FINANCIAL ACCOUNTING
INTRODUCTION:
 Accounting has been termed as the language of business. The basic function of accounting thus
is to communicate the operating results of the business to the stake holders and share holders of a
business.
LEARNING OBJECTIVES
After going through this chapter, the reader is expected to –
1. Understand what accounting is, does and how its different branches serve the purpose of
providing information to the needy
2. Know the various users of accounting information
3. Identify the objectives of financial statements
4. Understand the various functions and limitations of financial accounting
5. Understand the generally accepted accounting principles (GAAP) which governs the
preparation of financial statements of a concern
6. Understand the various financial statements such as – balance sheet and its related
concepts, profit and loss account and its related concepts etc
7.  Develop an idea about the concepts of inflation accounting and human resources
accounting
DEFINITION OF ACCOUNTING:
 The ​American Institute of certified public accountants (AICPA) ​defines accounting as “the art
of recording, classifying and summarizing in a significant manner and in terms of money
transactions and events which are in part at least of a financial character and interpreting the
results thereof”.
OBJECTIVES OF FINANCIAL STATEMENTS
The basic objective of financial statements according to AICPA is ‘to provide qualitative
financial information about the business enterprise that is useful to statement users, particularly
owners and creditors in making economic decisions. Apart from this the other important
objectives are :
1. To provide information about the economic activities of the enterprise to several external
groups who, otherwise have no access to such information.
2. To provide useful information to investors and creditors in taking decisions relating to
investment and lending.
3. To provide information to potential investors in evaluating the earning power of the
enterprise.
4. To provide economic information to the owners to judge the management on its
stewardship of the resources of the enterprise and the achievements of the corporate
objectives.
5. To provide information which enables the investors to compare the performance with
similar other undertakings and take appropriate decisions regarding retention or
disinvestments of their holdings.
6.  To provide information regarding accounting policies and contingent liabilities of the
enterprise as these have a barring in predicting, comparing and evaluating the earning
power of the enterprise.
FUNCTIONS OF FINANCIAL ACCOUNTING
1. Keeping systematic records
 2. Protecting the properties of the business
3. Communicating the results to the stake holders of the business
 
4. Meeting the legal requirements
LIMITATIONS OF FINANCIAL ACCOUNTING
1. Only transactions which can be measured in terms of money can be recorded in the books
of accounts. However events which may be important to the business do not find a place
in the accounts if they cannot be measured in terms of money.
2. According to the cost concept assets are recorded at the cost at which they are acquired
and therefore, the changes in values of assets brought about by changing value of money
and market factors are ignored.
3. There is conflict between one accounting principle and another. For example, current
assets are valued on the basis of cost or market price whichever is less according to the
principle of conservatism. Therefore in one year cost basis may be taken, whereas in
another year market price may be taken. This principle contravenes the principle of
consistency.
4. The balance sheet is largely the result of the personal judgement of the accountant with
regard to the adoption of accounting policies and as such objectivity factor is lost.
5. Financial accounting can be understood only by persons who have accounting
knowledge.
6. Inter firm comparison and comparative study of two periods is not possible under this
system as required past information cannot be made available.
7.  Financial accounting does not indicate the cost behaviour, therefore cost control cannot
be adopted.
COST ACCOUNTING
 DEFINITION​: According to the ​Institute of Cost and Works Accountants (ICWA), L ​ ondon,
Cost accounting is “ the process of accounting for costs from the point at which expenditure is
incurred or committed to the establishment of its ultimate relationship with cost centers and cost
units. In its widest usage it embraces the preparation of statistical data, the application of cost
control methods and the ascertainment of the profitability of activities carried out or planned.”
OBJECTIVES OF COST ACCOUNTING :
1. To aid in the development of long range plans by providing cost data that acts as a basis
for projecting data for planning.
2. To ensure efficient cost control by communicating essential data costs at regular intervals
and thus minimize the cost of manufacturing.
3. Determine cost of products or activities, which is useful in the determination of selling
price or quotation.
4. To identify profitability of each product, process, department etc of the business
5.  To provide management with information in connection with various operational
problems by comparing the actual cost with standard cost, which reveals the
discrepancies or variances.
LIMITATIONS OF COST ACCOUNTING
 Cost Accounting like other branches of accountancy is not an exact science but is an art which
was developed through theories and accounting practices based on reasoning and commonsense.
These practices are dynamic. Hence, it lacks a uniform procedure applicable to all the industries
across. It has to be customized for each industry, company etc.
MANAGEMENT ACCOUNTING
DEFINITION ​: According to M.A.Sahaf, Management Accounting is “ a system for gathering,
summarizing, reporting and interpreting accounting data and other financial information
primarily for the internal needs of the management. It is designed to assist internal management
in the efficient formulation, execution and appraisal of business plans.”
Management Accounting covers not only the use of financial data and a part of costing theory
but extends beyond these aspects. It ​scope ​covers
1. Financial accounting
2. Cost accounting
3. Financial statement analysis
4. Budgeting
5. Inflation accounting
6. Management reporting
7. Quantitative techniques
8. Tax accounting
9. Internal audit
10.  Office services
FUNCTIONS OF MANAGEMENT ACCOUNTING :
1. To help the management in planning, forecasting and policy formulation
2. To help in analysis and interpretation of financial information
3. To help in decision making- long term as well as short term
4. To help in controlling and coordinating the business operations
5. To communicate and report the operational results to the share and stock holders of the
business.
6. To motivate the employees by encouraging them to look forward
7.  To help the management in tax administration
TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING
1. Financial planning
2. Analysis of financial statements
3. Cost accounting
4. Standard costing
5. Marginal costing
6. Budgetary control
7. Funds flow analysis
8. Management reporting
9.  Statistical analysis
ADVANTAGES OF MANAGEMENT ACCOUNTING :
1. It increases efficiency of business operations
2. It ensures efficient regulation of business activities
3. It ensures utilization of available resources and thereby increases the return on capital
employed.
4. It ensures effective control of performance
5.  It helps in evaluating the efficiency of the companies’ business policies
LIMITATIONS OF MANAGEMENT ACCOUNTING :
 1. It is based on historical data, and it suffers from the drawbacks of the financial
statements.
2. The application of management accounting tools and techniques requires people who are
knowledgeable in subjects such as accounting, costing, economics, taxation, statistics,
mathematics, etc.
3. Though management accounting attempts to analyse both qualitative and quantitative
factors that influence a decision, the elements of intuition in managerial decision making
have not been completely eliminated.
4.  The installation of management accounting system is expensive and hence not suitable
for small firms.
USERS OF FINANCIAL ACCOUNTS
Many people use financial statements for varied purposes. The table below summarises the main
user groups and provides examples of their areas of interest in accounts:
 

ACCOUNTING PRINCIPLES (GAAP – GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES)
 Accounting principles, rules of conduct and action are described by various terms such as
concepts, conventions, tenets, assumptions, axioms, postulates, etc.
Accounting concepts
The term ‘Concept’ is used to mean necessary assumptions and ideas which are fundamental to
accounting practice. The various accounting concepts are as follows:
Business Entity concept : For accounting purposes, the proprietor of an entreprise is always
considered to be separate and distinct from the business which he/she controls
Dual aspect concept ​: Every business transaction involves two aspects – a receipt and a
payment. In other words, every debit has an equal and corresponding credit. The dual aspect
 concept is expressed as : Capital + Liabilities = Assets. This is known as ‘the accounting
equation’.
Going concern concept ​:Under this assumption, the entreprise is normally viewed as a going
concern. It is assumed that the entreprise has neither the intention nor the necessity of
liquidation of of curtailing materially the scale of its operations. That is why assets are valued
on the basis of going concern concept and are depreciated on the basis of expected life rather
than on the basis of market value.
Accounting period concept ​: ‘Accounting year’ is the period of 12 months for which accounts
are to be prepared under the Companies Act and Banking Regulation Act.
Money measurement concept :​ In accounting, every event or transaction which can be
expressed in terms of money is recorded in the books of accounts. This concept does not record
any fact or happening, even though it is important to the business, in the books of accounts if it
cannot be expressed in terms of money. And as per this concept, a transaction is recorded at its
money value on the date of occurrence and the subsequent changes in the money value are
conveniently ignored.
Historical Cost concept ​: The underlying idea of cost concept is –i) asset is recorded at the
price paid to acquire it, that is, at cost and ii) this cost is the basis for all subsequent accounting
for the asset. Fixed assets are shown in the books of accounts at cost less depreciation. Current
assets are periodically valued at cost price or market price whichever is less.
Revenue recognition concept ​: In accounting, ‘revenue’ is the gross inflow of cash, receivables
or other considerations arising in the course of an enterprise from the sale of goods, from the
rendering of services and from the holding of assets. In the case of revenue, the important
question is at what stage, the transaction should be recognized and recorded.
Periodic matching of cost and revenue concept :​ After the revenue recognition, all costs,
incurred in earning that revenue should be charged against that revenue in order to determine
the net income of the business.
Verifiable objective evidence concept ​: As per this concept, all accounting must be based on
objective evidence. In other words, the transactions should be supported by verifiable
documents.
Accrual concept :​ Under this concept, revenue recognition and costs for the relevant period,
depends on their realisation and not on actual receipt or payment. In relation to revenue, the
accounts should exclude amounts relating to subsequent period and provide for revenue
recognised, but not received in cash. Like wise, in relation to costs, provide for costs incurred
but not paid and exclude costs paid for subsequent period.
 
Accounting conventions
The term ‘convention’ is used to signify customs or traditions as a guide to the preparation of
accounting statements. The various accounting conventions are as follows.
Convention of disclosure : This convention implies that accounts must be honestly prepared
and all material information must be disclosed therein. The term ‘disclosure’ implies that there
should be a sufficient disclosure of information which is of material interest to proprietors,
potential creditors and investors. This concept also applies to events occurring after the balance
 sheet date and the date on which the financial statements are authorised for issue, which are
likely to have a substantial influence on the earnings and financial position of the enterprise.
Their non-disclosure would affect the ability of the users of such statements to make proper
evaluations and decisions.
Convention of materiality ​: As per this convention, financial statements should disclose all
items which are material enough to effect evaluations or decisions. The American Accounting
Association (AAA) defines ‘ materiality’ as “an item should be regarded as material if there is
reason to believe that knowledge of it would influence the decision of informed investor”.
Unimportant items can be either left out or merged with other items. Sometimes, items are
shown as footnotes or in parentheses according to their relative importance.
Convention of consistency ​: Consistency, as used in accounting means that persistant
application of the same accounting procedures or method by a given firm from one time period
to the next so that the financial statements of different periods can be compared meaningfully.
This convention thus implies that in order to enable the management to draw important and
meaningful conclusions of performance over a period or between different firms, accounting
practices should remain unchanged for a fairly long time.
Convention of conservatism ​: According to this convention, the accountant should be
conservative in his/her approach in his opinions and selection of procedure. In accounting,
conservatism refers to the early recognition of unfavourable events. For instance, all possible
and expected losses must be provided for. On the other hand, gains and other financial benefits
should not be provided for unless they are realised. In other words, ‘anticipate no profit and
provide for all possible losses’.
 
