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Unit – 1 and 2
FINANCIAL ACCOUNTING
INTRODUCTION
In all activities (whether business activities or non-business activities) and in all
organizations (whether business organizations like a manufacturing entity or trading
entity or non-business organizations like schools, colleges, hospitals, libraries, clubs,
temples, political parties) which require money and other economic resources,
accounting is required to account for these resources. In other words, wherevermoney
is involved, accounting is required to account for it. Accounting is often called the
language of business. The basic function of any language is to serve as a means of
communication. Accounting also serves thisfunction.

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
ofrecordingtransactionsinmoneyormoney’sworthsoaccuratelyandsystematically, 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 transaction.
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 opportunities 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.
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ACCOUNTING
Meaning of Accounting
Accounting, as an information system is the process of identifying, measuring
andcommunicatingtheeconomicinformationofanorganizationtoitsuserswhoneed 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 atleast, of a
financial character and interpreting the results thereof”.
Objective 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 up to 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.
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vi) To facilitate rational decision – making: Accounting records and
financial statements provide financial information which help the business in making
rationaldecisionsaboutthestepstobetakeninrespectofvariousaspectsofbusiness.
vii) To satisfy the requirement so flaw: 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 centers 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,
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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 pre-
determined 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
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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 mature 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.
i. Single Entry
ii. 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 twofold 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 at least 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
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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 toledger.
(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 Trailbalance.
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 etc.
vii) Comparative study is possible: Results of one year may be compared
with those of the precious year and reasons for the change may be ascertained.
viii) Helps management in decision making: The management may be also
to 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

Theterm‘debit’issupposedtohavederivedfrom‘debit’andtheterm‘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 Accounting
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
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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’. The accounts can also be classified as personal and impersonal. The
following chart will show the various types of 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
humanbeingistermedasanaturalpersons’personalaccount.eg.,Kamal’saccount,
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 tot group them
under one head and open a 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 all that 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
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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 or
expense 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 ANDACCOUNTING

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

Basis of
Book-keeping Accounting
difference
Transactions Recording of transactions To examine these
in books of original entry. recorded transactions in
order to find out their
accuracy.
Posting To make posting in ledger To examine this
posting in order to
ascertain its accuracy.
Total and Balance To make total of the To prepare trial balance
amount in journal and with the help of
accounts of ledger. To balances of ledger
ascertain balance in all the accounts.
accounts.
Income Statement Preparation of trading, Preparation of trading,
and Balance Sheet Profit & loss account and profits and loss account
balance sheet is not book and balance sheet is
keeping included in it.
Rectification of These are not included in These are included in
errors book-keeping accounting.
Special skill and It does not require any It requires special skill
knowledge special skill and knowledge and knowledge.
as in advanced countries
this work is done by
machines.
Liability A book-keeper is not liable An accountant is liable
for accountancy work. for the work of book-
keeper.
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BRANCHES OFACCOUNTING
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.
Now, let us understand these
terms.
Financial Accounting
The accounting system concerned only with the financial state of affairs and
financial results of operations is known as Financial Accounting. It is the original
from of accounting. It is mainly concerned with the preparation of financial
statements for the use of outsiders like creditors, debenture holders, investors and
financial institutions. The financial statements i.e., the profit and loss account and the
balance sheet, show them the manner in which operations of the business have been
conducted during a specified period.
Cost Accounting
In view of the limitations of financial accounting in respect of information
relating to the cost of individual products, cost accounting was developed. It is that
branch of accounting which is concerned with the accumulation and assignment of
historical costs to units of product and department, primarily for the purpose of
valuation of stock and measurement of profits. Cost accounting seeks to ascertain the
cost of unit produced and sold or the services rendered by the business unit with a
view to exercising control over these costs to assess profitability and efficiency of the
enterprise. It generally relates to the future and involves an estimation of future costs
to be incurred. The process of cost accounting based on the data provided by the
financial accounting.
Management Accounting
It is an accounting for the management i.e., accounting which provides
necessary information to the management for discharging its functions. According to
the Anglo-American Council on productivity, “Management accounting is the
presentation of accounting information is such a way as to assist management in the
creation of policy and the day-to-day operation of an undertaking.” It covers all
arrangements and combinations or adjustments of the orthodox information toprovide
the Chief Executive with the information from which he can control the business e.g.
Information about funds, costs, profits etc. Management accounting is not only
confined to the area of cost accounting but also covers other areas (such as capital
expenditure decisions, capital structure decisions, and dividend decisions) aswell.
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INTRODUCTION TO MANAGEMENT ACCOUNTING

The term management accounting refers to accounting for the management.
Management accounting provides necessary information to assist the management in
the creation of policy and in the day-to-day operations. It enables the management to
discharge all its functions i.e. planning, organization, staffing, direction and control
efficiently with the help of accounting information.
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 MANAGEMENTACCOUNTING
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 systematical location 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 MANAGEMENTACCORDING
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
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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
processandjobsthroughdifferentmethodsofcosting.Managementaccountingmakes 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 timeof
acquisition to the stage of disposal. This is done through various techniques of
inventorycontrollikestocklevels,ABCandVEDanalysisphysicalstockverification, 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 analysed 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.
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FUNCTIONS OF MANAGEMENTACCOUNTING
Main objective of management accounting is to help the management in
performing its functions efficiently. The major functions of management areplanning,
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 tothe
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.
Coordination
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.
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ADVANTAGES OF MANAGEMENTACCOUNTING
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 decisions 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-ordinating
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.
valuation 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 policies. This appraisal helps the management in assessing their impact
on the business.
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LIMITATIONS OF MANAGEMENTACCOUNTING
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 ACCOUNTINGAND
COSTACCOUNTING
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,
techniquesanddata.Thefunctionsofcostaccountingandmanagementaccountingare
complimentary. In cost accounting the emphasis is on cost determination while
managementaccountingconsidersboththecostandrevenue.Thoughitappearsthat
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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
FINANCIALACCOUNTING
The following are the main differences between financial accounting and
management accounting.
Objectives
Themainobjectiveoffinancialaccountingistosupplyinformationintheform 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.
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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 judgment. 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
Financialaccountingrecordsonlythosetransactionswhichcanbeexpressedin
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.
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.
 17

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 isdisclosed
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.

PRINCIPLES OF ACCOUNTING
INTRODUCTION
The word ‘Principle’ has been differently viewed by different schools of
thought. The American Institute of Certified Public Accountants (AICPA) has viewed
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. Canadian Institute of Chartered Accountants defined 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.
 18

ACCOUNTING CONCEPTS ANDCONVENTIONS

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 EntityConcept 2. Money MeasurementConcept
3. GoingConcernConcept 4. Dual AspectConcept
5.PeriodicityConcept 6. Historical CostConcept
7.MatchingConcept 8. RealisationConcept
9.AccrualConcept 10. Objective EvidenceConcept
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
caseofacompany,itsexistencedoesnotdependonthelifespanofanyshareholder.
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.
 19
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., atany
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.
vi) 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.
vii) Matching Concept: The essence of the matching concept lies in theview
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
receivedinadvance,etc.,duringthecourseofpreparingthefinancialstatementsatthe end of
the accounting period.
viii) 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
contractiscompleted,theprofitiscalculatedonthebasisofworkcertifiedeachyear.
ix) 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
 20
and accrual system is preferable to get rid of the limitations of each system.
x) 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
verifiableevidenceforthetransactionsshouldbefreefromthepersonalbias,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 ofcaution
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 opposedto
the convention of full disclosure. Thus, the convention of conservatism should be
applied very cautiously.
BASES OFACCOUNTING
There are three bases of accounting in common usage. Any one of the
following bases may be used to finalize accounts.
1. Cash basis
2. Accrual or Mercantile basis
3. Mixed or Hybrid basis.
Accounting on ‘Cash basis
Under cash basis accounting, entries are recorded only when cash is received
 21
or paid. No entry is passed when a payment or receipt becomes due. Income under
cash basis of accounting, therefore, represents excess of receipts over payments
during .Certain professional people record their income on cash basis, but while
recording expenses they take into account the outstanding expenses also. In such a
case, the financial statements prepared by them for determination of their income is
termed as Receipts and Expenditure Account.
Accrual Basis of Accounting or Mercantile System
Under accrual basis of accounting, accounting entries are made on the basis of
amountshavingbecomedueforpaymentorreceipt.Incomesarecreditedtotheperiod in
which they are earned whether cash is received or not. Similarly, expenses and losses
ere detailed to the period in which, they arc incurred, whether cash is paid or not. The
profit or loss of any accounting period is the difference between incomes earned and
expenses incurred, irrespective of cash payment or receipt. All outstanding expenses
and prepaid expenses, accrued incomes and incomes received in
advanceareadjustedwhilefinalisingtheaccounts.UndertheCompaniesAct1956,all
companies are required to maintain the books of accounts according to accrual basis
of accounting.
Mixed or Hybrid Basis of Accounting
When certain items of revenue or expenditure are recorded in the books of
account on cash basis and certain items on mercantile basis, the basis of accounting so
employed is called ‘hybrid basis of accounting’. For example, a company may follow
mercantile system of accounting in respect of its export business. However,
government subsidies and duty drawbacks on exports to be received from government
are recorded only when they are actually received i.e., on cash basis. Such a method
could be adopted because of uncertainty with respect of quantum, amount and time of
receipt of such incentives and drawbacks. Such a method of accounting followed by
the company is called the hybrid basis of accounting. In practice, the profit or loss
shown under this basis will not be realistic. Conservative people who prefer
recognising income when received but cautious to provide for all expenses, whether
paid or not prefer this system. It is not widely practiced due to the inconsistency.
ACCOUNTINGTERMINOLOGY
It is necessary to understand some basic accounting terms which are daily in
business world. These terms are called accounting terminology.
Transaction
“An event the recognition of which gives rise to an entry in accounting
records. It is an event which results in change in the balance sheet equation. That is,
whichchangesthevalueofassetsandequity.Inasimplestatement,transactionmeans the
exchange of money or moneys worth from one account to another account Events
like purchase and sale of goods, receipt and payment of cash for services or on
personal accounts, loss or profit in dealings etc., are the transactions”. Cash
transaction is one where cash receipt or payment is involved in the exchange.
Credit transaction, on the other hand, will not have ‘cash’ either received or
paid, for something given or received respectively, but gives rise to debtor and
 22
creditor relationship. Non-cash transaction is one where the question of receipt or
payment of cash does not at all arise, e.g. Depreciation, return of goods etc.,
Debtor
A person who owes money to the firm mostly on account of credit sales of
goods is called a debtor. For example, when goods are sold to a person on credit that
person pays the price in future, he is called a debtor because he owes the amount to
the firm.
Creditor
A person to whom money is owing by the firm is called creditor. For example,
Madan is a creditor of the firm when goods are purchased on credit from him
Capital
It means the amount (in terms of money or assets having money value) which
the proprietor has invested in the firm or can claim from the firm. It is also known as
owner’s equity or net worth. Owner’s equity means owner’s claim against the assets.
It will always be equal to assets less liabilities, say:
Capital = Assets - Liabilities.
Liability
It means the amount which the firm owes to outsiders that is, excepting the
proprietors. In the words of Finny and Miller, “Liabilities are debts; they are amounts
owed to creditors; thus the claims of those who ate not owners are called liabilities”.
In simple terms, debts repayable to outsiders by the business are known as liabilities.
Asset
Any physical thing or right owned that has a money value is an asset. In other
words, an asset is that expenditure which results in acquiring of some property or
benefits of a lasting nature.
Goods
It is a general term used for the articles in which the business deals; that is,
only those articles which are bought for resale for profit are known as Goods.
Revenue
It means the amount which, as a result of operations, is added to the capital. It
is defined as the inflow of assets which result in an increase in the owner’s equity. It
includes all incomes like sales receipts, interest, commission, brokerage etc.,
However, receipts of capital nature like additional capital, sale of assets etc., are not a
pant of revenue.
Expense
The terms ‘expense’ refers to the amount incurred in the process of earning
revenue. If the benefit of an expenditure is limited to one year, it is treated as an
expense (also know is as revenue expenditure) such as payment of salaries and rent.
 23
Expenditure
Expenditure takes place when an asset or service is acquired. The purchase of
goods is expenditure, where as cost of goods sold is an expense. Similarly, if an asset
is acquired during the year, it is expenditure, if it is consumed during the same year, it
is also an expense of the year.
Purchases
Buying of goods by the trader for selling them to his customers is known as
purchases. As the trade is buying and selling of commodities purchase is the main
function of a trade. Here, the trader gets possession of the goods which are not for
own use but for resale. Purchases can be of two types. viz, cash purchases and credit
purchases. If cash is paid immediately for the purchase, it is cash purchases, If the
payment is postponed, it is credit purchases.
Sales
When the goods purchased are sold out, it is known as sales. Here, the
possession and the ownership right over the goods are transferred to the buyer. It is
known as. 'Business Turnover’ or sales proceeds. It can be of two types, viz., ,cash
sales and credit sales. If the sale is for immediate cash payment, it is cash sales. If
payment for sales is postponed, it is credit sales.
Stock
The goods purchased are for selling, if the goods are not sold out fully, a part
of the total goods purchased is kept with the trader unlit it is sold out, it is said to be a
stock. If there is stock at the end of the accounting year, it is said to be a closing
stock. This closing stock at they earend will be the opening stock for the subsequent
year.
Drawings
It is the amount of money or the value of goods which the proprietor takes for
his domestic or personal use. It is usually subtracted from capital.
Losses
Loss really means something against which the firm receives no benefit. It
represents money given up without any return. It may be noted that expense leads to
revenue but losses do not. (e.g.) loss due to fire, theft and damages payable to others,
Account
It is a statement of the various dealings which occur between a customer and
the firm. It can also be expressed as a clear and concise record of the transaction
relating to a person or a firm or a property (or assets) or a liability or an expense or an
income.
Invoice
While making a sale, the seller prepares a statement giving the particularssuch
as the quantity, price per unit, the total amount payable, any deductions made and
shows the net amount payable by the buyer. Such a statement is called aninvoice.
 24
Voucher
A voucher is a written document in support of a transaction. It is a proof that a
particular transaction has taken place for the value stated in the voucher. Voucher is
necessary to audit the accounts.
Proprietor
The person who makes the investment and bears all the risks connected with
the business is known as proprietor.
Discount
When customers are allowed any type of deduction in the prices of goods by
the businessman that is called discount. When some discount is allowed in prices of
goods on the basis of sales of the items, that is termed as trade discount, but when
debtors are allowed some discount in prices of the goods for quick payment, that is
termed as cash discount.
Solvent
A person who has assets with realizable values which exceeds his liabilities is
insolvent.
Insolvent
A person whose liabilities are more than the realizable values of his assets is
called an insolvent.
ACCOUNTING EQUATION
As indicated earlier, every business transaction has two aspects. One aspect is
debited other aspect is credited. Both the aspects have to be recorded in accounts
appropriately. American Accountants have derived the rules of debit and credit
through a ‘novel’ medium, i.e., accounting equation. The equation is as follows:
Assets = Equities
The equation is based on the principle that accounting deals with property and
rights to property and the sum of the properties owned is equal to the sum of the
rights to the properties. The properties owned by a business are called assets and the
rights to properties are known as liabilities or equities of the business. Equities can be
subdivided into equity of the owners which is known as capital and equity of creditors
who represent the debts of the business know as liabilities. These equities may also be
called internal equity and external equity. Internal equity represents the owner’s
equity in the assets and external represents he outsider’s interest in the asset. Based on
the bifurcation of equity, the accounting equation can be restated as follows:
Assets = Liabilities + Capital
(Or)
Capital = Assets –Liabilities
(Or)
Liabilities = Assets – Capital.
 25
The equation is fundamental in the sense that it gives a foundation to the
double entry book-keeping system. This equation holds good for all transaction and
events and at all periods of time since every transaction and events has two aspects.
Rules for accounting equation:
Following rules help in making the accounting equation:
(i) Assets: If there is increase in assets, this increase is debited in assets
account. If there is decrease in assets, this decrease credited in assets
account.
(ii) Liabilities: When liabilities are increase, outsider’s equities are credited
and when liabilities are decreased, outsider’s equities are debited.
(iii) Capital: When capital is increased, it is credited and when capital is
withdrawn, it is debited.
(iv) Expenses: Owner’s equity is decreased by the amount of revenue
expenses.
(v) Income or profits: Owner’s equity is increased by the amount of revenue
income.
 26

