a) Incomplete Double Entry System : Dual aspect of a

transaction is not recorded under this system. Recording is
done according to convenience and information needs of the
business. As information needs of business entities are
governed by size of business, nature of Business, prevailing
circumstances etc., the procedure of recording followed by
different business entities may vary. Therefc -e, there is no
uniformity in maintenance of records under single entry system.

b) Flexibility : Single entry system is flexible as recording

procedure can be adjusted according to the information
needs of a particular business enterprise. As rules of double
entry system are not followed, knowledge of principles of
double entry system of book-keeping is not necessary.

c) Variation of Recording Process : Single entry system is

incomplete double entry system, varying according to
information needs of business entities. There is no hard and
fast rule for maintenance of records under this system. But,
generally, cash book and personal accounts are maintained
under this system.

d) Importance of Source Document: As complete recording is not

done urder single entry system, source document like sales
bills, purchase bills, vouchers etc., play very important role in
 collection of necessary information, for finding out profit (or
loss) and preparing financial position statement.
c) Less Expensive: As complete records are not kept, time and
labou; involved in maintaining accounting records is less in
comparison to double entry system.

d) Suitability : Use of single entry system is not permitted in case

of corporate entities. It is generally followed by non-corporate
entities of small size.

Limitations of Single Entry System. Single entry system has

following limitations;

a) Unscientific : There are no set rules for maintaining records

under such system. Absence of systematic recording of both
aspects of a transaction under single entry system makes it
unscientific.

b) No trial balance : Dual aspect of a transaction is not recorded

under this system. As a result, trial balance can not be
prepared from accounting records maintained. Hence,
arithmetical accuracy of accounting records can not be checked.

c) Determination of true profit (or loss) not possible : Nominal

accounts are not maintained and, therefore, it is not possible to
prepare trading account and profit and loss account to calculate
gross profit and net profit respectively. Although the amount of
net profit is determinable but the absence of details of revenue,
other incomes, expenses and losses affect sound decision
making.

d) True financial position cannot be determined: Absence of

real accounts makes the job of preparation of balance sheet a
 very difficult one. As information about assets is not available
from records, these items are estimated. Statement listing
assets and liabilities in this case is called 'Statement of Affairs'
instead of Balance sheet. Statement of affairs fails to reveal the
true financial position of the business.

e) More chances of errors and frauds : Trial balance cannot be

prepared to check prima facie arithmetical accuracy of accounts.
It encourages carelessness, misappropriations and frauds
because, in the absence of comolete records, detection of errors
and frauds is very difficult.

f) Unsuitable for planning and control : In the absence of

reliable information about nominal and real account, effective
planning and control over expenses, assets etc., is not
possible. :

g) Legally not recognised : According to the Indian Companies

Act, 1956, single entry system cannot be employed by
companies. Moreover, accounts maintained on single entry are
not accepted by sales tax and income tax authorities.

h) Inter- firm Comparisons not possible : Because of variation

in. accounting procedure and rules, comparisons of two or more
businesses is not possible.

'Inspite of the above limitations, an accountant is required

to ascertain profit, (or loss) and prepare financial position statement
at accounting date. Methods followed for this are a follows:

a) Statement of Affairs Method or Pure Single-Entry System.

b) Conversion Method or Quasi Single-Entry System.

Statement of Affairs Method

Under statement of affairs method, statement of affairs is

prepared in the beginning and the end of the year to calculate capital
in the beginning and the end of the year respectively. Statement of
affairs lists assets on right hand side, liabilities on the left hand side
and the excess of assets over liabilities is assumed to be capital and
recorded on left hand side so that total assets are equal to liabilities is
assumed to be capital and recorded on left hand side so that
information about assets and liabilities plus capital. It must be
remembered that complete information about assets and liabilities is
not available from accounting records and some of these assets and
liabilities are estimated. Proforma of a Statement of Affairs is as
follows;
Statement of Affairs as on...

Liabilities Amount Assets Amount

Creditors Cash
Bills payable Bank
Outstanding Debtors

expenses
Unearned income Bills receivable
Loans Stock
Capital (Balancing Prepaid expenses

figure)
Accrued income
Fixed assets

Distinction Between Statement of Affairs and Balance Sheet :

Following are the points of difference between a statement of affairs
and a balance shed.

a) Balance shees records balances of assets, liabilities and capital

drawn from the ledger books. Statement of Affairs contains
information either drawn from accounting records (if records are
maintained) or bases on estimates (if records are not
 maintained). Therefore, information contained in balance sheet
is more reliable as compared to information contained in the
statement of Affairs.

b) Balance sheet contains information about capital as per

accounting records In statement of affairs capital is taken as
balancing figure, being the difference between lotal assets and
total liabilities.

c) Balance sheet lists balances of assets, liabilities and capital

.drawn from accounting records based on double entry system.
If an asset or liability is omitted, balance sheet does not tally.
Then, error is detected and corrected. However, in case of
statement of affairs, omission of an asset or liability goes
unnoticed because capital is taken as balancing figure.

d) Balance sheet is prepared to show financial position of the

business as per accounting records. Statement of affairs, on the
other hand, is prepared to calculate capital at a particular point
of time.

Calculation of Profit (or loss): To calculated profit or 'oss following

steps are
required:

a) To find out capital in the beginning of the year (called opening

capital) prepare statement of affairs at the beginning of the year.

b) To calculate capital at the end of the year (called closing capital)

statement of affairs at the end of the year is prepared.

c) After calculating opening capital and closing capital, capita]

introduced and drawings made during the year are adjusted to
 find out profit (or loss) for the year by using the following
relationship.

Opening Capital + Additional Capital – Drawings + Profits **Closing

Capital
Or
Profit = Closing Capital - Additional Capital + Drawings - Opening
Capital

Calculation of profit or loss is shown in the form of a statement as

follows:
Statement of Profit (or loss) for the period ending....
Amount
Capital at the end
Add: drawings
Less: additional capital introduced during the

year
Less: capital in the beginning of the year
Profit (or loss) for the year

Adjustment to be made: Sometimes certain adjustments are given in

the' question. These adjustments may relate to interest on capital,
interest on drawings, depreciation on fixed assets, provi^ons for
doubtful debts etc., In this case statement of affairs, prepared to
calculate capital on the date of statement, records assets and
liabilities before any adjustment.

Profit as shown by statement of profit in this case is not net.profit

earned during
the year.

Profit as shown by statement cf profit is'adjusted to calculate net

profit as
follows:
 Profit and Lots Account /or the year ending.....
To Depreciation on Fixed Asset By Profit before

adjustment as shown in

the statement of profit

To Provision for Doubtful By Interest on Drawing

Debts
To Interest on Capital
To Net Profit transferred to
Capital Account

Conversion Method

Accounts maintained under single entry system are not

sufficient to extract trial balance at the end of the accounting period.
As a result, final accounts or financial statements cannot be prepared
from incomplete records unless steps are taken for their completion.
Under conversion method, cash accountant, debtors account,
creditors account etc., maintained on single entry basis are analysed
and an attempt is made to complete double entry by making
necessary posting is done. After completing records on the basis of
double entry system or preparation of final accounts from incomplete
records.

In actual practice, conversion involves completion of ledger

books, preparation of a trial balance and, then financial statements. ;
However, for solving examination problems, above mentioned
procedure of conversion and the absence of detailed information in the
question. To solve examination problems significant information
required for completion of trading account, profit and loss account
and balance sheet is calculated from whatever information is given in
the question. After calculating significant information missing in the
questions, final accounts are prepared as usual.

To calculate missing figures, the following steps are recommended:

a) Prepare statement of affairs in the beginning of the year.

b) Prepare cash book or cash account.

c) Prepare total debtors account and bills receivable account.

d) Prepare final accounts. :

Whatever information is given in the question, record that in

accounts) involved. Knowledge about items usually appearing in these
accounts gives an idea about information missing in the question.
Then an attempt is made to calculate missing information by using
rules of double entry system,

Proforma of Total Debtors Account, Total Creditors Account,

Bills Receivable Account and Bills Payable Account is given below to
have an idea about the items isuaily appearing in these accounts.

Dr. Total Debtors A/c

Cr.
To balance b/d By Cash or Bank A/c
(Debtor in the beginning) (Amount received from

debtors)
To Sales A/c To Bills receivable A/c
(Credit sales) (Bills drawn on debtors)
To Bills receivable A/c By Sales Return A/c
(Bill dishonoured) By Discount Allowed A/c
By Bad Debts A/c
By balance c/d
(Debtors at the end of the

year)

Dr. Bills Receivable A/c

Cr.
To balance b/d By Cash A/c & Discount A/c
(Balance in the beginning) (for B/R Discount)
To Debtors A/c By Creditors A/c
(Bills drawn during the year) (B/R endorsed to creditors)
 By Cash A/c
(B/R encashed on due date)
By Debtors A/c

(B/R dishonoured)
By balance c/d
(B/R at the end)

Dr. Total Creditors A/c

Cr.
To Cash A/c or Bank A/c By balance b/d
(Amount paid to creditors) (Creditors in the beginning)
To Bills Receivable A/c By purchases A/c
(for B/R endorsed) (Credit purchases)
To Bills Payable A/c By Bills payable A/c
(Bills accepted) (Bills payable dishonoued)
To Purchases Return A/c
To Discount Received A/c
To balance c/d
(Creditors at the end)

Dr. Bills Payable A/c

Cr.
To Cash A/c By balance b/d
(B/P paid on due dates) (B/P in the beginning)
To Creditors A/c By Creditors A/c
(B/P dishonoured) (Bills accepted during the
year)
To balance c/d
(B/P at the end)

Gross Profit Ratio: Sometimes, gross profit ratio (i.e. Gross profit /
Net sales x 100) is given in the question. In that, case, the amount of
gross profit figure in trading account, calculation of missing
information about any one of the items recorded in trading account
can take place. Items recorded in trading account are opening stock,
purchases, direct expenses and closing stock.
Illustration 1: Find out the amount of direct expenses from the
following
details:
Rs.
Stock on 1-4-98 17,000
Stock on 31-3-999 12,000
Purchases during 1998-99 000
Sales during 1998-99 1,28,000
Gross profit ratio 25%

Dr. Trading Account for the year ended March 31, 1999
Cr.

To Opening Stock 17,000 By Sales 1,28,000

To Purchases 77,000 By Closing Stock 12,000
To Direct Expenses 14,000
(Balancing figure)
To Gross Profit
(25% of Rs.

1,28,000)
1,40,000 1,40,000

Illustration 2:

Data Ram maintains his records on single entry system. While

records of. business takings and payments have been kept, these have
not been reconciled with cash in hand. From time to time cash has
been paid into a bank account and cheques thereon have been drawn
both for business use and private purposes. From the following
information, prepare the final accounts for the year 1998:

Assets and liabilities at the beginning and at the end of the period
have given below:

1-1-1998 31-12-1998
Stock 20,000 15,000
Bank Balance 8,000 12,000
Cash in hand 300 400
Debtors 14,000 20,000
Creditors 27,300 30,000
Investments 50,000 50,000

Other transactions are as follows:

Cash paid in bank 1,50,000
Private dividends paid into bank 59,700
Private payments out of bank 26,000
Business payments for goods out of bank 1,22,000
Cash takings 2,50,000
Payment for goods by cash and cheque 1,60,000
Wages 97,700
Delivery Expenses 7,000
Rent and rates 2,000
Lighting 1,000
General Expenses 4,600

During the year, cash amounting to Rs. 20,000 was stolen from
the till, ucods worth Rs. 24,000 were withdrawn from private use. No
record has been kept of amounts taken from cash for personal use
and a difference in cahs amounting to Rs. 7,300 is treated as private
expenses.

Dr. Cash A/c Cr.

To balance b/d 300 By Defalcation 20,000
To Sales A/c 2,50,000 By Bank A/c 1,50,000
To Debtors A/c 1,42,000 By Drawings A/c 7,300
(balancing figure) By Purchases A/c 1,02,300
(1,600,000-57,700)
By Wages A/c 97,700
By Delivery Expenses 7,000

A/c
By Rent& Rates A/c 2,000
By Lighting A/c 1,000
By General Exp. A/c 4,600
By balance c/d 400
3,92,300 3,92,300
Dr. Bank A/c Cr.
To balance b/d 8,000 By drawings A/c 26,000
To Cash A/c 1,50,000 By Business Payment 1,22,000

A/c
To Capital A/c 59,700 By Purcahse A/c 57,700

(Dividend)
(balancing figure)
By balance c/d 12,000
2,17,000 2,17,000

Dr. Sundry Debtors A/c

Cr.
To balance b/d 14,000 By Cash A/c 1,42,000
To Sales A/c (balancing By balance c/d 20,000

figure)
1,62,000 1,62,000

Dr. Sundry Creditors Cr.

To balance c/d 30,000 By balance b/d 27,300
By Purchases A/c (balancing 2,700

figure)
30,000 30,000
 Balance Sheet as at 1-1-98
Liabilities Amount Assets Amount
Creditors 27,300 Stock 20,000
Capital (Balancing figure) 65,000 Bank 8,000
Cash 300
Debtors 14,000
Investments 50,000
92,300 92,300

Trading & Profit & Loss A/c for the year ended 31-12-98
To Opening Stock 20,000 By Sales :

A/c
To Wages 97,700 Cash 2,50,000
To Purchaes : Credit 1,48,000
Cash 1,60,000 By closing Stock 15,000

A/c
Credit 2,700
1,62,000
Less Drawings 24,000 1,38,700
To Gross Profit 1,56,600
4,13,000 4,13,000

To Business Payment 1,22,000 By Gross Profit 1,56,600

A/c
To Rent & Rates A/c 2,000
To Lighting A/c 1,000
To General Expenses 4,600

A/c
To delivery Expenses A/c 7,000
To Defalcation A/c 20,000
1,56,600 1,56,600

Balance Sheet as at 31-12-98

Liabilities Amount Assets Amount
 Opening Capital 65,000 Investment 50,000
Add: Additional Capital 59,700 Stock 15,000
1,24,700 Debtors 20,000
Less: Drawings 57,300
(7,300+26,000+24,000 67,400 Bank 12,000

)
Creditors 30,000 Cash 400
97,400 97,400

Difference between Double Entry system and Single Entry System

Of difference between double u"Hry system aj)d single entry

system of book keeping.
a) Dual-Aspect : Under double ciury syrricrti bolh aspects of al!
business transactions are rcco:tie. Under single entry system
both aspects of all business transactions are not recorded.

b) Trial Balance: Under double entry system trial balance can be

prepared to check the arithmetical accuracy of accounts. Under
single entry sysuai trial balance cannot be prepared because
duaI-aspect of ail transactions are not recorded.
c) Type of Accounts: Under double entry system nominal,
persona! and real accounts are maintained. Under single entry
system, generally, personal accounts and cash books is
maintained.

d) Rules of Recording : Under double entry system, rules of

double entry system are followed by all concerns. Under single
entry system, as the system is adjusted according to
convenience and needs of the business, rules followed for
recording vary from concern to concern.

c) Cost : As complete records ore kept under double entry system,

cost of maintaining records is more in comparison to single
entry system.
d) Legal Recognition : Corporate entities cannot follow single entry
system as it goes against the provisions of the Indian
Companies Act, 1956. Even sales tax and income tax authorities
do not recognise single entry system.

g) Details of Net Profit (or Loss) : Under double entry system

details of expenses, revenue and incomes are available because
of maintenance of normal accounts. Under single entry system,
though net profit (or loss) is calculated, but details of expenses
revenue and incomes are not available.

h) Financial position : Under double entry system,

financial'position statement reveals trne financial position based
on accounting, records. Under single entry system, statement of
affairs based on incomplete records and estimates is prepared to
reveal financial position of 'he business.

i) Errors and Frauds : Non-preparation of trial balance due to

incomplete recording under single entry system encourages
carelessness, misappropriations and frauds. Fear of detection of
errors and frauds under double entry system reduces chances
of errors and frauds.

j) Inter-firm Comparisons : Comparison of two or more business,

concern is possible under double entry system because same
set of rules are followed by all concerns. Inter-firm comparisons
under single entry are not valid because of variation in rules of
recording.

k) Reliability : Absence of systematic recording on the basis of

double entry rules makes information available under single
 entry system less reliable as compared to information available
under double entry system.

l) Suitable : Double entry system is suitable for all types of

business. IS> enTry system suits only small non-corporate
enuues.
 LESSON - 9 FINANCIAL STATEMENT ANALYSIS

MEANING OF FINANCIAL STATEMENTS

According to Himpton John, "A financial statement is an

organized collection of data according to logical and consistent
accounting procedures. Its purpose is to convey an understanding of
some financial aspects of a business firm. It may show assets position
at a moment of time as in the case of a balance sheet, or may reveal a
series of activities over a given period of limes, as in the case of an
income statement ".

On the basis of the information provided in the financial

statements, management makes a review of the progress of the
company and decides the future course of action.

DIFFERENT TYPES OF FINANCIAL STATEMENTS

1. Income Statement
2. Balance Sheet
3. Statement of Retained earnings
4. Funds flow statement
5. Cash flow statement.
6. Schedules.

FUNDAMENTAL CONCEPTS OF ACCOUNTING

1. Going concern concept

2. Matching concept ( Accruals concept)
3. Consistency concept
4. Prudence concept ( conservation concept)
 5. Business entity concept
6. Stable monetary unit concept
7 Money measurement concept
7. Objectivity concept
8. Materiality concept
9. Realization concept.

LIMITATIONS OF FINANCIAL STATEMENTS

1. In profit and loss account net profit is ascertained on the basis

of historical
costs.

2. Profit arrived at by the profit and loss account is of interim

nature. Actual profit can be ascertained only after the firm
achieves the maximum capacity.

3. The net income disclosed by the profit and toss account is not
absolute but only relative.

4. The net income is the result of personal judgment and bias of

accountants cannot be removed in the matters of depreciation,
stock valuation, etc.,

5. The profit and loss account does not disclose factors like quality
of product, efficiency of the management etc.,

6. There are certain assets and liabilities which are not disclosed
by the balance sheet. For example the most tangible asset of a
company is its management force and a dissatisfied labour force
is its liability which are not disclosed by the balance sheet.
7. The book value of assets is shown as original cost less
depreciation. But in practice, the value of the assets may differ
depending upon the technological and economic changes.

8. The assets are valued in a Balance sheet on a going concern

basis. Some of the assets may not relate their value on winding
up.

9. The accounting year may be fixed to show a favorable picture of

the business. In case of Sugar Industry the Balance sheet
prepared in off season depicts a better liquidity position than in
the crushing season.

10. Analysis Investor likes to analyse the present and future

prospectus of the business while the balance sheet shows past
position. As such the use of a balance sheet is only limited.

11. Due to flexibility of accounting principles, certain liabilities like

provision for gratuity etc. are not shown in the balance sheet
giving the outsiders a misleading picture.

12. The financial statements are generally prepared from the point
of view of shareholders and their use is limited in decfsion
making by the management, investors and creditors.

13. Even the audited financial statements does not provide

complete accuracy.

14. Financial statements do not disclose the changes in

managernent, Loss of markets, etc. which have a vital impact on
the profitability of the concern.
15. The financial statements are based on accounting policies which
vary form company to company and as such cannot be formed
as a reliable basis of judgment.

FORMATS OF FINANCIAL STATEMENTS

The two main financial statements, viz the Income Statement

and the Balance sheet, can either be presented in the horizontal form
or the vertical form where statutory provisions are applicable, the
statement has to be prepared in accordance with such provisions.

Income Statement :

There is no legal format for the profit and loss A/C. Therefore, it
can be presented in the traditional T form, or vertically, in statement
form. An example of the two formats is given as under.

(i) Horizontal, or “T” form:

Manufacturing, Trading and profit and loss A/C of

………........... for the year ending .........................

Dr Cr
Particulars Rs. Particualrs Rs.
To opening stock By cost of finished Goods Xxxx

c/d
Raw materials xxx By closing stock
Work in progress xxx Raw materials xxx
Work in progress xxx
To purchases of raw xxx

materials
To manufacturing wages xxx
To carriage inwards xxx
To other Factory Expenses xxx
xxx xxx
By sales xxx
To opening stock of xxx By closing stock of xxx
finished finished
goods goods
To cost of Finished goods xxx By Gross Loss c/d xxx

b/d
To Gross Profit c/d xxx
xxx xxx
To Gross Loss b/d xxx By Gross profit b/d xxx
To office and Admn. xxx By Miscellaneous Receipts xxx

Expense
To Interest and financial xxx By Net Loss c/d xxx

expenses
To provision for Income-tax xxx
To Net Profit c/d xxx
xxx xxx
To net loss b/d xxx By Balance b/d xxx
To general reserve xxx (from previous year)
To Dividend xxx By Net profit b/d xxx
To Balance c/f xxx
xxx xxx

(ii) Vertical Form

Income statement of ………… for the year ending ……………...
Particulars Rs. Rs.
Sales xxxx
Less: Sales Returns xxx
Sales Tax/ Exise Duty xxx xxxx
Net sales (1) xxxx
Cost of Goods Sold
Materials Consumed xxxx
Direct Labour xxxx
Manufacturing Expenses xxxx
Add / less Adjustment for change in stock xxxx

(2)
xxxx
Gross Profit (1) – (2) xxx
Less: Operating Expenses
Office and Administration Expenses
Selling and Distribution Expenses xxx
xxx xxx
Operating Profit Xxxx
Add: Non-operating Income Xxx
Less: Non-oprating Expenses (including Interest) xxxx
 Profit before Tax xxx
xxxx
Less : Tax xxx
Profit After Tax xxxx
Appropriations
Transfer to reserves
Dividend declared /paid xxxx
Surplus carried to Balance sheet xxx
xxx
xxxx

Balance Sheet

The Companies Activities, 1956 stipulates that the Balance

sheet of a joint stock company should be prepared as per part I of
schedule VI of the Activities. However, the statement form has been
emphasized upon by accountants for the purpose of analysis and
Interpretation. The permission of the Centra! Government is necessary
for adoption of the 'statement* form.
(i) Horizontal Form
Balance sheet of .................... as on ....................
Liabilities Rs. Assets Rs.
Share Capital xxx Fixed Assets:
(with all paticulars of 1. Goodwill xxx

Authorized, Issued, 2. Land & Building xxx

Subscribed capital) Called xxx 3. Leasehold property xxx

up capital 4. Plant and Machinery xxx

5. Furniture and Fittings xxx

Less: Calls in Arrears xxx 6. Patents and Trademarks xxx
Add: Forfeited Shares xxx 7. Vehicles xxx
Reserves and Surplus : Investments
1. Capital Reserve xxx Current Assets, loans and
2. Capital Redemption Advances
reserve xxx (A) Current Assets
3. Share premium xxx 1. Interest accured on
4. Other premium xxx Investments xxx
Less: debit balance of Profit xxx 2. Loose tools xxx
and loss A/C (if any) 3. Stock in trade xxx
5. Profit and Loss xxx 4. Sundry Debtors xxx
Appropriation A/C Less: Provision for doubtful
6. Sinking Fund xxx debts
5. cash in hand xxx
6. cash in Bank xxx
Secured Loans (B) Loans and Advances
Debentures xxx 7. Advances to subsidiaries xxx
Add: Outstanding Interest xxx 8. Bills Receivable xxx
Loans from Banks xxx 9. Prepaid Expenses xxx
Unsecured Loans Miscellaneous Expenditure

(to the extent not written off

or
Fixed Deposits xxx adjusted) xxx
Short-term loans and xxx

advances
Current Liabilities and 1. Preliminary expenses xxx

Provisions 2. Discount on Issue of xxx

shares
and debentures
A. Current Liabilites 3. Underwriting Commssion xxx
1. Bills Payable xxx
2. Sudnry Creditors xxx Profit and Loss account

(Loss),
3. Income received in xxx if any

advance
4. unclaimed Dividends xxx
5. Other Liabilities xxx

B. Provisions
6. Provisions for Taxation xxx
7. Proposed Dividends xxx
8. Proposed funds & xxx

pension
fund contingent liabilities

not
Provided for
xxx xxx
(ii) Vertical Form:
Balance sheet of ………………………. as on …………………

Particulars Schedule No. Current Previous

year Year
I. Source of funds
1. Share holders funds
a. capital xxxx xxxx
b. Reserves and surplus xxxx xxxx
2. Loans funds
a. Secured Loans xxxx xxxx
b. Unsecured Loans xxxx xxxx
Total
II. Application of funds
1. Fixed Assets
a. Gross Block xxxx xxxx
b. less Deprciation xxxx xxxx
c. Net block xxxx xxxx
d. Capital work in progress xxxx xxxx

2. Investments xxxx xxxx

3. Current Assets, Loans and Advances

a. Inventions xxxx xxxx
b. Sundry Debtors xxxx xxxx
c. Cash and Bank balance xxxx xxxx
d. other current assets xxxx xxxx
e. Loans and Advances xxxx xxxx

Less : current Liabilities and Provisions

a. Current Laibilities xxxx xxxx
b. Provisions xxxx xxxx
xxxx xxxx
Net Current Assets
4. a. Miscellaneuos Expenditure to xxxx xxxx
the extent not written off or adjusted
b. Profit and Loss Account (debit) xxxx xxxx
Total xxxx xxxx
(ii) Vertical Form for analysis
Balance sheet of ……… as on ……………..

Particulars Rs.
ASSETS
Current Assets
Cash and Bank Balances xxxx
Debtors xxxx
Stock xxxx
Other Current Assets xxxx
(1) xxxx

Fixed Assets xxxx

Less: Depreciation xxxx
Investments xxxx
(2) xxxx
Total (1) + (2) xxxxx
LIABILITIES
Current Liabilities :
Bills Payable xxxx
Creditors
Other Current Liabilities
(3) xxxx
Long Term Debt
Debentures xxxx
Other Long-term Debts xxxx
(4) xxxx
Capital and Reserves
Share Capital xxxx
Reserves and surplus xxxx
(5) xxxx
Total Long term funds
Total (3)+(4)+(5) xxxxx

Statement of Retained Earnings:

Profit and Loss Appropriation Account

Particulars Rs. Particulars Rs.

To transfer to xxx By Last year’s xxx

Reserves balance
To Dividend xxx By Current Year’s net xxx

profit (Transferred
 from profit and loss

A/C)
To Dividend proposed xxx
To surplus carried to xxx By Excess provisions xxx
Balance sheet (which are no longer
required)
By Reserves

withdrawn
(if any) xxx
xxx xxxx

Illustration: 1
From the following information, prepare a vertical
Income
Statement.

Sales 2,00,000
Opening stock 10,000
Closing stock 15,000
Purchases 40,000
Operating Expenses 12,000

Rate of Tax 50%

Solution:

Income Statement
Particulars Rs. Rs.
Sales 2,00,000
Less : cost of goods sold:
Opening stock 10,000
Add: Pruchases 40,000
50,000
Less: closing Stock 15,000
35,000
Gross Profit 1,65,000
Less: operating expenses 12,000
Operating profit 1,53,000
Less: non-operating expenses 4,000
Profit before tax 1,49,000
Less: Income tax (50%) 74,500
Net profit after tax 74,500
Illustration: 2
From the following particulars, pertaining to Mohan Ltd.,
you are required to prepare a comparative Income Statement and
interpret the changes.

Particulars Rs. Rs.

Sales 58,000 65,200
Cost of goods sold 47,600 49,200
Administration expenses 1,016 1,000
Selling expenses 1,840 1,920
Non -operating expenses 140 155
Non-operating expenses 96 644
Sales returns 2000 1,200
Tax rate 43.75% 43.75%
Solution:
Comparative Income Statement of Mohan Ltd., for the years
2000 and 2001.

Particulars 2000 2001

Rs. Rs.
Sales 58,000 65,200
Less Returns 2,000 1,200
Net sales 56,000 64,000
Less: Cost of Goods sold 47,600 49,200
Gross Profit (A) 8,400 14,800
Less: Operating expenses
Administration expenses 1,016 1,000
Selling expenses 1,840 1,920
Total operating expenses (B) 2,856 2,920
Operating profit (A)-(B) 5,544 11,880
Add: non - operating incomes 96 644
Less: non- operating expenses 5,640 12,524
140 155
Net profit before tax 5,500 12,369
Less: Tax 2,406 5,411
Net profit after Tax 3094 6,958

Techniques of Financial Statement Analysis:

The following techniques are adopted in analysis of
financial statements of a business organization:
 Comparative Statements
 Common size Statements
 Trend Analysis
 Funds flow Analysis
 Cash flow Analysis
 Ration Analysis
 Value Added Analysis.

The first three topics are covered in this chapter and the rest
are discussed in the subsequent chapters in detail.
Comparative Financial Statements
Comparative financial statements are statements pf financial
position of a business designed to provide time perspective to the
consideration of various elements of financial position embodied in
such statements. Comparative Statements reveal the following: .
i. Absolute data (money values or rupee amounts)
ii. Increase or reduction in absolute data (in terms of moiwy
values)
iii. Increase or reduction in absolute data (in terms of percentages)
iv. Comparison (in terms of ratios)
v. Percentage of totals.

a. Comparative Income Statement or Profit and Loss Account:

A comparative income statement shows the absoluie figures for

two or more periods and the absolute change from one period to
another. Since the figures are shown side by side, the user can
quickly understand the operational performance of the firm in
different periods and draw conclusions.

b. Comparative Balance Sheet

Balance sheet as on two or more different dates are used for

comparing the assets, liabilities and the net worth of the company
Comparative balance sheet is useful for studying the trends of
analysis undertaking.
Financial Statements of two or more firms can also be compared
for drawing inferences. This is called interfirm Comparison.

Advantages:
 Comparative statements vidicate trends in sales, cost of
production, profits etc., and help the analyst to evaluate the
performance of the company.

Comparative statements can also be used to compare the

performance of the industry or inter-firm comparison. This helps in
identification of the weaknesses of the firm and remedial measures
can be taken; accordingly.

Weaknesses:
Inter-firm comparison can be misleading if the firms are not
identical in size and age and when they follow different accounting
procedures with regard to depreciation, inventory valuation etc.,

Inter-period comparison may also be misleading if the period

has witnessed changes in accounting policies, inflation, recession etc.