PROFIT AND LOSS ACCOUNT AND RELATED CONCEPTS:
The starting point in understanding the profit and loss account is to be clear about the
meaning of “profit”. Profit is the reward for taking risk. Profit has an important role in
allocating resources (land, labour, capital and enterprise). Put simply, falling profits signal
that resources should be taken out of that business and put into another one; rising profits
signal that resources should be moved into this business. The main task of accounts, therefore,
is to monitor and measure profits. Profit = Revenues less Costs. So monitoring profit also
means monitoring and measuring revenues and costs. It has two parts.
1. Recording financial data. This is the ‘book-keeping’ part of accounting.
2. Measuring the result. This is the ‘financial’ part of accounting.
Profits are ‘spent’ in three ways.
1. Retained for future investment and growth.
2. Returned to owners eg a ‘dividend’.
3.  Paid as tax.
Components of Profit and Loss Account
The Profit & Loss Account aims to monitor profit. It has three parts.
1. The Trading Account: This records the money in (revenue) and out (costs) of the
business as a result of the business’ ‘trading’ i.e. buying and selling. This might be
buying raw materials and selling finished goods; it might be buying goods wholesale
and selling them retail. The figure at the end of this section is the Gross Profit.
 2. The Profit and Loss Account : This starts with the Gross Profit and adds to it any
further costs and revenues, including overheads. These further costs and revenues
which may be in the nature of other operating, administrative, selling and distribution
expenses. This account also includes expenses which are from any other activities not
directly related to trading (non-operating). An example is interest on investments.
Thus, profit and loss account contains all other expenses and losses, incomes and
gains of the business for the accounting year for which financial statements are being
prepared. In this process, it follows the mercantile basis of accounting (i.e., it takes into
account all paid and payable expenses, and received and receivable receipts). The net
result of profit and loss account is called as net profit. The main feature of profit and
loss account is that it takes into account all expenses and incomes that belong to the
current accounting year and excludes those expenses and incomes that belong either to
the previous period or the future period.
3.  The Appropriation Account. This shows how the profit is ‘appropriated’ or divided
among the three uses mentioned above.
INTRODUCTION TO THE TRADING ACCOUNT:
 A Trading account is a statement prepared by a firm to ascertain its trading results for the
accounting year. Just like Profit & Loss account, it is also prepared for the year ending. It
takes into account the various trading expenses (usually all direct expenses) and incomes. The
net result will be either trading / gross profit or gross loss. In case of a manufacturing
concern, it will prepare an additional statement called a manufacturing account. A
manufacturing account is prepared by a manufacturer to ascertain the cost of goods
manufactured during the current accounting year.
FORMAT OF MANUFACTURING ACCOUNT:
Manufacturing account of ABC. Ltd for the year ending…..
 

FORMAT OF TRADING ACCOUNT

 Trading account of ABC. Ltd for the year ending…..
Uses
 

Uses of the Profit and Loss Account.

 1. The main use is to monitor and measure profit. This assumes that the information
recording is accurate. Significant problems can arise if the information is inaccurate,
either through incompetence or deliberate fraud.
2.  Once the profit or loss has been accurately calculated, this can then be used for
comparison or judging how well the business is doing compared to itself in the past,
compared to the managers’ plans and compared to other businesses.
The format of a typical profit and loss account is as follows:

sheet is a statement that is prepared usually on the last day of the accounting year, showing
the financial position of the concern as on that date. It comprises a list of assets, liabilities and
capital. An asset is any right or thing that is owned by a business. Assets include land,
buildings, equipment and anything else a business owns that can be given a value in money
terms for the purpose of financial reporting. To acquire its assets, a business may have to
obtain money from various sources in addition to its owners (shareholders) or from retained
profits. The various amounts of money owed by a business are called its liabilities.
To provide additional information to the user, assets and liabilities are usually classified in the
balance sheet as:
Current:​ those due to be repaid (​Current liabilities)​ or converted into cash within 12 months of
the balance sheet date (​Current Assets)​ .
Long-term:​ those due to be repaid (​Long term liabilities)​ or converted into cash more than 12
months after the balance sheet date (​Fixed Assets)​ .
 
Fixed Assets
 A further classification other than long-term or current is also used for assets. A “fixed asset”
is an asset which is intended to be of a permanent nature and which is used by the business to
provide the capability to conduct its trade. Examples of “tangible fixed assets” include plant &
machinery, land, buildings and motor vehicles. “Intangible fixed assets” may include
goodwill, patents, trademarks and brands - although they may only be included if they have
been “acquired”. Investments in other companies which are intended to be held for the
long-term can also be shown under the fixed asset heading.
Capital
Apart from borrowing from banks and other sources, all companies receive finance from their
owners. This money is generally available for the life of the business and is normally only
repaid when the company is “wound up”. To distinguish between the liabilities owed to third
parties and to the business owners, the latter is referred to as the “capital” or “equity capital”
of the company. In addition, undistributed profits are re-invested in company assets (such as
stocks, equipment and the bank balance). Although these “retained profits” may be available
for distribution to shareholders - and may be paid out as dividends on a future date - they are
added to the equity capital of the business in arriving at the total “equity shareholders’ funds”.
 At any time, therefore, the capital of a business is equal to the assets (usually cash) received
from the shareholders plus any profits made by the company through trading that remain
undistributed
The basic functions of a balance sheet are:
1. It gives the financial position of a company on any given date
2. It gives the liquidity picture of the concern
3.  It gives the solvency position of the concern
The basic components of a balance sheet are:

 Pro-formaof a Balance sheet is as follows:

Balance sheet of ABC Ltd as on 31st December 2005
 
ACCOUNTING MECHANICS
INTRODUCTION
The financial accounting has evolved over the number of years into a specialized profession. The
process of accounting starts with recording in the Journal, preparing ledger accounts, trial
balance and final accounts and at the end of this process, the financial statements are circulated
to the stakeholders and shareholders. Proper pricing and valuation of inventory and adoption and
maintenance of sound depreciation policy also contribute to maximize the earnings of the
concern.
LEARNING OBJECTIVES
After going through this chapter, the reader is expected to –
1. Understand the accounting cycle that is followed by all the businesses
2. Understand the basic records that every business maintains
3. Understand when revenue is recognized
4. Understand the concept of inventory pricing and valuation
 
5. Understand how depreciation is calculated and what are the various methods available for
calculating for depreciation.
BASIC RECORDS
The ​American Institute of certified public accountants (AICPA) d​ efines accounting as “is the
art of recording, classifying and summarizing in a significant manner and in terms of money
transactions and events which are in part at least of a financial character and interpreting the
results thereof”.
From the above definition the accounting process is very clear. This process of recording the
transactions in appropriate books, classifying the various accounts and summarizing in the form
of various financial statements and communicating them to all stock holders and stake holders is
known as the accounting cycle.
Journal is known as the original book of entry. It is a book in which a transaction is recorded for
the first time in the form of a journal entry. Whenever a transaction happens it is immediately
recorded in the journal. Ledger is a book where various transactions are grouped and classified
into several ledger accounts. The closing balances of these accounts give the input for the
preparation of trial balance. Ledger accounts are prepared periodically according to the need.
After ledger accounts are prepared, a statement showing the arithmetic accuracy of the recording
of information is prepared with the help of closing balances of ledger accounts. This statement is
known as a trial balance. This is usually prepared before the preparation of final accounts. The
matching of debit and credit column totals implies that the recording is accurate.
Once the trial balance is prepared, the next step is preparation of financial statements. The first
statement to be prepared is trading account, which shows the gross profit made by the concern
for the accounting year. After preparing the trading account, every business has to prepare the
profit and loss account which shows the net profit earned by the company during the current
year.
 
The last statement as the Balance sheet is prepared to show the financial position of the business
on any given day, usually the last day of the financial year. This statement shows the closing
balances of various assets and liabilities of the business.
PREPARATION OF FINANCIAL STATEMENTS
Every business has to prepare its own financial statements at the end of each accounting year.
Financial statements are the statements that show the operational results of a business for a given
period and also give the financial position of a concern on a given date. The financial statements
prepared by a manufacturing firm include – Manufacturing account, Trading account, Profit and
Loss account and Balance sheet. The financial statements prepared by a trading firm include –
the Trading account, Profit and loss account and Balance sheet Trading account is a statement
that is prepared for a period of one year.
It shows all manufacturing or factory expenses on the debit side and shows sales revenue and
closing stock on the credit side. The expenses are matched against the revenues and the result
may be Gross profit or Gross Loss. This is carried forward to the Profit & Loss account.
Profit and Loss account is the second statement that is prepared by all the businesses after the
trading account. This account shows all expenses other than manufacturing expenses, (office and
administration expenses, selling and distribution expenses) and both operating and non-operating
losses on its debit side. It shows all incomes and gains, both operating and non-operating on its
credit side. The matching of both expenses & losses with the incomes & gains gives the
operational results for the year.
Usually all businesses follow the mercantile system of accounting (accrual system) while
preparing their final accounts. When expenses are less than the incomes, the resulting figure is
known as Net profit and if the expenses are more than the incomes, then it will result in Net
Loss. This net profit or net loss is carried forward to the Balance sheet to be adjusted against the
capital.
Balance sheet is a statement showing the financial position of a business on a given date, which
is usually the last day of the financial year / accounting year. This statement shows the balances
of all liabilities it owes to the outsiders on the debit side and the balances of assets on the credit
side of the statement. All outstanding expenses which belong to the current year but have not yet
been paid will be shown on the liabilities and all expenses which are paid for the future period
are shown on the credit side of the statement. Similarly, all incomes which belong to the current
year, but have not yet been received will be shown on the credit side of the statement and all
incomes which belong to the future but have already been received in advance are shown on the
debit side of the statement.
The general rule is that both the sides must be the same. While preparing the final accounts, all
the adjustments which have not been made to the balances must be adjusted.
Illustration
The following trial balance is extracted from the books of Mr.Pillai on 31.03.2002

Adjustments:
1. Stock on hand on 31.3.2002 Rs.3,250
2. Depreciate Buildings @5% pa, Furniture @ 10% pa, Motor Vehicles @ 20% pa
3. Rs.85 is due for interest on bank overdraft
4. Salaries Rs.300 and taxes Rs.200 are outstanding
5. Insurance premium amounting to Rs.100 is prepaid
6. One third of the commission received is in respect of work to be done next year
7. Write off a further sum of Rs.100 as bad debts from debtors and create provision for
doubtful debts @ 5% on debtors Prepare a trading and Profit & Loss account and Balance
sheet of the company.
Solution:
Trading and P&L account for the year ended 31st March 2002
Balance sheet of Mr.Pillai as at 31st March 2002

Illustration 2
From the following Trial Balance of Evergreen and Company Limited, prepare Trading, Profit
and Loss Account and Balance Sheet. Trial Balance as on 31-12-2005:
Adjustments:
(1) Closing inventory as on 31-12-2005 : Rs. 50,000
(2) Outstanding wages : Rs. 5,000
(3) Depreciation on Plant & Machinery at 10% Furniture at 5%
Solution:
Trading and P&L account for the year ended 31st March 2002

