St.

Xavier’s Catholic College of Engineering

Department of Management Studies
Chunkankadai-629003

ACCOUNTING FOR MANAGEMENT – STUDY MATERIAL

DEGREE – MASTER OF BUSINESS ADMINSTRATION

Prepared By

G.Jenit Hanson
 MS22104 - ACCOUNTING FOR MANAGEMENT

UNIT I FINANCIAL ACCOUNTING 9

Introduction to Financial, Cost and Management Accounting – Generally accepted accounting

principles– Double Entry System – Preparation of Journal, Ledger and Trial Balance Preparation of

Final Accounts: Trading, Profit and Loss Account and Balance Sheet - Reading the financial statements

UNIT II ANALYSIS OF FINANCIAL STATEMENTS 9

Financial ratio analysis, Interpretation of ratio for financial decisions- Dupont Ratios – Comparative

statements - common size statements. Cash flow (as per Accounting Standard 3) and Funds flow

statement analysis – Trend Analysis.

UNIT III COST ACCOUNTING 9

Cost Accounts – Classification of costs – Job cost sheet – Job order costing – Process costing –

(excluding Interdepartmental Transfers and equivalent production) – Joint and By Product Costing –

Activity Based Costing, Target Costing.

UNIT IV MARGINAL COSTING 9

Marginal Costing and profit planning – Cost, Volume, Profit Analysis – Break Even Analysis –

Decision making problems -Make or Buy decisions -Determination of sales mix - Exploring new

markets - Add or drop products -Expand or contract.

UNIT V BUDGETING AND VARIANCE ANALYSIS 9

Budgetary Control – Sales, Production, Cash flow, fixed and flexible budget – Standard costing and

Variance Analysis – (excluding overhead costing) -Accounting standards and accounting disclosure

practices in India.
 ACCOUNTING FOR MANAGEMENT – STUDY MATERIAL

UNIT I FINANCIAL ACCOUNTING

Introduction to Financial, Cost and Management Accounting – Generally accepted
accounting principles– Double Entry System – Preparation of Journal, Ledger and Trial
Balance Preparation of Final Accounts: Trading, Profit and Loss Account and Balance Sheet
- Reading the financial statements

Introduction
Accounting is a business language which elucidates the various kinds of transactions
during the given period of time. Accounting is defined as either recording or recounting the
information of the business enterprise, transpired during the specific period in the summarized
form.
What is meant by accounting?
Accounting is broadly classified into three different functions viz

American Institute of Certified Public Accountants Association defines the term

accounting as follows "Accounting is the process of recording, classifying, summarizing in a
significant manner of transactions which are in financial character and finally results are
interpreted."
MEANING AND DEFINITION OF BOOK- KEEPING
Meaning
Book- keeping includes recording of journal, posting in ledgers and balancing of
accounts. All the records before the preparation of trail balance is the whole subject matter of
book- keeping. Thus, book- keeping many be defined as the science and art of recording
transactions in money or money’s worth so accurately and systematically, in a certain set of
books, regularly that the true state of businessman’s affairs can be correctly ascertained. Here it
is important to note that only those transactions related to business are recorded which can be
expressed in terms of money.
Definition
“Book- keeping is the art of recording business transactions in a systematic manner”.
A.H.Rosenkamph.
“Book- keeping is the science and art of correctly recording in books of account all
those business transactions that result
in the transfer of money or money’s worth”. R.N.Carter
Objectives of Book- keeping
I. Book- keeping provides a permanent record of each transactions.
II. Soundness of a firm can be assessed from the records of assets and abilities on a particular
date.
III. Entries related to incomes and expenditures of a concern facilitate to know the profit and
loss for a given period.
IV. It enables to prepare a list of customers and suppliers to ascertain the amount to be
received or paid.
V. It is a method gives that opportunity to review the business policies in the light of the past
records.
VI. Amendment of business laws, provision of licenses, assessment of taxes etc., are based on
records.
Meaning of Accounting
Accounting, as an information system is the process of identifying, measuring and
communicating the economic information of an organization to its users who need the
information for decision making. It identifies transactions and events of a specific entity. A
transaction is an exchange in which each participant receives or sacrifices value (e.g. purchase of
raw material). An event (whether internal or external) is a happening of consequence to an entity
(e.g. use of raw material for production). An entity means an economic unit that performs
economic activities.
Definition of Accounting
American Institute of Certified Public Accountants (AICPA) which defines accounting
as “the art of recording, classifying and summarizing in a significant manner and in terms of
money, transactions and events, which are, in part at least, of a financial character and
interpreting the results thereof’.
Objectives of Accounting
Objective of accounting may differ from business to business depending upon their
specific requirements. However, the following are the general objectives of accounting.
i) To keeping systematic record: It is very difficult to remember all the business
transactions that take place. Accounting serves this purpose of record keeping by
promptly recording all the business transactions in the books of account.
ii) To ascertain the results of the operation: Accounting helps in ascertaining result i.e.,
profit earned or loss suffered in business during a particular period. For this purpose, a
business entity prepares either a Trading and Profit and Loss account or an Income and
Expenditure account which shows the profit or loss of the business by matching the items
of revenue and expenditure of the same period.
iii) To ascertain the financial position of the business: In addition to profit, a
businessman must know his financial position i.e., availability of cash, position of assets
and liabilities etc. This helps the businessman to know his financial strength. Financial
statements are barometers of health of a business entity.
iv) To portray 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 distributions of
resources by the enterprise to owners and about other factors that may affect an
enterprise’s liquidity and solvency.
v) To protect business properties: Accounting provides upto date information about the
various assets that the firm possesses and the liabilities the firm owes, so that nobody can
claim a payment which is not due to him. To facilitate rational decision - making:
Accounting records and financial statements provide financial information which help the
business in making rational decisions about the steps to be taken in respect of various
aspects of business.
 vi) To satisfy the requirements of law: Entities such as companies, societies, public trusts are
compulsorily required to maintain accounts as per the law governing their operations
such as the Companies Act, Societies Act, and Public Trust Act etc. Maintenance of
accounts is also compulsory under the Sales Tax Act and Income Tax Act.
Importance of Accounting
i) Owners: The owners provide funds or capital for the organization. They possess
curiosity in knowing whether the business is being conducted on sound lines or not and
whether the capital is being employed properly or not. Owners, being businessmen,
always keep an eye on the returns from the investment. Comparing the accounts of
various years helps in getting good pieces of information.
ii) Management: The management of the business is greatly interested in knowing the
position of the firm. The accounts are the basis; the management can study the merits and
demerits of the business activity. Thus, the management is interested in financial
accounting to find whether the business carried on is profitable or not. The financial
accounting is the “eyes and ears of management and facilitates in drawing future course
of action, further expansion etc.”
iii) Creditors: Creditors are the persons who supply goods on credit, or bankers or
lenders of money. It is usual that these groups are interested to know the financial
soundness before granting credit. The progress and prosperity of the firm, two which
credits are extended, are largely watched by creditors from the point of view of security
and further credit. Profit and Loss Account and Balance Sheet are nerve centres to know
the soundness of the firm.
iv) Employees: Payment of bonus depends upon the size of profit earned by the firm.
The more important point is that the workers expect regular income for the bread. The
demand for wage rise, bonus, better working conditions etc. depend upon the profitability
of the firm and in turn depends upon financial position. For these reasons, this group is
interested in accounting.
v) Investors: The prospective investors, who want to invest their money in a firm, of
course wish to see the progress and prosperity of the firm, before investing their amount,
by going through the financial statements of the firm. This is to safeguard the investment.
For this, this group is eager to go through the accounting which enables them to know the
 safety of investment.
vi) Government: Government keeps a close watch on the firms which yield good
amount of profits. The state and central Governments are interested in the financial
statements to know the earnings for the purpose of taxation. To compile national
accounting is essential.
vii) Consumers: These groups are interested in getting the goods at reduced price. Therefore,
they wish to know the establishment of a proper accounting control,which in turn will
reduce to cost of production, in turn less price to be paid by the consumers. Researchers
are also interested in accounting for interpretation.
viii) Research Scholars: Accounting information, being a mirror of the financial performance
of a business organization, is of immense value to the research scholar who wants to
make a study into the financial operations of a particular firm. To make a study into the
financial operations of a particular firm, the research scholar needs detailed accounting
information relating to purchases, sales, expenses, cost of materials used, current assets,
current liabilities, fixed assets, long-term liabilities and share-holders funds which is
available in the accounting record maintained by the firm.

Functions of Accounting
i) Record Keeping Function: The primary function of accounting relates to recording,
classification and summary of financial transactions-journalisation, posting, and preparation of
final statements. These facilitate to know operating results and financial positions. The purpose
of this function is to report regularly to the interested parties by means of financial statements.
Thus accounting performs historical function i.e., attention on the past performance of a
business; and this facilitates decision making programme for future activities.
ii) Managerial Function: Decision making programme is greatly assisted by accounting.
The managerial function and decision making programmes, without accounting, may mislead.
The day-to-day operations are compared with some predetermined standard. The variations of
actual operations with pre-determined standards and their analysis is possible only with the help
of accounting.
iii) Legal Requirement function: Auditing is compulsory in case of registered firms.
Auditing is not possible without accounting. Thus accounting becomes compulsory to comply
with legal requirements. Accounting is a base and with its help various returns, documents,
statements etc., are prepared.
iv) Language of Business: Accounting is the language of business. Various transactions
are communicated through accounting. There are many parties-owners, creditors, government,
employees etc., who are interested in knowing the results of the firm and this can be
communicated only through accounting. The accounting shows a real and true position of the
firm or the business.
Advantages of Accounting
The following are the advantages of accounting to a business:
i) It helps in having complete record of business transactions.
ii) It gives information about the profit or loss made by the business at the close of a year
and its financial conditions. The basic function of accounting is to supply meaningful
information about the financial activities of the business to the owners and the managers.
iii) It provides useful information from making economic decisions,
iv) It facilitates comparative study of current year’s profit, sales, expenses etc., with those of
the previous years.
v) It supplies information useful in judging the management’s ability to utilize enterprise
resources effectively in achieving primary enterprise goals.
vi) It provides users with factual and interpretive information about transactions and other
events which are useful for predicting, comparing and evaluation the enterprise’s earning
power.
vii) It helps in complying with certain legal formalities like filing of income- tax and sales-tax
returns. If the accounts are properly maintained, the Assessment of taxes is greatly facilitated.
Limitations of Accounting
i) Accounting is historical in nature. It does not reflect the current financial position or
worth of a business.
ii) Transactions of non-monetary nature do not find place in accounting. Accounting is
limited to monetary transactions only. It excludes qualitative elements like
management, reputation, employee morale, labour strike etc.
iii) Facts recorded in financial statements are greatly influenced by accounting
conventions and personal judgements of the Accountant or Management. Valuation
 of inventory, provision for doubtful debts and assumption about useful life of an asset
may, therefore, differ from one business house to another.
iv) Accounting principles are not static or unchanging-alternative accounting procedures
are often equally acceptable. Therefore, accounting statements do not always present
comparable data
v) Cost concept is found in accounting. Price changes are not considered. Money value
is bound to change often from time to time. This is a strong limitation of accounting.
vi) Accounting statements do not show the impact of inflation.
vii) The accounting statements do not reflect those increase in net asset values that are not
considered realized.
Methods of Accounting
Business transactions are recorded in two different ways.
1. Single Entry
2. Double Entry
Single Entry: It is incomplete system of recording business transactions. The business
organization maintains only cash book and personal accounts of debtors and creditors. So the
complete recording of transactions cannot be made and trail balance cannot be prepared.
Double Entry: It this system every business transaction is having a two fold effect of benefits
giving and benefit receiving aspects. The recording is made on the basis of both these aspects.
Double Entry is an accounting system that records the effects of transactions and other events in
atleast two accounts with equal debits and credits.
Steps involved in Double entry system
(a) Preparation of Journal: Journal is called the book of original entry. It records the
effect of all transactions for the first time. Here the job of recording takes place.
(b) Preparation of Ledger: Ledger is the collection of all accounts used by a business.
Here the grouping of accounts is performed. Journal is posted to ledger.
(c) Trial Balance preparation: Summarizing. It is a summary of ledge balances
prepared in the form of a list.
(d) Preparation of Final Account: At the end of the accounting period to know the
achievements of the organization and its financial state of affairs, the final accounts
are prepared.
Advantages of Double Entry System
i) Scientific system: This system is the only scientific system of recording business
transactions in a set of accounting records. It helps to attain the objectives of accounting.
ii) Complete record of transactions: This system maintains a complete record of all
business transactions.
iii) A check on the accuracy of accounts: By use of this system the accuracy of
accounting book can be established through the device called a Trail balance.
iv) Ascertainment of profit or loss: The profit earned or loss suffered during a period
can be ascertained together with details by the preparation of Profit and Loss Account.
v) Knowledge of the financial position of the business: The financial position of
the firm can be ascertained at the end of each period, through the preparation of balance
sheet.
vi) Full details for purposes of control: This system permits accounts to be
prepared or kept in as much detail as necessary and, therefore, affords significant
information for purposes of control.
vii) Comparative study is possible: Results of one year may be compared with thoseof the
previous year and reasons for the change may be ascertained.
viii) Helps management in decision making: The management may be also obtain good
information for its work, especially for making decisions.
ix) No scope for fraud: The firm is saved from frauds and misappropriations since
full information about all assets and liabilities will be available.
Meaning of Debit and Credit
The term ‘debit’ is supposed to have derived from ‘debit’ and the term ‘credit’ from
‘creditable’. For convenience ‘Dr’ is used for debit and ‘Cr’ is used for credit. Recording of
transactions require a thorough understanding of the rules of debit and credit relating to accounts.
Both debit and credit may represent either increase or decrease, depending upon the nature of
account.
Types of Accounts
The object of book-keeping is to keep a complete record of all the transactions that place
in the business. To achieve this object, business transactions have been classified into three
categories:
 (i) Transactions relating to persons.
(ii) Transactions relating to properties and assets
(iii) Transactions relating to incomes and expenses.
The accounts falling under the first heading are known as ‘Personal Accounts’. The
accounts falling under the second heading are known as ‘Real Accounts’, The accounts falling
under the third heading are called ‘Nominal Accounts’.
Personal Accounts
Accounts recording transactions with a person or group of persons are known as personal
accounts. These accounts are necessary, in particular, to record credit transactions. Personal
accounts are of the following types:
(a) Natural persons: An account recording transactions with an individual human
being is termed as a natural persons’ personal account. eg., Kamal’s account, Mala’s
account, Sharma’s accounts. Both males and females are included in it
(b) Artificial or legal persons: An account recording financial transactions with an
artificial person created by law or otherwise is termed as an artificial person, personal
account, e.g. Firms’ accounts, limited companies’ accounts, educational institutions’
accounts, Co-operative society account.
(c) Groups/Representative personal Accounts: An account indirectly representing a person
or persons is known as representative personal account. When accounts are of a similar
nature and their number is large, it is better to group them under one head and open
representative personal accounts e.g., prepaid insurance, outstanding salaries, rent, wages
etc.
When a person starts a business, he is known as proprietor. This proprietor is represented
by capital account for that entire he invests in business and by drawings accounts for all that
which he withdraws from business. So, capital accounts and drawings account are also personal
accounts.
The rule for personal accounts is: Debit the receiver
Credit the giver
Real Accounts
Accounts relating to properties or assets are known as ‘Real Accounts’, A separate
account is maintained for each asset e.g., Cash Machinery, Building, etc., Real accounts can be
further classified into tangible and intangible.
(a) Tangible Real Accounts: These accounts represent assets and properties which can
be seen, touched, felt, measured, purchased and sold. e.g. Machinery account Cash
account, Furniture account, stock account etc.
(b) Intangible Real Accounts: These accounts represent assets and properties which
cannot be seen, touched or felt but they can be measured in terms of money. e.g.,
Goodwill accounts, patents account, Trademarks account, Copyrights account, etc.
The rule for Real accounts is: Debit what comes in
Credit what goes out
Nominal Accounts
Accounts relating to income, revenue, gain, expenses and losses are termed as nominal
accounts. These accounts are also known as fictitious accounts as they do not represent any
tangible asset. A separate account is maintained for each head orexpense or loss and gain or
income. Wages account, Rent account, Commission account, Interest received account are some
examples of nominal account
The rule for Nominal accounts is: Debit all expenses and losses
Credit all incomes and gains

DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

The difference between book-keeping and accounting can be summarized in a tabular
from as under:
Basis of difference Book-keeping Accounting

Transactions Recording of transactions in books of To examine these recorded

original entry. transactions in order to find out
Posting To make posting in ledger To examine this posting in order
to ascertain its accuracy.
Total and Balance To make total of the amount in journal To prepare trial balance with the
and accounts of ledger. To ascertain help of balances of ledger

Income Statement Preparation of trading, Profit & loss Preparation of trading, profits
and Balance Sheet account and balance sheet is not book and loss account and balance

Rectification of These are not included in book-keeping These are included in

Special skill and It does not require any special skill and It requires special skill and
knowledge knowledge as in advanced countries knowledge.

Liability A book-keeper is not liable for An accountant is liable for the

accountant work. work of bookkeeper.

Objectives of Accounting
1. Systematic and scientific record of events
2. Find out the operational efficiency
3. Effective control over inflows and outflows
4. Help the different parties related to the business

PROCESS OF ACCOUNTING
PRINCIPLES OF ACCOUNTING
INTRODUCTION
The word ‘Principle’ has been differently viewed by different schools of thought. The
word ‘principle’ as a general law of rule adopted or professed as a guide to action; a settled
ground or basis of conduct of practice”
Accounting principles refer, to certain rules, procedures and conventions which represent
a consensus view by those indulging in good accounting practices and procedures. The
accounting principle as “the body of doctrines commonly associated with the theory and
procedure of accounting, serving as an explanation of current practices as a guide for the
selection of conventions or procedures where alternatives exist. Rules governing the formation of
accounting axioms and the principles derived from them have arisen from common experiences,
historical precedent, statements by individuals and professional bodies and regulations of
Governmental agencies”. To be more reliable, accounting statements are prepared in conformity
with these principles. If not, chaotic conditions would result. But in reality as all the businesses
are not alike, each one has its own method of accounting. However, to be more acceptable, the
accounting principles should satisfy the following three basic qualities, viz., relevance,
objectivity and feasibility. The accounting principle is considered to be relevant and useful to the
extent that it increases the utility of the records to its readers. It is said to be objective to the
extent that it is supported by the facts and free from personal bias. It is considered to be feasible
to the extent that it is practicable with the least complication or cost. Though accounting
principles are denoted by various terms such as concepts, conventions, doctrines, tenets,
assumptions, axioms, postulates, etc., it can be classified into two groups, viz., accounting
concepts and accounting conventions.
ACCOUNTING CONCEPTS AND CONVENTIONS
Accounting concepts:
The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or
conditions upon the edifice of which the accounting super-structure is based. The following are
the common accounting concepts adopted by many business concerns.
1. Business Entity Concept 2. Money Measurement Concept
3.Going Concern Concept 4. Dual Aspect Concept
5.Periodicity Concept 6. Historical Cost Concept
7. Matching Concept 8. Realisation Concept
9. Accrual Concept 10. Objective Evidence Concept
i) Business Entity Concept: A business unit is an organization of persons established
to accomplish an economic goal. Business entity concept implies that the business unit is
separate and distinct from the persons who provide the required capital to it. This concept
can be expressed through an accounting equation, viz., Assets = Liabilities + Capital. The
equation clearly shows that the business itself owns the assets and in turn owes to various
claimants. It is worth mentioning here that the business entity concept as applied in
accounting for sole trading units is different from the legal concept. The expenses,
income, assets and liabilities not related to the sole proprietorship business are excluded
from accounting. However, a sole proprietor is personally liable and required to utilize
 non-business assets or private assets also to settle the business creditors as per law. Thus,
in the case of sole proprietorship, business and non-business assets and liabilities are
treated alike in the eyes of law. In the case of a partnership, firm, for paying the business
liabilities the business assets are used first and it any surplus remains thereafter, it can be
used for paying off the private liabilities of each partner. Similarly, the private assets are
first used to pay off the private liabilities of partners and if any surplus remains, it is
treated as part of the firm’s property and is used for paying the firm’s liabilities. In the
case of a company, its existence does not depend on the life span of any shareholder.
ii) Money Measurement Concept: In accounting all events and transactions are recode
in terms of money. Money is considered as a common denominator, by means of which
various facts, events and transactions about a business can be expressed in terms of
numbers. In other words, facts, events and transactions which cannot be expressed in
monetary terms are not recorded in accounting. Hence, the accounting does not give a
complete picture of all the transactions of a business unit. This concept does not also take
care of the effects of inflation because it assumes a stable value for measuring.
iii) Going Concern Concept: Under this concept, the transactions are recorded
assuming that the business will exist for a longer period of time, i.e., a business unit is
considered to be a going concern and not a liquidated one. Keeping this in view, the
suppliers and other companies enter into business transactions with the business unit.
This assumption supports the concept of valuing the assets at historical cost or
replacement cost. This concept also supports the treatment of prepaid expenses as assets,
although they may be practically unsaleable.
iv) Dual Aspect Concept: According to this basic concept of accounting, every
transaction has a two-fold aspect, viz., 1.Giving certain benefits and 2. Receiving certain
benefits. The basic principle of double entry system is that every debit has a
corresponding and equal amount of credit. This is the underlying assumption of this
concept. The accounting equation viz., Assets = Capital + Liabilities or Capital = Assets -
Liabilities, will further clarify this concept, i.e., at any point of time the total assets of the
business unit are equal to its total liabilities. Liabilities here relate both to the outsiders
and the owners. Liabilities to the owners are considered as capital.
v) Periodicity Concept: Under this concept, the life of the business is segmented into
different periods and accordingly the result of each period is ascertained. Though the business is
assumed to be continuing in future (as per going concern concept), the measurement of income
and studying the financial position of the business for a shorter and definite period will help in
taking corrective steps at the appropriate time. Each segmented period is called “accounting
period” and the same is normally a year. The businessman has to analyse and evaluate the results
ascertained periodically. At the end of an accounting period, an Income Statement is prepared to
ascertain the profit or loss made during that accounting period and Balance Sheet is prepared
which depicts the financial position of the business as on the last day of that period. During the
course of preparation of these statements capital revenue items are to be necessarily
distinguished.
i) Historical Cost Concept: According to this concept, the transactions are recorded
in the books of account with the respective amounts involved. For example, if an asset is
purchases, it is entered in the accounting record at the price paid to acquire the same and
that cost is considered to be the base for all future accounting. It means that the asset is
recorded at cost at the time of purchase but it may be methodically reduced in its value by
way of charging depreciation. However, in the light of inflationary conditions, the
application of this concept is considered highly irrelevant for judging the financial
position of the business.
ii) Matching Concept: The essence of the matching concept lies in the view that all
costs which are associated to a particular period should be compared with the revenues
associated to the same period to obtain the net income of the business. Under this
concept, the accounting period concept is relevant and it is this concept (matching
concept) which necessitated the provisions of different adjustments for recording
outstanding expenses, prepaid expenses, outstanding incomes, incomes received in
advance, etc., during the course of preparing the financial statements at the end of the
accounting period.
iii) Realisation Concept: This concept assumes or recognizes revenue when a sale is
made. Sale is considered to be complete when the ownership and property are transferred
from the seller to the buyer and the consideration is paid in full. However, there are two
exceptions to this concept, viz., 1. Hire purchase system where the ownership is
transferred to the buyer when the last instalment is paid and 2. Contract accounts, in
 which the contractor is liable to pay only when the whole contract is completed, the profit
is calculated on the basis of work certified each year.
iv) Accrual Concept: According to this concept the revenue is recognized on its
realization and not on its actual receipt. Similarly the costs are recognized when they are
incurred and not when payment is made. This assumption makes it necessary to give
certain adjustments in the preparation of income statement regarding revenues and costs.
But under cash accounting system, the revenues and costs are recognized only when they
are actually received or paid. Hence, the combination of both cash and accrual system is
preferable to get rid of the limitations of each system.
v) Objective Evidence Concept: This concept ensures that all accounting must be
based on objective evidence, i.e., every transaction recorded in the books of account must
have a verifiable document in support of its, existence. Only then, the transactions can be
verified by the auditors and declared as true or otherwise. The verifiable evidence for the
transactions should be free from the personal bias, i.e., it should be objective in nature
and not subjective. However, in reality the subjectivity cannot be avoided in the aspects
like provision for bad and doubtful debts, provision for depreciation, valuation of
inventory, etc., and the accountants are required to disclose the regulations followed.
Accounting Conventions
The following conventions are to be followed to have a clear and meaningful information
and data in accounting:
i) Consistency: The convention of consistency refers to the state of accounting rules,
concepts, principles, practices and conventions being observed and applied constantly,
i.e., from one year to another there should not be any change. If consistency is there, the
results and performance of one period can he compared easily and meaningfully with the
other. It also prevents personal bias as the persons involved have to follow the consistent
rules, principles, concepts and conventions. This convention, however, does not
completely ignore changes. It admits changes wherever indispensable and adds to the
improved and modern techniques of accounting.
ii) Disclosure: The convention of disclosure stresses the importance of providing
accurate, full and reliable information and data in the financial statements which is of
material interest to the users and readers of such statements. This convention is given
 due legal emphasis by the Companies Act, 1956 by prescribing formats for the
preparation of financial statements. However, the term disclosure does not mean all
information that one desires to get should be included in accounting statements. It is
enough if sufficient information, which is of material interest to the users, is included.
iii) Conservatism: In the prevailing present day uncertainties, the convention of
conservatism has its own importance. This convention follows the policy of caution or
playing safe. It takes into account all possible losses but not the possible profits or gains.
A view opposed to this convention is that there is the possibility of creation of secret
reserves when conservatism is excessively applied, which is directly opposed to the
convention of full disclosure. Thus, the convention of conservatism should be applied
very cautiously.

