MP103 PDF

MP-103
Vardhaman Mahaveer Open University, Kota
Accounting for Managers
1
Course Development Committee
Chairman
Prof. (Dr.) Naresh Dadhich
Vice-Chancellor
Convener and Members
Subject Convener and Co-ordinator
Prof. P.K. Sharma
Professor of Management
1. Prof. P.N. Mishra 6. Prof. R.K. Jain
Professor, Professor (Retd.),
Institute of Management Studies JLN Institute of Business Management,
Devi Ahilya University, Indore Vikram University, Ujjain
2. Prof. Kalpana Mathur 7. Prof. Isphita Bansal
Professor, Professor, WISDOM,
Deptt. of Management Studies, Banasthali Vidhyapeeth, Banasthali
J.N.V. University, Jodhpur 8. Prof. Karunesh Saxsena
3. Prof. Nimit Chaudhary Professor,
Professor, Faculty of Management Studies,
Indian Institute of Tourism & Travel Mohan Lal Sukhadia Univeristy, Udaipur
Management, Gwalior 9. Dr. Mahesh Chand Garg
4. Prof. Kamal Yadav Associate Professor,
Professor, Haryana Business School,
School of Management Studies, Guru Jambeshwar University of Science &
IGNOU, New Delhi Technology, Hisar
5. Prof. Gitika Kapoor 10. Dr. R.K. Jain
Professor, Assistant Professor,
R.A. Podar Institute of Management, Vardhaman Mahaveer Open University,
University of Rajasthan, Jaipur Kota
Editing and Course Writing

Editor
Dr. R.S. Agrawal
Vice-Principal,
Government College, Ratangarh (Raj.)
Ms. Swati Sharma (Unit No.-1,2) Dr. R.S. Agrawal (Unit No. 6,9,10,11)
Modi Institute of Management Vice-Principal,
& Technology, Kota Government College,
Ms. Priyanka Garg (Unit No.-3,4,7) Ratangarh
Modi Institute of Management Dr. N.K. Maheshwari (Unit No. -8,13)
& Technology, Kota Ex-Principal
Dr. Namita Jalan (Unit No.- 5) Somani College,
Vardhaman Girls College, Jodhpur
Beawar Ms. Upasana Tyagi (Unit No.- 14,15)
Dr. S. Maheshwari (Unit No.- 12) Modi Institute of Management
Visiting Faculty, & Technology, Kota
College of Commerce & Management,
MLS University, Udaipur.
Academic and Administrative Management
Prof. (Dr.) Naresh Dadhich Prof. M.K. Ghadoliya Mr. Yogendra Goyal
Vice-Chancellor Director (Academic) Incharge
Vardhaman Mahaveer Open University, Vardhaman Mahaveer Open University, Material Production and
Kota Kota Distribution Departmant
Course Material Production

Mr. Yogendra Goyal
Assistant Production Officer,
Vardhaman Mahaveer Open University,
Kota
PRODUCTION: March, 2011

All rights reserved. No part of this book may be reproduced in any from by mimeograph or any other means,
without permission in writing form the V.M. Open University, Kota.
Printed and published on behalf of V.M. Open University, Kota by Registrar.
MP-103
CONTENTS

Unit No. Name of Unit Page No.
BLOCK - I : INTRODUCTION
1 Accounting Concepts 1-8
2 Principles, Standards and Conventions 9-16
3 Double Entry System of Accounting 17-27

4 Journal and Ledger 28-53
5 Trial Balance 54-66
6 Final Accounts 67-87
BLOCK - II : COST ACCOUNTING

7 Cost Accounting 88-100
8 Marginal Costing 101-126
9 Cost Analysis for Decision Making 127-141
10 Process Costing 142-156
BLOCK - III : MANAGEMENT ACCOUNTING

11 Management Accounting 157-166
12 Standard Costing and Variance Analysis 167-188
13 Budgetary Control 189-208
BLOCK - IV : FINANCIAL ANALYSIS

14 Tools of Financial Analysis - Ratio Analysis 209-223
15 Funds Flow and Cash Flow Statements 224-247

INTRODUCTION
The purpose of this course is to develop an understanding for accounting

knowledge so that decision maker can interprete the information in business terms.
The course is devided into four blocks and 15 units in such a manner that the student
can go ahead in a systematic and sequential manner. Block - I : Introduction deals
with fundamental issues and concepts pertaining to Book-keeping, Accounting,
Accounting Principles, Standards and Conventions, Double Entry System, Journal
and Ledger entries, Trial Balance and Final Accounts. Block - II : Cost Accounting
explains the concept of cost accounting and marginal costing which are essential
components of cost management. Block III : Management Accounting explains
the role and functions of management accounting as a tool of decision making. It is
followed by standard costing and variance analysis. Block IV : Financial Analysis is
devoted to the tools of Financial Analysis such as Ratio Analysis and Funds Flow and
Cash Flow Statements. The Units in this Block will help to understand the financial
health of a firm.
MP-103

Unit -1 Accounting Concepts
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Need of Accounting
1.3 Development of Accounting
1.4 Definitions and Functions of Accounting
1.5 Objectives of Accounting
1.6 Accounting as Science or Art
1.7 Book-keeping, Accounting and Accountancy
1.8 Branches of Accounting
1.9 End users of Accounting Information
1.10 Limitations of Accounting
1.11 Summary
1.12 Key Words
1.13 Self Assessment Test
1.14 Reference Books
1.0 Objectives
After studying this unit you should be able to understand:
 Objective and Need for accounting
 Definition of accounting
 Book-keeping
 Types of accounting
 Accounting as source of accounting to various users
 Limitations of accounting
1.1 Introduction
A business enterprise engages itself in a number of activies, primarily in terms of money, with a view
to making profit and keeping it as a going concern for an indefinite period of time. A business enterprise of
even medium size deals with many customers, many employees and many suppliers and deals in many
business transactions. It is impossible to operate even a medium sized business just by remembering the
details of business transactions occuring therein. That is why there is a saying “ First record and then pay. If
errors, look what books say”.
A systematic and upto date record of varied and numemous business transactions, is therefore quite
essential to obtain the required information in respect of profit and loss, assets and liabilities and capital of
business and also to exercise control over various items of expenditure. Accounting plays a key role in
serving this purpose.
1.2 Need of Accounting
Accounting has rightly been termed as the language of business. The basic function of a language is
to serve as a means of communication. Accounting also serves this function. It communicates the results of
business operation to various parties who have some stake in the business viz the proprietor, creditor,
investors, government and other agencies. Though accounting is generally associated with business yet it is
not only business which make use of accounting. Persons like housewives, government and other
individuals also make use of accounting. For example, in case the housewife records her transactions
regularly, she can collect valuable information about the nature of her receipts and payments. For example
she can find out the total amount spent by her during a period on different items say milk, food, education,
entertainment etc. Similarly she can find the source of her receipt as salary, rent from property, cash gifts
from her relatives thus at the end of the period she can see for herself about her financial position i.e. what
she owes and what she owns. This will help her in planning her future income and expenses (or making out
a budget) to a great extent.
The need for accounting is all the more greater for a person who is running a business. He must
know: - (i) what he owns (ii) who he owes (iii) whether he has earned a profit or suffered a loss on account
of running a business (iv) what is his financial position i.e. whether he will be in a position to meet all his
commitments in the near future or he is in the process of becoming a bankrupt.
1.3 Development of Accounting

Accounting is as old as money itself. In India, Chanakya in his Arthashastra has emphasized the
existence and need of proper accounting and auditing. However, the modern system of accounting owes its
origin to Pacoili who lived in Italy in the 18th century. In those early days the business organizations and and
transactions were not so complex due to their being small and easily manageable by the proprietor itself.
Things have changed fast during the past 50 years. The evident of industrial revolution has resulted n large
scale production, cut throat competition and widening of the market. In the early stages accounting
developed as a result of the needs of the business firms to keep track of their relationship with outsiders,
listing of their assets and liabilities. In recent years changes in technology have also brought a remarkable
change in the field of accountancy. The whole concept of accounting has changed. “it has come to be
recognized as a tool for mastering the various economic problems with the business organization may have
to face..it systematically writes the economic history of the organization. It provides information that can be
drawn upon by those responsible for decision affecting the organization's future. Its history is mostly written
in quantitative terms. It consists partly of files of data, partly of reports summarizing various portions of these
data, and partly of the plans established by the management to guide its operations”.
1.4 Definitions and Functions of Accounting

In 1941, the American Institute of Certified Public Accountants (AICPA) defined accounting as
follows “ Accounting is the art of recording, classifying and summarizing in significant manner and in terms of
money, transactions and events which are, in part, at least a financial character and interpreting the results
there of”.
In 1966, the American accounting association (AAA) defined accounting as follows:
- “Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by the users of the information”.
- In 1970, the Accounting Principle Board (APB) of American Institute of Certified Public
Accountants enumerated the functions of accounting as follows:
- “The function of accounting is to provide quantitative information, primarily of financial nature,
about economic entities, that is needed to be useful in making economic decisions”.
- Thus accounting may be defined as the process of recording, classifying, summarizing, analyzing
and interpreting the financial transactions and communicating the result thereof to the persons
interested in such information.
The analysis of the definition brings out the following functions of accounting:
1. Recording: This is basic function of accounting. It is essentially concerned with not only ensuring
that all business transactions of financial character are in fact recorded but also that they are
recorded in an orderly manner. Recording is done in the book of”Journal”. This book may be
further sub divided into various subsidiary books such as cash journal (for recording cash
transactions), purchases journal( for recording credit purchase of goods) sales journal (for
recording credit sales of goods), etc…the number of subsidiary books to be maintained will be
according to the nature and size of the business.
2. Classifying: It is concerned with the systematic analysis of the recorded data, with a view to
keeping group transactions or entries of one nature at one place. The work of classification is done
in the book termed as 'ledger”. This book contains different pages of different accounts heads
under which all financial transactions of similar nature are collected. For example there may be
separate account heads for travelling expenses, printing and stationary, advertising etc.
3. Summarizing: This involves presenting the classified data in a manner which is understandable and
useful to the internal as well as external end users of accounting statements. The process leads to the
preparation of the following statements: (i) Trial balance, (ii) Income statement, and (iii) Balance
sheet.
4. Dealing with financial transactions: Accounting records only those transactions and events in
terms of money which are of financial character. For example, if a company has got a team of
dedicated and trusted employees, it is of great use to the business but since it is not of a financial
character and capable of being expressed in terms of money, it will not be recorded in the books of
business.
5. Analyzing and interpreting: This is the final function of accounting. The recorded financial data is
analyzed and interpreted in a manner that the end users can make a meaningful judgment about the
financial conditions and profitability of the business operations. The data is also used for preparing
the future plan and framing of policies for executing such plans.
6. Communicating: The accounting information after being meaningfully analyzed and interpreted
has to be communicated in a proper form and manner to the proper person. This is done through
preparation and distribution of accounting reports, which includes, besides the usual income
statement and the balance sheet, additional information in the form of accounting ratios, graphs,
diagrams, fund flow statement etc...
1.5 Objectives of Accounting

The following are the main objectives of accounting:
1. To keep systematic records. Accounting is done to keep a systematic record of financial
transactions. In the absence of accounting there would have been terrific burden on human memory
which in most cases would have been impossible to bear.
2. To protect business properties. Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of accounting by supplying the
following information to the managers or the proprietors:
(i) The amount of the proprietor's fund invested in the business
(ii) How much the business has to pay to the others.
(iii) How much the business has to recover from the others.
(iv) How much the business has in the form of (a) fixed assets; (b) cash in hand; (c)
cash at bank; (d) stock of raw materials, work in progress and finished goods.
Information about the above matters helps the proprietor in assuring that the funds of
the business are not unnecessarily kept idle or under-utilized.
3. To ascertain the operational profit or loss. Accounting helps in ascertaining the net profit earned
or loss suffered on account of carrying the business. This is done by keeping a proper record of
revenues and expenses of a particular period. The profit and loss account is prepared at the end of
a period and if the amount of revenue for the period is more than the expenditure incurred in earning
that revenue there is said to be a loss.
Profit and loss account will help the management, investors, creditors etc. in knowing whether
running the business has proved to be remunerative or not. In case it has not proved to be
remunerative or profitable, the cause of such a state of affairs will be investigated and necessary
remedial steps will be taken.
4. To ascertain the financial position of business. The profit and loss account gives the amount of profit
and loss made by the business during a particular period. However, it is not enough. The
businessman must know his financial position i.e. where he stands, what he owes and what he
owns. This objective is served by Balance Sheet or Position Statement. The Balance Sheet is a
statement of assets and liabilities of the business on a particular date. It serves as barometer for
ascertaining the financial health of the business.
5. To facilitate rational decision making. Accounting these days has taken upon itself the task of
collection, analysis and reporting of information at the required points of time to the required levels
of authority in order to facilitate rational decision making. The American Accounting Association
has also stressed this point while defining the term 'accounting' when it says that accounting is “the
process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of the information.” Of course, this is by no means an easy task.
However the accounting bodies all over the world and particularly the International Accounting
Standards Committee have been trying to grapple with this problem and have achieved success in
laying down some basic postulates on the basis of which the accounting statements have to be
prepared.
1.6 Accounting as Science or Art
Any organized knowledge based on certain principles is a 'science'. Accounting is also a science. It
is an organized knowledge based on scientific principles which have been developed as a result of study and
experience. Of course accounting cannot be termed as a perfect science like physics or chemistry where
experiments can be carried and perfect conclusions can be drawn. It a social science depending much on
human behavior and other social and economic factors.
Art is the technique which helps us in achieving our desired objective. Accounting is definitely an art.
The American Institute of Certified Public Accountants also defines accounting as” the art of recording,
classifying and summarizing the financial transactions”. Accounting helps in achieving the desired objectives
of maintaining proper accounts i.e.… to know the profitability and the financial position of the business by
maintaining proper accounts.
1.7 Book-keeping, Accounting and Accountancy

These three are sometimes considered as synonyms. However, there is fundamental difference
amongst bookkeeping and accounting and accountancy.
1.7.1 Bookkeeping
Bookkeeping is mainly concerned with record keeping or maintenance of books of accounts. The
maintenance of books of accounts include the following four activities
I. Identifying the transactions of financial nature from amongst the various transactions.
II. Measuring the identified transactions in terms of money.
III. Recording the identified transactions in the books of original entry.
IV. Classifying them into ledger.
The bookkeeping function is routine and clerical in nature and can be performed by persons having
limited knowledge of accounting. At present this function is increasingly done by computers.
1.7.2 Accounting
Accounting starts where book keeping ends. It includes the following activities:
I. Summarizing the classified data in the form of profit and loss account and balance sheet etc.
II. Analyzing and interpreting the summarized results. In other words, drawing the meaningful
information from profit and loss account and balance sheet.
III. Communicating the information to the interested parties.
Thus the accountant’s work goes beyond the work of a book keeper.
1.7.3 Accountancy
Accountancy refers to a systematic knowledge of accounting concerned with the principles and
techniques which are applied in accounting. It tells us how to prepare books of accounts, how to summarize
the accounting information and how to communicate it to the interested parties. According to Kohler,'
accountancy refers to the entire body of theory and practice of accounting.'
1.8 Branches of Accounting

In order to satisfy needs of different people interested in the accounting information, different branches
of accounting have developed. They can be broadly classified into three categories
i. Financial accounting: It is the original form of accounting. It is mainly confined to the preparation
of financial statements for the use of outsiders like shareholders, debentureholders, debtors,
creditors, bank and financial institutions. The financial statements i.e. the profit and loss account and
the balance sheet, show the manner in which the business operations of the business have been
conducted during the specified period.
ii. Management Accounting: It is accounting for the management i.e. accounting which provides
necessary information to the management for discharging its functions. According to Chartered
Institute of Management Accountants, London, “Management accounting is the formation of
policies and in planning and control of the operations of the undertaking.” It covers all the
arrangements and combinations or adjustments of orthodox information to provide the chief
executive with the information from which he can control the business.
iii. Cost accounting: The main purpose of cost accounting is to ascertain total cost and per unit cost
of goods produced and services rendered by a business. It also estimates the cost in advance and
helps the management in exercising strict control over cost.
1.9 End Users of Accounting Information

Accounting information is used by various groups of people who have contact with business
enterprise. They use accounting information in order to satisfy some of their varied needs for information.
The various users are as follows:
I. Proprietors: A business is done with the objective of making profit. Its profitability and financial
soundness are, therefore, matters of prime importance to the proprietors who have invested their
money into the business
II. Managers: Managers need financial information to run the business entity in an efficient manner
and take effective decisions on behalf the owners of the business.
III. Creditors: Creditors are the persons who have extended credit to the company. They are also
interested in the financial statements because they will help them in ascertaining whether the
enterprise will be in a position to meet its commitment towards them both regarding payment of
interest and the principal.
IV. Prospective investors: A person who is contemplating an investment in a business will like to
know about its profitability and financial position. A study of the financial statement will help him in
this respect.
V. Government: The government is interested in the financial statement of business enterprise on
account of taxation, labor and corporate laws, if necessary; government can ask its officials to
examine the accounting records of the business.
VI. Employees: The employees are interested in the financial statements on account of various profit
sharing and bonus schemes.Their interest may further increase in case they purchase shares of the
companies in which they are employed.
VII. Citizens: An ordinary citizen may be interested in the accounting records of the institutions with
which he comes in contact in daily life example bank, temple, and public utilities such as gas,
transport and electricity companies. In a broader sense, he is also interested in the accounts of the
government company, a public utility company etc...As a voter and a tax payer.
VIII.Researcher: Accounting information being a mirror of financial performance of the business
enterprise, is of immense value to the research scholars who want to make an in depth study of the
financial operations of the enterprise.
1.10 Limitations of Accounting
As discussed above, accounting provides information about the profitability and financial
soundness of the concern to the owners and the interested parties. In addition, it provides various other
valuable information also. However accounting has certain limitations which must be kept in mind while
using such informations. These limitations are as follows:
(1) Based on accounting concepts and conventions: Accounts are prepared on the basis of
number of accounting concepts and conventions. Hence, the profitability and the financial position
disclosed by it may not be realistic. For example, fixed assets are shown in the business as per going
concern concept. This means that fixed assets are shown at their cost and not at their market price
.The value realized on their sales may be more or less then the value stated in the balance sheet.
Similarly, on account of convention of conservatism, the profit and loss account does not disclose
the true profit of the business because future losses are provided for where as future profits are
ignored.
(2) Influenced by personal judgment: Accounting is not an exact science and accountant has to
exercise his personal judgment in respect of various items. For example, it is extremely difficult to
predict with any degree of accuracy the actual useful life of an asset which is needed for calculating
depreciation. Different personas are bound to have different opinions in respect of such things and
hence it will result in ascertainment of different figures of profit and loss of a business by different
persons. Hence the figures of profit cannot be taken as exact figures.
(3) Incomplete information: Accounting statements provide only the incomplete information because
the actual profit or loss of a business can be known only when the business is closed down.
(4) Omission of qualitative information: Accounts contain information which can be expressed in
terms of money. Qualitative aspects of the business unit are completely omitted from the books as
these cannot be expressed in monetary terms. Thus changes in management, reputation of the
business, cordial relations between management and labor, firm's ability to develop new product,
efficiency of management, satisfaction of firm's customers etc. which have the vital bearing on the
firm's profitability are all ignored and omitted from being recorded because all of these events are
qualitative in nature.
(5) Based on historical cost : Accounts are prepared on the basis of historical cost (i.e. the original
cost) and as such the figures given in financial statements do not show the effect of changes in price
level. The asset remain undervalued in many cases particularly land and building. The out come of
this practice is that balance sheet values of the asset are not helpful in estimating the true financial
position of the business.
(6) Affected by window dressing : The accounts are manipulated, so that the financial statements
may disclose a more favorable position than the actual position. For example, the purchase made at
the end of the year may not be recorded or the closing stock may be over valued. Hence correct
decision cannot be taken on the basis of such financial statements.
(7) Unsuitable for forecasting : Financial accounts are only a record of past events. Continuous
changes take place in the demand of the product, policies adopted by the firm, the position of the
competitors etc. as such; the financial analysis based on the past events may not be of much use for
forecasting.
1.11 Summary
Accounting is the art of recording ,classifying and summarizing in significant manner and in terms of
money, transactions and events which are in part, at least of financial nature and interpreting the results
thereof.
1.12 Key Words
 Accounting: the process of identifying, measuring and communicating economic information to
permit informed judgments and decision by the users of information.
 Management accounting: the presenting of accounting information in such a way as to assist
management in the creation of the policy and in the day to day operation of the undertaking.
 Assets: anything which is in possession or is the property of a business enterprise including the
amount due to it from others.
 Debtors: those persons or firms to whom goods have been sold or services rendered on credit and
payment has not been received from them. They still owe some amount to the business.
(1) “Only financial transactions are recorded in accountancy”. Explain the statement.
(2) Define accounting. State its functions.
(3) How is accounting different from book keeping?
(4) What are the limitations of accounting?
(5) What are the types of accounting?
(6) Which are the parties interested in the accounting information and why?

Monga J.R., Foundation Accountancy.
Grewal T.S. , Double Entry Book-keeping.
Jain, Khandelwal, Pareek, Foundation of Accounting.
Unit - 2 Accounting Principles, Standards and Conventions
Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Meaning of Accounting Principles
2.3 Accounting Concepts or Assumptions
2.4 Accounting Conventions
2.5 Generally Accepted Accounting Principles (GAAP)
2.6 Systems of Accounting
2.7 Summary
2.8 Key Words
2.10 References Books
2.0 Objectives
After studying this unit you should be able to understand :
 Generally Accepted Accounting Principles(GAAP)
 Accounting Concepts or Assumptions:
- Business entity concept
- Money measurement concept
- Going concern concept
- Accounting period concept
- Cost concept
- Dual aspect concept
- Revenue recognition( realization) concept
- Matching concept
 Accounting Conventions:
- Convention of full disclosure
- Convention of consistency
- Convention of conservatism(prudence)
- Convention of materiality
 Different Systems of Accounting
2.1 Introduction
The accounting profession has developed over the years, from experience, usage and necessity a
number of rules or guidelines called concepts, conventions. assumptions, principles etc; with the objective
of achieving consistency and comparability between the financial information. These financial information
may be of different enterprises for a given accounting period or of a particular business enterprises for a
number of years.
Accounting principles are judged on their general acceptability rather than universal acceptability
to the makers and user of financial statement, so they are known as Generally Accepted Accounting
Principles (GAAP). The GAAP is used to describe the concepts, conventions, rules etc. The general
acceptance of accounting principles depends on how well they satisfy relevance, objectivity and feasibility
2.2 Meaning of Accounting Principles

Unlike in the past when accounting statements were largely needed by the owners, these days
accounting statements are needed by various parties who have vested interest in the business, namely,
investors, creditors, government, banks and many others. Accounting statements disclose the profitability
and solvency of the business to various parties. It is, therefore, necessary that such statements should be
prepared according to some standard language and set of rules. These rules are usually called 'generally
accepted accounting principles '.These principles are generally accepted by accountants all over the world
as general guidelines for preparing the accounting statements .These rules(usually called GAAP) bring
uniformity and consistency to the process of accounting and enhance its utility to different users of
accounting information.
Accounting principles are described by various terms such as assumptions, conventions, concepts,
doctrines, postulates etc.These principles can be classified mainly into two categories:
1. Accounting Concepts or Assumptions
2. Accounting Conventions
2.3 Accounting Concepts or Assumptions

The term concepts includes those basic assumptions or conditions upon which accounting is based.
The following are the important accounting concepts:
I. Business Entity Concept : In accounting, business is treated as separate entity from its owners.
Accounts are prepared to give information about the business and not about those who own it. A
distinction is made between business transactions and personal transactions. Without such a
distinction, the affairs of the business will be mixed up with the private affairs of the proprietor and
the true picture of the firm will not be available. The 'business' and 'owner' are taken as two
separate entities. The accountant is interested to record transactions relating to business only. The
private transactions of the owner will be recorded separately and will have no bearing on the
business transactions. All the transactions of the business are recorded in the books of the business
from the point of view of the business as an entity and even the proprietor is treated as a creditor to
the extent of his capital. The concept of separate entity is applicable to all of business organizations.
For example, in case of a sole proprietorship business or partnership business, though the sole
proprietor or partners are not considered as separate entities in the eyes of law, yet for accounting
purposes they will be considered as separate entities. In the case of Joint Stock Company, the
business has a separate legal entity than the shareholders. The coming and going shareholders do
not affect the entity of the business. Thus, the distinction between owner and the business unit has
helped accounting in reporting profitability more objectively and fairly. It has also led to the
development of ‘responsibility accounting’ which enables us to find out the profitability of even the
different sub-units of the main business.
II. Going Concern Concept: According to going concern concept it is assumed that the business will
exist for a long time to come. Transactions are recorded in the books keeping in view the going
concern aspect of the business unit. A firm is said to be going concern when there is neither the
intention nor necessary to wind up its affairs. In other words, it should continue to operate at its
present scale in the future. On account of this concept the fixed assets are shown in the balance
sheet at a diminishing balance method i.e., going concern value. There is no need to show assets at
market value because these have been purchased for use in future and earn revenues and for sale
purpose. If the business is not to continue then market value will have significance. Since business is
to continue, fixed assets will be shown at cost less depreciation basis. It is due to the concept that
the fixed assets are depreciated on the basis of their expected life than on the basis of market value.
The concept also necessitates distinction between expenditure that will render benefit over a long
period and that whose benefit will be exhausted quickly, say within one year. The going concern
concept also implies that existing liabilities will be paid at maturity.
III. Money Measurement Concept: Accounting records only those transactions which can be ex-
pressed in terms of money. Transactions or events which cannot be expressed in money do not find
place in the books of accounts though they may be very useful for the business. For example, if a
business has got a team of dedicated and trusted employees, it is definitely an asset to the business,
but since their monetary measurement is not possible, they are not shown in the books of business.
It should be remembered that money enables various things of diverse nature to be added up
together and dealt with. The use of a building and the use of clerical service can be aggregated only
through money values and not otherwise.
IV. Cost Concept: This concept is closely related to the going concern concept. According to this
concept, an asset is ordinarily recorded in the books at the price at which it was acquired i.e., at its
cost price. This cost serves the basis for the accounting of this asset during the subsequent period.
The 'cost' should not be confused with 'value'. It must be remembered that as the real worth of the
assets changes from time to time, it does not mean that the value of such an asset is wrongly
recorded in the books. The book values of the assets as recorded do not reflect their real value.
They do not signify that values noted therein are the values for which they can be sold. Though the
assets are recorded in the books at cost, in course of time, they are reduced in value on account of
depreciation charges. The idea that the transactions should be recorded at cost rather than at a
subjective or arbitrary value is known as cost concept. With the passage of time, the market value
of fixed assets like land and buildings vary greatly from their cost. These changes in the value are
generally ignored by the accountants and they continue to value them in the balance sheet at
historical cost. The principle of valuing the fixed assets at cost and not at market value is the
underlying principle in cost concept. According to them the current values alone will fairly represent
the cost to the entity. The cost principle is based on the principle of objectivity. There is no room for
personal assessment in showing the figures in accounting records. If subjectivity is flowed in records
the same assets will be valued at different figures by different individuals. Every body will have his
own views about various assets. The cost concept is helpful in making truthful records. The records
become more reliable and comparable.
V. Dual Aspect Concept: This is the basic concept of accounting. Modern accounting system is
based on dual aspect concept. Dual concept may be stated as "for every debit, there is a credit".
Every transaction should have two sided effect to the extent of the same amount. For example, if A
starts a business with a capital of Rs.10,000. There are two aspects of the transaction. On the one
hand the business has assets of Rs10, 000 while on the other hand the business has to pay to the
proprietor a sum of Rs10, 000 which is taken as proprietor's capital. This expression can be shown
in the form of following equation:
Capital (Equities) = Cost (Assets)
10,000 = 10,000
The term 'assets' denotes the resources owned by a business while the term 'equities'
denotes the claims of various parties against the assets. Equities are of two types. They are owner's
equity and outsider's equity. Owner's equity (or capital) is the claim of the owner's against the assets
of the business while outsiders' equity (liabilities) is the claim of outside parties against the assets of
the business. Since all assets of the business are claimed by someone (either owners or outsiders),
the total of assets will be equal to total of liabilities. Thus:
Equities = Assets
Liabilities + Capital = Assets
Suppose business borrows Rs 5000 from a bank, dual aspect of this transaction will be
Capital + Liabilities = Assets
+A Loan
10,000 + 5000 = 15,000
Thus the accounting Equation states that at any point of time the assets of any entity must be
equal (in monetary terms) to the total of owner's equity and outsider's liabilities. As a mater of fact
the entire system of double entry accounting is based on this concept.
VI. Accounting period concept : According to this concept, the life of the business is divided into
appropriate segments for studying the results shown by the business after each segment. Since the
life of the business is considered to be indefinite (according to going concern concept) the
measurement of income and studying financial position of the business according to the above
concept, after a very long period would not be helpful in taking proper corrective steps at the
appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the
businessman must stop and see, how things are going on. In accounting such a segment or time
interval is called accounting period. It is usually of a year. At the end of each accounting period and
income statement/profit & loss account and a Balance Sheet are prepared. The income statement
discloses the profit or loss made by the business during the accounting period while Balance Sheet
discloses the financial position of the business as on the last day of the accounting period. While
preparing these statements a proper distinction has to be made between capital and revenue
expenditure.
VII. Matching concept : The aim of business is to earn profit. In order to ascertain the profit the costs
(expenses) are matched to revenue. The difference between income from sales and costs of
producing the goods will be the profit. When business is taken as a going concern then it becomes
necessary to evaluate the performance periodically. A correct statement of income requires a
distinction between past, present and future expenditures. A distinction between capital and
revenue expenditure is also necessary. The revenues and costs of the same period are matched. In
other words, income made by the business during a period can be measured only when the revenue
earned during a period is compared with the expenditure incurred for earning that revenue. The
question when the payment was received or made is irrelevant.
VIII. Realization Concept: This concept emphasizes that profit should be considered only when real-
ized. The question is at what stage profit should be deemed to have accrued? Whether at the time
of receiving the order or at the time of execution of the order or at the time of receiving the cash?
For answering this question the accounting is in conformity with the law and recognizes the
principle of law i.e., the revenue is earned only when the goods are transferred. It means that profit
is deemed to have accrued when property or goods passes to the buyer, viz., when sales are made.
2.4 Accounting Conventions

The term “conventions” includes those customs or traditions which guide the accountants while
preparing the accounting statements. The following are the important accounting conventions.
I. Convention of Disclosure: The disclosure of all significant information is one of the important
accounting conventions. It implies that accounts should be prepared in such a way that all material
information is clearly disclosed to the reader. The term disclosure does not imply that all information
that any one could desire is to be included in accounting statements. The term only implies that there
is a sufficient disclosure of information which is of material in trust to proprietors, present and
potential creditors and investors. The idea behind this convention is that any body who wants to
study the financial statements should not be misled. He should be able to make a free judgment. The
disclosures can be in the way of foot notes, within the body of financial statements, in the minutes of
meeting of directors etc.
II. Convention of Materiality: It refers to the relative importance of an item. According to this
convention only those events or items should be recorded which have a significant bearing and
insignificant things should be ignored otherwise accounting will be unnecessarily over burden with
minute details. There is no formula in making a distinction between material and immaterial events.
It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that
an item material for one concern may be immaterial for another. Similarly, an item material in one
year may not be material in the next year.
III. Convention of Consistency: This convention means that accounting practices should remain
unchanged from one period to another. For example, if stock is valued at cost or market price
whichever is less; this principle should be followed year after year. Similarly, if depreciation is
charged on fixed assets according to diminishing balance method, it should be done year after year.
This is necessary for the purpose of comparison. However, consistency does not mean inflexibility.
It does not forbid introduction of improved accounting techniques. If a change becomes necessary,
the change and its effect should be stated clearly.
IV. Convention of Conservatism: This convention means a cautious approach or policy of “play
safe”. This convention ensures that uncertainties and risks inherent in business transactions should
be given a proper consideration. If there is a possibility of loss, it should be taken into account at the
earliest. On the other hand, a prospect of profit should be ignored up to the time it does not
materialize. On account of this reason, the accountants follow the rule ‘anticipate no profit but
provide for all possible losses’. On account of this convention, the inventory is valued’ at cost or
market price whichever is less. ‘The effect of the above is that in case market price has gone down
then provide for the 'anticipated loss' but if the market price has gone up then ignore the 'anticipated
profits.' Similarly a provision is made for possible bad and doubtful debt out of current year's
profits. Critics point out that conservatism to an excess degree will result in the creation of secrets
reserves. This will be quite contrary to the doctrine of disclosure.
Activity
A business man follows the diminishing balance method for depreciating its assets, now he
wants to switchover to Fixed Instalment method. Say whether he can do so, if yes which
convention should he follow?
2.5 Generally Accepted Accounting Principles (GAAP)

GAAP is a term used to refer to the standard framework of guidelines for financial accounting used
in any given jurisdiction which are generally known as Accounting Standards. GAAP includes the
standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the
preparation of financial statements. The following is the list of accounting standards specified bythe Institute
of Chartered Accountants of India:
1. AS 1 Disclosure of Accounting Policies
2. AS 2 Valuation of Inventories
3. AS 3 Cash Flow Statements
4. AS 4 Contingencies and Events Occurring after the Balance Sheet Date
5. AS 5 Net Profit or Loss for the period, Prior Period Items and Changes in Accounting Policies
6. AS 6 Depreciation Accounting
7. AS 7 Construction Contracts (revised 2002)
8. AS 8 Accounting for Research and Development
9. AS 9 Revenue Recognition
10. AS 10 Accounting for Fixed Assets
11. AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003),
12. AS 12 Accounting for Government Grants
13. AS 13 Accounting for Investments
14. AS 14 Accounting for Amalgamations
15. AS 15 (revised 2005) Employee Benefits
16. AS 16 Borrowing Costs
17. AS 17 Segment Reporting
18. AS 18, Related Party Disclosures
19. AS 19 Leases
20. AS 20 Earnings Per Share
21. AS 21 Consolidated Financial Statements
22. AS 22 Accounting for Taxes on Income.
23. AS 23 Accounting for Investments in Associates in Consolidated Financial Statements
24. AS 24 Discontinuing Operation
25. AS 25 Interim Financial Reporting
26. AS 26 Intangible Assets
27. AS 27 Financial Reporting of Interests in Joint Ventures
28. AS 28 Impairment of Assets
29. AS 29 Provisions, Contingent` Liabilities and Contingent Assets
30. AS 30 Financial Instruments: Recognition and Measurement and Limited Revisions to AS
2, AS 11 (revised 2003), AS 21, AS 23, AS 26, AS 27, AS 28 and AS 29
31. AS 31, Financial Instruments: Presentation
32. Accounting Standard (AS) 32, Financial Instruments: Disclosures, and limited revision to
Accounting Standard (AS) 19, Leases
2.6 Systems of Accounting

There are basically two systems of accounting:
(i) Cash System of Accounting: It is a system in which accounting entries are made only when cash
is received or paid. No entry is made when a payment or receipt is merely due. Government system
of accounting is mostly on cash system. 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 statement prepared by them for determination of their income is termed
Receipts and Expenditure Account.
(ii) Mercantile or Accrual System of Accounting: It is a system in which accounting entries are
made on the basis of amounts having become due for payments or receipts. This system recognizes
the fact that if a transaction or event has occurred; its consequences cannot be avoided and
therefore should be brought into books in order to present a meaningful picture of profit earned or
loss suffered and also of the financial position of firm concerned.
The difference between “cash and mercantile systems” of accounting will be clear with the help of
the following example:
A firm closes its books on 31st December each year. A sum of Rs 500 has become due for payment
on account of rent for the year 1990. The amount has, however, been paid in January 1991.
In this case if the firm is following cash system of accounting, no entry will be made for having
become due in the books of account of the firm in 1990. The entry will be made only in January 1991 when
the rent is actually paid. However if the firm is following mercantile system of accounting, two entries will be
made: (i) on 31st December 1990, rent will be debited while the landlord's account will be credited by the
outstanding rent; (ii) in January, 1991 landlord's account will be debited while the cash account will be
credited with the amount of rent actually paid.
The ‘mercantile system’ is considered to be better since it takes into account the effects of all
transactions already entered into. This system is followed by most of the industrial and accounting firms.
2.7 Summary
Accounting principles may be defined as those rules of action or conduct which are adopted by
accountants universally while recording accounting transactions. “They are a body of doctrines commonly
associated with the theory and procedures of accounting, serving as an explanation of current practices and
as a guide for selection of conventions or procedures where alternatives exist”. These principles can be
classified in two categories:
1. Accounting Concepts- The term 'concepts' includes those basic assumptions or conditions Upon
which the science of accounting is based.
2. Accounting Conventions- The term 'conventions' includes those customs or traditions which
guide the accountant while preparing the accounting statements
2.8 Key Words
 Accounting Principles: rules of action or conduct adopted by the accountants universally while
recording accounting transactions
 Accounting Concepts: basic assumptions or conditions upon which the science of accounting is
based.
 Accounting Conventions: Customs and traditions which guide the accountants while preparing the
accounting statements.
 Cash System of Accounting: A system in which accounting entries are made only when cash is
received or paid.
 Mercantile System of Accounting: A system in which accounting entries are made on the basis of
amounts having become due for payment or receipts. It is also termed as Accrual System of
Accounting.
 Revenue : revenue in accounting means the income of a recurring nature from any source.It consists
of the amount received from sales of goods and from services provided to customers.

(1) What do you understand by GAAP?
(2) What do you mean by accounting assumption? State any three.
(3) Which system of accounting is mostly used in manufacturing industry and why?
(4) Explain the meaning and significance of business entity concept.

Grewal T.S, Double Entry Bookkeeping
Monga J.R., Foundation Accountancy
Unit - 3 Double Entry System of Accounting
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Meaning of Double Entry System of Accounting
3.3 Advantages of Double Entry System
3.4 Solved Illustrations
3.5 Summary
3.6 Key-Words
3.0 Objectives
 Meaning of Double Entry System of Accounting
 Meaning of Debit and Credit
 Rules of Debit and Credit
 Causes of popularity of Double Entry System
 Effect of Transactions on Accounting Equation
 Meaning of various Technical Accounting Terms
3.1 Introduction
A business transaction involves the transfer of value in the form of money, goods or services in terms
of money from one party to another. One party gives some value and another party receives the same in
exchange for an equivalent value. There is a reciprocal exchange of value between two parties, that is , each
party receives value and gives value in exchange. It must be carefully noted that the giving and receiving
aspects take place between accounts and in the same set of books.
In order to have complete record of each business transaction, its two-fold aspect must be recorded
simultaneously. The best known system which recognises the two-fold aspect of every business transaction
is called the Double Entry System. It is based upon the fact that just as every business transaction involves
atleast two parties so the record of each transaction must be made in the light of its two-fold aspects or two
accounts.
3.2 Meaning of Double Entry System of Accounting

According to this concept, every business transaction is recorded as having a dual aspect. In other
words, every transaction affects at least two accounts. If one account is debited, any other account must be
credited. The system of recording transactions based on this concept is called as “Double Entry System”.
It is because of this principle that the two sides of the Balance Sheet are always equal and the
following accounting equations will always hold good at any point of time :-
Assets = Liabilities + Capital
OR
Capital = Assets – Liabilities
3.2.1 Meaning of Debit and Credit
 Account
An account is a record of all business transactions relating to a particular person or item. In accounting
we keep a separate record of each individual, asset, liability, expense or income. The place where such a
record is maintained is termed as “Account”. Such as the account of Ram, the account of Rent, the account
of Machinery, the account of Salary and likewise.
All accounts are divided into two sides. The left side of an account is arbitrarily or traditionally
called Debit side and the right side of an account is called Credit side. In abbreviated form, Debit is written
as Dr. and Credit is written as Cr.
3.2.2 The Debit-Credit Rules
 Debit
Credit rules are globally accepted accounting conventions that facilitate double entry book keeping.
The rules are summarized in the table:
Item Debit Credit

Asset Increase in Assets Decrease in Assets
Liabilities Decrease in Liabilities Increase in Liabilities
Capital or Equity Decrease in Capital or Equity Increase in Capital or Equity
Income or Revenue Decrease in Income or Revenue Increase in Income or Revenue
Expense or Loss Increase in Expense or Loss Decrease in Expense or Loss
For example, if the Furniture is purchased in the business, Furniture is increased whereas the Cash
is decreased. Furniture and cash both are assets for the firm. Thus Furniture account is debited and Cash
account is credited.
Definition: - Double Entry System may be defined as follows:-
“The Double Entry System seeks to record every transaction in money or money’s worth in its
double aspect- The receipt of a benefit by one account and the surrender of a like benefit by another
account, the former entry being to the debit of the account receiving and the latter to the credit of that
account surrendering.”
- William Pickles
“Every business transaction has a two-fold effect and that it affects two accounts in opposite directions
and if a complete record were to be made of each such transaction, it would be necessary to debit one
account and credit another account. It is this recording of the two-fold effect of every transaction that has
given rise to the term Double Entry System.”
- J. R. Batliboi
Double Entry System is based upon the principle that “Every debit has a credit and every credit
has a debit.”
Example:
Mr. A sold goods for cash Rs. 2,000 to Mr. B. In this case the dual aspects of this transaction for
Mr. A and Mr. B are as follows:
Dual aspects for Mr. A Dual aspects for Mr. B
1. Receipt of cash Rs. 2,000. 1. Payment of cash Rs. 2,000.
2. Foregoing of goods of Rs. 2,000. 2. Receipt of goods of Rs. 2,000.
3.3 Advantages of Double Entry System

(1) Scientific System: - The transactions are recorded according to certain specified rules and as
such, the system is more scientific as compared to any other systems of Book-Keeping.
(2) Complete record of transactions: - In double entry system, both the debit and credit aspects of
a transaction are recorded, so that if the need arises, full details of every transaction can be easily
made available at any time in future.
(3) Preparation of Trial Balance:- In double entry system, the amount recorded to the debit sides of
various accounts will always be equal to the amounts recorded on the credit sides of various accounts.
As such, trial balance can be prepared to check the arithmetical accuracy of the accounts.
(4) Preparation of Trading and Profit and Loss Account:- With the help of trial balance, a trader
can prepare a Trading Account to find out the amount of gross profit or gross loss. Similarly, a profit
and loss account can be prepared to find out the net profit earned or loss suffered during a particular
period.
(5) Knowledge of financial position of the business:- In double entry system, separate accounts
are opened for each and every asset and liability of the firm and as such, a Balance Sheet can be
prepared which is a screen picture of the financial position of a business at a certain moment.
(6) Knowledge of various information:- In double entry system, information regarding various items
or persons is readily available at any point of time such as:
- Amount of sales, purchase ;
- Amount due to be received from customers or in other words , the total number of debtors and
the amount in each case;
- Amount due to be paid to suppliers or in other words , the total number of creditors and the
amount in each case;
- Amount paid on account of each head of expenses separately;
- Amount earned on account of each head of income separately.
(7) Lesser possibility of fraud:-This system of book-keeping records each transaction in two accounts,
as such, there is hardly any scope of forgery and manipulations as compared to other systems.
(8) Legal approval:- Double entry system meets legal requirements and books of accounts maintained
under this system are accepted as true and reliable by the Companies Act and various other Acts.
(9) Comparative Study: - Under this system, it helps the management to compare the expenditure of
the current year with those of the previous years and check the unnecessary expenditure.
(10) Helps management in decision making: - Under the system, the management can obtain all the
requisite information quickly and hence, can use the information for making decisions.
(11)Suitable for all types of Businessman: - The system is so flexible that it can be conveniently
introduced in small as well as big types of business.
3.4 Solved Illustrations

Illustration 3.4.1
A starts a new business and the following successive transactions take place:-
Transaction 1:- A started business with Rs. 75, 000 as Capital.
The effect of the transaction will be that the firm has received assets totaling Rs. 75, 000 in the form
of cash and the claims against the firm are also Rs. 75, 000 in the form of capital. The transaction can be
expressed in the form of an accounting equation as follows:-
Cash = Liabilities + Capital
75, 000 = 0 + 75, 000
Transaction 2:- A purchased Furniture for Cash Rs. 5, 000.
The effect of this transaction is that the cash is reduced by Rs. 5, 000, but a new asset of the same
amount has been acquired. The transaction decreases one asset and at the same time increases the other
assets with the same amount, leaving the total of the assets unchanged. The equation will now appear as
follows:-
Cash + Furniture = Liabilities + Capital
Old equation 75, 000 + 0 = 0 + 75, 000
Transaction (-)5, 000 + 5, 000 = 0 + 0
New equation 70, 000 + 5, 000 = 0 + 75, 000
Transaction 3:- A purchased goods for cash Rs. 20, 000.
As a result of this transaction, cash balance is reduced and another asset (goods) has come into
existence, leaving the total of the assets unchanged. The equation will appear as follows:-
Cash + Furniture + Goods = Liabilities + Capital
Old equation 70, 000 + 5, 000 +0 = 0 + 75, 000
Transaction (-)20, 000 + 0 + 20, 000 = 0 + 0
New equation 50, 000 + 5, 000 + 20, 000 = 0 + 75, 000
Transaction 4:- A purchased goods on credit for Rs. 16, 000.
This transaction will increase goods on the assets side and will create a liability in the form of
Creditors. (The persons from whom goods have been purchased on credit are called creditors.) The equation
will be as follows:-
Cash + Furniture + Goods = Creditors + Capital
Old equation 50, 000 + 5, 000 + 20, 000 = 0 + 75, 000
Transaction 0 +0 + 16, 000 = 16, 000 + 0
New equation 50, 000 + 5, 000 + 36, 000 = 16, 000 + 75, 000
Transaction 5:- Goods costing Rs. 12, 000 sold on credit for Rs. 15, 000.
This transaction will give rise to a new asset in the form of Debtors to the extent of Rs. 15, 000.
(Debtors are those persons to whom goods have been sold on credit.) But the goods will be reduced only
by Rs. 12, 000, the cost of goods sold. The net increase in assets Rs. 3, 000 is the amount of profit which
will be added to the capital. The effect of the transaction has been explained in the following equation:-
Cash + Furniture +Goods + Debtors = Creditors + Capital
Old equation 50,000 + 5,000 + 36,000 + 0 = 16,000 + 75,000
Transaction 0 +0 - 12,000 + 15,000 = 0 + 3,000
New equation 50,000 + 5,000 + 24,000 + 15,000= 16,000 + 78,000
Transaction 6:- Paid Rs. 1,000 for rent.
The effect of this transaction is that first, it reduces cash and secondly, as the rent is an expense, it
results in a loss which decreases the capital. The revised equation will appear as follows:-
Cash + Furniture +Goods + Debtors = Creditors + Capital
Old equation 50,000 + 5,000 + 24,000 + 15,000 = 16,000 + 78,000
Transaction (-)1,000 + 0 +0 +0 = 0 (-) 1,000
New equation 49,000 + 5,000 + 24,000 + 15,000= 16,000 + 77,000
From the study of the above transactions it may be concluded that every transaction has a double
effect and in each case Assets = Liabilities + Capital.
Illustration 3.4.2
Show the accounting equation on the basis of the following transactions:-
Rs.
1. Started business with cash 1,20,000
2. Rent received 10,000
3. Invested in Shares 50,000
4. Received dividend 5,000
5. Purchased goods on credit from X 35,000
6. Paid cash for household expenses 7,000
7. Sold goods for cash (costing Rs. 10,000) 14,000
8. Cash paid to X 35,000
9. Deposited into bank 20,000
Solution Accounting Equation
SNo. Assets = Liabilities + Capital
Cash + Shares + Stock + Bank = Creditors + Capital
1.Transaction 1,20,000 + 0 + 0 + 0 = 0 + 1,20,000
Equation 1,20,000 + 0 + 0 + 0 = 0 + 1,20,000
2.Transaction +10,000 + 0 + 0 + 0 = 0 + 10,000
New Equation 1,30,000 + 0 + 0 + 0 = 0 + 1,30,000
3.Transaction - 50,000 + 50,000 + 0 + 0 = 0 + 0
New Equation 80,000 + 50,000 + 0 + 0 = 0 +
4.Transaction 1,30,000
+ 5,000 + 0 + 0 + 0 = 0 +
5,000
New Equation 85,000 + 50,000 + 0 + 0 = 0 + 1,35,000
5.Transaction 0 + 0 + 35,000 + 0 = 35,000 + 0
New Equation 85,000 + 50,000 + 35,000 + 0 = 35,000 +
- 7,000 + 0 + 0 + 0 = 0 -
7,000
New Equation 78,000 + 50,000 + 35,000 + 0 = 35,000 +
+14,000 + 0 - 10,000 + 0 = 0 +
4,000
New Equation 92,000 + 50,000 + 25,000 + 0 = 35,000 +
-35,000 + 0 + 0 + 0 = -35,000 + 0
New Equation 57,000 + 50,000 + 25,000 + 0 = 0 +
-20,000 + 0 + 0 + 20,000 = 0 + 0
Final Equation 37,000 + 50,000 + 25,000 + 20,000 = 0 +
1,32,000
Explanation
Transaction 1:- Started business with cash Rs. 1, 20,000.
Accounts effected: - Assets: Cash increases.
Liabilities: Capital increases.
Transaction 2:- Rent received Rs. 10,000.
Liabilities: Rent received is income, thus Capital increases.
Transaction 3:- Invested in Shares Rs. 50,000.
Accounts effected:- Assets : Investment in Shares is asset, thus Shares increases and Cash
decreases.
Liabilities: No effect.
Transaction 4:- Received dividend Rs. 5,000.
Liabilities: Dividend received is income, thus Capital increases.
Transaction 5:- Purchased goods on credit from X, Rs. 35,000.
Accounts effected: - Assets: Stock increases.
Liabilities: Creditors increases.
Transaction 6:- Paid cash for household expenses, Rs. 7,000.
Accounts effected: - Assets: Cash decreases.
Liabilities: Capital decreases.
Transaction 7:- Sold goods for cash (costing Rs. 10,000) for Rs.14, 000.
Accounts effected: - Assets: Cash, to the value of sales, increases; Stock, to the extent of cost, decreases.
Liabilities: Profit on sale is Rs. 4,000, thus Capital increases to the extent of
Rs. 4,000.
Transaction 8:- Cash paid to X, Rs. 35,000.
Accounts effected: - Assets: Cash decreases.
Liabilities: Creditors decreases.
Transaction 9:- Deposited into bank, Rs. 20,000.
Accounts effected: - Assets: Cash decreases; Bank increases.
Liabilities: No effect.
Illustration 3.4.3
If the capital of a business is Rs. 2, 00,000 and outside liabilities are Rs. 50,000, calculate total
assets of the business.
Solution
= Rs. 50,000 + Rs. 2, 00,000
= Rs. 2, 50,000.
Illustration 3.4.4
If total assets of a business are Rs. 2, 00,000 and net worth (capital) is Rs. 1, 50,000, calculate
creditors.
Solution:-
Creditors (liabilities) = Assets – Capital
= 2, 00,000 – 1, 50,000
= 50,000
Illustration 3.4.5
(a) X started business on 1st Jan. 2009 with capital of Rs. 1, 50,000 and a loan of Rs. 40,000 taken
from HDFC Bank. On 31st Dec. 2009 his assets were Rs. 3, 00,000. Find out his capital on 31st
Dec 2009 and profits made or losses incurred during the year 2009.
(b) If in the above illustration, the proprietor had introduced additional capital of Rs. 25,000 and had
withdrawn Rs. 8,000 for personal purposes, find out the profit.
Solution
(a) Closing Capital = Closing Assets – Closing Liabilities
= Rs. 3, 00,000 – Rs. 40,000
= Rs. 2, 60,000
Profit = Closing capital – Opening capital
= Rs. 2, 60,000 – Rs. 1, 50,000
= Rs. 1, 10,000
(b) Profit = Closing capital + Drawing – Additional capital – Opening capital
= Rs. 2, 60,000 + Rs. 8,000 – Rs. 25,000 – Rs. 1, 50,000
= Rs. 93,000
3.5 Summary
Double entry system of Book-Keeping refers to a system of accounting under which both the
aspects (i.e., debit and credit) of every transaction are recorded in the accounts involved.
The individual record of a person or thing is called account. Every debit has equal amount of credit.
So the total of all debits must be equal to the total of all credits. This duality is the basis of double entry
records.
Activity
A started business with a capital of Rs. 6,00,000/-. He introduced Rs. 16000/- during the
year as on additional capital, while personal drawings Rs. 6000/-. At the end of the year
closing capital Rs. 8,00,000/-. What is his profit for the year?
3.6 Key Words

 Business: Any work which is legal and done with the intention of earning profit is called business.
 Capital: Capital represents the amount invested by the trader in his business. It may be in the form
of cash, goods or assets. In other words, the rights of the owner against the firm or the business are
called owner’s Equity or Capital. Capital is always equal to the difference between the assets and
liabilities of the enterprise.
 Goods: Goods is applicable to that commodity which a trader purchases for resale. It is insignificant
whether such a commodity is sold in the same form or after changing its form by processing. The
following are example of goods.
‘Fruit’ for a fruit vendor ; ‘Cloth’ for a cloth merchant; ‘Machinery’ for a machinery dealer;
and ‘Timber’ for a timber merchant. Goods may be classified as under.
(a) Purchases: The goods which are purchased in the business for the purpose of reselling them are
known as ‘Purchases’. It may be cash purchases or credit purchases.
(b) Sales: The goods which are purchased with a view to resale and when they are sold, they are
known as ‘Sales’. It may be cash sales or credit sales.
(c) Purchases Returns: If the goods purchased are returned by the trader to its supplier due to any
reason, they are called ‘Purchases Returns’ or ‘Returns Outwards’.
(d) Sales Returns: If any sold goods are returned by the customers to the trader for any reason, it is
known as ‘Sales Returns’ or ‘Returns Inwards’.
(e) Stock: When, on a particular date, the goods remain unsold with the trader it is known as ‘Stock’.
At the end of the accounting period it is called ‘Closing Stock’ and the same on the first day of the
next accounting period is known as ‘Opening Stock’.
 Transaction: A transaction is a business dealing entered into by a trader with his customer or
supplier. A transaction necessarily involves two parties. In every transaction, one of the two parties
is the receiver of the benefit and the other party is the giver of the benefit.
 Entry: ‘Entry’ means the recording of a business transaction in the books of accounts.
 Creditors: Whenever the purchases are made on credit, the persons who supply such goods are
known as ‘Creditors’.
 Debtors: The persons who take the goods and services on credit are called the ‘Debtors’.
 Discount: When an allowance is allowed by the trader to his customer from the amount of the
saleable goods or from the receivable amount of cash it is known as ‘Discount’. When it is allowed
from the amount of saleable goods, it is called ‘Trade Discount’ and when it is allowed from the
receivable amount of cash, it is called ‘Cash Discount’.
 Assets: Anything of value owned by a person or business is known as ‘Assets’.
 Liabilities: Anything owed, a debt, the claim of an outsider against the business is called a ‘Liability’.
 Drawings: The amount or the goods which are withdrawn from the business by the proprietor is
known as his drawings.
 Turnover: The total sales during a particular period-cash and credit sales are known as ‘Turnover’.
 Account: An account is a summarized record and systematic arrangement of transaction for a
period affecting one person, one kind of property or one class of gains and losses.
 Bad Debts: If the debtor is unable to make the payment standing in his name it is called ‘Bad
Debts’.
 Insolvent: If a person is unable to redeem his loan, he is treated as insolvent. The liabilities of such
person are more than the assets and he is not in a position to make full payments for the debts taken.