Balance sheet as at 31st March 2002

Illustration 3
From the following figures extracted from the books of Shri Ram, you are required to prepare a
Trading and Profit and Loss Account for the year ended 31st March, 2005 and a Balance Sheet
as on that date after making the necessary adjustments:
Adjustments:
1. Stock on 31st March, 2005 was valued at Rs.72,600
2. A new machine was installed during the year costing Rs.15,400, but it was not recorded in the
books as no payment was made for it. Wages Rs.1,100 paid for its erection have been debited to
wages account.
3. Depreciate:
Plant and Machinery by 33 1/3 %
Furniture by 10%
Freehold Property by 5%
4. Loose tools were valued at Rs.1,760 on 31.3.2005
5. Of the Sundry Debtors Rs.600 are bad and should be written off.
6. Maintain a provision of 5% on Sundry Debtors for doubtful debts.
7. The manager is entitled to a commission of 10% of the net profits after charging such
commission.
Solution:
Shri Ram
TRADING AND PROFIT & LOSS ACCOUNT
For the year ended 31.3.2005
Shri Ram
BALANCE SHEET as at 31.3.2005

Illustration 4
The following is the Tribal Balance of Omkar, as on 31st March 2005. You are required to
prepare the Trading and Profit and Loss Account for the year ended 31st March, 2005 and
Balance Sheet as on that date after making the necessary adjustments:
The following adjustments are to be made:
1. Stock on 31st March, 2005 was valued at Rs.7,25,000
2. A Provision for Bad and Doubtful Debts is to be created to the extent of 5 percent on Sundry
Debtors
3. Depreciate:
Furniture and Fittings by 10%
Motor Car by 20%
4. Omkar had withdrawn goods worth Rs.25,000 during the year
5. Sales include goods worth Rs.75,000 sent out to Shanti & Company on approval and
remaining unsold on 31st March, 2005. The cost of the goods was Rs.50,000.
6. The Salesmen are entitled to a Commission of 5% on total sales
7. Debtors include Rs.25,000 bad debts
8. Printing and Stationery expenses of Rs.55,000 relating to 2003 - 2004 had not been provided
in that year but was paid in this year by debiting outstanding liabilities
9. Purchases include purchase of Furniture worth Rs.50,000
OMKAR
TRADING AND PROFIT AND LOSS ACCOUNT
for the year ended 31st March, 2005
OMKAR
BALANCE SHEET As on 31.3.2005

Working Notes
1. Both Sales and Sundry Debtors have been reduced by Rs.75,000 representing invoice
value of goods sent on approval Rs.50,000 have been added to the closing stock being the
cost of goods sent on approval
2. Last year’s short provision for Printing and Stationery has not been charged to the current
year’s Profit and Loss Account. It is preferable to charge it directly to in Capital Account.
3. Sundry Debtors = Rs.5,00,000 = (Rs.75,000 Goods on Approval + Rs.25,000 Bad Debts)
= Rs.4,00,000.
Illustration 5
The Trial Balance of Unified Corporation, New Delhi, as on 30.09.2006 is as below:
Adjustments
1. Provide for interest @10% per annum on Capital. (No interest on drawings need be provided.)
2. A motor car purchased on 1.4.2005 for Rs.6, 000 has been included in “Purchase”.
3. Provide depreciation:
Machinery @ 10% p.a.
Motor Car @ 20% p.a.
Furniture and Fixtures @ 10% p.a.
4. Provision for unrealized rent in respect of a portion of the office sublet ar Rs.50 per month
from 1.4.2004 has to be made
5. Sundry Debtors include bad debts of Rs.400 which must be written off.
6. Provision for Bad and Doubtful Debts as on 30.9.2006 should be maintained at 10% of the
Debtors.
7. A sum of Rs.2,000 transferred from the Current Account with Bank of Bikaner Ltd., to Fixed
Deposit Account on 1.2.1999 has been passed through books. Make suitable adjustment and
provide for accrued interest @ 6% p.a.
8. Stock as on 30.9.1999. - Finished Goods Rs.5,000 Raw Materials Rs.1,000/- Work–in–
Progress Rs.5,500.
Prepare the Manufacturing, Trading and Profit and Loss Account for the year ended 30.9.1999
and Balance Sheet as on that date after making the necessary adjustments (Journals entries are
not required)
Solution:
Messrs Jagfay Corporation, New Delhi
MANUFACTURING ACCOUNT
for the year ended 30.9.2006.

TRADING AND PROFIT AND LOSS ACCOUNT For the year ended 30.9.2006

BALANCE SHEET
As on 30.9.2006
 

REVENUE RECOGNITION & MEASUREMENT

Under accrual system of accounting revenues from the sale of merchandise are considered to be
earned in the accounting year in which the ownership of goods passes from the seller to the
buyer. As a result even though cash for the sale may not be collected until the following period,
the revenue is recognized as being earned at the time of sale. Usually the physical delivery of
goods occurs at the same time as the sale of the goods.
Sales revenue is regarded as earned if the following conditions are satisfied.
1. The seller has passed the legal ownership of the goods to the buyer
2. The selling price of the goods has been established
 
3. The buyer has paid the purchase price of the goods or it is certain that he will pay the
price. If any of these conditions are not fulfilled revenue cannot be recorded.
MATCHING REVENUES AND EXPENSES
 
During the process of preparing the trading and profit loss account, the relevant expenses and
revenues are matched to arrive at the operating results of the business i.e. profit or loss. Expenses
may be categorized as manufacturing expenses, office and administration expenses and selling &
distribution expenses. Revenues may arise from sale of products and services or from sale of
fixed assets and income from investments. In trading account the manufacturing expenses are
matched against the sales and closing stock to arrive at the gross profit or loss. In profit and loss
account the office administration expenses, selling & distribution expenses along with other
non-operating expenses or less are matched against the operating and non-operating incomes
arising out of the business. This results in net profit or net loss. Usually the mercantile system of
accounting is adopted while preparing the financial statements. All the receivables and payables
are considered and shown in the appropriate statements provided they belong to the current year.
INVENTORY PRICING AND VALUATION
Inventories refer to unsold goods purchased or manufactured. According to the Accounting
Standard :2 (Revised), inventories are assets :
a. held for sale in the ordinary course of business ;
b. in the process of production for such sale or
c. in the form of materials or supplies to be consumed in the production process of in the
rendering of services.
Thus, the term inventory includes stock of (i) finished goods (ii) work-in-progress and (iii) raw
materials and components. In case of a trading concern, inventory primarily consists of finished
goods while in case of a manufacturing concern, inventory consists of raw materials,
components, stores, work-in-process and finished goods.
Objectives of inventory valuation
1. Determination of income
2. Determination of financial position
Inventory Systems :
1) Periodic inventory system :
Under this system the merchandise inventory account is updated only periodically, after a
physical count has been made. Usually, the physical count takes place at the end of the
accounting period. Many departmental stores use this system.
2) Perpetual inventory system :
Perpetual inventory system has been defined as ‘ a system of record maintained by the
controlling department, which reflects physical movement of stocks and their current balances
i.e. it is technique of controlling stock by maintaining stock records, such as bin card in stores
and stores ledger in accounts, in such a manner that the stock balance is available at any point of
time (perpetually)’. Under this system stores ledger is recorded after each transaction of receipt,
issue or transfer. This facilitates regular stock verification physically which obviates the
stoppage of work for stock taking.
The success of perpetual inventory system depends on (1) maintenance of bin cards and stores
ledger up-to-date (2) reconciliation of quantity balance as shown by bin cards with that in stores
ledger (3) continuous verification of physical stock with bin card quantity (4) reconciliation of
discrepancies arising out of physical verification, as well as comparison with stores ledger (5)
remedial action to remove the cause of discrepancies (6) correction of stock records.
Methods of valuation of inventories or Pricing Issues of Material :
Materials issued from stores should be valued at the rate they are carried in stock. The various
methods for pricing material issued from stores are classified as follows :
1) Specific identification method
This method is applicable to materials purchased for a particular job, order or process, and
identified when received either in stores or in the shop floor directly. Such materials are usually
non-standard and actual cost is charged to the job/order/process concern. No question of
difference arises out of such pricing.
2) First in First Out (FIFO)
This method assumes that materials are used in the order in which they are received in stores
(chronologically). Hence the price of the first lot is charged to all issues till the stock lasts. As a
result closing stock will be valued at latest purchase price. This method is useful in the slow
moving or less frequently used materials of bulk items and high unit costs.
3) Last In First Out (LIFO)
This method assumes that the last receipt of stock is issued first. Hence issues are priced at
current prices, while stock remains at historical cost. This method is useful under the inflationary
conditions of the market. This method is useful for materials used less frequently and under
inflationary conditions.
4) Highest in First Out (HIFO)
Under this method issues are valued at their highest price i.e. costliest items are issued at first,
and inventory is kept at lowest possible prices. Thus a secret reserve is created by undervaluing
stock. This method is complicated to administer if there are numerous purchases within a short
period. This method is mainly used for monopoly products or cost plus contracts.
5) Base Stock Method
This method assumes that a minimum stock is always carried at original cost. The issues are
priced using one of the conventionals method like FIFO, LIFO, etc, at actual costs. This method
will be suitable for tanning, smelting, oil refineries, etc. which use basic raw materials like hides,
non-ferrous metal, and crude oil for their products.
6) Next In First Out (NIFO)
Under this method issues are valued at the price expected the next purchase i.e. price of material
which has been ordered but not yet received. Problem may arise if the price ruling at the time of
supply differs from the purchase order price. However this method attempts to value issues at
nearest to current market prices.
7) Weighted Average Price Method
 
This method gives due importance to quantities received also. Issue prices are calculated at
average cost price of materials in hand i.e. by dividing the value of materials in stock by the
quantities in stock. Weighted average price remains the same till the next issue is received. Thus
issue prices are derived at the time of receipt but not at the time of issues. This method is suitable
where wide fluctuation of prices occurs as it evens out prices over the accounting period.
NET REALISATION VALUE :
According to International Accounting Standard 2 (IAS 2) the Net realizable value means “ the
estimated selling price in the ordinary course of business less costs of completion and less costs
necessarily to be incurred in order to make the sale”.
 
Under this method, Inventories are valued at cost or net realizable value whichever is less.
FIXED ASSETS AND DPERECIATION ACCOUNTING
Fixed Assets :
Fixed assets refer to the various tangible and intangible assets used in the business for producing
and selling the products or rendering services to the customers. Fixed assets are characterized by
their long term investment in the business.
Depreciation :
Depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset
due to use, wear and tear, obsolescence or effluxion of time.
Characteristics of Depreciation :
1. It refers to the fall or shrinkage in the true value of an asset
2. It refers to a fall in the book value of asset, which may or may not be equal to the market
value or the cost price of the asset.
3. The fall in the book value in a slow and gradual process
Need for providing Depreciation :
1. To ascertain the profits
2. To show the assets at their proper value
3. To create funds for replacement of assets
4. Provision of depreciation is a statutory need u/s 205 of the Indian Companies Act, 1956.
5. To spread over the cost of the fixed asset
6. To show correct financial position
7. To compute tax liability
8. To determine product cost for managerial decision making
Distinction between depreciation, depletion and amortization :
Depreciation is calculated on fixed, physical and tangible assets. Depletion refers to the physical
exhaustion of natural resources Amortization refers to writing -off of long term assets or
intangible assets. Such as leaseholds, copy rights, etc.
Causes of Depreciation :
1. Physical deterioration (wear & tear) (erosion, rust, rot and decay)
2. Economic factors (obsolescence & inadequacy)
3. Time factors – (eg. Intangible fixed assets such as patent rights)
 4. Depletion
Computation of Depreciation :
1. Depreciation base
2. Useful/Economic life
3. Depreciation method
Methods of Depreication :
1. Fixed installment or Straight line method
2. Diminishing balance or Written down value method
3. Sum of digits method
4. Annuity method
5. Depreciation fund/Sinking fund method
6. Insurance policy method
7. Revaluation method
8. Activity method (i) Production unit method (ii) Machine Hour rate method (iii) Service
unit (hrs) method (iv) Depletion’s method.
Illustration
1. A van was bought for Rs.1,86,000 on 1st Jan 2002. Extra partitions and a new counter were
fitted to make use of it as a traveling shop. The additional cost was Rs.18,000. Repairs during the
year amounted to Rs.2,000. The van was depreciated on its capital cost @ 15%. per annum show
the asset account on 31st Dec 2002
Solution:

Illustration: 2
Ranga Enterprises purchased second hand machinery on 1st April, 2005 for Rs.3,70,000 and
installed at a cost of Rs.30,000. On 1st October, 1998, it purchased another machine for
Rs.1,00,000 and on 1st October, 1999, it sold off the first machine purchased in 1997 for
Rs.2,80,000. On the same date it purchased a machinery fro Rs.2,50,000. On 1st October, 2000,
the second machinery purchased for Rs.1,00,000 was sold off for Rs.20,000.
In the beginning depreciation was provided on machinery at the rate of 10% p.a. on the original
cost each year on 31st March. From the year 1998-99, however, the trader changed the method
of providing depreciation and adopted the written down value method, the rate of depreciation
being 15% p.a.
Give the Machinery Account for the period 1997 to 2001.
Solution:
In the books of Giri Raj Enterprises
MACHINERY ACCOUNT

INTANGIBLE ASSETS
Intangible assets refer to those assets which cannot be seen or touched, such as goodwill. They
do not generate goods or services directly. They reflect the rights of the firm and include patent
rights, copy rights, trade marks and goodwill.

