Deacc506 Financial Reporting, Statements and Analysis PDF

Financial Reporting, Statements
and Analysis
DEACC506
Edited by
Dr. Sukhpreet
Financial Reporting, Statements
and Analysis
Edited By:
Dr. Sukhpreet
CONTENT
Unit 1: Introduction to Accounting 1

Razia Sehdev, Lovely Professional University
Unit 2: Corporate Financial Statements 43

Unit 3: Ratio Analysis 57

Unit 4: Financial Statement Analysis 79

Unit 5: Artificial Intelligence and Analysis 99

Unit 6: Cash Flow Statement 111

Unit 7: Basic aspects of Cost Accounting 126

Unit 8: Budgetary Control 146

Unit 9: Inventory Valuation 164
Unit 10: Marginal Costing and Profit Planning 178

Unit 11: Decision involving Alternative Choices 196
Unit 12: Transfer Pricing 215
Unit 13: Activity-Based Costing 227

Unit 14: Responsibility Accounting 242

Notes
Razia Sehdev, Lovely Professional University Unit 01: Introduction to Accounting
Unit 01: Introduction to Accounting

CONTENTS
Objectives
Introduction
1.1 Meaning of Accounting
1.2 Definition of Accounting
1.3 Characteristics of Accounting
1.4 Branches of Accounting
1.5 Objectives of Accounting
1.6 Users of Accounting Information
1.7 Advantages of Accounting
1.8 Limitations of Accounting
1.9 Accounting Terminology
1.10 Liabilities
1.11 Net Worth or Net Assets
1.12 Expenses
1.13 Profit/Loss
1.14 Stock/Goods/Inventory/Merchandise
1.15 Accounting Concepts
1.16 Accounting Conventions
1.17 Rules of Accounting
1.18 Application of Rules of accounting
1.19 Accounting Equation
1.20 Concept of IFRS and its relevance
1.21 Difference between IFRS and GAAP
1.22 Elements of financial statements
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Reading
Objectives
After studying this unit, you will be able to:
 Explain the meaning of Accounting.

 Illustrate the Accounting Process.
 Identify and classify economic events of organizations for recording in books of accounts.
 Explain the objectives of Accounting.
 Assess the need for accounting information by various users.
Lovely Professional University 1

Notes
Financial Reporting, Statements and Analysis
 Explain the advantages of Accounting.
 review the limitations of Accounting
 Explain accounting terms that are prominently found in financial reports prepared by
business entities.
 Review the use of accounting concepts and conventions in preparation of Books of Accounts
and Financial Statements.
 Adapt the accounting rules in recording the business transactions.
 Illustrate the impact of various transactions on the Accounting Equation of a Business Entity.
 Appraise the relevance of IFRS.
 Write the adoption process of IFRS in India.
 Compare the Indian GAAP, IFRS, and Ind-AS.
 Review the elements of four primary financial statements.
 Assess the purpose of preparing primary financial statements.
Introduction
The primary goal of a company is to make a profit. Accounting is the medium for documenting
business transactions and is regarded as a business language. The information pertaining to the cost
of managing a company and revenues made via business is gathered to determine the outcomes of
a business. The expenses and revenues are then compared to determine the business's profit or loss.
There is a clear relationship between a company's size and the amount of transactions it will do
throughout an accounting period. When the quantity of product sales is great and the number of
business transactions is significant, it is hard for a businessman to remember all of these
transactions. As a result, all of these commercial interactions must be recorded. Accounting is the
process of documenting company transactions or activity.
There is an old quote from a well-known accounting author, Prof. R.R. Gupta, Before delivering
products or rendering services, write or record them, and if there is a dispute in the future, use the
writing or record as proof to settle the misunderstanding or correct the faults.
The business operations are documented not only to determine the profit or loss of the company,
but also to assess the company's financial status. Company accounts are created from the
perspective of the business, but they also serve the owners of the business and outsiders. Creditors
and investors, for example, want to know how safe their investment is, workers want to know how
secure their employment is, clients of company goods/services want to know when their favourite
or favourite items will be available, and so on. Thus, company accounts serve as the foundation
upon which many stakeholders in a firm make financial choices.
After completing this unit, you will be able to understand the concept of accounting, the use of
accounting information, accounting principles, basic accounting terms, accounting equations,
accounting rules, the relevance of IFRS in today's business world, types of financial statements, and
financial statement elements.
Accounting is not an equivalent function to book-keeping. Accounting is broader in scope

than book-keeping.
1.1 Meaning of Accounting

Accounting is regarded as a business language. It keeps track of all monetary transactions that
happened within a certain time period. A company's accounts give vital information to its users.
1.2 Definition of Accounting

"Accounting is the art of recording, classifying, summarizing in a significant manner and terms of
money, transaction, and events which are, in part at least, of a financial character and interpreting
the results thereof."
2 Lovely Professional University

Notes
-American Institute of Certified Public Accountants
“Accounting system is a means of collecting, summarizing, analyzing and reporting, in monetary
terms, information about the business”.
- Robert N. Anthony
“Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of information”.
- The American Accounting Association (AAA)
Based on the above definitions, we conclude that accounting is a science as well as an art of
recording business events that can be measured in money and analyzing and interpreting them.
1.3 Characteristics of Accounting

Based on the above definitions, the characteristics of accounting may be drawn as follows:
1. Accounting is the art of recording financial transactions of the business: All financial
transactions of a firm are documented in the books of business accounts. Because worker honesty
cannot be quantified in money, it cannot be recognized in accounting.
2.Classifying and summarizing recorded data is done in accounting:Financial transactions
are documented in the journal in accounting. The captured data is sorted into a ledger under
suitable headings using a diary. The trial balance and financial statements are then created using
the ledger.
3. Data are recorded in terms of money:Accounting records financial data in a certain phrase,
namely money. There is no other unit that can be used to document the commercial transaction. If
100 goods are sold at a price of 50 each, just the monetary worth of these articles, 5,000 (100 x 50), is
reported.
4. Accounting is science also:It is also known as science because to the meticulous documenting
of economic transactions. First, the business transactions are recorded in the main records, i.e., the
journal, and then the ledger is prepared for categorization. The ledger is used to create the trial
balance, profit and loss account, and balance sheet. After a time, a profit and loss account and a
balance sheet are generated to determine the business's financial situation.
5. Analysing and interpretation of the results is done in accounting:It not only collects,
categorises, and summarises business data, but it also analyses and evaluates the findings for future
choices. Profit, sales, and other metrics may be forecasted using data.
1.4 Branches of Accounting

Different areas of accounting arose in response to the diverse kinds of accounting information
required by distinct classes of accounting information consumers. Each field arose as a result of
scientific, economic, or industrial advancements and has its own particular application.Let’s discuss
the basic three branches of accounting one by one:
1. Financial Accounting:It is the oldest kind of accounting. It refers to the recording of daily
financial transactions in company. The transaction is recorded in such a manner that the profit of
the company can be calculated after a specific length of time and a picture of the firm's financial
status can be given.
2. Cost Accounting:As the name implies, this accounting is concerned with determining the cost
of a product over a certain time. To manage costs, a record of raw materials used in manufacturing,
pay and labour paid, and other production expenditures is maintained under this method.
3. Management Accounting:Management accounting refers to the accounting that gives the
essential information to management. Under this, the analysis and interpretation of financial
accounting accounts are done in such a way that managers may foresee, plan for the future, and
formulate policies.
The above three mentioned branches of accounting are not a conclusive list. Accounting
does have other branches also viz. Inflation accounting, Forensic Accounting, Human
Resource Accounting, Social Accounting, Tax Accounting, etc.

Notes
Accounting Process
Based on characteristics of accounting, the accounting process or accounting cycle is determined as
follows:
Source: Author
Identifying: Only Business-related transactions have a place in the books of accounts.

Remember: Personal transactions of the Owner, shareholders, managerial personnel, and
employees will not be recorded in the accounts' books.
Measuring:Only those transactions that can be measured in monetary terms, i.e., Legal
tender/Currency of country, are recorded in the accounts' books.
Recording:After identifying business-related transactions measured in monetary terms, the
transaction is recorded in the book of "Journal." Journal is also known as a book of primary
or original entry.
Classifying:Post recording the transactions in "Journal," the transactions are organized and
posted in the book of "Ledger"/"General Ledger" under individual sub-ledger accounts.
Ledger is also known as a book of secondary or final entry. Each sub-ledger is further
balanced.
Summarizing:All the general ledger accounts that are prepared in the book of Ledger are
summarized in Trial Balance. Thus, a trial balance is nothing but a summary of all ledger
accounts. Trial balance forms the basis of preparing Financial Statements viz—statement of
Profit & Loss, Balance Sheet, and Cash Flow Statement.
Analyzing and Interpreting:In this step, Financial components that form part of various
Financial Statements are analyzed through appropriate Financial Statement Analysis
methods, and inferences are drawn to aid strategic decision making.
Communicating:Final reports consisting of analysis and interpretations are shared with
top-level management for decision making.
Case Study
Epson Ltd. is the dealer of computers and printers. It has an extensive range of
Multifunction printers which it used to buy from HP for resale purposes. It has bought
one printer for ₹5000 and showed this purchase in the financial statements as an
expense to the business.
A purchasing manager looked into the expense at the year-end and recommended (the
owners) a few cheaper alternatives to be considered for all future purchases.
Let's identify the steps involved in the accounting process in the case mentioned above.

Notes
Accounting Process Explanation of the steps

Steps
Identify The transaction "identified" was the purchase of a printer.
Measure The cost of the printer was "measured" as ₹5000.
Record The transaction was "recorded" in Journal systematically as

₹5000.
Classify The transaction was then moved to the Ledger

and "classified" with similar transactions.
Summarize Here the ledger balance was "summarized" and converted

into trial balance and financial statements accordingly.
Analyze The purchase manager "analyzed" the financial statements at

year-end.
Interpret The analysis led to the "interpretation" that the printer was
costly and cheaper alternatives were available.
Communicate Interpretation inferred from the analysis in the above step

was "communicated" to the owners as a recommendation for
future purchases of this kind.
Mr. Salman is the Owner of a coffee house. The Coffee House also has a menu of specialty
sandwiches, flatbreads, Veggie wraps, and bakery items for breakfast, lunch, and dinner,
along with quality coffee drinks.
Identify the Business events/transactions from the ahead given transactions of Mr.
Salman.
 On August 1, 2020, Mr. Salman bought coffee beans, brown bread, and vegetables for
₹7,000.
 On August 2, 2020, Mr. Salman sold 100 coffee cups for ₹100 each.
 On August 2, 2020, he went to Chandigarh for a business meeting.
 He came back on August 3, 2020, and on the way, he spent ₹ 2000 on petrol for an
official motorcar.
 On August 4, 2020, he purchased Milk, coffee powder, icing sugar, and other material
for ₹3,000.
 On August 5, 2020, he received ₹ 5,000 for coffee and snacks served at customers'
birthday party on the same day.
 On August 6, 2020, he appreciated his employees for putting in their hard work to
complete the targets well on time.
 On August 8, 2020, he got an order to supply 50 sandwiches for ₹100 each.
 On August 10, 2020, he got another order to supply 70 sandwiches for ₹100 each and
received ₹5000 in advance.
 On August 12, 2020, he went to watch a movie with his family and spent ₹5000.

Notes
1.5 Objectives of Accounting
Source: Author
To maintain a systematic record of business transactions:

Transactions are recorded in chronological order in 'Journal' and then posted to the principal book
i.e., 'Ledger' (recording of transactions group-wise).
To ascertain results:
To ascertain whether the company is running into profits or losses at the end of a particular period,
“Profit and Loss Account”is prepared.
To ascertain the financial position:

Another essential objective is to determine the financial position of the business for which the
'Balance Sheet' is prepared.
To assist the management:

Accounting assists management in handling business operations effectively by applying various
tools and techniques such as Common Size Financial Statement Analysis, Trend Analysis, Ratio
Analysis, Cash Flow Analysis, and so on to the financial statements being prepared to determine
profit/loss and financial position, i.e., Income Statement and Balance Sheet.
To provide information to various users:

Providing information to the various interested parties or stakeholders is one of the most crucial
accounting objectives. It is achieved by preparing 'Financial Reports.'
1.6 Users of Accounting Information

There are two types of persons interested in financial statements - 1. Internal users and 2. External
users.
Internal Users:These are (a) Shareholders, (b) Management, and (c) Trade union and Employees.
External Users:Many persons are not directly involved in business but still have an interest in
financial statements. They are termed, external users. For example: Investors, Creditors, Lenders of
Money, Government, Tax Authorities, Stock Exchanges, Media, Business Consultants, etc.

Notes
Source: Author
Shareholders: The financial accounts pique the curiosity of shareholders. They are really
concerned about the success of the company. They may learn about the operational
outcomes and the financial situation of the firm, as well as the earning capability of the
business, through such financial statements.
Investors:Accounting information is used by current and future investors to make
investment choices, such as whether to invest or withdraw money from a company's
shares. They are interested in the earning capability and financial soundness of the
company, which may be determined by financial statements.
Management:Because the majority of choices include money, management analyses
accounting information while making general judgments. Thus, determining whether
the firm has adequate finances to pursue particular possibilities, projects, or not requires
a thorough examination of its financial health.
Decisions related to whether the company should-
 Salary hikes, appraisals, or bonus in the current year or coming years related
decisions
 Expansion of business-related decisions
 Launching of new products, services, models, variants, or offering related decisions
 Marketing decisions
 Investment-related decisions
 Dividend distribution-related decisions
 Continue or Discontinue existing product or service or project-related decisions
All the above deliberations require in-depth analysis of accounting information to reach profitable
and fruitful decisions.
Trade Unions and employees:Trade unions and employees used accounting information to access
their career growth and appraisals related opportunities in the company.
Creditors:Short-term and Long-term creditors use accounting information for making lending
decisions. The creditors and lenders of money etc. can also know the financial soundness through

Notes
the financial statements. They have to see two things (i) Regularity of income and (ii) solvency of
the business so that their investment is risk-free.
Tax authorities:Tax authorities consider Financial statements for assessing the tax liabilities of
companies.
Customers:Clients utilizeaccounting information to judge the availability of corporate items,
particularly if they are regular customers of the company or its products. Customers are
particularly worried about the company's after-sales services when it comes to long-lasting items.
As a result, they assess the company's financial health in order to affirm its market presence in the
future.
Government:Accounting information from individual firms, industries, states, and nations is used
by the government and numerous other government agencies to establish various policies and
strategies, as well as to determine multiple national and state budgets. Financial accounts aid in the
computation of National Income figures, among other things.
Public:The public at large also uses accounting information for making informed decisions
Media, NGOs, and Business consultants/analysts are also users of accounting

information.
1.7 Advantages of Accounting

Accounting does offer manifold advantages to various stakeholders of the business. Let's discuss
some primary benefits of accounting as follows:
Maintenance of records
Accounting is the practice of documenting company transactions in a methodical manner.
Accounting records aid in the verification of any previous company transaction. As a result,
accounting is advantageous for business owners in maintaining the numerous records necessary for
internal business management and external parties. Accounting records can assist businesses in
adhering to the stipulations of certain laws and acts.
Preparation of financial statements

It is difficult to summarize transactions without documenting them in the Journal and Ledger book
because the number of transactions is too large. As a result, a trial balance is created, which serves
as the foundation for creating financial statements such as the profit and loss account, balance
sheet, and cash flow statement. These statements are important not only for the company, but also
for complying with certain rules of several Indian Acts and accounting standards. Financial
statements, too, serve as a tool to impress investors, lenders, and other stakeholders. There are
several reasons for creating financial statements, and one can only do so if the organization is
performing an accounting function.
Comparison of results
To understand the organization's current market position in a competitive business environment,
organizations must analyze their business growth in relation to its historical growth and rivals'
company development. Accounting data provides the foundation for such intra- and inter-
firm/industry comparisons.
Decision making
We know that the primary accounting process ends with the accounting information's
communication to the various users who need accounting information to make decisions. Users of
accounting information do primarily consider accounting information for making practical, timely
decisions.
As an Investor, you are required to decide that you should invest in one company or
move your investment to another company. Thus, you will evaluate companies' financial
statements to reach a particularly profitable investment decision.
Lenders (Individual or Institutional) have to decide about the borrower to whom they
should lend money as they have limited funds to lend but will have so many loan
borrowing applications from different borrowers. Based on the analysis of prospective

Notes
borrowers' accounting information, lenders will choose to lend money only to that
borrower where there is a high probability that they will recover their principal and
interest amount back on time.
Evidence in legal matters

Only commercial transactions backed by verified papers, such as invoices, bills, vouchers, and so
on, are recorded in the books of accounts. Even accounting books are audited. As a result, the
accounts may be used as evidence in court to defend and settle claims.
Provides information to related parties

Accounting makes financial information available to many stakeholders, including shareholders,
investors, lenders, managers, suppliers, the government and its agencies, the media, business
consultants, the general public, and anyone who are directly or indirectly associated to the firm.
Provides information about related party transactions

Accounting Standard 18 (AS-18) and Indian Accounting Standard 24 (Ind AS-24) require a parent
business to provide separate disclosures about its transactions with associates, joint ventures, or
subsidiaries, referred to collectively as Related parties. The goal of such separate disclosures is to
draw attention to the fact that transactions with related parties may have an impact on an entity's
financial statements and profit or loss.
Helps in taxation matters

Accounting information aids in the resolution of tax liability discrepancies. Various Income Tax
Department (ITD) tax bodies, such as the Central Board of Direct Taxes (CBDT) and Regional
headquarters, rely on the firms' accounts for taxation purposes.
Valuation of Business
Determining the genuine and fair worth of a company is essential when selling or converting one
firm into another. Accounting serves the function in such a business environment by providing
financial statements, namely a Balance Sheet, which reflects a company's real financial status on a
certain date. Accounting information makes it simple to establish or compute the purchase price,
selling price, and net value of a corporation.
Replacement of memory
A person cannot keep track of all transactions that occur at various times in time in his or her
thoughts. Memory loss is a problem that humans encounter. Accounting overcomes this limitation
of the human intellect by serving as a structured and genuine record of each company transaction.
Accounting therefore serves as a substitute for memory.
1.8 Limitations of Accounting

As a coin has two sides, accounting does have the following few limitations along with the benefits
discussed above:
Measurability: Ignores the qualitative elements

We know that only transactions that can be quantified in monetary terms can be recorded in the
books of accounts. As a result, despite their importance, qualitative aspects and information have
no place in the books of accounting. Employee morale; the company's ability to adapt to changes;
the intellect or inventiveness of business teams; the honesty of workers or management, and so on,
all have a genuine influence on business performance. However, they are not documented in the
books of accounts. As a result, one disadvantage of accounting is disregarding qualitative aspects in
the production of books of accounts.
Biasness
Accounting does allow an accountant to choose any technique from among those available for
valuing particular financial aspects such as current assets and non-current assets. All approaches
provide varying results for the underlying financial factors. Thus, accountants' influence, prejudice,
or management pressure to choose a certain approach influences the entity's financial information.

Notes
An accountant can use any method of depreciation (straight line method, written down
value method, units of production depreciation, etc.) to calculate the value of a company's
fixed assets to meet the needs and objectives of the company, as each method provides a
different yearly depreciation amount and closing value of fixed assets.
An accountant may use any technique for inventory valuation, including the FIFO, LIFO,
and Weighted Average methods. All approaches will provide a different inventory
closing value. Thus, an accountant might choose a solution that serves the management's
aim but may be deceptive to other stakeholders.
Estimates
In many circumstances, exact statistics are unavailable, forcing accountants to make educated
guesses about future spending, earnings, or other financial parts of financial statements. Because
estimates are based on the accountants' own opinions, intuitions, or experiences, they allow
subjectivity to enter accounting information. The subjectivity inherent in developing estimations
may impair the capacity of accounting information to obtain and report the real and fair value of
the business's condition of affairs.
Ignores Price Level Changes

This pertains to the idea of historical cost. We know that fixed assets are recorded in the books of
accounts at their historical cost rather than their market worth. In most cases, historical cost varies
from the initial cost of an object. As a consequence, disregarding price level changes and recoding
assets at historical cost distorts accounting results.
The danger of Window Dressing

The modification of accounting facts to satisfy the deeper goals of people or organisations is known
as window dressing. Accounting information that has been distorted or misrepresented by
accountants or management misleads stakeholders and distorts the entire objective of accounting,
which is to convey the real state of affairs of company to the internal and external world.
No Future Assessment
The financial statements depict the firm's financial situation as of the date of preparation. The
statement's users are more concerned with the statement's short- and long-term prospects.
Accounting, on the other hand, does not make such estimations. Accounting information is less
beneficial for making future choices since stakeholders cannot immediately estimate the company's
future performance and position based on current financial statements.
Historical Cost
Accounting, as previously established, disregards variables such as inflation, price fluctuations, and
so on, and instead measures values using past costs. This has an influence on the usefulness of such
accounting records and information.
Varied Accounting Policies

Accounting policies have no universal standard. In India, we follow Accounting Standards and
have advanced towards IFRS by developing convergent Accounting Standards (Ind AS), Americans
follow GAAP, and then there are international standards, especially the IFRS. Furthermore, if a
multinational corporation operates in more than one country, there may be uncertainty.
Because not all accounting rules follow the same line of thought, conflicts may emerge. It has long
been said that the whole globe must agree on universal accounting rules; yet, this has yet to occur.
To circumvent this accounting constraint, several nations throughout the world have begun to
adopt IFRS.
Verifiability
We have seen so many accounting scams which give evidence of non-verifiability of even audited
financial statements. An audit of the financial statements even does not guarantee the correctness of
such statements.
1.9 Accounting Terminology

Let's discuss some basic accounting terms that help you to understand accounting:

Notes
Business Entity
The word "entity" refers to anything or someone who has a distinct existence. A 'business entity' is a
distinct entity or existence of a commercial firm. In the perspective of the law, a Company or a
Corporate is a Separate Business Entity that exists apart from its owners.
"Gautam Adani" is an Individual entity that owns "Adani Group of Industries" which is a
separate business entity in the eyes of law. So, "Gautam Adani" and "Adani Group of
Industries" are two separate legal entities.
Transaction
A transaction is an economic activity that involves the exchange or transfer of values between two
parties.
Purchase or Sale of Goods, receiving cash from Debtors, payment made to creditors, paying
bills, receiving incomes, etc.
Capital
Capital is the amount of money or money's value invested or introduced by the entrepreneur into
his firm at the time of its inception. Entire assets minus total liabilities equals capital. Capital grows
as a result of more or additional capital and profits made by the firm. Withdrawals from the owner
and losses sustained by the firm reduce capital.
Proprietor or Owner
A proprietor is a person who invests money or money's worth into the business as capital and bears
all the risks of the business.
Drawings
Drawings refer to cash, goods, or any other asset withdrawn by the proprietor from his business for
his personal, private or domestic use or purpose. It reduces the amount of capital.
Assets
Assets mean resources, things or rights of value owned/ controlled by a business undertaking
which benefits future period or periods. Assets are categorized as Tangible Assets and Intangible
Assets based on Physical Existence.
Tangible Assets:
Any assets that have a physical presence.
Cash, Property, Buildings, Equipment, Furniture, Inventory
Intangible Assets:
Assets having no physical presence and it is usually difficult to determine their value. These are
subject to amortization except goodwill.
Patents, Goodwill, Copyrights, Trademark
Assets are categorized as Current Assets and Non-Current Assets based on Convertibility.
Current Assets:
These assets are short-term assets that include either cash itself or are expected to be converted into
cash within a year of the current operating period.
Cash in hand, Cash at Bank, Debtors, Stock/ Inventory
Non-current Assets:

Notes
These assets cannot be easily converted into cash as they are not for resale purposes and subject to
depreciation. They are used in a company for the long term that is for more than 1 year.
Property, Building, Equipment, Furniture
Caselet
Let's say you got a loan of ₹10,000, you went out and bought the latest model oven,
Bakemaster X-Series 3000.
Is Bakemaster X-Series 3000 an asset for you? Justify.
Caselet
Walmart acquired a majority stake in the Indian e-commerce giant Flipkart in 2019. It
attributed 77% of Flipkart's $24.1 billion in assets to intangibles and goodwill,
highlighting the premium the US retail giant paid.
Will Goodwill be treated as an Asset of Walmart post said acquisition?Justify.
1.10 Liabilities
Liabilities mean claims of outsiders against a business concern which binds the business concern to
others. Liabilities are categorized as Current Liabilities and Non-Current Liabilities.
Current Liabilities:
These liabilities are those obligations that are payable within 12 months or the operating cycle of a
business.
Trade Creditors, Bank Overdraft. Outstanding Expenses
Non-Current Liabilities:
These liabilities are those long-term debts or long-term liabilities which are payable beyond twelve
months in the future.
Long Term Loans, Debentures
1.11 Net Worth or Net Assets

Net worth or net assets means the excess of the total assets of a business over its total liabilities at
any particular point in time. That is why it is also termed as the Owner's capital.
1.12 Expenses
The amount of money spent to earn income during the year is known as an expense.
1.13 Profit/Loss
If incomes earned during the year are more than expenses incurred, there is profit otherwise loss to
the company.

Notes
1.14 Stock/Goods/Inventory/Merchandise
It refers to the goods purchased are for selling. Stock refers to the products that the business is
manufacturing, selling, or trading with. If the goods are not sold out fully, a part of the total goods
purchased is kept with the trader unlit it is sold out, it is said to be a stock.
In a stationary business, Pencils, pens, copies, books, and erasers, etc constitute goods.
In a garment business, clothes are goods
In a footwear business, Footwears are goods
In a construction business, Ready to sold flats, buildings, homes, etc constitute goods.
For a manufacturing business, there can be three types of Inventory i.e. Stock of Raw materials,
Work-in-progress, and Stock of Finished goods.
It is the type of business and use of the item that defines what is the business stock and
what is its assets?
Furniture will be treated as Stock/goods in a Furniture House, however, it will be treated
as an asset in other businesses. Moreover, if the furniture is placed in an office not meant
for sale in a Furniture House, then it will be treated as an asset, not stock.
1.15 Accounting Concepts

The term 'concept' is used to connote accounting postulates, which are necessary assumptions and
conditions upon which accounting is based. These are the theories on how and why certain
categories of transactions should be treated in a particular manner. The following are the basic
accounting concepts:
Let's discuss them one by one in details as follows:
Business entity concept

The business entity concept states that the Business and its Owner (s) are two separate entities.
Implications of Business entity concept
 The personal transactions of the Owner are not recorded in the books of accounts of a
business.

Notes
 The assets of the business are not treated as assets of the business owner, and vice versa.
 The liabilities, the financial obligations of the business are not treated as the personal
obligations of the businessman
 Whenever the Owner is contributing any money or money worth towards the business, it is
treated as capital, a liability for the business. And when the businessman, the proprietor
withdraws certain goods, cash, or any other belonging of the business. It is not treated as an
expenditure of the business. Rather, it is treated as drawings.
A Car purchased by the Owner for personal use is not recorded as an asset in the Books
of Account of the Business.
Going concern concept

Going concern concept implies that business will continue to operate for an indefinite period in the
future and transactions are recorded in books of accounts from this perspective.
Implications of going concern concept:
 Assets are classified as Current assets and Non-current assets in books of accounts.
 Liabilities are classified as Current liabilities and Non-current liabilities in books of accounts.
 Computation of depreciation based on the expected economic life of fixed assets.
 Existence of Prepaid Expenses, Accrued Expenses signifies the company is going to be
operative in the future, it is a going concern.
Caselet
A company purchased a plant and machinery of ₹1,00,000 and its life span is 10 years.
 In the absence of the Going concern concept, how will you record it? As a Fixed asset
or expense?
 As per the Going concern concept, how will you record it? As Fixed asset or, expense?
Justify your answers.
The going concern concept applies to the company's business as a whole. That is why if a
company discontinues its one product/service/brand/segment or even branch and
continues with others, it does not imply that the company is no longer to remain going
concern.
Money Measurement concept

According to the money measurement principle, in accounting, only accounting transactions or
events that can be measured and described in terms of money are recorded.
Implications of money measurement concept:
 Only quantitative information that can be expressed in monetary terms has a place in books of
accounts.
 Qualitative information though important, yet will not get any place in books of accounts.
Few instances of items that cannot be measured in monetary terms and thus will not
be found in books of account are:
Employees' skills, honesty, teamwork, creativity, experience, attitude,
innovativeness, working conditions, the efficiency of management.
Only monetary term i.e Legal tender/currency is used as a measurement unit. Thus,
other measurement units like kilograms, litre, square feet, meter, Kilometer, etc. cannot be

Notes
used to measure the transaction for recording purposes.
 An Indian company will measure its transactions in Indian Rupee (₹).

 A US company will measure its transactions in US Dollars ($).
 A Japanese company will measure its transactions in Japanese Yen (¥).
 Which will be the measurement unit for England companies for preparing their
books of accounts?
It will be Pound Sterling (£)
 Which will be the measurement unit for European companies for preparing their
books of accounts?
It will be Euros (€)
Accounting Period concept

As per the accounting period concept, for measuring the financial health of a business periodically,
the working infinite life of an undertaking is split into convenient artificial short periods called an
accounting period.
Implications of accounting period concept:
 Companies close their books of Accounts at the end of the Accounting year to evaluate the
company's performance and position.
 Companies can follow the financial year or calendar year as their accounting year.
Companies do prepare and evaluate monthly, quarterly, and semi-annually financial

statements for internal management purposes. However, preparing and publishing
annual financial statements is mandatory for registered companies as per applicable legal
provisions in India.
What is the difference between financial year and calendar year?

Financial Year starts on April 1 and ends on March 31. For example April 1, 2021, to
March 31, 2022. The calendar year starts on January, 1 and ends on December, 31. For
example- January 1, 2021, to December 31, 2021.
Which will be the closing date of business’ accounts, if a business is following the
financial year for preparing its books of accounts?
Which will be the closing date of business’ accounts, if a business is following the
calendar year for preparing its books of accounts?
Cost concept/Historical cost concept

The cost principle of accounting (also known as the historical cost concept) states that the assets and
liabilities of a business should be presented in accounting records at their historical cost.
What do you mean by the Historical cost of an asset?

Historical cost is the amount that has been spent to purchase that asset.
What do you mean by the Market value of an asset?
It is the price that can be realized by selling the asset on a particular date.
A business owner purchased Machinery for ₹5,00,000 on January 1, 2015 for his business.
The business provided annual depreciation of ₹50,000 at the closing date of each
accounting year. Thus, the carrying value of that machinery turned to be ₹3,00,000 as on
December 31, 2018, in the books of accounts. The business owner wanted to replace that
machinery with a new one, so when he assessed the value at which he could sell that
machinery, he realized it could be sold at ₹2,15,000 only.

Notes
In this example: The historical cost of the machinery is ₹5,00,000 and the Market value is
₹2,15,000.
The implication of cost concept:

● An asset acquired by a concern is recorded in the books of accounts at historical cost (i.e.,
at the price paid for acquiring the asset). The market price of the asset is ignored.
If an asset was purchased for ₹10 lakh in 2015 by the ITC company. So, ITC must have
to record that asset at that ₹10 lakh in the books of accounts of 2015. Plus, ITC would
have to deduct the depreciation amount every year to calculate the carrying value of
that asset in the subsequent years' books of accounts.
Dual Aspect concept

The dual aspect concept states that every transaction should have a two-sided effect to the extent of
the same amount for recording purposes. This concept is the basis of the double-entry system. In
accounting language, this concept states for "every Debit, there is an equivalent Credit". This
concept is derived from the Accounting equation that equates Assets with Liabilities plus Capital.
Assume you are the Owner of a Restaurant. You are required to buy crockery for your
restaurant. Say, it costs your business ₹50,000. So, as per the dual aspect, on one side,
cash of ₹50,000 will be moved out from your business, and crockery as an asset worth
₹50,000 will move in your restaurant.
Realization concept
The realization concept states revenues should be recorded in the books of accounts only when they
are earned. Revenue is earned when goods/services are delivered or provided to customers by the
business.
When does a business earn revenue?

● The revenue is earned once the underlying goods or services associated with the
revenue have been delivered or rendered, respectively.
Implications of realization concept
 Mere receipt of orders is not treated as Sales and Hence is not recorded as a transaction in
books of accounts.
 When the customer pays for the goods in advance is treated as Current liability because the
business has not performed its obligations either partially or fully.
Matching concept
The matching concept requires that the expenses incurred during a period be recorded in the same
period in which the related revenues are earned. This principle recognizes that businesses must
incur expenses to earn revenues.
Implications of Matching concept
 Business recognizes revenues and their related expenses in the same accounting period.
 Outstanding expenses are added in the total of that respective expenses and are treated as
Current Liabilities.
 Prepaid Expenses are deducted from the total of that respective expenses and are treated as
Current Assets.

Notes
 Accrued Incomes are added to the total of that respective income and are treated as Current
Assets.
 Pre-received incomes are deducted from the total of that respective income and are treated as
Current Liabilities.
Accrual Concept
Accounting's accrual concept assumes that revenue is realized at the time of sale of goods or
services, regardless of when the cash is received. In other words, regardless of when the actual cash
flows for the transaction are received, transactions must be recorded in the period in which they
occur. The accrual principle holds that financial events are properly recognized by matching
revenues against expenses when transactions occur, such as a sale, rather than when the actual
payment for the transaction is received.
The implication of accrual concept:

Existence of the following Accounts in accounting books:
 Outstanding Expenses
 Prepaid Expenses
 Accrued Incomes
 Pre-received incomes
1.16 Accounting Conventions

Accounting conventions are the common practices that are universally followed in recording and
presenting accounting information of the business. Following is the list of accounting conventions:
Let's discuss the above-mentioned accounting conventions one by one:
Materiality
The materiality convention is concerned with the relevance of information, as well as the size and
nature of transactions reported in financial statements.
Only transactions that are useful and significant to the business are recorded in books of accounts,
according to this convention. Immaterial and insignificant items do not need to be recorded by the
company.
Materiality is determined by the nature and size of the item. The rationale behind this convention is
that any information that could influence an accounting information user's decision must be
included.
Full disclosure
The full disclosure convention requires a company to report all required and relevant information
about its financial statements and operations to various stakeholders who need to make informed
business decisions about the company. This convention ensures that readers and users of financial
information from a business are not misled by a lack of information.
A company's annual report will include detailed notes to accounts as well as three primary
financial statements due to the full disclosure convention. Notes to accounts provide detailed
information about the accounting policies and methods used to calculate the values of financial
elements included in financial statements.
What are notes to accounts?

These are also referred to as footnotes. These provide additional information about a
company's operations and financial position and are considered to be an integral part of the

Notes
financial statements. The notes are required by the full disclosure principle.
What is an annual report of a company?
An annual report is a document that public corporations must provide annually to
shareholders that describes their operations and financial conditions.
Conservatism
When preparing books of accounts, the conservative convention states, "anticipate no profits but
provide for all losses." It emphasizes the importance of an accountant exercising due caution and a
high level of verification when preparing books of accounts.
Implications
 All probable or anticipated losses are recorded when they are identified, while profits or gains
can only be recorded when they are fully realized or earned.
 Making Provision for Bad and Doubtful Debts.
 Showing Depreciation on Fixed Assets, but not appreciation.
 Stock valuation sticks to the rule of the lower of either cost or net realizable value.
Consistency
A company should use the same accounting policies and principles to prepare books of accounts
across different accounting periods, according to the consistency convention. It denotes that once
an accounting method/policy/principle is chosen, the company should adhere to it in the future
unless there is a compelling reason to do otherwise.
In the absence of this convention, a company's financial statements will become incomparable and
inconsistent. As a result, users of accounting information will face difficulties analyzing the
company's financial position and performance in comparison to its past performance and industry
performance based on such inconsistent financial statements.
1.17 Rules of Accounting

Rules of accounting are useful for systematically recording the business transactions in Books of
Accounts.
What are Debit and Credit?