Illustration 3:
The following is the profit and loss account of Ashok Ltd., for
the years 2000 and 2001. Prepare comparative Income Statement and
comment on the profitability of the undertaking.
Particulars 2000 2001 Particulars 2000 2001
Rs. Rs. Rs. Rs.
To Cost of 2,31,625 2,41,950 By Sales 3,60,728 4,17,125

goods sold
To Office 23,266 27,068 Less 5,794 6,952

expenses Returns

To Interest 45,912 57,816 3,54,934 4,10,173

expenses
To Loss on 627 1,750 By Other

sale of incomes :

fixed
To Income 21,519 40,195 By Discount 2,125 1,896

Tax on purchase
To Net 35,371 44,425 By Profit on 1,500

Profit sale of land

3,60,457 4,13,379 3,60,457 4,13

,379
 Solution:
ASHOK LTD.
Comparative Income Statement for the years ending 2000 and 2001

Particulars 2000 Rs. 2001 Rs. Increase (+) Increase (+)

Decrease (-) Decrease (-)

Amount Percentages

(Rs.)
Sales 3,60,728 4,17,125 +56,397 +15.63
Less: Sales returns 5,794 6,952 +1.158 +19.98
3,54,934 4,10,173 +55,239 +15.56
Less: Cost of goods 2,31,625 2,41,950 + 10,325 +4.46

sold
Gross Profit 1,23,309 1,68,223 +44.914 +36.42
Operating Expenses:
Office 23,266 27,068 +3,802 + 16.34

expenses
Selling 45,912 57,816 +11,904 +25.93

expenses
Total operating 69,178 84,884 +15,706 +22.70

expenses
Operating profit 54,131 83,339 +29,208 +53.96
Add: Other incomes 5,523 3,206 -2,317 -41.95
59,654 86,545 +26.891 +45.08
Less: Other 2,764 1,925 -839 -30.35

expenses
Profit before tax 56,890 84,620 +27,730 +48.74
Less: Income tax 21,519 40,195 +18,676 +86.79
Net Profit after tax 35,371 44,425 +9,054 +25.60

The comparative Income statement reveals that while the net

sales has been increased by 15.5%, the cost of goods sold increased
by 4.46%. So gross profit is increased by 36.4%. The total operating
expenses has been increased by 22.7% and the gross profit is
sufficient to compensate increase in operating expenses. Net profit
after tax is 9,054 (i.e., 25.6%) increased. The overall profitability of the
undertaking is satisfactory.

Illustration: 4
The following are the Balance Sheets of Gokul Ltd., for the years
ending 31s1 December, 2000,2001.
 Particulars 2000 2001
Rs. Rs.
Liabilities
Equity share capital 2,00,000 3,30,000
Preference share capital 1,00,000 1,50,000
Reserves 20,000 30,000
Profit and Loss a/c 15,000 20,000
Bank overdraft 50,000 50,000
Creditors 40,000 50,000
Provision for taxation 20,000 25,000
Proposed Dividend 15,000 25,000
Total 4,60,000 6,80,000
Fixed Assets

Less: Depreciation 2,40,000 3,50,000

Stock 40,000 50,000
Debtors 1,00,000 1,25,000
Bills Receivable 20,000 60,000
Prepaid expenses 10,000 12,000
Cash in hand 40,000 53,000
Cash at Bank 10,000 30,000
Total 4,60,000 6,80,000
 Solution:
Comparative Balance Sheet
Particulars 31st Dec. 31st Dec. Inerease(+) Increase(+)

2000 2001 Decrease(-) Decrease(-)

Rs. Rs. Amount(Rs.) Percentages

ASSETS

Current Assets:
Cash at bank and in 50,000 83,000 +33,000 +66

hand Bills receivable 20,000 60,000 +40,000 +200

Debtors 1,00,000 1,25,000 +25,000 +25
Stock 40,000 50,000 +10,000 +25
Prepaid expenses 10,000 12,000 +2,000 +20

Total Current Assets 2,20,00 3,30,000 +1,10,000 +50

Fixed Assets 2,40,000 3,50,000 +1,10,000 +45.83
Total Assets 4,60,000 6,80,000 2,20,000 47.83
LIABILITIES
Current Liabilities:
Bank overdraft 50,000 50,000
Creditors 40,000 50,000 +10,000 +25
Proposed dividend 15,000 25,000 +10,000 +66.67
Provision for taxation 20,000 25,000 +5,000 +25

Total Current 1,25,000 1,50,000 +25,000 +20

Liabilities
Capital and Reserve:
Equity share capital 2,00,000 3,30,000 +1,30,000 +65
Preference share 1,00,000 1,50,000 +50,000 +50

capital
Reserves 20,000 30,000 +10,000 +50
Profit and Loss a/c 15,000 20,000 +5,000 +33.33
3,35,000 5,30,000 +1,95,000 +58.21
Total Liabilities 4,60,000 6,80,000 +2,20,000 +47.83

Interpretation:
1. The above comparative Balance sheet reveaJs the current
assets has been increased to 50%, while current liabilities
increase to 20% only. Cash increased to Rs.33,000 (i.e. 66%),
There is an improvement in liquidity position.

2. The fixed assets purchased was for Rs, 1,10,000. As there are
no long-term funds, it should have been purchased partly from
Share Capital.

3. Reserves and Profit and Loss a/c increased by 50% and 33.33%
respectively. The company may issue bonus shares in near
future.

4. Current financial position of the company is satisfactory. It

should issue more long-term funds.

COMMON SIZE STATEMENTS

The figures shown in financial statements viz. Frofit and Loss

Account and Balance sheet are converted to percentages so as to
establish each element to the total figure of the statement and these
statement are called Common Size Statements. These statements are
useful in analysis of the performance of the company by analyzing
each individual element to the total figure of the statement. These
statements will also assist in analyzing the performance over years
and also with the figures of the competitive firm in the industry for
making analysis of relative efficiency. The following statements show
the method of presentation of the data.

Illustration: 5
Common Size Income Statement of XYZ Ltd., for the year ended
31st March, 2001.
 Particulars Amount (Rs.) % to Sales

Sales (A) 14,00,000 100

Raw materials 5,40,000 16.4

Direct wages 2,30,000 16.4
Faciory expenses 1,60,000 11.4

(B) 9,30,000 66.4

GrossProfit (A) - 4,70,000 33.6

(B)
Less: Administrative 1,10,000 7.9

expenses
Selling and distribution 80,000 5.7

expenses
Operating Profit 2,80,000 20.0
Add: Non-operative income 40,000 2.9

3,20,000 22.9
Less: Non-operating 60,000 43

expenses
Profit before tax 2,60,000 18.6
Less: Income tax 80,000 5.7

Profit after tax 1,80,000 12.9

Common Size Balance Sheet of XYZ

Particulars Amount (Rs.) % to Total

ASSETS

Fixed Assets

Land 50,000 5.3

Buildings 1,10,000 11.7

Plant and Machinery 2,50,000 26.6

Current Assets :

Inventory
 Raw materials 80,000 8.5

Work-in-progress 50,000 5.3

Finished goods 1,60,000 17.0

Sundry debtors 2,10,000 22.4

Cash at Bank 30,000 3.2

Total 9,40,000 100.0

Capital and Liabiltiies

Euqity Share capital 2,50,000 26.6

Preference Share Capital 1,00,000 10.6

General reserve 1,60,000 17.0

Debentures 80,000 8.5

Current Liabilities

Sundry Creditors 2,20,000 23.4

Creditors for expenses 40,000 4.3

Bills payable 90,000 9.6

9,40,000 100.0

Analysis of performance and position can be made from the

above Common Size Statements.

llustration: 6
From the following P&L A/c prepare a Common Size Income
Statement-
Particulars 2000 2001 Particulars 2000 2001
Rs. Rs. Rs. Rs.
To Cost of goods 12,000 1 5,000 By Net Sales 16,000 20,000

sold
To Administrative 400 400
expenses
To Selling 600 800

expenses
 To Net Profit 3,000 3,800
16,000 20,000 16,000 20,000

Common Size Income Statement

Particulars 2000 2001
Rs. % Rs. %
Net sales 16,000 100.00 20,000 100.00
Less: Cost of goods sold 12,000 75.00 15,000 7500
Gross 4,000 25.00 5,000 25.00

Profit
Less: Operating

expenses
Administration 400 2.50 400 2.00

expenses
Selling expenses 600 3.75 800 4.00
Total Operating 1,000 6.25 1,200 6.00

expenses
Net Profit 3,000 18.75 3,800 19.00

Illustration: 7
Following are Balance sheet of Vinay Ltd. for the year ended 31 st
December 2000 and 2001.

Liabilities 2000 2001 Assets 2000 2001

Rs. Rs. Rs. Rs.

Equity capital 1,00,000 1 ,65,000 Fixed Assets (Net) 1 ,20,000 1,75,000
Pref. Capital 50,000 75,000 Stock 20,000 25,000
Reserves 10,000 15,000 Debtors 50,000 62,500
P&L A/c 7,500 10,000 Bills receivable 10,000 30,000
Creditors 20,000 25,000 Cash at Bank 20,000 26,500
Provision 10,000 12,500 Cash in hand 5,000 15,000

for taxation
Proposed 7,500 12,500

dividends
2,30,000 3,40,000 2,30,000 3,40,000

Prepare a common size balance sheet and interpret the same.

Solution;

Common Size Balance Sheet of Vinay Ltd.

for the year ended 31.12.2001 & 2002

Particulars 2000 2001

Rs. % Rs. %
Capital & Reserves:
Equity Capital 1,00,000 43,48 1 ,65,000 48.53
Pref. Capital 50,000 21,74 75,000 22.05
Reserves 10,000 4.34 15,000 4.41
P&L A/c 7,500 3.26 10,000 2.95
(i) 1,67,500 72.82 2,65,000 77.94
Current Liabilities:
Bank overdraft 25,000 10.87 25,000 7.35
Creditors 20,000 8.70 25,000 7.35
Provisions for taxation 10,000 4.35 12,500 3.68
Proposed dividends 7,500 3.26 12,500 3.68
(ii) 62,500 27.18 75,000 22.06
Total Liabilities (ij + (ii) 2,30,000 100.00 3,40,000 100.00
Fixed Assets (Net) (a) 1,20,000 52.17 1,75,000 51.47
Current Assets:
Stock 20,000 8.70 25,000 7.35
Debtors 50,000 21.74 62,500 18.38
Bills receivable 10,000 4.34 30,000 8.82
Cash al bank 20,000 8.70 26,500 7.79
Cash in hand 5,000 2.18 15,000 4.41
(b) 1,10,000 47.83 1,65,000 48.53
 Total Asses (a + b) 2,30,000 100.00 3,40,000 100.00

Interpretation :
(1) In 2001 Current Assets were increased from 47.83% to 48.53%.
Cash balance increased by Rs. 16,500.

(2) Current Liabilities were decreased from 27.18% to 22.06%. So,

the company can pay off the Current Liabilities from Current
Assets. The liquidity position is reasonably good.

(3) Fixed Assets were increased from Rs. 3,20,000 in 2000 to Rs.
1,75,000 in 2001. These were purchased from the additional
share capital issued.
(4) So, the ove.all financial position is satisfactory.

TREND ANALYSIS

In trend analysis ratios of different items are calculated for

various periods for comparison purpose. Trend analysis can be
.done by trend percentage, trend ratios and graphic and
diagrammatic representation. The trend analysis is a simple
technique and does not involve tedious calculations.

Illustration: 8
From the following data, calculate trend percentage taking 1999
as base.

Particulars 1999 2000 2001

Rs. Rs. Rs.
Sales 50,000 75,000 1,00,000
Purchases 40,000 60,000 72,000
Expenses 5,000 8,000 15,000
Profit 5,000 7,000 13,000
 Solution:
Particulars 1999 Rs. 2000 2001 Rs. Trend Percentage Base 1999

Rs.
Rs. Rs. Rs. 1999 2000 2001
Purchases 40,000 60,000 72,000 100 150 180
Expenses 5,000 8,000 15,000 100 160 300
Profit 5,000 7,000 13,000 100 140 260
Sales 50,000 75,000 1,00,000 100 150 200

Illustration: 9
From the following data, calculate trend percentages (1999 as
base)

Particulars 1999 2000 2001

Rs. Rs. Rs.

Cash 200 240 160

Debtors 400 500 650
Stock 600 800 700
Other Current Assets 450 600 750
Land 800 1,000 1,000
Buildings 1,600 2,000 2,400
Plant 2,000 2,000 2,400
Solution:

Particulars 2000 2001 (Base Year 1999)

Rs. Rs. Rs. 1999 2000 2001

Cash 200 240 160 100 120 80
Debtors 400 500 650 100 125 163
Other Current 450 600 750 100 133 167

Assets
Total Current 1,650 2,140 2,260 100 130 137

Assets
Fixed Assets:
Land 800 1,000 1,000 100 125 125
Buildings 1,600 2,000 2,400 100 125 150

Plant 2,000 2,000 2,400 100 100 120

Total Fixed Assets 4,400 5,000 5,800 100 114 132
 LESSON-10
RATIO ANALYSIS

INTRODUCTION

The financial statements viz. the income statement, the Balance

sheet The Income statement, the Statement of retained earnings and
the Statement of changes in financial position report what has
actually happened to earnings during a specified period. The balance
sheet presents a summary of financial position of the company at a
given point of time. The statement of retained. earnings reconciles
income earned during the year and any dividends distributed with the
change in retained, earnings between the start and end of the
financial. year under study. The statement of changes in financial
position provides a summary of funds flow during the period of
financial statements.

Ratio analysis is a very powerful analytical tool for measuring

performance of an organisation. The ratio analysis concentrates on
the interrelationship among the figures appearing in the
aforementioned four financial-statements. The ratio analysis helps the
management to analyse the past. performance of the firm and to make
further projections. Ratio analysis allow 1-interested parties like
shareholders, investors, creditors, Government analysts to make an
evaluation of certain aspects of a firm's performance.

Ratio analysis is a process of comparison of one figure against

another, which make a ratio, and the appraisal of the ratios to make
proper analysis about the strengths and weaknesses of the firm's
operations. The calculation of ratios is a relatively easy and simple
task but the proper analysis and interpretation of the ratios can be
made only by the skilled analyst. While interpreting the financial
information, the analyst has to be careful in limitations imposed by
the accounting concepts and methods of valuation. Information of
non-financial nature will also be taken into consideration before a
meaningful analysis is made.
Ratio analysis is extremely helpful in providing valuable insight into a
company's financial picture. Ratios normally pinpoint a business
strengths and weakness in two ways:

 Ratios provide an easy way to compare today's performance with

past.

 Ratios depict the areas in which a particular business is

competitively advantaged or disadvantaged through comparing
ratios to those of other businesses of the same size within the
same industry.

CATEGORIES OF RATIOS
The ratio analysis is made under six broad categories as follows:

 Long-term solvency ratios

 Short-term solvency ratios
 Profitability ratios
 Activity ratios
 Operating ratios
 Market test ratios

Long-Tenn Solvency Ratios

The long-term financial stability of the firm may be considered

as dependent upon its ability to meet all its liabilities, including those
not current payable. The ratios which are important in measuring the
'ong-term solvency L as follows:
  Debt-Equity Ratio
 Shareholders Equity Ratio .
 Debt to Networth Ratio
 Capital Gearing Ratio
 Fixed Assets to Long-term Funds Ratio
 Proprietary Ratio
 Dividend Cover
 Interest Cover
 Debt Service Coverage Ratio

1. Debt-Equity Ratio:

Capital is derived from two sources: shares and loans. It is quite

hkely for only shares to be issued when the company is formed, but
loans are invariably raised at some later date. There are numerous
reasons for issuing loan capital. For instance, the owners might want
to increase their investment but avoid the'risk which attaches to share
capital, and they can do this by making a secured loan. Alternatively,
management might require additional finance which the shareholders
are unwilling to supply and so a loan is raised instead. In either case,
the effect is to introduce an element of gearing or leverage into the
capital structure :of the company. There are numerous ways of
measuring gearing, but the debt-equity ratio is perhaps most
commonly used.

Long - term debt

Share holders funds

This ratio indicates the relationship between loan funds and net
worth of the company, which is known as gearing. If the proportion of
debt to equity is low, a company is said to be low-geared, and vice
versa. A debt equity ratio of 2:1 is the norm accepted by financial
institutions for financing of projects. Higher debt-equity ratio may be
permitted for highly capital intensive industries like petrochemicals,
fertilizers, power etc. The higher the gearing, the more volatile the
return to the shareholders.

The use of debt capital has direct implications for the profit
accruing to the ordinary shareholders, and expansion is often
financed in this manner with the objective of increasing the
shareholders' rate of return. This objective is achieved only if the rate
earned on the additional funds raised exceeds that payable to the
providers of the loan.

The shareholders of a highly geared company reap

disproportionate benefits when earnings before interest and tax
increase. This is because interest payable on a large proportion of
total finance remains unchanged. The converse is also true, and a
highly geared company is likely to find itself in severe financial
difficulties if it suffers a succession of trading losses. It is not possible
to specify an optimal level of gearing for companies but, as a general
rule, gearing should be low in those industries where demand is
volatile and profits are subject to fluctuation.

A debt-equity ratio which shows a declining trend over the years

is usually taken as a positive sigh reflecting on increased cash accrual
and debt repayment. In fact, one of the indicators of a unit turning
sick is a rising debt-equity ratio. Usually in calculating the ratio, the
preference share capital is excluded from debt, but if the ratio is to
show effect of use of fixed interest sources on earnings available to the
shareholders then it is to be included. On the other hand, if the ratio
is to examine financial solvency, then preference shares shall form
part of the capital.
2. Shareholders Equity Ratio :
This ratio is calculated as follows:

Shareholders Equity

Total assets (tan gible)

It is assumed that larger the proportion of the shareholders'

equity, the stronger is the financial position of the firm, This ratio will
supplement the debt-equity ratio. In this ratio the relationship is
established between the shareholders funds and the total assets.
Shareholders funds represent both equity and preference capital plus
reserves and surplus less losses. A reduction in shareholder's equity
signaling the over dependence on outside sources for long-term
financial needs and this carries the risk of higher levels of gearing.
This ratio indicates the degree to which unsecured creditors are
protected against iosr in the event of liquidation.

3. Debt to Net worth Ratio :

This ratio is calculated as follows:

Long - term debt

Networth

The ratio compares long-term debt to the net worth of the firm
i.e., the capital and free reserves less intangible assets. This ratio is
finer than the debt-equity ratio and includes capital which is invested
in fictitious assets like deferred expenditure and carried forward
tosses. This ratio would be of more interest to the contributories of
long-term finance to the firm, as the ratio gives a S factual idea of the
assets available to meet the long-term liabilities.

4. Capital Gearing Ratio :

 It is the proportion of fixed interest bearing funds to Equity
shareholders, funds:
Fixed int eresi bearing funds :

Equity Shareholder's funds

The fixed interest bearing funds include debentures, long-term loans
and preference share capital. The equity shareholders funds include
equity share capital, reserves and surplus. Capital gearing ratio
indicates the degree of vulnerability of earnings available for equity
shareholders. This ratio signals the firm which is operating on trading
on equity. It also indicates the changes in benefits accruing to equity
shareholders by changing the levels of fixed interest bearing funds in
the organisation.

5. Fixed Assets to Long-term Funds Ratio :

The fixed assets is shown as a proportion to long-term funds as
follows:

Fixed Assets

Long - term Funds

The ratio includes the proportion of long-term funds deployed in

fixed assets. Fixed assets represents the gross fixed assets minus
depreciation provided on this till the date of calculation. Long-term
funds include share capital, reserves and surplus and long-term
loans. The higher the ratio indicates the safer the funds available in
case of liquidation. It also indicates the proportion of long-term funds
that is invested in working capital.

6. Proprietor Ratio :
It express the relationship between net worth and total asset
 Net worth
Total Assets

Net worth = Equity Share Capital-t-Preference Share

Capital+Fictitious Assets Total Assets = Fixed Assets + Current Assets
(excluding fictitious assets)
Reserves earmarked specifically for a particular purpose should
not be included in calculation of Net worth. A high proprietory ratio
indicative of strong financial position of the business. The higher the
ratio, the better it is.

7. Interest Cover:
Profil before interest depreciationand tax

Interest

The interest coverage ratio sLjws how many times interest

charges are covered by funds that are available for payment of
interest. An interest cover of 2:1 is considered reasonable by financial
institutions. A very high ratio indicates that the firm is conservative in
using debt and a very low ratio indicates excessive use of debt.

8. Dividend Cover :
Net Profit after tax
Dividend

This ratio indicates the number of times the dividends are

covered by net profit his highlights the amount retained by a company
for financing of future operations.

9. Debt Service Coverage Ratio :

 It indicates whether the business is earning sufficient profits to
pay not only the interest charges, but also the instalments due to the
'principal' amount. It is calculated as:
PBIT
Interest + Periodic Loan Instalment
(1 - Rate of Income Tax)
The greater the debt service coverage ratio, the better rs the
servicing ability of the organisation.

Short-term Solvency Ratios

The short-term solvency ratios, which measure the liquidity of
the firm and its liability of the firm and its ability to meet it- maturing
short-term obligations. Liquidity is defined as the ability to realise
value in money, the most liquid of assets. It refers to the ability to pay
in cash, the obligations that -are due.

The corporate liquidity has two dimensions viz., quantitative

and qualitative concepts. The quantitative concept includes the
quantum, structure and utilisation of liquid assets and in the
qualitative concept, it is the ability to meet all present and potential
demands on cash" from any source in a manner that minimizes cost
and maximizes the value of the firm. Thus, corporate liquidity is, a
vital factor in business - excess liquidity, though a guarantor of
solvency would reflect lower profitability, deterioration in managerial
efficiency, increased speculation and unjustified expansion, extension
of too liberal credit and dividend policies. Too little liquidity then may
lead to frustration' of-i business objectives, reduced rate of return,
business opportunity missed and& weakening of morale. The
important ratios in measuring short-term solvency are:

(1) Current Ratio

(2) Quick Rarip
(3) Absolute Liquid Ratio
1. Current Ratio :

Current Assets, Loans & Advances

Current Liabilities & Provisions

This ratio measures the solvency of the company in the short-

term. Current assets are those assets which can be converted into
cash within a year. Current liabilities and provisions are those
liabilities that are payable within a year. A current ratio 2:1 indicates
a highly solvent position. A current ratio 1.33:1 is considered by
banks as the minimum acceptable level for providing working capital
finance. The constituents of the current assets are as important as the
current assets themselves for evaluation of a company's solvency
position, A very high current ratio will have adverse impact on the
profitability of the organisation. A high current ratio may be due to the
piling up of inventory, inefficiency in collection of debtors, high
balances in Cash and Bank accounts without proper investment
2. Quick Ratio or Liquid Ratio:

Current Assets, Loans & Advances - Inventories

Current Liabilities & Provisions- Bank Overdraft

Quick ratio used as measure of the company's ability to meet its

current obligations. Since bank overdraft is secured by the
inventories, the other current assets must be sufficient to meet other
current liabilities. A quick ratio of 1:1 indicates highly solvent
position. This ratio is also called acid test ratio. This ratio serves as a
supplement to the current ratio in analysing liquidity.

3. Absolute Liquid Ratio (Super Quick Ratio):

 It is the ratio of absolute liquid assets to quick liabilities.
However, for calculation'purposes, it is taken as ratio of absolute
liquid assets to current liabilities. Absolute liquid assets include cash
in hand, cash at bank and short term or temporary investments.

Absolute Liquid Assets

Current Liabilities

Absolute Liquid Assets =Cash in Hand + Cash at Bank + Short term

investments

The ideal Absolute liquid ratio is taken as 1:2 or 0.5.

Activity Ratios or Turnover Ratios

Activity ratios measure how effectively the firm employs its

resources. These ratios are also called turnover ratios which involve
comparison between the level of sales and investment in various
accounts - inventories, debtors, fixed assets etc. activity ratios are
used to measure the speed with which various accounts are converted
into sales or cash. The following activity ratios are calculated for
analysis:

1. Inventory :

A considerable amount of a company's capital may be tied up in

the financing of raw materials, work-in-progress and finished goods. It
is important to ensure that the level of stocks is kept a low as
possible, consistent with the need to fulfill customer's orders in time.
Inventory Turnover Ratio = Cost of goods sold
Average Inventory

Sales
Average Inventory

Average inventory = Opening stock+Closing stock

2

The higher the stock turn over rate the lower the stock turnover
period the better, although the ratios will vary between companies.
For example, the stock turnover rate in a food retailing company must
be higher than the rate in a manufacturing concern. The level of
inventory in a company may be assessed by the use of the inventory
ratio, which measures how much has been tied up in inventory.
Inventory Ratio = Inventory
X 100
Current Assets

The inventory turnover ratio measures how many times a

company's inventory has been sold during the year. If the inventory
turnover ratio has decreased from past, it means that either inventory
is growing or sales are dropping. In addition to that, if a firm has a
turnover that is slower than for its industry, then there may be
obsolete goods on hand, or inventory stocks may be high. Low
inventory turnover has impact on the liquidity of the business.

2. Debtors :
The three main debtor ratios are as follows:

(1) Debtor Turnover Ratio

 Debtor turnover, which measures whether the amount of
resources tied up in debtors is reasonable and whether the company
has been efficient in converting debtors into cash. The formula is:
Credit Sales
Average Debtors
The higher the ratio, the better the position.

(ii) Average Collection Period

Average collection period, which measures how long it take to

collect amounts from debtors. The formula is:
Average debtors
X 365
Credit Safes

The actual collection period can be compared with the stated

credit terms of the company. If it is longer than those terms, then this
indicates some insufficiency in the procedures for collecting debts.

(ii) Bad Debts

Bad debts, which measures the proposition of bad debts to
sales:
Bad debts
Sales
This ratio indicates the efficiency of the credit control
procedures of the company. Its level will depend on the type of
business. Mail order-companies have to accept a fairly high level of
bad debts, white retailing organisations should maintain very low
levels or, if they do not allow credit accounts, none at all. The actual
ratio is compared with the target or norm to decide whether or not it is
acceptabie.

3. Creditors:
(i) Creditors Turnover Period

The measurement of the creditor turnover period shows the

average time taken to pay for goods and services purchased by the
company. The formula is:
Average creditors
X 365
Purchases
In general the longer the credit period achieved the better,
uecause delays in payment mean that the operation of the company
are being financed interest free by, suppliers of funds. But there will
be a point beyond which-delays in payment will damage relationships
with suppliers which, if they are operating in a seller's market, may
harm the company. If too long a period is taken to pay creditors, the
credit rating of the company may suffer, thereby making it more
difficult to obtain suppliers in the future.

(ii) Creditors Turnover Ratio

Credit purchases
Average creditors

The term creditors include trade creditors and bills payable.

4. Assets Turnover Ratios:

This measures the company's ability to generate sales revenue

in relation to the size of the asset investment A low asset turnover
may be remedied by increasing sales or by disposing of certain assets
or both. To assist in establishing which part of the asset structure is
not being used efficiently, the asset turnover ratio should be sub-
analysed.

(i) Fixed Assets Turnover Ratio

Sales
 Fixed assets
This ratio will be analysed further with ratios for each main
category of asset This is a difficult set of ratios to interpret as asset
values are based on historic cost An increase in the fixed asset figure
may result from the replacement of an asset at an increased price or
the purchase of an additional asset intended to increase production
capacity. The later transaction might be expected to result in
increased sales whereas the former would more probably be reflected
in reduced operating costs.

The ratio of the accumulated depreciation provision to the total

of fixed assets at cost might be used as an indicator of the average age
of the assets; particularly when depreciation rates are noted in the
accounts.
The ratio of sales value per share foot of floor space occupied is
particularly significant, for trading concerns, such as a wholesale
warehouse or a department store.

(ii) Total Assets Turnover Ratio

This ratio indicates the number of times total assets are being turned
over in a year.
Sales
Total assets
The higher the ratio indicates overtrading of total assets while a
low ratio indicates idle capacity.

5. Working Capital Turnover Ratio :

This ratio is calculated as follows:

Sales
Working capital
This ratio indicates the extent of working capital turned over in
achieving sales of the firm.
6. Sales to Capital Employed Ratio :
This ratio is ascertained by dividing sales with capital employed.
Sales
——————————
Capital employed

This ratio indicates, efficiency in utilisation of capital employed

in generating revenue.

Profitability Ratios

The purpose of study and analysis of profitability ratios are to

help assess the adequacy of profits earned by the company and also to
discover whether profitability is increasing or declining. The
profitability of the firm is the net result of a large number of policies
and decisions. The profitability ratios are measured with reference to
sales, capital employed, total assets employed; shareholders funds etc.
The major profitability rates are as follows:
(a) Return on capital employed (or Return on investment) [ROI
or ROCE]

(b) Earnings per share (EPS)

(c) Cash earnings per share (Cash EPS)

(d) Gross profit margin

(e) Net profit margin

(f) Cash profit ratio

(g) Return on assets

(h) Return on Net worth (or Return on Shareholders equity)

I. Return on Capital Employed (ROCE) or Return on Investment
(ROI)

The strategic aim of a business enterprise is to earn a return on

capital. If in any particular case, the return in the long-run is not
satisfactory, then the deficiency should be corrected or the activity be
abandoned for a more favourable one. Measuring the historical
performance of an investment center calls for a comparison of the
profit that has been earned with capital employed. The rate of return
on investment is determined by dividing net profit or income by the
capital employed or investment made to achieve that profit.
ROI = Profit
X 100
Invested capital
ROI consists of two components viz, I. Profit margin, and fl.
Investment turnover, as shown below:
ROI = Net profit = Net profit X Sales
Investment Sales Investment in assets

It will be seen from the above formula that ROI can be improved
by increasing one or both of its components viz., the profit margin and
the investment turnover in any of the following ways:

 Increasing the profit margin

 Increasing the investment turnover, or
 Increasing both profit margin and investment turnover

The obvious generalisations that can be made about the ROI formula
are that any action is beneficial provided that it:

 Boosts sales
 Reduces invested capital
 Reduces costs (while holding the other two factors constant)
 Table-1: Computation of Capital Employed
Share capital of the company xxx
Reserves and surplus xxx
Loans (secured/ unsecured) xxx
xxx
Less: (a) Capital-in-progress xxx
(b) Investment outside the business xxx

(c) Preliminary expenses

(d) Debit balance of Profit and Loss xxx xxx

A/c
Capital employed xxx

Return on in vestment analysis provides a strong incentive for

optimal utilisation of these assets of the company. This encourages
mangers to obtain, assets that will provide a satisfactory return on
investment and to dispose of assets that are not providing an
acceptable return. In selecting amongst alternative long-term
investment proposals, ROI provides a suitable measure for
assessment of profitability of each proposal.