COST ACCOUNTING AND MANAGEMENT ACCOUNTING

1. INTRODUCTION
Cost Accounting is a major accounting information bearing on the problems of internal
managerial control. Financial accounts are unable to meet informational needs about the cost
information required for internal decision making and control. It is very important to develop an
accounting system by which cost information may be developed.
2. LEARNING OBJECTIVES
After going through this chapter, the reader is expected to –
1. Understand the basic concepts of cost accounting
2. Understand the nature of various elements of cost
3. Understand how cost sheet is prepared
4. Understand the various methods of costing such as marginal costing,
its relationship with other cost systems, etc.
5. Understand the nature of cost volume profit analysis and related concepts
6. Understand the various concepts covering the break even analysis
such as – its merits, demerits, concepts, applications, etc.
7. Understand the meaning of standard costing, and its applications
8. Understand the term variance analysis – what it is, how it is done, the
various types of variances, etc.

3. DEFINITION OF COST ACCOUNTING

DEFINITION​: According to the ​Institute of Cost and Works Accountants (ICWA), ​London,
Cost accounting is “ the process of accounting for costs from the point at which expenditure is
incurred or committed to the establishment of its ultimate relationship with cost centers and cost
units. In its widest usage it embraces the preparation of statistical data, the application of cost
control methods and the ascertainment of the profitability of activities carried out or planned.”

4. ​OBJECTIVES OF COST ACCOUNTING :

1) To aid in the development of long range plans by providing cost data that acts as a basis for
projecting data for planning.
2) To ensure efficient cost control by communicating essential data costs at regular intervals and
thus minimize the cost of manufacturing.
3) Determine cost of products or activities, which is useful in the determination of selling price
or quotation.
4) To identify profitability of each product, process, department, etc. of the business
5) To provide management with information in connection with various operational problems by
comparing the actual cost with standard cost, which reveals the discrepancies or variances.

5. ADVANTAGES OF COST ACCOUNTING

1. It aids in effective decision making
2. It helps in cost reduction
3. It is helpful in fixation of selling price
4. It leads to effective inventory control
5. It helps in the reduction of wastage

6. LIMITATIONS OF COST ACCOUNTING

Cost Accounting like other branches of accountancy is not an exact science but is an art which
was developed through theories and accounting practices based on reasoning and commonsense.
These practices are dynamic and evolving. Hence, it lacks a uniform procedure applicable to all
the industries across. It has to be customized for each industry, company, etc.
1. It is expensive and as such may not be useful for small businesses
2. It is based on estimations.
3. It may not be applicable to all types of industries.
4. Sometimes, the errors in financial statements may get reflected in cost
accounts.
7. ELEMENTS OF COST

There are three elements of cost – material, labour and expenses or

overheads. These are further divided into direct and indirect material,
direct and indirect labour and direct and indirect expenses. All direct
costs (material, labour and expenses) are traceable to the final product
or service of the firm. All indirect costs (material, labor and expenses)
cannot be traced to the final product or service of the firm. They are
called overheads. These overheads are further classified into – factory
overheads, office and administration overheads and selling & distribution
overheads.
8. COST CONCEPTS / CLASSIFICATION OF COSTS
1. According to functions
​ roduction cost / factory cost / manufacturing cost
•P
•A​ dministration cost / office cost
•S ​ elling cost
•D ​ istribution cost
2. According to the nature of the costs
•F ​ ixed cost
•V ​ ariable cost
•S ​ emi – variable or semi-fixed cost
•S ​ tep costs
3. According to the controllability
•C ​ ontrollable cost (controllable through authority and responsibility
laid down by the organizational structure)
•U ​ ncontrollable cost(Uncontrollable through authority and
responsibility laid down by the organizational structure)
4. According to normality
•N ​ ormal cost
•A ​ bnormal cost
5. According to relevance to decision making
•S ​ hut down cost (fixed cost)
•S ​ unk cost (historical or past paid cost)
• I​ mputed cost (non- cash cost which is calculated)
•R ​ eplacement cost (cost of replacing assets)
•C ​ onversion cost(cost of converting raw material into finished stock)
6. Others
•O ​ ut of pocket cost (Cash expenses)
•R ​ elevant cost and irrelevant cost (relevant to the decision at hand)
•O ​ pportunity cost (cost of an opportunity lost)
• I​ mputed or Hypothetical cost (non-cash expenditure)
•D ​ irect cost and indirect cost (based on traceability to the final product
or service)
•P ​ roduct costs and period costs (fixed costs and variable costs)
•D ​ ecision making costs and accounting costs
•A ​ voidable / escapable costs and unavoidable
•D ​ ifferential, incremental or decremental costs
•T ​ raceable, untraceable / common costs
• J​ oint costs and common costs etc
9. METHODS OF COSTING:
1. Job costing: Job costing is the basic costing method applicable to those
industries where the work consist of separate contracts, jobs, or batches,
each of which is authorized by a specific order or contract.
2. Contract costing: It is the form of specific order costing, generally
applicable where work is undertaken to customer’s special requirements
and each order is of long duration such as a building construction, etc.
3. Batch costing: It is that form of specific order costing which applies
where similar articles are manufactured in batches either for sale or for
use within the undertaking.
4. Process costing: This method of costing is applicable where goods or
services result from a sequence of continuous or repetitive operations or
processes and products are identical and cannot be segregated
5. Operation costing: It refers to those methods where each operation in
each stage of production or process is separately calculated. Thereafter
the cost of finished unit is determined
6. Unit costing/ Output costing / Single costing: This method is used when
the production is uniform and identical and a single article is produced.
The total production cost is divided by the no. of units produced to get
unit or output cost Ex: mining, breweries, etc.
7. Operating costing: This method is employed where expenses are
incurred for providing services such as those rendered by transport cos,
electricity cos, etc.
8. Departmental costing: This refers to the method of ascertaining the cost
of operating a department or cost centre. Total cost of each department
is ascertained and divided by total units produced in that department to
arrive at unit cost.
9. Multiple / Composite costing: Under this method, the cost of different
sections of production are combined after finding out the cost of each
and every part manufactured. This method is applicable to companies
where a product comprises many assembled parts.
10. Activity based costing: Under this type of costing, costs are not
allocated through various production and service departments. Instead,
they are traced to their originating activities in the first stage and in the
second stage, they are absorbed into the products according to the
extent of activities demanded by the products. The activity based
costing system is a system based on activities linking spending on
resources to the products /services produced /delivered to customers.
This system is also known as ABC /ABM system. The major benefits of
adopting this system include – i) it does not under cost complex low
volume products and over cost high volume simple products because the
cost drivers used by ABC system are unrelated to volume, ii) It may
result in improved cost control as the costs are broken into a no. of
activities rather than into a few cost pools. The major limitations of this
system include – i) It is very expensive to develop and maintain, ii) it
does not measure the incremental costs required to make a product as it
uses full costing (which includes fixed costs also) instead of using
incremental costs.
11. Target costing : It is an integrated approach to determine product features,
product price, product costs and product design, that helps to ensure a
company will earn reasonable profit on new products. The components
of the target costing process include (1) Target cost, which is the cost of
the resources that should be consumed to create a product, that can be
sold at a target price (2) Target price – it is the estimated price for a
product or service that potential customers will pay. (3) Target Operating
Income per unit – It is the operating income that a company aims to earn
per each unit of a product or service sold. (4) Target cost per unit – It is
the estimated long run cost per unit of a product or service that enables a
company to achieve its target operating income per unit, when selling at
the target price.
COST SHEET
According to ICMA, London, ‘ a cost sheet is a document which provides
for the assembly of the estimated detailed cost in respect of a cost centre
or a cost unit’. It analyses and classifies in a tabular form the expenses on
different items for a particular period. It is prepared at given intervals of
time and provides information regarding the elements of cost incurred in
production. It is also known as a production statement.
10. SPECIMEN OF A COST SHEET

Illustration:
From the following particulars of product A, prepare a production statement
(cost sheet) for the month of September 2005
Materials used in the manufacturing Rs.5,500
Materials used in packing materials Rs.1,000
Materials used in selling the product Rs.150
Materials used in the factory Rs.75
Materials used in the office Rs.125
Labor required in producing Rs.1,000
Labor required for supervision of the management – Factory Rs.200
Expenses – Direct factory Rs.500
Indirect factory expenses Rs.100
Office expenses Rs.125
Depreciation on office building and equipment Rs.75
Factory depreciation Rs.175
Selling expenses Rs.350
Freight Rs.500
Advertising Rs.125
Assuming that all the products manufactured are sold, what should be the
selling price to earn a profit of 25% on selling price?
Solution:
Statement of Cost for product A for the month of September 2005
…….
11. MARGINAL