JOURNAL ANDLEDGER
INTRODUCTIONS

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. Journaling 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 OFJOURNAL

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 of journal

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.
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
 27
arrangement of accounts in any required manner.

Ruling of ledger account

The ruling of a ledger account is as follows:

Dr. Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
To name of the By name of the
account to be credited account to be debited

Distinction between journal and ledger

(i) Journalisa book of prime entry, where as 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,whereasintheledgerinformationaboutaparticularaccountisfound 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 theledger.
(vii) Vouchers, receipts, debit notes, credit notes etc., from the basic documents
form journal entry, whereas journal constitutes basic record for ledger
entries
 28
Difference Between Trade Discount and Cash Discount

Trade discount Cash discount

It is given by the It may be allowed by seller to any

manufacturer or the debtor.
wholesaler to a retailer and
not toothers.

It is allowed on a certain It is allowed on payment being

quantity being purchased. made before a certain date.

It is a reduction in the It is a reduction in the amount

catalogue price of anarticle. dueby a debtor.

It is not usually accounted for This discount must have to be

in the books since the net accounted for in the books since it
amount (i.e. after deducting is deducted from the gross selling
discount) is shown. price.

It is allowed only when there It is allowed only when there is

is a sale either cash or credit. cash receipt or cash payment
includingcheques.

It is usually given at the same It varies from customer to customer

rate which is applicable to all depending on the time and period
customers. ofpayment.

It is allowed or not allowed It is allowed only on condition. The

according to sales policy dues should be paid within the
followed by a business stipulated time. If not, the debtor is
concern. not eligible for cash discount.

TRIAL BALANCE

INTRODUCTION
According to the dual aspect concept, the total of debit balance must beequal
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 trailbalance.

MEANING ANDDEFINITION
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
ofthedebitandcreditamountcolumnsofthetrailbalanceareequal,itisassumedthat the
 29
posting to the ledger in terms of debit and credit amounts is accurate. The agreement
of a trail balance ensures arithmetical accuracy only, A concern can prepare trail
balance at any time, but its preparation as on the closing date of an accounting year
iscompulsory.
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”.

OBJECTIVESOFPREPARINGATRAILBALANCE
(i) It gives the balances of all the accounts of the ledger. The balance of
anyaccount can be found from a glance from the trail balance without going
through the pages of theledger.
(ii) Itisacheckontheaccuracyofposting.Ifthetrailbalanceagrees,itproves:
(a) Thatboththeaspectsofeachtransactionarerecordedand
(b) That the books are arithmeticallyaccurate.
(iii) Itfacilitatesthepreparationofprofitandlossaccountandthebalancesheet.
(iv) Important conclusions can be derived by comparing the balances of two or
more than two years with the help of trail balances of thoseyears.

FEATURES OF TRAIL BALANCES

The following are the important features of a trail balances:

(i) Atrailbalanceispreparedasonaspecifieddate.
(ii) Itcontainsalistofallledgeraccountincludingcashaccount.
(iii) ItmaybepreparedwiththebalancesortotalsofLedgeraccounts.
(iv) Totalofthedebitandcreditamountcolumnsofthetrailbalancemusttally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are
arithmeticallyaccurate.
(vi) Difference in the debit and credit columns points out that some mistakes
have beencommitted.
(vii) Tallying of trail balance is not a conclusive profit of accuracy ofaccounts.

LIMITATIONS OF TRAILBALANCE

The following are the important limitations of trail balances:

(i) The trail balance can be prepared only in those concerns where double entry
systemofbook-keepingisadopted.Thissystemistoocostly.
(ii) A trail balance is not a conclusive proof of the arithmetical accuracy of
thebooks 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 trailbalance.
(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 theconcern.
METHODS OF PREPARING TRAILBALANCE
A trail balance refers to a list of the ledger balances as on a particular date. It
can be prepared in the following manner:
 30
TotalMethod
According to this method, debit total and credit total of each account of ledger
are recorded in the trailbalance.
BalanceMethod
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……..
Debit Total Credit Total
S.No. Name of Account L.F Amount Account
Rs. Rs.

Method II: BalanceMethod:

MT’s Books
Trail Balance as on……..

Debit Credit
S.No. Name of Account L.F balance balance
Rs. Rs.
 31
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
 32

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 TRADINGACCOUNT
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.
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.
ii) 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:

iii) 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.
iv) 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
openingstockisascertainedfromtrialbalancebutclosingstockisnotapartofledger. 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
 33
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)
xxx
Sales Returns
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 xxx
production 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
 34

PROFIT AND LOSSACCOUNT

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 LOSSACCOUNT
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 organization. Operating expenses include
administration, selling, distribution, finance, depreciation and maintenance expenses.
(2) Non operating expenses: These expenses are not directly associate with day to
day 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.Otherrevenueincomesalsoappearonthecreditsideofprofitandtoaccount. 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 taxetc.
 35
THE SPECIMEN OF 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 xxx
capital A/c (Bal. 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 xxx

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
 36
Repairs

Note: *Either net profit or net loss is the 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 AND LOSS ACCOUNT

1. Only revenue receipts should be entered
2. Only revenue expenses together with losses should be taken in to 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.
 37
BALANCESHEET

INTRODUCTION
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 revealedby 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
uniformityinaccountingsystems.Generally,thefollowingtitlesareusedinrespectof
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 BALANCESHEET:
“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 asunder:
(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
 38
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,
trademarks and licenses 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 capitalized 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 dishonored, unpaid calls on
 39
investments.
PRFORMA OF BALANCESHEET
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 xxx
(advances )
Loan on mortgage xxx Investments
Current assets
Bank loan xxx Closing stock xxx
Current liabilities Sundry debtors xxx
Sundry creditors xx Bills receivable xxx
Bills payable x Prepaid expenses xxx
Bank overdraft xx Accrued incomes xxx
Creditors for outstanding exp. xx Cash at bank xxx
Income received in advance xx Cash in hand xxx
xx Fictitious assets
xx Preliminary expenses xxx
xx Advertisement expenses xxx
Underwriting commission xxx
Discount on issue of xxx
shares
Discount on issue of xxx
debentures
xxx xxx
 40
RATIO ANALYSIS
A ratio shows the relationship between two numbers. Accounting ratio shows the relationship between two
accounting figures. Ratio analysis is the process of computing and presenting the relationships between the items
in the financial statement. It is an important tool of financial analysis, because it helps to study the financial
performance and position of a concern. Ratios show strengths and weaknesses of the business.
Definition:
In the words of Kennedy and Mc Millan ―the relationship of an item to another
expressed in simple mathematical form is known as a ratio‖
OBJECTIVES OF RATIO ANALYSIS
Intercompany comparison is a technique of comparing the information of other similar concerns for
Assessing company's own performance. Reasons for any difference in efficiency can be ascertained
with the help of such comparison.
Ratio Analysis has been widely used as a tool for analyzing the performance of the company over
the years. Trend of the ratios indicates whether the company is moving in the right direction or not.
There are certain ratios for which no standard is available to compare the performance with e.g.
Gross Profit ratio, operating ratio etc. These ratios can be studied & interpreted only when they
compared with the last years' ratios. Such comparison is known as inter-period comparison of the
same company.

 To show the firm’s relative strengths and weaknesses.

 To help to analyze the past performance of the firm and to make future projections.
 To allow interested parties like shareholders, investors, creditors and the government to
analyze and make evaluation of certain aspects of firm’s performance.
 To concentrate on inter-relationship among the figures appearing in the financial statements.
 To provide an easy way to compare present performance with the past.
 To depict the areas in which the business is competitively advantageous and disadvantageous.
 To determine the financial condition and performance of the firm.
 To help to make suitable corrective measures when the financial conditions and financial
performance are un favourable to the firm.
ADVANTAGES OF RATIO ANALYSIS
Simplifies Financial Statements
Ratio analysis simplifies the comprehension of financial statements. Ratios tell the whole story of
changes in the financial condition of a business.
Analyze Past and Forecast Future
It helps to analyze and understand the financial health and trend of a business, indicating past
performance and making it possible to forecast the future trends.
Decision-Making and Cost Control
It serves as a useful tool in management control process for decision-making and cost control
purpose.
Summaries Accounting Figures
It makes the accounting figures easy to understand and highlight the inter-relationship between
various segments of the business.
Overall Profitability
Different users of accounting information make use of specific ratios to meet or satisfy their
requirements. But the management is always interested in overall profitability and efficiency of the
business enterprise.
Liquidity Position
The short-term creditors are more interested in the liquidity position of a firm in the sense that their
money would be repaid on due dates. The ability of the firm to pay short-term obligations can be
found by computing liquidity ratios.
 41
Long term Solvency
This is required by long-term creditors, security analyst and the present and potential shareholders
of the company. The help of capital structure ratios kept the above in assessing the financial status
of the organization.

LIMITATIONS OF RATIO ANALYSIS

The ratio analysis is not a full-proof method in financial statement analysis. It suffers from a
number of limitations. Some of the important one are:
Ratios ignore qualitative factors
Ratios are obtained from the figures expressed in monetary terms. In this way, qualitative
factors, which may be important are ignored.
Trends are not the actual ratios
The different ratios calculated from the financial statements of a business enterprise for one
single year are of limited value. It would be more useful to calculate the important figures in
the case of income, dividends, working capital, etc., for a number of years. Such trends are
more useful than absolute ratios.
Defective accounting information
The ratios are calculated from accounted data in the financial statements. It means if the
information is defective then the calculation of ratios would be wrong. Thus, the deliberate
omissions would affect the ratios too.
Change in accounting procedures
A comparison of result of two firms becomes difficult when we find that the firms are using
different procedures related to certain items, such as inventory valuation and treatment of
intangible assets.
Variations in general operating conditions
While interpreting the results based on ratio analysis, all business enterprises have to work
within given general economic conditions, state of the industry in which the firms are
operating and the position of the individual companies within the industry. For example, if the
firm is forced by the government to sell their products at a fixed price, its comparison with
other firms would become impossible.
Single ratio not sufficient
It is very necessary to take into account the combined effect of various ratios so that the results
are correctly interpreted regarding the financial condition and the profit-making performance
of the business. Each ratio plays a part in interpreting the financial statement.
The use of standard ratio
The financial statements represent historical data and, therefore, the ratios based on them
would only disclose what happened in the past

DIFFERENT FORMS IN WHICH RATIO CAN BE EXPRESSED

 There are three different forms in Pure ratio
 Percentage
 Rate
which an accounting ratio can be expressed:
Pure Ratio:
A pure ratio is a simple division of one number by another. The relationship between Current
Assets & Current Liabilities is expressed in this way. If the Current assets are Rs. 2,00,000 and
Current Liabilities Rs. 1,00,000, the ratio is derived by dividing Rs. 2,00,000 by Rs. 1,00,000.
It will be expressed as 2:1
 42
Percentage :
Certain accounting ratios become more meaningful if expressed as a percentage. The
relationship between profits and sales is expressed in this way. For example, if sales are Rs.
4,00,000 and Gross Profit is Rs. 2,00,000 then it is expressed as gross profit being 50% of
sales.
Rate:
Sometimes ratios are expressed as rates i.e. 'number of times' over a certain period.
Relationship between stock and sales is expressed in this way. If stock turnover rate is said to
be '8' times in a year, it means that the stock is converted into sales 8 times in 12 months.