2. Earnings Per Share (EPS):

The objective of financial Management is wealth or value

maximisation of a corporate entity. The value is maximized when
market price of equity shares is maximised. The use of the objective of
wealth maximisation or net present value maximisation has been
advocated as an appropriate and operationally feasible criterion to
choose among the alternative financial actions. In practice, the
performance of a corporation Is better judged in terms of its earnings
per share (EPS). The EPS is one of the important measures of
economic performance of a corporate entity.

The flow of capital to the companies under the present imperfect

capital market conditions woold be made on the evaluation of EPS.
Investors lacking inside and detailed information would look upon the
EPS as the best base to lake their investment decisions. A higher EPS
means better capital productivity.
EPS = Net Profit after tax and preference dividend
No. of Equity Shares
I EPS when Debt and Equity used
= (EBIT – 1) (1 – T)
N
II. EPS when Debt, Preference and Equity used
= (EBIT – I ) (1 – T) - DP
N
Where EBIT = Earnings before interest and tax
I = Interest
T = Rate of Corporate tax
DP = Preference Dividend
N = Number of Equity shares

EPS is one of the most important ratios which measures the net
profit earned per share. EPS is one of the major factors affecting the
dividend policy of the firm and the market prices of the company.
Growth in EPS is more relevant for pricing of shares from absolute
EPS. A steady growth in EPS year after year indicates a good track of
profitability.

3. Cash Earnings Per Share :

The cash earnings per share (Cash EPS is calculated by dividing

the net profit before depreciation with number of equity shares.

Net profit + Depreciation

No. of Equity Shares

This is a more reliable yard stick for measurement of

performance of companies, especially for highly capital intensive
industries where provision for depreciation is substantial. This
measures the cash earnings per share and is also a relevant factor for
determining the price for the company's shares. However, this method
is not as popular as EPS and is used as a supplementary measure of
performance only.

4. Gross Profit Margin :

The gross profit margin is calculated as follows:

= Sales - Cost of goods sold X 100 Gross profit X 100
Sales Sales

The ratio measures the gross profit margin on the total net sales
made by the company. The grosi, profit represents the excess of sales
proceeds during the 1 period under observation over their
cost, before taking into account administration, selling and
distribution and financing charges. The ratio . measures the
efficiency of the company's operations and this can also be ; compared
with the previous years results to ascertain the efficiency partners
with respect to the previous years.

When everything normal, the gross profit margin should remain

unchanged, irrespective of the level of production and sales, since it is
based on the assumption that all costs deducted when computing
gross profit which are directly variable with sales. A stable gross profit
margin is therefore, the norm and any variation from it call for careful
investigations, which may be caused; due to the following reasons:

(i) Price cuts: A company need to reduce its selling price to achieve
the desired increase in sales.
(ii) Cost increases: The price which a company pay its suppliers
during period of inflation, is likely to rise and this reduces the
gross profit margin unless an appropriate adjustment is made to
the selling price.

(iii) Change in mix: A change in the range or mix of products sold

causes the overall gross profit margin assuming individual product
lines earn different gross profit percentages.
(iv) Under or Over-valuation of stocks.

If closing stocks are under-valued, cost of goods sold is inflated

and profit understated. An incorrect valuation may be the result of an
error during stock taking or it may be due to fraud The gross profit
margin may be compared with that of competitors in the industry to
assess the operational performance relative to the other players in the
industry.

5. Net Profit Margin:

The ratio is calculated as follows:
Net profit before interest and tax X 100
Sales
The ratio is designed to focus attention on the net profit margin
arising from business operations before interest and tax is deducted.
The convention is to express profit after tax and interest as a
percentage of sales. A drawback is that the percentage which results,
varies depending on the sources employed to finance business
activity; interest is charged 'above the line while dividends are
deducted 'below the line'. It is for this reason that net profit i.e.
earnings before interest and tax (EBIT) is used.

This ratio reflects nt: profit margin on the total sales after
deducting all expenses but before deducting interest and taxation.
This ratio measures the efficiency of operation of the company. The
net profit is arrived at from gross profit after deducting
administration, selling and distribution expenses. The non-operating
incomes and expenses are ignored in computation of net profit before
tax, depreciation and interest

This ratio could be compared with that of the previous year's

and with that of competitors to determine the trend in net profit
margins of the company and its performance in the industry. This
measure will depict the correct trend of performance where there are
erratic fluctuations in the tax provisions from year to year. It is to be
observed that majority of the costs debited to the profit and loss
account are fixed in nature and any increase in sales will cause the
cost per unit to decline because of the spread of same fixed cost over
the increased number of units sold.

6. Cash Profit Ratio

Cash profit
X 100
Sales

Where Cash profit = Net profits Depreciation

Cash profit ratio measures the cash generation in the business

as a result of trie operations expressed in terms of sales. The cash
profit ratio is a more reliable indicator of performance where there are
sharp fluctuations in the profit before tax and net profit from year to
year owing to difference in depreciation charged. Cash profit ratio
eva)'iates the efficiency of operations in terms of cash generation and
is not affected y the method of depreciation charged. It also facilitate
the inter-firm comparison of performance since different methods of
depreciation may be adopted by different companies.

7. Return on Assets :
This ratio is calculated as follows:
 Net profit after tax X 100
Total assets
The profitability, of the firm is measured by establishing relation
of net profit with the total assets of the organisation. This ratio
indicates the efficiency of utilisation of assets in generating revenue.

8. Return on Shareholders Funds or Return on Net Worth

Net profit after interest and tax
X 100
Net worth

Where, Net worth = Equity capital + Reserves and Surplus.

This ratio expresses (he nel profit in Icrms of the equity

shareholders funds. This ratio is an important yardstick of
performance of equity shareholders since it indicates the return on the
funds employed by them. However, this measure is based on the
historical net worth and will be high for old plants and low for new
plants.

The factor which motivates shareholders to invest in a company

is the expectation of an adequate rate of return on their funds and
periodically, they will want to assess the rate of return earned in order
to decide whether to continue with their investment. There are various
factors of measuring the return including the earnings yield and
dividend yield which are examined at later stage. This ratio is useful
in measuring the rate of return as a percentage of the book value of
shareholders equity.

The further modification of this ratio is made by considering the

profitability from equity shareholders point of view can also be worked
out by taking the profits after preference dividend and comparing
against capital employed after deducting both long-term loans and
preference capital.

Operating Ratios
The ratios of all operating expenses (i.e. materials used, labour,
factory-overheads, administration and selling expenses) to sales is the
operating ratio. A comparison of the operating ratio would indicate
whether the cost content is high or low in the figure of sales. If the
annual comparison shows that the sales has increased the
management would be naturally interested and concerned to know as
to which element of the cost has gone up. It is not necessary that the
management should be concerned only when the operating ratio goes
up. If the operating ratio has fallen, though the unit selling price has
remained the same, still the position needs analysis as it may be the
sum total of efficiency in certain departments and inefficiency in
others, A dynamic management should be interested in making a
complete analysis.
It is, therefore, necessary to break-up the operating ratio into
various cost ratios. The major components of cost are: Material,
labour and overheads. Therefore, it is worthwhile to classify the cost
ratio as:

1. Materials Cost Ratio = MaterialsConsumed

X 100
Sales

2. Labour Cost Ratio = Labour Cost Sales

X 100
Sales

3. Factory Overhead Ratio X 100

= Factory Expenses
Sales

4. Administrative Expense Ratio = Administrative Expenses

X 100
 Sales

5. Selling and distribution

expenses ratio = Selling and Distribution ExpensesX 100
Sales

Generally all these ratios are expressed in terms of percentage. Then

total up all the operating ratios. This is deducted from 100 will be
equal to the net profit ratio. If possible, the total expenditure for
effecting sales should be divided into two categories, viz. Fixed and
variable and then ratios should be worked out. The ratio of variable
expenses to sales will be generally constant; that of fixed expenses
should fall if sales increase, it will increase if sales fall.

Market Test Ratios

The market test ratios relates the firm's stock price to its
earnings and book value per share. These ratios give management an
indication of what investors think of the company's past performance
and future prospectus. If firm's profitability, solvency and turnover
ratios are good, then the market test ratios will be high and its share
price is also expected to be high. The market test ratios are as follows:
-

1. Dividend payout ratio

2. Dividend yield ;

3. Book value
4. Price/Earnings ratio

1. Dividend Payout Ratio:

Dividend per share

Earnings per share
 Dividend payout ratio is the dividend per share divided by the
earnings per share. Dividend payout indicates the extent of the net
profits distributed to the shareholders as dividend. A high payout
signifies a liberal distribution policy and a low payout reflects
conservative distribution policy.

2. Dividend Yield
Dividend per share
X 100
Market price

This ratio reflects the percentage yield that an investor receives

on this investment at the current market price of the shares. This
measure is useful for
investors who are interested in yield per share rather than capital
appreciation.

3. Book Value:

Equity Capitalf +Reserves - Prqfit&Lass debit balance.

Total number of equity shares;

This ratio indicates the net worth per equity share. The book
value is a reflection of the past earnings and the distribution policy of
the company. A high book value indicates that a company has huge
reserves and is a potential bonus candidate. A low book value signifies
liberal distribution policy of bonus and dividends, or alternatively, a
poor track record of profitability. Book value is considered less
relevant for the m^ker price as compared to EPS, as it reflects the past
record whereas the market discounts the future prospects.

4. Price Earnings Ratio (P/E Ratio):

Current market price

 Earnings per share

This ratios measures the number of times the earnings of the

latest year at which the share price of a company is quoted. It
signifies the number of years, in which the earnings can equal to
current market price. This ratio reflects the market's assessment of
the future earnings potential of the company. A high P/e ratio reflects
earnings potential and a low P/E ratio low earnings potential. The P/E
ratio reflects the market's confidence in the company's equity. P/e
ratio is a barometer of the market sentiment Companies with excellent
track record of profitability, professional management and liberal
distribution policy have high P/E ratios whereas companies with
moderate track record, conservative distribution policy and average
prospects quote a low P/E ratios. The market price discounts the
expected earnings of a company for the current year as opposed to the
historical EPS.

LIMITATIONS IN THE USE OF RATIO ANALYSIS

Ratios by themselves mean nothing. They must always be
compared with:
 a norm or a target

 previous ratios in order to assess trends

 the ratios achieved in other com; arable companies (inter-

company comparisons), and

 caution has to be exercised in using ratios.

The following limitations must be taken into account:

 Ratios are calculated from financial statements w'.ach are

affected by the financial bases and policies adopted on such
matters as depreciation and the valuation of stocks.
 Financial statements do not represent a complete picture
of the business, but merely a collection of facts which can be
expressed in monetary terms. They may not refer to other
factors which affect performance.

 Over use of ratios as controls on managers could be

dangerous, in that management might concentrate more on
simply improving the ratio than on dealing with the significant
issues. For example, the return on capital employed can be
improved by reducing assets rather than increasing profits.

 A ratio is a comparison of two figures, a numerator and a

denominator In comparing ratios it may be difficult to
determine whether differences are due to changes in the
numerator, or in the denominator or in both.

 Ratios are inter-connected. They should not be treated in

isolation. The effective use of ratios, therefore, depends on being
aware of all these limitations and ensuring that, following
comparative analysis, they are used as a trigger point for
investigation and corrective action rather than being treated as
meaningful in themselves.

 The analysis of ratios clarifies trends and weaknesses in

performance as a guide to action as long as proper comparisons
are made and the reasons for adverse trends or deviations from
the norm are investigated thoroughly.

Illustration 1: From the given Balance Sheets calculate:

(a) Debt-equity ratio
(b) Liquid ratio
(c) Fixed assets to current assets ratio
 (d) Fixed assets to Net worth ratio
Balance Sheet
Liability Rs. Assets Rs.
Share Capital 1,00,000 Goodwill 60,000
Reserve 20,000 Fixed assets (Cost) 1,40,000
Profit and Loss a/c 30,000 Stock 30,000
Secured Loans 80,000 Debtors 30,000
Creditors 50,000 Advances 10,000
Provisions for taxation 20,000 Cash 30,000
3,00,000 3,00,000

Solution:
(a) Debt-equity ratio = Outsiders Funds
Shareholders Funds

Outsider's Funds Rs. Shareholders' Rs.

Funds
Secured Loans 80,000 Share Capital 1,00,000
Creditors 50,000 Reserves 20,000
Provisions for taxation 20,000 Profit and Loss a/c 30,000
1,50,000 1,50,000

Debt-equity ratio = 1,50,000= 1:1

1,50,000

(b) Liquid ratio = Liquid Assets

Current Liabilities

Note: Advances are treated as current asset.

Secured Joans are treated as current liability.

Liquid ratio = 70,000

= 0.47:1
1,50,000
(c) Fixed Assets to Currents Assets Ratio = Fixed Assets
Current Liabilities
Fixed Assets = 1,40,000 Current Assets (Rs)
Cash 30,000
Stock 30,000
Debtors 30,000
Advances 10,000
1,00,000
Fixed assets to current assets ratio = 1,40,000
= 1.4:1
1,00,000

(d) Fixed Assets to Net worth Ratio = Fixed Assets

Net worth
 Share Capital 1,00,000
Reserves 20,000
P & L a/c 30,000
1,50,000
Less: Provision for taxation 20,000
1,30,000

Fixed Assets to Net worth ratio = 1,40,000

1,30,000 = 1.08:1

Illustration 2: From the following data calculate;

(a) Current ratio
(b) Quick ratio
(c) Stock Turnover ratio
(d) Operating ratio
(e) Rate of return on equity capital
Balance Sheet as on Dec., 31,2001

Liabilities Rs. Assets Rs.

Equity Share 1,00,000 Plant and Machinery 6,40,000

Capital (Rs. 10 shares)

Profit and loss 3,68,000 Land and buildings 80,000

account
Creditors 1,04,000 Cash 1, 60,000
Bills payable 2,00,000 Debtors

3,60,000

Less: Provision for 3,20,000

bad debts

40,000
Other Current 20,000 Stock 4,80,000

liabilities
Prepaid Insurance 12,000
 16,92,000 16,92,000

Income Statement for the year ending 31st Dec., 2001

(Rs.)
Sales 4,00,000
Less: Cost of goods sold 30,80,000
9,20,000
Less: Operating expenses 6,80,000
Net Profit 2,40,000
Less: Income tax paid 50% 1,20.000
New Profit after tax 1,20,000

Balances at the beginning of the year:

Debtors Rs. 3,00,000

Stock Rs. 4,00,000

Solution:

(a) Current ratio = Current Assets

Current Liabilities
 Current Assets Rs. Current Liabilities Rs.
Cash Creditors 1,04,000
Debtors 3,20,000 Bills Payable 2,00,000
Stock 4,80,000 Other Current 20,000

Liabilities
Prepaid insurance 12,000
9,72,000 3,24,000

Current ratio = 9,72,000

3:1
3,24,000

(b) Quick ratio = Liquid Assets

Current Liabilities

Liquid assets (Rs.)

Cash Debtors 1,60,000 Current liabilities Rs.3,24,000

3,20,000
4,80,000

Liquid ratio = 4,80,000 = 1.48:1

3,24,000

(c) Stock Turnover Ratio = Cost of goods sold

Average slock
Cost of goods sold = 30,80,000
Average Stock = Opening Stock + Closing Stock
2
= 4,00,000 + 4,80,000 = 4,40,000
2

Stock Turnover Ratio = 3,80,000

= 7 times
 4,40,000

(d) Operating Ratio = Cost of goods sold + Operating expressesX 100

Net Sales

X 100
= 30,80,000 + 6,80,000 + 40,00,000 = 94%

40,00,000

(e) Rate of return on equity capital:

= Net profit afer lax
Equity share capital

= 1,20,000 X 100 = 12%

10,00,000

Illustration 3: The following are the Trading and P&L A/c for the year
ended 31st December 2001 and the Balance Sheet as on that date of
K. Ltd.
Trading and P & L A/c

Particulars Rs. Particulars Rs.

To Opening Stock 9,950 By Sales 85,000
To Purchases 54,5.25 By Closing Stock 14,900
To Wages 1,425
To Gross Profit 34,000
99,900 99,900
To Administrative 15,000 By Gross Profit 34,000

Expenses
To Selling Expenses 3,000 By Interest 300
To Financial Expenses 1,500 By Profit on sale 600

of shares
 To Loss on sale of assets 400
To Net Profit 15,000
34,900 34,900

Balance Sheet
Liabilities Rs. Assets Rs.
Share Capital 20,000 Land and Buildings 15,000
Reserves 9,000 Plant & Machinery 8,000
Current Liabilities 13,000 Stock 14,900
P&LA/c 6,000 Debtors 7,1000
Cash at Bank 3,000
48,000 48,000

You are required to Calculate;

(a) Current Ratio
(b) Operating Ratio
(c) Stock Turnover Ratio
(d) Net Profit Ratio
(e) Fixed Assets Turnover Ratio

Solution:
(a) Current ratio = Current Assets
Current Liabilities

Current Assets (Rs.)

Cash at Bank 3,000
Current liabilities Rs. 13,000
Debtors 7,100
Stock 14,900
 25,000

Current ratio = 25,000 Rs. 1.923:1

13,000

(b) Operating Ratio = Cost of goods sold + Operating expresses

X 100
Net Sales

Cost of goods sold = 9,950 + 54,525 + 1,425 - 14,900 = 51,000

Operating expenses = 19,500

Operating Ratio = 51,000 + 19,500 X 100 = 82.94%
85,000

(c) Stock Turnover Ratio = Cost of goods sold

Average stock
Average Stock = 9,950 + 14,900 = 12,425
2

Stock Turnover Ratio = 51,000 = 4.1 times

12,425

(d) Net Profit Ratio = Net Profit = 100

Net Sales

= 15,000 = 100 = 17.65%

85,000

(e) Fixed Assets Turnover Ratio = Net Sales

Fixed Assets
 = 85,000 = 3.7 times
23,000

Illustration 4; The following is the Trading and Profit and Loss a/c
and Balance Sheet of a firm.

Trading and P & L A/c

Particulars Rs. Particulars Rs.
To Opening Stock 10,000 By Sales 1,00,000
To Purchases 55,000 By Closing Stock 15,000
To Gross Profit c/d 50,000
1,15,000 1,15,000
To Administrative Expenses 15,000 By Gross Profit b/d 50,000

To Interest 3,000
To Selling Expenses 12,000
To Net Profit 20,000
50,000 50,000

Balance Sheet
Liabilities Rs. Assets Rs.
Capital 1,00,000 Land and Buildings 50,000
Profit and Loss a/c 20,000 Plant & Machinery 30,000
Creditors 25,000 Stock 15,000
Bills Payable 15,000 Debtors 15,000
Bills receivable 12,500
Cash at Bank 17,500
Furniture 20,000
1,60,000 1,60,000

Calculate the following ratios:

 (a) Inventory turnover ratio
(b) Current Ratio
(c) Gross profit ratio
(d) Net profit ratio
(e) Operating ratio
(f) Liquidity ratio
(g) Proprietary ratio
Solution:
(a) Inventory Turnover ratio = Cost of goods sold
Average stock
Cost of goods sold
Opening Stock 10,000
Purchases 55,000
65,000
Less: Closing Stock 1 5,000
50,000

Average Stock = Opening Stock + Closing Stock

2
= 10,000 + 15,000
= 12,500
2

Stock Turnover ratio = 50,000 = 4 times

12,500

(b) Current ratio = Current Assets

Current Liabilities

Current Assets (Rs.)

Current Assets Rs. Current liabilities Rs.
Stock 15,000 Creditors 25,000
Debtors 15,000 Bills Payable 15,000
B/R 12,500
Cash at Bank 17,500
 60,000 40,000

Current ratio = 60,000

= 1.5:1
40,000
(b) Gross Profit Ratio = Gross Profit
X 100 = 50%
Net Sales

(c) Net Profit Ratio = Net Profit X 100

Net Sales

= 20,000 = 20%
1,00,000

(d) Operating Profit = Cost of goods sold + Operating expresses = 100

Net Sales
Cost of goods sold = 50,000

Operating expenses (Rs.)

Administration expenses Selling expenses 15,000
12,000
27,000

Operating ratio = 50,000 + 27,000 X 100

77 %
1,00,000

(e) Liquidity ratio = Liquid Assets

Current Liabilities
Current Assets (Rs.)
Liquid Assets Rs. Current liabilities Rs.
Cash at Bank 17,500 Creditors 25,000
Bills Receivable 12,500 Bills Payable 15,000
 Debtors 15,000
45,000 40,000

Liquidity ratio = 45,000

40,000

(f) Proprietary ratio = Shareholder’s Funds X 100

Total Assets
Shareholder's Furuis (Rs.)
Capital Profit and Loss a/c 1,00,000
Total Assets Rs. 1,60,000
20,000
1,20,000

Proprietary ratio = 1,20,000 = 75%

X 100
1,60.000

Illustration 5: A company has a profit margin of 20% and asset

turnover of 3 times. What is the company's return on investment?
How will this return on investment vary if –

(i) Profit margin is increased by 5% ?

(ii) Asset turnover is decreased to 2 times?
(iii) Profit margin is decreased by 5% and asset turnover is
increased to 4 times.

Calculation of impact of change in profit margin and change in asset

turnover on return on investment

Return on investment = Profit Margin x Asset Turnover

= 20% x 3 times = 60%

(i) If profit margin is increased by 5% :

ROI = 25% x 3 = 75%
(ii) If asset turnover is decreased to 2 times:
ROI = 20% x 2 = 40%
(iii) If profit margin decreased, by 5% and asset turnover is increased
to 4 times:
ROI = 15% x 4 = 60%

Illustration 6: There are three companies in the country

manufacturing a particular chemical. Following data are available for
the year 2000-2001.
(Rs. lakhs)
Company Net Sales Operating Cost Operating Assets
A Ltd. 300 255 125
B Ltd. 1,500 1,200 750
C Ltd. 1,400 1,050 1,250

Which is the best performer as per your assessment and why?

Comparative Statement of Performance
Particulars A Ltd. B Ltd. C Ltd.
Sales 300 1,500 1,400
Less: Operating Cost 255 1,200 1,050
OperatingProfit (A) 45 300 350
Operating Assets (B) 125 750 1,250
Return on capital employed 36% 40% 28%

(A) / (B) x 1 00
Analysis: Basing on the return on capital employed, B Ltd., is the
best performer as compared to A Ltd. and C Ltd.
Illustration 7: Calculate the P/E ratio from the following:
(Rs.)
Equity Share Capital (Rs. 20 each) 50,00,000
Reserves and Surplus 5,00,000
Secured Loans at 15% 25,00,000
Unsecured Loans at 12.5% 10,00,000
Fixed Assets 30,00,000
Investments 5,00,000

Operating Profit 25,00,000,

Income-taxRate50% (Rs.)

Operating Profit 25,00,000

Less: Interest on
Secured Loans @ 15% 3,75,000
Unsecured Loans @ 12.5% 1,25,000 5,00,000
Profit before tax (PBT) 20,00,000
Less: Income-tax @ 50% 10,00,000
Profit aaer tax (PAT) 10,00,000

No. of Equity shares 2,50,000

EPS = Profit after tax
No. of Equity shares
= Rs. 10,00,000 = Rs. 4
Rs. 2,50,000

Market price per share = Rs. 50

P/E Ratio = Market price per share / EPS
= Rs.50/Rs.4 = 12.50
Illustration 8: The capital of Growfast Co. Ltd., is as follows:
 10% Preference shares of Rs.10 each 50,00,000
Equity shares of Rs. 100 each 70,00,000
1,20,00,000

Additional information:
Profit after tax at 50% Rs. 15,00,000
Deprication Rs. 6,00,000
Equity dividend paid 10%
Market price per equity share Rs. 200

Calculate the following:

(i) The cover for the preference and equity dividends

(ii) The earnings per share

(iii) The price earnings ratio

(iv) The net funds flow

Solution:

(i) The cover for the Preference and Equity dividends:

Profit after tax

= Preference dividend + Equity dividend

= Rs. 15,00,000 = 1.25 times

Rs. 5,00,000 + to 7,00,000

(ii) The Earning Per Share:

= Net profit after preference dividend
No. of Equity Shares
= Rs. 15,00,000 – Rs. 5,00,000 = Rs. 14.29
Rs.7,00,000

(iii) The Price Earnings Ratio:

 = Market price per share
Earning per share

= Rs.200 = 14 times
Rs. 14.29

(iv) The Net Funds Flow:

(Rs.)
Profit after tax 15,00,000
Add: Depreciation 6,00,000
21,00,000
 LESSON-II
FUNDS FLOW ANALYSIS

INTRODUCTION
The Profit and Loss account and Balance Sheet statements are
the common important accounting statements of a business
organisation. The Profit and Loss account provides financial
information relating to only a limited range of financial transactions
entered into during an accounting period and which have impact on
the profits to be reported. The Balance Sheet contains information
relating to capital or debt raised or assets purchased. But both the
above two statements do not contain sufficiently wide range of
information to make assessment of organization by the end user of the
information.

FUNDS FLOW ANALYSIS

In view of recognised importance of capital inflows and outflows,

which often involve large amounts of money should be reported to the
stakeholders, the funds flow statement is devised. This statement is
also called 'Statement of Sources and application of funds' and
'Statement of changes in financial position'.

The Funds flow statement contain all the details of the financial
resources which have became available during an accounting period
and the ways in which those resources have been used up. This
statement discloses the amounts raised from various sources of
finance during a period and. then explains how that finance has been
used in the business. This statement is valuable in interpretation of
the accounts.
 It is a very useful tool in analysis of finrncial statements which
analyses the changes taking place between two balance sheet dates.
The statement analyses the change between the opening and closing
balance sheets for the period.

A balance sheet sets out the financial position at a point of time,

setting liabilities from which funds have been raised against assets
acquired, by the use of those funds. A funds flow statement analyses
the changes which have taken place in the assets and liabilities
during certain period as disclosed by a comparison of the opening and
closing balance sheets.

Concept of'Fund’

The term ‘fund’, has been defined and interpreted differently by

different experts. Broadly, the term 'fund' refers to all the financial
resources of the company. However, the most acceptable meaning of
the ‘fund’ is 'working capital'. Working Capital is the excess of Current
Assets over Current fi Liabilities. While attempting to understand the
concept of funds Flow Analysis! & we shali also abide by the popular
definition of funds, meaning working capital.

Concept of Flow

The ‘flow’ of funds refer to transfer of economic values from one

asset equity to another. When 'funds' mean working capital, flow of
funds refers to movement of funds which cause a change in working
capital of the organisation. To identify a 'flow' of funds, we have to
understand the difference between ‘Current’ and ‘Non-Current’ account
CLASSIFICATION OF BALANCE SHEET ITEMS

For preparation of funds flow statement, the whole iterrs of the

sheet is classified into the following four categories as shown in Table

Table 1: CLASSIFICATION OF BALANCE SHEET ITEMS

Liabilities Rs. Assets Rs.

1. Non-Current Liabilities II. Non-Current Assets
Equity Share Capital Land XXX
Preference Share Capital XXX Buildings XXX
Reserves and Surplus XXX Plant and Machinery XXX
Debentures XXX Less: Depreciation
Long-term loans XXX Furniture and Fittings XXX
Vehicles XXX
Patents XXX
Non-Current Liabilities II. Non-Current Assets
Trade Marks XXX
Goodwill XXX
Preliminary expenses XXX
Profit and Loss A/c (Debit XXX
balance)
Total (A) XXX
Total (A) XXX Total (A) XXX
III. Current Liabilities IV. Current Assets
Trade Creditors XXX Inventories XXX
Bank Overdraft XXX Trade Debtors XXX

Bills Payable Provisions XXX Bills Receivable XXX

against current liabilities XXX Cash and Bank Balances XXX
Loans and Advances XXX
Investments Temporary) XXX
Total (B) XXX Total (B) XXX
Grand Total (A+B) XXX Grand Total (A+B) XXX
 The excess of current assets over current liabilities is called
working capital. The excess of funds generated over funds outgo from
non-current assets and non-current liabilities will lead to increase or
decrease in working capital. This can further be analysed into
increase or decrease in respective current assets and current
liabilities.

IDENTIFICATION OF 'FLOW OF FUNDS

A 'flow' of funds takes place only if a Current Account is

involved. To identify a flow, journalise the transaction, identify the two
accounts involved as 'Current' and 'Non-Current' and apply the
General Rule.
General Rule
 Transactions which involve only Current Accounts do not result
in a flow.
 Transactions which involve only Non-Current Accounts do not
result in a flow.
 Transactions which involve one Current Account and one Non-
Current Account results in a flow of funds.

Proformas of Funds Flow Statement

The relationship between sources and application of funds and

its impact j on working capital is explained in the format of Statement
of Sources and Application of Funds given in Tables 2 and 3.

Table 2: PROFORMA OF STATEMENT OF SOURCES AND

APPLICATION
OF FUNDS
Stage 1: Statement of Sources and Application of Funds of XYZ Ltd.,
for the year ended 31st March, 2001.

Rs.
Fund from Operations xxx
Issue of Share Capital xxx
Raising of long-term loans xxx
Receipts from partly paid shares, called up xxx
Sales of non-current (fixed) assets xxx
Non-trading receipts, such as dividends received xxx
Sale of Investments (long-term) xxx
Decrease in Working Capital (as per schedule of xxx

changes in w.c)
Total xxx

Application or Uses of Funds:

Funds Lost in Operations xxx
Redemption of Preference Share Capital xxx
Redemption of Debentures xxx
Repayment of long-term loans xxx
Purchase of non-current investments xxx
Non-trading payments xxx
Payments of dividends xxx
Payment of tax xxx
Increase in Working Capital (as per schedule of xxx

changes in w.c)
Total xxx

The funds flow statement can also be presented in a vertical

form, wherein all Sources are listed down, totaled and then all
Applications are listed at one place and totaled. The totals should be
the same, the difference being the Increase or Decrease in Working
Capital. However, the Horizontal format is more commonly used.

Table 3: FORM OF FUNDS FLOW STATEMENT

Funds Flow Statement of XYZ Ltd., for the year ended 31" March,
2001

Sources Rs. Applications Rs.

Funds from Operations xxx Funds lost in Operations xxx
Issue of Share Capital xxx Redemption of Preference , Share xxx

capital
Issue of Debentures xxx Redemption of Debentures: xxx
Raising of long-term xxx Repayment of long-term loans xxx

loans
Receipts from partly paid xxx Purchase of non-current (fixed) xxx

shares, called up assets

Sale of non-current xxx Purchase of long-term xxx

(fixed) assets : Investments

Non-trading receipts xxx Purchase of long-term xxx

such as dividends investments

Sale of long-term xxx Payment of Dividends xxx

Investments
Net Decrease in Working xxx Payment of tax* xxx

Capital
Net Increase in Working Capital xxx
xxx xxx

*Note: Payment of dividend and tax will appear as an application of

funds only when these items are appropriations of profits and not
current liabilities.