11. MARGINAL COSTING:

According to the Charatered Institute of Management Accountants,
London, the term ‘Marginal cost’ means – ‘the amount at any given volume
of output by which aggregate costs are changed if the volume of output is
increased or decreased by one unit’. Marginal costing is a technique
where only the variable costs are considered while computing the cost of
a product. The fixed costs are met against the total fund arising out of the
excess of selling price over total variable cost. This fund is known as
‘CONTRIBUTION’ in marginal costing. According to the Chartered
Insitute of Management Accountants, London, ‘Marginal costing’ is a
technique where ‘only the variable costs are charged to cost units, the
fixed costs attributable being written off in full against the contribution for
that period’.
12. MARGINAL COSTING Vs DIRECT COSTING
Direct costing is the technique where only direct costs are considered
while calculating the cost of the product. Indirect costs are met against
the total margin (excess of selling price over direct costs) given by all the
products taken together. A DIRECT COST is a cost that can be identified
readily with a department, a function, a unit of product or some other
relevant unit. A direct cost thus may be fixed or variable. Though most of
the direct costs are variable costs, all direct costs may not be direct.
13. DIFFERENTIAL COSTING :
Marginal costing is sometimes confused with differential costing. The term
‘DIFFERENTIAL COSTING’ means ‘a technique used in the preparation
of adhoc information in which only cost and income differences between
alternate courses of action are taken into consideration’. Thus, while
decision making, only alternatives with overall profit are selected. The
word ‘differential cost’ means the net increase or decrease in total costs
resulting form a variation in production. The differential cost is termed as
‘incremental cost’ when the cost increases and ‘decremental cost’ when
the cost decreases.
14. MARGINAL COSTING AND DIFFERENTIAL COSTING
1. Differential costing can be used both in case of absorption costing
and marginal costing
2. In case of marginal costing, fixed costs are excluded and only variable
costs are considered whereas in the case of differential costs, both
are considered.
3. Separate analytical statements are prepared while calculating the
differential costing whereas in the case of marginal costing, marginal
costs may be included in the accounting itself.
4. In the case of marginal costing, contribution and profit-volume ratio
are the main yardsticks for performance evaluation and decision
making. Whereas in the case of differential costing, differential costs
are compared with differential revenue for decision making.
15. COST PROFIT VOLUME ANALYSIS
Cost profit volume (CVP) analysis is an important tool for profit planning.
It can be defined as – ‘ a managerial tool showing the relationship between
various ingredients of profit planning, ie, cost (fixed and variable), selling
price and volume of activity. It provides information regarding-
1. The behavior in relation to volume
2. Volume of production or sales, where the business will break-even
3. Sensitivity of profits due to variation in output
4. Amount of profit for a projected sales volume
5. Quantity of production and sales for a target profit level
16. USES OF CVP ANALYSIS
1. It helps in forecasting accurate profit.
2. It enables preparation of flexible budgets.
3. It is useful in performance appraisal/evaluation and management
control.
4. It aids in formulating price policy.
5. It helps in determining the amount of overhead cost to be charged to
various levels of operations.
6. It is highly useful in managerial decision making.
17. BREAK EVEN ANALYSIS
Break even analysis is a widely used technique to study cost-volumeprofit
relationship. It can be defined as – ‘a system for determination of
that level of activity where total cost equals total selling price’, or ‘as a
system of analysis which determines probable profit at any level of
activity’. It gives the relationship between cost of production, volume of
production and the sales value.
18. BREAK EVEN ANALYSIS AND CVP ANALYSIS
Some times, both are taken as synonymous. But, where CVP analysis
includes the activity of profit planning, break even analysis is only one of
the techniques used for that process.
19.ASSUMPTIONS OF BREAK EVEN ANALYSIS
1. All costs are divided into fixed and variable costs.
2. Fixed costs always remain constant.
3. Variable costs change in direct proportion to production.
4. Selling price will not change despite competition.
5. There is no change in operating efficiency.
6. There is no change in general price level.
7. Volume of sales and volume of production are equal.
8. Volume of production is the only affecting factor.
9. Only one product or sales mix is same.
20. CONCEPTS OF BREAK EVEN POINT
•F​ IXED COST: Fixed cost is a period cost and is usually unrelated to
changes in production. The total fixed cost remains constant for all
levels of production whereas the fixed cost per unit changes with
changes in the production level.
•V ​ ARIABLE COST: Variable cost is a product cost and is usually
directly related to production. Total variable cost changes with
changes in the production level, but variable cost per unit remains the
same for all levels of production.
•C ​ ONTRIBUTION: It is the difference between the sales and the
marginal cost of sales and it contributes towards fixed expenses and
profit. It is different from the profit which is the net gain in activity or
the surplus and remains after deducting fixed expenses from the total
contribution. In marginal costing, the concept of contribution is very
important as it helps to find out the profitability of a product,
department or division, to have a better product mix, for profit planning
and to maximize the profits of a concern.
Contribution = Sales – Variable cost (or) Fixed cost +Profit (or) Fixed
cost – Loss
•M​ ARGIN OF SAFETY (MOS): It refers to the difference between
the actual sales and break even sales. It represents a cushion to the
creditors of the firm.

•A​ NGLE OF INCIDENCE : It is an angle that is formed when the total

sales line intercepts the total cost line from below in the breakeven
chart. It is inferred that higher the angle, higher is the profit, and
lower the angle lower the profit.
•P ​ ROFIT VOLUME RATIO: It is also known as contribution to sales
(C/S) ratio. It is one of the most important ratios for studying the
profitability of operations of a business and establishes the relationship
between contribution and sales. The inference is – higher the P/V
ratio, lesser will be the profit.

•B​ REAK EVEN POINT: It represents a level of production where

there is no loss and there is no profit. In other words, it is a point
where the total cost is equal to total sales. Sales beyond this level
represent profit and sales below this point represent loss.

21. MERITS OF BREAK EVEN POINT

1. Margin of safety is known
2. Cost-Volume-Profit relationship is known
3. Helps in forecasting profit and growth
4. Helps in cost control
5. Helps in knowing profit at various levels
6. Helps in fixing target profit
7. Helps in forecasting the effect of change in price and angle of incidence
22. DEMERITS OF BREAKEVEN POINT
1. It ignores considerations such as effect of government policy changes,
changes in the marketing environment, etc.
2. Fixed cost, sales, total costs cannot be represented as straight lines.
3. It is difficult to handle advertisement expenditure.
4. Fixed costs also may change in the long run.
5. It ignores economies of scale in production.
6. Semi-variable costs are ignored.
7. Volume of production and volume of sales are always not equal.
8. Selling price may or may not be the same.
23. UTILITY OF BREAK EVEN POINT IN MANAGERIAL
DECISION MAKING
1. It helps in determination of sales mix.
2. It helps in exploring new markets.
3. It helps in deciding about discontinuance of a product line.
4. It helps in taking make or buy decisions.
5. It helps in taking equipment replacement decisions.
6. It aids in investment of assets.
7. It aids in decision making relating to change Vs status quo – which may
include situations like – i) adoption of new method of operation ii)
overtime Vs second shift or iii) Sale Vs further processing, etc.
8. It helps in making decisions as to expand or contract.
9. It helps in decisions relating to shut down or continue operating.
Break even chart ​: The break even chart is a graphical way of finding
out the break even point. It is a graph with output or sales on the X –axis
and costs (fixed, variable and total) plotted on the Y – axis. The point at
which the total sales line intercepts the total cost line from below is known
as break even point. At this point, total cost is equal to total revenue.
Beyond this point, lies the profit zone and below this point lies the loss
zone.
Illustrations
1. From the following particulars, calculate the break even point
Variable cost per unit = Rs.12
Fixed expenses = Rs.60,000
Selling price per unit = Rs.18
Solution:

(Selling Price – Variable Cost = Contribution)

Rs.18 – Rs.12 = 6)
Rs.60,000 / Rs.6 = 10,000 units
B.E.P. Sales = 10,000 x Rs.18 = Rs.1,80,000
2. A Company estimates that next year it will earn a profit of Rs.50,000.
The budgeted fixed costs and sales are Rs.2,50,000 and Rs.9,93,000
respectively. Find out the break-even point for the company.
Solution :
3. From the following particulars, find out the selling price per unit if B.E.P.
is to be brought down to 9,000 units.
Variable cost per unit Rs.75
Fixed expenses Rs,2,70,000
Selling price per unit Rs.100

Contribution is Rs.30 per unit, in place of Rs.25. Therefore, the selling

price should have been Rs.105 i.e. Rs.75 + Rs.30.
4. From the following data, determine the break even volume and margin of
safety, both absolute and relative
Sales = Rs.12,000
Variable cost = Rs.7,000
Fixed cost = Rs.3,000
Solution:
5. AB Co.Ltd supplies you the following information
Sales = Rs.2,00,000
Fixed cost = Rs.90,000
Variable cost = Rs.1,25,000
Calculate (i) BEP (ii) Ascertain how much the value of sales must be
increased for the company to breakeven
Solution:

24. STANDARD COSTING:

STANDARD COSTING is a technique which uses standards for costs
and revenues for the purpose of control through variance analysis. It can
be used either with operations or processes or with specific order type of
cost accounting system.
A STANDARD COST is defined as ‘a pre-determined calculation of
how much costs should be under specified working conditions. It is built
up from the assessment of the value of cost elements and correlated
technical specifications and qualifications of materials, labor and other
costs to the prices and / or wage rates expected to apply during the period
in which the standard cost is intended to be used.
25. PURPOSES OF STANDARD COSTING
1. Measuring efficiencies
2. Controlling and reducing costs
3. Simplifying costing procedure
4. Valuing inventories and
5. Setting selling prices
26. ADVANTAGES OF STANDARD COSTING
1. It provides a yardstick for measurement of performance.
2. It facilitates ‘Management By Exception’.
3. It enables the management to focus more on those expenses and
activities which indicate high favourable or adverse variances, thus
saving lot of time and expense.
4. It provides motivation for achieving high performance.
5. It provides an opportunity for continuous re-appraisal of the methods
of production, production design, use of material, etc. leading to cost
reduction and establishing new standards.
6. It is easier and economical to operate.
7. It can be used as an aid for budgeting.
8. It eliminates wastages by detecting variances and suggesting corrective
measures for them.
27. LIMITATIONS OF STANDARD COSTING
1. It may be very difficult or impossible to fix standards for all operations.
2. Wrong standards may result in wastage of time, money and energy.
3. Standards must be reviewed from time to time, otherwise, they lose
relevancy.
4. It presupposes determination of actual costs.
difference is called favourable variance. If the actual
cost is more than the standard cost, it is called unfavourable variance.
Variance analysis is the basis of cost control under standard costing and
leads to cost reduction as well as revision of standards. The variance
analysis helps to pinpoint responsibilities to the managers, who can exercise
the technique of ‘management by exception’. Variances are basically
divided into two groups, i) arising out of price and ii) arising out of usage
or volume.
30. TYPES OF VARIANCES
Variances are computed for all the three basic elements of cost – direct
material, direct labor and overhead variance
1. Direct material variance:
2. Direct labor variance and
3. Overhead variance
MATERIAL VARIANCES:
Direct Material Cost Variances (DMCV):
This variance is an overall difference in the standard direct material cost
and the actual direct material cost. This variance may exist because of
difference in either the price of the material or the quantity that is purchased.

i) Material Price Variance (MPV):

This may be defined as the difference between the actual price and
the standard price of the materials consumed.
MPV = Actual quantity used (Standard price – Actual price)
Reasons for Price variance may be
•C ​ hanges in the market price of direct material
• “​ Emergency buying” in smaller quantities
•C ​ ash discount not availed
•C ​ arriage, freight and other charges absorbed instead of being charged
to the suppliers
•C ​ laims not made on the suppliers for substandard materials or short
receipt of materials
ii) Material Usage Variance (MUV)​:
This is the difference between the actual quantity of material consumed
and standard quantity which should have been consumed, expressed in
terms of the standard price of the material.
MUV = Standard price (Standard quantity for actual production – Actual
quantity used)
Reasons for usage variance may be
•D ​ efective material
•C ​ arelessness in the use of material
•W ​ astages due to bad methods or bad workmanship
•C ​ hange in the quality of materials used
•N ​ on-standard mix of materials used
Material Usage Variance can be split up further into two components (in
process industries) – a) ​Materials mix variance :​ It can be defined as
that portion of direct material usage variance which is the difference
between the actual quantities of ingredients used in a mixture at standard
price and the total quantity of ingredients used at the weighted average
price per unit of ingredients as shown by the standard cost sheet.
MMV = Standard Price (Standard Quantity – Actual Quantity)
(or) when standard is revised due to the shortage of a particular type of material
MMV = Standard Price (Revised Standard Quantity – Actual Quantity)

b​) Direct material yield variance (MYV) :​ It has been defined by the
ICMA, London, as ‘the difference between the standard yield of the
actual material input and the actual yield, both valued at the standard
material cost of the product’.
MYV = Standard yield rate (Standard yield – Actual yield)
(or) Standard Revised rate (Actual loss – Standard loss),