BRANCHES OF ACCOUNTING
The changing business scenario over the centuries gave rise to specialized branches of
accounting which could cater to the changing requirements. The branches of accounting are;
i) Financial accounting;
ii) Cost accounting; and
iii) Management accounting.

Financial Accounting
Financial accounting may be defined as the science and art of recording and classifying
business transactions and preparing summaries of the same for determining year and profit and
loss and the financial position of the concern.
Functions of Financial Accounting
1. Recording information
2. Classification of data
3. Making Summaries
4. Dealing with financial transaction
5. Interpreting financial information
6. Communicating results
 7. Making Information more reliable
Limitations of Financial Accounting
1. Historical Nature
2. Provides information about the concern as a whole
3. Not helpful in price fixation
4. Cost control not possible
5. Appraisal of Policies not possible
6. Only actual costs recorded
7. Not helpful in taking strategic decision
8. Changes of manipulations
Cost Accounting
Cost Accounting is the classifying, recording and appropriate allocation of expenditure for
the determination of the costs of products or services and for the presentation of suitably
arranged data for purpose of control and guidance management
Scope of cost accounting
Cost ascertainment
Cost Accounting
Cost Control

Advantages Of Cost Accounting

1. Profitable and unprofitable activities are disclose.
2. It enables a concern to measure the efficiency and then to maintain and improve it.
3. It provides information upon which estimates and tenders are based.
4. It guides future production policies
5. It helps in increasing profits
6. It enables a periodical determination of Profit and loss.
7. Helpful to the government
8. Helpful to consumers
9. Efficiency of public enterprises
Financial Accounting Vs Cost Accounting
  Purpose
 Forms of accounting (Companies Act.)
 Recording (Nature of exp.)
 Control
 Periodicity of reporting
 Analysis of profits
 Reporting of costs
 Nature of transaction (commercial transaction)
 Information (Monetary & Non monetary)
 Fixation of selling price
 Figures (Actual & Estimated data)
 Reference (Company law board)
 Relative Efficiency

Management Accounting
It is study about managerial aspect of accounting “Management accounting is concerned with
the accounting information that is useful to management”
Characteristics – Management Accounting
1. Providing Accounting Information
2. Cause and effect Analysis
3. Use of special techniques and concepts
4. Taking important decision
5. Achieving of objectives
6. No fixed norms followed
7. Increase in efficiency
8. Supplies information are not decision
9. Concerned with forecasting
Objectives – Management Accounting
1. Planning and policy formulation
2. Helpful in controlling performance
3. Helpful in organizing
 4. Helpful in interpretation financial statements
5. Motivating employees
6. Helps in making decision
7. Helpful in co-ordination
8. Report to management
9. Tax Administration
Management Accounting Vs Financial Accounting
 Object
 Nature (Historical)
 Subject Matter (Whole business)
 Compulsion
 Precision (figures)
 Reporting (outsiders)
 Description (Monetary & non-monetary)
 Quickness
 Accounting principles
 Period
 Publication
 Audit
ACCOUNTING RECORDS
JOURNAL AND LEDGER
INTRODUCTION
When the business transactions take place, the first step is to record the same in the books
of original entry or subsidiary books or books of prime or journal. Thus journal is a simple book
of accounts in which all the business transactions are originally recorded in chronological order
and from which they are posted to the ledger accounts at any convenient time. Journalsing refers
to the act of recording each transaction in the journal and the form in which it is recorded, is
known as a journal entry.
ADVANTAGES OF JOURNAL
The following are the inherent advantages of using journal, though the transactions can
also be directly recorded in the respective ledger accounts;
 1. As all the transactions are entered in the journal chronologically, a date wise record
can easily be maintained;
2. All the necessary information and the required explanations regarding all transactions
can be obtained from the journal; and
3. Errors can be easily located and prevented by the use ofjournal or book of prime
entry.
The specimen journal is as follows:
Date Particulars L.F. Debit Credit
Rs. Rs.

1 2 3 4 5
- -

The journal has five columns, viz. (1) Date; (2) Particulars; (3) Ledger Folio; (4)
Amount (Debit); and (5) Amount (Credit) and a brief explanation of the transaction by way of
narration is given after passing the journal entry.
(1) Date: In each page of the journal at the top of the date column, the year is written
and in the next line, month and date of the first entry are written. The year and month need not be
repeated until a new page is begun or the month or the year changes. Thus, in this column, the
date on which the transaction takes place is alone written.
(2) Particulars: In this column, the details regarding account titles and description are
recorded. The name of the account to be debited is entered first at the extreme left of the
particulars column next to the date and the abbreviation ‘Dr.’ is written at the right extreme of
the same column in the same line. The name of the account to be credited is entered in the next
line preceded by the word “To” leaving a few spaces away from the extreme left of the
particulars column. In the next line immediately to the account credited, a short about the
transaction is given which is known as “Narration”. “Narration” may include particulars required
to identify and understand the transaction and should be adequate enough to explain the
transaction. It usually starts with the word “Being” which means what it is and is written within
parentheses. The use of the word “Being” is completely dispense with, in modern parlance. To
indicate the completion of the entry for a transaction, a line is usually drawn all through the
particulars column.
(3) Ledger Folio: This column is meant to record the reference of the main book, i.e.,
ledger and is not filled in when the transactions are recorded in the journal. The page number of
the ledger in which the accounts are appearing is indicated in this column, while the debits and
credits are posted o the ledger accounts.
(4) Amount (Debit): The amount to be debited along with its unit of measurement at
the top of this column on each page is written against the account debited.
(5) Amount (Credit): The amount to be credited along with its unit of measurement at
the top of this column on each page is written against the account credited.
SUB-DIVISION OF JOURNAL
When innumerable number of transactions takes place, the journal, as the sole book of
the original entry becomes inadequate. Thus, the number and the number and type of journals
required are determined by the nature of operations and the volume of transactions in a particular
business. There are many types of journals and the following are the important ones:
1. Sales Day Book- to record all credit sales.
2. Purchases Day Book- to record all credit purchases.
3. Cash Book- to record all cash transactions of receipts as well as payments.
4. Sales Returns Day Book- to record the return of goods sold to customers on credit.
5. Purchases Returns Day Book- to record the return of goods purchased from suppliers on
credit.
6. Bills Receivable Book- to record the details of all the bills received.
7. Bills Payable Book- to record the details of all the bills accepted.
8. Journal Proper-to record all residual transactions which do not find place in any of the
aforementioned books of original entry.
LEDGER
Ledger is a main book of account in which various accounts of personal, real and
nominal nature, are opened and maintained. In journal, as all the business transactions are
recorded chronologically, it is very difficult to obtain all the transactions pertaining to one head
of account together at one place. But, the preparation of different ledger accounts helps to get a
consolidated picture of the transactions pertaining to one ledger account at a time. Thus, a ledger
account may be defined as a summary statement of all the transactions relating to a person, asset,
expense, or income or gain or loss which have taken place during a specified period and shows
their net effect ultimately. From the above definition, it is clear that when transactions take place,
they are first entered in the journal and subsequently posted to the concerned accounts in the
ledger. Posting refers to the process of entering in the ledger the information given in the journal.
In the past, the ledgers were kept in bound books. But with the passage of time, they became
loose-leaf ones and the advantages of the same lie in the removal of completed accounts,
insertion of new accounts and arrangement of accounts in any required manner.
Ruling of ledger account
The ruling of a ledger account is as follows:
Type- 1
Date Particulars J.F. Dr. Cr. Dr. / Cr. Balance
Rs. Rs. Rs.
To name of the account By name of the
to be credited account to be debited

Type- 2
Dr. Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
To name of the account to be By name of the account to
credited be debited
Ledger Account Type 1 is followed in almost all the business concerns, whereas Type 2
is followed only in banking institutions to save space, time and clerical work involved.
Sub-division of ledger
In a big business, the number of accounts is numerous and it is found necessary to
maintain a separate ledger for customers, suppliers and for others. Usually, the following three
types of ledgers are maintained in such big business concerns.
(i) Debtors’ Ledger: It contains accounts of all customers to whom goods have been
sold on credit. From the Sales Day Book, Sales Returns Book and Cash Book, the entries are
made in this ledger. This ledger is also known as sales ledger.
(ii) Creditors’ Ledger: It contains accounts of all suppliers from whom goods have been
bought on credit. From the Purchases Day Book, Purchases Returns Book and Cash Book, the
 entries are made in this ledger. This ledger is also known as Purchase Ledger.
(iii) General Ledger: It contains all the residual accounts of real and nominal nature. It is
also known as Nominal Ledger.
Distinction between journal and ledger
(i) Journal is a book of prime entry, whereas ledger is a book of final entry.
(ii) Transactions are recorded daily in the journal, whereas posting in the ledger is made
periodically.
(iii) In the journal, information about a particular account is not found at one place, whereas
in the ledger information about a particular account is found at one place only.
(iv) Recording of transactions in the journal is called journalizing and recording of
transactions in the ledger is called posting.
(v) A journal entry shows both the aspects debit as well as credit but each entry in the ledger
shows only one aspect.
(vi) Narration is written after each entry in the journal but no narration is given in the ledger.
(vii) Vouchers, receipts, debit notes, credit notes etc., from the basic documents form journal entry,
whereas journal constitutes basic record for ledger entries.

DISCOUNTS
Trade discount
When a customer buys goods regularly or buys large quantity or buys for a large amount,
the seller is usually inclined to allow a concession in price. He will calculate the total price
according to the list of catalogue. But after the total is arrived at, he will make a deduction 5% or
10% depending upon his business policy. This deduction is known as Trade discount.
Cash Discount
An amount which is allowed for the prompt settlement of debt arising out of a sale
within a specified time and calculated on a percentage basis is known as cash discount, i.e., it is
always associated with actual payment.
Difference between Trade Discount and Cash Discount
Trade discount
i. It is given by the manufacturer or the wholesaler to a retailer and not to others.
ii. It is allowed on a certain quantity being purchased.
 iii. It is a reduction in the catalogue price of an article.
iv. It is not usually accounted for in the books since the net amount (i.e. after deducting
discount) is shown.
v. It is allowed only when there is a sale either cash or credit.
vi. It is usually given at the same rate which is applicable to all customers.
vii. It is allowed or not allowed according to sales policy followed by a business concern.

Cash discount
i. It may be allowed by seller to any debtor.
ii. It is allowed on payment being made before a certain date.
iii. It is a reduction in the amount due by a debtor.
iv. This discount must have to be accounted for in the books since it is deducted from the
gross selling price.
v. It is allowed only when there is cash receipt or cash payment including cheques.
vi. It varies from customer to customer depending on the time and period of payment.
vii. It is allowed only on condition. The dues should be paid within the stipulated time. If not,
the debtor is not eligible for cash discount.

TRIAL BALANCE
INTRODUCTION
According to the dual aspect concept, the total of debit balance must be equal to the
credit balance. It is a must that the correctness of posting to the ledger accounts and their
balances be verified. This is done by preparing a trail balance.
MEANING AND DEFINITION
Meaning
Trial balance is a statement prepared with the balances or total of debits and credits of
all the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the name
indicates it is prepared to check the ledger balances. If the total of the debit and credit
amount columns of the trail balance are equal, it is assumed that the posting to the ledger
in terms of debit and credit amounts is accurate. The agreement of a trail balance ensure
arithmetical accuracy only, A concern can prepare trail balance at any time, but its preparation as
on the closing date of an accounting year is compulsory.

Definition
According to M.S. Gosav “Trail balance is a statement containing the balances of all
ledger accounts, as at any given date, arranged in the form of debit and credit columns placed
side by side and prepared with the object of checking the arithmetical accuracy of ledger
postings”.
OBJECTIVES OF PREPARING A TRAIL BALANCE
(i) It gives the balances of all the accounts of the ledger. The balance of any account
can be found from a glance from the trail balance without going through the pages of the ledger.
(ii) It is a check on the accuracy of posting. If the trail balance agrees, it proves:
(a) That both the aspects of each transaction are recorded and
(b) That the books are arithmetically accurate.
(iii) It facilitates the preparation of profit and loss account and the balance sheet.
(iv) Important conclusions can be derived by comparing the balances of two or more
than two years with the help of trail balances of those years.
FEATURES OF TRAIL BALANCES
The following are the important features of a trail balances:
(i) A trail balance is prepared as on a specified date.
(ii) It contains a list of all ledger account including cash account.
(iii) It may be prepared with the balances or totals of Ledger accounts.
(iv) Total of the debit and credit amount columns of the trail balance must tally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are
arithmetically accurate.
(vi) Difference in the debit and credit columns points out that some mistakes have been
committed.
(vii) Tallying of trail balance is not a conclusive profit of accuracy of accounts.
LIMITATIONS OF TRAIL BALANCE
The following are the important limitations of trail balances:
(i) The trail balance can be prepared only in those concerns where double entry system of
 book- keeping is adopted. This system is too costly.
(ii) A trail balance is not a conclusive proof of the arithmetical accuracy of the books of
account. It the trail balance agrees, it does not mean that now there are absolutely no errors in
books. On the other hand, some errors are not disclosed by the trail balance.
(iii) It the trail balance is wrong, the subsequent preparation of Trading, P&L Account and
Balance Sheet will not reflect the true picture of the concern.
METHODS OF PREPARING TRAIL BALANCE
A trail balance refers to a list of the ledger balances as on a particular date. It can be
prepared in the following manner:
Total Method
According to this method, debit total and credit total of each account of ledger are
recorded in the trail balance.
Balance Method
According to this method, only balance of each account of ledger is recorded in trail
balance. Some accounts may have debit balance and the other may have credit balance. All these
debit and credit balances are recorded in it. This method is widely used.
Ruling of a trail balance:
The following is the form of a trail balance Method I: Total Method
ST’s Books Trail Balance as on ................................
S.No. Name of Account L.F Debit Total Credit Total
Amount Rs. Account Rs.

Method II: Balance Method:

MT’s Books Trail Balance as on
S.No. Name of Account L.F Debit balance Credit balance
Rs. Rs.

Note: Accounts of all assets, expenses, losses and drawings are debit balances. Accounts of
incomes, gains, liabilities and capital are credit balances.
Trial balance disclosed some of the errors and does not disclosed some other errors.
This is given below.
A) Trial Balance disclosed by the Errors
i) Wrong totaling of subsidiary books
ii) Posting of an amount on the wrong side
iii) Omission to post an amount into ledger
iv) Double posting or omission of posting
v) Posting wrong amount
vi) Error in balancing
B) Trail Balance not disclosed by the Errors
i) Error of principle
ii) Error of omission
iii) Errors of Commission
iv) Recording wrong amount in the books of original entry
v) Compensating errors

TRADING ACCOUNT
INTRODUCTION
Trading account is prepared for an accounting period to find the trading results or gross
margin of the business i.e., the amount of gross profit the concern has made from buying and
selling during the accounting period. The difference between the sales and cost of sales is gross
profit. For the purpose of computing cost of sales, value of opening stock of finished goods,
purchases, direct expenses on purchasing and manufacturing are added up and closing stock of
finished goods is reduced. The balance of this account shows gross profit or loss which is
transferred to the profit and loss account.
PREPARATION OF TRADING ACCOUNT
Trading account is a ledger account. It has to be prepared in conformity with double
entry principles of debit and credit.
Items shown in trading account:
(A) Debit side
i) Opening stock: The stock at the beginning of an accounting period is called
opening stock. This is the closing stock as per the last balance sheet. It includes stock of raw
materials, work in progress, (where manufacturing account is not separately prepared) and
finished goods. Trading account starts with opening stock on the debit side.
ii) Purchases: The total value of goods purchased after deducting purchase returns is
debited to trading a/c. Purchases comprise of cash purchases am credit purchases.
iii) Direct expenses: Direct expenses are incurred to make the goods sale able. They
include wages, carriage and freight on purchases, import duty, customs duty, clearing and
forwarding charges manufacturing expenses or factor. Expenses (where manufacturing account
is not separately prepared). All direct expenses are extracted from trial balance.
Items shown in trading account:
(B) Credit side:
i) Sales: It includes both credit and cash sales. Sales returns are reduced from sales and
net sales are shown on the credit side of trading account. The sales and returns are extracted from
the trial balance.
ii) Closing stock: Closing stock is the value of goods remaining at the end of the
accounting period. It includes closing stock of raw materials, work progress (where
manufacturing account is not separately prepared) and finished stock. The opening stock is
ascertained from trial balance but closing stock is not a part of ledger. It is separately valued and
given as an adjustment. If it is given in trial balance, it is after adjustment of opening and closing
stocks in purchases. If closing stock is given in trial balance it is shown only as current asset in
balance sheet. If closing stock is given outside trial balance, it is shown on credit side of trading
account and also as current asset in the balance sheet
CLOSING ENTRIES RELATING TO TRADING ACCOUNT
The Journal entries given below are passed to transfer the relevant ledger account
balances to trading account.
(i) For opening stock, purchases and direct expenses.
Trading A/c Dr xxx
To Opening Stock A/c xxx
xxx
xxx
 To Purchases (Net) A/c

To Direct expenses A/c

[Being transfer of trading a/c debit side items]

(ii) For transfer of sales (after reducing sales returns)
Sales (net) A/c Dr Xxx
To Trading A/c xxx
[Being transfer of sales to Trading A/c]
(iii) For transferring gross profit
Trading A/c Dr xxx
To Profit & Loss A/c xxx
[Being transfer of gross profit to P&L A/c]

(iv) For Gross Loss

Profit & Loss A/c Dr xxx
To Trading A/c xxx
[Being transfer of gross loss to P&L A/c]
Note: Closing stock is taken into account by an adjustment journal entry along with other adjustments.

A SPECIMEN OF TRADING ACCOUNT IS SHOWN BELOW Trading account for the

year ended
Particulars Rs. Rs. Particulars Rs. Rs.

To Opening stock xxx By Sales Xxx

To purchases Xxx Less: Returns inwards
(or)
Sales Returns xxx
Less: purchase returns Xxx xxx xxx
To Direct expenses:
Wages xxx By closing stock
Fuel & Power xxx By Gross loss c/d * xxx
Carriage inwards xxx (transferred to profit xxx
and loss A/c)
Royalty on production xxx
Power xxx
Coal water, Gas xxx
Import duty xxx
Consumable stores xxx
Factory expenses xxx
To Gross profit c/d xxx
(transferred to profit and
loss A/c)
* Balancing figure will be either gross profit or loss in Trading A/c

PROFIT AND LOSS ACCOUNT

INTRODUCTIONS
Profit and loss account is prepared to ascertain the net profit of the business concern for
an accounting period

DEFINITION
In the words of Prof. Carter “Profit and loss account is an account into which all gains
and losses are collected in order to ascertain the excess of gains over the losses or vice versa.”

PREPARATION OF PROFIT AND LOSS ACCOUNT

Profit and loss account starts with gross profit brought down from trading account on
the credit side. (If gross loss, on the debit side). All the indirect expenses are debited and all the
revenue incomes are credited to the profit and loss account and then net profit or loss is
calculated. If incomes or credit is more, than the expenses or debit, the difference is net profit.
On the other hand if the expenses or debit side is more, the difference is net loss.

Debit side:
Expenses shown on the debit side of profit and loss account are classified into two
categories
1. Operating expenses and 2. Non operating expenses
(1) Operating expenses: These expenses are incurred to operate the business efficiently. They
are incurred in running the organisation. Operating expenses include administration, selling,
distribution, finance, depreciation and maintenance expenses.
(2) Non operating expenses: These expenses are not directly associate with day today
operations of the business concern. They include loss on sale of assets, extraordinary losses, etc.

Credit side
Gross profit is the first item appearing on the credit side of profit and loss account. Other
revenue incomes also appear on the credit side of profit and to account. The other incomes are
classified as operating incomes and non operating incomes.
(1) Operating incomes: These incomes are incidental to business and earned from usual
business carried on by the concern. Examples: discount received, commission earned, interest
received etc.
(2) Non operating incomes: These incomes are not related to the business carried on by
the firm. Examples are profit on sale of fixed assets, refund of tax etc.

CLOSING ENTRIES FOR PROFIT AND LOSS ACCOUNT

1. For transferring expenses to profit and loss account:
Profit and Loss A/c Dr xxx

To expenses A/c xxx

[Being transfer of all P&L A/c debit side items]

2. For transfer of incomes to profit and loss account
Incomes A/c Dr xxx
To Profit and Loss A/c xxx
[Being transfer of Incomes to P&L A/c]
3. For net profit:
P&L A/c Dr xxx
To Capital A/ xxx
[Being net profit credited to capital]
4. For transfer of Net Loss
Capital A/c Dr xxx
To P&L A/c xxx
[Being net loss transferred to capital]
Note: In case of partnership, the profit or loss is divided between partners in their profit sharing
ratio and credited or debited to the individual partners. In case of limited companies, Net profit
or loss is transferred to the P&L Appropriation A/c for disposal.