 Debits and credits are simply additions to or subtractions from an account.
 "Dr." used in journal entries to refer to debits and "Cr." used in journal entries for a credit.
 Asset, Expense, and Loss accounts normally have debit balances.
 Liability, income, and capital accounts normally have credit balances.
Rules of accounting can be discussed in two different ways i.e. Traditional or 3 Golden rules of
accounting and Modern rules of accounting. Let us discuss them one by one as follows:
Traditional or 3 Golden Rules of Accounting

As per traditional or Golden rules of accounting, accounts and categorized into three broad
categories, and the rules of debiting or crediting them are summarized as follows:
Debit the receiver

Personal accounts
Credit the giver

Notes
Debit what comes in

Real accounts
Credit what goes out
Debit all expenses or losses

Nominal accounts
Credit all incomes or profits or gains
Source: Author
Personal accounts:These are those general accounts that represent persons. Persons can be natural
persons, artificial persons. These can be representative personal accounts as well.
Natural Personal Account:Natural Persons mean persons who have taken birth through the natural
process like human beings. Therefore, we include the accounts belonging to them under this head.
Sangeeta Account, Ramesh Account, Triveni Account, Jerry Account, Debtors Account,
Creditors Account, Capital Account, Drawings Account, etc.
Artificial Personal Account:Artificial persons connotes those legal entities that have taken birth
through a legal process such as companies, partnership firms, NGOs, insurance companies, banks,
other financial institutions, cooperative societies, hospitals, educational bodies, etc.
Tata Steel Account, Bharti Airtel Account, M/S Vinod Textiles Account, PNB Account,
etc.
Representative Personal Account:These accounts represent several natural or artificial persons.
Outstanding Wages Account, Prepaid Commission Account, Accrued Rent Account,

Unearned Brokerage Account, etc.
Real accounts:These accounts represent various assets and liabilities accounts of a company.
Building Account, Cash Account, Stock Account, Patent Account, Trademark Account,
Loan Account, Debentures Account, Bonds Account, Plant & Machinery Account, etc.
Nominal accounts:These accounts represent various expenses and losses that a company is
incurring plus various incomes, profits, and gains that a company is earning.
Rent Paid Account, Salaries Account, Insurance premium Account, Commission Account,
Commission received Account, Discount allowed Account, Discount received Account,
Loss due to theft Account, Loss due to fire Account, Interest paid Account, Interest
received Account, etc.
Modern Rules of Accounting:

As per modern rules of accounting, accounts are categorized in five categories as follows:
Source: Author
As per modern rules of accounting, the above five types of accounts have to debited or credited
when:

Notes
Source: Author
1.18 Application of Rules of accounting

Let's learn how to apply the discussed rules of accounting at times of recording transactions in
Books of Accounts particularly in Journal.
Transaction 1: Akash started Business with Cash of ₹10,000.
Let's identify the different accounts involved in the above transaction along with their type or
nature:
Source: Author
Thus, the above transaction will be recorded as a journal entry in the book of Journal as follows:
Cash A/c---Dr. ₹10,000

To Capital A/c ₹10,000
Transaction 2: Akash sold goods to Mr. Vivan for ₹6,000 on credit.

nature:
Source: Author
Mr. Vivan A/c---Dr. ₹6,000

Notes
To Sales A/c ₹6,000
Transaction 3: Akash paid Salaries worth ₹1,000.

nature:
Source: Author
Salaries A/c---Dr. ₹1,000

To Cash A/c ₹1,000
Transaction 4: Akash received Commission worth ₹1,000.

nature:
Source: Author
Cash A/c---Dr. ₹1,000

To Commission A/c ₹1,000
Transaction 5: Akash received ₹500 from Mr. Vivan.

nature:

Notes
Cash A/c---Dr. ₹500

To Mr. Vivan A/c ₹500
Identify the accounts involved in the following transactions and pass journal entries for
the same:
1. Akash purchased goods worth ₹5,000 for the business.

2. Akash deposited business cash worth ₹1,500 in business' HDFC Bank A/c.
3. Akash withdrew ₹500 from business' HDFC Bank A/c for his personal use.
4. Akash paid ₹800 for Rent.
5. Akash purchased goods for ₹1,800 from Mr. Lokesh.
1.19 Accounting Equation

The word equation comes from the word equal. For any equation, one side always equals another.
The accounting equation is as follows:
Source: Author
Sometimes, we expand the Accounting Equation to show all the Equity components as follows.
This is called theExpanded Accounting Equation.
Source: Author
Note: This equation mustALWAYS BE IN BALANCE
Case:
Let's learn how transactions impact the Accounting Equation with the help of the following
transactions:
Transaction 1: Owners of S. Company contributed ₹20,000 cash to start the business.
Transaction 2: Purchased goods by paying ₹1,000 Cash.
Transaction 3: Purchased equipment for ₹15,000 from Tridev Ltd.
Transaction 4: Sold good Costing ₹500 for ₹1,000.
Solution:
The impact of the above transactions on the accounting equation is as follows:

Notes
Source: Author
Show the effect of the following transactions on the Accounting Equation.
1. Started Business with cash ₹45,000

2. Opening a Bank Account with a deposit of ₹4,500
3. Bought goods from M/S Sunflames for ₹11,200
Show the effect of the following transactions on the Accounting Equation?

2. Paid Salaries ₹1,000
3. Received Rent ₹2,000
4. Outstanding Wages ₹1,500
5. Prepaid insurance ₹1,000
Prepare accounting equation from following transactions:

2. Received Rent in advance ₹1,000
3. Accrued Interest ₹2,000
4. Purchased Machinery for ₹15,000 on credit
5. Depreciation provided ₹1,500
1.20 Concept of IFRS and its relevance

The globe has become one economic digital village in the current period of liberalization,
globalization, and digitalization. Because of the globalization and digitization of the corporate
sector, as well as the structures and rules that support it, it is critical to design and adhere to a
single internationally acknowledged financial reporting system. Several multinational companies
have established operations in different developing economies throughout the globe in order to
reap the advantages of lower-cost business operations provided by such emerging economies. Even
most multinational corporations set up shop in many nations throughout the globe to achieve
various business goals such as generating money, diversifying company risks, achieving organic or
inorganic business growth, and so on. Companies do list their securities in international capital
markets in order to raise funds from such markets. Thus, the corporate world need well-integrated
financial markets from many nations. The employment of multiple accounting frameworks in
different nations, which require differing accounting treatment and presentation of the same
underlying economic activities, causes accounting information consumers to get confused. This
misconception leads to inefficiencies in stock markets throughout the globe. As a result of the

Notes
increasing complexity of financial reporting and the globalization of capital markets, a single set of
high-quality widely recognized accounting standards is required.
High financial reporting standards promote investors' confidence in financial and non-financial
information offered by diverse firms. As a result of the necessity for a single set of internationally
recognized accounting standards, several countries have converged their national accounting
standards with IFRS.
Answer the following questions:

● What do mean by accounting standards?
● Who does prepare and issue accounting standards in India?
● What is the need for accounting standards?
What is IFRS?
The International Accounting Standards Board (IASB) created International Financial Reporting
Standards (IFRS) for the compilation of corporate financial statements. They are regarded as
"principles-based" norms. They provide general guidelines rather than precise accounting methods
for underlying transactions. Every major country has already adopted or is in the process of
implementing IFRS to some degree. A substantial number of global capital market regulatory
bodies compel public corporations, including financial institutions and insurance companies, to
utilize IFRS when preparing statutory financial reports. IFRS is considered as a globally recognized
business language.
It is a collection of high-quality, internationally recognized financial accounting standards that
specify how certain kinds of transactions and other events should be represented in financial
statements. It aspires to create an uniform worldwide language for business activities so that
company accounting can be understood and compared across borders.
Need of IFRS
The need for IFRS stems from the lack of comparability of financial statements across the countries
resulted from following different accounting standards. The following considerations seed the need
of setting a common business language to be followed across the world.
 The need to communicate across the border has increased due to globalized capital markets.
 Need for harmonization of accounting policies and financial reporting.
 To have a common accounting language, so business and accounts can be understood from
company to company and country to country.
 To facilitate the investment climate of emerging and globalized economies like India.
 To integrate the financial reporting of a specific country with the rest of the economies of the
globe.
 For making International Acquisitions for inorganic business growth.
 To have a standard quality of MIS.
 To enhance confidence among the global stakeholders for investing in international markets.
 What is harmonization?
Harmonization in the accounting context may be defined as the process aimed at

enhancing the comparability of the financial statements produced in different
countries' accounting regulations.
Let’s understand with an example:
Investors would like to direct their capital to the most efficient and productive
companies globally provided they are in a position to understand their
accounting/financial reports. So, if all countries across the globe would have adopted
the standard accounting standards. It makes it easier to use financial reports for
taking prudent investment decisions by investors across their borders.
Hence, It lays down the rationale behind the harmonization of accounting standards
across the globe.
 What is MIS?

Notes
A management information system (MIS) is a computer system consisting of

hardware and software that serves as the backbone of an organization’s operations.
An MIS gathers data from multiple online systems, analyzes the information, and
reports data to aid in management decision-making.
Who prepares and issues IFRS?

The International Accounting Standards Board (IASB) is an independent organisation that was
established in 2001 with the express purpose of developing International Financial Reporting
Standards (IFRS). It superseded the Worldwide Accounting Standards Committee (IASC), which
had previously been tasked with developing international accounting standards. The IASB is
headquartered in London. It has also supplied the 'Conceptual Framework for Financial Reporting,'
which was published in September 2010, and which gives a conceptual understanding and the
foundation for IFRS accounting processes.
Modes of IFRS compliance

● Countries can comply with IFRS through two modes i.e. Adoption and Convergence.
● Under adoption, countries adopt IFRS as it is formed by IASB with zero modification.
● Under convergence, countries prepare their standards in line with IFRS.
India's approach to move towards IFRS

The Institute of Chartered Accountants of India (ICAI) began the process of transitioning to IFRS in
2006 in order to improve the acceptability and transparency of financial reporting produced by
Indian enterprises. The Government of India eventually agreed to this shift toward IFRS (GOI).
Following an in-depth review of IFRS requirements, the Government of India decided to converge
with IFRS in conjunction with the ICAI and other stakeholders. As a result, while producing IFRS-
converged Accounting Standards (Ind AS), every attempt was made to maintain these standards as
close to the equivalent IAS/IFRS as feasible, and any deviations were deemed necessary. At the
G20 conference in 2009, India pledged to adopting IFRS beginning in 2011. It was chosen to follow
IFRS via convergence rather than adoption since convergence allows for country-specific
modifications. Indian Accounting Standards are accounting standards that have converged with
IFRS (Ind AS). From April 1, 2015, India voluntarily introduced Ind AS for all firms (with
comparatives). Ind AS, on the other hand, became required for some enterprises on April 1, 2016.
What is Ind AS?

Ind AS are a set of accounting standards announced by the Government of India's Ministry of
Corporate Affairs that are convergent with IFRS. The Accounting Standards Board (ASB) of the
Institute of Chartered Accountants of India develops these standards (ICAI). MCA has notified 41
Ind ASs as revised by the Companies (Indian Accounting Standards) Amendment Rules, 2015,
along with a detailed implementation plan.
Roadmap of Implementing Ind AS

Look at a snapshot of the roadmap for implementing Ind AS as follows:
Source: Author

Notes
For companies other than banks, NBFCs, and Insurance companies:
Phase 1 April 1, 2015, or thereafter: Voluntary basis for all companies (with
Comparatives)
April 1, 2016: Mandatory Basis
a. Companies listed/in process of listing on Stock Exchanges in India or

outside India having net worth ≥ ₹5 Billion
b. Unlisted companies having a net worth ≥ of ₹5 Billion
c. Parent, Subsidiary, Associate, and Joint Venture of above
Phase 2 April 1, 2017: Mandatory Basis
a. Companies listed/in process of listing on Stock Exchanges in India or

outside India not covered in Phase 1 (other than companies listed on
SME exchanges)
b. Unlisted companies having net worth is >₹2.5 Billion but <₹5 Billion
c. Parent, Subsidiary, Associate, and Joint Venture of above
For Scheduled commercial banks (excluding RRBs), NBFCs, and Insurance companies:
Phase 3 Planned As:
Applicable from April 1 2018 (with comparatives)
a. Applicable to all banks, NBFCs & insurance companies having a net

worth ≥ ₹5 Billion.
b. Parent, Subsidiary, Associate, and Joint Venture of above other than
already covered under the corporate roadmap
Phase 4 Planned As:

Applicable from April 1, 2019 (with comparatives)
Applicable to NBFCs having net worth is >₹2.5 Billion but <₹5 Billion
Actual Scenario of implementation of Ind AS on Commercial Banks/Insurance

companies:
As previously stated, Scheduled Commercial Banks (SCBs) except Regional Rural Banks
(RRBs) were obliged to apply Indian Accounting Standards (Ind AS) from April 1, 2018.
The RBI (Reserve Bank of India) postponed the implementation of Ind AS by one year in
a press statement dated April 5, 2018, i.e., 2019-20 would have been the first year of Ind
AS, with 2018-19 as the comparative year. In order for banks to comply with the
disclosures required by Ind AS, some legal adjustments in the style of financial
statements were necessary. To make the format change compatible with Ind AS accounts,
the third schedule of the Banking Regulation Act, 1949 must be amended.
The RBI has suspended the implementation of Ind AS to all scheduled commercial banks
till further notice in a notification dated March 22, 2019. This is because the adjustments
proposed by RBI are still under consideration of the Government of India, consequently,
RBI has decided to suspend the implementation of Ind AS until further notice.
On January 21, 2020, the Indian Insurance Regulatory and Development Authority
(IRDAI) decided to postpone the adoption of the Indian Accounting Standard (Ind-AS),
which was scheduled to begin in 2020-21, indefinitely for the domestic insuranceindustry.

Notes
Previously, IRDAI extended the effective date of adoption of Ind AS in the domestic
insurance industry to FY 2020-21 in its circular dated June 28, 2017.
Given the costs and difficulties required, as well as the asset-liability mismatch (as
described in the background section), IRDAI resolved in its meeting on December 20,
2019 to adopt Ind AS 109, Financial Instruments, and Ind AS 117 concurrently, along with
other related Ind AS. However, the effective date of adoption would be determined once
the IASB finalised IFRS 17.
Final stage
 In June 2020, the International Accounting Standards Board (Board) amended IFRS
17 Insurance Contracts.
 Issued in May 2017, IFRS 17 sets out the requirements for a company reporting information
about insurance contracts it issues and reinsurance contracts it holds.
 The amendments are aimed at helping companies implement the Standard and making it
easier for them to explain their financial performance.
 IFRS 17 incorporating the amendments is effective from annual reporting periods beginning
on or after January 1, 2023.
Benefits of Convergence with IFRS

Many beneficiaries will get benefit from such convergence such as the economy, investors,
industry, etc.
Economy: The convergence boosts the economy by increasing international trade and enhancing
foreign investors' confidence in investing in international capital markets. Only if an investor is
convinced that he or she understands the financial information offered by foreign firms will he or
she accept foreign origin companies as an investment choice. This assurance arises from
standardized global accounting terminology, which occurs when organizations use the same set of
accounting rules, procedures, and standards to generate and present their financial data.
Investors:Financial information compiled in accordance with a common set of accounting
standards assists investors in understanding investment possibilities available in international
markets. As a result, convergence with IFRS helps investors comprehend and trust high-quality
financial statements.
Industry:The industry may finance itself at a reduced cost from overseas markets if it can instil
trust in the eyes of foreign investors that its financial statements adhere to globally recognised
accounting standards.
1.21 Difference between IFRS and GAAP

Following is the list of ten basic differences between Indian GAAP, IFRS, and Ind AS.
Basis INDIAN GAAP IFRS IND AS
Components a) Balance a) Statement of financial a) The balance

of Financial sheet position. sheet at the

Notes
Statements b) Statement of b) Statement of income end of the
Profit & loss with profit/ loss period
c) Cash flow c) Statement of cash including
statement flows changes in
d) Explanatory d) Statement of changes equity
notes with in equity b) Statement of
significant e) Notes with a profit/ loss
accounting summary of c) Cash flow
policies significant statement
Comparativ accounting policies d) Explanatory
e figures for Comparative figures notes with
one year are for one year are also significant
also to be to be presented. accounting
presented. policies
Comparativ
e figures for
one year are
also to be
presented.
Format of Under Schedule VI of Only illustrative formats have No format

Financial Companies Act, 1956 been given. prescribed.
Statements have provided earlier
Now, Under
Schedule III of
Companies Act, 2013
Accounting Financing activities Cash & cash equivalents Same as IFRS

Treatment of
Bank
Overdraft
Cash flows To be classified as Cash flow statements do not Same as IFRS

from operating, financing, reflect any items as
extraordinar and investing extraordinary.
y items activities.
Interest and For financial entities: May be classified as Same as Indian

dividend Interests operating/investing/financin GAAP
paid/received, or g activities in a manner
Dividends received consistent from time to time.
are to be classidied as
operating activities.
Dividends paid to be
classified as financing
activities.
For other entities:
Interest and
dividends received
are required to be
classified as investing
activities. Interest and
dividends paid are
required to be
classified as financing
activities.

Notes
Dividends Dividends declared Declared dividend to be Same as IFRS

declared or proposed after the recognized in the period when
balance sheet date it is declared.
but before approval
of financial
statements will have
to be recorded as a
Current liability.
Convertible The entire instrument Shareholders' Fund Same as IFRS

Debt is treated as Debt
based on its legal
form.
Parent Any company Any company having control Same as IFRS

Company holding 51% or more over decision-making or
shares of the control on the ownership of
subsidiary. other companies.
Cash Flow Exempted if SMEs No such exemption Same as IFRS

Statement
Property, AS 6 - Depreciation IAS 16- Property, plant, and IND- AS 16-

plant, and accounting equipment IFRIC 1 – changes Property, plant, and
equipment in existing decommissioning, equipment
AS 10 - Accounting
Restoration, and Similar
for fixed assets
Liabilities
Source: https://www2.deloitte.com/content/dam/Deloitte/in/Documents/audit/in-audit-
indian-gaap-ifrs-and-indas-a-comparison-noexp.pdf
Above is not the conclusive list of differences among Indian GAAP, IFRS, and Ind AS.
You can read the other differences at:
https://www2.deloitte.com/content/dam/Deloitte/in/Documents/audit/in-audit-
indian-gaap-ifrs-and-indas-a-comparison-noexp.pdf
1.22 Elements of financial statements

Broad classes of transactions and events as per their respective economic characteristics are termed
as elements of financial statements. Four main following financial statements are mandatory to get
prepared and published by companies. These financial statements are accessible to external and
internal stakeholders.
1. Balance Sheet
2. Statement of Profit & Loss
3. Cash Flow Statement
4. Statement of Changes in Equity
Let's discuss these financial statements one by one in a detailed manner.
Balance Sheet
It is a snapshot representing the state of a company's finances at a moment in time (as on a specific
date). It shows what a company owns and owes and how much shareholders have invested in the
company.

Notes
Elements of Balance Sheet

The balance sheet is constituted by major three elements which further can have their sub-forms.
Source: Author
Answer the following questions:
 What do you mean by assets?

 What is meant by Equity?
 Do assets have any types?
 What are Liabilities of Business?
 Do liabilities have any types?
All elements of a Balance Sheet have been discussed under the Accounting Terminologies
of this unit.
Presentation of Balance Sheet

Balance Sheets can be prepared and presented in horizontal format or vertical format. A vertical
Balance Sheet is generally prepared and published by public companies.
Following is the specimen of a Horizontal Balance Sheet:
Balance Sheet of ________as on March 31, 2021:
Liabilities Amount Assets Amount

(₹) (₹)
Equity XXX Non-Current Assets XXX

Owner’s capital
+ Retained earnings
- Drawings
Non-Current Liabilities XXX Current Assets XXX
Current Liabilities XXX
Total XXX Total XXX
Source: Author
Following is the specimen of a Vertical Balance Sheet:
Balance Sheet of ________as on March 31, 2021:
Particulars Amount
(₹)

Notes
Application of Funds
Non-Current Assets XXX
Current Assets XXX
Total Assets XXX
Sources of Funds
Equity XXX
Owner’s capital
+ Retained earnings
- Drawings
Non-Current Liabilities XXX
Current Liabilities XXX
Total Equity and Liabilities XXX
Source: Author
The above specimens of a horizontal and vertical balance sheet are prepared in the
solvency/permanency order. Companies can prepare their Balance Sheet in either
Solvency order or Liquidity order. Generally, public companies do follow
solvency/permanency order to prepare balance sheets.
What is meant by marshalling a Balance Sheet?

The arrangement of assets and liabilities in the balance sheet is called “Marshalling“.
There are two methods of marshalling a balance sheet i.e., order of permanency and order
of liquidity.
Key Questions that can get answered through the Balance Sheet are as follows:
 What is the value of assets that the company owns?

 How much financial obligation does the company owe to externals?
 How much stake the shareholders have in the company?
 What is the cash position of the Company?
 How many reserves and surplus the company has on a specific date?
The Balance Sheet is always equated. It means the total assets should always be equal to
equity and liabilities.
Statement of Profit & Loss

It displays the company's revenues, expenditures, and expenses over a certain time period. It also
displays if a corporation is profitable or losing money over a certain time period. The profit and loss
statement is the same as the income statement. It describes a company's capacity or inability to
make profit via growing revenue, decreasing expenses, or both. The Statement of Profit and Loss is
also known as the profit and loss statement, income statement, statement of income, statement of
operations, statement of financial results or income, earnings statement, or expenditure statement.
Elements of Statement of Profit & Loss

Sales/Revenue:Revenue is the total amount of income generated by the sale of goods or services
related to the company's primary operations. Revenue, also known as gross sales, is often referred
to as the "top line" because it sits at the top of the income statement. Income, or net income, is a
company's total earnings or profit.

Notes
Both revenue and net income are useful in determining the financial strength of a company,
but they are not interchangeable.
Revenue is commonly referred to as sales. But revenue is any income a company generates
before expenses are subtracted while sales are what the firm earns from selling goods and
services to its customers.
COGS:Cost of Goods Sold (COGS) are the direct costs associated with the production of the goods
sold in a company. This amount includes the cost of the materials used in creating a company's
products along with the direct labor costs used to produce them.
Formula:
COGS = Opening stock + Cost of Raw materials consumed + Direct labor + Any other Direct
expense related to production – Closing Stock
Gross Profit:Gross profit is revenue minus the cost of goods sold (COGS). It is also known as “top
line” profit because it sits at the top of the income statement.
Other Operating Expenses:All fixed and variable expenses associated with operating the business,
such as salaries, insurance, rent, commission, utilities, and payroll, etc. for a particular accounting
period.
Operating Profit/Loss:Operating profit is the positive figure that is earned by deducting all other
operating expensed from gross profit earned by business during a particular accounting period.
A company will earn operating profit if its gross profit exceeds all other operating
expenses. And a company will incur an operating loss if all other operating expenses
exceed its gross profit.
Non-Operating Expenses/Loss:Non-Operating Expenses or losses are all expenses that are

unrelated to core business operations. It includes interest payments, losses due to disposition of
assets, reorganizing costs, and charges on obsolete goods or inventory. Non-Operating Expenses
are usually non-recurring and do not include day-to-day business costs.
Non-Operating Profits/income
es/gains:Non-operating income is the portion of an organization's income that is earned from non-
core business operations.
Dividend income, profits, or losses from investments, profits, or losses from the sale of
fixed assets, as well as gains or losses incurred by foreign exchange and asset write-
downs.
PBIT:PBIT stands for Profit before Interest and Taxes. PBIT is that portion of an organization's
profit that is derived by deducting all other operating expenses of business from operating profit
earned by business during a particular accounting period.
PBIT = Operating Profit – other operating expenses

PBIT = Gross Profit- Total Operating cost
Total Operating Cost = COGS + other operating expenses
Finance Cost: It is known as “borrowing costs” and “financing costs”. It generally includes the
interest expenses that a company incurs on its long-term and short-term borrowings.
 Indian companies follow either Ind AS 23 or AS 16 for accounting for their

Borrowing cost.
 As per Ind AS 23, “Borrowing costs” means ”Interest and other costs”, which is
incurred by an enterprise for the arrangement and then allocation of funds.

Notes
Profit: Profit before taxes is abbreviated as PBT. PBT is the fraction of an organization's profit
obtained by subtracting all other Finance expenditures (Interest Expenses) from PBIT produced by
the firm during a certain accounting period.
Tax:Tax refers to a company's income tax burden. It is the amount of tax that a firm is obligated to
pay to the Income Tax Department (ITD) on its PBT based on the income tax slabs in effect for the
accounting year.
PAT: PAT is an abbreviation for Profit after Tax. It is the fraction of a company's profit that remains
after tax costs have been deducted. It is the amount/surplus left for the company's shareholders
after all operational and non-operating expenditures, borrowing charges, and tax responsibilities
have been met. The company's management selects how much PAT may be delivered to
shareholders as dividends and how much PAT can be held as retained earnings to capitalize on
valuable business opportunities and meet business exigencies.
Following is the specimen of a Vertical Statement of Profit & Loss:
Statement of Profit & Loss of________for the year ending March 31, 2021:
Source: Author
Key Questions that can get answered through the Statement of Profit & Loss are as follows:
 Did a company earn a profit?

 What is the company’s rate of return?
 Are revenues higher or lower than the last period?
 Are expenses higher or lower than the last period?
 How did we do this month vs. last month? This quarter vs. last quarter? This year vs.
last year?
 How do our actual results compare to the budget?
 How do our firm’s financials compare to others in our industry?
Cash Flow Statement

The cash flow statement provides a summary of all transactions related to cash inflows and cash
outflows in an organization during an accounting period. It gives reasons for cash receipts and
payments in an accounting period. It is used to analyze the cash position of a company by various
stakeholders.
What is meant by cash flows?

Cash Flows mean the movement of cash in or out of an organization. When the company
pays cash for any cause, it is termed Cash outflow. And when the company received cash
for any cause, it is termed Cash inflow.
Components of a Cash Flow Statement

Notes
● Income tax payments

● Salary and wage payments to employees
● Rent payments
● Receipts from sales of goods and services
● Payments made to suppliers of goods and services used in production
● Any other type of operating expenses
Cash flows from investing activities:The investing activities on the Cash flow statement include
any sources and uses of cash from investment-related business activities such as the Sale and
purchase of Non-current assets and long-term investments.
● Purchase of Plant
● Sale of Machinery
● Purchase of trademark
● Sale of a Brand
● Purchase of Long-term investments
● Interest received on Long-term investments
Cash flows from financing activities:The financing activities include sources and use of cash from
financing activities such as raising funds through equity share, borrowing funds from banks, the
redemption of debt-instruments, long-term borrowing cost, etc.
 Raised Long term loan

 Issue of Equity shares
 Redemption of Preference shares
 Redemption of Debentures
 Interest paid
 Dividend paid
There are two methods namely the Direct Method and the Indirect Method to calculate
Cash flows from operating activities. Mostly, public companies prepare and present cash
flow statements using the Indirect Method.
You will learn detailed format, preparation, and analysis of cash flow statements in Unit
6.
Statement of Changes in Equity

It is a reconciliation between the opening balance and closing balance of shareholder’s equity. It
summarizes the transactions related to the shareholder’s equity over an accounting period. It
records movement in retained earnings, other reserves, and changes in share capital.
As per the IND AS, this statement of changes in equity is to be presented and it includes the
following:
 Reconciliation of the opening and closing balances of equity, describing the changes in detail.
 Details of comprehensive income for the accounting period.
 Details of changes and the impact when components of equity are restated or applied
retrospectively following the IAS/Ind-AS 8.

Notes
Summary
 Accounting is the process of documenting, categorizing, and summarizing major financial
transactions, followed by the interpretation of the findings.
 The revenues are recognized only at the moment of realization but the expenses are
recognized at the moment of payment.
 The charges which were paid only are taken into consideration but the outstanding, not yet
paid is not considered.
 The revenues are recognized only at the time of occurrence and expenses are recognized only
at the moment of incurring.
 The financial statements are found to be more useful to many people immediately after
presentation only to study the financial status of the enterprise from the angle of their
objectives.
 The entire accounting system is governed by the practice of accountancy.
 Accountancy is being practiced through the universal principles which are wholly led by the
concepts and conventions.
 The money measurement concept tunes the system of accounting as fruitful in recording the
transactions and events of the enterprise only in terms of money.
 Business entity concept treats the owner as totally a different entity from the business.
 Going concern concept deals with the quality of long-lasting status of the business enterprise
irrespective of the owners’ status, whether he is alive or not.
 The matching concept only makes the entire accounting system a means to determine the
volume of earnings or losses of the firm at every level of the transaction.
 Duality or Double-entry accounting concept is the only concept that portrays the two
 sides of a single transaction.
 Journal is the first book of the original entries in which all the business transactions of the
financial nature are recorded, then posted to ledger accounts.
 Accounts are of three types – Personal, Real, and Nominal Account.
 A Personal Account is an account which deals with a due balance either to or from these
individuals on a particular period.
 Real Accounts is the account that especially deals with the movement of assets.
 A nominal Account is an account deals with the number of expenses incurred or incomes
earned.
 IFRS is a set of high-quality and globally acceptable financial accounting standards stating
how particular types of transactions and other events should be reported in financial

Notes
statements. It aims to provide a common global language for business affairs so that company
accounts are understandable and comparable across international boundaries.
 Ind AS are a set of accounting standards notified by the Ministry of Corporate Affairs,
Government of India which are converged with IFRS. These standards are formulated by the
Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI).
Keywords
Accounting Conventions:Customs and traditions which guide the accountants to record the
financial transactions.
Accounting Equation:The recording of business transactions in the books of account is based on a
fundamental equation called Accounting Equation.
Accounting Process:It includes the recording of financial transactions, ledger posting, preparation
of financial statements, and analyzing and interpretation of them.
Accounting Standards:It is a set of certain generally accepted rules, principles, concepts, and
conventions issued by the Institute of Chartered Accountants of India in consultation with other
International Accounting bodies.
Asset:Any physical thing or right owned that has monetary value is an asset.
Cost Accounting:Accounting relating to the ascertainment of the cost of the product.
Financial Statements:These include the Trading and Profit & Loss Account, and Balance Sheet of
the business.
Golden Rules: These are fundamental rules for the entry of recording the financial transactions
under the duality concept.
Gross Loss:It is the excess of the cost of sales over sales.
Gross Profit:It is calculated by comparing the sales and cost of sales. It is the excess of sales over the
cost of sales.
Journal:The primary book in which the business transactions are recorded for the first time.
Ledger:It is the classification of accounts in which various accounts are maintained.
Net Loss:Excess of expenditures over revenues is called a net loss.

Net Profit:It is the excess of revenues over expenses. It is depicted by P& L A/c.
Nominal A/c: Accounts which are relating to the revenues, incomes, expenses, and losses of the
business are called nominal accounts.
Personal A/c:Accounts that are related to the persons, firms, companies, and representatives.
Stock:The goods purchased are for selling, if the goods are not sold out fully, a part of the total
goods purchased is kept with the trader unlit it is sold out, it is said to be a stock.
Trial Balance:It is the list of accounts taken from the ledger.