1. What do you meant by double-entry system of accounting? State the rules of debit and credit.
2. If the capital of a business is Rs. 2, 40,000 and liabilities are Rs. 40,000, calculate the total assets
of the business.
[Ans. 2, 80,000]
3. What entry (debit or credit) would you make to:-
(a) increase in revenue;
(b) decrease in expense;
(c) record drawings;
(d) Record the fresh capital introduced by the owner.
[Ans. (a) credit; (b) credit; (c) debit in capital account, (d) credit in capital account.]
4. The position of a businessman on 31st Mar, 2010 was as follows:-
Cash Rs. 5,000; Debtors Rs. 20,000; Machinery Rs. 60,000; Stock Rs. 25,000; Capital Rs.
75,000. Calculate his liabilities.
[Ans. Rs. 35,000]
5. If a transaction has the effect of decreasing an asset, is the decrease recorded as a debit or as a
credit? If the transaction has the effect of decreasing a liability, is the decrease recorded as a debit
or as a credit?
[Ans. Decrease in asset will be recorded on credit side; Decrease in liability will be recorded on
debit side.]
6. A commenced business on 1st April, 2009 with a capital of Rs. 1,00,000. On 31st Mar, 2010, his
assets were worth Rs. 1, 60,000 and liabilities Rs. 15,000. Find out his closing capital and profits
earned during the year.
[Ans. Closing capital= Rs. 1, 45,000; Profit= Rs. 45,000]
7. Prove that the accounting equation is satisfied in all the transactions of M/s RamTraders:-
Rs.
(a) Started business with cash 50,000
(b) Bought furniture for 500
(c) Purchased goods on credit 4,000
(d) Sold goods on cash (cost Rs. 500) for 700
(e) Received rent 200
(f) Purchased goods for cash 1,000
(g) Withdrew for personal use 700
(h) Paid to creditors 400
(i) Paid for salaries 200
[Ans. Cash Rs. 48,100; furniture Rs. 500; stock Rs. 4,500; creditors Rs. 3,600;
capital Rs. 49,500.]
8. Use accounting equation to show the effect of the following transactions of M/s Ajay Traders:-
Rs.
(a) Started business with cash 1, 20,000
(b) Purchased goods for cash 10,000
(c) Rent received 5,000
(d) Salary outstanding 2,000
(e) Prepaid insurance 1,000
(f) Received interest 700
(g) Sold goods for cash (costing Rs. 5,000) 7,000
(h) Goods destroyed by fire 500
[Ans. Cash Rs. 1, 21,700; stock Rs. 4,500; prepaid exp. Rs. 1,000; outstanding exp. Rs.
2,000; capital Rs. 1, 25,200.]
Hint. Salary outstanding is salary due but not paid, thus is a liability of the firm.Prepaid insurance
is insurance paid but not due, thus is an asset of the firm.Goods destroyed by fire will result
in decrease in stock and decrease in capital.
9. (a) A commenced business on 1st Jan. 2009 with a capital of Rs. 5, 00,000 and a loan
of Rs. 1, 00,000 borrowed from Citi Bank. On 31st Dec. 2009, his assets were Rs.
8,00,000. Calculate his closing capital and profits earned during the year.
(b) If in the above case, the proprietor had introduced fresh capital of Rs. 40,000 and
had withdrawn Rs. 10,000 for personal purposes, calculate his profits.
[Ans. (a) Closing capital Rs. 7, 00,000; profit Rs. 2, 00,000.
(b) Profit Rs. 1, 70,000.]
10. Mohit has the following transactions, prepare accounting equations:-
Rs.
(a) Business started with cash 1, 75,000
(b) Purchased goods from Rohit 50,000
(c) Sold goods on credit to Manish (costing Rs. 17,500) 20,000
(d) Purchased furniture for office use 10,000
(e) Cash paid to Rohit in full settlement 48,500
(f) Cash received from Manish 20,000
(g) Rent paid 1,000
(h) Cash withdrew for personal use 3,000
[Ans. cash Rs. 1, 32,500; stock Rs. 32,500; furniture Rs. 10,000; capital Rs. 1, 75,000.]
11. Y started a business on 1st Jan. 2009 with a capital of Rs. 2, 00,000 and a loan of Rs. 75,000 from
the bank. During the year, he had introduced additional capital of Rs. 60,000 and had withdrawn
Rs. 36,000 for personal purposes. On 31st Dec. 2009 his assets were Rs. 3, 80,000. Find out his
capital as on 31st Dec. 2009 and profit earned during the year 2009.
[Ans. closing capital Rs. 3, 05,000; profit Rs. 81,000.]
3.8 Reference Books

Paul, S. Kumar, Book-keeping and Accountancy
Grewal Shukla, Accountancy
Monga, J.R., Foundation Accountancy
Grewal T.S., Double Entry Book-keeping
Unit - 4 Journal and Ledger
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Types of Accounts
4.3 Journalisation
4.4 Recording of Special Transactions
4.5 Purchase Day Book
4.6 Sales Day Book
4.7 Cash Book
4.8 General Ledger
4.9 Summary
4.10 Key Words
4.0 Objectives
 Types of Accounts
 Meaning and Format of Journal
 Rules of Journalising
 Recording of Entries in a Journal
 Recording of Transactions in Special Purpose Subsidiary Books
- Purchase Day Book
- Sales Day Book
- Cash Book
 Posting from Journal to Ledger
4.1 Introduction
The ultimate objective of the financial accounting is to prepare two basic financial statements: the
income statement and the balance sheet. The accounting process helps in achieving that objective.
The details of each business transaction are first entered in source documents. Then there is recording
of economic effects of each business transaction chronologically in the journal before posting to the ledger
accounts pertaining to persons, properly, expenses and gains. Trial balance is extracted form the ledger
which is base for financial statements.
4.2 Types of Accounts

 Types of Accounts
An account is a summarized record of business transactions and affects a particular type of asset,
liability or capital. Recording of business transaction in an account is called entry. For the purpose of
recording, these transactions are classified into- (i) personal transactions; (ii) transactions related to assets,
properties and liabilities; and (iii) transactions related to expenses, losses, income and gain. Based on this
classification of transactions, the accounts are classified as shown in the chart given below:-
ACCOUNTS
PERSONAL ACCOUNTS IMPERSONAL ACCOUNTS
NATURAL ARTIFICIAL REPRESENTATIVE REAL NOMINAL
TANGIBLE INTANGIBLE
Figure - 4.1
4.2.1 Personal Accounts
The accounts which relate to an individual, firm, company or an institution are called personal
accounts. Accounts of Mohan, Account of D. C. M. Ltd., Account of Delhi University, Bank Account,
Capital Account of the proprietor, Drawings Account of the proprietor etc., are examples of Personal
Accounts. Personal Accounts can be classified into the following three categories:-
(a) Natural Personal Accounts: Accounts of ‘Natural Persons’ means the accounts of human beings.
For example, Mohan A/c, Sohan A/c, Proprietor’s Capital A/c, Debtors A/c, Creditors A/c are
also included in this category.
(b) Artificial Personal Accounts: These accounts do not have physical existence as human beings
but they work as personal accounts. These are treated as artificial persons for the recording of
personal transactions. For example, any Firm’s account, any Company’s account, accounts of
government departments, any bank’s account, etc.
(c) Representative Personal Accounts: When an account represents a particular person or group
of persons, it is termed as a representative personal account. For example, if the salaries for the
month of December are not paid to the employees, the amount payable to theses employees will be
added and put under one common title “Salaries outstanding account”. This account represents the
accounts of all the persons to whom salaries have to be paid. This is therefore known as
“Representative Personal account”. Other examples are Prepaid Insurance Account, Unearned
Commission Account.
4.2.2 Real Accounts
The accounts of all those things whose value can be measured in terms of money and which are the
properties of the business are termed as Real Accounts, such as Cash Account, Furniture Account, Goodwill
Account, etc. These are of two types:-
(a) Tangible Real Accounts: These are the accounts of those things which can be touched, felt,
measured, etc. Examples are Cash Account, Stock Account, Furniture Account, etc.
(b) Intangible Real Account: These accounts represent such things which cannot be touched, but of
course their value can be measured in terms of money. For example, Goodwill Account, Patent
Account.
4.2.3 Nominal Accounts
These accounts include the accounts of all expenses and incomes. Examples - salaries paid, rent
paid, bad debts, etc.
 Debit credit rules:
Classification Debit-Credit Rules
Personal Account Debit the receiver and Credit the giver
Real Account Debit what comes in and Credit what goes out
Nominal Account Debit expenses and losses and Credit revenue and
gains
Activity
Bank Account and prepaid insurance account are in the nature of ......................account.
Illustration 4.2.1:
Analyze the following transactions, according to double entry system:
(a) Ram started business with cash
(b) Purchased furniture
(c) Purchased goods for cash
(d) Sold goods for cash
(e) Received cash from Shayam
(f) Deposited into bank
(g) Withdrew from bank for office use
(h) Received a cheque from a customer Shayam
(i) Withdrew from bank for personal use
(j) Withdrew cash for personal use
(k) Sold goods to Shayam on credit
(l) Purchased goods from Raman on credit
(m) Purchased furniture from Mohan on credit
(n) Borrowed from Mahesh
(o) Deposited Shayam’s cheque next day
(p) Paid Raman by cheque
(q) Paid salary
(r) Paid rent by cheque
(s) Goods withdrawn for personal use
Trans- Accounts involved Nature of How affected Whether to

actions accounts be debited or
involved credited
(a) Cash A/c Real Cash is coming in. Debit
Capital A/c Personal Ram is the giver to the business. Credit
(b) Furniture A/c Real Furniture is coming in. Debit
Cash A/c Real Cash is going out. Credit
(c) Purchases A/c Real Goods are coming in. Debit
(d) Cash A/c Real Cash is coming in. Debit
Sales A/c Real Goods are going out. Credit
(e) Cash A/c Real Cash is coming in. Debit
Shayam A/c Personal Shayam is the giver. Credit
(f) Bank A/c Personal Bank is the receiver. Debit
(g) Cash A/c Real Cash is coming in. Debit
Bank A/c Personal Bank is the giver. Credit
(h) Cash A/c Real Cash (in the form of cheque) is Debit
coming in.
Shayam A/c Personal Shayam is the giver. Credit
(i) Drawings A/c Personal Ram is the receiver. Debit
(j) Drawings A/c Personal Ram is the receiver. Debit
(k) Shayam’s A/c Personal Shayam is the receiver. Debit
Sales A/c Real Goods are going out. Credit
(l) Purchases A/c Real Goods are coming in. Debit
Raman’s A/c Personal Raman is the giver. Credit
(m) Furniture A/c Real Furniture is coming in. Debit
Mohan’s A/c Personal Mohan is the giver. Credit
(n) Cash A/c Real Cash is coming in. Debit
Loan from Mahesh is the giver.
Mahesh A/c Personal Credit
(o) Bank A/c Personal Bank is the receiver. Debit
Cash A/c Cash (in the form of cheque) is
Real going out. Credit
(p) Raman’s A/c Personal Raman is the receiver. Debit
(q) Salary A/c Nominal Salary is an expense. Debit
(r) Rent A/c Nominal Rent is an expense. Debit
(s) Drawings A/c Personal Ram is the receiver. Debit
Purchases A/c Real Goods are going out. Credit
Activity
1. Patent account is a ........................................ account.
2. Rule for Nominal account is :
4.3 Journalisation
4.3.1 General Principles
There are four phases in the accounting process:
1. Journalisation of transactions and events.
2. General ledger posting and balancing.
3. Preparation of a Trial Balance.
4. Preparation of Final Account, i. e., the Profit and Loss A/c and the Balance Sheet.
In the first phase, the transactions and events are analysed and recorded in the journal. Accountants
use different types of journals, listed hereinafter, for recording different types of transactions and events.
1. Purchase day book : To record transactions relating to credit purchases of goods
in trade.
2. Sales day book : To record transactions relating to credit sales.
3. Purchase return book : To record transactions relating to purchase returns.
4. Sales return book : To record transactions relating to sales return.
5. Cash book : To record cash, bank and discount transactions.
6. Journal proper : To record other transactions for which no specific journal is
mentioned, and for recording entries to rectify mistakes in
books of accounts.
Transactions and events are recorded in the journal in chronological order. The ledger folio in which
the transaction is posted in the general ledger is entered in the journal for cross referencing. In addition, the
‘Journal Proper’provides a brief narration of the transaction or the event. Papers or documents that evidence
of the transaction or event should support each entry in the journal. Those papers and documents are
known as Vouchers.
4.3.2 Journal
The business transactions, after their analysis, are listed in a chronological order day-by-day and
first recorded in a book of accounts called journal. A journal is a chronological record of accounting
transactions showing the names of accounts that are to be debited or credited, the amounts of the debits and
credits, and any useful supplementary information about the transaction. Journal is referred to as book
of original or prime entry or simply subsidiary book. A journal is a form of diary for business transactions.
Functions of journal:-
(i) To keep a chronological (i.e., date-wise) record of all transactions.
(ii) To analyse each transaction into debit and credit aspects by using double entry system of book-
keeping.
(iii) To provide a basis for posting into ledger.
(iv) To maintain the identity of each transaction by keeping a complete record of each transaction at
one place on a permanent basis.
The format of journal is shown as follows:-
Date Particulars L.F.No. Dr. Cr.

Amount (Rs.) Amount (Rs.)
(1) (2) (3) (4) (5)
The columns have been numbered only to show how the Journal is written up; otherwise the columns
are not numbered.
1. Date Column: This column shows the date on which the transaction is recorded. The year and the
month are written once, till they change.
2. Particulars Column: Under this column, first the names of the accounts to be debited, then the
names of the accounts to be credited and lastly, the narration (i.e., a brief explanation of the
transaction) are entered.
3. L. F. i.e. Ledger Folio Column: All entries from the journal are later posted into the ledger
accounts. The page number or folio number of the ledger account where the posting has been made
from the journal is recorded in the L.F. column of the journal.
4. Debit Amount Column: Under this column, the amount to be debited is entered.
5. Credit Amount Column: Under this column, the amount to be credited is entered.
4.3.3 Journalising
The process of recording a transaction in the journal with the help of debit-credit rules of the double
entry system is called Journalising. The various steps to be followed in journalising business transactions are
given below:
 Step 1: Ascertain what accounts are involved in a transaction.
 Step 2: Ascertain what the nature of the accounts involved is.
 Step 3: Ascertain which rule of Debit and Credit is applicable for each of the accounts involved.
 Step 4: Ascertain which account is to be debited and which is to be credited.
 Step 5: Record the date of transaction in the ‘Date column’.
 Step 6: Write the name of the account to be debited, very close to the left hand side i.e. the line
demarcating the ‘Date column’ and the ‘Particulars column’ along with the abbreviation ‘Dr.’ on the
same line against the name of the account in the ‘Particulars column’, and the amount to be debited
in the ‘Debit Amount Column’ against the name of the account.
 Step 7: Write the names of the account to be credited in the next line preceded by the word ‘To’ at
a few spaces towards right in the ‘Particulars column’ and the amount to be credited in the ‘Credit
Amount Column’ against the name of the account. The modern practice shows inclination towards
omitting “Dr.” and “To”.
 Step 8: Write ‘Narration’ (i. e. a brief description of the transaction) within brackets in the next line
in the ‘Particulars column’.
 Step 9: Draw a line across the entire ‘Particulars column’ to separate one journal entry from the
other.
Illustration 4.3.1
Record the following transactions in the journal of V:-
2010 Rs.
May 1 Commenced business with cash 5, 00,000
2 Goods purchased from M for cash 50,000
3 Goods purchased from A 1, 20,000
4 Goods returned to A 5,000
8 Goods sold to R 40,000
12 R returned 10% of goods
Solution:
Journal of V
Date Particulars L. F. Dr. Cr.
No. Amount (Rs.) Amount (Rs.)
2005 Cash A/c Dr. 5, 00,000
May 1 To Capital A/c 5, 00,000
(Amount brought in by V as Capital)
May 2 Purchases A/c Dr. 50,000
To Cash A/c 50,000
(Goods purchased from M for cash)
May 3 Purchases A/c Dr. 1, 20,000
To A A/c 1, 20,000
(Goods purchased from A)
May 4 A A/c Dr. 5,000
To Purchases Return A/c 5,000
(Goods returned to A)
May 8 R A/c Dr. 40,000
To Sales A/c 40,000
(Goods sold to R)
May 12 Sales Return A/c Dr. 4,000
To R A/c 4,000
(10% of goods sold to R returned by
him: 10% of 40,000 = Rs. 4,000)
Total Rs. 7, 19,000 7, 19,000
4.3.4 Compound Journal Entries

The business transactions recorded in above illustration 2 are examples of single entry in which only
two accounts are affected viz., one account to be debited and another to be credited with an equal amount.
On the other hand, when more than two accounts are involved in a transaction and the transaction is
recorded by a single journal entry instead of passing several journal entries, such single journal entry is
termed as ‘compound journal entry’. In a compound entry, there may be-
(a) Several accounts to be debited and only one to be credited; or
(b) One account to be debited and several others to be credited; or
(c) Several accounts are to be debited and several others to be credited.
Journal entries falling within classes (a) and (b) above are generally termed as ‘single compound
entries and those in class (c) are generally termed as ‘double compound entries’.
A compound entry should never be made in order to combine two entries which are
not related or which did not occur on the same date or where there is no common
account to be debited ( or credited) in more than one instance.
Illustration 4.3.2:
Journalise the following transactions:
2010
June 1 Purchased goods worth Rs. 300 from Vimal and Rs. 500 from Kamal on credit.
June 3 Sale of goods worth Rs. 1,000 to Balram and Rs. 700 to Dhanram.
June 5 Cash of Rs. 900 received from Ramasamy and Rs. 800 from Krishnasamy.
June 7 Paid Rs. 800 to Pradeep and Rs. 500 to Kuldeep.
June 9 Withdrawn from bank Rs. 600 for office use and Rs. 300 for personal use.
Solution:
Journal
Date Particulars L.F. Dr. Cr.
2010
June 1 Purchases A/c Dr. 800
To Vimal A/c 300
To Kamal A/c 500
(Purchased goods worth Rs. 300
from Vimal and Rs. 500 from Kamal
on credit)
June 3 Balram’s A/c Dr. 1,000

Dhanram’s A/c Dr. 700
To Sales A/c 900
(Sale of goods worth Rs. 1,000 to
Balram and Rs. 700 to Dhanram)
June 5 Cash A/c Dr. 1,700

To Ramasamy’s A/c 900
To Krishnasamy’s A/c 800
(Cash of Rs. 900 received from Ramasamy and Rs.
800 from Krishnasamy)
June 7 Pradeep’s A/c Dr. 800

Kuldeep’s A/c Dr. 500
To Cash A/c 1,300
(Paid Rs. 800 to Pradeep and Rs. 500 to Kuldeep)
June 9 Cash A/c Dr. 600

Drawings A/c Dr. 300
To Bank A/c 900
(Withdrawn from bank Rs. 600 for office use and
Rs. 300 for personal use)
4.4 Recording of Special Transactions

(1) Trade Discount: Trade discount is allowed by the seller of the goods to the buyer of the goods at
a certain percentage of the catalogue or price list. It is not recorded in the books. Both, the seller
and the buyer, make the entries in their books with the net amount of the goods, i.e. after deducting
the amount of trade discount from the list price of the goods. If any goods from such goods are
returned by the buyer, the entries for the returned goods will be made with the net amount after
deducting the trade discount. For example, if a trader sales goods of the list price of Rs. 10,000 at
20% trade discount for cash, the entry will be:-
Cash A/c Dr. 8,000
To Sales A/c 8,000
(2) Cash Discount: Generally, goods are bought or sold on credit. In the case of credit sales, the
purchaser is expected to pay the amount due to the seller within a fixed period. To encourage the
buyer to make his payment within the stipulated period, the seller may allow the customer a certain
deduction from the amount due from him. This deduction is called ‘cash discount’. It is recorded in
the books. It is worth while to note that cash discount is calculated on the amount, which is arrived
at by deducting trade discount out of the total amount of sale. For example, if a trader sells goods
of the list price of Rs. 20,000 at 10% trade discount and 2% cash discount, the net amount will be
calculated as under:
Rs.
List price 20,000
Less: trade discount @ 10% 2,000
18,000
Less: cash discount @ 2% (18,000 * 2%) 360
17,640
It means that Rs. 17,640 will be paid if the payment is made in cash.
(3) Withdrawal of goods from the business by the proprietor: The proprietor of the business,
sometimes, takes goods from the business for his personal use like cash. In this respect the following
entry is made:
Drawings A/c Dr.
To Purchases A/c
(Goods taken away for personal use)
(4) Goods given in charity: Sometimes, the proprietor gives away in charity. Thus, goods given in
charity is not treated as sale, hence it is a deduction in the amount of purchased goods. The entry is
made as follows:
Donations/Charity A/c Dr.
To Purchases A/c
(Goods given away in charity)
(5) Distribution of free samples: A trader distributes free samples of goods for the purpose of
promoting sales. The cost of free samples so distributed is debited to ‘Advertisement or Publicity
A/c’ and credited to ‘Purchases A/c’.
(6) Loss of goods on theft or other reasons: Sometimes when goods are stolen from the business
or goods are damaged by fire, or on any other account, there is a loss to the goods. Such a loss is
considered as a business loss. In this case, ‘Loss on theft A/c’ or ‘Loss by fire A/c’ is debited, and
‘Purchases A/c’ is credited.
(7) Bad debts: When any debtor does not pay the amount due from him on account of his insolvency
or due to some other cause, it becomes irrecoverable and it is known as ‘bad debt’. In this situation
the following entry is passed:
Bad debts A/c Dr.
To Debtors Personal A/c
(The amount of bad debts)
(8) Bad debts recovered: When any amount is debited to bad debts account previously, treating it as
irrecoverable and later on if it is recovered, the following entry is made in this respect:
Cash A/c Dr.
To Bad debts recovered A/c
(Bad debts recovered)
(9) On insolvency of a debtor: When any debtor becomes insolvent, the full payment cannot be
realized from the property of the insolvent debtor; only partial payment is received and it is called
‘Dividend’. Hence for whatever amount that is not realized; the entry in the books is made, treating
it as bad debt.
Activity
Goods sold for Rs. 20000 at a trade discount 10% and cash discount 5% write down the
Journal entry for the same.
Illustration 4.4.1
Record the following transactions of A & Co. in the journal proper form:
2010 Rs.
Jan 1 Assets: Cash in hand 500
Cash at bank 8,000
Stock of goods 4,000
Machinery 20,000
Furniture 5,000
Roy & Co. (amount due to A & Co.) 2,000
Sen & Co. (amount due to A & Co.) 3,000
Liabilities: Loan from State Bank of India (SBI) 10,000
Amount due to Vishwanath & Co. 5,000
Jan 2 Bought goods on credit from Patel & Co. 2,000
Jan 3 Sold goods for cash to Bose & Co. 500
Jan 4 Sold goods to Roy & Co. on credit 1,000
Jan 5 Received from Roy & Co. in full settlement of amount due on Jan 1 1,900
Jan 6 Payment made to Vishwanath & Co. by cheque
(Vishwanath & Co. allowed discount of Rs. 50) 4,950
Jan 8 Old furniture sold for cash (Book value Rs. 300) 350
Jan 10 Bought goods for cash 1,000
Jan 11 Received cheque from Sen & Co., deposited in bank 3,000
Jan 12 Paid for repairs to machinery 200
Jan 13 Bought goods from Vishwanath & Co. on credit 2,000
Paid cartage on these goods 100
Jan 14 Received cheque from Roy & Co., deposited in bank
(discount allowed to them Rs. 50) 950
Jan 17 Paid cheque to Vishwanath & Co. 2,000
Jan 18 Bank intimates that cheque received from Roy & Co. has been
returned unpaid 950
Jan 19 Sold goods for cash to Dey & Co. 2,000
Jan 21 Cash deposited in bank 1,000
Jan 22 Paid municipal taxes in cash 100
Jan 25 Borrowed from New Age Investment Co., for erecting own
Premises (amount deposited with bank) 20,000
Jan 26 Paid for advertisements 500
Jan 29 Sold old newspapers 50
Jan 31 Paid rent by cheque 500
Paid salaries for the month 500
Drawn by Mr. A out of the bank for personal use 500
Solution:
Journal
Date Particulars L. F. Dr. Cr.
2010
Jan 1 Cash A/c Dr. 500
Bank A/c Dr. 8,000
Stock A/c Dr. 4,000
Machinery A/c Dr. 20,000
Furniture A/c Dr. 5,000
Roy & Co. A/c Dr. 2,000
Sen & Co. A/c Dr. 3,000
To Loan from SBI A/c 10,000
To Vishwanath & Co. 5,000
To Capital A/c (balancing fig.) 27,500
(being the assets and liabilities brought
forward from the previous reporting
period)
Jan 2 Purchases A/c Dr. 2,000
To Patel & Co. A/c 2,000
(Bought goods on credit from Patel & Co.
as per bill no….)
To Sales A/c 500
(Sold goods for cash to Bose & Co. as per
cash memo no…)
Jan 4 Roy & Co. A/c Dr. 1,000
To Sales A/c 1,000
(Sold goods to Roy & Co. on credit as per
invoice no…)
Jan 5 Cash A/c Dr. 1,900
Discount A/c Dr. 100
To Roy & Co. A/c 2,000
(Received from Roy & Co. in full settlement
of amount due on Jan 1)
Jan 6 Vishwanath & Co. A/c Dr. 5,000
To Bank A/c 4,950
To Discount A/c 50
(being the amount paid by cheque to
Vishwanath & Co. towards settlement of Rs.
5,000)
To Furniture A/c 300
To Profit on sale of furniture A/c 50
(being profit on sale of old furniture, book
value Rs. 300, payment received in cash)
To Cash A/c 1,000
(being purchase of goods for cash as per cash
memo no…)
Jan 11 Bank A/c Dr. 3,000
To Sen & Co. A/c 3,000
(being cheque no… received from Sen & Co.
and deposited in bank)
Jan 12 Repairs to Machinery A/c Dr. 200
To Cash A/c 200
(being the amount paid for repairs to
machinery as per bill no….)
To Vishwanath & Co. A/c 2,000
(being goods purchased from Vishwanath &
Co. as per invoice no….)
Jan 13 Freight Inward A/c Dr. 100
To Cash A/c 100
(being freight paid on goods purchased from
Vishwanath & Co.)
Jan 14 Bank A/c Dr. 950
Discount A/c Dr. 50
To Roy & Co. A/c 1,000
(being amount received from Roy & Co. vide
cheque no… dated… drawn on…., discount
allowed Rs. 50)
Jan 17 Vishwanath & Co. A/c Dr. 2,000
To Bank A/c 2,000
(being amount paid to Vishwanath & Co. vide
cheque no…dated…drawn on…)
Jan 18 Roy & Co. A/c Dr. 1,000
To Bank A/c 950
To Discount A/c 50
(being cheque no…dated…drawn on….
received from Roy & Co., returned by bank
unpaid)
Jan Cash A/c Dr. 2,000
19 To Sales A/c 2,000
(being goods sold for cash to Dey & Co. vide
cash receipt no….)
Jan Bank A/c Dr. 1,000
21 To Cash A/c 1,000
(being cash deposited with bank)
Jan Municipal Taxes A/c Dr. 100
22 To Cash A/c 100
(being municipal taxes paid vide cash memo
no…)
Jan Bank A/c Dr. 20,000
25 To loan from New Age Investment Co 20,000
(being amount borrowed for erecting old
premises, received vide cheque
no…dated….drawn on…..)
Jan Advertisements A/c Dr. 500
26 To Cash A/c 500
(being amount paid towards advertisement in
…. Vide cash memo no….)
Jan Cash A/c Dr. 50
29 To Sale of newspapers A/c 50
(being old newspapers sold)
Jan Rent A/c Dr. 500
31 To Bank A/c 500
(being Rent for the month of Jan, paid vide
cheque no…dated…drawn on….)
Jan Salaries A/c Dr. 500
31 To Cash A/c 500
(being salaries for the month of Jan., paid)
Jan Capital A/c Dr. 500
31 To Bank A/c 500
(being amount drawn by Mr. A for private use
vide cheque no… dated…. Drawn…)
In Illustration 4.4.1, we recorded all types of transactions in a ‘Journal Proper’. However, in practice,
cash and bank transactions are recorded in a Cash Book, credit purchases are recorded in a Purchase Day
Book, credit sales are recorded in a Sales Day Book, and only the following types of transactions are
recorded in the ‘Journal Proper’:
1. Opening entries: At the commencement of the reporting period, opening balances of assets, liabilities
and equity are journalized to record carry forward balances in the books of accounts for the period.
2. Closing entries: At the close of the reporting period, while preparing the profit and loss account
revenue, gain, expense and loss accounts are closed by transferring their balances in the general
ledger to the profit and loss account through the journal proper.
3. Rectification entries: An error occurred while recording a transaction or event is rectified through
the journal proper.
4. Transfer entries: Transfer from one account head to another account head is made through the
journal proper.
5. Adjustment entries: At the close of a reporting period, expenses and revenue are adjusted to match
expenses with revenue for the period. Usually, those entries pertain to outstanding expenses, prepaid
expenses, interest on capital and depreciation. Adjustment entries are recorded in the journal proper.
6. Dishonouring of cheques and other negotiable instruments: Non-payment or dishonouring of
negotiable instruments (promissory notes, bill of exchange and cheques) is taken on record through
the journal proper.
7. Miscellaneous entries: Transactions other than credit purchases, credit sales and cash and bank
transactions are recorded through the journal proper.
4.5 Purchase Day Book

In view of the large number of transactions, a separate journal entitled, ‘purchase day book’ is
maintained by enterprises to record credit purchases. However, credit purchases, other than purchases of
stock-in-trade or materials being used in the manufacturing process, are not recorded in the ‘purchase day
book’. Similarly, cash transactions are not recorded in this journal.
Enterprises also maintain a ‘purchase return book’ to record return of goods to suppliers.
Illustration 4.5.1 presents the format of a ‘purchase day book’.
Illustration 4.5.1: A & Co. deals in ladies garments. The rough book of the firm shows the following
transactions for the month of Jan 2010.
Jan 1 Purchased from B & Co. on credit:
10 cotton salwar suits @ Rs. 500 per suit
10 silk salwar suits @ Rs. 1,500 per suit
Less: Trade discount @ 10%
Jan 10 Purchased in cash from C & Co.:
Jan 15 Purchased a calculator for office use from B & Co. on credit for Rs. 500
Jan 20 Purchased from Y & Co. on credit:
10 cotton sarees @ Rs. 600 per saree
10 silk sarees @ Rs. 2,000 per saree
Jan 31 Purchased 10 cotton suit lengths @ Rs. 300 per suit length from Z & Co. on credit
Prepare the purchase day book of A & Co. for the month of Jan 2010.
Solution:
Purchase Day Book Of A & Co.
Date Particulars L. F. Amount (Rs.) Net Amount (Rs.)
Jan. 1 M/s B & Co.
2010 10 cotton salwar suits @ Rs. 500 5,000
10 silk salwar suits @ Rs. 1,500 15,000
20,000
Trade discount @ 10% (2,000) 18,000
Jan. 20 M/s Y & Co.
10 cotton sarees @ Rs. 600 6,000
10 silk sarees @ Rs. 2,000 20,000
26,000
Trade discount @ 10% (2,600) 23,400
Jan. 31 M/s Z & Co.
10 cotton suit lengths @ Rs. 300 3,000
Total 44,400
Note: Transactions pertaining to cash purchase (Jan 10) and credit purchase of calculator (Jan 15)
have not been recorded in the purchase day book.
The total of the purchase day book is posted to the general ledger through the journal proper
periodically. The journal entry for Jan 2010 (illustration 4.5.1) should be as follows:
Dr. Cr.
Purchases A/c Rs. 44,400
To B & Co. A/c Rs. 18,000
To Y & Co. A/c Rs. 23,400
To Z & Co. A/c Rs. 3,000
Usually, the number of transactions being large, personal accounts of individuals creditors is not
maintained in the general ledger. Personal accounts of individuals creditors are maintained in a subsidiary
ledger that does not form a part of the main books of accounts. Only the control account of creditors is
maintained in the general ledger. The balance in the control account entitled ‘trade creditors account’,
reflects the amount of liability towards suppliers of goods. The journal entry from the purchase day book
should be as follows:
Purchases A/c Dr. Rs. 44,400
To Trade creditors A/c Rs .44,400
Individual accounts in the subsidiary ledger are posted from the purchase day book for each
transaction. The aggregate of balances in individual accounts in the subsidiary ledger should agree with the
balance appearing in the ‘Trade creditors account’ in the general ledger.
Subsidiary ledgers, which do not form part of the main books of accounts, are known as memorandum
books, because accounting entries in those ledgers do not form a part of the double entry accounting
system. Subsidiary ledgers are usually maintained for ‘Trade debtors’, ‘Advance to employees’, ‘Advances
from customers’ and such other credit transactions where a large number of personal accounts are required
to be maintained by the firm.
4.6 Sales Day Book

Enterprises record credit sales of stock-in-trade in a ‘Sales Day Book’. The mechanics of posting
entries from the sales day book to the general ledger and the subsidiary ledger for debtors are similar to
those of postings from the purchase day book. The following illustration presents the format of a sales day
book:
Illustration 4.6.1:
A & Co.deals in ladies’ garments. The rough book of the firm shows the following transactions for the
month of Jan 2010.
Jan 2 Sold to Alpha & Co. on credit:
Jan 3 Sold old furniture to M & Co. for Rs. 100 on credit
Jan 8 Sold to Beta & Co. on credit:
Jan 15 Sold 2 silk sarees to M/s. Beauty for Rs. 2,500 in cash
Jan 31 Sold to Gamma & Co. on credit:
10 cotton sarees @ Rs. 800 per saree
10 silk sarees @ Rs. 2,500 per saree
Prepare the sales day book of A & Co. for the month of Jan 2010.
Solution:
Sales Day Book of A & Co.
Date Particulars L.F. Amounts (Rs.) Net Amount (Rs.)
Jan. 2 M/s Alpha & Co.
2010 5 cotton salwar suits @ Rs. 600 3,000
12,000
Trade discount @ 10% (1,200) 10,800
Jan. 8 M/s Beta & Co.

5 cotton salwar suits @ Rs. 600 3,000
12,000
Trade discount @ 10% (1,200) 10,800
Jan. 31 M/s Gamma & Co.
10 cotton sarees @ Rs. 800 8,000
10 silk sarees @ Rs. 2,500 25,000
33,000
Trade discount @ 10% (3,300) 29,700
Total 51,300
Periodical posting of the total of the sales day book to the general ledger should be made through
the following journal entry:
Trade Receivables A/c Dr. Rs. 51,300
To Sales A/c Rs. 51,300
Postings to personal accounts of trade debtors should be made in the subsidiary ledger for trade
debtors. As in the case of the purchase day book, the aggregate of balances in personal accounts in the
subsidiary ledger should agree with the balance in the ‘Trade receivables account’, in the general ledger.
Enterprises also maintain a ‘Sales Return Book’ to record inward return of goods from customers.
4.7 Cash Book

Cash and bank transactions are recorded direct in the ‘Cash Book’. A cash book is primarily a
journal. It also serves the purpose of a ledger account and, therefore, the cash account and bank account
are not maintained in the general ledger. Balances in the cash book are taken direct to the trial balance that
lists out balances in various account heads in the general ledger. Thus, a cash book serves the dual purpose
of maintaining a journal to record cash and bank transactions, and also maintaining cash and bank accounts
in the general ledger. The following are the different types of cash books that are being maintained by
enterprises:
1. Single-column cash book: It records only cash receipts and cash payments.
2. Double-column cash book: It provides additional information on discount received and discount
allowed.
3. Three-column cash book: It has an additional column to record bank transactions.
The following illustration presents a single column cash book.
Illustration 4.7.1:
Record the following cash transactions entered by A & Co. in Jan 2010 in a single column cash
book:
Rs.
Jan 1 Cash-in-hand 1,000
Jan 6 Received from B & Co. 600
Jan 10 Paid rent 500
Jan 15 Sold goods for cash 2,000
Jan 27 Purchased furniture for cash 1,200
Jan 31 Paid salaries 800
A double-column cash book provides additional information on discount received and discount
allowed. There are additional columns for discount on both debit and credit sides of the cash book. The
total of discount columns are posted in the ‘discount account’ in the general ledger. Illustration 4.7.2 presents
a double-column cash book.
Solution:
Cash Book of A & Co.
Dr. Reciepts Payments Cr.
Date Particulars L. Amount Date Particulars L. Amount
F. (Rs.) F. (Rs.)
2010
Jan.1 To balance b/d 1,000 Jan.10 By rent a/c 500
Jan.6 To B & Co. a/c 600 Jan.27 By furniture a/c 1,200

Jan.15 To sales a/c 2,000 Jan.31 By salaries a/c 800
Jan.31 By balance c/d 1,100
3,600 3,600
Feb.1 To balance b/d 1,100
Illustration 4.7.2: A & Co. commenced business on Jan 1, 2010 with a cash balance of Rs. 2,000 as
capital. It had the following cash transactions for the month of Jan 2010. Prepare the cash book.
Rs.
Jan 1 Purchased furniture 200
Jan 2 Purchased goods 300
Jan 4 Sold goods 400
Jan 6 Paid to B & Co. 500
Allowed discount 20
Jan 15 Received from C & Co. 600
Allowed discount 30
Jan 20 Purchased calculator 200
Jan 31 Paid Salaries 500
Solution:
Cash Book of A & Co.
Dt. Particulars L Discoun Cash Dt. Particulars L Discount Cash
F t (Rs.) (Rs.) F (Rs.) (Rs.)
2010 2010
Jan 1 To Capital A/c 2,000 Jan 1 By Furniture A/c 200
Jan 4 To Sales A/c 400 Jan 2 By Purchases A/c 300
Jan 15 To C & Co. A/c 30 600 Jan 6 By B & Co. A/c 20 500
Jan 20 By Calculator A/c 200
Jan 31 By Salaries A/c 500
Jan 31 By balance c/d 1,500
Total 30 3,000 Total 20 3,000

2010
Feb 1 To balance b/d 1,500
In a three-column cash book, additional columns are provided to enter bank transactions. This
helps to dispense with the ‘bank account’ in the general ledger. However, in case an enterprise operates
more than one bank account, it is better to have a separate ‘bank book’ or ‘bank accounts’ in the general
ledger. Illustration 4.7.3 presents a three-column cash book.
Illustration 4.7.3: A commenced business as A & Co. on Jan 1, 2010 with a cash balance of Rs. 2,000.
Record the transactions for the month of Jan 2010 in a cash book with discount and bank columns.
Rs.
Jan 1 Deposited cash with bank 1,500
Jan 4 Received cheque from B & Co. 1,000
Jan 5 C & Co. is paid by cheque. He allowed a discount of Rs. 20 330
Jan 6 Received cheque from M & Co. after allowing a discount of Rs. 50 450
Jan 10 Goods sold in cash to R & Co. 500
Jan 12 Cash drawn for office use 500
Jan 15 Paid for office expenses in cash 500
Jan 25 Paid salaries for Jan in cash 500
Jan 25 Cheque received from Y & Co. 400
Jan 31 Cheque received from Y & Co. returned unpaid by bank 400
Solution: Cash Book of A & Co.
Dt. Particulars LF Dis. Cash Bank Dt. Particulars L Dis. Cash Bank
(Rs) (Rs.) (Rs.) F (Rs.) (Rs.) (Rs.)
2010 2010
Jan 1 To Capital 2,000 Jan 1 By Bank C 1,500
Jan 1 To Cash C 1,500 Jan 5 By C & Co. 20 330
Jan 4 To B & Co. 1,000 Jan 12 By Cash C 500
Jan 6 To M & Co. 50 450 Jan 15 By Office

expenses 500
Jan 10 To Sales 500 Jan 25 By Salaries 500
Jan 12
To Bank C 500 Jan 31 By Y & Co. 400
Jan 25
To Y & Co. 400 Jan 31 By balance 1,620
c/d 1,000
Total 50 3,000 3,350 Total 20 3,000 3,350

2010
Feb 1 By balance b/d 1,000 1,620
4.7.1 Petty Cash Book

As a matter of convenience, an imprest (a predetermined amount of cash) is sanctioned to some
individuals authorized to make payments of small amounts of high frequency. Examples of such payments
are: postage, conveyance, carriage, and stationery. The individual so authorized maintains a cash book
known as a petty cash book. The individual periodically recoups his ‘imprest’ by submitting an account of
payments released to him during the period. A petty cash book, usually has multiple columns to accommodate
different types of payments.
4.8 General Ledger
After recording transactions in journals, the next phase in the accounting process is to prepare
accounts in the general ledger. A general ledger is the principal book of accounts. Financial statements are
prepared on the basis of balances in ledger accounts at the end of the accounting period. Journal entries
provide information on accounts to be debited and credited in the general ledger. Therefore, journal entries
form the basis for preparing accounts in the general ledger. Periodically, accounts in the general ledger are
balanced. For example, if in a particular account the total of the debit side comes to Rs. 10,000 and the total
of the credit side comes to Rs. 8,000, the account shows a debit balance of Rs. 2,000. Thus, a debit
balance of Rs. 2,000 reflects that the total of the debit side exceeds the total of the credit side by Rs. 2,000.
Illustration 4.8.1 explains the process of posting transactions from journal to accounts in the General Ledger.
Accounts in the general ledger are often termed as Ledger Accounts.
Illustration 4.8.1: From the information provided in Illustration 4.4.1 prepare ledger accounts in the general
ledger of A & Co.
Solution: General Ledger of A & Co.: Capital A/c
Dr. Cr.
Date Particulars L. F. Amount (Rs.) Date Particulars L. F. Amount(Rs.)
2010 2010
Jan 31 To Bank A/c 500 Jan 1 By balance b/d 27,500
31 To balance c/d 27,000
27,500 27,500
Feb 1 By balance b/d 27,000
Cash A/c
Dr. Cr.
Date Particulars L. F. Amount (Rs.) Date Particulars L. F. Amount(Rs.)
2010 2010
Jan 1 Jan 10 By Purchases A/c 1,000
3 To balance b/d 500 Jan 11 By Repairs to
5 To Sales A/c 500 Machinery A/c 200
8 To Roy & Co. 1,900 Jan 13 By Freight Inward
19 To Sundries A/c 350 A/c 100
29 To Sales A/c 2,000 Jan 21 By Bank A/c 1,000
To Sale of Jan 22 By Municipal
newspapers A/c 50 Taxes A/c 100
Jan 26 By Advertisement
A/c 500
Jan 31 By Salaries A/c 500
5,300 5,300
Bank A/c
D r. C r.
D ate Particulars L. F . A mount Date P articulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1 Jan 6 B y V ishwanath & Co 4,950
11 To balance b/d 8,000 Jan 17 B y V ishwanath & Co 2,000
14 To Sen & Co. 3,000 Jan 18 B y R oy & Co . 950
21 To Roy & Co. 950 Jan 31 B y R ent A/c 500
25 To Cash A/c 1,000 Jan 31 B y C apital A/c 500
To Loan fro m Jan 31 B y b alance c/d 24,050
New A ge Inv.
Co. A /c 20,000
32,950 32,950
Stock A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
1 To balance b/d 4,000 Jan 31 By balance c/d 4,000
4,000 4,000
Feb
1 To balance b/d 4,000
Machinery A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan 1
To balance b/d 20,000 Jan 31 By balance c/d 20,000
20,000 20,000
Furniture A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan 1
To balance b/d 5,000 Jan 8 By Cash A/c 300
5,000 5,000
Roy & Co. A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan 1 Jan 5 By Cash A/c 1,900
4 To balance b/d 2,000 Jan 5 By Discount A/c 100
18 To Sales A/c 1,000 Jan 14 By Bank A/c 950
To Bank A/c 950 Jan 14 By Discount A/c 50
Jan 31 By balance c/d 950
3,950 3,950
Feb 1 To balance b/d 950
Sen & Co. A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan 1 To balance b/d 3,000 Jan 11 By Bank A/c 3,000
3,000 3,000
Loan from SBI A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 1 By balance b/d 10,000
10,000 10,000

Vishwanath & Co. A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 1 By balance b/d 5,000
6 To Bank A/c 4,950 Jan 13 By Purchases A/c 2,000
6 To Discount A/c 50
17 To Bank A/c 2,000
7,000 7,000
Purchases A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
2 To Patel & Co. 2,000
10 To Cash A/c 1,000
11 To Vishwanath &
Co. 2,000 Jan 31 By balance c/d 5,000
5,000 5,000
Feb
1 To balance b/d 5,000
Patel & Co. A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 2 By Purchases A/c 2,000
2,000 2,000
Sales A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 3 By Cash A/c 500
Jan 4 By Roy & Co. 1,000
31 To balance c/d 3,500 Jan 19 By Cash A/c 2,000
3,500 3,500

Discount A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 6 By Vishwanath &
5 To Roy & Co. 100 Co. 50
14 To Roy & Co. 50 Jan 31 By balance c/d 100
150 150
Feb
1 To balance b/d 100
Profit on Sale of Furniture A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 8 By Cash A/c 50
31 To balance c/d 50
50 50
Feb 1 By balance b/d 50

Repairs to Machinery A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
12 To Cash A/c 200 Jan 31 By balance c/d 200
200 200
Freight Inward A/c

Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
100 100
Municipal Taxes A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
100 100
Feb
1 To balance b/d 100
Loan from New Age Inv. Co. A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 25 By Bank A/c 20,000
20,000 20,000
Advertisement A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
500 500
Sale of newspapers A/c

Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan Jan 29 By cash c/d 50
31 To balance c/d 50
50 50
Feb.1 By balance b/d 50
Rent A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
31 To bank a/c 500 Jan 31 By balance c/d 500
500 500
Salaries A/c
Dr. Cr.
(Rs.) (Rs.)
2010 2010
Jan
31 To cash a/c 500 Jan 31 By balance c/d 500
500 500
4.9 Summary
In the double entry system, it was stated that it is possible to record all types of business transactions
in the journal in the chronological order before posting then to the ledger. Now-a-days, the vast majority of
transactions are recorded in the special journals such as cash book, purchase day book, sales day book,
cash book etc.
The ledger contains in a summarised and a classified form a permanent record of all business
transactions in the form of various accounts transferred to it from general journal and other books of original
entry.
4.10 Key Words

 Cash Journal: A journal meant for recording all cash transactions.
 Contra Entry: An accounting entry which is recorded on both the debit and credit sides of Cash
Book.
 Imprest: The amount advanced to the petty cashier in the beginning of a period.
1. Prepare proper subsidiary journal (Books) and post to the ledger from the following transactions
for the month of Feb 2010:
2010 Rs.
Feb 1 Goods sold to Sachin for 5,000
Feb 4 Purchased from Kushal Traders for 2,480
Feb 6 Sold goods to Manish Traders for 2,100
Feb 7 Sachin returned the goods for 600
Feb 8 Returns to Kushal Traders 280
Feb 10 Sold to Mukesh 3,300
Feb 14 Purchased from Kunal traders for 5,200
Feb 15 Furniture purchased from Tarun for 3,200
Feb 17 Bought of Naresh 4,060
Feb 20 Return to Kunal Traders for 200
Feb 22 Return Inward from Mukesh 250
Feb 24 Purchased goods from Kirti & Co. for list price of Rs. 5,700,
Less 10% Trade Discount
Feb 25 Sold to Shri Chand goods for Rs. 6,600, less 5% trade discount
Feb 26 Sold to Ramesh Brothers for 4,000
Feb 28 Return Outwards to Kirti & Co. for Rs. 1,000,
Less 10% trade discount
Feb 28 Ramesh Brothers return the goods 500
2. What are the types of accounts? Give two examples of each
3. Write short notes on the following:-
(i) Narration
(ii) Petty Cash Book
(iii) Opening Entry
(iv) Compound Entry

Grewal, T.S., Double - Entry Book-Keeping
Paul, S. Kumar, Book-Keeping and Accountancy
Monga, J.R., Foundation Accountancy
Unit - 5 Trial Balance
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Meaning of Trial Balance
5.3 Features of Trial Balance
5.4 Objectives of Trial Balance
5.5 Preparation of Trial Balance
5.6 Steps to Locate the Errors
5.7 Types of Errors
5.8 Summary
5.9 Key Words
5.9 Self Assessment Questions
5.0 Objectives
After studying this unit, you will be able to
 State the meaning of trial balance
 Assess the characteristics of trial balance
 Enumerate the objectives of preparing trial balance
 Define the preparation of trial balance
 Identify steps to locate the Errors
 Explain the types of Errors
5.1 Introduction
A Trial Balance is a statement, prepared with the debit and credit balances of the ledger accouts to
test the arithmetical accuracy of the books. J.R. Batliboi
All the businessmen after completion of postings from Journal or Subsidiary Books to the Ledger,
want to verify accuracy of the posting. On the basis of principal of accounting we know that for every debit
there will be an equal credit. If the sum of all debits equal the sum of all credits, it is presumed that the
posting to the ledger in terms of debit and credit amounts is accurate. The trial balance is a tool for verifying
the correctness of debit and credit amounts. It is an arithmetical check under the double entry system which
verifies that both aspects of every transaction have been recorded accurately.
5.2 Meaning of Trial Balance
A Trial Balance is prepared after having posted the journal entries into the Ledger and balancing the
accounts. The balance of an account is the difference between the total of the debit side and the total of the
credit side. It is called a ‘Debit Balance’, if the debit side total is greater. vice versa, it is called a ‘Credit
Balance’, if the total of credit side is greater.
A Trial Balance is a statement showing the balances, or total of debit and credit sides of all the
accounts in the Ledger with a view to verifying the arithmetic accuracy of posting into the Ledger accounts.
Trial Balance is an important statement in the accounting process, which shows final position of all accounts
and helps to prepare the final statements.
According to Carter, “Trial Balance is the list of debit and credit balances, taken out from ledger. It
also includes the balances of cash and bank taken from cash book.”
William Pickles defines the Trial Balance as, “The statement prepared with the help of ledger
balances, at the end of financial year (or at any other date) to find out whether debit total agrees with credit
total is called Trial Balance.”
Format of a Trial Balance
Trial Balance of ............ as on March 31, 2010
Account Title L.F. Debit Amount (Rs.) Credit Amount (Rs.)
Total
(i) Trial Balance is prepared on a particular date which should be written on the top.
(ii) In the first column, the name of the account is written.
(iii) In the second column, Ledger folio, i.e., the page number of the Ledger where the balance
appears.
(iv) In the third column, the total of the debit side of the account concerned or the debit balance, if any
is entered.
(v) In the fourth column, the total of credit side or the credit balance is written.
(vi) The two columns are totalled at the end.
5.3 Features of Trial Balance

(i) It is a list of balances of all ledger accounts and the cash book.
(ii) It is just a statement, and not an account.
(iii) It is neither a part of double entry system, nor does it appear in the actual books of accounts. It is
just a working paper.
(iv) It can be prepared at any time during the accounting period, say, at the end of every month, every
quarter, every half year or every year. Usually it is prepared at the end of accounting year before
preparing the final accounts.
(v) It is always prepared on a particular date and not for a particular period.
(vi) It verifies the airthmetical accuracy of posting of entries from the Journal to the Ledger.
(vii) If the books are arithmetically accurate, the total of all debit balances of a trial balance will be equal
to the total of all credit balances.
(viii) A tallied Trial Balance is not a conclusive proof of the accuracy of the books of accounts since
certain type of errors remain even when the Trial Balance tallies. For example, error of principle.
5.4 Objectives of Trial Balance
The Trial Balance is prepared to fulfill the following objectives :
1. To ascertain the arithmetical accuracy of the ledger accounts.
2. To help in locating errors.
3. To help in the preparation of the financial statements.
4. To obtain a summary of the ledger accounts.
(1) To Ascertain the Arithmetical Accuracy of Ledger Accounts
The purpose of preparing a trial balance is to ascertain whether all debits and credits are properly
recorded in the ledger or not and that all accounts have been correctly balanced. It is a list of accounts and
their balances. When the totals of all the debit balances and credit balances in the trial balance are equal, it
is assumed that the posting and balancing of accounts is arithmetically correct. The tallying of the trial
balance is not a conclusive proof of the accuracy of the accounts. It only ensures that both the aspects of
each transaction have been posted into the ledger.
(2) To Help in Locating Errors
When a trial balance does not tally, we know that at least one error has occured. The errors may
have occured at one of those stages in the accounting process : (i) totalling of subsidiary books, (ii) posting
of journal entries in the ledger (iii) calculating account balances, (iv) carrying account balances to the trial
balance (v) totalling the trial balance columns.
If the trial balance does not tally, then the accountant will then proceed to locate such errors. Even
a small difference in the trial balance is to be given the same importance and attention as a large difference
because it is possible that there may be a number of errors which have offset the effect of one another,
resulting in a small composite difference.
(3) To Help in the Preparation of the Financial Statements
Trial Balance is considered as the connecting link between accounting records and the preparation
of financial statements. For the preparation of financial statement, the availability of a tallied trial balance is
the first step. Then the accountant need not refer to the ledger. All revenue and expenses accounts
appearing in the trial balance are transferred to the trading and profit and loss account and all liabilities,
capital and assets accounts are transfered to thebalance sheet. Without trial balance, if it is not impossible
but the work may be difficult.
(4) To Obtain Summary of Ledger Accounts
A trial balance serves as a summary of all the ledger accounts. Scanning the trial balance enables
one to know the assets, liabilities, expenses, incomes etc. The ledger may have to be referred to only when
more detail is required in respect of an account.
Activity - 5-1
1. “A Trial Balance is only a prime facie evidence of the arithmetical accuracy of
records.” - Do you agree with this statement ? Give reason.
2. Trial Balance facilitates the preparation of final accounts. Is it correct ? Give reason.
5.5 Preparation of Trial Balance
A trial balance may be prepared at any time, we can say, at the end of every month, quarter, half-
year or year. Normally it is prepared at the end of the accounting period, so as to verify the arithmetical
accuracy of the ledger accounts before the preparation of final accounts. It is always prepared on a particu-
lar date and not for a particulars period. There are three methods used for the preparation of a trial balance.
(i) Balance Method (ii) Total Amount Method (iii) Total cum Balance Method
5.5.1 Balance Method
To prepare a trial balance under this method, all the accounts showing debit balances in the Ledger
are put on the debit side of the trial balance and the accounts showing credit balances are put on its credit
side. If an account shows no balance, the account is not included in the trial balance. After this process, the
debit and credit columns of the trial balances are totalled and if the total is equal, it is clear that the trial
balance has tallied. In trial balance, normally in place of balances in individual accounts of the debtors, a
figure of sundry debtors is shown, and in place of individual accounts of creditors, a figure of sundry
creditors is shown. This is the commonly used method of preparing a trial balance because it facilitates the
preparation of the final accounts.
Illustration. 1
Given below is a Cash Book and Ledger extracts from the books of Mukesh Bros. as on 30th April
2010 :
CASH BOOK
Date Particulars L.F. Cash Bank Date Particulars L.F. Cash Bank
2010 Rs. Rs. 2010 Rs. Rs.

April To Capital 2,00,000 April By Bank A/c C 1,50,000
1 A/c 2 By Purch- 20,000
To Cash A/c C 1,50,000 4 ases A/c
2 To Sales A/c 24,000 By Machin-
6 To Ravi 4,50,000 12 ery A/c 25,000
20 To Rohit 2,50,000 By Rakesh 4,10,000
22 23 By Rent 4,000
25 By Salar-
30 ies A/c 14,000
2,24,000 8,50,000 1,68,500 4,55,000
By Balance
c/d 55,500 3,95,000
2,24,000 8,50,000 2,24,000 8,50,000
To Balance
b/d 55,500 3,80,000
Capital Account
Date Particulars Folio Amount Date Particulars Folio Amount
2010 Rs. 2010 Rs.