Classification of Ratios:
Financial Ratios can be classified in many ways. Different authors have
classified the Ratios in different groups. The most common classification is as
follows:

I. Liquidity Ratios
Liquidity Ratios measure the firms‘ ability to pay off current dues i.e., repayable
within a year. Liquidity ratios are otherwise called as Short Term Solvency
Ratios. The important liquidity ratios are
1. Current Ratio
2. Liquid Ratio
3. Absolute Liquid Ratio

1. Current Ratio:
This ratio is used to assess the firm‘s ability to meet its current liabilities. The
relationship of current assets to current liabilities is known as current ratio.
The ratio is calculated as:

Current Assets
Current Ratio = ————————
Current Liabilities

Current Assets are those assets, which are easily convertible into cash within
one year. This includes cash in hand, cash at bank, sundry debtors, bills
receivable, short term investment or marketable securities, stock and prepaid
expenses.
Current Liabilities are those liabilities which are payable within one year. This
includes bank overdraft, sundry creditors, bills payable and outstanding
expenses.

2. Liquid Ratio
This ratio is used to assess the firm‘s short term liquidity. The relationship of
liquid assets to current liabilities is known as liquid ratio. It is otherwise called
as Quick ratio or Acid Test ratio. The ratio is calculated as:

Liquid Assets
Liquid Ratio = ————————
Current Liabilities
Liquid assets means current assets less stock and prepaid expenses.

3. Absolute Liquid Ratio

It is a modified form of liquid ratio. The relationship of absolute liquid assets to
liquid liabilities is known as absolute liquid ratio. This ratio is also called as
‗Super Quick Ratio‘. The ratio is calculated as:
 43

Absolute Liquid Assets Absolute Liquid Ratio = ———

————–——
Liquid Liabilities
Absolute liquid assets means cash, bank and short term investments. Liquid
liabilities means current liabilities less bank overdraft.
(Note : All liquidity ratios are expressed as a proportion)

II. Solvency Ratios

Solvency refers to the firms ability to meet its long term indebtedness. Solvency
ratio studies the firms ability to meet its long term obligations. The following are
the important solvency ratios:

1. Debt-Equity Ratio
2. Proprietory Ratio

1. Debt Equity Ratio

This ratio helps to ascertain the soundness of the long term financial position of
the concern. It indicates the proportion between total longterm debt and
shareholders funds. This also indicates the extent to which the firm depends
upon outsiders for its existence. The ratio is calculated as:

Total long term Debt

Debt-Equity Ratio = ————————
Shareholders funds

Total long term debt includes Debentures, long term loans from banks and
financial institutions. Shareholders funds includes Equity share capital,
Preference share capital, Reserves and surplus.

2. Proprietory Ratio
This ratio shows the relationship between proprietors or shareholders funds and
total tangible assets. The ratio is calculated as:

Share holders funds (Proprietors funds)

Proprietory Ratio = ———————————————
Total tangible assets

Tangible assets will include all assets except goodwill, preliminary expenses etc.

III. Profitability Ratios

Efficiency of a business is measured by profitability. Profitability ratio measures
the profit earning capacity of the business concern. The important profitability
ratios are discussed below:
1. Gross Profit Ratio
2. Net Profit Ratio
3. Operating Profit Ratio
4. Operating Ratio

1. Gross Profit Ratio

This ratio indicates the efficiency of trading activities. The relationship of Gross
profit to Sales is known as gross profit ratio.The ratio is calculated as:
 44
Gross Profit
Gross Profit Ratio = —————— x 100
Sales

Gross profit is taken from the Trading Account of a business concern. Otherwise
Gross profit can be calculated by deducting cost of goods sold from sales. Sales
means Net sales.
2. Net Profit Ratio:
This ratio determines the overall efficiency of the business. The relationship of
Net profit to Sales is known as net profit ratio. The ratio is calculated as:

Net Profit
Net Profit Ratio = ————— x 100
Sales

Net profit is taken from the Profit and Loss account of the business concern or
the gross profit of the concern less administration expenses, selling and
distribution expenses and financial expenses.

3. Operating Profit Ratio

This ratio is an indicator of the operational efficiency of the management. It
establishes the relationship between Operating profit and Sales. The ratio is
calculated as:
Operating Profit
atio = —————— x 100 Sales

Where operating profit is Net profit + Non-operating expenses – – Non-operating

income. Where, Non-operating expenses are interest on loan and loss on sale of
assets.
Non-operating income are dividend, interest received and profit on sale of asset.
(or) Operating profit = Gross profit –– Operating expenses.
Operating expenses include administration, selling and distribution expenses.
Financial expenses like interest on loan are excluded for this purpose.

4. Operating Ratio
This ratio determines the operating efficiency of the business concern.
Operating ratio measures the amount of expenditure inurred in production,
sales and distribution of output. The relationship betweenOperating cost to Sales
is known as Operating Ratio. The ratio is calculated as:

Cost of goods sold + Operating expenses

Operating Ratio = —————————— x 100
Sales
(Note: All profitability ratios will be expressed in terms of percentage.)

IV. Activity Ratios

Activity ratios indicate the performance of the business. The performance of a
business is judged with its sales (turnover) or cost of goods sold. These ratios are
thus referred to as turnover ratios. A few important activity ratios are discussed
below:
1. Capital turnover ratio
2. Fixed assets turnover ratio
3. Stock turnover ratio
 45

4. Debtors turnover ratio

5. Creditors turnover ratio

1. Capital Turnover Ratio

This shows the number of times the capital has been rotated in the process of
carrying on business. Efficient utilisation of capital would lead to higher
profitability. The relationship between Sales and Capital employed is known as
Capital Turnover Ratio. The ratio is calculated as:

Sales
Capital Turnover Ratio = ————————
Capital Employed

Where Sales means Sales less sales returns and Capital employed refers to
total long term funds of the business concern i.e., Equity share capital,
Preference share capital, Reserves and surplus and Long term borrowed funds.

2. Fixed Assets Turnover Ratio:

This shows how best the fixed assets are being utilised in the business concern.
The relationship between Sales and Fixed assets is known as Fixed assets
turnover ratio. The ratio is calculated as:

Sales
Fixed assets turnover Ratio = ——————
Fixed assets

Fixed assets means Fixed assets less depreciation.

3. Stock Turnover Ratio

This ratio is otherwise called as inventory turnover ratio. It indicates whether
stock has been efficiently used or not. It establishes a relationship between the
cost of goods sold during a particular period and the average amount of stock in
the concern. The ratio is calculated as:

Cost of goods sold

Stock turnover ratio = ————————
Average stock

Opening stock + closing stock Average stock = ————————

—————
2
If information to calculate average stock is not given then closing stock may be
taken as average stock.

4. Debtors Turnover Ratio

This establishes the relationship between credit sales and average accounts
receivable. Debtors turnover ratio indicates the efficiency of the business
concern towards the collection of amount due from debtors. The ratio is
calculated as:
CreditSales Debtors turnover Ratio = ————
 46
————————
Average Accounts Receivable

Accounts receivable includes sundry debtors and bills receivable.

Opening (debtors + bills receivable) + Closing (debtors + bills receivable)

Average accounts receivable = —————————————
2

In case credit sales is not given, total sales can be taken as credit sales.

5. Creditors Turnover Ratio:

This establishes the relationship between credit purchases and average accounts
payable. Creditors turnover ratio indicates the period in which the payments are
made to creditors. The ratio is calculated as:

Credit Purchases
Creditors turnover ratio = ———————————
Average Accounts payable

Accounts payable include sundry creditors and bills payable.

Opening (creditors + bills payable) + Closing (creditors + bills payable)
Average accounts payable = —————————————
2

In case credit purchases is not given total purchases can be taken as credit
purchases.
(Note: All turnover ratios will be expressed in terms of times.)

DuPont Ratio
DuPont Analysis is a framework used to break apart the underlying components of the return on
equity (ROE) metric to determine the strengths and weaknesses of a company.
Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical
company, the model is used to analyze the return on equity (ROE) as broken down into different
parts in order to analyze the contribution of each part.

In a 3-step DuPont analysis, the equation states that if a company’s net profit margin, asset
turnover, and financial leverage are multiplied, you will arrive at the company’s return on
equity (ROE).
 47
As the simpler version between the two approaches, the return on equity (ROE) is broken into
three ratio components:

1. Net Profit Margin = Net Income ÷ Revenue

2. Asset Turnover = Revenue ÷ Average Total Assets
3. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity
The starting point to arrive at these three components is the return on equity (ROE) formula.

Return on Equity (ROE) = Net Income ÷ Average Shareholders’ Equity

If we multiply the ROE formula above by two ratios: 1) “Revenue ÷ Revenue” and 2) “Average
Total Assets ÷ Average Total Assets”, we are essentially multiplying the ROE by one, since the
numerator and denominator are the same in both ratios.

But with some re-arranging of the terms, we arrive at the three standard ratios mentioned earlier:

 Ratio #1 → Net Profit Margin

 Ratio #2 → Asset Turnover Ratio

 Ratio #3 → Leverage Ratio

DuPont Analysis Formula
The 3-step DuPont formula shown below is the most commonly used equation:

Upon splitting up the return on equity (ROE) calculation into these three components, the changes
in ROE can be better understood and what is driving the net increase (or decrease).

The DuPont analysis implies that a company can increase its ROE if it:

 Generates Higher Net Profit Margin

 Efficiently Utilizes Assets to Generate More Revenue

 Increases its Financial Leverage

DuPont Analysis Ratios: ROE Equation Components

 48

1. Net Profit Margin Ratio

Net Profit Margin = Net Income ÷ Revenue
 The net profit margin represents a company’s “bottom line” profitability once all expenses have
been deducted, including the interest expense payments on debt obligations and taxes to the
government.
 If the net profit margin increases, each dollar of revenue will bring in more earnings to the
company, resulting in a higher return on equity (ROE).

 Therefore, a company’s net income represents the remaining profits left over, which are
attributable to one specific group of capital providers – the equity shareholders.
2. Asset Turnover Ratio
Asset Turnover = Revenue ÷ Average Total Assets
 For the second component, the total asset turnover ratio is an efficiency ratio tracking the ability of
a company to generate more revenue per dollar of asset owned.
 If a company improves upon its turnover ratio, the ROE increases because the implication is that it
can utilize its assets better – i.e. generate more revenue with fewer assets.

 The first two components – the net profit margin and total asset turnover – represent measures of
operating efficiency and asset efficiency.
3. Financial Leverage Ratio
Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity
 The third and final component is financial leverage, which is the amount of debt in the
company’s capital structure.
 The use of more debt financing leads to higher interest expenses, which are tax-deductible and
create a “tax shield” that reduces the amount of taxable income.

 Often called the “equity multiplier,” increasing the amount of debt to benefit from the lower taxes,
the lower cost of capital, and obtaining access to a cheaper funding source could easily backfire
from irresponsible decision-making. Hence, the company must be led by a management team with
their interests aligned with that of its shareholders.
 The company must strike the right balance between benefiting from debt financing but not placing
excess leverage on the company, where the company’s cash flows are insufficient to handle all the
debt obligations and are now at risk of default.
 49

TRIAL BALANCE AND ACCOUNTING ERRORS

You have learnt the method of recording transactions in journal and its sub-divisions. You have also
learnt their posting to various accounts in the ledger. This process of recording and posting continues
throughout the year. At the end of the year it becomes necessary to check the arithmetical accuracy of
the books of accounts before the preparation of final accounts. For this purpose we prepare a
statement called TrialBalance. In this unit you will learn about the preparation of Trial Balance and
theextent up to which it can be relied upon for testing the accuracy of accounts. You willalso learn about
the errors that may be disclosed and that may not be disclosed bythe preparation of Trial Balance and
the method of locating such errors.

Meaning of Trail Balance

Numerous transactions take place in business every day. They are first recorded in books of original
entry i.e., Journal Proper or one of its sub-divisions. Then they are posted to the appropriate accounts
in the ledger. Each ledger account is balanced periodically so as to ascertain the net effect of various
transactions posted therein. In the process, some accounts may get closed; the final accounts are
prepared for ascertaining the profit or loss and the financial position of the business. The quality and
reliability of the results obtained depend, largely on the correctness of the entries made in various books of
accounts and their ledger posting. Hence, it is necessary to ascertain the accuracy of these entries and ledger
postings before we proceed with the preparation of final accounts. For this purpose, we prepare a
statement called ‘Trial Balance’, which shows balances of all the ledger accounts. The names of each
account having debit balances are shown in the debit column and if it shows a credit balance, the
amount is entered in the credit balances column. You know that the total of the debit balances column
must tally with the total of the credit balance column, because for every debit there is a corresponding
credit and vice versa. When the two totals tally, it is considered as a preliminary proof of the arithmetical
accuracy of the accounts. It isan assurance that entries in the journal and posting into ledger have been
correctlydone and that equality between debits and credits has been maintained throughout.However,
if the two totals do not tally it implies that there are some errors in the booksof accounts.
Trial Balance can thus, be defined as a statement (or a schedule) listing, in separate columns, the debit
and credit balances of all ledger accounts on a particular date. Itindicates that the books of accounts
have been prepared in accordance with the rules of double entry and ensures, to a great extent, the
arithmetical accuracy of accounting entries. Trial Balance provides a check on arithmetical
accuracy of the recording of financial transactions in different books such as journal and the ledger.
Such a check can be performed by preparing a statement called trial balance. Trial balance is a
statement prepared by taking up the debit and credit totals or balances of all ledger accounts on a
particular date.

Objectives preparing Trail Balance:

i) To check arithmetical accuracy : With the help of trial balance we can identify the arithmetical
error, committed by the accountant or his assistant, because in such a situation the trial balance will not
agree. Under such situations it is assumed that some errors have been committed.After identifyingsuch errors
the same are rectified.
ii) To prepare final accounts of the enterprise : Trial balance becomes the basis of preparing final
 50
accounts. If we do not prepare trial balance and just start preparing final accounts, it may be possible that
we forget to record some transactions that were not recorded while preparing the final accounts because
information about the same was not available at that time.
iii) Comparative study of each account : Trial balance helps in comparing the present balance of an
account with the previous period balance. By preparing trial balance, we can estimate whether
closing balance of accounts will increase or decrease within two accounting periods. It can also be
used as a tool to decide whether there is need to decrease the rate of depreciation for showing improved profit
position.

iv) To make financial budget : Previous years trial balance figures are also helpful to estimate the future
amount. In other words, we can make differentfinancial budgets with the help of trial balance.