Notes
SelfAssessment
Fill in the Blanks:
1. …………………… is the process of recording, classifying, summarizing in a significant

manner of transactions which are in financial character, and finally results are interpreted.
2. The users of accounting are …………………… and external.
3. Accounting records all the transactions which can be expressed either in …………………….
4. The creditors are interested to know the ………………… of the business.
5. The primary objective of accounting is to maintain the records of all …………………… of the
business.
6. Every financial transaction of the business has................. And recorded at two places.
7. The revenues are recognized only at the moment of................. .
8. Book Value = Gross (Original) value of the asset................. .
9. The................. are the persons who owe to an enterprise an amount for receiving goods or
services on credit.
10. ................ is a liability which arises only on the happening of an uncertain event.
11. ................. = total assets – total liabilities.
Multiple Choice Questions:
12. Three key activities of the accounting function are identifying transactions, recording
transactions, and communicating transactions. The proper order for these activities is
considered to be which of the following?
A. Communicating, recording, and identifying
B. Recording, communicating, and identifying
C. Identifying, communicating, and recording
D. Identifying, recording, and communicating
E. None of the above
13. Which one of the following users of accounting information is considered to be an external
user of accounting information rather than an internal user of accounting information?
A. Sales staff
B. Company managers
C. Company customers
D. Officers and directors
E. Budget officers
14. All of the following people can properly be called managers. Which one of the following
individuals is not considered an internal user of accounting information?
A. Service manager
B. Research and development manager
C. Production manager
D. Partner in CA firm charged with conducting the company’s external audit
E. Human resources manager

Notes
15. A college student pays 150 cash for her textbook. In the student’s opinion, the textbook is
worth 50. In accounting, however, the value of the textbook is assumed to be and is recorded
at the 150 amount. The accounting principle that is most demonstrated by this example is:
A. The cost principle
B. (b) The going-concern principle
C. (c) The business entity principle
D. (d) The monetary unit principle
E. (e) The conservatism principle
16. The basic accounting equation is Assets = Liabilities + Equity. The Equity term of the equation
can be further broken down into several other terms. Assume that the entity is a sole
proprietorship. Which of the following statements is correct?
A. Additional investments by the business owner will increase equity, and revenues will
decrease equity.
B. Additional investments by the business owner will decrease equity, and revenues will
increase equity.
C. Increases in expenses will decrease equity, and owner withdrawals will decrease equity.
D. Revenues will increase equity, and owner withdrawals will increase equity.
E. Revenues will decrease equity, and owner withdrawals will increase equity.
17. If at the end of the accounting period the company’s liabilities total ₹19,000 and its equity
totals ₹40,000, then what must be the total of assets?
A. ₹14,000
B. ₹40,000
C. ₹21,000
D. ₹59,000
E. None of the above
18. If during the current accounting period the company’s assets increased by ₹24,000 and equity
increased by ₹5,000, then how did liabilities change?
A. Increased by ₹29,000
B. Increased by ₹24,000
C. Decreased by ₹5,000
D. Decreased by ₹19,000
E. Increased by ₹19,000
19. As being an active investor of Indian Capital Markets, if you will get confronted with some
Financial reporting issue in the annual reports of certain companies of the same industry
related to 1 certain Accounting standard, which body will you refer to raise that issue?
A. Company Law Board
B. Institute of Chartered Accountants of India
C. Income Tax Department
D. Reserve Bank of India

Notes
20. One Indian MNC which has 7 subsidiaries and 3 associates operating in India is required to
follow Ind AS for preparing its financial statements as per the guidelines of MCA. The given
MNC will be required to prepare which financial statements as per Ind AS?
A. Both consolidated as well as standalone financials of the company.
B. Only consolidated financials
C. Only standalone financials
D. Optional

1. Accounting 2. Internal 3. Money or 4. Solvency 5. Transactions
money’s
worth
6. Dual Effect 7. Realization 8. Accumulated 9. Debtors 10. Contingent

depreciation liability
11. Capital 12. D 13. C 14. D 15. A
16. C 17. D 18. E 19. B 20. A
Review Questions
1. Accounting is the process of recording, classifying, and summarizing accounting
transactions. Explain.
2. What are the key internal and external users of accounting information?
3. State the key branches of accounting.
4. What is the meaning of Debit and Credit?
5. Explain the various types of accounts.
6. Every debit transaction is appropriately equated with the transaction of credit. Define.
7. Singhania Chartered Accountants Firm established in the year 1956, having a very good
number of corporate clients. It continuously maintains the quality in audit administration
with the clients since its early inception. The firm is eagerly looking for promising
students who are having greater aspirations to become auditors. The firm is having an
objective to recruit freshers to conduct a preliminary auditing process with their corporate
clients. For which the firm would like to select the right person who is having conceptual
knowledge as well as application on the subjects. It has given the following Balance sheet
to the participants to study the conceptual applications. The participants are required to
enlist the various concepts and conventions of accounting.
(a) List out the various accounting concepts dealt with in the above balance sheet.
(b) Explain the treatment of accounting concepts.
8. What are the key accounting conventions?
9. “Accounting equation remains intact under all circumstances” Justify the statement with
the help of an example.
10. Prepare accounting equation from the following Transactions:
(i) Hemant started the business with cash of ₹3,00,000
(ii) Purchased goods for cash ₹80,000
(iii) Sold goods [costing 30,000] for cash ₹45,000
(iv) Purchased goods from Monika ₹70,000

Notes
(v) Salary paid ₹7,000
(vi) Commission received ₹5,000
(vii) Paid Cash to Monika in full settlement ₹69,000
11. Prepare accounting equation based on the following:
(i) Anup started a business with cash of ₹250,000
(ii) Purchased goods for cash ₹35000
(iii) Purchased office furniture for cash ₹12000
(iv) Paid rent ₹7000
(v) Sold goods (costing ₹30000) for ₹50000 for cash
12. Show the accounting equation based on the following transactions:
(i) Manu started business Cash ₹600000 Goods ₹100000
(ii) Purchased office machine for cash ₹90000
(iii) Sold goods (costing ₹60000) for credit to Asha
(iv) Purchased building for cash ₹130000
(v) Cash received from Ashu₹80000
(vi) Purchased goods on credit to M/s Ashok Trader for cash ₹70000
(vii) Salaries paid ₹6000
(viii) Insurance prepaid ₹10000
(ix) Cash paid to M/s Ashok traders in full settlement ₹68000
13. Identify the accounts, and their nature involved in each following transaction and pass
journal entries of the same:
June 1 Ram commenced business with cash ₹10,000
June 2 Paid to Bank ₹8,000
June 3 Bought goods for cash ₹500
June 4 Bought Furniture for office ₹400
June 10 Withdrew from Bank cash for office ₹1,000
June 13 Goods sold to Shyam₹600
June 15 Bought goods of Krishan ₹410
June 18 Trade Expenses paid ₹100
June 19 Received cash from Shyam₹590 and allowed him a discount of ₹10
June 25 Wages paid ₹50
June 28 Krishan paid off in full settlement of his account ₹400
June 30 Rent paid ₹100
14. Classify the following accounts as per the modern classification of accounts:
(a) Cash brought in as capital
(b) Machinery purchased
(c) Goods sold for cash
(d) Goods purchased for cash
(e) Goods sold for credit
(f) Goods purchased on credit
(g) Rent Paid
(h) Dividend Received
(i) Discount allowed
(j) Discount received

Notes
(k) Plant purchased
(l) Furniture sold.
(m) Withdrew for personal use
(n) Cash received from debtors
(o) Electricity Paid
(p) Wages Paid
(q) Royalty Received
(r) Bad debts written off
(s) Bank overdraft
(t) Purchases returns /returns inward
(u) Sales returns/returns outward.
(v) Purchases during the period
(w) Sales during the period
15. ABC Ltd.'s transactions for the month of January were as follows:
Jan. 1 Issued equity shares of ₹20,00,000 (cash received in full).
Jan. 5 Purchased land for ₹5,75,000.
Jan. 8 Purchased a building for ₹4,40,000, paying ₹1,40,000 in cash and the balance
payable in three monthly installments.
Jan. 15 Purchased machinery worth ₹2,20,000.
Jan. 20 Purchased syrup (raw material) for making soft drinks worth ₹5,75,000, paying
₹1,75,000 in cash.
Jan. 25 Purchased further machinery worth ₹50,000.
Jan. 31 Sold cold drinks worth ₹50,000 (consuming ₹30,000 of syrup).
Show the effects of the above transactions upon the accounting equation.
16. Journalise/explain the rule of debit and credit in the following cases, indicating clearly the
nature of the accounts.
July 1 Goods purchased from Rao for ₹20000
July 5 Goods sold for cash ₹4000
July 7 Paid to Rao ₹10000
July 10 Goods purchased for cash ₹3000
July 17 Paid salaries ₹5000
July 24 Goods sold to Reddy ₹12000
July 31 Rent paid ₹2000
17. What is IFRS? Who issues IFRS?
18. Explain the need for following IFRS.
19. Explain the roadmap of implementing IFRS in India.
20. Why do investors need financial statements?
21. Why do shareholders and management need financial statements?
22. State the reasons for which creditors, tax authorities, Government consider the company’s
23. Why does a company prepare financial statements?
24. Which financial statements are prepared and presented by a company?
Further Reading
1. Management Accounting by Khan M.Y And Jain P.K, Mcgraw Hill Education
2. Financial Accounting for Management by Shah Paresh, Oxford University
Press
3. A Textbook of Accounting for Management by Maheshwari. S.N, Maheshwari
Sharad. K, Maheshwari Suneel. K, Vikas Publishing House

Notes
4. Financial Accounting for Management: An Analytical Perspective by Gupta
Ambrish, Pearson Education India
5. Financial Accounting by Goyal V.K, Excel Books, New Delhi
6. Accounting & Finance for Managers by Pandikumar M.P, Excel Books, New
Delhi.
Web Links
1. https://www.iedunote.com/accounting-
objectives#:~:text=The%20main%20objectives%20of%20accounting,ascertained
%20through%20the%20accounting%20process.
2. https://outbooks.co.uk/latest-thinking/what-are-the-different-branches-or-
types-of-accounting/
3. https://www.iedunote.com/users-of-accounting-
information#:~:text=Users%20of%20accounting%20information%20are,manag
ers%2C%20employees%20of%20the%20company.
4. https://cleartax.in/s/applicability-ind-
as#:~:text=The%20Ministry%20of%20Corporate%20Affairs,the%20Accounting
%20period%202016%2D17.
5. https://cleartax.in/s/accounting-golden-rules
6. https://www.accountingcoach.com/accounting-equation/explanation
7. https://www.accountingtools.com/articles/types-of-financial-
statements.html

Notes
Razia Sehdev, Lovely Professional University Unit 02: Corporate Financial Statement
Unit 02: Corporate Financial Statements

CONTENTS
Objectives
Introduction
2.1 Features and Importance
2.2 Types of Corporate Financial Statements
2.3 Vertical Format of Corporate FinancialStatements
2.4 Conceptual Framework of Depreciation and Amortization
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 Explain the meaning and features of Corporate Financial Statements.

 Review the importance of preparation of Corporate Financial Statements.
 Prepare vertical corporate financial statements.
 Illustrate the meaning of depreciation and amortization.
 Assess the value of depreciation as per various methods.
 Measure the amortization value of an intangible asset.
Introduction
According to Section 129(1) of the Companies Act of 2013, financial statements must I give an
accurate and fair view of the company or companies' state of affairs, (ii) comply with the
accounting standards notified under Section 133, (iii) be in the form or forms as may be provided
for different classes or classes of companies in Schedule III, and (iv) the items contained in such
financial statements must be in accordance with the accounting standards.
Section 129(2) requires the Business's Board of Directors to provide financial statements for the
fiscal year at every public meeting of the company.
The basic components of the Corporate Balance Sheet are assets, liabilities, and capital. The major
aspects of the Corporate Income Statement are Revenues, Cost of Goods Sold, Gross Profit,
Operating and Non-operating Expenses. Fixed assets account for a significant component of the
company's overall assets. As a result, their inclusion in the financial statements is critical. Fixed
assets are also important in assessing profit and portraying the financial status of the organization.
Tangible assets are depreciated, whereas intangible assets are amortized. This course discusses the
elements and relevance of corporate financial statements, vertical layouts of balance sheets and
profit and loss statements, and the idea of depreciation and amortization.

Notes
2.1 Features and Importance

Corporate Financial statements are written and formal records that convey the business activities
and the company's financial performance.
Features of Corporate Financial Statements

 The need and desire for accounting information by different users, such as investors, lenders,
government entities, tax authorities, creditors, and so on, results in core qualitative features
that are desirable in accounting information presented via business financial statements.
 The following are the qualities or qualitative characteristics of corporate financial statements
that the corporation should adhere to while creating them.
 Understandability
 Materiality or relevance
 Reliability or Faithful representation
 Comparability
 Full Disclosure or Completeness
 Prudence
 Standardized Format
 Timeliness
 General Acceptability
 Consistency
 Compliance
 Substance over form
 Verifiability
 Neutrality
Understandability
The information provided in financial statements must be easily and readily understandable to
users of the financial statements. It means that information must be presented clearly, with
additional information supplied in the supporting footnotes as needed to clarify.
Use of Lots of Jargon and complicated phrasing in the annual report must be avoided as
they may not be understood by users of financial statements or can make them confused.
No material information should be left out of the statementbecause it is deemed too

complex. Even if the information is difficult to understand, it must be included if it is of
importance.
Materiality or relevance
Materiality or relevance refers to how useful the information is for financial decision-making
processes. For accounting information to be relevant, it must possess:
 Confirmatory value – Provides information about past events.

 Predictive value – Provides predictive power regarding possible future events.
Thus, the information can be predictive or confirmatory and usually both.
 The information about the dividend paid in the last year is valuable information for
a potential investor.
 Similarly, information about the company's asset structure can help a user evaluate
the future of a company.

Notes
Unit 02: Corporate Financial Statement
Material information refers to information that is important in the context of decision-

making. Any information whose existence or absence may affect or modify a decision-
economic maker's choice is significant or relevant. Material information about the firm
might be both bad and beneficial.
The company's intention to shut 10 key branches in the next fiscal year is substantial
information. It has the potential to influence investors' choices to invest in the company's
shares. This firm's strategy may also influence lenders' decisions to grant future
financing to the company. As a result, the corporation should inform its numerous
stakeholders.
Any penalty paid by the firm should be stated individually, even if the amount paid is
little; any tax payment should likewise be disclosed separately and should not be
blended with office or miscellaneous expenditures.
Reliability or Faithful representation

Faithful representation, also known as reliability, is the degree to which information accurately
reflects a company's resources, obligatory claims, transactions, events, etc. For accounting
information to possess reliability, it must be complete, neutral, free from errors, and not misleading.
Thus, the financial statements and the information thereof should faithfully represent transactions
and other events, reflect the underlying substance of events, and prudently represent estimates and
uncertainties through proper disclosure.
If the information is relevant, but a reliable estimate cannot be made. In such a situation,
the information should be included in the notes to accounts.
Comparability
To embed the comparability feature in financial statements, the companies should follow
consistent accounting standards and policies throughout each accounting period and
prepare and publish their financial statements in comparative form, i.e., current year
figures, previous year figures of financial elements are also given in financial statements.
It will enable the users to draw insightful conclusions about the trends and performance
of the company over time.
Full Disclosure or Completeness

According to the full disclosure characteristic, company financial statements should provide
complete and accurate information about an enterprise's performance, position, development, and
prospects. Any substantial transaction, event, or other occurrence should not be excluded from
If litigation is ongoing and the company predicts they will have to pay a fine. However, the
amount of the fine is not predictable. This is essential information, so it should be disclosed.
Prudence
Uncertainty surrounds many of the reported events in the financial statements. It is dealt with in
those statements by disclosing the nature and extent of the uncertainty involved and exercising
prudence.
Prudence is the extent to which caution has been exercised in making the estimates required under
uncertain conditions, such that gains and assets are not overstated, and losses and liabilities are not
understated.

Notes
Under such circumstances,it requires more confirmatory evidence about the existence of, and
greater reliability of measurement for, assets and gains than is required for liabilities and losses.
Did you know? What is meant by Prudence?

Prudence means beingcareful or wise in handling practical matters: exercising good judgment. In
an accounting context, prudence refers to provide for or recognize all losses but ignoring
anticipated profits.
If the valuation of inventory is always done at a cost, consider a situation where the market
price of the relevant goods has reduced below the cost price, then valuing the stock at cost
price means ignoring anticipated losses. Similarly, if inventory is always valued at market
price, the take a situation where cost price is below market price, indirectly we recognize
the anticipated gross profit on the stock in the books. Therefore, accounting policy should
be cost price or market price, whichever is less; in this case, we ignore anticipated profits (if
any), but any anticipated losses would be taken care of
Standardized Format
Consistency
The financial statements should not be affected by inconsistencies arising from the accountant's
personal judgment and procedural choices. Companies should apply the same accounting
standards and policies throughout each accounting period. Consistency can also be helpful in
enhancing comparability between entities' financial statements.
Consistency should not be confused with a need for absolute uniformity.
Compliance
Financial statements must adhere to any legal requirements regarding form, content, disclosures,
and processes.
Companies in India must compile and report their financial statements in accordance with
Schedule III of the Companies Act, 2013. Furthermore, they must adhere to Ind AS or Indian
accounting standards for preparing financial accounts.
Substance over form

The accounting treatment and presentation in the financial statement of transactions and events
should be governed by their substance and not merely by the legal form.
The ownership of an asset purchased on hire purchase is not transferred till the payment
of the last installment is made, but the asset is shown in the books of the hire purchaser.
Similarly, in the case of the amalgamation, the entry for amalgamation in the books of the
amalgamated company is recorded based on the status of shareholders of amalgamating
company after amalgamation, i.e., if all or almost all the shareholder of the amalgamating
company by virtue of amalgamation, we record all the transactions as Amalgamation in

Notes
nature of Merger otherwise it is recorded as Amalgamation in nature of the purchase.
Verifiability
Verifiability is the extent to which information is reproducible given the same data and
assumptions.
If a company owns equipment worth ₹21,000 and told an accountant the purchase cost,
salvage value, depreciation method, and useful life, the accountant should be able to
reproduce the same result. If they cannot, the information is considered not verifiable.
Neutrality
Neutrality is often characterized as "independence from prejudice" or "objectivity." It indicates that
while developing or implementing standards, the major emphasis should be the information's
relevance and dependability.
Financial statements must contain information that is impartial, that is, devoid of purposeful or
systematic bias. Financial information is not neutral if it has been chosen or presented in such a
manner that it influences decision-making or judgment in order to reach a planned result or
conclusion.
Relevance and faithful representation are fundamental qualitative characteristics of

financial information; however, other features enhance qualitative aspects.
Importance of Corporate Financial Statements
For Management
For the most part, management need current, reliable, and systematic financial information.
Financial statements assist management in understanding a company's situation, development, and
prospects in relation to its history and the industry. Financial statements assist management to
create appropriate company policies and future courses of action by revealing the reasons of
business performance.
Notes: The importance of corporate financial statements lies in the assistance that these
statements provide to management for taking various business decisions and framing
business policies & strategies.
For Shareholders
These financial statements inform shareholders about the management's efficiency and
effectiveness, as well as the company's earning capability and financial strength. Because a
company's management and ownership are in separate hands, the financial statements serve as a
way of conveying financial outcomes and the company's position to shareholders.
Published financial statements are the primary source of information for prospective investors.
For Lenders/Creditors
Lenders/creditors may learn about a company's liquidity, profitability, and solvency by carefully
reviewing its financial statements. It would assist them in making future loan choices in the context
of a given firm.
For Employees
The employees areentitled to salary hikes, appraisals, promotions, bonuses depending upon the
size of profit as disclosed by an audited statement of profit and loss.

Notes
For Economy
Financial statements are also required by numerous regulatory organizations such as tax
authorities, company registrars, and so on. By analyzing the financial accounts, they may determine
if the restrictions are being carefully observed and whether the rules are having the intended
impact.
There are other groups of users, such as consumers, customers, business consultants,
etc., who use financial statements for making decisions.
2.2 Types of Corporate Financial Statements

There are the following four primary corporate financial statements:
 Balance Sheet
 Statement of Profit & Loss
 Cash Flow Statement
 Statement of Changes in Equity
We have already discussed the meaning and significant components of above mentioned
four corporate financial statements in the previous unit.
2.3 Vertical Format of Corporate FinancialStatements

Vertical Balance Sheet
Some Critical Elements of the Balance Sheet are explained as follows:
Capital work-in-progress: Itrepresents costs incurred to date on a fixed asset that is

still under construction at the balance sheet date.
Debentures: It is long-term security,i.e.,the type of bond or other debt
instrumentyielding a fixed rate of interest, issued by a company and generally
unsecured by collateral.
Deferred tax assets:A deferred tax asset results from an overpayment or advance
payment of taxes. It is the opposite of a deferred tax liability, which represents income
taxes owed.
Financial assets:A financial asset is a non-physical asset whose value is derived from
a contractual claim, such as bank deposits, bonds, and participation in companies' share
capital. Financial assets are usually more liquid than other tangible assets, such as
commodities or real estate.
Provisions:A provision is an amount set aside from a company's profits to cover an
expected liability or a decrease in the value of an asset, even though the specific amount
might be unknown.
Goodwill: Goodwill is an intangible asset associated with the purchase of one
company by another. Specifically, goodwill is recorded in a situation in which the
purchase price is higher than the sum of the fair value of all visible solid assets and
intangible assets purchased in the acquisition and the liabilities assumed in the process.
The value of a company's brand name, solid customer base, good customer relations,

Notes
good employee relations, and any patents or proprietary technology represent some
examples of goodwill.
The following is the format of the Vertical Balance Sheet prepared in order of permanency:
Balance Sheet as at March 31, 2021

As at March As at March
Particulars Note 31, 2021 (₹) 31, 2020 (₹)
ASSETS
(1) Non Current assets
i. Property, Plant and Equipment
ii. Capital work-in-progress
iii. Goodwill
iv. Other Intangible assets
v. Financial assets
•Investments in subsidiaries, joint ventures and associates
•Investments
•Loans
•Other Financial assets
vi. Non-current tax assets (net) Part I
vii. Deferred Tax assets (net) of
viii. Other non-current assets Balance
Sheet
(2) Current Assets
i) Inventories
ii) Financial Assets
•Investments
•Trade Receivables
•Cash and Cash Equivalents
•Bank Balance
•Other Financial Assets
iii) Other Current Assets
iv) Assets held for sale
TOTAL
EQUITY AND LIABILITIES
(1) Equity/Shareholders’ funds
a) Share capital
b) Reserves and surplus
c) Money received against share warrants
(2) Liabilities
2.1) Non-current liabilities
a) Bonds/Debentures Part II
b) Term loans from banks or from other parties of
c) Deferred tax liabilities (Net) Balance
d) Other Long term liabilities Sheet
e) Long-term provisions
2.2) Current liabilities
a) Short-term borrowings
b) Trade payables
c) Other current liabilities
d) Short-term provisions
TOTAL
Source: Author
Vertical Statement of Profit and Loss

The Key Elements of the Statement of Profit and Loss are explained as follows:
Revenue from Operations:Revenue is the total amount of income generated by the sale of goods
or services related to the company's primary operations. Revenue, also known as gross sales, is
often referred to as the "top line" because it sits at the top of the income statement. Income, or net
income, is a company's total earnings or profit.
COGS:Cost of Goods Sold (COGS) are the direct costs associated with producing the goods sold in
a company. This amount includes the cost of the materials used in creating a company's products
and the direct labor costs used to produce them.

Notes
The following is the format of Vertical Statement of Profit and Loss:
Statement of Profit and Loss for the year ended March 31, 2021
Year Year
ended ended
March 31, March 31,
Particulars Note 2021 (₹) 2020 (₹)
Income
Revenue from operations
Other income Part I
Total Income (A)

Expenses
i. Cost of material consumed
ii. Purchases of Stock-in-trade
iii. Changes in inventory of finished goods
(including stock-in-trade) and work in progress
iv. Employee benefits expenses Part II
v. Finance costs
vi. Depreciation and amortization expenses
vii. Other expenses
Total Expenses (B)
• Profit before exceptional items and tax (A-B)
• Exceptional items (net)
• Profit before tax
• Tax expenses Part III
• Current tax
• Deferred tax credit / (charge)
Profit for the year
Source: Author
You are required to download HUL annual report 2021 and analyze the elements of its
Balance Sheet and Statement of Profit and Loss.
2.4 Conceptual Framework of Depreciation and Amortization

Depreciation
An asset's monetary value decreases over time due to use, wear, tear, or obsolescence. This decrease
is measured as depreciation.Depreciation is an accounting method of allocating the cost of a
tangible or physical asset over its useful life or life expectancy. Depreciation represents how much
of an asset's value has been used up.
Depreciating assets helps companies earn revenue from an asset while expensing a portion of its
cost each year the asset is in use.Businesses can depreciate long-term assets for both tax and
accounting purposes.
Definitions
In the AS-6, depreciation is defined as, "Depreciation is a measure of wearing out, consumption or
other loss of value of a depreciable asset, arising from use, afflux ion of time or obsolescence
through technology and market changes. Depreciation is allocated for charging a fair proportion of
the depreciable amount in each accounting period during the asset's expected useful life.
Depreciation includes amortization of assets whose useful life is predetermined."
As per International Accounting Standards Committees, "Depreciation is the allocation of the
depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period
is charged to income either directly or indirectly".

Notes
According to J.H. Burton, "Depreciation is the shrinkage in the value of an asset at a given date as
compared with its value at a previous date."
From the above definition, it is clear that depreciation is a gradual fall in the value of the assets due
to some reasons.
Accumulated Depreciation
It refers to the sum of all depreciation recorded on an asset to a specific date.
Carrying value of PPE/Asset

The carrying value of an asset on the balance sheet is its historical cost minus all accumulated
depreciation.
Objectives of Providing for Depreciation
 To ascertain the true results of operations:The true profit can be confirmed only after
deducting all costs from the revenue of a period as the assets are used in the business to earn
revenues. The value of assets falls due to such use in the business. Therefore, such a fall in the
value should be treated as a cost and charged against the profit. Payment for the purchase of
assets should be treated as a prepaid expense, and it should be spread over a period to
ascertain the actual profit.
 To present the true and fair value of the fixed asset: Depreciation is computed on the
fixed assets. It is shown against the fixed assets in the balance sheet. By doing so, the balance
sheet depicts the true and fair view of the business's financial position if wedo not make a
provision for depreciation for fixed assets.
To accumulate funds for the asset replacement: If the depreciation on fixed assets is provided and
charged against the profit every year, there will be a reduction in the profit by the amount of
depreciation. If the amount is transferred into a fund account, there will be a depreciation fund to
replace the fixed assets on the expiry of the machine's life.
Charging Depreciation on PPE (Property, Plant, and Equipment)
 Each part of an item of property, plant, and equipment with a cost should be depreciated
separately.
 The depreciation expense for each period should be recognized in the statement of profit and
loss.
 The depreciable amount of an asset should be allocated on a systematic basis over its useful
life.
Depreciation Methods
The following are the critical methods of providing depreciation on PPE:
Source: Author
Straight-line method
The straight-line depreciation method charges cost evenly throughout the useful life of a fixed
asset.This depreciation method is appropriate where economic benefits from an asset are expected
to be realized evenly over its useful life. The straight-line method is also convenient to use where no

Notes
reliable estimate can be made regarding the pattern of economic benefits expected to be derived
over an asset's useful life.
Formula
Depreciation per annum = (Cost − Residual Value) / Expected Useful Life in years
Written Down Value

Written Down Value method is a depreciation technique that applies a constant rate of depreciation
to the net book value of assets each year, thereby recognizing more depreciation expenses in the
early years of the life of the asset and less depreciation in the later years of the life of the asset.
Formula
Depreciation per annum = (Cost of Asset net of residual value - Depreciation charged in the
previous year) *Rate of Depreciation in (%)
Units of Production Method

This method of charging depreciation on the asset is based on the units produced during the year.
The estimated total production of the asset is the criteria for providing depreciation.
Formula
Depreciation per annum = [(Cost − Residual Value) / Total No. of units expected to be produced
from the asset] *Actual no. of units produced
Amortization
 Amortization is an accounting technique used to periodically lower the book value of a loan
or intangible asset over a set period.
 Concerning a loan, amortization focuses on spreading out loan payments over time.
 When applied to an intangible asset, amortization is similar to depreciation.
It is the systematic allocation of the depreciable amount of an intangible asset over the best
estimates of its useful life. Amortization should start when the asset is available for use.
Did you know: What is the difference between Depreciation, Amortization, and Depletion?
Amortization is associated with charging intangible assets to expense over time, and depreciation is
associated with charging tangible assets to fee over time. Similarly, depletion is related to charging
the cost of natural resources to expense over their usage period.
The following is the snapshot of the Accounting treatment of an intangible asset as per Ind AS 38:
Source: Author
What is impairment?
It is a permanent reduction in fixed assets or an intangible assets' value of a company.
During the impairment test for an asset, the total benefits in terms of total profit or cash

Notes
flows expected to be generated by that specific asset are periodically compared with its
current book value. Suppose the book value of the asset exceeds the future benefits of the
asset. In that case, the difference between the book value and future cash flows or benefits
is written off, and the asset's value declines on the company's balance sheet.
An asset is impaired when its carrying value is greater than its recoverable value.
Summary
 The corporate financial statements actually summarize the firm's financial condition and
profitability in both the long and short term.
 The prime objective of corporate financial statements is to give information on the
performance, financial strength, and financial position changes of a company.
 The four basic types of corporate financial statements are:
1. Income statement
2. Balance sheet
3. Statement of cash flows
4. Statement of changes in Equity
 The uses of financial statements vary from entity to entity. For different people, they have
different uses.
 As the historical costs and money measurement concepts govern the preparation of the
balance sheet and income statements, hence these financial statements are essentially
statements reflecting historical facts.
 Fixed assets are those assets held to be used to produce goods or provide services and are not
held for sale in the ordinary course of business.
 The fixed asset cost comprises its purchase price, direct costs and import duties, and directly
attributable costs.
 Depreciation is the decrease in the value of assets at the given date due to wear and tear,
obsolescence, efflux of time, accident, and exhaustion.
 There are several methods for providing depreciation on fixed assets. The depreciation
method is selected based on various factors as – types of assets, nature of business and
circumstances prevailing in the business, etc.
 Depreciation is a permanent and gradual diminution in the value of an asset caused by usage
and effluxion of time.
 The accounting treatment is designed to record all transactions of purchase and sale of an
asset and charge depreciation to reduce the value of an asset to zero or its residual value as the
case may be.
Keywords
Amortization:The process of writing off intangible assets.
Balance Sheet:The balance sheet is based on the equation: assets = liabilities + owners' equity.
Corporate Financial Statements:Corporate financial statements are the financial reports or
formal records of a firm's financial and business activities.
Cost of Assets:It includes the cost of acquisition, installation, commissioning, etc.
Depreciable Assets:Assets used in business for more than one accounting year have a limited
useful life and are used in the production business and not for sale.

Notes
Depreciation:A permanent fall in the value of assets due to its use in business, efflux of time,
obsolescence, and market changes.
Fixed Assets:Those assets held in the business to produce goods or provide services and not held
for sale during the normal course of business are called fixed assets.
Income Statement:The income statements are also called the profit-loss statements.
Residual Value:It is that value that will be fetched from the sale of the assets on the expiry of the
useful life of the assets.
Useful Life of Assets:The estimated period for which the assets will be used in the business
efficiently.
SelfAssessment
1. The purpose of the …………………… is to show managers and investors whether the
company made or lost money during the period being reported.
2. The …………………… provides an insight into the financial status of a company at a
particular time.
3. Depreciation is the permanent decrease in the value of the …………………….
4. Depreciation is calculated based on…………………….
5. …………………… can be created for replacement of fixed assets.
6. Amount of depreciation if charged based on…………………… remains constant forevery
year.
7. The original value of the asset is the …………………… of the asset.State true or false:
8. The prospective equity investors and lenders use financial statements to decide whether or
not to invest in an organization.
9. Existing Customers of an organization use its financial statements to benchmark their
financial results.
10. Board of directors of an organization uses its financial statements to review the performance
of management in general and the company in particular.
Multiple Choice Questions:
11. How do we describe the process of adjusting the value of a tangible asset by recognizing
that it is consumed in a way that does not completely eliminate the resource?
A. Adjustment
B. Depreciation
C. Amortization
D. Depletion
12. Which one of the following most closely defines 'Amortization'?

A. The depreciation of tangible fixed assets
B. The depreciation of intangible fixed assets
C. The depreciation of current assets
D. The revaluation of land
13. Carrying value = cost minus _____________?

A. Current Liabilities
B. Salvage value
C. Accumulated depreciation

Notes
D. Residual value
14. What is the process called, where costs of the natural resources are allocated over its useful
life?
A. Adjustment
B. Depreciation
C. Amortization
D. Depletion
15. Depreciation arises due to?

A. Physical wear and tear
B. Fall in the market value of an asset
C. Fall in the value of money
D. None of these

1. Income 2. Balance 3. Fixed assets 4. Cost price 5. Depreciation
statement sheet funds
6. Straight- 7. Purchase 8. True 9. False 10. True

line method value
11. B 12. B 13. C 14. D 15. A
Review Questions
1. Briefly explain the four basic types of corporate financial statements.
2. State the qualitative features of Corporate Financial Statements.
3. Exemplify the importance of Corporate Financial Statements?
4. Who are the users of Corporate Financial Statements?
5. Describe the key elements of Corporate Financial Statements.
6. Draw a specimen of a vertical balance sheet.
7. Prepare a vertical statement of profit and loss.
8. What do you understand by Depreciation?
9. What is amortization?
10. Explain the key methods of providing depreciation.
Further Readings
 Khan, M.Y., & Jain, P.K. (2017). Management Accounting, 7th Edition, McGraw
Hill Education.
 Shah, Paresh. (2019). Financial Accounting for Management, 3rd Edition, Oxford
University Press.
 Maheshwari, S.N., Maheshwari, Sharad. K., & Maheshwari, Suneel. K. (2018). A
Textbook of Accounting for Management, 4th Edition, Vikas Publishing House.
 Gupta, Ambrish. (2018). Financial Accounting for Management: An Analytical

Notes
Perspective, 6th Edition, Pearson Education India.
 Goyal, V.K. (2010). Financial Accounting, 3rd Edition, Excel Books, New Delhi.
 Lanen, N. William., Anderson, W. Shannon., & Mather, W. Michael. (2010)
Fundamentals of Cost Accounting, 3rd Edition, McGraw Hill Education.
 Belverd E., Needles. Accounting for Decision Making, Cengage Learning.
Web Links
 https://corporatefinanceinstitute.com/resources/knowledge/accounting/qualita
tive-characteristics-of-accounting-information/
 https://www.accountingtools.com/articles/what-are-the-qualitative-
characteristics-of-financial-statem.html
 https://library.croneri.co.uk/spfp003
 https://www.accountingnotes.net/financial-reporting/top-11-qualitative-
characteristics-of-accounting-information/5409
 https://www.yourarticlelibrary.com/accounting/financial-statements/financial-
statements-features-importance-and-limitations/61727
 https://taxadda.com/depreciation-meaning-methods-calculations/

Notes
Razia Sehdev, Lovely Professional University Unit 03: Ratio Analysis
Unit 03: Ratio Analysis

CONTENTS
Objectives
Introduction
3.1 What is Ratio Analysis?
3.2 Importance and Objectives
3.3 Types of Ratios
3.4 Liquidity Ratios
3.5 Turnover Ratios
3.6 Profitability Ratios
3.7 Solvency Ratios or Leverage ratios
3.8 Du-Pont Analysis
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 Illustratethe use of ratio analysis.

 Assess the Liquidity position of an organization through liquidity ratios.
 Measure the operational efficiency of an organization through efficiency ratios.
 Review analyze the financial performance of an organization through profitability ratios.
 Assess the long-term financial position of an organization through solvency ratios.
Introduction
Experts use ratio analysis, the process of calculating and analyzing financial ratios, to determine the
relevance of diverse financial data. A financial ratio is a connection that reveals something about a
company's operations, such as the ratio of current assets to current liabilities or accounts receivable
to yearly sales. The major sources of these ratios are the company's financial statements, which
provide information on assets, liabilities, earnings, and losses.
The analyst may use ratio analysis to compare items on one financial statement or to investigate the
links between items on two financial statements. After computing ratios for each year's financial
data, the analyst may examine the company's patterns through time. Because ratios account for
size, adopting this analytical technique allows for both inter- and intra-company comparisons.
Financial ratios are only useful when compared to other data...
3.1 What is Ratio Analysis?

It is an analysis of financial statements with the help of the 'accounting ratio'. It is a quantitative
method of gaining insight into a company's liquidity, operational efficiency, profitability, and

Notes
solvency position by studying its financial statements.Its purpose is to provide a meaningful
understanding of the performance and financial position of an enterprise.
What exactly is a ratio?

The ratio depicts the connection between the two variables.
What exactly is an accounting ratio?
Accounting ratios are calculated using accounting information collected from financial
statements.
To begin, financial statement ratios serve as "flags" that indicate areas of strength or
weakness. One or more ratios may be deceptive, but when coupled with other
information about a company's management and economic conditions, ratio research
may reveal a lot about it. Second, there is no one right ratio value. The analyst's viewpoint
and the company's competitive strategy influence whether a given ratio's value is too
high, too low, or just right. Third, a ratio is only significant when compared to some
benchmark, such as an industry trend, a ratio trend, a ratio trend for the individual firm
under consideration, or a declared management target.
Definition
According to J. Betty, "The term accounting is used to describe relationships significantly which
exist in between figures shown in a balance sheet, Profit & Loss A/c, Trading A/c, Budgetary
control system or any part of the accounting organization."
Source: Author
According to Myers, "Study of relationship among the various financial factors of the enterprise".
3.2 Importance and Objectives

Objectives of Ratio Analysis
 Simplify accounting information.
 Determine Long-term solvency.
 Determine Short-term solvency.
 Assess the operating efficiency of the business.
 Analyze the profitability of the business.
 Help in comparative analysis, i.e., inter-firm and intra-firm comparisons.
Importance of Ratio Analysis

Accounting ratios help understand the financial position and performance of an enterprise.
Bankers, investors, creditors, etc., all can analyze the Balance Sheet and Statement of Profit and Loss
using ratios for taking prudent decisions.