THE SPECIMEN OF PROFIT AND LOSS ACCOUNT IS SHOWN BELOW

Profit and Loss Account
For the year ended 31st March 2001
Particulars Rs. Particulars Rs.
To Gross loss b/d xxx By Gross profit b/d xxx
To Administration expenses By Dividends received xxx
Salaries xxx By Interest received xxx
Rent rates & taxes xxx By Discount received xxx
Printing & Stationery xxx By commission received xxx
Postage and Telegrams xxx By Rent received xxx
Telephone expenses xxx By Profit on sale of assets xxx
Legal charges xxx By Sundry revenue receipts xxx
Insurance xxx By Net loss transferred to capital A/c (Bal. xxx
Fig)*
Audit fees xxx
Directors fees xxx
General expenses xxx
To Selling & Distribution Expenses
Showroom expenses xxx
Advertising xxx
Commission paid to salesmen xxx
Bad debts xxx
Provision for doubtful debts xxx
Godown rent xxx
Carriage outward xxx
Upkeep of delivery vans xxx
To Depreciation and maintenance
Depreciation xxx
To Financial expenses
Interest ob borrowings xxx
Discount allowed xxx
To abnormal losses
Loss on sale of assets xxx
To Net profit transferred to capital xxx
A/c (bal.fig)
xxx xxx
Note: *Either net profit or net loss ie balancing figure in P & L A/c

The purpose and importance of preparing profit and loss account.

To determine the future line of action To know the net profit or loss of business To calculate
different ratios. To compare the actual performance of the business with the desired one.

PRINCIPLES OF PREPARING PROFIT OF LOSS ACCOUNT

1. Only revenue receipts should be entered
2. Only revenue expenses together with losses should be taken into account.
3. Expenses and incomes relating only to the period for which the accounts are being
prepared should be considered.
4. All expenses and income relating to the period concerned should be considered even if
the expense has not yet been paid in cash or the income has not yet been received in cash.
5. All personal expenses of the proprietor and partners must be debited to the capital or
drawings accounts and must not be debited to the profit and loss account. Similarly any
income has been earned from the private assets of the proprietor which is received by firm;
it must be credited to the capital or drawings account.

BALANCE SHEET
 The Balance sheet comprises of lists of assets, liabilities and capital fund on a given
date. It presents the financial position of a concern as revealed by the accounting records. It
reflects the assets owned by the concern and the sources of funds used in the acquisition of those
assets. In simple language it is prepared in such a way that true financial position is revealed in a
form easily readable and more rapidly understood than would be possible from a view of the
detailed information contained in the accounting records prepared during the currency of the
accounting period. Balance sheet may be called a ‘statement of equality’ in which equality is
established by representing values of assets on one side and values of liabilities and owners'
funds on the other side.
TITLE
A Balance sheet is called by different names probably due to lack of uniformity in
accounting systems. Generally, the following titles are used in respect of balance sheet:
(i) Balance sheet or General Balance sheet;
(ii) Statement of Financial position or condition;
(iii) Statement of assets and liabilities;
(iv) Statement of assets and liabilities and owners’ fund etc.
Of the above, the title 'Balance sheet" is mostly used. The use of this title implies that
data presented in it have been taken from the balances of accounts,
DEFINITIONS OF BALANCE SHEET:
“Balance sheet is a ‘Classified summary’ of the ledger balances remaining after closing
all revenue items into the profit and loss account.” - Cropper.
“Balance sheet is a screen picture of the financial position of a going business concern
at a certain moment” - Francis.

CLASSIFICATION OF ASSETS AND LIABILITIES

A clear and correct understanding of the basic divisions of the assets and liabilities and
the meanings which they signify and the amounts which they represent is very essential for a
proper perspective of financial position of a business concern. Assets and liabilities are classified
under the following major headings.
Assets:
Assets are properties of business. They are classified on the basis of their nature.
Different types of assets are as under:
(i) Fixed assets: Fixed assets are the assets which are acquired and held permanently
and used in the business with the objective of making profits. Land and building, Plant and
machinery, Furniture and Fixtures are examples of fixed assets.
(ii) Current assets: The assets of the business in the form of cash, debtors bank
balances, bill receivable and stock are called current assets as they can be realised within an
operating cycle of one year to discharge liabilities.
(iii) Tangible assets: Tangible assets have definite physical shape or identity and
existence; they can be seen, felt and have volume such as land, cash, stock etc. Thus tangible
assets can be both fixed assets and current assets.
(iv) Intangible assets: The assets which have no physical shape which cannot be seen
or felt but have value are called intangible assets. Goodwill, patents, trade marks and licences are
examples of intangible assets. They are usually classified under fixed assets.
(v) Fictitious assets: Fictitious assets are not real assets. Past accumulated losses or
expenses which are capitalised for the time being, expenses for promotion of Organisations
(preliminary expenses), discount on issue of shares, debit balance of profit and loss account etc.
are the examples of fictitious assets.
(vi) Wasting assets: These assets are also called depleting assets. Assets such as
mines, Timber forests, quarries etc. which become exhausted in value by way of excavation of
the minerals, cutting of wood etc. are known as wasting assets. Such assets are usually natural
resources with physical limitations.
(vii) Contingent assets: Contingent assets are assets, the existence, value
possession of which is based on happening or otherwise of specific events. For example, if a
business firm has filed a suit for a particular property now in possession of other persons, the
firm will get the property if the suit is decided in its favour. Till the suit is decided, it is a
contingent asset.
Liabilities
A liability is an amount which a business firm is ‘liable to pay’ legally. All the amounts
which are claims by outsiders on the assets of the business are known as liabilities. They are
credit balances in the ledger. Liabilities are classified into bur categories as given below.
(1) Owner's capital: Capital is the amount contributed by the owners of the business.
In addition to initial capital introduced, proprietors may introduce additional capital and
withdraw some amounts from business over a period of time. Owner’s capital is also
called ‘net worth. Net worth is the total fund of proprietors on a particulars date. It
consists of capital, profits and interest on capital subject to reduction of drawings and
interest on drawings.
In case of limited companies, capital refers to capital subscribed by shareholders. Net
worth refers to paid up equity capital plus reserves and profits, minus losses.
(2) Long term Liabilities: Liabilities repayable after specific duration of long period
of time are called long term liabilities. They do not become due for payment in the
ordinary ‘operating cycle’ of business or within a short period of lime. Examples are long
term loans and debentures. Long term liabilities may be secured or unsecured, though
usually they are secured.
(3) Current liabilities: Liabilities which are repayable during the operating cycle of
business, usually within a year, are called short term liabilities or current liabilities. They
are paid out of current assets or by the creation of other current liabilities. Examples of
current liabilities are trade creditors, bills payable, outstanding expenses, bank overdraft,
taxes payable and dividends payable.
(4) Contingent liabilities: Contingent liabilities will result into liabilities only if
certain events happen. Examples are:
Bills discounted and endorsed which may be dishonoured, unpaid calls on investments.

PRFORMA OF BALANCE SHEET

Balance Sheet as on...................................................................
Liabilities Rs. Assets Rs.
Capital xxx Fixed assets xxx
Add: Net profit xxx Goodwill xxx
Add: Interest on capital xxx Land & Buildings xxx
Loose tools xxx
Less: Drawing xxx Furniture & fixtures xxx
Less: Int. on drawings xxx Vehicles xxx
Less: Loss if any xxx Patents xxx
xxx Trade marks xxx

Long term liabilities Long term loans (advances) xxx

Loan on mortgage xxx Investments Current assets

Bank loan xxx Closing stock xxx

Current liabilities Sundry debtors xxx
Sundry creditors xxx Bills receivable xxx
Bills payable xxx Prepaid expenses xxx
Bank overdraft xxx Accrued incomes xxx
Creditors for outstanding exp. xxx Cash at bank xxx
Income received in advance xxx Cash in hand Fictitious xxx
assets xxx
Preliminary expenses xxx
Advertisement expenses xxx
Underwriting commission xxx
Discount on issue of shares xxx
Discount on issue of
debentures
xxx xxx

Adjustments

1. Bad Debts

In order to display high amount of sales figures, goods are frequently sold out to known
customers on credit. Some of these customers fail to pay their debts due to insolvency. These
debts, which cannot be recovered, are called Bad Debts. It is a loss to the business and an
adjustment is needed. The required entry will be:

Bad Debts A/c Dr

 To sundry debtors A/c and then

Profit & Loss Account Dr.

To Bad Debts A/c

It should be noted here that no adjustment is required for any bad debt that already appears in the
Trial Balance. Bad debt appearing in the Trial Balance should be debited only to Profit & Loss
Account of the Period.

2. Provision for Bad Debts

Credit sales are recognised as income at the time of the sale without knowing the exact
time of collection. In the course of time, loss may result from unsuccessful attempts to collect the
dues from the customers. Every organisation creates a provision for this anticipated loss, from
the reported income of the credit sales in the current period.

There are different methods of creating provision for bad debts. However, we will discuss only
one method here. Accounting entry will depend upon the situation as to whether provision for
bad debts is or is not appearing in the Trial Balance.

Situation 1: When provision for Bad Debts not appearing in the Trial Balance:

The accounting entry will be:

Profit & Loss Account Dr.

To Provision for Bad Debts Account

(To be shown in the Balance Sheet as a deduction for Debtors)

Situation 2: When provision for Bad Debts appearing in the Trial Balance:
At first, calculate the amount of provision to be created at the end of the period in the same way
as above. Now compare the provision with the provision appearing in the Trial Balance. There
are two resultant options:

If the new provision exceeds the provision appearing in the Trial Balance, pass the following
entry:

Profit & Loss Account Dr.

To provision for Bad Debts

If the new provision is less than the provision appearing in the Trial Balance, pass the following
entry:

Provision for Bad Debts Dr.

To Profit & Loss Account

Here, it should be noted that only new provision should be shown in the Balance Sheet as a
deduction from Sundry Debtors.

3. Provision for Discount on Debtors

Many business organisations offer to give a cash discount to all those debtors who
arrange to make their payment on or before the due date. It is clear that the real worth of debtors
will be the gross figure of debtors minus the cash discount that they would be given. The figure
of debtors should be accordingly adjusted.

The difficulty, however, is that nobody knows how many debtors will entertain cash
discount and what the amount will be. Therefore, all that is possible is to make a rough estimate.
Usually, it is made at a percentage of outstanding debtors who actually repay their obligation.
Therefore, the estimate amount of bad debt should be deducted from the total of debtors and
provision for discount on debtors should be made only on the balance.

Profit & Loss Account Dr.

 To Provision for discount on Debtors Account (To be shown in the Balance Sheet by way
of deduction from Sundry debtors)

4. Reserve for discount on Creditors

If goods are purchased on credit and cash is paid to creditors in time, creditors allow cash
discount. It is considered to be the income of the business. For this, following entries are passed:

Creditors Account Dr.

To bank Account

To Discount Account

Discount Received Account Dr.

To Profit & Loss Account

At the end of the accounting year, we may expect certain discount out of such creditors.
However, that discount will be received in the next year though it is actually related to the
current period. An adjustment is requested for the expected discount from creditors that should
be reflected in the accounts at the year-end as follows:

Step 1

Calculate probable amount of discount to be received from creditors. Generally, it is

calculated by applying a percentage on outstanding creditors.

Step 2

Pass the following entry to record it:

Reserve for Discount on Creditors Account Dr.

Profit & Loss Account

Step 3
 Show this reserve for Discount on Creditors in the Balance Sheet by way of deduction
from creditors.

In the next year, when the actual discount is received, the following entry is to be passed:

Creditors Account Dr.

To Bank/ Cash Account To Discount Received Account

Discount Received Account Dr.

To Reserve for Discount on Creditors Account

Reserve for Discount on Creditors Account is bound to leave a balance. This should be adjusted
while creating similar reserve on creditors outstanding on the last date of the accounting year in
question.

Note: In actual practice, no organization makes any reserve for discount on creditors due to the
principle of conservatism.

5. Depreciation

According to Pickles, "Depreciation is the permanent and continuing diminution in the

quality, quantity or value of an asset". It is a measure of wearing out, consumption or other loss
of values of a depreciable asset arising from use and passage of time. It is generally charged to
such assets as Plant & Machinery, Building, Furniture, Equipment, etc. Initially, the cost of the
assets including installation cost is debited to the particular assets. In each accounting period, a
portion of the cost expires and it needs adjustment for showing correct profit of the period and
correct value of the assets. Adjustment entries are:

When assets account is maintained at written down value:

Depreciation Account Dr.

 To Assets Account (Being depreciation charged)

Profit & Loss Account Dr.

To Depreciation Account (Being depreciation transferred to profit & Loss Account)

When assets account is maintained at cost price:

Depreciation Account Dr.

To Provision for Depreciation Account (Being depreciation Charged)

Profit & Loss Account Dr.

To Depreciation Account (Being depreciation transferred to profit & Loss Account)

Total accumulated depreciation is shown in the Balance Sheet liabilities side.

Alternatively, it can be shown by way of deduction from the original cost of assets side. Here, it
should be noted that no adjustment is required for depreciation that already appears in the Trial
Balance. Depreciation that already appears in the Trial Balance should only be debited to Profit
& Loss Account.

6. Goods Distributed as Free samples:

This is one kind of advertisement. When goods are distributed to the prospective
customers as free samples, an expense is incurred (known as advertisement expense) and there is
a usual reduction from the stock of goods. The following entry is passed:

Advertisement Account Dr.

To Purchase Account (For a trader)

7. Drawing Made by the Proprietors

 Drawing made by the proprietor(s) may be in cash or in kind. Drawing relates to the
resources of the business and the capital of the owner(s).

Drawings made in Cash: In this case, following entries are passed:

Drawings Account Dr.

To Cash/Bank Account

Capital Account Dr.

To Drawings Account

If the drawings made by the owner are incorporated in sales, we are to pass a reverse
entry to cancel the original entry. For the drawings, the above two entries are to be passed:

8. Interest on Capital

Sometimes, it may be required to make a provision for interest on the capital contributed
by the proprietor or the partner. Such interest is not a charge against profit but an appropriation
of profit. In this connection, the following two entries have to be passed:

Profit & Loss Appropriation Account Dr.

To Interest on Capital Account (Being interest on capital payable)

Interest on Capital Account Dr.

To Capital/Current Account

(Being interest on capital transferred to Capital/Current Account)

9. Interest on Drawings
 Sometimes, interest on drawing may be charged to restrict the frequent drawings by the
partners. Such interest increases the divisible profit. The following two entries have to be passed:

Capital/Current Account Dr.

To Interest on Drawing Account

(Being interest on Drawing Transferred to Capital/Current Account)

Interest on Drawings Account Dr.

To Profit and Loss Appropriation Account

(Being interest on drawings Charged)

COST ACCOUNTING
INTRODUCTION
Industrialization and advent of factory system during the second half of 19 th Century
necessitating accurate cost information have led to the development of cost accounting. The
growth of cost accounting was slow. To quote Eldons Handristen “Not until the last 20 years of
the 19th Century was there much literature on the subject of cost accounting in England and even
very little was found in the United States. Most of the literature until this time emphasized the
procedure for the calculation of prime costs only”.
Rapid development in cost accounting has taken place after 1914 with the growth of
heavy industry and large scale production as a consequence of First World War when cost other
than material and labour (overhead) constituted a significant portion of total cost.
The development of cost accounting in India is of recent origin and it is given
importance after independence, when provision for Cost Audit under Sec.233 B of Companies
Act was made. Vivian Bose Enquiry Committee revealed the malpractices of manufacturing
companies. It was felt that the financial audit falls short of expectations to reveal the
malpractices. Therefore, under the Companies Act, the government was given the power to order
for cost audit. This has given impetus to the development of cost accounting in India.
DEFINITION OF COST, COSTING, COST ACCOUNTING AND COST
ACCOUNTANCY
Cost: The term ‘cost’ has to be studied in relation to its purpose and conditions. As per
the definition by Institute of Cost and Management Accountants (I.C.M.A.), now known as
Chartered Institute of Management Accountants (C.I.M.A.), London ‘cost’ is the amount of:
actual expenditure incurred on a given thing.
Costing: The I.C.M.A., London has defined costing as the ascertainment of costs. “It
refers to the techniques and processes of ascertaining costs and studies the principles and rules
concerning the determination of cost of products and services”.
Cost Accounting: It is the method of accounting for cost. The process of recording and
accounting for all the elements of cost is called cost accounting.
C.M.A. has defined cost accounting as follows: “The process of accounting for cost
from the point at which expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centers and cost units. In its widest usage it embraces the preparation of
statistical data, the application of cost control methods and the ascertainment of the profitability
of activities carried out or planned”.
Cost Accountancy: It is an aid to management for decision making.
C.M.A., has defined cost accountancy as follows: “The application of costing and
cost accounting principles, methods and techniques to the science, art and practice of cost control
and the ascertainment of profitability. It includes the presentation of information derived there
from for the purpose of managerial decision making”.
SCOPE OF COST ACCOUNTING
The term scope here refers to filed of activity. Cost accounting is concerned with
ascertainment and control of costs. The information provided to the management is helpful for
cost control and cost reduction through functions of planning, decision making and control. In
the initial stages of evolution, cost accounting confined itself to cost ascertainment and
presentation of the same with the main objective of finding the product cost. With the
development of business activity and introduction of large scale production, the scope of cost
accounting was broadened and providing information for cost control and cost reduction has
assumed equal significance along with finding out cost of production.
In addition to enlargement of scope, the area of application of cost accounting has also
widened. Initially cost accounting was applied in manufacturing activities only. Now, it is
applied in service organizations, government organizations, local authorities, farms, extractive
industries, etc.
OBJECTIVES OF COST ACCOUNTING
Ascertainment of Cost
It enables the management to ascertain the cost of product, job, contract, service or unit
of production so as to develop cost standard. Costs may be ascertained, under different
circumstances, using one or more types of costing principles-standard costing, marginal costing,
uniform costing etc.
Fixation of Selling Price
Cost data are useful in the determination of selling price or quotations. Apart from
cost ascertainment, the cost accountant analyses the total cost into fixed and variable costs. This
will help the management to fix the selling price; sometimes, below the total cost but above the
variable cost. This will increase the volume of sales- more sales than previously, thus leading to
maximum profit.
Cost Control
The object is to minimize the cost of manufacturing. Comparison of actual cost with
standards reveals the discrepancies- variances. It the variances are adverse, the management
enters into investigation so as to adopt corrective action immediately.
Matching Cost with Revenue
The determination of profitability of each product, process, department etc. is the
important object of costing.
Special Cost Studies and Investigations
It undertakes special cost studies and investigations and these are the basis for the
management in decision-making or policies. This will also include pricing of new products,
contraction or expansion programmes, closing down or continuing a department, product mix,
price reduction in depression etc.
Preparation of Financial Statements, Profit and Loss Account, Balance Sheet
To prepare these statements, the value of stock, work-in-progress, finished goods etc.,
are essential; in the absence of the costing department, when we have to close the accounts it
rather takes too much time. But a good system of costing facilitates the preparation of the
statements, as the figures are easily available; they can be prepared monthly or even weekly.
FUNCTIONS OF COST ACCOUNTING
According to Blocker and Weltemer, “Cost Accounting is to serve management in the
execution of polices and in comparison of actual and estimated results in order that the value of
each policy may be appraised and changed to meet the future conditions”. The main functions of
cost accounting are:
i) To serve as a guide to price fixing of products.
ii) To disclose sources of wastage in process of production.
iii) To reveal sources of economy in production process.
iv) To provide for an effective system of stores, materials etc.
v) To exercise effective control on factors of production.
vi) To ascertain the profitability of each product.
vii) To suggest management of future expansion policies.
viii) To present and interpret data for management decisions.
ix) To organize cost reduction programmes.
x) To facilitate planning and control of business activity.
xi) To supply timely information for various decisions.
xii) To organize the internal audit systems etc.
ADVANTAGES OF COST ACCOUNTING
Helps in Decision Making
Cost accounting helps in decision making. It provides vital information necessary for
decision making. For instance, cost accounting helps in deciding:
a. Whether to make a product buy a product?
b. Whether to accept or reject an export order?
c. How to utilize the scarce materials profitably?
Helps in fixing prices
Cost accounting helps in fixing prices. It provides detailed cost data of each product
(both on the aggregate and unit basis) which enables fixation of selling price. Cost accounting
provides basis information for the preparation of tenders, estimates and quotations.
Formulation of future plans
Cost accounting is not a post-mortem examination. It is a system of foresight. On the
basis of past experience, it helps in the formulation of definite future plans in quantitive terms.
Budgets are prepared and they give direction to the enterprise.
Avoidance of wastage
Cost accounting reveals the sources of losses or inefficiencies such as spoilage, leakage,
pilferage, inadequate utilization of plant etc. By appropriate control measures, these wastages
can be avoided or minimized.
Highlights causes
The exact cause of an increase or decrease in profit or loss can be found with the aid of
cost accounting. For instance, it is possible for the management to know whether the profits have
decreased due to an increase in labour cost or material cost or both.
Reward to efficiency
Cost accounting introduces bonus plans and incentive wage systems to suit the needs of
the organization. These plans and systems reward efficient workers and improve productivity as
well improve the morale of the work -force.
Prevention of frauds
Cost accounting envisages sound systems of inventory control, budgetary control and
standard costing. Scope for manipulation and fraud is minimized.
Improvement in profitability
Cost accounting reveals unprofitable products and activities. Management can drop
those products and eliminate unprofitable activities. The resources released from unprofitable
products can be used to improve the profitability of the business.
Preparation of final accounts
Cost accounting provides for perpetual inventory system. It helps in the preparation of interim
profit and loss account and balance sheet without physical stock verification.
Facilitates control
Cost accounting includes effective tools such as inventory control, budgetary control and
variance analysis. By adopting them, the management can notice the deviation from the plans.
Remedial action can be taken quickly.