As mentioned earlier, when the Trial Balance does not tally it means that some errors have been
committed while preparing the accounts. Let us, now analyze the errors which usually affect the
Trial Balance and lead to its disagreement.
i) Omission of posting in one account : You are aware that both the debit and credit aspects of a
transaction have to be posted in the ledger accounts. If you post it to the debit of one account and
forget its posting to the credit of the other concerned account, it is bound to affect the
Trial Balance. For example, an amount of `200 received from Ali, correctly
entered on the debit side of the cash book but is not posted to the credit side of Ali’s Account,
because of this error the totals of the debit column ofthe trial balance will be more than the total of the
credit column and hencethe trial balance will not agree.
ii) Double posting in one account : If by mistake you post an entry two times to the debit or to the
credit of an account it would result in extra debit or credit and as such cause disagreement in the Trial
Balance for example `
4000 received from Ashok were credited twice in his account will increase
the total of the credit column by `4000 and the trial balance will not agree.
iii) Posting in the wrong side of an account : When an entry is posted in the wrong side of an account
i.e. instead of debit side it is posted in the credit side and vice-versa, it would also cause disagreement
of the Trial Balance. In such a situation, the difference will be for double the amount. For example,
`300 received from Khan which is correctly entered on the debit side of
the Cash Book, but while posting it to Khan’s Account it is wrongly posted to the debit side of his
account instead of the credit side. This would mean that a debit of `600 (`300 in Cash Account and
`300 in Khan’s Account)
has no corresponding credit. With the result the total of the Credit column of
the trial balance will be lesser by `600.
iii) Posting wrong amount in an account : If you post an entry to the correct side of an account but
commit an error in writing the amount, this would affect the Trial Balance. Suppose, in the above
example you post the entrycorrectly on the credit side of Khan’s Account but the amount is wrongly
written as `200. It would cause a difference of `100. In the Trial Balance, the credit side will be
lesser by `100.
iv) Wrong Casting of the subsidiary books : If any subsidiary book is overcast or undercast, it
affects the concerned account in ledger. Supposethe correct total of Sales Journal is `5,600, but it has
been totalled as
`5,300 when now posted to the credit of Sales Account, the Sales Account
 51
will be short by `300, and the Trial Balance will not tally.
v) Omitting to post the total of a subsidiary book : If the total of a subsidiary book is not
posted to the concerned account, it would affect the Trial Balance. Such mistake relates only to the
account where posting wasto be done and as such affects only one account. For example, if the totals
of the Sales Book `18,900 are not posted to the credit of Sales Account, the credit side on the Trial
Balance will be lesser by `18,900.
vi) Wrong totaling or balancing of an account : When an account is wrongly totaled or wrongly
balanced, this would affect the Trial Balance. Suppose total of the debit side of Shyam’s Account has
been written as `1,300
instead of `1,100. It would lead to wrong balance in Shyam’s Account.
Consequently, the debit total in the Trial Balance will be higher by `200.
Similarly, if the totaling is correctlydone but a mistake is committed in balancingthe account, it would also
cause a difference in the Trial Balance.
vii) Omission of an account from Trial Balance : You know that all accountswhich show some balance
must be included in the Trial Balance. If you forget to write the balance of any account in the Trial
Balance, it will nottally. In practice cash book balances are often omitted from Trial Balance.

viii) Writing the balance of an account in the wrong column of the TrialBalance : If the balance of
an account which is to be shown in the debit column of the Trial Balance is actually shown in the credit
column, the TrialBalances will not tally. It will be affected by double the amount.
ix) Wrong totaling of the Trial Balance: If an error is committed in totaling the amount columns of the
Trial Balance itself, the Trial Balance will not tally.
Thus, you have learnt about various errors which may cause difference in the TrialBalance. Note that
these errors affect only one aspect (debit or credit). This upsets the debit-credit equality leading to the
disagreement of the Trial Balance
Errors not Disclosed by Trail Balance
Agreement of the trial balance is not a conclusive proof of the accuracy of the accounts. There
may be certain errors which might have been crept into the accounts but do not affect the agreement of
the trial balance. Such errors have been discussedbelow :

i) Errors of Complete Ommission : If a transaction is completely omitted from being recorded in the
books of accounts, such an omission will not affect the agreement of the trial balance for example a
credit purchase of `
6000 from Ravi was omitted from being recorded in the Purchase Book.
Because of this omission the totals of the purchases book and Ravi’s account will not be affected and
hence trial balance will also not be affected.
ii) Errors of commission : These types of errors happen due to the negligence of accountants and cannot
be located by preparing trial balance. Suppose a sales of `10,000 was recorded in books as `100. The
balances both the
accounts i.e sales accountant and cash account will be affected only by `
100 and hence the trial balance will not be affected.

iii) Compensating Errors : Suppose, an accountant posted `500 less in the debit side of purchase
account and at the same time he also posted `500
 52
less in credit side of sales account. In this case an error has been compensated by another error. Such
errors are called compensating error and will notaffect the trial balance.
Errors of principles : When an accounting principle has been violated while recording a transaction in
the books of accounts, such errors are callederrors of principle e.g. the purchase of an asset if recorded in the
purchases account will be an error of principle but since the purchase account will be debited and the
suppliers accounts will be credited with the same amountthis error will not affect the trial balance

Errors not Disclosed by Trail Balance

If the Trial Balance does not tally, it will indicate that certain errors have been committed which have
affected the agreement of the Trial Balance. The accountant will then proceed to locate such errors.
On location such errors are rectified. Errors disclosed by trial balance have been explained below:
i) Wrong Casting : If the total of the Cash Book or some other Subsidiary Book is casted wrong, the Trial
Balance will not tally. For example, the total of the Purchase book has been casted `2000 more. When this
total will be posted to
the debit side of the purchase account, it will also show an excess debit of `
2000 and hence, the Trial Balance will not agree.
ii) Posting to the Wrong Side of an Account : If instead of posting an amount on the debit side of an
account, it is posted on the credit side, or vice versa, the Trial balance will not tally. For example, goods
for `2,000 purchased
from Sohan. If instead of posting the amount on the credit side of Sohan’s
account it is posted to his debit, the debit side of the Trial Balance will exceed the credit side by
`4,000.
iii) Posting of Wrong Amount : The Trial Balance will not tally if the posting inan account is made with an
incorrect amount. For example, goods for `600have been purchased from Anil. If, it has been correctly
entered in the
Purchase Book or purchase account, but while posting to Anil’s account, in credit side (correct side)
the amount posted is `60 instead of `600, the Trial Balance will not tally.
iv) Omission of Posting of One aspect of a Transaction : For example, if
`500 has been received from Shyam and correctly entered in the Cash Book but if it is omitted to
be posted on the credit side of Shyam’s Account, the Trial Balance will not tally.

v) Posting an amount twice in an Account : For example `500 has received from Vinod and correctly
entered in the Cash Book, but if it is posted twice on the credit side of Vinod’s account, the Trial Balance
will not tally.
vi) Errors of Totaling and Balancing of Accounts in the Ledger : Errors may occur in the totaling
of debit or credit sides of accounts in the Ledger or in the balancing of accounts in the Ledger.
Because the balances of accounts are transferred to the Trial Balance, resulting in transferring
wrong balances in the Trial Balance. This will result into the disagreement of the trial balance.

Process locating Errors

If an error exists in the books, it affects the accuracy of results of business operations revealed by the
financial statements. Therefore, the errors must be located for rectification. The task of locating
errors is, however not easy. The location of errorswill be easier if the following steps are systematically
taken.
 53
i. Check the total of the trial balance.
ii. Compare the ledger account balances carried to the trial balance.
iii. Verify the total of subsidiary books and their posting to ledger accounts.
iv. Verify that all journal entries have been correctly posted to the different ledger accounts.
v. If you find that you have an unbalanced trial balance, in other words the debits don’t equal the
credits, it indicates that some errors have been committed during the course of accounting process.
Such errors have to befound and corrected. The first step in finding an error is to simply add thecredit and
debit columns again to verify your totals. If they still don’t agreethen subtract the smaller totals from the
bigger and look for the missingamount in the smaller column. If you find it, you’ve found your error.
vi. There are other standard techniques to track down an error in a trial balance. If the debits and credits are
not equal, see if the numeral 2 divides equally the difference. If it does, look for an account, incorrectly in
the column withthe larger total that equals half the difference. If you find this, you’ve found your error.
vii. Another technique is to use the numeral 9 to find a transposition error. If the numeral 9 divides evenly
the difference between the credits and debits, you have a transposition error. Go back over your credit and
debit entries to tryto find your transposition error.

Preparation of Trail Balance

After recording all financial transactions in the subsidiary books and journal proper the same are
posted into the ledger. The ledger accounts are then, balanced. The Balances of the ledger accounts
are then transferred to the relevant columns of thetrial balance to verify that the debits are equal to the
credits. The trial balance is the next step in the accounting cycle. Trial balance is not an account. It is
only a statement that lists the balances of ledger accounts including cash and bank balances. It is
prepared on a particular date. It is prepared on a sheet with two amount columns for debit and credit
balances. The accounts having debit balances are entered in the debit amount column and the
accounts having credit balances are entered in the credit amount column. The sum of each column
should be equal. It is actually the first step in the “end of the accounting period” process. In practice
the trial balance is prepared with debit and credit balances of various accounts in the ledger along
with balances in the cash book. The following is the format of a Trial Balance .

Limitation of Trail Balance

i) As there are certain errors which are not disclosed by a trial balance. Therefore again it can be
said that the agreement of a trial balance is not a conclusive proof of the accuracy of accounts.
ii) A trial balance gives only condensed information of each account.
iii) It does not give the information about the profit or loss made by the businessin the accounting period.
iv) If trial balance is not prepared accurately, the final accounts prepared fromsuch a trial balance would not
be reliable.
v) It does not ensure that all the transactions have been actually recorded in thesubsidiary books.
vi) It is prepared only by those enterprises which make use of double entrysystem.

SUSPENSE ACCOUNT
When the trial balance does not agree, because of errors committed by the accountant during the accounting
process and he decides to prepare the final accounts then the difference is written on the shorter column
against an account called ‘Suspense Account’. After wards the errors that affect the trial balance are
rectified through the suspense account. Once all such errors are rectified the suspense account opened to
artificially balance the trial balance will finally be balanced.
 54
Unit 3 - Budgets and Budgetary Control

BUDGETING
INTRODUCTION
Modern business world is full of competition, uncertainty and exposed to
different types of risks. This complexity of managerial problems has led to the
development of various managerial tools, techniques and procedures useful for the
management in managing the business successfully. Budgeting is the most common,
useful and widely used standard device of planning and control. The budgetary
control has now become an essential tool of the management for controlling costs and
maximising profit. Costs can be reduced, wastage can be prevented and proper
relationship between costs and incomes can be established only when the various
factors of production are combined in profitable way. The resources of a business can
be effectively utilised by efficient conduct of its operations. This requires careful
working out of proper plans in advance, co-ordination and control of activities on the
part of management.
A proper planning and control are essential for an efficient management. A
good number of tools and devices are available. Of all these, the most important
device used is budget. Cost accounting aims not only at cost ascertainment, but also
greatly at cost control and cost reduction. This the management aims at the proper
and maximum utilization of resources available. It is possible when there is a Pre-
planning. Modern management aims that all types of operations should be
predetermined in advance, so that the cost can be controlled at every step. The more
important point is that the actual programme is compared with the pre-planned
programme and the variances are analysed and investigated. All are familiar with the
idea of budget, at every walk of life-state, firm, business etc.,

MEANING AND DEFINITION OFBUDGET:

A budget is the monetary and / or quantitative expression of business plans
and policies to be pursued in the future period of time. Budgeting is preparing
budgets and other procedures for planning, coordination and control or business
enterprises.
I.C.M.A. defines a budget as “A financial and / or quantitative statement,
prepared prior to a defined period of time, of the policy to be pursued during that
period for the purpose of attaining a given objective”.

Objectives of Budget
1. It directs the attention of all concerned to the attainment of a common goal.
2. It l ea d s to the disclosure of organizational weakness. The budgets are
compared with actual performance; and variances, if any, are investigated.
3. It aims at careful control over the performance and cost of every function.
4. It contributes to co-ordinate efforts of all departments in order to achieve an
integrated goal. Budgets grow from bottom and are controlled from top-level.

BUDGETING
Budgeting refers to the process of preparing the budgets. It involves a detailed
 55
study of business environment clearly grasping the management objectives, the
available resources of the enterprise and capacity of the enterprise.
Budgeting is defined by J.Batty as under: “The entire process of preparing the
budgets is known as budgeting”. In the words of Rowland and Harr: “Budgeting may
be said to be the act of building budgets”.
Thus budgeting is a process of making the budget plans. Preparation of
budgets or budgeting is a planning function and their implementation is a control
function. ‘Budgetary control’ starts with budgeting and ends with control.

Objectives of Budgeting
The main objectives of budgeting are:
1. To obtain more economical use of capital.
2. To prevent waste and reduce expenses.
3. Tofacilitatevariousdepartmentstooperateefficientlyandeconomically.
4. To plan and control the income and expenditure of the firm,
5. To create a good business practice by planning for future.
6. To fix responsibilities on different departments or heads.
7. To co-ordinate the activities of various departments.
8. To ensure the availability of working capital.
9. To smooth out seasonal variations, by developing new products.
10. To ensure the matching of sales with productions.

CONTROL
Control may be defined as “comparing operating results with the plans, and
taking corrective action when results deviate from the plans”. Control is a mechanism
according to which something or someone is guided to follow the predetermined
course.
Control requires two things; first that there is a clear-cut and specific plan
according to which any work is to proceed. Secondly, that it is possible to measure
the results of operations with a view to detecting deviations. Only then action can be
taken to prevent or correct deviations.