Notes
3.3 Types of Ratios
The accounting ratios are classified into various categories, viz.:
1. Based on financial statements
2. Based on functions
Based on Financial Statements

1. Income Statement Ratios:These ratios are computed using the enterprise's trading statements
and profit and loss account. The Gross Profit Ratio, Net Profit Ratio, Expenses Ratio, and so on are
all important ratios.
2. Balance Sheet or Positional Statement Ratios:These ratios are calculated from the
enterprise's balance sheet, which generally displays the financial condition of the position, i.e.,
short-term, long-term financial situation, the owners' portion of the enterprise's total assets, and so
on.
3. Inter Statement or Composite Ratio Mixture:These ratios are calculated by extracting
accounting information from both financial statements in order to determine stock turnover ratio,
debtor turnover ratio, return on capital employed, and so on.
Using Functions
1. Based on the businesses' solvency position: The firms' short-term and long-term solvency
positions.
2. Based on firm profitability:Firm profitability is analyzed based on total capital employed,

total asset utilized, and so on.
3. Based on the efficacy of the company:The effectiveness of the firm is analyzed using
turnover ratios such as stock turnover ratio, debtor turnover ratio, and so on.
4. Capital structure ratios:Leverage and coverage ratios are used to assess the capital structure
status.
3.4 Liquidity Ratios

To study the short-term solvency or liquidity of the firm, the following are various ratios:
1. Current Ratio
2. Acid –Test Ratio
3. Cash Ratio
Current Ratio
It is one of the essential accounting ratios to determine the business fleeces' ability to meet the short
financial commitment. This ratio establishes the relationship between the current assets and current
liabilities.
Current Assets =Cash + Bank + Receivables + Short Term Investments+ Inventory +

Prepaid Expenses
Current Liability =Creditors + Bank overdraft + Payables + Outstanding Expenses+
Short Term loans + Provision for Taxation + Proposed Dividend
Tata steel has current assets worth of ₹ 30 lac, while the liabilities amount to ₹ 15 lac.
What is the current ratio of the firm?
Solution:Current Ratio = 30/15 = 2

Notes
Standard norm of the current ratio:

The ideal norm is 2:1, which means that two rupees of current assets appropriately cover
every one rupee of current liability.
Interpretation
A high ratio than the specified norm denotes that the firm possesses excessive current assets, then
the requirement portrays idle funds invested in the current assets.
A significant limitation of the current ratio is that the current assets are equally weighed against
each other to match the current liabilities under this ratio. One rupee of cash is equally weighed at
par with the one rupee of closing stock, but the closing stock and prepaid expenses cannot be
immediately realized like cash and marketable securities.
Acid-Test/Quick/Liquid Ratio
It indicates the company's ability to instantly use its near-cash assets (assets that can be converted
quickly to cash) to pay down its current liabilities; it is also called the acid test ratio.
Quick Assets =Cash + Bank + Receivables + Short Term investment

or
Quick Assets =Current Assets- Inventory - Prepaid Expenses
A company has a closing stock of ₹30,000 while its prepaid expenses are ₹5000. What
will be its quick assets ratio if the current assets are worth₹50000 while current liabilities
are worth ₹15000?
Solution:
Quick/Liquid Asset = Current Assets – (Closing Stock + Prepaid Expenses)
= 50000 – (30000 + 5000) = 15000
Quick Assets Ratio = Liquid Assets / Current Liabilities
= 15000/15000 = 1:1
Standard norm of the ratio:

The ideal norm is 1:1, which means that one rupee of current liabilities is matched with
one rupee of quick assets.
Interpretation
It is a more stringent and reliable ratio for analyzing the Liquidity ratio because assets forming part
of quick assets are easily converted into cash on short notice without shrinking their value. The
higher the ratio, the better is the liquidity position of the company.
However, the too high ratio will bring negative consequences as it too high a liquid ratio suggests
that the business is carrying ideal cash or liquid assets.
Cash/Absolute Liquid Ratio

The ratio establishes the relationship between absolute liquid assets and the current liabilities of the
firm.

Notes

The most favorable and optimum value for this ratio is 1: 2.
The following are the various current assets owned and current liabilities by Basmati
mills as of March 31, 2021:
Amount Amount
Current Liabilities Current Assets
(₹) (₹)
Bills Payable 60000 Bills Receivable 70000
Sundry Creditors 70000 Sundry Debtors 90000
Bank Overdraft 30000 Bank Balance 25000
Outstanding Expenses 5000 Marketable Securities 15000
Prepaid Expenses 5000
Stock 30000
Total 165000 Total 235000
Calculate the following from the above information:
a) Current Ratio
b) Acid-test Ratio
c) Cash Ratio
3.5 Turnover Ratios

A turnover ratio represents the number of assets or liabilities a company replaces to its sales. The
ratio indicates that the firm's rate of speed for converting the assets into sales. Turnover ratios help
determine the efficiency with which a business utilizes its assets.
Types of Turnover Ratios

1. Inventory Turnover Ratio
2. Debtor Turnover Ratio
3. Creditor Turnover Ratio
4. Inventory Turnover Ratio
Inventory/Stock Turnover Ratio

The ratio expresses the speed of converting the stock into sales. In other words, how fast the stock is
being converted into sales in a year.
COGS = Sales- Gross Profit

or
Opening Stock + Purchases + Direct Expenses – Closing stock

Notes

The higher the ratio, is better the firm in converting the stock into sales and vice versa.
Interpretation
A higher number is better. A lower number (compared with the previous period or competitors)
suggests a problem with stock control.
Some issues to consider
 Inventory turnover varies from industry to industry.

 It is not relevant for many service sector businesses.
 Seasonal fluctuations in demand during the year may not be reflected in the calculations.
Inventory Conversion Period or Stock Velocity

The next step is to determine the number of days or weeks, or months that have been taken or
consumed by the firm to convert the stock into sales volume. It reports to us about the average time
to convert our total inventory into sales. Inventory Conversion Period (in Days)
Stock velocity can be calculated in months and weeks as well. In such case, the formula
of calculating stock velocity will be:
Interpretation
Lower the duration is better for the firm position in converting the stock into sales and vice versa.
Compute the inventory turnover ratio and average selling period from the following
data of a trading company:
Sales: ₹75,000
Gross profit: ₹35,000
Opening inventory: ₹9,000
Closing inventory: ₹7,000
Debtors or Receivable Turnover Ratio

It is an accounting measure used to measure how effective a company is in extending credit and
collecting debts.
Net Credit Annual Sales = Total Sales –Cash Sale

Trade Debtors/ Receivables = (Sundry Debtors + Bills/Notes Receivables)
Average Trade Debtors = (Opening Trade Debtors + Closing Trade Debtors)

Notes
2
Interpretation
The higher the ratio is, the better the position of the firm in collecting the overdue. A higher ratio
means the effectiveness of the collection department and vice versa.
Average Collection Period or Debtors Velocity

The collection period is the amount of time it takes for a business to receive payments owed by its
clients.Companies calculate the average collection period to ensure they have enough cash on hand
to meet their financial obligations.
Debtors' velocity or Average collection period can be calculated in months and weeks as
well. In such case, the formula of calculating debtors' velocity will be:
Interpretation
Lesser the duration shows greater effectiveness in collecting the dues, which means that the
collection department takes only a minimum collection period and vice versa.
Sundaram & Co. Sells goods on a cash as well as credit basis. The following particulars
are extracted from the books of accounts for the calendar 2020:
Calculate the average collection period.

Solution: To find out the average collection period, the first debtors turnover ratio has to
compute:

Notes
Calculate Debtors Turnover Ratio and Average Collection Period (in days) from the
following.
Total Sales – ₹6,00,000

Cash Sales – 20% of Total sales
Trades Receivable at the beginning of the year- ₹80,000
Trades Receivable at the end of the year- ₹1,60,000
Creditors or Payable Turnover Ratio

It is a short-term liquidity measure used to quantify the rate at which a company pays off its
suppliers and depicts how many times a company pays off its. It also shows the firm's effectiveness
in making use of the credit period allowed by the creditors during the moment of credit purchase.
Net Credit Purchase = Total Sales –Cash purchases

Trade Creditor/ Payables = (Sundry Creditors + Bills Payable)
Average Trade Creditor = (Opening Trade Creditor + Closing Trade Creditor)
2
Interpretation
The lesser the ratio is, the better the position of the firm in liquidity management. A lower ratio
means enjoying more credit period from the creditors and vice versa.
Creditors / Payables Payment Period or Creditors Velocity

It estimates the average time it takes a business to settle its debts with trade suppliers. The ratio is a
helpful indicator when it comes to assessing the liquidity position of a company.
A high payment period indicates organizations make payments slowly.
Caution,Creditors' velocity or Average payment period can be calculated in months and

weeks as well. In such case, the formula of calculating creditors velocity will be:
Interpretation
The greater the duration, the better the firm's liquidity management is in availing the creditors'
credit period and vice versa.
Metro trading company makes most of its purchases on credit. The extracted data for
the year 2012 is given below:
Total purchases: ₹570,000
Cash purchases: ₹150,000
Accounts payable at the start of the year: ₹65,000

Notes
Accounts payable at the end of the year: ₹40,000
Notes payable at the beginning of the year: ₹20,000
Notes payable at the end of the year: ₹15,000

Required: Calculate the average payment period from the above data assuming 360
days in a year.
3.6 Profitability Ratios

Profitability ratios are used to evaluate the company's ability to generate income/earnings relative
to its revenue, operating costs, balance sheet assets, or shareholders' equity over time, using data
from a specific point in time.
Types of Profitability Ratio

These ratios are a measurement of the profitability of the firms in various angles, viz:
1. On sales
2. On investments
3. On capital employed and so on
While discussing the measure of the profitability of the firm, the profits are normally classified into
various categories:
1. Gross Profit
2. Net Profit
3. Operating Profit Ratio
4. Return on Assets Ratio
5. Return on Capital Employed
All profitability ratios are typically expressed only in terms of (%). The return is usually
expressed only in terms of percentage, which warrants this ratio's expression to be also in
percentage.
1. Gross Profit Ratio

The ratio elucidates the relationship between gross profit and sales volume. It facilitates the study
of the firm's profit-earning capacity out of the manufacturing or trading operations.
Interpretation
A high Gross Profit ratio indicates low production & high sales cost, whereas a low Gross Profit
ratio indicatesthe high cost of production & low selling price.
Om enterprises has earned a gross profit of ₹ 6,00,000 in the first quarter. Calculate the
gross profit ratio if the corresponding sales amounted to a value of₹30,00,000. What does
it imply?
Solution:
The ratio implies that the firm has earned good profits out of sales in the first quarter.
2. Operating Ratio
The operating ratio measures the relationship between operating cost & net sales.

Notes
Interpretation
The lower the ratio, the more favorable and better the firm's position is, highlighting the percentage
of absorption, cost of goods sold and operating expenses out of sales and vice versa. The lower ratio
leads to a higher margin of operating profit.
The cost of goods sold by Mangamal operators is ₹ 2,000. What will be the firm's
operating ratio if the operating expenses are 50,000 and net sales is that of ₹5,00,000?
What does it mean?
Solution:
Since the ratio is relatively low, the firm is in quite a favourable position and thus has a
high margin of operating profit.
3. Operating Profit Ratio

The operating profit ratio measures the relationship between operating profit & net sales.
Interpretation
The higher the ratio, the better it is for the firm. A higher operating profit ratio suggests a high
operating margin used to pay other non-operating expenses, finance cost, and taxes.
4. Net profit Ratio

The ratio expresses the relationship between the net profit and sales volume. It facilitates the
portrayal of the overall operating efficiency of the firm. The net profit ratio is an indicator of the
firm's overall earning capacity in terms of return out of sales volume.
Total Revenues =Revenue from operations + Other Income
Total expenses = Cost of goods sold + Office expenses + Administrative expenses +

Sellingexpenses + Distribution expenses + Interest on loans + Tax
Net profit =Total revenues – Total expenses
Interpretation
The higher the ratio, the better the firm's position is, which means that the firm earns greater profits
out of the sales and vice-versa.
5. Expense Ratio
The expense ratio shows the relationship of various expenses to net sales. It indicates the
proportion of each expense consumed in sales of ₹100.The lower the ratio, the better it is.

Notes
From the following information, calculate:

Gross Profit Ratio
Operating Ratio
Operating profit Ratio
Net profit ratio
Opening stock = ₹2600
Purchases = ₹8000
Wages = ₹2400
Manufacturing expenses = ₹1600
Sales = ₹16000
Closing stock = ₹3800
Selling expenses = ₹400
General expenses = ₹2400
Loss of furniture due to fire = ₹80
The compensation received for land acquisition = ₹480
6. Return on Investment (ROI)

ROI indicates the return that investors could receive on their investment in a company. This ratio
indicates the 'overall efficiency' of the firm.
Total funds =Equity share capital+ Reserves and surplus – fictitious assets (or
accumulated losses) + Preference Share Capital+ Debt Funds
Interpretation
The higher the ratio, the better it is.
7. Return on Equity capital (ROEC)/Shareholder Funds

This ratio is also known as 'Return on Net Worth. The profitability & performance of the company
is judged using this ratio. Equity shareholders use this ratio to take their investment decisions.
Shareholder Funds =Equity share capital + Reserves and Surplus – Accumulated losses
Interpretation
 High ROEC will satisfy the shareholders (or owners).

 Low ROEC indicates the low profitability of the company.
From the following information (in ₹), calculate

Return on Investment and,
Return on Shareholder Funds
Equity share capital = ₹400,000
Preference share capital = ₹100,000

Notes
10% debenture = ₹400,000
General reserve = ₹184,000
Net profit after interest and after tax = ₹150,000
Tax amount = ₹50,000
8. Earnings Per Share (EPS)

It measures the net income (in rupees) earned by each share
Interpretation
The higher the ratio, the better it is, as it means
 The company is more profitable and

 The company has more profits to distribute to its shareholders.
 The company has a strong financial position.
 It is a reliable company to invest money.
9. Dividend per Share

It shows the amount of profit which is distributed to shareholders per share
10. Price-Earnings ratio (P/E ratio)

It shows the relationship betweenthe stock price and the earnings of the company. It indicates how
much an investor is willing to pay to buy one share based on its' earnings.
Interpretation
A high P/E ratio indicates that the company's share is sold in the stock market at a high price, and
the investors have high expectations. At the same time, it indicates the low profits of the company
as the EPS (denominator) is less.
11. Dividend Yield Ratio

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how
much a company pays out in dividends each year relative to its stock price.
Interpretation
Mature companies are more likely to pay dividends.
Companies in the utility and consumer staple industries often have higher dividend yields.
Investors need to keep in mind that higher dividend yields do not always indicate attractive
investment opportunities because the dividend yield of a stock may be elevateddue to a declining
stock price.
From the following information calculate

(i) Earning per Share
(ii) Price-earnings ratio

Notes
70,000 equity shares of ₹10 each = ₹700,000
Net Profit after tax = ₹1,75,000
The market price of a share = ₹13
3.7 Solvency Ratios or Leverage ratios

The capital structure ratios are classified into two categories:
1. Leverage Ratios or Solvency ratios:Long-term solvency position of the firm — Principal
repayment.
2. Coverage Ratios: Fixed commitment charge solvency of the firm — Dividend coverage and
Interest coverage.
Solvency Ratios
Solvency ratios are calculated to determine the ability of the business to pay its debt in the long run.
Need for Solvency Ratios

The persons who have given money to the business on a long-term basis are interested in the safety
of their periodic payment of interest, as well as the repayment of the principal amount at the end of
the loan period. Thus, solvency ratios assist the lender to assess the capacity of the company to pay
back the principal amount.
Types of Solvency Ratios

Let's discuss some important solvency ratios as follows:
1. Debt Equity Ratio

The debt-to-equity ratio compares a company's total debt to total equity. A higher debt to equity
ratio indicates that more debt financing (long term loans) is used than investor financing
(shareholders).
The debt to equity ratio (also termed as debt-equity ratio) is a long-term solvency ratio that
indicates the soundness of the long-term financial policies of a company. It shows the relation
between the portion of assets financed by creditors and the portion of assets financed by
stockholders. As the debt-to-equity ratio expresses the relationship between external equity
(liabilities) and internal equity (stockholder's equity), it is also known as the "external-internal
equity ratio". The debt-equity ratio can be understood into two different forms:
1. Long-term debt-equity ratio
2. Total debt-equity ratio
Let us understand each of them one by one.
Long-term Debt-equity Ratio
It is a ratio expressing the relationship between the outsiders' contribution through debt financial
resource and shareholders' contribution through equity share capital, preference share capital and
past accumulated profits. It reveals the cover or cushion enjoyed by the firm due to the owners'
contribution over the outsiders' contribution.
Total Equity/Net-worth =Equity share capital + Preference shares Capital+ All Reserve
& Surplus – Fictitious Assets
Interpretation
A higher ratio indicates the riskier financial status of the firm which means that the firm
has been Notes financed by the greater outsiders' fund rather than that of the owners'
fund contribution and vice-versa.
Total Debt-equity Ratio

Notes
The ultimate purpose of the ratio is to express the relationship total volume of debt
irrespective of nature and shareholders' funds. If the owners' contribution is lesser in
volume in general irrespective of its nature leads to a worse situation in recovering the
amount of outsiders' contribution during the moment of liquidation.
The long-term debt of company Lakme Ltd. is 3 crores and the net worth of the company
is 5 crores. If the company has short-term debt of 1 crore, what is the total debt-equity
ratio of Lakme Ltd.?
Solution:
Assume a company has ₹ 100000 bank lines of credit and a ₹ 500000 mortgage on its
property. The shareholders of the company have invested ₹1.2 million. Calculate Debt
Equity Ratio.
2. Proprietary Ratio
The ratio illustrates the relationship between the owners' contribution and the total volume of
assets. In simple words, how much funds are contributed by the owners in financing the assets of
the firm? Greater the ratio means that greater contribution made by the owners' in financing the
assets.
Interpretation
A higher ratio is a better position for the firm as well as safety to the creditors.
Arvind Company has shareholders' equity of ₹2,000,000 and total assets of ₹5,000,000.
There is no goodwill on its Balance sheet, nor any intangible assets. Its proprietary ratio
will be?
3. Debt Ratio
This ratio measures the long-term debt of a firm in comparison to its total assets.
Total Debt = Long term Loan + Debentures
Interpretation
A high debt ratio tells you that a company has more debt than assets and indicates financial
leverage.A low debt ratio indicates a financially stable business.
Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and
pipelines having much higher debt ratios than other industries such as the technology or service
sector
From the balance sheet given below calculate the proprietary ratio

Notes
Coverage Ratios
These ratios are used to determine the firm's solvency in making periodic payments of interest and
preference dividends. The interest and preference dividends are to be given regardless of the
profits available to the company. In other terms, they are known as the firm's set commitment fee.
1. Ratio of interest coverage

The corporations are required to pay the interest on their borrowings on time. This ratio enables a
potential lender to assess the enterprise's ability to make monthly interest payments out of total
revenue. The interest coverage ratio or debt service coverage ratio is used to analyze the ability to
pay interest.
Interpretation
Higher the ratio, more safety available to creditors.
MrAshmit Ahuja had an earning of ₹ 3,00,000 before he paid the interests and taxes.
What will be the interest coverage ratio if he pays ₹30,000 as an interest? What will it
mean?
Solution:
Since the
interest coverage ratio is substantially high, it means that Mr Ahuja has quite a good
capacity in making the payment of interest and has high safety.
1. Dividend Coverage Ratio

It demonstrates the firm's capacity to pay preferred dividends out of profits available in the firm's
hands after taxes is paid. The larger the earnings after taxes, the larger the buffer for the payment of
preference dividends, and vice versa.
Preference dividends must be paid without fail, regardless of the earnings available in the firm's
hands after taxes.
Hindustan Manufacturers have to make a preference dividend of ₹60,000. The earnings

after taxation are ₹ 3,00,000. What will be the Dividend coverage ratio? What does it
mean?
Solution:
Since the value of the dividend coverage ratio is quite high, the company has a strong
cushion for the payment of preference dividend.

Notes
3.8 Du-Pont Analysis
DuPont Analysis is a comprehensive evaluation of a company's Return on Equity (ROE) that
includes Net Profit Margin, Asset Turnover, and Financial Leverage. The DuPont Corporation
created this study in the year 1920.
In other words, it dissects the ROE to see how corporations might enhance the return to their
shareholders. It provides a framework for a more in-depth examination of a company's strengths
and weaknesses.
The company can increase its Return on Equity if it-
1. Generates a high Net Profit Margin.
2. Effectively uses its assets to generate more sales
3. Has a high Financial Leverage
DuPont: ROE can be decomposed into three components:
Sources: Author
This analysis has 3 components to consider:
1. Profitability or Profit margin:This is a very basic profitability ratio. This is calculated

bydividing the net profit by total revenues.
2. Efficiency or Total Asset turnover:This ratio indicates the efficiency of the firm in
employing its assets. This is derived by dividing revenues by average assets. This ratio
vary among sectors but is helpful in comparing enterprises in the same industry. If the
firm's asset turnover improves, this favorably influences the ROE of the company.
3. Leverage:This refers to the debt used to finance the assets. The companies should strike a
balance in the usage of debt. The debt should be used to finance the operations and
growth of the company. However, usage of excess leverage to push up the ROE can turn
out to be detrimental to the health of the company.
DuPont Framework

Notes
Source: Author
Dupont Analysis Interpretation

It provides a more comprehensive assessment of the company's Return on Equity. It showcases the
company's strengths while also identifying areas for development. If shareholders are unhappy
with the reduced ROE, the corporation may use the DuPont Analysis method to determine if the
lower ROE is attributable to a low profit margin, low asset turnover, or bad leverage. Once the
company's management has identified the weak spot, it may take corrective action.
The DuPont equation can be further decomposed to have an even deeper insight
where the net profit margin is broken down into EBIT Margin, Tax Burden, and
Interest Burden.
Return on Equity = EBIT Margin x Interest Burden x Tax Burden x Asset Turnover
Ratio x Financial Leverage
ROE = (EBIT / Sales) x (EBT / EBIT) x (Net Income / EBT) x (Sales / Total Assets) x
(Total Assets / Total Equity)
Case StudyEvaluation of Hindustan Unilever Limited

With over 85 years of heritage in India, HUL is India's largest fast-moving consumer goods
company. On any given day, nine out of ten Indian households use our products, giving HUL a
unique opportunity to build a brighter future. HUL is known for its great brands, the positive social
impact it creates and its belief in doing business the right way.
The following is the data of key financial ratios of HUL from March 2016 to March 2020.
Key Financial Ratios 20-Mar 19-Mar 18-Mar 17-Mar 16-Mar
Earnings per share 31.13 27.89 24.2 20.75 19.12
Dividend per share (₹) 34.5 22 20 17 16
Net profit ratio (%) 17.37 15.79 15.16 14.07 13.31
Return on Net worth (%) 83.89 78.8 74.02 69.18 65.88
Return on Assets (%) 34.37 33.78 30.53 30.43 29.71
Total Debt to Equity ratio 0 0 0 0 0
Asset Turnover ratio (%) 197.86 213.96 201.32 216.18 223.13
Current Ratio 1.31 1.36 1.29 1.3 1.43
Quick Ratio 1.02 1.07 1.02 0.97 1.05
Inventory Turnover Ratio 14.71 15.78 14.64 13.5 12.29
Source:https://www.moneycontrol.com/financials/hindustanunilever/ratiosVI/HU
Required:
a. Comment on the HUL's liquidity position.

b. Assess and comment on HUL's profitability position.
c. Review and comment on HUL's solvency position
d. Comment on HUL's efficiency to manage its assets.
e. Comment on HUL's leverage position.
Summary
 Ratio analysis is one of the important tools of financial statement analysis to study the
financial structure of the business fleeces.
 Financial ratio analysis is the calculation and comparison of ratios that are derived from the
information in a company's financial statements.

Notes
 The level and historical trends of these ratios may be used to draw conclusions about a
company's financial state, operations, and investment attractiveness.
 Financial ratios are generated using information from a company's financial statements.
 The usefulness of a ratio increases as it is compared to other data and standards.
 Liquidity, leverage, profitability, activity, integrated, and growth ratios are the many types of
ratios.
 Despite the fact that financial ratio analysis is well-developed and the actual ratios are well-
known, professional financial analysts often tailor their measurements to specific sectors or
even individual organizations.
 Analysts' opinions from the same ratio study can varied dramatically.
Keywords
Balance Sheet or Positional Statement Ratios: These sorts of ratios are determined from the
enterprise's balance sheet, which generally displays the financial condition of the position, i.e.
short-term, long-term financial position, the owners' portion of the enterprise's total assets, and so
on.
Ratios of Capital Structure: Leverage and coverage ratios are used to assess the capital structure
status.
Current assets include: Current assets include cash, cash equivalents, or quickly converted into
cash.
Current liabilities:Current liabilities are short-term financial resources that are due in a short
period of time inside a year.
Income Statement Ratios: These ratios are calculated using the enterprise's Trading, Profit &
Loss Account statements.
SelfAssessment
1. Ratio is an expression of:
A. Quotient
B. Time
C. Percentage
D. Fraction
E. All of these
2. Accounting ratios are to study:

A. Accounting relationship among the variables
B. The relationship between the variables of financial statements
C. The relationship between the variables of financial statements for analysis and
interpretations
D. None of the above.
3. Accounting ratios are of:

A. Income statement ratios
B. Positional statement ratios
C. Both (a) & (b)
D. None of the above

Notes
4. Solvency position of the firm studied and interpreted through:

A. Short-term solvency ratios
B. Long-term solvency ratios
C. Coverage ratios
D. (a), (b) & (c)
5. Efficiency and effectiveness of the firm to utilize its resources to generate income is studied
through:
A. Liquidity ratios
B. Leverage ratios
C. Profitability ratios
D. Efficiency ratios
6. Profitability ratios to study the potential to earn profits:

A. On Assets
B. On capital employed
C. On Sales
D. (a), (b) & (c)
7. Standard norm of the current ratio is:

A. 2:1
B. 1:5
C. 1:2
D. 3:1
8. Absolute Liquid assets do not include:

A. Closing stock
B. Prepaid expenses
C. Sundry debtors
D. Both (a) & (b)
9. The term accounting is used to describe relationships significantly which exist in between
figures shown in a:
A. Balance sheet
B. Profit & Loss A/c
C. Trading A/c
D. All of these
10. Which of the following is not a purpose of the Ratio Analysis?

A. To study the liquidity of the firm
B. To study the leverage position of the firm
C. To interpret the profit earning capacity of the firm
D. To identify the turnover of the firm

Notes
11. Ratio analysis is an outcome of the analysis of historical transactions known as:
A. Premortem Analysis
B. Postmortem Analysis
C. AntimortemAnlaysis
D. Mortem Analysis
12. Which of the following is not a ratio account based on Financial Statements?
A. Income Statement Ratios
B. Positional Statement Ratios
C. Composite Mixture of Ratios
D. None of these
13. Which of the following is not a short-term solvency ratio?

A. Current Assets Ratio
B. Defensive Interval Ratio
C. Super Quick Assets Ratio
D. None of these
14. The net profit ratio is an indicator of overall ...................... of the firm in terms of return out
of sales volume.
15. The operating ratio is establishing the relationship between the ...................... and operating
expenses with the total sales volume.
Answers for SelfAssessment

1. E 2. C 3. C 4. D 5. D
6. C 7. A 8. D 9. D 10. D
11. B 12. D 13. D 14. Earning 15 Cost of

Capacity goods
sold
Review Questions
1. Is the firm satisfies the standard norm of the current asset ratio and liquid assets ratio?

Notes
2. Liquid Assets 65,000; Stock ₹20,000; Pre-paid expenses ₹5,000; Working capital ₹60,000.
Calculate current assets ratio and liquid assets ratio.
3. The current ratio of Bicon Ltd. is 4.5:1 and the liquidity ratio is 3:1 stock is ₹6,00,000. Find out the
current liabilities
4.
Gross profit in a year amounts to ₹1,60,000. There is no long term loan or overdraft. Reserves and
surplus amount to ₹56,000. Liquid assets are ₹1,94,666. Closing stock of the year is ₹4,000 more
than the opening stock Bill receivable amount to ₹10,000 and bills payable to ₹4,000. Find out:
(i) Sales
(ii) Closing stock
(iii) Sundry debtors
(iv) Fixed assets
(v) Sundry creditors
(vi) Proprietors' fund.
5. You have been hired as an analyst for Mellon Bank and your team is working on an independent
assessment of Daffy Duck Food In(c) (DDF In(c)) DDF In(c) is a firm that specializes in the
production of freshly imported farm products from France. Your assistant has provided you with
the following data for Flipper Inc. and their industry.

Notes
In the annual report to the shareholders, the CEO of Flipper Inc wrote, "2008 was a good year for
the firm concerning our ability to meet our short-term obligations. We had higher liquidity largely
due to an increase in highly liquid current assets (cash, account receivables and short-term
marketable securities)." Is the CEO correct? Explain and use only relevant information in your
analysis.
6. In the above question, what will you say when you are asked to provide the shareholders with an
assessment of the firm's solvency and leverage. Be as complete as possible given the above
information, but do not use any irrelevant information.
7.Firm A has a Return on Equity (ROE) equal to 24%, while firm B has an ROE of 15% during the
same year. Both firms have a total debt ratio (D/V) equal to 0.8. Firm A has an asset turnover ratio
of 0.9, while firm B has an asset turnover ratio equal to 0.4. What can we analyze about the
relationship between both the firms?
8. State the different profitability ratios.
9. What is Dupont analysis? How is it useful for analyzing a company's performance?
10. The data summarized in the table below show the performance of two firms A and B, over five
years.
Using the information in the table explain the comparative attractiveness of the two firms to a
potential investor.
Further Readings
 Management Accounting by Khan M.Y And Jain P.K, Mcgraw Hill Education
 Financial Accounting for Management by Shah Paresh, Oxford University Press
 A Textbook of Accounting for Management by Maheshwari. S.N, Maheshwari
Sharad. K, Maheshwari Suneel. K, Vikas Publishing House
 Financial Accounting for Management: An Analytical Perspective by Gupta
Ambrish, Pearson Education India
 Financial Accounting by Goyal V.K, Excel Books, New Delhi
 Accounting & Finance for Managers by Pandikumar M.P, Excel Books, New Delhi.
Web Links
 https://www.elearnmarkets.com/blog/dupont-analysis/
 https://corporatefinanceinstitute.com/resources/knowledge/finance/ratio-
analysis/

Razia Sehdev, Lovely Professional University Notes
Unit 04: Financial Statement Analysis

CONTENTS
Objectives
Introduction
4.1 Objectives of Analysis
4.2 Various Stakeholders and their Interests
4.3 Techniques of Financial Statement Analysis
Summary
Keywords
Self Assessment
Review Questions
Further Reading
Objectives
 Illustrate the meaning and purpose of performing Financial Statement analysis by various
stakeholders.
 Explain the tools of Financial Statement Analysis.
 Measure the financial position and performance of any company through comparative
statement analysis.
 Review the financial position and performance of any company through trend analysis.
 Assess the financial position and performance of any company through common size financial
statement analysis.
Introduction
Financial statement analysis is the process of reviewing and investigating a company’s financial
statements by establishing relationships among various components of Financial statements to
make better economic decisions. It includes both ‘Analysis’, and ‘Interpretation’.
Did you Know? What is meant by “analysis”?
It is a systematic categorization of the data in the financial statements that simplifies financial data.
What exactly is "interpretation"?
It means' simplifying the meaning and value of the facts.' It refers to obtaining conclusions from
financial statement analysis and comprehending what it means.
Example
In 2020, If the Tea bag Company is selling 1 kg tea for Rs. 100 and incurring the cost of Rs. 80 per kg
to manufacture same, how much is the profit margin that the company earn per unit sold?