April 30 To Balance c/d 2,00,000 April 1 By Cash A/c 2,00,000
May 1 By Balance b/d 2,00,000
Purchases Account
2010 Rs.
April 4 To Bank A/c 20,000
30 To Sundries as per
Purchases Book 4,70,000
(Credit Purchases)
Sales Account
Rs. 2010 Rs.
April 6 By CashA/c 24,000
30 By Sundries as
per Sales Book
(Credit Sales) 8,30,000
Rakesh
2010 Rs. 2010 Rs.
April 10 To Purchases April 8 By Purchase A/c
Return A/c 2000 (Credit Purchase) 4,70,000
23 To Bank A/c 4,10,000
23 To Balance c/d 58,000
4,70,000 4,70,000
May 1 By Balance b/d 58,000
Ravi
2010 Rs. 2010 Rs.
April 10 To Sales A/c April 20 By Bank A/c 4,50,000
(Credit Sales) 5,30,000 30 By Balance c/d 80,000
5,30,000 5,30,000
Rohit
2010 Rs. 2010 Rs.
April 11 To Sales A/c April 22 By Bank A/c 2,50,000
(Credit Sales) 3,00,000 30 By Balance c/d 50,000
3,00,000 3,00,000
Machinery Account
2010 Rs. 2010 Rs.
April 12 To Bank A/c 25,000 April 30 By Balance c/d 25,000

Rent Account
2010 Rs
April 25 To Cash A/c 4,000
Salaries Account
2010 Rs
April 30 To Cash A/c 14,500
Salaries Account
Rs 2010 By Sundries as per Rs.
April 30 Purchases Return
Book 2,000
You are required to prepare the Trial Balance by the Balance Method.
SOLUTION
Trial Balance of Mukesh Bros.
as on 30th April 2010
Name of Accounts L.F. Balance Balance
Dr. Cr.
Rs. Rs.
Cash A/c 55,500
Bank A/c 3,95,000
Capital A/c
Purchase A/c 4,90,000 2,00,000
Sales A/c
Rakesh 8,54,000
Ravi 80,000 58,000
Rohit 50,000
Machinery 25,000
Rent A/c 4,000
Salaries A/c 14,500
Purchases Return A/c 2,000
Total 11,14,000 11,14,000
5.5.2 Total Amount Method
Under this Method, the total amount of debit side of each ledger account is put on the debit side of
the trial balance and the total amount of credit side of each ledger account is put on this credit side of the trial
balance. The total of debit column of trial balance should agree with the total of credit column in the trial
balance because the accounts are based on double entry system. Under this method trial balance can be
prepared immediately after the completion of posting to the ledger.
ILLUSTRATION 2.
Taking the same particulars as given in Illustration 1, prepare the Trial Balance by Total Amount
Method.
SOLUTION :
TRIAL BALANCE OF MUKESH BROS.
as on 30th April 2010
Name of Accounts L.F. Balance Balance
Dr. Cr.
Rs. Rs.
Cash A/c 2,24,000 1,68,500
Bank A/c 8,50,000 4,55,000
Capital A/c 2,00,000
Purchase A/c 4,90,000
Sales A/c 8,54,000
Rakesh 4,12,000 4,70,000
Ravi 5,30,000 4,50,000
Rohit 3,00,000 2,50,000
Machinery 25,000
Rent A/c 4,000
Salaries A/c 14,500
Purchases Return A/c 2,000
Total 28,49.500 28,49,500
5.5.3 Total-cum Balances Method
This method is a combination of total amount method and balances method. Under this method,
four columns are prepared for writing amounts. First two columns are used for writing the debit and credit
totals of different accounts and the next two columns for writing the debit and credit balances of these
accounts. This method is not used in practice because it is time consuming and it does not serve any special
purpose.
Illustration 3
Taking the same particulars as given in Illustration 1, prepare the Trial Balance by “Totals-cum-
balances Method’ :
SOLUTION :
TRIAL BALANCE OF MUKESH BROS.
as on 30th April, 2010
(Using Total-cum-Balances Method)
Name of Accounts L.F. Total of Total of Balance Balance
Debit Credit Dr. Cr.
Items Items
Rs. Rs. Rs. Rs.
Cash A/c 2,24,000 1,68,500 55,500
Bank A/c 8,50,000 4,55,000 3,95,000
Capital A/c 2,00,000
Purchase A/c 4,90,000 4,90,000 2,00,000
Sales A/c 8,54,000
Rakesh 4,12,000 4,70,000 8,54,000
Ravi 5,30,000 4,50,000 80,000 58,000
Rohit 3,00,000 2,50,000 50,000
Machinery 25,000 25,000
Rent A/c 4,000 4,000
Salaries A/c 14,500 14,500
Purchases Return A/c 2,000 2,000
Total 28,49.500 28,49.500 11,14,000 11,14,000
5.5.4 Difference between a Trial Balance by Balance Method and a Trial Balance by Totals
Method.
Trial Balance by Balance Method Trial Balance By Totals Method
1. It can be prepared after all the Ledger It can be prepared immediately after the
accounts have been balanced. completion of posting from books of
original entry to the Ledger.
2. It shows the balances of all the accounts It shows the total amounts of the debit and
in the Ledger credit sides in each Ledger Accounts.
It considers only those accounts which It considers all accounts of the Ledger.
show a balance. If an account shows no
balance, it will not be considered.
5.5.5 Special Points may be noted for preparing a Trial Balance

The balances of accounts depends upon double entry system, so they have a fixed nature. In such
a way the under mentioned points may be noted for preparing a trial balance : -
(1) As all Assets have debit balances, their balances should be shown on the debit side of the Trial
Balance. Assets include Cash, Bank Balance, Bills Receivable or B/R, Debtors, Furniture,
Machinery, Building, Patents, Goodwill etc.
(2) As all Liabilities have credit balances, their balances should be shown on the credit side of the Trial
Balance. Liabilities include Bank Overdraft, Bills Payable or B/P, Creditors etc.
(3) Capital account shows a credit balance, so it is written on the credit side of the Trial Balance
(4) Drawings account shows a debit balance, as such it is written on the debit side of the Trial Balance.
(5) I. Purchases Account always shows a debit balance.
II. Sales Account always shows a credit balance.
III. Purchases Returns Account always shows a credit balance.
IV. Sales Returns Account always shows a debit balance.
(6) All expenses and losses show debit balances, as such they should be written on the debit side of the
Trial Balance.
(7) All incomes and profits show credit balances, as such they should be written on the credit side of
the Trial Balance.
Account Title L.F. Debit Amount Credit Amount

Rs. Rs.
-
Capital
Land and Buildings -
Plant and Machinery -
Equipment -
Furniture and Fixtures -
Cash in Hand -
Cash at Bank -
Debtors -
Bills Receivable -
Stock of Raw Materials -
Work in Progress -
Stock of Finished Goods -
Prepaid Insurance -
Purchases -
Carriage Inwards -
Carriage Outwards -
Sales -
Sales Return -
Purchases Return -
Interest Paid -
Commission/Discount Received -
Salaries -
Long Term Loan -
Bills Payable -
Creditors -
Outstanding Salaries -
Outstanding Interest Earned -
Advances from Customers -
Drawings -
Reserve Fund -
Provision for Doubtful Debts -
Total xxx xxx
5.6 Steps to Locate the Errors

Even if there is only a small difference in the trial balance, it is clear indication that at least one error
has occured. Steps must be taken to locate the errors which are causing difference. The following steps may
be taken, to locate the errors:
Step 1 Recheck the totals of both the debit and credit amount columns of the Trial Balance.
Step 2 The exact figure of difference in the Trial Balance should be ascertained. After this, the
subsidiary books should be gone through to see if any item of that amount remains
unposted. For example, if the difference is of Rs. 2500, all the entries of Rs. 2500
should be scanned to ensure that they have been duly posted.
Step 3 The difference should be halved to find out if some figure equal to half the difference
has been posted on the wrong side of an account thereby making the difference double.
For example, if the total of debit side of the Trial Balance exceeds by Rs. 2500, it is
possible that a credit item of Rs. 1250 may have been posted to the debit side of a
Ledger account.
Step 4 The difference in the Trial Balance should be divided by 9. If the difference is com
pletely divisible, it can be a mistake of transposition of figures. For example, if the
figure of 974 is written as 479, the difference is of Rs. 495. This figure is completely
divisible by 9, Likewise, if ‘O’ is added against a figure, the difference will also be
divisible by 9. For example, if the figure of 28 is written 280, the difference is Rs. 252
which is completely divisible by 9.
Step 5 In case, the difference is in a round figure, say Re. 1, Rs. 10, Rs. 100 etc., there will be
a possibility of wrong totalling or wrong carry forwards of the totals of a subsidiary
book or there will be an error in the balancing of an account. Hence, the totalling and
balancing must be checked.
Step 6 Re-do and check the correctness of balances of individual accounts in the Ledger that
they have been included in the Trial Balance on the correct side and with the correct
amount.
Step 7 Check whether all the closing balances from the previous year’s Balance Sheet have
been correctly carried forward and recorded in respective ledger accounts.
Step 8 Check the figures which are not clearly written.
Step 9 It is possible that the balance of a certain Ledger account has not been included in the
Trial Balance. Then the difference may be of a big amount. This can be detected by
comparing the Trial Balance of the current year with that of the previous year. Also,
if the figures of accounts under the same head show abnormal variation, the account
should be rechecked to find out the cause of variation.
Step 10 If, in spite of all the above efforts, there is still a difference in the Trial Balance, a
complete checking of the postings of all the entries will be necessary. A check mark
should be placed at the right of each amount to show that the item has been checked.
It should also be ckecked that the totals of the subsidiary books have been posted to
the relevant accounts in the Ledger.
5.7 Types of Errors

All errors may be classified into the following two categories :
(1) Errors affecting Trial Balance (2) Errors not affecting Trial Balance
5.7.1 Errors Affecting Trial 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 find out the errors and
ultimately the errors will be located. Such errors are called errors which affect the agreement of Trial
Balance. Until such errors are rectified, the trial balance will not agree. Some of these type of errors as
follows: -
(i) Wrong Posting : If the total of the Cash Book or some other Subsidiary Book is wrong, the trial
balance will not tally. For example, the total of the Sales Book has been added Rs. 2000 in excess,
when this total will be posted to the credit side of the sales account, it will also show an excess
credit of Rs. 2000 and hence, the trial balance will not tally.
(ii) Posting to the Wrong Side : If an amount is posted on the credit side of an account, instead of
posting on the debit side or viceversa, the trial balance will not tally. For example, goods for Rs.
1000 have been purchased from Shyam, It is posted to the debit side of Shyam’s account, instead
of posting the amount on credit side, the debit side of the trial balance will exceed the credit by Rs.
2,000.
(iii) Posting of Wrong Amount : If the posting in an account is made with an incorrect amount, the trial
balance will not tally. For example, goods worth Rs. 6,000 have been sold to Ramesh, if it has been
correctly entered in the sales book but while posting to Ramesh’s debit side, the amount posted is
Rs. 600 instead of Rs. 6,000. So the trial balance will not tally.
(iv) Omission of Posting of One Side of An Entry : When the recording of transaction is partly omitted
from the books, the trial balance will not tally. For example, if Rs. 5,000 have been received from
Suresh and correctly entered in the Cash Book, but if it is omitted to be posted on the credit side of
Suresh’s account, the trial balance will not tally.
(v) Double Posting in a Single Account : When an amount is posted twice in an account, the trial
balance will not tally. For example, if Rs. 2000 have been received from Mohan and correctly
entered in the Cash Book, but if it is posted twice on the credit side of Mohan’s account, the trial
balance will not tally.
(vi) Errors of Totalling and Balancing of Accounts in the Ledger : Errors may occur in the totalling 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, it will not tally.
5.7.2 Errors Not Affecting Trial Balance
The main object of preparing a Trial Balance is to check the accuracy of the accounts. However,
the equality of debits and credits of the Trial Balance does not mean that there are absolutely no errors in the
books of accounts. There may be a number of errors which may remain undetected in spite of the
agreement of a Trial Balance. As such, it is true to say that ‘Trial Balance is not a conclusive proof of the
accuracy of the books of accounts.’ There are certain errors which do not affect the agreement of the Trial
Balance. Such errors are also called limitations of Trial Balance. These may be discussed as below :-
(i) Errors of Omission : If a transaction remains altogether unrecorded either in the Journal or in
Subsidiary Books, it will be termed as an error of omission. Such an error will not affect the
agreement of a Trial Balance, as neither the transaction has been entered on the debit side of an
account nor on the credit side of any other account. For example, suppose goods for Rs. 2,000
have been sold to Ram on credit and the transaction was omitted to be recorded in the books. The
omission will not affect the Trial Balance in any way, because neither has it been recorded on the
debit side of Ram’s account nor on the credit side of sales account.
(ii) Errors of Commission : Errors of commission are errors which arise due to wrong recording, wrong
posting, wrong carry forward, wrong casting of subsidiary books, wrong balancing etc. If a wrong
amount is entered either in the journal or in the subsidiary books, the trial balance will not tally
because the same amount will be posted in both the accounts affected by the transaction. For
example, Purchases of goods being recorded as Rs. 50,000 instead of Rs. 5,000.
(iii) Compensatory Errors : When two or more errors are committed in such a way that the net effect of
these errors on the debits and credits of accounts is nil, such errors are called compensatory errors.
Such errors do not affect the tallying of the trial balance. For example, if purchases book has been
overcast by Rs. 1,000, resulting in excess debit of Rs. 1,000 in purchases account and sales return
book is undercast by Rs. 1,000 resulting in short debit to sales returns account is a case of two
errors compensating each other’s effect.
(iv) Errors of Principle : Accounting entries are recorded as per the generally accepted accounting
principles. When some fundamental principle of accountancy is violated while recording a
transaction the error is termed as error of principle. An error of principle may occur due to incorrect
classification of expenditure or receipt between capital and revenue. This is very important because
it will have an impact on financial statements. If may lead to under/over stating of income or assets
or liabilities. etc. For example, amount spent on additions to the buildings should be treated as
capital expenditure and must be debited to the asset account. Instead, if this amount is debited to
maintenance and repairs account, it has been treated as a revenue expense.
Activity -5.2
Which of these errors would be disclosed by the Trial Balance and why ?
(i) Cheque of Rs. 9,500 from Manish entered into Manish’s account as Rs. 5,900.
(ii) Selling expenses have been debited to Sale Account ?
(iii) Credit purchases of Rs. 1,000 entered in both the accounts as Rs. 100.
(iv) A sales of Rs. 5,000 was omitled entirely from the books.
Activity -5.3
Which of the following do not affect the Trial Balance agreement and why ?
(i) Purchases of Rs. 2,500 from Naman entered in Aman’s account ?
(ii) Payment of Rs. 2,000 for repair entered only in Repair account.
(iii) Salary Account added up incorrectly by Rs. 1,000 being short totalled.
5.8 Summary
A Trial Balance is a statement of accounts appearing in the Ledger. It may be prepared either by
taking the balances of each account or the total amounts of debit and credit items.The agreement of Trial
Balance ensures arithmetical accuracy and not accounting accuracy. Functions of a Trial Balance are (i) to
ascertain arithmetical accuracy. (ii) to provide summary of ledger accounts. (iii) to help in the preparation of
final accounts. (iv) to help in locating errors. There are three methods of preparing a trial balance. These are
(i) Balance method (ii) Totals method (iii) Total - cum - balances method. There are two types of errors (i)
Errors affecting trial balance (ii) Errors not affecting trial balance. Errors not affecting trial balance are (a)
errors of commission (b) errors of omission (c) errors of principle (d) compensating errors.
5.9 Key Words

 Trial Balance: A statement showing the balance or total of Debit and Credit sides of all
accounts in the Ledger.

1. What is a Trial Balance ? State any four functions of a Trial Balance.
2. Explain the methods of preparing Trial Balance.
3. What are the steps taken by an accountant to locate the errors in the trial balance ?
4. Is the agreement of a Trial Balance absolute proof of the accuracy of the books of accounts ? If not,
what are the errors which remain even after agreement ?

Paul S. Kr., Book-Keeping and Accountancy
Grewal T.S., Double Entry Book-Keeping
Unit - 6 Final Accounts
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Classification of Capital and Revenue Items
6.3 Distinction between Capital andRevenue Items
6.4 Income Statement- Trading Account
6.5 Income Statement - Profit & Loss Accounts
6.6 Difference between Trading and Profit & Loss Account
6.7 Balance Sheet
6.8 Grouping of Assets and Liabilities
6.9 Classification of Assets and Liabilities
6.10 Distinction between Trial Balance and Balance Sheet
6.11 Methods of Preparing Final Accounts
6.12 Summary
6.13 Key Words
6.0 Objectives
After studying this unit you will be able to understand :
 Meaning of financial statements
 Classification and distnction between capital and revenue items
 Meaning and formation process of Trading Account and Profit & Loss Account
 Meaning, importance and Preparation of Balance Sheet
 How grouping, Marshalling of Assets and Liabilities can be done
 Classification of Assets and Liabilities
 Distinction between Trading and Profit & Loss Account
 Methods of Preparing of Final Accounts
6.1 Introduction
Final Accounts refers to such statements which report the profitability and the financial position of
the business at the end of the accounting period. These statements are called as “financial Statements”
which is prepared to know profit or loss and also the financial position of the business. These statements are
prepared for users of accounting information for decision making. Financial statements are prepared from
the Trial Balance drawn taking the ledger balances and cash book balances. Final Accounts includes:
(i) Income Statement (Trading and Profit & Loss Account), which shows results of the business
operations during an accounting period.
(ii) Statement of Financial Position (or Balance Sheet) which shows final position of the business at a
specific point of time.
Objectives of preparing Final Accounts are :
(i) To present a true and fair view of financial performance of a business;
(ii) To present true and fair view of the financial position of the business.
6.2 Classification of Capital and Revenue Items

While preparing final accounts there are certain rules governing the classification of expenditure and
receipts between capital and revenue. These are as follows :
6.2.1 Capital Expenditure
An amount spent by an institution on purchase of fixed assets that are used in the business to earn
income and are not intended for resale. The benefit yield for over a period extending beyond the accounting
period. Examples are: purchase of assets, installation of fixed assets, extension or improvement in fixed
assets, expenditure incurred to acquire right to carryout of the business, legal charges for accquiring assets.
Capital expenditure is debited to a fixed account which appears in the balance sheet.
6.2.2 Revenue Expenditure
It is an amount spent on running a business. The benefit of these expenditures is exhausted in the
accounting period in which it is incurred. Examples : Day to day running expenses for business, expenses
incurred for upkeep of fixed assets, expenditure incurred on purchases of goods which are used during the
year, depreciation of fixed assets.
Activity 6.1
Can you think of an example which is wrongly treated as revenue expenditure but it is
actually Capital expenditure ?
6.2.3 Deferred Revenue Expenditure

Revenue expenditure, which is incurred during an accounting period but the benefit arising out of it
extends beyond that accounting period. Example : Large amount spent on advertisement of a new product,
which will give benefit over a period. It is charged to profit and loss account in a phased manner, hence
balance of such expenses is a fictitious asset and is to be shown in assets side of balance sheet.
6.2.4 Capital Receipts
An amount received in the form of additional capital introduced in the business, loan received and
sale proceeds of the fixed assets are examples of Capital receipts. It either increases liabilities or reduce the
assets.
6.2.5 Revenue Receipts
An amount received in the regular and normal course of the business i.e. receipts from sale of goods
and services. It does not need to return to any one. These are shown in credit side of Income Statement.
6.3 Distinction between Capital and Revenue Items
6.3.1 Distinction between Capital Expenditure and Revenue Expenditure
S.No. Capital Expenditure Revenue Expenditure
1. Its benefit extends to more than Its benefit extends to only one year.
one year.
2. It is debited to an asset account. It is debited to an expense account.
3. It increases the earning capacity of It is incurred for earning profits.

the business
4. It is incurred for acquisition of It is incurred to carry on the business
fixed assets
5. It is a real account. It is a nominal account.
6. It is shown in the Balance Sheet. It is part of the Trading or Profit and
Loss Account.
6.3.2 Distinction between Capital Receipt and Revenue Receipt
S.No. Capital Receipt Revenue Receipt
1. It is the amount realised by sale of It is the amount realised through
fixed assets or by issue of shares or sale of goods or rendering of
debentures or by loans taken. services.
2. It is an item of Balance Sheet. It is an item of Trading and
Profit and Loss Account.
3. Capital receipts are normally of non- Revenue receipts are normally
recurring nature. of recurring nature
4. Capital receipts are the receipts . Revenue receipts are obtained
which are not obtained in normal in the course of normal trading
course of business activities operations.
5. Capital receipts are normally not Revenue receipts net of revenue
available for payment as profit to the expenses and expired portion of
owner of the business. capital expenditure/deferred
revenue expenditure are
available for distribution to the
owner of the business.
Activity 6.2
Expenditure to launch a new product in the market, is called ................
6.4 Income Statement - Trading Account

It is a statement which is summary of accounts that affects the profit or loss of an enterprise. It is
divided in two parts :
1. Trading Account : It reveals gross profit or gross loss, and
2. Profit and Loss Account : It reveals net profit or net loss.
6.4.1 Trading Account
It is the first phase in the process of preparing final accounts. It is prepared to show the results of
manufacturing, buying and selling of goods.
Importance of Trading Account :
(1) It provides information about the direct expenses
(2) It provides information about gross profit or gross loss.
(3) It compares closing stock with that of the previous year.
(4) It provides safety against possible losses.
6.4.2 Preparation of Trading Account
 Item written on the Dr. side of the Trading Account
(1) Opening Stock The closing stock of the last year becomes the opening stock of the current year.
Opening stock will include the following: -
I. Opening Stock of Raw Materials,
II. Opening Stock of Semi-finished goods, and
III. Opening Stock of Finished goods.
(2) Purchases & Purchases Return Goods which have been bought for resale are termed as
Purchases and goods which are returned to suppliers are termed as purchases returns or returns
outwards. Purchase Account will be given on the debit side of the tiral balance and Purchase Return
Account on the credit side of the trial balance, Purchase returns will be shown as a deduction from
Purchases on the debit side of the trading account. Purchases include cash as well as credit
purchase.
(3) Direct Expenses All expenses incurred in purchasing the goods, bringing them to the godown and
manufacturing of goods are called direct expenses, Direct expenses include the following:
(i) Wages Wages are paid to workers who are directly engaged in the loading, unloading and
production of goods and as such are debited to the trading account. It should be noted that if the
item “Wages and Salaries’ is given in the question it will be shown on the trading account. On the
contrary, if ‘Salaries and Wages’ is given it will be shown on the Profit & Loss Account.
(ii) Carriage or Carriage Inwards or Freight These expenses should be debited to trading
account because these are generally paid for bringing goods to the factory or place of the business.
However, if any carriage or freight is paid on bringing an asset, the amount should be added to the
asset account and must not be debited to trading account.
(iii) Manufacturing Expenses All expenses incurred in the manufacture of goods are shown on
the debit side of the trading account such as Coal, Gas, Fuel, Water, Power, Factory Rent, Factory
Lighting etc.
(iv) Import Duty or Custom Duty Custom duty is paid on import as well as on export of goods.
Custom duty when paid on the purchase of goods is charged to Trading Account. In the absence of
specific instructions, these are debited to trading account.
(v) Octori The amount is levied by the Municipal Committee when the goods enter the city and
hence debited to Trading Account.
(vi) Royalty This is the amount paid to the owner of a mine or patent for using his right or patent,
Royalty is usually charged to Trading Account because it increases the cost of production.
However, if it is specifically stated in the question that the Royalty is based on sales, it will be
charged to Profit & Loss Account.
 Items written on the Cr. Side of the Trading Account
(1) Sales and Sales Returns : - Both Cash and Credit sales will be included in sales. The sales
account will be a credit balance whereas, the sales return account or returns inwards account will
be a debit balance. Sales return will be deducted out of Sales on the credit side of the trading
account.
(2) Closing Stock : - The goods remaining unsold at the end of the year is known as Closing Stock. It
is valued at cost price or market price whichever is less. It includes the closing stock of raw
material, closing stock of semi-finished goods and closing stock of finished goods.
Normally, the Closing Stock is given outside the Trial Balance. This is so because its valuation is
made after the account have been closed. It is incorporated in the books by means of the following entry
Closing Stock A/c Dr.
To Trading A/c
(Closing Stock transferred to Trading A/c)
When the above entry is passed, the Closing Stock Account is opened. On the one hand, it will be
posted to the credit side of the trading account and on the other hand, will be shown on the Assets side of
the Balance Sheet, in order to complete the double entry. Sometimes, the Closing Stock in given inside the
Trial Balance. This will mean that the entry to incorporate the closing stock in the books has already been
passed. It would imply that the Closing Stock must have been deducted out of Purchases Account. Hence,
in such a case, Closing Stock will not be shown in the Trading Account but will appear on the Assets side of
the Balance Sheet only.
6.4.3 Closing Entries Relating to Trading Account
(i) Purchases Returns Account is closed by transferring its balance to Purchases Account. Following
entry is recorded for this purpose :
Purchases Return A/c Dr.
To Purchases A/c
(Transfer of Purchases Returns Account to purchases account)
(2) Similarly, the Sales Returns Account is closed by transferring its balance to the Sales Account as:
Sales A/c Dr.
To Sales Return
(Transfer of Sales Return Account to Sales Account)
(3) Closing Entry for those accounts which are to be transferred to the Dr. side of the Trading Account:
Trading A/c Dr.
To Opening Stock A/c
To Purchases A/c
To Wages A/c
To Direct Expenses A/c
To Carriage A/c
To Gas, Fuel & Power A/c
To Freight Octroi & Cartage A/c
To Manufacturing Exp. A/c
To Factory Rent & Lighting A/c
To Custom Duty A/c
To Royalty A/c
(The Transfer of above accounts to the Dr. Side of the Trading A/c)
(4) Closing Entry for those accounts which are to be transferred to the Cr. Side of the Trading Account
:
Sales A/c Dr.
To Trading A/c
(The Transfer of above accounts to the Cr. Side of the Trading A/c)
(5) Another Closing Entry is needed to close the Trading Account it self. If the credit side of the Trading
Account exceeds the debit, the difference will be Gross Profit. The Gross Profit will be transferred
to the credit of a newly opened account called Profit & Loss Account -
Trading A/c Dr.
To Profit & Loss A/c
(The transfer of Gross Profit to the Credit Side of P & L A/c)
(6) If the debit side of the Trading Account exceeds the credit, the difference will be Gross Loss, it will
be transferred to the debit of P & L A/c by means of the following entry : -
Profit & Loss A/c Dr.
To Trading A/c
(The Transfer of Gross Loss to the Debit side of P & L A/c)
Format of a Trading Account
Trading A/C
(for the year ended ......................)
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Opening Stock By Sales
To Purchases Less: Sales Return or
Less: Purchases Returns or Return inwards
Purchases outward By Closing Stock
To Wages By Gross loss
To Wages & Salaries (if any) transferred to
Profit
To Direct Expenses and Loss A/c
To Carriage, or (Balancing figure)
To Carriage inwards, or
To Carriage on Purchase
To Gas, Fuel and Power
To Freight, octroi and cartage
To Manufacturing Expenses, or
Productive Expenses
To Factory Expenses, such as:
Factory Lighting
Factory Rent etc.
To Import Duty or Custom Duty
To Royalty
To Gross Profit Transferred to P & L
A/c
(Balancing Figure)
Illustration 1
Prepare a Trading Account for the year ended 31st March 2010 from the following balances :
Rs. Rs.
Opening Stock 30,000
Purchases Return 12,000
Purchases 12,00,000
Sales Return 20,000
Sales 15,00,000
Carriage on Purchases 8,000
Freight and Octroi 6,500
Carriage on Sales 10,000
Wages 30,000
Factory Rent 12,000
Factory Lighting 10,800
Office Rent 7,500
Coal, Gas and Water 2,700 Import Duty 32,000
Closing Stock is valued at Rs. 50,000.
Solution :
Trading A/C
(for the year ended 31 March 2010)

Rs.
Rs.
To Opening Stock 30,000 By Sales 15,00,000
To Purchases 12,00,000 Less: Sales Return 20,000 14,80,000
Less : Purchases return 12,000 11,88,000 By Closing Stock 50,000
To Freight and Octroi 6,500
To Wages 30,000
To Factory Lighting 10,800
To Coal, Gas and Water 2,700
To Carriage on Purchases 8,000
To Factory Rent 12,000
To Import Duty 32,000
To Gross Profit transferred
2,10,000
15,30,000 15,30,000
 Cost of Goods sold :

Cost of Goods sold = Opening Stock + Purchases + Direct Expenses* - Closing Stock * Direct
Expenses Means expenses debited to the Trading Account.
6.5 Income Statement - Profit and Loss Account

Trading account discloses the gross profit earned as a result of buying and selling of goods.
However, a businessman has to incur a number of expenses which are not taken to trading account. Hence,
a businessman is more interested in knowing the net profit earned or net loss incurred during the year. As
such, a Profit & Loss Account is prepared which contains all the items of losses and gains pertaining to the
accounting period.
6.5.1 Importance of Profit & Loss Account
1. To ascertain the Net Profit or Net Loss
2. Comparison with previous years’ profits
3. Control over Expenses
4. Helpful in the preparation of Balance Sheet.
6.5.2 Preparation of Profit and Loss Account
A Profit and Loss Account is started with the amount of gross profit or gross loss brought down
from the Trading Account all. Those expenses which have not been debited to Trading Account are now
debited. It includes administrative expenses, selling expenses, distribution expenses.etc. These are called
‘Indirect Expenses.’ Profit and Loss Account is a Nominal Account and as such, all the expenses and losses
are shown on its debit side and all the incomes and gains are shown on its credit side.
 Items Written on the Dr. Side of Profit & Loss Account
1. Gross Loss : - If trading account discloses Gross Loss, it is shown on the debit side first of all.
2. Office and Administrative Expenses: - such as salary of office employees, office rent, lighting,
postage, printing, legal charges, audit fees. etc.
3. Selling and Distribution Expenses :- as advertisement charges, commission, carriage outwards,
bad-debts, packing charges etc.
4. Miscellaneous Expenses : - such as interest on loan, interest on capital, repair charges,depreciation,
charity etc.
 Items Written on the Cr. Side of Profit & Loss Account
1. Gross Profit: - The starting point of the Cr. side of Profit & Loss Account is the gross profit brought
down from the Trading Account.
2. Other Incomes and Gains : - All items of incomes and gains are shown on the credit side of the
Profit & Loss Account, such as income from investments, rent received, discount received,
commission earned, interest received, dividend received etc.
If the credit side of the profit and loss account exceeds that of debit side, the difference is termed as
net profit. On the other hand, the excess of the debit side over the credit side is termed as net loss. Net profit
is added to the capital whereas net loss is deducted from the capital.
6.5.3 Closing Entries relating to Profit and Loss Account
The preparation of Profit & Loss Account requires that the balances of all items concerned are
transferred to it by posting the following closing entries : -
1. Accounts of various items of expenses and losses are transferred to the debit side of Profit and
Loss Account by means of the following entry: -
Profit and Loss A/c Dr.
To Rent, Rates and Taxes A/c
To Printing and Stationery A/c
To Postage and Telegrams A/c
To General Expenses etc.
(The transfer of nominal accounts showing Dr. balances to the Debit of P & L A/c)
2. Balances of all the accounts of incomes and gains will be transferred to the credit side of Profit and
Loss Account by means of the following entry : -
Interest Received A/c Dr.
Commission Received A/c Dr.
Rent Received A/c Dr.
(The transfer of nominal accounts showing Cr. balances to the Credit of P & L A/c)
3. For the transfer of credit balance of Profit & Loss A/c, known as net profit: -
Profit and Loss A/c Dr.
To Capital A/c
(The transfer of net profit to Capital A/c)
4. For the transfer of debit balance of Profit & Loss A/c, known as net loss : -
Capital A/c Dr.
To Profit and Loss A/c
(The transfer of net loss to Capital A/c)
Format of a Profit and Loss Account
Profit and Loss A/c
(For the year ending ......................)
Dr. Cr.
Particular Amount Particular Amount
Rs. Rs.
To Gross Loss b/d By Gross Profit b/d
(Transferred from Trading (Transferred from Trading A/c)
A/c)
Office expenses : By Rent received
To Salaries By Discount received
To Salaries & Wages By Commission Received
To Rent, Rates & Taxes By Interest on Investment
To Printing & Stationery By Dividend on Shares
To Postage & Telegram By Bad-Debts Recovery
To lighting By Apprentice Premium
To insurance Premium By Profit on sale of Assets
To Telephone Charges By Income from other Sources
To Legal Charges By Miscellaneous Receipts
To Audit Fees By Net Loss (if any)
To Traveling Expenses Transferred to Capital A/c
To Establishment Expenses
To Trade Expenses
To General Expenses
Selling and Distribution
Expenses:
To Carriage Outwards,
To Advertisement
To Commission
To Brokerage
To Bad-debts
To Export duty
To Packing charges
To Delivery Van Expenses
To Stable expenses
Miscellaneous expenses :
To Discount
To Repairs
To Depreciation
To Interest Paid
To Bank Charges
To Entertainment Expenses
To Conveyance Expenses
To Donation and Charity
To Loss on Sale of Assets
To Net Profit-
Transferred to Capital
A/c
Notes: - (1) Those expenses which are not related to the business are not written in the Profit and Loss
Account such as (I) Domestic and household expenses of the proprietor, (II) Income- Tax, and (III) Life
Insurance Premium etc. These expenses are known as Drawings and deducted from Capital at the liabilities
side of the Balance Sheet.
Illustration 2
From the following particulars, prepare a Profit & Loss Account for the year ending 31st March
2010 : -
Rs. Rs.
Gross Profit 2,00,000 Discount allowed 3,000
Trade Expenses 2,000 Lighting 700
Carriage on Sales 10,000 Commission Received 800
Office Salaries 15,800 Bad-debts ,1200
Postage and Telegram 700 Discount (Cr.) 6000
Office Rent 7,500 Interest on Loan 3,600
Legal Charges 400 Stable Expenses 1,400
Audit fee 1,600 Export Duty 2,300
Donation 1,100 Miscellaneous Receipts 500
Sundry Expenses 300 Unproductive Expenses 4,100
Selling Expenses 5,300 Travelling Expenses 2,500
Solution :
Profit & Loss Account
for the year ending on 31st March, 2010
Dr. Cr.
Particular Amount Particular Amount
Rs. Rs.
To Trade Expenses 2,000 By Gross Profit 2,00,000
To Carriage on sales 10,000 By Commission received 800
To Office Salaries 15,800 By Discount 6000
To Postage & Telegram 700 By Miscellaneous Receipts 500
To Office Rent 7,500
To Legal charges 400
To Audit fee 1,600
To Donation 1,100
To Sundry expenses 300
To Selling expenses 5,300
To Discount allowed 3,000
To Lighting 700
To Bad - Debits 1,200
To Interest on Loan 3,600
To Export duty 2,300
To Unproductive expenses 4,100
To Travelling expenses 2,500
To Net Profit transferred to
Capital Account 1,45,200
2,07,300 2,07,300
6.6 Difference between Trading and Profit & Loss Account

Difference between Trading and Profit & Loss Account
S.No. Trading Account Profit and Loss Account
1. The Gross Profit or Gross Loss The Profit and Loss Account is prepared to
is ascertained from the Trading ascertain the net profit or net loss of the
Account. business.
2. The balance of the Trading The balance of the Profit and Loss Account is
Account is transferred to the transferred to the Capital Account of the
Profit and Loss Account. proprietor.
3. Items shown in the Trading Items like indirect expenses related to sales,
Account are purchases, sales, distribution, administration, finance, etc., are
stock, direct expenses, etc. shown in the Profit and Loss Account.
6.7 Balance Sheet

After ascertaining the net Profit or Loss of the business enterprise, the businessman would also like
to know the exact financial position of his business. For this purpose a statement is prepared which contains
all the Assets and Liabilities of the business enterprise. The statement so prepared is called a Balance Sheet
because it is a sheet of balances of ledger accounts which are still open after the transfer of all nominal
accounts to the Trading and Profit & Loss Account. Balances of all the personal and real accounts are
grouped as assets and liabilities. Liabilities are shown on the left hand side of the Balance Sheet and Assets
on the right hand side. “A Balance Sheet is a statement prepared with a view to measuring the exact financial
position of a business on a fixed date.”
6.7.1 Importance of Preparing a Balance Sheet
1. To ascertain the true financial position of the business at a particular point of time.
2. To ascertain the nature and cost of various assets of the business.
3. To determine the nature and amount of various liabilities of the business.
4. To know about the exact amount of capital at the end of the year.
5. To prepare the Opening Entries at the beginning of the next year.
6.7.2 Drafting a Balance Sheet
1. A Balance Sheet is a part of the Final Accounts. This is the reason that the Trading and Profit and
Loss Account and the Balance Sheet are together called ‘Final Accounts’.
2. It is a statement and not an account. It has no debit or credit side and as such the words ‘To’ and
‘By’ are not used before the names of the accounts written therein.
3. It is a summary of the Personal and Real Accounts, which are still open and have not been closed by
transfer to the Trading and Profit & Loss Account. Debit balances of all Personal and Real
Accounts are put on the right hand side known as Assets side, whereas the credit balances are put
on the left hand side known as liabilities side.
4. The totals of the two sides of the Balance Sheet must be equal. If the totals are not equal, there will
be an error somewhere.
5. It is prepared on a particular date and not for a fixed period.
6. It shows the financial position of the business according to the going concern.
6.8 Grouping of Assets and Liabilities

The Assets and Liabilities shown in the Balance Sheet are properly grouped and presented in a
particular order. The term ‘grouping means showing the items of similar nature under a common heading.
‘Marshalling’ is the arrangement of various assets and liabilities in a proper order. Marshalling can
be done in any of the following two ways.
6.8.1 In the Order of Liquidity
An asset which is most easily convertible into Cash such as Cash in hand is written first and then will
follow those assets which are comparatively less easily convertible, so that the least liquid asset such as
goodwill, is shown last.
In the same way, those liabilities which are to be paid at the earliest will be written first. In other
words current liabilities are written first of all, then fixed or long-term liabilities and lastly, the proprietor’s
capital.
Proforma of a Balance Sheet in the order of liquidity will be as follows :
Balance Sheet
as on .........................................
Liabilities Amount Assets Amount
Rs. Rs.
Bank Overdraft Cash in Hand
Bills Payable Cash at Bank
Sundry Creditors Bills Receivable
Outstanding Expenses Short Term Investments
Unearned Income Sundry Debtors
Long term loans Closing Stock
Reserves Capital Prepaid Expenses
Add : Net Profit Accrued Income
Add : Drawings Long Term Investments
Less : Income Tax Furniture
Less : Life Insurance Losse Tools
Premium
Motor Vehicle
Plant & Machinery
Land and Buildings
Patents
Goodwill
6.8.2 In the Order of Permanence

This method is exactly the reverse of the first method. Assets which are most difficult to be
converted into cash such as Goodwill are written first and the assets which are most liquid such as Cash in
hand are written last. Similarly, those liabilities which are to be paid last, will be written first. In other words,
the proprietor’s capital is written first of all, then fixed or long term liabilities and lastly, the current liabilities.
Joint stock companies are required under the Companies Act to prepare their Balance Sheet in the order of
permanence.
6.9 Classification of Assets and Liabilities

6.9.1 Classification of Assets
(i) Fixed Assets “Fixed Assets are assets of a relatively permanent nature used in the operations of
business and not intended for sale”. As the purpose of keeping such assets is not to sell but use
them, changes in their market values are ignored and these are always shown in the Balance Sheet
at cost less depreciation.
(ii) Current Assets Current Assets are those which are either in the form of cash or can be easily
converted into cash within one year of the date of the Balance Sheet.
(iii) Liquid Assets Liquid Assets are those which are either in the form of Cash or can be quickly
converted into cash, such as, Bills Receivable, Short Term Investments, Debtors, Accrued Income
etc. In other words, if Prepaid Expenses and Closing Stock are excluded from Current Assets, the
balance will be liquid Assets.
(iv) Fictitious or Nominal Assets Which cannot be realised in Cash or no further benefit can be
derived from these assets. Such assets include Debit balances of P & L A/c and the expnditure not
yet written off such as Advertisement Expenses etc. These assets are not really assets but are
shown on the Assets side only for the purpose of transferring them to the Profit & Loss Account
gradually over a period of time.
(v) Wasting Assets Which are exhausted or consumed over a period of time such as mines and
oil- wells. Their value reduces through being used. These also include Patents and the properties
taken on lease for a definite period of time.
(vi) Tangible and Intangible Assets Tangible Assets are those which have a physical existence like
Plant and Machinery, Building, Furniture, Stock, Cash etc. Intangible Assets are those which do not
have any physical existence such as the Goodwill, Trade Marks, Patents etc.
6.9.2 Classification of Liabilities
(i) Fixed or Long-term Liabilites : Those liabilities which are to be repaid after one year or more
are termed as long-term liabilities. These include Public Deposits, Long-term Loans, Debentures
etc.
(ii) Current or Short Term Liabilities : Those liabilities which are expected to be paid within one
year of the date of the Balance Sheet are termed as current or short - term liabilities. These include
Bank Overdraft, Creditors, Bills Payable. Outstanding expenses etc.
(3) Contingent Liabilities : These are the liabilities which will become payable only on the happening
some specific event otherwise not such as:
(i) Liabilities for bill discounted
(ii) Liability in respect of a suit pending in a court of law
(iii) Liability in respect of a guarantee given for another person
 Contingent liabilities are not shown in the Balance Sheet. They are, however, shown as a
footnote just below the Balance Sheet so that their existence may be revealed.
6.10 Distinction between Trial Balance and Balance Sheet

Distinction between Trial Balance and Balance Sheetof
S.No. Trial Balance Balance Sheet
1. It is prepared to check the It is prepared to know the true financial
arithmetical accuracy of the books position of the firm.
of accounts.
2. It is not possible to have Since net profit or loss is recorded in the
information about net profit or net Capital shown in Balance Sheet, it is
loss from a trial balance. possible to have the information about net
profit or net loss from a Balance Sheet.
3. The headings of its two columns are The headings of its two sides are assets and
debit and credit. liabilities.
4. It is normally prepared every month It is normally prepared half-yearly or yearly
or whenever needed. at the end of the accounting period.
5. All types of accounts whether Only personal and real accounts are included
personal, real or nominal must be in it.
written in it.
6. It can be prepared without making It cannot be prepared without making
adjustments for outstanding adjustments for outstanding expenses,
expenses, prepaid expenses, accrued prepaid expenses, accrued incomes etc.
incomes etc.
llustration 3
From the following balances of a businessman, prepare a Balance Sheet as on 31st March, 2010.
Dr. Cr.
Rs. Rs.
Plant & Machinery 80,000
Land and Building 60,000
Furniture 15,000
Cash in Hand 2,000
Bank overdraft 18,000
Debtors and Creditors 16,000 8,000
Bills Receivable and Bills Payable 10,000 6,000
Closing Stock 20,000
Investments (Short-term) 8,000
Capital 1,30,000
Drawings 10,000
Net Profit 59,000
2,21,000 2,21,000
BALANCE SHEET
as on 31st March, 2010
Rs. Rs.
Bank overdraft 18,000 Cash in hand 2,000
B/P 6,000 B/R 10,000
Creditors 8,000 Investments (Short-term) 8,000
Capital 1,30,000 Debtors 16,000
Add : Net Profit 59,000 Closing Stock 20,000
1,89,000 Furniture 15,000
Less Drawings 10,000 1,79,000 Plant & machinery 80,000
Land & Building 60,000
2,11,000 2,11,000
Illustration 4
From the following Trial Balance of Shri Ram prepare Trading and Profit and Loss A/c for the year
ending 31st March, 2011 and Balance Sheet as on that date. The Closing Stock on 31st March 2011was
value at Rs. 15,000.
Rs. Rs.
Stock (1.4.10) 10,000 Sundry Creditors 15,000
Purchases 75,000 Purchases Returns 3,000
Sales Return 8,000 Sales 2,50,000
Freight and Carriage 44,000 Commission 2,000
Salaries 12,000 Capital 1,70,000
Repairs 1,200 Interest on Bank Deposit 2,000
Trade Expenses 4,000 B/P 6,200
Rent and Taxes 24,000
Cash in Hand 5,000
B/R 4,000
Debtors 55,000
Plant and Machinery 1,60,000
Withdrawals (Drawings) 16,000
Bank Deposit 20,000
4,38,200 4,38,200
Solution :
Trading and Profit and Loss Account
for the year ending on 31st March, 2011
Dr. Cr.
Rs.
Rs.
10,000
To Opening Stock By Sales 2,50,000
To Purchases 75,000 Less Sales Return 8,000 2,42,000
By Closing Stock
Less: Purchase Returns 3,000 72,000 15,000
To Freight & Carriage 44,000
To Gross Profit c/d 1,31,000
2,57,000 2,57,000
12,000 1,31,000
To Salaries By Gross Profit b/d
1,200 2,000
To Repairs By Commission
4,000 By Interest on Bank Deposit 2,000
To Trade Expenses
24,000
To Rent & Taxes
24,000
To Net Profit transferred
to Capital A/c 1,35,000 1,35,000
Balance Sheet
as on 31st March, 2010

Rs. Rs.
B/P 6,200 Cash in hand 5,000
Sundry Creditors 15,000 B/R 4,000
Capital 1,70,000 Sundry Debtors 55,000
Add : Net Profit 93,800 Closing Stock 25,000
2,63,800 Bank Deposit 20,000
Less : Drawings 16,000 2,47,800 Plant & Machinery 1,60,000
2,69,000 2,69,000
6.11 Methods of Preparing Final Accounts

The Trading and Profit and Loss Account and the Balance Sheet can be presented either in the
Horizontal Form or in Vertical Form.
(i) Horizontal Form: Under this form of presentation, the items are presented in “T” form, which we
have already discussed in this chapter. The final accounts in the above illustrations have been
prepared in horizontal form.
(ii) Vertical Form: Under this form of presentation, the items are presented in a single column
statement in a purposeful sequence.
The Vertical format of a Trading Account is given below.
Trading Account of A
for the year ended 31st March, 2011
Particulars Rs. Rs. Rs.
Sales 200000
Less: Returns Inwards 2000 198000
Opening Stock 10000
Purchases 80000
Less : Purchases Outwards 2000 78000
Direct Expenses 2000
Freight and Carriage 15000
Customs and Insurance 20000
Wages 20000
Gas, Water and Fuel 2000
Lighting and Heating 3000
Factory Expenses 2000
64000
152000
Less : Closing Stock 2000
Cost of Goods Sold 150000
Gross Profit 48000
The Vertical format of Profit and Loss Account is given below.

Profit And Loss Account of A
for the year ended 31st March, 2011
Particulars Rs. Rs.

Gross Profit 48000
Discount Received 500
Commission Received 600
Bank Interest 100
Rent of Property Let-out 300
Profit on Sale of Machinery 150
Profit on Sale of Investments 250 1900
49900
Cont….
Particulars Rs. Rs.
Salaries (Administrative) 17000
Office Rent, Sales and Taxes 6000
Printing and Stationery 500
Telehpone Charges 400
Insurance 200
Audit Fees 100
Legal Fees 150
Electricity Charges 250
Repairs and Renewals 120
Depreciation on Machinery 180
Salaries (Selling Staff) 140
Advertisement 160
Godown Rent 1000
Carriage Outwards 1500
Bad Debts 1000
Provision for Bad Debts 500
Selling Commission 500
Bank Charges 500
Interest on Loans 600
Discount on Bills 400
Discount Allowed to Customers 300
Loss on Sale of Fixed Asset 400
Loss on Sale of Investment 400
Loss by Fire or Accident 400 32700
Net Profit transferred to Capital A/c 17200
The Vertical Format merely involves a rearrangement of the information shown by a Balance Sheet
presented in the Horizontal Format. The Vertical Format of a Balance Sheet is shown below (using
imaginary figures):
Balance Sheet of Z
as at 31st March, 2008
Particulars Rs. Rs. Rs.

Fixed Assets
Land 2,00,000
Building 10,00,000
Plant and Machinery 4,00,000
Furniture 2,00,000
Delivery Van 6,00,000
24,00,00
Current Assets
Stock 5,00,000
Debtors 3,00,000
Bills Receivable 1,00,000
Cash at Bank 30,000
70,000
Cash in Hand 10,00,000
Current Liabilities
3,00,000
Creditors
80,000
Bills Payable
20,000
Outstanding Expenses 4,00,000
6.00,000
Working Capital (Current Assets -
Current Liabilites)
30,00,000
Net Assets Employed
Financed by
Capital 25,00,000
Add: Net Profit
5,00,000
30,00,000
6.12 Summary
The term financial statements as used to denote ‘Final Accounts’ consists of two basic statements
: (1) Trading and Profit and Loss Account (Income statement) (2) Balance Sheet. The users of financial
statements are present and potential investors, lenders, short terms creditors employees, customers,
government, tax authorities, providers of loan, which satisfy their specific needs. Trading account contains
the revenue incomes and expenditures which are related to purchases or goods manufactured i.e. direct
expenses related to production. This account shows gorss profit or loss. Profit & Loss account contains all
indirect expenses related to business and all indirect incomes related to enterprise. It shows net profit or
loss. The Balance Sheet is a statement, which depicts the financial position of a business on a particular
date. Income statements is a period statement whereas Balance Sheet is a point statement. Grouping &
marshalling refers to collect same nature of items in one group and arrange them in a particular order.
Vertical presentation is a system of presentation of information of trading, profit and loss Account and
Balance Sheet instead of side by side, in such a way that important information are revealed to the readers
a a glance.
6.13 Key Words

 Final Accounts - Financial statement which includes Trading Account, Profit and Loss Account
and Balance Sheet. It is prepared to know profit earned in a particular period and to know the
financial position of a particular date.
 Contingent Liabilities- A liability that becomes payable on the happening of an event. If the event
does not happen, no amount is payable examples : Liabilities in respect of bills discounted,
disputed loans etc.
 Wasting Assets - Which are exhausted over a period of time. Their value reduces through being
used. Examples : Patents taken on a lease for a definite period, mines & oil wells.
 Intangible Assets - Those which do not have any physical extistence like, goodwill, Trade mark,
Patents. These assets are valuable as tangible assets.
 Fictitious Assets - Which cannot be realised in cash or no further benefit can be derived from
these assets. These are like deferred revenue expenditure of which benefit is derived over a period
of more than one year. Such assets are advertisement expenses. Debit balance of Profit and Loss
Account.

1. Explain the following terms :
(a) Capital Expenditure (b) Revenue Expenditure (c) Contingent Liabilities (d) Wasting assets
2. Distinguish between :
(1) Capital Receipts and Revenue Receipts (2) Capital Expenditure and Revenue Expenditure
(3) Trial Balance and Balance Sheet.
3. Give five examples of each of the following :
(a) Direct Expenses (b) Indirect Expenses
4. What do you mean by “Grouping and Marshalling a Balance Sheet ?
5. List out the 4 examples of each of the following :
(i) Fixed Assets
(ii) Current Assets
(iii) Contingent Liabilities
6. Prepare the Trading and Profit & Loss Account and Balance Sheet of Jagat Shah as on 31st
March, 2008 from the following balances :
Rs. Rs.
Capital (Cr.) 3,600 Salaries 600
Machinery 700 General Expenses 200
Sales 8,200 Rent 500
Purchases 4,000 Purchases Returns 50
Sales Returns 100 Debtors 3,000
Stock on April 1, 2010 1,000 Cash 400
Drawings 400 Carriage Outward 200
Wages 1,000 Advertising 200
Carriage Inward 50 Creditors 500
Closing Stock was valued at Rs. 2,000

7. From the following Trial Balance, prepare a Trading and Profit and Loss Account for the year
ending March 31, 2010 and the Balance Sheet as on that date:
Rs. Rs.
Capital 5,00,000
Plant & Machinery 1,00,000
Land and Buildings 1,20,000
Sales 8,00,000
Furniture and other Equipment 60,000
Trade Expenses 30,000
Cash at Bank 2,50,000
Wages and Salaries 60,000
Repairs 10,000
Purchases 5,00,000
Opening Stock 2,00,000
Sundry Creditors/Sundry Debtors 1,00,000 1,30,000
Purchases Returns 10,000
Rent 12,000
Discount 8,000
Drawings 35,000
Bills Receivable/Bills Payable 10,000 10,000
Bad Debts 45,000
Interest 4,000
14,97,000 15,82,000
The Stock on 31st March, 2010 was valued at Rs. 1,40,000.

Paul S. Kr., Book-Keeping and Accountancy
Grewal T.S., Double Entry Book-Keeping
Unit - 7 Cost Accounting
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Terminology of Cost Accounting
7.3 Objectives of Cost Accounting
7.4 Cost Accounting vs. Financial Accounting
7.5 Cost Accounting vs. Management Accounting
7.6 Advantages of Cost Accounting
7.7 Limitations of Cost Accounting
7.8 Types of Costing
7.9 Methods of Costing
7.10 Cost, Expenses and Losses
7.11 Classification of Costs
7.12 Codification of Costs
7.13 Elements of Costs
7.14 Determination of Total Cost
7.15 Summary
7.16 Key Words
7.0 Objectives
After studying this unit you should be able to understand :
 Terminology of Cost Accounting
 Objectives and Advantages of Cost Accounting
 Cost Accounting differentiated from Financial Accounting and Management Accounting
 Limitations of Cost Accounting
 Types of Costing
 Classification of Costs
 Codification of Costs
 Elements of Cost
 Determination of Total Cost
7.1 Introduction
Priror to industiral revolution, there was a need of book-keeping, because business were small and
it is characterised between individuals. By the seventeenth century in France and eighteenth century in
England, the cost accounting information gathered by one or two manufacturing organisation. During world
war I and II the importance of cost accounting grew due to high defence expenditure of each country. The
emphasis of industry in general has very rightly turned to reduction in costs while improving internal
efficiencies and product quality. In the current scenario it has become difficult in the industry to sustain and
survive unless the costs are correctly accounted for, controlled and reduced so as to sustain and remain in
the industry. In the period of severe competition, financial accounting has failed to meet the exeptations of
owners in this regard. Issues such as cost determination, cost control, cost reduction and product pricing
paved the way for the emergence of cost accounting.
7.2 Terminology of Cost Accounting

 Cost: It may defined as the amount of expenditure either actual or notional incurred on or
attributable to a given thing or to ascertain to cost of a given thing. Hence cost is the amount of
resources used for something, which can be measured in terms of money.
 Costing: It is defined as “the techniques and process of ascertaining costs. Weldon defines “costing
as the classifying, recording and appropriate allocation of expenditure for the determination of cost
of products or services and for the presentation of suitably arranged data for purposes of control
and guidance of management. It deals with the cost of production, selling and distribution.”
 Cost Accounting: Weldon defines it as “the classifying, recording and appropriate allocation of
expenditure for determination of costs of products or services, the relation of these costs to sales
values, and the ascertainment of profitability. It deals with collection, analysis of relevant cost data
for interpretation and presentation for various problem of management.”
 Cost Accountancy: CIMA defines Cost Accountancy as “the application of costing and cost
accounting principles, methods and techniques to the science art and practice of cost control and
the ascertainment of profitability as-well-as presentation of information for the purpose of
managerial decision making.”
7.3 Objectives of Cost Accounting

The important objectives of cost accounting are as follows:
1. To ascertain of cost per unit.
2. To determine the selling price.
3. To control over cost and to minimise cost.
4. To ascertain cost of each division/unit/activity/centre.
5. To help the management in decision making.
6. To provide a base for operating policies.
7. To provide basis for comparative analysis.
8. To facilitate cost estimation.
9. To facilitate continuous review and help in speedy preparation of reports.
7.4 Cost Accounting vs. Financial Accounting

1. Transcations are identified with cost units whereas in financial accounting transcations are
recorded for a definite period.
2. It is an internal reporting system for an organisactions’s own management for decision making
whereas, it is more attached with reporting the results and position of business to persons and
authorities.
3. It is concerned with short term planning and reporting period is much better than financial account-
ing.
4. Items of costs are analysed, classified in order to acertain the cost per unit of product or service, but
in financial accounting the items of costs are expressed in totals.
5. It is use with both monetary and notional items, but in financial accounting only monetary informa-
tion is used.
6. It gives more importance to control aspect whereas, financial accounting does not give importance
to control aspect.
7. Cost accounting is concerned with the ascertainment, allocation, distribution and accounting as-
pects of costs but financial accounting is concerned with determination of overall performance and
position of the enterprise.
8. Cost accounting system can be installed with proper financial accounting system but financial
accounting system can be installed without proper cost accounting system.
9. It needs reconciliation of its profit with that of financial records to findout correct profit, but financial
accounting does not need any such reconciliation.
10. Cost accounting is not obligatory but financial accounting is obligatory as required by companies
Act, Income Tax Act etc..
11. Cost accounting deals with estimates also but in financial accounting there is no room for estimates.
7.5 Cost Accounting vs. Management Accounting

1. Cost Accounting serves as a base to which the tools and techniques of management accounting can
be applied to make it more purposeful, the management accounting data is derived from financial
and cost accounts.
2. The scope of cost accounting is narrower than management accounting, but scope of management
accounting is broder, because the management accountant places the data in a wider perspective
than the cost accountant.
3. Cost Accounting is not dependent on management accounting but management accounting can not
be installed without proper cost accounting system.
4. Cost accounting emphasizes collection, analysis, interpretation and presentation of cost data, the
main thrust in management accounting is towards corporate planning and strategy effective and
meaning ful.
5. Cost accounting is concerned with assisting in management function and does not provide for
evaluation and performance of management but management accounting is concerned with
evaluation and performance of management.
6. Cost accounting is mostly historical in its approach but management accounting is futuristic in its
approach.
7. Cost accouting deals with collection, classification and analysis of cost data whereas, management
accounting deals with various divisions, departments of the business and report about profitability
and performance of each of them.
7.6 Advantages of Cost Accounting
A good cost accounting system serves the needs of a large section viz:
 To Management :
1. It helps in identifying unprofitable activities and losses.
2. It is useful for identifiying exact causes for decrease or increase in profit or loss of the business.
3. It provides data to the management, which are helpful for them to take business decisions.
4. It plays an important role to assist the management in price fixing.
5. It enables the management to make inter-firm comparison or intra-firm comparison.
6. Cost comparison help in cost control.
7. It is helpful for cost reduction and also provides information for value analysis and for other efforts.
8. It points out deviation in pre-determined cost and actual cost, thus suitable action may be taken to
eliminate such deviation in future.
 To Employees :
1. Cost accounting provides information to distinguish between efficient and inefficient workers. Through
this efficiency can be recoginsed and rewarded.
2. Cost accounting provides a system for sound wages policy, it aids the management in devising
suitable wage policy.
3. Cost accounting provides the information with regard to productivity, it helps the management to
serve it with workers in the form of bonus.
 To Lenders :
1. It gives correct picture of business, so lenders can judge the soundness.
2. Cost information is helpful for them, while taking decisions of merger, takeover etc..
 To Government:
1. Cost information can help the government for the preparation of the national plan.
2. Cost accounting is useful to government in so many ways like making the policies for taxation,
export, import and subsidy decisions.
 To Society :
1. Cost accounting facilitates customers to get goods at fair prices and of better quality.
2. Cost accounting paves a vital role in development and prosperity of industries, hence it is beneficial
to all section of society.
7.7 Limitations of Cost Accounting

1. It does not give the outright solution, it gives only base for taking best decisions.
2. It is a time consuming system and also expensive.
3. There are different views for inclusion of an item to ascertain the cost.
4. Cost data varies with purpose. Hence cost called for certain purpose will not be suitable for the
other.
5. It is not exact science. It involves elements of judgement.
6. There are so many methods for apportionment and absorption of overheads, valuation of stock,
segregation of fixed and semi-fixed cost, provision for deprectiation etc. that may lead to cost
difference.
7. There is no uniform procedure.
7.8 Types of Costing

The important types of costing systems are discussed below:
1. Historical costing: The cost actually incurred are recorded and then the costs are ascertained, it is
useful for post mortem examination of actual costs incurred. These data are available at the end of
the accounting period hence it is too late to use these data for control purpose.
2. Absorption costing: In this system also costs are charged either fixed or variable. It is allocated
to cost units and total overheads are absorbed according to activity level. It is a traditional form of
cost ascertainment. In this system costs are absorbed on the basis of the benefit received from these
costs.
3. Marginal costing: Under this method, variable cost are charged to unit cost and fixed costs are
treated as period costs and it is deducted from the contribution (excess of sales over variable cost)
to arrive the profit. The techniques is widely used for managerial decisions.
4. Standard costing: The cost which is computed in advance on basis of factors affecting costs. It
provides base for control through variance analysis. It is helpful for management to take corrective
action.
5. Uniform costing: A common method of costing is used by similar units of the same industry known
as uniform costing. It facilitates valid comparisons between the same type of units and help in
elimination of inefficiencies.
6. Life-Cycle costing: It is a system, which accumulates costs for all activities occuring over the
entire life cycle of a product. It includes all costs either of capital nature or of revenue nature.
7. Activity Based costing: Cost of indirect activites are charged to cost units on the basis of benefits
received from such activity. Cost of each activity is ascertained seperately.
Activity- 7.1
For the comparison of cost between the same type of units, which type of costing should be
adopted by similar concerns?
7.9 Methods of Costing

There are a number of costing methods of cost ascertainment depending upon the nature of busi-
ness and the type of its products. The methods are given in the chart below :
Methods of costing
Specific Order Costing Continuous opertation costing
Job Contract Batch Unit Process Operating Operation

Costing costing costing Costing Costing Costing Costing
1. Job costing It refers to a system of costing in which costs are ascertained in terms of special
requirement, which is not comparable with each other. It is a method which is used in such indus-
tries, where production is carried on demand or order of a customer like a printing press, interior
decorator, repair shop and automobile garage.
2. Contract costing Contract costing is “that form of specific order costing which is applied where
work is undertaken to customer’s special requirement and each order is of long term duration. It is
an agreement between two parties to complete a special nature of job at the fixed price known as
“control Price”. This method is suitable for industries engaged in the construction of bridges,
buildings on a contract basis.
3. Batch costing Where a customer orders certain quantity of identical items or a production which
can be completed in a specific quantum of production. The cost can be ascertained on the basis of
units produced in a batch. It is used in readymade garments, toys, backery items etc.
4. Unit costing It is applicable to all such industries where there is a production of single article on a
large scale by a continuous process of manufacture. This method is adopted in industries like
cement, steel, breweries etc. It is also called as single or output costing:
5. Process costing Where material is passed through various operations to obtain a final product, in
this case, it is desired to calculate the cost of each operation seperately for a given period of time. It
is applicable to industries like chemicals, textiles, paper, oil manufacturing etc.
6. Operating costing Cost of services rendered by a unit is calculated and cost per unit of the service
is arrived at. This method is used by the undertakers who render services like transportation,
electricity companies. This systems is also known as service costing.
7 Operation costing A manufacturing process may sometimes be sub-divided into a number of
operations, each production process is considered as a separate cost centre. It is applicable to such
industries where there is mass and repetitive production conducted through different operations.
8. Composite costing In this method, two or more methods of costing are used to determine the cost
of a product. Total cost can be ascertained by computing costs through job/process costing and
then aggregating costs with the use of output costing. It is applicable to motor cars, computers
industries.
7.10 Cost, Expenses and Losses
Cost refers to the amount of expenditure incurred for an economic benefit. It includes deferred as
well as expired cost. Expenses includes expired cost with a matching economic benefit. Loss refers to the
amount which has been spent without any matching economic benefit.
7.11 Classification of Costs