STATEMENT OF CHANGES IN WORKING CAPITAL

This statement follows the Statement of Sources and
Application, of Funds. The primary purpose of the statement is to
explain the net change in Working Capital, as arrived in Funds Flow
Statement. In this statement, all Current Assets and Current
Liabilities are individually listed. Against each of account, the figure
pertaining to that account at the beginning and at the end of the
accounting period is shown. The net change in its position is also
shown. The changes taking place with respect to each account should
add up to equal the ; net change in working capital, as shown by the
Funds Flow Statement. A proforma of the Statement of changes in
-Working Capital is being presented ' below:

 Increase in current assets and decrease in current liabilities

: The acquisition of current assets and repayment of current
liabilities will result in funds outflow. The funds may be
applied to finance an increase in stock, debtors etc or to reduce
the amount owed to trade creditors, bank overdraft, bills
payable etc.

 Decrease in current assets and increase in current liabilities:

The reduction in current assets e.g. stock or debtors balances
will result in release of funds to be applied elsewhere. Short-
term funds raised during the period by any increase in the
current liabilities like trade creditors, bank overdraft and tax
dues, means that these sources have lent more at the end of the
year than at the beginning.
STATEMENT OF CHANGES IN WORKING CAPITAL
Table 4: PROFORMA OF STATEMENT OF ANALYSIS OF CHANGES
IN
WORKING CAPITAL

The relation between Stage I and Stage II is given below in the figure:

Stage I : List the sources from which capital has been derived
during the accounting period, and the ways in which
working capital has been used up, i.e. list the
transactions which cause working capital to increase or
decrease

Stage IIl : Analyse the net increase or decrease in working capital

into changes in the constituent items i.e. stock, debtors,
creditors and cash

The basic rules in preparation of the funds flow statement is as

follows:
 An increase in an asset over the year is an application of funds.
 A decrease in an asset over the year is a source of funds.
 A decrease in a liability over the year is an application of funds.
  An increase in a liability over the year is a source of funds.

SOURCES OF FUNDS
The funds inflow into the organisation will come from the following
sources:

Funds Generated from Operations

During the course of trading activity; a company generates

revenue" mainly in the form of sale proceeds and paid out for costs.
The difference between these two items will be the amount of funds
generated by the trading operations. The funds generated from
business operations are aruved at after making the following
adjustments:
Table 5: PROFORMA FOR COMPUTATION OF FUNDS GENERATED
FROM OPERATIONS
Funds from operations can also be calculated by preparing Adjusted
Profit and Loss Account as follows:

ADJUSTED PROFIT AND LOSS ACCOUNT

Table 6: PROFORMA OF ADJUSTED PROFIT AND LOSS ACCOUNT
Notes :
 Depreciation on fixed assets or amortisation of intangible assets
like preliminary expenses, patens, goodwill etc., written off is
charged, against profit to reflect the use of fixed assets or
written off of intangible asset. In, these transactions there is no
corresponding cash outlay occurs and hence, add back the
 amount charged against profit, to arrive at the total funds
generated from business operations.

 The Profit or Loss on sale of non-current assets (fixed asses and

long-term, investments) is adjusted to arrive at the true funds
from operations.

 The provision for tax made in the profit and loss account is to
be added back to the reported profit The actual amount paid as
tax is to be shown as the' application of funds in the funds flow
statement. The provision for tax, if it' is shown in the balance
sheet, need not be considered for calculation of funds! generated
fro operations.

 Any amount appropriated in the Profit and Loss account

towards transfer to reserves or proposed dividend is to be added
back to arrive at the funds generated from operation. The actual
amount paid as dividend is to be shown, as application of funds
in the funds flow statement. The dividend proposed but awaiting
payment is a current liability in tie balance sheet. If this amount
increases, from one year end to the next, the extra liability
appears as a source of funds.

Funds raised from Shares, Debentures and Long-term Loans

The long-term funds injected into the business during the year
by issue of new shares or debentures and by raising long-term loans.
If any premium is collected, that is also form part of funds raised from
the above said sources of finance.
Sale of Fixed Assets and Long-term Investments

Any amount generated from sale of fixed assets or long-term

investments is a source of funds. While preparation of the funds flow
statement the gross sale proceeds from sale is taken as source of
funds. This activity does not produce fresh funds, but it releases
funds used to finance the assets. Any profit or loss arising from such
sale is adjusted in the funds generated from operations.

APPLICATION OF FUNDS

The use of funds in an organisation take place in the following

forms:

1. Repayment of Preference Capital or Debentures or Long-term

Debt: This represents the application of organisation's funds
released from business through redemption of preference shares
or debentures, repayment of long-term loans previously made
by the organisation. Any reduction in Equity capital is also
taken as application of funds.

2. Purchase of Fixed Assets or Long-term Investments: The

funds used to purchase long-term assets are usually the most
significant application of fund during the year. This group
includes capital expenditures on land, building plant and
machinery, furniture and fittings, vehicles and long-term
investments outside the business.

3. Distribution of Dividends and Payment of Taxes: The

dividends distributed to the shareholders and tax paid during
the year is the application of funds for the firm.
4. Loss from Operations: Losses made in the trading activities
use up the funds. If costs exceed revenue, a cash outflow will be
experienced. The adjustments are made as shown above in
point (i) in the sources of funds,

Illustration 1: Calculate funds from operations with the help of the

following Profit and Loss A/c.

Calculation of funds from operations

Illustration 2: From the following Manufacturing, Trading and Profit
& Loss Account of a company, calculate Funds from operations.
Manufacturing, Trading, Profit & Loss Appropriation A/c
The amount Rs. 35,000 is transferred to Adjusted Profit and Loss a/c
and the tax paid Rs.25,000 is shown on the applications side of the
Funds Flow Statement

Illustration 4: Following are the extracts from the Balance Sheets

of{a; company-on two different dates

Particulars 31-3-2000 31-23-2001

Rs. Rs.
P&L A/c 50,000 80,000
Provision for Taxation 10,000 15,000
Proposed Dividends 5,000 10,000

Additional Information
1) Tax Paid during the year 2000 – 2001 Rs.
2,500
2) Dividends paid for the period 2000- 2001 Rs. 1,000

On the basis of the above information, calculate ‘Funds from

Operations’ taking provision for tax and proposed dividend as (a) Non-
current liabilities (b) Current liabilities.

a) Provision for tax and proposed Dividend are taken as non-current

liabilities
Provision for Taxation A/c

Particulars Rs. Particulars Rs.

To Income Tax A/c 2,500 By balance b/d 10,000

(tax paid|) (opening balance)

To Balance c/d 15,000 By P&L A/c (provision 7,500

(closing balance) made in the current

year)

[bal.fig.]
 17,500 17,500

Particulars Rs. Particulars Rs.

To Dividend A/c 1,000 By Balance b/d 5,000

(being dividend paid (Opening balance)

during the year)

To balance c/d 10,000 By P&L A/c (Proposed 6,000

(closing balance dividend for the

current
11,000 11,000

Adjusted P & L A/c

Particulars Rs. Particulars Rs.
To Provision for 7,500 By Balance b/d 50,000

Taxation (opening balance)

A/c
To proposed Dividend 6,000 By Funds from 43,500

Operations

(bal. fig.)
To Balance c/d 80,000

(closing balance
93,500 93,500

Illustration 5: The following information has been extracted from the Balance
Sheets of a company
Particulars 31st Dec. 2000 31st Dec. 2001
Machinery 80,000 2,00,000
Accumulated Depreciation 30,000 35,000
Profit and Loss Account 25,000 40,000

The following additional information is also available:

(i) A machine costing Rs. 20,000 was purchased during the year by
issue of equity shares.
(ii) On January 1, 2001, a machine costing Rs. 15,000 (with an
accumulated depreciation of Rs.5,000) was sold for Rs.7,000.

Find out sources/ application of funds.

Particulars Rs. Particulars Rs.
To Machinery A/c 5,000 By Balance b/d 30,000
To Balance c/d 35,000 By Adjusted P&L A/C 10,000

(balancing figure)

40,000 40,000
Machinery A/c

Particulars Rs. Particulars Rs.

To Balance b/d 80,000 By cash (sales) 7,000
To Share Capital 20,000 By Accumulated 5,000

depreciation
To Cash-Purchases 1,15,000 By Adjusted P & L A/c 3,000

(balancing figure) (Loss on sale)

By Balance c/d 2,00,000
2,15,000 2,15,000

Accumulated Depreciation A/c

Particulars Rs. Particulars Rs.
To Accumulated 10,000 By Balance b/d 25,000

Depreciation A/c
To Machinery A/c (Loss 3,000 By Funds from 28,000

on sale) Operations (bal. fig.)

To Balance c/d 40,000

53,000 53,000

(i) Purchase of machinery for Rs.20,000 by issue of equity shares is

neither a source nor an application of funds.

(ii) Sale of machinery for Rs.7,000 is a source of funds,

(iii) Purchase of machinery for Rs.1,15,000 for cash is an application

of funds, (iv) Funds from operations of Rs.28,000 is a source of
funds.

Illustration 6: From the following information, you are required to

ascertain the amount of flow of funds on account of Plant.
 Rs.
Opening Balance of Plant 1,32,500
Closing Balance of Plant 1,97,500
Provision for Depreciation on Plant at the beginning 45,000

of the year
Provision for Depreciation on Plant at the end of the 61,000

year

During the year, a plant costing Rs. 65,000 was purchased in

exchange for fully paid debentures. An old Plant costing Rs. 40,000
was sold for Rs.34,000. Depreciation provided on the same amounted
to Rs.18,000.

Accumulated Deprecation A/c

Particulars Rs. Particulars Rs.

To Machinery A/c 40,000 By Balance b/d 4,24,000

(Depn.

of sold Machine)
To Closing balance c/d 4,11,000 By Adjusted P&L A/c 27,000

(Balancing Figure( [Depn.

provided during the year]

4,51,000 4,51,000

Illustration 8 :
Extracts from Balance Sheets
Particulars As on 31st As on 31st March

March, 2001

2000
Rs. Rs.
Equity from Balance Sheets 4,00,000 5,00,000
8% Preference Share Capital 2,00,000 1,50,000

Additional Information :
(i) Equity shares were issued during the year against purchase
of machinery for Rs.50,000.
(ii) 8% Preference shares worth Rs. 1,00,000 were redeemed
during the year.

Prepare necessary accounts to find out sources/applications of funds.

Equity Share Capital A/c

Particulars Rs. Particulars Rs.

To Machinery A/c 40,000 By Balance b/d 4,24,000

(Depn.

of sold Machine)
To Closing balance c/d 4,11,000 By Adjusted P&L A/c 27,000

(Balancing Figure( [Depn.

provided during the year]

4,51,000 4,51,000

Equity Share Capital A/c

Particulars Rs. Particulars Rs.
To Balance c/d 5,00,000 By Balance b/d 4,00,000

By Machinery A/c 50,000

By Cash-Issue (balancing 50,000

figure)
5,00,000 5,00,000

8% Preference Share Capital A/c

Particulars Rs. Particulars Rs.
To cash (Application) 1,00,000 By Balance b/d 2,00,000

To Balance c/d 1,50,000 By Cash-Issue (balancing 50,000

figure)

2,50,000 2,50,000

1. Issue of equity shares purchase of machinery is neither a source

nor application of funds.
2. Issue of shares worth Rs.50,000 for cash is a source of funds.
3. Redemption of preference shares worth Rs.1,00,000 is an
application of funds.
4. Issue of preference shares of Rs. 50,000 is a source of funds.

Illustration 9 :
Prepare a statement showing changes in working capital
Particulars 2000 2001
Assets
Cash 60,000 94,000
Debtors 2,40,000 2,30,000
Stock 1,60,000 1,80,000
Land 1,00,000 1,32,000
Total 5,60,000 6,36,000
Capital & Liabilities
Share Capital 4,00,000 5,00,000
Creditors 1,40,000 90,000
Retained earnings 20,000 46,000
Total 5,60,000 6,36,000

Statement showing changes in working capital

Particulars 2000 2001 Increase Decrease

(+) (-)
Current Assets
Cash 60,000 94,000 34,000
Debtors 2,40,000 2,30,000 10,000
Stock 1,60,000 1,80,000 20,000
4,60,000 5,04,000

Current Liabilities
Creditors 1,40,000 90,000 50,000
Working Capital (CA- 3,20,000 4,14,000

CL)
Net increase in 94,000 94,000

Working Capital
4,14,000 4,14,000 1,04,000 1,04,000
Illustration 10 : Following are summerised Balance Sheets ‘X’ Ltd. as
on 31st December, 2000 and 2001. You are required to prepare a
Funds Statement for the year ended 31st December, 2001.

Liabilities 2000 2001 Assets 2000 2001

Share Capital 1,00,000 1,25,000 Goodwill - 2,500
General Reserve 25,000 30,000 Buildings 1,00,000 95,000
P&L A/c 15,250 15,300 Plant 75,000 84,500
Bank Loan 35,000 67,600 Stock 50,000 37,000

(Long-term)
Creditors 75,000 - Debtors 40,000 32,100
Provision for Tax 15,000 17,500 Bank - 4,000
Cash 250 300
2,65,250 2,55,400 2,65,250 2,55,400

Additional Information:
(i) Dividend of Rs. 11,500 was paid.
(ii) Depreciation written off on plant Rs.7,000 and on buildings
Rs.5,000.
(iii) Provision for tax was made during the year Rs. 16,500.

Statement showing Changes in Working Capital

Particulars 2000 2001 Increas Decrease

e (-)

(+)
Current Assets
Cash 250 300 50
Bank - 4,000 4,000
Debtors 40,000 32,100 7,900
Stock 50,000 37,000 13,000

90,250 73,400
Current Liabilities
Creditors Working 75,000 - 75,000 -

Capital (CA - CL)

15,250 73,400
Net increase in Working 8,150 58,150

Capital
73,400 73,400 79,050 79,050

Funds Flow Statement

Sources Rs. Application Rs.
Funds from 45,050 Purchase of Plant 16,500

operations
Issue of Shares 25,000 Income tax paid 14,000
Hank Loan 32,600 Dividend paid 11,500
Goodwill paid 2,500
Net increase in 58,150

Working Capital
1,02,650 1,02,650

Working Notes:
Share Capital A/c
Particulars Rs. Particulars Rs
To Balance c/d 1,25,000 By Balance b/d 1,00,000
By Bank a/c 25,000
1,25,000 1,25,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 30,000 By Balance b/d 25,000
 By P&L a/c 5,000
30,000 30,000

Provision for Taxation A/c

Particulars Rs. Particulars Rs.

To Bank a/c 14,000 By Balance b/d 15,000
To Balance c/d 17,500 By P&L a/c 16,500
31,500 31,500

Bank Loan A/c

Particulars Rs. Particulars Rs.
To Balance c/d 67,600 By Balance b/d 35,000
By Bank a/c 2,600
67,600 67,600

Land and Building A/c

Particulars Rs. Particulars Rs.
To Balance c/d 1,00,000 By Depreciation 5,000

a/c (P&L a/c)

By Balance c/d 95,000

1,00,000 1,00,000

Plant A/c

Particulars Rs. Particulars Rs.

To Balance c/d 75,000 By Depreciation a/c 7,000

(P&L a/c)

To Bank 16,500 By Balance c/d 84,500

91,500 91,500
Goodwill A/c
Particulars Rs. Particulars Rs.
To Bank 2,500 By Balance c/d 2,500
2,500 2,500

Calculation of Funds from Operations:

(Rs.)
Balance of P&L a/c (2001)
Add: Non-fund and non-operating

items which have already debited to

P&L a/c:
General reserve 5,000
Provision for tax 16,500
Dividends paid 11,500
Depreciation:
On Buildings 5,000
On Plant 7,000 45,000
60,300
Less: Balance of P&L a/c (2000) 15,250
Funds from Operations 45,050

Illustration 11: From the following Balance Sheets of ABC Ltd. on

31st Dec. 2000 and 2001, you are required to prepare (i) A Schedule of
changes in working capital, (ii) A Funds Flow Statement.
(Rs.)
Liabilities 2000 2001 Assets 2000 2001

Share Capital 2,00,000 2,00,000 Goodwill 24,000 24,000

General Reserve 28,000 36,000 Buildings 80,000 72,000

P&L A/c 32,000 26,000 Plant 74,000 72,000

Creditors 16,000 10,800 Investments 20,000 22,000

Bills payable 2,400 1,600 Stock 60,000 46,800,

Provision for Tax 32,000 36,000 Bills 4,000 6,400

receivable
Provision for 800 1,200 Debtors 36,000 3 8,000
doubtful debts

Cash & Bank 13,200 30,400

balances
3,11,200 3,11,600 3,11,200 3,11,600

Additional Information:
(i) Depreciation provided on plant was Rs.8,000 and on
Buildings Rs.8,000
(ii) Provision for taxation made during the year Rs.38,000
(iii) Interim dividend paid during the year Rs. 16,000.
Statement showing Changes in Working Capital
Increase Decrease
Particulars 2000 2001
in W.C. in W.C.
Current Assets
Cash & Bank 13,200 30,400 17200

Balances
Debtors 36,000 38,000 2,000
Bills Receivable 4,000 6,400 2,400
Stock 60,000 46,800 13,200
1,13,200 1,21,600
Current Liabilities
Provision for 800 1,200 400

doubtful debts
Bills Payable 2,400 1,600 800
Creditors Working 16,000 10,800 5,200

Capital (CA - CL)

19,200 13,600
94,000 1,08,000
Increase in Working 14,000 14,000

Capital
1,08,000 1,08,000 27,600 27,600
Funds Flow Statement
Sources Rs. Application Rs.
Funds from 72,000 Purchase of Plant 6,000

operations
Tax paid 34,000
Purchase of investments 2,000
Interim dividend paid 16,000
Increase in Working Capital 14,000
72,000 72,000

Working Notes:
Provision for Taxation A/c
Particulars Rs. Particulars Rs:

To Balance c/d 36,000 By P&L a/c 32,000

To Balance c/d 36,000 By P&L a/c 28,000
70,000 70,000

Plant A/c

Particulars Rs. Particulars Rs:

To Balance c/d 74,000 By Depreciation 8,000

To Balance (Purchase) 6,000 By Balance c/d 72,000
80,000 80,000

Buildings A/c

Particulars Rs. Particulars Rs:

To Balance c/d 80,000 By Depreciation 8,000

By Balance c/d 72,000
80,000 80,000

Investments A/c
Particulars Rs. Particulars Rs.
To Balance b/d 20,000 By Balance c/d 22,000
To Bank (Purchase) 2,000
22,000 22,000

Adjusted Profit & Loss A/c

Particulars Rs. Particulars Rs.

To Non-fund and Non- By Balance on (31-12-200) 32,000

operating items already By Funds from operations 72,000

debited to P&L a/c:

Transfer to General Reserve 8,000
Provision for Tax 38,000
Depreciation on Plant 8,000
Depreciation on Buildings 8,000
Interim dividend 16,000
To Balance on 3 1-1 2-2001 26,000
1,04,000 1,04,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 36,000 By Balance 28,000
By P&L a/c 8,000
36,000 36,000

Illustration 12: From the following Balance Sheet of X Ltd., as on

31st December, 2000 and 31st December 2001, you are required to
prepare a funds | flow statement.
(Rs.)
Liabilities 2000 2001 Assets 2000 2001

Share Capital 4,00,000 5,00,000 Land and 4,00,000 4,80,000

Buildings
General 80,000 1,40,000 Machinery 3,60,000 2,60,000
Reserve
P&L A/c 64,000 78,000 Stock 2,00,000 2,52,000
Bank Loan 3,20,000 80,000 Debtors 1,60,000 1,28,000

(Long term)
Creditors 3,00,000 2,60,000 Cash at Bank 1,04,000 18,000

Provision for 60,000 80,000

Taxation
12,24,000 11,38,000 12,24,000 11,38,000

Additional Information :
(i) During the year ended 31st December 200 dividend of
Rs.84,000 was paid.

(ii) Assets of another company were purchased for a

consideration of Rs. 1,00,000 payable by the issue of shares.
The assets included Land- ' and Buildings of Rs.50,000 and
stock of Rs.50,000.

(iii) Depreciation written off on machinery is Rs.24,000 and on

Land and '. Buildings is Rs.45,000.

(iv) Income-tax paid during the year was Rs.70,000.

(v) Additions to Buildings were for Rs.75,000.

Statement showing Changes in Working Capital

Particulars 2000 2001 Increase in Decrease

W.C. in W.C.
Current Assets
Cash at Bank 1,04,000 18,000 86,000
Debtors 1,60,000 1,28,000 32,000
Stock 2,00,000 2,52,000 52,000
4,64,000 3,98,000
Current Liabilities
Creditors Working 3,00,000 2,60,000 40,000

Capital
1,64,000 1,38,000
1,64,000 1,38,000
Decrease in working 26,000 26,000

capital
1,64,000 1,64,000 1,18,000 1,18,000

Funds Flow Statement for the year ending 31st Dec. 2001

Sources Rs. Application Rs.

Issue of Shares 50,000 Purchase Of Land & 75,000

Buildings
Sale of Machinery 76,000 Bank Loan paid 2,40,000
Funds from 3,17,000 Dividend paid 84,000

operations
Decrease in 26,000 Income-tax paid 70,000

Working Capital
4,69,000 4,69,000

Working Notes:
Provision for Taxation A/c
Particulars Rs. Particulars Rs.
To Cash 70,000 By Balance b/d 60,000
To Balance b/d 80,000 By Adj. P&L a/c 90,000
1,50,000 1,50,000

Machinery A/c
Land and Buildings A/c
Particulars Rs. Particulars Rs.
To Balance b/d 3,60,000 By Adj. P&L a/c 24,000
By Sale of Machinery 76,000
By Balance c/d 2,60,000
3,60,000 3,60,000

Land and Buildings A/c

Particulars Rs. Particulars Rs.

To Balance b/d 4,00,000 By Adj. P&L a/c 45,000
To Share Capital 50,000 By Balance c/d 4,80,000
To Cash 75,000
5,25,000 5,25,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 1,40,000 By Balance b/d 80,000
By Adj. P&L a/c 60,000
1,40,000 1,40,000

Adjusted Profit & Loss A/c

Particulars Rs. Particulars Rs.

To Machinery 24,000 By Opening Balance 64,000
To Land & 45,000 By Funds from 3,17,000

Buildings Operations
To Provision for 90,000

tax
To General 60,000

Reserve
To Dividends paid 84,000
To Closing 78,000

balance
3,81,000 3,81,000

FUNDS FLOW STATEMENT Vs. PROFIT AND LOSS ACCOUNT

Following are the main differences between a Funds Flow
Statement and a Profit and Loss Account:
1. Objective: The main objective of preparing a Funds Flow
Statement is to ascertain the funds generated from
operations. The statement reveals the sources of funds and
their uses. The main objective of preparing a Profit and Loss
Account is to ascertain the net profit earned/ loss incurred
by the company out of the business operations at the end of
a particular period.

2. Basis: The Funds Flow Statement is prepared based on the

financial statements of two consequent years. A Profit and
Loss Account is prepared on the basis of nominal accounts.

3. Usefulness: The Funds Flow Statement is useful for

creditors and management. The Profit and Loss Account is
useful not only to creditors and management but also to the
shareholders and outside parties.

4. Type of Data Used: The Funds Flow Statement takes into

account only the funds available from trading operations
but also the funds available from other sources like issue of
share capital/ debentures, sale of fixed assets etc. Whereas,
the Profit and Loss Account uses only income and
 expenditure transactions relating to trading operations of a
particular period.

For instance, when shares are issued for cash, the same is shown in
funds flow statement as a source of funds whereas in profit and loss account
it is now shown as income.

5. Legal Necessity: Preparation of Funds Flow Statement is not

a statutory obligation and is left to the discretion of
management. Preparation of Profit' and Loss Account is a
statutory obligation.

FUNDS FLOW STATEMENT Vs. BALANCE SHEET

Following are the main difference between a Funds Flow

Statement and a Balance Sheet.

1. Objective: The Funds Flow Statement is prepared to know the

total sources and their uses in a year. Balance Sheet is
prepared to know the financial position of a company as on a
particular date.

2. Basis: The Funds Flow Statement is prepared with the help of

the balance sheets of two consecutive years. The Balance Sheet
is prepared oh the basis of different accounts in the ledger.

3. Usefulness: Funds Flow. Statement is useful for the

management for internal financial management. A Balance
Sheet is useful not only for the management but also to the
shareholders, creditors, outsiders and Government agencies etc.

4. Treatment of Current Assets and Current Liabilities: In

Funds Flow Statement current assets and current liabilities are
 used to find out increase or decrease in working capital. In
Balance Sheet, current assets and current liabilities are shown
itemwise.

5. Legal Necessity: Preparation of Funds Flow Statement is at the

discretion of management. Preparation of Balance Sheet is a
statutory obligation.

USES OF FUNDS FLOW STATEMENT

(1) To determine financial consequences of operations: Funds

Flow Analysis determines the financial consequences of
business operations. In the following cases, Funds Flow
Analysis helps the management to understand the movement
of funds and in effective funds management:
 Many a time, a company inspite of earning large profits
may have unsatisfactory liquidity position. The reasons
for such a position and the financial consequences of
business operations can be ascertained with the help of
funds flow statement.

 The company may be incurring losses but its liquidity

position is sound or the firm will be investing in fixed
Assets despite losses.

 The firm may declare dividend inspite of losses or low

profits.

 The profit earned by the firm from different sources is not

easily understood by the management.

 There may be sufficient cash in the business. But how

such high liquidity is existing is not known.
To fill financial blind spots : The Funds Flow Statement is designed
to fill financial blind spots of the operating statement. It translates the
economic consequences of operations into financial information as a
basis for action.

(2) Working capital utilisation: The Funds Flow Statement helps

the management in assessing the activity of working capital
and whether the working capital has been effectively used to
the maximum extent in business operations or not. The
statement also depicts the surplus or deficit in working
capital than required. This helps the management to use the
surplus working capital profitability or to locate the sources of
additional working capital in case of scarcity.

(3) To aid in securing new finances: A statement of changes in

financial position is useful for the creditor in considering the
company's request for new term loan.

(4) Helps in allocation of financial resources: Funds Flow

Statement helps the management in taking decisions
regarding allocation of the limited financial resources among
different projects on priority basis.

(5) Helps in deciding the urgency of a problem: Funds Flow

Analysis helps to relate the time factor to financial planning.
This enables the management to identify critical points
throughout the passage of time. The management as also the
outsiders concern themselves with the information system
geared up; towards changes in financial position as the
behaviour of funds flow figures relates to the criteria upon
which management strategy is based.
(6) Helps in evaluation of operational issues: The statement of
changes functions as an analytical guide for evaluating
operational issues. The statement enables the management to
ascertain in which the study of trends of success or failure of
operations and available resources.

DRAWBACKS OF FUNDS FLOW ANALYSIS

 Historical nature: The funds flow statement is historical in

nature like any other financial statement. It does not estimate
the sources and application of funds for the near future.

 Structural changes are not disclosed: The funds flow

statement does not disclose the structural changes in financial
relationship in a firm not it discloses the major policy changes
with regard to investment in current assets and short term
financing. Significant additions to inventories financed by short
term creditors are not furnished in the statements as they are
offset by each other while computing net changes in working
capital.

 New items are not disclosed: The funds flow statement does
not disclose any new or original items which affect the financial
position of the business. The funds flow statement simply
rearranges the data given in conventional financial statements
and schedules.

 Not relevant: A study of changes in cash is more relevant than

a study of changes in funds for the purpose of managerial
decision-making.

 Not foolproof: The funds flow statement is prepared from the

data provided in the balance sheet and profit and loss account.
Hence, the defects in financial statements will be carried over to
funds flow statement also.
 LESSON-12
CASH FLOW ANALYSES

INTRODUCTION

Cash flow statement provides information about the cash

receipts and payments of a firm for a given period. It provides
important information that compliments the profit and loss account
and balance sheet. The information about the cash-flows of a firm is
useful in providing users or financial statements with a basis to
assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilise these cash flows.
The economic decisions that are taken by users require an evaluation
of the ability of an enterprise to generate cash and cash equivalents
and the timing and certainly of their generation. The statement deals
with the provision of information about the historical changes in cash
equivalents of an enterprise by means of a cash flow statement which
classifies cash flows during the period from operating) investing and
financing activities.

Meaning of certain Terms

 Cash comprises cash on hand and demand deposit with banks.

 Cash equivalents are short-term, highly liquid investments that

are readily convertible into known amounts of cash and which
are subject to an insignificant risk of changes in value.
Examples of cash equivalents are, treasury bills, commercial
paper etc.

 Cash flows are inflows and outflows of cash and cash

equivalents. It means the movement of cash into the
organisation and movement of cash out of the organisation. The
 difference between the cash inflow and outflow is known as net
cash flow which can be either net cash inflow or net cash
outflow.

 Classification of cash flows

The cash flow statement during a period is classified into three main
categories of cash inflows and cash outflows:

 Cash flows from Operating activities:

Operating activities are the principal revenue-producing activities of
the enterprise and other activities that are not investing and financing
activities. Operating activities include cash effects of those
transactions and events that enter into the determination of net profit
or loss. Following are examples of cash flows from operating activities:

 Cash receipts from the sale of goods and the rendering of

services
 Cash receipts from royalties, fees, commissions, and other
revenue
 Cash payment to suppliers for goods and services
 Cash payments to and on behalf of employees
 Cash receipts and payments of an insurance enterprise for
premiums and claims, annuities and other policy benefits
 Cash payments or refunds of income-taxes unless they can be
specifically identified with financing and investing activities.
 Cash receipts and payments relating to future contracts,
forward contracts, option contracts, and swap contracts when
the contracts are held for dealing or trading purpose etc.,
Cash From Operations

Funds from Operations xxx

(as learnt in the previous chapter)
Add: Increase in Current Liabilities xxx
(excluding Bank Overdraft)
Decrease in Current Assets xxx xxx
(excluding cash & bank balance)

xxx
Less: Increase in Current Assets xxx
(excluding cash & bank balance)
Decrease in Current Liabilities xxx xxx
(excluding bank overdraft)

Cash from Operations xxx

 Cash Flows from Investing Activities:

Investing activities are the acquisition and disposal of long-term
assets and other investments not included in cash equivalents. In
other words, investing activities include-transactions and events that
involve the purchase and sale of long-term productive assets, (e.g.,
land, building, plant and machinery, etc) not held for re sale and
other investments. The following are examples of cash flows arising*
from investing activities:
 Cash payments to acquire fixed assets (including intangibles). ;

 These payments include those relating to capitalised research

and development costs and self-constructed fixed assets.