Notes
In 2021, if the inputs costs of manufacturing 1 kg of tea increase to Rs. 85, will the company be able
to earn the same profit margin per unit sold as of 2020?
Analysts can obtain useful information by comparing a company’s most recent financial statements
with its results in previous years and with the results of other companies in the same industry
through performing financial statement analysis.
4.1 Objectives of Analysis

The purpose of analysis depends upon the person interested in such analysis and his or her object.
Primary objectives of Financial Statement Analysis

To understand and diagnose the information contained in the financial statement to judge the
profitability and financial soundness of the firm, and to make a forecast about prospects of the firm
relative to the firm’s past performance & soundness and competitor’s or industry’s performance
and soundness.
Secondary objectives of Financial Statement Analysis

 To assess the earning capacity or profitability of the firm.
 To assess operational efficiency and managerial effectiveness.
 To assess the short term as well as long term solvency position of the firm.
 To identify the reasons for the change in profitability and financial position of the firm.
 To make the inter-firm comparison.
 To assess the progress of the firm over a period.
 To help in decision making and control.
 To guide or determine the dividend action.
 To provide important information for granting credit.
4.2 Various Stakeholders and their Interests

The following are the stakeholders that have interest in performing financial statement analysis.
Source: Author
Notes
Financial statement analysis is a useful tool for investors and creditors, financial analysts, and
others in making decisions about stocks, bonds, and other financial instruments. The purpose of
reviewing financial statements is to evaluate a company's previous performance and present
financial situation and to forecast its future performance. Investors who purchase stock are mainly

Notes
concerned with a company's profitability and their chances of profiting from dividends and/or
raising the market value of their stock holdings. Creditors and investors interested in debt
instruments, such as bonds, are more concerned with liquidity and solvency: the company's
capacity to pay its obligations in the short and long term. Financial analysts, who usually specialize
in tracking certain sectors, regularly evaluate a company's profitability, liquidity, and solvency to
provide recommendations concerning the acquisition or sale of assets such as stocks and bonds.
4.3 Techniques of Financial Statement Analysis

The following figure is depicting the bifurcation of tools of Financial Statement Analysis.
Source: Author
Notes
Two primary types of financial statement analysis are commonly known as horizontal analysis and
vertical analysis based on Modus Operandi.
Cautions
Financial analysis may be classified into two forms based on the material used: external analysis
and internal analysis.
Financial analysis may be classified into two forms based on the entities involved: cross-sectional or
inter-firm analysis and time-series or intra-firm analysis.
Financial analysis may be classified into two forms based on the length of time involved: short-term
analysis and long-term analysis.
Horizontal Analysis
Horizontal analysis occurs when an analyst analyses financial information from one accounting
period to information from previous accounting periods for the same firm. Analysts utilise this
method to discover and evaluate past patterns in a company's performance and position. It also
aids in determining a company's financial development and competitive position. It is sometimes
referred to as "Dynamic Analysis" since it is based on year-to-year data rather than any one year's
data. Horizontal financial statement analysis is done in two ways: comparative statement analysis
and trend analysis.
Comparative Statement Analysis

Notes
Comparative statement analysis involves comparing a company’s financial condition and

performance of a particular accounting period with the prior period or any other selected period.
Thus, it involves the analysis of financial statements across time.
Steps to perform Comparative Statement Analysis:

Step 1: Calculating Change in INR/Rupee Amounts
ℎ ( )= −
Notes
If we measure the amount of the change between 2019 and 2020, the Rupee amounts for 2019
become the “base” year figures. Thus, the previous year will become the base year.
Step 2: Calculating Change as a Percentage
ℎ
ℎ = × 100
Task
From the following Balance sheet of Samiksha enterprise, you are required to prepare
Comparative Balance Sheet and Interpret its Liquidity and Solvency Position.
Liabilities 2020 (₹
) 2019 (₹
) Assets 2020 (₹
) 2019 (₹
)
Share Capital 250,000 250,000 Furniture 10,000 8,000
12% Debentures 50,000 80,000 Land & Building 280,000 300,000
Reserves 25,000 70,000 Machinery 1,00,000 95,000
Creditors 40,000 60,000 Debtors 35,000 50,000
Bills payable 20,000 40,000 Stock 70,000 44,000
Outstanding 25,000 15,000 Cash 15,000 18,000
expenses
410,000 515000 410,000 515,000
Task
From the following Balance sheet of Madhurikaenterprise, you are required to prepare
Comparative Balance Sheet and Interpret its Liquidity and Solvency Position.
3/31/2020 3/31/2019 3/31/2020 3/31/2019

ASSETS LIABILITIES
(in ₹) (in ₹) (in ₹) (in ₹)
Land & Building 40,000 60,000 Share Capital 2,50,000 3,50,000
Plant & Machinery 2,50,000 4,00,000 Profit & Loss A/c 50,000 80,000
Stock 50,000 37,500 General Reserve 25,000 35,000
Debtors 70,000 75,000 Creditors 81,500 1,00,000
Prepaid Expenses 7,000 6,000 Bills Payable 15,000 20,000
Cash at Bank 8,000 9,000 Pre-received Rent 3500 2500
TOTAL 4,25,000 5,87,500 TOTAL 4,25,000 5,87,500
Case Study
Evaluation of HUL the financial soundness and performance in 2020 versus 2019 through
Comparative Statements Analysis
Let’s learn comparative financial statement analysis through Hindustan Unilever Limited (HUL)

Notes
financial statements and assess the financial soundness and performance of HUL in 2020 versus
2019.
The HUL Balance sheet as of March 31, 2020, and March 31, 2019, has been converted in
Comparative Balance Sheet by performing the above discussed two steps to perform
comparative statement analysis. 2019 is taken as the base year. In the first step, absolute change
in rupee terms is calculated and in the second step, the percentage change is calculated for 2020
figures relative to 2019 figures. After performing these two steps, the following comparative
balance sheet of HUL is formed:
HUL: Comparative Balance Sheets (in ₹Cr.) as on March 31, 2020 and 2019
Increase (Decrease)
2020 2019 Amount %
EQUITIES AND LIABILITIES
SHAREHOLDER'S FUNDS
Equity Share Capital 216 216 0.00 0.00
Reserves and Surplus 7,815.00 7,443.00 372.00 5.00
Total Shareholders Funds 8,031.00 7,659.00 372.00 4.86
NON-CURRENT LIABILITIES
Other Long Term Liabilities 1,269.00 804 465.00 57.84
Long Term Provisions 1,198.00 1,049.00 149.00 14.20
Total Non-Current Liabilities 2,467.00 1,853.00 614.00 33.14
CURRENT LIABILITIES
Trade Payables 7,399.00 7,070.00 329.00 4.65
Other Current Liabilities 1,287.00 782 505.00 64.58
Short Term Provisions 418 501 (83.00) (16.57)
Total Current Liabilities 9,104.00 8,353.00 751.00 8.99
Total Capital And Liabilities 19,602.00 17,865.00 1737.00 9.72
ASSETS
NON-CURRENT ASSETS
PPE 4,625.00 3,907.00 718.00 18.38
Intangible Assets 431 436 (5.00) (1.15)
Capital Work-In-Progress 513 373 140.00 37.53
Fixed Assets 5,569.00 4,716.00 853.00 18.09
Non-Current Investments 252 256 (4.00) (1.56)
Deferred Tax Assets [Net] 261 339 (78.00) (23.01)
Long Term Loans And Advances 453 396 57.00 14.39
Other Non-Current Assets 1,159.00 784 375.00 47.83
Total Non-Current Assets 7,694.00 6,491.00 1203.00 18.53
CURRENT ASSETS
Current Investments 1,248.00 2,693.00 (1445.00) (53.66)
Inventories 2,636.00 2,422.00 214.00 8.84
Trade Receivables 1,046.00 1,673.00 (627.00) (37.48)
Cash And Cash Equivalents 5,017.00 3,688.00 1329.00 36.04
OtherCurrentAssets 1,961.00 898 1063.00 118.37
Total Current Assets 11,908.00 11,374.00 534.00 4.69
Total Assets 19,602.00 17,865.00 1737.00 9.72

Notes
Source: Author
Caution:Negative figures are shown in brackets as per accounting norms.
Interpretations
 There is an increase in Reserve and Surplus by 5% that implies ploughing back of profits. It
is a sign of the improved operational efficiency of HUL in 2020.
 An increase in Shareholder’s funds by 5%implies the owner’s contribution in business has
been gone up.
 An increase in Non-Current Liabilities (Outsider’s funds) by 33%implies an increase in
financial risk due to an increase in interest payment obligations, outsiders’ claim on
business got increased. It may be the case that HUL is on its way to expansion or
undertaking strategic changes.
 An increase in Current Liabilities by 9% signifies more credit period taken from creditors.
Such an increase may adversely affect the liquidity position of HUL.
 An increase in Fixed assets by 18.09% depictsthe increase in production capacity of HUL.
Hence, it is inferred that HUL is on its way to expansion.
 A decrease in Non-current Investments by 1.56%implies investments are sold and funds
are either invested in business operations or kept idle for future opportunities.
 An increase in Current Assets by 4.69% signifiesan improvement in liquidity position.
 An increase in Long term Loans and advances by 14.39%implies HUL has lent more credit
in 2020.
 A decrease in Current investments by 53.66% in 2020 relative to 2019 implies the short
investments are sold for generating cash.
 An increase in Stock by 8.84% suggests that sales have been decreased andthe stock has
been piled up in 2020.
 Decrease in Trade receivables by 37.48% exhibits less credit sales, strict credit policy, less
chance of bad debts in 2020 relative to 2019.
 An increase in Cash and Cash Equivalents by 36.04%implies idle cash that is reaping no
return.
 Current Assets in 2020 have been increased by 4.69%, however Current Liabilities in 2020
has been increased by 9%. The percentage increase in Current Liabilities is more than the
increase in Current Assets. It may harm HUL’s Working capital Management or Liquidity
position i.e., the ability of the company to pay its short-term liabilities.
 If individual amounts of Current Assets and Current Liabilities of both years are
considered then definitely Current Assets are still above than Current Liabilities that
establishes strong Liquidity position of HUL.
 The percentage increase in Non-Current Assets in 2020 relative to 2019 is 18.53% that is far
less than the percentage increase in Non-Current Liabilities that is 33%. It may give a
negative impact on the Solvency position of HUL.
 However, if Rupee change is considered then Non-Current Assets (₹1203 crores) have been
increased almost double than the increase in Non-Current Liabilities (₹614 crores), hence
implying that the Solvency position of HUL is strong enough.
 An ideal Financing policy is “A company should finance all of its Non-Current assets
through Non-Current liabilities and all current assets should be financed from current
liabilities”.

Notes
 Non-Current assets should never get financed by raising current liabilities. However, part
of current assets can get financed through Non-Current liabilities.
Thus, the afore-said inferences have been obtained about HUL’ financial position post
performing comparative statement analysis on its balance sheet for 2020.
Now, let’s analyze and comment on the financial performance of HUL through performing
comparative statement analysis on its statement of profit & loss for the year ending 2020 by
taking 2019 as base year as follows:
Source: Author
Caution:Negative figures are shown in brackets as per accounting norms.
Interpretations
 The revenue has been increased by just 1.63% in 2020 but the Profit After Tax (PAT) has
been increased by 11.63% due to efficiently control over expenses as they have been
increased by 0.30%.
 Finance Cost has increased by 278.57%, implying a hike in Non-Current Liabilities
tremendously.
 Depreciation is increased by 79.01% implying the purchase of more Fixed Assets in 2020. It
is a sign of HUL’ Expansion.
Overall Interpretations
Now, let’s make overall interpretations by considering both comparative balance sheet and
statement of profit & loss together:
Fixed Asset Utilization
Increase in Fixed Assets by 18.09% and on another side, Revenue from operations has also
increased by 1.63%. It implies Fixed Asset utilization has been improved. As the Fixed Assets
have been increased highly comparatively to increase in sales. So, it gives further scope to HUL
for taking the best utilization of its investment in Fixed Assets.

Notes
Operational Efficiency
The profits in 2020 have got increased by 11.63% and Reserves are also increased by 5%. It
implies improvement in the Operational efficiency of HUL in 2020.
Inventory Management
The increase in inventory is 8.84% is much higher than the increase in Sales, implying less
efficient Inventory management. The inventory has been piled up.
Creditors/ Trade Payable Management
Purchases of Finished goods have been increased by 34.71%, however, Trade payables have just
risen by 5% in 2020 implying HUL has purchased the Finished goods more on cash in 2020. So, it
signifies better payable management. Even the Cost of Material consumed has been decreased
that signifies a decrease in production comparatively to 2019.
Debtors/Receivable Management
The revenue has been increased by 1.63%, however, the trade receivables have been decreased
by 37.48%. It implies that there were more cash sales in 2020 and HUL has recollected their funds
from Debtors. It shows better Receivable management. But the rate of decrease in Debtors is too
high that is 37.48%, it implies that HUL has followed a strict credit policy in 2020 and it can give
an adverse impact on its total sales overa long period.
Leverage—To know the Finance Risk
Long term debt has been increased by 33%, even short-term debt has been risen by 9%. On the
other side, the shareholder’s funds have been increased by just 5% that is due to an equivalent
increase in R&S. It may increase Finance risk for HUL in long run. It will also increase the
burden of regular interest payment. However, if individual amounts are considered then
Shareholders funds is too high as compared to Non-Current Liabilities thus provides a safe
window for lenders to provide credit to HUL.
Source: Author
Trend Analysis
Trend analysis examines important financial statement numbers or connections through time for
the same organization. It typically covers more than three years of data and aids in the
development of prediction models and forecasting financial statements. It entails the computation
of trend percentages, which are important in assessing the financial status of the firm through base
year performance ratio computation. This not only indicates the trend movement of the enterprise's
financial performance, but it also exposes the enterprise's strengths and shortcomings. Financial
Elements may trend upward, downward, or sideways (horizontally). This study starts with a base
year of 100% and then displays consecutive years' growth or declines over the base year.
The formula of Calculating Trend percentages:
= × 100
Let’s perform trend analysis on few key financial elements of HUL for the last five years starting
from 2016 as follows:

Notes
Trend Analysis of Key elements of HUL ------------------- in ₹Cr. -------------------

Mar 20 19-Mar 18-Mar 17-Mar 16-Mar
Revenue From Operations [Gross] 38,273 37,660 34,619 33,895 32,929
Total Operating Revenues 38,785 38,224 34,525 31,890 31,061
Cost of Materials Consumed 11,572 13,240 12,491 11,363 11,267
Purchase of Stock-In Trade 6,342 4,708 3,812 4,166 3,951
Employee Benefit Expenses 1,691 1,747 1,745 1,620 1,573
Finance Costs 106 28 20 22 15
Depreciation And Amortisation Expenses 938 524 478 396 321
Total Expenses 30,229 30,139 27,747 26,261 25,648
Profit/Loss For The Period 6,738 6,036 5,237 4,490 4,137
Trend Percentages
Revenue From Operations [Gross] 116% 114% 105% 103% 100%
Total Operating Revenues 125% 123% 111% 103% 100%
Cost of Materials Consumed 103% 118% 111% 101% 100%
Purchase of Stock-In Trade 161% 119% 96% 105% 100%
Employee Benefit Expenses 108% 111% 111% 103% 100%
Finance Costs 707% 187% 133% 147% 100%
Depreciation And Amortisation Expenses 292% 163% 149% 123% 100%
Total Expenses 118% 118% 108% 102% 100%
Profit/Loss For The Period 163% 146% 127% 109% 100%
Source: Author
Task
Comment upon the financial performance of HUL in 2020 based on the above-given Trend
analysis.
Importance of Horizontal Analysis

Horizontal helps the analyst to examine relationships for detecting strengths and weaknesses of a
business entity such as faster growth in the cost of sales compared to sales.The purpose of
horizontal analysis is primarily to direct attention to the financial elements that require further
investigation. It helps to identify trends in various financial elements and forms the basis of forecast
the future performance and position of a business entity.
Vertical Analysis
It is a method of financial statement analysis in which each line item is listed as a percentage of a
base figure within the statement. The most common use of vertical analysis is within a financial
statement for a single reporting period, so that one can see the relative proportions of account
balances. It is also known as Static Analysis.
Vertical analysis can become a more potent tool when used in conjunction with horizontal analysis,
which considers the finances of a certain period such as on a comparative basis over five years.For
example, if the cost of goods sold has a history of being 40% of sales in each of the past four years,
then a new percentage of 48% would be a cause for alarm.
Notes
To prepare common size statements, the components are translated as a percentage of selected Key
component of the financial statement for analysis and interpretations.
For the Common size Statement of profit & loss, Net sales are considered as a base for the
computation of common size percentages of each financial element present in the Statement of
profit & loss.
For the Common size Balance Sheet, Total Assets is considered as a base for the computation of
common size percentages of each financial element present in the Balance sheet.
Caution

Notes
In the case of preparing a common size balance sheet and statement of profit & loss, at time
calculating common size percentages, same year data is considered. That is why it is known as
Static or Vertical Analysis.
Below are the Common Size Balance Sheet and Common Size Statement of Profit & Loss of HUL for
2020 and 2019. Thus, in the following analysis, common size analysis is extended to Horizontal
Analysis by considering two years for deriving better inferences.
Notes
The common Size Balance Sheet is prepared by calculating common size percentages of 2020 and
2019 separately.
In the case of the Common Size Balance Sheet, for 2020 common size percentages, all individual
financial elements of the Balance Sheet of 2020 are divided by Total assets of 2020 and then
multiplied by 100.
For 2019 common size percentages, all individual financial elements of the Balance Sheet of 2019 are
divided by the total assets of 2019 and then multiplied by 100.
In the case of Common Size Statement of Profit & Loss, for 2020 common size percentages, all
individual financial elements of Statement of Profit & Loss of 2020 are divided by Revenue from
Operations [Net]/Sales of 2020 and then multiplied by 100.
For 2019 common size percentages, all individual financial elements of Statement of Profit & Loss of
2019 are divided by Revenue from Operations [Net]/Sales of 2019 and then multiplied by 100.

Notes
HUL Common Size Balance Sheets (in ₹Cr.) as on March 31, 2020 and
2019
% of Total
Assets
2020 2019 % %
SHAREHOLDER'S FUNDS
Equity Share Capital 216.00 216.00 1.10 1.21
Reserves and Surplus 7815.00 7443.00 39.87 41.66
Total Shareholders Funds 8031.00 7659.00 40.97 42.87
Other Long Term Liabilities 1269.00 804.006.47 4.50
Long Term Provisions 1198.00 1049.00
6.11 5.87
Total Non-Current Liabilities 2467.00 12.59 10.37
1853.00
CURRENT LIABILITIES 0.00 0.00
Trade Payables 7399.00 7070.00 37.75 39.57
Other Current Liabilities 1287.00 782.00 6.57 4.38
Short Term Provisions 418.00 501.00 2.13 2.80
Total Current Liabilities 9104.00 8353.00 46.44 46.76
Total Capital And Liabilities 19602.00 17865.00 100.00 100.00
ASSETS
NON-CURRENT ASSETS
PPE 4625.00 3907.00 23.59 21.87
Intangible Assets 431.00 436.00 2.20 2.44
Capital Work-In-Progress 513.00 373.00 2.62 2.09
Fixed Assets 5569.00 4716.00 28.41 26.40
Non-Current Investments 252.00 256.00 1.29 1.43
Deferred Tax Assets [Net] 261.00 339.00 1.33 1.90
Long Term Loans And Advances 453.00 396.00 2.31 2.22
Other Non-Current Assets 1159.00 784.00 5.91 4.39
Total Non-Current Assets 7694.00 6491.00 39.25 36.33
CURRENT ASSETS
Current Investments 1248.00 2693.00 6.37 15.07
Inventories 2636.00 2422.00 13.45 13.56
Trade Receivables 1046.00 1673.00 5.34 9.36
Cash and Cash Equivalents 5017.00 3688.00 25.59 20.64
Other Current Assets 1961.00 898.00 10.00 5.03
Total Current Assets 11908.00 11374.00 60.75 63.67
Total Assets 19602.00 17865.00 100.00 100.00
Source: Author

Notes
Task
Comment on the following financials of HUL based on the above given Common Size Balance
Sheets as of March 31, 2020, and March 31, 2019.
1. Shareholder’s Funds
2. Reserves
3. Long term debt
4. Current Liabilities
5. Non-Current Assets
6. Current Assets
7. Solvency Position
8. Liquidity Position
9. Leverage
HUL: Common Size Statement of Profit & Loss for the year ended March 31, 2020 and 2019
% of Net Revenue
(in ₹Cr.) from Operation
2020 2019 2020 2019
Revenue From Operations [Net]/Sales 38273.00 37660.00 1.00 1.00
Other Operating Revenues 512.00 564.00 0.01 0.01
Total Operating Revenues 38785.00 38224.00 1.01 1.01
Other Income 733.00 664.00 0.02 0.02
Total Revenue 39518.00 38888.00 1.03 1.03
EXPENSES
Cost of Materials Consumed 11572.00 13240.00 0.30 0.35
Purchase of Stock-In Trade 6342.00 4708.00 0.17 0.13
Changes In Inventories of FG,WIP and Stock-In Trade (121.00) 12.00 (0.00) 0.00
Employee Benefit Expenses 1691.00 1747.00 0.04 0.05
Finance Costs 106.00 28.00 0.00 0.00
Depreciation and Amortisation Expenses 938.00 524.00 0.02 0.01
Other Expenses 9701.00 9880.00 0.25 0.26
Total Expenses 30229.00 30139.00 0.79 0.80
Profit/Loss Before Exceptional, ExtraOrdinary Items And Tax 9289.00 8749.00 0.24 0.23
Exceptional Items (197.00) (227.00) (0.01) (0.01)
Profit/Loss Before Tax 9092.00 8522.00 0.24 0.23
Total Tax Expenses 2354.00 2486.00 0.06 0.07
Profit/Loss For The Period 6738.00 6036.00 0.18 0.16
Source: Author
Task
From the above give Common Size Statement of Profit & Loss of HUL for the year ending 2020
and 2019, Comment on the following:
1. Revenue
2. Cost of Material Consumed
3. Employee Cost
4. Finance Cost
5. Depreciation
6. Profitability Position

Notes
Notes
The following are the individual items that can be analyzed and interpreted through Financial
Statement Analysis.
 Fixed Assets
 Investments
 Current Assets
 Shareholder’s Funds
 Reserves
 Outsider’s Funds
 Current Liabilities
The following are the overall performance measures that can be analyzed and commented upon
through Financial Statement Analysis.
 Fixed Assets Utilization

 Operational Efficiency
 Inventory Management
 Creditors/Payment Management
 Debtors/Collection Management
 Financial Efficiency
 Working Capital/Liquidity Management
 Solvency Position
 Leverage to know Financial Risk
Summary
Financial statement analysis is a process used by interested parties such as investors, creditors, and
management to assess the firm's historical, present, and forecast circumstances and performance.
Under financial statement analysis, the available information is organized to extract the relevant
connection that already exists between them; for interpretation and analysis.
Horizontal analysis and vertical analysis are the two main methods of financial statement analysis.
The study of the financial accounts yields some qualitative information about the company in terms
of solvency, liquidity, profitability, financial policy, and so on.
Comparative (income) financial statement analysis is performed comparing income statements
from the firm's different accounting periods, other businesses in the industry, and the industry
average.
Financial statement analysis is very useful for comparing a company's financial status and
performance to its predecessors, rivals, and industry. As a result, it is important in both inter- and
intra-firm comparisons.
Keywords
Analysis: is a thorough categorization of the data in financial statements that simplifies financial
data.
Interpretation: It meanssimplifying the meaning and relevance of the evidence.' It refers to
obtaining conclusions from financial statement analysis and comprehending what it means.
A common size financial statement shows entries as a percentage of a common base value rather
than absolute numerical figures.

Notes
Statements of Comparison: Comparative statements are financial statements that have the same
structure but cover various time periods. Comparative statements are quite valuable for identifying
patterns.
A financial statement is a written report that quantitatively summarizes a company's financial
condition.
Analysis of Financial Statements: It is the process of assessing links between financial statement
parts and comparing them to relevant data.
Financial ratios:or financial variables are compared across time, generally years, in trend analysis.
SelfAssessment
1. Which financial elements of the Balance Sheet should be considered to analyze and
comment on Working Capital Management or Liquidity Management of a Company?
A. Current Assets, Fixed Assets
B. Current Liabilities, Current Assets
C. Current Assets, Non-Current Liabilities
D. Non-Current Assets, Non-Current Liabilities
2. Which financial elements of the Balance Sheet should be considered to analyze and
comment on the Solvency position of a company?
A. Current Assets, Current Liabilities
B. Non-Current Assets, Non-Current Liabilities
C. Current Assets, Fixed Assets
D. Non-Current Assets, Current Liabilities
3. Comparison of financial statements highlights the trend of the _________ of the business.
A. Financial position
B. Financial Performance
C. Operational Efficiency
D. All of above
4. Which technique used for figures of two or more periods are placed side by side to
facilitate easy and meaningful comparisons?
A. Comparative statement
B. Common‐size statement
C. Trend Analysis
D. None
5. The main objective of preparing a Common Size Statement of Profit and /loss is:
A. To present changes in assets and liabilities
B. To judge the financial soundness
C. To establish a relationship between revenue from operations and other items of statement
of Profit and Loss
D. All of the above

Notes
6. In the Common Size Balance sheet:

A. The figure of current liabilities is assumed to be 100
B. The figure of fixed assets is assumed to be 100
C. The figure of total assets is assumed to be 100
D. The figure of share capital is assumed to be 100
7. Tata steel’s current assets decreased from ₹4,00,000 to ₹3,00,000. What is the percentage
of change?
A. 25%
B. 33%
C. 30%
D. 40%
8. …………… refers to drawing inferences from the performed financial statement analysis
and understanding what does it indicate.
A. Summarization of Financial statements
B. Analysis of Financial statements
C. Interpretation of Financial statements
D. Preparation of Financial statements
9. Financial Statement analysis is performed to assess:

A. The earning capacity or profitability of the firm
B. The operational efficiency and managerial effectiveness of the firm
C. The short term as well as long term solvency position of the firm
D. All of above
10. The term financial statement analysis includes both --------- and interpretation
A. Comparison
B. Analysis
C. Conclusion
D. Constructions
11. If the total assets of a firm are ₹8,20,000 and its fixed assets are ₹5,90,400, what will be
the percentage of current assets on total assets?
A. 42%
B. 58%
C. 28%
D. 72%
12. Total assets of a firm are ₹40,00,000 and its fixed assets are ₹16,00,000. What will be the
percentage of fixed assets on total assets?
A. 60%
B. 40%

Notes
C. 29%
D. 71%
13. Horizontal Analysis shows the comparison of data for several years against a
chosen……………
A. Base year
B. Financial year
C. Previous year
D. Calendar year
14. Comparison of financial variables of a firm over a period of time is known as

………………
A. Comparative
B. Common-size
C. Trend analysis
15. Common size Income Statement presents the various items as a percentage of …………….
A. Sales
B. Credit sales
C. Cash sales
D. Cost of Sales

1. B 2. B 3. D 4. A 5. C
6. C 7. A 8. C 9. D 10. B
11. C 12. B 13. A 14. C 15. A
Review Questions
1. What is meant by Financial Statement Analysis? Explain the tools of Financial Statement
Analysis.
2. State the objectives of performing Financial Statement Analysis.
3. Explain the stakeholders that are interested to perform Financial Statement Analysis and give
the reasons thereof.
4. Illustrate the meaning and tools of Horizontal analysis.
5. Illustrate the meaning, methods and purpose of Vertical analysis.
6. Perform Vertical Analysis (Common size) on ITC Profit and Loss Account.

Notes
ITC Profit & Loss account …... In ₹crore …....

Mar '20 Mar '19
Revenue From Operations [Gross] 46,323.72 45,221.41
Less: Excise/Sevice Tax/Other Levies 1,187.64 788.74
Revenue From Operations [Net] 45,136.08 44,432.67
Other Operating Revenues 483.62 562.98
Total Operating Revenues 45,619.70 44,995.65
Other Income 3,013.66 2,484.54
Total Revenue 48,633.36 47,480.19
EXPENSES
Cost of Materials Consumed 13,121.76 13,184.97
Purchase of Stock-In Trade 4,289.71 4,300.32
Changes In Inventories of FG,WIP And Stock-In Trade -176.34 -180.14
Employee Benefit Expenses 2,658.21 2,728.44
Finance Costs 55.72 34.19
Depreciation and Amortisation Expenses 1,563.27 1,311.70
Other Expenses 7,822.11 7,656.55
Total Expenses 29,334.44 29,036.03
Profit/Loss Before Exceptional, ExtraOrdinary Items And Tax
19,298.92 18,444.16
Exceptional Items -132.11 0.00
Profit/Loss Before Tax 19,166.81 18,444.16
Total Tax Expenses 4,030.76 5,979.84
Profit/Loss For The Period 15,136.05 12,464.32
Make Interpretations on the following:
1. Cost of Material Consumed
2. Employee Cost
3. Finance Cost
4. Depreciation
5. Profitability Position
7. Perform Trend Analysis on given Key financial element for ITC and Comment on--
1. Receivable Management
2. Payable Management
3. Fixed Asset Utilization
4. Inventory Management

Notes
ITC Balance Sheet------------------- in ₹Cr. -------------------

Mar 20 19-Mar 18-Mar 17-Mar 16-Mar
Total Shareholders Funds 64,029.16 57,949.79 51,400.07 45,340.96 32,929.00
Total Non-Current Liabilities 2,116.79 2,226.57 2,124.64 2,044.92 2,001.57
Total Current Liabilities 9,089.41 9,621.56 8,856.60 6,830.07 14,587.86
Fixed Assets 23,297.75 21,887.76 20,591.57 18,417.26 16,705.36
Non-Current Investments 13,455.59 14,071.45 13,493.77 8,485.51 6,392.90
Inventories 8,038.07 7,587.24 7,237.15 7,863.99 8,519.82
Trade Receivables 2,092.00 3,646.22 2,357.01 2,207.50 1,686.35
Cash and Cash Equivalents 6,843.27 3,768.73 2,594.88 2,747.27 6,563.95
Short Term Loans And Advances 4.87 5.02 4.15 3.37 501.84
Total Current Assets 36,506.91 29,568.96 24,503.00 24,537.39 24,134.74
Revenue From Operations [Net] 45,136.08 44,432.67 40,254.67 39,641.91 36,475.27
Total Operating Revenues 45,619.70 44,995.65 40,627.54 40,088.68 36,837.39
Total Expenses 29,334.44 29,036.03 26,318.58 26,571.63 23,682.74
Profit/Loss Before Tax 19,166.81 18,444.16 16,851.70 15,502.96 14,958.39
Cost of Materials Consumed 13,121.76 13,184.97 11,756.21 11,765.56 11,054.75
Purchase of Stock-In Trade 4,289.71 4,300.32 2,991.98 3,566.57 2,590.08
Finance Costs 55.72 34.19 86.65 22.95 49.13
Depreciation and Amortisation Expenses 1,563.27 1,311.70 1,145.37 1,038.04 1,034.45
8. Perform Comparative Financial Statement Analysis on ITC’s Balance Sheet as of March 31, 2020,
and March 31, 2019, and Interpret the following:
1. Fixed Assets
2. Investments
3. Current Assets
4. Shareholder’s Funds
5. Reserves
6. Outsider’s Funds
7. Current Liabilities
8. Solvency Position
9. Liquidity Position
10. Leverage

Notes
ITC Balance Sheet-----in ₹Cr. ------

Mar 20 19-Mar
Equity Share Capital 1,229.22 1,226
Reserves and Surplus 60,777.76 54,725.99
Employees Stock Options 2,022.18 1,997.94
Total Shareholders Funds 64,029.16 57,949.79
Long Term Borrowings 5.63 7.89
Deferred Tax Liabilities [Net] 1,617.65 2,044.14
Other Long Term Liabilities 349.72 41.9
Long Term Provisions 143.79 132.64
Total Non-Current Liabilities 2,116.79 2,226.57
CURRENT LIABILITIES
Short Term Borrowings
Trade Payables 3,446.74 3,368.28
Other Current Liabilities 5,524.73 6,228.04
Short Term Provisions 117.94 25.24
Total Current Liabilities 9,089.41 9,621.56
Total Capital And Liabilities 75,235.36 69,797.92
ASSETS
NON-CURRENT ASSETS
Tangible Assets 19,612.74 17,945.65
Intangible Assets 519.45 540.75
Capital Work-In-Progress 2,776.31 3,391.47
Intangible Assets Under Development 3.89 9.89
Other Assets 385.36 0
Fixed Assets 23,297.75 21,887.76
Non-Current Investments 13,455.59 14,071.45
Long Term Loans And Advances 3.31 6.21
Other Non-Current Assets 1,971.80 4,263.54
Total Non-Current Assets 38,728.45 40,228.96
CURRENT ASSETS
Current Investments 17,175.02 12,506.55
Inventories 8,038.07 7,587.24
Trade Receivables 2,092.00 3,646.22
Cash and Cash Equivalents 6,843.27 3,768.73
Short Term Loans And Advances 4.87 5.02
Other Current Assets 2,353.68 2,055.20
Total Current Assets 36,506.91 29,568.96
Total Assets 75,235.36 69,797.92

Notes
Further Reading
 A Textbook of Accounting for Management by Maheshwari. S.N, Maheshwari Sharad.
K, Maheshwari Suneel. K, Vikas Publishing House
 Financial Accounting for Management: An Analytical Perspective by Gupta Ambrish,
Pearson Education India
 Accounting & Finance for Managers by Pandikumar M.P, Excel Books, New Delhi
Web Links
 https://www.yourarticlelibrary.com/accounting/financial-statements-
analysis/types-financial-statements-analysis/4-important-types-of-financial-analysis-
in-a-firm-
accounting/66776#:~:text=Comparative%20statements%20and%20trend%20percentag
es%20are%20two%20tools%20employed%20in%20horizontal%20analysis.&text=In%20
this%20types%20of%20analysis,known%20as%20'Static%20Analysis'.
 https://www.readyratios.com/reference/analysis/horizontal_analysis_of_financial_s
tatements.html
 https://www.investopedia.com/terms/h/horizontalanalysis.asp#:~:text=Horizontal
%20analysis%20is%20also%20referred,of%20the%20base%20year%20amounts.
1.

Notes
Razia Sehdev, Lovely Professional University Unit 05: Artificial Intelligence and Analysis
Unit 05: Artificial Intelligence and Analysis

CONTENTS
Objectives
Introduction
5.1 What is Artificial Intelligence (AI)?
5.2 Artificial Intelligence in Accounting
5.3 Accounting Tasks which Machines can Do
5.4 AI doesn’t Mean Job Losses?
5.5 How are Accountants using AI Capabilities?
5.6 Practical Challenges with AI
5.7 Roles and Skills
Summary
Keywords
Self Assessment
Review Questions
Further Reading
Objectives
 Explain the role of Artificial Intelligence in the world of Accounting and Finance.
 Review the impact ofArtificial Intelligence on the job descriptions and opportunities of
accountants.
 Predict the future prospects of Artificial Intelligence in the world of Accounting and Finance.
 Assess the Artificial Intelligence capabilities in the world of Accounting and Finance.
 Criticize the Artificial Intelligence in the world of Accounting and Finance through reviewing
the practical challenges it carries with itself.
Introduction
As Artificial Intelligence (AI) has been implemented for every industry, it is significantly impacting
the world of accounting and finance. Due to tremendous hike in regulations and clients’
requirements, many accounting firms are adopting to a new type of workforce to assist them in
performing their time-consuming tasks. This novel workforce and its provided support can assist
companies to carry out the most complicated and complex tasks without asking for a weekly,
monthly or yearly pay. That’s because, this novel workforce is artificial but not human.
Over the years, accountants have embraced waves of automation to improve the efficiency and
effectiveness of their profession. However, it cannot be denied that technology has yet to replace
the requirement for professional knowledge and decision-making. Thus, accountants have
welcomed AI in their profession while also acknowledging that their own talents and expertise are
critical to taking full benefit of AI in their fields. This section provides information on the
significance of artificial intelligence and its function in the accounting industry.

Notes
5.1 What is Artificial Intelligence (AI)?

Artificial Intelligence (AI) expands the potentialities and capabilities of computing to a whole new
position. It allows systems to make forecasts and make changes accordingly in the data– just as
humans would. It renders computers to perform machine-based learning, which earlier was left to
humans.
5.2 Artificial Intelligence in Accounting

Although AI methods such as machine learning are not new, and the rate of development is rapid,
their use in business and accounting is still in its early phases. To establish a good future vision,
accountants must first get a thorough grasp of how AI may address accounting and business issues,
as well as the practical obstacles and abilities necessary to operate alongside intelligent
technologies.
AI-enabled accounting and finance solutions, which save money and time while also providing
insights, are the way accounting and finance professionals and their organisations will gain a
competitive advantage and attract the next generation of workers and consumers.
In the accounting profession, where people deal with rote jobs, AI is a replacement of human
talents for the better.
The MIT-Boston Consulting Group recently conducted a poll. Nearly 85 percent of individuals feel
that AI leads to a competitive edge, and 79 percent believe that technology boosts organisational
productivity. As a result, the survey's results point to a broader spectrum of AI application in the
business and accounting worlds in the future.
Relevance of Artificial Intelligence in Accounting

Artificial intelligence is being used by many accounting firms where it analyses a large volume of
data at high speed, which would not be easy for humans.
AI in the Accounting Sector

Many Companies these days are accepting and implementing new technologies to streamline their
Accounting function. That is due to so many positive results in terms of increased productivity,
improved accuracy, and reduced cost that AI provides to business and accounting world.
AI is used increasingly for accounting and administrative tasks, resulting in several structural
changes in the way accounting function and other administrative tasks are performed.
Example:AI enables all the data handling and processing process as completely
automated. Therefore, AI brings one of key benefit to the business in the area of
compliance. As, the data generated by any tax or other business’ functional report
would have assured accuracy levels and will be generated quickly. This is due to least
computing errors that AI incurs in data handling and processing stage.
Additionally, with the assistance of AI, data can be easily and quickly recognized and
classified from different sources to the right accounting head. Several other dedicated
tasks that were done by accountants like processing of accounts receivables and
payables are simply handled by AI. This ends upin improved cost management by
corporations.
5.3 Accounting Tasks which Machines can Do

The following are some common tasks that machines can perform with high efficiency and
effectiveness.
 Audit
 Procurement
 Accounts payable/receivable
 Monthly or quarterly close procedure

Notes
 Expense Management
 AI Chatbots
Audit
It becomes an easy task to track about which file is accessed by whom,when and how many times
through Digitalization. Thus, AIenhances the security of data and files. Even it assists Auditing
function as auditors do not require tofind file cabinets for documentation as they can easily have
access to the digital files during an audit.
This, in turn, improves the accuracy and efficiency of audits and makes it possible to audit 100
percent of a firm’s financial transactions instead of just samples.
Procurement
Many companies’ tracking and procuring method is filled with lots of paperwork and companies
use various file formats which may not be compatible with each other. However, machines with
APIs (Application Programming Interface) can be integrated, and unstructured data can be
processed. This makes the procurement process paperless and easier. One can easily track the
changes in price among multiple suppliers with the help of AI.
Accounts Payable/Receivable
The existing AI systems meant to resolve accounting function of a firm already has an AI-powered
invoice management process which can make accounts payable/receivable processing more
streamlined with the help of digital workflow. They can learn the accounting code for the
respective invoice.
Monthly or Quarterly Close Procedure

The sooner you get the numbers, the longer time your company has to take for making strategies
about what can be done with those numbers. AI can give you data from numerous sources,
consolidate, and merge it. This would not only accelerate up this monthly process but would also
be bring more accuracydue to involvement of machines.
Expense Management
It can be a time-consuming process to review and approve all the incomes and expenses to make
sure that they are compliant with the company’s policies. AI makes it much easier and quicker as
machines can check receipts, review expenses, and warn people if there is any breach.
AI Chatbots
Computers or machines can effectively resolve certain common queries from users, such as when
bills are getting due, the latest account balance, and status on accounts with the help of AI chatbots.
5.4 AI doesn’t Mean Job Losses?