It is a process of grouping costs according to their common characteristics. The different bases are
as follows: - (a)Element-wise classification:
Total Cost
Direct Costs Indirect Costs
Direct Direct Direct Indirect Indirect Indirect

Material Labour Expenses Material Labour Expenses
Direct costs are those which can be identified easily with a costing unit or cost centre. These costs
can be directly allocated to a particular cost unit. These costs are also called as traceable costs.
Indirect costs can be approtioned to cost centres or cost units but it can not be allocated directly,
hence these are called as “common costs” or “untraceable costs.”
(b) Functional Classification :
Total Cost
Production Administration Selling Distribution R&D

Cost Cost Cost Cost Cost
The production cost includes all direct costs plus indirect costs related to manufacturing operations.
The Administration cost is the sum of these costs associated with administrative functions. Selling cost is
cost of marketing a produce or service like advertisement. Distribution cost includeds the costs which are
incurred on goods or service made available to the customers. Research cost includes cost of searching
new ideas/products/process, improvement of exisitng products.Development cost is the cost which is
incurred for putting the research results on commercial basis.
(c) Classification of Costs for Decision Making:
(i) Product and Periods costs It is aggregate of costs that are associated with a unit of product. It
includes an element of overheads depending upon the types of costing system in force like
absorption or direct. Period costs are the costs which are associated with a time period rather than
level of activity. These are in the nature of fixed costs.
(ii) Explicit and Implicit costs Explicit costs involves payment to other parties, hence it is called as
“outof pocket cost. Implicit costs are the costs which do not require current cash payments like
depreciation. It is also called as ‘imputed’ or ‘book cost’ or economic costs”.
(iii) Sunk costs and Pre-determined cost Sunk cost is a past cost. Investment in plant, is a sunk
costs, which will not relevant for decisions. Pre-production costs are incurred at the time of trial run
production. These are generally treated as deferred revenue expenditure, except to the extent of
capitalised portion of such costs.
(iv) Opportunity cost It is a value of benefit forgone of an alternative course of action. Notional rent of
own-building is an example. It is used in decision making but not entered into books of accounts.
(v) Shut down cost It refers to the minimum fixed costs which are incurred even at the temporary
closure of dept., division. It is irrelevant for decision making.
(vi) Conversion cost The cost which is attributable for converting raw material into finished product.
Hence, it is production cost excluding direct material cost.
(vii) Replacement cost It is the cost of replacing existing capital asset with new one, which is usually
identical.
Activity - 7.2
Depreciation is an example of ....................... cost, while rent is an example of .........cost.
(D) Classification based on cost Behaviour :
Total Costs
Variable Semi-variable Fixed

Cost Cost Cost
Variable Fixed
Component Component
Variable cost is a cost which varies in accordance with the level of activity within relevant range and
within a given period of time. There is a linear relationship between volume and variable costs. These are
constant per unit. The fixed cost is a cost which is unaffected by the changes in the level of activity during a
given period of time and within relevant range. It has inverse relationship between volume and fixed cost
per unit. Semi-variable cost are neither perfectly variable nor absolutely fixed. These costs have neither
linear or curvilinear relationship with output but it moves in steps with the changes in activity levels. Such
classifaction affects C.V.P. analysis, direct costing, flexible budgeting and decision making. There are five
methods of segregating semi variable costs : (a) Graphical method (b) High & Low-point method (c)
Analytical method (d) Comparison by period or level of activity method (e) Least Square Method.
(E) Classification According to Controllability :
Total Costs
Controllable Costs Non-Controllable Costs
Controllable costs are the costs which can be controlled by the action of a specified person of an
organisation. But uncontrollable costs can not be influenced by the action of a specified person of an
organisation, such as price of raw material.
7.12 Codification of Costs

It is a system which assigns code numbers to each head, sub-head. It facilitates systematic and easy
recording, accounting and summerization of cost data for ascertainment of costs. A good coding system
should consist clear, unambiguous and distinctive codes in order to systemise the analysis of cost. Methods
of Codification of Costs :
(a) Straight numbering method It is a numerical coding system in which a seperate number in given
to each item of expenses.
(b) Decimal method The numeric codes are alloted to various expenses classifying them into parts
like :
1. Administrative overhead
i Office rent and rates.
ii Office lighting
iii Postage & Telegram.
iv Repairs and Maintenance of office premises
(c) Number blocks : Each major head of expenditure is given one block of numbers like as :
Depreciation 1 to 50
Salaries 51 to 100
Repairs & Maintenance 101 to 150
(d) Numerical codes : This system consists of nine digit code for each item. First two digits denotes
the nature (variable/fixed), the next three digits indicate head of expenses (Salaries, Rent), the next
two digits stand for analysis of expenses (office salaries, selling dept. salaries) and the last two digits
indicate the relevant cost centre.
7.13 Elements of Cost

Elements of Cost
Materials Labour Expenses
Direct Indirect Direct Indirect Direct Indirect
Overheads
Manufacturing Administrative Selling & distribution

Overheads Overheads overhead
Materials may be defined as substances from which products are manufactured. It may be direct or
indirect. The material which can be economically identified in the final product are called direct materials.
However, such materials which are not economically feasible to identify that quantity or which is of very
small value or is used in small quantity are called as indirect materials.
Labour may be defined as the human or machanical effort by which materials are converted into
final product. It may be direct and indirect. Labour cost which is economically identified or attributed wholly
to final product is called direct labour cost. Labour costs which cannot be allocated but can be apportioned
to or absorbed by cost unit or cost centre is called indirect labour cost.
Costs other than materials and labour cost are known as expenses. It may be direct or Indirect.
Expenses which are specifically incurred for a particular product other than direct material and labour are
called direct expenses. All the expenses which are other than direct expenses are known as indirect ex-
penses.
Overheads is the aggregate of indirect material costs, indirect labour costs and indirect expenses.
It may be classified into production (factory), administration (office) and selling and distribution
overheads.Some example items included in above:
Direct Direct Direct Factory office & Selling &
Material Labour Expenses Overheads Administration
Overheads Distribution
Overheads
-Raw Materials -Labour -Cost of -Consumable -office Printing -Salary of
-Parts and engaged special stores -Salary to sales dept.
Components in production patterns -Salaries of office staff -Traveling
-Primary -involved in drawings factory staff -Directors Exp.
packing direct -cost of patents -Overtime Salary -Warehouse
materials inspection -fees paid to bonus -Legal charges Charges
-Office rent
-Specific involved in consultant -Rent of factory -Carriage
Purchases for specific -cost of premises outwards
a product product -Power, fuel
operating -After sales
machine service cost
-Excise duty
-Samples &
free gifts.
Expenses excluded from cost :

The following expenses are excluded from costs :
Purely financial Purely financia l Appropria tion of Abnormal
Incom es charges profits Expe nses & losses
-Interest on Deposits -C apital losses -Dividend Paid -Abnorm al
-Tra nsfer fees received -Penalties and fines -Charities & donations wastage
-R ent received -Interest on loan & -Appropriation to funds -Lost by theft
-Dividend rece ive d debentures. interest -Transfer to reserve -Lost by fire
-C omm ission, broker -Loss on sales of -Am ount written off -Cost of abnorm al
-age , discount assets - goodwill idle time
received -C ash discount - Preliminary Exp.
- Discount on issue of
Debe ntures
Activity - 7.3
List out any three items, which are excluded from cost accounts:
7.14 Determination of Total Cost

Total costs of a product consists of various elements of cost. The logical process of determination
of total cost can be done through following chart :
Statement of Total Cost
Direct Material Used
Opening stock of Raw Material -
+ Purchases of Raw Material -
+ Carriage inwards -
- Closing Stock of Raw Material -
- Sale price of normal loss of material - -
Direct Labour cost -
Direct Expenses -
Prime Cost -
Add: Works overheads -
Works cost -
Opening stock of work-in-progress -
Less: Closing stock of work-in-progress -
Less: Sale price of wastage (if not directly deducted
from material cost) -
Net works cost -
Add: Office and Administration overheads -
Add: office stock of finished goods -
Less Closing stock of finished goods -
Net cost of production -
Add: Selling and distribution overheads -
Total cost/cost of sales -
Add: Profit -
Sales -
The above statement is prepared to provide the classification of costs in summarised form, to
estimate the cost and to provide information for comparative study.
7.15 Summary
Cost accounting grew with the growth of each country with the advent of the industrial revolution
and large sized industries. The amount of expenditure either actual or notional incurred to a specific article
or activity is called cost. Costing is the technique and process of ascertaining costs. Cost accounting
involves all accounting procedures relating to recording of all income and expenditure. It also involves
preparation of reports for controlling the costs. Cost accountancy is used in a broader sense. It includes
costing, cost accounting and it is concerned with the formulation of principles, methods, techniques to be
applied for acertaining costs. The purpose of cost accoounting is to ascertain the cost, to fix the selling price
and to control and reduce the costs. Cost accounting and financial accounting have distinct features. Cost
accounting offers a number of advantages to management, employees, lenders, government and to society.
Cost accounting have some limitations like expenses, unnecessary, unrreliable etc. There are two major
methods of costing viz. Specific order costing, Process costing. There are different types of costing which
are adopted for controlling costs and for making mangerial decisions. Cost can be ascertained by grouping
of elements of cost.
7.16 Key Words
 Cost Object: Anything for which a separate measurement of cost is desired like a customer, a
product, a service etc.
 Cost Centre: A location, person or an item for which cost may be ascertained. It is of two types
one a personal cost centre which consists of a person or group of persons and an impersonal cost
centre which consists of a location or an item.
 Production Cost Centre: Where raw material is handled for conversion into finished product.
 Service Cost Centre: A centre where a cost of ancillary unit to a production such as : power
house, plant maintenance centre etc.
 Cost Unit: A product, service or time (or combination of these) in relation to which costs may be
ascertained or expressed. Cost unit are usually the units of physical measurement like number,
weight, area, volume, length, time and value.
 Profit Centres: The centres which have the responsibility of generating and maximising profits.
 Investment Centres: The centres which are concerned with earning an adequate return on
investment.
 Responsibility Centre: It is an activity centre of a business organisation for the purpose of
control. It can be classified into three categories : Cost centres,Profit centres and Investment
centres.
 Imputed Costs: It is a hyphothetical cost, which is neither spent nor accounted in the books,
Examples: Interest on capital.
 Discretionary Cost: Which may be reduced or partially dropped according to the policy of
management and need of hour. These are advertisement, research and development expenses.
 Differential Cost: It represents changes in total cost due to change in activity level it may be
incremental or decremental.
1. Define cost, costing, cost accounting and cost Accountancy?
2. What are the main objectives of cost accounting?
3. What are benefits of cost accounting to all segments?
4. What are the different types of cost centres?
5. What are the limitations of cost accounting?
6. What are the different methods of costing?
7. What are the different types of costing?
8. Distinguish cost and management accounting.
9. “Reducing costs is an imperative of an emerging competitive environment.” Discuss.
10. “Cost can be classified in a variety of ways.” Explain and discuss the statement giving examples.
11. State how you would allocate the following items under their headings of (a) factory overhead (b)
office overhead (c) selling an distribution overhead.
(i) Repairs and maintenance of factory.
(ii) Directors fees
(iii) Delivery van expenses
(iv) Depreciation of plant and machinery.
(v) Depreciation of office furniture.
(vi) Carriage outward.

Saxena and Vasishtha, Essentials of Cost Accounting
Arora M.N., Cost Accounting
Ravi M. Kishore, Cost Accounting
Unit - 8 Marginal Costing
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Marginal Cost and Marginal Costing
8.3 Advantages and Disadvantages of Marginal Cost
8.4 Break Even Analysis
8.5 Profit – Volume Ratio
8.6 Break Even Point
8.7 Sales and Profit Level
8.8 Margin of Safety
8.9 Marginal Costing - A Management Tool for Decision Making
8.10 Summary
8.11 Key Words
8.12 Self-Assessment Test
8.0 Objectives
The main objectives of this unit are to make you familiar with-
 The concept of Marginal Costing
 Profit-Volume Ratio, Break-Even Analysis, relationship between Sales & Profit level.
 The benefits & limitations of Marginal Costing
8.1 Introduction
The cost elements are mainly material, labour & overhead which are further divided into variable,
semi-variable & fixed. The cost of product is determined by total costing or marginal costing In marginal
costing only variable costs are considered. In calculating cost of product & fixed costs are charged against
the revenue of the period. In Marginal Costing we will consider only variable cost which changes in direct
proportion to the change in output.
8.2 Marginal Cost and Marginal Costing

In simple words "Marginal Cost" means the additional cost for producing additional unit. The costing
terminology of I.C.W.A. defines Marginal Cost as "the prime cost plus variable overhead". i.e., the total
cost less fixed overhead. It is the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased. Here unit means an order or a batch or articles
or a single unit.
Increase (decrease) in total cost

Marginal Cost per unit 
Increase (decrease) in total quantity
Eg : If production of 1000 units of an article requires material of Rs. 12000 and labour Rs. 8000 or,
total cost is Rs. 20,000 and if production cost of 1001 units is Rs. 22000 then marginal cost is (Rs. 22000-
20000) 2000.
Marginal Costing is defined as a technique of determining marginal cost (amount of change in
aggregate cost due to an increase of one unit) by differentiating between fixed & variable costs. It is a
technique concerned with the effect on profit when the volume or type of output changes. In Marginal
Costing total cost is divided into fixed & variable. Semi variable cost is also divided into fixed & variable
cost. The fixed cost remains the same. Marginal Cost is equal to the increase in total variable, because
within existing production capacity, an increase in variable one unit of production will cause an increase in
variable costs only. The stock of work-in-progress & finished goods are valued at Marginal Cost. The
revenue generated from the excess of sales over variable costs is called contribution. Fixed cost is period
cost and variable cost is product cost.
Total Sales - Variable Cost = Contribution [S-VC =C]
Contribution - Fixed Cost = Profit [C - FC = P]
Illustration - 1
Find out the amount of profit earned during the year using marginal costing technique from the
following particulars with total fixed cost of Rs 160000.
Product Output Selling Price (Per unit) Variable Cost (per unit)
P 20000 Rs. 10 Rs. 6
Q 40000 Rs. 10 Rs. 7.5
R 120000 Rs. 5 Rs. 4.5
Solution:
Marginal Costing Statement
Particulars P Q R Total
Units 20000 40000 120000 180000
Rs. Rs. Rs. Rs.
Sales Revenue 200000 400000 600000 1200000
Marginal Cost 120000 300000 540000 960000
Contribution 80000 100000 60000 240000
Fixed Cost - - - 160000
Profit 80000
8.3 Advantages and Disadvantages of Marginal Costing

Marginal Costing is a useful tool to management in taking various policy decisions profit planning &
cost control. The following are the main advantages -
1. Marginal Costing is helpful in cost control as it classifies the cost into fixed & variable costs,
management can give more emphasis on control of variable cost, fixed cost is controlled to a limited
extent only.
2. Stock valuation in Marginal Cost is more realistic & uniform because work-in-progress & finished
goods are valued only at variable costs. No fictitious profit can arise due to fixed cost being absorbed
& capitalized in unsold stock.
3. Marginal Costing is helpful to management, through information available, in various management
decisions like make or buy, product mix, add or drop selling price below cost utilization of spare
capacity, etc.
4. Marginal Costing makes possible efficient sales planning and proper profit planning.
5. Marginal Costing is a simple technique as it does not involve complicates of absorption, allocate,
apportionment.
Marginal Costing suffers from the following limitations -
(i) The accuracy of Marginal costing depends upon correct segregation of fixed & variable costs. But
such segregation of cost is not possible in some cases.
(ii) Non-consideration of fixed cost may be dangerous, or the stock is undervalued and pricing of
product may be inappropriate.
(iii) Marginal costing is not suitable for all industries like capital intensive industries, contract, shipping
etc.
(iv) The assumption of Marginal costing i.e. same Marginal cost per unit is partly true because Marginal
cost per unit is influenced by trade discount of bulk purchase, scarcity of men & material, etc.
8.4 Break - Even Analysis

The analysis of cost behavior is required for planning, control & decision making which means
analysis of variability of each cost element in relation to the level of output. The total variable cost (Product
cost) like direct material, direct labour, selling commission, etc, varies in direct proportion to the volume of
output but per unit variable cost remains the same. The total fixed costs (period cost) like rent, insurance,
salary, etc remain the same irrespective of the level of output but per unit fixed cost goes on decreasing with
the increasing level of output. The semi-variable cost like power, fuel is also divided into variable & fixed.
The cost and level of production changes due or many reasons like scarcity men & material,
introduction of new technology, new product, boom & recession, demand etc, consequently profit changes.
The management with the help of study of cost-volume-profit relationship knows the effect of such changes
on profit. Such study is known as "break-even analysis".
Break-even Analysis involves -
(a) Contribution (b) Profit/volume Ratio
(c) Break Even Point (d) Margin of Safety
Break even analysis is based on following assumptions:
1. All cost can be segregated into two parts i.e., fixed and variable.
2. Fixed costs remain constant at various levels of activity.
3. Variable costs change directly with production. It means variable cost per unit.
4. Selling price per unit remains constant at various levels of activity.
5. Technological methods and efficiency of men and machines will not be changed.
6. No inventory exists in the beginning or at the end of the period.
7. Either there is only one product or if several products are being produced and sold then sales mix
remains constant.
8. Break even analysis assumes linear relationship in total costs and total revenues.
9. Break even analysis ignores the capital employed in the business.
Contribution: The difference between Marginal cost of sales & sales value is know as contribution
(Gross Margin). The portion of contribution left after absorbing fixed costs is Net Profit. The study of
contribution is helpful in deciding the best possible product process, optimum product mix, accepting or
rejecting new order received.
Contribution = Sales - Variable (Marginal) Cost [C = S- VC]
Sales - Variable Cost = Fixed Cost + Profit [S- VC = F+P]
8.5 Profit Volume Ratio (P/V Ratio)

The relationship between contribution & sales is expressed by profit volume ratio. It is the profit
earning rate. It depicts the soundness of the company's product. Its study is used to determine break even
for a product or products, to know how the profit changes if changes are made in cost, profit, volume or any
combination of these. There exist direct relationship between profit volume ratio & contribution. The P/V
Ratio can be improved by improving contribution and contribution can be improved by increasing selling
price, decreasing variable cost.
Contribution X 100  C 
Profit Volume Ratio (P/V)    100
Sales S 
FP S- V 
 100 or, 100
 S S 
When sales & Profit of two years is Given-
Change in profit
P/V Ratio  x 100
Change in sales
Estimation of sales value with contribution & P/V Ratio
Fixed Cost  Desired Profit

Sales value 
P/V Ratio
Illustration: 2
Mahalaxmi Ltd. produces three products P, Q, R. The cost data is as follows:
Fixed cost Rs. 25000
P Q R
Rs. Rs. Rs.
Sales 50,000 25,000 30,000
Variable Cost 20,000 20,000 18,000
You are required to:

(1) Calculate the Profit Volume ratio of each product
Solution:
P Q R Total
Rs Rs. Rs. Rs.
Sales 50,000 25,000 30,000 1,05,000
Marginal Costs 20,000 20,000 18,000 58,000
Contribution 30,000 5,000 12,000 47,000
Profit Volume ratio 3/5 or 0.60 5/25 or 0.20 12/30 or 0.40 47/105 or 0.45
The sequence should be P, R, and Q (Descending order of P/V Ratio)

Product Sales Variable Contribution Cumulative Fixed Cumulative Cumulative
cost contribution Cost profit Sales
P 50,000 20,000 30,000 30,000 25,000 5,000 5,0000
Q 30,000 18,000 12,000 42,000 25,000 17,000 80,000
R 25,000 20,000 5,000 47,000 25,000 22,000 1,05,000
 Profit Volume Graph

For preparing the profit volume graph, following steps are involved:
 Sales are depicted on x-axis and profit and loss on y-axis.
 X-axis divides the graph into two parts. The lower area of the x-axis depicts loss and upper area
depicts the profit. When sales is zero, loss is equal to fixed cost.
 At a particular level of sales volume, the profit is depicted on y-axis. Both the points are joined by
a straight line called profit line.
 The point where profit line inter- sects the x-axis is called the break even point.
 The angle between sales line and profit line is called angle of incidence.
Illustration: 3
Construct profit volume graph with the help of the following data:
ABC Ltd. reports the following results on 31st March 2010:
Sales @ Rs. 3 each Rs. 3,00,000/-
Variable Cost Rs. 2 each Rs. 2,00,000/-
Fixed Cost Rs. 50,000/-
Construct the P/V chart.
Solution:
Contributi on
P/V Ratio 
Sales
Contribution = Sales - Variable Cost
= Rs. 300000 - Rs. 200000
= Rs. 100000
On X-axis, OX represents sales volume, on Y-axis OY represents profit while OY' loss, OFC
represents fixed cost. The line FCP represents fixed cost and profit as well as total contribution. BE is the
break-even point. The area BEX represents margin of safety while XBEP profit area. PBEX is the angle of
incidence.
8.6 Break Even Point

Break Even Point is point of no profit no loss. Here contribution is equal to fixed cost. If is the point
(volume) of output where total cost is exactly equal to revenue. It is the point after which profit begins.
According to Charles T. Harngren, "The break-even point is the point of activity (sales volume) where total
revenue and total expenses are equal, it is the point of zero profit and zero loss".Break-Even Point' is
affected by increase and decrease in variable expenses, selling price or fixed cost.
8.6.1 Calculation of Break Even Point
Fixed Cost
B E P (in units) 
Contributi on per unit
Fixed Cost
B E P(in value )   100
P \ V Ratio
BE Sales
BEP (in terms of sales capacity) (%)  100
Sales 100% capacity
Fixed Cost  Contributi on 

BEP (Sales in Rupees)   contribution ratio  
Contribution Ratio  Sales 
Break Even Sales = Total Variable Cost + Total Fixed Cost
Illustration: 4
The ratio of the variable costs to sales is 70 percent. The break even point occurs at 60 percent of
the capacity. Find the break even point sales when fixed costs are Rs. 90000. Also compute profit as 75%
of the capacity sales.
Solution:
As the variable cost to sales ratio = 70%
VC
P/V ratio or contribution ratio  1 -  1 - 0.70
Sales
= 0.30
Fixed Cost Rs. 90000

BEP (In value)  
P/V Ratio .30
= Rs. 300000
BEP occurs at 60 percent of the capacity utilization
Capacity Utilization Sales
60% Rs. 300000
75%
We can apply unitary method or proportion method.
Rs. 300000 x 75
X  RS. 375000
60
Now we can compute, contribution earned when sales is Rs. 375000 Sales multiplied by P/V ratio
gives the contribution.
Contribution = Sales x P/V Ratio
= Rs. 375000x 30%
= Rs. 112500
Profit = Contribution - Fixed Cost
= Rs. 112500 - Rs. 90000
= Rs. 22,500
Activity
If Selling prices is Rs. 30 per unit, variable cost Rs. 18 per unit fixed cost Rs. 36000.
Calculate sales units at BEP.
Illutstration: 5
Ummaid Ltd. is manufacturing and selling four types of products, A,B,C,D. The sales mix and
variable costs are as follows:
Product Sales per month Variable Cost Ratio

A 1,00,000 50%
B 75,000 50%
C 50,000 75%
D 1,25,000 40%
The fixed costs are Rs. 75000 per month. Calculate break even point.
Solution:
Particular A B C D TOTAL
Sales (Rs.) 1,00,000 75,000 50,000 1,25,000 3,50,000
Variable Cost (Rs.) 50,000 37,500 37,500 50,000 1,75,000
Contribution (Rs.) 50,000 37,500 12,500 75,000 1,75,000
Fixed Cost (Rs.) 75,000
Profit (Rs.) 1,00,000
Total Contribution Rs. 175000

P/V Ratio    0.50 (i.e., 50%)
Total Sales Rs. 350000
Rs. 75000
Break Even Point (in Value)   Rs. 150000
0.50
Variable Costs Rs. 175000

Variable Cost Ratio    0.50 (i.e., 50%)
Total Costs Rs. 350000
Fixed Costs Rs. 75000

BEP (in Value)    Rs. 150000
Variable cost 1 - 0.50
1-
Total Sales
8.6.2 Graphical Presentation of BEP
The break even point can also be shown graphically, the BEP chart shows the relationships between
cost, volume and profit at various levels of output. Fixed cost, variable costs and sales revenues are shown
on Y-axis and volume of output on X-axis. The break even point is that point at which the total cost line and
total sales line intersect each other. This point represents "no profit, no loss".
The following steps are involved in construction of break even chart:
 Sales volume is plotted on X-axis. Sales volume may be expressed in terms of value (rupee), units
of percentage of capacity.
 Cost and Revenue are depicted in Y-axis. Fixed costs remains constant irrespective to the sales
volume. Hence it is parallel to the X-axis. Variable cost starts from (0,0) because no sales volume,
no variable cost and as the volume increases variable cost also increases. When there is a parallel
line of variable cost drawn from the fixed cost line in Y-axis, it depicts the total cost line. The sales
revenue curve also starts from (0,0)
 The point of intersection of sales revenue line and total cost line depicts break even point.
 The area to the left side of break even point depicts loss zone as cost curve is at a higher level and
sale revenue line is at a lower level. The area to the right hand side of break even point is called
profit zone as sale revenue line lies at a higher level than the total cost line.
 The angle formed by the intersection of sale value line and total cost line is known as angle of
incidence. Larger the angle, lower is the break even point and vice versa.
Illustration 6
Let us draw a break even chart with the help of data given below at different production levels of 0,
80,000, 90,000, 1,00,000, 1,10,000, and 1,20,000 units.
Sale Price = Rs. 3 per units
Variable Cost = Rs. 2 per units
Fixed Cost = Rs. 90000
Solution
The costs and profits and different levels of output are computed as follows:
Output Variable cost Fixed cost Total cost Sales Rev. Profit
Rs. Rs. Rs. Rs. Rs.
0 0 90000 90000 0 -90000
80000 160000 90000 250000 240000 -10000
90000 180000 90000 270000 270000 0
100000 200000 90000 290000 300000 10000
110000 220000 90000 310000 330000 20000
120000 240000 90000 330000 360000 30000
The above data if presented on a graph, it appears as follows:
8.6.3 Contribution break even chart

Form this chart we can ascertain the contribution earned at different levels of activity. Under this
method, total cost line is not drawn, instead the contribution line is drawn form the (0,0) point or origin.
Intersection of cost line and sales line does not arise in this case as break even point occurs where contribution
is equal to fixed cost. When contribution is greater than fixed cost it is profit and vice versa. The contribution
break even chart shows the contribution at different levels of activity and any level of activity below the BEP
will not cover the fixed cost.
Let us represent the data as given in illustration 6 by means of contribution break even chart.
Solution
Output Variable cost Fixed cost Total cost Sales Rev. Profit
Rs. Rs. Rs. Rs. Rs.
0 0 90000 90000 0 0
80000 160000 90000 250000 240000 80000
90000 180000 90000 270000 270000 90000
100000 200000 90000 290000 300000 100000
110000 220000 90000 310000 330000 110000
120000 240000 90000 330000 360000 120000
8.7 Sales and Profit Level

8.7.1 Calculation of Required Sales for Desired Profit
At BEP, profit is zero but for calculating the sales volume required to earn a desired profit, the profit
value is put as desired profit.
Sales - Variable cost = Contribution = Fixed Cost + Desired Profit

Required Sales Volume (in unit) 
Contribution per unit
(Fixed cost  Desired Profit) Sales
Required Sales Volume (in value) 
Total Contribution


1 - Variable Cost / Sales
Illustration 7
A company producing a single product sells it at Rs. 30 per unit. Variable cost is Rs. 18 per unit and
fixed cost is Rs. 120000 per annum. Calculate (a) Break even point, (b) Sales volume required to earn a
profit of Rs. 180000 per annum.
Solution:
Contribution = SP - VC = Rs. 30 - Rs. 18
= Rs. 12 per unit
Fixed Costs
BEP (in units) 
Contribution Per unit
Rs. 120000
  10000 Units
Rs. 12
Fixed Costs
BEP (in value) 
P/V Ratio
Total Contributi on
P/V Ratio 
Total Sales
Rs. 120000
  0.40
Rs. 300000
Rs. 120000
BEP 
0.40
= Rs. 300000
Fixed Costs  Desired Profit

Sales volume required to Earn a desired profit (in units) 
Rs. 120000  Rs. 180000


Rs. 12
Rs. 300000
  25000 units
Rs. 12

Sales volume required to earn desired profit (in value) 
P/V Ratio
Rs. 120000  Rs. 180000

  Rs. 750000
0.40
8.7.2 Calculation of Sales Volume Required for Desired per unit Profit
Fixed Cost
Selling price - (Variable Cost - Desired profit)
Fixed Cost
(VC  Desired Profit Percentage on Sales)
1-
Sales
Fixed Cost
Selling Price per unit   Variable Cost
Desired BEP
Illustration 8
The cost information computed by the cost accountant is as follows:
Sales = 1,00,000 units
Selling Price = Rs. 10 per unit
Variable cost or out of pocket- Cost = Rs. 6 per unit
Fixed Cost or Burden = Rs. 60,000 per annum
Compute the following:
(a) Make a profit of Rs. 40000
(b) Make a profit of Rs 2 per unit
(c) Make a profit of 30% on sales
Solution
(a) Sales volume required to earn a profit of Rs. 40000
In units


Rs. 60000  Rs. 40000

  25000 units
Rs. 4
In value


P/V Ratio
Rs. 60000  Rs. 40000

  Rs. 250000
0.40
(b) Sales volume required to earn a profit of Rs. 2 per unit
In unit
Fixed Costs

SP - (VC  P)
60000
  30000 units
Rs. 10 - (Rs. 6  Rs. 2)
Fixed Costs

1 - (VC  PD)/SP
60000

1 - (6  2) / 10
60000
  Rs. 300000
2 / 10
(c) Sales volume required to earn a profit of 30% on sales
In units
Fixed Cost

SP - (VC  30% of SP)
Rs. 60000
  60000 units
Rs. 10 - (6  3)
In Value
Fixed Cost

1 - (VC  30% of SP) / SP
60000
  Rs. 600000
1 - (6  3) / 10
8.7.3 Calculation of Sales Required to Maintain Present Profit
(i) Sales volume required to meet proposed expenditure
Proposed Expenditur e
Additional Required Sales Volume (in unit) 
Proposed Expenditur e
Additional Required Sales Volume (in value)   100
P/V Ratio
Illustration 9
Sales 10000 Units
Variable Cost Rs. 200000
The selling price is Rs. 36 per unit. The company is spending Rs. 100000 on advertisement to
promote its product. Find the sale volume required to earn the present profit.
Solution:
Extra sales volume required to meet the additional publicity expenditure of Rs. 100000 so as to maintain the
present profit level is worked out as follows:
Rs. 200000
Variable Cost Per Unit   Rs 20 per unit
10000 units
Contribution Margin = Rs. 36 - Rs. 20 = Rs. 16 per unit
Rs. 100000
Additional sales required (in units)   6250 units
Rs.16
When a company sells 6250 units extra, then present level of profit will be maintained. For example,
before spending money the company was earning a profit of Rs. 60000 which is as follows.
Profit = Contribution - Fixed Cost
= Rs. 16 x 10000 - Rs. 100000
= Rs. 160000 - Rs. 100000 = Rs. 60000
When sales volume increase to 16250 units (i.e. 10000 units + 6250) then profit will be
= Rs. 16 x 16250 - Rs. 200000 (F.C. 100000+ Advertisement Rs. 100000)
= Rs. 260000 - Rs. 200000 = Rs. 60000
(ii) Sales volume required to offset price reduction
Illustration 10
Jodhana Ltd. manufactures and markets a product whose cost data is as follows:
Material Cost = Rs. 32 per unit
Conversion (Variable Cost) = Rs. 24 per unit
Dealer's Margin = Rs. 8 per unit (10% of selling price)
Selling Price = Rs. 80 per unit
Fixed Cost = Rs. 8 per unit
Present sales = Rs. 90000 units
Capacity Utilisation = 60%
Management has the following two suggestions, which alternative is better so as to maintain the
present profit level?
(a) Reduction is selling price by 5%
(b) Increasing the dealer's margin by 25% over the existing rates.
Solution
Total variable costs = Rs. 32 + Rs.24 + Rs. 8 = Rs. 64 per unit
Contribution per unit = Rs. 80 - Rs. 64 = Rs. 16 per unit
Present Profit Level = Rs. 16x 90000 - Rs. 1000000 = Rs. 440000
(a) Price Reduction By 5%
New selling price = (Rs. 80 - Rs. 4) = Rs. 76 per unit
New Dealer's Commission = 10% of Rs. 76 = Rs. 7.60
New Contribution = Rs. 76 - (Rs. 32 + Rs. 24 + Rs. 7.60)
= Rs. 12.40 per unit
FC  DP
Sales volume requires to earn a desired profit ( in units) 
Rs.1000000  Rs. 440000

Sales volume required (In unit) 
Rs. 12.40
Rs.1440000
  116129 units
Rs.12.40
(b) Increasing dealer's commission by 25%
New Dealer's Commission = Rs. 8 + 25% of Rs. 8 = Rs 10 per unit
New Contribution = Rs. 80 - (Rs.32 + Rs.24 + Rs.10) = Rs.14 per unit
Rs. 1000000
Sales required (in units)   Rs. 440000
Rs. 14
= 102857 units
In the second alternative, lesser units are required to be sold as compared to the first alternative.
Contribution margin is also high in the second alternative. Hence the second alternative is better in comparison
to the first.
(iii) New Sales volume or new selling price to offset the impact of change in variable cost and
fixed costs
New selling price with the same volume and to earn the same profit when variable costs changes-
New selling price = Old selling + New Variable Cost - Old Variable Cost
New fixed cost - old fixed cost

When fixed cost changes  Old Selling 
Volume of Product
Illustration 11
The cost of information supplied by the cost accountant is as follows:
Sales 10000 units @ Rs. 10 per unit Rs. 100000
Variable cost Rs. 6 per unit Rs. 60000
Contribution Rs. 40000
Profit Rs. 25000
Calculate the (a) new sales quantity and (b) new selling price to earn the same profit if
(i) Variable cost increase by Rs. 2 per unit
(ii) Fixed cost increase by Rs. 5000
(iii) Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs.5000
Solution
(i) Variable cost increases by Rs. 2
F  DP
(a) New sales quantity required 
SP - Vn
Where Vn is new variable cost
Rs. 15000  Rs. 25000 Rs. 40000

   20000 Units
Rs. 10 - Rs. 8 Rs. 2
(b) New selling price
= Old selling price + change in variable cost per unit
= Rs. 10 + Rs. 2 = Rs. 12 per unit
To earn the same amount of profit, the management should either increase the production to 20000
units or increase the selling price to Rs. 12 per unit.
(ii) Fixed cost increases by Rs. 5000
(a) Sales volume needed to earn a desired profit
Fn  DP

SP - VC
Fn is the new fixed costs
Rs. 20000  Rs. 25000

  11250 units
Rs. 10 - Rs. 6
(b) New Selling price
SP  Fn - Fo

Q
SP is old selling price, Fn is new fixed cost and Fo is old fixed cost.
Rs. 20000 - Rs. 15000

 10   Rs. 10.50
10000 units
To earn the same amount of profit i.e. Rs. 25000 the management should either increase the sales
volume to 11250 units or increase the selling price to Rs. 10.50
(iii) Variable cost increases by Rs. 1 per unit and fixed cost reduces by Rs. 5000
(a) Sales volume required to earn a desired profit
Fn  DP

SP - Vn
Rs. 10000  Rs. 25000 Rs. 35000

   11667 units
Rs. 10 - Rs. 7 Rs. 3
(b) New selling price
(VCn - VCO)
 SP   Fn - Fo
Q
Rs. 10000 - Rs. 15000

 Rs. 10   Rs. 7 - Rs 6
10000 units
= Rs. 10 - Rs. 0.50 + Rs 1
= Rs. 10.50
To earn the same profit i.e. Rs. 25000 the management should either increase the sales to 11667
units or increase the selling price to Rs. 10.50
Illustration 12
The cost data of Kota Ltd. is as follows:
Product A Product B Product C Total Rs.
Sales (40:50:10) (Rs.) 80000 100000 20000 200000
Variable Costs (Rs.) 50000 60000 10000 120000
Contribution (Rs.) 30000 40000 10000 80000
Fixed (Rs.) - - - 50000
Profit - - - 30000
Calculate
(i) Break Even point, and
(ii) Break even point if sales mix ratio is changed to 30:50:20
Solution
(i) Break Even point
When the company is producing multi products, then for computing break even equation in terms of
value should be used.
Fixed Costs x Total Sales

BEP (in value) 
Total sales - Variable costs
Rs. 50000 x Rs. 200000


Rs. 200000 - Rs. 120000
Rs. 50000  Rs. 200000

  Rs. 1250000
Rs. 80000
(ii) Change in sales mix ratio
New sales mix A:B:C = 30 : 50 : 20
Sales
30
A  Rs. 200000   Rs. 60000
100
50
B  Rs. 200000   Rs. 100000
100
20
C  Rs. 200000   Rs. 40000
100
Variable Cost Ratio (as variable cost per unit remains same)
Rs. 50000 5
A  
Rs. 80000 8
Rs. 60000 6
B  
Rs. 100000 10
Rs. 10000 1
C  
Rs. 20000 2
Product A Product B Product C Total Rs.
Sales (Rs.) 60000 100000 40000 200000
Variable Costs (Rs.) 37500 60000 20000 117500
Contribution (Rs.) 22500 40000 20000 82500
Fixed (Rs.) - - - 50000
Profit - - - 32500
Break Even Point after change in sales mix:
Fixed Cost x Sales


Sales - Variable Costs
Rs. 50000 x Rs. 200000 Rs. 50000 x Rs. 200000


Rs. 200000 - Rs. 117500 Rs. 82500
= Rs. 121212.12
8.8 Margin of Safety

The difference between actual sales and B E P sales is known as margin of safety. Higher the margin
of safety higher the protection to the company. It indicates the sales volume below which the firm will suffer
loss. There is a positive relation between margin of safety and soundness of the business.
Actual Sales - Break even Sales (in unit)

Margin of Safety (in unit) 
Margin of Safety (in value) = Actual Sales - Break Even Sales (in value)
Profit  100
Margin of Safety (in value) 
P/V Ratio
Actual Sales - Break Even Sales

Margin of Safety (in %)   100
Actual Sales
Illustration 13
Sri Ram Ltd. has earned contribution of Rs. 2,00,000 and net profit of Rs. 1,50,000 on sales of Rs.
8,00,000 Calculate Margin of Safety if Break Even Sales is Rs. 2,00,000
Solution
Contribution 200000
P/V Ratio   100   100  25%
Sales 800000
Profit 150000
M/S(in val ue)   100   100  Rs. 600000
P/V Ratio 25
Actual Sales - B.E. Sales 800000 - 200000
M/S(in %)   100   100  75%
Actual Sales 800000
Activity
If present sales is Rs. 300000, sales at BEP Rs. 240000, calculate margin of Safety in
terms of percentage.
Illustration 14
From the following data prepare the marginal cost statement and find out (I) P/V Ratio (ii)
B E P (iii) M/S
Direct Material Rs. 60,000
Direct Labour 48,000
Variable Factory Overhead 25 % of wages
Variable Administration Overhead 10 % of works cost
Fixed Expenses 48,000
Variable Selling Overhead 15 % of works cost
Sales 2,500 units @ Rs 80 per unit
Marginal Cost Statement
Rs. Rs.
Saels 2500 units @ Rs. 80 200000
Less: Marginal cost:
Direct Material 60000
Direct Labour 48000
Prime cost 108000
Add: Works overhead (variable 25% of labor) 12000
Marginal Works cost 120000
Add: admistration overhead (variable 10% of w.c) 12000
Marginal Cost of Production 132000
Add: selling overheard (variable 15% of w.c.) 18000
Total Marginal Cost 150000
Contribution 50000
Contributi on 50000
(1) P/v Ratio   100   100  25%
Sales 200000
Fixed Cost 48000

(2) BEP   100   100  192000
P/V Ratio 25
Profit 2000
(3) M/s   100   100  8000
P/V Ratio 25
Profit = C-FC = Rs. 50000 - 48000 = Rs. 2000
Illustratin 15
Ashish Ltd., Multi Product company, furnishes the following data:
Particular Period I Period II
Sales (Rs.) 45000 50000
Total Cost (Rs.) 40000 43000
Assuming that there is no change in price and variable costs, fixed expenses are incurred equally in
the two periods. Calculate the following;
(i) Profit volume ratio.
(ii) Fixed expenses
(iii) Break even point
(iv) Percentage M/S to sales in Period II
(v) Sales required to earn profit = Rs. 10000
(vi) Profit when sales is Rs. 80000.
Solution
Particular Period I Period II Profit (Rs.)
Period II 50000 43000 70000
Period I 45000 40000 5000
Change 5000 3000 2000
Change in Profit Rs. 2000

(i) P/V Ratio    0.40
Change in Sales Rs. 5000
(ii) Fixed expenses
Contribution = Sales x P/V ratio
Period I Contribution = Rs. 50000 x 0.40 = Rs. 20000
Contribution = Fixed Cost + Profit
Rs. 20000 = FC + Rs. 7000
FC = Rs. + 13000
Period II Contribution = Rs. 45000 x 0.40 = Rs. 18000
FC = Contribution - Profit
= Rs. 18000 - Rs. 5000 = Rs. 13000
Fixed Costs
(iii) Break Even point =
P/V Ratio
Rs. 13000
BEP ( in value) =  Rs. 32500
0.40
(iv) Margin of Safety (M/S) = Actual Sales - BEP (in value)
= Rs. 50000 - Rs. 32500
= Rs. 17500
Rs. 17500
% of M/S to sales =  100  35%
Rs. 50000
(v) Sales required to earn a desired profit of Rs. 10000
FC  DP
=
P/V Ratio
Rs. 13000  Rs. 10000
=  Rs. 57500
0.40
(vi) Profit when sales is Rs. 80000
Contribution = Sales x P/V ratio
= Rs. 80000 x 0.40
= Rs. 32000
Profit = Contribution - FC
= Rs. 32000 - Rs. 13000
= Rs. 19000
8.9 Marginal Costing - A Tool for Decision Making

Decision making is a process of selecting any of the alternatives available after evaluation of all
options with an aim of maximizing the profit of the concern. The decision making process starts withrecognizing
the problem, then identifying the various alternatives, then after evaluating different alternatives with the
helps of cost benefit analysis and finally adopt the most profitable course of action.
Therefore, Marginal Costing is a useful tool to management in taking various policy decisions, profit
planning & cost control. Marginal Costing is very useful technique to the management in formulating policies
& making the following decisions:
(a) Price Fixation –
(b) Exploring New Markets and Acceptance of Special Order
(c) Make or Buy Decision
(d) Add or Drop Decision
(e) Sales Mix Decision
(f) Plan shut Down Decision
(g) Key Factor / Limiting Factor
(a) Price Fixation Pricing process is different in different industries. It differs according to the nature,
cost and demand of the product. Every product. Every producer accepts the different criterion for
pricing product. In normal business conditions, the price fixed must cover full costs otherwise firm
will incur losses,. In certain circumstances like trade depression, dumping, seasonal fluctuation in
demand, highly competitive market etc. pricing is fixed with the help of marginal costing. During
trade depression, the price may go down even below the full cost of the product. In such case, the
main emphasis of management is to minimize its losses. The firm should continue its production
activities so long as the selling price is more than the marginal costs because any contribution earned
will help in recovery of the fixed costs which results in reduction of loss. Dumping means selling the
product in foreign market at a price less than its total cost. The firm recovers its fixed cost from the
domestic market and marginal cost of the product becomes the basis for price fixation. Similarly if
the firm produces product of seasonal demand or perishable goods marginal costing is useful technique.
(b) Exploring New Markets and Acceptance of Special Order In case of spare capacity, a firm
can increase its total profits by accepting an special order above the marginal cost and at a price
lower than its regular selling price. The additional contribution earned form the special order will be
the additional profit to the firm. When additional order is accepted additional markets is explored at
a price below prevailing price to utilize idle capacity, it should be carefully seen that it will not affect
the normal market and goodwill of the company.
(c) Make or Buy Decision A particular component used in the main product may be purchased or
may be manufactured in its own factory by utilizing the idle capacity of the existing facilities. In such
make or buy decision, the marginal cost of manufacturing in the unit is compared with the purchase
price from the market. If marginal cost is less than the purchase price, then the component should
be manufactured in its own unit, otherwise it should be purchase form the market. Fixed expenses
are not taken in the cost of manufacturing on the assumption that they have been already incurred,
the additional cost involved is only variable cost.
(d) Add or drop decision An organization may have a number of product lines or departments,
certain product lines or departments may turn out to be unprofitable with the passage of time or due
to technological developments. Production of such products or departments can be discontinued.
The marginal costing approach assisting these situations to take decision. It helps in the introduction
of a new product line and work as a good guide for deciding the optimum mix keeping in mind the
available resources and demand of the product. The contribution of different products or departments
is to be compared and the product or department whose P/V ratio is the lowest is to be dropped
out.
(e) Sales Mix Decision In marginal costing, profit is calculated by subtracting fixed cost from
contribution. It means management should try to maximize the contribution. When a business firm
produces variety of product lines, then problem of best sales mix arises. The best sales mix is that
which yields the maximum contribution. The product which gives the maximum contribution are to
be retained and their production should be increase keeping in view the demand. The products,
which yield less contribution, should be reduced or close down depending upon the situation.
(f) Plant Shut Down Decision This type of decision is being taken when the nature of business is
seasonal, cut-throat competition and other un-favorable conditions of the market are there. When
one shuts down his plant, there are some avoidable, traceable or escapable fixed costs such as
salaries of temporary workers and salary of sales man, which can be stopped by this decision.
Some unavoidable or un-escapable costs are: depreciation on fixed assets, rent of office and factory,
insurance, interest and salaries of permanent staff. These can not be stopped by shutting down the
plant temporarily. Some additional cost of Shut Down or Reopening Cost should be considered as
the part of the unavoidable costs. Normal decisions are for maximizing the profit; but Shut Down
decision is for reducing the loss as it always considers the savings under loss.
Calculation of net avoidable costs
Net Avoidable FC = Total FC – (Un-avoidable FC + Re-opening Cost)
8.9.1 Key Factor/ Limiting Factor
The marginal costing technique provides that the product with highest contribution per unit is preferred.
This inference holds true so long as it is possible to sell as much as it can produce. But sometimes an
organization can sell all it produces but production is limited due to scarcity of raw material, labour, electricity,
plant capacity or capital.
These are called key factors or limiting factors. A key factor or limiting factor puts a limit on production
and profit of the firm. In such a situation, the management has to take a decision whether production is to be
increased, decreased or stopped. In such cases, the selection of a product is done on the basis ofcontribution
per unit of scarce factor of production. The key factor or scarce factor should be utilized in such a manner
that contribution per unit of scarce resource is the maximum.
Contribution
Profitabil ity 
Key Factor
For example, if raw material is the limiting factor, the profitability of each product is determined by
contribution per kg of raw material. If machine capacity is a limiting factor then contribution per machine
hour is calculated. If electricity is the limiting factor, then contribution per unit of electricityof each product
is calculated.
8.10 Summary
Marginal costing involves computations of marginal cost. It comprises direct material, direct labour
and variable overheads. Marginal costing helps the management in taking various managerial decisions like
price fixation, profit planning, add and drop decisions, make or buy decision, sales mix decision etc. Marginal
costing technique has some limitations. The categorization of expenses into fixed and variable elements is
tedious and complex task. The behavior of per unit variable and total fixed cost is questionable as assumed
in marginal costing.
Break even analysis helps in ascertaining the level of production where total costs equals to total
revenue. Below this level of production, there are losses and above this point depicts the profit zone. It
represents the level of activity at which revenue from sale of goods and services is just equal to total cost
incurred to produce and sell the same. If sales volume exceeds the break even volume even by one unit the
company earns profit. The amount of profit is equal to total cost incurred to the product of excess of units
sold over and above break even volume. Similarly, if the sales volume falls below Break even volume even
by one unit, the company sustains loss. The analysis is based on cost classification into fixed and variable
costs. Break even analysis helps in measuring the effect of changes in volume, costs, selling price and
product mix on profit. It is expressed in terms of units or in value terms. This technique is very useful in profit
planning and decision making. It can be applied to estimate profits at a given sales volume, sales volume
required to earn a desired profit, calculating sale volume required to offset price reduction, ascertaining the
margin of safety, measuring the effect of changes in profit factors etc. The other tools in this analysis are
profit-volume ratio, margin of safety and angle of incidence.
Before taking a decision, one must analyze the alternatives available before him and then one should
take a decision, which is beneficial to the management. The decision should be in such a way that it increases
the profit of the company. When we take a decision for a short period, normally we look at the contribution
we received in all the available alternatives and compare them and one should accept the alternative, which
provides more contribution, as in shorter period it is presumed that fixed costs will not change.
8.11 Key Words

 Marginal Cost: It comprises direct material, direct labour and variable overhead or cost of
producing one additional unit.
 Marginal Costing: It is a technique where only variable costs are considered while computing the
cost of product. The fixed costs are met against the total contribution of all the products taken
together.
 Cost - Volume - Profit Analysis It is a technique to study the effects of costs and volume variations
on profit.
 Contribution: The difference between sale price and variable costs is called contribution.
 Break Even Point: A level of production activity, where sales revenue is equal to variable cost
and fixed cost or contribution is equal to fixed cost. It is also called 'no profit, no loss' point.
 Profit Volume Ratio It is a relationship between contributions to sales.
 Margin of Safety is the difference between actual sales and sales at break even point. It shows the
amount by which sales may decrease before losses occur.

1. Explain the application of marginal costing in managerial decision making.
2. The profit is the product of the P/V ratio and the margin of safety'. Comment.
3. 'Cost -volume profit analysis and break even point analysis are the same' Comment.
4. Explain the significance of Profit-Volume Ratio, Margin of safety and Angle of incidence.
5. What is Contribution? How does it help the management in taking managerial decisions?
6. From the following data prepare marginal cost statement-
X Y Z
Sales 30000 60000 80000
Direct Material 12000 25000 36000
Direct Labour 8000 10000 14000
Factory Overhead:
Variable 2000 3000 5000
Fixed 6000 8000 6000
Administrative
Overhead Fixed: 1000 2000 2000
Selling Overhead
Variable: 1000 3000 3000
Fixed 2000 2000 3000
(Ans: Profit: Rs. 16000, X:Rs. 2000, Y Rs. 7000, Z Rs. 11000)
7. Calculate (1) P/V Ratio, BEP, Fixed Overhead
(2) Sales of Earn a profit of Rs. 1.60 Lakh
(3) Profit Earned when sales are Rs. 2 Lakh.
Following information is taken out form books of company-
Period I Period II
Rs. Rs.
Sales 4,00,000 6,00,000
Profit 40,000 80,000
(Ans.: (1) 20%, Rs. 2 Lakh, Rs. 40000, (2) Rs. 10 Lakh (3) BEP)
8. Rudra Ltd. manufactures and sells four types of products under the brand names of P, Q, R and S.
The sale mix in value comprises 34%, 40%, 16% and 10% of P, Q, R and S respectively. The total
budgeted sales (100%) are Rs. 60000 per month. Operating costs are:
Variables costs ratio is (variable cost on % of sales)
P 60%
Q 65%
R 70%
S 40%
Fixed costs are Rs. 15,000 per Month. Calculate the break even point for the products on overall
basis. (Ans BEP Rs. 39062.50)
9. Explain from the following data, how the reduction in selling price would affect the break even point
and margin of safety.
Selling price per unit Rs. 10
Variable cost Material Rs. 3
Labour Rs. 2
Variable overhead Rs. 1
Fixed overhead is Rs. 4000. Full capacity of the plant is 5000 units. Reduced selling Price is Rs. 8
per unit.
(Ans: BEP increase by 1000 units and M/S decrease by Rs. 16000)
10 Ashish Ltd., has a margin of safety 37.5% with an overall contribution sale ratio of 40%. The fixed
cost is Rs. 5 lakhs.
Calculate the following:
(i) Break even point
(ii) Total Sales
(iii) Total variable cost
(iv) Profit
(Ans: i)Rs. 12,50,000 ii) 20,00,000 iii) Rs. 12,00,000 iv) Rs. 3,00,000)
11 The P/V ratio of a concern is 50% and margin of safety is 40%. Calculate the net profit of the sales
is Rs. 1,00,000.
(Ans : profit Rs. 20,000)
12. AXE Ltd. has earned a contribution of Rs. 200000 and net profit of Rs. 150000 on sales of Rs.
800000. What is the break even point and margin of safety?
(Ans: Rs. 200000 M/S is Rs. 600000)
13. From the following cost information:
2009 2010
Sales (Rs.) 1,50,000 2,00,000
Profit (Rs.) 30,000 50,000
Calculate:
(i) P/V Ratio
(ii) Break even point
(iii) Sales required to earn a profit of Rs. 80,000
(iv) Profit when sales is Rs. 2,50,000
[Ans: (i) 0.40 (ii) Rs. 75,000 (iii) Rs. 2,75,000 (iv) Rs. 70,000]
14 Chitragupt Ltd. furnishes the following data relating to year 2010
Sales Total Cost
Jan to June Rs. 1350000 1200000
July to Dec. Rs. 1500000 1290000
Calculate: (i) P/V Ratio, Break Even Sales, Fixed Cost, and Margin of safety.
(ii) Sales needed of proit of Rs. 4.40 Lakh
(iii) Profit when sales are Rs. 30 Lakh
(iv) Sales to earn a profit of 10% on sales.
[Ans: (i) 40%, Rs. 19.50 Lakh, Rs. 7.80 Lakh, 31.58% (ii) Rs. 34.75 Lakh (iii) Rs.
4.2 Lakh (iv) Rs. 26 Lakh]
15. Price during depression have reduced to increase sales, find the volume of sales to maintain the
same profit if reduction in S. P is 10%
Sales 20,000 Units @ Rs. 10 p.u.
Variable cost Rs. 7 p.u.
Fixed Cost Rs. 40,000 p.a.
[Ans: P/V Ratio before reduction 30% after 22.2%, 30000 Units be sold maintain profit
as Before]
Agrawal Sharma, Agrawal, Shah, Agrawal, Financial Accounting and Decision Making.
Agrawal M.R., Management Accounting.
Jain, Khandelwal, Pareek, Dave, Financial Accounting and Decision Making.
Unit - 9 Cost Analysis for Decision Making
Unit Structure
9.0 Objectives
9.1 Introduction
9.2 Meaning and Nature of Decision Making
9.3 Financial and Non-financial Considerations
9.4 Techniques of Decision Making
9.5 Summary
9.6 Key Words
9.8 Reference Books
9.0 Objectives
After studying this unit you should able to understand:
 Definition and stages of Decision Making
 Financial and non-financial factors to be considered
 Various techniques of Decision Making
 Analysis of cost data for pricing decisions
 Analysis of cost data for selection of optimum Product
 Analysis of cost data for Make or Buy Decisions
 Analysis of cost data for profit Planning
 Analysis of cost data for plant shut down Decisions
 Analysis of cost data for Further Processing or selling Decisions
 Analysis of cost data for determination of optimum level of production
 Analysis of cost data for Adding or Dropping a product line
 Analysis of cost data for Replacement Decisions.
9.1 Introduction
One of the basic functions of management is decision making and decision making often involves
selecting a course of action from among a set of alternatives. There are two or more alternatives available
for each problem, of which one such alternative should be considered.
The most useful contribution of marginal costing technique, break even analysis, differential cost
analysis is to give assistance to the management in vital decision making. Specific areas where marginal
costing proves its worth is in decision making process for example operating decisions and establishment
decisions in which marginal costing and other techniques prove their role.
9.2 Meaning and Nature of Decision Making
Decision making is a process in which the best course of action is selected to get desirable results.
According to D.E. MC Forland “A decision is an act of choice when in an executive forms a conclusion
about what must not be done in a given situation.” A decision represents a course of behaviour chosen from
a number of possible alternatives. Decision is a dynamic process, it is a process of defining the problem,
identifying the possible alternatives and evaluating each alternative to get best course of action. It includes
forecasting too. It cannot be specified by any formula, it includes risk, uncertainty and opprotunity of action.
Stages of Decision Process :
1. Identifing the problem : First of all it is necessary to identify the problem in the correct Perspective.
2. Analysing the problem : Now the next step is to analyse the various aspects of the problem. It is
necessary to collect additional information, which is useful in decision making.
3. Identifying various alternatives : The next step is to develop the possible ways to take best
decision. It can be developed by a team which consists of experts in that field.
4. Screening the alternatives : After developing possible alternatives these should be screened on the
basis of risk, economy, timing and limitation of resources.
5. Considering non-cost factors : It is necessary to consider various non-cost factors, which will
affect the decision.
6. Making a decision : Now the best alternative is chosen on the basis of its merits.
7. Implementing and following the decision-Implementation is the important phase in decision making.
Practical efficacy of decision can be measured after implementing it.
9.3 Financial and Non-financial Considerations
 Financial factors: During the course of decision making necessary facts are collected for each
alternative in numerical form or in term of money. It is called as financial consideration. It includes
factors like cost, revenue and capital employed for each decision.
 Costs useful while taking decisions : Imputed costs, opportunity cost, relevant and irrelevant
costs, out of pocket costs, sunk costs, postponable costs, discretionary costs, etc. The meaning of
each costs has already been discussed in unit eight.
 Non-Financial factors: Some of the other factors, which are not measurable numerically, are also
considerable for a decision. These factors can not be measured, but they have considerable effect
for a decision. These are as follows:
1. Employee Morale
2. Health, safety and working conditions.
3. Government policies, Regulations, control and incentives.
4. Nature of industry.
5. Economic Environment.
6. Effect on relation with customer, government and general public.
7. Stability, quality and reliability.
Activity
1. In a sugar industry which is the most considerable non financial factor, while
taking decision?
2. ‘Differential costing is useful for decision making’. Discuss.
9.4 Techniques of Decision Making
There are two techniques viz. costing techniques and statistical techniques. We are considering here
only costing techniques which are as follows:
1. Marginal costing - Seperately discussed in unit 14.
2. Break - Even Analysis -Seperately discussed in unit 14.
3. Differential cost technique : Differential cost is the difference in cost between one alternative and
another. It is obtained by substracting the cost of one alternative from the cost of another alternative.
Normally the differential cost is synomymous with the variable costs of producing the specific num-
ber of units. It is useful in the following decisions:
1. Determining optimum level of production.
2. Further processing.
3. Adding or dropping a product line.
4. Replacement decisions.
9.4.1 Specific Decision : Pricing Decision
In general condition of the market pricing decision is based on cost and normal profit. But it is
regulate by market conditions and other economic factors. The marginal cost approach is useful while taking
this decision. Sometimes price can be fixed lower than the normal selling price or lower than the total costs,
but it cannot be less than marginal cost in any case. These specific conditions are: (1) Trade depression and
competition (ii) use of unutilised capacity (iii) export sale decisions, (v) acquiring new customer.
Sometimes the pricing decision can be taken at lower than the marginal cost, but it should be for
very short term period. In the following conditions, such type of decisions can be taken (i) to dispose of
perishable goods (ii) to explore new market (iii) to aid new product in market (iv) to eliminate the competi-
tors from the open market.
Illustration: Marginal cost is Rs. 7 per unit, fixed cost is Rs. 1,00,000, selling price per unit is Rs. 8 and
50,000 units can be sold at this price. Say whether the decision of selling the product should be taken.
Solution:
(50,000  7)  1,00,000 4,50,000

Total cost and per unit cost for 50,000 units   Rs. 9
50,000 50,000
Thus, although the selling price does not cover the total cost, it is a wise decision to continue to
produce and sell because it reduces the loss on account of fixed cost, which is unavoidable in normal
circumstances. If production is stopped, the loss would be Rs. 1,00,000 and if it is continued then loss is
[50,000 X 8 - 4,50,000] = Rs. 50,000 only. But such a decision can be taken after considering non cost
factors also and for short term only.
Ilustration: A comnpany has a capacity to produce 5,000 units but demand in home market is only 2,000
units at a selling price of Rs. 80 per unit. The cost structure is:
Material Rs. 20 per unit, wages Rs. 18 per unit, variable factory overhead Rs. 10 per unit and
variable selling overhead Rs. 8 per unit. Fixed costs : Administration Rs. 18000 and Selling overheads Rs.
10,000.
An additional export order for the supply of 3000 unit is received at Rs. 65 per unit. Should this
order be acceped or not ?
Solution: Statement showing profitability
Home Market Export Market Total
(2000 Units) (3000 Units) (5000 units)
Variable costs
1,12,000 1,68,000 -
(20+18+10+8)
Sales 1,60,000
1,95,000 -
Contribution (S-V) 48,000 27,000 75,000
(-) Fixed cost (18000+10000) 28,000 -

28,000
Profit 20,000 27,000 47,000

Since fixed costs have already been recovered from the home market and additional contribution of
Rs. 27,000 is being fetched it should be accepted. But several non-cost factors should also be considered
viz whether sale at foreign market affects the prices of home market ? If, it is so, then decision may be
changed.
The student should note that fixed cost is normally unavoidable, hence it will always effect the
decision.
Illustration: A company is operating at 70% of its capacity. It has annual normal capacity of 10 lakh direct
labour hours. The company has recently been approached by a customer to buy 1,50,000 units of its
product at a selling price of Rs. 10.40per unit. Present cost structure : Materials 6 kg per unit @ Rs. 0.40
per kg., wages 2 hours per unit @ Rs. 2.5 per hour, variable overhead 2 hours per unit @ Rs. 0.75 per
hour. Fixed cost Rs. 12,00,000.
The management of the company is to decide would it be profitable to accept this offer. ?
Solution:
Incremental Revenue (1,50,000 X 10.40) Rs. 15,60,000

Incremental costs :)
Material (2.40 X 1,50,000) 3,60,000
Wages (5 X 1,50,000) 7,50,000
Variable overhead (1.5 X 150000) 2,25,000 Rs.13,35,000
Incremental Profit Rs. 2,25,000
Hence, offer should be accepted because it is beneficial.