LABOR VARIANCES:
Labor Cost Variance (LCV):
According to ICMA, London, ‘Labor cost variance is the difference
between the standard direct wages specified for the production achieved,
whether completed or not and actual direct wages incurred’. If the
standard cost is higher, the variation is favourable and vice versa.
LCV = Standard cost of labor – Actual cost of labor
= (Standard time x Standard rate) – (Actual time x Actual rate)
Labor Rate Variance (LRV):
According to ICMA, London, this variance is ‘the difference between the
standard and the actual direct labor rate per hour for the total hours
worked’. If the standard rate is higher, the variance is favourable and
vice versa
LRV = Actual time (Standard wage rate x Actual wage rate)
Reasons for rate variance may be :
•C ​ hanges in the basic wage rates
•F​ aulty recruitment
•O ​ vertime work at higher or lower than the specified rate
•C ​ hange in the composition of the gang at a different rate from the standard
•E ​ mploying people of different grades than planned
•E ​ xcessive overtime
•H ​ igher or lower rate paid to casual laborers, etc.
Labor Time or Labor Efficiency Variance (LEV) :​
This variance has been defined as – ‘that portion of the direct wages cost
variance which is the difference between the standard direct wages cost
for the production achieved whether completed or not, and the actual
hours at standard rates (plus incentive bonus). This variance may be
favourable or unfavourable.
LEV = Standard rate (Standard time – Actual time)
Reasons for efficiency variance may be :
•B ​ ad workmanship due to inefficient training or incomplete instructions
or dissatisfaction among the workers
•B ​ ad working conditions
•P​ roduction delays and hold-ups
•D ​ efective equipment, tools and materials
•D ​ efective supervision
Labor Idle Time Variance (LITV):
This variance arises because of the time during which the labor remains
idle due to abnormal reasons such as – power failure, strikes, machine
breakdowns, etc.
LITV = Abnormal idle time x Standard hourly rate
Labor Mix Variance or Gang Composition Variance (LMV): T ​ his is
that part of Labor cost variance that results from employing different grades
of labor from the standard fixed in advance. It is the difference between
the standard composition of workers and the actual gang of workers.
LMV = (Standard cost of standard mix) – (Standard cost of Actual mix)
Labor Yield Variance (LYV): It is the difference between the standard
labor output and actual output or yield. If the actual production is more
than the standard production, it would result in a favourable variance and
vice versa.
OVERHEAD VARIANCES
Unlike direct material and labor, the manufacturing overhead is not entirely
variable with the level of production. Therefore, standard costs for factory
overheads are based on budgets rather than standards. These variances
arise due to the differences between the actual overhead cost incurred
and the standard overhead cost charged to production. There are two
components to overhead variances – i) Variable Overhead
Variances and ii) Fixed Overhead Variances.
Variable Overhead Variance (VOHV):
This variance is defined by ICMA, London, as ‘the difference between
the standard variable production overhead absorbed in the production
achieved, whether completed or not, and the actual production overhead’.
This variance can be divided into – i) Variable Overhead Expenditure
Variance and ii) Variable Overhead Efficiency Variance.
VOHV= (Actual hours worked x Standard variable overhead rate per
hour) – Actual variable over heads
i) Variable overhead variance:​
It is the difference between actual overhead expenditure incurred and the
standard variable overheads set in for a particular period.
Variable overhead variance = (Standard variable overhead) – (Actual
variable overhead)
ii) Variable Overhead Efficiency Variance ​:
It shows the effect of change in labor efficiency overheads recovery.
Variable Overhead Efficiency Variance = Standard rate (Standard quantity
– Actual quantity) where Standard rate = (Standard time for actual output
– Actual time)
Fixed Overhead Variance (FOV) ​:
Fixed overhead variance has been defined by ICMA, London, as ‘the
difference between the standard cost of fixed overhead absorbed in the
production achieved, whether completed or not, and the actual fixed
overhead, attributed and charged to that period’.
FOV = (Actual production x Standard fixed overhead recovery rate) –
Actual overheads incurred
This variance may be divided into – i) Fixed Overhead Expenditure
Variance and ii) Fixed Overhead Volume Variance.
i) Fixed Overhead Expenditure Variance (FOEV):
This variance has been defined by ICMA, London as ‘the difference
between the budget cost allowance for production for a specified control
period and the amount of actual fixed expenditure attributed and charged
to that period’.
FOEV = Budgeted fixed overhead – Actual fixed overhead
(or) Budgetary quantity x Standard overhead rate – Actual Fixed overhead
ii) Fixed Overhead Volume Variance (FOVV):
This variance has been defined by ICMA, London as ‘that portion of the
fixed production overhead variance which is the difference between the
standard cost absorbed in the production achieved, whether completed
or not, and the budget cost allowance for a specified control period’.
FOVV = Standard Fixed overhead recovery rate (Actual quantity –
Budgeted quantity) Fixed Overhead Volume Variance can further be divided
into – i) Capacity variance and
ii) Productivity variance
i) Fixed Overhead Capacity Variance (FOCV) :​
This variance has been defined by ICMA, London as ‘that portion of the
fixed production overhead volume variance which is due to working at
higher or lower capacity than standard’.
FOCV= Standard recovery rate (Standard quantity – Budgeted quantity)
ii) Fixed Overhead Productivity Variance (FOPV):
This variance has been defined by ICMA, London as ‘that portion of the
fixed production overhead volume variance which is the difference between
the standard cost absorbed in the production achieved, whether completed
or not, and the actual direct labor hours worked (valued at the standard
hourly absorption rate).
FOPV = Standard overhead rate (Actual quantity – Standard quantity)
Some times, another variance, called as calendar variance may also be
calculated as –
Standard rate per hour (Possible hours – Budgeted hours) (or)
Standard rate per unit (Possible units – Budgeted units)
SALES REVENUE VARIANCE (SRV):
The word ‘Sales Variance’ is denoted by the expression ‘operating profit
variance due to sales’ by ICMA. It is defined as the difference between
the budgeted operating profit and the margin between the actual sales and
the standard cost of those sales’. This variance is subdivided into – i)
Sales price variance and ii) Sales volume variance.
i) Sales price variance (SPV): ​It is the difference between actual
selling price and standard selling price.
SPV = Actual quantity (Actual selling price – Standard selling price)
ii) Selling Volume Variance (SVV):
It is the difference between the actual no. of units sold and the planned
sale of units.
SVV = Standard selling price (Actual quantity – Standard quantity)
PROFIT VARIANCES
Sales variances are significant as they have a direct bearing on profits
earned by the organization. Hence, they can be used as the basis of
determining profit variance. The overall Profit Variance is divided into –
i) Sales price variance and ii) Sales Volume Variance, which is subdivided
into – a) Sales Price variance b) Sales Volume Variance and iii)
Cost Variance. Except Cost Variance, there is no difference between the
various Sales Variances and Profit Variances.
Overall Sales Variance = Standard / Budgeted profit – Actual profit
(Unfavorable)
(or) Actual Profit – Standard / Budgeted profit (Favorable)
Cost Variances : They arise when actual costs are different from standard
costs.
Cost Variances = (Standard cost – Actual cost)Actual quantity sold
(Favorable)
(or) (Actual cost – Standard cost) Actual quantity sold (Unfavorable)
Illustration 1 ​:
The standard cost of material for manufacturing a unit of a particular
product is estimated as follows :
20 Kg. of raw materials @ Rs. 2 per kg.
On completion of the unit, it was found that 25 kg. of raw material costing
Rs.3 per kg. has been consumed.
Solution :

Illustration 2 :
From the following data calculate material usage variance.
Illustration 3
The following information is available for a particular product
Standard output = 1000 units
Standard quantity = 5 kgs per unit
Standard rate = Rs.3 per kg
Actual output = 900 units
Actual quantity used = 5000 kgs
Actual rate paid = Rs.5 per unit
Compute material cost variance.
Illustration 4
From the following data, compute the labor cost variance
Standard labor hours per unit = 50 hours
Standard labor rate per hour = Rs.5
Actual production = 100 units
Actual labor rate per unit = Rs.6
Actual labor hours for production = 4,000 hours
Solution:
Standard labor hours per unit = 50 hours
Standard labor rate per hour = Rs.5
Standard labor cost per unit = 50 hrs x Rs.5 = Rs.250
Standard labor cost for actual production = (100units x Rs.250) =
Rs.25,000
Actual labor rate per hour = Rs 6
Actual labor hours for production = 4000 hrs
Actual labor cost for production = (Rs.6 x 4000 hrs) = Rs.24,000
Labor cost variance (LCV) = Standard cost of labor – Actual cost of
labor
= (Standard time x Standard rate) – (Actual time x Actual rate)
LCV = (Rs.25,000 – Rs.24,000) = Rs.1,000 (Favorable)
Labor Rate Variance (LRV) = Actual time (Standard wage rate x Actual
wage rate)
LRV = 4000 hrs (Rs5 – Rs.6) = (-) Rs.4,000 (Adverse)
Labor Efficiency Variance (LEV) = Standard rate (Standard time – Actual
time)
LEV = Rs.5 (5,000 hrs – 4000 hrs) = Rs.5 x 1,000 hrs = Rs.5,000
(Favorable)