BUDGETARYCONTROL
Budgetary control is the process of preparation of budgets for various
activities and comparing the budgeted figures for arriving at deviations if any, which
are to be eliminated in future. Thus budget is a means and budgetary control is the
end result. Budgetary control is a continuous process which helps in planning and
coordination. It also provides a method of control.
Definition
According to Brown and Howard “Budgetary control is a system of
coordinating costs which includes the preparation of budgets, coordinating the work
of departments and establishing responsibilities, comparing the actual performance
with the budgeted and acting upon results to achieve maximum profitability”.
Wheldon characterizes budgetary control as planning in advance of the various
functions of a business so that the business as a whole is controlled.
I.C.M.A. define budgetary control as “the establishment of budgets, relating
the responsibilities of executives to the requirements of a policy, and the continuous
comparison of actual with budgeted results either to secure by individual actions the
objectives of that policy or to provide a basis for its revision”.
 56
Objectives of Budgetary Control
Budgetary control is inevitable for policy formulation, planning, control and
coordination. The essence of budgeting is to plan and control. Following are the main
objectives of budgetary control.
i) Planning: Budgeting ensures effective planning by setting up of budgets.
ii) Coordination: Budgets are helpful in coordination of business activities.
iii) Efficiency and Economy: Effective budgetary control results in cost control
and cost reduction.
iv) Increase in Profitability: Cost are controlled with help of budgets and profits
targeted are achieved.
v) Anticipation of future capital expenditure: Estimated increase in sales
necessitating higher production capacity provides advance warning for the
possible capital expenditure in near future.
vi) Control: Controlling function is made to be effective as the control is
centralized while budgets are prepared and implemented.
vii) Deviations: Ascertainments of deviations is essential to fix responsibility and
correct the deviations as far as possible.

FORECAST AND BUDGET

(i) Forecast is mainly concerned with probable events; but budget is concerned
with planned events.
(ii) Forecast may be done for longer time; but budget is prepared for shorter
periods.
(iii) Forecast is only a tentative estimate and can be revised; but budget remains
unchanged for the budget period.
(iv) Forecast results in planning and the planning results in budgeting.
(v) Forecast is the base while a budget is the structure built on the base.
(vi) Forecast is not used for evaluating the efficiency of performance while a
budget is always used for this purpose.
ORGANISATION
The following are the essentials for a sound system of budgetary control

Budget centre
For the purpose of effective budgetary control, budget centres are defined. A
budge centre may be a department or a section of the undertaking. Separate budgets
arepreparedforeachdepartmentandthedepartmentalheadisresponsibleforcarrying out
budgets. Departmental heads should have effective control over the execution of the
budget, to prevent unfavourble variation.
Budget manual
It is a document which sets out the responsibilities of persons engaged in the
routine work. Budget manual lays down the objectives of the organization,
responsibilities of all executives and the procedure to be followed for budgetary
control. Duties, authorities, powers of each official of the different departments are
clearly defined, so as to avoid conflicts among the personnel. It also specifies
different forms and records to be used for the purpose of budgetary control.
Budget Period
This is the period or time for which the budget is prepared and remains in
 57
operation. The length of period depends on the nature of business, the production
period, the control aspect etc. There is no definite rule as regards the duration of a
budget period. Generally, the budget is prepared for a year, which is preferred by
most concerns. For example manufacturers of consumer goods may prepare budgets
for a year, whereas in industries like ship-building the period of the budget may be 5
to 10 years.
CLASSIFICATION OFBUDGETS
Budgets are classified according to their nature. The following are the different
classifications of budgets.
Classification according to time
1. Long-term budgets
2. Short-term budgets
3. Current budgets
Classification based on functions
1. Functional or subsidiary budgets
2. Master budget
Classification on the basis of flexibility
1. Fixed budget
2. Flexible budget

Classification on the basis of Time

(1) Long-term Budgets: Long-term budgets are prepared to reflect long-term
planning of the business. Generally, the long-term period varies between five to ten
years. They are prepared by the top level management. Long-term budgets are
prepared for specialised activities like capital expenditure, research and development,
long-term finances, etc.
(2) Short-term Budgets: These budgets are generally for a duration of one
year and are expressed in monetary terms.
(3) Current Budgets: The duration of current budgets is generally in months
and weeks. These budgets are prepared for the current operations of the business. As
per I.C.M.A. London, ‘current budget is a budget which is established for use over a
short period of time and is related to current conditions”.

Classification on the basis of functions

(1) Functional Budgets: These budgets relate to various functions of the
concern. Following are the commonly prepared functional budgets:
(a) Purchase Budget
(b) Cash budget
(c) Production budget
(d) Materials budget
(e) Sales budget
(2) Master Budget: This budget is a summary of various functional budgets. It
encompasses the activities of the whole organisations. According to I.C.M.A., London
“The master budget is the summary budget incorporating its functional budgets”.
Master budget is prepared to coordinate the activities of various functional
departments.

Classification on the basis of flexibility

1. Fixed Budget: it is prepared for a given level of activity and remains same
irrespective of change of activity.
 58
2 Flexible budget: It is a budget prepared for various levels of activity by
classification of expenditure under fixed, variable and semi fixed
categories.
Some Important Budgets
(1) Sales Budget:
In the budgeting process, sales are a starting point, as sales is the key factor in
many cases. W.W.Bigg Writes, “This is probably most important budget, as it is
usually the most difficult of forecast to attain”.
(2) Production Budget:
This budget is based on sales budget, unless production itself is the key-factor. It
shows the budgeted quantity of output to be produced during a specific period. It has
two parts, one showing the output for the period and the other showing production
costs. The following key elements are considered while preparing the production
budget.
(3) Materials Budget:
This budget is prepared in coordination with production budget. Preparation of
materials budget is useful and helpful in achieving continuous, uninterrupted
production as the non-availability of materials at the right time can affect the
production. Material budget consists of two parts, one is the consumption budget and
another is materials purchase budget.
(4) Labour budget:
Labour budget is also a part of production budget. Labour budget is prepared by the
personnel department. This budget consists of the following details:
(1) Number of different grades of workers required
(2) Rates of wages of workers
(3) Labour hours needed for production.
(4) Labour cost for the period, etc.
(5) Overhead budget:
(a) Production overhead budget: It is a budget of indirect costs in the form
of indirect wages, indirect material and indirect expenses to be incurred in the factory.
It is prepared with the help of production, and labour budgets. It is prepared on the
basis of past year’s figures and future changes expected.
(b) Administration overhead budget: This budget is prepared to estimate
the expenditure to be incurred for planning, organizing, direction and control
functions of the management. The budget is based on the past year’s expenditure
incurred with expected future changes.
(c) Selling and distribution overhead budget: This budget is prepared to
estimate expenditure to be incurred to sell the product and is distribution. It is based
on sales budget. It is generally prepared in consultation with sales managers of each
territory.
(6) Research and Development Budget
This budget is prepared to estimate the research and development expenditure
to be incurred during specific period. The budget is prepared in two parts, one is for
revenue expenditure and another is to estimate the capital expenditure to be incurred.
(7) Capital Expenditure Budget:
This budget is prepared to estimate the capital expenditure on fixed assets-
Buildings, machinery, plant, furniture, etc. It is generally a long-term budget. It is
prepared for replacement of assets, expansion of production facilities, adoption of
new technologies, diversification, etc.
 59

6) Cash Budget :
Cash budget is an important budget. It estimates the amount of cash receipts
and payments and the balance of cash during a specific budget period. The cashbudget
is based on forecasts of cash or estimates of cash showing what funds would be
available at what times and whether the funds available would meet requirements.
The objective of cash budget is to provide for all cash requirements in time and avoid
accumulation of excess cash.
Methods of preparing cash budget
(1) Receipts and payments method
(2) Balance Sheet method
(3) Adjusted Profit and Loss Account method.
(8) Master Budget:
A comprehensive master budget is prepared for the entire organisation, by
integrating all the functional budgets of a period. The master budget is an overall plan
for the guidance of the management. I.C.M.A., England, defines it as “summary
budget incorporating its component functional budges which is finally approved,
adopted and employed”.

Flexible Master Budget

I.C.M.A., London defines a flexible budget as “a budget which, by recognising the
difference between fixed, semi-variable and variable costs is designed to change in
relation to the level of activity attained”.
Flexible budget is prepared to know the costs at different levels of activity. It is also
termed as ‘variable budget’ or ‘sliding scale budget’.
Steps involved in preparing the Flexible Budgets
After completing the above mentioned preliminary steps, the following are the
steps in preparing a flexible master budget.
1. Classification of cost: The cost is classified according to variability as
variable, cost, fixed and semi variable cost.
2. Estimation of Variable Cost: Variable cost comprises of all those costs
which varyindirectproportiontothelevelofactivity.Usually,allthedirectcostsand
variable portions of the indirect costs are combinedly called ‘variable cost’.
3. Estimation of Fixed Costs: All those expenses which remain constant
irrespective of the level of activity are fixed costs. They usually include all the
fixedportionoftheoverheads.Thetotalofsuchexpenseshastobeestimated.
4. Estimation of Semi-variable Cost: It remains fixed upto a particular level of
capacity and there after it increases if the activity level goes up further. The
semi variable cost should be estimated for the chosen activity levels.
Presentation of Flexible Budget
The flexible budget can be presented in the following forms:
1. In Tabular Form: This is the most commonly used method. Under this
method costs are classified under fixed variable and semi variable. These costs
are estimated for different levels of activity.
2. In Graph Form: Here also expenses are classified as under tabular from and
presented on a graph sheet.
3. In the Form of Rations: This method is used by concerns with standard lines
of business and the expenses are uniform. The expenses are expressed in terms
ofratiosorpercentagesofproduction.Theratiosaregenerallyexpressedin
 60
terms of percentages for any level with a variation of 10% say 70%, 80%, 90%
and 100%etc.
Zero Base Budgeting(Z.B.B.)
The purpose of management control is to ensure better performance and better
utilisation of scarce resources. Traditional budgeting fails to achieve this objective of
management effectively. ‘Zero base budgeting’ provides a solution towards this end.
‘Zero base budgeting’ was originally developed by Peter A. Pyhrr at Texas
Instruments. PeterA. Pyhrrhas defined ZBB as“ an operating, planning and budgeting
process which requires each manager to justify his entire budget request in detail
from scratch (hence zero base) and shifts the burden of proof to each manager to
justify why we should spend any money a tall”.
Process of Zero Base Budgeting:
The following are the steps involved in ZBB.
1. Specification of decision units.
2. Development of decision packages.
3. Prioritization of activities projects and programmes.
4. Approval and allotment of funds.

ILLUSTRATIONS

Illustration -1
Larsen Ltd., plans to sell 1,10,000 units of a certain product line in the first
fiscal quarter, 1,20,000 units in the second quarter, 1,30,000 units in the third quarter
and 1,50,000 units in the fourth quarter and 1,40,000 units in the first quarter of the
following year. At the beginning of the first quarter of the current year, there are
14,000 units of product in stock. At the end of each quarter, the company plans to
have an inventory equal to one-fifth of the sales for the next fiscal quarter.

How many units must be manufactured in each quarter of the current year?
Solution:
PRODUCTION BUDGET
First Second Third Fourth
Quarter Quarter Quarter Quarter
Units Units Units Units
Sales 1,10,000 1,20,000 1,30,000 1,50,000
Add: Desired closing
stock
closing stock 24,000 26,000 30,000 28,000
1,34,000 1,46,000 1,60,000 1,78,000
Less: Opening stock 14,000 24,000 26,000 30,000
Estimated production 1,20,000 1,22,000 1,34,000 1,48,000
 61
Illustartion -2
The Sales Director of a manufacturing company reports that next year he expects to
sell 50,000 units of a particular product.
The production Manager consults the Storekeeper and casts his figure as follows:
Two kinds of raw materials A and B, are required for manufacturing the product.
Each unit of the product requires 2 units of A and 3 units of B.
The estimated opening balances at the commencement of the next year are:
Finished product : 10,000 units
Raw Materials :
A :12,000 units;
B: 15,000 units
The desirable closing balances at the end of the next year are:
Finished product 14,000 units,
A: 13,000 units
B: 16,000 units
Prepare Production Budget and Materials Purchase Budget for the next year.
Solution:
Production Budget (Units)
Estimated sales 50,000
Add: Desired closing stock 14,000
64,000
Less: Opening stock 10,000
Estimated Production 54,000

Production Budget (Units)

Material A Material B
Estimated consumption 2 x 54,000 1,08,000 1,62,000
(3 x 54,000) 16,000
Add: Desired closing stock 13,000
1,21,000 1,78,000
Less: Opening stock 12,000 15,000
Estimated purchases 1,09,000 1,63,000
 62
Illustartion - 3
Rajeswari Ltd., manufactures two products X and Y and sells them through
two divisions East and West. For the purpose of submission of sales budget to the
budget committed the following information has been made available:
Budgeted sales for the current year were:
Product East West
X 400 at Rs.9 600 at Rs.9
Y 300 at Rs.21 500 at Rs.21

Actual sales for the current year were:

Product East West
X 500at Rs.9 700 at Rs.9
Y 200 at Rs.21 400 at Rs.21

Adequate market studies reveal that product X is popular but under priced. It
is observed that if price of X is increased by Re.1 it will find a ready market. On the
other hand, Y is over-priced to customers and market could absorb more if sales price
of Y be reduced by Re.1. The management has agreed to give effect to the above
price changes.
From the information based on these price changes and reports from
salesman, the following estimates have been prepared by divisional managers:
Percentage increase in sales over current budget is:
Product East West
X +10% +5%
Y +20% +10%

With the help of an intensive advertisement campaign, the following

additional sales above the estimated sales of divisional managers are possible:
Product East West
X 60 70
Y 40 50

You are required to prepare Budget for Sales incorporating the above
estimates and also show the budgeted and actual sales for the current year.
 63
Solution:
Rajeswari Ltd.
Sales Budget for the year........
Budget for future period Budget for current period Actual sales for current period