9.4.2 Specific decision : Selection of Optimum Product Mix
When a manufacturing concern produces more than one product then combination of all products
in total production should be decided to fetch maximum profit. We can understand this by the following
illustration.
Illustration:
A manufacturing unit gives the following information:
Product X Product Y
Rs. Rs.
Direct materials per unit 20 25
Direct labour @ Rs. 1 per hour 10 20
Variable overhead 100% of direct labour - -
Selling price per unit 60 100
Fixed overhead Rs. 10,000 per annum
You are required to recommend which of the following sales mix should be adopted:
(a) 900 units of X and 600 units of Y (B) 1200 units of X and 400 unit of Y (c) 1200 units of Y only (D)
1800 unit of X only.
Solution: First to calculate contribution per unit of each product.
Product X Product Y
Rs. Rs.
Direct materials 20 25
Direct wages 10 20
Variable overhead 10 20
Marginal cost 40 65
Contribution 20 35
Selling price 60 100
Statement showing Contributions & profits of different sales mixtures
Sales Mix Total Contribution Fixed cost Profit
(A) 900 units of x 900 X 20 = 18000
600 units of y 600 X 35 = 21000
35000 10000 25000
(B) 1200 units of x 1200 X 20 = 24000
400 units of y 400 X 35 = 14000
38000 10000 28000
(C) 1200 units of y 1200 X 35 42000 10000 32000
(D) 1800 units of x 1800 X 20 36000 10000 26000
Decision : Sales mix (c) is recommended as it yields the highest profit i.e. Rs. 32000. It is due to contribution
per unit of y is more than x.
Some times limiting factor (key factor) is given in that case to select opitmum production mix, such product
should be considered, which gives higher contribution per unit of key factor.
Contribution
Profitabil ity 
Key factor
We can understand this by the following illustration :
Illustration :
A factory produces three products and furnishes the following details :
A B C
Materials per unit 20 kg 12 kg 30 kg
Labour hours per unit 3 hrs. 5 hrs. 4 hrs.
Selling Price per unit Rs. 250 Rs. 200 Rs. 400
Maximum possible output in units 1400 900 800
(i) 48000 kg of raw material @ Rs. 10 per kg. can be obtained. you are required to calculate
optimum product mix.
(ii) If 9200 hours are available at a cost of Rs. 10 per hour. Calculate optimum product mix.
Solution:
Profitability Statement
Particulars A B C
Rs. Rs. Rs.
Raw material per unit 200 120 300
Wages per unit 30 50 40
Marginal cost per unit 230 170 340
Sales per unit 250 200 400
Contribution 20 30 60
Contribution per kg of material  1.00 2.5 2.00
Material per unit
Contribution 6.67 6.00 15.00
Contribution per labour hour : 
Labour hr. per unit
(i) When 48000 kg of material is available, optimum production mix will be in sequence of B,C and
A on the basis of contribution per kg.
Full production of B 900 unit X 12 kg. = 10800 kg
Full production of C 800 units X 30 kg = 24000 kg
Remaining material (48000 - 34800) = 13200 kg
13200kg.
will be used for productionof A   660 units
20 kg.
Hence when material is in short supply, to get maximum profit 900 units of B, 800 units of C and
660 units of A should be produced.
(ii) If 9200 hours are available, optimum production mix will be in sequence of C, A and B (on the
basis of contribution per hr.) :
Full Production of C 800 units X 4 hrs. = 3200 hrs.
Full Production of A 1400 Units X 3 hrs. = 4200 hrs.
Remaining hours (9200-7400) = 1800 in the
1800 hrs
productionof B producti.e.   660 units
5 hrs.
Hence when raw material is in short supply, to get maximum profit 800 units of C, 1400 units of A
and 360 units of B should be produced.
9.4.3 Specific Decision: Make or Buy
Marginal costing renders useful assistance when a decision has to be taken by the management
whether a component should be manufactured internally to fulfil the idle capacity or purchased from the
open market. For such a decision marginal cost to make is compared with buying cost. If marginal cost is
less than buying cost, the decision taken is to make the component otherwise not we can learn it by follow-
ing example:
Illustration
Product M takes 20 hours on machine No. 51 It has a selling price of Rs. 150 and Direct material,
Direct wages and Variable overhead per unit are Rs. 50, 40 and 20 only. A component Y could be made on
machine No. 51 in 4 hours. The marginal cost of component is Rs. 9 and if it is purchased supplier price is
Rs. 15 per component.
Should one make or buy Y component. Assume machine hour is the key factor and there is no
unutilised capacity.
Solution
Contribution per unit of M product = [150-(50+40+20)] = Rs. 40
Rs. 40
Contribution per machine hour :  Rs. 2 per hr
20 hrs.
If component Y takes 4 hours, the loss of contribution is Rs. 8 (i.e. 4 hrs. X Rs. 2). Hence total cost
of component will be Rs. 9 + 8 = Rs. 17. Hence it is better to buy it. If however, there was some unutilised
capacity, then there should be no loss of contribution and then decision of making is beneficial.
9.4.4 Specific Decsion : Profit Planning
Marginal costing is quite a useful technique in planning profit through cost - volume profit analysis
while taking such decisions the manager requires a thorough knowledge about inter-relationship of selling
prices, sales volume, variable costs and fixed costs. We can learn this by taking the following example. :
Illustration
A company is producing 60,000 pieces at 60 % capacity at a selling price of Rs. 14.50 per piece.
The cost details are as follows :
Direct material Rs. 4 per piece, Direct wages Rs. 1 per piece, factory overhead Rs. 6 per piece
(50% fixed), selling overhead Rs. 1 per piece (75% fixed.)
During the current year, he intends to produce the same number of units, but anticipates that (a)
fixed cost will go up by 10% (b) material and wages will go up by 5% each, (c) minumum profit Rs.
1,50,000 is required, what minimum selling price would you reommend?
Solution : Statement showing Marginal cost
Marginal Cost Past Present

Rs. Rs.
Direct Material 4.00 4.20
Direct Labour 1.00 1.05
Variable factory overhead 3.00 3.00
Variable selling overhead 0.25 0.25
Total Marginal Cost 8.25 8.50
New fixed cost. Rs.
Fixed factory overhead 1,80,000

Add. 10% increase 18,000 1,98,000
Fixed selling overhead (1 X 60,000) X 75% 45,000

Add 10% increase 4,500 49,500
Total fixed cost 2,47,500
Selling price at a profit of Rs. 1,50,000
V.C.  F.C.  Profit (60,000 X 8.50)  2,47,500  1,50,000

  Rs. 15.125.
No. of Units 60,000
9.4.5 Specific Decsion : Plant Shutdown Decisions
Due to depression or acute competition business can be shut down temporarily or permanently.
Normally in short term business, activities are suspended temporarily, in that case decision depends on
escapable fixed cost and additional cost of overhauling the plant to restar it. If total contribution exceeds net
escapable cost then plant should continue, if, otherwise, it should be shut down. Shut down point can be
measured by the following formula :
Net EscapableFixed Cost[Totalfixed cost - (unescapable fixed cost  additionalcost of shut down)]
We can learn this by taking the following example:
Illustration:
Advise whether to continue or to close down the factory from the following data :
Production capacity 60% 6000 units
Contribution per unit Rs. 2
Fixed Expenses Rs. 20,000
Fixed expenses when the factory is shut down Rs. 12,000
Additional Expenses in closing down Rs. 1,000
Also calculate shut down point.
Solution:
(i) If factory continues : Rs.
Total Contribution (6000 X 2) 12,000
Less: fixed costs 20,000
Net Loss 8,000
(ii) If factory shut down :
Unescapable fixed costs 12,000
Additional Expenses on shut down 1,000
Net Loss 13,000
Loss to continue the factory is less than when shut down hence it is advisable to continue the
business.
Net Escapable fixed cost

Calculatio n of shut down Point 
[20,000 - (12,000  1000)]

  3500 units
Rs. 2
Verification :
Contribution at shut down point 3500 X 2 Rs. 7,000
(-) Fixed cost Rs. 20,000
Loss (It is equal to loss at shut down) Rs. 13,000
Sometimes, return on capital invested is not fetching at normal rate and there is no chance of
recouping this condition, the business man can take the decision of permanent closure of the business. While
taking this decision if income when continue the business is higher than income from investment of the selling
value of the business, then business should not discontinue and if otherwise it should be discontinued. It can
be learnt through the following example :
Illustration :
A company manufactures a product whose sales have declined to Rs. 280000 per annum and there
is no hope of improvement in the near future. Plant estimated life is 5 years, and there is no chance of using
this machine for other purpose. Variable costs are 60% of sales and fixed costs Rs. 1,00,000 including plant
depreciation Rs. 50,000. The factory may be sold for Rs. 260000 and there would be no residual value. If
factory is sold and money invested else where it may earn an interest of 6% which may be considered as the
normal rate of return on investment in the business.
The management seeks your advice as to whether they should continue to operate or should close
down immediately. From the interest table you find that the compound value of Rs. 1 at the end of 5 years
is 5.637.
Solution :
(i) If Business continues to next 5 years- Rs.
Sales 2,80,000
(-) Marginal costs (60% of sales) 1,68,000
Contribution 1,12,000
(-) fixed cost (excluding depreciation) 50,000
Net cash inflow 62,000
Future value of net cash inflow after 5 years
(62000 X 5.637) 3,49,494
Expected Income 3,49,494
(ii) If factory is sold immediately : Rs.
Sale Value 2,60,000
Add: Interest @ 6% for one year on Rs. 2,60,000
i.e. Rs. 15,600
for five years compound value (15,600 X 5.637) 87,937
Total Income 3,47,937
It is beneficial to continue the business because expected income is higher in case of continuing the
present business instead of sale.
9.4.6 Specific Decision (6) : Processing of By Product or Scrap
The raw material is passed through various processes for completion, but during the course of
processing that product can be sold at split-off point without further processing. Now the question arises,
whether such goods should be sold at split-off point or processed should be further and then sold after
completion. We can learn it by the following example, how decision can be made by the management in the
interest of the business:
Illustration :
A company purchases crude oil. It refines it. The refining process results in four products at split-off
point viz. A,B,C and D Product A,B,C and D can be individually further refined into AX, BX, CX and DX.
Product Sales at Split- Sales after Output at Split- A dditional
off point (Rs.) further off point P rocessing (Rs.)
Processing (R s.) (ga llons)
A 20,00,000 1,20,00,000 3,00,000 80,00,000
B 12,00,000 40,00,000 1,00,000 32,00,000
C 20,00,000 60,00,000 50,000 30,00,000
D 28,00,000 48,00,000 50,000 36,00,000
Joint costs upto split-off point were Rs. 40,00,000.

You are required to (i) determine which products the firm should sale at the split-off point and which
after further processing. (ii) determine most profitable action and calulate amount of profit at this situation.
Solution
(i) Decision about further processing
Products A B C D
Sales revenue after further processing 1,20,00,000 40,00,000 60,00,000 48,00,000
(-) Sales revenue at split-off point 20,00,000 12,00,000 20,00,000 28,00,000
Incremental sales revenue 1,00,00,000 28,00,000 40,00,000 20,00,000
(-) Further processing cost 80,00,000 32,00,000 30,00,000 36,00,000
Profit/Loss arising due to further 20,00,000 (4,00,000) 10,00,000 (16,00,000)
Processing
Suggestion : From the above analysis product A & C should be further processed but product B & D
should be sold at split-off point.
(ii) Income Statement at best profitable situation:
Products A B C D Total
Sale Value (After Processing) 1,20,00,000 - 60,00,000 - 18000000

(Before Processing) - 12,00,000 - 28,00,000
4000000
1,20,00,000 12,00,000 60,00,000 28,00,000 22000000
(-) Additional Processing Costs for A & C 80,00,000 - 30,00,000 - 11000000
40,00,000 12,00,000 30,00,000 28,00,000 11000000

(-) Joint Costs (allocation not needed) - - - - 4000000
- - - - 7000000
Profit
9.4.7 Specific Decision : Determination of optimum level of Production
In most of the industrial units the production level is not always the same, it is different due to certain
circumstances. Fixed costs increases over certain capacity and sale price decreases due to more supply in
the market, hence, such level of production should be decided where profit is maximum. In order to arrive
at a decision of this type, the differential costs are compared with incremental revenue at various levels of
output. When incremental revenue is equal to differential cost or incremental revenue is slightly higher to
differential costs, such level of production is called best profitable level of production and it should be
maintained to earn more profits. It can be clarified through the following example :
Illustration :
A company has a capacity of producing 1,00,000 units of a certain product in a month. The sales
department reports that the following schedule of sale prices is possible :
Volume of Production 60% 70% 80% 90% 100%
Selling Price per unit : (Rs.) 0.90 0.80 0.75 0.68 0.64
Total Semi variable costs (Rs.) 300 400 500 400 400
The variable cost is Rs. 0.15 per unit and fixed costs is Rs. 40,000.
Prepare a statement showing incremental revenue and differential cost of each stage. At which
volume of production will the profit be maximum ?
Solution :
Statement showing the Total Differential Costs and Incremental Revenue.
Output Semi Variable Fixed Total Differen- Total Incremen-
Variable Cost Cost Cost tial cost Sales tal Revenue
Cost Rs. Rs. Rs. Rs. Rs. Rs. Rs.
60,000 300 9,000 40,000 49,300 - 54,000 -
70,000 400 10,500 40,000 50,900 1,600 56,000 2,000
80,000 500 12,000 40,000 52,500 1,600 60,000 4,000
90,000 400 13,500 40,000 53,900 1,400 61,200 1,200
1,00,000 400 15,000 40,000 55,400 1,500 64,000 1,000
At 80% level of production, the profit is maximum becuase incremental revenue is higher than
differential costs upto this level only. After 80% level differential cost exceeds incremental revenue thereby
resulting in a loss.
9.4.8 Specific Decision : Adding or Dropping a Product Line
In a multi-product production unit, the management may have to decide on adding or dropping a
product line. If a new product line is added, its sales and certain costs will also be increased and the reverse
will happen when a product line is dropped. In order to arrive at a decision a comparative profit statement
should be prepared for both the conditions. It is explained by the following example.
Illustration :
The management of a company is thinking whether it should drop product ‘B’ due to less
contribution and replace it with another. Given below are cost and output data.
Product Sales price per unit (Rs.) Variable costs per unit (Rs.) Percentage ofSales
A 60 40 30%
B 100 60 20%
C 200 120 50%
Total fixed costs for the year Rs. 7,00,000
Total sales Rs. 25,00,000
If product ‘B’ is dropped a new product ‘D’ can be introduced, the manufacturer forecasts the following
cost and output data :
Product Sales price per unit (Rs.) Variable costs per unit (Rs.) Percentage ofSales
A 60 40 50%
C 200 120 10%
D 160 100 40%
Total fixed costs for the year Rs. 7,00,000
Total sales Rs. 27,00,000
Is this proposal to be accepted ?
Comparative Profit Statement
Existing Situation Present Situation

A B C Total A C D Total
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Sales 7,50,000 5,00,000 12,50,000 25,00,000 13,50,000 2,70,000 10,80,000 27,00,000
(-)V.cost 5,00,000 3,00,000 7,50,000 15,50,000 9,00,000 1,62,000 6,75,000 17,37,000
Contrib 2,50,000 2,00,000 5,00,000 9,50,000 4,50,000 1,08,000 4,05,000 9,63,000
ution
(-)Fixed Cost 7,00,000 7,00,000
Profit 2,50,000 2,63,000

The profit position improves if the line is replaced. Therefore, the proposal should be accepted.
9.4.9 Specific Decision: Replacement Decisions
Sometimes, the management have to decide to replace the present plant by a new one. This type of
decisions can be made by calculating net income of each situation. Then, higher income alternative is
chosen. The cost of removing the existing plant and interest on additional investment should also be taken
into consideration. From the following example we can understand this type of situation :
Illustration
A Ltd. purchased a machine 5 years ago. A proposal is under consideration to replace it by a new
machine. The existing machine can be sold at Rs. 60,000. As the cost Accountant of the company, you are
required to submit your recommendations based on the following information : Interest is paid @ 10% per
annum on fresh capital introduced.
Existing Machine New Machine
Rs. Rs.
Initial cost 1,50,000 4,00,000
Marginal cost per unit 60 55
Selling price per unit 125 125
Fixed expenses 50,000 1,50,000
Annual production (units) 2,000 4,000
Life (years) 10 10
Scrap value of machine - -
Solution
Statement showing comparative Profitability
Existing Machine New Machine
Rs. Rs.
Total Marginal cost 1,20,000 2,20,000
Total fixed cost 50,000 1,50,000
Interest on additional capital
10% of (Rs. 4,00,000-60,000) - 34,000
Depreciation (SLM Method) 15,000 40,000
Loss on sale of old machine - 1,500
Total Cost 1,85,000 4,45,500
Total sales 2,50,000 5,00,000
Profit 65,000 54,500
Decision : Existing machine is profitable because it provides more profits than a new one.
Note : Loss on sale of old machine is divided in economic life of new machine : Rs.
WDV of old machine on this date 75,000
(-) sale consideration 60,000
Loss 15,000
Loss per year 15,000/10 = Rs. 1500
Activity
While taking replacement decisions, which points should be kept in mind?
9.5 Summary
Cost accounting paves a vital role in managerial decisions. Marginal costing, differential costing and
CVP analysis are the basic techniques for decision making. Each decision is affected by financial as-well-as
non-financial factors. Some times due to strong non-financial factors, financial results are ignored for
decision making. Decision is a process of identifying the problem, analysing the problem, identifying the
alternatives, screening them, to get outcome. There are several types of decisions, which are to be taken in
course of running the business. Each decision has its own importance, which cannot be neglected.
9.6 Key Words

 Marginal Costing: It is the ascertainment of marginal cost, by differentiating between fixed and
variable costs, and of the effect on profit of changes in volume or type of output.
 Differential Costing: It is the difference in cost between one alternative and another. It is synonymus
with the variable costs of producing the specific number of units in normal course.
 Break Even Analysis: It is a system of analysis that can be used to determine probable profits/
Loss at a given level of output.
 Key Factor: A factor in the activities of an undertaking, which at particular point of time or over a
period will limit the volume of output.

1. Discuss the nature of decision making function of management and mention the techniques of
decision making.
2. What are the financial and non-financial considerations in management decision making ?
3. Explain factors to be considered while taking make or buy decision ?
4. A company produces two products A & B. The following information is given :
Product A Product B
Contribution per unit Rs. 3 Rs. 5
Required production hours per unit 1 2
Sales (units) 1500 800
Available production hours 2000 - -
Determine the optimum product mix.
Ans: A 1500 units (1500 hours), B-250 units (500 hours)
5. A ltd. purchases 20,000 belts per annum for an outside supplier at Rs. 5 each. The management
feels that these should be manufactured and not purchased. A machine costing Rs. 60,000 will be
required to manufacture the item within the factory. The machine has an annual capacity of 25,000
units and life of 5 years. The following additional information is available:
Material cost Rs. 2 per unit, labour cost Rs. 1.00 per unit.
variable overheads 100% of labour cost
You are required to advise whether (i) the company should continue to purchase the belts from the
outside supplier or should make them in the factory.
Ans : Rs. 4.60 or 5, to be purchased.
6. A firm gives the following data :
Fixed Expenses Rs. 16,000
Additional Expenses in closing down Rs. 1,200
Fixed Expenses when the factory is shutdown temporarily Rs. 10,000
Production at 40% capacity is 4,000 units
Contribution per unit is Re. 1
Advise whether to continue the factory or to close it down. Also calculate shut down point.
Ans: To continue loss Rs. 12,000 and when shut down Rs. 11,200 hence not to continue, shut
down point 4,800 units.
7. A company is producing three type of products. The following information is given :
A B C
Rs. Rs. Rs.
Marginal cost per unit 27 38 43
Fixed cost per unit 5 8 9
Selling price per unit 42 62 63
Net profit per unit 10 16 11
Production in units 4000 2000 5000
The sales manager wants to discontinue one product from market and guarantees that
production of other two products shall rise by 50 per cent. He wants to discontinue A as it appears
to be least profitable. Do you agree ? If not, which product should be discontinued?
Ans: Agree, profit will increased from Rs. 1,27,000 to Rs. 1,41,000
9.8 Reference Books

Gorden Snillinglaw, Cost Accounting : Analysis & control
Saxena, Vashist, Cost Accounting
Ghosh T. P., Cost Accounting
Unit - 10 Process Costing
Unit Structure
10.0 Objectives
10.1 Introduction
10.2 Definition and Characteristics
10.3 Advantages and Disadvantages
10.4 Preparation of Process Accounts - I
10.5 Preparation of Process Accounts - II
10.6 Treatment of Normal, Abnormal Wastages and Abnormal Gains
10.7 Treatment of Fully Completed Stock
10.8 Treatment of Joint and by Products
10.9 Calculation of Inter Process Profit.
10.10 Treatment of Partially Completed Stock under (equivalent Production) FIFO Method
10.11 Summary
10.12 Key Words
10.0 Objectives
 The concept and features of process costing.
 Advantages and limitations of process costing.
 Preparing Process Account when there is no loss and no stock
 Treatment of wastage and scrap.
 Preparing Process Accountwhen normal, abnormal loss and abnormal gain is given
 Treatment of fully completed stock.
 Methods of accounting joint products and by products.
 Calculation of unrealised profit.
 Valuation of work-in-progress under FIFO method and weight average cost method.
10.1 Introduction
Process costing is used where the production moves from one process or department to next until
its final completion. There is a continuous production of identical units through a series of processing
operations. Process is a check entity of an industrial unit in which specific work is done through the various
well defined stages of production. This method of cositng is used to know the cost of product in each
process. A standard product passes through various stages of production called as processes. It is also
called as continuous costing or average costing.
10.2 Definition and Characteristics
CIMA defines “The costing method is applicable to where goods or services result from a
sequence of continuous or repetitive operations or processes Costs are averaged over the units produced
during the period.” It is a method of costing in which costs are accumulated for each independent but inter
related process. It is used in such industries where the material has to pass through two or more processes
for being converted into final shape. This method of costing is useful in manufacturing concerns like steel,
soap, chemicals, varnish, cotton textiles, oil refinery etc.
Charecteristics : The distinctive features are as follows :
1. Factory is divided into a number of processes, which will be called as cost centres.
2. All the costs of each cost centre are accumulated.
3. Manufacturing activity is carried on continuously by means of one or more process as run
sequentially.
4. Each process has its own ledger, in which costs are charged.
5. The output of one process becomes input of another process till it become the final product.
6. Appropriate method is used in absorption of overheads to each cost centre i.e. process.
7. The total costs of each process are averaged over the total production of that process.
8. Normally output at the end may be a single product or a by product or a joint product.
10.3 Advantages and Disadvantages

Advantages :
1. The final product is of uniform type, hence the computation of average cost is easier.
2. The result of each process is more accurate, because indirect expenses are allocated to each
process rationaly.
3. Managerial control is easier because activity of each process is uniform.
4. The cost is calculated periodically and not at the time of completion.
5. Unit cost can be easily calculated through averaging of total cost, hence determination of price
becomes easier.
Disadvantages :
1. The process costs are collected at the end of the period, they are in nature of historical costs,
hence the disadvantages of historical costing are associated with process costing.
2. Average cost may not be accurate for control of the performance of a process.
3. Error in calculation of average cost is carried over upto the last process.
4. Apportionment of joint expenses results in further inaccuracies.
10.4 Preparation of Process Accounts - I
A seperate account is maintained for each process, because each process is a separate cost centre.
Main elements of process costing are material, labour, direct expenses and production overhead. Total cost
of production of each process is transferred to next process. Output of one process becomes the raw
material of the next process.
Process account is prepared as follows :
Process Account
Particulars Unit Amount Particulars Unit Amount
Rs. Rs.
To Direct Materials - - By Transfer to Process B A/c - -
To Direct Labour -
To Direct Expenses -
To Factory Overhead -
- - - -
Process B Account
Rs. Rs.
To Process A (Transfer) - - By Transfer to
To Direct Materials - Finished stock* - -
To Direct Labour -
To Direct Expenses -
To Factory Overhead
- - - -
*It is assumed that there are two processes only if; there are more processes then instead of “Transfer to
finished sotck” “Transfer to next Process” will be shown.
Finshied Stock Account
Rs. Rs.
To Process B (Transfer) - - By Sales - -
To Profit & Loss A/c (B/F) - By Profit & Loss Account
(if any) (B/F) -
- - - -
- - - -
10.5 Preparation of Process Accounts - II

Normally output of a product is not similar to input, because there is a loss during processing of the
raw material. These losses may be (a) scrap- The scrap is a residue of raw material from a certian
manufacturing operations that has relatively very nominal value. The examples are saw dust, outlined metals
etc. It is shown on the credit side of Process Account, weight in unit coloumn and sale price in amount
column. (b) Wastage - A portion of raw material is lost during processing and which has no value or
negative value. Such loss may be physical. Loss due to evaporation, dust, smoke shrinks in a manufacturing
process. It is shown on the credit side of the Process Account in quantity coloumn only. Here we are not
categorising loss. It is mentioned in the next heading.
10.6 Treatment of Normal, Abnormal Wastages and Abnormal Gains

As explained in 10.5, there may be loss during processing, it may be classified into normal and
abnormal. The accounting treatment is as follows:
 Normal Loss
The loss which can not be eliminated for example, part of cloth cut to make a shirt. Such loss is
uncontrollable and unavoidable. It can be determined in advance on the basis of past experience. Such cost
is regarded as a part of cost of output and it is absorbed by good unit. Sale value and quantity is credited to
process Account in their respective column.
 Abnormal Loss
It is an excess part of loss over normal (standard) loss. It is caused due to unforseen circumstances
like accident, break down, etc. Abnormal Loss = Actual Loss - Normal Loss.
It cannot be anticipated in advance. The cost of abnormal loss will not affect the cost of good units.
It is transferred to costing profit and loss Account, first of all cost of abnormal loss is transferred into a
seperate account and then after adjusting sale value of such loss, remaining amount is transferred to Costing
P & L Account. We can easily understand the procedure by taking an example shown below.
If actual loss is less than normal loss, such excess is called as abnormal gain. It is due to wrong
estimation of normal loss quantity. Cost of abnormal gain will not affect the cost of good production. Cost
of abnormal gain units will be transferred to seperate account by debiting it in process account and then
after adjusting the notional value of sale, remaining amount is transferred to Costing Profit and Loss
Account. We can understand it by following example :
Activity
Say Whether sale price of abnormal wastage will be shown in process Account. If yes on
what side and If no, where is it shown?
Illustration: A product passes through two processes viz x and y. Prepare Process Account Normal,
Abnormal Loss and Abnormal gain Account from the following :
Particulars Process A Process B
Rs. Rs.
Units Introduced 5,000 @ 10 per unit 50,000 -
Material used 20,000 15,000
Direct Wages 10,000 5,000
Manufacturing Expenses 5,000 3,030
Percentage of normal loss on input 5% 10%
Sale price of normal loss per unit 1.80 2
Output in units 4,700 4,300
Process X Account
Particulars U n it A m ount. Pa rticulars Unit Am o un t.
Rs. R s.
T o U nits introd uced 50 0 0 50 ,0 00 B y No rm al W astage 2.5 0 450
T o M aterial - 20,0 00 B y Ab no rm al w astage 50 890
T o W ages - 10,0 00 B y Transfer to Pro cess 4 ,70 0 83 ,660
T o M an ufactu rin g Ex p - 5,0 00 Y A ccou nt @ Rs. 1 7.8 0
5,000 85,0 00 5 ,00 0 85 ,000
Normal cost
Cost of Abnormal Loss   Units of abnormal loss
Normal output
(50,000  20,000  10,000  5,000 - 450)
Cost of Abnormal Loss   50  Rs. 890
5,000 - 250
Process Y Account
Particulars Unit Amt. Particulars Unit Amt.
Rs. Rs.
To Transfer from Process ‘X’ 4,700 83,660 By Normal Wastage 470 940
To Material 15,000 By Transfer to finished 4,300 1,07,500
To Wages 5,000 Stock A/c @ Rs. 25
To Manufacturing Expenses 3,030
To Abnormal gain @ Rs. 25 70 1,750
4,770 1,08,440 4,770 1,08,440
(83,000  15,000  5,000  3030 - 940)
Cost of Abnormal Loss   70  Rs. 1750
4700 - 470
Process Loss Account
Rs. Rs.
To Process X Account 50 890 By Cash (Sales) @ Rs. 1.80 50 90
By Costing P & L A/c (B/f) - 800
4,770 1,08,440 4,770 1,08,440
Process Gain Account
Rs. Rs.
To Normal Wastage 70 140 By Process Y Account 70 1750
Costing P & L A/c (B/f) - 1610
70 1750 70 1750
10.7 Treatment of Fully Completed Stock

Sometimes all units of goods transferred from preceding process are not used in manfacturing of
next process. It means remaining units of second process are valued at cost of first process and remaining
units of third process at the cost of second process.
But some times, production of each process is transferred to seperate account i.e. process stock
account and may be issued to next process as and when required. Normally the valuation of such stock is
made at current cost of that process.
10.8 Treatment of Joint and By Products

10.8.1 Joint Products
CIMA defines joint products as “two or more products seperated in processing each having a
sufficiently high sale value to merit recognition as a main product.”
The process of a particular raw material may result in the output of two or more products of real
economic importance and none of them can be treated as main product have significant value. Products
which are not distinguishable from each other upto the point of seperation and cost are common upto this
point The examples of Joint products are :
Oil refining industry - Petrol, diesel, liquid Petroleum gas, Kerosene, Paraffin,
Lubricants, naptha, coltar etc.
Coal Processing - Coke, Sulphate of amonia, benjol, gas etc.
Before seperation they have no seperate entity, additional costs may or may not be incurred to
make then saleable.
10.8.2 Co-Products
A product is produced in different varieties, for example : furniture manufacturing organisation
manufactures almirah, table, chair etc. Each of co-product may be requiring a diiferent type of raw material,
but frequently use the common facilities of organisation. Joint products will arise from common process and
can be identified only at split-off point, but co-product will not arise from the same process, it can be
identified from starting point.
10.8.3 Accounting Methods
(1) Physical Units Method: Allocation of total cost upto split-off point is apportioned on the basis of
physical units like weight, volume. It is a simple, easy and technically sound method. Sale price of
each joint product has no importance, and allocation is made irrespective of its quality.
(2) Market Value Method: Joint costs are apportioned in the ratio of selling price of respective
products. Ability to absorb the joint costs measured either by sale value or sale price. There are
three methods of absorption by this method :
(i) Market Value at seperation point: Joint costs are apportioned on the basis of ratio
of market value at separation point.
(ii) Market value at finished stage: Joint costs are apportioned to the joint products in
the ratio of final selling price of each product. In this method further processing costs
will be added to the respective joint products for determination of product costs.
(iii) Reverse cost method: Joint costs are apportioned in the ratio of net value of joint
product at split-off point. This method is normally used. Net value is calculated as
follows:
Activity
Give two examples of Joint Products...........................................
Give two examples of Co-Products...........................................
Statement showing approtionment of Joint costs

Particulars Joint Products
X Y Z
Rs. Rs. Rs.
Sales - - -
(-) Estimated Profit - - -
Total cost - - -
(-) Selling & Distribution Expenses (if any) - - -
Cost of goods sold - - -
(-) Further processsing costs - - -
Net value (i.e. basis of apportionment of joint costs) - - -
(iv) Average unit cost method: Joint costs upto the seperation point are divided by the total units
produced to arrive at average costs per unit of production.
(v) Survey method: Weights are determined on the basis of technical survey to apportion the joint
costs. This method is more scientific in which weights are arrived at after considering several
factors.
(vi) Contribution margin method: In this method, joint costs are segregated into fixed and variable,
average variable costs upto split off point per unit is calculated and then total variable costs (pre &
post) is calculated and now contribution per unit is arrived at after deducting total costs from selling
price. The fixed costs are apportioned to the ratio of contribution margin to each joint product.
(vii) Standard costs method: In this method joint costs are approtioned on the basis of standard costs
set for the respective joint products.
10.8.4 By Products
A by-product is a secondary product which incidently results from the manufacturing
operations of the main product. It has relatively small value. The accounting treatments are as follows:
(i) Standard cost method: Standard costs of by product is determined on the basis of technical
assessment and it is credited to the process account of the main product.
(ii) Opportunity method (replacement cost method): By products are consumed in same organisation
as raw material for other items in place of existing material in use. If such by product in purchased
from open market, then cost of material replaced is the same. Hence, the process account of main
product is credited by this opportunity cost.
(iii) Apportionment like joint products: When the by-products have considerable value, then the by-
products will be treated at equal fotting, hence apportionment of joint costs are made by using
physical unit method at the split-off point.
(iv) By product sale value added to main product sales : In this method all costs are deducted from
the combined sale value of main and by product.
(v) By product sales deducted from total cost: In this method such sale value is deducted out of
cost of production.
(vi) Credit of By product Net Sale Value to Process Account: The sale value of by products after
deducting direct selling costs and other process costs incurred after point of seperation are credited
to process account.
(vii) Other Income method: When sale value is negligible then, sale value of by product is shown as
other income in the profit and loss account. This method is criticised because valuation of stock of
main product is inflated because no value is assigned to the by products. a charging to main prod-
ucts is not technically good.
(viii) Reverse cost method - Cost of by product is determined as follows :
Sale proceed of by products ---
(-) Estimated Profit ---
Total cost ---
(-) Selling & Distribution Expenses ---
Cost of sales ---
(-) Further processing costs after split-off point ---
Net amount (cost of by product) ---
10.8.5 Distinction Between Joint and By-Products :
1. Joint products have equal economic importance, while by-products have less economic
importance.
2. Joint products have significant impact on total cost at the seperation point, while by products have
a very little impact on total costs.
3. Joint products are produced simultaneously, while by-products is just incidental to the production
of the main product.
Activity
Write one major distinction between Joint & By Products.
10.8.6 Decision making for further processing of a joint product

When we have to take the decision, whether further processing is made or not, we have to look on
incremental revenue and incremental costs. If incremental revenue is more then incremental costs product
should be further processed. Apportionment of joint costs are not relevant in decision making regarding
further processing of joint products after split-off point.
Illustration :
A company purchases crude oil. It does refining of the same. It results in four products at the split-
off point : A, B, C and D. Product C is fully processed at the split-off point. The output at split-off point was:
Product A 3,00,000 gallons, Product B 1,00,000 gallons, Product C 50,000 gallons, Product D
50,000 gallons. The Joint cost of purchasing crude oil and processing it were Rs. 40,00,000. The company
had no beginning and closing inventories. Sale of product ‘C’ were Rs. 20 lakhs. The total output ofA, B
and D is further refined and then sold.
Further processing costs (Rs.) Sales (Rs.)
Products A 80,00,000 1,20,00,000
B 34,00,000 42,00,000
D 38,00,000 50,00,000
Sale value at split-off point was Product A Rs. 20,00,000, B Rs. 12,00,000 D Rs. 28,00,000.
you are required to show how joint cost of Rs. 40 lakhs was to be allocated between each product under
(a) sale value at split-off (b) physical output and (c) estimated net realisable value .
Solution
(A) Statement showing Allocation of Joints costs on sale value at split-off stage.
Product Sale value at split-off stage % Allocation of joint costs
(Rs.)
A 20,00,000 25 10,00,000
B 12,00,000 15 6,00,000
C 20,00,000 25 10,00,000
D 28,00,000 35 10,00,000
80,00,000 100 40,00,000
(B) Statement showing Allocation of Joint costs by using Physical output method.
Product Physical output (gallons) Proportion Allocation joint costs (Rs.)
%
A 3,00,000 60 24,00,000
B 1,00,000 20 8,00,000
C 50,000 10 4,00,000
D 50,000 10 4,00,000
5,00,000 100 40,00,000
(C) Statement Showing Allocation of Joint costs by using Net Realisable value method:
Products Sale revenue Sale Revenue Further Net Proportion Joint
after further at the split Processing Realisable (%) Costs
processing -off point Costs Value Allocated
Rs. Rs. Rs. Rs. Rs. Rs.
A 1,20,00,000 - 80,00,000 40,00,000 50 20,00,000
B 42,00,000 - 34,00,000 8,00,000 10 4,00,000
C - 20,00,000 - 20,00,000 25 10,00,000
D 50,00,000 - 38,00,000 12,00,000 15 6,00,000
80,00,000 40,00,000
10.9 Calculation of Inter Process Profit

Some times the output of one process is transferred to another at the market price of comparble
goods or on transfer price. Thus, profit or loss made by each process is revealed and the efficiency of a
process is not affected by the performance of the previous process. But the following difficulties arise due to
transfer at a profit: - The closing sotck of each process is valued at market value, hence profit of current
year increases hypothetically. This system will show unrealised profits in respect of closing stock. Thus, it is
necessary to eliminate such profits which are included in closing stocks at each stage at the end of the
accounting period. A provision for such unrealised profit is made to workout real profit of the business.
Through the following example, we can learn the procedure of calculating unrealised profit: -
Illustration
There are three distinct processes. The output of ‘A’ is charged to ‘B’ at a profit of 25% on cost,
and the output of process ‘B’ is charged to process ‘C’ on a similar basis. The completed units are trans-
ferred into stock at price which gives process ‘C’ a profit of 25% on cost. From the following particulars,
prepare Process Accounts and finished stock Account.
Process A B C
Rs. Rs. Rs.
Material consumed 1,40,000 2,10,000 70,000
Wages 2,10,000 1,40,000 2,80,000
Closing stock 70,000 1,40,000 2,10,000
Closing stock of finished goods amounts to Rs. 1,40,000. The remaining goods were sold for Rs.
12,60,000. Show also the actual realised profit, which is to be transferred to Profit and Loss Account.
Assume that stock in each process has been valued at prime cost.
Solution :
Process ‘A’ Account
Particulars Cost Profit Total Particulars Cost Profit Total
To Materials 140000 - 140000 By Process 280000 70000 350000
To Wages 210000 - 210000 ‘B’ A/c
Prime Cost 350000 - 350000
(-) Closing Stock 70000 - 70000
280000 - 280000
To P&L A/c - 70000 70000
(25% on cost) 280000 70000 350000 280000 70000 350000
Process ‘B’ Account

By Process ‘A’ A/c 280000 70000 350000 By Process 504000 196000 700000
To Material 210000 - 210000 ‘C’ A/c
To Wages 140000 - 140000
Prime Cost 630000 70000 700000
(-) Closing Stock 126000 14000 140000
504000 56000 560000
To P&L A/c - 140000 140000
(25% on cost) 504000 196000 700000 504000 196000 700000
Process ‘C’ Account
By Process ‘B’ A/c 504000 196000 700000 By Finished 683200 366800 1050000
To Material 70000 - 70000 Stock A/c
To Wages 280000 - 280000
Prime Cost 854000 196000 1050000
(-) Closing Stock 170800 39200 210000
683200 156800 840000
To P&L A/c - 210000 210000
(25% on cost) 683200 366800 1050000 683200 366800 1050000
Finished Stock Account
By Process ‘B’ A/c 683200 366800 1050000 By Sales 592107 667893 1260000
To P&L A/c - 350000 350000 By Cl. Stock 91093 48907 140000
(25% on cost) 683200 366800 1050000 683200 366800 1400000
Valuation of Closing Stock
6,30,000
Process ‘ B’ cost  1,40,000  Rs. 1,26,000
7,00,000
Profit = (1,40,000 - 1,26,000) = Rs. 1,4000
8,54,000
Process ‘ C’ cost   2,10,000  Rs. 1,70,800
10,50,000
Profit = (2,10,000 - 1,70,800) = Rs. 39,200
6,83,200
Process ‘ C’ cost  1,40,000  Rs. 91,093
10,50,000
Profit = (1,40,000 - 91,093) = Rs. 48,907
The profit (in finished stock A/c) has been calculated after deducting Rs. 10,50,000 out of Rs.
14,00,000 (total of credit side of finished stock a/c = Rs. 14,00,000, After writing this on debit side of
finished stock a/c as Total now B/F “To P&L A/c.Total of debit side of all the three columns of finished
stock A/c is shown as total of credit side of the same account. Hence difference is cost of sale and profit on
sales.
Total Profit = Process A + B+C+Finished stock A/c
70,000+1,40,000+2,10,000+3,50,000 = Rs. 7,70,000
Unrealised Profit : Rs.
Profit in closing stock of Process A Nil
Profit in closing stock of Process B 14,000
Profit in closing stock of Process C 39,200
Profit in closing stock of Process D 48,907
1,02,107
10.10 Equivalent Production
Equivalent production units represent the output of a process in terms of completed units. The
continuous nature of process implies that there always exists opening and closing work in progress. The
percentage of completion with regard to material, wages and overheads are not 100% on these incompleted
units. Hence equivalent units should be calculated seperately, so as to calculate cost per completed unit.
When work-in-progress and its degree of completion is given, the following statements are
prepared:
Step I - Statement of Equivalent Production
Step II- Statement of cost per Equivalent Unit
Step III - Statement of Apportionment of cost incurred during the period.
Step IV - Process Account : It is prepared either by using FIFO method or weighted Average cost method.
In FIFO method it is assumed that opening WIP units are completed and transferred first and then the
current period production is completed and transferred. In average cost method opening WIP costs are
combined with the current period costs. Hence for determination of average cost, both costs are included
and then the average rate is obtained.
These steps can be learnt through the following example;
Illustration
From the following information prepare : (a) Statement of Equivalent Production (b) Statement of
cost per Equivalent Unit (c) Statement of Apportionment (d) Process B Account.
The following data relates to process ‘B’
(i) Opening work-in-Progress 4,000 units.
degree of completion : Materials (100%)Rs. 24,000
Labour (60%) Rs. 14,400
Overhead (60%) Rs. 7,200
(ii) Received during month of June from process A 40,000 units Rs. 1,71,000
(iii) Expenses incurred in process ‘B’ during the month : Materials Rs. 80,000, Labour Rs. 1,38,230,
overheads Rs. 69,120
(iv) Closing work-in-progress 3,000 units.
Degree of Completion : Materials 100%, Labour and overhead 50%.
(v) Unit scrapped - 4,000
Degree of Completion : Materials 100%, Labour and overheads 80%.
(vi) Normal Loss : 5% of current input
(vii) Scrap realised Rs. 2.00 each
(viii) Completed units are transferred to warehouse, Use FIFO method.
Solution
(A) Statement Showing Equivalent Units
Input Particulars Output Equivalent Production
Materials Labour Overheads
% Units % Units % Units
4,000 Opening WIP 4,000 - - 40 1,600 40 1,600
40,000 Completed & Transferred
to warehouse 33,000 100 33,000 100 33,000 100 33,000
Closing WIP 3,000 100 3,000 50 1,500 50 1,500
Normal Loss 2,000 - - - - - -
Abnormal Loss 2,000 100 2,000 80 1,600 80 1,600
Equivalent Units 38,000 37,700 37,700
44,000 44,000
(C) Statement of Apportionment
Total Cost Cost per
Unit
Rs. Rs.
Materials Cost
From Previous process 1,71,000
Introduced 80,000
(-) Sale of normal loss(2 X 2,000) 4,000 76,000
2,47,000 / 38,000 2,47,600 6.50
Labour 1,38,230
Overheads 69,120
2,07,350 / 37,700 2,07,350 5.50
12.00
(A) Total cost of 37,000 completed units transferred to warehouse:
Opening WIP cost Rs. 45,600
Labour and overheads (1,600 X 5.50) Rs. 8,800
Completed Units (33,000 X 12) Rs. 3,96,000
Rs. 4,50,400
(B) Cost of Closing WIP
Materials (3,000 X 6.50) Rs. 19,500
Wages and overheads (1,500 X 5.50) Rs. 8,250
Rs. 27,750
(C) Cost of Abnormal loss
Materials 2,000 X 6.50 13,000
Wages and overheads 1,600 X 5.50 8,800
21,800
(D) Process ‘B’ Account
Particulars Units Amount Particulars Units Amount
Rs. Rs. Rs.
To Opening WIP 4,000 45,600 By Normal Loss 2,000 4,000
To Transfer from ‘A’ 40,000 1,71,000 By Completed Units 37,000 4,50,400
To Materials - 80,000 By Closing WIP 3,000 27,750
To Wages - 1,38,230 By Abnormal Loss 2,000 21,800
To Overheads - 69,120
44,000 5,02,950 44,000 5,02,950
10.11 Summary
Processing costing is applicable where production moves from one process to the next until final
output comes out. It is used basically in industries like chemicals, oil refining, textile etc., The costs are
accumulated to each process. The unit cost is the average cost of process for a given period. The process
losses may arise and it is categorised into Normal Loss, Abnormal Loss. If output of one process in trans-
ferred to another at the market price, then closing stock of each process is valued at market price, hence
profit of current year increases hypothetically. A provision for unrealised profit is made for such. When there
is work-in-progress at the end, the WIP is converted into equivalent fully completed units so as to derive
correct cost of production. When two or more products arise simultaneously in the course processing and
has a significant sale value, it is called “joint products”. Where a product which arises incidentlly and has a
relatively small value in comparison of the main product is called as “by-product.”
10.12 Key Words

 Process costing : A standard product that passes through various stages of production is called
process.
 Normal Loss: The loss, which is expected during the normal course of operations, and due to
unavoidable reasons is called normal loss.
 Abnormal Loss : The loss, which is above the normal rate of loss for the process. It is not included
in the process costs but removed from the appropriate process account and seperately reported.
 Abnormal Gain : If actual loss is less then pre-determined loss, it is considered abnormal gain.
 Equivalent Production - A notional quantity of complected units as a substitute of incomplete units
in progress.
 Joint Product : When two or more products arise simultaneously in the course of processing and
each have sufficient sale value.
 By-Product : When a product or products produced in addition to the main product incidently
during course of processing and which have relatively small sales value.
1. What do you mean by process costing. ? Explain its advantages and disadvantages.
2. Write down the charecteristics of process costing.
3. Explain Normal loss, Abnormal loss and Abnormal gain and state how they should be dealt in
process cost accounts. ?
4. What is “equivalent unit”. Explain briefly the procedure for valuation of work-in-progress.
5. When output of one process in transferred to another at market price, how you will deal with
unrealised profits in respect of closing stock. ?
6. Distinguish between “Joint and By-Products.”
7. What are the different methods of accounting for By-Products? Discuss.
8. Discuss the different methods of allocating joint costs, stating their merits.
9. While taking decision for further processing after split-off point, what should be kept in mind.?
10. A product passes through two processes viz. M and N. prepare Process Accounts, Abnormal
Wast age and Abnormal gain Account from the following :
Process M Process N
Rs. Rs.
Unit introduced 1000 at a cost of 20,000 -
Material Consumed 24,000 12,000
Direct Labour 28,000 16,000
Normal Loss on input 5% 10%
Manufacturing Expenses 8,000 8,567
Scrap Value of Normal Wastages (per 100 units) 40 50
Output in units 9,400 8,500
11. Three products A, B, and C are produced by a business man 2,000 units, 3,000 units and 1,000
units. Joint costs of Rs. 25,000. The market prices of products are as follows :
Product Additional further processing Market price at Selling Price
costs after split-off split-off point After Processing
Point (Rs.) (Rs. per unit) (Rs. per unit)
A 4,000 14.00 10
B 10,000 5.00 20
C 4,000 7.00 8
Apportion the Joint costs by (i) market value at the point of seperation (ii) sale value after further
processing (iii) Net realisable value method.
12. From the following information prepare statement of equivalent production, statement of cost and
also prepare process account by using FIFO method.
(i) Opening WIP 2000 units
Materials (100 % complete) Rs. 7,500
Wages (60 % complete) Rs. 3,000
Overhead (60 % complete) Rs. 1,500
(ii) Units introduced into this process 8,000 and process costs for the period are materials Rs. 1,00,000,
wages Rs. 78,000, overheads Rs. 39,000.
(iii) Closing WIP 2,000 units which are completed 100% for materials, 50% for wages and overhead.
(iv) 8,000 units are transferred to next process.