OBJECTIONS OF COST ACCOUNTING

Cost accounting has become indispensable tool to management for exercising effective
decisions. However, the following are the usual objections raised against cost accounting:
Cost Accounting is costly to operate
One of the objections against cost accounting is that it involves heavy expenditure to
operate.No doubt, expenses are involved in introduction and operation of cost accounting
system. This is the case with any accounting system; the benefits derived by operating the system
are more than the cost. Therefore an organization need not hesitate to install and operate the
system.
Cost Accounting is unnecessary
It is felt by a few that cost accounting is of recent origin and an enterprise can survive
without cost accounting.No doubt financial accounting may be helpful to draw P & L Account
and Balance Sheet but an enterprise can work efficiently with the help of cost accounting and it
is necessary to increase efficiency and profitability in the long run.
Cost Accounting involves many forms and statements
It is pointed against cost accounting that it involves usage of many forms and statements
which leads to monotony in filling up of forms and increase of paper work. It is true that cost
accounting is operated by introducing many forms and preparation of statements. This will
become routine and as time passes the utility of forms is realized and the forms can be reviewed,
revised, simplified and minimized.
Costing may not be applicable in all types of Industries
Existing methods of cost accounting may not be applicable in all types of industries.
Cost accounting methods can be devised for all types of industries, and services.
It is based on Estimations
Some people claim that costing system relies on predetermined data and therefore it is
not reliable. Costing system estimates costs scientifically based on past and present situations
and with suitable modifications for the future. This leads to accurate cost figures based on which
management can initiate decisions. But for the predetermined costs, cost accounting also
becomes another ‘Historical Accounting’.
CHARACTERISTICS OF A GOOD COSTING SYSTEM
An ideal system of cost accounting must possess some characteristics which bring all the
advantages, discussed above; to the business, in order to be ideal and objective. The main
characteristics are:
Simplicity
It must be simple, flexible and adaptable to the changing conditions. And it must be
easily understandable to the personnel. The information provided must be in the proper order, in
right time and to the right persons so as to be utilized fully.
Flexibility and Adaptability
The costing system must be flexible to accommodate the changing conditions and
circumstances. The expansion, contraction of changes must be adopted in the existing system
with minimum changes.
Economy
The costing system must suit the finance available. The expenditure must be less than the
benefits derived from the system adopted.
Comparability
The management must be able to make comparison of the facts and figures with the past
figures, figures of other concerns, or other departments of the same concern.
Suitability to the Firms
Before accepting a costing system, the nature, requirements, size, conditions of the
business etc., must be carefully considered. The system must be capable of prompt and accurate
reporting to different levels of management according to their requirements.
Minimum Changes to the Existing one
When introducing a costing system, it may cause minimum disturbance to the existing
set up of the business.
Uniformity of Forms
Forms of different colours can be used to distinguish them. Forms must be uniform in
size and quality. Form should contain instructions to fill, to use and for disposal.
Less Clerical Work
Printed forms will involve less labour to fill in, as the workers may be a little educated.
They may not like to spend much time in filling the forms.
Efficient Material Control and Wage System
There must be a proper procedure for recording the time spent on different jobs, by
workers for the payment of wages. A systematic method of wage system will help in the control
of labour cost. Since the cost of material forms a great proportion to the total cost, there must be
an efficient system of stores control.
A Sound Plan
There must be proper and sound plans to collect, to allocate and to apportion overhead
expenses on each job or each product in order to find out the cost accurately.
Reconciliation
The systems of costing and financial accounting must be facilitated to reconcile in the
easiest manner.
Overall Efficiency of Cost Accountant
The work of the cost accountant under a good system of costing must be clearly defined
as to his duties and responsibilities to the firm are very essential.
INSTALLATION OF A COSTING SYSTEM
The costing system of an organization should be carefully planned in order to achieve its
objectives. The important steps for the installation of a costing system are discussed below:
Determination of objectives
The first and foremost stop is to clearly lay down the objectives of the costing system. If
the objective is only to ascertain the cost, a simple system will be sufficient. However, if the
objective is to get information for decision making, planning and control, a more elaborate
system of costing is necessary.
Study of the nature of business
The nature of the business and other technical aspects like nature of the products,
methods and stages of production cycle should be carefully analyzed. Such an analysis is
necessary to decide the method of costing to be adopted. For example, contract costing is
suitable for large construction projects. Operating costing is adopted by service industries like
transport.
Study of the nature of the organization
The costing system should be designed to meet the requirements of the organization.
Hence, it is necessary to study the nature, size and layout of the organization. The factors to be
considered are:
a. Size of the organization and the size of the departments.
b. The physical layout of the organization.
c. The different levels of management.
 d. The extent of decentralization of authority.
e. The nature of authority relationships.
Deciding the structure of cost accounts
A suitable costing system can be developed on the basis of the study of the nature of
business and organization. The structure of cost accounts should be simple and in accordance
with the natural production process.
Determination of cost rates
This step involves a thorough study of the following points for developing an integrated
costing system.
a. Classification of costs into direct and indirect cots.
b. Grouping of indirect costs (overheads) into production, administration, selling and
distribution etc.
c. Methods of pricing issues.
d. Treatment of wastes of all types.
e. Absorption of overheads.
f. Calculation of overhead rates.
Organization of the cost office
The cost office is responsible for the efficient operation of the costing system. The cost
office, with adequate staff must be located a close as possible to the factory. The following are
the major functions of the cots office.
a. Stores accounts.
b. Labour accounting
c. Recording of cost data and
d. Cost control.
Further, the role and duties and responsibilities of the cost accountant must be clearly
defined. He must have the necessary authority to discharge his duties effectively.
Introducing the system
 After completion of the above steps, the costing system may be formally introduced.
Introduction of the system in an existing organization should be done gradually. Before
introduction, the feature of the systems, its working and advantages must be explained to the
concerned employees to secure their co-operation.

COST CONCEPTS
1. Cost Unit
2. Cost Centre
3. Profit Centre
Cost Unit:
A cost unit refers to a unit of product, service or time in relation to which costs may be
ascertained or expressed. In other words, cost unit is the unit of output for which cost is
ascertained. For examples, the cost of air-conditioner is ascertained per unit.
The selection of cost unit is important in cost accounting. It should be carefully
selected to suit the nature of business operation. The selected unit should be neither too small nor
too big, but ideal for cost ascertainment. Cost unit may be expressed in terms of number (units),
weight, area, length etc. The following are the cost units in various industries.
Thus, cost units may vary from industry to industry. An enterprise which produces more than
one type of product may have more than one cost unit.
Cost Centre
A large business is divided into a number of functional departments (such as production,
marketing and finance) for administrative convenience. These departments are further divided
into smaller divisions for cost ascertainment and control. These smaller divisions are called cost
centers.
A cost centre is a location, person or item of equipment (or group of these) in relation to
which cost can be ascertained and controlled. In simple words, it is a subdivision of the
organization to which cost can be charged.
A cost centre can be: (a) a location i.e. an area such as works department, store yard (b)
a person such as supervisor, sales man (c) an item of equipment e.g. delivery van, or a particular
machine.
The determination of suitable cost centre is very important for the purpose of cost
ascertainment and control. The manager of a cost centre is held responsible for control of cost of
his cost centre. The number and size of cost centers vary from organization to organization. The
selection of a suitable cost centre depends on the following factors:
a. Nature and size of the business.
b. Layout and organization of the factory.
c. Availability of various cost data and information.
d. Management policy regarding cost ascertainment and control.
Types of cost centers:
Cost centers may be of the following types.
Production cost center: A cost center is which production is carried on is known as production
cost center. e.g., machine shop, welding shop, assembly shop, etc.
Service cost center: A cost center which renders service to production cost centre is known as
service center e.g. power house, stores department, maintenance department etc.
Personal cost center: It consists of a person or a group of persons e.g. Sales manager, Works
manager etc.
Impersonal cost center: It consists of a location or a machine or a group of machines. e.g.
canteen.
Operation cost center: It consists of machines and / or persons carrying out similar operations.
e.g. machines and operators engaged in welding or turning.
Profit Centre
A profit center is a responsibility center which accumulates revenues as well as costs. In
other words, it is a department or segment of the organization which has been assigned control
over both revenues and cost. For instance, if there are two divisions in a textile company, say
readymade and clothing, each one may be regarded as a profit center.
Distinguish between cost center and profit center
Important differences between cost center and profit center are:
i) Cost center is created by the cost accountant. On the other hand, a profit center is
created by the top management.
ii) Cost center is created for the purpose of cot ascertainment and control. But the profit
center is created for the purpose of evaluation of performance.
iii) Cost center is a small segment, whereas profit center is a large segment.
 iv) Cost center’s do not enjoy autonomy. But, profit center’s enjoy autonomy.
v) Cost center does not have a target of costs. But a profit center has a target of profit
for performance evaluation.
COST CONTROL
Cost control can be defined as the comparative analysis of actual costs with appropriate
standards of budgets to facilitate performance evaluation and formulation of corrective measures.
It aims at accomplishing conformity between actual result and standards or budgets. Cost control
is keeping expenditures within prescribed limits. Cost control has the following features:
i) Creation of responsibility center’s with defined authority and responsibility for
costincurrence.
ii) Formulation of standards and budgets that incorporate objectives and goals to be
achieved.
iii) Timely cost control reports (responsibility reporting) describing the variances between
budgets and standards and actual performance.
iv) Formulation of corrective measures to eliminate and reduce unfavorable variances.
v) A systematic and fair plan or motivation to encourage workers to accomplish budgetary
goals.
vi) Follow-up to ensure that corrective measures are being effectively applied.
Cost control does not necessarily mean reducing the cost but its aim is to have the
maximum utility of the cost incurred. In other words, the objective of cost control is the
performance of the same job at a lower cost or a better performance for the same cost.
COST REDUCTION
Cost reduction may be defined as an attempt to bring costs down. Cost reduction implies
real and permanent reduction in the unit cost of goods manufactured or services rendered without
impairing their (product or goods) suitability for the use intended. The goal of cost reduction is
achieved in two says: (i) by reducing the cost per unit and (ii) by increasing productivity. The
steps for cost reduction include elimination of waste, improving operations, increasing
productivity, search for cheaper materials, improved standards of quality, finding other means to
reduce unit costs.
Cost reduction has to be achieved using internal factors within the organisation.
Reduction of costs due to external factors such as reduction in taxes, government subsidies,
grants etc. do not come under the concept of cost reduction.
MANAGEMENT ACCOUNTING
DEFINITIONS
“Management accounting is concerned with accounting information that is useful to
management”. - R.N. Anthony.
“Management accounting is the presentation of accounting information is such a way as
to assist management in the creation of policy and in the day-to-day operations of an
undertaking”.- Anglo American Council of Productivity.
OBJECTIVES OF MANAGEMENT ACCOUNTING
The objectives of management accounting are:
(1) To assist the management in promoting efficiency. Efficiency includes best possible
services to the customers, investors and employees.
(2) To prepare budget covering all functions of a business (i.e. production, sales,
research and finance).
(3) To analysis monetary and non-monetary transactions.
(4) To compare the actual performance with plan for identifying deviations and their
causes.
(5) To interpret financial statements to enable the management to formulate future
policies.
(6) To submit to the management at frequent intervals operating statements and short-
term financial statements.
(7) To arrange for the systematic allocation of responsibilities.
(8) To provide a suitable organization for discharging the responsibilities.
In short, the objective of management accounting is to help the management in making
decisions and implementing them efficiently.
SCOPE OF MANAGEMENT ACCORDING
Management accounting has various facets. The field of management accounting is very
wide. The main purpose of management accounting is to provide information to the management
to perform its functions of planning directing and controlling. Management accounting includes
various areas of specialization to render effective service to the management.
Financial Accounting
Financial Accounting deals with financial aspects by preparation of Profit and Loss
Account and Balance Sheet. Management accounting rearranges and uses the financial
statements. Therefore management accounting does not exclusively maintain factual data for
itself. It is closely related and connected with financial accounting. thus, management accounting
is dependent on financial accounting which limits its scope.
Cost Accounting
Cost accounting is an essential part of management accounting. Cost accounting, through
its various techniques, reveals efficiency of various divisions, departments and products. It also
provides information regarding cost of products process and jobs through different methods of
costing. Management accounting makes use of all this data by focusing it towards managerial
decisions.
Budgeting and Forecasting
Budgeting is setting targets by estimating expenditure and revenue for a given period.
Forecasting is prediction of what will happen as a result of a given set of circumstances. Targets
are fixed for various departments and responsibility is pinpointed for achieving the targets.
Actual results are compared with preset targets and performance is evaluated.
Inventory Control
This includes, planning, coordinating and control of inventory from the time of
acquisition to the stage of disposal. This is done through various techniques of inventory control
like stock levels, ABC and VED analysis physical stock verification, etc.
Statistical Analysis
In order to make the information more useful statistical tools are applied. These tools
include charts, graphs, diagrams index numbers, etc. For the purpose of forecasting, other tools
such as time series regression analysis and sampling techniques are used.
Analysis of Data
Financial statements are analyzed and compared with past statements, compared with
those of other firms and with standards set. The analysis and interpretation results in drawing
reports and presentation to the management.
Internal Audit
Internal audit helps the management in fixing individual responsibility for internal
control.
Tax Accounting:
Tax liability is ascertained from income statements. Tax planning in done by following
the various tax incentives offered by the Central and State Governments. Knowledge of tax
provisions helps the management in meeting the tax liabilities and complying with other
legislations like Sales tax, Companies Act and MRTP Act.

Methods and Procedures:

In includes keeping of efficient system for data processing and effective reporting of
required data in time.
FUNCTIONS OF MANAGEMENT ACCOUNTING
Main objective of management accounting is to help the management in performing its
functions efficiently. The major functions of management are planning, organizing, directing and
controlling. Management accounting helps the management in performing these functions
effectively.
Presentation of Data
Traditional Profit and Loss Account and the Balance Sheet are not analytical for decision
making. Management accounting modifies and rearranges data as per the requirements for
decision making through various techniques.
Aid to Planning and Forecasting
Management accounting is helpful to the management in the process of planning through
the techniques of budgetary control and standard costing. Forecasting is extensively used in
preparing budgets and setting standards.
Decision Making
Management accounting provides comparative data for analysis and interpretation for
effective decision making and policy formulation.
Communication of Management Policies
Management accounting conveys the polices of the management downward to the
personnel effectively for proper implementation.
Effective Control
Standard costing and budgetary control are integral part of management accounting.
These techniques lay down targets, compare actual with standards and budgets to evaluate the
performance and control the deviations.
Incorporation of non-financial information
Management accounting considers both financial and non-financial information for
developing alternative courses of action which leads to effective and accurate decisions.
Co ordination
The targets of different departments are communicated to them and their performance is
reported to the management from time to time. This continual reporting helps the management in
coordinating various activities to improve the overall performance.
ADVANTAGES OF MANAGEMENT ACCOUNTING
The advantages of management accounting are summarized below:
Helps in Decision Making
Management accounting helps in decision making such as pricing, make or buy,
acceptance of additional orders, selection of suitable product mix etc. These important decision
are taken with the help of marginal costing technique.
Helps in Planning
Planning includes profit planning, preparation of budgets, programmes of capital
investment and financing. Management accounting assists in planning through budgetary control,
capital budgeting and cost-volume-profit analysis.
Helps in Organizing
Management accounting uses various tools and techniques like budgeting, responsibility
accounting and standard costing. A sound organizational structure is developed to facilitate the
use of these techniques.
Facilitates Communication
Management is provided with up-to-date information through periodical reports. These
reports assist the management in the evaluation of performance and control.
Helps in Co-ordination
The functional budgets (purchase budget, sales budget, and overhead budget etc.) are
integrated into one known as master budget. This facilitates clear definition of department goals
and coordination of their activities.
Evaluation and Control of Performance
Management accounting is a convenient tool for evaluation of performance. With the
help of ratios and variance analysis, the efficiency of departments can be measured. Management
accounting assists the management in the location of weak spots and in taking corrective actions.
Interpretation of Financial Information
Management accounting presents information in a simple and purposeful manner. This
facilitates quick decision making.
Economic Appraisal
Management accounting includes appraisal of social and economic forces and
government polices. This appraisal helps the management in assessing their impact on the
business.
LIMITATIONS OF MANAGEMENT ACCOUNTING
Management accounting suffers from the following limitations:
Based on Accounting Information
Management accounting derives information from past financial accounting and cost
accounting records. If the past records are not reliable, it will affect the effectiveness of
management accounting.
Wide scope
Management accounting has a very wide scope incorporating many disciplines. This
results in inaccuracy and other practical difficulties.
Costly
The installation of management accounting system requires a large organization. Hence,
it is very costly and only big concerns can afford to adopt it.
Evolutionary Stage
Management accounting is still in its initial stages. Tools and techniques are not fully
developed. This creates doubts about the utility of management accounting.
Opposition to Change
Introduction of management accounting system requires a number of changes in the organization
structure, rules and regulations. This rearrangement is not generally liked by the people involved.
Intuitive Decisions
Management accounting helps in scientific decision making. Yet, because of simplicity
and personal factors the management has a tendency to arrive at decisions by intuition.
Not an Alternative to Management
Management accounting will not replace the management and administration. It is a tool
of the management. Decisions are of the management and not of the management accountant.

DISTINGUISH BETWEEN MANAGEMENT ACCOUNTING AND COST

ACCOUNTING
Cost accounting and Management accounting are tow modern branches of accounting.
Both the systems involve presentation of accounting data for the purpose of decision making and
control of day-to-day activities. Cost accounting is concerned not only with cost ascertainment,
but also cost control and managerial decision making. Management accounting makes use of the
cost accounting concepts, techniques and data. The functions of cost accounting and
management accounting are complimentary. In cost accounting the emphasis is on cost
determination while management accounting considers both the cost and revenue. Though it
appears that there is overlapping of areas between cost and management accounting, the
following are the differences between the two systems.
Purpose
The main objective of cost accounting is to ascertain and control the cost of products or
services. The function of management accounting is to provide information to management for
efficiently performing the functions of planning, directing, and controlling.
Emphasis
Cost accounting is based on both historical and present data, whereas management
according deals with future projections on the basis of historical and present cost data.
Principles and Procedures
Established procedures and practices are followed in cost accounting. No such prescribed
practices are followed in Management accounting. The analysis is made and the resulting
conclusions are presented in reports as per the requirements of the management.
Data Used
Cost accounting uses only quantitative information whereas management accounting
uses both qualitative and quantitative information.
Scope
Management accounting includes, financial accounting, cost accounting, budgeting, tax
planning and reporting to management, whereas Cost accounting is concerned mainly with cost
ascertainment and control.
DISTINGUISH BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL
ACCOUNTING
The following are the main differences between financial accounting and management
accounting.
Objectives
The main objective of financial accounting is to supply information in the form of profit
and loss account and balance sheet to outside parties like shareholders, creditors, government etc.
But the objective of management accounting is to provide information for the internal use of
management.
Performance Analysis
Financial accounting is concerned with the overall performance of the business. On the
other hand management accounting is concerned with the departments or divisions. It report
about the performance and profitability of each of them.
Data Used
Financial accounting is mainly concerned with the recording of past events whereas
management accounting is concerned with future plans and policies.
Nature
Financial accounting is based on measurement while management accounting is based
on judgement. Because of this, financial accounting is more objective and management
accounting is more subjective.
Accuracy
Accuracy is an important factor in financial accounting. But approximations are widely
used in management accounting. This is because most of the information is related to the future
and intended for internal use.
Legal Compulsion
Financial accounting is compulsory for all joint stock companies but management
accounting is only optional .
Monetary Transactions
Financial accounting records only those transactions which can be expressed in terms of
money. On the other hand, management accounting records not only monetary transactions but
also non- monetary events, namely technical changes, government polices etc.
Control
Financial accounting will not reveal whether plans are properly implemented.
Management accounting will reveal the deviations of actual performance from plans. It will also
indicate the causes for such deviations.
Write your answer in the space given below.
DISTINGUISH BETWEEN COST ACCOUNTING AND FINANCIAL ACCOUNTING
Differences between Cost Accounts and Financial Accounts are listed below:
Objective
The main objective of cost accounting is to provide cost information to management for
decision making. The main objective of financial accounting is to prepare Profit and Loss A/c
and Balance Sheet to report to owners and outsiders.
Legal Requirement
Cost accounts are maintained to fulfil the internal requirements of the management as
per conventional guideline. Financial records are maintained as per the requirement of
Companies Act and Income Tax Act.
Classification of Transactions
Cost accounting records and analyses expenditure in an objective manner viz., according
to purpose for which costs are incurred. Financial accounting classifies records and analyses
transactions in a subjective manner i.e., according to nature of expenses.
Stock Valuation
In cost accounts stocks are valued at cost. In financial accounts, stocks are valued at cost
or realizable value, whichever is lesser.
Analysis of Profit and Cost
Cost accounts reveal Profit of Loss of different products, departments separately. In
financial accounts, the Profit or Loss of the entire enterprise is disclosed into.
Accounting period
Cost report are continuous process and are prepared as per the requirements of
managements, may be daily, weekly, monthly, quarterly, or annually. Financial reports are
prepared annually.
Emphasis
Cost accounting lays emphasis on ascertainment of cost and cost control. Financial
accounts emphasis is laid on the recording of transactions and control aspect is not given
importance.
Nature
Cost accounts lay emphasis on both historical and predetermined costs. Financial
accounts are maintained on the basis of historical records.

UNIT II ANALYSIS OF FINANCIAL STATEMENTS

Financial ratio analysis, Interpretation of ratio for financial decisions - Dupont

Ratios – Comparative statements - common size statements. Cash flow (as per Accounting
Standard3) and Funds flow statement analysis – Trend Analysis.

Financial statement analysis

The terms ‘financial analysis’ also known as analysis and interpretation of financial
statements, refers to the process of determining financial strengths and weaknesses of the firm by
establishing strategic relationship between the items of the balance sheet, profit and loss account
and other operative data.
Nature of financial statements
1. Record facts
The term recorded fact refers to the data taken out from the accounting records. The
records are maintained on the basis of actual cost data.
2. Accounting conventions
Though there are accounting standards laid down by various accounting bodies, the
managements are free to choose an accounting policy suited to their concerns. Accounting policy
differ with regard to valuation of inventory, depreciation, research, development and so on.
3. Personal judgement
 Rate of depreciation adopted, valuation of inventories, provision for bad and doubtful
debts.
Objectives of Financial Statements
1. To provide reliable financial information about economic resources and obligations of a
business firm.
2. To provide other needed information about changes in such economic resources and
obligations
3. To provide reliable information about changes in net resources arising out of business
activities
4. To disclose, to the extent possible, other information related to the financial statement
that is relevant to the needs of the users.

i) On the basis of Material Used

a) External Analysis

This analysis is deone by outsiders who do not have access to the detailed internal
accounting records of the business firm. These outsiders include investors, potential investors,
creditors, potential creditors, government agencies and the general public.
Tools of financial analysis
1. Comparative statements
2. Trend analysis
3. Common-size statements
4. Funds flow analysis
5. Cash flow analysis
6. Ratio analysis
7. Cost-volume profit analysis
Ratio analysis
A ratio is an expression of the quantitative relationship between tow numbers. Ratio
analysis is the process of determining numerical relationships based on financial statements. It is
the technique of interpretation of financial statements with the help of accounting ratios derived
forms the balance sheet and the profit and loss account.

USES AND SIGNIFICANCE

1. Managerial uses of Ratio analysis
a) Helps in decision making
Ratio analysis helps in making decisions from the information provided in these financial
statements
b) Helps in financial forecasting and planning
Ratio analysis is of much help in financial forecasting and planning. Planning is looking
ahead and the ratios calculated for a number of years work as a guide for the future.
c) Helps in communicating
The financial strength and weakness of a firma are communicated in a more cash and
understandable manner by the use of ratios.
d) Helps in co-ordination
Ratios even help in co-ordination which is of utmost importance in effective business
management. Better communication of efficiency and weakness of an enterprise results in better
co-ordination in the enterprise.
e) Helps in control
 Ratio analysis even helps in making effective control of the business. Standard ratios can
be based upon proforma financial statements and variance or deviations, if any, can be found by
comparing the actual with the standards so as to take a corrective action at the right time.
f) Other uses
There are so many other uses of the ratio analysis. It is an essential part of the budgetary
control and standard costing. Ratios are of immense importance in the analysis and
interpretation of financial statements as they bring the strength or weakness of a firm.
2. Utility to shareholders / investors
An investor in the company will like to assess the financial position of the concern where he
is going to invest. His interest will be the security of his investment and then a return in the form
of dividend or interest.
3. Utility to Creditors
The creditors or suppliers extent short-term credit to the concern. They are interested to
know whether financial position of the concern warrants their payments at a specified time or
not.
4. Utility to employees
The employees are also interest in the financial position of the concern especially
profitability. Their wages increases and amount of fringe benefits are related to the volume of
profits earned by the concern.
5. Utility to Government
Government is interest to know the overall strength of the industry. Various financial
statements published by industrial units are used to calculate ratios for determining short-term,
long-term and overall financial position of the concerns.
6. Tax Audit requirements.
Section 44 AB was inserted in the Income Tax Act by the Finance Act, 1984. Under this
section every assesse engaged in any business and having turnover or gross receipts excessing
Rs.40 lakh is required to get the accounts audited by a chartered accountant and submit the tax
audit report before the due date for filling the return of income under section 139 (I).