2.2 MANAGEMENT ACCOUNTING

1. INTRODUCTION
Managerial decision making is a specialized function and it assumes highest
importance while making strategic financial decisions which involve
identifying the alternatives, evaluating the alternatives and selecting the
best alternative which will maximize the shareholders’ wealth maximization.
The strategic financing decision situations include – make or buy, expand
or contract, shut down or function, selecting the best sales mix, accepting
or rejecting special orders, selling below cost etc.
2. LEARNING OBJECTIVES
After going through this chapter, the reader is expected to –
1. Understand the meaning of accounting cycle
2. Understand the various records which aid in the preparation of
financial statements
3. Understand how to prepare final accounts
4. Understand how revenue is recognized and measured
5. Understand the various concepts and types of inventory valuation
6. Understand the back ground of depreciation
3. RELEVANT COST FOR DECISION MAKING
Managerial decision making essentially is a process of selecting from
alternatives. Relevant information should be used by the decision maker
in evaluating the alternatives and in taking decisions. Relevant
information implies costs and revenues (benefits) which are relevant to
the decision at hand, and which is useful while evaluating alternatives, to
ascertain the effort of various alternatives on profit and to finally select the
alternative with the greatest benefit.
Relevant revenues and relevant costs are defined as the current and future
values of the alternatives under consideration. The differences between
alternatives are called differentials and the analysis concerned with the
effect of alternatives on revenues and costs is called differential analysis.
Relevant information is characterized by certain features which include
the following
(i) Past (historical) costs may serve as the basis for making predictions.
But, for decision making, they are always irrelevant.
(ii) The expected total future revenues and costs of different alternatives
may be compared by examining those differences.
(iii) Not all expected future revenues and costs are relevant. Expected
future revenues and costs that do not differ across alternatives are
irrelevant and hence can be eliminated from the analysis.
(iv) Due consideration must be given to qualitative factors and quantitative
non-financial factors.
Relevant Revenues :
Relevant (differential) revenue refers to the amount of increase or decrease
in future revenue expected from a particular course of action as compared
with an alternative courser of action. For short-run managerial decisions,
timing of cash flow, i.e. when the cash flows are received, are not so
important. However, for long-run decisions the timing of cash flows is
important in the evaluation of alternatives and in making decisions.
Relevant Costs :
Relevant costs are also known as differential costs or decision making
costs. Relevant or differential cost is the difference in the total costs
between alternative choices. Theses costs must be considered when a
decision has to be made involving an increase or decrease of ‘n’ units of
output above a specified output. When a decision result in an increased
cost, it is known as incremental cost. And if the cost decreases, it is
known as decremental cost. The incremental cost covers full cost.
Relevant costs vary with the type of decisions.
The characteristic features of relevant costs are (1) relevant costs are
expected future costs (2) they differ between different decision alternatives.
4. INCREMENTAL ANALYSIS
This type of analysis is very popular today. It involves calculating the
incremental costs and incremental revenues arising out of decision
alternatives and taking a decision after appropriate analysis of the same.
This type of analysis is also known as differential analysis. The term
‘DIFFERENTIAL COSTING’ means ‘a technique used in the preparation
of adhoc information in which only cost and income differences between
alternate courses of action are taken into consideration’. Thus, while
making decisions, only alternatives with overall profit are selected. The
word ‘differential cost’ means the net increase or decrease in total costs
resulting form a variation in production. The differential cost is termed as
‘incremental cost’ when the cost increases and ‘decremental cost’ when
the cost decreases.
Marginal costing is sometimes confused with differential costing. The major
differences between Marginal costing and differential costing are as
follows
1. Differential costing can be used both in case of absorption costing
and marginal costing.
2. In case of marginal costing, fixed costs are excluded and only variable
costs are considered whereas in the case of differential costs, both
are considered.
3. Separate analytical statements are prepared while calculating the differential
costing whereas in the case of marginal costing, marginal costs may be
included in the accounting itself.
4. In the case of marginal costing, contribution and profit-volume ratio are
the main yardsticks for performance evaluation and decision making.
Whereas in the case of differential costing, differential costs are compared
with differential revenue for decision making.
Incremental or differential costs include Variable costs and additional fixed
costs resulting from particular decisions. They are highly useful in
planning and decision making. This type of analysis is highly useful in
making strategic financing decisions .
5. SPECIAL ORDER DECISION
This is another business situation which is usually faced by many
manufacturing units, especially industries following job costing or batch
costing. This decision relates to whether to accept the special orders or
not. Similar decisions related to these type of situations include one time
quantity sale, sales to foreign customers, etc. The decision criteria in
such situations is, as long as such sales do not affect the normal sales and
incremental contribution is higher the decision is to be taken otherwise
not.
Illustration :
Assume that Evergreen Ltd. has excess capacity. The normal plant
capacity is 3,00,000 units per year and current production is 2,00,000
units. There is no alternative use for the idle facilities. The company
receives an offer from a foreign customer to buy 1,00,000 units at Rs. 10
a unit. The regular market price is Rs.14 a unit. The current manufacturing
and selling costs are :

(a) Should the offer be accepted assuming that shipment charges of Rs.50,000
are to be borne by the seller ? There will be a special packing of the
products which will involve packing cost of Rs.0.25 per unit. Being an
export order, the management is convinced of the fact that the regular
market price of Rs. 14 a unit will not be affected.
(b) Assume that the order is from a local supplier and, therefore, should the
order be accepted, all products in future are to be offered at special
order price.
Solution :
(a) ​Decision analysis

Comment: As the incremental contribution is (14,25,000 – 12,00,000) =

2,25,000, the order should be accepted
6. PRODUCTION CONSTRAINT DECISION
Incremental analysis can be used to allocate scarce resources that are
limited in quantity (key factor). The key factor refers to any resource
(raw materials, skilled labour, capacity of the machine, etc.) which is in
short supply. If raw material is in short supply the management should
produce according to the largest contribution margin per each unit of
input. If capacity of the machine is the key factor the most profitable,
course of action is to use the available machine hours for manufacturing
the products, which contribute the highest contribution margin per
machine hour. Similarly for any scarce resource contribution per unit of
key factor should be the guiding principle. As long as the decision
maximizes the contribution per unit of key factor, it should be favoured.
7. MAKE OR BUY DECISIONS
Many of the manufacturing industries face this decision almost every day.
This is a strategic financial decision which involves the use of incremental
costs and revenues in taking effective decision.
This decision must be taken after considering the following points.
1. The quality of the product maintained by the supplier
2. The regularity of the supplier in supplying the required quantity at
required time intervals.
3. The financial and technical reliability of the supplier
4. The appropriate time span to be covered by the analysis.
Apart from this, there are many services which an outside Specialist may
perform more satisfactorily than company personnel, especially if the
amount of services required is a relatively insignificant part of the
company’s activities. On the other hand, if the company performs the
service itself, it may have better control over its quality than if it relies on
an outside source.
In this analysis, the differential cost in the variable overhead only should
be considered. The option which gives lesser cost should be selected.
In highly complex decision situations where alternative use of idle
capacities is involved which may result in generating some income, then
the supplier’s cost gets reduced by the amount of such income generated.
Illustration :
In its manufacturing operations ABC Ltd. uses a component ‘X’ that can
be purchased from a supplier for Rs.20 per unit. The same component X
is manufactured by ABC Ltd. at the following unit cost :

Give your suggestion whether to make or buy this component.

Solution :
If the component ‘X’ is purchased it will cost Rs.20 per unit. However,
the purchasing cost should not always be compared with the full cost of
internal manufacture, which amounts to Rs.23. For short run decision
making purposes, fixed overheads will remain constant regardless of the
alternative chosen. Therefore the outside purchase price should be
compared only with internal manufacturing costs that can be avoided if
the outside purchase is made. These avoidable cost include :