Artificial intelligence is definitely freeing up accountants from doing menial, rote and
administrative tasks. However, it does not let accountants free from their jobs as AI allows them to:
 Broaden their roles.

 To deliver high value and better service to clients.
 To concentrate on the company’ growth and its overall success.
Example:We can take an example of auditing of expense claims where AI can be utilized to
remember and implement a company’s expense policy.
This would mean that accountants would no longer have to look through the receipts and
categorize dates and GST numbers. Similar to cloud accounting disruption in the accounting sector,
accounting professionals will have to rethink their profiles.

Notes
Opportunities for Accountants

Accounting responsibilities are already shifting in response to new data analytics capabilities.
Accountants, in fact, are well-positioned to work successfully with data analytics because they
combine high levels of numeracy with good business acumen. AI will accelerate these tendencies.
To handle challenging and unique instances, certain positions will continue to prioritise human
judgement and technical accounting competence.
Other duties may include improving communication and collaborating with other sections of the
organisation to assist them obtain the proper meaning from data and models. There will also be
new work opportunities.
Example:Accountants will require being involved in training or testing models, or auditing

algorithms. They may necessitate getting involved in projects to help frame the problems
and integrate results into business processes.
Other accountants may be more directly involved in managing the inputs or outputs, such as
exception-handling or preparing data.
What is Left for Accountants?

Having better technologywouldn't mean anything on the off chance that one can't follow up on it.
That is the place where the job of an accountant comes. Regardless of whether machines can play
out every one of the computations or starting review related undertakings, somebody would be
required to bring meaning inferences from such calculations.
The following tasks are left for accountants post performance of regular calculative tasks by AI:
 To analyze the process and draw a meaningful conclusion.

 To move their roles into consulting and advising to ensure that they are taking full advantage
of automation while helping their business grow.
 To focus more on strategic tasks like planning the financial budget, capital optimization,
process improvement, and more.
What’s Ahead?
Small Medium Businesses (SMBs) don’t have the same resources as compared to bigger firms to
create their own AI products. However, experts believe that AI would be widely available even for
smaller firms at a standard farein the coming years.
Artificial Intelligence is already affecting the marketing sector and would also bring radical changes
in the accounting sector with a huge possibility of the reduction in costs and increased productivity.
This is in addition to the accuracy and precision which AI can bring in any menial and repetitive
manual tasks which have been automated.
In view of the remarkable progress made by AI, this new world would be well-known to
accountants long before self-driving truck drops invoices in their office.
5.5 How are Accountants using AI Capabilities?

 Accountants use their technical accounting and finance expertise to assist organisations and
stakeholders in making better choices. Accountants need high-quality financial and non-
financial information and analysis to support their decision-making and advising.
 This is mirrored in a broad range of accounting responsibilities in business and practise,
which gather, prepare, check, and convey information, conduct analysis, and make a wide
range of judgments.
 For many years, accountants have used technology to assist them deliver better advice and
make better judgments. Technology can help them achieve this by addressing three major
issues: providing better and cheaper data to support decision-making; generating new

Notes
insights from data analysis; and freeing up time to focus on more valuable tasks such as
decision-making, problem solving, advising, strategy development, relationship building, and
leadership.
 The nature of machine learning methods allows for major advancements in all aspects of
accounting, and may provide accountants with fantastic new capabilities as well as mechanise
or automate countless activities and choices.
 As a result, it is necessary to identify accounting and business challenges where AI is likely to
be highly beneficial and difficulties where these methods may be less suited. This ensures that
appropriation efforts are motivated by business needs rather than just technological
capabilities. Until now, there has been limited use in real-world accounting; however, early
exploration and implementation projects include: • using machine learning to code
accounting entries and improve on the accuracy of rules-based approaches, enabling greater
automation of processes; • improving fraud detection through more sophisticated, machine
learning models of 'normal' activities and better prediction of fraudulent activities;
5.6 Practical Challenges with AI

Data quality and volumes are extremely significantfor AI systems to get succeed. Models will
simply not be able to learn without enough good data.
Transactional accounting data should be a promising starting point for developing models due to
its high quality and well-structured nature. However, given many organizations’ long-standing
data challenges, particularly those with complicated and unintegrated legacy systems, this is still
likely to be a substantial barrier in reality. Smaller organizations may lack the necessary data to get
appropriate findings. Similarly, there may be insufficient data on highly particular situations to
enable excellent models. Powerful models may need external data sources, which may not always
be available at a reasonable cost.
Furthermore, it is difficult to predict how successful AI will be. Models learn from a certain dataset.
As a result, accumulating experience from both profitable and ineffective examples will aid in
guiding future adoption.
Another key concern will be privacy and ethics, especially if AI systems depend on sensitive or
personal data. For example, misrepresentation detection or fraud detection may rely on the content
of emails written by employees, which will have lawful and ethical cut-off points.
The economics and commercial reasons for AI will also eventually drive adoption. This will
represent two distinct ways in which organizations will use machine learning skills.
To begin, AI is increasingly being included into commercial and accounting software. As a result,
many bookkeepers and accountants may encounter AI without realizing it, similar to how we use
these skills in our internet searching and buying activities. This is how more modest and smaller
organizations, in particular, are destined to accept AI apparatuses or tools.
Second, careful selection of AI talents or capacities to address specific business or accounting
concerns will often need considerable expenditure. While there is a lot of free and open-source
programming tools available in this field, the use of set up programming services may be required
for legal or administrative reasons. Given the data amounts involved, substantial equipment and
handling force may be necessary, regardless of whether it is accessed through a cloud premise. As a
result, AI investments will most likely concentrate on the areas with the greatest financial effect,
particularly cost-cutting possibilities or those critical for competitive positioning or customer
service. Other areas, although potentially profitable, may not have a strong investment case.
Furthermore, employing AI to produce more insightful things in expert accounting fields may fall
short of accessible potential to justify investment from programming developers.

Notes
5.7 Roles and Skills

Organizations will also need access to the necessary expertise. Obviously, this starts with technical
knowledge of machine learning. However, as with data analytics, these technological abilities must
be matched with a thorough grasp of the business environment around the data and the desired
insight.
Accounting occupations are altering as a result of increased data analytics capabilities. Accountants
are unquestionably well-equipped to work effectively with data analytics, as they combine very
high levels of numeracy with good business mindfulness or awareness. AI will accelerate these
trends. A few positions will continue to emphasise specialist accounting competence and human
judgement to handle difficult and unique scenarios.
Different professions may emerge to increase cooperation and partnership with other areas of the
organisation to aid them in extracting the proper relevance from data and models. There will also
be fresh opportunities.
The abilities needed of accountants will reflect this change. Some positions, such as training
models, may need extensive expertise of machine learning methods. In other cases, accountants
may just require a basic understanding of machine learning to conduct informed interactions with
specialists and other sections of the organisation. Critical thinking and communication abilities are
going to become more crucial in the future.
In order to make the most of machine learning techniques, accountants may need to adopt new
ways of thinking and behaving in addition to abilities. Investing more effort on predictive and
proactive activities, for example, placing forecasts in context or developing capacity to shift course
fast, will need new ways of thinking.
Case StudyArtificial Intelligence projects from Deloitte
Deloitte has chosen to be on the positive side of the spectrum. "We think that artificial
intelligence will be highly beneficial to us and our customers," says Richard Roovers, Deloitte
Netherlands partner and Innovation Lead Transformational Solutions North-West Europe.
According to Richard, artificial intelligence will help us to address issues that humans are
incapable or barely capable of tackling. "Artificial intelligence is capable of digesting vast
amounts of data and discovering patterns that even the most brilliant mathematicians are unable
to identify." That alone brings up a plethora of new options."
The case studies give an overview of how Deloitte is trying to build artificial intelligence-infused
solutions, both internally and for client usage. The applications are numerous, use many
technology, and may be found in a wide variety of sectors. Apart from all of the future
projections, this demonstrates that artificial intelligence has already been a reality in the business
sector for some time and constitutes a resource that might potentially offer your firm with a
decisive lead.
How is Deloitte using AI?

Deloitte is putting all of its efforts into artificial intelligence. As a result, it has consolidated all of
its artificial intelligence projects and activities under the Artificial Intelligence Centre of
Expertise (AICE), which includes hundreds of AI professionals from throughout the
organisation. According to Innovation Lead Richard Roovers, learning is critical. "From a
technological standpoint, there may be significant overlap between the AI applications utilised
in various businesses." Consider picture recognition: you can use it to automatically recognise
installations on satellite photographs, but you can also use it in an app to detect skin cancer.
Bringing employees from many areas together allows us to exchange expertise and accelerate
learning."
Deloitte maintains contact with the AI external community via Meetups and hackathons. This
allows the organisation to stay current on technological changes. According to Roovers, it is also
a question of learning as much as possible, as soon as possible: "And we're not just talking about
AI, we're doing it." We're experimenting, trying new ideas, bringing in experts, and investing in
technology. Only then can you fully grasp how and when you may employ artificial intelligence
wisely."
To successfully innovate, it is necessary to create support throughout the organisation as a

Notes
whole, rather than merely investing in technology. As a result, Deloitte has initiated an internal
effort to raise awareness of the opportunities presented by artificial intelligence, especially
among staff with no technological expertise. "AIME" the AI-robot was created to make an
abstract topic like artificial intelligence more concrete. AIME stood at the entrance to the Deloitte
headquarters and was active on social media to give personnel a sense of the possibilities
presented by artificial intelligence.
According to Roovers, the goal was to raise attention to artificial intelligence in an approachable
manner. "And it was effective. The employees were both astonished and fascinated. They began
talking to AIME and snapped pictures with her. She proved to be a great discussion starter." To
understand more about AI, our workers might freely enrol in our "AI for Dummies" course. "The
motivation was significant - even our CEO participated in the training," Roovers adds.
In terms of the corporation, Roovers sees artificial intelligence as an opportunity rather than a
danger. "It is true that artificial intelligence can take over jobs traditionally performed by
humans – and even accomplish them far more swiftly and accurately." But the most essential
element of our company, the job that distinguishes us from the competition, is the interaction we
have with our customers and offering a tailored service, which you just cannot outsource to an
algorithm." He goes on to say that artificial intelligence can make our jobs more exciting. "Dumb,
repetitive job can be outsourced, freeing up time for the creative effort that allows us humans to
make a difference."
What types of solutions is AI able to offer your company?

AI technologies are used to enhance service via chatbots, to prevent cyberattacks, to track down
possible fraudsters, to automatically prepare benchmarking reports, to predict the risks that new
customers bring to insurance firms, to sift enormous amounts of digital data, and much more.
In summary, artificial intelligence has enormous promise. "The challenge is to figure out how we
can make it useful inside our own organisation," says Roovers. On the one hand, we can do this
via the development of better procedures, but we can also employ artificial intelligence to launch
whole new goods or services."
But where do you begin? The first need is understanding of the technology. Following that, you
may investigate the possibilities inside your own organisation and discover opportunities and
dangers. Following that, proofs of concept must be developed, and if successful, they may be
scaled up.
Deloitte can help with all of these aspects, from examining the potential to producing proofs of
concept and long-term cooperation and co-creation processes. "Artificial intelligence is not a
panacea," Roovers says. "It's a matter of carefully determining what issue you want to tackle and
what solutions are accessible." In certain circumstances, less sophisticated technology are
adequate to tackle the issue."
According to Roovers, artificial intelligence will allow us to address issues that people are
unable or unwilling to handle.
Few Key Areas where Deloitte is applying AI

Tax and Legal Matters (TAX – I)
What if this early legal process could be automated? It would allow a tax matter to be resolved
not just faster, but also more efficiently and precisely. That was the concept behind Deloitte's
TAX-I, a virtual legal research assistant. TAX-I can analyse hundreds of tax cases from the
European Court of Justice, compare them to comparable cases, summarise them, and even
anticipate how a court will decide in a case using artificial intelligence.
An AI benchmark study of Transfer Pricing

If a corporation is a member of an international group, the pricing and terms under which it sells
products and services must be comparable to those of third parties. This is meant to prevent
illicit profit shifting between nations. However, it presents a challenge for businesses, according
to MartijnKrassenburg, Manager Transfer Pricing at Deloitte. After all, whose firms' pricing are
deemed'similar'?
To answer the question, a benchmark study is required. One type of such research examines
whether firms engage in equivalent operations in a similar industry, and the stated margins are
compared to those of the company in issue. That is a time-consuming procedure in which

Notes
numerous repeated operations are performed manually. "This is why we decided to test whether
we could automate this process," Krassenburg explains.
"Robotic Process Automation is the automation of basic, repetitive processes, which in our
instance are scanning websites and saving screenshots, and it has allowed us to significantly
speed up that process," says Krassenburg.
But the team's goals go beyond that. "We're hard at work building artificial intelligence that will
automatically evaluate how comparable a firm is," he says. The system can currently do
preliminary screening, and since it is self-learning, it will grow more accurate as it is utilised.
SONAR: find labeling errors in databases

SONAR was created for a specific customer, but Smit thinks the technique is general enough to
be applied to other issues. It works well with datasets having at least 2,500 goods, and a
reference database is required. "SONAR enables you to examine human-entered data
unquestionably more quickly and accurately," says Smit. "What's more, the more you utilise the
technology and the more product information that becomes accessible, the more accurate the
findings will be."
Audit
When auditors evaluate a risk plan, they draw on expertise collected from previous audits.
Deloitte is currently creating a smart personal assistant to aid auditors by using the collective
experience of all its colleagues.
A chatbotserving as a search engine for an online technical library
Deloitte's online technical library is so large that it's easy to get lost in it. As a result, workers will
soon be able to use a smart chatbot to help them navigate the maze of rules, regulations, auditing
and accounting standards, and expert literature.
According to marketing strategist Heather Pemberton Levy, we will have more discussions with
bots than with human partners, despite the fanfare. That very well might be the case: with more
firms employing chatbots and smart speakers like Amazon Alexa and Google Home on the
increase, virtual assistants are becoming more interwoven into daily life.
Advisory on Risk
At the moment, this sort of risk assessment is still mostly done using labour-intensive models,
and delivering a new risk model might take a long time. Deloitte is collaborating with new
technology to assist insurers in making faster and more accurate assessments.
Other topics include Predicting Payment Behaviour, Eagle Eye: Using the Web for Early
Detection of Credit Migrations, and Using machine learning to combat benefit fraud, To find a
needle in a haystack, machine learning and network analytics are used. Clustering unstructured
data in BrainSpace, for example, is one example of how Deloitte is using AI to provide speedy
and accurate answers.
Source: https://www2.deloitte.com/content/dam/Deloitte/nl/Documents/innovatie/deloitte-nl-
innovatie-artificial-intelligence-16-practical-cases.pdf
Summary
As Artificial Intelligence (AI) has been implemented for every industry, it is significantly impacting
the world of accounting and finance.
Artificial Intelligence (AI) expands the potentialities and capabilities of computing to a whole new
position. It allows systems to make forecasts and make changes accordingly in the data– just as
humans would.
Artificial intelligence is being used by many accounting firms where it analyses a large volume of
data at high speed, which would not be easy for humans.
AI is used increasingly for accounting and administrative tasks, resulting in several structural
changes in the way accounting function and other administrative tasks are performed.
The following tasks are left for accountants post performance of regular calculative tasks by AI:

Notes
 To analyze the process and draw a meaningful conclusion.

 To move their roles into consulting and advising to ensure that they are taking full advantage
of automation while helping their business grow.
 To focus more on strategic tasks like planning the financial budget, capital optimization,
process improvement, and more.
Small Medium Businesses (SMBs) don’t have the same resources as compared to bigger firms to
create their own AI products. However, experts believe that AI would be widely available even for
smaller firms at a standard fare in the coming years.
Keywords
Artificial Intelligence (AI):It allows systems to make forecasts and make changes accordingly in
the data– just as humans would. It renders computers to perform machine-based learning, which
earlier was left to humans.
Machine learning:It is a research field that is capable of recognizing patterns in data and
developing systems that will learn from those.
Supervised machine learning:It teaches systems by presenting instances that have been
categorized (labeled) by humans, such as: these transactions are fraudulent; those transactions are
not fraudulent. The algorithm learns what the underlying patterns of those sorts of items are based
on the features of that categorized data and is then able to forecast which fresh transactions are
extremely likely to be fraudulent.
Unsupervised machine learning: It can detect patterns in enormous amounts of unlabeled data.
It makes its own efforts to find an underlying structure, such as grouping examples that are similar
to one another and creating relationships. Retailers, for example, might utilize buying data to
identify which goods are often purchased together and change their offer to reflect this, or even
create customized offers.
Natural language processing:It is an area of research that focuses on training artificial models to
process a human language.
SelfAssessment
1. _______________ allows systems to make predictions and make changes accordingly, just
as humans would.
A. Artificial Intelligence
B. Computerization
C. Digitalization
D. Accounting
2. Artificial Intelligence (AI) enables computers to perform _____________, which earlier was
left to humans.
A. Machine-based learning
B. Accounting learning
C. Learning
D. All of above
3. In the accounting profession, where people deal with rote tasks, AI is a replacement of
___________ for the better.

Notes
4. Artificial intelligence is being used by many accounting firms where it analyzes a

____________ of data at ____________, which would not be easy for humans.
A. Large volume, high speed
B. Small volume, high speed
C. Large volume, slow speed
D. Small volume, slow speed
5. Companies today are embracing and implementing AI to streamline their Accounting

function. That is because AI is providing positive results such as:
A. Increased productivity
B. Improved accuracy
C. Reduced cost
D. All of Above
6. The following benefit/s is/are provided by Artificial Intelligence in accounting world:

A. Manual data handling & processing
B. Improved cost management
C. Preparation of inaccurate tax reports
D. All of above
7. Select the accounting task/s that machines can do from the following:
A. Procurement
B. Audit
C. Expense management
D. All of above
8. With AI, machines can efficiently resolve common queries from users, such as when bills
are due, the latest account balance, and status on accounts through ________
A. Expense management
B. Accounts receivable management
C. Procurement
D. AI Chatbots
9. Artificial intelligence is definitely freeing up accountants from doing menial and

administrative tasks.
A. True
B. False
10. Artificial intelligence allows accountants to:

A. Narrowing their roles
B. Deliver low value and poor service to clients
C. Focus on the growth of the company and overall success
D. Focus on the growth of the company

Notes
11. Artificial Intelligence create new job opportunities for Accountants. For example,
Accountants will need to be involved in ______________.
A. training models
B. training or testing models
C. testing models
D. training or testing models, or auditing algorithms
12. With the rise of AI, accountants are expected:

A. To analyze the process and draw a meaningful conclusion
B. To study the process
C. To ask heads to draw a meaningful conclusion
D. To sit ideal
13. In the companies which have implemented AI for accounting function, accountants are
expected:
A. To move their roles into consulting and advising to ensure that they are taking full
advantage of automation while helping their business grow
B. To focus less on strategic tasks like planning the financial budget, capital optimization,
process improvement, and more
C. To focus on regular calculative tasks
D. To prepare the books of accounts
14. Many experts believe that in the coming years, AI would be widely available even for
smaller firms at a standard fare.
A. True
B. False
15. Technology can help accountants to use AI capabilities by solving _______ broad
problems.
A. One
B. Two
C. Three
D. Four
Review Questions
1. What do you mean by Artificial Intelligence? Explain its relevance and role of Artificial
Intelligence in the accounting world.
2. State the impact of Artificial Intelligence on the job profiles of Accountants.
3. Does Artificial Intelligence mean Job losses for Accountants? Explain.
4. Explain the accounting tasks that can be easily and quickly performed through Artificial
Intelligence.
5. State the practical challenges emerged in accounting world due to Artificial Intelligence.
6. How are Accountants using AI Capabilities?

Notes

1. A 2. A 3. human 4. a 5. D
capabilities
6. B 7. D 8. d 9. a 10. C
11. D 12. A 13. a 14. a 15. c
Further Reading
Web Links
 https://www2.deloitte.com/content/dam/Deloitte/nl/Documents/innovatie/deloit
te-nl-innovatie-artificial-intelligence-16-practical-cases.pdf
 https://www.accountingtoday.com/news/case-studies-ai-data-analytics-in-2020
 https://www.icaew.com/-/media/corporate/files/technical/technology/thought-
leadership/artificial-intelligence-report.ashx
 https://www.hitachi.com/rev/archive/2016/r2016_06/pdf/r2016_06_104.pdf
 http://jultika.oulu.fi/files/nbnfioulu-201905081636.pdf
 https://bernardmarr.com/default.asp?contentID=1929#:~:text=AI%20can%20often%
20provide%20real,the%20data%20show%20unfavourable%20trends.

Razia Sehdev, Lovely Professional University Notes
Unit 06: Cash Flow Statement

CONTENTS
Objectives
Introduction
6.1 Meaning and Significance
6.2 Objectives of Preparing Cash Flow Statement
6.3 Important Definitions
6.4 Classification of Cash Flow Statement
6.5 Construction of Cash Flow Statement
6.6 Analysis of Cash Flow Statement
Summary
Keywords
Self Assessment
Review Questions
Further Reading
Objectives
 Explain the meaning of the Cash flow statement and the significance of preparing the same.
 Categorize the inflow and outflow of cash under three heads of the Cash flow statement.
 Prepare the Cash flow statement of a Business entity.
 Comment on an entity's cash position post-analysis of its Cash flow statement.
Introduction
Cash is regarded as one of the firm's most important resources for meeting day-to-day financial
obligations. Daily financial commitments are satisfied only using available resources. The financial
resources of the commercial firm are obtained via two distinct receipts: sales, dividends, and
interest known as regular receipts and sale of assets, investments known as irregular receipts. To
ensure the efficient functioning of a firm, it should have enough financial resources for both routine
operations and unexpected events. The availability of financial resources is mostly determined by
the cash inflows of businesses. The smoothness of the enterprise's operations is achieved by the
proper matching of cash inflows and cash outflows.
To ensure the proper running of the business, the company should have an enough amount of
financial resources. This smoothness may be achieved by careful study and planning of the firm's
financial resources. Meaningful analysis is only achievable via cash flow statement analysis, which
allows the organisation to discover prospective cash sources and applications.
6.1 Meaning and Significance

Meaning of Cash Flow Statement
The statement of cash flows, or the cash flow statement, is a financial statement that summarizes
the amount of cash and cash equivalents entering and leaving a company. The cash flow statement

Notes
is being prepared based on extracted information of historical records of the enterprise. Cash flow
statements can be prepared for a year, for six months, quarterly, and even monthly.
Notes:The annual Cash Flow Statement is a mandatory Financial Statement and has to get
published in the annual reports of all listed Indian companies. AS 3 and Ind AS 7 provides
accounting rules and format of preparing & presenting cash flow statement for Indian
companies.
Features of Cash Flow Statement

 It is a periodical statement since it covers a certain time period, such as a month or year.
 It shows the movement of cash in between two balance sheet dates.
 It establishes the relationship between net profit and changes in the cash position of the firm.
 It does not involve matching costs against revenue.
 It shows the sources and application of funds during a particular period.
 It records the changes in fixed assets as well as current assets.
 A projected cash flow statement is referred to as a cash budget.
 It is an indicator of the cash earning capacity of the firm.
 It reflects clearly how the financial position changes over some time due to its operating
activities, investing activities, and financing activities.
6.2 Objectives of Preparing Cash Flow Statement

 To access the cash earning capacity of the firm.
 To identify the different sources of cash and various applications of cash during a
particular period.
 To give answers for various perplexing questions often encountered by management, such
as:
 why is the firm unable to pay dividend instead of making enough profit?
 Why is there a substantial idle cash balance despitethe loss suffered?
 Where have the proceeds of the sale of fixed assets gone?
 To assist the management in cash planning and control so that there is no shortage or
surplus of cash at any pointin time.
 To evaluate the ability of the firm to meet obligations such as loan repayment, dividends,
taxes, etc.
 To ensure that the investment gets regular returns in the future from a prospective
investor.
 To disclose the reasons for differences among net income, cash receipts, and cash
payments.
 To assist the management in making capital budgeting decisions more scientifically.
6.3 Important Definitions

Cash:Cash comprises cash on hand and demand deposits.
Cash Equivalents:Cash equivalents are short-term, highly liquid investments that are readily
convertible to known amounts of cash and are subject to an insignificant risk of changes in value.
Cash flows:Cash flows are inflows and outflows of cash and cash equivalents.

Notes
6.4 Classification of Cash Flow Statement
Examples:
Investing Activities
These activities consist of the acquisition and disposal of long-term assets and other investments
not included in cash equivalents.
Financing Activities
These activitiesresult in changes in the size and composition of the contributed equity and
borrowings of the entity.
Examples:

Notes
Task
Let's classify the transactions under Operating, Investing, and Financing Activities.
 Ravish Invests ₹5 million in Cash in Samiksha Software Limited (SSL).

 SSL took a loan of ₹2 million from Venugopal.
 SSL purchased using cash: computers & furniture, costing ₹5.8 million.
 SSL purchased stationary worth ₹6,00,000 on credit from M/S Hardeep.
 SSL pays ₹2,00,000 to its creditors for supplies.
6.5 Construction of Cash Flow Statement

The Cash Flow statement has three components viz. Cash flows from Operating Activities, Cash
flows from Investing Activities, and cash flows from Financing Activities.
Caution:
Cash flows from operating activities can be calculated either by Direct method or Indirect method.
In this unit, the cash flow statement where the Indirect Method's cash flows from operating
activities is discussed. The following is the format of the Cash Flow Statement where Cash flows
from operating activities have been calculated by Indirect Method:

Notes
(Source: Author)
Example:
Solution:

Notes
Example:
From the following information, calculate Cash Flow from Investing Activities:
₹ ₹
Purchase of Machine 2,50,000 Purchase of Investments 1,60,000
Purchase of Goodwill 1,00,000 Sale of Patents 40,000
Sale of Machine 35,000 Interest and Dividend 10,000

received
Sale of Investment 50,000
A building was purchased as an investment out of surplus, which was let out for commercial
purposes. Rent received ₹20,000.
Solution:
Cash Flows from Investing Activities

Particulars ₹
(Purchase of Machine) (250000)
(Purchase of Goodwill) (100000)
Sale of Machine 35000
Sale of Investment 50000
(Purchase of Investments) (160000)
Sale of Patents 40000
Interest and Dividend Received 10000
Rent Received 20000
Net cash used in Investing Activities (355000)
Example:
From the following information, calculation Cash Flow from Financing Activities:
Particulars March 31, 2020 March 31, 2019

(₹) (₹)
Equity Share Capital 10,00000 9,00,000

Notes
Securities Premium Reserves 2,60,000 2,50,000
12% Debentures 1,00,000 1,50,000
Additional Information: Interest paid on debentures ₹18,000.

Solution:
Cash Flows from Financing Activities

Particulars ₹
Issue of Equity share Capital 110000
(Redemption of 12% Debentures) (50000)
(Interest Paid) (18000)
Net cash generated from
Financing Activities 42000
Task
From the following Balance Sheet of Young India Ltd., prepare a Cash Flow Statement
6.6 Analysis of Cash Flow Statement

A cash flow statement can bring any one of the following eight scenarios. The interpretation of the
eight scenarios is given in the following table.
Cash flow from activities (Cases)
Operating Investing Financing Interpretation
The company usescash generated from

operations and sale of assets and financing to
build up a pile of cash. Thus, it is a very liquid
company and possibly looking for an acquisition.
The company uses cash generated from

operations to buy fixed assets and pay down

Notes
debt or pay owners.
The company usescash generated from

operations and from the sale of fixed assets to
pay down debt or pay owners.
The company usesthe cash generated from

operations and borrowings (or from owner
investment) to expand, i.e., to invest in long-term
assets.
The company's operating cash flow problems are

covered by selling fixed assets and borrowing or
shareholder contributions.
The company is growing rapidly but has

shortfalls in cash flows from operations and from
the purchase of fixed assets financed by long-
term debt or new investment.
The company is financing operating cash flow

shortages and payments to creditors and
stockholders via the sale of fixed assets.
The company uses cash reserves to finance

operation shortfall, finance its fixed assets and
pay long-term creditors and investors.
Case Study
Evaluation of the Cash position of Hindustan Unilever Limited (HUL) in 2020 versus 2019
through Cash Flow Statement Analysis
With over 85 years of heritage in India, HUL is India's largest fast-moving consumer goods
company. On any given day, nine out of ten Indian households use our products, giving us a
unique opportunity to build a brighter future. We are known for our great brands, the positive
social impact we create, and our belief in doing business the right way.HUL works to create a
better future every day and helps people feel good, look good and get more out of life with
brands and services that are good for them and good for others.
Let's learn Cash Flow Statement analysis through Hindustan Unilever Limited (HUL) Cash Flow
Statement and assess the Cash position of HUL in 2020 versus 2019.
The HUL' Cash Flow Statement as of March 31, 2020, and March 31, 2019, has been provided
below:

Notes
Source: https://www.hul.co.in/Images/annual-report-2019-20_tcm1255-552022_1_en.pdf
Interpretation:
HUL has generated cash flows from its operation worth ₹7305 crores in 2020 and ₹5728 crores
in 2019. It implies HUL has earned high cash flows from its operations in 2020 relative to 2019.
HUL has generated cash flows from investing activities worth ₹1926 crore. The primary reasons
behind the same are less purchase and sale of current investments in 2020 than 2019 and
redemption of term deposits.
HUL has used cash in financing activities worth ₹ 6676 crores in 2020, comparatively higher
than 2019, in which HUL has used cash in financing activities worth ₹5462. The reasons behind
such use of cash in financing activities are payment of dividend, Dividend distribution tax, and
lease liabilities.
Hence, HUL is inferred to be using cash earned from operations and from the sale of long-term
investments or assets to pay down its lease payment, dividend, and dividend distribution tax in

Notes
2020. However, HUL uses cash generated from operations to buy Current assets under investing
activities and pay down long-term debt, dividend, and dividend distribution taxin 2019.
Summary
 The cash flow statement shows the sources of cash inflows and the transactions of cash
outflows for a certain time. • It is a critical tool for financial analysis and is required for all
publicly traded organizations.
 The cash flow statement shows inflows and outflows in three categories: (1) operating, (2)
financing, and (3) investment.
 Cash inflows include cash received from customers and creditors, interest received, dividend
received, revenues from the sale of assets or investments, and cash generated.
 Cash outflows include the acquisition of assets or investments as well as the redemption of
financial resources.
 There are two ways to transform net profit into net cash flows from operations:
a. The direct method, and
b. Indirect method.
Keywords
SelfAssessment
1. …………… and ………… provides accounting rules and format of preparing & presenting
cash flow statements.
A. AS 33 and Ind AS 7
B. AS 3 and Ind AS 7
C. AS 13 and Ind AS 7
D. AS 23 and Ind AS 17
2. ………………. are short-term, highly liquid investments that are readily convertible to
known amounts of cash and are subject to an insignificant risk of changes in value.
A. Cash Equivalents
B. Cash
C. Cash and Cash Equivalents
D. Cash flows
3. "Proceeds from selling of goods and rendering services to customers" will be treated as
following while preparing a cash flow statement.

Notes
4. "Purchase of property" will be treated as following while preparing a cash flow statement.
A. Cash inflow from operating activities
B. Cash outflow from financing activities
C. Cash outflow from investing activities
D. Cash outflow from operating activities
5. "Redemption of preference shares" will be treated as following while preparing a cash

flow statement.
6. "Payment of dividends" will be treated as following while preparing a cash flow

statement.
B. Cash outflow from financing activities
C. Cash outflow from investing activities
D. Cash outflow from operating activities
7. "Receipt from Interest" will be treated as following while preparing a cash flow statement.
B. Cash inflow from financing activities
C. Cash inflow from investing activities
D. Cash outflow from financing activities
8. The closing stock of Hyundai Ltd was ₹1,50,000 as of March 31, 2020, and it decreased to
₹ 70,000 as of March 31, 2021. In the cash flow statement of Hyundai Ltd for the year
ending 2021, such decrease in closing stock will be shown as:
A. Cash inflow from operating activities by ₹80,000
B. Cash outflow from operating activities by ₹80,000
C. Cash inflow from investing activities by ₹80,000
D. Cash inflow from financing activities by ₹80,000
9. The debtors of Mahindra Ltd were ₹50,000 as of March 31, 2020, and they increased to ₹
70,000 as of March 31, 2021. In the cash flow statement of Mahindra Ltd for the year
ending 2021, such increase in debtors will be shown as:

Notes
A. Cash inflow from operating activities by ₹20,000

B. Cash outflow from operating activities by ₹20,000
C. Cash inflow from operating activities by ₹70,000
D. Cash outflow from operating activities by ₹70,000
10. Raymond mills Ltd. sold its one of old machinery at ₹ 6,70,000 as of December 15, 2020.
How will such a sale be shown in the cash flow statement of Raymond mills Ltd. for the
year ending March 31, 2021?
B. Cash inflow from investing activities
C. Cash inflow from financing activities
D. Will not be shown
11. If Tata motors' cash flow statement for the year ending March 31, 2021, is depicting cash
inflows from its operating, investing, and financing activities. What can be inferred from
such facts:
A. Tata motors is a very liquid company, and it is possibly looking for an acquisition.
B. Tata motors uses the cash flow generated from operations to buy fixed assets and pay
down debt or pay owners.
C. Tata motors uses cash earned from operations and the sale of fixed assets to pay down
debt or pay owners.
D. Tata motors is using cash from operations and from borrowings (or from owner
investment) to expand.
12. If Amazon's cash flow statement for the year ending March 31, 2021, is depicting cash
inflows from its operating and financing activities, cash outflows from its investing
activities. What can be inferred from such facts:
A. Amazon is a very liquid company, and it is possibly looking for an acquisition.
B. Amazon uses cash flow generated from operations to buy fixed assets and pay down debt
or pay owners.
C. Amazon uses cash from operations and from the sale of fixed assets to pay down debt or
pay owners.
D. Amazon uses cash from operations and from borrowings (or from owner investment) to
expand its business.
13. If Google's cash flow statement for the year ending March 31, 2021, is depicting cash
inflows from its operating and investing activities, cash outflows from its financing
activities. What can be inferred from such facts:
A. Google is a very liquid company, and it is possibly looking for an acquisition.
B. Google uses cash flow generated from operations to buy fixed assets and pay down debt
or pay owners.
C. Google uses cash from operations and from the sale of fixed assets to pay down debt or
pay owners.