Division Product Quantity Price Value Quantity Price Value Quantity Price Value
Rs. Rs. Rs. Rs. Rs.
East X 500 10 5,000 400 9 3,600 500 9 4,500
Y 400 20 8,000 300 21 6,300 200 21 4,200
Total (A) 900 13,000 700 9,900 700 8,700
West X 700 10 7,000 600 9 5,400 700 9 6,300
Y 600 20 12,000 500 21 10,500 400 21 8,400
Total (B) 1,300 19,000 1,100 15,900 1,100 14,700
Total X 1,200 10 12,000 1,000 9 9,000 1,200 9 10,800
Total Y 1,000 20 20,000 800 21 16,800 600 21 12,600
Total (A+B) 2,200 32,000 1,800 25,800 1,800 23,400
Working
Budget for future period.
East : ProductX400+(10%increase)40+60=500units
Product Y 300 + (20% increase) 60 + 40 = 400 units
West : Product X 600 +(5%increase) 30 + 70 = 700units
Product Y 500 + (10%increase) 50 +50 = 600units
Illustartion - 4
Summarised below are the Income and Expenditure forecasts of Jothi Ltd. for
the months of March to August, 2000:
Month Sales Purchases Wages Manufacturing Office Selling
(all (all Expenses Expenses Expenses
credit) credit)
Rs. Rs. Rs. Rs. Rs. Rs.
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
 64
You are given the following further information.
(a) Plant costing Rs.16,000 is due for delivery in July payable 10% on delivery
and the balance after three months.
(b) AdvanceTaxofRs.8,000 is payable in March and June each.
(c) Period of credit allowed (i) by suppliers 2 months and (ii) to customers 1
month.
(d) Laginpaymentofmanufacturingexpenses½month.
(e) Laginpaymentofallotherexpenses1month.
You are required to prepare a cash budget for three months starting on 1 st May,
2000 when there was a cash balance of Rs.8,000.
Solution:
Jothi Limited
Cash Budget for the quarter ended 31 July, 2000
May June July
Rs. Rs. Rs.
Receipts:
Opening Balance 8,000 15,750 12,750
Debtors 62,000 64,000 58,000
Total (A) 70,000 79,750 70,750
Payments:
Creditors 36,000 38,000 33,000
Wages 8,000 10,000 8,500
Manufacturing Expenses 3,750 4,000 3,750
Office Expenses 1,500 2,500 2,000
Selling Expenses 5,000 4,500 3,500
Advance Tax - 8,000 -
Delivery of Plant (10% Payment on delivery) - - 1,600
Total (B) 54,250 67,000 52,350
Closing Balance (A-B) 15,750 12,750 18,400
 65
Illustration- 5
The expenses for budgeted production of 10,000 units in a factory are
furnished below:

Per Unit
Rs.
Material 70
Labour 25
Variable Overheads 20
Fixed Overheads (Rs.1,00,000) 10
Variable Expenses (Direct) 5
Selling Expenses (10% Fixed) 13
Distribution Expenses (20% Fixed) 7
Administration Expenses 5
Total Cost per unit 155

Prepare a budget for production of:

(a) 8,000units
(b) 6,000units
(c) indicate cost per unit at both the levels.
Assume that administration expenses are fixed for all levels of production.

Solution

Flexible Budget

10,000 Units 8,000 Units 6,000 Units

Per Total Per Total Per Total
Unit Amount Unit Amount Unit Amount
Rs. Rs. Rs. Rs. Rs. Rs.
Production Expenses:
Materials 70.00 7,00,000 70.00 5,60,00 70.00 4,20,000
Labour 25.00 2,50,000 25.00 2,00,000 25.00 1,50,000
Overheads 20.00 2,00,000 20.00 1,60,000 20.00 1,20,000
Direct variable 5.00 50,000 5.00 40,000 5.00 30,000
expenses
Fixed Overheads: 10.00 1,00,000 12.50 1,00,000 16.667 1,00,000
(Rs.1,00,000)
 66
Selling Expenses:
Fixed 1.30 13,000 1.625 13,000 2.167 13,000
Variable 11.70 1,17,000 11.700 93,600 11.700 70,200
Distribution Expenses:
Fixed 1.40 14,000 1.750 14,000 2.334 14,000
Variable 5.60 56,000 5.600 44,800 5.600 33,600
Administration 5.00 50,000 6.250 50,000 8.333 50,000
Expenses
155.00 15,50,000 159.425 12,75,400 166.801 10,00,800
Working:
Fixed expenses remain fixed irrespective of the level of output.
Selling expenses Rs.13; Variable expenses per unit is constant.
10
Fixed 10% (i.e. 13 x ) = Rs.1-30.
100
For 10,000 units = 10,000 x 1.30 = Rs.13,000
90
Variable 90% (i.e. 13x ) = Rs.11.70
100
Illustartion-6
Draw up a flexible budget for overhead expenses on the basis of the following data
and determine the over head rates at70%,80%and90%plantcapacity.

At 70% At 80% At 90%

Capacity Capacity Capacity
Rs. Rs. Rs.

Variable Overheads:
Indirect labour - 12,000 -
Store including spares - 4,000 -
Semi-Variable Overheads:
Power
(30% fixed, 70% variable) - 20,000 -
Repairs and maintenance (60% - 2,000 -
fixed, 40% variable)
Fixed Overheads:
Depreciation - 11,000 -
Insurance - 3,000 -
Salaries - 10,000 -
Total Overheads - 62,000 -
Estimated direct labour hours: 1,24,00 hrs.
 67
Solution:
Flexible Budget for the period
At 70% At 80% At 90%
Capacity Capacity Capacity
Rs. Rs. Rs.
Variable Overheads:
Indirect labour 10,500 12,000 13,500
Stores including spares 3,500 4,000 4,500
Semi-Variable Overheads:
Power- Fixed (30%) 6,000 6,000 6,000
Variable (70%) 12,250 14,000 15,750
Repairs and Maintenance
Fixed (60%) 1,200 1,200 1,200
Variable (40%) 700 800 900
Fixed Overheads:
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
Total Overheads 58,150 62,000 65,850
Estimated direct labour hours 1,08,500 1,24,000 1,39,500
Direct labour hour rate Rs.0.536 Rs.0.500 Rs.0.472

Working:
Direct labour rates have been computed as follows:
Rs.58,150
At 70%capacity  = Re. 0.536
1,08,500hrs.

Rs.62,000
At 80%capacity  = Re. 0500
1,24,000hrs.

Rs.65,850
At 90% capacity  = Re. 0.472
1,39,500hrs.
 UNIT- 4

DEPRECIATION
Expenditure on assets of the business like furniture, fixtures and fittings of the shop,
motor vans, machines and equipments are neither goods nor expenses of a year.
Expenditures of this nature give services to the business for many years and therefore
called fixed assets. If the expenditure on the fixed assets is deducted from the profit of
any one year, it would be wrong. Since their benefit is enjoyed by the business for more
than one years. The correct thing will be to distribute their cost over the years of their
useful life to the business. The portion of the cost of fixed assets charged each year as
expense is named as depreciation. In this lesson you will learn about the meaning and
methods of charging depreciation and how depreciation is recorded in the books of
accounts, together with the preparation of Fixed Assets account.

Meaning of Depreciation

You already know the meaning of terms assets and liabilities. Assets are broadly divided
in to two categories- current assets (cash, debtors or customers balances, stock of
materials and goods) and fixed assets (buildings, furniture and fixtures, machinery and
plant, motor vehicles). Fixed assets are also called long term assets as they provide
benefits to the business for more than one year. Most fixed assets loose their value over
time as these are put in use and as the years pass by. The fixed assets loose their
usefulness due to arrival of new technologies and change of fashions etc. These are then
generally required to be replaced, as their useful life is over. Hence, the cost of a fixed
asset is allocated over its useful life. Each year’s allocation of the cost is charged as
depreciation expense for that year. For example an office chair is purchased for ` 2,500
and it is estimated that after ten years it will be scraped. The useful life of the chair is ten
years over which the cost of ` 2,500 will be distributed. Each year’s allocation may be
calculated as:-

Thus ` 250 is the depreciation expense for each year.

Thus, depreciation is an expense charged during a year for the reduction in the value of
fixed assets, arising due to:

• Normal wear and tear out of its use and passage of time

• Obsolescence due to change in technology, fashion, taste and other market conditions

Causes of Depreciation

Following are the causes for which depreciation is provided in accounts.

i) Normal wear and tear

 (a) Due to usage - Every asset has a life for which it can run, produce or give service.
Thus, as we put the asset to use its worth decreases. Like decrease in the efficiency and
functioning of a bicycle due to its running and usage.

(b) Due to passage of Time – As the time goes by elements of nature, wind, sun, rain etc,
cause physical deterioration in the worth of an asset. Like reduction in the worth of a
piece of furniture due to passage of time even when it is not used.

ii) Obsolescence

(a) Due to development of improved or superior equipment : Sometimes fixed assets

are required to be discarded before they are actually worn out due to either of the above
reasons. Arrival of superior equipments and machines etc. allow production of goods at
lower cost. This makes older equipments worthless as production of goods with their use
will be costlier and non competitive. For example, Steam engines became obsolete with
the arrival of diesel and electric locomotives.

(b) Due to change in fashion, style, taste or market conditions : Obsolescence may
also result due to decline in demand for certain goods and services with a change in
fashion, style, taste or market conditions. The goods and services that are no longer in
vogue lead to decrease in the value of the assets which were engaged in their production -
like factories or machines meant for making old fashioned hats, shoes, furniture etc. Loss
in the value of fixed assets for such reasons is called obsolescence and also charged as
depreciation

Objectives of Depreciation

Following are the objectives of charging depreciation of Assets:

i) To show the True Financial Position of the Business : As are Fixed Assets have some
effective working life during which it can be economically operated. Depreciation is the
gradual loss in the value of fixed assets. If depreciation is not provided, profit and loss
A/c will not disclose the true profit made during the accounting period. At the same, the
Balance Sheet will not disclose the true Financial position as Fixed assets appearing in
the Balance Sheet will be over valued. If depreciation is ignored year after year,
ultimately when asset is worn out, the proprietor will not be is a position to continue the
business smoothly.

ii) To retain funds in the business for replacement of the asset : Net profit is the yield of
the capital invested by proprietor and may be wholly withdrawn by him in the form of
cash. If depreciation is provided, this figure of net profit will be reduced and the amount
withdrawn by the proprietor will also be decreased. As such the cash equivalent to the
change for depreciation will be left over the business. This accumulated amount will
enable the proprietor to replace a new asset.

Factors affecting Depreciation

(i)Cost of Asset : Cost of asset is the purchase price of the asset and includes all such
expenses which are incurred before it is first put to use. For example expenses on loading,
carriage, installation, transportation and unloading of the asset up to the point of its
location, expense on its erection and assembly.

ii) Useful Life of the Asset : Useful life is the expected number of years for which the
asset will remain in use.

iii) Scrap Value : Scrap value is the residual value at which the asset could be sold to
scrap dealer (Kabari) after its useful life.

(iv) Depreciable value of asset : Depreciable value is the cost of asset minus the scrap
value

Illustration 1

A generator was purchased for ` 5,00,000. ` 1,500 was paid for the crane for its loading
on the truck, ` 7,000 was paid for transporting the generator to the factory. ` 2,000 was
spent on its unloading at the factory site. The generator was estimated to run for 10 years
and thereafter would be saleable for ` 60,000. Calculate the depreciable value of the
generator.

The cost of the asset is : Purchase price ` 5,00,000

Expenses on Loading ` 1,500

Transportation ` 7,000

Expenses on unloading ` 2,000

Total ` 5,10,500

The useful life of the generator is 10 years The scrap value is ` 60,000. Depreciable value
of the generator = ` 5,10,500 – ` 60,000 = ` 4,50,500

METHOD OF CHARGING DEPRECIATION

Most popularly used methods for charging depreciation are: i. Straight Line Method and
ii. Diminishing Balance Method

Straight Line Method of Depreciation

Under this method, the amount of depreciation is uniform from year to year. Suppose, if
an asset costs ` 1,00,000 and depreciation is fixed @ 10%, then ` 10,000 would be
written off every year. That is why this method is also called ‘Fixed Installment Method’
or ‘Original Cost Method’. In this method, the amount to be written off every year is
arrived at as under:
Out of the cost of the asset, its scrap value is deducted and it is divided by the number of
years of its estimated life

For example: a machine is purchased for ` 1,20,000 and it is estimated that its useful life
is 10 years. After its useful life its scrap value is ` 20,000. Depreciation of one year can
be calculated as under:

If its scrap cannot be sold or no money can be realized from its scrap, then depreciation
of one year is:

In this method the amount of depreciation is same for each year. Therefore this method is
called Straight Line Method, Fixed Installment Method or Original Cost Method.

MERITS OF STRAIGHT LINE METHOD

 Simplicity : Calculation of depreciation under this method is very simple and

therefore the method is widely popular. Once the amount of depreciation is
calculated, the same amount is written off as depreciation each year. Hence this
method is simple and calculations are easier to understand.
 Asset is completely Written Off : Under this method, the book value of an asset is
reduced to net scrap value or zero value. In other words, in the books of accounts
the value of the asset at the end of its useful life is equal to zero or its residual
value.