Limitations of ratio analysis

1. Limited use of single ratio
 A single ratio usually does not convey much of a sense. To make a better interpretation a
number of ratios have to be calculated which is likely to confuse the analyst than help him in
making any meaningful conclusion.
2. Lack of adequate standard
There are no well accepted standards or rules of thumb for all ratios which can be accepted as
norms. It renders interpretation of the ratios difficult.
3. Inherent limitations of accounting
Like financial statements, ratios also suffer from the inherent weakness of accounting records
such as their historical nature. Ratios of the past are not necessarily true indicators of the future.
4. Change of accounting procedure
Change in accounting procedure by a firm often makes ratio analysis misleading, e.g. a
change in the valuation of methods of inventories, from FIFO to LIFO increases the cost of sales
and reduces considerably the value of closing stocks which makes tock turnover ratio to be
lucrative and an unfavorable gross profit ratio.
5. Window dressing
Financial statements can easily be window dressed to present a better picture of its financial
and profitability position to outsiders.
6. Personal bias
Ratio are only means of financial analysis and not an end in itself. Ratios have to be
interpreted and different people may interpret the same ratio in different ways.
7. Un comparable
Not only industries differ in their nature but also the firms of the similar business widely
differ in their size and accounting procedures etc.
8. Absolute figures distortive
Ratios devoid of absolute figures may prove distortive as ratios analysis is primarily a
quantitative analysis and not a qualitative analysis.
9. Price level changes
While making ratio analysis, not consideration is made to the changes in price levels and this
makes the interpretation of ratios invalid
10. Ratios no substitutes
 Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if
separated from the statements from which they are computed.
11. Absolute figures distortive
12. Price level changes
13. Ratios no substitutes
Classification of ratios
BALANCE SHEET RATIOS
1. Current Ratio
2. Liquid ratio
3. Absolute liquid ratio ( Cash position ratio)
4. Proprietary Ratio
5. Capital Gearing Ratio
6. Debt – Equity Ratio
7. Ratio to fixed assets to Current Assets

1. Current ratio
Current ratio may be defined as the relationship between current assets and current liabilities.
This ratio is also know a working capital ratio.
 A ratio equal or near to the rule of thumb of 2:1, where the current asset double the current
liability, is considered to be satisfactory.
Components of current ratio
Current Assets Current liabilities
1. Cash in hand 1. Creditors
2. Cash at bank 2. Bills payable
3. Debtors 3. Bank overdraft
4. Bills receivable 4. Expenses outstanding
5. Prepaid expenses 5. Interest due or payable
6. Money at call and short 6. Installment payable on long
notice term loans
7. Stock 7. Income tax payable
8. Sundry supplies 8. Any other amount which is
9. Other amount receivable payable in short period
within a year
Note : Bank overdraft arrangement facility with the bank is more or less permanent, therefore, it
is insisted that this should be excluded when current ratio is calculated. At the same time, it can
also be claimed that overdraft facility may be cancelled by the bank at any time. Thus, it is
advisable to include bank overdraft in current liabilities
3. Liquid ratio
Liquid ratio is also known as acid test ratio or quick ratio or near money ratio. The term
‘liquidity’ refers to the ability of a firm to pay its short-term obligations as and when they
become due
 Stock & Prepaid expenses is exclude from liquid assets on the ground that it is not
converted into cash in the immediate future. Liquid liabilities consist of all current liabilities
minus bank overdraft
Rule of Thumb of 1:1 is to be considered satisfactory
4. Absolute liquid ratio (cash position ratio)
Absolute liquidity ratio is calculated when liquidity is highly restricted in terms of cash
and cash equivalents. This ratio measures the relationship between cash and near cash items on
the one hand and immediately maturing obligations on the other

The acceptable norm for this ratio is 0.5:1 or 1:2 i.e. Rs.1 worth absolute liquid assets are
considered adequate to pay for Rs. Worth current liabilities in time as all the creditors are not
accepted to demand cash at the same time and, then, cash may also be realized from debtors and
inventories
Proprietary ratio
Proprietary ratio is a test of the financial and credit strength of the business. It relates
shareholders funds to total assets. This ratio shows the long-term or future solvency of the
business.
Proprietary ratio is also known as: worth debt ratio or net worth to total asset ratio or
equity ratio net worth ratio or proprietors funds to total asset backing ratio. It is calculated either
by dividing shareholders funds by the total assets or by dividing proprietors funds by total asset
or total funds.
 The relationship is expressed as a pure ratio or as a percentage
Proprietor’s funds include equity share capital, preference share capital, capital reserve,
revenue reserve, surplus and undistributed profits less accumulated losses and unamortized
miscellaneous expenditure items.
Proprietary ratios are also analyzed as ratio of fixed assets to proprietors’ funds and ratio
of current assets to proprietor’s funds

Capital gearing ratio

Capital gearing ratio is also known as capitalization ratio or leverage ratio. This ratio brings out
the relationship between two types of capital: that carries a fixed rate of dividend or interest and
that does not carry a fixed rate of dividend or interest. It is modified counterpart of debt equity
ratio

Fixed interest or dividend – bearing capital comprises debentures, secured and unsecured
loans and preference share capital. Non-fixed interest or dividend-bearing fund is the equity
share capital
The capital gearing reveals the company’s capitalization. That is
Equity capital = Loan capital = Ever Gear
Equity capital > Loan capital = Low gear = Over-capitalisation
Equity Capital <Loan capital = High Gear = Under-Capitalisation
Debt equity ratio
Debt-equity ratio express the relationship between the external an the internal equities or that
between the borrowed capital and the owners capital.

Shareholders’ funds consist of preference share capital, equity share capital, capital
reserve, revenue reserve, reserve for contingencies, redemption of debentures less fictitious
assets. Outsiders funds include all debts/liabilities to outsiders: long-term and short term.
Generally a ratio of 1:1 is considered to be satisfactory. Some business, say financial
institutions, favours high ratio 2:1.
RATIO OF FIXED ASSETS TO CURRENT ASSETS

Profits and loss account ratios

1. Gross profit ratio
2. Operating ratio
3. Expenses ratio
4. Operating profit ratio
5. Net profit ratio
1. Gross profit ratio
Gross profit ratio measures the relationship of gross profit to net sales and is usually
represented as a percentage.
Cost of goods sold = Opening stock + Purchases + Direct Expenses – Closing stock
A ratio of 25 to 30% may be considered good
2. Operating ratio
Operating ratio establishes relationship between the cost of goods sold and the other
operating expenses and sales.

Cost of goods sold = Opening stock + Purchases + Direct Expenses – Closing stock
Operating Expenses = Administrative exp. + Financial exp. + Selling Exp.
3. Expenses ratio
Expenses ratio is also known as supporting ratio to operating ratio. It becomes
imperative that each aspect of cost of sales and/or operating expenses be analyzed in detail just to
find out how far the concern is able to save or making over expenditure in respect of different
items of expenses.
4. Operating Profit Ratio

This ratio establishes relationship between the operating net profit and sales.

Operating Profit
Operating profit ratio =------------------------- 100
Sales

(or)
Operating profit ratio = 100 – Operating ratio.
Operating profit = Net profit + Non-operating expenses – Non operating Income
(or)
=Sales – (Cost of goods sold + administrative expenses
+ selling & distribution expenses)
5. Net profit ratio
Net profit ratio is also called net profit to sales ratio. Profit margin is indicative of the
management's ability to operate the business with sufficient success not only to recover from the
revenues of the period, the cost of merchandise or services, the expense of operating the business
and the cost of borrowed funds, but also to leave a margin of reasonable compensation to the
owners for providing their capital at risk. Higher the ratio of net operating profit to sales, better
is the operational efficiency of the concern.

Inter statement ratios

1. Stock turnover ratio
 2. Debtors turnover ratio
3. Creditors turnover ratio
4. Working capital turnover ratio
1. Stock turnover ratio
Stock turnover ratio is also known as inventory ratio ro inventor turnover ratio or stock
turn ratio or merchandise turnover ratio or stock velocity ratio or simply velocity of stock. This
ratio measures the number of times the stock turns, flows or rotates in an accounting period
compared to the sales effected during that period.

The number of times the inventory has been sold and replaced during a given period of
time

Cost of Goods sold = Sales – Gross profit

Cost of goods sold = Opening stock + purchases + Direct expenses – Closing stock
Note: If opening stock is not known, closing stock can be taken
2. Debtors turnover ratio
 Debtors turnover ratio or debtors velocity is alternatively known as turnover of debtors
ratio or accounts receivable ratio. This ratio attempt to measure the collectability of debtors and
other account receivables.

Trade Debtors = Sundry debtors + Bills receivables or Accounts receivable

If the information in respect of credit sales and average debtors is not available, the method to
calculate the debtors turns over ratio

Debtors collection period

It indicates the extent to which the debts have been collected in time. It gives the average
debt collection period.
3. Creditors turnover ratio
Creditors turnover ratio is also known as Accounts payable or creditors velocity. It shows
the speed with which payments are made to the suppliers for the purchase of goods from them.
It is a relationship between net credit purchase and average creditors

4. Working capital turnover ratio

Working capital turnover ratio indicates the number of times the working capital is turned
over in the course of a year. It measure the efficiency with which the working capital is used by
the firm. It helps in determining the liquidity of a firm in as much as it gives the rate at which
inventories are converted to sales and then to cash. A high ratio indicates the efficient utilization
of working capital and a low ratio indicates otherwise. But a very high ratio is not good for the
firm.

Working capital = Current assets – Current liabilities

Overall profitability ratio

1. Return on shareholder investment
2. Return on equity capital
3. Earning per share
4. Return on capital employed
1. Return on shareholder investment
Return on shareholder’s investment, popularly known as ROI, is the relationship between net
profit (after interest and tax) and the proprietors funds.

Shareholder’s funds include equity share capital + Preference share capital + Reserves &
Surpluses less accumulated losses.
Net profit = Net profit after payment of interest and taxes
Return on equity capital (rec)

This ratio is meaningful to the equity shareholders, and the interpretation is the higher the
ratio, the better the result.
Earnings per share (EPS)
Earnings per share are calculated by dividing the net profit after taxes and preferences
dividend by the total number of equity shareholders.

Return on Capital Employed

Return on capital employed establishes the relationship between profits and the capital
employed. The term capital employed refers to the total of investments made in a business.
1. Gross Capital Employed

Adjusted Net profits

Return on Gross Capital Employed = ------------------------ 100
Gross Capital Employed

2. Net Capital Employed

Adjusted Net profits

Return on Net Capital Employed = ---------------------------- 100
Net Capital Employed
3. Proprietors Net Capital Employed

Adjusted Net profits

Return on Proprietors Net Capital Employed =--------------------------100
Proprietors Capital Employed

a) Gross capital employed:

Fixed Assets + Current Assets

b) Net Capital Employed = Total assets – Current liabilities

c) Proprietors Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities (Both
long term and short term)

Market test or valuation ratios

1. Dividend yield ratio
2. Dividend payout ratio
3. Price earning ratio
4. Earning yield ratio

1. Dividend yield ratio

Dividend yield ratio is calculated to evaluate the relationship between dividend per share
paid and the market value of the share.
Dividend pay-out ratio
Dividend pay-out ratio or simply pay-out ratio is calculated to find the extent to which
earnings per share have been retained in the business. It is important ratio because ploughing
back of profits enables a company to grow and pay more dividends in future.

Price-earning ratio (P/E Ratio)

Price-earning ratio is the ratio between market price per equity share and earnings per
share. This ratio is calculated to make an estimate of appreciation in the value of a share of a
company and is widely used by investors to decide whether or not to buy shares in a particular
company. This ratio is calculated as

Generally, the higher the price-earning ratio, the better it is. If P/E ratio falls, the
management should look into its causes.
Earnings-yield ratio
Earnings-yield ratio also shows a relationship between earnings per share and market
value of shares. It can be calculated as follows.

RATIO ANALYSIS ( IMPORTANT RATIOS)

I. BALANCE SHEET RATIOS

Current Assets

1. Current Ratio = ––––––––––––––

Current Liabilities
 Quick or Liquid Assets

2. Liquid Ratio = –––––––––––––––––––

Quick /Liquid Liabilities

Absolute Liquid Assets Cash & Bank + Short term securities

3. Absolute Liquid Ratio = ––––––––––––––––––– (or) –––––––––––––––––––––––––––––

Current Liabilities Current Liabilities

Proprietors Funds

4. Proprietary Ratio = –––––––––––––––––––

Total Assets

Fixed Assets

4.1 Fixed assets to Shareholders Fund= –––––––––––––––––

Proprietor’s fund

Current Assets

4.2 Current assets to Shareholders Fund = ––––––––––––––––––

Proprietor’s fund

Fixed interest-bearing Funds

5. Capital Gearing Ratio = ––––––––––––––––––––––––––

Equity Capital

Outsiders Funds

6.1. Debt – Equity Ratio = ––––––––––––––––––

Shareholders fund
 External Equities

6.2. Debt – Equity Ratio = –––––––––––––––––––––

Internal Equities

Total Long term debt

6.3 Debt – Equity Ratio = –––––––––––––––––––

Total long term funds

External Equities

6.4. Debt – Equity Ratio = –––––––––––––––

Internal Equities

Total long-term debt

6.5 Debt – Equity Ratio = –––––––––––––––––

Shareholders Funds

Fixed Assets

7. Fixed assets to Current Assets = –––––––––––––

Current Assets
II: PROFITS AND LOSS ACCOUNT RATIOS

Gross Profit

8.1 Gross Profit Ratio = –––––––––––––––X 100

Net sales

Sales – Cost of Goods sold

8.2 Gross Profit Ratio = ––––––––––––––––––––––––– X 100

Net sales

Operating Cost

9.1 Operating Ratio = ––––––––––––––––– X 100

Net sales

Cost of Goods sold + Operating Expenses

9.2. Operating Ratio = ––––––––––––––––––––––––––––––––––––X 100

Net sales

Factory Expenses

10.1. Factory Expenses Ratio = –––––––––––––––––––––––X 100

Net sales

Administrative Expenses

10.2. Administrative Expenses Ratio = –––––––––––––––––––––––––––– X 100

Net sales
 Selling Expenses

10.3. Selling expenses Ratio = –––––––––––––––––––––– X 100

Net sales

Operating Profit

11. Operating profit ratio = ––––––––––––––––– x 100

Sales

Net profit

12. Net profit Ratio = ––––––––––––––––– X 100

Net sales

III: INTER STATEMENT RATIOS

Cost of Goods Sold

13.1. Stock Turnover Ratio = –––––––––––––––––––––––X 100

Average Stock

Net sales

13.2. Stock Turnover Ratio = ––––––––––––––––––––––––X 100

Average Inventory at cost

Net Sales

13.3. Stock Turnover Ratio = ––––––––––––––––––––––––––––––––––X 100

Average Inventory at Selling Price

 Opening stock + Closing Stock

13.4. Average Stock = ––––––––––––––––––––––––––––––––––––––

Credit Sales

14. Debtors Turnover Ratio = ––––––––––––––––––––

Average Trade Debtors

Opening Trade Debtors + Closing Trade Debtors

14.1. Average Trade Debtors = ––––––––––––––––––––––––––––––––––––––––––––––

Total Sales

14.2. Debtors Turnover Ratio = –––––––––––––––––––––

Closing Debtors

14.3. Debtors collection period

Months in a year

–––––––––––––––

Debtor’s turnover

(or)

Average Debtors X Months in a year

–––––––––––––––––––––––––––––––
 Net credit sales for the year

(or)

Accounts Receivable

––––––––––––––––––––––––––––––

Average monthly or daily credit sales

Net Credit Purchase

15. Creditors Turnover Ratio = –––––––––––––––––––––––

Average Trade Creditors

Average Trade creditors (Creditors + Bills receivable)

15.1. Average Payment period = ––––––––––––––––––––––––––––––––––––––––––––––

Average Daily Purchase

Annual purchase

15.2. Average Daily purchase = –––––––––––––––––––––––––––––

No. of Working days in a year

Number of working days

15.3. Average Payment Period = ––––––––––––––––––––––––––––––

Creditors Turnover ratio

Cost of sales (Or sales)

16. Working capital turnover ratio = ––––––––––––––––––––

Net Working Capital

IV: OVERALL PROFITABILITY RATIO

Net profit (after interest and tax)

17. Return on shareholder’s investment= –––––––––––––––––––––––––––––––X 100

Shareholder’s funds

Net profit (after interest and tax) – Preference Dividend

18. Return on Equity capital = –––––––––––––––––––––––––––––––––––––––––––––––X 100

Equity share capital

Net profit (after interest and tax) – Preference Dividend

19. EPS = –––––––––––––––––––––––––––––––––––––––––––––––––

No. of equity shares

20. Return on Capital Employed

20.1. Return on Gross Capital Employed =

Adjusted Net profits

–––––––––––––––––––––––x 100

Gross Capital Employed

20.2. Return on Net Capital Employed =

Adjusted Net profits

–––––––––––––––––––––x 100
 Net Capital Employed

20.3. Return on Proprietors Net Capital Employed =

Adjusted Net profits

–––––––––––––––––––––––––x 100

Proprietors Capital Employed

V: MARKET TEST OR VALUATION RATIOS

Dividend per share

21. Dividend Yield Ratio = ––––––––––––––––––––––––––

Market Value per share

Dividend paid to shareholders

21.1. Dividend Per share = –––––––––––––––––––––––––––––

Number of Shares

Dividend per equity share

22. Dividend Pay-out ratio= –––––––––––––––––––––––––––––

Earning per share

Market price per equity share

23. Price – Earning Ratio = ––––––––––––––––––––––––––-

Earning per share

Earnings per share

24. Earning s-Yield Ratio = –––––––––––––––––––––X 100

Market price per share

Fund flow statement

Fund flow statement
Many changes take place in the assets, equities, revenues and expenses in the course of
business operations. These changes in an asset or an equity account or in revenue or an expenses
account over a period of time can be examined and presented in the form of a flow statement.
The funds flow statement describes the sources from which additional funs were derived
and the uses to which these funds were put.
The funds flow statement is denoted by various titles, such as a statement of sources and
application of funds, statement of changes in working capital, got and tone statement and
statement of resource provided and applied.
Objectives of funds flow statement
1. To help to understand the changes in assets and assets sources which are not readily
evidence in the income statement or the financial position statement.
2. To inform as to how the loans to the business have been used.
3. To point out the financial strengths and weaknesses of the business
4. Indication of financial results
5. Emphasis on significant changes
6. Revealing financial strength and weaknesses
7. Distinguishing internal and external sources
8. Giving prominence to dynamic concept of business
Classification of balance sheet items
 Non current liabilities
 Current liabilities
 Non current assets
 Current assets

 Non Current liabilities

These liabilities are not required to payable within a year and out of current assets. These
liabilities are generally payable either in the long period or at the close of the business
Equity share capital
Pref. share capital
Debentures
Long term loans
Profit and loss a/c
Share premium
Share forfeiture
Capital reserve
 Current liabilities
Current liabilities are payable within a year and out of current assets. The values of these
liabilities change within one year.
Sundry creditors
Bank over draft
Outstanding expenses
Income tax payable
Bills payable
 Non-current assets
These assets are obtained in business for use over a long period of time for earning purpose.
These assets are not purchased for the purpose of selling and include tangible, intangible and
fictitious assets.
Building
Land
 Plant and machinery
Furniture and fixtures
Patent right
Trade mark
Preliminary expenses
Current assets
Current assets are easily converted into cash. These assets are reasonably expressed to be
realized in cash or sold or consumed within a year.
Cash in hand
Cash at bank
Marketable securities
Debtors
Bills receivables
Stock
Advance
Accrued incomes
Prepaid expenses
Preparation of funds flow statement
1. Statement of changes in working capital
2. Funds flow statement
3. Funds from operations
4. Adjusted profit and loss account
Statement of changes in working capital
A statement shows the complete details for the contribution of each item of current assets
and current liabilities is called as ‘schedule of changes in working capital.
The following important principles for preparation of working capital statement.
Increase in current assets - Increase working capital
Decrease in current assets - Decreases in working capital
Increase in current liability - Decreases in working capital
Decrease in current liability - Increase in Working capital
 Schedule of changes in w.c
Particulars Year Year Changes in W.C

(Rs.) (Rs.) Increase Decrease

Current assets
Cash
Bank balance
Stock
Sundry debtors
Trading investment
Prepaid expenses
Bills receivables
Total (A)

Less : Current Liabilities

Creditors
Bills payable
Outstanding expenses
Short term loans
Bank overdraft
Total (B)

Working Capital
(Increase/Decrease) (A-B)

Net working capital

Funds from operation

Funds are generated from the regular operation of and enterprise or applied to such
operation are known as funds from operation. It can be calculates by adding non-operating
expenses and deducting non-operating income from the net profit.
If the net amount is positive it is called fund from operation and if it is negative it is
called fund lost from operations
 Adjusted profit and loss account
Particulars Rs. Particulars Rs.

To depreciation Xxx By Balance b/d Xxx

To loss on sale of fixed assets Xxx By Profit on sale of fixed assets Xxx
To loss on sale of investment Xxx By Profit on sale of investment Xxx
To goodwill written off Xxx By income from investment Xxx
To discount on issue of shares Xxx By income tax refund Xxx
To provision for tax Xxx By Funds from operations (Bal. fig) Xxx
To proposed dividend Xxx
To balance C/d xxx
Adjusted profit and loss account
Particulars Rs. Rs.

Net profit for the year Xxx Xxx

Add : Non Operating Expenses Xxx Xxx
Depreciation on fixed assets Xxx
Loss on sale of fixed assets Xxx
Loss on sales of investment Xxx
Goodwill written off Xxx
Discount on debentures written off Xxx
Provision for tax Xxx
Proposed dividend Xxx
Less: Non Operating Incomes Xxx
Profit on sale of fixed assets Xxx
Profit on sale of investment Xxx
Income from investment
Income tax refund
 Dividend Received
Funds from operation

Adjusted profit and loss account

Net profit = Closing balance of P&L A/c – Opening Balance of P&L A/c
Treatment of provision for taxation
Provision for tax may taken as current liability
Provision for tax may be taken only as an appropriation of profit
Treatment of proposed dividend
Proposed dividend may be taken as a current liability
Proposed dividend may derived from appropriation of profits.