Notes
D. Google uses cash from operations and from borrowings (or from owner investment) to
14. If McDonald's cash flow statement for the year ending March 31, 2021, shows cash inflows
from its investing and financing activities; cash outflows from its operating activities.
What can be inferred from such facts:
A. McDonald's uses cash flow generated from operations to buy fixed assets and pay down
debt or pay owners.
B. McDonald's uses cash from operations and from the sale of fixed assets to pay down debt
or pay owners.
C. McDonald's uses cash from operations and borrowings (or from owner investment) to
D. McDonald's operating cash flow problems are covered by selling fixed assets and
borrowing or by shareholder contributions.
15. If SAIL's cash flow statement for the year ending March 31, 2021, shows cash outflows
from its operating and investing activities; cash inflows from its financing activities. What
can be inferred from such facts:
A. SAIL uses cash from operations and from the sale of fixed assets to pay down debt or pay
owners.
B. SAIL uses cash from operations and from borrowings (or from owner investment) to
C. SAIL is growing rapidly but has shortfalls in cash flows from operations and from the
purchase of fixed assets financed by long-term debt.
D. SAIL's operating cash flow problems are covered by selling fixed assets and borrowing or
by shareholder contributions.

1. B 2. A 3. A 4. c 5. B
6. A 7. c 8. A 9. b 10. B
11. A 12. d 13. C 14. d 15. C
Review Questions
1. Explain the purpose of preparing a cash flow statement.
2. Describe the components of a cash flow statement.
3. The comparative Balance Sheets of M/s Ram Brothers for the two years were as follows:
Liabilities March 31 Assets March 31
2018 2019 2018 2019

Notes
Loan from SBI 50,000 Cash 40,000 50,000
Bills Payable 1,00,000 80,000 Debtors 1,40,000 1,60,000
Creditors 1,80,000 2,00,000 Stock 1,00,000 90,000
Loan from Bank 3,20,000 2,00,000 Machinery 4,00,000 2,80,000
Capital 3,00,000 3,50,000 Land & Building 2,20,000 3,00,000
9,00,000 8,80,000 9,00,000 8,80,000
Additional Information:
(a) Net profit for the year 2019 amounted to ₹1,20,000.
(b) During the year, a machine costing ₹50,000 (accumulated depreciation ₹20,000) was
sold for ₹26,000. The provision for depreciation against machinery as of March 31, 2018,
was ₹1,00,000, and on March 31, 2019, ₹1,70,000.
You are required to prepare a cash flow statement.
4. Digital World Ltd. supplies you the following balance on March 31, 2015, and 2016.
Liabilities March 31 Assets March 31
2015 2016 2015 2016
Reserves 20,080 21,120 Goodwill 20,000 10,000
Provisions for 1,400 1,600 Land 40,000 60,000

debts
Bills Payable 20,720 23,680 Stock 98,400 85,400
Debentures 24,000 12,000 Debtors 29,800 35,400
Share Capital 1,40,000 1,48,000 Cash at Bank 18,000 15,600
2,06,200 2,06,400 2,06,200 2,06,400
(a) Dividends amounting to ₹7,000 were paid during the year 2016.
(b) Land was purchased for ₹20,000.
(c) ₹10,000 were written off on goodwill during the year.
(d) Bonds of ₹12,000 were paid during the year.
You are required to prepare a cash flow statement
5. Discuss the procedure of determining cash provided by operating activities. Give a

suitable example to illustrate your answer.
6. Calculate cash flow from Investing Activities of Rudra Enterprise for the year 2018 from
the following information:
Particulars 2017 (₹) 2018 (₹)
Land and Building 200000 250000

Notes
Furniture 100000 95000
Investments 400000 320000
Loan given to Textile Ltd. 200000 100000
 Depreciation worth ₹5000 is provided on furniture

 Interest received from Textile Ltd. ₹3000
 Dividend paid ₹5000
Further Reading
 A Textbook of Accounting for Management by Maheshwari. S.N, Maheshwari Sharad.
K, Maheshwari Suneel. K, Vikas Publishing House
 Financial Accounting for Management: An Analytical Perspective by Gupta Ambrish,
Pearson Education India
 Accounting & Finance for Managers by Pandikumar M.P, Excel Books, New Delhi
Web Links
 https://www.edupristine.com/blog/understand-interpret-cash-flow-
statement#:~:text=A%20cash%20flow%20statement%20finds,in%20a%20cash%20flow
%20statement.
 https://infimoney.com/cash-flow-statement-analysis/
 https://www.wallstreetmojo.com/cash-flow-analysis/
 https://ncert.nic.in/textbook/pdf/leac206.pdf

Notes
Razia Sehdev, Lovely Professional University Unit 07: Basic aspects of Cost Accounting
Unit 07: Basic aspects of Cost Accounting

CONTENTS
Objectives
Introduction
7.1 Important Cost concepts
7.2 Meaning and Definition of Cost Accounting
7.3 Purpose of Cost Accounting
7.4 Users of Cost Accounting
7.5 Objectives and Functions of Cost Accounting
7.6 Difference between Cost Control and Cost Reduction
7.7 Basis of Cost Classification
7.8 Preparation of Cost Sheet
7.9 Preparation of Estimated Cost Sheet
Summary
Keywords
Self Assessment
Review Questions
Further Reading
Objectives
 Illustrate the meaning of cost, expense, and loss.

 Explain the meaning and importance of Cost Accounting.
 Identify and explain the various types of costs that a company can incur for producing a
product or rendering the service.
 Measure the prime cost, work cost, production cost, cost of goods sold, and cost of sales that a
company is incurring to produce a product or render a service.
 Assess the profit/loss per unit a company earns/incurs by selling a product or rendering a
service.
 Comment on cost elements of a company's cost sheet.
 Compose an estimated cost sheet from provided information to determine the estimated cost,
profit/loss, or selling price per product/service.
Introduction
Cost accounting is the categorization, recording, and proper distribution of the different costs
involved in the production of goods or the provision of services, as well as the right display of data
for control and management reasons. The cost of a work, contract, batch, process, and so on is often
included in cost accounting. It often depicts the cost components of the company, such as
manufacturing cost, administration cost, selling cost, and distribution cost. The cost accounting
method indicates the amount of expenses associated with the product or service. It sets the methods
and means for cost management through budgets and standard costs in order to sustain a firm's

Notes
profitability. Thus, the most important approaches used by cost accountants for cost ascertainment,
management, and reduction include budgetary control, standard costing, cost-volume-profit
analysis, process costing, and job costing. The cost accounting system is not separate from the
financial accounting system. It is just an extension of the core financial accounting system.
The current unit discusses major cost-related topics such as the meaning, aims, and functions of
cost accounting, cost kinds, cost sheet preparation, and projected cost sheet.
7.1 Important Cost concepts

Let's discuss some following essential concepts before discussing the meaning of Cost accounting.
Concept of "Cost"
Cost is defined as the amount of expenditure (actual or notional) incurred or attributable to
specified things or activities.
"Cost is the cash, and cash equivalent value sacrificed for goods and services that are expected to
bring a current or future benefit to the organization." --- (Hansen and Mowen)
"A cost is the value of economic resources used as a result of producing or doing the things costed."
---- (W M Harper)
Expense
It is a depreciation expense coming from the productive use of an asset. Expenses are expenditures
that have been levied against revenue for a certain accounting period in accordance with the cost-
torevenue concept.
Examples:Cost of goodssold, office salaries of the period in which they are incurred.
Loss
It represents diminution in ownership equity other than from withdrawal of capital for which no
compensating value has been received, e.g., destruction of property by fire.
Cost Centre
It is a place, person, or piece of equipment (or a set of these) for which costs may be calculated and
utilized for control." —- (CIMA)
As a result, a cost centre is a component of the firm to which expenses may be attributed.
 Cost centers are primarily of two types: Personal cost centre and Impersonal cost centre.
 Cost centers can be a Location such as a department, sales area, welding dept, finishing shop.
 Cost centers can be an item of equipment (a machine, a delivery van), and
 Cost centers can be a person (salesman, machine operator)
 Impersonal cost centre—can be production cost centre, service cost centre
Cost Unit
It is a product, service, or time-related item for which a cost may be calculated or represented.
—- (CIMA)
Cost units are the "things" that a firm is set up to deliver, the cost of which is determined.
Examples: For a sugar mill, cost per tonne of sugar is ascertained,
For textile---cost per metre,

For nursing home—bed per day,

Notes
For electricity---kilowatt-hour
For transport----passenger-km, and so on
Cost Object
It may be defined as "anything for which a separate measurement of the cost may be desired."
Examples:Product — Car, Television, Fan.
Service — Taxi Service, Electricity

Process — Weaving process in Textile mill, welding process in a steel mill
Activity — Procurement of Raw materials, Development of website
Department — Personnel department, Production department
7.2 Meaning and Definition of Cost Accounting
7.3 Purpose of Cost Accounting
7.4 Users of Cost Accounting

Cost accounting information is mainly for internal use, i.e., for management.
It is not to be provided to external parties such as shareholders, creditors, potential investors, etc.
Neither do outsiders claim this information, except government agencies, to whom cost
information may have to be submitted.
7.5 Objectives and Functions of Cost Accounting

The following are the primary objectives of Cost accounting.
 Ascertainment of Cost
 Cost Control
 Cost Reduction
 Determining the selling price
 Ascertainment of Profit

Notes
 Guide to Business policy

 Measuring and improving performance
7.6 Difference between Cost Control and Cost Reduction
Source: Author
7.7 Basis of Cost Classification

Cost can be classified into various types based on the following:
1. Element
2. Degree of Traceability
3. Cost Behavior
4. Function
5. Control
6. Decision making
7. Degree of Association with the product
1.On the basis of 'Element' of Cost

The following figure is depicting the classification of cost based on its elements.
Source: Author
Direct Material

Notes
Direct materials are materials that can be easily recognized with and assigned to cost units and are
physically integrated in the completed product.
Sometimes material is used in the completed product but is not considered as direct material, such
as nails in furniture. Because the worth of such elements is so minimal that measuring them is
pointless.
Examples: Timber in a furniture company, Cotton in the textile industry, Leather in a

shoemaking company, and Rubber in a tire factory.
Indirect Materials
The materials used in the production process but are not directly traceable to a product or job are
indirect materials.
Examples: Gloves, Tools, Masks, Sanitizers, Helmets, Cleaning supplies, Office chairs, and
Desks, etc.
Direct labor
Direct Labor refers to the labor engaged in the product's manufacture. It is labor that may be
directly associated with a unit of final product. All labor expenditures incurred in modifying the
product's structure, composition, confirmation, or condition are covered. It comprises the payment
of direct salaries to the following direct labor groups:
(a) Direct labor involved in the actual manufacturing of the product.
(b) Direct labor involved in adding value in the manufacture of a product via supervision,
maintenance, and tool setup, among other things.
(c) Specialized inspectors, analyzers, and other personnel are necessary for such manufacturing.
Examples:
Assembly line workers, Machine operators, Factory Workers, Engineers, Quality Control, Raw
material delivery workers, etc.
Indirect Labor
Workers who are not directly involved in converting raw materials into finished goods are termed
Indirect Labor.
Examples: Accountants, Sales personnel, Maintenance personnel, Administrative employees

& assistants, Marketing personnel, etc.
Direct expenses
All the expenses incurred by the company in the manufacturing of the product are termed Direct
expenses.
 Custom duty paid for importing the raw material from the US to the factory site in India.
 Carriage inwards paid for transporting the raw material from different states to the factory
site.
 Fuel, heating, lighting expenses, and factory electricity expenses are incurred in
manufacturing a product.
Indirect expenses
Indirect expenses are incurred to operate a business as a whole and cannot be directly related to a
specific product or service.
Examples: Rent, Rates, Taxes, Insurance, Maintenance, Depreciation, etc.

Notes
2.Onthe basis of 'Degree of traceability' to product

Cost is classified as Direct cost and Indirect cost based on the degree of traceability.
Direct cost
Direct cost is related to the particular cost object and can be traced to it in an economically feasible
way. Direct cost involves Direct materials cost, direct labor costs, and direct expenses.
Examples: Wood is a primary raw material for wooden furniture, and Cotton is a primary
raw material for yarn production.
Indirect cost
Indirect cost is related to the number of cost objects but cannot be traced to it in an economically
feasible way. Indirect cost involves indirect materials cost, indirect labor costs, and indirect
expenses.
Examples:
 The thread used for tailoring the shirt is an indirect cost as it cannot be measured or
quantified in specific length and ascertained the cost.
 Cost of supervisor, cost of the inspectors, and so on.
 Rent of the factory, salesmen salary and so on.
3. On basis of cost 'behavior'

The following figure is depicting the segregation of cost based on its behavior.
Source: Author
Fixed Costs
 Fixed costs do not change in relation to the number of units produced.

 Total Fixed cost remains 'constant' in proportion to changes in the number of units produced.
 The per-unit fixed cost changes and become smaller as the number of units produced
increases.
Examples:Rent, advertising, insurance, depreciation, salaries, etc.
Variable Costs
 It changes in direct proportion to the level of production.

 Total variable cost increase when more units are produced and
 Total variable cost decreases when fewer units are produced.
Examples:Direct material, direct labor, direct expenses, etc.

Notes
Semi–variable Costs
Semi-variable costs which remain constant up to a certain level of output and after which they
become variable. It is a mixture of both fixed costs and variable costs.
Examples:Salesmen's Salary, Electricity charges, telephone charges.
Graphical Presentation
The following is the graphical presentation of Fixed cost, Variable cost, and Semi-variable cost.
Source: https://images.app.goo.gl/4U69of1eX2ZKv5Nu9
4. On the basis of 'Function'

Based on function, a cost is further classified as follows:
a) Production cost
It refers to the costs concerned with production activity. From the supply of material to the primary
packing of the product, production covers all.
It includes direct material, direct expenses, direct labor, and manufacturing expenses.
b) Administration cost
It is also called the office cost;it incurs while administrative functions of the organization are
carried.
Examples:Salaries to employees, Office rent, Stationery charges, etc.
c) Selling and Distribution cost

Selling and Distribution cost refers to the cost of maintenance and creation of demand for the
product and making them available in the customers' hands.
5. On the basis of 'Control'

Cost is classified as controllable costs and uncontrollable costs based on control.
a) Controllable costs
These are the costs that can be controlled, as in changed or altered by the action of an individual or
a specific manager.
Notes: Deciding on how supplies are ordered or the payroll for a manufacturing company
would be controllable but not necessarily avoidable
b) Uncontrollable costs
Anyone's actions do not influence these costs. These are unchangeable.
Examples:Rent, Insurance, etc.

Notes
6. On the basis of 'Managerial Decisions'

The cost is classified as the following costs based on managerial decisions.
a) Opportunity Costs
Opportunity cost is the potential benefit that is given up when one alternative is selected over
another.
Example:When you decide to pursue a college degree, your opportunity cost would include
a 4-year's potential earnings foregone.
Nike Inc. has limited production capacity. What would be Nike's opportunity cost of
accepting a special order from the military for combat boots?
If Nike accepts the special order, they may not be able to produce enough products for
other sales. So, Nike would lose the profit from the other sale.
b) Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. They should
be ignored when making decisions.
Example: You bought an automobile that cost ₹10,000 two years ago. The ₹10,000 cost is
sunk because whether you drive it, park it, trade it, or sell it, you cannot change the ₹
10,000 cost.
c) Marginal Costs
The increase or decrease in the total cost of a production run for making one additional unit of an
item.
d) Imputed Costs
It is also known as 'implicit costs' or 'hidden costs. When an asset is used for a 'particular use' rather
than for alternative use, it is incurred.
Caution: Imputed costs are not reported in financial statements as they do not involve cash
outlay.
Example:If the company uses its own building for production purposes, it will lose income
from renting it to a third party.
e) Differential cost
Differential costs are the increase or decrease in total costs resulting from producing additional or
fewer units or adopting an alternative course of action.
f) Incremental cost
The incremental cost is the extra cost associated with manufacturing one additional unit of
production. It can be helpful when formulating the price to charge a customer as part of a one-time
deal to sell additional units. For example, it can be of interest to determine the incremental change
in cost when:
 A person's employment is terminated

 A production line is shut down
 A distribution center is closed
 A subsidiary is sold off
g) Out of Pocket Cost (Explicit cost)

Out of Pocket cost is the cost that involves cash outlay, that is, payment of cash.
Out-of-pocket costs refer to expenses incurred by employees that require a cash payment. The
employer typically reimburses employees for these costs through an expense reporting and check
payment system.

Notes
h) Replacement cost
Replacement cost is the amount of money required to replace an existing asset with an equally
valued or similar asset at the current market price. In other words, it is the cost of purchasing a
substitute asset for the current asset being used by a company.
7. On the basis of "Degree of Association with the product"

Cost is classified as product cost and period cost based on the degree of association with the
product.
a) Product Cost
The cost which is directly related to the buying and selling of the merchandise is known as Product
Cost. These costs are associated with the procurement and conversion of raw material to finished
goods ready for sale.
Simply put, the cost which is a part of the cost of production is product cost. These costs can be
apportioned to products.
Example:Material cost, Labor Cost, etc.
b) Period Cost
The cost which cannot be allocated to the product but belongs to a particular period is known as
Period Cost. These costs are charged against the sales revenue for the accounting period in which
they take place.
Example:Interest, salary, rent, advertisement, commission to the salesman, depreciation of

office assets, audit fees, etc.
7.8 Preparation of Cost Sheet

A cost sheet is a document that assembles an estimated detailed cost in terms of cost centres and
cost units. It evaluates and categorizes the spending on various things for a certain time in a tabular
format. Additional columns may be added to display the cost of a particular unit for each item of
expenditure as well as the overall per-unit cost.
Depending on the approach used and the goal to be attained, the cost sheet may be generated using
real data (historical cost sheet) or projected data (estimated cost sheet).
The statement of cost is essential in calculating the cost of manufacturing, cost of goods sold, cost of
sales, and selling price of a product at each step in order to determine the unit cost of the product,
profit margin per product, or selling price of a product.
Format of Cost Sheet

The following is the format of a cost sheet.
Particulars Total Cost Cost Per Unit

₹ ₹
Opening Stock of Direct Raw Materials XXX
Add: Purchases XXX
Add: Carriage Inward and other expenses on Purchases XXX
Add: Octroi and Custom Duty XXX
Less: Closing Stock of Direct Raw Materials (XXX)
Cost of Direct/Raw Material Consumed XXX
Add: Direct or Productive Wages XXX
Add: Direct or Chargeable Expenses XXX
Prime Cost XXX XXX

Notes
Add: Works or Factory Overheads

Indirect Materials XXX
Indirect Wages XXX
Leave Wages XXX
Overtime Premium XXX
Fuel and Power XXX
Coal XXX
Factory Rent and Taxes XXX
Insurance XXX
Factory Lighting XXX
Supervision XXX
Works Stationery XXX
Canteen and Welfare Expenses XXX
Repairs XXX
Works Salaries XXX
Depreciation of Plant & Machinery XXX
Works Expenses XXX
Gas and Water XXX
Drawing Office Salaries XXX
Technical Director's Fees XXX
Laboratory Expenses XXX
Works Telephone Expenses XXX
Internal Transport Expenses XXX
Less: Sale of Scrap (XXX)
Add: Opening Stock of Work-in-progress XXX
Less: Closing Stock of Work-in-progress (XXX)
Works Cost XXX XXX

Notes
Items excluded from Cost at times of preparing cost sheet

The following items are financial by nature and thus not included while preparing a cost sheet as
these following items form part of financial statements.
Example:The Bangalore Ltd. supplies you with the following information and requires you
to prepare a cost sheet
Solution:

Notes
Task:
Mr. Zia furnishes the following data related to the manufacture of a standard product during
August 2020
You are required to prepare a cost sheet from the above, showing the cost per unit, cost per unit

Notes
sold, and profit for the period.
7.9 Preparation of Estimated Cost Sheet

Example: Following are the particulars for the production of 800 waterproofs of K
Waterproofs Manufactures Ltd. for the year ending 31st March 2020:
Cost of Material ₹32,000

Direct wages ₹48,000
Manufacturing charges ₹20,000
Office Salaries ₹24,000
Rent and Taxes ₹4,000
Selling expenses ₹8,000,
General expenses ₹12,000
Sales ₹1,60,000.
Solution:

Notes
Task:
From the following particulars, prepare the cost and profit statement of Popular Stoves
Manufacturing Co. for the year 2018:
₹ ₹
Stock of material as on 1-1-2018 35,000 Establishment expenses 10,000
Stock of material as on 31-12-2018 4,900 Completed stock as on 1-1-2018 nil
Purchases of material 2,500 Completed stock as on 31-12-2018 35,000
Direct wages 95,000 Sales 1,89,000
Factory expenses 17,500
The number of stoves manufactured during the year 2018 was 4,000. The company wants to
quote for a contract for the supply of 1,000 electric stoves during the year 2019. The stoves to be
quoted are of uniform quality and make and similar to those manufactured in the previous year,
but the cost of material has been increased by 15% and the cost of factory labor by 10%.
Prepare the statement showing the price to be quoted to give the same percentage of net profit
on turnover as was realized during the previous year 2018, assuming the cost per unit of
overheads will remain the same as in the last year.
Summary
 Cost is defined as the amount of expenditure (actual or notional) incurred or attributable to
specified things or activities.
 In brief, the cost is nothing but the total of all expenses incurred for manufacturing a product
or attributable to a given cost object.
 Costs can be classified into different types based on various parameters such as function,
period, traceability, managerial decision, etc.
 Costs that cannot be controlled are known as uncontrollable costs.
 Costs that can be controlled are known as controllable costs.
 It isn't easy to control all fixed costs incurred by a company to make a product or render a
service.
 Direct cost is related to the particular cost object and can be traced to it in an economically
feasible way. Direct cost involves Direct materials cost, direct labour costs, and direct
expenses.
 Indirect cost is related to the number of cost objects but cannot be traced to it in an
economically feasible way.
 Materials that can be conveniently identified with and allocated to cost units and
physicallyincorporated in the finished product are called direct materials.
 Direct labor is the cost of labor that is directly engaged in the production of a product or
service.
 Indirect expenditures are those that are not direct costs in the creation of a product.
 Indirect expenditures are those that are not directly related to the production of a product
or service.
Keywords
Cost Centre: The location at where the cost of the activity is ascertained.

Notes
Cost of Production: It is the combination of the cost of manufacturing an article or a product and
administrative cost.
SelfAssessment
1. ……………… is the cash and cash equivalent value sacrificed for goods and services
expected to bring a current or future benefit to the organization.
2. "Destruction of property by fire" is an example of:
A. Cost
B. Expense
C. Loss
D. Revenue
3. Which of the following is shown as an asset in the Balance Sheet?

A. Expired cost
B. Unexpired cost
C. Expense
D. Loss
4. Cost accounting information is mainly available to and used by:

A. Internal management
B. Creditors
C. Potential investors
D. External parties
5. A technique used to economize the unit cost without lowering the quality of the product is
known as …………….
A. Cost accounting
B. Cost control
C. Cost reduction
D. All of above

Notes
6. Star Loafs manufactures two types of bread sold as wholesale products to various
specialty retail bakeries. Each loaf of bread requires a three-step process, viz. Mixing,
Baking, and Finishing. For Star Loafs, "Flour" will be:
A. Direct variable cost
B. Direct fixed cost
C. Indirect variable cost
D. Indirect fixed cost
7. Pizza Hut offers ten types of Pizza. It uses five different kinds of ovens for baking Pizzas
to meet the high demand for Pizzas at its place. For Pizza Hut, "Depreciation on Ovens"
will be:
A. Controllable Cost
B. Uncontrollable Cost
C. Opportunity Cost
D. Marginal Cost
8. At the Hugs ice cream parlor, you have to choose between "Sandy Road" and "Rocky
Thrones," the two specialized flavors of Hugs due to less money in hand. When you
select"Sandy Road," the enjoyment that you can get by eating "Rocky Thrones" ice cream
will be:
A. Imputed cost
B. Out of Pocket cost
C. Opportunity cost
D. Sunk Cost
9. The cost which remains constant in totality for various level of output but changes unit
wise indirectly with changes in the level of output is known as:
A. Fixed Cost
B. Variable Cost
C. Semi-Variable Cost
D. Direct Cost
10. Pizza Hut, Jalandhar offers an exciting menu consisting of its signature pizzas, appetizers,
pastas, desserts, and beverages. It is using 20 delivery bikes for quick and safe delivery of
orders at customers' locations. For Pizza Hut, "Depreciation on delivery bikes" will be:
A. Variable cost
B. Fixed cost
C. Direct cost
D. Marginal cost
11. Rudra, manager at Kala Kriti, a designer boutique, has got an order to stitch a designer
Lehenga of silk fabric. When the Lehenga was ready, Rudra started analyzing the various
cost components to stitch that Lehenga. He got to know that to stitch the Lehenga, 8
meters of silk cloth is used versus 6 meters set as a standard for such Lehenga. He asked

Notes
the Mohit tailor for such deviation in the material used. Mohit informed Rudra that due to
the wrong cutting of cloth, 2 meters of fabric got wasted.
In the above situation, which of the following function of cost accounting is Rudra
performing?
A. Cost control
B. Cost reduction
C. Cost determination
D. Cost analysis
12. "Arvind Limited," a textile industry in Rajasthan, buys "Cotton" from Punjab. It has to pay
"IGST" (a tax levied on all Inter-State supplies of goods and services in India under the
GST regime). "Arvind Limited" spent₹ 5,00,000 IGST on its purchases of Cotton from
Punjab in 2020. The cost accountant is making a Cost sheet; suggest to him where he
should add this ₹5,00,000 in Cost Sheet to calculate the Total Cost.
A. In Raw Materials Purchase Cost
B. In Works Overheads
C. In Selling Overheads
D. In-Office Overhead
13. "Sara textiles" pays₹ 6,00,000 each month as wages to workers who actually work on
"Knitting" and "cloth cutting" machines. The cost accountant is making the Cost sheet,
suggest him this ₹6,00,000 should form part of which of the following.
A. Works overhead
B. Prime Cost
C. Office Overhead
D. Selling Overhead
14. During the COVID-19 pandemic, Blackberry focused on marketing via micro-blogs,
Podcasts, Internet radio, TV, RSS, Pay-Per-Click, SEO, and email. Affiliate Marketing Blogs
was also another online marketing medium used by Blackberry. It spent ₹3 crores on its
marketing in 2020. Such marketing cost will form part of:
A. Works overhead
B. Prime Cost
C. Administration Overhead
D. Distribution Overhead
15. RedStar Safety is a subsidiary company of MSF Group, focusing entirely on industrial
safety work-wear. It is a reputable manufacturer and exporter of work-wear fabric and
clothing. It pays ₹ 1.5 Lakh as a monthly salary to its Chief Chartered Accountant. At
times of preparing cost sheet, such salary will form part of:
A. Works overhead
B. Prime Cost
C. Administration Overhead
D. Distribution Overhead

Notes
16. Raymond Textile is incurring a Total Cost of ₹ 3,00,000 to produce 1000 meters of Jute
Cloth. Calculate the Total Sales value that Bharat Textile should make to earn a profit of
20% on its Selling Price.
A. ₹3,00,000
B. ₹3,20,000
C. ₹3,60,000
D. ₹3,75,000
17. Calculate Prime cost from the following information: -

Opening stock of Raw Material ₹ 14,000, Raw Material Purchases ₹ 75,000, Carriage
Inwards ₹5,000, Closing stock of Raw Material ₹22,000, Direct Wages ₹47,000
A. ₹1,12,000
B. ₹1,39,000
C. ₹1,19,000
D. ₹1,22,500
18. Calculate Cost of Production from the following information: -

Work Cost ₹30,000, Depreciation on Factory Building ₹5,000, Manager's Salary ₹25,000,
Office Stationery ₹2,000, Depreciation on Office Building ₹3,000.
A. ₹30,000
B. ₹35,000
C. ₹65,000
D. ₹60,000
19. Calculate Cost of Sales from the following information: -

Cost of Production ₹ 42,000, Depreciation on Office Building ₹ 3,000, Sales agent's
commission ₹6,000, Carriage outward ₹8,000.
A. ₹42,000
B. ₹46,000
C. ₹59,000
D. ₹56,000
20. Calculate Profit/Loss from the following information: -

Prime Cost ₹35,000, Work Cost ₹30,000, Cost of Production ₹42,000, Cost of Goods Sold
₹46,000, Cost of Sales ₹56,000, Total Sales ₹70000.
A. ₹14,000
B. ₹24,000
C. ₹40,000
D. ₹28,000

Notes
Review Questions
1. What is meant by Cost accounting? Explain the objectives of cost accounting.
2. Differentiate between cost control and cost reduction.
3. Illustrate the concept of a cost sheet through an example.
4. Illustrate indirect and direct expenses with the help of an example.
5. Explain the types of cost based on any five bases.
6. Differentiate between direct costs and indirect costs with the help of an example.
7. Prepare a cost sheet showing sales from the following details:
Particlulars (₹
) Particlulars (₹)
Opening stock Director’s fees 15500
 Raw materials 35000 Bad debts 6000
 Work in progress 45000 Factory rent 4500
 Finished goods 30000 Cash Discount 3200
Closing stock Dividend 6700
 Raw materials 22500 Counting house salary 2500
 Work in progress 40000 Selling expenses 17000
 Finished goods 28000 Repairs and maintenance 2500
Purchase of raw materials 100000 Profit 48000
Works overheads 32000 Warehouse expenses 2500
General expenses 17000 General manager’s salary 10000
Donations 5000 Carriage inward 12400
Depreciation on Machinery 4500 Office rates and taxes 20000
8. Prepare a cost sheet showing sales from the following details:
Particulars (₹) Particulars (₹)

Opening stock Carriage outward 7500
 Raw materials 25000 Office rates and taxes 5000
 Finished goods 21500 Director’s fees 12000
 Work in progress 31000 Bad debts 4500
Closing stock Factory rent 9500
 Raw materials 20000 Drawing office salary 8000
 Finished goods 24500 Profit 40000
 Work in progress 28000 Warehouse expenses 24600
Purchase of raw materials 65000 Administration overheads 12500
Works expenses 18500 Depreciation of Plant 12300

Notes
Further Reading
 Khan, M.Y., & Jain, P.K. (2017). Management Accounting, 7th Edition, McGraw Hill
Education.
University Press.
Web Links
 https://www.yourarticlelibrary.com/cost-accounting/cost-accounting-meaning-
objectives-principles-and-
objections/55218#:~:text=Objectives%20of%20cost%20accounting%20are,making%20a
nd%20determination%20of%20break%2D
 https://www.toppr.com/guides/fundamentals-of-accounting/fundamentals-of-cost-
accounting/meaning-of-cost-costing-and-cost-accounting/
 http://www.himpub.com/documents/Chapter1133.pdf
 https://www.yourarticlelibrary.com/cost-accounting/problems-cost-accounting/top-
14-cost-accounting-problems-with-solutions/75727
 https://www.dynamictutorialsandservices.org/2019/04/cost-sheet-solved-practical-
problems-2_68.html
 https://ca-intermediate.in/wp-content/uploads/2018/08/Chapter-6-Cost-Sheet.pdf

Notes
Razia Sehdev, Lovely Professional University Unit 08: Budgetary Control
Unit 08: Budgetary Control

CONTENTS
Objectives
Introduction
8.1 Meaning and Definition of Budget
8.2 Meaning of Budgetary Control
8.3 Classification/Types of Budget
8.4 Zero Base Budgeting
8.5 Preparation of Cash Budget
8.6 Preparation of Flexible Budget
Summary
Keywords
Self Assessment
Review Questions
Further Reading
Objectives
 explain the meaning and use of Budgets and Budgetary control.
 illustrate the steps involved in implementing Budgetary control in an organization.
 explain the various types of budget that a business entity can prepare.
 review the advantages and limitations of Budgetary control.
 assess closing balance of Cash at end of day, week, month or year through preparing cash
budget.
 assess cost of a product/services, profit per product/service or selling price of a
product/service at various levels of production through preparation of flexible budget.
Introduction
A budget is a monetary plan that is expressed numerically. It covers a certain time frame, such as a
year, quarter, month, or week. An annual budget is one that is prepared for the whole fiscal year.
Many organisations refer to their annual budget as a profit plan since it outlines the activities that
the company intends to take across its many divisions, sectors, and branches in order to accomplish
its profit goals.
A budget aids in the creation and coordination of short-term strategies. It serves as the foundation
for assessing the performance of divisions and their managers. It serves as a standard for
monitoring a company's ongoing operations. It serves as a means of conveying these plans to the
administrators of the responsibility centres.
Budgets are used by businesses to coordinate and regulate the operations of their separate divisions
as well as their overall activities. Budgetary control is the technique of utilising budgets to govern
corporate activity. This lesson discusses the definition and kinds of budgets, the definition and
application of budgetary control, and the advantages and limitations of budgetary control.
Caution:

Notes
Under the right conditions, standard costing and budgetary control may work together to create
harmonies and make planning and control more successful.
8.1 Meaning and Definition of Budget

Meaning of Budget
A budget is a plan of action to achieve stated objectives based on predetermined series of related
assumptions. It generally includes both financial and non-financial aspects of the plan, and it serves
as a blueprint for the company to follow in an upcoming period.
Definition of Budget
Characteristics/ Elements of Budget

 Plan: Budget is an accounting plan that serves as forecasting and controlling device for a
company.
 Quantitative or Financial Terms: Budget is a formal plan of action expressed in monetary
terms such as Indian Rupee, US dollar, Pound, Japanese yen, etc. It is basically
quantitative blue print for future course of action.
 Operations and resources: A firm’s operations and resources are planned through a
mechanism called Budget. A budget should be able to accurately quantify the expenses to
be incurred on goods or services incurred for earning revenues and the incomes &
revenues to be realized from products/services. It should also cover the assets i.e.,
resources of the firm.
 Specified future period: As budget is plan so it is always prepared for a specified future
period. Such specified period can be a year, quarter, semi-annual, month, or week
depending upon the requirement of the company, department, division, or individual
setting the budget.
 Comprehensiveness: A budget is comprehensive in and of itself since it includes all of an
organization's operations and activities. Budgets are created for each division, segment,
department, aspect, project, and activity within a company. These departments, divisions,
activities, and segments are all part of the total budget for the organisation. This whole
budget is referred to as the master budget.
 Coordination: The budget coordinates an enterprise's numerous operational operations in
order to address the challenges and conditions of each sub-part or component. Budgets for
each component are produced in concert with one another in order to make budgets more
effective and relevant.
Do you know?What is Budgeting?

The act of preparing budgets is called Budgeting. It helps managers gather relevant information for
improving future performance.