Thus, total avoidable costs of Rs.18.50 per unit is less than the Rs.20
outside purchase price. Therefore, it is suggested the ABC Ltd. should
continue to manufacture the components ‘X’.
8. SELL, SCRAP OR RE-BUILD DECISIONS
These decisions also are special decisions where incremental or differential
analysis is highly useful. The choice of decision should be wherever the
contribution is the highest.
9. JOINT PRODUCT DECISIONS
Another decision situation faced by many manufacturing units which
manufacture joint products is whether to sell joint outputs at the split off
point or process further. The decision criteria should be to choose that
alternative which will maximize the overall contribution of the various
joint products to the common processing costs. Here the relevant costs
refer to the additional common processing costs.
10. RESPONSIBILITY ACCOUNTING & PERFORMANCE
EVALUATION
The Institute of Cost and Works Accountants of India d​ efines
Responsibility Accounting as ‘a system of management accounting under
which accountability is established according to the responsibility
delegated to various levels of management and a management information
and reporting system instituted to give adequate feed back in terms of the
delegated responsibility’. Under this system, divisions or units of an
organization under a specified authority are developed as responsibility
centres and evaluated individually for their performance.
The concept of Responsibility accounting essentially involves establishing
financial responsibility. Various decision areas are called Responsibility
Centres (RCs).
Performance evaluation based on mere financial or quantitative
responsibility is not balanced in its approach. Moreover some RC’s such
as Service responsibility centre cannot be reasonably evaluated in terms
of financial responsibility alone when the primary objective may be quite
different.
Steps involved in Responsibility Accounting :
The various steps involved in Responsibility accounting include :
1) The division of organization into various responsibility centres
2) Allotment of responsibility centres to managers who are held responsible
for the performance of that particular centre
3) Effective circulation of accounting information to various
responsibility centres by setting up of an effective communication system
4) Wherever variances are identified taking corrective steps.
11. BUDGET AS A PLANNING AND CONTROL TOOL
A BUDGET is a quantitative expression of a business plan for a specified
future period, usually a year.
BUDGET is the planned future course of action
BUDGET is a plan of action expressed in financial or non financial terms.
BUDGET is a financial or quantitative statement prepared prior to a
defined period of the policy to be pursued during the period for that
purpose of attaining a given objective - ICMA.
12. DEFINITION OF BUDGET
According to the Institute of Cost & Management (ICMA), London, a
BUDGET is ‘a financial and / or quantitative statement, prepared and
approved prior to a defined period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective. It may
include income, expenditure and the employment of capital’.
13. DEFINITION OF BUDGETARY CONTROL
According to ICMA, BUDGETARY CONTROL is the establishment of
budgets, relating the responsibilities of executives to the requirements of a
policy, and the continuous comparison of actually with budgeted results
either to secure the objectives of that policy by individual action or to
provide a basis for its revision’.
BUDGETARY CONTROL is the system of management control and
accounting in which all operations are forecasted as far as possible and
are planned ahead and actual results are compared with planned &
forecasted ones - J.A.SCOTT.
14. FEATURES OF A BUDGET:
a. It is prepared for a definite period.
b. It is expressed in money or quantity or both.
c. It is a statement defining objectives of a concern and policies to be
adopted to attain such objectives.
15. OBJECTIVES OF BUDGETARY CONTROL
1. To plan and measure the performance
2. To co-ordinate and communicate
3. To improve the efficiency and economy in operations (cost control
and cost reduction)
4. To increase the profitability of operations
5. To anticipate the future capital expenditure
6. To exercise control
7. To locate deviations and correct them
16. ADVANTAGES OF BUDGETARY CONTROL
1. Profits are maximized.
2. It facilitates controlling of activities.
3. Effective co-ordination is made possible.
4. Executive performance is evaluated.
5. Clear cut goals and targets are laid.
6. Economy in operations is achieved through planned expenses. i.e, It
results in reduction of cost.
7. It creates cost consciousness.
8. It facilitates availing of bank credit.
9. It avoids over / under capitalisation.
10. MBE (Management by exceptions) is possible, as it identifies
deviations and saves the mangers’ valuable time.
11. Inefficiencies / ineffectiveness is revealed.
12. Continuous monitoring and correction of performance is done.
13. Incentive system may be introduced.
14. Unprofitable products and activities can be shut down.
17. LIMITATIONS OF BUDGETARY CONTROL
1. It involves predicting the future which is highly uncertain.
2. Market is dynamic and continuously evolving. Hence budgets based
on past data may not be relevant.
3. Too much reliance on budget will result in complacence on the part of
the employees.
4. In reality, gaining full co-ordination of all the employees may be
difficult.
5. There may be conflict among different departments.
6. Preparation of a budget is very difficult.
7. Resistance in accepting also will not result in achieving the set goals.
8. It is highly expensive.
18. STEPS IN BUDGETARY CONTROL
1. Quantification of plans in relation to production, sales, distribution
and finance in terms of goals and objectives set by the management.
i.e, Prepare budgets for each section of organization
2. Record actual performance
3. Compare actual & budgeted performances
4. Remedial action to be taken if there is any difference
5. Revise budgets if necessary
19. ESSENTIALS OF SUCCESSFUL BUDGETARY CONTROL
1. Top management support
2. Clearly defined organization structure
3. Efficient accounting system
4. Reporting of deviations
5. Motivation
6. Realistic targets
7. Participation of all departments concerned
8. Flexibility
20. CLASSIFICATOIN OF BUDGETS
Budgets can be classified on the basis of many bases. There are three
popular bases for classifying budgets. They are – time, functions and
flexibility. Apart from these classifications, several other budgets can also
be found in practice such as – performance budget, ZBB, control ratios,
etc.
On The Basis Of Time
• Long term budget ​: According to National Association of
Accountants, America, a long term budget is, a systematic and
formalized process for purposeful directing and controlling future
operations towards a desired objective for periods extending beyond
one year.
• Short term budget :​ Short term budget covers a budget period of
one year or less.
• Current budget ​: These budgets cover a very short period such as a
month or a quarter. They are essentially short term budgets adjusted
to current conditions or prevailing circumstances.
On The Basis Of Functions
•F​ unctional / Subsidiary budgets: A Functional budget is a budget of
income or expenditure appropriate to or the responsibility of a
functions, such as production, sales, purchase, etc. Each functional
department prepares its own budget, and all these functional budgets
are integrated into the Master budget.
Sales budget:​ It gives details about volume, price and sales mix. It also
gives details about the quantity of sale, month-wise or quarter-wise,
market-wise, area-wise and on whatever other basis be important to the
organization. The responsibility for preparation of this budget falls on the
sales manager. While preparing this budget, he/she has to consider certain
influencing factors such as – past sales figures and trend, salesmen’s
estimates, plant capacity, general trade practice, orders in hand, proposed
expansion or discontinuance of products, seasonal fluctuations, potential
market, availability of material and supply, finance, etc.
Production budget:​ It includes details about the types, quantity and
cost of goods and services produced in the organization. The responsibility
of preparing this budget falls on the Works manager or departmental
Works managers.
Production cost budget ​: It is divided into material cost budget, labour
cost budget and overhead cost budget, because cost of production includes
material, labour and overheads.
Materials budget​: It includes details about the kinds and quantity of
material required, price paid for it, cost of transportation and storage,
etc.
Labor budget​: It includes details about the types and number of
workers, the number of hours required, the wage rates and other
allowances, the welfare and other facilities provided and cost thereof,
etc.
Overheads budget :​ It gives details of items of factory overhead
expenses, their quantity and cost.
Research and Development budget :​ Every organization of some size,
particularly, of a manufacturing or technical type, has a Research and
Development Department. Expenses incurred by it are parts of operating
cot, until efforts lead to some findings that can be used for improvement
of quality of product technology improvement, and/or for producing
something new, at which stage all expenses incurred are capitalised.
Capital expenditure budget :​ This budget shows the estimated
expenditure on fixed assets such as land and buildings, plant and
machinery, etc. It is a long term budget. This budget is prepared to plan
for replacement of old machines, increased demand of products,
expansion of activities, etc.
Cash budget:​ A Cash budget deals with cash, including its equivalent,
like bank balance and bills receivable. It shows the inflows of cash and
outflows of cash during a particular period of time. It can be prepared for
a year, but for better control and management of cash, it is normally
prepared on monthly basis. It takes into account only cash transactions.
• Master budget​: This budget summarises the various functional
budgets. It is also called as summary budget. It generally includes
details relating to production, sales, stock, debtors, cash position,
fixed assets, etc, in addition to important control ratios.
On The Basis Of Flexibility
• Fixed budget​: A Fixed budget is designed to remain unchanged
irrespective of the volume of output or turnover attained. The budget
remains fixed over a given period and does not change with the change
in the volume of production or level of activity attained.
• Flexible budget​: It is also known as variable budget. A Flexible
budget is designed to change along with the changes in the output or
turnover. It changes according to the levels of activity.
Other Related Budgets
1. Performance budget ​: Performance budget involves evaluation of
the performance of the organization in the context of both specific
and overall objectives of the organization. According to National
Institute of Bank Management, performance budgeting is the process
of analyzing, identifying, simplifying and crystallizing specific
performance objectives of a job to be achieved over a period in the
frame work of the organizational objectives, the purpose and the
objectives of the job.
Performance budgeting requires preparation of performance reports
which compare the budget and actual data and show the variances
existing between both. The responsibility for preparing these reports
lies on the respective departmental head. Each departmental head
will be supplied with a copy of the section of the master budget
appropriate to his sphere. This report may be prepared on a daily
basis, weekly basis, monthly basis or any basis based on the size of
business and the budget period. The purpose of submitting these
reports is to convey promptly the information about the deviations in
actual and budgeted activity to the decision makers so that necessary
corrective actions can be taken to correct the deviations.
The various ADVANTAGES of Performance budgeting are as follows:
• I​ t aims at continuous growth of the organisation in the long-run.
• I​ t enables the organisation to be sensitive and adaptive, preventing it
from developing rigidities which may retard the process of growth.
• I​ t facilitates performance appraisal.
PRE-REQUISITES
for a successful adoption of Performance budgeting are :
• I​ t requires preparation of periodic performance reports.
•T ​ he accounting system should be sufficiently detailed and co-ordinated
to provide necessary data for reports designed for the particular use
of the individual or cost centres having primary responsibility for
specific costs.
2. Zero base budget​: Zero base budgeting (ZBB) is a new technique
which was first used by the US Department of Agriculture in 1961. Texas
instruments, a n MNC, has used it in the private sector. But, it was
Peter.A.Pyhr who had designed its logical basic framework in 1970 and
successfully developed, implemented and popularized the use of ZBB in
private sector. Hence, he is known as the ‘father of ZBB’. The technique
became more popular in USA when the then President of USA, Mr.Carter,
in 1979, had issued a mandate asking for the use of ZBB through out the
federal government agencies. Though it had become popular in many
countries, especially the common wealth countries, in India, despite the
various efforts of the Institute of Chartered Accountants of India and the
Institute of Costs and Works Accountants of India, it had not gained
popularity in India.
ZBB has been ​defined ​by many management experts in many ways. Some
of those definitions are –
‘ZBB is an operating planning and budgeting process which requires each
manager to justify his entire budget requests in detail from scratch. Each
manager states why he should spend money at all. This approach requires
that all activities be identified as decision packages which would be
evaluated by systematic analysis ranked in order of importance’
‘ZBB is a management tool which provides a systematic method of
evaluating all operations and programmes, current or new, allows for
budget reductions and expansions in a rational manner and allows reallocation
of sources from low to high priority programmes’
A Zero base budget is not an old budget with incremental changes, as in
the case of an incremental budget. It starts with a scratch or a zero level
and if an item is found to be necessary it is included in the new budget,
and if it is necessary, how much amount should be budgeted for.
ZBB has many ​advantages ​to the management covering –
1) it provides a solution for all the limitations of traditional budgeting by
enabling the top management to focus on key areas, alternatives and
priorities of action throughout the organization.
2) It enables the management to concentrate only on essential programs.
3) It enables the management to approve departmental budgets on the basis
of cost benefit analysis.
4) It helps in identifying wasteful expenditure, and if desired, it can also be
used for suggesting alternative courses of action.
5) It can be used for introducing the system of Management by objectives,
etc.
Even though there are many advantages with this type of budgeting, there
are various disadvantages also associated with its use. Some of them are
1) Successful implementation of ZBB requires top management support.
Its absence may lead to implementation problems.
2) There are other problems related to the implementation of the ZBB
program such as – fixing of suitable authority and responsibility for
preparing the budgets, fixing the minimum level of effort required,
etc.
3) It is expensive and may not suit smaller firms.
4) It is time consuming and may not be relevant in taking emergency
decisions, etc.
3. Control ratios :​ Three important ratios are commonly used by the
management to find out whether the variations from budgeted results
are favourable or unfavourable. These ratios are expressed as
percentages and any ratio beyond 100% is favourable and a ratio
less than 100% is unfavourable. The three ratios are :
a) Activity Ratio​: It is a measure of the level of activity attained over a
period.

b) Capacity Ratio :​ This ration indicates whether and to what extent

budgeted hours of activity are actually utilized.
c) Efficiency Ratio ​: This ratio indicates the degree of efficiency attained
in production

21. ORGANISATION FOR BUDGETARY CONTROL (or)

PRE-REQUISITES FOR THE INTRODUCTION OF AN
EFFECTIVE BUDGETARY CONTROL SYSTEM
1. BUDGET CENTRE​: It is a section of the organization of an
undertaking defined for the purpose of budgetary control.
2. ORGANISATION CHART​: A properly drawn organizational chart
shows the functional responsibilities of each member of management
and ensure that he / she knows his / her position in the organization
and his relationship with others.
3. BUDGET COMMITTEE​: It comprises all executives in charge of
major functions and entrusted with the preparation and finalization of
budgets for various centres and also for the whole company called
Master budget. Generally, the CEO of the company is the Chairman
of the committee and executives in charge of major functions of the
business are the members.
4. BUDGET MANUAL​: It is a document or rule book which provides
for instructions in framing the budgets. It is defined as – ‘a document
which sets out the responsibilities of the persons engaged in the routine
of and the forms and records required for budgetary control’.
5. BUDGET PERIOD​: It is the duration of a budget, which generally
is one year. It is the period of time for which the budget is prepared
and used.
6. PRINCIPAL BUDGET FACTOR / KEY FACTOR /LIMITING
FACTOR / GOVERNING FACTOR: ​It refers to the factor which
dominates the business operations and which acts as an obstacle or
impediment in accomplishing the desired result specified in the
company’s budget. It will limit the activities of an undertaking. It
usually refers to any factor which is in short supply such as – demand,
stock, etc. To ensure that the functional budgets are reasonably
fulfilled, the extent of the influence of this factor must be first assessed.
ILLUSTRATIONS
Illustration 1
Prepare a cash budget for the first four months from the following estimated
revenues and expenses
Additional information​:
I. Cash balance on 1​st ​April was Rs.35,000
II. 50% of sales are on credit basis which are realized in the subsequent
month
III. Suppliers are paid in the month following the month of supply
IV. Delay in payment of wages and overheads is 30 days
V. Dividends on investments amounting Rs 10,000 may be recd. in Apl
& July
The company plans to purchase a machine for Rs.60,000 for which it
has to pay the consideration in three equal installments in the month
of April, June and July.
SOLUTION:
CASH BUDGET FOR THE FOUR MONTHS APRIL TO JULY

Illustration 2
A company produces and sells three items : A,B and C. the company has
divided its market into 2 zones: Zone X and Zone Y. The actual figures
for the previous year sales are given below.
For the current year, it is estimated that sale of A will go up by 10% in Zone B and of C by
25,000 units in Zone A. The company plans to introduce a publicity film for B in the TV. The
budgeted figures for B are to be increased by 20% in both the zones. The prices of A and C are to
be maintained but for C, a bonus cut of Re.1 will be announced. You are required to prepare
quantitative cum financial budget for sales in the current year.
SOLUTION:
SALES BUDGET

Illustration 3
A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces
10,000 buckets per month. The present cost break up for one bucket is given below.
Material Rs.10
Labor Rs.3
Overheads Rs.5 (60% fixed)
The selling price is Rs.20 per bucket. If it is desired to work the factory
at 505 capacity, the selling price falls by 3%. At 90% capacity, the selling
price falls by 5% accompanied by a similar fall in the price of the material.
You are required to prepare a statement showing the profit at 50% and
90% capacities and also calculate the break even points at the capacity
production.
SOLUTION:
FLEXIBLE BUDGET