Funds flow statement

Sources of Funds Rs. Applications or Uses of funds Rs.

a) Internal sources Xx Purchase of fixed assets Xx

Funds from operations Xx Purchase of long term investment Xx
 b) External Sources Xx Redemption of preference shares Xx
Issue of equity shares Xx Redemption of debentures Xx
Issue of preference shares Xx Repayment of long term loans Xx
Issue of debentures Xx Payment of dividend Xx
Public deposits Xx Payment of tax liability Xx
Long term loans Xx Outflow of funds Xx
Sale of fixed assets Xx
Sale of long term investment Xx

Cash flow statement

Cash flow includes cash inflows and out flows-cash receipts and cash payments during a
period. Movements of cash are of vital importance to the management. The short term liquidity
and short term solvency positions of a firm are dependent on its cash flows.
A cash flow statement is a statement which reflects the changes in the cash position
between two accounting periods. The detailed analysis provided in such a statement a clear
insight to the management about the different sources of cash inflows and the different uses or
applications for which cash is required. It helps in taking short term financial decision and also
in the preparation of cash budget for the next period.
Cash flow statement can be defined as a statement which summaries the sources of cash
inflows and uses of cash outflows of a firm during particular period of time, say a month or a
year.
Such a statement can be prepared from the data made available from comparative balance
sheets, profit and loss accounts and additional information's.
Advantages
1. It helps to evaluate the current cash position of the firms
2. It helps in making short term financial decisions relating to liquidity
3. It shows the major sources and uses of cash
4. It helps in taking loan from banks and other financial institutions.
5. It helps the management in planning the repayment of loans, replacement of assets, credit
arrangements, etc.
 Cash flow (as per Accounting Standard 3)

Particulars Amount (Rs.) Amount (Rs.)

1) Cash flow from operating activities

Net Profit xxx

Adjustments

Non Operating Expenses xxx

Non Operating Income (xxx)

Operating profit before Working capital changes xxx

Increase in Current Asset (xxx)

Decrease in Current Asset xxx

Increase in Current Liabilities xxx

Decrease in Current Liabilities (xxx)

Cash generated from operation xxx

Income tax paid (xxx)

Cash flow from extraordinary item xxx

Other proceeds xxx

Net cash flow from operating activities xxx

2) Cash flow from investing activities

Purchase of fixed assets

Sale of fixed assets (xxx)

Interest received xxx

Dividend received xxx

Net cash flow from investing activities xxx

3) Cash flow from financing activities

Issue of shares xxx

Issue of debentures xxx

Redemption of shares (xxx)

Redemption of debentures (xxx)

Interest paid (xxx)

Dividends paid (xxx)

Net cash used in financing activities xxx

Cash and cash equivalent at beginning of period xxx

Cash and cash equivalent at end of the period

 xxx

Cash inflow transactions

1. Cash from operations
2. Increase of all current liabilities
3. Raising of long term loan
4. Sale of fixed assets and long-term investments
5. Decrease of all current assets.
6. Issue of shares and debentures

Cash Outflows
1. Cash lost in operations
2. Payment of cash dividends
3. Drawings of a partner
4. Redemption of preference share and debentures
5. Purchase of fixed assets and long term investment
6. Decrease of all current liabilities
7. Repayment of long term loans
8. Payment of taxes
9. Increase of all current assets

UTILITY OF CASH FLOW STATEMENT

Utility of cash flow statements are as follows:
1. To identify the reasons for the reduction or increase in the cash balances irrespective
level of the profits earned by the firm.
2. It facilitates the management to maintain an appropriate level of cash resources. l It
guides the management to take futuristic decisions on the prospective demands and
supply of cash resources through projected cash flows.
3. How much cash resources are required?
4. How much cash requirements could be internally settled?
 5. How much cash resources are to be raised through external sources?
6. Which type of instruments is going to be floated for raising the required resources?
7. It helps the management to understand its capacity at the moment of borrowing for
any further capital budgeting decisions.
8. It paves way for scientific cash management for the firm through maintenance of
appropriate cash levels i-e optimum level cash of resources.
9. It avoids in holding excessive or inadequate cash resources through proper planning
of cash resources.
10. It moots control through identification of variations occurred in the cash expenses and
expenditures.

Cash flow statement vs Fund flow statement

UNIT III COST ACCOUNTING 9

Cost Accounts – Classification of costs – Job cost sheet – Job order costing – Process
costing – (excluding Interdepartmental Transfers and equivalent production) – Joint and
By Product Costing – Activity Based Costing, Target Costing.

Cost
Cost is the amount of expenditure incurred or attributable to a given thing.
Costing
 “Techniques and process of ascertaining costs”.
Cost Accounting
Cost Accounting is the process of recording, classifying, allocating & reporting various
costs incurred in the business.
Cost Accounting -Objectives
1. Cost findings
2. Control of cost
3. Reduction of Cost
4. Fixation of selling price
5. Providing information for framing business policy
Element of cost

Classification of Costs

1. By Nature or Element or Analytical Classification

According to this classification, the costs are divided into three categories i.e. Materials,
Labour and Expenses. There can be further sub classification of each element; for example,
material into raw material components, and spare parts, consumable stores, packing material etc.
This classification is important as it helps to find out the total cost, how such total cost is
constituted and valuation of work in progress.
2. By Functions
According to this classification costs are divided in the light of the different aspects of
basics managerial activities involved in the operation of a business undertaking. It leads to
grouping of cost according to the broad divisions or functions of a business undertaking i.e.,
production, administration selling and distribution. According to this classification costs are
divided as follows:
Manufacturing and Production Cost: This is the total of costs involved in
manufacture, construction and fabrication of units of production.
Commercial Cost: This is the total of costs incurred in the operation of a business
undertaking other than the cost of manufacturing and production. Commercial cost may further
be sub-divided into (a) administrative cost and (b) selling and distribution cost. These terms will
be explained in a subsequent chapter.
4. As Direct and Indirect
According to this classification, total cost is divided into direct costs and indirect costs.
Direct costs are those which are incurred for and may be conveniently identified with a
particular cost centre or cost unit. Materials used and labour employed in manufacturing an
article or in a particular process of production are common examples of direct costs. Indirect
costs are those cost which are incurred for the benefit of number of cost centres or cost units and
cannot be conveniently identified with a particular cost centre or cost unit. Examples of indirect
cost include rent of building, management salaries, machinery depreciation etc. The nature of
the business and the cost unit chosen will determine which costs are direct and which are
indirect. For example, the hire of a mobile crane for use by a contractor at site would be
regarded as a direct cost but if the crane is used as a part of the services of a factory, the hire
charges would be regarded as indirect cost because it will probably benefit more than one cost
centre. The importance of the distinction of costs into direct and indirect lies in the fact that
direct costs of a product or activity can be accurately determined while indirect costs have to be
apportioned on certain assumptions as regards their incidence.
5. By Variability
According to this classification, costs are classified according to their behaviour in
relation to changes in the level of activity or volume of production. On this basis, costs are
classified into three groups viz. fixed, variable and semi-variable.
 (i) Fixed or period costs are commonly described as those which remain fixed in total
amount with increase or decrease in the volume of output or productive activity for a
given period of time. Fixed cost per unit decreases as production increases and increases
as production declines. Examples of fixed costs are rent, insurance of factory building,
factory manager’s salary etc. These fixed costs are constant in total amount but fluctuate
per unit as production changes. These costs are known as period costs because these are
dependent on time rather than on output. Such costs remain constant per unit of time
such as factory rent of Rs.10,000 per month remaining same for every month irrespective
of output of every month.
(ii) Variable or product costs are those which vary in total in direct proportion to the
volume of output. These costs per unit remain relatively constant with changes in
production. Thus, variable costs fluctuate in total amount but tend to remain constant per
unit as production activity changes. Examples are direct material costs, direct labour
costs, power, repairs etc. Such costs are known as product costs because they depend on
the quantum of output rather than on time.
(iii) Semi-variable costs are those which are partly fixed and partly variable. For example,
telephone expenses included a fixed portion of annual charge plus variable charge
according to calls; thus total telephone expenses are semi-variable. Other examples of
such costs are depreciation, repairs and maintenance of building and plant etc.
6. By Controllability
Under this, costs are classified according to whether or not they are influenced by the
actions of a given member of the undertaking. On this basis it is classified into two categories:
(i) Controllable costs are those which can be influenced by the action of a specified
member of an undertaking, that is to say, costs which are at least partly within the
control of management. An organization is divided into a number of responsibility
centres and controllable costs incurred in a particular cost centre can be influenced by
the action of the manager responsible for the centre. Generally speaking, all direct costs
including direct material, direct labour and some of the overhead expenses are
controllable by lower level of management.
(ii) Uncontrollable costs are those which cannot be influenced by the action of a
 specified member of an undertaking that it is to say, which are within the control of
management. Most of the fixed costs are uncontrollable. For example, rent of the
building is not controllable and so are managerial salaries. Overhead cost, which is
incurred by one service section and is apportioned to another which receives the service,
is also not controllable by the latter.

The distinction between controllable and uncontrollable is sometimes left to individual

judgment and is not sharply maintained. It is only in relation to a particular level of management
or an individual manager that we may say whether a cost is controllable or uncontrollable. A
particular item of cost which may be controllable from the point of view of one level of
management may be uncontrollable from another point of view. Moreover, there may be an item
of cost which is controllable from long term point of view and uncontrollable from short term
point of view. This is partly so in the case of fixed costs.
7. By Normality
Under this, costs are classified according to whether these are cost which are normally
incurred as a given level of output in the conditions in which that level of activity is normally
attained. On this basis, it is classified into two categories:
(a) Normal cost: It is the cost which is normally incurred at a given level of output in
the conditions in which that level of output is normally attained. It is a part of cost of
production.
(b) Abnormal cost: It is the cost which is not normally incurred at a given level of
output in the conditions in which that level of output is normally attained. It is not a part
of cost of production and charged to Costing Profit and Loss Account.
8. By Capital and Revenue or Financial Accounting Classification
The cost which is incurred in purchasing assets either to earn income or increasing the
earning capacity of the business is called capital cost. For example, the cost of a rolling machine
in case of steel plan. Such cost is incurred at one point of time but the benefits accruing from it
are spread over a number of accounting years. It any expenditure is done in order to maintain the
earning capacity of the concern such as cost of maintaining an asset or running a business it is
revenue expenditure e.g. cost of materials used in production, labour charges paid to convert the
material into production, salaries, depreciation, repairs and maintenance charges, selling and
distribution charges etc. The distinction between capital and revenue items is important in
costing as all items of revenue expenditure are taken into consideration while calculating cost
whereas capital items are completely ignored.
9. By Time
Cost can be classified as (i) Historical costs and (ii) Predetermined costs.
i) Historical costs: The cost which is ascertained after their incurrence is called
historical costs. Such costs are available only when the production of a particular thing
has already been done. Such costs are only of historical value and not at all helpful for
cost control purposes. Basic characteristics of such costs are:
(a) They are based on recorded facts.
(b) They can be verified because they are always supported by the evidence of their
occurrence.
(c) They are mostly objective because they relate to happenings which have already
taken place.
ii) Predetermined costs: Such costs are estimated costs i.e. computed in advance of
production taking into consideration the previous period’s costs and the factors affecting
such costs. Predetermined cost determined on scientific basis becomes standard cost.
Such costs when compared with actual costs will give the reasons of variance and will
help the management to fix the responsibility and to take remedial action to avoid its
recurrence in future.
Historical costs and predetermined costs are not mutually exclusive but they work
together in the accounting system of an organization. In competitive age, it is better to lay down
standards, so that after comparison with the actual, the management may be able to take stock of
the situation to find out as to how far the standards fixed by it have been achieved and take
suitable action in the light of such information. Therefore, even in a system when historical costs
are used, predetermined costs have a very important role to play because a figure of historical
cost by itself has no meaning unless it is related to some other standard figure to give
meaningful information to the management.
10.According to Planning and Control
Planning and control are two important functions of management. Cost accounting
furnishes information to the management which is helpful is the due discharge of theses two
functions. According to this, costs can be classified as budgeted costs and standard costs.
i) Budgeted costs: Budgeted costs represent an estimate of expenditure for different
phases of business operations such as manufacturing, administration, sales, research and
development etc. coordinated in a well conceived framework for a period of time in
future which subsequently becomes the written expression of managerial targets to be
achieved. Various budgets are prepared for various phases, such as raw material cost
budget, labour cost budget, cost of production budget, manufacturing overhead budget,
office and administration overhead budget etc, Continuous comparison of actual
performance (i.e. actual cost) with that of the budgeted cost is made so as to report the
variations from the budgeted cost to the management for corrective action.
ii) Standard Cost: Budgeted costs are translated into actual operation through the
instrument of standard costs. The Institute of Cost and Management Accountants,
London defines standard cost as follows: “Standard cost is the predetermined cost based
on a technical estimate for materials, labour and overhead for a selected period of time
and for a prescribed set of working conditions”. Thus, standard cost is a determination,
in advance of production of what should be the cost.
Budgeted costs and standard costs are similar to each other to the extend that both of
them represent estimates for cost for a period of time in future. In spite of this, they differ in the
following aspects:
1. Standard costs are scientifically predetermined costs of every aspect of business
activity whereas budgeted costs are mere estimates made on the basis of past actual
financial accounting data adjusted to future trends. Thus, budgeted costs are
projection of financial accounts whereas standard costs are projection of cost
accounts.
2. The primary emphasis of budgeted costs is on the planning function of management
whereas the main thrust of standard costs is on control because standard costs lay
emphasis on what should be the costs.
3. Budgeted costs are extensive whereas standard costs are intensive in their
application. Budgeted costs represent a macro approach of business operations
because they are estimated in respect of the operations of a department. Contrary to
this, standard costs are concerned with each and every aspect of business operation carried in a
department. Thus, budgeted costs deal with aggregates whereas standard costs deal with
individual parts which make the aggregate. For example, budgeted costs are calculated for
different functions of the business i.e. production, sales, purchases etc. whereas standard costs
are compiled for various elements of costs i.e. materials, labour and overhead.
11. For Managerial Decisions
On this basis, costs may be classified into the following costs:
i) Marginal cost: Marginal cost is the total of variable costs i.e. prime cost plus
variable overheads. It is based on the distinction between fixed and variable costs.
Fixed costs are ignored and only variable costs are taken into consideration for
determining the cost of products and value of work in progress and finished goods.
ii) Out of pocket costs: This is that portion of the cost which involves payment to
outsiders i.e., gives rise to cash expenditure as opposed to such costs as depreciation,
which do not involve any cash expenditure. Such costs are relevant for price fixation
during recession or when make or buy decision is to be made.
iii) Differential costs: The change in costs due to change in the level of activity or
pattern or method of production is known as differential costs. It the change increases
the cost, it will be called incremental cost. If there is decrease in cost resulting from
decrease of output, the difference is known as decremental cost.
iv) Sunk costs: A sunk cost is an irrecoverable cost and is caused by complete
abandonment of a plant. It is the written down value of the abandoned plant less its
salvage value. Such costs are not relevant for decision making and are not affected by
increase or decrease in volume.
v) Imputed costs: These costs are those costs which appear in cost accounts only e.g.
national rent charged on business premises owned by the proprietor, interest on
capital for which no interest has been paid. These costs are also known as notional
costs. When alternative capital investment projects are being evaluated it is necessary
to consider the imputed interest on capital before a decision is arrived as to which is
the most profitable project.
vi) Opportunity cost: It is the maximum possible alternative earning that might have
been earned if the productive capacity or services had been put to some alternative
 use. In simple words, it is the advantage, in measurable terms, which has been
foregone due to not using the facility in the manner originally planned. For example,
if an owned building is proposed to be used for a project, the likely rent of the
building is the opportunity cost which should be taken into consideration while
evaluating the profitability of the project.
vii) Replacement cost: It is the cost at which there could be purchased an asset or
material identical to that which is being replaced or revalued. It is the cost of
replacement at current market price.
viii) Avoidable and unavoidable cost: Avoidable costs are those which can be eliminated
if a particular product or department, with which they are directly related, is
discontinued. For example, salary of the clerks employed in a particular department
can be eliminated, if the department is discontinued. Unavoidable cost is that cost
which will not be eliminated with the discontinuation of a product or department. For
example, salary of factory manager or factory rent cannot be eliminated even if a
product is eliminated.

Cost Sheet
It is a statement & it is one of the functions of cost accounting. It may be defined as “
detailed statement of the elements of cost incurred in production, arranged in a logical order,
order various head such as material, labour & over head, prepared at short intervals of time”.
Cost Sheet (without adjustments)
Particulars Amount

Direct Material Xxx

Direct Labor Xxx
Direct Expenses Xxx

PRIME COST Xxx

Add: Factory Over heads Xxx

FACTORY/MANUFACTURING/WORKS COST Xxx

 Add: Office & Administrative Overheads Xxx

COST OF PRODUCTION Xxx

Add: Selling & Distribution Overheads Xxx

COST OF SALES Xxx

Profit Xxx

Sales Xxxx
====

Cost Sheet (with adjustments)

Particulars Amount
Opening Stock of Material Xxx
Add: Purchase of Raw Material Xxx
Add: Carriage Inwards Xxx

Less: Closing Stock of raw Material Xxx

Sale of Raw Material Xxx
Returns Xxx

RAW MATERIALS CONUMED Xxx

Add :Direct Labor Xxx
Direct Expenses xxx

PRIME COST Xxx

Add: Factory Over heads Xxx

FACTORY/MANUFACTURING/WORKS COST INCURRED Xxx

Add : opening stock of Work – in progress Xxx
Less: Closing Stock of Work-in progress xxx
 FACTORY COST Xxx
Add: Office & Administrative Overheads Xxx

COST OF PRODUCTION Xxx

Add: Opening stock of finished Goods Xxx
Less: Closing Stock of finished goods Xxx

COST OF GOODS SOLD Xxx

Add: Selling & Distribution Overheads Xxx

COST OF SALES Xxx

Profit Xxx

Sales Xxxx
====
1. Prime Cost
It is otherwise called as Direct cost. It includes all Direct material, Direct Labor & Direct
Expenses
If opening stock Raw material and Closing Stock Raw Material is given then we have to
find out the Raw Material Consumed.

2. Factory Cost
It is otherwise called as ‘Works cost’ or manufacturing cost’. It refers to indirect
material, indirect labour and indirect expenses. If opening of work-in-progress and closing stock
of work-in progress is given, then we have to find out the factory cost incurred.
3. Cost of Productions
It can be arrived by adding the office and administrative over heads with factory cost.
These overheads are not having direct link with production but they are required for funning a
business unit. If there is opening stock of finished goods and closing stock of finished goods then
we have to calculate cost of goods sold.
4. Cost of Sales
To arrive cost of sales, the selling & distribution over heads should be add with the cost
of production, if there is no opening stock of finished goods or closing stock of finished goods.
If either opening or closing stock of finished goods is given, then selling and distribution
overheads should be add with cost of goods sold to arrive the cost of sales.
5. Sales
It is the selling price i.e. the price at which goods are sold. The sales can be calculated by
adding the profit with cost of sales. The profit can be either on ‘sales’ or on ‘cost’. If nothing is
given, then we have assumed on the basis of sales.

Job Costing
Job costing as “ than form of specific order costing which applies where work is
undertaken according to customer’s specifications”.
Job costing is a method of cost accounting where by cost is complied for a specific
quantity of product, equipment, repair or other service that moves through the production process
as a continuously identifiable unit, applicable material, direct Labour, direct expenses and
usually a calculated portion of overheads being charged to a job order.
Which Industries Job Costing is Applied
Job costing is applied in those industries where the goods are manufactured or services
are rendered against specific orders as per customer’s specifications. It is generally applied in
 Engineering Industries
 Construction Industries
 Ship- Building Industries
 Furniture Making Industries
 Machine Manufacturing Industries
 Automobile Service Industries
 Repair shops Industries
Features of Job order Costing
1. The production is generally against customer’s order but not for stock.
 2. There is no uniformity in the flow of production from department to department. The
nature of the job determines the departments through which the job has to be processed.
The production is intermittent and not continuous.
3. Each job is treated as a cost unit under this method of costing.
4. The cost of production of every job is ascertained after the completion of the job.
5. The work-in progress differs from period to period according to the number of jobs in
hand.
6. A separate job cost sheet or job card is used for each job and is assigned a certain number
by which the job is identified.
Objectives of Job Costing
1. It helps to find out the cost of production of every job or order and to know the profit or
loss made on its execution.
2. It helps the management to make more accurate estimates for costs of similar jobs to be
executed in future on the basis of past records.
3. It helps the management to control the operational inefficiency by making a comparison
by making a comparison actual costs with estimated ones.
4. It helps the management to provide a valuation of work- in-progress.
Advantages of Job Order Costing
1. To know a detailed analysis of cost of materials, Labour and overheads charged to each
job.
2. To ascertain profit or loss made on each job.
3. To estimate the costs and profitability of similar jobs to be taken up in future.
4. To control operational inefficiency by comparing the actual costs with the estimated
costs.
5. To identify jobs where waste, scrap, spoilage and defectives occurred and take corrective
action against the responsible person or department.
Documents Used in a Job Order Cost System
The following are the important documents used in a job order cost system.
1. Production order or Manufacturing Order:
This is a works order authorizing the production department to produce a specified
quantity of a product which constitutes the job.
2. Cost Sheet:
For recording costs, very often a separate record called a cost sheet is used. The cost
sheet and the works order may also be combined, when costs are recorded on the production
order itself.
3. Other Documents:
The other documents which are used as actual mechanism by the dispatching function are
material requisitions, tool orders, time tickets, inspection order etc..
Procedure of Job order cost system
1. Receiving an Enquiry:
The customer will usually enquire about the price, quality to be maintained, the duration
within which the order is to be executed and other specification of the job before placing an
order.
2. Estimation of the price of the job:
The cost accountant estimates the cost of the job keeping in mind the specification of the
customer.
3. Receiving the order:
If the customer is satisfied with the quotation price and other terms of execution, he will
then place the order.
4. Production Order:
If the job is accepted, a production order is made by the planning department. It contains
all the information regarding production. It is prepared with sufficient copies so that a copy of
the same ma be given to all the departmental managers or foreman who are required to take any
part in the production.
Recording of cost
The costs are collected and recorded for each job under separate order number.
The basis of collection of costs are
a) Materials : Material Requisitions, Bill of material or materials issue analysis sheet.
b) Wages: Operation Schedule, job card or wage analysis sheet.
c) Overheads: Standing Order Numbers or Cost Account Numbers
6. Completion of Job:
On completion of a job, a completion report sent to costing depart. The expenditure under each
element of cost is totaled and the total job cost is ascertained. The actual cost is compared with
the estimated cost so as to reveal efficiency or inefficiency in operation.
7. Profit or loss on job:
It is determined by comparing the actual expenditure or cost with the price obtained.
Process Accounting
Process costing as “ that form of operation costing which applies where standardized
goods are produced”.
Process costing is a method of costing under which the all costs are accumulated for each
stage of production and the cost per unit of product is ascertained at each stage of production by
dividing the total cost of each process by the normal output of that process.
Features of process costing
1. The production is continuous.
2. The product is homogeneous.
3. The processes are standardized.
4. The output of one process becomes the input of another process.
5. The output of the last process is transferred to finished stock account.
6. Costs are collected process wise
7. Cost per unit is calculated at the end of period by dividing the total process cost by the
normal output produced.