 Cash receipts from disposal of fixed assets (including

intangibles)
 Cash payments to acquire shares, warrants, or debt
instruments of other enterprises and interests in joint ventures
(other than payments for those instruments considered to be
cash equivalents and those held for dealing or trading purposes)

 Cash receipts from disposal of shares, warrants, or debt

instruments of other enterprises and interests in joint ventures
(other than receipts from those instruments considered to be
cash equivalents and those held for dealing or trading purposes)

 Cash advances and loans made to third parties (other than

advances and loans made by a financial enterprise)

 Cash receipts from the repayment of advances and loans made

to third parties (other than advances and loans of a financial
enterprise)

 Cash receipts and payments relating to future contracts,

forward contracts,, option contracts, and swap contracts except
when the contracts are, held for dealing or trading purposes, or
the receipts are classified as financing activities.

 Cash Flows from Financing Activities:

Financing activities are activities that result in changes in the size and
composition of the owners’ capital (including preference share capital
in the case of a company) and borrowings of the enterprise. Following
are the examples of cash flows arising from financing activities:
 Cash proceeds from issuing shares or other similar instruments
 Cash proceeds from issuing debentures, loans notes, bonds and
other short-term borrowing
 Cash repayments of amounts borrowed
 Payment of dividend
Information required for Cash Flow Statement

The following basic information is needed for the preparation of a

cash flow statement:
 Comparative Balance Sheets: Balance Sheets at the beginning
and at the end of the accounting period indicate the amount of
changes that have taken place in assets, liabilities and capital.

 Profit and Loss Account : The profit and loss account of the
current period enables to determine the amount of cash
provided by or used in operations during the accounting period
after making adjustments for non-cash, current assets and
current liabilities.

 Additional Data: In addition to the above statements, additional

data are collected to determine how cash has been provided or
used e.g., Sale or purchase of assets for cash.

Cash Flow Statement of XYZ Ltd. for the year ending 31" March
2001

Source Rs. Application Rs.

Opening Balances Opening Balances
Cash XXX Bank overdraft
Bank XXX Cash outflows
Cash Inflows Redemption of Redeemable XXX

Cash from Operations
Issue of Shares
Raising of Long Term
Loans/Debentures
Preference Shares
XXX Redemption of Debentures XXX
XXX Repayment of Loans XXX
Non Operating Expenses XXX
XXX Closing Balances XXX
Sale of Fixed Assets XXX Cash XXX

and Investments
Non Trading Receipts XXX Bank XXX
XXX XXX

Note : The Cash Flow Statement can also be presented in the vertical
form. However, the horizontal form given above is convenient and is
more commonly used.

Funds Flow Statement vs. Cash Flow Statement

Both funds flow and cash flow statements are used in analysis of past
transactions of a business firm. The difference between these two
statements are given below:
 Funds flow statements is based on the accrual accounting
system. In case of preparation cash flow statements all
transactions effecting the cash or cash equivalents is only taken
into consideration.

 Funds flow statement analysis the sources and application of

funds of long-term nature and the net increase or decrease in
long-term funds will be reflected on the working capital of the
firm. The cash flow statement will only consider the increase or
decrease in current assets and current' liabilities in calculating
the cash flow of funds from operations.

 Funds Flow analysis is more useful for long range financial

planning. Cash flow analysis is more useful for identifying and
correcting die current liquidity problems of the firm.

 Funds flow statement analysis is a broader concept, it takes

into account both long-term and short-term funds into account
 in analysis. But cash flow statement only deal with the one of
the current assets on balance sheet assets side.

 Funds flow statement tallies the funds generated from various

sources with various uses to which they are put. Cash flow
statements Start with the opening balance of cash and reach to
the closing balance of cash by proceeding through sources and
uses.

Illustration: 1
From the following information, you are required to ascertain cash
flow operation

Particulars 31.12.2000 31.12.2001

Net Profit 70,000
Debtors 42,000 40,000
Bills Receivable 8,000 13,000
Creditors 47,000 50,000
Bills payable 15,000 10,000
Stock 58,000 65,000
 Calculation of Cash from operations
Profit made during the year 70,000
Add: Decrease in debtors 2,000
Increase in Creditors 3,000 5,000
75,000
Less: Increase in Bill Receivable 5,000
Increase in stock 7,000
[ Decrease in Bills payable 5,000 17,000
Cash from operations 58,000

Illustration: 2
From the following balances, you are required to calculate cash from
operations:

Particulars December December

31 2000 31 2001
Debtors 50,000 47,000
Bill Receivable 10,000 12,500
Creditors 20,000 25,000
Bills Payable 8,000 6,000
Outstanding Expenses 1,000 1200
Prepaid Expenses 800 700
Accrued Income 600 750
Income Received in Advance 300 250
Profit made during the year - 1,30,000

Calculation of Cash from operations

Profit made during the year 1,30,000
Add: Decrease in debtors 3,000
Increase in Creditors 5,000
Increase in Outstanding Expenses 200
Decrease in Prepaid Expenses 100
1,38,000
Less: Increase in Bill Receivable 2,500
Increase in Accrued Income 150
Decrease in Bills Payable 2,000
Decrease in Income Receive in Advance 50 4,700
Cash from Operations 1,33,600
Illustration: 3
From the following information, calculate cash from operations
Particulars 2000 2001
P&LA/c (credit) 40,000 50,000
Debtors 20,000 26,000
Bills Receivable 20,000 12,000
Prepaid Rent 2,000 3,000
Prepaid Insurance 1,000 800
Goodwill 20,000 14,000
Depreciation 32,000 40,000
Creditors 20,000 30,000

Statement showing Cash from operations

Closing balance P&L A/c 50,000
Add: Decrease in Bill Receivable 8,000
Decrease in Prepaid Insurance 200
Increase in Creditors 10,000
Depreciation 8,000
Goodwill 6,000 32,200
82,200
Less: Increase in debtors 6,000
Increase in prepaid rent 1,000
Opening balance of P&L A/c 40,000 47,000
Cash from Operations 35,200

Illustration: 4
From the following balance sheets of Sulekha Ltd. you are required to
prepare a cash flow statement

Liabilities 2000 2001 Assets 2000 2007

Rs. Rs. Rs. Rs.

Share capital 3,00,000 3,75,000 Cash 45,000 70,500

Trade editors 1,05,000 67,500 Debtors 1,80,000 1,72,500

P&L A/c 15,000 34,500 Stock in Trade 1,20,000 1,35,000

Land 75,000 99,000

4,20,000 4,77,000 4,20,000 4,77,000

Cash flow Statement of Sulekha Ltd. for the year 2001

Sources Rs. Application Rs.
Opening Balance of cash 45,000 Purchase of Land 24,000
Issue of Share Capital 75,000 Decrease in Trade 37,500

Creditors
Cash Operating Profit 19,500 Closing balance 70,500

(Diff. In P&L A/c)

Decrease in Debtors 7,500
1,47,000 1,47,000

Illustration: 5
From the following balance sheets of Zindal Ltd/prepare cashflow
statement.

Liabilities 2000 2007 Assets 2000 2007

Share Capital 600 800 Goodwill 230 180
8% redeemable Pref. 300 200 Land & Buildings 400 340
Shares
General reserve 80 140 Plant 160 400
P&L Account 60 96 Debtors 320 400
Proposed dividend 84 100 Stock 154 218
Creditors 110 166 Bills Receivable 40 60
Bills Payable 40 32 Cash in hand 30 20
Provision for tax 80 100 Cash at Bank 20 16
Total 1354 1634 1354 1634
Additional information:
1) Depreciation of Rs.20,000 and Rs.40,000 have been charged on
plant account and land and buildings account, respectively in
2001.
2) An interim dividend of Rs.40,000 has been paid in 2001.
3) Income tax Rs.70,000 was paid during the year 2001.

1. Plant Account

Particulars Rs. Particulars Rs.

To Opening Balance 1,60,000 By Depreciation 20,000

on 1-1-2001
To Purchases-cash 2,60,000 By closing balance 4,00,000

on 31-12-2001
4,20,000 4,20,000

2. Land and Building Account

Particulars Rs. Particulars Rs.

To Opening Balance 4,00,000 By Depreciation 40,000

on 1-1-2001
By cash (sales-

balancing figure)
By closing balance on 3,40,000

31-12-2001
4,00,000 4,00,000

3. Provision for taxation Account

Particulars Rs. Particulars Rs.

Cash 70,000 By Opening Balance on 80,000

1-1-2001
To closing balance 1,00,000 By P&L Account 90,000

on 31-12-2001 (balancing figure)

1,70,000 1,70,000

Calculation of cash from operations

Closing balance P&L A/c on 31-12- 96,000

2001:
Less: Balance of P&L A/c on 1-1-2001: 60,000 36,000
Add: Profit used for reserves &

provisions:
Proposed dividend 1,00,000
Interim dividend 40,000
Provisions for taxation 90,000
Transfer to general reserve 60,000 2,90,000
3,26,000
Add : Profit used for writing off non-

cash A/c:
Goodwill 50,000
Depreciation:
Plant 20,000
Land & Building 40,000
1,10,000
4,36,000
Add: increase in creditors 56,000
Funds from operations 4,92,000
Less: Increase in current assets:
Debtors 80,000
Stock 64,000
Bills Receivable 20,000 1,64,000
3,28,000
Less: Decrease in current liabilities:
Bills Payable 8,000
Cash from Operations 3,20,000

Cash flow statement for the year ended December 31,2001

Cash in-flows Rs. Cash out-flows Rs.
Op. Bal. As on 1-1-2001
Cash 30,000 Purchase of plant 2,60,000
Bank 20,000 Payment of final 84,000
 dividend for 2000
Payment of interim 40,000

dividend
Add: Cash inflows: Income-tax paid 70,000
Operations 3,20,000 Redemption of Pref. 1,00

Shares
Sale of land & bldg. 20,000 1,00,000
Issue of shares 2,00,000
5,54,000
Closing balance on

31-12-2001
Cash in hand 20,000
Cash in bank 16,000
5,90,000 5,90,000

Illustration: 6
From the following information you are required to prepare a Cash
Flow Statement of Shanti Stores Ltd for the year ended 31" December,
2001

Balance Sheets

Liabilities 2000 2001 Assets 2000 2001

Share Capital 70,000 70,000 Plant 50,000 91,000

Machinery
Secured Loans Inventory 15,000 40,000
Repayable (2001) 40,000 Debtors 5,000 20,000
Creditors 14,000 39,000 Cash 20,000 7,000
Tax payable 1,000 3,000 Prepaid 2,000 4,000

General Exp.
P&L A/c 7,000 10,000
92,000 1,62,000 92,000 1,62,000
 Profit & Loss A/c for the year ended 31" December, 2001

Particulars Rs. Particulars Rs.

To Opening Inventory 15,000 By sales 1,00,000
To Purchases 98,000 By Closing inventory 40,000
To Gross Profit c/d 27,000
1,40,000 1,40,000
To General Expenses 11,000 By Gross Profit b/d 27,000
To Depreciation 8,000
To Taxes 4,000
To Net Profit c/d 4,000
27,000 27,000
To Dividend 1,000 By Balance b/d 7,000
To Balance c/d 10,000 By Net Profit b/d 4,000
11,000 11,000
Working Notes:
Machinery A/c

Particulars Rs. Particulars Rs.

To Balance b/d By Depreciation a/c 8,000
(Opening balance) 50,000 By Balance c/d –

(closing balance) 91,000

To Bank a/c -
Purchases (bal. Fig.) 49,000
99,000 99,000

Provision for Taxation

Particulars Rs. Particulars Rs.

To Bank a/c - tax By Balance b/d 1 ,000
Paid (bal. Fig.) 2,000 By P & L a/c -
To Balance c/d - (current year) 4,000

closing balance 3,000

5,000 5,000
 (Rs.)
Net Profit 4,000
Add: Depreciation 8,000
Taxes 4,000
Funds from Operations 16,000

Cash from Operations

Rs.
Funds from Operations 16,000
Add: Increase in Creditors 25,000
41,000
Less: Increase in Debtors 15,000
Increase in Inventory 25,000
Increase in Prepaid General Expenses 2,000 42,000
Cash lost in Operations 1,000

Cash Flow Statement of M/s Shanti Stores Ltd.

for the year ending 31" December, 2001
Sources Rs. Application Rs.
To Balance c/d - Cash Outflow
Opening Cash Balance 20,000 Machine Purchased 49,000
Cash Inflows
Secured Loans raised 40,000 Taxes Paid 2,000
Dividends paid 1,000
Cash lost in Operations 1,000
Closing cash Balance 7,000
60,000 60,000

Illustration: 7
The following are the balance Sheets of X Ltd. For the year ending 31 st
December 2000 and 2001
 Particulars 2000 2001
Liabilities Rs. Rs.
Share Capital 2,00,000 3,00,000
Profit and Loss Account 1,20,000 1,60,000
Sundry creditors 60,000 50,000
Provision for taxation 40,000 50,000
Proposed Dividend 20,000 30,000
4,40,000 5,90,000

Particulars 2000 2001

Assets: Rs. Rs.
Fixed Assets 1,60,000 2,00,000
Add: Additions 40,000 60,000
2,00,000 2,60,000
Less: Depreciation 18,000 24,000
1,82,000 2,36,000
Investments 8,000 16,000
Stock 1,60,000 2,18,000
Debtors 60,000 80,000
Cash 30,000 40,000
4,40,000 5,90,000

Additional information:
1) Taxes Rs. 44,000 and dividend Rs. 24,000 were paid during the
year 2001
2) The net profit for the year 2001 before depreciation Rs. 1,34,000

Cash Flow Statement for the year ending 31 st December, 2001

Sources Rs. Application Rs.
Opening Balance of Cash Outflows

Cash
(1-1-2001) 30,000 Purchase of fixed assets 60,000
Cash inflows: Taxes paid 44,000
Issue of share capital 1,00,000 Dividend paid 24,000
Cash from operations 1,34,000 Purchase of investments 8,000
Increase in Stock 58,000
Increase in debtors 20,000
Decrease in creditors 10,000
Closing balance of cash 40,000
2,64,000 2,64,000

Working Notes:
Fixed Assets a/c
Particulars Rs. Particulars Rs.
To Balance 2,00,000 By Balance c/d 2,60,090
To Bank a/c 60,000
2,60,000 2,60,000

Investments a/c

Particulars Rs. Particulars Rs.

To Balance b/d 8,000 By Balance c/d 16,000
To Bank 50,000
(Balancing figure) 94,000 16,000

Provision for taxation a/c

Particulars Rs. Particulars Rs.
To Bank 44,000 By Balance c/d 44,000
To Balance c/d 50,000 By P & L a/c 50,000
94,000 94,000

Proposed dividends a/c

Particulars Rs. Particulars Rs.
To Bank 24,000 By Balance c/d 24,000
To Balance c/d 30,000 By P & L a/c 30,000
54,000 54,000

Calculation of cash from operations

Rs.
Profit and Loss a/c balance on (3 1-12-2001) 1,60,000
Add: Non-cash and non-operating items

already debited to Profit and Loss a/c :

Depreciation on fixed assets 6,000
Proposed dividend 34,000
Provision for taxation 54,000 94,000
2,54,000
Less: Non-cash and non-operating items

which have already been credited to P&L a/c

Profit and Loss a/c on 1-1-2001 1,20,000 1,20,000

Cash operating profit 1,34,000

Illustration: 8
From the following Balance Sheets of Exe. Ltd. Make out the
statement of sources and uses of cash:
Liabilities 2000 2001 Assets 2000 2001

Rs. Rs. Rs. Rs.

Equity Share 3,00,000 4,00,000 Goodwill 1,15,000 90,000

Capital
8% Redeemable 1,50,000 1,00,000 Land and 2,00,000 1,70,000

Preference Share Buildings

Capital
General Reserve 40,000 70,000 Plant 80,000 2,00,000

Profit & Loss 30,000 48,000 Debtors 1,60,000 2,00,000

Account
Proposed 42.000 50,000 Stock 77,000 1,09,000

Dividend
Creditors 55,000 83,000 Bills 20,000 30,000

Receivable
Bill Payable 20,000 16,000 Cash in Hand 15,000 10,000

Provision for 40,000 50,000 Cash at Bank 10,000 8,000

Taxation
6,77,000 8,17,000 6,77,000 8,17,000

Additional information:
a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged
on Plant and Land and Building respectively in 2001.

b) An interim dividend of Rs. 20,000 has been paid in 2000.

c) Rs. 35,000 Income-tax was paid during the year 2001.

Working Notes:

(i) Adjusted Profit & Loss account

Particulars Rs. Particulars Rs.

To Depreciation on 10,000 By Balance b/d 30,000

plant
To Depreciation 20,000 By Funds from 2,18,000

to buildings operations

(balancing figure)
To Goodwill written off 25,000
To Provision of 45,000

taxation
To Interim dividend 20,000
To Dividend proposed 50,000
To Transfer to 30,000

General Reserve
To Balance c/d 48,000
2,48,000 2,48,000

(ii) Provision for taxation account

Particulars Rs. Particulars Rs.

To Bank 35,000 By Balance b/d 40,000

To Balance c/d 50,000 By P.& L A/c 45,000
85,000 85,000

(iii) Land and building account

Particulars Rs. Particulars Rs.

To Balance b/d 2,00,000 By Depreciation 20,000

By Bank (sale) 10,000

By Balance c/d 1,70,00
2,00,000 2,00,000
(iv) Plant account
Particulars Rs. Particulars Rs.

To Balance b/d 80,000 By Depreciation 10,000

To Bank (purchase) 1,30,000 By balance c/d 2,00,000

2,10,000 2,10,000

(v) Cash from operations

Rs.
Funds from operations 2,18,000
Add: Increase in creditors 28,000
2,46,000
Less:
Decrease in Bills Payable 4,000
Increase in Debtors 40,000
Increase in Stock 32,000
Increase in Bills receivable 10,000 86,000
Cash from operations 1,60,000

(vi) In the absence of information, it has been presumed that there

is no profit (loss) and no accumulated depreciation on that part
of land and buildings which has been sold.
Cash flow statement for the year ending 31 st December 2001
Cash Balance as on 1- Rs. Outflows of cash: Rs.

1-2001
Cash in hand 1 5,000 Redemption of 50,000

Redeemable
Cash at bank 10,000 Preference share 20,000
Add: Inflows of cash: Payments of interim 42,000

dividend
Issue of Shares 1,00,000 Payment of tax 35,000
Sale of Land and 10,000 Purchase of Plant 1,30,000

Building
Funds from operations
Increase in creditors
2,18,000 Decrease in bills payable 4,000
28,000 Increase in debtors 40,000
Increase in stock 32,000
Increase in B/R 10,000
Cash Balance as on 31-

12-2001
Cash in hand 10,000
Cash at bank 8,000
3,81,000 3,81,000

Illustration: 9
Balance Sheets of XYZ Ltd. as on 1-1-2000 and 31-12-2001 was as
follows:
Liabilities 1-1-2001 31-12-2001
Capital 1,25,000 1,53,000
Creditors 1,40,000 1,44,000
Bank loan 65,000 50,000
Bills Payable 20,000 30,000
3,50,000 3,77,000
Assets:
Cash 20,000 17,000
Debtors 30,000 80,000
Stock 45,000 35,000
Machinery 80,000 65,000
Land 90,000 80,000
Buildings 65,000 70,000
Goodwill 20,000 30,000
3,50,000 3,77,000

During the year, a machine costing Rs. 12,000 (accumulated

depreciation Rs.4,000) was sold for Rs.7,000. Balance of provisions
for depreciation against machinery as on 1-1-2001 was Rs.35,000 and
on 31-12-2001 Rs. 50000 Prepares cash Flow statement.

Cash Flow Statement for the year ending 31 st December 2001

Sources Rs. Applications Rs.
Opening balance of Cash 20,000 Cash outflows:
Cash inflows: Building Purchased 5,000
Sale of Machinery 7,000 Machinery Purchased 12,000
Sale of Land 10,000 Bank Loan repaid 15,000
Increase in creditors 4,000 Goodwill 10,000
Increase in Bills Payable 10,000 Drawings 27,000
Decrease in stock 10,000 Increase in debtors 50,000
Cash from operations 75,000 Cash balance (31-12-2001) 17,000
1,36,000 1,36,000

Machinery a/c
Sources Rs. Applications Rs.
To Balance b/d 1,15,000 By Bank (Sale) 7,000
To Bank (Purchase) 12,000 By Provisions for depreciation 4,000

a/c
By P & L a/c (Loss on sale) 1,000
By Balance c/d 1,15,000
1,27,000 1,27,000

Land a/c
Particulars Rs. Particulars Rs.
To Balance b/d 90,000 By Bank (Purchase) 10,000
 By Balance c/d 80,000
90,000 90,000
 Buildings a/c
Particulars Rs. Particulars Rs.
To Balance b/d 65,000 By Balance c/d 70,000
To Bank (Purchases) 5,000
70,000 70,000
Goodwill a/c
Particulars Rs. Particulars Rs.
To Balance b/d 20,000 By Balance c/d 30,000
To Bank 10,000
30,000 30,000

Bank Loan a/c

Particulars Rs. Particulars Rs.
To Bank 15,000 By Balance c/d 65,000
To Balance c/d 50,000
65,000 65,000

Provisions for Depreciation a/c

Particulars Rs. Particulars Rs.
To Machinery a/c 4,000 By Balance c/d 35,000
To Balance c/d 50,000 By P & L a/c 19,000
54,000 54,000

Calculation of Cash from operations

Balance of P & L a/c
(Net Profit on (31/12/2001) 55,000
Add : Non-cash and non-operating items

debited to P & L a/c

Depreciation on Machinery 19,000
Loss on sale of Machinery 1,000 20,000
Cash from operations 75,000

Capital a/c
Particulars Rs. Particulars Rs.
To Drawings 27,000 By Balance b/d 1,25,000

(Balancing figure)
To Balance c/d 1,53,000 By Net Profit 55,000
1,80,000 1,80,000

USES CASH FLOW STATEMENT

 Helps in efficient cash management - One of the most
important functions of the management is to manage company's
cash resources in such a way that adequate cash is available to
meet the liabilities. A projected cash flow statement enables the
management to plan and co-ordinate the financial operation of
the business efficiently.

 Helps in internal financial management - The cash flow

analysis helps the management in exploring the possibility of
repayment of long term debts which depends upon the
availability of cash.

 Discloses the movement of cash - The cash flow statement

discloses the increase or decrease in cash and the reasons
therefore. It helps the finance Manager in explaining how the
company is short of cash despite higher profit and vice versa.

 Discloses success or failure of cash planning - Comparison of

actual and budgeted cash flow statement will disclose the
failure or success of the management in managing cash
resources and necessary remedial measures can be taken in
case of deviations. :

 Helps to determine the likely flow of cash - Projected cash

flow statements help the management to determine the likely
inflow or outflow of cash from operations and the amount of
cash required to be raised from other sources to meet the future
needs of the business.

 Supplemental to funds flow statement - Cash flow analysis

supplements the analysis provided by funds flow statement as
cash is a part of the working capital.
 Better tool of analysis - For payment of liabilities which are
likely ,to be matured in the near future, cash is more important
than the working capital. As such, cash flow statement is
certainly a better tool of analysis than funds flow statement for
short term analysis.

LIMITATIONS OF CASH FLOW ANALYSIS

 Misleading inter-industry comparison - Cash flow statement
does not measure the economic efficiency of one company in
relation to another. Usually a company with heavy capital
investment will have more cash inflow. Therefore, inter-industry
comparison of cash flow statement may be misleading.

 Misleading comparison over a period of time - Just because

the company's cash flow has increased in the current year, a
company may not be better off than the previous year. Thus, the
comparison over a period of time can be misleading.

 Misleading inter-firm comparison - The terms of purchases

and sales will differ from firm to firm. Moreover, cash inflow
does not always mean profit. Therefore, inter-firm comparison of
cash flow may also be misleading.

 Influenced by changes in management policies - The cash

balance as disclosed by the cash flow statement may not
represent the real liquid position of the business. The cash can
be easily influenced by purchases and sales policies, by making
certain advance payments or by postponing certain payments.

 Cannot be equated with income statement - Cash flow

statement cannot be equaled with the income statement. An
income statement, takes into account both cash as well as non-
 cash items. Hence net cash flow does not necessarily mean net
income of the business.

 Not a replacement of other statements - Cash flow statement

is only a supplement of funds flow statement and cannot
replace the income statement or the funds flow statement as
each one has its own function or, purpose of preparation.

Despite the above limitations, cash flow statement is a very useful tool
of financial analysis. It discloses the volume and speed at which cash
flows in various segments of the business and the amount of capital
tied-up in a particular segment.
 LESSON- 13
BUDGETING AND BUDGETARY CONTROL

BUDGET

Budget is a financial and/or quantitative statement, prepared

and approved prior to a defined period of time, of the policy to be
pursued during that period for the purpose of attaining a given
objective.
- CIMA Official Terminology
-
It is a plan quantified in monetary terms, prepared and
approved prior to a defined period of time, usually showing planned
income to be generated and/or expenditure to be incurred during that
period and the capital to be employed to attain a given objective. It is a
plan of future activities for an organisation. It is expressed mainly in
financial terms, but also usually incorporates many non-official
quantitative measures as well.

BUDGETING

Budgeting is the whole process of designing, implementing and

operating budgets. The main emphasis in this is short-term budgeting
process involving the prevision of resources to support plans which
are being implemented.

BUDGETARY CONTROL

Budgetary control is the establishment of budgets relating the

responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results, either to
secure by individual action
the objective of that policy or to provide a basis for its revision.
 - CMA Official Terminology

FORECAST Vs. BUDGET

A forecast is a prediction of the future state of world, in

connection with those aspects of the world, which are relevant to and
likely to affect on future activities. Forecast is calculation of probable
events. Both forecasting and planning involve recognition of the
relevant factors in a given situation and understanding of what each
factor has contributed to it and how each is likely to affect the future.
Any organised business cannot avoid anticipating or calculating
future conditions and trends for the framing of its future policy and
decision. Forecast is concerned with 'probable events' and the
budgeting relates to 'planned events' Budgeting should be preceded by
forecasting, but forecasts may be made for purpose other than
budgeting.

Requirements of a Sound Budgeting System

The following are the essential requirements of a sound

budgeting system:

 Clear lines of authority and responsibility have to be established

throughout the organisation and the authority and
responsibility of different levels of management and
departmental executives are clearly defined.

 The organisational goal should be quantified and clearly stated.

These goals should be within the framework of organisation’s
strategic and long range plans. The setting of budgets is not a
process detached from planning of the company's overall policy.
 A well defined business policy and objective is a prerequisite for
budgeting.

 The budget system should be established on the highest

possible level of motivation. All levels of management should
participate in setting budgets. Since this can produce more
realistic targets, lead to better understanding of corporate
objectives and the constraints within which organisation works.
Participation in budgeting process will motivate the personnel to
achieve budget levels of efficiency and activity.

 The budget control system should provide for a degree of

flexibility designed to change in relation to the level of activity
attained and the impact of changes in sales and production
levels on revenue, expenses are known. It enables more
accurate assessment of managerial and organisational
performance.

 Proper communication systems should be established for

management reporting and information service so that
information relating to actual performance is presented to the
manager responsible for it promptly to enable the manager to
know the nature of variations so that remedial action is taken
wherever necessary.

 Educating the budget process and creation of cost awareness

atmosphere will lead to effective implementation of budgets.

 The top management's involvement in budget process is

essential for successful implementation of the budgets. It
should take interest not only in setting the budgets and targets
but also to check upon the actual attainment, motivating the
personnel, rewarding for achievements, investigation into
 reasons for any deviation of actuals from budgeted results,
taking punitive action wherever necessary.

 A sound system for generating accurate and reliable and prompt

accounting information is basic for successful implementation
of budget system in an organisation.

Advantages of Budgeting
 Budgetary control establishes a basis for internal audit by
regularly evaluating departmental results.

 Only reporting information which has not gone according to

plan, it economises on managerial time and maximizes
efficiency. This is called 'Management by Exception reporting.

 Scarce resources should be allocated in an optimal way, thus

controlling expenditure

 It forces management to plan ahead so that long-term goals are

achieved.

 Communication is increased throughout the firm and

coordination should be improved.

 An effective budgetary control system will allow people to

participate in the setting of budgets, and thereby have a
motivational impact on the work force. Individual and corporate
goals are aligned.

 Areas of efficiency and inefficiency are identified. Variance

analysis will prompt remedial action where necessary
 The budget provides a yardstick against which the performance
of the firm can be evaluated. It is better to compare actual with
budget rather than with the past, since the latter may no longer
be suitable for current and expected conditions.

 People are made responsible for items of cost and revenue, i.e.
areas of responsibility are clearly delineatea.

Problems in Budgeting
 Budgets are perceived by the work force as pressure devices
imposed by top management. This can have an adverse effect on
labour relations.

 It can be difficult to motivate an apathetic work force.

 The pressure in the budgeting system may result in inaccurate

record keeping. :

 Managers may over-estimate costs in order that they will not be

held responsible in the future for over spending. The difference
between the minimum necessary costs and the costs built into
the budget is called slack.

 Departmental conflict arises because of competition for resource

allocation. Departments blame each other if targets are not
achieved.

 Uncertainties can occur in the system,' e.g. uncertainty over

demand, inflation, technological change, competition, weather
etc. ;
 It may be difficult to align individual and corporate goals.
Individual goals often change and may be much lower than the
firm's goals.

 It is important to match responsibility with control, otherwise, a

manager will be demotivated. Costs can only be controlled by a
manager if they occur within a certain time span and can be
influenced by that manager. A problem arises when a cost can
be influenced by more than one person.

 Managers are often accused of wasting expenditure when they

either

(i) demand a greater budget allowance than is really

needed, or
(ii) unnecessary spending in order to fully utilise their
allowance through fear of future cut-backs. Zero base
budgeting can overcome this problem.