Ghosh T. P., Cost Accounting.
Saxena & Vashist, Cost Accounting.
Gorden Shillinglaw, Cost Accounting Analysis and control.
Unit- 11 Management Accounting
Unit Structure
11.0 Objectives
11.1 Introduction
11.2 Accounting as an Information System
11.3 Management Accounting
11.4 Nature
11.5 Scope
11.6 Functions
11.7 Tools and Techniques
11.8 Limitations
11.9 Summary
11.10 Key Words
11.0 Objectives
 Meaning of management accounting
 Relationship of management accounting to cost accounting and financial accounting
 Origin of management accounting
 Characteristics and Scope of management accounting
 Functions and tools and techniques of management accounting
 Limitations of management accounting
11.1 Introduction
Accounting is being used in the business world and is in existence in some from since the inception
of business. When the business grew in size and became complex, accounting began to take a systematic
shape. In the changed business scenario, various new requirements such as further planning, evaluation of
plan and policies, cost control, delegation of authority and responsiblity, timely decisions etc. have emerged
on account of increasing size of business, increased production level, technical complexities, government
interference and public awareness towards social responsibilities of industries. Management Accounting
has originated to serve the managers and to assist them in meeting their needs. Management Accounting is
not a separate accounting. It is only the use of accounting in solving the problems of management and taking
timely decision.
11.2 Accounting as an Information System

Accounting is a part of information system of an enterprise. It serves the purpose of providing
financial information relating to a business. Such information is provided to people who have an interest in
the organization, such as shareholders, managers, creditors, debenture holders, bankers, tax authorities and
others. Broadly speaking, on the basis of the type of accounting information and the purpose for which such
information is used, accounting may be divided into three categories:
1. Financial Accounting (or General Accounting);
2. Cost Accounting; and
3. Management Accounting.
11.2.1 Financial Accounting
Financial accounting is mainly concerned with recording business transactions in the books of accounts
for the purpose of presenting final accounts. It is defined as “the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions and events, which are in
part at least, of a financial character and interpreting the results thereof.” The information supplied
by financial accounting is summarized in the following two statements at the end of the accounting period,
generally one year.
(a) Profit and Loss Account showing the net profit or loss during the period.
(b) Balance Sheet showing the financial position of the firm at a point of time.
The objective of financial accounting is to provide information to external parties such as shareholders,
creditors, employees, potential investors, government agencies, etc.
11.2.2 Cost Accounting
Cost accounting is a branch of accounting which specializes in providing information about the
detailed cost of products or services being supplied by the undertaking. Compared with financial accounting,
cost accounting is relatively a recent development. It has primarily developed to meet the needs ofmanagement.
Profit and Loss Account and Balance Sheet are presented to management by the financial accountant. But
modern management needs much more detailed information than supplied by these financial statements.
Cost accounting provides detailed cost information to various levels of management for efficient performance
of their functions. The information supplied by cost accounting acts as a tool of management for making
optimum use of scarce resources and ultimately adds to the profitability of business.
The terms ‘costing’ and ‘cost accounting’ are often used interchangeably. The Chartered Institute
of Management Accountants (CIMA) of UK has defined costing as “the techniques and processes of
ascertaining costs”. Thus, costing simply means cost finding by any process or technique. It consists of
principles and rules which are used for determining:
(a) The cost of manufacturing a product; e.g., motor car, furniture, chemical, paper, steel, etc. and
(b) The cost of providing a service; e.g., electricity, transport, education, etc.
Cost accounting information is mainly for internal use i.e. for management. It is not to be provided
to external parties such as shareholders, creditors, potential investors, etc. Neither do they have any claim
on this information, excepting government agencies, to whom cost information may have to be submitted.
11.3 Management Accounting

11.3.1 Meaning and Definition
The term ‘management accounting’ is the modern concept of accounts as a tool of management. It
is a broad term and is concerned with all such accounting information that is useful to management. In simple
words, the term management accounting is applied to the provision of accounting information for management
activities such as planning, controlling and decision making, etc.
According to the Institute of Chartered Accountants of England, “any form of accounting
which enables a business to be conducted more efficiently” may be regarded as management accounting.
Management accounting information can help managers identify problems, solve problems and evaluate
performance.
The Institute of Cost and Works Accountants of India (ICWAI) has defined management
accounting as “a system of collection and presentation of relevant economic information relating to an
enterprise for planning, controlling and decision making”.
The Chartered Institute of Management Accountants (CIMA) of UK has given a very
authoritative and comprehensive definition as follows:
“Management Accounting is an integral part of management concerned with identifying,
presenting and interpreting information used for-
(i) formulating strategy;
(ii) planning and controlling activities;
(iii) decision-making;
(iv) optimizing the use of resources;
(v) disclosure to shareholders and others external to the entity;
(vi) disclosure to employees; and
(vii) safeguarding assets.”
According to National Association of Accountants (USA), management accounting is “the
process of identification, measurement, accumulation, analysis, preparation and communication of
financial information used by management to plan, evaluate and control within the organisation
and to assure appropriate use and accountability for its resources.”
These definitions make it clear that management accounting plays a vital role in providing the necessary
information to managers in performing their functions of planning, controlling, organizing and decision making.
Management accounting should serve as a decision support system to all levels of management.
11.3.2 Relationship of Management Accounting to Cost Accounting and Financial Accounting
The three types of accounting, i.e., financial accounting, cost accounting and management accounting
are closely linked. The management accounting uses the principles and practices not only of cost accounting
but also of financial accounting. Information provided by financial accounting proves extremely useful for
management accounting. For example, Profit and Loss Account and Balance Sheet become the basis of
ratio analysis and comparative financial statements, etc., which are used by the management accounting as
important tools of planning and control. Financial accounting records also become basis of preparing detailed
cost computation and reports. Cost accounting is a more detailed application of financial accounting and
provides detailed cost information about products, services, departments, etc. This information is used by
management accounting for planning, controlling and decision making purposes. Following fig. shows the
evolution of management accounting and its relationship to cost accounting and financial accounting:
PREPARING
PROFIT & LOSS FINANCIAL
ACCOUNT & ACCOUNTING
BALANCE SHEET
ANALYSING COST
COST
FOR CONTROL &
MAXIMISING ACCOUNTING
EFFICIENCY
ASSISTING
MANAGEMENT FOR MANAGEMENT
PLANNING DECISION ACCOUNTING
MAKING & CONTROL
Fig. Relationship of Financial, Cost and Management Accounting

11.3.3 Management Accountant is The Controller
In USA, the management accountant is called ‘Controller’ or ‘Financial Controller’ and is a part
of the top management team.
Management accountant plays a very important role in an organisation. He analyses and interprets
accounting information and meets the informational needs of the management at different levels. In an
organisation, a management accountant generally performs a staff function i.e. advisory role. But if he is
permitted to participate in planning and decision making, he is a part f the management team and thus
becomes the part of the line function. It is very important that status of the management accountant in the
organisation is clearly defined so that the scope of his work and responsibilities are accordingly determined.
11.3.4 Origin
The basic principles of management accounting emerged during the period 1400 to 1600 in the
form of standards for materials, employee productivity, job cost system and budgets. But no standardized
management accounting was in practice until 1885 when Henry Metcalf published the ‘Cost of Manufacture’.
The real growth of management accounting was in 20th century in USA due to the emergence of large and
integrated companies such as DuPont and General Motors. A demand was created for measuring the
performance of different parts of the business. Measures such as return on investment, performance evaluation
systems, innovations in costing, etc. were developed during the latter half of the 20th century.
Infact the growth of management accounting is because of the need to overcome the limitations of
financial and cost accounting.
 Limitations of Financial Accounting
Financial accounting is extremely useful to different categories of users. But it also suffers from the
following limitations:
1. Shows only overall performance: Financial accounting provides information about profit, loss,
cost, etc. of the collective activities of the business as a whole. It does not give data regarding costs
by departments, products, processes and sales territories, etc.
2. Historical in nature: Financial accounting is historical, since the data are summarized only at the
end of the accounting period. There is no system of computing day-to-day cost and also computing
pre-determined costs.
3. No performance appraisal: In financial accounting, there is no system of developing norms and
standards to appraise the efficiency in the use of materials, labour and other costs by comparing the
actual performance with what should have been accomplished during a given period of time.
4. No material control system: Generally, there is no proper system of control of materials losses
which may arise in the form of obsolescence, deterioration, excessive scrap, misappropriation, etc.
5. No labour cost control system: In financial accounting, there is no system of recording loss of
labour time; i.e., idle time. Labour cost is not recorded by jobs, processes or departments and as
such no system of incentives may be easily used to compensate workers for their above-standard
performance.
6. No proper classification of costs: In financial accounting, expenses are not classified into direct
and indirect, fixed and variable and controllable and uncontrollable. These classifications have utility
of their own.
7. No analysis of losses: Financial accounting does not fully analyse the losses due to idle time, idle
plant capacity, inefficient labour, sub-standard materials, etc. Thus, exact causes of the losses are
not known.
8. Inadequate information for price fixation: Costs are not available as an aid in determining
prices of products, services or production orders.
9. No cost comparison: Comparison is the foundation of modern management control. But financial
accounting does not provide data for comparison of costs of different periods, different jobs or
departments, or sales territories, etc.
10. Fails to supply useful data to management: Financial accounting fails to supply useful data to
management for taking various decisions like pricing of products, make or buy, selection of the
most profitable product mix, etc.
11.4 Nature
It is clear from the definitions of management accounting that it is concerned with accounting data
that is useful in decision making. The main characteristics of management accounting are as follows:
1. Useful in decision making: The essential aim of management accounting is to assist management
in decision making and control. It is concerned with all such information which can prove useful to
management in decision making.
2. Financial and cost accounting information: Basic accounting information useful for management
accounting is derived from financial and cost accounting records.
3. Internal use: Information provided by management accounting is exclusively for management for
internal use. Such information is not to be given to parties external to the business like shareholders,
creditors, banks, etc.
4. Purely optional: Management accounting is a purely voluntary technique and there is no statutory
obligation. Its adoption by any firm depends upon its utility and desirability.
5. Concerned with future: As management accounting is concerned with decision making, it is related
with the future because decisions are taken for future course of action and not the past.
6. Flexibility in presentation of information: Unlike financial accounting, in management accounting
there are no prescribed formats for presentation of information to the management. The form of
presentation of information is left to the wisdom of the management accountant who decides which
is the most useful format of providing the relevant information, depending upon the utility of each
type of form and information.
Activity
Management Accounting is useful for ....................................
11.5 Scope
Management accounting has a very wide scope. It includes not only financial accounting and cost
accounting but also all types of internal financial controls, internal audit, tax accounting, office services, cost
control and other methods and control procedures. Thus scope of management accounting, inter alia includes
the following:
1. Financial accounting: Financial accounting provides basic historical data which helps the
management to forecast and plan its financial activities for the future. Thus for an effective and
successful management accounting, there should be a proper and well designed financial accounting
system.
2. Cost Accounting: Many of the techniques of cost control like standard costing and budgetary
control and techniques of profit planning and decision making like marginal costing, CPV analysis
and differential cost analysis are used by the management accounting.
3. Budgeting and forecasting: In order to plan business activities for the future, forecasting and
budgeting play a very significant role. Forecasting helps in the preparation of budgets and budgeting
helps management accountant in exercising budgetary control.
4. Tax planning: In order to take advantage of various provisions of tax laws, management accountant
has to depend upon tax accounting and planning to minimize its tax liabilities and save more funds
for the business.
5. Reporting to management: For effective and timely decisions, there should be a system of prompt
and intelligent reporting to management. But routine and special reports are prepared for submission
to top management, middle order management and operating level management depending on their
requirements.
6. Cost control procedures: Any system of management accounting is incomplete without effective
cost control procedures like inventory control, labour control, overhead control, budgetary control,
etc.
7. Statistical tools: Various tools of analyzing and presenting statistical data like graphs, tables, charts,
etc., are used in preparing reports for use by the management.
8. Internal control and internal audit: Management accountant heavily depends on internal financial
controls like internal audit and internal check to plug loop holes in the financial system of the concern.
9. Financial analysis and interpretation: Management accountant employs various techniques to
analyse and interpret financial data to make it understandable and useable to the management. Such
analysis helps management to achieve objectives of management in a more efficient manner.
10. Office services: Management accountant is expected to maintain and control office routines and
procedures like filing, copying, communicating, electronic data processing and other allied services.
11.6 Functions
The main functions of management accounting are as follows:
1. Planning: Information and data provided by management accounting helps the management to
forecast and prepare short-term and long-term plans for the future activities of the business and
formulate corporate strategy. For this purpose management accounting techniques like budgeting,
standard costing, marginal costing, probability, correlation and regression, etc. are used.
2. Coordinating: Management accounting techniques of planning also help in coordinating various
business activities. For example, while preparing budgets for various departments like production,
sales, purchases, etc., there should be full coordination so that there is no contradiction. By proper
financial reporting, management accounting helps in achieving coordination in various business
activities and accomplishing the set goals.
3. Controlling: Controlling is a very important function of management and management accounting
helps in controlling performance by control techniques such as standard costing, budgetary control,
control ratios, internal audit, etc.
4. Communication: Management accounting system prepares reports for presentation to various
levels of management which show the performance of various sections of the business. Such
communication in the form of reports to various levels of management helps to exercise effective
control on various business activities and successfully running the business.
5. Financial analysis and interpretation: In order to make accounting data easily understandable,
the management accounting offers various techniques of analyzing, interpreting and presenting this
data in non-accounting language so that every one in the organisation understands it. Ratio analysis,
cash flow and funds flow statements, trend analysis, etc., are some of the management accounting
techniques which may be used for financial analysis and interpretation.
6. Qualitative information: Apart from monetary and quantitative data, management accounting
provides qualitative information which helps in taking better decisions. Quality of goods, customers
and employees, legal judgements, opinion polls, logic, etc., are some of the examples of qualitative
information supplied and used by the management accounting system for better management.
7. Tax policies: Management accounting system is responsible for tax policies and procedures and
supervises and coordinates the reports prepared by various authorities.
8. Decision-making: Correct decision-making is crucial to the success of a business. Management
accounting has certain special techniques which help management in short-term and long-term
decisions. For example, techniques like marginal costing, differential costing, discounted cash flow,
etc., help in decisions such as pricing of products, make or buy discontinuance of a product line,
capital expenditure, etc.
11.7 Tools and Techniques

Management accounting uses a number of tools and techniques to help management in achieving
business goals. Some of the important tools and techniques are as follows:
1. Budgeting.
2. Standard costing and variance analysis.
3. Marginal costing and cost volume profit analysis.
4. Ratio analysis.
5. Comparative financial statements.
6. Differential cost analysis.
7. Fund flow statement.
8. Cash flow statement.
9. Responsibility accounting.
10. Accounting for price level changes.
11. Statistical and graphical techniques.
12. Discounted cash flow.
13. Risk analysis.
14. Value analysis.
15. Work study, etc.
Activity
Specify any two tools & techniques used in Management Accounting.
11.8 Limitations
Management accounting is a very useful tool of management. However, it suffers from certain
limitations as stated below:
1. Based on historical data: Management accounting helps management in making decisions for the
future but it is mainly based on the historical data supplied by financial accounting and cost accounting.
This implies that historical data is used for making future decisions. The accuracy and dependability
of such data will leave their mark on the quality of management decisions. In other words, if past
data is not accurate, management decisions may not be correct.
2. Lack of wide knowledge: The management accountant should have knowledge of not only financial
and cost accounting but also many allied subjects like economics, management, taxation, statistical
and mathematical techniques, etc. Lack of knowledge of these subjects on the part of management
accountant limits the quality of management accounting.
3. Complicated Approach: Management accounting provides mass of data using various accounting
and non-accounting subjects for decision making purpose. But sometimes management avoids this
complicated and lengthy course of decision making and makes decisions based on intuition. This
leads to unscientific approach to decision making.
4. Not a substitute of management: Management accounting only provides information to
management for decision making but it is not a substitute of management and administration.
5. Costly system: The installation of management accounting system in an organisation is a costly
affair as it requires a wide net-work of management information system, rules and regulations. All
this requires heavy investment and small concerns may not be able to afford it.
6. Developing stage: Management accounting is a relatively recent development and it has not fully
developed as yet. This limits the utility of this system to management in making perfect and correct
decisions.
7. Lack of objectivity: The interpretation of information provided by management accounting may
be influenced by personal bias of the interpreter of data. This tells upon the quality of managerial
decisions.
8. Resistance from staff: The existing accounting and management staff may not welcome the
introduction of management accounting system. This may be because they look at the system with
suspicion that it will add to their work and responsibilities.
11.9 Summary
Management accounting has originated to serve the managers and to assist them in meeting their
needs. In due course of time, accounting was being used as management tool and that in now-a-days called
“management accounting”. It was developed as branch of accounting but separate from financial accounting.
Though management accounting is not a separate accounting, it is only the use of accounting in solving the
problems of management and taking timely decisions.
11.10 Key Words
 Financial Accounting Financial Accounting is mainly concerned with recording business transaction
in the books of accounts for the purpose of presenting final accounts.
 Cost Accounting Cost Accounting is a branch of accounting which specializes in providing
information about the detailed cost of products or services being supplied by the undertaking.
 Management Accounting Management Accounting denotes every accounting technique which
may be useful to management in discharging its function viz planning, organising, directing co-
ordinating, comunicating and controlling.

1. Define management accounting and explain its objectives.
2. What are the functions of management accounting?
3. Explain the nature and scope of management accounting.
4. Explain the relationship of management accounting with financial accounting and cost accounting.
5. A student planning a career in management commented “Look, I am going to be a manager, so why
do not we just leave the accounting to the accountants.” Discuss this comment.

Maheshwari S.L., Management Accounting
Maheshwari Mittal., Management Accounting
Goyal Man Mohan, Management Accounting
Unit- 12 Standard Costing and Variance Analysis
Unit Structure
12.0 Objectives
12.1 Introduction
12.2 Need of Standard Costing
12.3 Aims and Explanations
12.4 Variance Analysis Cycle
12.5 Types of Variances
12.6 Relationship between Variances
12.7 Summary
12.8 Key Words
12.0 Objectives
By the end of this unit you should be able to:
 Describe the nature and purpose of standard costing;
 Identify the main steps involved in implementing and operating a standard costing system;
 Calculate standard costing performance measures;
 Calculate sales, direct materials, direct labour, variable overhead, and fixed overhead variances;
 Prepare a standard cost operating statement;
 Outline the importance of standard costing and variance analysis.
12.1 Introduction
Costing is the determination of the value of resources used for specified goods or services. The
major purposes of costing are:
First to determine what amount of resources were required to provide the goods or services.
Second is to help to resource usage through the use of budgets that clearly identify managers’ work
responsibility. It is the second purpose that is considered in the following discussion:-
Methods of Costing Identified in Budgets
Budget figures may be based on actual, budgeted, or standard costs. These categories are not
mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a
standard cost. An actual cost may or may not be the budgeted cost.
Budgets based on actual costs reflect expense anticipated or planned for the level of resource use.
Budgeted costs are generally described as the best estimate or planning about what should be allowed for
next or upcoming activity. To establish budgeted costs, actual costs of the previous year, information from
department heads about where resources might be more efficiently and effectively used, and the decision
about the need to save resources are often considered. The main object of standard costs is to calculate the
costs that reflect the effective and efficient use of resources.
12.2 Need of Standard Costing
Standard costing is an important subtopic of cost accounting. Standard costs are usually associated
with a manufacturing company’s costs of direct material, direct labor, and manufacturing overhead. Standard
costs are costs established through identifying an objective relationship between specified inputs and budgeted
outputs.
12.3 Aims and Explanations

A standard cost is the planned cost of manufacturing a single unit or a number of product units
during a planned period in the immediate future. It is the predetermined cost of a product under current and
/ or expected operating conditions.
A standard is a scale for the measurement of performance. Standards are found everywhere in the
hotels, hospitals, constructions etc. Standards are also widely used in managerial accounting where they
relate to the quantity and cost of inputs used in manufacturing goods and producing services. Actualquantities
and actual costs are then compared with the set standards. In case of variance or deviations, managers
investigate the differences. The purpose is to find the problem and then to solve it to avoid its reoccurrence
and this process can also be explained as management by exception.
Standard costs are specifically related to thorough analysis of cost at both the ends i.e at various
planning departments and workplaces as well. To understand it better suppose, in the factory of a company
that produces high-quality purses for women, standard costs are used for materials and labor. To make out
the standard usage of fabric for a single purse, the cutting possibilities are analyzed in the laboratory, where
attention can be given to how much fabric must be used if the purse is cut as specified. At this point, the
focus is not on how many minutes are needed by an experienced cutter to perfectly cut the fabric so as to
minimize usage. Rather, there is experimentation in the ways of cutting and the time required for each way
considered. Experimentation continues until the most economical combination of fabric usage and cutting
time is established. That combination is likely to be modified to take account of less than perfect conditions
in the factory.
The aim of the department responsible for setting standard costs is to provide realistic standards.
Staff and labors are to be motivated to achieve result with specified standards. If standards are not reasonable
either too high or too low the output expected is not achieved which on another hand will cause labor
dissatisfaction and discouragement which results into poor work quality. If standards are too easy to achieve,
there may be an unnecessary waste of resources.
Standard costing finds its application in all types of business activity. The process described briefly
above can be applied, for example, for processing documents in a banking or financial services business.
12.4 Variance Analysis Cycle
This basic approach to identifying and solving problems is explained in the variance analysis cycle,
the cycle begins with the preparation of standard cost performance reports in the accounts department.
These reports shows the variances, which are actually the differences between achieved or actual results
and what should have occurred according to the planned standards and if there is any difference then the
question arises why this variance occurred or it is more than the previous years figure. The significant
differences termed as variances are examined deeply to understand their root causes so that precautionary
actions can be taken before the next operational period. Now the new cycle starts with the preparation of
a new standard cost performance for the current period keeping in mind the old variances and the reasons
for the same. The goal is to improve operations - not to find blame.
Variance Analysis Cycle
Take Corrective
Identify Questions ? Receive Explanations ?
Actions
? ?
Conduct Next
Analyze Variances
Period's Operations
? ?
? ? Prepare Standard Cost Performance Report ? ?
Rather than assigning the actual costs to resources (direct material, direct labor) and manufacturing
overhead to a product, many producers assign the standard cost. This means that a manufacturer’s stock
and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a
product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always
differences between the actual costs and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises,
management becomes aware that manufacturing costs have differed from the standard (budgeted, expected
or planned) costs.
 If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance
tells management that if everything else remains stable the company’s actual profit will be less than
planned.
 If actual costs are less than standard costs the variance is favorable. A favorable variance tells
management that if everything else remains stable the actual profit shall be more than the planned
profit.
Variance analysis is usually associated with explaining the difference (or variance) between actual
costs and the standard costs allowed for the standard output. For instance, the difference in materials costs
can be divided into a materials price variance and a materials usage variance. The difference between the
actual direct labor costs and the standard direct labor costs can be divided into a rate variance and an
efficiency variance. The difference in manufacturing overhead can be divided into spending, efficiency, and
volume variances. Mix and yield variances can also be calculated. All theses variances are explained in
detail in this chapter.
Variance analysis helps management to understand the present costs and then to plan and control
future costs.
Variance analysis is also used to explain the difference between the actual sales and the budgeted
sales. Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance
The sooner that the accounting system reports a variance, the sooner that management can direct its
attention to the difference from the planned amounts.
Usually there will be two variances computed for each input:
Input for Product Variance #1 Variance #2

Direct material Price (or cost) Usage (or quantity)
Direct labor Rate (or cost) Efficiency(or quantity)
Manufacturing overhead-variable Spending Efficiency
Manufacturing overhead-fixed Budget Volume
 Sample Standards Table
Let’s assume that Ram runs a retail outlet that sells cotton pants in two sizes. Ram suggests that you
get into the manufacturing side of the business, so on January 1, 2010 you start up a pants production
company called Cotton Works. Using the best information at hand, the two of you compile the following
estimates to use as standards for 2010
 Standards Table for Cotton Works
Large Pants Small Pants
Cotton material needed for each pants* 2.0 mts. 1.3 mts.
Time required to cut and sew each pants 0.3 hr. 0.2 hr.
Cotton cost per square meter Rs.3
Labor cost per hour (includes payroll taxes) Rs.10
Electricity and supplies used per hour of labor Rs.2
Rent for space per month (includes heat/air) Rs.600
Rent for equipment per month Rs.100
Planned production for the year 2010 5,000 pants 3,000 pants
Planned meters of cotton needed for 2010 13,900 mts. 10,000 mts. 3,900 mts.
Planned hours to cut and sew in 2010 2,100 hr. 1,500 hr. 600 hr.
*The cotton comes on rolls that are one meter wide, so one meter (mts.) of cotton is the same as one square
meter of cotton.
The pants are easy to produce, and no pants are ever left unfinished at the end of any given day.
This means that your company never has work-in-process inventory.
12.5 Types of Variances
 Direct Materials Purchased: Standard Cost and Price Variance
Direct materials refers to raw materials that are directly and clearly identifiable into a product. In
your pants business the direct material is the cotton. (In a food manufacturer’s business the direct materials
are the ingredients such as flour and sugar etc.)
Cotton Works purchases its cotton from a local supplier with terms of net 30 days, FOB destination.
This means that ownership to the cotton passes from the seller to Cotton Works when Cotton Works
receives the material. When the cotton arrives, Cotton Works will account the cotton received in its Direct
Materials Inventory at the standard cost of Rs.3 per meter (see standards table above) and will record the
liability at the actual cost for the amount received. Any difference between the standard cost of the material
and the actual cost of the material received is recorded as a purchase price variance.
 Examples of Standard Cost of Materials and Price Variance
Let’s assume that on January 2, 2010 Cotton Works placed an order for 1,000 meters of cotton at
Rs.2.90 per meter. On January 8, 2010 CottonWorks receives 1,000 meters of cotton and an invoice for
the actual cost of Rs.2,900. On January 8, 2010 Cotton Works becomes the owner of the material and has
a liability of payment to the seller. On January 8 Cotton Works’ Direct Materials stock is increased by the
standard cost of Rs.3,000 (1,000 meters of cotton at the standard cost of Rs.3 per meter), Accounts
Payable is credited for Rs.2,900 (the actual amount owed to the supplier), and the difference of Rs.100 is
credited to Direct Materials Price Variance. In journal format the entry looks like this:
Date Account Name Debit Credit
Jan. 8, 2010 Direct Materials Inventory 3,000

Accounts Payable 2,900
Direct Materials Price Variance 100
The Rs.100 credit to the price variance account shows immediately (when the cotton arrives) that
the company is experiencing actual costs that are more favorable than the planned, standard cost.
In February, Cotton Works orders 3,000 meters of cotton at Rs.3.05 per meter. On March 1,
2010 Cotton Works receives the 3,000 meters of cotton and an invoice for Rs.9,150 due in 30 days. On
March 1, the Direct Materials Inventory account is increased by the standard cost of Rs.9,000 (3,000
meters at the standard cost of Rs.3 per meter), Accounts Payable is credited for Rs.9,150 (the actual cost
of the cotton), and the difference of Rs.150 is debited to Direct Materials Price Variance as an unfavorable
price variance:
Mar. 1, 2010 Direct Materials Inventory 9,000

After the March 1 posting for transaction is done, the Direct Materials Price Variance account
shows a debit balance of Rs.50 (the Rs.100 credit on January 2 combined with the Rs.150 debit on March
1). A debit balance in a variance account is always unfavorable which shows that the total of actualcosts is
higher than the total of the planned standard costs. In other words, the company’s profit will be Rs.50 less
than expected unless you take some action to rectify the variance.
On June 1 your company receives 3,000 meters of cotton at an actual cost of Rs.2.92 per meter for
a total of Rs.8,760 due in 30 days. The entry is:
June 1, 2010 Direct Materials Inventory 9,000

Direct Materials Inventory is debited for the standard cost of Rs.9,000 (3,000 meters at Rs.3 per
meter), Accounts Payable is credited for the actual amount owed, and the difference of Rs.240 is credited
to Direct Materials Price Variance. A credit to the variance account indicates that the actual cost is less than
the standard cost.
After this transaction is recorded, the Direct Materials Price Variance account shows an overall
credit balance of Rs.190. A credit balance in a variance account is always favorable. In other words, your
company’s profit will be Rs.190 greater than planned due to the favorable cost of direct materials.
 Direct Materials Usage Variance
Under a standard costing system, production and stocks are reported at the standard cost—including
the standard quantity of direct materials that should have been used to make the products. If the manufacturer
actually uses more direct materials than the standard quantity of materials for the products actually
manufactured, the company will have an unfavorable direct materials usage variance. If the quantityof direct
materials actually used is less than the standard quantity for the products produced, the company will have
a favorable usage variance. The amount of a favorable and unfavorable variance is recorded in a general
ledger account Direct Materials Usage Variance. (Alternative account titles include Direct Materials
Quantity Variance or Direct Materials Efficiency Variance.) Let’s understand this variance with the following
information.
 January 2010
In order to calculate the direct materials usage or quantity variance, we start with the number of acceptable
units of products that have been manufactured. At Cotton Works this is the number of pants physically
produced. If Cotton Works produces 100 large pants and 60 small pants during January, the production
and the finished goods inventory will begin with the cost of the direct materials that should have been used
to make those pants. Any difference will be a variance.
NOTE: We are not determining the quantity of pants that Cotton Works should have made. Rather, we are
determining whether the 100 large pants and 60 small pants that were actually manufactured were produced
efficiently i.e. proper use of inventory and other resources. In the case of direct materials, we want to
determine whether or not the company used the proper amount of cotton to make the 160 pants that were
actually produced.
Standard costs are sometimes also termed as the “should be costs.” Cotton Works should be using
278 meters of cotton to make 100 large pants and 60 small pants as shown in the following table.
Large Small
Total
Pants Pants
Actual pants manufactured 100 60
2.0 1.3
Standard meters of cotton per pants manufactured
mts. mts.
Total standard meters of cotton for the actual good pants
78 278
manufactured—the number of meters of cotton that should 200
mts. mts.
have been used to make the good output
We determine the total standard cost of the cotton that should have been used to make the 160
pants by multiplying the standard quantity of cotton (278 meters) by the standard cost of a meter of cotton
(Rs.3 per meter):
Large Small
Total
Pants Pants
Total standard meters of cotton for the actual good 200 278
78 mts.
(pants) manufactured mts. mts.
Standard cost per meter Rs.3 Rs.3 Rs.3
Standard cost of cotton in the good output—the pants
Rs.600 Rs.234 Rs.834
actually produced in January
An stock account is debited for Rs.834; this is the standard cost of the direct materials component
in the pants manufactured in January 2010.
The Direct Materials Inventory account is reduced by the standard cost of the cotton actually
removed from the direct materials inventory. Let’s assume that the actual quantity of cotton removed from
the direct materials inventory and used to make the pants in January was 290 meters. Because Direct
Materials Inventory reports the standard cost of the actual materials on hand, we reduce the account
balance by Rs.870 (290 meters used Rs.3 standard cost per meter). After removing 290 meters of materials,
the balance in the Direct Materials Inventory account is Rs.2,130 (710 meters x Rs.3 standard cost per
meter).
The Direct Materials Usage Variance is: [the standard quantity of material that should have been
used to make the good output less the actual quantity of material used] X the standard cost per meter.
In our example, Cotton Works should have used 278 meters of material to make 100 large pants
and 60 small pants. Because the company actually used 290 meters of cotton, we say that Cotton Works
did not operate efficiently—an extra 12 meters of cotton was used (278 vs. 290 = 12). When we multiply
the 12 meters by the standard cost of Rs.3 per meter, the result is an unfavorable direct materials usage
variance of Rs.36.
Let’s put the above information into a format commonly used for computing variances:
 Direct Materials Usage/Quantity/Efficiency Variance Analysis
1. Debit Inventory-FG
for the standard meters 2. Credit Direct
3. Direct Material
of cotton that should Materials Inventory
Usage Variance
have been used to make for the actual meters
(Std Yd - Act Yd) x
the good output x the of cotton used x the
Std Cost
standard cost per standard cost per
meter of cotton meter of cotton
Std Yd x Std Cost Act Yd x Std Cost Difference
278 std yd x Rs.3 290 act yd x Rs.3 (12 yd) x Rs.3
Rs.834 Rs.870
Rs.36 Unfavorable
The journal entry for the direct materials portion of the January production is:
Jan. 31, 2010 Inventory-FG 834

Direct Materials Usage Variance 36
Direct Materials Inventory 870
 February 2010
Let’s assume that in February 2010 CottonWorks produces 200 large pants and 100 small pants
and that 520 meters of cotton are actually used. From this information we can compute the following:
L a r ge S m a ll
T o ta l
P a n ts P a n ts
A ct u a l pa nt s m an u f act ur ed 2 00 1 00 30 0
S ta n d ard m ete rs o f co tt o n p er p an ts m a nu fa ctu re d 2 .0 m ts. 1 .3 m t s.
T ot al s tan da rd m e te rs o f co tt on for t he ac tua l p an ts
4 00 m t s. 1 30 m t s. 53 0 m ts .
m a nu fac tu red
S ta n d ard co st p er m et er R s.3 R s.3 R s.3
S ta n d ard co st o f co tto n i n th e g o o d ou tp ut R s.1 ,2 00 R s.3 90 R s .1 ,5 9 0
Let’s put the above information into our format:

 Direct Materials Usage (or Quantity) Variance Analysis
1. D ebit Inv en tory -F G fo r
2. C re dit D irec t
the stan dard m eters of
M aterials In ventory 3. D irect M aterial
cotto n that sh ou ld h ave
fo r the actu al m eters Us ag e Va rian ce (Std
bee n u sed to m ake the
o f co tton u sed x th e Yd - A ct Y d) x Std
goo d o utpu t x the
stan da rd cos t per Co st
sta nd ard cost per meter o f
m eter o f co tto n
cotto n
A ct Y d x Std C ost Differenc e Std Yd x Std C o st
5 20 act yd x Rs .3 10 yd x Rs .3 530 std yd x R s.3
R s.1 ,5 60 R s .1 ,59 0
Rs.30 Fav orab le
The journal entry for the direct materials portion of the February production is:
Feb. 28, 2010 Inventory-FG 1,590

Direct Materials Usage Variance 30
Direct Materials Inventory 1,560
 Direct Labor: Standard Cost, Rate Variance, Efficiency Variance
“Direct labor” refers to the work done by those employees who actually make the product on the
production line. (“Indirect labor” is work done by employees who work in the production area, but do not
work on the production line. Examples include employees who set up or maintain the equipment.)
Unlike direct materials (which are obtained prior to being used) direct labor is obtained and used at
the same time. This means that for any given good output, we can compute the direct labor rate variance,
the direct labor efficiency variance, and the standard direct labor cost at the same time.
 January 2010
Let’s begin by determining the standard cost of direct labor for the good output produced in January
2010:
L ar ge S m a ll
T o ta l
P a n ts P a n ts
A ct ua l pa n t s m an uf act ur ed 1 00 60
S ta nd ard ho u r s o f d ir ec t lab o r per p a n ts m anu fa ct ur ed 0 .3 h r . 0 .2 h r.
T ot al s ta nd ard ho u r s o f d ire ct l ab o r f o r act ua l p an ts
3 0 hr. 1 2 hr . 42 h r .
m a n u fac tu red
S ta nd ard co st p er d ir ect l ab o r h o ur in cl . p a y ro ll t ax es R s.1 0 R s.1 0 R s .10
S ta nd ard co st o f di re ct la b o r in th e go o d o u tp u t R s.3 00 R s.1 2 0 R s .4 2 0
Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of
pay (including payroll taxes) is Rs.9 per hour, our analysis will look like this:
 Direct Labor Variance Analysis for January 2010:
1. Debit Inventory-
2. Actual FG for the standard
hours of direct 3. Direct hours of direct labor
4. Credit Wages labor used x Labor that should have been
Payable for the 5. Direct Labor the standard Efficiency used to make the
actual direct Rate Variance hourly pay Variance(Std good output x the
labor cost. Act Hr x (Std rate Hr - Act Hr) x standard hourly pay
Rate - Act Rate) Std Cost rate.
Act Hr x Act Act Hr x Std
Difference Difference Std Hr x Std Rate
Rate Rate
50 act hr x
50 act hr x Rs.9 50 hr x Rs.1 (8 hr) x Rs.10 42 std hr x Rs.10
Rs.10
Rs.450 Rs.500 Rs.420
Rs.80
Rs.50Favorable
Unfavorable
In January, the direct labor efficiency variance (#3 above) is unfavorable because the company
actually used 50 hours of direct labor—this is 8 hours more than the standard quantity of 42 hours allowed
for the good output. The additional 8 hours is multiplied by the standard rate of Rs.10 to give us an unfavorable
direct labor efficiency variance of Rs.80. (The direct labor efficiency variance could be called the direct
labor quantity variance or usage variance.)
Note that Cotton Works paid Rs.9 per hour for labor when the standard rate is Rs.10 per hour.
This Re.1 difference—multiplied by the 50 actual hours—results in a Rs.50 favorable direct labor rate
variance. (The direct labor rate variance could be called the direct labor price variance.)
The journal entry for the direct labor portion of the January production is:
Direct Labor Efficiency Variance 80
Direct Labor Rate Variance 50
Wages Payable 450
 February 2010
In February your company manufactures 200 large pants and 100 small pants. The standard cost of
direct labor for the good output produced in February 2010 is computed here:
Large Pants Small Pants Total
Standard hours of direct labor per pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor for actual
60 hr. 20 hr. 80 hr.
pants manufactured
Standard cost per direct labor hour incl. payroll
Rs.10 Rs.10 Rs.10
taxes
Standard cost of direct labor in the good output Rs.600 Rs.200 Rs.800
If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay
(including payroll taxes) is Rs.11 per hour, the total equals Rs.825. The analysis for February 2010 looks
like this:
 Direct Labor Variance Analysis for February 2010:
2. Actual hours 3. Direct Labor 1. Debit Inventory-FG
4. Credit Wages of direct labor Efficiency for the standard hours of
Payable for the 5. Direct Labor used x the Variance(Std direct labor that should
actual direct Rate Variance standard Hr - Act Hr) x have been used to make
labor cost. Act Hr x (Std hourly pay rate Std Cost the good output x the
Rate - Act Rate) standard hourly pay rate.
Act Hr x Act Act Hr x Std
Difference Difference Std Hr x Std Rate
Rate Rate
75 act hr x
75 act hr x Rs.11 75 hr x (Rs.1) 5 hr x Rs.10 80 std hr x Rs.10
Rs.10
Rs.825 Rs.750 Rs.800
Rs.75 Rs.50
Unfavorable Favorable
Notice that for the good output in February, the total actual labor costs amounted to Rs.825 and the total
standard cost of direct labor amounted to Rs.800. This unfavorable difference of Rs.25 agrees to the sum
of the two labor variances:
Direct labor efficiency variance Rs.50 Favorable
Direct labor rate variance Rs.75 Unfavorable
Total Direct Labor Variance Rs.25 Unfavorable
The journal entry for the direct labor portion of the February production is:
Feb. 28, 2010 Inventory-FG 800
Direct Labor Rate Variance 75
Direct Labor Efficiency Variance 50
Wages Payable 825
Later in Part 5 we will discuss what to do with the balances in the direct labor variance accounts
under the heading "What To Do With Variance Amounts".
 Variable Mfg Overhead: Standard Cost, Spending Variance, Efficiency Variance
"Manufacturing overhead costs" refer to any costs within a manufacturing facility other than direct
material and direct labor. Manufacturing overhead includes such things as indirect labor, indirect materials
(such as manufacturing supplies), utilities, quality control, material handling, and depreciation on the
manufacturing equipment and facilities.
"Variable" manufacturing overhead costs will increase in total as output increases. An example is the
cost of the electricity needed to operate the machines that cut and sew the cotton. Another example is the
cost of the manufacturing supplies (such as needles and thread) that increase when production increases. In
our example we assume that these variable manufacturing overhead costs fluctuate in response to the number
of direct labor hours. Recall the original estimates made when CottonWorks was formed:
Large Pants Small Pants
Time required to cut and sew 0.3 hr. (18 min.) 0.2 hr. (12 min.)
Electricity and supplies used per hour of Rs.2
labor
January 2010
Let's begin by determining the standard cost of variable manufacturing overhead for the good output
that CottonWorks produces in January 2010:

Standard hours of direct labor per pants 0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor in the good 30 hr. 12 hr. 42 hr.
pants manufactured
Standard cost of variable manufacturing Rs.2 Rs.2 Rs.2
overhead per direct labor hour
Standard cost of variable manufacturing Rs.60 Rs.24 Rs.84
overhead in the good output
Recall that there were 50 actual direct labor hours in January. Let's assume that the actual cost for
the variable manufacturing overhead (electricity and manufacturing supplies) during January is Rs.90.
Our analysis will look like this:
 Variable Manufacturing Overhead Analysis for January 2010:
1. Debit
2. Actual hours of Inventory-FG for
direct labor used x 3. Variable the standard hours
4. Actual variable the standard manufacturing of direct labor that
manufacturing 5. Variable variable overhead should have been
overhead used manufacturing manufacturing efficiency variance used in the good
overhead overhead rate (Std Hr - Act Hr) x output x the
spending variance Std Rate standard variable
Act Hr x (Std manufacturing
Rate - Act Rate) overhead rate
Act Hr x Act Rate Difference Act Hr x Std Rate Difference Std Hr x Std Rate
50 act hr x 50 act hr x
50 act hr x Rs.2 (8 hr) x Rs.2 42 std hr x Rs.2
Rs.1.80* Rs.0.20
Rs.90 Rs.100 Rs.84
Rs.10 Favorable Rs.16 Unfavorable
*Actual cost of Rs.90 divided by 50 actual hours.
Notice that for the good output produced in January, the actual cost of variable manufacturing
overhead was Rs.90 and the total standard cost of variable manufacturing overhead cost allowed for the
good output was Rs.84. This unfavorable difference of Rs.6 agrees to the sum of the two variances:
Variable manufacturing overhead efficiency variance Rs.16 Unfavorable
Variable manufacturing overhead spending variance Rs.10 Favorable
Total Variable Manufacturing Overhead Rs. 6 Unfavorable
 Variable Manufacturing Overhead Efficiency Variance
As the above analysis shows, CottonWorks did not produce the good output efficiently-it used 50
actual direct labor hours instead of the 42 standard direct labor hours allowed.
The additional 8 hours no doubt caused the company to use additional electricity and supplies.
Measured at the originally estimated rate of Rs.2 per direct labor hour, this amounts to Rs.16 (8 hours x
Rs.2). This is referred to as an unfavorable variable manufacturing overhead efficiency variance.
 Variable Manufacturing Overhead Spending Variance
In the analysis above, item 2 shows that based on the 50 direct labor hours actually used, electricity
and supplies could reasonably add up to Rs.100 instead of the standard of Rs.84. (If the good output took
8 actual direct labor hours more than the standard hours to cut and sew the cotton, the company will likely
have additional electricity and supplies costs since it is operating the machines for an additional8 hours.) We
find, however, that the actual cost of the electricity and supplies is Rs.90, not Rs.100. This Rs.10 favorable
variance indicates that the company did not spend the planned Rs.2 per direct labor hour. (Perhaps electricity
rates were lower than the rates anticipated when the standard costs were established.)
Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable. For example:
Jan. 31, 2010 Var. Mfg. O/H Incurred 90

Accounts Payable 90
Another entry records how these overheads are assigned to the product based on standard costs:

Var. Mfg. O/H Applied 84
As our analysis notes above and these entries illustrate, CottonWorks has an actual variable
manufacturing overhead of Rs.90, but only Rs.84 (the standard amount) was applied to the products. The
Rs.6 difference is "explained" by the two variances:
Variable manufacturing overhead efficiency variance Rs.16 Unfavorable
Variable manufacturing overhead spending variance Rs.10 Favorable
Total Variable Manufacturing Overhead Rs. 6 Unfavorable
February 2010
Recall that in February 2010 the company produced 200 large pants and 100 small pants. We use
that good output to compute the standard cost of variable manufacturing overhead for February 2010:
Standard hours of direct labor per good pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor in the good pants
60 hr. 20 hr. 80 hr.
manufactured
Standard cost of variable manufacturing overhead per
Rs.2 Rs.2 Rs.2
direct labor hour
Standard cost of variable manufacturing overhead in the
Rs.120 Rs.40 Rs.160
good output
Given that there were 75 actual direct labor hours in February and assuming that the actual cost for
the variable manufacturing overhead in February was Rs.156, our analysis will look like this:
Variable Manufacturing Overhead Analysis for February 2010:
1. Debit
2. Actual hours Inventory-FG for
of direct labor 3. Variable the standard
4. Actual variable used x the manufacturing hours of direct
manufacturing 5. Variable standard overhead labor that should
overhead used manufacturing variable efficiency have been used in
overhead manufacturing variance (Std Hr the good output x
spending variance overhead rate - Act Hr) x Std the standard
Act Hr x (Std Rate variable
Rate - Act Rate) manufacturing
overhead rate
Act Hr x Std
Act Hr Act Rate Difference Difference Std Hr x Std Rate
Rate
75 act hr x
75 hr x (Rs.0.08) 75 act hr x Rs.2 5 hr x Rs.2 80 std hr x Rs.2
Rs.2.08*
Rs.156 Rs.150 Rs.160
Rs.6 Rs.10
Unfavorable Favorable
*Actual cost of Rs.156 divided by 75 actual hours.

The favorable difference between the actual cost of Rs.156 and the standard cost of Rs.160 agrees
to the sum of the two variances:
Variable manufacturing overhead efficiency variance Rs.10 Favorable
Variable manufacturing overhead spending variance Rs. 6 Unfavorable
Total Variable Manufacturing Overhead Rs. 4 Favorable
Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable. For example:
Feb. 28, 2010 Var. Mfg. O/H Incurred 156

Accounts Payable 156
Another entry records how these overheads are assigned to the product:
Feb. 28, 2010 Inventory-FG 160

Var. Mfg. O/H Applied 160
As our analysis notes above and as these entries illustrate, even though CottonWorks had actual
variable manufacturing overhead of Rs.156, the standard amount of Rs.160 was applied to the products.
For the month of February 2010 the company applied more variable manufacturing overhead to its products
than it actually incurred.
 Fixed Manufacturing Overhead: Standard Cost, Budget Variance, Volume Variance
"Fixed" manufacturing overhead costs remain the same in total even though the volume of production
may increase by a modest amount. For example, the property tax on the manufacturing facility might be
Rs.50,000 per year and it arrives as one tax bill in December. The amount of the property tax bill was not
dependent on the number of units produced or the number of machine hours that the plant operated. Other
examples include the depreciation or rent on production facilities; salaries of production managers and
supervisors; and professional memberships and training for personnel in the manufacturing area. Although
the fixed manufacturing overhead costs present themselves as large monthly or annual expenses, theyare, in
reality, a small part of each product's cost.
CottonWorks has two fixed manufacturing overhead costs:
Rent for space per month including heat/air Rs.600
Rent for equipment per month Rs.100
Total Fixed Manufacturing Overhead per Month Rs.700
A small amount of these fixed manufacturing costs must be allocated to each pants produced. This
is known as absorption costing and it explains why some accountants say that each product must "absorb"
a portion of the fixed manufacturing overhead costs.
A simple way to assign or allocate the fixed costs is to base it on things such as direct labor hours,
machine hours, or pounds of direct material. (Accountants realize that this is simplistic; they know that
overhead costs are a result of-or are driven by-many different factors.) Nonetheless, we will assign the
fixed manufacturing overhead costs to the pants by using the same method we used for variable manufacturing
overhead-by using direct labor hours.
 Establishing a Predetermined Rate
Companies typically establish a standard fixed manufacturing overhead rate prior to the start of the
year and then use that rate for the full year. Let's assume it is December 2008 and CottonWorks is developing
the standard fixed manufacturing overhead rate to use in 2010. (As mentioned above, we will assign the
fixed manufacturing overhead on the basis of direct labor hours.)
Step 1. Project/estimate the fixed manufacturing overhead costs for the year 2010.
We indicated above that CottonWorks' only fixed manufacturing overhead costs are rents of Rs.700
per month (space and equipment) totaling to Rs.8,400 for the year 2010.
Step 2. Project/estimate the total number of standard direct labor hours that are needed to manufacture
your products during 2010.
We can do that from the information given earlier (and repeated here):
L arge Pa nts S m all Pa nts T o tal
0 .3 hr . (18 0 .2 hr. (12
T im e req uired to cut a nd sew - the stan d ard
m in .) m in .)
Plann ed pro d uctio n fo r th e year 2 0 10 5 ,0 00 pants 3 ,0 0 0 pants
T o tal s tand ard direc t labo r ho urs in the p lan ned
1 ,5 00 6 00 2,10 0
p ro duction fo r th e year 20 10
Step 3. Compute the standard fixed manufacturing overhead rate to be used in 2010.
= Expected fixed manufacturing ÷ Expected total standard direct
overhead for 2010 labors hours (DLH) for 2010
= Rs.8,400 ÷ 2,100 Standard DLH
= Rs.4 per Standard Direct Labor Hour
NOTE:
One of the reasons a company develops a predetermined annual rate is that the rate is uniform
throughout the year, even though the number of units manufactured may fluctuate month by month.
For example, if the company used monthly rates, the rate would be high in the months when few
units are manufactured (monthly fixed costs of Rs.700 ÷ 100 units produced = Rs.7 per unit) and low when
many units are produced (monthly fixed costs of Rs.700 ÷ 350 units = Rs.2 per unit).
 Fixed Manufacturing Overhead Budget Variance
The difference between the actual amount of fixed manufacturing overhead and the estimated amount
(the amount budgeted when setting the overhead rate prior to the start of the year) is known as the fixed
manufacturing overhead budget variance. In our example, we budgeted the annual fixed manufacturing
overhead at Rs.8,400 (monthly rents of Rs.700 x 12 months). If CottonWorks pays more than Rs.8,400
for the year, there is an unfavorable budget variance; if the company pays less than Rs.8,400 for the year,
there is a favorable budget variance.
 Fixed Manufacturing Overhead Volume Variance
Recall that the fixed manufacturing overhead (such as the large amount of rent paid at the start of
every month) must be assigned to each pants produced. In other words, each pants must absorb a small
portion of the fixed manufacturing overhead. At CottonWorks, the fixed manufacturing overhead is assigned
to the good output by multiplying the standard rate by the standard hours of direct labor in each pants.
Hopefully, by the end of the year there are enough good pants produced to absorb all of the fixed manufacturing
overhead.
The fixed manufacturing overhead volume variance compares the amount of fixed manufacturing
overhead budgeted to the amount that was applied to (or absorbed by) the good output. If the amount
applied is less than the amount budgeted, there is an unfavorable volume variance-there was not enough
good output to absorb the budgeted amount of fixed manufacturing overhead. If the amount applied to the
good output is greater than the budgeted amount of fixed manufacturing overhead, the fixed manufacturing
overhead volume variance is favorable. In brief, if CottonWorks applies more than the amount budgeted,
the volume variance is favorable; if it applies less than the amount budgeted, the volume variance is unfavorable.
 Illustration of Fixed Manufacturing Overhead Variances for 2010
Let's assume that in 2010 Cotton Works manufactures (has actual good output of) 5,300 large pants and
2,600 small pants. Let's also assume that the actual fixed manufacturing overhead costs for the year are
Rs.8,700. As we calculated earlier, the standard fixed manufacturing overhead rate is Rs.4 per standard
direct labor hour. We begin by determining the fixed manufacturing overhead applied to (or absorbed by)
the good output produced in the year 2010:
Large Small
Total
Pants Pants
Actual pants manufactured 5,300 2,600
Standard hours of direct labor hours per pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor in the good pants
1,590 hr. 520 hr. 2,110 hr.
manufactured
Standard cost per direct labor hour for fixed
Rs.4 Rs.4 Rs.4
manufacturing overhead
Standard cost of fixed manufacturing overhead in
Rs.6,360 Rs.2,080 Rs.8,440
(applied to) the good output
Our analysis looks like this:
 Fixed Manufacturing Overhead Analysis for the Year 2010:
1. Debit
2. Fixed Inventory-FG for
manufacturing 3. Fixed the standard
4. Actual fixed overhead budget manufacturing hours of direct
manufacturing 5. Fixed for the year 2010 overhead volume labor that should
overhead manufacturing variance be in the good
overhead budget output x the
variance Budgeted (1 - 2) standard fixed
Amount - Actual manufacturing
Amount overhead rate
Std Hr x Std
Actual Amount Difference Annual Budget Difference
Rate
2,110 std hr x Rs.4
Rs.8,700 Rs.8,400 Rs.8,440
Rs.300
Rs.40 Favorable
Unfavorable
This analysis shows that the actual fixed manufacturing overhead costs are Rs.8,700 and the fixed
manufacturing overhead costs applied to the good output are Rs.8,440. This unfavorable difference of
Rs.260 agrees to the sum of the two variances:
Fixed manufacturing overhead volume variance Rs. 40 Favorable
Fixed manufacturing overhead budget variance Rs.300 Unfavorable
Total Fixed Manufacturing Overhead Variance Rs.260 Unfavorable
Actual fixed manufacturing overhead costs are debited to overhead cost accounts. The credits are
made to accounts such as Accounts Payable or Cash. For example:
During 2010 Fixed Mfg. O/H Incurred 8,700

Another entry records how these overheads are assigned to the product:
During 2010 Inventory-FG 8,440

Fixed Mfg. O/H Applied 8,440
12.6 Relationship Between Variances

If the direct labor is not efficient at producing the good output, there will be an unfavorable labor
efficiency variance. That inefficiency will likely cause additional variable manufacturing overhead-resulting in
an unfavorable variable manufacturing overhead efficiency variance. If these inefficiencies are significant, it
is possible that the company may not be able to produce enough good output to absorb the planned fixed
manufacturing overhead-resulting in an unfavorable fixed manufacturing overhead volume variance.
We will pursue the interdependence of variances in the following examples.
Example 1
Assume your company's standard cost for cotton is Rs.3 per meter, but you buy some cotton at a
bargain price of Rs.2.50 per meter. For each meter of cotton purchased, Cotton Works reports a favorable
direct materials price variance of Rs.0.50.
Let's also assume that the quality of the low-cost cotton ends up being slightly lower than the quality
to which your company is accustomed. This lesser quality cotton causes the production to be a bit slower as
workers spend additional time working around flaws in the material. In addition to this decline in productivity,
you also find that some of the cotton is of such poor quality that it has to be discarded. Further, some of the
finished pants don't pass the final inspection due to occasional defects not detected as the pants were made.
You get the picture. If the favorable Rs.0.50 per meter price variance correlates with lower quality,
that cotton was no bargain. The Rs.0.50 per meter favorable variance may be more than offset by the
following unfavorable quantity variances:
 direct material usage variance
 direct labor efficiency variance
 variable manufacturing overhead efficiency variance
Keep in mind that the standard cost is the cost allowed on the good output. Putting material, labor,
and manufacturing overhead costs into products that will not end up as good output will likely result in
unfavorable variances.
Example 2
Let's assume that you decide to hire an unskilled worker for Rs.9 per hour instead of a skilled
worker for the standard cost of Rs.15 per hour. Although the unskilled worker will create a favorable direct
labor rate variance of Rs.6 per hour, you may see significant unfavorable variances such as direct material
usage variance, direct labor efficiency variance, variable manufacturing overhead efficiency variance, and
possibly a fixed manufacturing volume variance.
These two examples highlight what experienced managers know-you need to look at more than
price. A low cost for an inferior input is no bargain if it results in costly inefficiencies.
 What To Do With Variance Amounts
Throughout our explanation of standard costing we showed you how to calculate the variances. In
the case of direct materials and direct labor, the variances were recorded in specific general ledger accounts.
The manufacturing overhead variances were the differences between the accounts containing the actual
costs and the accounts containing the applied costs. Now we'll discuss what we do with those variance
amounts.
 Direct Materials Price Variance
Let's begin by assuming that the account Direct Materials Price Variance has a debit balance of
Rs.3,500 at the end of the accounting year. You can see from the following journal entry (a hypothetical
entry which assumes that all of the direct materials were purchased at one time) that a debit balance is an
unfavorable variance:
Account Name Debit Credit
Direct Materials Inventory (standard cost) 10,000

Direct Materials Price Variance 3,500
Accounts Payable (actual cost) 13,500
Because of the cost principle, CottonWorks is obligated to report its transactions at their actual
cost in the financial statements that are made available to the public. If none of the direct materials purchased
in this journal entry was used in production (all of the direct materials remain in the direct materials inventory),
the company's balance sheet needs to report the direct materials inventory at Rs.13,500-the actual cost. In
other words, the balance sheet will report the direct materials inventory as the standard cost of Rs.10,000
plus the price variance of Rs.3,500. If all of the materials were used in making products, and all of the
products have been sold, the Rs.3,500 price variance is added to the company's standard cost of goods
sold. If 20% of the materials remain in the direct materials inventory and 80% of the materials are in the
finished goods that have been sold, then Rs.700 of the price variance (20% of Rs.3,500) is added to the
standard cost of the direct materials inventory, Rs.2,800 (80% of Rs.3,500) is added to the standard cost
of goods sold.
Let's say the direct materials are in various stages of use: 20% have not been used yet; 5% are in
work-in-process; 15% are in finished goods on hand; and 60% are in finished goods that have been sold.
We need to apportion the Rs.3,500 direct materials price variance to each of these stages. Since the
Rs.3,500 is an unfavorable amount, the following amounts are added to the standard costs:
Direct materials inventory Rs. 700 (20% of Rs.3,500)

Work-in-process inventory 175 ( 5% of Rs.3,500)
Finished goods inventory 525 (15% of Rs.3,500)
Cost of goods sold 2,100 (60% of Rs.3,500)
Total Rs.3,500
The accounting professional follows a materiality guideline which says that a company may make
exceptions to other accounting principles if the amount in question is insignificant. (For example, a large
company may report amounts to the nearest Rs.1,000 on its financial statements, or an inexpensive item like
a wastebasket can be expensed immediately instead of being depreciated over its useful life.) This means
that if the total variance of Rs.3,500 shown above is a very, very small amount relative to the company's net
income, the company can charge the entire Rs.3,500 to cost of goods sold instead of allocating some of the
amount to the inventories.
If the balance in the Direct Materials Price Variance account is a credit balance of Rs.3,500 (instead
of a debit balance) the method and discussion would be the same, except that the standard costs would be
reduced instead of increased.
 Direct Materials Usage Variance
Let's assume that the Direct Materials Usage Variance account has a debit balance of Rs.2,000 at
the end of the accounting year. A debit balance is an unfavorable balance resulting from more direct materials
being used than the standard amount allowed for the good output.
The first question to ask is "From where did this unfavorable variance of Rs.2,000 arise?" If it was
caused by mistakes and/or inefficiencies, it cannot be included as part of the cost of the inventory. Errors
and inefficiencies are never considered to be assets; therefore, the entire amount must be expensed.
If the unfavorable Rs.2,000 variance is the result of an unrealistic standard for the quantity of direct
materials needed, then we should allocate the Rs.2,000 variance to wherever the standard costs of direct
materials are physically located. If 90% of the related direct materials have been sold and 10% are in the
finished goods inventory, then the Rs.2,000 should be allocated and added to the standard direct material
costs as follows:
Direct materials inventory Rs. 0
Work-in-process inventory 0
Finished goods inventory 200 (10% of Rs.2,000)
Cost of goods sold 1,800 (90% of Rs.2,000)
Total Rs.2,000
If Rs.2,000 is an insignificant amount relative to a company's net income, the entire Rs.2,000
unfavorable variance can be added to the cost of goods sold. This is permissible because of the materiality
guideline.
If the Rs.2,000 balance is a credit balance, the variance is favorable. This means that the actual
direct materials used were less than the standard quantity of materials called for by the good output. We
should allocate this Rs.2,000 to wherever those direct materials are physically located. However, if Rs.2,000
is an insignificant amount, the materiality guideline allows for the entire Rs.2,000 to be deducted from the
cost of goods sold on the income statement.
12.7 Summary
Standard cost is a predetermined cost, which is computed, is advance of production on the basis of
specification of all the factors affecting cost. A standard figure is one which may be used as a yard stick for
measuring the efficiency or inefficiency of the actual preformance. Standards are set for each element of
cost viz. direct material, direct labour and overheads for each cost centre. The standards are determined
and set and are shown in standard cost statement. Actual result of performance are compared with the
standards by preparing a comparating statement of cost. The variations is actual and standards are ascertained.
When standard cost is compared with the actual cost a difference is found between them. This difference is
known as variance. Variance analysis is the process of analysing variances by sub dividing the total variance.
When the actual cost is less than standard cost the difference is termed as farourable (f) variance. On the
contrary, if actual cost is more than standard cost, the difference is called as adverase variance. The difference
between standard cost and the actual cost may be regregated element wise-direct material cost, direct
labour cost and overhead cost variances. Different variances are used in different industries.
Following formulas are used for calculation of variances.
(A) Direct Material Cost Variance
MCV = (SQxSP) - (AQxAP)
MPV = (SP - AP) x AQ
MUV = (SQ - AQ) x SP
Varification - MCV = MPV + MUV
When two or more than two materials are used:
MMV = (RSQ - AQ) x SP
MSUV = (SQ - RSQ) x SP
Verification - MUV = MMV + MSUV
(B) Labour Variances
LCV = (SH x SR) - (AH x AR)
LRV = (SR - AR) x AH
LEV = (SH - AH) x SR
LITV = (O - IH) x SR
LMV = (RSH - AH) SR
LSEV = (SH - RSH) SR
Verification - LCV = LRV + LEV
LEV = LMV + LSEV
(C) Variable Overhead Variances
(i) on the basis of unit of output
VOCV = (SR - AR) x AO
VO exp. V = (SO x SR) - (AO x AR)
VO Eff. V = (AO - SO) x SR
(ii) on the basis of standard hours
VOCV = (SH x SR) - (AH x AR)
VO Exp. V = (SR - AR) x AH
VO Eff. V = (SH - AH) x SR
Verification - VOCV = VO Exp. V + VO Eff. V
(D) Fixed Overhead Variances
(i) on the basis of units of output
FOCV = (SR - AR)
FO Exp. V = (BO - AO) x SR
FOVV = (AO - BO) x SR
FO Eff. V = (AO - SO) x SR
FOCV = (SO - BO) x SR
(ii) on the basis of standard hours
FOCV = (SH x SR) - ( AH x AR)
FO Exp. V = (BH x SR) - (AH x AR)
FOVV = (SH - BH) x SR
FO Eff. V = (SH - AH) x SR
FOCV = (AH - BH) x SR
Varification - FOCV = FO Exp. V + VOVV
FOVV = FO Eff. V + FOCV
(E) Sales Variances
(a) Sales turnover method.
(i) Sales Value Variance = (AP x AQ - SP x SQ)
(ii) Sales Price Variance = AQ (AP - SP)
Varifiaction = SVV = SPV + S vol. V
(b) Sales margin method
(i) Total sales margin variance = Actual margin - Budgeted margin
(ii) Sales margin price variance = AQ(Actual margin-Budgeted margin)
(iii) Sales margin volume variance = Budgeted margin (AQ - BQ)
12.8 Key Words

 Direct labour efficiency variance A standard costing variance showing the difference between
the actual hours worked and the hours that should have been worked for the actual production
valued at the standard hourly rate.
 Direct labour rate variance A standard costing variance showing the difference between the
actual rate and the standard rate for the actual number of hours worked.
 Direct labour total variance A standard costing variance showing the difference between actual
direct labour cost and the direct labour hours that should have been worked for the actual number
of units produced valued at the standard hourly rate.
 Direct materials price variance A standard costing variance showing the difference between the
actual cost and the standard cost of the actual materials used in production.
 Direct materials total variance A standard costing variance showing the difference between the
actual cost of materials used in production and the standard quantity of the actual production valued
at the standard cost.
 Direct materials usage variance A standard costing variance showing the difference between
the actual quantity of materials used in production and the standard quantity valued at the standard
cost.
 Fixed production capacity variance A standard costing variance showing the difference between
the budgeted fixed production overhead expenditure and the actual hours worked valued at the
fixed production overhead absorption rate.
 Fixed production overhead efficiency variance A standard costing variance showing the
difference between the actual hours worked and the standard hours for the actual production valued
at the fixed production overhead absorption rate.
 Fixed production overhead expenditure variance A standard costing variance showing the
difference between the actual fixed production overhead and the budgeted fixed production overhead.
 Fixed production overhead total variance A standard costing variance showing the difference
between the actual fixed production overhead incurred and the standard hours of the actual production
valued at the fixed production overhead absorption rate.
 Fixed production overhead volume variance A standard costing variance showing the difference
between the budgeted fixed production overhead expenditure and the standard hours worked for
the actual production valued at the fixed production overhead absorption rate.
 Sales total variance The difference between actual profit based on the standard cost of the actual
quantity sold and the standard profit for the budgeted quantity.
 Sales variances Variances showing the difference between the actual sales revenue and the standard
or budgeted sales revenue analysed into price and volume variances. A volume variance is sometimes
also analysed into mix and quantity variances.
 Sales volume profit variance The difference between the actual quantity of units sold and the
budgeted quantity valued at the standard profit per unit.
 Standard The amount or level set for the performance of a particular activity.
 Standard cost The budgeted or planned cost of material, labour, or overheads expected to be paid
during a given accounting period.
 Standard costing A control method involving the preparation of detailed cost and sales budgets.
Such budgets are then compared with the actual results for a specific account period and any
significant variances between the actual and the budgeted results are investigated. Unexpected
trends are corrected if they are not acceptable or they cannot be accommodated.
 Variable production overhead efficiency variance The difference between the actual hours
worked and the hours that should have been worked for the actual production valued at the variable
production overhead absorption rate.
 Variable production overhead expenditure variance The difference between the actual variable
production overhead incurred and the actual hours worked valued at the variable production overhead
absorption rate.
 Variable production overhead total variance The difference between the actual variable overhead
incurred and the standard hours that ought to have been worked for the actual output valued at the
variable production overhead absorption rate.
 Variance The difference between the actual cost and the budgeted or standard cost of a particular
activity, or the actual sales revenue and the budgeted or standard sales revenue.
 Variance analysis An investigation into the causes of variances.
1. The following data are related to production of ‘x’ Calculate material variances:
Material Standard Actual
X 400 Kgs. @ Rs. 10 550 Kgs. @ Rs. 9
Y 500 Kgs. @ Rs. 5 350 Kgs. @ Rs. 7
(Ans. MCV = 900(A), MPV = 150(A), MUV = 750 (A).
2. From the following informations calculate Labour Variances:
Standard Actual
Workmen Hours Rate Total Hours Rate (Rs.) Total
(Rs.) (Rs.) (Rs.)
A 20 40 800 30 30 900
B 60 30 1800 46 40 1840
Ans. : LCV=270(A), LRV = 160 (A), LEV = 110(A), LMV = 110(A) LSEV = 0
3. From the following data, calculate variable and fixed overhead variance:
Budgeted output 50 lot
Actual output 60 lot
Fixed overhead absorption rate per hour Rs. 3
Variable overheads (actual as well as budgeted) Rs. 7500
Standard hours per lot 100 hours
Actual fixed overheads Rs. 14500
Actual hours worked 5600 hours
Ans. : VOCV = 1500(f), VOEV = 600 f, VO Exp. V = 900(f) FOCV = 3500(f), FO Exp. V
500(f), FOVV = 3000(f), FO Eff. V = 1200(f), FO cap. V = 1800 f.
4. Compute sales variances from the following data:
Product R Product S
Sales Quantity (Units)
Standard 400 Units 400 Units
Actual 500 Units 900 Units
Selling price per units (Rs.)
Standard Rs. 12 Rs. 15
Actual Rs. 15 Rs. 20
(Ans.: SVV = 12700(f), SPV = 5500(f), SVV = 7200(f), SMV = 450 (f) SSVV6750 (f).