LIMITATIONS OF STRAIGHT LINE METHOD

 Difficulty in Computation : When there are various machines having different

life-spans, the computation of depreciation becomes complicated because the
depreciation on each machine will have to be calculated separately for each asset.
 Illogical : It is well known that the expense on its repairs and maintenance
increases as the asset becomes older. Thus, the total burden on Profit and Loss
Account, depreciation plus repair expenses, is more in later years in comparison
to earlier years. This is illogical because the efficiency and productivity of the
asset is more in earlier years and less in later years

DIMINISHING BALANCE METHOD

Under this method, as the value of asset goes on diminishing year after year, the amount
of depreciation charged every year goes on declining. The amount of depreciation is
calculated as a fixed percentage of the diminishing value of the asset shown in the books
at the beginning of each year. Under this method the value of an asset never comes to
zero.
Suppose, the cost of the asset is ` 40,000 and the percentage to be written off each year is
10%. In the first year the amount of the depreciation will be ` 4,000 i.e., 10% of ` 40,000.
This will reduce the book value to ` 36,000 i.e. ` 40,000 – ` 4,000. Now, at the beginning
of the next year the book value is ` 36,000. The amount of the depreciation for the next
year will be ` 3,600, i.e., 10% of ` 36,000. Thus, every year the amount of the
depreciation will go on reducing. This method of charging depreciation is also known as
Reducing Balance Method or written down value method.

MERITS OF DIMINISHING BALANCE METHOD

Equal Burden on Profit & Loss Account

The productivity of the asset is more hence its contribute to profit is also relatively
greater. Therefore the cost charged in terms of depreciation should also be greater.

In the initial year, the depreciation charges are more and repair expenses are less. In
later years, depreciation charges are less and repair expenses are more. Hence the total
burden, depreciation plus repair expenses, is some what equal on Profit & Loss Account
for each year.

DEMERITS OF DIMINISHING BALANCE METHOD

i) Asset cannot be completely written off : Under this method, the value of an asset is not
reduced to zero even when there is no scrap value.

ii) Complexity: Under this method, the rate of depreciation cannot be determined easil

MEANING OF FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with planning and
controlling of the firm’s financial resources. In other words it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly to
maximise the shareholder’s wealth).
It can be defined as
“Financial Management comprises of forecasting, planning, organizing, directing,
co-ordinating and controlling of all activities relating to acquisition and
application of the financial resources of an undertaking in keeping with its
financial objective.

There are two basic aspects of financial management viz., procurement of funds and an
effective use of these funds to achieve business objectives.

Procurement of
funds
AspectsofFinancial
Management

Utilization of Fund
Scope of Financial Management
To understand the financial management scope, first, it is essential to understand the
approaches that are divided into two sections.

1. Traditional Approach
2. Modern Approach

Approach 1: Traditional Approach to Finance Function

During the 20th century, the traditional approach was also known as corporate finance.
This approach was initiated to procure and manage funds for the company. For studying
financial management, the following three points were used
(i) Institutional sources of finance.
(ii) Issue of financial devices to collect refunds from the capital market.
(iii) Accounting and legal relationship l between the source of finance and business.
In this approach, finance was required not for regular business operations but occasional
events like reorganization, promotion, liquidation, expansion, etc. It was considered
essential to have funds for such events and regarded as one of the crucial functions of a
financial manager.
Though he was not accountable for the effective utilization of funds, however, his
responsibility was to get the required funds from external partners on a fair term. The
traditional approach of finance management stayed until the 5th decade of the 20th
century. The traditional approach only emphasized on the fund’s procurement only by
corporations. Hence, this approach is regarded as narrow and defective.
Also Read: Types of Financial Statements

Limitations of Traditional Approach

 One-sided approach- It is more considerate towards the fund procurement and the
issues related to their administration, however, it pays no attention to the effective
utilization of funds.
 Gives importance to the Financial Problems of Corporations- It only focuses on
the financial problems of corporate enterprises, so it narrows the opportunity of
the finance function.
 Attention to Irregular Events- It provides funds to irregular events like
consolidation, incorporation, reorganization, and mergers, etc. and does not give
attention to everyday business operations.
 More Emphasis on Long Term Funds- It deals with the issues of long-term
financing.

Approach 2: Modern Approach to Finance Function

With technological improvement, increase competition, and the development of strong
corporate, it was important for Management to use the available financial resources in its
best possible way. Therefore, the traditional approach became inefficient in a growing
business environment.
The modern approach had a more comprehensive analytical viewpoint with a focus on the
procurement of funds and its active and optimum use. The fund arrangement is an
essential feature of the entire finance function.
The main elements of this approach are an evaluation of alternative utilisation of funds,
capital budgeting, financial planning, ascertainment of financial standards for the
business success, determination of cost of capital, working capital management,
Management of income, etc. The three critical decisions taken under this approach are.
(i) Investment Decision
(ii) Financing Decision
(iii) Dividend Decision

Features of Modern Approach

The following are the main features of a modern approach.

 More Emphasis on Financial Decisions- This approach is more analytic and less
descriptive as the right decisions for a business can be taken only on the base of
accounting and statistical data.
 Continuous Function- The modern approach is a constant activity where the
financial manager makes different financing decisions unlike the traditional
method,
 Broader View- It gives importance not only to optimum use of finance also abut
the fund’s procurement. Similarly, it also incorporates features relating to the cost
of capital, capital budgeting, and financial planning, etc.
 The measure of Performance- Performance of a firm is also affected by the
financial decision taken by the Management or finance manager. Therefore, to
maximize revenue, the modern approach keeps a balance between liquidity and
profitability.
The other scope of financial management also includes the acquisition of funds, gathering
funds for the company from different sources, assessment and evaluation of financial
plans and policies, allocation of funds, use of funds to buy fixed and current assets,
appropriation of funds, dividing and distribution of profits, and the anticipation of funds
along with estimation of financial needs of the company.

Roles of Financial Management:

 Taking part in utilising the funds and controlling productivity.

 Recognizing the requisites of capital (funds) and picking up the sources for that
capital.
 Investment accords incorporate investment in fixed assets known as capital
budgeting. Investing in current assets are part and parcel of investment decisions
known as working capital decisions.
 Financial decisions associated with the finance raised from different sources
which would rely upon the accord on – the kind of resource, when is the financing
done, cost incurred and the returns as well.
 In the case of dividend decision, the finance manager is the who is responsible for
the accord that is taken by him or her; regarding the net profit distribution (NPD).
However, Net profits are classified into two(2) types:
 1. Dividend for shareholders: The rate of dividend and the amount of dividend has to
be decided
2. Retained profits: The amount of contained (retained) gains has to be ascertained
which would rely upon the development and variety of strategies of the trading
concern

Functions of Financial Management

Financial management is essential for properly and efficiently managing financial
resources. Financial management functions ensure that the appropriate amount of funds is
available when needed for a business. These functions range from the acquisition of
funds to their proper and effective utilisation. So, here are various functions of Financial
Management:

1. Determine the Capital Requirement: The first function of a financial manager is to

estimate the total capital required by the business to fulfil its mission and
objectives. The amount of capital required is determined by several factors,
including the size of the business, expected profits, company programmes, and
policies.
2. Establish the Capital Structure: After estimating the required capital, the structure
must be determined. Short-term and long-term equity is used in the structure. It
will also determine how much capital the company must own and how much must
be raised from outside sources, such as IPOs (Initial Public Offerings), and so on.
3. Determine the Funding Sources: The next financial management function is to
determine where the capital will come from. The company may decide to take out
bank loans, approach investors for capital in exchange for equity, or hold an IPO
to raise funds from the public in exchange for shares. The source of funds is
chosen and ranked based on the benefits and limitations of each source.
4. Fund Investment: Another function of financial management is deciding how to
allocate funds to profitable ventures. The financial manager must calculate the
risk and expected return for each investment. The investment methods must also
be chosen so that there is minimal loss of funds and maximum profit optimisation.
5. Implement Financial Controls: Controls can take the form of financial forecasting,
cost analysis, ratio analysis, profit distribution methods, and so on. This
information can assist the financial manager in making future financial decisions
for the company.

6. Mergers and Acquisitions: They both are one method of business growth. Buying
new or existing businesses that align with the buyer company's mission and goals
is referred to as an acquisition. A merger occurs when two current companies
combine to form a new company. One of the responsibilities of a financial
manager is to assist in the merger and acquisition decision by carefully examining
the financials and securities of each company.
7. Work on Capital Budgeting: Capital budgeting refers to decisions made regarding
the purchase of assets, the construction of new facilities, and the investment in
stocks or bonds. Prior to making a significant capital investment, organisations
must first identify opportunities and challenges.
Objectives of Financial Management
Financial Management refers to the process of efficient acquisition, utilization, and
distribution of finance and then disposal of surplus or profit to run the organization
smoothly. Financial management helps in finding the answer to various questions like
what should be the size and composition of fixed assets, what should be the amount and
composition of current assets, what should be the amount of long-term and short-term
financing, what should be the fixed debt-equity ratio in the capital, etc.

A financial manager is responsible for making the decisions to bring effective financial
management to the organization. His/her decisions should be gainful for the shareholders
as well as the company. So the decisions which increase the value of the share in the
market are considered to be good and fruitful. Increased value of shares fulfills many
other objectives also but it does not means that the manager should use manipulative
activities to raise the prices of the shares. This boom must come with the growth of the
organization, with the increase in profits, and with the satisfaction of all the parties which
are directly or indirectly associated with the firm.

Some of the prime objectives of financial management are as follows:

1. Profit Maximization

A business is set up with the main aim of earning huge profits. Hence, it is the most
important objective of financial management. The finance manager is responsible to
achieve optimal profit in the short run and long run of the business. The manager must be
focused on earning more and more profit. For this purpose, he/she should properly use
various methods and tools available.

2. Wealth Maximization

Shareholders are the actual owners of the company. Hence, the company must focus on
maximizing the value or wealth of shareholders. The finance manager should try to
distribute maximum dividends among the shareholders to keep them happy and to
improve the goodwill of the company in the financial market. The declaration of dividend
and payout policy is decided with the help of financial management. A proper dividend
policy related to the declaration of dividends or retaining the company's profit for future
growth and development is part of dividend decisions. But this is based on the
performance of the company and the amount of profit earned. Better performance means
a higher value of shares in the financial market. In nutshell, the finance manager focuses
on maximizing the value of sha

3. Maintenance of Liquidity

With the help of proper financial management, the manager can easily monitor the
regular supply of liquidity in the company. But it is not as easy as it sounds. To maintain
the proper cash flow, the manager must keep an eye over all the inflows and outflows of
money to reduce the risk of underflow and overflow of cash. The finance manager is
responsible to maintain an optimal level of liquidity in the organization. Healthy cash
flow means a higher possibility of survival and success of the business. Because it helps
the business to deal with uncertainty, timely payment of dues, getting cash discounts,
making day-to-day payments without delays, etc.

4. Proper Estimation of Financial Requirements

Financial management also helps the finance manager in estimating the proper financial
needs of the company. This means the estimations related to the requirement of capital to
start or run a business, the need for fixed and working capital of the company, etc., can be
done with effective management of finance. If this management will not be present in the
company then there will be a higher possibility of having a shortage or surplus of
finance. For this estimation, a financial manager checks various factors like the
technology used by the organization, the number of employees working, the scale of
operations, and the legal requirements of the company to run its business.

5. Proper Mobilization

Financial management helps in the effective utilization of sources of finance. It means

without wasting them and getting the maximum benefit from the available resources. The
finance manager is responsible for managing the different sources of funds such
as shares, debentures, bonds, loans, etc. So, after estimating the financial requirements,
the manager must decide which source of the funds he/she should use to avail the
maximum benefit.

6. Proper Utilization of Financial Resources

With proper financial management, the organization can make optimum utilization of
financial resources. To achieve this, a financial manager has various tools that he/she can
use. They include managing receivables, better management of inventory, and effective
payment policy in hand. This will not only save the finance of the organization but will
also reduce the wastage of other resources.

7. Improved Efficiency

Financial management is also beneficial in increasing the efficiency of all sections and
departments of the organization. If the finance is effectively distributed to all the
departments then they will work efficiently. It will support the company to achieve its
targets easily which will be further helpful for the growth of the entire company.

8. Meeting Financial Commitments with Creditors

Financial management is helpful in the timely payment of dues to the creditors. The
financial manager can list out the creditors, their due amount, and due date from the
financial accounts and can make their payments on time. This will increase the goodwill
of the company in the market and creditors will also provide the goods to the company on
credit without having any problem. So, if there will be strong management of finance
then the company will be able to meet the financial commitments with creditors easily.

9. Creating Reserves

The business environment is full of uncertainty such as sudden changes in customers'

preferences, climate change, natural calamity, change in technology, etc. To overcome
such unplanned issues, the company should have a sufficient amount in the form of
reserves. The company can create reserves over the year by having an optimal dividend
payout policy. The company should also keep some part of profits in the form of reserves.
The reserves are not only helpful in dealing with unwanted situations but also to expand
the business and face contingencies in the future. This benefit can only be taken if the
company has effective management of finance.

10. Decreases the Cost of Capital

This objective includes measuring the cost of capital, risk evaluation, and calculating the
approximate profits out of a particular project. Financial managers are responsible for the
effective investments of available funds in the current or fixed assets to get the maximum
benefits or ROI.

11. Decreases Operating Risk

There are lots of risks and uncertainties that a financial manager has to face in the day-to-
day operations of the business. Financial management helps in reducing these issues and
gives the solutions to deal with the problems. It can avoid the high-risk allocation of
capital for the expansion and growth of the business. Other than this, FM also tells how
the decisions can be taken with a proper consultancy.

12. Balanced Structure

Financial management also provides a balanced capital structure to the company. In other
words, it brings a proper balance between the various sources of capital such as loans,
equity, bonds, retained earnings, etc. This balance is required for flexibility,
liquidity, and stability in the organization as well as the economy.

13. Developing Financial Scenarios

With the help of financial management, financial scenarios can be developed. It can be
done by forecasts and the current state of the company. But for this purpose, the financial
manager has to assume a wide range of possible outcomes as per the current and future
market conditions.

14. Measure Your Success

The prime motive of any organization is to earn huge profits. So, we can say that the
success of a company is based on its revenue. Financial management not only helps in
earning more revenue but also in measuring the success of the company. With proper
financial reports or accounts, the organization can compare its current year's performance
with the previous year's performance.

Other than this, the financial manager can also compare the performance of the
organization with the performance of the competitors in the market. Such
information motivates the management team as well as all the employees to work harder
for the company's growth.