 Sub-optimal decisions may arise when a manager tries to

enhance his short-run performance in a way which is
detrimental to the organisation as a whole, e.g. delaying
expenditure urgently needed repairs.

 They are based on assumed conditions (e.g. rates of interest)

and relationship (e.g. product-wise held constant) that are not
varied to reflect the actual circumstances that come about.

 They make allowance for tasks to be performed only in relation

to volume rather than time.

 They compare current costs with estimates "based only on

historical analysis.
 Their short-term horizon limits the perspective, so short-term
results may be sought at the expense of longer term stability or
success.

 They have a built-in bias that tends to perpetuate inefficiencies.

For example, next year's budget is determined by increasing last
year's by 15 per cent, irrespective of the efficiency factor in last
year.

 As with all types of budgets the game of 'beating the system'

may take more energy factor in last year.

 The fragile internal logic of static budget will be destroyed if top

management reacts to draft budgets by requiring changes to be
made to particular items, which are then not reflected through
the whole budget.

BUDGETING PROCESS

The method by which the annual budget is prepared will differ from
organisation to organisation. In some organisations budgeting may be
a well organised, well documented procedures while in others the
budget may be prepared in a rather ad hoc and disorganised manner.
The budget process is shown in the following figure. The steps in
budgeting process representative to all organisations is given below:

1. Specification and Communication of Organisational

Objectives :

Budget is a medium through which organisation's objectives

and polices are reflected. Budgeting is used as a tool for implementing
the organisational objectives. It is essential to understand,
specification and documentation of organisational objectives before
the managers start for budgeting the organisational activities.
Following from a statement of objectives, a corporate long-range or
strategic plan can be built up. Distinction may be drawn between
current operating activities and future strategic activities. Budgeting
is a management tool used for shorter term planning and control. This
classification of activities into short-term and strategic long-term and
communication to the managers will lay down a sort of guide for
budgeting the activities within the specified objectives and activities.
2. Determination of Key Success Factors :

The performance of every organisation will be particularly

influenced by certain critical success factors, key factor will influence
the activities of an undertaking and it will limit the volume of output
and will have direct impact on the profitability of the organisation.
Critical success factors may consist of a specified raw material, a
specific type of labour skill, a tool, a service facility, floor space, cash
resources etc. The limitation or shortage of such critical factors may
result in restricting capacity utilisation. The limiting factors may shift
from time to time due to external and internal circumstances,. In
organisations which are already operating at maximum capacity, the
most critical success factor is likely to be productive capacity. In
majority of organisation the most critical factor is likely to be
consumer demand or the expected level of revenues or funds. Because
of this, the sales or funds budget is usually the first budget to be
prepared. It will determine the content of other related budgets.

3. Establishment of Clear Ones of Authority and

Responsibility:

An organisational chart defining the lines of authority and

responsibility of the managers responsible for accomplishment of
organisational objectives is to be prepared. The organisational chart
should define the following:
 The responsibility of individual functional managers
 Delegation of authority to the concerned functional managers
 Inter-functional relationship of the organisation.

4. Establishment of Budget Centres :

Budget centre is a section of an organisation for which separate

budgets can be prepared and control exercised (CMA official
terminology). The entire organisation is divided into different
segments, which are clearly defined for the purpose of budgetary
control according to responsibilities of departmental heads. These
segments of an organisation defined for the purpose of budgetary
controL are technically referred to as budget centers.

5. Determination of Budget Period :

Budget period is a period for which the budget is prepared. A

budget can; be a long-term budget or short-term budget. A short term
budget is generally prepared for one year or lesser period. Quarterly,
monthly or even weekly budget can be prepared for certain operations
of the company. The short-term budget will generally not exceed the
full accounting year. The long-term budget which extend to five or
even more years. This long-term budget will agree with long-term
forecast of sales, organisational schemes for expansion
modernisation, diversification etc. The long-term budgets are used for
planning whereas short-term budget is used for implementation of
long range plans, activities, objectives and also for control purposes.
Capital expenditure budget and Research and development
expenditure budget are the examples of long-term budgets. Annual
sales budget, Income and expenditure budget are the examples of
short-term budgets.
6. Establishment of Budget Committee :

In small organisations, the person incharge of finance and

accounting functions will involve in preparation of budgets. The
setting up of a budget Committee is necessary in case of large and
complex organisations. As the budget involves the various functional
activities, the closest association of functional managers is essential
for satisfactory formulation and implementation of the budget The
budget committee will be composed of major functional heads. It can
be effective medium for coordination and review of the budget
programme. The main functions of budget committee are as follows:

 To review the functional budget estimates.

 To recommend the functional budgets for revision.
 To review and advise on the general policies affecting more than
one function.
 To review, approval and adoption of revised budgets.
 To receive and analyse the-periodic performance reports from
budget centers.
 To examine the budget reports showing actuals compared with
budget.
 To locate the responsibility for discrepancies between actuals
and budgets, and recommends the corrective action.
 To participate in decision making in strategic issue like,
expansion, modernisation, diversification and revision of
organisational activities, which have direct relationship to the
company's budgets.

7. Appointment of Budget Controller :

 Proper budget administration is facilitated by the budget
controller who is made responsible for the preparation of the budget
and coordinating activities of the individual departments. His
functions and responsibilities will include the following:

(a) Generation and dissemination of information needed for

decision-making and planning to each person in the
organisation having such responsibilities. The information may
include, but is not limited to, forecasts of economic and social
conditions, governmental influences, organisation goals and
standards for decision making, economic and financial
guidelines, performance data, performance standards and the
prerequisite plans of others in the enterprise.

(b) Establishing and maintaining a planning system which:

 Channels of information to each of persons responsible for
planning,

 Schedules the formulation of plans,

 Structures the plans of sub-sections of the enterprise into

composites at which points, tests are made for significant
deviations from economic and financial guidelines and from
goal achievement and repeats the process for larger
segments to and including the enterprises as a whole, and

 Disseminates advice of approval, disapproval or revision of

plans to affected individuals in accordance with established
lines of authority and organisational responsibilities.

(c) Construction and using models of the enterprise both in total

and by sub-sections, to test the effect of internal and external
variables upon the achievement of organisation goals.
(d) Ensuring the accumulation of performance data related to
responsibility centers within the organisation, measured
against the plans, whether period or project, for each centre,
transmitted to each centre, and the analysis of deviations of
actual from planned performance.

The budget controller is responsible for the final preparation,

presentation and interpretation of the financial plan of the company.
He is responsible for development of budget procedures. He will act as
a staff manager coordinating all budget functions.

8. Preparation of Budget Manual:

Budget manual is the documentation of policies and procedures

involved in implementation of budgetary control system. A budget
manual will normally set out the following:
 Responsibility and authority of different levels of management.
 Establishment of organisational hierarchy.
 Definition and clarification of various terms used in budgets.
 Fixation of responsibility for preparation and implementation of
budgets and budgetary system.
 Specification and timing of statements and reports.
 Procedures in management information system in the
organisation.
 Procedures in feed-back and feed-forward control systems.
 Exhaustive programme of budget preparation.

The budget manual contains the standardised form which become

information generation for preparation of budgets. It contains a
complete programme of activities involved in budget preparation. The
budget' manual should provide detailed procedure for preparation and
development and control of each budget like Sales budget, Production
budget, Direct material budget, Direct labour budget, Overhead
budget, Capital expenditure budget, R&D expenses budget etc.

PREPARATION OF SALES OR REVENUE BUDGET

The sales revenue budget is the starting point of most master

budgets. In manufacturing organisations sales budgeting begins with
the forecasting of the sales of individual products. These forecasts
may be by geographical area, by class of customer or by some other
segment. In case of manufacturing companies, the budgeting will
begin with the Revenue budget of the organisation. Forecasting sales
is a difficult task as many assumptions need to be made about
consumer demand, environmental conditions likely customer demand
at different prices, the probable prices for similar products sold by
competitors, the number of economic activity in the regions where the
product is sold, the number of sales personnel required to service the
estimated demand, the appropriate level of advertising and
promotional expenditures, the impact of anticipated changes in
exchange rates and changes in the taxes such as value added tax or
customs and excise duties.

PREPARATION OF BUDGETS

Once the sales budget has been determined from a range of

sales forecasts it is possible to construct the following other budgets:

1. Production Budget

The production budget is an estimate of the quantity of goods

that must be produced during the budget period. The aim of the
production function will presumably be to supply finished goods of a
specified quality to meet marketing demands. The sum of sales
requirements plus changes in stock levels of finished goods gives the
production requirements for the period being budgeted. In order to
construct the production budget we need the level of sales expected
and the desired levels of stock of finished goods. The following formula
is used for calculation of units to be produced.

Production = Sales + Closing stock - Opening stock

Production budget should be developed keeping in view the

optimal, balance between sales, inventories and production so as to
result in minimum cost. Once the production level is determined, it
becomes the starring point for the direct materials, direct labour and
manufacturing overhead budgets.

2. Plant Utilisation Budget

Plant utilisation budget is prepared for the estimation of plant

capacity to meet the budgeted production during the period
considered under the budget" For this purpose the plant capacity is
expressed in terms of convenient units of measurement like
production in hours, production in weight (M.T./Kg.) production in
units etc. Budgeted machine load in each department should be
worked out. In case the budgeted plant utilisation is more than the
plant capacity the management may think of extra shift working,
purchase of new machinery, overtime working, sub-contracting etc.
When the budgeted plant utilisation in lesser than the plant capacity,
management should consider the ways to increase sales volume.

3. Direct Materials Budget

The direct materials budget specifies the budgeted quantities of

each raw material required for the budgeted production. The
requirement to purchase of direct material can be calculated with the
help of the following formula.
 Purchases = Closing stock + Usage - Opening stock

The materials budget provides basis for fixing optimum levels of

inventory stocks, establishment of control over material usage and
purchase cost budget.

4. Direct Labour Budget

The direct labour budget will ensure that the plan will make the
required number of employees of relevant grades and suitable skills
available at the right times. It specifies the direct labour requirement,
of various products as envisaged in the production budget. The direct
labour budget will be developed for both direct labour hours and
direct labour cost. After the labour requirements relating to different
grades are finalized, estimated rate per hour and labour cost per unit
is arrived at:

Illustration 1:

The direct labour hour requirements of three of the products

manufactured in a factory, each involving more than one labour
operation, are estimated as follows:

Direct Labour Hour / per unit (in minutes)

Product 1 2 3

Operation
1 18 42 30
2 - 12 24
3 9 9 -
The factory works 8 hours per day, 6 days in a week. The budget
quarter is taken as 13 weeks and during a quarter, lost hours due to
leave and holidays and other causes are estimated to be 124.

The budgeted hourly rates for the workers manning the

operations, 1, 2 and 3 are Rs.2.00, Rs.2.50 and Rs.300 respectively.
The budgeted sales of the product during the quarter are:

Product 1 9,000 units

2 15,000 units
3 12,000 units

There is a carry over of 5,000 units of Product 2 and 4,000 units of

Product 3 and it is proposed to built up a stock at the end of the
budget quarter as follows:

Product 1 1,000 units

3 2,000 units

Prepare a manpower budget for the quarter showing for each

operation:
(i) Direct labour hours, (ii) Direct labour cost, and (iii) Number of
workers.
Before preparing the quarterly manpower budget for 3 products
operation-wise, it is necessary to work out the following:

(a) Production budget, (b) Direct labour hours for each product
operation-wise, (c) Number of workers required for each operation.

(a) Production Budget for the quarter ending .....

Particulars Product 1 Product 2 Product 3
Budgeted Sales (units) 9,000 15,000 12,000
Add: Stock to (closing) 1,000 - 2,000

be built up
Total 10,000 15,000 14,000
Less: Carry-over (opening) - 5,000 4,000

stock
Budgeted 10,000 10,000 10,000

Production

(b) Direct Labour Hour for each Product (operation-wise)

Operation I
Particulars Product 1 Product 2 . Product 3
Direct labour hrs. per unit 18 42 30
(minutes)
Budget Production (units) 10,000 10,000 10,000

Direct labour hrs. required: 10,000 x 18 10,000 x 42 10,000 x 30

60 60 60

3,000 hrs. 7,000 hrs. 5,000 hrs.

Total labour hours required for Operation I = 15,000 hours.

Operation II
Particulars Product 1 Product 2 . Product 3
Direct labour hrs. per unit - 12 24
(minutes)
Budget Production (units) 10,000 10,000 10,000

-
Direct labour hrs. required: 10,000 x 12 10,000 x 24
60 60

- 2,000 hrs. 4,000 hrs.

Total labour hours required for Operation II = 6,000 hours.

Operation III
 Particulars Product 1 Product 2 . Product 3
Direct labour hrs. per unit 9 6 -
(minutes)
Budget Production (units) 10,000 10,000 10,000

-
Direct labour hrs. required: 10,000 x 9 10,000 x 6
60 60

1,500 hrs. 1,000 hrs. -

Total labour hours required for Operation III = 2,500 hours.

(c) Number of Workers required for each Operation

Working hrs. of factory in a quarter = 13 624 hours

weeks x 6 days week x 8 hours a day

Less: Loss of hours due to leave, holidays 124 hours

and others causes

Total available hours per man 500 hours

Now, the requirements for manpower for each operation can be

worked out.

Manpower Requirement:
Total direct labour hrs./ Total available hours required per man
a. Operation I = 15,000/500 = 30 men
b. Operation II = 6,000/500 = 12 men
c. Operation III = 2,500/500 = 5 men

Now, manpower budget for the quarter can be prepared for the three
products and for each operation. The same is given below:
 Hr. No. of
Operation Product I Product II Product 3 Total
rate workers

D.I. Cost D.L. Cost D.L. Cost D.L. Cost

Rs.
Hrs. Rs. Hrs. Rs. Hrs. Rs. Hrs. Rs.
14,000 10,000 15,000 30,000 30
I 2.00 3,000 6,000 7,000 5,000

2.50 - - 2,000 5,000 4,000 10,000 6,000 15,000 12

II

3.00 1,500 4,500 1,000 3,000 - - 2,500 7,500 5

III

Total 4,500 10,500 10,000

22,000 9,000 20,000 23,500 52,500 47

5. Manufacturing Expenses Budget

Manufacturing overhead refers to the aggregate' of factory

indirect material, indirect labour and indirect expenses which can be
divided into fixed and variable elements of manufacturing overhead.
The fixed manufacturing overhead will not vary with the change in the
level of activity and it can be estimated with a fair degree of accuracy.
On the other hand, variable manufacturing overhead per unit will be
estimated and the total variable manufacturing overhead will be
determined with the help of the activity level. Preparation of variable
overhead budget is based on scheduled production and operating
conditions.

Illustration 2:

Gama Engineering Company Limited manufacturers two

Products X and Y. An estimate of the number of units expected to be
sold in the first seven months of 2001 is given below:

Months Product X Product Y

January 500 1,400
February 600 1,400
March 800 1,200
April 1,000 1,000
May 1,200 800
June 1,200 800
July 1,000 980

It is anticipated that:
(a) There will be no work-in-progress at the end of any month;
(b) Finished units equal to half the anticipated sales for the next
month will be in stock at the end of each month (including
June 2001).

The budgeted production and production costs for the year ending 31 st
June, 2001 are as follows:

Particulars Product X Product Y

Production (units) 11,000 12,000
Direct materials per unit (Rs.) 12 19
Direct wages per unit (Rs.) 5 7
Other manufacturing charges (Rs.) 33,000 48,000

apportionable to each type of

product

You are required to prepare:

(a) Production budget showing the number of units to be
manufactured each month.
(b) Summarised production cost budget for the 6 month-
period January to June 2001.
(a) Production Budget (for the 6 months ending 30th June, 2001)

(units)
 Particulars Jan. Feb. March April May June
Product X
Closing Stock 300 400 500 600 600 500
Sales 500 600 800 1,000 1,200 1,200
800 1,000 1,300 1,600 1,800 1,700
Less: Opening Stock 250 300 400 500 600 600
Production (in units) 550 700 900 1,100 1,200 1,100

Product Y

Closing stock 700 600 500 400 400 450

Sales 1,400 1,400 1,200 1,000 800 800

2,100 2,000 1,700 1,400 1,200 1,250

Less: Opening Stock 700 700 600 500 400 400

Production (in units) 1,400 1,300 1,100 900 800 850

(b) Summarised Production Cost Budget (for the 6 months ending 30 th

June, 2001) .
(Rs.)
Production X-5,550 units Y-6,350 units

Unit Total Cost Unit Cost Total Cost

Cost
Direct materials 12 66,600 19 1,20,650
Direct wages 5 27,750 7 44,450
Manufacturing 3 16,650 4 25,400

charges
Total 20 1,11,000 30 1,90,500

Note: Manufacturing charges have been presumed to be variable costs

in the absence of any other information. They could, however be
presumed to be fixed charges also for the whole year. In such a case
they will be taken as 50% of the annual charges for the first six
months in each case.

6. Administrative Expenses Budget

Administrative expenses in an organisation will be incurred for
the following activities:
(a) Formulation of policies,
(b) Directing the organisation, and
(c) Controlling the operations of an organisation etc.

The administrative expenses will not include those expenses which

are incurred for manufacturing, selling and distribution, R&D
functions. The administrative overheads are of a fixed nature and the
change in the level of activity will not bring any change in the
administrative expenses incurred. Cm study o behaviour of costs, if
any administrative expenses are of variable or semi-variable nature,
those expenses can be budgeted with the Level of activity.

7. Selling and Distribution Expense Budget

Selling expenses refers to expenses incurred relating tc the
activities:
(a) Creation and stimulation of demand of company's product,
and
(b) Secure orders.

Selling expenses include salesmen's salaries, commissions,

expenses and related administrative cost etc. Distribution expenses
refers fo expenses incurred relating to the following activities:
(a) Maintaining and creating demand of product, and
(b) Making the goods available in the hands of the customer.

Distribution expenses include transportation, freight charges,

stock control, warehousing etc.
 Preparation of selling and distribution expense budget is based on
the sales budget. The selling and distribution expenditure can be
estimated with the help of flexible budgeting technique.

8. Research and Development Budget

This will cover materials, equipment and suppliers, salaries,

expenses and other costs relating to design, development and
technical research projects.

9. Capital Expenditure Budget

The capital expenditure budget represents the expected

expenditure on fixed assets during the budget period. It is an outlay
on assets that are required and held for the purpose of generating
income, e.g. plant and machinery, motor vehicles, premises etc. It is a
plan for capital expenditure, in monetary terms. Capital expenditure
may be incurred for expansion, diversification, modernisation plans. It
relates to projects involving huge capital outlay and long-term
commitments. A capital expenditure budget must reveal following
information projectwise:
 Original appropriation
 Cumulative expenditure up-to-date
 Unutilised appropriation
 Fresh appropriation, and
 Limit carried to next period

Programme budgeting technique is more appropriate for capital

expenditure budgeting.

Capital expenditure authorisation is the formal authority to

incur capital expenditure which meets the criteria defined to achieve
the results laid down under a system of capital appraisal. Levels of
authority must be clearly defined and the reporting structure of actual
expenditure through prior authorisation on a formal proposal basis
and monitoring as expenditure is incurred.

10. Manpower Budget

Manpower budget will taken an overall view of the organisations

needs for manpower for all areas of activity - sales, manufacturing,
administrative, executive and so on for a period of years.

11. Marketing Expenditure Budget

Marketing budget include estimated expenditure to be inquired

for advertising promotional activities, public relations, marketing
research, customer services etc. during the budget period.

12. Capital Budget

Capital budget is concerned with the question of capacity and

strategic direction. This must deal with the evaluation of alternate
dispositions of capital funds as well as with the choice of the best
capital structure.

PREPARATION OF MASTER BUDGET AND ITS IMPLEMENTATION

Master budget is a budget which is prepared from, and

summarises the functional budgets. It is a summary budget that
incorporates the key figures and totals of ail other budgets. The
process in preparation of Master budget is shown in the figure
Budgetary Process (given at the beginning of this chapter).
 The Master budget may closely reflect two dimension of
the organisations:
(1) Organisational Structure: All revenues and expenditures
must be attributed to the budget centre and managers
responsible for them. At the control stage, later, a system
of responsibility accounting reports must be built up to
inform responsible managers for the progress of that
result against budgets.

(2) Products or Programmes: In this dimension, the budget

information is organised to show the revenues, costs,
contributions, profits and levels of production/ sales
activity for each product or programme produced by, the
organisation.

Negotiation of Budgets :

Budgets may be prepared in a top-down or bottom-up manner.

In either process, the budget will need to be negotiated by superiors,
subordinates and by different departments competing for the scarce
resources. This process of negotiation allows the exercise of both
formal and informal power. Participation in budgeting appears to lead
to more positive attitude towards the budget and greater acceptance of
it.

Coordination and Review of Budget:

Incompatibility and inconsistency may arise because the

budgeting process, usually involves a number of different departments
- e.g. sales,-production, marketing and numerous senior and lower
level managers. It should be ensured that consistency is arrived at in
finalisatcin of master budget.
Acceptance of Communication of Budgets :

After the master budget is accepted and agreed upon by all the
levels of organisational hierarchy, it will be passed on for
implementation. It is essential that each manager responsible for
implementing the budget policy be informed as to his responsibility.

Budget Monitoring:

It is important that the actual performance of each manager

should be regularly and frequently compared against budget targets in
order to prevent it from getting 'out of control' and in case of change in
internal and external business environment a revision of the budget
may be necessitated.

CASH FLOW BUDGET

Cash flow budget is a detailed budget of income and cash

expenditure incorporating both revenue and capital items. The cash
flow budget should be prepared in the same format in which the
actual position is to be presented. The year's budget is usually phased
into shorter periods for control, e.g. monthly or quarterly. Cash
budget is concerned with liquidity must reflect changes between
opening and closing debtor balances and between opening and closing
creditor balances as well as focusing attention on other inflows and
outflows of cash. The cash budget shows the cash flows arising from
the operational budgets and the profit and assets structure. A cash
budget can be prepared in the following ways:

1. Receipts and Payments Method :

In this method all the expected receipts and payments for

budget period are considered. All the ash inflow and outflow of all
functional budgets including capital expenditure budgets are
considered. Accruals and adjustments in accounts will not affect the
cash flow budget. All anticipated cash inflow is added to the opening
balance of cash and all ash payments are deducted from this to arrive
at the closing balance of cash. This method is commonly used in
business organisations.

2. Adjusted Income Method :

In this method the annual cash flows are calculated by

adjusting the sales revenues and costing figures for delays in receipts
and payments (changes in debtors and creditors) and eliminating non-
cash items such as Depreciation.

3. Adjusted Balance Sheet Method :

In this method, the budgeted balance sheet is predicted by

expressing each type of assets and short-term liabilities as percentage
of the expected sales. The profit is also calculated as a percentage of
sales, so that the increase in owners equity can be forecast. Known
adjustments, may be made to long-term liabilities and the balance
sheet will then show if additional finance is needed.

It is important to note that the capital budget will also be

considered while preparation of cash flow budget because the annual
budget may disclose a need for new capital investments and also, the
costs and revenues of any new projects coming on stream will need to
be incorporated in the short-term budgets. A number of additional
financial statements, such as sources and application of funds
statement or schedules or loan service payments or capital raising
schedules may be produced.

Illustration 3:
 Prepare a cash budget for the three months ending 30 th June,
2001 from the information given below:
a. (Rs.)
Month Sales Materials Wages Overheads

February 14,000 9,600 3,000 1,700

March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,200 2,000
May 17,000 10;000 3,600 2,200
June 18,000 10,400 4,000 2,300

b. Credit Terms:
Sales/ Debtor - 10% sales are on cash, 50% of the credit sales are
collected next month and the balance in the following month.

Creditors Materials 2 months

Wages ¼ month
Overheads ½ month

c. Cash and bank balance on l" April, 2001 is expected to be

Rs.6,000.

d. Other relevant information is:

(i) Plant and Machinery will be installed in February 2001 at a
cost of Rs.96,000. The monthly instalments of Rs.2,000 is
payable from April onwards.
(ii) Dividend @ 5% on Preference Share Capital of Rs.2,00,000
will be paid on 1st June.
(iii) Advance to be received for sale of vehicles Rs.9,000 in June.
(iv) Dividends from investments amounting to Rs. 1,000 are
expected to be received in June.
(v) Income-tax (advance) to be paid in June, is Rs.2,000.
Working Notes:
Collection from Sales/ Debtors

Month Calculation April May June

February (14,000-10% of 14,000) x 50% 6,300 - -
March (15,000-10% of 15,000) x 50% 6,750 6,750 -
April 10% of 16,000 1,600 - -
(16,000-10% of 16,000) x 50% - 7,200 7,200
May 10% of 17,000 - 1,700 -
(17,000-10% of 17,000) x 50% - - 7,650
June 10% of 18,000 - - 1,800
14,650 15,650 16,650

Cash budget for the quarter April - June 2001

Particulars April May June Total
1. Balance b/f 6,000 3,950 3,000 6,000
2. Receipts
Sales (Note 1) 14,650 15,650 16,650 46,950
Dividend - - 1,000 1,000
Advanced against - - 9,000 9,000
vehicle
Total 20,650 19,600 29,650 62,950
3. Payment
Creditors* 9,600 9,000 9,200 27,800
Wages* 3,150 3,500 3,900 10,550
Overhead* 1,950 2,100 2,250 6,300
Capital Expenditure 2,000 2,000 2,000 6,000
Income tax advance - - 2,000 2,000
Total 16,700 16,600 29,350 62,650
4. Balance c/f 3,950 3,000 300 300
* Payments for creditors, wages and overhead have been computed on
the same pattern.

FLEXIBLE BUDGETING

Flexible budget is a budget which, by recognising the difference

in behaviour between fixed and variable costs in relation to
fluctuations in output, turnover, or other variable factors etc. It is
designed to change in relation to the level of activity actually attained.

A flexible budget is one that takes account of a range of possible

volumes It is sometimes referred to as a multi-volume budget. The
range of possible outputs may be known as the relevant range.
'Flexing' a budget takes place when the original budget is deliberately
amended to take account of change activity levels.

The flexible budget is based on the fundamental difference in

behaviour of fixed costs, variable costs and semi-variable costs. Since
fixed costs do not vary with short-run fluctuations in activity it can be
seen that the flexible budget will really consist of two parts: The first is
a fixed budget begin made up of fixed costs and the fixed component
of semi-variable costs. The second part is a truly flexible budget that
consists solely of variable costs.

Steps in Preparation
The steps involved in preparation of flexible budget are as
follows:
 Specify the time period that is used.
 Classify all costs into fixed, variable and semi-variable
categories.
 Determine the types of standards that are to be used.
 Analyse cost behaviour patterns in response to past levels of
activity.
  Build up the appropriate flexible budget for specified levels of
activity.

Importance

Flexible budgets are important aids to decision making which

help the management in the following ways:
 Flexible budget enable an organisation to predict its
performance and income levels at a given range of sales levels
and activity levels. It can be seen the impact of changes in sales
and production levels on revenue, expenses and ultimately
income.
 Flexible budgets enables more accurate assessment of
managerial and organisational performance.

Disadvantages

The procedure for drawing up a flexible budget is quite straight

forward. The flexed budget is only accurate, if costs behave in a
predicted manner. All too often assumptions are made about cost
behaviour which are too simplistic and hence do not reflect what
actually happens.

 Flexible budgets assume linearity of costs and therefore take no

account of, for example discounts for bulk purchases of
materials Labour costs are unlikely to behave in a linear fashion
unless a piecework scheme is in operation.

 Such budgets also rely on the assumption of continuity when

costs may actually behave in a stepped or discontinue matter.

 The method of determining the fixed and variable elements of

costs is often arbitrary and hence the flexed cost bear little
 relation to the correct budgeted cost for the flexed level of
activity.

 Although flexed budgets tend to maintain fixed costs at the

same level whatever the level of output/ sales, very often fixed
costs are actually fixed only over a relevant output range.

Illustration 4:

ABC Ltd. Manufactures a single product for which market

demand exists for additional quantity. Present sale of Rs.60,000 per
month utilised only 70% capacity of the plant. Sales Manager assures
that with a reduction of 10% in the price he would be in a position to
increase the sale by about 25% to 30%

The following data are available:

a) Selling price Rs. 10 per unit

b) Variable cost Rs.3 per unit
c) Semi-variable cost Rs.6,000 fixed plus Re.0.50 per unit
d) Fixed cost Rs.20,000 at present level estimated to be

Rs.24,000 as 80% output.

You are required to submit the following statements to the Board

showing:
1. The operating profits at 60%, 70% and 80% levels at current
selling price and at proposed selling price.
2. The percentage increase in the present output which will be
required to maintain the present profit margin at the
proposed selling price.

Statement of Operating Profit at different capacity levels at

Current Selling Price
(Rs.)
 Capacity Levels Product and Sales 60% 70% 80%

(units) 6,000 7,000 8,000

Sales (@Rs. 10) (A) 60,000 70,000 80,000

Costs:
Variable cost (@ Rs.3) 18,000 21,000 24,000
Semi-variable cost
Fixed component 6,000 6,000 6,000
Variable component (@ Re.0.50 per unit) 3,000 3,500 4,000

Fixed cost 20,000 20,000 24,000

Total cost (B) 47,000 50,500 58,000
Profit (A) - (B) 13,000 19,500 22,000

Statement of Operating Profit at different capacity levels at

proposed Selling Price

(Rs.)
Capacity Levels 60% 70% 80%
Sales (@ Rs.9) 54,000 63,000 72,000
Less: Total cost 47,000 50,500 58,000
Profit 7,000 12,500 14,000

Calculation of Percentage Increase in present output for desired

profit
(Rs. per unit)
Proposed selling price 9.00
Less: Variable cost (Rs.3.00 + Re.0.50) 3.50
Contribution per unit 5.50

(Rs.)
Present Profit 13,000
Add: Fixed cost (Rs.20,000 + Rs.6,000) 26,000
Desired Contribution 39,000

Required Output

Desired Contribution
= Contribution per unit

Rs.39,000
= Rs.5.50 = 7,091 units

Increase in Production required

= 7,091 units - 6,000 units = 1,091 units

Percentage increase over present Output

1,091
= 6,000 x 100 = 18.18%
 LESSON-14
CAPITAL BUDGETING

MEANING OF CAPITAL BUDGETING

Capital budgeting is the process of making investment decisions

in the capital expenditures. A progressive business firm always moves
ahead, its fixed assets and other resources continue to expand or
there comes a need for expanding them. Capital budgeting actually
the process of making investment decisions in capital expenditure, or
fixed assets. A capital expenditure may be as an expenditure the
benefits of which are expected to be received over a period of time
exceeding one year. Capital expenditure is one which is intended to
benefit future periods and normally includes investments in fixed
assets and other development projects. It is essentially a long-term
function. Capital budgeting is also known as Investment Decision
Making, Capital Expenditure Decisions, Planning Capital Expenditure
etc.