1. Tulsian P.C., Cost Accounting.
2. Robert Nelson G.H., Standard costing in theory and practice.
3. Kishore M. Ravi, Cost Accounting.
Unit- 13 Budgetary Control
Unit Structure
13.0. Objectives
13.1 Introduction
13.2 Meaning of Budget and Budgeting
13.3 Definitions
13.4 Essentials of Effective Budgeting
13.5 Characteristics of Budgetary Control
13.6 Objectives of Budgetary Control
13.7 Advantages of Budgetary Control
13.8 Limitations of Budgetary Control
13.9 Budget Control Process
13.10 Types of Budgets
13.11 Summary
13.12 Key Words
13.0 Objectives
The study of this unit will enable you to understand:-
 The concept meaning and definition of budget and budgetary control.
 Objectives, Characteristics, Advantages and Disadvantages of Budgetary Control.
 Budgetary Control Process
 Types of Budgets.
13.1 Introduction
The efficiency of management depends upon the accomplishment of the goals of an organization. It
is effective when it attains the objective with least cost and effort. A systematic approach for attaining
effective management performance is budgeting, which is on integral part of management. This is the
process of pre- estimation of cost, revenue, profit and other figures for the next year or period and on the
basis, actual expenses incurred revenue generated/earned. Afterwards budget is used as a standard for
measuring actual performance. The deviations are found out and responsibility is fixed for deviations.
Various budgets are prepared for different purposes.
13.2 Meaning of Budget and Budgeting

In our routine life we prepare budgets for matching the expenses with income and available funds
can be invested in business. Likewise, in business, budgets are prepared on the basis of future estimated
cost, revenue, profit etc. Budget is a financial or quantitative statement prepared prior to a defined period of
time for the purpose of execution of management, policies for accomplishing the given goal. It is a tool of
plan as the making of budget is nothing else but an advance planning. It provide standards by which actual
operations can be evaluated to know variations from planned expenditure, profits.
Budgeting is the formulation of plans for the future activities of a business after careful consideration
of goals. It provides yardsticks by which deviations from achievements can be measured. It helps in
remaining unproductive activities and intimation of waste because preparation of budgets involves careful
analysis of different phases of business, it is a tool of control as it fixes the individual responsibilities for
fulfilling the plan.
Budgetary Control is a technique which uses budgets as a means of controlling all business aspects
and is designed to assist management. In allocation of responsibility and authority, measurement of actual
performance, analysis of variance between actual and budgeted.
Budgeting process includes - Budget and Budgetary control. Budget is means and budgetary
control is the end result.
13.3 Definitions
The major definitions of budget are as follows-
1. C.I.M.A. (England) “Budget is 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
object”
2. Heman. C. Heises “Budget is overall blueprint of comprehensive plan of operations and actions
expressed in financial terms.”
3. Bartzal “ A budget is forecast in detail, of the results of an officially reorganized programmed of
operations based on the highest reasonable expectation of operating efficiency”
The prominent definition of budgetary control is as under-
1. C.I.M.A., England "Budgetary control is the establishment of budgets relating to the
responsibilities of executives to the requirement of a policy and the continuous comparison of actual
with budgeted results either to secure by individual action the objectives of that policy or to provide
a basis for its revision.
2. J. Batty "Budgetary control is a system which uses budgets as a means of planning and controlling
all aspects of producing and selling commodities or service.
3. Welsch "Budgetary control is the use of budgets and budgetary reports throughout the period to
co-ordinate, evaluate and control day to day operations in accordance with the goals specified by
the budget."
13.4 Essentials of Effective Budgeting
The essential components of successful budgeting system are as under:-
(a) There must be full support by every member of top management without which no system can be
effective.
(b) There should be a well defined responsibility center within the organization with clearly shown
controllable cost for each such center.
(c) The business policies of organization must be clearly defined as budget are based on such policies.
(d) The accounting system must be complete in all regards from which reliable historical data is taken
which form basis for preparing budgets.
(e) The budgets must be reasonable so that responsible executives may agree. For this formation of
budgets should be handed over to those executives by whom such budgets are to be used.
(f) The ultimate goal is maximizing profit through budget system so it should not cost more than its
worth.
13.5 Characteristics of Budgetary Control

The major characteristics of budgetary control are as under:-
(1) Budgetary control implies the planning of activities as a plan cover all phases of operation for
definite period.
(2) Budgetary control assists the management in co-coordinating their efforts in attaining the objectives
of the organization.
(3) Budgetary control is a control tool aimed at keeping management, informed that whether
predetermined plans are achieved or not.
(4) Budgetary control makes appraisal to find out variances by comparing actual with budgeted ones
and fixing responsibilities.
(5) Budgetary control follow-up to make corrective measure and modify targets.
13.6 Objectives of Budgetary Control

The following are objectives of budgetary control.
(a) To run production activities in efficient manner by leaving behind the chances of interruption in
production due to lack of any article.
(b) To control the cost and increase revenue, so as to know project at different stages of production.
(c) To bring economy by comparing actual data with budgeted data so that timely corrective actions
can be taken.
(d) To predict short-term and long term financial positions for better financial position and management
of working capital in a better manner.
13.7 Advantages of Budgetary Control
It is well known fact that a planned activity has better chances of success than unplanned one. The
budgeting is forward planning and effective control following are advantage of budgetary control.
(a) Budget preparation involves participation of management at all levels of organization which brings
co-operation and team spirit.
(b) It acts as tool for periodical evaluation of managerial policies and appraisal of performance of
individual and department. So that corrective action can be taken in time to improve efficiency.
(c) Budgetary Control inspires management to develop a sense of care and caution before making
decisions.
(d) Budgetary Control contributes to national economy by providing stability of employment,
economic use of resources & effective prevention of waste.
(e) Budgetary control provide for self - examination and self- criticism which is indispensable for the
success of organization.
13.8 Limitations of Budgetary Control
Although Budgetary Control is desirable to an organization but it has certain limitations which are as
under:-
(a) Budgetary control faces objections by employees as the performance of employees is judged
continuously.
(b) It requires the experienced and technical man-power, which is costly affair.
(c) Budgeting is an elaborate process which is time consuming affair.
(d) Budgetary control loses its usefulness due to rigidity, if budgets are not revised regularly with
changing business environment.
(e) Forecasting, planning or budgeting is estimation not exact science and certain amount of
judgment is present in budgeting.
13.9 Budget Control Process
For preparing an efficient budget, there is an urgent need of well-versed system for preparing the
budget. This process is required an efficient system of implementation within the organization. The main
essentials of establishment of system of budgeting are:
1. Budget Centres Budget centre are defined as various sections of an organization, where budget-
ary control measures are to be applied and for the purpose, separate budgets are to be prepared
with the help of the head of these centers so that these may be executed more efficiently.
2. Budget Committee The budget committee is a group of representatives of various interrelated
function in an organization, e.g. Sales manager, Production Manager, R&D Manager, Materials
Manager, etc. It is necessary to discuss the targets so that a mutually agreed programmed can be
determined. This is really the co-ordination in budget making. It is a powerful force in knitting
together the various activities of the business and enforcing real control over operations.
3. Budget Officer To link up the various functions, to bring them together and to co- ordinate their
efforts in the matter of preparation to target figures, there should be a person called budget Officer
or Budget controller. He is enabling to provide ready data relating to all the functions. He helps in
preparation of the various budgets and their co-ordinations and compilation into the master budget,
bringing to the notice of the management the need for revision of budgets and assisting them in the
task.
4. Budget Manual Budget manual is defined as a document which sets outstanding instructions, the
responsibility of the persons engaged in, and the procedures, forms and records relating to the
preparation and use of budgets. It is a booklet of budget policies which lays down the details of the
organizational set up with duties and responsibilities of executives including the budget committee
and budget officer and procedures to be followed for developing budget in respect of various
activities.
5. Budget period This is the period for which forecasts can reasonably be made and budgets can be
formulated. Budget periods vary between short-term and long -term and no specific period can be
laid down for all budgets. The length of the budget period depends on the type of the business, the
length of the manufacturing cycle from raw material to finished products, the ease or difficulty of
forecasting future market conditions and other factors.
6. Budget Key Factor or Determining Principal Budget Factor The key factor is also known as
limiting factor, governing factor, etc. and may be defined as the factor which at particular time or
over a period will limit the activities of and undertaking. The limiting factor is, usually, the level of
demand for the products or services of the undertaking, but it could be a shortage of one of the
productive resources, e.g. skilled labor, raw material, or machine capacity etc. The key factor is
normally temporary in nature. In the long run, they can be overcome by proper planning and man-
agement action.
7. Forecasting Forecasting is the statement of events likely to occur. It is usually the practice to judge
the accuracy of forecasts on the basis of actual performance, taking the latter to be correct. A
forecast forms the basis for the budget. A budget indicates a target and it is a statement of planned
events, evolved from forecast.
8. Determining Level of Activity The level of activities are determined on the basis of
information and estimates provided regarding future conditions and activities of market and position
of product in the market by departmental heads or concerned managers, for this purpose, detailed
discussions, analysis, preparation of reports are to be done and then written report to be formed
and submitted to budget committee for their decision making.
9. Preparation of Budget The budget should be prepared by the manager who is responsible for
meeting the budgeted performance after discussing all the factors which may affect the process of
budgeting. The budget should originate at the lowest levels of management and be refined and
coordinated at higher levels. This will enable managers to participate in the preparation of their
budgets and increase the probability that they will accept the budget and strive to achieve the
budgeted targets.
13.10 Types of Budgets
Budgets can be classified into different categories on the basis of time, functions or flexibility. The
different budgets covered under each category are shown in the following chart:
13.10.1 Classification of Budgets
Time Function Flexibility

 Long-term  Sales  Fixed
 Shrot-term  Production  Flexible
 Current  Cost of Production
 Purchase
 Personnel
 Research
 Capital Expenditure
 Cash
 Master
13.10.2 Classification According to Time

The Budget, on the basis of time, may be classified as:
1. Current Budget The budget prepared for a period of a week, a month, or a quarter is termed as
a current budget. They are essentially short-term budgets adjusted to current conditions or
prevailing circumstances.
2. Short Term Budget The budget prepared for a period of less then 5 year is short term budget.
Generally short term budgets are prepared for a period of one to two years. They are generally
prepared in terms of physical as well as in monetary units.
3. Long - Term Budget A budget designed for a long period is termed as long term budget. The
period generally is of 5 to 10 years. These budgets are concerned with planning of the operations of
a firm over a considerably long period of time. They are generally prepared in terms of physical
quantities.
13.10.3 Classification According to Function
Budgets can be classified on the basis of functions, they are meant to perform. Different types of
budgets under this head are as follows:
1. Sales Budget: - This is the most important budget on which all other budgets are based. The sales
manager is responsible for preparation and execution of the budget. The budget forecasts total
sales in terms of quantity, value, items, periods, areas etc. Normally it is called as Key Folder
Budget utmost cases sales is a governing factor for a manufacturing concern.
Activity
Normally which budget is treated as key factor budget?
Illustration :1
Shri Ram and Delhi Manufacturers make two types of toys, Bunty and Babli and sell them in Jaipur
and Delhi markets. The followings information is made available for the current year 2009-2010:
Places/Markets Type of Toys Budgeted Sales Actual Sales

2008-2009 2008-2009
Jaipur Bunty 400 at Rs. 9 each 500 at Rs. 9 each
Babli 300 at Rs. 21 each 200 at Rs. 21 each
Bunty 600 at Rs. 9 each 700 at Rs. 9 each
Delhi Bubli 500 at Rs. 21 each 400 at Rs. 21 each
Market studies reveal that toy Bunty is popular as it is under priced. It is observed that if its price is
increased by Rs. 1 it will find a ready market. On the other hand, Babli over-priced and the market could
absorb more sales if its selling price is reduced to Rs. 20. The management has agreed to give effect to the
above price changes.
On the above basis, the following estimates have been prepared by the sales manager:
Product % increase in Sales Over Current Budget
Jaipur Delhi
Bunty +10% +5%
Babli +20% +10%

With the help of an intensive advertisement campaign, the following additional sales above the
estimated sales are possible:
Product Jaipur Delhi
Bunty 60 Units 60 Units
Babli 40 Units 50 Units

You are required to prepare a budget for sales incorporating the above estimates.
Solution
Budgetd for the 2008-2009 Actual Sales 2008- Budget for the
year 2009 future
Place Product Units Price Value Units Price Value Units Price Value
Jaipur Bunty 400 9 3600 500 9 4500 500 10 5000
Babli 300 21 6300 200 21 4200 400 20 8000
Total 700 - 9900 700 - 8700 900 - 13000
Delhi Bunty 600 9 5400 700 9 6300 700 10 7000
Babli 500 21 10500 400 21 8400 600 20 12000
Total 1100 - 15900 1100 - 14700 1300 - 19000
Total Bunty 1000 9 9000 1200 9 10800 1200 10 12000
Babli 800 21 16800 600 21 12600 1000 20 20000
Total 1800 - 25800 1800 - 23400 2200 - 32000
Working Note:-
(i) Calculation of Budget Estimates
Jaipur Delhi
Bunty Budgeted 400 600
Increase 40(+10%) 30(+5%)
440 630
Advertisement effect 60 70
500 700
Babli Budgeted 300 500
Increase 60(+20%) 50(+10%)
360 550
Advertisement effect 40 50
400 600
2. Production Budget The budget is basically based on sales budget. It forecasts quantity of
production in terms of items, periods, areas, etc. The works manager is responsible for the
preparation of overall production budget and departmental works manager is responsible for
departmental production budgets.
Illustration :2
Suraj Manufacturing Company wishes to prepare a production budget in respect of three products
A,B, and C, the sales farecast for which is 80,000 units, 72,000 units and 85,000 units respectively. The
estimated requirement of inventory both at the beginning and at the end of the budget period are shown in
the following Schedule:
Inventory Schedule
A B C
Ist January (Units) 16,000 12,000 20,000
3Ist December (Units) 20,000 11,000 27,000
You are required to prepare the Production Budget:

Solution:
Suraj Manufacturing Company
Production Budget
for the year ending 31st December
Particular Products
A (Units) B (Units) C (Units)
Sales Budget 80,000 72,000 85,000
Add: Closing Inventory 20,000 11,000 27,000
Total Units required 1,00,000 83,000 1,12,000
Less: Opening Inventory 16,000 12,000 20,000
Planned Production 84,000 71,000 92,000
3. Purchase Budget: The budget forecasts the quantity and value of purchases required for
production. It gives quantity-wise and period-wise information about the materials to be purchased.
It correlates with sales forecast and production planning.
Budgeted purchase Quantity = Budgeted consumption Quantity + Required closing
Stock - Opening Stock
Illustration:3
The following information relates to a manufacturing company:
Targeted sales of product P 2,00,000 units. Each unit of product P requires 3 units of material X
and 4 units of material Y.
Estimated opening balance at the commencement of the next year.
Finished Product : 40,000 units
Material X : 48,000 units
Material Y : 60,000 units
The desirable closing balances at the end of the next year are:
Finished Product : 56,000 units
Material X : 52,000 units
Material Y : 64,000 units
From the above information prepare a Material Budget.
Solution:
The number of units to be produced.
Opening Stock + Production = Sales + Closing Stock
Units to be produced = Sales + Closing Stock - Opening Stock
2,00,000+56,000-40,000
= 2,16,000 units
Material required:
Material A = 2,16,000 x 3 = 6,48,000 units
Material B = 2,16,000 x 4 = 8,64,000 units
Material Purchase Budget (Units)
Particular Finished Product Material required
X Y
Budget Production 216000 648000 864000
Add: Opening Stock + 40000 (-) 48000 (-) 60000
Less: Closing Stock 256000 600000 804000
Estimated product for Sales (-) 56000 (+) 52000 (+) 64000
Estimated Material required: 200000 652000 868000
4. Personnel budget: The budget anticipates the quantity of personnel required during a period for
production activity. This may be further split up between direct and indirect personnel budgets.
5. Cost of Production Budget: It forecasts the cost of production. Separate budgets are prepared
for different elements of costs such as direct materials budgets, direct labour budget, factory overheads
budget, office overheads budget, selling and distribution overhead budget, etc.
Illustration: 4
The following information is abstracted form the books of Mahalaxmi Co. Ltd., for the six months
of 2010 in respect of products XX.
The following units are to be sold in different months of the year 2010.
January 2200
February 2200
March 3400
April 3800
May 5000
June 4600
July 4000
There will be work in progress at the end of the month. Finished units are equal to half the sales of
the next month's stock at the end of every month ( including December, 2009). Budgeted production and
production cost for the half-year ending 30th June, 2010 are as follows:
Production (Units) 40000
Direct material per unit Rs. 5
Direct Wages per unit Rs. 2
Factory Overheads apportioned to production Rs. 160000
You are required to prepare product Budget and production Cost Budget for the six months of the
year 2010.
Solution:
Production Budget (in Units)
January February March April May June Total
Estimated Sales 2200 2200 3400 3800 5000 4600
Add: Closing Stock 1100 1700 1900 2500 2300 2000
3300 3900 5300 6300 7300 6600
Less: Opening stock 1100 1100 1700 1900 2500 2300
Production 2200 2800 3600 4400 4800 4300 22100
Production Cost Budget
(Production : 22,100 units)
Rs.
Direct Material @ Rs. 5 for 22,100 units 1,10,500
Direct Wages @ Rs. 2 for 22,100 units 44,200
Factory Overheads @ Rs. 4 for 22,100 units 88,400
(Rs. 1,60,000/40,000 units)
Total Production Cost 2,43,100
6. Cash Budget:- The budget is a forecast of the cash position, for a specific duration of time of
different time periods. It states the estimated amount of cash receipts and cash payments and the
likely balance of cash in hand at the end of different periods,
Method of preparing cash Budgets
There are basically three methods for preparing cash budgets.
1. Receipts And Payments Method
2. Adjusted Profit And Loss Account Method
3. Balance Sheet Method
Activity
A company wants to know future liquidity position, so that liquidity can be arranged.
Which budget should be prepared by the company?
Illustration: 5
A company newly starting manufacturing operations on 1st January 2010 has made adequate
arrangement for funds required for fixed assets. It wants you to prepare an estimate of funds required as
working capital. It is to be remembered that:
(a) In the first month there will be no sale, in the subsequent month sale will be 25% cash and 75%
credit. Customer will be allowed one month credit.
(b) Payments for purchase of raw materials will be made on one month credit basic.
(c) Wages will be paid fortnightly on the 22nd and 7th of each month.
(d) Other expenses will be paid one month in arrear except that 5% of selling expenses are to be paid
immediately on sale being affected.
The estimated sales and expenses for the first six months, spread evenly over the period subject to
(a) above are us under:
Rs. Rs.
Sales 360000 Administrative Expenses 54000
Material Consumed 150000 Selling Expenses 42000
Wages 60000 Depreciation on fixed assets 50000
The article produced is subject to excise duty equal to 10% of the selling price. The duty is payable
on March 31, June 30, September 30, and December 31 for sales up to February 28, May 31, August 31
and November 30 respectively.
Prepare cash Budget for each of the six months indicating the requirement of the working capital.
Solution:
Cash Budget
For the six month ended on June 30, 2010
Particular January February March April May June
Rs Rs. Rs. Rs. Rs. Rs.
Receipts:
Opening Balance - (-)7500 (-) 45000 (-) 39200 (-) 26200 (-)13200
Cash Sales - 18000 18000 18000 18000 18000
Receipts from - - 54000 54000 54000 54000
customer
Cash Available (A) 10500 27000 32800 45800 58800
Payments:
Wages 7500 10000 10000 10000 10000 10000
Materials - 25000 25000 25000 25000 25000
Manufacturing Exp. - 8000 8000 8000 8000 8000
Administrative Exp. - 9000 9000 9000 9000 9000
Selling Exp. - 3500 7000 7000 7000 7000
Excise Duty - - 7200 - - 21600
Total Payments(B) 7500 55,500 66200 59000 59000 80600
Closing Balance (-) 7500 (-) 45000 (-) 39200 (-) 26200 (-) 13200 (-) 21800
(A-B)
Note:- The company needs overdraft facility to the extent indicated above for every month.
Illustration: 6
The following data are available to you. You are required to prepare a cash budget according to
Adjusted Profit and loss Method.
Balance Sheet As On 31st December, 2010
Liab ilities A mount A ssets A m ou nt
R s. R s.
Sh are C apital 10 0000 Pre mises 50 000
G en eral Re serve 20 000 M achinery 25 000
P rofit a nd L oss A /c 10 000 Debtors 40 000
Cred itor 50 000 C losing S tock 20 000
B ills P ayab le 10 000 Bills R ece iv able 5 000
O u tstand in g R en t 2 000 P repaid Com m ission 1 000
B an k 51 000
19 2000 19 2000
Projected Trading and Profit and Loss Account
for the year ending 31st December, 2010
Rs. Rs.
To Opening Stock 20000 By Sales 200000
To Purchases 150000 By Closing Stock 15000
To Ocori 2000
To Gross Profit C/d 43000
215000 215000
By Gross Profit b/d 43000
To Interest 3000 By Sundry Receipts 5000
To Salaries 6000
To Depreciation (10% on
premises and Machinery) 7500
To Rent 6000
Less: Outstanding
(Previous year) 2000
4000
Add: outstanding
(current year) 1000 5000
To Commission 3000
Add- Prepaid (Previous Year) 1000 4000
To Office expenses 2000
To Net profit c/d 1000
19500
48000
48000
To Dividends 8000 By Balance of Profit
(from last year) 10000
4000
To Addition to Reserves 19500
To Balance c/d 17500
29500
29500
Closing Balance of Certain Items:

Share Capital Rs. 120000, 10% Debentures Rs. 3000, Creditors Rs. 40000, Debtors Rs. 60000
Bills Payable Rs. 12000, Bill Receivable Rs. 4000, Furniture Rs.15000 and Plant Rs. 50000 (Both these
assets are purchased at the end of year).
Solution:
Cash Budget
For the period ending 31st December 2010
Rs. Rs.
Opening balance as on 1st January 2010 51000
Add: Net profit of the Year 19500
Depreciation 7500
Decrease in Bill Receivable 1000
Increase in Bill Payable 2000
Issue of share Capital 20000
Issue of Debentures 30000
Decrease in Prepaid commission 1000
Decrease of Stock 5000 86000
137000
Less: Purchase of Plant 50000
Purchase of Furniture 15000
Increase of debtors 20000
decrease of Creditors 10000
Decrease in outstanding Rent 1000
Dividend Paid 8000 104000
Closing Balance as on 31st December 2010 Rs. 33000
Illustration: 7
Prepare the cash Budget using Balance Sheet method on the basis of figures given in illustration 6.
Solution:
Budgeted Balance Sheet
as on 31st December, 2010
Rs. Rs.
Shares Capital 120000 Premises 50000
10% Debentures 30000 Less: Depreciation 5000 45000
General Reserve 24000 Machinery 25000
(Rs. 20000 +Rs. 40000)
Profit and Loss A/c 17500 Less: Depreciation 2500 22500
Creditors 40000 Furniture 15000
Bill Payble 12000 Debtors 60000
Outstanding Rent 1000 Bill Receivable 4000
Plant 50000
Closing Stock 15000
Bal. (Balancing Figures) 33000
244500 244500
7. Capital Expenditure Budget: The budget is the plan of the proposed outlay on fixed assets such
as land, buildings, plant and machinery. The budget is prepared after taking into account the
available productive capacities, probable reallocation of existing assets and possible improvement
in production technique. etc.
Capital expenditure budget serves the following purposes:
(a) It facilitates long term planning and policy-making.
(b) It facilitates replacing the old machinery by latest machinery or to change the methods of production
for reducing costs.
(c) It helps in the estimates of capital requirement after taking into account the disposable value of old
assets.
(d) It helps in preparation of cash budget and also assessing the capital cost of improving working
conditions or adopting safety measures, etc.
8. Master Budget: It is a summary budget incorporating all functional budgets in a capsule form. It
interprets different functional budgets and covers within its range the preparation of projected
income statement and projected balance sheet.
Illustration:8
A Glass Manufacturing Company requires you to calculate and present the budget for the next year
from the following information.
Sales:
Toughened glass Rs. 300000
Bent toughened glass Rs. 500000
Direct material Cost 60% of sales
Direct Wages 20 Workers @ Rs 150 per month
Store and spares 2.5% on Sales
Depreciation on Machinery Rs. 12600
Light and Power Rs. 5000
Factory Overhead:
Indirect Labour:
Works Manager Rs. 500 per month
Foreman Rs. 400 per month
Repairs and maintenance 10% on direct wages
Administration, selling and distribution expenses Rs. 14000 per year.
Solution
Master Budget
For the period ending on…………….
Sales (as per Sales Budget) Rs. Rs. Rs.
Toughened Glass……. Units @ Rs. 300000
Bent toughened glass …… Units@ Rs 500000 800000
Less: Cost of Production (as per Cost of Production Budget):
Direct Materials ( …… Units @ Rs. ….) 480000
Direct Wages 36000
Prime Cost 516000
Factory Overhead:
Variable: Stores and Spares (2.5% of Sales) 20000
Light and Power 5000
Repair and Maintenance 8000 33000
Fixed : Works Manager's Salary 6000
Forman's Salary 4800
Depreciation 12600
Sundries 3600 27000
Work Cost 576000
Gross Profit 224000
Less: Administration, Selling and Distribution Overhead 14000
210000
13.10.3 Classification According to Flexibility
Budget can also be classified in the following categories:
1. Fixed Budget: A budget prepared on the basis of a standard or a fixed level of activity is called a
fixed budget. It does not change with the change in the level of activity. If the output and sales do not
fluctuate from year to year or if an accurate prediction of the same can be made, a fixed budget can
be prepared.
2. Flexible Budget: A Budget designed in manner so as to give the budgeted cost of any level of
activity is termed as a flexible budget. Such a budget is prepared after considering the fixed and
variable elements of cost and the change that may be expected for each item at various levels of
operation.
llustration : 9
Prepare a flexible budget for production at 80% and 100% activity on the basis of the following
information:
Production of 50% capacity 5000 Units
Raw Material Rs. 80 Per Unit
Direct Labour Rs. 50 Per Unit
Expenses Rs. 15 Per Unit
Factory Expenses Rs. 50,000 (50% fixed)
Administration Expenses Rs. 60,000 (60% variable)
Solution
Flexible Budget
Particular Activity
80% 100%
(8000 Units) (10000 Units)
Rs. Rs.
A Fixed Expenses
Fixed factory expenses (50% of Rs. 50,000) 25,000 25,000
Fixed Administrative expenses (40% of Rs. 60,000) 24,000 24,000
Total 49,000 49,000
B Variable Expenses
Material @ 80 Per Unit 6,40,000 8,00,000
Labour @ 50 Per Unit 4,00,000 5,00,000
Expenses @ 15 Per Unit 1,20,000 1,50,000
Factory Expenses @ 5 Per Unit 40,000 50,000
Administrative Expenses @ 4.80 Per Unit 57,000 72,000
Total 13,06,600 15,72,000
Total ( A+ B ) 13,55,600 16,21,000
Calculation of Factory Expenses per unit
Total - Fixed
25,000
Rs. 50,000 - 25,000   @ 5 Per Unit
5,00
Calculation of Administrative Expenses per unit
36,000
Rs. 60,000  60%   @ 7.20 Per Unit
5,00
Activity
When production of a Factory has a variation, then which budget is suitable to know
cost of production?
13.11 Summary
A budget is in the nature of an estimate for future actions to coordinate and control the use of
resources for a specified period. It is used as a standard with which actual performance is measured.
Budgeting is a process which includes both budget and budgetary control. Budget is a planning function and
budgetary control is a system and technique which uses budgets as a means of controlling all aspects of the
business and is designed to assist management in the measurement of actual performance, in the analysis of
deviations from the budgeted targets and to evaluate performance and efficiency of the operations. Agood
budgeting system requires good organizational system with the lines of authority and responsibility clearly
mentioned. The important essentials required for the establishment of a sound system of budgeting includes
budget centers, budget committee, budget officer, budget manual, budget period, budget key factor,
forecasting, determining level of activity and preparation of budget. Budget may be classified on the basis of
time, function and flexibility.
Budgeting is the main instrument for projecting the future costs and revenues and for financial
control of the organization. Preparation of budgets involves a number of forecasts or projections, it starts
with sales forecasting and ends with the compilation of master budget.
13.12 Key Words

 Budget: A comprehensive and coordinated plan, expressed in financial terms, for the operations
and resources of an enterprise for some specific period in the future.
 Budgeting: The process of preparing plans for future activities of business enterprise for attaining
the objectives of an organization.
 Budgetary control: The establishment of budgets relating to the responsibilities of executives to
the requirement of a policy and the continuous comparison of the actual with budgeted results either
to secure by individual action the objectives of that policy or to provide a basis for its revision.
 Budget key factor: The factor which at a particular time or over a period will limit the activities of
an undertaking.
 Forecasting: A statement of events likely to occur.
 Master Budget: A summary budget incorporating all functional budgets which is finally
approved, adopted and employed.
 Cash Budget: A summary statement of future cash receipts and payments over a projected time
period.
1. "A budget is a means and budgetary control is the end result". Explain.
2. What is budgeting? What are the advantages and limitations of Budgeting?
3. What do you mean by Budgeting? Mention different types of budgets that a big industrial concern
would normally prepare.
4. Write short notes on the following:
(a) Sales Budget
(b) Material Budget
(c) Production Cost Budget
5. What is a Master Budget? What are its components?
6. From the following particulars, prepare a Production budget of a manufacturing company for year
ended 31st March 2010:-
Product Sales Budget Estimated Stock (units)
(Units) 01-04-2009 31-03-2010
A 7500 700 750
B 5000 250 725
C 3500 400 400
(Ans: A: 7550 Units, B: 5475 Units, C: 3500 Units)

7. Prepare a material procurement budget (in Units) from the following Information:
Estimated sales of product 40000 units. Each unit of the product requires 3 units of Mate-
rial P and 4 units of Material Q Estimated opening balance at the Beginning of the next year:
Units
Finished products 5000
Material P 19000
Material Q 31,000
The desired level of closing balances at the end of the next year:
Finished Product 7000
Material P 23,000
Material Q 35,000
(Ans. Production 42000 Units, Material required: Material P: 130000 Units, Material Q: 172000
Units)
8. A company produces and sells three products: Product X, Product Y and Product Z. The company
has divided its market into two areas as East zone and West zone. The actual sales for the year
2010 were as follows:
Products East Zone West Zone

Price per unit No. of units Price per unit No. of units
(Rs.) (Rs.)
X 12 800000 12 500000
Y 15 500000 15 700000
Z 16 600000 16 600000
For the current year i.e. 2009, it is estimated that the sales of product X will go up by 10% in West
zone and of product Z by 5000 Units in East zone. The company plans to launch an intensive advertisement
campaign through which budgeted figures for product Y are to be increased by 20% in both the Zones.
There will be no change in the pries of the Product X and Z but price of product Y will be reduced
by Rs. 1.
You are required to prepare a sales budget for the year 2010.
Ans:
East Zone West Zone Total Budget
(Units) (Units) (Rs.)
Product X 800000 550000 16200000
Product Y 600000 84000 20160000
Product Z 650000 600000 20000000
9. Jammu Co. Ltd. has three sales divisions at Jodhpur, Delhi, Patna. It sells two products-I and II.
The budgeted sales for the year ending 31st December, 2009 at each place are given below:
Jodhpur Product I 50000 units @ Rs. 16 each
Product II 35000 units @ Rs. 10 each
Delhi Product II 55000 Units @ Rs. 10 each
Patna Product I 75000 Units @ Rs. 16 each
The actual sales during the same period were:
Jodhpur Product I 62500 units @ Rs. 16 each
Product II 37500 units @ Rs. 10 each
Delhi Product II 62500 Units @ Rs. 10 each
Patna Product I 77500 Units @ Rs. 16 each
From the reports of the sales department it was estimated that the sales budget for the yea
ending 31st December 2010 would be higher than 2009 budget in the following.
Jodhpur Product I 4000 Units
Product II 2500 Units
Delhi Product II 6500 Units
Patna Product I 5000 Units
Intensive sales campaign in Delhi and Patna is likely to result in additional sales of 12500
units of product I in Delhi and 9000 Units of product II in Patna. Let us prepare a sales budget for
the period ending 31st December 2010.
(Ans:) Jodhpur Product I 54000 Units
Delhi Product I 12500 Units
Patna Product I 80000 Units
Product II 9000 Units)
10. Draw a Material Procurement Budget (Quantitative) from the following information:
Estimated sales of a product are 20000 units. Each units of the product requires 3 Units of material
X and 5 Units of Material Y.
Estimated opening balance at the commencement of next year:
Finished Product 2500 Kgs.
Material X 6000 Units
Material Y 10000 Units
Material on Order:
The desirable closing balance at the end of the next year:
Finished Product
3500 Units
Material on order:
11. A company is expecting to have Rs. 500000 cash in hand on 1st April, 2010 and it requires you to
prepare an estimate of cash position during the three months, April to June 2010. The following
information is supplied to you:
Sales Purchase Wages Expenses

February 1400000 800000 160000 120000
March 1600000 1000000 160000 140000
April 1840000 1040000 180000 140000
May 2000000 1200000 200000 160000
June 2400000 1100000 240000 180000
Additional Information:
(a) The credit period allowed by supplies is two months.
(b) 25% of sales is for cash and credit period allowed to customers is one month.
(c) Delay in payment of wages and expenses is one month.
(d) Income tax Rs. 500000 is to be paid in June 2010.
(Ans: April Rs. 1060000, May Rs. 1620000, June Rs. 1820000)
12. From the following information, you are required to prepare cash budget according to Adjusted
Profit and Loss method as well as Balance Sheet Method.
Balance Sheet as on 01-01-2010
Liabilities Rs. Assets Rs.
Share capital 50000 Debtors 500000
Reserves 1000000 Stock & Store 300000
Debentures 300000 Fixed assets 1300000
Public deposits 200000 Cash balance 100000
Current liability 200000
2200000 2200000
Projected Trading and Profit and Loss A/c for the year ending 31-12-2010
Particular Rs. Particular Rs.

To Opening Stock 300000 By Sales 1500000
To Direct Cost of production 1200000 By closing Stock 600000
To Depreciation
To variable selling and 100000
distribution costs 200000
To net profit c/d 300000
2100000 2100000
To Dividends 50000 By net profit b/d 300000
To Balance c/d 250000
300000 300000
Additional Information :
Collection of debtors and sales proceeds during the year Rs. 1700000, refund of public deposits Rs.
100000 increase in current liability Rs. 50000.
(Ans: Cash balance as on 31.12.2010: Rs. 300000, Debtors as on 31.12.2010: Rs. 300000 (opening
debtors Rs. 500000+sales Rs. 1500000- Collection form debtors Rs. 1700000)
Agrawal , Sharma, Agrawal, Shah & Agrawal, Financial Accounting and Decision Making.
Agrawal M.R., Management Accounting.
Jain, Khandelwal, Pareek & Dave, Financial Accounting and Decision Making.
Ravi, M. Kishore, Cost Accounting.
Unit-14 Tools of Financial Analysis - Ratio Analysis
Unit Structure
14.0 Objectives
14.1 Introduction
14.2 Meaning
14.3 Importance
14.4 Classification of Ratios
14.5 Limitations
14.6 Summary
14.7 Key Words
14.0 Objectives
After studying this unit, you should be able to understand:
 The concept of Ratio anaylsis.
 Importance of Ratio anaylsis.
 The various types of Ratio anaylsis and their calculations.
 The various limitations associated with Ratio anaylsis.
14.1 Introduction
To make rational decisions in keeping with the objectives of the firm, the financial manager must have
analytical tools. The firm itself and outside providers of capital-creditors and investors-all undertake financial
statement analysis. The type of analysis varies according to the specific interests of the party involved. Trade
creditors (suppliers owed money for goods and services) are primarily interested in the liquidity ofa firm. The
claims of bondholders, on the other hand, are long term. Accordingly, bondholders are more interested in the
cash-flow ability of the firm to service debt over a long period of time. They may evaluate this ability by
analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s profitability over time,
and projections of future profitability.
Investors in a company’s common stock are principally concerned with present and expected
future earnings as well as with the stability of these earnings about a trend line. As a result, investors usually
focus on analyzing profitability. They would also be concerned with the firm’s financial condition in so far as
it affects the ability of the firm to pay dividends and avoid bankruptcy.
Internally, management also employs financial analysis for the purpose of internal contol and to
better provide what capital suppliers seek in financial condition and performance from the firm. From an
internal control standpoint, the management needs to undertake financial analysis in order to plan and
control effectively. To plan for the future, the financial manager must assess the firm’s present financial
position and evaluate opportunities in relation to this current position. With respect to internal control, the
financial manager is particularly concerned with the return on investments provided by the various assets of
the company and in the efficiency of asset management. Finally, to bargain effectively for outside funds, the
financial manager needs to discuss all aspects of financial analysis that outside suppliers of capital use in
evaluating the firm. We see, then, that the type of financial analysis undertaken varies according to the
particular interests of the analyst.
14.2 Meaning
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to
interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical
performance and current financial condition can be determined. The term ratio refers to the numerical or
quantitative relationship between two variables.
14.3 Importance
1. Helps in evaluating the firm’s performance: With the help of ratio analysis conclusion can be
drawn regarding several aspects such as financial health, profitability and operational efficiency of
the undertaking. Ratio points out the operating efficiency of the firm i.e. whether the management
has utilized the firm’s assets correctly to increase the investor’s wealth. It ensures a fair return to its
owners and secures optimum utilization of firm’s assets.
2. Helps in inter-firm comparison: Ratio analysis helps in inter-firm comparison by providing necessary
data. An inter-firm comparison indicates relative position. It provides the relevant data for the
comparison of the performance of different departments. If comparison shows a variance, the
possible reasons of variations may be identified and if results are negative, the action may be initiated
immediately to bring them in line.
3. Simplifies financial statement: The information given in the basic financial statements serves no
useful purpose unless it is interrupted and analyzed in some comparable terms. The ratio analysis is
one of the tools in the hands of those who want to know something more from the financial statements
in the simplified manner.
4. Helps in determining the financial position of the concern: Ratio analysis facilitates the
management to know whether the firm’s financial position is improving or deteriorating or is constant
over the years by setting a trend with the help of ratios. The analysis with the help of ratio analysis
can know the direction of the trend of strategic ratio may help the management in the task of
planning, forecasting and controlling.
5. Helpful in budgeting and forecasting: Accounting ratios provide a reliable data, which can be
compared, studied and analyzed. These ratios provide sound footing for the future. The ratios can
also serve as a basis for preparing budgeting future line of action.
6. Helps in analyzing liquidity position: With the help of ratio analysis conclusions can be drawn
regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is
able to meet its current obligation when they become due. The ability to meet short term liabilities is
reflected in the liquidity ratio of a firm.
7. Helps in assessing long term solvency position: Ratio analysis is equally useful for assessing
the long term financial ability of the firm. The long term solvency is measured by the leverage or
capital structure and profitability ratio which shows the earning power and operating efficiency.
Solvency ratio shows relationship between total liability and total assets.
8. Helps in measuring operational efficiency: Yet another dimension of usefulness of ratio analysis,
relevant from the view point of management is that it throws light on the degree of efficiency in the
various activity. Ratios measures this kind of operational efficiency.
17.4 Classification of Ratios
Different ratios are used for different purposes. These ratios can be grouped into various classes
according to the financial activity. Ratios are classified into four broad categories.
14.4.1 Liquidity Ratio
Liquidity ratio measures the firm’s ability to meet its current obligations i.e. ability to pay itsobligations
when they become due. They compare short-term obligations to short-term (or current) resources available
to meet these obligations. From these ratios, much insight can be obtained into the present cash solvency
of the firm and the firm’s ability to remain solvent in the event of adversity. Commonly used liquidity ratios
are:
(A) Current ratio: Current ratio is the ratio, which expresses relationship between current asset and
current liabilities. It shows a firm’s ability to cover its current liabilities with its current assets. Current
assets are those which can be converted into cash within a short period of time, normally not
exceeding one year. The current liabilities are of short- term maturity.
Current Assets
Current ratio 
Current liabilitie s
Ideal Ratio is 2:1
(B) Quick/ Liquid Ratio: Quick Ratio is the measure of the instant debt paying ability of the business
enterprise, hence it is also called ‘quick ratio’ or ‘acid test ratio’. It measures the ability of the firm
to meet its short term obligations as and when due without relying upon the realization of stock.
Quick ratio is considered to be superior to current ratio in evaluating the liquidity position of
the firm. Sometimes, a situation arises when the firm has to meet its current liabilities immediately. In
such cases, it can pay off these liabilities out of its quick assets of equal value without any difficulty.
Thus, quick ratio is an indication of a firm’s ability to meet unexpected demand for working capital.
Quick Assets Current Assets – (Stock  prepaid expenses)

Quick Ratio  
Quick Liabilitie s Current Liabilitie s – Bank overdraft
Ideal Ratio is 1:1
(C) Absolute Liquidity Ratio: The absolute liquidity ratio is the relationship between the absolute
liquid or super quick assets to liquid or quick liabilities. This is variation of quick ratio and is even
called, ‘super quick ratio’.
Cash  Bank  Marketable Securities

Absolute liquidity Ratio 
Quick Liabilitie s
A standard of 0.5:1 in absolute liquidity ratio is an acceptable norm, because fifty paisa worth of
absolute liquid assets are considered sufficient for one rupee worth of current liabilities.
Activity
Which ratio indicates the ability to meet unexpected demand of working capital?
Illustration 1:
Following is the Balance Sheet of SUN Ltd. as on 31st March 2010:
Share Capital: Fixed Assets:
4,000 Equity Shares of Rs. 4,00,000 Buildings 1,70,000
100/-each.
Reserve & Surplus: Furniture 1,14,000
General Reserve 20,000 Machinery 1,10,000
Capital Reserve 8,000 Investments 20,000
Current Liabilities: Current Assets:
Creditors 6,000 Stock 10,000
Bills Payables 4,000 Debtors 7,000
Outstanding Expenses 2,000 Bills Receivable 5,000
Cash & Bank Balance 2,000
Marketable Securities 2,000
4,40,000 4,40,000
Calculate the following ratios:

(a) Current Ratio,
(b) Quick Ratio,
(c) Absolute Liquidity Ratio
Solution:
Current Assets 26,000

(a) Current Ratio    2.17 : 1
Current Liabilitie s 12,000
Current Assets = 10,000+7,000+5,000+2,000+2,000 = Rs. 26,000
Current Liabilities = 6,000+4,000+2,000 = Rs. 12,000
Quick Assets 16,000

(b) Quick Ratio    1.33 : 1
Quick Liabilitie s 12,000
Quick Assets = Current Assets – Stock = 26,000 – 10,000 = Rs. 16,000
Quick Liabilities = Current Liabilities – Bank overdraft = Rs. 12,000
Absolute Liquid Assets 4,000

(c) Absolute Liquid Ratio    0.33 : 1
Quick Liabilitie s 12,000
Absolute Liquid Assets =Cash & Bank Balance + Marketable Securities
= 2,000 + 2,000
= Rs. 4,000
14.4.2 Leverage or Capital Structure Ratio
Leverage or capital structure ratios are the ratios, which indicate the relative interest of the owners
and the creditors in an enterprise. These ratios indicate efficiency of the funds provided by the long-term
creditors and owners. To judge the long term financial position of the firm, following ratios are applied.
(A) Debt–Equity Ratio: Debt-Equity ratio expresses the relationship between debt and equity. This
ratio explains how far owned funds are sufficient to pay outside liabilities. It is calculated by the
following formula:
Debt or External liabilitie s
Debt - Equity Ratio 
Equity or Net worth
Debt = Long-term and Short-term loans + Current Liabilities
Net worth = Share Capital + Reserves & Surpluses
A high Debt-Equity ratio shows that the claims of creditors are greater than those of the
owners. A very high ratio is unfavorable from the owner’s point of view. This causes hindrance in
the firm’s operations due to the increasing pressure and interference of creditors in the management.
A high debt company finds difficulty in raising additional debt.
A low Debt-Equity ratio shows a greater claim of owners than creditors. From the creditor’s
point of view, it represents a larger margin of safety since owners equity is treated as margin of
safety by creditors.
(B) Proprietary Ratio: This ratio is also known as ‘Net Worth to Total Assets Ratio’ or ‘Shareholders
Equities to Total Equities Ratio’ or ‘Equity Ratio’.
This ratio establishes relationship between Net Worth and Total Tangible Assets.
Proprietor’ s Fund
Proprietary Ratio 
Total tangible Assets
This ratio shows how much capital is introduced by the owner in business. Higher ratio
means a sound position of business, because it shows that the organization is not running through
outside funds which mean less interference and pressure of outsiders.
(C) Interest Coverage Ratio: This ratio indicates the relationship between net profits before interests
and taxes on long term debt. The objective of calculating this ratio is to measure the debt servicing
capacity of a firm so far as fixed interest on long term debt is concerned.
Net Profit before Interest and Tax

Interest Coverage Ratio 
Interest payable on Long - term debt
Interest Coverage ratio shows the number of times the interest charges are covered by the
income out of which they will be paid. Higher the ratio the more beneficial for the lenders, because
this ratio measures the margin of safety for the lenders.
Illustration 2:
From the following statement, calculate:
(a) Debt-Equity Ratio, (b) Proprietary Ratio.
Balance Sheet
As on 31st March, 2010

Share Capital 1,00,000 Fixed Assets 2,70,000
Reserves & Surplus 50,000 Stock 80,000
Debentures 2,00,000 Debtors 30,000
Creditors 30,000 Cash at Bank 20,000
Bills Payable 20,000
4,00,000 4,00,000
Solution:
Debt or External Liabilitie s

(a) Debt - Equity Ratio 
Equity or Net Worth
Rs. 2,50,000
  1.67 : 1
Rs. 1,50,000
Proprietary Funds or Net Worth

(b) Proprietary Ratio 
Total Tangible Assets
Rs. 1,50,000
  0.38 : 1
Rs. 4,00,000
Working notes:
1. External Liabilities = Debentures + Creditors + Bills Payable
= Rs. (2,00,000+30,000+20,000)
= Rs. 2,50,000
2. Net Worth = Share Capital + Reserve & Surplus
= Rs. (1,00,000+50,000)
= Rs. 1,50,000
3. Tangible Assets = Fixed Assets + Stock + Debtors + Cash at Bank
= Rs. (2,70,000+80,000+30,000+20,000)
= Rs. 4,00,000
Illustration 3:
From the following information, calculate interest coverage ratio:
Rs.
Net Profit after Tax 4,00,000
Rate of Income tax 50%
Fixed Interest Charges 60,000
Solution:
Net Profit before interest and tax

Interest Coverage Ratio 
Fixed interest charges
Net profit after tax  Tax  Interest


Fixed interest charges
Rs. 4,00,000  Rs. 4,00,000  Rs. 60,000


Rs. 60,000
Rs. 8,60,000
  14.33 Times
Rs. 60,000
Working Notes: Rs.
Net profit before tax 8,00,000
(4,00,000  100 )
50
Less: Tax @ 50% 4,00,000
Net profit after tax 4,00,000
14.4.3 Profitability ratio
Profitability ratios are the best indicators of overall efficiency of the business concern, because they
compare return of value over and above the value put into business with sales or service carried on by the
firm with the help of assets employed. Profitability ratio can be determined on the basis of:
 Sales  Investment
I. Profitability Ratios related to Sales:
(A) Gross Profit Ratio: The gross profit to sales ratio establishes relationship between gross profit
and sales to measure the relative operating efficiency of the firm to reflect pricing policy. Gross
profit ratio indicates the average margin on the goods sold. It shows whether the selling prices are
adequate or not. It also indicates the extent to which selling prices may be reduced without resulting
in losses.
A low gross profit ratio may indicate a higher cost of goods sold due to higher cost of
production. It may also be due to low selling prices. A high gross profit ratio, on the other hand,
indicates relatively low cost and is a sign of good management.
Sales - cost of goods sold
Gross profit to sales ratio   100
Sales
(B) Net Profit Ratio: The net margin indicates the management’s ability to earn sufficient profit on sales
not only to cover all revenue operating expenses of the business, the cost of borrowed funds and
the cost of goods or servicing, but also to have sufficient margin to pay reasonable compensation to
shareholders on their contributions to the firm.
Net profit after interest and taxes

Net profit Ratio   100
Sales
Illustration 4:
Following is the Trading and Profit & Loss A/c of A Ltd. for the year ending 31st March 2010:
Trading and Profit & Loss A/c For the year ended 31st March, 2010
Items Rs. Items Rs.
To Opening Stock 1,10,000 By Sales 6,50,000
To Purchases 4,00,000 By Closing Stock 1,60,000
To Wages 1,00,000
To Gross Profit c/f 2,00,000
8,10,000 8,10,000
To Interest 3,000 By Gross Profit b/f 2,00,000
To Administrative Expenses 60,000
To Net Profit 1,37,000
2,00,000 2,00,000
From the above information, calculate the following ratios:
1. Gross Profit Ratio 2. Net Profit Ratio
Solution:
Gross Profit
1. Gross Profit Ratio   100
Sales
2,00,000
  100  30.77%
6,50,000
Net Profit
2. Net Profit Ratio   100
Sales
1,37,000
  100  21.07%
6,50,000
II. Profitability Ratios related to Investments:
(A) Return on Equity or Return on Shareholder’s Fund: This ratio measures the return on the total
equity of the shareholders. This ratio is also known as ‘Return on Shareholder’s Fund’.

Return on assets   100
Shareholde r’ s Fund
Net profit for the purpose of this ratio is calculated after charging interest on long term
liabilities and payment of taxes. Shareholder’s funds include equity capital, preference capital, capital
reserve, general reserve and other undistributed profits.
(B) Return on Capital Employed (ROCE) or Return on Investment (ROI):
This is most important test to measure overall profitability of a business. It is ascertained by comparing
profit earned and capital (or funds) employed to earn it.