Application of Process Costing

1. Chemical Works
2. Textile, weaving, spinning etc.
3. Soap making
4. Paper mills
5. Biscut works
6. Oil refining
7. Food products
8. Coke works
9. Paint, ink and varnishing etc.
10. Milk diary
Comparison Between job costing and process costing
 Basis of Job costing Process Costing
distinction

1. Production Production against specific orders It is continuous flow, product

being homogeneous
2. Cost Costs are determined for each job separately. Costs are complied for each
Determination process for department on
time basis.
3. Entity Each job is separate and independent of others Manufactured in a continuous
flow
4. Unit Cost Total cost of a job is divided by the number of Avg. cost per unit = Total cost
units produced in the job in order to calculate of each process is divided by
unit cost of a job production for the process.
5. Cost Costs are complied when a job is completed Cost are calculated at the end
Calculation of the cost period
6. Transfer There is no transfer of cost one job to another Costs are transfer to one
process to next process
7. W. I. P May or may not be W.I. P at beginning or end Always some W.I.P. at
of the accounting period beginning or end of the
accounting period.
8. Control Proper control is difficult production is not Easier
continuous
9. Forms & It requires more forms and details regarding It requires few form and less
Details materials and Labour due to the need for the details but a closer analysis of
allocation of Labour to so many orders and operations is needed.
material is issued in bulk to depts.
10. Suitability It is suitable when goods are made to Goods are made for stock and
customer’s order continuous production.

Procedure of process Costing

1. Classification of Production activities into distinct processes.
 2. Classification of cost by process
3. Separate Account
4. Items of debit side
 Cost of Material
 Cost of Labour
 Direct Exp.
 O/H Charges
 Cost of Rectification or normal defectives
 Cost of Abnormal gain
5. Items of credit side
 Scrap value or normal Loss
 Cost of abnormal loss
Equivalent product units:
Production units denoted into equivalent percentage
Calculation of Average cost per Unit
Total cost – Scrap Value of Normal Loss ( if any)
Avg. Cost per unit =
Input – Units of Normal Loss

Transfer the cost of output

The cost of output of each process may be transferred directly to next process A/c

Process Account
Particulars Units Rs. Particulars Units Rs.

To Basic Materials By Normal loss A/c

To direct Materials By Abnormal Loss A/c
To direct wages By Process Loss A/C
To direct expenses (Output t/f to next process)
To Production O/H By process I Stock A/c
To cost of Rectification of Normal (Out put t/f to process I
defectiveness stock A/c)
 By P & L a/c (Out put sold)

Normal Loss = Input x Expected % of Normal loss

Abnormal Loss (Units) = Expected Output – Actual Output
Total cost incurred – scrap value of Normal loss
Cost of Abnormal Loss =
Input – Units of Normal Loss

Activity Based Costing

Activity based costing (ABC) is a technique of charging overheads to cost objects (i.e.
products, services, jobs, customers etc.,) under which O.H. are first calculated separately for each
activity and then are charged to various cost objects on the basis of activities consumed by these
objects
ABC systems calculate the cost of individual activities and assign costs to cost objects
such as products and services on the basis of activities undertaken to produce each product or
service.s
Terms Used in ABC
a) Activity
An activity may be defined as a particular task or unit of works with a specific purpose.
For example, placing of a purchase order, setting up of a machine, after sales service etc.
b) Cost Object:
It is an item for which cost measurement is required. For example a product a service, a
job or a customer.
c) Cost Driver:
It is a factor that influences the cost of an activity. Cost driver is of tow types , Resource
cost driver and activity cost driver
 Resource Cost driver:
It is a measure of the quantity of resource consumed by an activity.
 Ex: Number of purchase orders placed will influenced the cost of purchasing the
materials.
 Activity cost Driver:
It is a measure of the frequency and intensity of demand placed on the activities
by cost objects. It is used to assign activity cost to cost objects consuming the activity.

Some Activities with Cost Drivers

Functional Areas Activities Suitable Cost Drivers

Material management Issue of Purchase orders No. Of purchase order
Inspection of materials No of purchase order
Stores management Storing Materials Value of Materials stores
Servicing of requisitions No. of requisitions
Inspection and verification No. of times inspected
Stock Value of stock
Taking
Quality Control Testing Samples No. of batches produced
Personnel Recruitment of employed No. of employees required
management Maintenance of leave records and attendance No. of employees
Marketing Demand creation Increase in sales
Advertising Increase in sales
Dispatches No. of orders
R& D Research No. of Research Projects
Machining Set- up Cost No. of production runs
Power cost Machine hours

Benefits and weakness of ABC

ABC is more expensive than the traditional system. So a cost-benefit analysis is
desirable. The benefits of ABC are many.
1. In the traditional system cost analysis is done by product. In ABC managers focus
attention on activities rather than products because activities in various departments may be
combined and costs of similar activities ascertained e.g. quality control, handling of materials,
repairs to machines, etc. If detailed costs are kept by activities, the total company costs for each
activity can be obtained, analysed, planned and controlled.
2. Because costs are identified with activities and then allocated to products or
services, based on appropriate cost drivers, more accurate product/service costs result. Since
overhead or indirect costs occupies a significant proportion of the total costs of the firm, the
overall impact of allocation of indirect costs to products/ services more accurately is significant.
3. Managers manage activities and not products. Change in activities lead to changes
in costs. Therefore, if the activities are managed well, costs will fall and resulting products will
be more competitive.
4. Allocating overhead cost to production based on a single cost driver (allocation
base) can result in an unrealistic product cost because the traditional system fails to capture cause
and effect relationships. To manage activities better and to make wiser economic decisions,
managers need to identify the relationships of causes (activities) and effects (costs) in a more
detailed and accurate manner. ABC focuses on this aspect. It may be mentioned that activities
drive costs. Therefore, costs should be assigned to factors that cause them.

5. ABC highlights problem areas that deserve management’s attention and more
detailed analysis. Many actions are possible on pricing, on process technology, on product
design, on operational movements and on product mix, once management realises that a large
number of its products and customers may be breakeven or unprofitable. The ABC systems are
useful in setting priorities for managerial attention and action.
ABC is not free from certain weakness, as argued by the critics. They are
mentioned below:
1. ABC fails to encourage managers to think about changing work processes to make business
more competitive.

2. ABC does not conform to generally accepted accounting principles in some areas. For
example, ABC encourages allocation of such non-product costs as research and development to
products while committed product costs such as factory depreciation and not allocated to
products. In the USA, most companies have accordingly used ABC for internal analysis and
continued using the traditional costing for external reporting.

3. Using ABC for short-run decisions may sometimes prove costly in the long run. Consider, for
example, the decision about lowering sales order handling costs by eliminating small orders that
generate lower margins. While this strategy reduces the number of sales orders (the driver),
customers may want frequent delivery at small lots at infrequent intervals. In a competitive
environment (when other companies may be willing to meet the customers’ needs); long term
profits may suffer due to elimination of small orders.

4. ABC does not encourage the identification and removal of constraints creating delays and
excesses. An overemphasis on cost reduction without regard to the constraints does not create an
environment for learning about the problems and their management.

Target Costing
In today’s corporate board rooms, where global competition, increased customer
expectation and competitive pricing in many industries have forced firms to look for ways to
reduce cost year after year at the same time producing products with increased levels of quality
and functionality.
The firms has two options for reducing costs to a target cost level
a) By integrating new manufacturing technology, using advanced cost management
techniques such as activity based costing and seeking higher productivity.
b) By redesigning the product or service. This method is beneficial for many firms because
it recognizes that decisions account for much of total product life cycle costs.
Target costing in the cost life cycle
Implementing in Targeting Costing
Implementing in target costing approach involves five steps
1. Determine the market price
2. Determine the desired profit
3. Calculate the target cost at market price less desired profit.
4. Use value engineering to identify ways to reduce product cost.
5. Use kaizen costing and operational control to further reduce costs.

Using target cost in the concept and design stages

Target costing is an iterative process that cannot be de-coupled from design. The pre-
production stages can be categorized in a variety of different ways in the detailed discussion
below five different stages are used and the different activities are now listed.

1. Planning
This includes fixing concept and the primary specifications for performance and design. A
very brief concept might be a small town car for two people with a large amount of easily
accessible luggage space and low fuel consumption –aimed at those in their mid-twenties and so
style is important. (In reality the concept would be much is fuller.) Value engineering analysis
(VE) could be used to identify new and innovative, yet cost effective, product features that
would be valued by customers and meet their requirements.

Once the concept has been developed a planned sales volume and selling price, which
depend on each other, will be set, as well as the required profit discussed earlier. From this the
necessary target cost (or allowable cost as it is often know) can be ascertained.

Target cost = Planned selling price -- Required profit

2. Concept design

The basic product is designed. The total target cost is split up as illustrated in figure below.
Firstly an allowance for development costs and manufacturing equipment costs are deducted
from the total. The remainder is then split up into units costs that will cover manufacturing and
distribution etc. The manufacturing target cost per unit is assigned to the function areas of the
new product. For example, a function area for a ballpoint per might be the flow of ink to the tip
and function area for a car might be the steering mechanism.

The breakdown of target cost

Total Target cost

Development Manufacturing Target

cost

costs equipment per unit

Manufacturing
Distribution cost

cost per unit

per unit

Functional Functional Functional

product area cost product area cost product area cost

per unit per unit per unit

 3. Basic design

The components are designed in details so that they do not exceeds the functional target
costs. Value engineering is used to get the costs down to the target. If one function cannot meet
its target, the targets for the others must be reduced or the product redesigned.

4. Details design

The detailed specifications and costs estimates are set down from the basic design stage.

Joint Product and By Product Costing

Exercise-1

The Master Company manufactures three products – product 1, product 2 and product 3. The production data of
three products for the month of January 2019 is given below:

 Product 1: 3,000 units

 Product 2: 4,000 units
 Product 3: 5,000 units

The sales prices or market values at split-off point are given below:

 Product 1: $4.40
 Product 2: $2.50
 Product 3: $2.56

During January 2019, the Master Company incurred a total joint production cost of $27,000.

Required: Allocate the joint production cost among joint products using market value method.

Solution

*Allocation of joint cost:

The joint cost is 75% of total market value ($27,000/$36,000 = 0.75 or 75%)
  Product 1: $13,200 × 0.75 = $9,900
 Product 2: $10,000 × 0.75 = $7,500
 Product 3: $12,800 × 0.75 = $9,600

Exercise-2

The Sam & Gibs Company processes a single raw material to produce three different products – product K,
product L and product M. After split-off point, all three products require a further processing before they can be
placed in salable condition. A summary of cost, production and sale for the year 2019 is given below:

There was no finished goods and work-in-process inventory at the start and end of the year 2019.

Required: Allocate the joint production cost to all three products and compute the gross profit of each product.

Solution
*Allocation of joint cost:

The joint production cost ($240,000) is 60% of the hypothetical market value ($400,000). The allocation has been
made as follows:

 Product K: $50,000 × 0.6 = $30,000

 Product L: $168,000 × 0.6 = $100,800
 Product M: $202,000 × 0.6 = $121,200

**Gross profit

Gross profit is equal to ultimate market value less total cost.

 Product K: $60,000 – $40,000 = $20,000

 Product L: $200,000 – $132,800 = $67,200
 Product M: $240,000 – $159,200 = $80,800

Exercise-3

During April 2019, the Merhaba Company incurred a total joint cost of $18,250 to produce three joint products –
product X, product Y and product Z. The number of units produced during April and sales price per unit at split-
off point are given below:

The company uses a weighted average method for allocating joint production cost to all of its three products. For
this purpose, the following weights are assigned to each unit of a product:

 Product X: 5
 Product Y: 3
 Product Z: 3

Required: Allocate the company’s joint cost for the month of April to three products using weighted average
method.

Solution
*Computation of cost per weighted unit:

$18,250/73,000
= $0.25 per weighted unit

Exercise-4

The Monster Company runs a joint production process to produce three different products. The joint production
cost for July is $200,000. The information about quantity produced, ultimate market value and processing cost
after split-off point for each product is given below:

Required:

1. Allocate the joint production cost to each product using using average unit cost method and compute the
total production cost of each product.
2. Allocate the joint production cost to each product using market value method and compute the total
production cost of each product.

Solution

1. Average unit cost method

*Average unit cost:
Total joint cost/total number of units produced
= $300,000/20,000 units
= $15

2. Market value method

*Joint production cost is 60% of hypothetical market value as computed below:

$300,000/$500,000
= 0.6 or 60%

Hypothetical market value is computed by subtracting processing cost after split-off from the ultimate market
value.

UNIT IV MARGINAL COSTING 9

Marginal Costing and profit planning – Cost, Volume, Profit Analysis – Break Even
Analysis – Decisionmaking problems -Make or Buy decisions -Determination of sales mix
- Exploring new markets - Add or drop products -Expand or contract.
Marginal Cost
“The amount at any given volume of output by which aggregate costs are changed if the
volume of output is increased or decreased by one unit”
Marginal Costing
“ Marginal costing is a technique of determining the amount of changes in the aggregate costs
due to an increase of in unit over the existing level of production”
Features of Marginal Costing
 It is a method of recording costs and reporting profits;
 All operating costs are differentiated into fixed and variable costs;
 Variable cost charged to product and treated as a product cost whilst
 Fixed cost treated as period cost and written off to the profit and loss account
Advantages of Marginal Costing
 It is simple to understand re: variable versus fixed cost concept;
  A useful short term survival costing technique particularly in very competitive
environment or recessions where orders are accepted as long as it covers the marginal
cost of the business and the excess over the marginal cost contributes toward fixed costs
so that losses are kept to a minimum;
 Its shows the relationship between cost, price and volume;
 Under or over absorption do not arise in marginal costing;
 Stock valuations are not distorted with present years fixed costs;
 Its provide better information hence is a useful managerial decision making tool;
 It concentrates on the controllable aspects of business by separating fixed and variable
costs
 The effect of production and sales policies is more clearly seen and understood.
Disadvantages of Marginal Costing
 Marginal cost has its limitation since it makes use of historical data while decisions by
management relates to future events;
 It ignores fixed costs to products as if they are not important to production;
 Stock valuation under this type of costing is not accepted by the Inland Revenue as its
ignore the fixed cost element;
 It fails to recognize that in the long run, fixed costs may become variable;
 Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;
 It’s not a good costing technique in the long run for pricing decision as it ignores fixed
cost. In the long run, management must consider the total costs not only the variable
portion;
 Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can
be distorted if fixed cost is classify as variable.
Aspects of Marginal costing
1. Ascertainment of Marginal Cost.
2. Deriving of Cost-Volume Profit Relationship by differentiating fixed cost from variable
costs.
Marginal Cost Statement
Particulars Amount (Rs.)
 Variable Costs:
Direct Material Xxx
Direct Wages Xxx
Factory Overheads Xxx

Fixed Cost: xxx

Administrative Expenses Xxx

Total Cost Xxx

Profit Xxx

Sales Xxx

Concepts & Terms Used in Cost –volume-profit Analysis

1. Variable Costs:
These costs are varying in proportion to the level of production and sales.
Ex: Direct Material, Direct Wages, Direct Expenses and Variable Overheads.
2. Fixed Cost:
Irrespective of the level of activity, these costs are fixed in nature. Hence, these costs are
called ‘sunk cost’ or ‘period cost’ or ‘time costs’.
Ex: Office rent, Factory Rent, Manager’s Salary etc.
3. Contribution:
Contribution is the difference between sales and variable cost. Contribution is the
amount that is contributed towards fixed expenses and profit. In Practice majority of the
managerial decisions are based on the principle of contribution.
Contribution = Sales – Variable cost
Contribution = Fixed Expenses + Profit
Contribution = Fixed Expenses - Loss
4. Profit Volume Ratio (P/V Ratio) or Contribution to Sales Ratio (C/S Ratio):
The proportion of contribution to sale is called P/V ratio. P/V ratio generally expressed as a
percentage. A high P/V ratio indicates high profitability and a low P/V ratio indicates low
profitability.
Formula:
P.V.R = (Contribution / Sales )X100
P.V.R = (Changes in Profit / Changes in Sales ) x 100

5. Break Even Analysis

Break even analysis determines at what level cost and revenue are in equilibrium.
Assumptions:
1. All elements of costs are divided into fixed and variable costs.
2. Variable costs vary in relation to the volume of production.
3. Fixed costs remain constant at all volumes of output.
4. The selling price remains constant at all levels of output
5. The volume of production is the only factor that influences cost.
6. There is only one product or in the case of multiple products, sales mix remains stable.
6 .Break Even Point
The point which breaks the total cost and the selling price evenly to show the level of
output or sales at which there shall be no profit or no loss is called “ Break Even Point”. In other
words, the point of sales volume at which total revenue is equal to total cost.
7. Margin of Safety
The excess of actual or budgeted sales over the break even sales is called the Margin of
safety. The margin of safety is calculated in rupees, units or even in percentage form.
This Margin of safety can be improved by adopting the following steps:
1. By increasing the volume of production
2. By increasing the sale price of the product
3. By reducing the fixed cost through adopting the innovative technologies
4. By reducing the variable cost by means of cost reduction and cost consciousness
principles.
5. By eliminating unprofitable products
6. By adopting the optimal sales mix to increase the viability of the product.
 Formula’s
1. P.V.R = (Contribution /Sales) x 100
2. P.V.R = (Changes in profit / Changes in sales) x 100
3. B.E.P. (in units) = Fixed expenses / Contribution per unit
4. B.E. P (in Rs.) = (Fixed Expenses / Contribution per unit ) x Selling price per unit
5. B.E. P (in Rs.) = (Fixed Expenses / Contribution) x Sales
6. B.E. P (in Rs.) = Fixed Expenses /PVR
7. Margin of Safety = Profit / PVR (or) Actual sales – BEP Sales
8. No. of units to be sold to earn a profit of Rs.---
(Fixed Expenses + Desired Profit)
=
Contribution Per unit

Applications of Marginal costing in Decision Making

1. Pricing Decision
2. Make or Buy Decision
3. Key or Limiting Factor
4. Selection of Suitable product mix

Explain CVP Analysis.

Definition of Cost Volume Profit Analysis (CVP Analysis)

Cost Volume Profit Analysis (CVP) looks at the impact on the operating profit due to the varying levels of
volume and the costs and determines a break-even point for cost structures with different sales volumes
that will help managers in making economic decisions for short term.

Importance of Cost Volume Profit Analysis

1. Cost Volume Profit Analysis includes the analysis of sales price, fixed costs, variable costs, the
number of goods sold, and how it affects the profit of the business.

2. The volume of sales is dependent upon production volume, which in turn is related to costs that are
affected by the volume of production, product mix, internal efficiency of the business, production method
used, etc.

3. CVP analysis helps management in finding out the relationship between cost and revenue to
generate profit.

4. CVP Analysis helps them to BEP Formula for different sales volume and cost structures.
5. With CVP Analysis information, the management can better understand the overall performance
and determine what units it should sell to break even or to reach a certain level of profit.

6. CVP analysis helps in determining the level at which all relevant cost is recovered, which is also
called the breakeven point.

7. It is that point at which volume of sales equals total expenses (both fixed and variable). Thus CVP
analysis helps decision-makers understand the effect of a change in sales volume, price, and variable cost
on the profit of an entity while taking fixed cost as unchangeable.

8. CVP Analysis helps in understanding the relationship between profits and costs on the one hand
and volume on the other.

9. CVP Analysis is useful for setting up flexible budgets that indicate costs at various levels of
activity. CVP Analysis also helpful when a business is trying to determine the level of sales to reach a
targeted income.

5. BEP Analysis

What is a Break-Even Analysis?

Break-even is a situation where an organisation is neither making money nor losing money, but all the
costs have been covered.

Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For
example, say Happy Ltd has fixed costs of Rs. 10,000 vs Sad Ltd has fixed costs of Rs. 1,00,000 selling
similar products, Happy Ltd will be able to break-even with the sale of lesser products as compared to Sad
Ltd.

Break-even chart

The break-even analysis assumptions:

1. The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

2. The cost and revenue functions remain linear.

3. The price of the product is assumed to be constant.

4. The volume of sales and volume of production are equal.

5. The fixed costs remain constant over the volume under consideration.

6. It assumes constant rate of increase in variable cost.

7. It assumes constant technology and no improvement in labour efficiency.

8. The price of the product is assumed to be constant.

9. The factor price remains unaltered.

10. Changes in input prices are ruled out.

11. In the case of multi-product firm, the product mix is stable.

The advantages of break-even point are as follows-

1. The breakeven point concept gives an accurate estimate of the number of units that must be sold to
start making actual profits for the organization

2. The point helps to identify the variable and fixed costs and coordinate the relationship between
them

3. It is a measurement tool that is used effectively to set targets

4. The breakeven point can predict the consequence of cost and efficiency changes on the
profitability of a business.

5. The breakeven point can help a company to calculate the profit and loss figures at various level of
sales and production

6. The organization uses a breakeven point to evaluate future demand

7. It helps to make a viable forecast about the probable effect of the change on the sales price

8. The information provided by the breakeven point helps the management in making important
decisions for example while applying for loans, in setting prices and while preparing competitive bids

Limitations of Break-Even Analysis:

1. In the break-even analysis, we keep everything constant.

2. In the break-even analysis since we keep the function constant,.

3. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc.,

5. When break-even analysis is based on accounting data may suffer from various limitations.

6. Selling costs are specially difficult to handle break-even analysis.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate income tax.

8. It usually assumes that the price of the output is given .

UNIT V BUDGETING AND VARIANCE ANALYSIS

Budgetary Control – Sales, Production, Cash flow, fixed and flexible budget – Standard
costing and Variance Analysis – (excluding overhead costing) -Accounting standards and
accounting disclosure practices in India.

Budget
Budget is a blue Print of a plan expressed in quantitative terms. It is prepared for a
definite period well in advance. A budget is the monetary and/or quantitative expression of
business plans and policies to be pursued in the future period of time.

Budget, Budgeting & Budgetary Control

A budget is the blue print of a plan expressed in quantitative terms. On the other hand,
budgeting is a technique for formulating budgets.
Budgetary control refers to the principles, procedures and practices of achieving given
objectives through budgets.
Objectives of Budgetary Control
1. To Reduce Wastages
2. To predict the capital expenditures
3. To increase profitability
4. To record the actual performance
5. To correct deviations from established standards.
Classification of Budget
1. Production Budget
2. Raw Material budget
3. Production cost Budget
4. Labour Budget
5. Selling and Distribution overhead budget
6. Sales Budget
7. Master Budget
8. Flexible Budget
9. Capital Expenditure Budget
10. Cash Budget
11. Zero Base Budgeting
1. Cash Budget
An estimation of the cash inflows and outflows for a business or individual for a specific
period of time. Cash budgets are often used to assess whether the entity has sufficient cash to
fulfill regular operations and/or whether too much cash is being left in unproductive capacities.

“Cash budget is a detailed plan showing how cash resources will be acquired and used over some
specific time period”
How To Create A Cash Budget
There are three main components necessary for creating a cash budget. They are:
 Time period
 Desired cash position
 Estimated sales and expenses

 Time Period
The first decision to make when preparing a cash budget is to decide the period of time
for which your budget will apply. That is, are you preparing a budget for the next three months,
six months, twelve months or some other period? In this Business Builder, we will be preparing a
3-month budget. However, the instructions given are applicable to any time period you might
select.
 Cash Position
The amount of cash you wish to keep on hand will depend on the nature of your business,
the predictability of accounts receivable and the probability of fast-happening opportunities (or
unfortunate occurrences) that may require you to have a significant reserve of cash.
You may want to consider your cash reserve in terms of a certain number of days' sales. Your
budgeting process will help you to determine if, at the end of the period, you have an adequate
cash reserve.