Capital budgeting is the most important and complicated

problem of managerial decisions. Because it is concerned with
designing and carrying out through a systematic investment
programme. It involves the planning of such expenditures which
provide yields over a number of years.

Charles T Homgreen has defined capital budgeting as, "Capital

budgeting is long term planning for making and financing proposed
capital outlays.

According to Philippatos, "Capital budgeting is concerned with

the allocation of the firm's scarce financial resources among the
available market opportunities. The consideration of investment
opportunities involves the comparison of the expected future streams
of earnings from a project, with the immediate and subsequent
streams of expenditure for it".

Richard and Green have defined "Capital budgeting as acquiring

inputs with long-run return".

According to Lynch, "Capital budgeting consists in planning

development of available capital for the purpose of maximising the
long-term profitability of the concern"

Features of Investment Decisions:

 Capita] budgeting decisions

 Huge funds are invested in long-term asets.
 The future benefits will occur to the firm over a series of years.
 They involve the exchange of current funds for the benefits to be
achieved in future.
 They have a significant effect on the profitability of the
concerns.
 They are 'strategic' investment decisions.
 They are irreversible decisions.

Capital budgeting has a vital role to play in the broader process of

strategic planning and budgetary control. Capital budgeting systems
should strive to create an atmosphere which encourages the
generation of new investment proposals and evaluates them as
accuracy as possible. However, loss-making proposals must be
identified at the earliest possible moment.
IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting means planning for capital assets. Capital

budgeting decisions are among the most crucial and critical business
decisions. It is the most important single area of decision-making for
the management. Unsound investment decision may prove to be fatal
to the very existence of the concern. The significance of capital
budgeting arises mainly due to the following:

(1) Large Investment:

Capital budgeting decisions, generally, involve large investment

of funds. The funds available with the firm are always limited and the
demand for the funds far exceeds the resources. These funds are
raised by the firm from various internal and external resources at
substantial cost of capital. A wrong decision prove disastrous for the
continued survival of the firm. Hence it is very important for a firm to
plan and control its capital expenditure.

(2) Long-Term Commitment of Funds:

The funds involved in capital expenditure are not only large but
more or less permanently blocked also in long-term investment. The
longer the time, the greater the risk involved. Greater the risk
involved, greater is the need for careful planning of capital
expenditure, i.e. capital budgeting. The long-term commitment of
funds increases the financial risk involved in the investment decision.
Firm's decision to invest in long-term assets has a decisive influence
on the rate and direction of its growth. An unsound investment
decision may prove to, be fatal to the very existence of the firm. Hence
a careful planning is essential:
(3) Irreversible in Nature :

Most investment decisions are irreversible. Once the decision for

acquiring a permanent asset is taken, it is very difficult to reverse that
decision. It is difficult to find a market of such capital goods once they
have been acquired. The only alternative will be to scrap the capital
assets so purchased or sell them at a substantial loss in the event of
the decision being proved wrong.

(4) Complicacies of Investment Decisions :

The long term investment decisions are more complicated in

nature. The capital budgeting decisions require an assessment of
future events which are uncertain. It is really a difficult task to
estimate the probable future events. In most projects the investment
of funds has to be made immediately but the returns are expected
over a number of future years. Both returns as well as the length of
the period over which they will accrue are uncertain.

(5) Long-term Effect on Profitability:

Capital budgeting decisions have a long-term and significant on
the profitability of a concern. Capital budgeting is of utmost
importance to avoid over-investment or under-investment HI fixed
assets. An unwise decision may prove disastrous and fatal to the very
existence of the concern. The future growth and profitability of the
firm depends upon the investment decision taken today. Capital
expenditure projects exercise a great impact on the profitability of the
firm for a very long time.

(6) National Importance:

Investment decision taken by individual concern is of national
importance because it determines employment, economic activities
and economic growth.
CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions

to the investment of current funds for the benefit to be achieved in
future and the future is always uncertain. A capital budgeting process
may involve a number of steps depending upon the size of the
concern, nature of projects, their numbers, complexities and
diversities etc. That is, capital budgeting decisions of a firm have a
pervasive influence on the entire spectrum of entrepreneurial
activities. Hence they require a complex combination and knowledge
of various disciplines for their effective administration, such as
economics, finance, mathematics, economic forecasting, projection
techniques and techniques of financial control. In order to tie all these
elements, a financial manager must keep in mind the three
dimensions of capital budgeting programme - policy, plan and
programme. These three Ps constitute a sound capital budgeting
programme.

Quinin G David has suggested that (a) project generation, (b)

project evaluation, (c) Project selection and (d) project execution are
the important steps involved in a capital budgeting process. However,
the following procedure may be adopted in the process of capital
budgeting.
(1) Identification of Investment Proposals

Investment opportunities have to be identified or searched for:

they do not occur automatically. The capital budgeting process begins
with the identification of investment proposals. The first step in
capital budgeting process is the conception of a profit-making idea.
Investment proposals of various types may originate at different levels
within a firm, depending on their nature. They may originate from the
level of workers to top management level. Most of the proposals, in the
nature of cost reduction or replacement or process for product
improvement take place at plant level. The proposal for adding new
product may emanate from the marketing department or from plant
manager who thinks of a better way of utilizing idle capacity.
Suggestions for replacing an old machine or improving the production
techniques may arise at the factory level. The departmental head
analyses the various proposals in the light of the corporate strategies
and submits suitable proposals to the capital expenditure planning
committee in case of large organisation or to the officers concerned
with the process of long-term investment decisions.

A continuous flow of profitable capital expenditure proposals is

itself an indications of a healthy and vital business concern. Although
business may pursue many goals, survivals and profitability are two
of the most important objectives.

(2) Screening the Proposals

Screening and selection procedures would differ from firm to

firm. Each proposal is then subjected to a preliminary screening
process in order to assess whether it is technically feasible; resources
required are available and the expected returns are adequate to
compensate for the risk involved. In large organisations, a capital
expenditure planning committee is established for screening for
various proposals received from different departments. The committee
views these proposals from various angles to ensure that these are in
accordance with the corporate strategies or selection criterion of the
firm and also do not lead to departmental imbalances. All care must
be taken in selecting a criterion to judge the desirability of the
projects. The criterion selected should be a true measure of the
investment project's profitability, and as far as possible, it must be
consistent with the firm's objective of maximising its market value.
This stage involves the comparison of the proposals with other
projects according to criteria of the firm. This is done either by
financial manager or by a capital expenditure planning committee.
Such criteria should encompass the supply and cost of capital and the
expected returns from alternative investment opportunities.

(3) Evaluation of Various Proposals

The next step in the capital budgeting process is to evaluate the

profitability of various proposals. If a proposal satisfies the screening
process, it is then analysed in more detail by gathering technical,
economic and other data. Projects are also classified, for example, new
products or expansion or improvement and ranked within each
classification with respect to profitability, risk and degree of urgency.
There are many methods which may be used for this purpose such as
pay back period method, rate of return method, net present value
method etc. All these methods of evaluating profitability of capital
investments proposals have been discussed in detail below. The
various proposals of investments may be classified as:
(a) Mutually exclusive proposals
(b) In-dependent proposals
(c) Contingent proposals

Mutually Exclusive Proposals serve the same purpose and

compete with each other in a way that the acceptance of one
precludes the acceptance of other or others. Thus, two or more
mutually exclusive proposals cannot both or all be accepted. Some
technique has to be used for selecting the better or the best one. Once
this is done, other alternative automatically gets eliminated. A
company may, for instance, propose to use semi-automatic machine
or highly automatic machine for production. Here choosing the highly
automatic machine precludes the acceptance of the semi-automatic
machine.

Independent Proposals are those which do not compete with

one another and the same may be either accepted or rejected on the
basis of minimum return on investment required. For instance, when
there are two proposals, a firm can undertake both the proposals.

Contingent or Dependent Proposals are those whose

acceptance depends upon the acceptance of one or more other
proposals. For instance, a firm decides to build a factory in a remote
area, it may have to invest in houses, hospitals, roads etc. for the staff
Thus, building a factory also requires investment in facilities for
employees. The total investment will be treated as a-single investment.
(4) Establishing Priorities

After evaluation of various proposals, the unprofitable or

uneconomic proposals are rejected, the accepted proposals i.e.
profitable proposals are put in priority. It may not be possible for the
firm to invest immediately in all the acceptable proposals. Thus, it is
essential to tank the various proposals and to establish priorities after
considering urgency, risk and profitability involved therein.

(5) Final Approval

Proposals finally recommended by the committee are sent to the

top management along with a detailed report, both of capital
expenditures and of sources of capital. Financial manager will present
several alternative capital budgets. When capital expenditure
proposals are finally selected, funds are allocated for them. Projects
are then sent to the budget committee for incorporating them in the
capital budget.

(6) Implementing Proposals

Preparation of a capital expenditure budgeting and

incorporation of a particular proposal in the budget does not itself
authorise to go ahead with the implementation of the project. A
request for authority to spend the amount should further be made to
the capital expenditure committee which may like to review the
profitability of the project in the changed circumstances. Further,
while implementing the project, it is better to assign responsibilities
for completing the project within the given time frame and cost limit
so as to avoid unnecessary delays and cost over runs. Network
techniques used in the project management such as PERT and CPM
can also be applied to control and monitor the implementation of the
projects.
(7) Performance Review

Last but not the least important step in the capital budgeting
process is an evaluation of the performance of the project, after it has
been fully implemented. It is the duty of the top management or
executive committee to ensure that funds are spent in accordance
with the allocation made in the capital budget. A control over such
capital expenditure is very much essential and for that purpose a
monthly report showing the amount allocated, amount spent, amount
approved but not spent should be prepared and submitted to the
controller. The evaluation is made through post completion audit by
way of comparison of actual expenditure on the project with the
budgeted one, and also by comparing the actual return from the
investment with the anticipated return. The unfavourable variances, if
any, should be looked into and the causes of the same be identified so
that corrective action may be taken in future.

EVALUATION OF INVESTMENT PROPOSALS

The funds available with the firm are always limited and it is
not possible to invest funds in all the proposals at a time. Therefore,
it is very essential to select from amongst the various competing
proposals, those which give the highest benefit. A firm may face a
situation where more investment proposals may be poor- The
management has to select the most profitable project or to take up the
most profitable project first. There are many considerations, economic
as well as non-economic, which influence the capital budgeting
decisions. Because of the utmost importance of the capital budgeting
decision, a sound appraisal method should be adopted to measure the
economic worth of each investment project. Capital expenditures
represent long-term commitment in the sense that current investment
yields benefits in future. The capital expenditure decisions assume
great importance for the future development of the concern. The
important factor that influences the capital budgeting decision is the
profitability of the prospective investment. The risk involved in the
proposal cannot be ignored because profitability and risk are directly
related, that is, higher the profitability, the greater because
profitability and risk are directly related, that is, higher the
profitability, the greater the risk and vice-versa. The goal of financial
management of a firm is the worth maximisation of the firm, and in
order to achieve this goal, the management must select those projects
which deserve first priority in terms of their profitability. While
evaluating, two basic principles are kept in mind, namely, the bigger
benefits are always preferable to small ones and that early benefits are
always better than the deferred ones. The essential property of sound
evaluation technique is that it should maximise the shareholders'
wealth. The following other characteristic should also be possessed by
a sound investment evaluation criterion:

(1) It should provide a means of distinguishing between

acceptable and unacceptable projects
(2) It should provide clear cut ranking of the projects in order of
the profitability or desirability.
(3) It should also solve the problem of choosing among alternative
projects.
(4) It should be a criterion which is applicable to any conceivable
investment project.
(5) It should emphasise upon early and bigger cash benefits in
comparison to distant and smaller benefits.
(6) The method should be suitable according to the nature and
size of capital project to be evaluated.
METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS

A number of appraisal methods may be recommended for

evaluating the capital expenditure proposals. The most important and
commonly used methods are:
Traditional Methods:

1. Pay-back period Method or Pay-out or Pay-off Method

2. Improvements in Traditional Approach to Pay-back period
Method.
3. Rate of Return Method or Accounting Method.

Time Adjusted Methods or Accounting Methods:

4. Net Present Value Method
5. Internal Rate of Return Method
6. Profitability Index Method.

TRADITIONAL METHODS
(1) Pay-back Period Method

The term pay-back (or pay-out or pay-off or break-even period

or recoupment period) refers to the period in which the project will
generate the necessary cash to recoup the initial investment. Business
units, while selecting investment projects, would consider the recovery
of cost as the first and foremost concern even though earning
maximum profits is their ultimate .goal. This method describes in
terms of period of time the relationship between annual savings (cash
inflow) and total amount of capital expenditure (investment), payback
period is defined as the number of years required for the savings in
costs or net cash inflow (after tax but before depreciation) to recoup
the original cost of the project In simple sentence, it represents the
number of years in which the investment is expected to "pay for itself.
Under this method, various investments are ranked according to the
length of their pay-back period in such a manner that the investment
with a shorter pay-back period is preferred to the one which has
longer pay-back period.
Calculation of Pay-back Period
(a) In the case of even cash inflows :

If the annual cash inflows are constant, the pay-back period can
be computed by dividing cash outlay (original investment) by annual
cash inflows. For instance, if a project requires Rs. 10,000 as initial
investment and it will generate an annual cash inflow of Rs.2,500 for
ten years, the pay-back period will be 4 years, calculated as follows:

Initial Investment
Pay - back Period = Annual Cash Inflow

Rs. 10,000
= Rs. 2,500 = 4 years

(b) In the case of uneven inflows :

If cash inflows are not uniform, the calculation of pay-back

period takes a cumulative form. In such a case the pay-back period
can be found out by adding up the figure of net cash inflows until the
total is equal to initial investment. For instance, if-a project requires
an initial investment of Rs. 10,000 and the annual inflow for 5 years
are Rs.3,000; Rs.4,000; Rs.2,500; Rs.2,000 and Rs.2,000 respectively,
the pay-back period will be calculated as follows:

Year Annual Cash Cumulative Cash

Inflows Inflow
Rs. Rs.
1 3,000 3,000
2 4,000 7,000
3 2,500 9,500
4 2,000 11,500
 5 2,000 13,500

The above workings show that in 3 years Rs.9,500 has been

recovered. Rs.500 is left out of in-tial investment. In the fourth year
the cash inflow is Rs.2,000. It means the pay-back period is between 3
to 4 years, calculated as follows:
Rs.500
Pay - back Period = 3 years + Rs.2,000

= 3.25 years

Illustration 1: Payoff Ltd., is producing articles mostly by manual

labour and is considering to replace it by a new machine. There are
two alternative models M and N of the new machine. Prepare a
statement of profitability showing the payback period from the
following information:

Machine M Machine N
Estimated life of machine 4 years 5 years
Cost of machine Rs.9,000 Rs. 18,000
Estimated savings in scrap Rs.500 Rs.800
Estimated savings in direct wages Rs. 6,000 Rs. 8,000
Additional cost of maintenance Rs.800 Rs. 1,000
Additional cost of supervision Rs. 1,200 Rs. 1,800
Solution:
Statement showing annual cash inflows

Machine M Machine N Rs.

Rs.
Estimated savings in scrap 500 800
Estimated savings in direct wages 6,000 8,000
Total savings (A) 6,500 8,800
Additional cost of maintenance 800 1,000
Additional cost of supervision 1,200 1,800
Total additional cost (B) 2,000 2,800
New cash inflow (A) - (B) 4,500 6,000

Original Investment
Pay-back Period = Annual Average Cash Inflow

Rs.9,000 Rs.18,000
= Rs.4,500 = 2 years Rs.6,000 = 3 years

Machine M should be preferred because it has a shorter pay-back

period.

Acceptance or Reject Criterion :

Many firms use the pay-back period as an accept or reject

criterion as well as a method of ranking projects. If the pay-back
period calculated for a project is less than the maximum pay-back
period set by management, it would be accepted; if not, it would be
rejected. As a ranking method, it gives highest ranking to the project
which as shortest pay-back period and lowest ranking to the project
with highest pay-back period. Thus, if die firm has to choose among
two mutually exclusive projects, project with shorter pay-back period
will be selected.
Advantages of Pay-back Method :

1) It is easy to calculate and simple to understand.

2) It saves in cost, as it requires lesser times and labour as
compared to other methods.
3) Under this method, a shorter pay-back period is preferred to the
one having a longer pay-back period, and it reduces the loss
through obsolescence and is more suited to the developing
countries, like India, which are in the process of development
and have quick obsolescence.
4) This method is useful to a concern which is short of cash and is
eager to get back the cash invested in a capital expenditure
project.
5) As the method considers the cash flows during the pay-back
period of the project, the estimates would be reliable and the
result may be comparatively more accurate.

Disadvantages of Pay-back Method :

(1) It does not take into account the cash inflows earned after the
pay-back period and hence the true profitability of the project
cannot be correctly assessed.

(2) This method does not consider the amount of profit earned on
investment after the recovery of cost of investment.

(3) It does not take into consideration the cost of capital which is a
very important factor in making a sound investment decisions.

(4) It may be difficult to determine the minimum acceptable pay-

back period, it is usually, a subjective decision.
(5) It ignores interest factor which is considered to be a very
significant factor in taking sound investment decision.

(6) Too much emphasis on the "liquidity of the investment",

ignoring the "profitability of investment" may not be justified in
a number of situations.

(7) It ignores time value of money. Cash flows received in different

years are treated equally.

(8) It doe not take into account the life of the project, depreciation,
scrap-value, interest factor etc. Because, a rupee tomorrow is
worthless than a rupee today.

(2) Improvement in Traditional Approach to Pay-back Period

One of the most commonly used techniques for evaluating

capital investment proposal is the cash pay-back method. Some
authorities on accountancy, in order to make up the deficiencies of
the pay-back period method, evolved new concepts. The improvements
are discussed below:

(a) Post Pay-back Profitability :

One of the limitations of the pay-back period method is that it

neglects the profitability of investment beyond the pay-back period.
This method is also known as Surplus Life over pay-back period.
According to this method, the project .Which gives the greatest post
pay-back period profits may be accepted. It has been explained in the
following illustration:

Post pay-back profitability = Annual Cash Inflow (Estimated Life -

Pay-back Period)
 Further, post pay-back profitability index can also be calculated
by multiplying the above formula with 100.

Illustration 2: A concern is considering two projects X and Y.

Following are the particulars in respect of them:

Project X Project Y
Cost (Rs.) 1,40,000 1,40,000
Economic Life (in years) 10 10
Estimated Scrap (in Rs.) 10,000 14,000
Annual Savings 25,000 20,000

Ignoring income-tax, recommend the best of these projects

using (a) payback period, (b) post pay-back profit, and (c) index of post
pay-back profit.
Solution:
Project X Project Y
1. Cost 1,40,000 1,40,000
2. Savings 25,000 20,000
3. Pay-back period 5.6 years 7 years

4. Economic Life 10 years 10 years

5. Surplus Life 4.4 years 3 years

6. Post pay-back profit (2 x 5) 1,10,000 60000
7. Index of post pay-back profit 1,10,000 60,000

1,40,000 x 100 1,40,000 x 100

= 78.6% = 42.9%

Project X is the best one by all the methods of ranking.

(B) Discounted Pay-back Period :

 Another serious limitation of pay-back period method is that it
ignores the time value of money. This method can be improved or
modified to consider the time value of money. Under this method the
present values of all cash outflows and inflows are computed at an
appropriate discount rate. The number of periods taken in recovering
the investment outlay on the present value basis is called the
discounted pay-back period. The present values of all inflows are
cumulated in order of time. The time period at which the cumulated
present value of cash inflow equals the present value of cash outflows
is known as discounted payback period.

Illustration 3: The following are the particulars relating to a project

Rs.
Cost of the project 50,000
Operating Savings:
1st year 5,000
2nd year 20,000
3rd year 30,000
4th year 30,000
5th year 10,000

Calculate (i) pay-back period ignoring interest factor and (ii)

discount pay-back period taking into account interest factor at 10%.
Solution:
(i) Pay-back period
Year Annual Cumulative

Savings Rs. Savings Rs.

1 5,000 5,000
2 20,000 25,000
3 30,000 55,000
Upto second year, Rs.25,000 recovered
Rs.50,000- Rs.25,000
Therefore, pay-back period = 2 years + Rs.30,000
 Rs.25,000
= 2 + Rs.30,000

= 2 years 10 months
(ii) Discounted Pay-back period at 10% interest factor

Discounted Cumulative
Years Savings PV Factor
Savings Discounted Savings
Rs. Rs. Rs.
1 5,000 0.9091 4,546 4,546
2 20,000 0.8265 16,530 21,076
3 30,000 0.7513 22,539 43,615
4 30,000 0.6830 20,490 64,105,

Rs. 50,000 - Rs.43,615

Discounted pay-back period = 3 years + Rs.20,490

= 3 years 4 months

(C) Pay-back Reciprocal

Sometimes, pay-back reciprocal method is employed to estimate

the internal rate of return generated by a project.

Annual Cash Inflow

Pay-back Reciprocal = Total Investment

However, this method of ranking investment proposals should

be used only when:
 Annual savings are even for the entire period.
 The economic life of the project is at least twice of the pay-back
period.
(3) Rate of Return Method (Accounting Method)

This method is also known as Accounting Rate of Return

method or Return on Investment of Average Rate of Return method.
According to this method, various projects are ranked in order of the
rate of earnings or rate or return. Projects which yield the highest
earnings are selected and others are ruled out. The return on
investment can be expressed in several ways, as follows:

(a) Average Rate of Return Method

Here, average profit, after tax and depreciation, is calculated

and then it is divided by the total capital outlay or total investment in
the project. This method establishes the ratio between the average
annual profits to total outlay.

Average Annual Profit

Average Rate of Return = Outlay of the Project x 100

Project giving a higher rate of return will be preferred over those giving
lower rate of return.

(b) Return Per unit of Investment Method

In this method, the total profit after tax and depreciation is

divided by the total investment. This gives us the average rate of
return per unit of amount invested in the project.

Total Profit
Return per unit of Investment = Net Investment x 100

(c) Return on Average Investment Method

 Under this method the percentage return on average amount of
investment is calculated. To calculate the average investment, the
outlay of the project is divided by two.

Total Profit after deprec. & Taxes

Return on Average Investment = Total Net Investment /2 x 100

(d) Average Return on Average Investment Method

Under this method, average profit after depreciation and taxes is

divided by the average of amount of investment. This is an appropriate
method of rate of return on investment.
Average Annual
Average Return on Average Investment = Net Investment / 2 x 100

Illustration 4: Calculate the average rate of return for projects A and

B from the following:
Project A Project B
Investment Rs.20,000 Rs.30,000
Expected Life (no salvage value) 4 years 5 years

Projected Net Income, after interest, depreciation and taxes:

Years Project A Project B

Rs. Rs.
1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 - 1,000
Total 6,000 10,000

If the required rate of return is 1 2% which project should be

undertaken?

Solution:
Project A Project B
 Rs. Rs.
Total profit, after interest, 6,000 10,000

depreciation and taxes

Expected Life 4 years 5 years

Average Profit 1,500 2,000

Investment 20,000 30,000
Average Rate of Return 1-500 2,000
Average Rate of Return 1,500 2,000

20,000 x 100 = 7.5% 30,000 x 100 = 6.6%

Average Return on 1,500 2,000

Average Investment 20,000/2 x 100 = 15% 30,000/2 x 100 = 13.33%

The average return on average investment is higher in the case

of Project A, besides it is also higher than the required rate of return
of 12%. Project A is suggested to be undertaken.
Merits of Rate of Return Method
The following are the merits:
 It is simple to understand and easy to calculate.
 It takes into consideration the total earnings from the project
during its life time. Thus this method gives a better view of
profitability as compared to pay-back period method.
 It is based upon accounting concept of profit. It can be
calculated from the financial data.
Demerits of Rate of Return Method :
This method suffers from the following demerits:
 It ignores the time value of money. Profits earned in different
periods are valued equally.
 This method may not reveal true and fair view in the case of
long-term investments.
 It does not take into consideration the cash flows which is more
important than the accounting profits.
 It ignores the fact that profits can be reinvested.
  There are different methods for calculating the Accounting Rate
of Return. Each method gives different results. This reduces the
reliability of the method.

TIME ADJUSTED METHOD (DISCOUNTED CASH FLOW METHOD)

Discounting is just opposite of compounding. In compound rate

of interest, the future value of the present money is ascertained
whereas in discounting, the present alue of future money is
calculated. The rate at which the future cash flows are reduced to
their present value is termed as discount rate. Discount rate,
otherwise called time value of money, is some interest rate which
expresses the time preference for a particular future cash flow.

The discounted cash flow method is an improvement on the

pay-back method as well as accounting rate of return. This method is
based on the fact that future value of money will not be equal to the
present value of money. That is, discounted cash flow technique
recognises that Re. one of today (cash outflow) is worth more than Re.
one received at a future date (cash inflow). Die time adjusted or
discounted cash flow method take into account the profitability and
also the time value of money. The discounted cash flow method for
evaluating capital investment proposals are of three types:

1. Net Present Value Method

This method is also known as Excess Present Value or Net Gain

Method or Time Adjusted methods. Under this method, cash inflows
and cash outflows associated with each project are first worked out.
The present values of these cash inflows and outflows are then
calculated at the rate acceptable to the management. This rate of
return is considered as the cut-off rate and is generally determined on
the basis of cost of capital suitably adjusted to allow for the risk
element involved in the project.

The present values of total of cash inflows should be compared

with present values of cash outflows. If the present value of cash
inflows are greater than (or equal to) the present value of cash
outflows (or initial investment), the project would be accepted. If it is
less, then proposal will be rejected.

Illustration 5: A company is considering the purchase of the two

machines with the following details:

Machine I Machine II
Life Estimated 3 years 3 years
Rs. Rs.
Capital Cost 10,000 10,000
Net earning after tax:
1st year 8,000 2,000
2nd year 6,000 7,000
3rd year 4,000 10,000

You are required to suggest which machine should be preferred.

Solution:
Calculation of Net Present Value (10%)

Machine I Machine II
Year PV Factor Cash Present Cash Present

Inflow Rs. Value Rs. Inflow Rs. Value Rs.

1 0.909 8,000 7,272 2,000 1,818
2 0.826 6,000 4,956 7,000 5,782
3 0.751 4,000 3,004 10,000 7,510
15,232 15,110
Less: Cost Net Present Value 10,000 10,000
5,232 5,110

Machine I should be preferred as net present value is Rs.5,232

which is higher than Rs.5,110 in case of Machine II.
Merits of Net Present Value Method
The merits of this method of evaluating investment proposal are
as follows:s

 This method considers the entire economic life of the project.

 It takes into account the objective of maximum profitability.
 It recognises the time value of money.
 This method can be applied where cash inflows are uneven.
 It facilitates comparison between projects.
Demerits of this method are as follows:
 It is not easy to determine an appropriate discount rate.
 It involves a great deal of calculations. It is more difficult to
understand and operate.
 It is very difficult to forecast the economic life of any investment
exactly.
 It may not give good results while comparing projects with
unequal investment of funds.

2. Internal Rate of Return Method

This method ^ popularly known as time adjusted rate of return

method or discounted rate of return method. The internal rate of
return is defined as the interest rate that equates the present value of
the expected future receipts to the cost of the investment outlay. This
internal rate of return is found by trial and error. First, we compute
the present value of the cash-flows from an investment, using an
arbitrarily selected interest rate. Then, we compare the present value
so obtained with the investment cost. If the present value is higher
than the cost figure, we try a higher rate of interest and go through
the procedure again. Conversely, if the present value is lower than the
cost, lower the interest rate and repeat the process. The interest rate
that brings about this equality is defined as the internal rate of return.
This rate of return is compared to the cost of capital and the project
having higher difference, if they are mutually exclusive, is adopted
and other one is rejected. As this determination of internal rate of
return involves a number of attempts to make the present value of
earnings equal to investment, this approach is also called the Trial
and Error Method.

Illustration 6: Initial Investment Rs.60,000

Life of the Asset 4 years
Estimated net annual cash-flows:
1st year Rs. 15,000
2nd year Rs.20,000
3rd year Rs.30,000
4th year Rs.20,000
Calculate Internal Rate of Return.
 Solution:
Calculation of Internal Rate of Return
Annual PVF PVF PVF PVF
Year PV PV PV PV
Cashflow 10% 12% 14% 15%
1 15,000 0.909 13,635 0.892 13,380 0.877 13,155 0.869 13,035

2 20,000 0.856 16,520 0.797 15,940 0.769 15,380 -0.756 15,120

3 30,000 0.751 22,530 0.711 21,330 0.674 20,220 0.657 19,710

4 20,000 0.683 13,660 0.635 12,700 0.592 11,840 0.571 11,420

66,345 63,350 60,595 59,285

Total of PV of Cash inflow

Initial investment is Rs.60,000. Hence internal rate of return

must be between 14% and 15% (Rs.60,595 and Rs.59,285). The
difference comes to Rs. 1.310 (Rs.60,595 - Rs.59,285).

For a difference of 1,310, difference in rate = 1%

(Excess PV: 60595-60,000=595)
595
Therefore, exact Internal Rate of Return = 14% +1,310 x 1%
= 14% + 0.45%

=14.45%

3. Profitability Index Number

It is also a time adjusted method of evaluating the investment

proposals. Profitability index also called Benefit Cost Ratio or
Desirability factor. It is the ratio of the present value of cash inflows,
at the required rate of return to the initial cash outflow of the
investment. The probability index is less than one. By computing
profitability indices for various projects, the financial manager can
rank them in order of their respective ratio of profitability.
PV of Cash Flows
Profitability Index = Initial Cost Outlay

Illustration 7: The initial cash outlay of a project is Rs.50,000.

Estimated cash inflows:
1st year Rs.20,000
2nd year Rs. 15,000
3rd year Rs.25,000
4th year Rs. 10,000

Compute Profitability Index.

Solution:
Calculation of Profitability Index

Cash Inflows PV Factor at

Year PV Rs.
Rs. 10%
1 20,000 9.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
Total 56,175
Total Present Value = Rs.56,175
Less: Initial Outlay = Rs.50,000
Net Present Value = 6,175
PV Cash Inflow
Profitability Index (gross) =
Initial Cash Outflow
56,175

50,000 = 1.1235

Profitability index is higher than 1, the proposal can be accepted.