Return on capital employed   100
Total capital employed
Capital Employed = (Share capital + Reserves & Surpluses + Long term loans) - Fictitious assets
ROI is the only ratio which measures the overall performance of the business from the view point ofprofitability.
This ratio indicates how well the management has utilized the funds supplied by the owners and creditors. In
other words, this ratio is intended to measure the earning power of the net assets of the business. The higher
the ROI, the more efficient the management is considered to be in using the funds available.
Illustration 5:
Rs.
Net Worth or Shareholders fund 8,25,000
Capital Employed 13,10,000
From the above information, calculate the following ratios
1. Return on Capital Employed
2. Return on Shareholders Fund
Solution:
Net Profit after Interest & Taxes

1. Return on Capital Employed   100
Capital Employed
2,25,000
  100  17.18%
13,10,000
Net Profit after Interest & Taxes

2. Return on Shareholders Fund   100
Shareholde rs Fund
2,25,000
  100  24.85%
8,25,000
Activity
By which ratio can overall profitability be determined?
14.4.4 Activity Ratio or Efficiency Ratio

Activity ratios are sometimes called efficiency ratios. Activity ratios are concerned with how efficiency
of the assets of the firm are managed. These ratios are also known as turnover ratios because they indicate
the speed with which assets are being converted or turned into sales. These ratios express relationship
between level of sales and the investment in various assets investors, receivables, fixed assets etc.
The important activity ratios are as follows:
(A) Inventory Turnover Ratio: This ratio establishes a relationship between cost of goods sold and
average stock. This ratio tells the rate at which stock is converted into sales.
Cost of goods sold

Inventory turnover ratio 
Average Stock
Cost of goods sold = Opening Stock + Purchase + Direct expenses – Closing Stock
Or
Net Sales – Gross profit
* If cost of goods sold and average stock can not be calculated, then sales and closing stock can be
used, and in that condition:-
Net Sales
Inventory Turnover Ratio 
Closing Stock
This ratio provides how many times purchases are made during the year. Higher ratio shows
that more sales are being produced by a unit of investment in stocks. Companies in which stock
turnover ratio is high generally work on comparatively low margin of profit.
(B) Debtors Turnover Ratio: This ratio shows how quickly debtors are converted into cash. The
objective of calculating this ratio is to determine the efficiency with which the trade debtors are
managed.
Net credit Sales

Debtors turnover ratio 
Average Receivable s
(Opening debtors & B/R)  (Closing Debtors & B/R)
Average Receivable s 
2
(C) Average Collection Period Ratio or Debtor’s Velocity: This period indicates an average period
for which the credit sales remain outstanding and measures the quality of debtors. It indicates the
speed with which the money is collected from debtors.
Average receivable s
Average Collection Period   365/52/12
Average Credit Sales
Activity
By which ratio can we judge the period for which the credit sales remain outstanding?
(D) Working Capital Turnover Ratio: This ratio shows the number of times the working capital turns
in trading transaction. If it has an increasing trend over the previous year it shows that the working
capital is being used efficiently.
The higher the ratio the less is the investment in working capital and the greater are the
profits. A very high ratio is a sign of over trading and a low ratio indicates under trading, i.e.,
working capital is not effectively used.
Cost of Good Sold or Sales

Working Capital Turnover Ratio 
Net Working Capital
Illustration 6:
Rs.
Opening Stock 40,000
Closing Stock 30,000
Purchases 80,000
Carriage Inwards 10,000
Sales 1,50,000
Opening Debtors 36,000
Closing Debtors 24,000
Calculate the following ratios from the above information:
1. Stock Turnover Ratio
2. Debtor’s Turnover Ratio
3. Average Collection Period
Solution:
Cost of Good Sold

1. Stock Turnover Ratio 
Average Stock
Rs. 1,00,000
  2.86 Times
Rs. 35,000
Working notes:
Cost of Good Sold = Opening Stock + Purchases + Carriage Inwards - Closing Stock
= Rs. (40,000+80,000+10,000-30,000)
= Rs. 1, 00,000
Opening Stock  Closing Stock

Average Stock 
2
Rs. (40,000  30,000)

  Rs. 35,000
2
Net Credit Sales

2. Debtor’s Turnover Ratio 
Rs. 1, 50,000
  Rs. 5 Times
Rs.30,000
Working notes:
Rs. (36,000  24,000)

Average Receivable s   Rs. 30,000
2
3. Average Collection Period   365
Net Credit Sales
Rs. 30,000
  365  73 days
Rs. 1, 50,000
Illustration 7:
From the following information given below, calculate Working Capital Turnover Ratio:
Particulars Rs.
(A) Current Assets
Stock 15,000
Debtors 10,000
Bills Receivables 4,000
Cash at Bank 12,000
Cash in hand 4,000
45,000
(B) Current Liabilities
Sundry Creditors 10,000
Bills Payable 5,000
Tax Payable 4,000
Proposed Dividend 4,000
Interest Payable 2,000
25,000
Net Sales during the year was Rs. 6, 00,000

Solution:
Sales
1. Working Capital Turnover Ratio
Working Capital
Rs.6,00,000

Rs.20,000
Working notes:
1. Working Capital = Current Assets - Current Liabilities
= Rs. (45,000-25,000)
= Rs. 20,000
14.5 Limitations
Inspite of many advantages, there are certain limitations of the ratio analysis techniques and they
should be kept in mind while using them in interpreting financial statements. The following are the main
limitations of accounting ratios:
1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of
one firm can not always be compared with the ratio of the other firm. Some firms may value the
closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may
be difference in providing depreciation of fixed assets or certain provisions for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from accounting records. In case that
data is correct, then only the ratios will be correct. For example, valuation of stock is based on very
high price, the profits of the concern will be inflated and it will indicate a wrong financial position.
The data therefore must be absolutely correct.
3. Effect of Price Level Changes: Price level changes often make the comparison of figures
difficult over a period of time. Changes in price affects the cost of production, sales and also the
value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before
any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus,
ignores qualitative factors, which may be important in decision making. For example, average
collection period may be equal to standard credit period, but some debtors may be in the list of
doubtful debts, which is not disclosed by ratio analysis.
5. Effect of window-dressing: In order to cover up their bad financial position some companies
resort to window dressing. They may record the accounting data according to the convenience to
show the financial position of the company in a better way.
6. Costly Technique: Ratio analysis is a costly technique and can be used only by big business
houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be misleading. For example,
the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales
are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000.
Although the profitability of the two firms is same yet the magnitude of their business is quite different.
8. Absence of standard universally accepted terminology: There are no standard ratios, which
are universally accepted for comparison purposes. As such, the significance of ratio analysis
technique is reduced.
14.6 Summary
Financial analysis, though varying according to the particular interests of the analyst, always involves
the use of various financial statements – primarily the balance sheet and income statement. The Balance
sheet summarizes the assets, liabilities and owner’s equity of a business at a point in time, and the income
statement summarizes revenues and expenses of a firm over a particular period of time.
A conceptual framework of Ratio analysis provides the analyst with an interlocking means for
structuring the analysis. For example, in the analysis of external financing, one is concerned with the firm’s
funds needs, its financial condition and performance, and its business risk. Upon analysis of these factors,
one is able to determine the firm’s financing needs and to negotiate with outside suppliers of capital.
Financial Ratios are the tools used to analyze financial condition and performance. We calculate
ratios because in this way we get a comparison that may prove more useful than the raw numbers by
themselves.
Financial ratios can be divided into five basic types: liquidity, leverage(debt), coverage, activity and
profitability. No one ratio is itself sufficient for realistic assessment of the financial condition and assessment
of the financial condition and performance of the firm. With a group of ratios, however, reasonable judgments
can be made. The number of key ratios needed for this purpose is not particularly large – about a dozen or
so.
The usefulness of ratios depends on the ingenuity and experience of the financial analyst who employs
them. By themselves, financial ratios are fairly meaningless; they must be analyzed on a comparative basis.
Comparing one company to similar companies and industry standards over time is crucial. Such a comparison
uncovers leading clues in evaluating changes and trends in the firm’s financial condition and profitability. This
comparison may be historical, but it may also include an analysis of the future based on projected financial
statements.
14.7 Key Words
 Liquidity Ratios : Liquidity ratios are used to measure the ability of the firm to meet its short-term
obligations out of its short-term resources.
 Leverage Ratios : Leverage ratios help in measuring the long-term solvency of the business.
 Efficiency Ratios : Efficiency ratios helps the management to measure the effectiveness of the
resources for the command of the firm.
 Profitability Ratios: Profitability ratios are used to measure the end result of business operations.
 Return on Capital Employed: This ratio expresses the relationship between profit and capital
employed.
 Gross Capital Employed : Total assets used in business.
 Net Capital Employed: Total assets minus current liabilities.
14.8 Self-Assessment Test
1. What do you understand by ‘RATIO ANALYSIS’? What are its limitations?
2. What is the importance of ratio analysis? Explain any two ratios each for measuring Liquidity and
Profitability?
3. What are Capital Structure Ratios and Activity Ratios? Explain with illustration.
4. Following is the Balance Sheet of B Ltd. as on 31st March, 2010:
Equity Share Capital 2,00,000 Plant & Machinery 2,50,000
Profit & Loss A/c 20,000 Stock 40,000
Debentures 80,000 Sundry Debtors 30,000
Sundry Creditors 50,000 Cash in hand 25,000
Provision for Taxation 10,000 Cash at Bank 10,000
Prepaid Expenses 5,000
3,60,000 3,60,000
Calculate the following ratios:
(a) Current Ratio
(b) Quick Ratio
(c) Absolute Liquidity Ratio
5. From the following Balance Sheet, calculate:
(a) Debt-Equity Ratio (b) Proprietary Ratio
Balance Sheet
As on 31st March, 2010

Equity Share Capital 4,00,000 Fixed Assets 5,00,000
Preference Share Capital 2,00,000 Investments 1,00,000
General Reserve 1,00,000 Stock 2,00,000
Profit & Loss A/c 50,000 Debtors 1,00,000
10% Debentures 1,00,000 Cash in Bank 50,000
Creditors 80,000
Proposed Dividend 20,000
9,50,000 9,50,000
6. From the following information, calculate Interest Coverage Ratio:
Particulars Rs.
Income Tax 3,00,000
Interest Charges 2,00,000
7. Trading and Profit & Loss A/c

For the year ended 31st March, 2010
Particulars Rs. Particulars Rs.

To Opening Stock 1,00,000 By Sales 9,00,000
To Purchases 4,00,000 By Closing Stock 1,20,000
To Carriage 50,000
To Wages 2,50,000
To Gross Profit c/d 2,20,000
10,20,000 10,20,000
To Adm. Expenses 1,00,000 By Gross Profit b/d 2,20,000
To Selling Expenses 20,000
To Net Profit 1,00,000
2,20,000 2,20,000
You are required to calculate:
(a) Gross Profit Ratio (b) Net Profit Ratio.
8. From the following information, calculate:
(a) Return on Capital Employed (b) Return on Shareholder’s Fund.
Equity Share Capital 2,00,000
8% Preference Share Capital 1,00,000
General Reserve 1,00,000
10% Debentures 1,25,000
Current Liabilities 1,75,000
Fixed Assets 4,00,000
Current Assets 3,00,000
Net Profit after Tax 78,000
9. From the following information, calculate:
(a) Stock Turnover Ratio
(b) Debtors Turnover Ratio
(c) Average Collection Period.
Particulars Rs.
Opening Stock 1,45,000
Closing Stock 1,55,000
Opening Debtors 1,00,000
Closing Debtors 80,000
Purchases 6,10,000
Sales 7,50,000
10. From the following information, calculate Working Capital Turnover Ratio:
Particulars Rs.
(A) Current Assets
Inventories 40,000
Debtors 27,000
Bills Receivables 15,000
Cash in hand 20,000
1,02,000
(B) Current Liabilities

Creditors 26,000
Bills Payables 14,000
Outstanding Expenses 10,000
50,000
Agarwal M. R., Financial Management

Agarwal & Agarwal, Management Accounting
Maheshwari S.N., Management Accounting
Unit -15 Funds Flow and Cash Flow Statements
Unit Structure
15.0 Objectives
15.1 Introduction
15.2 Meaning of Fund
15.3 Funds Flow Statement
15.4 Importance of Funds Flow Statement
15.5 Limitations of Funds Flow Statement
15.6 Steps for Funds Flow Statement
15.7 Sources of Funds
15.8 Application of Funds
15.9 Cash Flow Statement
15.10 Uses of Cash Flow Statement
15.11 Limitations of Cash Flow Statement
15.12 Distinction between Funds Flow and Cash Flow Statement
15.13 Distinction between Funds Flow Statement and Balance Sheet
15.14 Format of Cash Flow Statement
15.15 Method of Cash Flow Statement
15.16 Preparation of Cash Flow Statement
15.17 Summary
15.18 Key Words
15.0 Objectives
 The concept of funds flow and cash flow statements.
 Objectives behind preparing funds flow and cash flow statements.
 The various limitations associated with funds flow and cash flow statements.
 The various sources and uses of funds.
 Difference between fund flow, cash flow statements and balance sheet.
 Preparing funds flow and cash flow statements.
15.1 Introduction
The second portion of the tools of financial analysis and planning deals with the analysis of funds
flows and cash flows. A flow of funds statement (also known as a sources and used of funds statement or
a statement of changes in financial position) is a valuable aid to a financial manager or a creditor in evaluating
the uses of funds by a firm and in determining how the firm finances those uses. The purpose of the cash flow
statement is to report a firm’s cash inflows and outflows. Flow of funds is segregated into three categories:
operating, investing and financing activities. Although this statement certainly serves as an aid for analyzing
cash receipts and disbursements, important current period investing and financing noncash transactions are
omitted. Therefore, the analyst will still want to prepare a flow of funds statement in order to fully under-
stand the firm’s funds flows.
Every business concern prepares two basic financial statements at the end of accounting period,
namely, Balance Sheet or Position Statement and Profit and Loss Account or Income Statement. Balance
Sheet reveals the financial position of the business concern at a certain point of time. It reveals the financial
status of the business concern. The Profit and Loss Account reveals the net results of operations over a
period of time i.e., how much profit was earned (or loss sustained) by the business enterprise during the
accounting period.
The Balance Sheet provides only a static view of the business. It does not show the movement of
funds. In business concerns, funds flow from different sources and similarly funds are invested in various
sources of investment. The study and control of this fund flow process is the main objective of financial
management to assess the soundness and solvency of a business and little about its flow of funds, i.e.,
financing and investing activities over a related period. Like Balance Sheet, even Profit and Loss Account
does not depict the changes that have taken place in financial condition of a business concern between two
dates. Hence, there is a need to prepare additional statement to know the changes in assets, liabilities and
owner's equity between dates of two Balance Sheets. Such a statement is called Funds Flow Statement or
Statement of Sources and Uses of funds.
15.2 Meaning of Funds
Funds Flow Statement is widely used tool in the hands of financial executives for analyzing the
financial performance of a business concern. The term Funds has a variety of meanings:
(a) In a narrow sense- In a narrow sense funds means only cash. Funds Flow Statement prepared on
this basis is called Cash Flow Statement. In this type of Statement, only inflow and outflow of cash
is taken into account.
(b) In a broader sense - In a broader sense, the term fund refers to money value in whatever form it
may exist. Here fund means all financial resources in the form of men, money, materials, and
machines, etc.
(c) Popular Sense - In a Popular Sense, the term fund means Working Capital i.e., the excess of
current assets over current liabilities.
15.3 Meaning and Definition of Funds Flow Statement

Funds Flow Statement is prepared to study the changes in the financial position of a business over
a period of time, generally one year. Funds Flow Statement reveals both inflow and outflow of funds. The
inflow of funds is known as sources of funds and the outflow of funds means uses or application of funds.
Funds Flow Statement highlights changes in the financial structure of an undertaking. It determines the
financial consequences of business operations.Funds Flow Statement gives detailed analysis of changes in
distribution of resources between two Balance Sheet dates.
Definitions:-
According to Foulke a statement of sources and application of funds is a technical device designed
to analyze the changes in the financial condition of a business enterprise between two dates.
According to Anthony Funds Flow Statement describes the sources from which additional funds
were derived and the use to which these sources were put.
A Statement is either prospective or retrospective, setting out the sources and applications of the
funds of an enterprise. The purpose of the statement is to indicate clearly the requirements of funds and how
they are proposed to be raised and the efficient utilization and application of the same.
15.4 Importance of Funds Flow Statement

Funds Flow Statement is an analytical tool in the hands of financial manager. The basic purpose of
this statement is to indicate on historical basis the changes in the working capital i.e., where funds came from
and if they are used during a given period.
The utility of this statement can be measured on the basis of its contributions to the financial
management. It generally serves the following purposes:-
(1) Analysis of Financial Position The basic purpose of preparing the statement is to have a rich into
the financial operations of the concern. It analyses how the funds were obtained and used in the
past. In this sense, it is a valuable tool for the finance manager for analyzing the past and future plans
of the firm and their impact on the liquidity. He can identify the reasons for the imbalances in uses of
funds in the past and take necessary corrective actions. In analyzing the financial position of the firm,
the Funds Flow Statement answers such questions as-
1. Why were the net current assets of the firm down, though the net income was up or vice versa?
2. How was it possible to distribute dividends in absence of or in excess of current income for the
period?
3. How was the sale proceeds of plant and machinery used?
4. How was the sale proceeds of plant and machinery used?
5. How were the debts retired?
6. What became to the proceeds of share issue or debenture issue?
7. How was the increase in working capital financed?
8. Where did the profits go?
Though it is not an easy job to find the definite answers to such questions because funds derived
from a particular source are rarely used for a particular purpose. However, certain useful assumptions can
often be made and reasonable conclusions are usually not difficult to arrive at.
(2) Evaluation of the Firm's Financing One important use of the statement is that it evaluates the
firm' financing capacity. The analysis of sources of funds reveals how the firm financed its
development projects in the past i.e., from internal sources or from external sources. It also reveals
the rate of growth of the firm.
(3) An Instrument for Allocation of Resources In modern large scale business, available funds
are always short for expansion programmes and there is always a problem of allocation of
resources. It is, therefore, a need of evolving an order of priorities for putting through their
expansion programmes which are phased accordingly, and funds have to be arranged as different
phases of programmes get into their stride. The amount of funds to be available for these projects
shall be estimated by the finance with the help of Funds Flow Statement. This prevents the business
from becoming a helpless victim of unplanned action.
(4) A Tool of Communication to Outside World Funds Flow Statement helps in gathering the
financial status of the Business. It gives an insight into the evolution of the present financial
position and gives answer to the problem 'where have our resources been moving'? In the present
world of credit financing, it provides a useful information to bankers, creditors, finance, and
government etc. regarding amount of loan required, its proposes, the terms of repayment an sources
for repayment of loan etc. the financial manager gains a confidence born out of a study of Funds Flow
Statement. In fact, it carries information regarding firm's financial policies to the outside world.
(5) Future Guide An analysis of Funds Flow Statements of several years reveals certain valuable
information for the financial manager for planning the future financial requirements of the firm and
their nature too i.e. Short term, long-term or mid term. The management can formulate its financial
policies based on information gathered from the analysis of such statements. Financial manager can
rearrange the firm's financing more effectively on the basis of such information along with the
expected changes in trade of payables and the various accruals. In this way, it guides the
management in arranging its financing more effectively.
(6) Control deviceIt serves as a measure of control for the management. If actual figures are compared
with budgeted/projected figures, management can take remedial action, if there are any deviations.
15.5 Limitations of Funds Flow Statement

The following are the important limitations of Funds Flow Statement:
1. Funds Flow Statement is not a substitute of Income Statement or a Balance Sheet. It furnishes
only some additional information as regards changes in the working capital.
2. This statement lacks originality. It is rearrangement of data appearing in account books.
3. It indicates only past changes. It can not reveal continuous changes.
4. Some management accountants are of the opinion that Funds Flow Statement is not an ideal tool for
financial analysis.
15.6 Steps for Funds Flow Statement
The objective of funds flow statement is to analyse the causes for net increase or decrease in the
working capital as shown by the schedule of working capital changes. This statement is prepared on the
basis of changes in fixed assets, long-term liabilities and capital. Funds flow statement has two parts (i)
Sources of funds and (ii) uses or application of funds. The difference between these two parts represents
net changes is working capital. The amount of net increase or decrease as shown in funds flow statement
should be equal to the amount shown by the schedule of working capital changes. The following steps
should be taken to prepare funds flow statement:
I Step
From the current assets and current liabilities shown in the balance sheet. prepare a schedule of
working capital changes. This will result in either an increase or decrease in net worming captial.
 Increase in current assets increases working capital.
 Decrease in current assets decreases working capital.
 Increase in current liabilities decreases working capital.
 Decrease in current liabilities increases working capital.
II Step
Open respective accounts for all other non-current assets and non-current liabilities taking their
opening and closing balances.
III Step
Journalise the adjustments using double entry system and post them in respective accounts.
IV Step
Close the accounts which will result either as an item of source of funds or an item of use or
application of funds or close the remaining accounts by transferring to adjustment profit and loss acounts.
The balance of adjusted profit and loss account will be profit or loss from operation, that is to be shown in
funds flow statement following accounts are open for these calculations.
1. Funds From Operation The major source of working capital is the net profit from operations. The
net profit from operations is the source of funds and net loss from operations is the use or application fo
funds. The net profit or loss disclosed by profit and loss account is not treated profit or loss from operations
for the purpose of funds flow statement, because profit and loss account contains such items which do not
effect working capital. So the appripriate adjustments are to be made in the profit disclosed by the profit
and loss account to arrive at the fund from operation.
(a) Item to be added in Net Profit The non-funds items which do not affect current assets or current
liabilities and non-trading expenses and losses are added in the profit to arrive at funds from operation.
These are:
 Depreciation
 Loss on sale of fixed assets or long term investment.
 discount on issue of share and debentures.
 Premium on redemption of debentures.
 Prelimising expenses written off.
 Deferred revenue expenses.
 Goodwill written of.
 Patents; Trade marks written off.
 Provision for tax.
 Proposed dividend.
 Transfer to reserves.
(b) Items to be deducted from net profit
Items which do not affect current assets or current liabilities and non trading incomes and gains will
be deducted from the net profit to arrive at fund from operations. These are:
 Profit or gain on sale of fixed assets.
 Dividend received or receivable (not being trading income).
 Interest received on investments. Compensation received.
 Refund of tax.
 Profit on revaluation of assets.
 Increase in value of goodwill and patents.
 Transfer from reserves to profit and loss account.
 Calculation of Non-cash expenses and Non-trading losses.
Information regarding non-cash expenses and non-trading losses is not generally explicity
provided. When the amount of intangible and factious assets are written off like goodwill preliminary
expenses etc. are less in the current year’s balance sheet than previous years balance sheet, then it is
presumed that the deficiency is written off in the profit and loss account.
Sometime information regarding current year’s depreciation is provided but sometimes it has to be
calculated. If the amount of accumulated depreciation is given, than it is ascertained by preparing accumu-
lated depreciation account. If the amount of accumulated depreciation is not given, then it should be calcu-
lated as follows:
Rs.
Book value of fixed assets in last year’s B/S ................
Add: Fixed assets purchased during the yeas ................
Less : Book value of fixed assets in current year’s B/S/ ................
Current year’s depreciation ................
If the information regarding profit or loss on sale of fixed assets and long term investments is not
given, then difference between sale proceeds and book value of the assets should be presumed as profit or
loss.
 Purchase/Sale of Fixed Assets
The amount of source or use of funds from purchase or sale of fixed assets can be ascertained by
opening an account for the concerned assets as it appears in the ledger. The opening balance of the assets
is posted on the debit side and closing balance on the credit side of the assets account. Then the additional
information is journalised by double entry system and the entry is posted in the concerned assets account.
The balancin figure of the assets account may be either purchase or sale. If the balance falls short in the debit
side, it represents purchase of the assets, on the contrary, if the balance falls short in the credit side, it is sale
of the assets.
 Purchase/Sale of Investment
In a business concern, investment may be treated as current assets or as fixed assets. Investment in
marketable securities or government securities representing temporary investment or short term investments
are treated as current assets. Any change in the figures of such investments between the two balance sheet
dates is automatically adjusted through the schedule of changes in working capital.
Investment in shares or debentures of other companies or subsidiary companies i.e. long term or
trade investment are treated as fixed assets. Any sale of such investments is a source of funds while
purchase represents use of funds.
 Increase/Decrease in Share Capital and Long Term Liabilities
Between the two balance sheet dates, increase in share capital or long term liabilities during the year
arising on account of fresh issue of shares or debentures result in a source of funds. The redemption of
preference shares or buy back of equity shares or debentures is an application or use of funds as it reduces
the value of these instruments. If these share or debentures are issued at premium the account of premium is
also treated an increase in share or debenture capital.
 Provision for Taxation
As a current liability - When the provision for taxation is treated as current liability, it is shown as
the statement of changes in working capital and any tax paid by the firm during the year is ignored. The
amount paid not shown is the fund flow statement and it will not be added back to the net profit for
ascertaining funds from operations.
As an appropriation of Profits - When provision for taxation is treated as an appropriation of
profits, the amount of tax paid will be shown as an application or use of funds in the funds flow statement.
The amount of provision for taxation charged from the profit and loss account during the year is added back
to the net profit for the year while calculating funds from operations.
Proposed Dividend - Proposed devidend prior to the approval of the annual financial statement in
the annual general meeting represents only an appropriation of profits. When it is approved by the
shareholders in the annual general meeting, it becomes a current liability for the company. According to the
circumstances in each case, proposed dividend can be treated as provision for Taxation.
Interim Dividend - Dividend paid in advance against current year’s profit is known as ‘interim
dividend’. The amount interim dividend paid during the year is shown as an application or use of funds in
funds flow statement and in the debit side of adjusted profit and loss account or added back to net profit for
calculating the funds from operation.
In the end, the balances of funds flow statement will be equal to the increase or decrease is net
working capital as shown in the schedule of working capital changes.
15.7 Sources of Funds

Transactions that increase Working Capital are sources of funds. Some of them are:-
1. Funds from issue of Share Capital
2. Funds from issue of Debentures, Acceptance of Public Deposits, and other Long-term Loans.
3. Sale of Fixed Assets or Long-term Investments such as Land, Building, Machinery, Furniture, etc.
4. Non-trading income such as dividend, rent, interest, etc.
5. Fund from Operations.
6. Decrease in Working Capital.
Note- Share or Debentures issued and allotted for other than cash considerations, do not generate fund.
15.8 Application of Funds

1. Redemption of Equity & Preference Share Capital.
2. Redemption of Debentures.
3. Repayment of Long-Term Loans
4. Purchase of Fixed Assets or Long Term Investments.
5. Non-trading payment.
6. Funds lost in operations.
Note- If any fixed asset is purchased for a consideration of issue of shares or debentures, it does not involve
any funds and hence it is not an application of funds.
Activity
Write any four items which can be treated as sources of funds.
Illustration 1
The balance sheets of Ram & Company as on 31st march 2008 and 2009 were as follows:
Liabilities 2008 2009 Assets 2008 2009
Rs. Rs. Rs. Rs.
Creditors 37,400 42,000 Bank 4,000 5,000
P&L A/c 20,000 30,000 Debtors 36,000 39,000
9% debentures - 20,000 Stock 22,000 26,000
General reserve 10,000 15,000 Fixed Assets 93,400 1,66,000
Equity share capital 90,000 1,30,000 Preliminary Expenses 2,000 1,000
1,57,400 2,37,000 1,57,400 2,37,000
Additional Information
(1) Depreciation written off against Fixed Assets was Rs. 23,400.
(2) Dividend of Rs. 20,000 was paid on Share Capital.
Prepare Schedule of Changes in Working Capital and Fund Flow Statement.
Solution
Statement of Changes in Working Capital
Particulars 31 March 31 March Changes in Working
2008 2009 Capital
Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets:
Bank 4,000 5,000 1,000 -
Debtors 36,000 39,000 3,000 -
Stock 22,000 26,000 4,000 -
Total (A) 62,000 70,000
Current Liabilities:
Creditors 37,400 42,000 - 4,600
Total (B) 37,400 42,000
Net Working Capital (A-B) 24,600 28,000 8,000 4,600

Increase in Working Capital 3,400 - - 3,400
28,000 28,000 8,000 8,000
Funds Flow Statement

Sources of Funds Amount Uses of Funds Amount
Rs. Rs.
Issue of Share Capital 40,000 Dividend Paid 20,000
Issue of Debentures 20,000 Purchase of Fixed Assets 96,000
Funds from Operations 59,400 Increase in Working Capital 3,400
1,19,400 1,19,400
Working Notes
To Balance b/d 93,400 By Depreciation 23,400
To Cash (Purchase of Fixed 96,000 By Balance c/d 1,66,000
Assets)
1,89,400 1,89,400
Dr. Profit & Loss Adjustment A/c Cr.

To Dividend 20,000 By Balance b/d 20,000
To Depreciation 23,400 By Funds from Operations 59,400
To Written off Preliminary 1,000
Expenses
To General Reserve 5,000
To Balance c/d 30,000
79,400 79,400
Illustration 2
From the following balance sheets of X Ltd. on 31st march 2009 and 2010, you are required to prepare:
(a) A Statement of changes in Working capital;
(b) A Funds Flow Statement.
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000
General Reserve 14,000 18,000 Building 40,000 36,000
P&L A/c 16,000 13,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investment 10,000 11,000
Bills Payable 1,200 800 Stock 30,000 23,400
Provision for 16,000 18,000 Bills Receivable 2,000 3,200
Taxation Debtors 18,000 19,000
Provision for 400 600 Cash at Bank 6,600 15,200
Doubtful debts
1,55,600 1,55,800 1,55,600 1,55,800
The following additional information have also been given:
(a) Depreciation charged on Plant was Rs.4,000 and on Building Rs.4,000
(b) Provision for Taxation of Rs.19,000 was made during the year.
(c) Interim Dividend of Rs.8,000 was paid during the year.
Solution:
Funds Flow Statement
For the year ended 31st March, 2010
Sources Rs. Applications Rs.
Funds from Operations 36,000 Purchase of Plant 3,000
Purchase of Investment 1,000
Payment of Interim Dividend 8,000
Payment of Tax 17,000
Increase in Working Capital 7,000
36,000 36,000
Statement of Changes in Working Capital
Items 31st March 2009 31st March 2010 Increase Decrease

Rs. Rs. Rs. Rs.
(A)Current Assets:
Debtors 18,000 19,000
Less: Provision for Doubtful 400 600
debts
17,600 18,400 800 -
30,000 23,400 - 6,600
Stock 2,000 3,200 1,200 -
Bills Receivable 6,600 15,200 8,600 -
Cash at Bank
56,200 60,200
Total(A)
(B)Current Liabilities: 8,000 5,400 2,600 -

Sundry Creditors 1,200 800 400 -
Bills Payable
9,200 6,200
Total (B)
47,000 54,000 13,600 6,600
Net Working Capital(A-B) 7,000 - - 7,000
Increase in W.C.
54,000 54,000 13,600 13,600
Working Notes:
Dr. Adjusted Profit & Loss A/c Cr.
To General Reserve 4,000 By Balance b/d 16,000
To Provision for Taxation 19,000 By Funds from Operations 36,000
To Interim Dividend 8,000
To Depreciation:
Building 4,000
Plant 4,000
52,000 52,000
Dr. Provision for Taxation A/c Cr.
To Bank A/c 17,000 By Balance b/d 16,000
To Balance c/d 18,000 By Adjusted P&L A/c 19,000
35,000 35,000
Dr. Building A/c Cr.
To Balance b/d 40,000 To Depreciation 4,000
40,000 40,000
Dr. Plant A/c Cr.
To Bank A/c By Balance c/d 36,000
(Balancing Figure) 3,000
40,000 40,000
15.9 Cash Flow Statement

Three major financial statements that are ordinarily required for external reports are an income
statement, a balance sheet, and a statement of cash flows. The purpose of the statement of cash flow is to
highlight the major activities that directly and indirectly impact cash flows and hence affect the overall cash
balance. The manager focuses on cash for a very good reason. Without sufficient cash balance at the right
time, a company may miss golden opportunities or may even fall into bankruptcy. The cash flow statement
answers questions that cannot be answered by the income statement and a balance sheet.
The statement of cash flows is a valuable analytical tool for managers as well as for investors and
creditors, although managers tend to be more concerned with forecasted statements of cash flows that are
prepared as a part of the budgeting process. The statement of cash flows can be used to answer crucial
questions such as the following:
1. Is the company generating sufficient positive cash flows from its ongoing operations to remain
viable?
2. Will the company be able to repay its debts?
3. Will the company be able to pay its usual dividends?
4. Why is there a difference between net income and net cash flow for the year?
5. To what extent will the company have to borrow money in order to make needed
investments?
For the statement of cash flows to be useful to managers and others, it is important that
companies employ a common definition of cash. It is also important that a statement be constructed using
consistent guidelines for identifying activities that are sources of cash and uses of cash. The proper
definition of cash and the guidelines to use in identifying sources are discussed in coming paragraphs.
Definition of Cash:
In preparing a statement of cash flows, the term cash is broadly defined to include both cash and
cash equivalents. Cash equivalents consist of short term, highly liquid investments such as treasury bills,
commercial paper, and money market funds that are made solely for the purpose of generating a return on
temporary idle funds. Instead of simply holding cash, most companies invest their excess cash reserves in
these types of interest bearing assets that can be easily converted into cash. These short term liquid invest-
ments are usually included in marketable securities on the balance sheet. Since such assets are equivalent
to cash, they are included with cash in preparing a statement of cash flows.
15.10 Uses of Cash Flow Statement
Its main advantages are as follows:
(i) Planning and Co-ordination of Financial Operations: Cash Flow Statement is useful for
evaluating Financial policies and current cash position. Since cash is the basis for carrying on
operations, the Cash Flow Statement prepared on an estimated basis for the next accounting
period will enable the management to plan and co-ordinate the financial operations. It is
especially useful in preparing cash budgets.
(ii) A Control Device : Cash Flow statement is also a control device for the management. A
comparison of cash flow statement of previous year with the budget for that year would indicate to
what extent the resources of the enterprise were raised and applied according to the plan. Thus a
comparison of original forecast with actual results may highlight trends of movement that might
otherwise go undetected.
(iii) Useful to internal Financial Management : Since it gives a clear picture of cash inflow from
operations (and not income flow of operation), it is, therefore, very useful to internal financial
management in considering the possibility of retiring long-term debts, in planning replacement of
plant facilities or in formulating dividend policies.
(iv) Profit and Cash Positions: It enables the management to account for situation when business has
earned huge profits yet run without money or when it has suffered a loss and still has plenty of
money at the bank.
(v) Short-term Financial Decisions : Cash Flow Statement helps the management in taking
short-term financial decisions. Suppose, a firm wants to know its state of solvency after one month,
it is possible only from Cash Flow analysis and not from Funds Flow Statement. Shorter the period,
greater is the importance of Cash Flow Statement.
15.11 Limitations of Cash Flow Statement

Cash flow statement suffers from the following limitations:
(1) A Cash Flow Statement only reveals the inflow and outflow of cash. The cash balance disclosed by
the cash flow statement may not represent the real liquid position of the concern.
(2) Cash Flow Statement is not suitable for judging the profitability of a firm as non-cash changes are
ignored while calculating cash flows from operating activities
(3) Cash Flow Statement is based on cash accounting. It ignores the basic accounting concept of the
accrual basis.
Cash Flow Statement does not give a complete picture of financial position of the concern.
15.12 Distinction between Funds Flow and Cash Flow Statements

A distinction between these two statements may be briefed as under:
(i) Funds Flow Statement is concerned with all items constituting funds (Working Capital) for the
business while Cash Flow Statement deals only with cash transactions. In other words, a transac-
tion affecting working capital other than cash will affect Funds statement, and not the Cash Flow
Statement.
(ii) In Funds Flow Statement, net increase or decrease in working capital is recorded while in Cash
Flow Statement, individual item involving cash is taken into account.
(iii) Cash Flow Statement is started with the opening cash balance and closed with the closing cash
balance while there are no opening or closing balances in Funds Flow Statement.
15.13 Distinction between Funds Flow Statement and Balance Sheet
A summary of main points of differences between these two is give below:
(i) Balance sheet is a statement showing the financial position of the concern on a particular date. The
asset side portrays the development of resources in various types of properties and liabilities side
indicates the manner in which these resources are obtained. It shows all assets and liabilities whether
current or fixed, tangible or intangible etc., while Funds Flow Statement shows the changes in
current assets and current liabilities during a particular period of time.
(ii) Balance Sheet shows the total financial position on a particular date and in this way, it is of a
historical nature and therefore, its utility is very limited for the management. On the other hand,
Funds Flow Statement is a comparative statement of assets and liabilities and depicts the changes in
working capital during the period of two Balance sheets.
(iii) Funds Flow Statement is an analysis and control device for the management. Management can
ensure the long term and the short term solvency of the firm by studying the internal funds flow
cycles. It is a modern technique of knowing the inflows and outflows of funds during a particular
period. Balance Sheet represents the balance of various assets and liabilities and does not present
analysis of any kind.
(iv) There are two views of the financial position of the firm-long term and short-term. Short-term
financial position means the technical solvency of the firm in the near future while on the other hand,
long-term financial position means future financial structure of the firm. Both are inter-related but
there is a differences in their analysis. The short-term view of the financial position of the firmcannot
be obtained from the Balance Sheet.
15.14 Format of Cash Flow Statement

The cash flow statement is divided into three sections:
1. Cash flow from Operating Activities: Shows the results of cash inflows and outflows related to
the fundamental operations of the basic line or lines of business in which the company engages.
(Example: cash receipts from the sale of goods or services and cash outflows for purchasing
inventory and paying rent and taxes).
2. Cash flow from Investing Activities : Associated with purchases and sales of non-current assets
(Example: building and equipment purchases or sales of investments or subsidiaries).
3. Cash flow from Financing Activities : Associated with financing the firm (Example: selling and
paying off bonds and issuing stock and paying dividends).
15.15 Methods of Cash Flow Statement

There are two methods of preparing the Cash Flow Statement. Both methods give the same results
in respect of the final total as well as sub-totals of the three sections - operating, investing and financing.
They differ only in the manner the information regarding cash flow from operating activities is presented.
(1) Indirect Method
Format of Cash Flow Statement for the year ended......
As per Accounting Standard - 3 (Revised)
Particulars Rs. Rs.
(i) Cash flows from operating Activities
Net Profit as per Profit and Loss A/c or difference between closing balance xxx xxx
and opening balance of Profit and Loss A/c
Add : Transfer to reserve xxx
Proposed dividend for current year xxx
Interim dividend paid during the year xxx
Provision for tax made during the current year xxx
Extraordinary items, if any, debited to Profit and Loss A/c xxx xxx
Less: Extraordinary Items, if any, credited to Profit and Loss A/c xxx
Refund of Tax credited to Profit and Loss A/c xxx (xxx)
A. Net profit before taxation and Extra-Ordinary items Xxxx
(Adjustment for Non-Cash and Non-Operating Items)
B. Add :
– Depreciation xxx
– Preliminary expenses xxx
– Discount on issue of shares and debentures written off xxx
– Interest on borrowings and debentures xxx
– Loss on sale of fixed assets xxx xxx
C. Less :
– Interest income/received xxx
– Dividend income received xxx
– Rental income received xxx
– Profit on sale of fixed asset xxx xxx
D. Operating profits before working capital changes (A + B – C) xxxx

E. Decrease in current assets and increase in current liabilities xxx
F. Less: Increase in current assets and decrease in current liabilities xxx
G. Cash generated from operations (D + E – F) xxx
H. Less: Income tax paid (Net tax refund received) xxx
I. Cash flow from before extraordinary items xxx
Adjusted extraordinary items (+/–) xxx
Net cash flow from operating activities xxxx
(ii) Cash Flow from Investing Activities
Add:
– Proceeds from sale of fixed assets xxx
– Proceeds from sale of investments xxx
– Proceeds from sale of intangible assets xxx
– Interest and dividend received xxx xxx
Less:
– Rent income xxx
– Purchase of fixed assets xxx
– Purchase of investment xxx
– Purchase of intangible assets like goodwill xxx (xxx)
Net cash from (or used in) investing activities Xxxx
(iii) Cash Flow from Financing Activities
Add:
Proceeds from issue of shares and debentures xxx
Proceeds from other long term borrowings xxx xxx
Less:
Final dividend fund xxx
Interim dividend fund xxx
Interest on debentures and loans paid xxx
Repayment of loans xxx
Redemption of debenture preference shares xxx (xxx)
Net cash flow from (or used in) financing activities xxxx
(iv) Net increase/Decrease in cash and cash equivalent (i + ii + iii) xxxx
(v) Add: Cash and Cash equivalents in the beginning of the year
– Cash in hand xxx
– Cash at bank overdraft xxx
– Short term deposit xxx
– Marketable securities xxx xxxx
(vi) Less: Cash and Cash equivalents in the end of the year
– Cash in hand xxx
– Cash at Bank (by bank overdraft) xxx
– Short term deposits xxx
– Cash flow from operation xxx (xxx)
Nil
(2) Direct Method

Format for Cash flow Statement for the year ended...
As per Accounting Standard-3 (Revised)
Particulars Rs. Rs.
(i) Cash Flow from Operating Activities
A. Operating Cash Receipts
– Cash sales xxx
– Cash received from customers xxx
– Trading commission received xxx
– Royalties received xxx xxx
B. Less: Operating cash payment
– Cash purchase xxx
– Cash paid to the supplier xxx
– Cash paid for business expenses like office expenses, Manufacturing xxx (xxx)
expenses, selling and distribution expenses
C. Cash generated from operation ( A – B) xxxx
D. Less: Income tax paid (Net of tax refund received) (xxx)
E. Cash flow before extraordinary items xxx
F. Adjusted extraordinary items (+/–)/Receipt/payment xxx
G. Net Cash Flow from (or used in) Operating Activities xxxx
(ii) Cash Flow from Investing Activities xxxx
(calculation same as under indirect method)
(iii) Cash Flow from Financing Activities xxxx
(Calculation same as under indirect method)
(iv) Net increase/decrease in cash and cash equivalents (i + ii + iii) xxxx
(v) Add: cash and cash equivalent in the beginning of the year xxx
(calculated same as under indirect method)
(vi) Less: Cash and Cash equivalent in the end of the year (xxx)
Nil
Activity
What are the main headings while preparing cash flow statement by indirect method.
15.16 Preparation of Cash Flow Statement
15.16.1 Operating Activities
Cash flow from operating activities are primarily derived from the principal revenue generating
activities of the enterprise. A few items of cash flows from operating activities are:
(i) Cash receipt from the sale of goods and rendering services.
(ii) Cash receipts from royalties, fee, Commissions and other revenue.
(iii) Cash payments to suppliers for goods and services.
(iv) Cash payment to employees
(vi) Cash payment or refund of Income tax.
Determination of cash flow from operating activities:-
There are two stages for arriving at the Cash Flow from Operating Activities:-
Stage-I
Calculation of operating profit before working capital changes, it can be calculated in the following
manner:-
Net profit before Tax and extra-ordinary Items xxx

Add: Non-cash and non-operating Items
(Which have already been debited to profit and Loss Account)
- Depreciation xxx
- Amortization of intangible assets xxx
- Loss on the sale of Fixed assets xxx
- Loss on the sale of Long term Investments xxx
- Provision for tax xxx
- Dividend paid xxx xxx
xxxx
Less: Non-cash and Non-operating Items
(Which have already been credited to profit & loss Account)
- Profit on sale of fixed assets xxx
- Profit on sale of Long term investment xxx (xxx)
Operating profit before working Capital changes xxxx
Stage-II
After getting operating profit before working capital changes as per stage I, adjust increase or
decrease in the current assets and current liabilities.
The following general rules may be applied at the time of adjusting current assets and current
liabilities.
A. Current assets
(i) An increase in an item of current assets causes a decrease in cash inflow because cash is blocked in
current assets.
(ii) A decrease in an item of current assets causes an increase in cash inflow because cash is released
from the sale of current assets.
B. Current liabilities
(i) An increase in an item of current liability causes a decrease in cash outflow because cash is saved.
(ii) A decrease in an item of current liability causes increase in cash out flow because of payment of liability.
15.16.2 Investing Activities
Investing Activities refer to transactions that affect the purchase and sale of fixed or long term assets
and investments.
Examples of cash flow arising from Investing activities are:-
1. Cash payments to acquire fixed Assets.
2. Cash receipts from disposal of fixed assets.
3. Cash payments to acquire shares, or debenture investment.
4. Cash receipts from the repayment of advances and loans made to third parties.
Thus, Cash Inflow from Investing activities is:-
- Cash sale of plant and machinery, land and Building, furniture, goodwill etc.
- Cash sale of investments made in the shares and debentures of other companies.
- Cash receipts from collecting the Principal amount of loans made to third parties.
Cash Outflow from Investing Activities is:
- Purchase of fixed assets i.e. land, building, furniture, machinery etc.
- Purchase of Intangible assets i.e. goodwill, trade mark etc.
- Purchase of shares and debentures
- Purchase of Government Bonds
- Loan made to third parties
15.16.3 Financing Activities
The third section of the cash flow statement reports the cash paid and received from activities with
non-current or long term liabilities and shareholders Capital. Examples of cash flow arising from financing
activities are:
- Cash proceeds from issue of shares or other similar instruments.
- Cash proceeds from issue of debentures, loans, notes, bonds, and other short-term borrowings.
- Cash repayment of amount borrowed.
Cash Inflow from financing activities is:
- Issue of Equity and preference share capital for cash only.
- Issue of Debentures, Bonds and long-term note for cash only
Cash Outflow from financing activities is:
- Payment of dividends to shareholders.
- Redemption or repayment of loans i.e. debentures and bonds.
- Redemption of preference share capital.
- Buy back of equity shares.
15.16.4 Treatement of Special Items
(i) Payment of Interim Dividends The following procedure is followed:
- The amount of interim dividend paid during the year is shown as outflow of cash in cash flow
statement.
- It will be added back to the profits for the purpose of calculating cash provided from operating
activities.
- No adjustment is necessary if the cash provided from operating activities is calculated on the basis
of revised figure of net profit.
(ii) Proposed dividend The dividend is always declared in the general meeting after the preparation of
Balance Sheet. It is therefore, a non-operating item which should not be permitted to affect the
calculation of cash generated by operating activities. Thus, the amount of proposed dividends would
be added back to current year’s profit and payments made during the year in respect of dividends
would be shown as an outflow of cash.
(iii) Share Capital The increase in share capital is regarded as inflow of cash only when there is a
increase in share capital. For example, if a company issues 10000 equity shares of Rs.10 each for
cash only, Rs. 100,000 would be shown as inflow of cash from financing activities. Similarly, the
redemption of preference share is an outflow of cash. But where the share capital is issued to
finance the purchase of fixed assets or the debentures are converted into equity shares there is no
cash flow. Further, the issue of bonus shares does not cause any cash flows.
(iv) Purchase or sale of fixed Assets The figures appearing in the comparative balance sheets at two
dates in respect of fixed assets might indicate whether a particular fixed asset has been purchased
or sold during the year. This would enable to determine the inflows or outflows of cash. For
example, If the plant and machinery appears at Rs 60,000 in the current year and Rs.50,000 in the
previous year, the only conclusion, in the absence of any other information is that there is a purchase
of fixed assets for Rs.10000 during the year. Hence, Rs.10000 would be shown as outflow of cash.
(v) Provision for Taxation It is a non-operating expense or an item of appropriation in the Income
statement/Profit and Loss Account and therefore should not be allowed to reduce the cash
provided from operating activities. Hence, if the profit is given after tax and the amount of the
provision for tax made during the year is given, the same would be added back to the current year
profit figure. In the cash flow statement, the tax paid would be recorded separately as an outflow of
cash. The item of provision for taxation would not be treated as current assets.
Sometimes, the only information available about provision for taxation is two figures appearing in
the opening balance sheet and closing balance sheet. In such a case the figure in the opening balance sheet
is treated as an outflow of cash while the figure in the closing balance sheet is treated as a non-cash and
non-operating expense and thus is added back to net Income figure to find out the cash provided from
operating activities.
Illustration 3
From the summarized cash account of ABC Limited (Ltd.) prepare cash flow statement for the year
ended 31st December 2006 in accordance with AS-3 (Revised) using the direct method and indirect
method. The company does not have any cash equivalents:
Summarized Cash A/c
(Rs. 000) (Rs. 000)
Balance on 1.1.2006 50 Payment to Suppliers 2000
Issue of equity shares 300 Purchase of fixed assets 200
Receipts from customers 2800 Overhead expenses 200
Sale of fixed assets 100 Wages and salaries 100
Taxation 250
Dividend 50
Repayment of Bank 300
Loan
Balance on 31.12.2006 150
3250 3250
Additional information: Net profit before tax for the year 2006 was Rs 5,00,000.
Solution:
Cash Flow Statement of ABC Ltd
for the year ended 31st December 2006 (Indirect method)
Rs ‘000 Rs ‘000
A. Cash flow from operating activities
Net profit before tax 500
Income tax paid (250)
Net cash from operating activities 250
B. Cash flow from investing activities
Purchase of fixed assets (200)
Sale of fixed assets 100
Net cash used in investing activities (100)
C. Cash flow from financing activities
Issue of equity shares 300
Repayment of bank loan (300)
Dividend paid (50)
Net cash used in financing activities (50)
Net increase in cash (A+B+C) 100
Add: Cash at the beginning of the year 50
Cash at the end of the year 150
Cash Flow Statement (Direct Method) of ABC Ltd.

for the year ended 31st December 2006
Rs ‘000 Rs ‘000
A. Cash flows from Operating Activities
Cash receipts from customers 2800
Cash payments to suppliers (2000)
Cash paid for wages and salaries (100)
Cash paid for overhead expenses (200)
Income tax paid (250)
Net cash from operating activities 250
B. Cash flows from Investing Activities
Purchase of fixed assets for cash (200)
Proceeds from sale of fixed assets 100
Net cash used in investing activities (100)
C. Cash Flows from Financing Activities
Proceeds from issue of equity shares 300
Payment of bank loan (300)
Dividend paid (50)
Net cash used in financing activities (50)
Net increase in cash (A+B+C) 100
i.e. Net cash from activities
Cash at the beginning 50
Cash at the end 150
Illustration 4
From the following information, you are required to prepare the cash flow statement of Classic Ltd. for the
year ended 31st March (both methods):
Balance Sheet
as at 31st March 2006
Rs. Rs. Rs. Rs.
Share Capital 70,000 70,000 Fixed Assets 50,000 91,000
Secured Loans - 40,000 Inventory 15,000 40,000
Creditors 14,000 39,000 Debtors 5,000 20,000
Tax payable 1,000 3,000 Cash 20,000 7,000
Profit & Loss A/c 7,000 10,000 Prepaid expenses 2,000 4,000
92,000 162,000 92,000 162,000
Profit and Loss Account
for the year ended 31st March 06
Dr. Cr.
Rs. Rs.
Opening Stock 15,000 Sales 100,000
Purchases 98,000 Closing Inventory 40,000
Gross profit c/d 27,000
1,40,000 1,40,000
General Expenses 11,000 Gross profit b/d 27,000
Depreciation 8,000
Provision for tax 4,000
Net Profit c/d 4,000
27,000 27,000
Dividend (interim) 1,000 balance b/d 7,000
balance c/d 10,000 Net profit b/d 4,000
11,000 11,000
Solution:
Cash Flow Statement (Direct Method)
for the year ended, March 31, 2006
Particular Amount Amount
Rs. Rs.
(A) Cash Flow from Operating Activities
Cash receipts from Debtors (see Debtors A/c) 85,000
Cash payment for :
Cash paid to suppliers (see creditors A/c) (73,000)
(73,000)
General expenses (13,000) (86,000)
Cash from operating activities (1,000)
Taxes paid (2000)
Net Cash outflow from operating activities (3,000)
(B) Cash flow from Investing Activities
Purchase of fixed Assets (49,000)
Net cash used in investing Activities (49,000)
(C) Cash flow from Financing Activities
Proceeds from Raising secured loans 40,000
Dividend paid (1,000)
Net cash from Financing Activities 39,000
Net Decrease in cash (– 3000 – 49000 + 39000) (13,000)
[A + B + C]
Working Notes:
Dr. Debtors A/c Cr.
Rs Rs
To Balance b/d 5,000 By Cash A/c (Received) 85,000
(Bal. Fig.)
To Sales A/c (Credit) 1,00,000 By Balance c/d 20,000
1,05,000 1,05,000
Dr. Creditors A/c Cr.

Rs Rs
To Cash A/c 73,000 By Balance b/d 14,000
(Bal. Fig.)
To Balance c/d 39,000 By Purchases A/c 98,000
1,12,000 1,12,000
Dr. Fixed Assets A/c Cr.

Rs Rs
To Purchase of fixed asset 49,000 By Balance c/d 91,000
99,000 99,000
Cash flow Statement (Indirect Method)

For the year ended March, 31, 2006
Particulars Rs. Rs.
(A) Cash flow from Operating Activities :
Net profit as per Profit and Loss A/c 4,000
Add : Provision for Tax (See provision for Tax Account) 4,000
Net profit be fore Tax 8,000
Add : Depreciation 8,000
Operating profit before working
Capital Changes 16,000
Add : Decrease in Current Assets or
Increase in Current liabilities
Increase in Creditors 25000
Less : Increase in current assets or Decrease in Current liabilities
Increase in Debtors (15000)
Increase in Inventory (25000)
Increase in prepaid expenses (2,000) (17000)
Cash from Operating Activities (1,000)
Taxes paid (2,000)
Net cash from Operating Activities (3,000)
(B) Cash flow from Investing Activities :
Purchase of Fixed Assets (See fixed assets) (49000)
Net cash used in Investing Activities (49000)
(C) Cash Flow from financing Activities
Proceeds from Raising Secured loan 40000
Dividend paid (1000)
Net Cash flow from Financing Activities 39000
Net Decrease in Cash a Cash equivalent (13000)
Working Notes:
Dr. 1. Fixed Assets A/c Cr.
Rs. Rs.
To Balance b/d 50,000 By Depreciation A/c (Given) 8,000
To Cash A/c (Purchases) (Bal. fig.) 49,000 By Balance C/d 91,000
99,000 99,000
Dr. 2. Provision for Tax Account (Tax Payable A/c) Cr.
Rs Rs
To Cash A/c (Tax paid) 2,000 By Balance 1,000
(Bal Fig) c/d
To Balance c/d 3,000 By Profit & 4,000
(Given) (Provision made during the year) loss A/c
5,000 5,000
15.17 Summary
Funds flow statement is an analytical tool in the hands of financial manager. The basic purpose of
this statement is to indicate on historical basis the changes in the working capital i.e. where funds came from
and where they are used during a given period.
Cash flow statement is a statement of sources and use of cash and cash equivalents in an enterprise
during a specified period of time. A cash flow statement, summarises the causes of changes in cash position
of a business enterprise between dates of two balance sheets.
15.18 Key Words
 Net Working Capital Net working capital means difference between current assets and current
liabilities.
 Flow of Funds Flow of funds refers to increase or decrease in net working capital.
 Cash Flow Inflows and outflows of cash and cash equivalents.
 Cash Equivalents Cash equivalents are short term highly liquid investments that are readily
convetible into cash and their maturity so near that they present insignificant risk of changes in value
and interest rates.
1. Explain the meaning of funds flow statement. What are its main objectives?
2. What are the various sources and uses of funds?
3. The following are the summarised Balance Sheets of Pratiksha Limited as on 31st December, 2004 and
31st December, 2005 respectively :
Assets (Rs. in Thousands)
2004 2003
Freehold Property at cost 33.00 24.00
Plant and Machinery (cost less Dep.) 20.80 60.30
Inventories 30.35 32.85
Sundry Debtors 20.10 24.75
Cash and Bank 9.25 16.80
Preliminary Expenses 1.20 0.60
114.70 159.30
Liabilities
Issued Share Capital 60.00 75.00
Share Premium Account - 5.00
Capital Reserve - 17.00
Profit and Loss Account 21.50 21.20
Sundry Creditors 27.20 32.60
Proposed Dividend 6.00 8.50
114.70 159.30
No Plant and Machinery was sold during 2005. Depreciation written off during 2005 was
Rs. 7,500. Net profit for the year was Rs. 8,200. Rs 6,000 dividend was paid during 2005 in resect
of previous year. Capital Reserve represents profit on sale of freehold premises.
Answer : Increase in working capital Rs. 9,300 ; Funds from Operations Rs. 16,300; Total
of Funds Flow Statement Rs. 62,300; Sale of Freehold Property Rs. 26,300. Purchase of plant an
Machinery Rs. 47.00]
4. What is a cash Flow Statement? How does it differ from the Funds Flow Statement?
5. Following are the comparative Balance Sheets of Asian Paints Limited as on 31st December, 2004
and 31st December 2005 :
Rs. Rs. Rs. Rs.
Equity Share Capital 2,00,000 2,00,000 Land 10,000 10,000
Profit and Loss A/c. (Cr.) 23,500 52,000 Building (at cost) 75,000 90,000
Debentures 40,000 35,000 Mahinery (at cost) 25,000 40,000
Outstanding Expenses 3,500 4,500 Investments 50,000 30,000
(Long-tem)
Creditors 33,000 40,000 Stock 32,000 40,000
Accumulated Depreciation Debtors 80,000 90,000
Machinery 3,000 7,500 Prepaid Expenses 2,000 2,000
Building 12,000 18,000 Cash 43,000 58,000
Prov. for Doubtful Debts 2,000 3,000
3,17,000 3,60,000 3,17,000 3,60,000
Additional Information
(i) Dividend paid during 2005 was Rs. 26,500.
(ii) Investments Costing Rs. 20,000 were sold in 2005 for Rs. 25,000.
(iii) Machinery costing Rs. 5,000 on which Rs. 1,000 depreciation was accumulated, was sold for Rs.
6,000 in the year 2005.
(iv) The provision for doubtful debts charged to profit was Rs. 1,500.
Prepare a Cash Flow Statement for the year 2005.
[Answer : Cash from Operating Activities Rs. 50,500; Investing Activities Rs. (4,000);
Financing Activities Rs. (31,500)]
6. The following are the balance sheets of Swaraj Ltd. for the year ended 31st March, 2005 and
2006. Prepare a Cash Flow Statement for the year 2005-06.
Balance Sheet
Liabilities 31.3.05 31.3.06 Assets 31.3.05 31.3.06
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 2,00,000 Goodwill 15,000 10,000
General Reserve 63,250 68,250 Plant 1,50,000 2,40,000
Depreciation Fund 50,000 55,000 Land & Buildings 20,000 40,000
Debentures 50,000 - Debtors 75,000 80,000
Sundry Creditors 1,22,750 1,14,850 Stock 1,08,000 60,000
Accrued Expenses 9,000 18,000 Bank Balance 29,000 28,000
Provision for Tax 5,000 5,400 Prepaid 3,000 3,500
Insurance
4,00,000 4,61,500 4,00,000 4,61,500
Additional Information:
1. Sales for the year 2005-06 amounted to Rs. 10,50,000. In arriving at the Net Profit, items
deducted from the sales includes among others : Cost of goods sold Rs. 8,25,000; Depreciation on
Plant Rs. 25,000; Wages and salaries Rs. 1,00,000; and a profit of Rs. 5,000 on sale of a plant.
The machinery was sold for Rs. 15,000 and had a cost of Rs. 30,000 (accumulated depreciation
Rs. 20,000).
2. The Company declared and paid dividends of Rs. 30,000.
3. Debentures were redeemed for Rs. 49,000.
[Answer : Cash from Operating Activities Rs. 1,03,000; Investment Activities Rs. (1,25,000);
Financing Activities Rs. 21,000]

Maheshwari S.L., Management Accounting.
Maheshwari Mittal, Management Accounting.
Agarwal and Agarwal, Management Accounting.

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MP-103

Vardhaman Mahaveer Open University, Kota

Accounting for Managers

Editing and Course Writing

Course Material Production

PRODUCTION: March, 2011

Vardhaman Mahaveer Open University, Kota

Accounting for Managers

2 Principles, Standards and Conventions 9-16

3 Double Entry System of Accounting 17-27

5 Trial Balance 54-66

6 Final Accounts 67-87

BLOCK - II : COST ACCOUNTING

8 Marginal Costing 101-126

9 Cost Analysis for Decision Making 127-141

10 Process Costing 142-156

BLOCK - III : MANAGEMENT ACCOUNTING

12 Standard Costing and Variance Analysis 167-188

13 Budgetary Control 189-208

BLOCK - IV : FINANCIAL ANALYSIS

15 Funds Flow and Cash Flow Statements 224-247

The purpose of this course is to develop an understanding for accounting

Vardhaman Mahaveer Open University, Kota

Accounting for Managers

1.3 Development of Accounting

1.4 Definitions and Functions of Accounting

1.5 Objectives of Accounting

1.7 Book-keeping, Accounting and Accountancy

1.8 Branches of Accounting

1.9 End Users of Accounting Information

1.14 Reference Books

2.2 Meaning of Accounting Principles

2.3 Accounting Concepts or Assumptions

2.4 Accounting Conventions

2.5 Generally Accepted Accounting Principles (GAAP)

2.6 Systems of Accounting

2.9 Self Assessment Test

2.10 References Books

3.2 Meaning of Double Entry System of Accounting

Item Debit Credit

3.3 Advantages of Double Entry System

3.4 Solved Illustrations

3.6 Key Words

3.7 Self Assessment Test

3.8 Reference Books

4.2 Types of Accounts

PERSONAL ACCOUNTS IMPERSONAL ACCOUNTS

NATURAL ARTIFICIAL REPRESENTATIVE REAL NOMINAL

Trans- Accounts involved Nature of How affected Whether to

Date Particulars L.F.No. Dr. Cr.

4.3.4 Compound Journal Entries

June 3 Balram’s A/c Dr. 1,000

June 5 Cash A/c Dr. 1,700

June 7 Pradeep’s A/c Dr. 800

June 9 Cash A/c Dr. 600

4.4 Recording of Special Transactions

4.5 Purchase Day Book

4.6 Sales Day Book

Jan. 8 M/s Beta & Co.

4.7 Cash Book

Jan.6 To B & Co. a/c 600 Jan.27 By furniture a/c 1,200

Jan 4 To Sales A/c 400 Jan 2 By Purchases A/c 300