15. Optimizing Marketing Activities

Marketing plays a huge role in the revenue of a firm. A company advertises its products
or services through different means of marketing. But marketing is a department that
demands more funds. So, before investing in any advertising campaign, it is a must to
figure out what return the company can get from investing in that campaign. And if the
program is not giving the expected returns to the company then it should be optimized or
temporarily stopped. That's why the financial manager should check the reports prepared
by the marketing department regarding the returns from any advertising campaign and
then he/she should manage and allocate the funds by keeping the results in mind.

16. Business Survival

In this era of high competition, it is not easy for a company to survive in the market and
earn profits. Hence, the finance manager should take the big decisions carefully after
consulting with the experts.

Inventory Management

Meaning
Inventory Management is a business process which is responsible for managing, storing,
moving, sorting, arranging, counting and maintaining the inventory i.e. goods,
components, parts etc. Inventory management ensures that the right inventory is available
as per the demand at low costs. Inventory Management makes sure that the core
processes of a business keep running efficiently by optimizing the availability of
inventory

Importance of Inventory Management

Inventory Management includes managing and controlling raw materials, stocks,
finished goods, warehousing, storage and other aspects which help reach the product
from production to distributor or retailer. Each organization regularly strives on efficient
inventory management to uphold optimum inventory to be able to meet its necessities
and avoid over or under inventory that can impact the monetary statistics of the firm.
Inventory is forever dynamic. A prerequisite of inventory management is steady and
vigilant assessment of exterior and interior factors and control via planning and
evaluation. Most of the businesses have an individual department of inventory planners
who incessantly observe, control and evaluate inventory and interface with
manufacturing, procurement and finance sections of the firm.
In a business or association, all the functions are interlinked and coupled to each other
and are time and again overlapping. Some key features like supply chain management,
logistic handling and inventory management form the spine of the business delivery
function. Therefore these functions are very significant to the managers.
Any organization which is into manufacturing, trading, sale and repair of a product will
unavoidably hold stock of a range of physical possessions to assist in future utilization
and sale. While inventory is a necessary evil of any such business, the organizations
cling to inventories for various reasons; some of them are speculative purposes,
functional purposes, physical necessities etc.
• All organizations occupied in fabrication or trade of products keep inventory in one
form or the other.
• Inventory can be in whole state or unfinished state.
• Inventory is held to assist in future use, sale or further value accumulation.
• All inventoried resources have profitable value and can be measured as assets of the
firm

Challenges of Inventory Management

There are certain challenges in inventory management process, following are the
important ones:
1. Understanding the Inventory
Organizations should take a holistic view into knowing both basic vs. non-basic matter
and at what time they should be ordered. Basic items are those that you sell ant time of
the year and need incessant replenishing of stock.
By sorting these out from non-basic or seasonal items inventory levels can be much
more allied with a recognized schedule and product lifecycle. However, knowing your
items are is just the first step. One must have knowledge about stock capacity, what is
going to be ordered, the size of the order, and what needs to be refilled.
2. Incompetent Processes
Built on or rely on dated software or manual processes are used for inventory
management systems. This creates an extremely demanding work setting for anybody
caught up in the inventory management process. One must begin with a review of
current standard operating procedures and settle on where gaps may lie in the systems.
3. Client Demand
Customer’s needs are varying daily and they are looking to their distributors to allow for
elasticity in orders. With the mounting demand of struggle it becomes more taxing to
keep up with the exclusive needs of the consumers to reassure they do not have those
needs met by some other firm. All these factors help in understanding inventory
management.

Inventory Management Parameters

Inventory management can be efficiently done on the basis of 4 broad parameters:
Number of units in the stock
Inventory is nothing but a collection of similar or different stock keeping units (SKU)
which have to be stored efficiently before being sold or sent to next stakeholder. Now
the number of these items would decide how big or small space we would need, how
much staff would be required to manage them, their retrieval mechanism and many
other considerations.
Cost of managing inventory
There are lot of inventory costs involved in the process of managing the inventory like
carrying costs, holding costs, storage costs etc. Before going into inventory
management, a company needs to budget the costs which would be required.
Availability of inventory on time
Inventory is useful for business if it arrives at time and leaves at time. If there are delays
in availability of inventory to the right person at the right time, then inventory
management will become difficult.
Location for storing inventory
As discussed above as well, the location is very important. We see there are lot of
warehouses near airports, highways etc. where managing the inventory and
transportation would be easier as compared to a location which is far off. It has to be
compared to the inventory cost like rent and manage the inventory efficiently.
 UNIT-5
Insurance Claims for Loss of Stock and loss of profit
Business enterprises gets insured against the loss of stock on the happening of certain events such
as fire, flood, theft, earthquake etc. Insurance being a contract of indemnity, the claim for loss
is restricted to the actual loss of assets .Sometimes an enterprise also gets itself insured against
consequential loss of profit due to decreased turnover, increased expenses etc.
If loss consequential to the loss of stock is also insured, the policy is known as loss of profit or
consequential loss policy.
Insurance claim can be studied under two parts as under:-
 Claim for loss of stock
 Claim for loss of profit

Meaning of Fire

For purposes of insurance, fire means:

1. Fire (whether resulting from explosion or otherwise) not occasioned or happening through:
(a) Its own spontaneous fomentation or heating or its undergoing any process involving the
application of heat;
(b) Earthquake, subterraneous fire, riot, civil commotion, war, invasion act of foreign
enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution,
insurrection, military or usurped power.
2. Lightning.
3. Explosion, not occasioned or happening through any of the perils specified in 1 (a) above.
(i) of boilers used for domestic purposes only;
(ii) of any other boilers or economisers on the premises;
(iii) in a building not being any part of any gas works or gas for domestic purposes or
used for lighting or heating the building.
The policy of insurance can be made to cover any of the excepted perils by agreement and
payment of extra premium, if any. Damage may also be covered if caused by storm or
tempest, flood, escape agreement with the insurer

Usually, fire policies covering stock or other assets do not cover explosion of boilers used for
domestic purposes or other boilers or economisers in the premises but policies in respect of
profit cover such explosions.

Claim for Loss of Stock

Fire insurance being a contract of indemnity, a claim can be lodged only for the actual amount
of the loss, not exceeding the insured value. In dealing with problems requiring determination
of the claim the following point must be noted:
a. Total Loss: If the goods are totally destroyed, the amount of claim is equal to the actual
loss, provided the goods are fully insured. However, in case of under insurance(i.e.
insurable value of stock insured is more than the sum insured),the amount of claim is
restricted to the policy amount.
b. Partial Loss: If the goods are partially destroyed, the amount of claim is equal to the
actual loss provided the goods are fully insured. However in case of under insurance,the
amount of claim will depend upon the nature of insurance policy as follows:
I) Without Average clause:- Claim is equal to the lower of actual loss or the sum
insured.
II) With Average Clause:- Amount of claim for loss of stock is proportionately
reduced, considering the ratio of policy amount (i.e. insured amount) to the value of
stock as on the date of fire (i.e insurable amount) as shown below:
Amount of claim = Loss of stock x sum insured / Insurable amount (Total Cost)

Amount of claim in case of

Total Loss( Goods fully Partial Loss ( Goods partially

destroyed) destroyed)
Actual loss (provided the goods are Actual loss (provided the goods are
fully insured) fully insured)

Amount of claim in case of Under insurance

Total Loss
Partial Loss

Restricted to the With Average

Without Average clause
policy amount Clause

Loss of stock x sum

Actual loss Or Sum
insured / Insurable
insured whichever
amount (Total Cost)
is lower
Claim for Loss of Profit
When a fire occurs, apart from the direct loss on account of stock or other assets destroyed, there is
also a consequential loss because, for sometime, the business is disorganised or has to be
discontinued, and during that period, the standing expenses of the business like rent, salaries etc.
continue. Moreover, there is loss of profits which the business would have earned during the
period. This loss can be insured against by a "Loss of Profit" or "Consequential Loss" policy; there
must be a separate policy in respect of the consequential loss but claim will be admitted in respect
of the policy unless the claim on account of fire is also admitted under other policies.
The Loss of Profit Policy normally covers the following items:
(1) Loss of net profit
(2) Standing charges.
(3) Any increased cost of working e.g., renting of temporary premises.
In every business, there is some standard by which its activity or progress can be accurately
judged: it may be sales affected or the quantity of goods (or services) produced. To measure the
loss suffered by a firm due to fire, it is necessary to set up some standard expressed in such units to
represents the volume of work. There should be a direct relation between the amount of standard
and the amount of profit raised. A comparison between the amount of the standard before and after the
fire will give a reliable indication of the loss of profit sustained. The most satisfactory unit of
measuring the prosperity (and therefore profits) is usually turnover:
A claim for loss of profits can be established only if :
(i) the insured’s premises, or the property therein, are destroyed or damaged by the peril
defined in the policy; and
(ii) the insured’s business carried on the premises is interrupted or interfered with as a result
of such damage.
A claim for loss of profits cannot arise if the claim for loss of property as a result of the fire is
not also admitted. This is very convenient as it avoids independent investigation into loss of
property for purposes of loss of profits policy. It is possible that the business of the insured
may suffer because of fire in the neighbourhood, not causing damage to the property of the
insured, say by closing the street for some time. Such eventualities may be covered by agreement
with the insurer on payment of extra premium. If fire does not affect the volume of business,
there can be no claim for loss of profits.
Also, it does not follow that if there is a large property claim, there will be necessarily a large
claim for loss of profit or vice versa.
Terms Defined
The following terms should be noted:
Gross Profit is the sum produced by adding to the Net Profit the amount of the Insured
Standing Charges, or, if there be no Net profit, the amount of the Insured Standing Charges
less such a proportion of any net trading loss as the amount of the Insured Standing Charges
bears to all the standing charges of the business.
Net Profit is the net trading profit (exclusive of all capital) receipts and accretion and all outlay
properly (chargeable to capital) resulting from the business of the Insured at the premises after
due provision has been made for all standing and other charges including depreciation.
Insured Standing Charges: Interest on Debentures, Mortgage Loans and Bank Overdrafts,
Rent, Rates and Taxes (other than taxes which form part of net profit) Salaries of Permanent
Staff and Wages to Skilled Employees, Boarding and Lodging of resident Directors and/or
 Manager, Directors’ Fees, Unspecified Standing Charges [not exceeding 5% (five per cent) of
the amount recoverable in respect of Specified Standing Charges].
Conditions included in a Loss of Profit Insurance Policy
Insurance policies covering loss of profit contain the following conditions usually:
Rate of Gross Profit: The rate of Gross Profit earned on turnover during the financial year
immediately before the date of damage.
Annual Turnover: The turnover during the twelve months immediately before the damage.
Standard Turnover: The turnover during that period in the twelve months immediately before
the date of damage which corresponds with the Indemnity Period.
To which such adjustment shall be made as may be necessary to provide for the trend of the
business and for variations in or special circumstances affecting the business either before or after
the damage or which would have affected the business had the damage not occurred, so that the
figures thus adjusted shall represent, as nearly as may be reasonably practicable the results which but
for the damage would have been obtained during the relative period after damage.
Indemnity Period: The period beginning with the occurrence of the damage and ending not
later than twelve months thereafter during which the results of the business shall be affected
in consequence of the damage.
Memo 1: If during the indemnity period goods shall be sold or services shall be rendered
elsewhere than at the premises for the benefit of the business either by the insured or by others
on the Insured’s behalf, the money paid or payable in respect of such sales or service shall be
brought into account in arriving at the turnover during the indemnity period.
Memo 2: If any standing charges of the business be not insured by this policy then in
computing the amount recoverable hereunder as increase in cost of workings that proportion
only of the additional expenditure shall be brought into account which the sum of the Net Profit
and the insured Standing Charges bear to the sum of the Net Profit and all standing charges.
Memo 3: This insurance does not cover loss occasioned by or happening through or in
consequence of destruction of or damage to a dynamo motor, transformer, rectifier or any part
of an electrical installation resulting from electric currents however arising.
The student should note the following:
(i) The word ‘turnover’ used above may be replaced by any other term denoting the basis
for arriving at the loss of profit e.g., output.
(ii) Insured standing charges may include additional items, by agreement with the insurer.
(iii) Net profit means profit before income tax based on profit.
(iv) Depending upon the nature of business, the indemnity period may extend beyond 12
months (it may be as long as 6 years). Indemnity period shall not be confused with the
period of insurance which cannot be more than one year.
The insurance for Loss of Profit is limited to loss of gross profit due to :
(i) reduction in turnover, and
(ii) increase in the cost of working.
The amount payable as indemnity is the sum of (a) and (b) below :
(a) In respect of reduction in turnover : The sum produced by applying the rate of gross
profit to the amount by which the turnover during the indemnity period shall, in
consequence of the damage, falls short of the standard turnover.
(b) In respect of increase in cost of working : The additional expenditure [subject to the
provisions of Memo (2) given above] necessarily and reasonably incurred for the sole
purpose of avoiding or diminishing the reduction in turnover which, but for that
expenditure, would have taken place during the indemnity period in consequence of the
damage : the amount allowable under this provision cannot exceed the sum produced by
applying the rate of gross profit to the amount of reduction avoided by the additional
expenditure.
The amount payable arrived at as above is reduced by any sum saved during the indemnity
period in respect of such of the insured standard charges as may cease or be reduced in
consequence of the damage.
Insurance policies provide that if the sum insured in respect of loss of profit is less than the
sum produced by applying the rate of gross profit to the annual turnover (as adjusted by the trend
of the business or variation in special circumstances affecting the business either before or after
the damage or which would have affected the business had the damage not occurred), the amount
payable by the insurer shall be proportionately reduced. This is nothing but application of the
average clause.
The turnover of a business rarely remains constant and where there has been an upward or
downward trend since the date of the last accounts and upto the date of the fire, the "standard
turnover" should be appropriately adjusted, as per definition given above.
Similarly, where the earning capacity of the business has changed, the rate of gross profit may
not represent a correct indication of the lots and mutually agreed rate may be used for the