CAPITAL RATIONING

Capital rationing is a situation where a firm has more

investment proposals than it can finance. Many concerns have limited
funds. Therefore, all profitable investment proposal may not be
accepted at a time. In such event the firm has to select from amongst
the various competing proposals, those which give the highest
benefits. There comes the problem of rationing them. Thus capital
rationing may be defined as a situation where the management has
more profitable investment proposals requiring more amount of
finance than the funds available to the firm. In such a situation, the
firm has not only to select profitable investment proposals but also to
rank the projects from the highest to lowest priority

Illustration 8: X Ltd. is considering the purchase of a machine. Two

machines are available, A and B. The cost of each machine is
Rs.60,000. Each machine has an expected life of 5 years. Net profits
before tax but after depreciation during the expected life of the
machine are given below:
Year Machine A Machine B
Rs. Rs.
1 15,000 5,000
2 20,000 15,000
 3 2500 20,000
4 15,000 30,000
5 10,000 20,000

Following the method of return on investment ascertain which

of the alternates will be more profitable. The average rate of tax may
be taken at 50%.

Solution :
Computation of profit after tax

year Machine A Machine B

Profit Tax at Profit Profit Tax at Profit
before tax 50% after tax before tax 50% after tax

Rs. Rs. Rs. _ Rs.

1 15,000 7,500 7,500 5,000 2,500 2,500

2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
Total 85,000 42,500 42,500 90,000 45,000 45,000

Machine A Machine B
Average profit Rs. 42,000 Rs. 45,000

after tax 5 = Rs. 8,500 5 = Rs. 9000

Investment Rs. 60,000 Rs. 60,000

Average Rs. 60,000 Rs. 60,000

Investment 2 = Rs. 30,000 2 = Rs. 30,000

Average Return on Rs. 8,500 Rs. 9,000

Investment 60,000 x 100 = Rs. 14.17% 60,000 x 100 = Rs. 15%

Average Return on Rs. 8,500 Rs. 9,000

Average 30,000 x 100 = Rs. 28.34% 30,000 x 100 = Rs. 30%

Investment

Machine B is more profitable.

Illustration 9 : A Ltd. Company is considering the purchase of a new

machine which will carry out operations preformed by labour. X and
Y are alternative models. From the following information, you are
required to prepare a profitability statement and work out the pay-
back period for each model.
 Model X Model Y
Rs. Rs.
Estimated Life 5 years 6 years
Cost of Machine 1,50,000 2,50,000
Cost of indirect materials 6,000 8,000
Estimated savings in scrap 10,000 15,000
Additional cost of maintenance 19,000 27,000
Estimated savings in direct

wages:
Employees not required 150 200
Wages per employee 600 600

Taxation to be regarded 50% of profit before charging depreciation.

Which model you recommend ?

Solution:
Profitability Statement
Model X Model Y (Rs)

(Rs)
Estimated saving per 10,000 15,000

year scrap

Wages (150x600) 90,000 1,35,000

(200x600)

Total Savings 1,00,000 1,35,000

Less: Additional Cost
Cost of indirect 8,000

materials 6,000
Cost of Maintenance

19,000 25,000 27,000 35,000

Additional Earnings 75,000 1,00,000
Less: Tax @ 50% 37,500 50,000
Cash flow (annual) 37,500 50,000
Less: Depreciation: 30,000 2,50,000 » 6 41,667

1,50,000 » 5
Net Increase in 7,500 8,333
earnings
Pay-back period: 1,50,000 2,50,000

37,500 = 4 years 50,000 = 5 years

Cost of Machine

Annual Cash Flow

7,500 8,300

1,50,000 x100 = 2,50,000 x100 = 3.3%

5%

A pay-back period of Model X is less than that of Model Y, ^nd

also the return on Investment is higher in respect of X, Model X is
recommended.

Illustration 10: A company proposing to expand its production can

go either for an automatic machine costing Rs.2,24,000 with an
estimated life of 5V2 years or an ordinary machine costing Rs.60,000
having an estimated life of 8 years.

Automatic Ordinary

Machine Machine
The annual sales and Rs. Rs.

costs
are estimated as follows:
Sales 1,50,000 1,50,000
Costs:
Materials 50,000 50,000
Labour 12,000 60,000
Variable Overhead 24,000 20,000

Compute the comparative profitability under pay-back method.

Solution:
 Automatic Machine Ordinary Machine

Rs. Rs.

Annual Sales 1,50,000 1,50,000

Less: Variable Cost
Materials 50,000

50,000
Labour 60,000

12,000
Overheads 24,000 86,000 20,000 1,30,000
Marginal Profit 64,000
20,000

2,24,000 3 ½ years 60,000

Pay-back period: 64,000 20,000 = 3 years

Post pay-back profitability 1 _ 1 20,000 (8-5

64,000 5 2 32 yrs.)
= Rs. 1,28,000 = Rs. 1,00,000

Illustration 11: The Tamil Nadu Fertilizers Ltd. is considering a

proposal for the investment of Rs.5,00,000 on product development
which is expected to generate net cash inflows for 6 years as under:

Year Net Cash Flows ('000)

1 Nil
2 100
3 160
4 240
5 300
6 600

The following are the present value factors @ 15% p.a.

Year 1 2 3 4 5 6

Factor 0.87 0.76 0.66 0.57 0.50 0.43

Solution:
Calculation of Net Present Value

Year Cash Inflows PV Factor Present Values

('000) Rs. ('000) Rs.

1 Nil 0.87 Nil
2 100 0.76 76.0
3 160 0.66 105.60
4 240 0.57 136.80
5 300 0.50 150.00

6 600 0.43 258.00

Total 726.40
Less: Cash Outlay 500.00
Net Present Value 226.40

As the net present value is positive, the proposal is acceptable.

Illustration 12: The financial manager of a company has to advise

the Board of Directors on choosing between two compelling project
proposals which require an equal investment of Rs. 1,00,000 and are
expected to generate cash flows as under:

Project I Project II
Rs. Rs.
End of year 1 48,000 20,000
2 32,000 24,000
3 20,000 36,000
4 Nil 48,000
5 24,000 16,000
6 12,000 8,000

Which project proposal should be recommended and why? Assume

the cost of capital to be 10% p.a. The following are the present value
factors at 10% p.a.
Year 1 2 3 4 5 6

Factor 0.909 0.826 0.751 0.683 0.621 0.564

Solution:
Calculation of Net Present Value
Year Project I Project II PV PV of PV of

Net Cash Net Cash Factor Project I Project

Inflows Inflows @ 10% 11

Rs. Rs. Rs. Rs.
1 48,000 20,000 9.909 43,632 18,130
2 32,000 24,000 0.826 26,432 19,8.24
3 20,000 36,000 0.751 15,020 27,036
4 Nil 48,000 0.683 Nil 32,784
5 24,000 16,000 0.62.1 14,904 9,936
6 12,000 8,000 0.564 6,768 4,512
Total 1,06,756 1,12,272
Less: Cash Outlay 1,00,000 1,00,000
Net Present Value 6,756 12,272

Project II should be accepted as the NPV is more than that of

Project I.

Illustration 13: From the following information, calculate the net

present value of the two projects and suggest which of the two profits
should be accepted assuming a discount rate of 10%.

Profit X Profit Y
Rs. Rs.
Initial Investment 20,000 30,000
Estimated Life 5 years 5 years
Scrap Value 1,000 2,000
Profits before depreciation and after
taxes are as follows:

Year Profit X Profit Y

Rs. Rs.
1 5,000 20,000
2 10,000 10,000
3 10,000 5,000
4 3,000 3,000
5 2,000 2,000
Solution :
Present Value of Net
PV of Re.1
Cash Flows
Year
Cash Flow
@10%
Project X Project Y Project X Project Y
Rs. Rs. Rs. Rs.
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.836 8,260 8,260
3 10,000 5,000 0.751 8,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242
6 1,000 2,000 0.621 621 1,242
24,227 34,728
20,000 30,000
4,227 4,728
Project Y should be selected as NPV of Project Y is higher.

Illustration 14: A firm is considering the purchase of a machine. Two

machines A and B are available, each costing Rs.50,000. In comparing
the profitability of those machines a discount rate of 10% is to be
used- Earnings after taxation are expected to be as follows:
You are also given the following data:

Year Machine A Cash Machine B Cash

Inflow Inflow
Rs. Rs.
1 15,000 5,000
2 20,000 1 5,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000

You are also given the following data :

year PV Factor @ 10%

discount
 1 0.909
2 0.826
3 0.751
4 0.683
5 0.621

Evaluate the projects using:

(a) the pay-back period
(b) the accounting rate of return
(c) the net present value
(d) the profitability index

Solution:
Year Cash Inflow Cumulative Cash Inflow

Rs. Rs.

1 15,000 15,000
2 20,000 35,000
3 25,000 60,000
4 15,000 75,000
5 10,000 85,000

The above calculation shows that in two years Rs.35,000 has

been recovered. Rs. 15,000 is left out of initial investment. In the 3 rd
year cash inflow is Rs.25,000. It means the pay-back period is
between 2nd and 3 year, thus:

15,000
Pay-back Period = 2+ 25,000 = 2.6 years

(b) Machine B
Year Cash Inflow Cumulative Cash Inflow
 Rs. Rs.

1 5,000 5,000
2 15,000 20,000
3 20,000 40,000
4 30,000 70,000
5 20,000 90,000

In three years Rs.40,000 has been recovered. The balance left

out of initial investment is Rs. 10,000. It means the pay-back period is
between 3rd and 4th year, thus:
10,000
Pay-back Period = 3+ 30,000 = 3.33 years

Machine A should be purchased. Because pay-back period is

less.
Accounting Rate of Return
Machine A
Total Returns = Rs.85,000
Average Return = Rs.85,000 » 5 = Rs.17,000

17,000
Average Rate of Return = 50,000 x 100 = 34%

Machine B
Total Returns = Rs.90,000
Average Return = Rs.90,000 » 5 = Rs.18,000

18,000
Average Rate of Return = 50,000 x 100 = 36%

Net Present Value

Calculation of Net Present Value

PV Factor Cash Inflows Cash Inflows PV PV

s
@ 10% Machine A Machine B Machine B Machine A
Rs. Rs. Rs. Rs.
1 0.909 15,000 5,000 13,635 4.545
2 0,826 20,000 15,000 16,520 12,390
3 0.751 25,000 20,000 18,775 15,020
4 0.683 15,000 30,000 10,245 20,490
5 0.621 10,000 20,000 6,210 12,420
Total 65,385 64,865
Less: Cash Outlay 50,000 50,000
Net Present Value 15,385 14,865

The Net Present Value of Machine A is more than that of

Machine B. So, Machine A should be purchased.

Probability Index

Present Values 65,385

Machine A = Cost of Investment = 50,000 = 1.308

64,865
Machine B = 50,000 = 1.297

Probability Index of Machine A is more than that of Machine B

and therefore, Machine A should be preferred.
 LESSON - 15 : CASE STUDY
CASE-1
BUSINESS DECISION

Adams Company and Baker Company are in the same line of

business and both were recently organized, so it may be assumed that
the recorded costs for assets are close to extent market values. The
balance sheets for the two companies are as follows at July 31, 19

ADAMS COMPANY
Balance Sheet
July 31,19
Assets $ Liabilities & Owner's $

Equity
Cash 4,800 Liabilities:
Accounts 9,600 Notes payable (due in 62,400

receivable 60 days)
Land 36,000 Accounts payable 43,200

Building 60,000 Total liabilities 105,600

Office equipment 12,000 Owner's Equity
Ed Adams, capital 16,800
122,400 122,400

BAKER COMPANY
Balance Sheet
 July 31,19 ___

Liabilities & Owner's

Assets $ $
Equity
Cash 24,000 Liabilities:
Accounts 48,000 Notes payable (due in 60 14,400

receivable days)
Land 7,200 Accounts payable 9,600

Building 12,000 Total liabilities 24,000

Office equipment 1,200 Owner's Equity
Ed Adams, capital 68,400

92,400 92,400

Questions :

(1) Assume that you are a banker and that each company has
applied to you for a 90-day loan of $ 12,000. Which would you
consider to be the more favourable prospect?

(2) Assume that you are an investor considering the purchase of

one or both of the companies. Both Ed Adams and Tom Baker
have indicated to you that they would consider selling their
respective business. In either transaction you would assume the
existing liabilities. For which business would you be willing to
pay the higher price? Explain your answer fully. (It is recognised
that for either decision, additional information would be useful,
but you are to reach your decisions on the basis of the
information available).

CASE- 2
BUSINESS DECISION
 Richard Fell, a college student with several summers' experience
as a guide on canoe camping trips, decided to go into business for
himself. To start his own guide service, Fell estimated that at least $
4,800 cash would be needed. On June 1, he borrowed $ 3,200 from
his father and signed a three-year note payable which stated that no
interest would be charged. He deposited this borrowed money along
with $ 1,600 of his own savings in a business bank account to begin a
business known as Birchbark Canoe Trails. The $ '3,200 note payable
is a liability of the business entity. Also on June I, Birchbark Canoe
Trails carried out the following transactions:
(i) Bought a number of canoes at a total cost of $ 6,400, paid $
1,600 cash and agreed to pay the balance within 60 days.
(ii) Bought camping equipment at a cost of $ 3,200 payable in
60 days,
(iii) Bought supplies for cash, $ 800.

After the close of the season on September 10, Fell asked

another student, Joseph Gallal, who had taken a course in
accounting, to help him determine the financial position of the
business. ;

The only record Fell had maintained was a checkbook with

memorandum notes written on the check stubs. From this source
Gallal discovered that Fell had invested an additional $ 1,600 of his
own savings in the business on July 1, and also that the accounts
payable arising from the purchase of the canoes and camping
equipment had been paid in full. A bank statement received from the
bank on September 10 showed a balance on deposit of $ 3,240.
Fell informed Gallal that he had deposited in the bank all cash
received by the business. He had also paid by check all bills
immediately upon receipt; consequently, as of September 10, all bills
for the season had been paid.
 The canoes and camping equipment were all in excellent
condition at the end of the season and Fell planned lo resume
operations the following summer, In fact he had already accepted
reservations from many customers who wished to return. Gallai felt
that some consideration should be given to the wear and tear on the
canoes and equipment but he agreed with Fell that for the present
purpose the canoes and equipment should be listed in the balance
sheet at the original cost. The supplies remaining on hand had cost $
40 and Fell felt that he could obtain a refund for this amount by
returning them to the supplier.

Gallai suggested that two balance sheets be prepared, one to

show the condition of the business on June 1 and the other showing
the condition on September 10. He also recommended to Fell that a
complete set of accounting records be established.

Questions :

1. Use the information in the first paragraph (including the three

numbered transactions) as a basis for preparing a balance
sheet dated June 1.

2. Prepare a balance sheet at September 10. (Because of the

incomplete information available, it is not possible to
determine the amount of cash at September 10, by adding
cash receipts and deducting cash payments throughout the
season. The amount on deposit as reported by the bank at
September 10, is to be regarded as the total cash belonging to
the business at that date).

3. By comparing the two balance sheets, compute the change in

owner's equity. Explain the sources of this change in owner's
equity and state whether you consider the business to be
successful. Also comment on the cash position at the
beginning and end of the season. Has the cash position
improved significantly? Explain.
 CASE-3
BUSINESS DECISION

Condensed comparative financial statements for Pacific

Corporation appear below:

PACIFIC CORPORATION
Comparative Balance Sheets
As of May 31
(in thousands of dollars)

Assets Year 3 Year 2 Year l

$ $ $
Current assets 3,960 2,610 3,600
Plant and equipment (net of 21,240 19,890 14,400

depreciation)
Total assets 25,200 22,500 18,000
Liabilities & Stockholder's Equity
Current liabilities 2,214 2,052 1,800
Long-term liabilities 4,716 3,708 3,600
Capital stock ($10 par) 12,600 12,600 8,100
Retained earnings 5,670 4,140 4,500
Total liabilities & stockholder's 25,200 22,500 18,000

equity
 PACIFIC CORPORATION
Comparative Income Statements
For Years May 31
(in thousands of dollars)

Assets Year 3 Year 2 Year l

$ $ $
Net sales 90,000 75,000 60,000
Cost of goods sold 58,500 46,500 36,000
Gross Profit on sales 31,500 28,500 24,000
Operating expenses 28,170 25,275 21,240
Income before income taxes 3,330 3,225 2,760
Income taxes 1,530 1,500 1,260
Net income 1,800 1,725 1,500
Cash dividends paid (plus 20% in 270 465 405

stock in Year 2)
Cash dividends per share 063 1.11 1.50

Questions ;
1. Prepare a three-year comparative balance sheet in percentages
rather than dollars, using Year 1 as the base year.

2. Prepare common size comparative income statements for the

three-year period, expressing all items as percentage
components of net sales for each year.

3. Comment on the significant trends and relationships revealed

by the analytical computations in 1 and 2. These comments
should cover current assets and current liabilities, plant and
equipment, capital stock, retained earnings, and dividends.
4. If the capital stock of this company were selling at $ 11.50 per
share, would you consider it to be overpriced, underpriced, or
fairly priced? Consider such factors as book value per share,
earnings per share, dividend yield, trend of sales and trend of
the gross profit percentage. Also consider the types of
investors to whom the stock would be attractive or
unattractive.

CASE-4
BUSINESS DECISION

Combelt Cereal Company is engaged in manufacturing a

breakfast cereal. You are asked to advise management on sales policy
for the coming year.

Two proposals are being considered by management which will"

(i) increase the volume of sales, (ii) reduce the ratio of selling expense
to sales, and (iii) decrease manufacturing cost per unit. These
proposals are as follows:

Proposal No.1: Increase advertising expenditures by offering

premium stamps

It is proposed that each package of cereal will contain premium

stamps which will be redeemed for cash prizes. The estimated cost of
this premium plan for a sales volume of over 500,000 boxes is
estimated at $ 60 per 1,000 boxes sold. The new advertising plan will
take the place of all existing advertising expenditures and the current
selling price of 70 cents per unit will be maintained.

Proposal No. 2 : Reduce selling price of product

 It is proposed that the selling price of the cereal be reduced by
5% and that advertising expenditures be increased over those of the
current year. This plan is an alternative to Proposal No.1, and only
one will be adopted by management.

Management has provided you with the following information as

to the current year's operations:

Quantity sold 500,000 boxes

Selling price per unit $0.70
Manufacturing cost per unit $0.40

Selling expenses, 20% of sales (one-fourth of which was for newspaper

advertising)
Administrative expenses, 6% of sales
Estimates for the coming year for each proposal are shown below:
Proposal No. 1 Proposal No. 2
Increase in unit sales 50% 30%

volume
Decrease in manufacturing 10% 5%

cost per unit

Newspaper advertising None 10% of sales
Other selling expenses 8% of sales 8% of sales
Premium plan expense $ 0.06 per box None
Administrative expenses 5% of sales 10% of sales

Questions:
1. Which of the two proposals should management select?

2. In support of your recommendation, prepare a statement

comparing the income from operations for the current year
with the anticipated income from operations for the coming
year under Proposal No.l and under Proposal No.2. In
preparing the statement use the following column headings:
 Current Year
 Proposal No. 1; and
 Proposal No. 2
 MODEL QUESTION PAPER
Paper 1.6: FINANCIAL AND MANAGEMENT ACCOUNTING
Time : 3 hours Maximum Marks: 100

PART-A (5x8= 40 marks)

Answer any Five questions
1. What are the advantages of management accounting, how it
differ from financial accounting?
2. What are the different types of errors, how this can be managed
well?
3. Describe the various accounting standards.
4. What are the advantages and limitations of ratio analysis?
5. State the difference between cash flow and fund flow statement.
6. State the requisites for an effective budgetary control system.
7. From the trial balance and the additional information of a
public school, prepare Income and Expenditure Account for the
year ending December 31, 1998 and the Balance Sheet as at
that date.

Trial Balance as at December 31, 1998

Amount Amount

(Dr.) Cr.)
Building 2,50,000 Admission Fees 5,000
Furniture 40,000 Tuition Fees 2,00,000
Library Books 60,000 Rent of Hall 4,000
16% Investments 2,00,000 Creditors for Books 6,000

(1-1-98) Supplied
Salaries 2,00,000 Miscellaneous Receipts 12,000

Stationery 15,000 Annual Government 1,40,000

rant
General Expenses 8,000 Donations Received for 25,000
 library books
Annual Sports Expense 6,000 Capital Fund 4,00,000
Cash 1,000
Bank 20,000 Interest on Investments 8,000
8,00,000 8,00,000

Additional Information:
1) Tuition fees receivable for the year 1998 amounted to Rs.
10,000.
2) Salaries payable for the year 1998 amounted to Rs. 12,000
3) Furniture costing Rs. 10,000 was purchased on 1-7-1998.
Charge depreciation on furniture @ 10% p.a.
4) Depreciate building by 5% and library books by 20%.

8. A book keeper while preparing his trial balance finds that the
debit exceeds by Rs. 7,250. Being required to prepare the final
account he places the difference to a suspense account. In the
next year the following mistakes were discovered:

a) A sale of Rs. 4,000 has been passed through the

purchase day book. The entry in the customer's account
has been correctly recorded,

b) Goods worth Rs. 2,500 taken away by the proprietor for

his use has been debited to repairs account;

c) A bill receivable for Rs. 1,300 received from

Krishna has been dishonoured on maturity but no
entry passed;

d) Salary of Rs. 550 paid to a clerk has been debited to his

personal account;
 e) A purchase of Rs. 750 from Raghubir has been debited
to his account. Purchase account has been correctly
debited;

f) A sum of Rs. 2,250 written off as depreciation on

furniture has not been debited to depreciation account.

Draft the journal entries for rectifying the above mistakes and prepare
the suspense account and profit and loss adjustment account
Journal
a) Suspense A/c Dr. 8,000

To Profit & Loss Adjustment A/c 8,000

(Being wrong recording of sales as purchase last

year rectified)
b) Drawings A/c Dr. 2,500

To Profit & Loss Adjustment A/c 2,500

(Being Drawings made last year inadvertently

shown as repairs now rectified)

c) Krishna A/c Dr. 1,300

To Bills Receivable A/c 1,300

(Being bill dishonoured last year now recorded in

the books)
d) To Profit & Loss Adjustment A/c 650 650

Dr.

To Clerk's Personal A/c

(Being salary paid to clerk last year inadvertently

shown in his personal account now rectified)

e) Suspense A/c Dr. 1,500

To Raghubir A/c 1,500

 (Being purchase from Raghubir )shown on debit

side of his account inadvertently now rectified

f) Profit & Loss Adjustment A/c Dr 2,250

To Suspense A/c 2,250

(Being depreciation not shown last year

now rectified)

PART - B (4 x 15 = 60 marks)
Answer any Four questions.
Question No. 15 is compulsory

9. Data Ram maintains his records on single entry system. While

records of business takings and payments have been kept, these
have not been reconciled with cash in hand. From time to time
cash has been paid into a bank account and cheques thereon
have been drawn both for business use and private purposes.
From the following information, prepare the final accounts for
the year 1998:

Assets and liabilities at the beginning and at the end of the

period have given below:

1-1-1998 31-12-1998
Stock 20,000 15,000
Bank Balance 8,000 12,000
Cash in hand 300 400
Debtors 14,000 20,000
Creditors 27,300 30,000
Investments 50,000 50,000
Other transactions are as follows:
Cash paid in bank 1,50,000
Private dividends paid into bank 59,700
Private payments out of bank 26,000
Business payments for goods out of bank 1,22,000
Cash takings 2,50,000
Payment for goods by cash and cheque 1,60,000
Wages 97,700
Delivery Expenses 7,000
Rent and rates 2,000
Lighting 1,000
General Expenses 4,600

During the year, cash amounting to Rs. 20,000 was stolen from the
till. Goods worth Rs. 24,000 were withdrawn from private use. No
record has been kept of amounts taken from cash for personal use
and a difference in calls amounting to Rs. 7,300 is treated as private
expenses.

10. Following are summarised Balance Sheets of 'X' Ltd. as on 31 st

December, 2000 and 2001. You are required to prepare a Funds
Flow Statement for the year ended 31st December, 2001.
Liabilities 2000 2001 Assets 2000 2001
Share Capital 1,00,000 1,25,000 Goodwill - 2,500
General 25,000 30,000 Buildings 1,00,000 95,000

Reserve
P&L A/c 15,250 15,300 Plant 75,000 84,500
Bank Loan 35,000 67,600 Stock- 50,000 37,000

(Long-term)
Creditors 75,000 - Debtors 40,000 32,100
Provision for 15,000 17,500 Bank - 4,000

Tax
Cash 250 300
2,65,250 2,55,400 2,65,250 2,55,400

Additional Information:
 (i) Dividend of Rs.11,500 was paid.
(ii) Depreciation written off on plar.t Rs. 7,000 and on buildings
Rs. 5,000.
(iii) Provision for tax was made during the year Rs. 16,500.

11. From the following Balance Sheets of Exe. Ltd. Make out the
statement of sources and uses of cash:

Liabilities 2000 2001 Assets 2000 2001

Equity Share 3,00,000 4,00,000 Goodwill 1,15,000 90,000

Capital
8% Redeemable 1.50.000 1,00,000 Land and 2,00,000 1,70,000

Preference Share Buildings

Capital
General Reserve 40,000 70,000 Plant 80,000 2,00,000
Profit & Loss 30,000 48,00 Debtors 1,60,000 2,00,000

Account
Proposed 42,000 50,000 Stock 77,000 1,09,000

Dividend
Creditors 55,000 83,000. Bills 20,000 30,000

Receivable
Bill Payable 20,000 16,000 Cash in 15,000 10,000

Hand
Provision for 40,000 50,000 Cash at 10,000 8,000

Taxation Bank
6,77,000 8,17,000 6,77,000 8,17,000

Additional info
(a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged
on Plant and Land and Building respectively in 2001.
(b) An interim dividend of Rs. 20,000 has been paid in 2000,
(c) Rs. 35,000 Income-tax was paid during the year 2001.
2. Gama Engineering Company Limited manufacturers two
Products X and Y. An estimate of the number of units expected
to be sold in the firs; seven months of 2001 is given below:

Months Product X Product Y

January 500 1,400

February 600 1,400
March 800 1,200
April 1,000 1,000
May 1,200 800
June 1,200 800
July 1,000 980

It is anticipated that:

(a) There will be no work-in-progress at the end of any month;

(b) Finished units equal to half the anticipated sales for the next
month will be in stock at the end of each month (including
June 2001).

The budgeted production and production costs for the year ending 3l rt
June, 2001 are as follows:
 Particulars Product X Product Y
Production (Units) 11,000 12,000
Direct materials per unit (Rs.) 12 19
Direct wages per unit (Rs.) 5 7
Other manufacturing charges (Rs.) 33,000 48,000

apportionable to each type of

product

You are required to prepare:

a) Production budget showing the number of units to be
manufactured each month.

b) Summarised production cost budget for the 6 month-period

January to June – 2001.

13. A firm is considering the purchase of a machine. Two machines

A and B are available, each costing Rs.50,000. In comparing the
profitability of those machines a discount rate of 10% is to be
used. Earnings after taxation are expected to be as follows:

Year Machine A cash Machine B cash

Inflow Inflow
Rs. Rs.
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000

You are also given the following data:

Year PV Factor @ 10%

discount
 1 0.909
2 0.826
3 0.751
4 0.683
5 0.621

Evaluate the projects using :

(a) the pay-back period
(b) the accounting rate of return
(c) the net present value
(d) the profitability index
 14. Following are Balance sheet of Vinay Ltd. for the year ended 31 st
December 2000 and 2001.
Liabilities 2000 2001 Assets 2000 2001
Rs. Rs. Rs. Rs.
Equity capital 1,00,000 1,65,000 Fixed Assets 1,20,000 1,75,000

(Net)
Pref. Capital 50,000 75,000 Stock 20,000 25,000
Reserves 10,000 15,000 Debtors 50,000 62,500
P&L A/c 7,500 10,000 Bills 10,000 30,000

receivable
Creditors 20,000 25,000 Cash at 20,000 26,500

Bank
Provision for 10,000 12,500 Cash in 5,000 15,000

taxation hand
Proposed dividends 7,500 12,500
2,30,000 3,40(000 2,30,000 3,40,000
Prepare a common size balance sheet and interpret the same.
15. Attempt the following Case:

CASE: BUSINESS DECISION

Condensed comparative financial statements for appear
below:

PACIFIC CORPORATION
Comparative Balance Sheets
As of May 31
(in thousands of dollars)

Assets Year 3 Year 2 Year 1

$ $ $
Current assets 3,960 2,610 3,600
Plant and equipment (net of 21,240 19,890 14,400

depreciation)
Total assets 25,200 22,500 18,000
Liabilities & Stockholder's Equity
Current liabilities 2,214 2,052 1,800
Long-term liabilities 4,716 3,708 3,600
Capital stock ($10 par) 12,600 12,600 8,100
Retained earnings 5,670 4,140 4,500
Total liabilities & stockholder's 25,200 22,500 18,000

equity
 PACIFIC CORPORATION
Comparative Income Statements
For Years May 31
(in thousands of dollars)

Assets Year 3 Year 2 Year 1

$ $ $
Net sales 90,000 75,000 $ 60,000
Cost of goods sold 58,500 46,500 36,000
Gross Profit on sales 31,500 28,500 24,000
Operating expenses 28,170 25,275 21,240
Income before Income taxes 3,330 3,225 2,760
Income taxes 1,530 1,500 1,260
Net income 1,800 1,725 1,500
Cash dividends paid (plus 20% in 270 465 405

stock in Year 2)
Cash dividends per share 0.63 1.11 1.50

Questions:

1. Prepare a three-year comparative balance sheet in

percentages rather than dollars, using Year 1 as the base
year.

2. Prepare common size comparative income statements for the

three-year period, expressing all items as percentage
components of net sales for each year,

3. Comment on the -significant trends and relationships revealed

by the analytical computations in 1 and 2. These comments
should cover current assets and current liabilities, plant and
equipment, capital stock, retained earnings, and dividends.

4. If the capital stock of this company were selling at $ 11.50 per

share, would you consider it to be overpriced, underpriced, or
fairly priced? Consider such factors as book value per share,
earnings per share, dividend yield, trend of sales and trend of
the gross profit percentage. Also consider the types of
investors to whom the stock would be attractive or
unattractive.