Particulars
Beginning cash balance
Add: Cash Receipts:
Cash Sales
Collection of accounts receivable
Other income
Total cash collected
Less: cash payments:
 Raw materials (or inventory)
Payroll
Other direct expenses
Advertising
Selling expense
Administrative expense
Other payments
Total cash expenses
Cash surplus (or deficit)

Flexible Budget
A Flexible budget is, “ a budget designed to change in accordance with the level of
activity actually attained”
Thus, a budget prepared in a manner so as to give the budgeted cost for any level of
activity is knows as a ‘flexible budget’. Such a budget is prepared after considering the fixed
and variable elements of cost and the changes that may be expected for each item at various level
of operations.
Master Budget
A master budget is defined as “ the summary budget incorporating the functional budgets
which is finally approved, adopted and employed”, The budget may take the form of budgeted
profit and loss account and balance sheet. It contains sales, production cost, cash position,
debtor, fixed assets, bills payable etc.
Zero Base Budgeting
A Planning and budgeting process which requires each manager to justify his entire
budget request in detail form scratch (Hence Zero Base) and shifts the burden of proof to each
manager to justify why he should spend money at all. The approach requires that all activities be
analyzed in decision packages which are evaluated by systematic analysis and ranked in order of
importance
Steps or process involved in ZBB
1. The objective of budgeting should be clearly determined because the objectives differ
from concern to concern.
 2. Whether it should be adopted in all operational areas or only in specific areas should be
decided.
3. Proper decision packages must be identified.
4. Cost benefit analysis is undertaken, which will help in fixing priority for various projects.
5. Last step is to finalize the budget.
Merits of ZBB
1. It helps the management to allocate the funds, according to benefits.
2. It will be very helpful for the management to improve the efficiency.
3. It helps in identifying and controlling the wasteful areas.
4. It will allow, only those activities which will help in the achievement of organizational
goals.
5. It will be helpful in determining the utility of each and every activity of the business.
6. It is an important tool in integrating the managerial activities of planning and control.
Demerits of ZBB
1. Flexible budgeting is not possible under ZBB
2. It is a time consuming one
3. The cost of operating it is highly expensive
4. It is not suitable for non-financial matters.
Standard Costing
A Predetermined cost which is calculated from management’s standards of efficient
operation and the relevant necessary expenditure.
Characteristics
1. Flow of information
2. No Actual costs
3. Appraisal of Performance
4. Appropriate for repetitive activities
Objectives
1. Cost Control
2. Develops cost conscious attitude
3. Fixation of prices
4. Fixing prices and formulating Policies
 5. Management planning
Steps of Standard Costing

ADVANTAGES OF STANDARD COSTING

1. Cost control:
Standard costing is universally recognised as a powerful cost control system. Controlling
and reducing costs becomes a systematic practice under standard costing.
Elimination of wastage and inefficiency:
Wastage and inefficiency in all aspects of the manufacturing process are curtailed, reduced
and eliminated over a period of time if standard costing is in continuous operation.
2. Norms:
Standard costing provides the norms and yard sticks with which the actual performance can
be measured and assessed.
3. Locates sources of inefficiency:
It pin points the areas where operational inefficiency exists. It also measures the extent of
the inefficiency.
4. Fixing responsibility:
Variance analysis can determine the persons responsible for each variance. Shifting or
evading responsibility is not easy under this system.
5. Management by exception:
The principle of ‘management by exception can be easily followed because problem areas
are highlighted by negative variances.
6. Improvement in methods and operations:
Standards are set on the basis of systematic study of the methods and operations. As a
consequence, cost reduction is possible through improved methods and operations.
 7. Guidance for production and pricing policies:
Standards are valuable guides to the management in the formulation of pricing policies and
production decisions.
8. Planning and Budgeting:
Budgetary control is far more effective in conjunction with standard costing. Being
predetermined costs on scientific basis, standard costs are also useful in planning the operations.
9. Inventory valuation:
Valuation of stocks becomes a simple process by valuing them at standard cost.
LIMITATIONS OF STANDARD COSTING
1. It is costly, as the setting of standards needs high technical skill.
2. Keeping of up-to-date standard is a problem. Periodic revision of standard is a costly
thing.
3. Inefficient staff is incapable of operating this system.
4. Since it is difficult to set correct standards, it is difficult to ascertain correct variance.
5. Industries, which are subject to frequent changes in technological process or the quality
of material or the character of labour, need a constant revision of standard. But revision
of standard is more expensive.
6. For small concerns, standard costing is expensive.

Standard Setting
Normally setting up standards is based on the past experience. The total standards cost
includes direct material direct labor and overheads. Normally, all these are fixed to some extent.
The standards should set up in a systematic way so that they are used as a tool for cost control.
Process of setting standards
a. Determination of cost centre
b. Current standards
c. Ideal standard
d. Basic standard
e. Normal standards
 f. Organization for standard costing
g. Accounting system
h. Revision of standards

Variance
Variance is the difference between actual costs and standard costs during an
accounting period. It refers to variation of actual results with planned results. Variance
analysis is a systematic process which analyses and interprets the variances. It refers
to the break-down of thetotal variances into different components.
Analysis of Variance
“ The analysis of variances arising in a standard costing system into their constituent
parts”

Classification and computation of Variances

Material Cost Variance (MCV)
Direct Materials Cost Variance can be defined as the difference between the
standard costs ofdirect material specified and the actual cost of direct material used.

MCV = Standard Material cost – Actual Material Cost

(or) MCV = MPV + MUV
(or) MCV = MPV + MMV

Standard Material cost = Standard price per unit x standard quantity

of materialsActual Material Cost = Actual price per unit x Actual
Quantity of Materials
Components of MCV
1. Material Price Variance (MPV)
Difference between standard price and the actual price of the material is
the materialprice variance.

MPV = Actual Quantity ( Standard price – Actual Price)

2. Material Usage Variance (MUV)

Difference between standard quantity of material and actual quantity used is
the materialusage variance.

MUV = Standard price (Standard Quantity – Actual Quantity)

The Material Usage Variance may further be sub-divided into:

a) Material Mix Variance
b) Material Yield Variance
a) Material Mix Variance:
Material mix variance is the difference between standard price of
standard mix andstandard price of actual mix. The standard price is used in
calculating this variance.
The Variance is calculated under two situations
 When Actual weight and standard weight of Mix are equal
= Standard cost of standard mix – standard cost actual mix
(Or)
=(Standard price x Standard Quantity) – ( Standard Price x Actual quantity)
(Or)
= Standard unit cost ( Standard Quantity – Actual Quantity)

i. When actual weight of mix is equal to standard weight of mix

Incase Standard quantity is revised due to shortage of one material, the formula will be
= Standard unit cost ( Revised standard quantity – Actual quantity)
(OR)
= Standard cost of revised standard mix – Standard cost of actual mix

ii) When Actual and standard Weight Mix are different

When quantities of actual material mix and standard material mix is different, the formula will
be

Total weight of actual mix

--------------------------------- x Standard cost of standard mix - (Standard cost of actual
mix)
Total weight of Standard mix

Incase the standard is revised due to the shortage of one material then revised standard
will beused instead of standard, formula will become

Total weight of actual mix

------------------------------- x standard cost of revised Std. mix - (Standard cost of actual
mix)
Total weight of revised standard mix

b) Materials Yield variance

It results from the difference between actual yield and standard yield.
 MYV = Std. Rate (Actual yield – Std. Yield)
Standard cost of standard mix
Standard rate =
Net std. output (i.e. gross output – std. loss)
(or)
Standard cost of revised standard mix
=
Net standard output

LABOUR COST VARIANCES (LCV)

The difference between the standard direct labour cost and actual direct labour
cost
incurred for theproduction achieved.
LCV = Standard cost – Actual cost
i.e. ( Std. hours x std. rate) – (Actual hours x Actual rate)

When the actual output differs from standard output, standard labour cost of
actual outputis to be worked out and then the following formula applied

LCV = Standard cost of actual production – Actual cost

1. Labour rate of pay or wage rate variance

Labour rate variance is “ that portion of the wages variance which is due to the
differencebetween the standard rate specified and the actual rate paid.

Labour rate of pay variance = Actual time ( Standard rate – Actual rate)

2. Labour Efficiency or Labour time variance

It is that part of labour cost variance which arises due to the difference
between standardlabour hours specified and the actual labour hours spent.

Labour Efficiency Variance = Std. Wage rate ( Standard time for actual output – Actual time)

i) Idle time variance: (LITV)

It is the standard cost of actual time paid to workers for which they have not
 worked due to abnormal reasons. The reasons for idle time may be power failure,
defect in machinery, non- supply of materials, etc. This variance is calculated as
follows.

LITV = Standard Rate (Actual hours paid – Actual hours worked)

LITV = Standard Rate x Actual hours of Idle time.

ii) Labour Mix or Gang Composition Variance: This variance arises due to change
in the actual gang composition than the standard gang composition. The change in
labour composition may be caused by the shortage of one grade of labour
necessitating the employment of another grade of labour. This variance shows to the
management how much labor cost variance is due to the change in labor composition.
It may be calculated in two ways:
When standard and actual times of the labour mix are same:

Labour mix variance = std. cost of std. labour mix – Std. Cost of Actual labour mix.

Due to the non-availability of one grade of labour, there may be change in standard
labour mix, and the revised standard will be used for standard mix.

Labour mix variance = std. cost of revised std. labour mix – std. cost of actual labour mix.

When standard and actual time of labour mix are different:

Total time of actual labour mix

-----------------------------xStandard cost of standard labour mix-(Standard cost of Actual labour
Total time of standard labour mix mix)

As in the earlier case, if labour composition is revised because of non-availability of

one grade oflabour then revised standard mix will be used instead of standard mix and
the formula will become.

Total time of actual labour mix

-------------------------------- x std. cost revised std. labour mix - ( Standard cost of Actual labour
Total time of revised std. labour mix mix)
 iii) Labour Yield Variance
The purpose of computing variances is to find out the causes of variances in
order to exercise proper control. Some variances are controllable while others are non-
controllable. In case of controllable variances, appropriate remedial measures should
be taken to avoid their recurrence in future. If a variance is non-controllable, future
standards should be revised

Labour Yield variance = (Actual output – Std. Output for actual time taken) x std. cost per unit

Over Head Cost Variance (OHCV)

Difference between the standard cost of overhead allowed for the actual output
achievedand the actual overhead cost incurred.

= Actual output x std. over head rate per unit – Actual Overhead cost.

Overhead cost can be classified as

1. Variable overhead variance
2. Fixed overhead variance
1. Variable Overhead Variance
It is the difference between the standard variable overhead cost allowed for the actual
outputachieved and the actual variable overhead cost.

= Actual output x std. variable overhead rate – Actual variable overhead.

a) Variable overhead expenditure variance:

= Actual hours worked x standard variable overhead per hour – Actual variable overhead
(OR) Actual hours ( Std. Variable overhead rate per hour – Actual variable overhead rate per hour)

b) Variable Overhead Efficiency Variance:

= Standard time for actual production x standard variable overhead rate per hour – Actual
hours worked x standard variable overhead rate per hour.
(OR)
= Standard variable overhead rate per hour ( Std. hours for actual production – Actual hours)
2. Fixed Overhead Variance

It is that portion of total overhead cost variance which is due to the difference between
the standard cost of fixed overhead allowed for the actual output achieved and the
actual fixed overhead cost incurred.

= Actual output x standard fixed overhead rate per unit – Actual fixed overheads
(OR)
Standard hours produced x standard fixed overhead rte per hour- actual fixed overheads
Standard hours produced = Time which should be taken for actual output i.e. std. time for
actual output.

Expenditure variance
It is a portion of the fixed overhead variance which is due to the difference between
the budgeted fixed overhead and the actual fixed overheads incurred during a
particular period.

= Budgeted fixed overheads – Actual fixed overheads

(OR)
= Budgeted hours x std. fixed overhead rate per hour – Actual fixed overheads.

Volume Variance:
It is that portion of the fixed overhead variance which arises due to the
difference between the standard cost of fixed overhead allowed for the actual output
and the budgeted fixed overheads for the period during which the actual output has
been achieved.
 = Actual output x std. rate – Budgeted fixed overheads.
(OR) Std. rate (Actual output – budgeted output)
(OR) Volume variance = std. rate per hour (Standard hours produced – Actual hours)

Volume variance can be further subdivided into three variance as given below

i) Capacity variance:
It is a portion of the volume variance which is due to working at higher or
lower capacitythan the budgeted capacity.

= Std. Rate ( Revised budgeted units – Budgeted units)

(OR)
= Std. Rate ( Revised budgeted hours – Budgeted Hours)

ii) Calendar Variance:

It is a portion of the volume variance which is due to the difference between
the number of working days in the budget period and the number of actual working
days in the period to which the budget is applicable.

= Increase or decrease in production due to more or less working days at the rate of budgeted
capacity x Std. rate per unit.

iii) Efficiency Variance:

It is that portion of the volume variance which is due to the difference
between thebudgeted efficiency of production and the actual efficiency achieved.

=Std. rate per unit ( actual production (in units) – Std. Production ( in units))
(OR) Standard Rate per hour ( Standard hours produced – Actual hours)

Abbreviations
SQ = Standard
quantity or UsageSP
= Standard Price
AQ = Actual
Quantity or Usage
 AP = Actual price
SH =
Standard
HoursSR
=
Standard
Rate AH =
Actual
Hours AR
= Actual
rate
F = Favorable
U (OR) A = Unfavorable or Adverse

Current Practices Followed in Disclosing the Accounting Policies

1. Disclosure Required by Law
Sometimes, law requires a business entity to disclose certain accounting policies followed by it in
order to prepare and present financial statements. In such cases, the entity needs to necessarily disclose
these accounting policies.

2. Disclosure Required by ICAI

Institute of Chartered Accountants of India (ICAI)) has been issuing notifications over a period of time
recommending disclosure of certain accounting policies.

Thus, an enterprise following such accounting policies while preparing its financial statements needs
to disclose these policies necessarily.

For example, translation policies in respect of foreign currency items.

3. Disclosure in Annual Reports to Shareholders

Few enterprises in India include a separate statement showcasing their accounting policies used to
prepare their financial statements.

Thus, an enterprise can even include a separate statement reflecting its accounting policies. However,
such a statement must be included in the annual reports to the shareholders of the enterprise.

4. Disclosure of Accounting Policies not Fully Disclosed

It has been witnessed that the accounting policies at present are not disclosed in the financial
statements regularly and fully. Many enterprises prefer inserting descriptions pertaining to the
important accounting policies in the notes to their financial statements.
The enterprises can follow such a practice. However, the nature and degree of such a disclosure varies
immensely. It varies between corporate and non – corporate sectors as well as the units in the same
sector.

5. Disclosure in case of Enterprises

Including a Separate Statement of Accounts A wide variation pertaining to the nature
and degree of disclosure also exists. The variation exists especially among those enterprises
that include a separate statement of accounting policies in their annual reports presently.
In such cases, there are few firms that include such a separate statement of accounting policies in their
books of accounts. While others give such details in the form of supplementary information.

6. Purpose of Disclosure of Accounting Policies

The very purpose behind giving a statement of accounting policies is to encourage better
understanding of the financial statements. Further, it also helps in facilitating more meaningful
comparison between financial statements of various companies.

Thus, a separate accounting standard on Disclosure has been established to achieve these objectives.
This accounting standard promotes the disclosure of accounting policies. Further, it also describes the
manner in which such accounting policies need to be disclosed in the financial statements.

Is there a Need to Disclose Fundamental Accounting Assumptions?

Usually, an enterprise need not specifically state or disclose the fundamental accounting assumptions
followed in preparing its financial statements.

However, it needs to disclose such assumptions only if it fails to follow them while preparing its
financial statements.

Following are the generally accepted fundamental accounting assumptions followed while
preparing financial statements:

1. Going Concern

Generally, an enterprise is assumed to be a going concern. This means the enterprise continues to
operate for the foreseeable future.

In other words, it is assumed that an enterprise neither intends nor is necessarily required to liquidate
or cut down its scale of operations significantly.

2. Consistency

According to this assumption, the accounting policies followed by an enterprise to prepare its financial
statements are consistent across different periods.

3. Accrual

As per this assumption, the revenues and costs are recognized as they are earned or incurred rather
than when money is received or paid. Such accrued revenues or costs recorded in the financial
statements concern to the periods to which they relate.
Nature of Accounting Policies

Meaning of Accounting Policies

The term ‘accounting policies’ in AS 1 refer to the following while preparing financial statements an
enterprise: specific accounting principles methods to apply those accounting principles

No Standardized List of Accounting Policies

There is no standardized list of accounting principles applicable to varied circumstances experienced

by different enterprises.

Thus, varied accounting principles and methods to apply to those principles are followed by different
enterprises. These enterprises operate in a diverse and complex environment of economic activity.

So, the management of each enterprise has to make considerable amount of judgement at its own level.
This is done in order to choose an appropriate set of accounting principles and methods to apply those
principles in specific circumstances faced by each of them.

Number of Alternative Accounting Policies Reduced

ICAI as well as other regulatory bodies have made efforts to reduce the number of alternative
accounting policies to be followed in preparing financial statements. These efforts have been made,
particularly in the case of corporate enterprises.

However, the possibility to completely eliminate the availability of the alternative accounting
principles and the methods to apply those principles is not likely. This is because each enterprise has to
encounter different circumstances under different conditions.

Areas in which Different Accounting Policies are Encountered

Following are the areas where different accounting policies may be adopted by different
enterprises:

Methods of depreciation, depletion and amortization

Treatment of expenditure during construction

Conversion or translation of foreign currency items

Valuation of inventories

Treatment of goodwill

Valuation of investment

Treatment of retirement benefits

Recognition of profit on long-term contracts

Valuation of fixed assets

Treatment of contingent liabilities

However, the above list is not an exhaustive list.

What are the Considerations to Keep in mind While Selecting Accounting Policies?
The basic consideration while selecting accounting policies to prepare financial statements is
that such policies should represent a true and fair view the company’s affairs. This also includes
presenting true and fair view of the profit or loss earned by a business enterprise at the closing date.

Besides this primary consideration, there are a few major considerations to be kept in mind while
selecting accounting policies. These include:

1. Prudence

An enterprise cannot forecast its profits keeping in mind the uncertainty related to the future events.
Instead, it can only recognize the profits when they are realized.

Further, such recognized profits are not necessarily realized in cash. In addition to this, an enterprise
also creates a provision for all known liabilities and losses.

This is despite the fact that the amount of such liabilities and losses cannot be determined with
certainty. Thus, it means that such a provision represents only a best estimate of such liabilities and
losses according to the information available.

2. Substance over Form

As per this consideration, the accounting treatment and presentation of transactions and events in the
financial statements must be governed by their substance.

This means merely the legal form of accounting treatment and presentation of such events in the
financial statements should not be considered.

3. Materiality

The financial statements should disclose all the material items. The material items are the ones that
influence the decisions of the financial statement users once they become aware of such items.

Disclosure of Accounting Policies

It is necessary to disclose all the significant accounting policies adopted while presenting &
preparing financial statements. This is done to ensure proper understanding of financial statements.

The disclosure of significant accounting policies should form part of the financial statements.

Disclosure of accounting policies must be made in one place as it helps the financial statement users in
reading such statements. Such a disclosure should not be made in a way that it is scattered over several
statements, schedules and notes.

An enterprise should disclose any change in an accounting policy that has a material effect. Further,
the enterprise should also disclose the amount by which any item in the financial statements is affected
by such a material change. Such an amount needs to be disclosed to the extent ascertainable.
However, only the fact of such a material change needs to be indicated where such amount is not
ascertainable wholly or partly. On the other hand, there might be cases where a change in the
accounting policies does not have a material impact on the current period’s financial statements.

But are reasonably expected to have a material impact in later periods. In such cases, an enterprise
needs to disclose the fact of such a change in the period in which the change is adopted.

A business entity needs to keep in mind that a disclosure of accounting policies or of changes therein
cannot remedy a wrong or inappropriate treatment of the item in the accounts.

. List of ICAI’s Mandatory Accounting Standards (AS-1 to AS-29) as on

01/02/2022
Now 27 Accounting Standards of ICAI as of 01/02/2022. All these accounting standards are
mandatory in nature, as of 01/07/2017 and onwards:

ICAI’s AS-1: Disclosure of Accounting Policies (as on 01/02/2022)

ICAI’s AS-2: Valuation of Inventories (as on 01/02/2022)

ICAI’s AS-3: Cash Flow Statements (as on 01/02/2022)

ICAI’s AS-4: Contingencies and Events Occurring After Balance Sheet Date (as on 01/02/2022)

ICAI’s AS-5: Net profit or Loss for the period, Prior Period Items and Changes in Accounting Policies
(as on 01/02/2022)

ICAI’s AS-7: Construction Contracts (as on 01/02/2022)

ICAI’s AS-9: Revenue Recognition (as on 01/02/2022)

ICAI’s AS-10: Property, Plant and Equipment (as on 01/02/2022)

ICAI’s AS-11: The Effects of Changes in Foreign Exchange Rates (as on 01/02/2022)

ICAI’s AS-12: Government Grants (as on 01/02/2022)

ICAI’s AS-13: Accounting for Investments (as on 01/02/2022)

ICAI’s AS-14: Accounting for Amalgamations (as on 01/02/2022)

ICAI’s AS-15: Employee Benefits (as on 01/02/2022)

ICAI’s AS-16: Borrowing Costs (as on 01/02/2022)

ICAI’s AS-17: Segment Reporting (as on 01/02/2022)

ICAI’s AS-18: Related Party Disclosures (as on 01/02/2022)

ICAI’s AS-19: Leases (as on 01/02/2022)

ICAI’s AS-20: Earnings Per Share (as on 01/02/2022)

ICAI’s AS-21: Consolidated Financial Statements (as on 01/02/2022)

ICAI’s AS-22: Accounting for Taxes on Income (as on 01/02/2022)

ICAI’s AS-23: Accounting for Investments in Associates (as on 01/02/2022)

ICAI’s AS-24: Discontinuing Operations (as on 01/02/2022)

ICAI’s AS-25: Interim Financial Reporting (as on 01/02/2022)

ICAI’s AS-26: Intangible Assets (as on 01/02/2022)

ICAI’s AS-27: Financial Reporting of Interests in Joint Ventures (as on 01/02/2022)

ICAI’s AS-28: Impairment of Assets (as on 01/02/2022)

Standards) Amendment Rules, 2018 notified by MCA: AS 11 amended

List of ICAI’s Non-Mandatory Accounting Standards (AS 30~32)

ICAI has announced on 15 Nov. 2016 that ‘AS 30- Financial Instruments: Recognition and
Measurement’, ‘AS 31- Financial Instruments: Presentation’, ‘AS 32- Financial Instruments:
Disclosures’ stands withdrawn. For details, please refer: AS-30, AS-31, AS-32 withdrawn by ICAI.

**************End****************