Notes
8.2 Meaning of Budgetary Control
Need and Objectives of Budgetary Control

The following are the primary objectives of budgetary control:
 Planning
 Co-ordination
 Measurement of success
 Motivation
 Communication
 Control
Planning: Detailed plans relating to raw-material requirements, production, labor needs, sales,
capital additions, etc. are drawn out. In short, budgeting pushes the management to foresee and
prepare for the anticipated conditions. Planning is a constant process since it requires constant
revision with changing conditions.
Co-ordination: Budgeting helps managers in coordinating their efforts so that problems of the
business are solved in harmony with the objectives of its divisions.
Measurement of success: Budgets present a useful means of informing managers how well they are
performing in meeting targets they have previously helped to set.
Motivation: Budget is always considered as useful tool for encouraging managers to complete
things in line with the business objectives. If individuals have intensely participated in the
preparation of budgets, it acts as a strong motivating force to achieve the goals.
Communication: A budget serves as a means of communicating information within a firm.
Control: Budgetary control is a very powerful tool in hand of management to control its activities.
Steps involved in implementing Budgetary Control
The following figure is depicting the steps involved in implementing budgetary control.
Source: Author
Advantages of Budgetary Control
The following are the key advantages of budgetary control.
 Efficiency
 Anticipation
 Coordination

Notes
 Maximization of profits
 Provides a yardstick
Efficiency: Budgetary control increases the efficiency of the organization. As the management or
the persons involved in various activities of the organization, they want to achieve their budgeted
performance. Thus, they will be working with more efficiencies with minimum wastages of
resources and time. Hence, they will be able to achieve the right results at right time.
Anticipation: As we know that budget is a plan, the managers are forecasting the best
opportunities and the worst problems that they may confront with in coming future. Hence, in
advance managers are preparing solutions for those unforeseen negative, or adverse situations.
Coordination: Budgetary control helps the managers to coordinate with each other, so that all
managers and all key personnel of various departments will be able to achieve the goals of
organization in harmony with each other.
Maximization of profits: Budgetary control assists the management to maximize the overall profits
of the business as it renders all the activities to have been performed at right time, without
incurring any wastages through gaining effectiveness and efficiency in various business operations.
Provides a yardstick: It provides a yardstick or tool against which the performance is being
observed and compared. That is why, it acts as a yardstick for controlling the business activities.
Limitation of Budgetary Control
The following are the key limitations of budgetary control.
 Danger of Rigidity
 Expensive technique
 Budget is only a tool of management
 Creation of conflicts
 Does not ensure proper implementation
Danger of Rigidity: It tends to bring about rigidity in operations, which is very harmful. For
instance, when an employee has the capability to outperform the budgeted performance but he
may not be motivated to go beyond achieving his budgeted performance as he knows that he
would be answerable for the attainment of budgeted performance.
Expensive technique: It is beyond the capacity of small undertakings as the mechanism of
budgetary control system is a detailed process involving too much of time and costs which
generally micro and small enterprises cannot spend.
Budget is only a tool of management: Budgeting cannot take a position of management as it is
only an instrument of the management.
Creation of conflicts: Sometimes budgetary control may produce conflicts among managers, as
each of them tries to take credit of achievement of the budgeted targets.
Does not ensure proper implementation: Preparation of good budgets does not ensure their
proper implementation. Hence, the whole purpose of budgetary control gets futile if the budgets
are not implemented in right spirit with proper mechanism.
Essentials of Budgetary Control

The following are key essentials of budgetary control.
 Support of top management
 Teamwork
 Realistic Objectives
 Excellent Reporting System

Notes
 Structure of Budget team

 Well defined Business Policies
 Integration with Standard Costing System
 Inspirational Approach
8.3 Classification/Types of Budget

On functional basis, the budgets can be classified into three categories as follows:
Production Budget
The production budget is mostly determined by the sales budget. The production budget's ultimate
goal is to determine the amount of production to be produced throughout the year based on the
selling volume. It might be in terms of numbers, such as kilogrammes in monetary terms, and so
on.
Materials/Purchase Budget
This budget is created only after determining the amount of completed items anticipated to be
produced to suit the requirements and wants of clients and consumers throughout the season.
Sales Budget
A sales budget is an estimate of sales in the near future created by the person responsible for the
selling of a product taking into account the many sources of impact. Typically, a sales budget is
created in terms of quantity and value.
Sales Overhead Budget
It is prepared by the sales manager who is responsible for the sales volume of the enterprise to
increase through various devices/tools of sales promotion.
Labor Budget
This budget may be classified into labor requirement budget and labor recruitment budget. The
labor requirements in the various job categories such as unskilled, semi‐skilled and supervisory
are determined with the help of all the head of the departments.
Selling and Distribution Budget
The Selling and Distribution Cost budget is estimating of the cost of selling, advertising, delivery of
goods to customers etc. throughout the budget period. This budget is closely associated to sales
budget in the logic that sales forecasts significantly influence the forecasts of these expenses.
Administration Cost Budget

Notes
This budget includes the administrative costs for non‐manufacturing business activities like
managing directors’ salaries, director’s fees, office lightings, air condition and heating etc. Most of
these expenses are fixed so they should not be too difficult to forecast.
Capital-Expenditure Budget
This budget stands for the expenditure on all fixed assets for the duration of the budget period.
This budget is normally prepared for a longer period than the other functional budgets.
Cash Budget
Cash Budget ' One of the most crucial and last to be prepared is the cash budget. It is a thorough
prediction of all cash revenues and cash payments for all purposes, as well as the resulting cash
balance for the whole budget period.
Budgetary Control
It is a budget that is intended to stay constant regardless of the degree of activity accomplished.
This budget is ineffective since circumstances are constantly changing and cannot be expected to
remain stable.
Flexible Budget
A flexible budget is one that "changes in relation to the level of activity attained."
Budget Flexibility vs. Fixed Budget
The table below illustrates the difference between a fixed and a flexible budget.
Point of
Fixed Budget Flexible Budget
Distinction
It is flexible and can be suitably re-

It is inflexible and does not change with
Flexibility casted quickly according to the level
the actual volume of output achieved.
of activity attend
It assumes that conditions would It is designed to change according to

Condition
remain static. changed conditions.
Costs are not classified according to

Classification Costs are classified according to
their variability i.e. fixed, variable and
of cost changed conditions.
semi-variable.
Comparison of actual and budgeted Comparisons are realistic as the

Comparison performance cannot be done correctly if changed plan figure are placed
the volume of output differs. against actual ones.
It clearly shows the impact of various

It is difficult to forecast accurately the
Forecasting expenses on the operational aspect of
result in it.
the business.
Long‐term Budget
These budgets are prepared on the basis of long‐term projection and portray a long‐range
planning. These budgets generally cover plans for three to ten years.
Short-term Budget
In this budget forecasts and plans are given in respect of its operations for a period of about one to
five years.
Current Budget
These budgets cover a very short period, may be a month or a quarter or maximum one year.
Rolling Budget

Notes
Master Budget
 It is a review budget which combines all functional budgets.
 It may take the form of Financial Statements at the end of budget period.
 It is also called the operating budget.
 It embraces the impact of both operating decisions and financing decisions.
 It provides the necessary plan for operations during the period when all detailed budgets
have been completed.
 It is an annual profit plan, which may be broken into months or quarters.
Merits of the Master Budget
 A review of all the functional budgets in specific form is available in one report.
 It presents an overall profit position of the organization for the budget.
 It also contains the information regarding the forecast balance sheet.
 It examines the fitness of all the functional budgets.
8.4 Zero Base Budgeting
Rationale of Zero-Based Budgeting

The method of ZBB suggests that the business should not only make decision about the proposed
new programs, but it should also, regularly, review the suitability of the existing programs.
Presumptions of Zero-Based Budgeting
 There is an efficient budgeting system within the enterprise.
 Managers can develop quantitative measures for use in performance evaluation.
 Among the new suggestions and programs, along with old ones are put to a strict
scrutiny.
 Funds are diverted from low‐priority suggestions to high priority suggestions.
8.5 Preparation of Cash Budget

Cash budget is nothing but an estimation of cash receipts and cash payments for specified period. It
is prepared by the head of the accounts department, i.e. chief accounts officer.
Example:
From the following budget figures, prepare a cash budget of three months to June 30, 2020:

Notes
Solution:
1) The working notes of calculation of cash received from debtors are as follows:

Notes
2) As in case of materials and overheads, they are paid during the month following the
month of supply. Thus, in month of April, the material cost and overhead cost of March
will be paid and in the month of May, the material cost and overhead cost of April will be
paid. In the same manner, in the month of June, the material cost and overhead cost of
May will be paid.
Example:
From the following information prepare a monthly cash budget for the three months ending 31st
Dec.2019.
Admin &
Production
Sales Materials Wages Selling
Month Expenses
Expenses
(₹
) (₹
) (₹
) (₹) (₹)
June 3,000 1,800 650 225 160
July 3,250 2,000 750 225 160
Aug. 3,500 2,400 750 250 175
Sep. 3,750 2,250 750 300 175
Oct. 4,000 2,300 800 300 200
Nov. 4,250 2,500 900 350 200
Dec. 4,500 2,600 1,000 350 225
(i) Credit terms are:
(a) Sales — 3 months to debtors. 10% of sales are on cash.
(b) Creditors for material provide 2 months credit period.
(ii) Lag in payment of Wages is 1/4 month and overheads is 1 month.
(iii) Cash and Bank Balance on 1st Oct. expected ₹1,500.
(iv) Other information
(a) Plant and Machinery to be installed in Aug. at a cost of ₹24,000. It will be paid for by monthly
installments of ₹5,00 each from 1st October.
(b) Preference share dividend @ 5% on ₹50,000 are to be paid on 1st December.
(c) Calls on 250 equity shares @ ₹2 per share expected on 1st November.
(d) Dividends from investments amounting to ₹250 are expected on 31st December.
(e) Income tax (advance) to be paid in December ₹500.
Solution:

Notes
Particulars Oct (₹) Nov (₹ ) Dec (₹ )

Opening Balance 1500.00 662.50 612.50
Receipts
Cash Sales 400.00 425.00 450.00
Debtors 2925.00 3150.00 3375.00
Equity Call money 500.00
Dividend received 250.00
Total Receipts 3325.00 4075.00 4075.00
Payments
Materials 2400.00 2250.00 2300.00
Wages (3/4th) Same month 600.00 675.00 750.00
Wages (1/4th) 1 month credit 187.50 200.00 225.00
Overheads
Production 300.00 300.00 350.00
Admin and Selling 175.00 200.00 200.00
Plant and Machinery Instal. 500.00 500.00 500.00

Preference dividend 2500.00
Income tax 500.00
Total Payments 4162.50 4125.00 7325.00
Closing balance of Cash 662.50 612.50 (2637.50)
8.6 Preparation of Flexible Budget

A flexible budget is one “which is designed to change in relation to the level of activity attained.”
Example:
Solution:

Notes
Example:
Solution:

Notes
Summary
A budget is an estimate created for a certain future time, either financial or non-financial.
The budgetary control system is comprised of two distinct processes: budget preparation and
budget control.
The production budget is a list of commodities and the amount that should be produced.
The production budget's ultimate goal is to determine the amount of production to be produced
throughout the year based on the selling volume.
A sales budget is an estimate of future sales created by the person in charge of selling a product
while taking into account numerous aspects of impact.
A cash budget is simply an estimate of cash collections and cash payments for a certain time period.
It is created by the Chief Accounts Officer, the leader of the accounting department.
The fixed budget is primarily intended for the firm's fixed overheads, which are constant in volume
regardless of output level.
Keywords
A budget is a financial statement produced for a certain activity in the future.
Budgeting refers to the activity of creating a budget.
Budget Control: A quantitative controlling approach used to evaluate an organization's
performance.
Cash Budget: This is a statement made by the organisation to determine future cash requirements
and revenues from previous activity.
Fixed Budget: It is intended for the firm's fixed overheads, which are consistent in volume
regardless of output level.
A flexible budget is one that is intended to adapt in response to the level of activity reached.
The master budget is a review budget that incorporates all functional budgets.
A rolling budget is a continuous budget that is updated on a regular basis as the previous budget
period ends, or it may be thought of as an extension of the current period budget. Budget rollover is
another term for rolling budget.
SelfAssessment
1. On the basis of ______, budget is classified into long term budget, short term budget and
current budget.
A. Functions
B. Control
C. Time
D. All of above
2. Variable budget is also known as _______ budget.

A. Fixed
B. Semi-variable
C. Flexible
D. Master
3. The budget prepared according to ________ is known as functional budgets.

Notes
A. Period
B. Controls
C. Functions
D. Zero Based Budgeting
4. _____ budget is a budget which is designed to remain unchanged irrespective of the volume
of output or turnover achieved.
A. Fixed
B. Flexible
C. Cash
D. Master
5. A _______ budget is the budget which shows the quantity and value of goods to be purchased
during the budget period to meet the day-to-day needs of the business.
A. Sales
B. Cash
C. Purchase
D. Labor
6. Given estimated sales in February, March, April, May and June are ₹96,000, ₹ 90,000, ₹
52,000, ₹ 67,000 and ₹ 69,000. In case 50% of sales are realized in the next month and
balance in the next of next month, determine cash collection from sales in May.
A. ₹71,000
B. ₹70,500
C. ₹59,500
D. ₹68,000
7. Given estimated sales in February, March, April, May and June are ₹ 56,000, ₹ 60,000, ₹
balance in the current month, determine cash collection from sales in April.
A. ₹63,000
B. ₹68,000
C. ₹66,000
D. ₹86,000
8. Given estimated sales in February, March, April, May and June are ₹ 96,000, ₹ 90,000, ₹
balance in the next of next month, determine cash collection from sales in June.
A. ₹59,500
B. ₹70,500
C. ₹68,000
D. ₹71,000

Notes
9. In a firm, the forecast of wages for month of December, January, February and March are₹
4,800, ₹ 6,000, ₹ 6,400 and ₹ 6,800. The time-lag in payment of wages is 1/8 month.
Determine the amount of wages payable in the month January.
A. ₹6,750
B. ₹5,850
C. ₹6,350
D. ₹4,800
10. Cash budget deals with historical data whereas Cash Flow Statement deals with future data.
A. True
B. False
11. Calculate estimated material cost for 1100 units in 2021 from the following information:
Cammy, a soap making company is producing 800 units of soap presently (2020). It is incurring
₹90 per soap for Fat (1 type of Raw material) in current year. Cammy’s purchase manager
is expecting that there will be increase in the prices of Fat by ₹6 per soap in 2021.
A. ₹69,300
B. ₹36,300
C. ₹1,05,600
D. ₹66,000
12. The cost of material at 50% capacity is ₹8,000 and budget is to be prepared at 60%, 90% and
100% of normal capacity. The cost of material at 90% capacity will be:
A. ₹9,600
B. ₹14,400
C. ₹4,800
D. ₹7,200
13. SPSS, a software developer incurs Distribution Expenses (20% fixed) ₹ 2.50 per Software
package. Presently, it is producing 100 packages. Calculate Total Distribution Expenses that
SPSS will incur for 120 packages.
A. ₹240
B. ₹50
C. ₹290
D. ₹300
14. Bira Beverages incurs Selling Expenses (10% fixed) ₹ 7.50 per Juice Bottle. Presently, it is
producing 100 Juice Bottles. Calculate Total Variable Selling Expenses that Bira Beverages
will incur for 140 packages.
A. ₹75
B. ₹945
C. ₹1020
D. ₹1050

Notes
15. Calculate estimated material cost for 900 units in 2021 from the following information:
Lifeboy, a soap making company is producing 800 units of soap presently (2020). It is incurring
₹80 per soap for Fat (I type of raw materials) in current year. Lifeboy’s purchase manager is
expecting that there will be increase in the prices of Fat by ₹5.5 per soap in 2021.
A. ₹72,000
B. ₹68,400
C. ₹76,950
D. ₹64,000
Answers forSelfAssessment
1. C 2. C 3. C 4. A 5. C
6. A 7. A 8. A 9. B 10. B
11. C 12. B 13. C 14. B 15. C
Review Questions
1. From the following information, prepare a cash budget of three months starting from April, 2020:
Months Sales (₹) Material (₹) Wages (₹)
January 40000 10000 5000
February 54000 12000 6600
March 55000 14000 6000
April 64000 15000 7400
May 70000 18000 7600
June 72000 21000 8000
2. From the following information, prepare a cash budget of three months ending June 30, 2020:

Notes
3. From the following information, prepare a cash budget of three months starting from April, 2021:
Material
Months Sales (₹) (₹) Wages (₹)
January 30000 7000 600
February 34000 8000 760
March 35000 8000 700
April 34000 9000 840
May 30000 7000 780
June 32000 10000 800
1. Expected cash balance on 1stApril, 2021 was ₹7500.
2. Materials are paid during the following month of supply.
3. Wages are paid in the same month.
4. All sales proceeds are collected within the month of sale.
4. What do you mean by budget? Explain the various types of Budgets.

5. What is meant by Budgetary control? Illustrate the steps of implementing Budgetary control in
an organization.
6. Differentiate between Fixed Budget and Flexible Budget.
7. State the advantages and limitations of Budgetary control.
8. What is a master budget? Explain its merits of preparing the same.
9. What is Zero-based budgeting? Elaborate the rationale and presumption of Zero-based
budgeting.
10. Summarize the essentials of implementing Budgetary Control in an organization.
11. The Expenses for the budget production of 10,000 units in a factory are furnished below:
Material- ₹80/unit
Labor – ₹35/unit

Notes
Variable overheads – ₹30 /unit

Fixed Overheads are ₹1,00,000
Administrative Overheads ₹50,000
Selling expenses (10% Fixed) – ₹15/unit
Distribution expenses (20 % Fixed)- ₹10/unit
Prepare a budget for production for 8000 units and 12,000 units and indicate cost per unit also.
12. ABC Ltd. has prepared the budget for the production of one lakh units of the only commodity
manufactured by them for a costing period as under:
₹(Lakh)
Raw material 2.52
Direct Labor 0.75
Direct expenses 0.10
Works overhead (60% Fixed) 2.25
Administrative overheads (80% Fixed) 0.40
Selling overheads (50% Fixed) 0.20
The actual production during the period was only 60,000 units. Calculate the revised budgeted cost
per unit.
13. From the following budgeted figure, prepare a cash budget in respect of three months to May,
2019:
Months Credit Sales (₹) Material (₹) Wages (₹) Overheads (₹)
January 40,000 12,000 1,200 600
February 70,000 14,000 3,200 300
March 68,000 13,000 3,000 200
April 52,000 14,000 2,500 100
May 40,000 3.000 1,500 200
Expected cash balance on 1st March, 2019 was ₹25,000.
a) Lag in payment of wages 1/2 months.
b) 50% of sales are realized in the month following the sale and remaining 50 % in the second
month following.
Further Reading
 Fundamentals Of Cost Accounting ByWiiliam N. Lanen, Shannon W.
Anderson, Michael W. Maher, Mcgraw Hill Education
 Management Accounting By Shah Paresh, Oxford University Press
 A Textbook Of Accounting For Management By Maheshwari. S.N,
Maheshwari Sharad.K, Maheshwari Suneel.K, Vikas Publishing House

Notes
 Accounting For Decision Making By Needles Belverd. E, Cengage Learning

 Financial Accounting For Management: An Analytical Perspective By Gupta
Ambrish, Pearson
Web Links
https://www.accountingnotes.net/cost-accounting/budget/budget-definition-
purpose-elements-and-steps/4795
https://www.iedunote.com/budget
http://egyankosh.ac.in/bitstream/123456789/7193/1/Unit-14.pdf

Notes
Razia Sehdev, Lovely Professional University Unit 09: Inventory Valuation
Unit 09: Inventory Valuation
CONTENTS
Objectives
Introduction
9.1 What are Inventories?
9.2 Inventory Cost
9.3 Risk of Holding Excessive Inventory
9.4 Inventory Control
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 illustrate the meaning of inventory.
 write the relevance and techniques of inventory control.
 explain the various methods of pricing material issues.
 assess the closing value of inventory on a specific date if inventories are issued as per the
FIFO method.
 measure the closing value of inventory as on a certain date if inventories are issued as per
the LIFO method.
Introduction
Inventory is a significant factor of production in a manufacturing organization. It is the primary
element of a product cost. Inventories account for nearly 50-60 percent of the cost of production,
depending upon the nature of industries. This fact can be inferred from an analysis of the financial
statements of a large number of organizations.
Uninterrupted supply of inventory of required quality and quantity as needed for the production
department is a prerequisite for carrying out continuous production activities. The non-availability
of materials or stock will bring the entire production activities to a standstill. And, the implications
of production stoppage are very well known for its multi-negative consequences. Besides, this
element of cost provides several avenues for cost control, such as at the time of purchase, during
manufacturing. Hence, greater emphasis is to be laid on Inventory control.

Notes
9.1 What are Inventories?
Examples:
9.2 Inventory Cost

Three sub-costs that constitute inventory cost are Carrying cost, Ordering cost, Shortage cost. Let’s
discuss these costs as follows:
a) Carrying cost: It is the cost of holding an item in inventory.
b) Ordering cost: It is the cost of replenishing inventory.
c) Shortage cost: It is the temporary or permanent loss of sales when demand cannot be met.
9.3 Risk of Holding Excessive Inventory

The following are the key risks that arise as a consequence of holding excessive inventory:
 Price decline
 Product Deterioration
 Product Obsolescence
 Risk of an item not getting sold
 Higher storage costs
 Risk of natural disasters
 Higher insurance premiums
:
Price decline: Holding excessive inventory can result in a price decline of inventory. The old
inventories may turn into old models that have been out of fashion and are not demanded by
customers anymore.
Product deterioration: There will be deterioration in the product quality, appearance, and usability
if products are just kept in the warehouses and cannot get sold or consumed by the company.
Product Obsolescence: Product obsolescence means a product may go out of fashion due to the
launch of new updated variants. For instance, every year, mobile-making companies such as
Samsung, Apple, etc. come up with new models of their various mobile brands. With the
introduction of new models, old models turn out of fashion, and their prices also get declined.
Risk of an item not getting sold: When the product’s conditions deteriorate or get obsolete, there
will be higher chances that the product will not get sold at its maximum retail price. Even

Notes
companies give high discounts to clear such outdated or deteriorated stock as holding them in
warehouses will shot up the company’s storage cost.
Higher storage costs: If an older inventory is still piled up in the various places of the company’s
warehouse, the company will first have to arrange new stores to keep its new inventory; secondly,
it has to hire more storekeepers and has to spent high carrying cost.
Risk of natural disasters: Holding excessive inventory increase the chances of bearing high cost
due to natural disasters.
Higher insurance premiums: Holding excessive inventory will increase the insurance cost.
9.4 Inventory Control

Inventory control is the systematic management and regulation of the procurement, storage, and
use of goods in order to ensure an equitable flow of production while preventing excessive material
investment.
Efficient material control eliminates material losses and waste that might otherwise go unreported.
Objectives of Inventory Control
The following are the critical objectives of exercising Inventory control:
 Preventing dead Stock or Perishability
 Optimizing Storage Cost
 Maintaining Sufficient Stock
 Enhancing Cash Flows
 Reducing Purchase Cost of Goods
Inventory Control – Techniques
The following are the essential techniques of Inventory control:
 ABC Techniques
 Fixing and Maintaining appropriate Stock Levels
 Economic Order Quantity (EOQ)
 Just-in-time (JIT) system
 Use of Control Ratios
 Review of Slow and Non-moving Items.
 Material Budgets
 VED analysis
 Proper purchase procedure
 Use of Perpetual Inventory System and Continuous Verifications
Methods of pricing material issues

The following table is showing the various methods of pricing material issues.

Notes
First-in First-out (FIFO) Method
Rising and Falling prices

 The FIFO method produces higher profits during rising prices and results in higher tax
liabilities because lower cost is charged to production.
 The FIFO method produces lower profits during falling prices and results in lower taxes
because they are derived from a higher cost of goods sold.
Example:

Notes
Prepare a Stores ledger account from the following information adopting the First-in-First-out
(FIFO) Method of pricing of issues of Materials:
Solution:
Date Receipts Issue Balance

Qty (Units) Rate (₹
) Amt. (₹) Qty (Units) Rate (₹) Amt. (₹) Qty (Units) Rate (₹) Amt. (₹)
2-Sep 3000 1.5 4500
4-Sep 4000 2.15 8600 3000 1.5 4500
4000 2.15 8600
5-Sep 2200 1.5 3300 800 1.5 1200
4000 2.15 8600
6-Sep 800 1.5 1200
800 2.15 1720 3200 2.15 6880
8-Sep 2000 2.15 4300 1200 2.15 2580
11-Sep 4800 2.5 12000 1200 2.15 2580
4800 2.5 12000
12-Sep 1200 2.15 2580
600 2.5 1500 4200 2.5 10500
14-Sep 5000 2.85 14250 4200 2.5 10500
5000 2.85 14250
17-Sep 1600 2.5 4000 2600 2.5 6500
5000 2.85 14250
19-Sep 2600 2.5 6500
1400 2.85 3990 3600 2.85 10260
20-Sep 1000 3 3000 3600 2.85 10260
1000 3 3000
25-Sep 1200 2.85 3420 2400 2.85 6840
1000 3 3000
29-Sep 600 2.85 1710 1800 2.85 5130
1000 3 3000
Closing Balance of Stock as on Sep 29, 2020, is 2800 units for ₹8130.
Example:
From the following information, prepare a stores ledger account under the FIFO method:

Notes
Solution:

Qty (Units) Rate (₹
) Amt. (₹
)Qty (Units) Rate (₹) Amt. (₹) Qty (Units) Rate (₹) Amt. (₹)
1/1/2020 1200 5 6000
2/1/2020 800 6 4800 1200 5 6000
800 6 4800
4/1/2020 1100 5 5500 100 5 500
800 6 4800
5/1/2020 500 6.2 3100 100 5 500
800 6 4800
500 6.2 3100
8/1/2020 100 5 500 600 6 3600
200 6 1200 500 6.2 3100
11/1/2020 250 6 1500 350 6 2100
500 6.2 3100
15/1/2020 700 6.5 4550 350 6 2100
500 6.2 3100
700 6.5 4550
20/1/2020 150 6 900 200 6 1200
500 6.2 3100
700 6.5 4550
1400 8850
Closing Stock as on Jan 20, 2020, is 1400 units for ₹8850
Last-in First out (LIFO) Method

Notes
Rising and Falling prices

 During rising prices, profits and tax liability under LIFO would be lower than under the
FIFO method.
 In the period of falling prices, the closing stock would be valued at a higher price, and
thus the profits and taxes would also be higher.
Example
From the following information, prepare a stores ledger account under the LIFO method:
Date Transactions
1/1/2020 Opening stock, 1200 units at ₹5 each
2/1/2020 Purchased 800 units at ₹6 each
4/1/2020 Issued 1100 units
5/1/2020 Purchased 500 units at ₹6.20 each
Solution:

Notes

Qty (Units) Rate (₹ ) Amt. (₹
) Qty (Units) Rate (₹) Amt. (₹) Qty (Units) Rate (₹) Amt. (₹)
1/1/2020 1200 5 6000
2/1/2020 800 6 4800 1200 5 6000
800 6 4800
4/1/2020 800 6 4800 900 5 4500
300 5 1500
5/1/2020 500 6.2 3100 900 5 4500
500 6.2 3100
8/1/2020 300 6.2 1860 900 5 4500
200 6.2 1240
11/1/2020 200 6.2 1240 850 5 4250
50 5 250
15/1/2020 700 6.5 4550 850 5 4250
700 6.5 4550
20/1/2020 150 6.5 975 850 5 4250
550 6.5 3575
1400 7825
Closing Stock is 1400 units costing ₹7825.
Example:
Prepare a Stores ledger account from the following information adopting the Last-in-First-out
Method of pricing of issues of Materials:
Solution:

Notes

Qty (Units) Rate (₹) Amt. (₹) Qty (Units) Rate (₹) Amt. (₹
) Qty (Units) Rate (₹) Amt. (₹)
2-Sep 3000 1.5 4500
4-Sep 4000 2.15 8600 3000 1.5 4500
4000 2.15 8600
5-Sep 2200 2.15 4730 3000 1.5 4500
1800 2.15 3870
6-Sep 1600 2.15 3440 3000 1.5 4500
200 2.15 430
8-Sep 200 2.15 430 1200 1.5 1800
1800 1.5 2700
11-Sep 4800 2.5 12000 1200 1.5 1800
4800 2.5 12000
12-Sep 1800 2.5 4500 1200 1.5 1800
3000 2.5 7500
14-Sep 5000 2.85 14250 1200 1.5 1800
3000 2.5 7500
5000 2.85 14250
17-Sep 1600 2.85 4560 1200 1.5 1800
3000 2.5 7500
3400 2.85 9690
19-Sep 3400 2.85 9690 1200 1.5 1800
600 2.5 1500 2400 2.5 6000
20-Sep 1000 3 3000 1200 1.5 1800
2400 2.5 6000
1000 3 3000
25-Sep 1000 3 3000 1200 1.5 1800
200 2.5 500 2200 2.5 5500
29-Sep 600 2.5 1500 1200 1.5 1800
1600 2.5 4000
2800 5800
Summary
 Inventory control, therefore, aims at ensuring the availability of required quality material
in the required quantity, at the necessary time or period, and place with minimum cost.
 Inventory involves an investment of money and locking up precious space which has
alternate uses.
 Inventory control is generally exercised over raw materials and work in progress.
 The basic purpose of inventory control is to maintain an optimum level of inventory.
 Three components usually constitute the inventory cost: Acquisition cost of materials,
Ordering cost of materials and Carrying cost of materials.
 A system of classifying materials and supplies according to value is known as ABC
Analysis.
 The important operation of inventory management is inventory valuation through the
store's ledger. Inventory valuation is being executed through the following various
methodologies:
 First-in-First-out (FIFO)
 Last-in-First-out (LIFO)
 Highest in First out (HIFO)
 Simple Average Method (SAM)
 Weighted Average Method (WAM)
 Base Stock Method

Notes
Keywords
ABC Analysis: Analysis of exercising the control on the inventory based on value. Always Better
Control Analysis; A- High control for high-value goods; B- Moderate control for lesser value goods
and C- Little control on the least value goods.
Carrying Cost: Cost incurred for carrying the materials from the place of purchase to the area of
production centre/profit centre.
FIFO method: This method is based on the assumption that earlier purchased materials are issued
first.
Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods, and Stock
of Spares, but not Stock of Loose tools.
Inventory control: Inventory control is the systematic control and regulation of the purchase,
storage, and usage of materials in such a way as to maintain an even flow of production and at the
same time avoiding excessive investment in materials.
LIFO method: Under this method, the issues are made at the price of the latest consignment.
Ordering Cost: Cost incurred at the moment of placing the order of goods or materials,
administration costs, cost of communication, and so on.
SelfAssessment
1. Mango cloth mills is incurring ₹ 2,00,000 as monthly warehouse rent to keep its inventory.
Such warehouse rent will be treated as the following for Mango cloth mills.
A. Carrying cost of inventory
B. Ordering cost of inventory
C. Shortage cost of inventory
D. Total inventory cost
2. Kartik sports Ltd. incurs ₹50,000 every time to replenish its inventory of wood used to make
“Bats.” Such ₹50,000 will be treated as follows for Kartik sports Ltd.
3. Raspberry enterprises Ltd. is in the business of making fresh juices of different berries. Due to
the shortage of raspberries in its inventory, Raspberry enterprises Ltd. lost an order of ₹
3,50,000 for selling Raspberry Juices to its regular client. Such lost order of ₹3,50,000 will be
treated as the following for Raspberry enterprises Ltd.
4. Mehta enterprises’ owner, Mr. Jagdish, is always in favor of holding excessive inventory to
avoid loss of sales due to shortage of inventory. In the capacity of the inventory manager,
suggest to him the risk of having excessive inventory from the following.
A. Risk of Price surge

Notes
B. Risk of Product Deterioration

C. Risk of lower storage cost
D. Risk of paying lower insurance premiums
5. Shyamlata enterprises has hired you as its Inventory manager. In the board meeting, you are
required to discuss and suggest to the board the various inventory control techniques from
the following:
A. ABC Techniques
B. Fixing and Maintaining appropriate Stock Levels
C. Economic Order Quantity (EOQ)
D. All of above
6. First-in First-out falls under the following methods of pricing of material issues.
a) Cost Price methods
b) Average Price methods
c) Notional Price methods
d) Market Price methods
7. The following method is based on the assumption that earlier purchased materials are issued
first.
A. Specified Price
B. First-in First-out (FIFO)
C. Last-in First-out (LIFO)
D. Highest-in First-out (HIFO)
8. In periods of rising prices, the FIFO method produces:

A. Higher profits and results in higher tax liabilities
B. Produces lower profits
C. Lower tax liabilities
D. Higher cost of goods sold
9. In the period of falling prices, the FIFO method produces:

A. Higher profits
B. Higher tax liabilities
C. Lower profits and results in higher taxes
D. Lower profits and results in lower taxes
10. The FIFO method is a good inventory management system because:

A. The oldest units are used first, and inventory consists of the latest stock
B. It facilitates inter-firm and intra-firm comparisons
C. It is easy to understand and operate
D. All of above

Notes
11. Last-in First-out falls under the following methods of pricing of material issues.
A. Cost Price methods
B. Average Price methods
C. Notional Price methods
D. Market Price methods
12. The following method is based on the principle that the materials used in production should
be taken from the latest purchase.
A. Specified Price
B. First-in First-out (FIFO)
C. Last-in First-out (LIFO)
D. Highest-in First-out (HIFO)
13. In periods of rising prices, the LIFO method produces:

A. Lower profits
B. Lower profits and Higher tax Liabilities
C. Lower profits and Lower tax Liabilities
D. Higher profits and Lower tax Liabilities
14. In the period of falling prices, the LIFO method produces:

A. Higher profits
B. Higher profits and Higher Tax Liabilities
C. Higher profits and Lower Tax Liabilities
D. Lower profits and Lower Tax Liabilities
15. The following is treated as one of the significant limitations of the LIFO method:
A. The cost of different batches varies greatly, making inter-firm and intra-firm comparison
difficult.
B. It minimizes unrealized inventory gains and losses and stabilizes reported operation profits,
especially when the industry is prone to sharp price fluctuations.
C. It reveals real income in times of rising prices.
D. It matches current costs with current revenues in a better way.

l. A 2. B 3. C 4. B 5. D
6. A 7. B 8. A 9. D 10. D
11. A 12. C 13. C 14. B 15. D

Notes
Review Questions
1. Illustrate the meaning of Inventory. Explain the cost components of Inventory cost.
2. What is Inventory control? Explain the objectives of exercising inventory control in an
organization.
3. List the Inventory control techniques.
4. List the various methods of pricing inventory issues.
5. What is the FIFO method? Explain its advantages and limitations.
6. Explain the LIFO method along with its merits and demerits.
7. The basic purpose of material control is to maintain an optimum level of inventory. Discuss.
8. Which method is most suitable for perishable commodities? Why? Reason out the suitability of
the model.
9. From the following information, prepare a stores ledger account under both FIFO and LIFO
methods.
10. From the following information, prepare a store ledger account under both FIFO and LIFO
methods.
2/1/2018 Returned to store 100 units at ₹45 each
11. Prepare a store ledger account from the following information adopting the LIFO method of
pricing of issues of materials.
March 1 Opening balance 500 tonnes @ ₹200
March 4 Received from supplier 200 tonnes @ ₹190
March 8 Issue 80 tonnes
March 13 Issue 150 tonnes
March20 Received from supplier 240 tonnes @ ₹195.
12. From the following information, prepare a stores ledger account under the FIFO method


Notes
Further Readings
Hill Education.
University Press.
Web Links
https://www.bigcommerce.com/blog/inventory-management/#inventory-management-
techniques
https://cleartax.in/g/terms/first-in-first-out-
fifo#:~:text=First%20In%2C%20First%20Out%20(FIFO)%20is%20part%20of%20an,at%20last
%20are%20sold%20first.
https://www.freshbooks.com/hub/accounting/what-is-
lifo#:~:text=LIFO%20stands%20for%20%E2%80%9CLast%2DIn,ones%20used%20in%20the
%20calculation.
https://www.accountingtools.com/articles/2017/5/13/last-in-first-out-method-lifo-
inventory-method

Notes
Razia Sehdev, Lovely Professional University Unit 10: Marginal Costing and Profit Planning
Unit 10: Marginal Costing and Profit Planning
CONTENTS
Objectives
Introduction
10.1 Marginal Cost and Marginal Costing
10.2 Cost-Volume-Profit (CVP) Analysis: Introduction
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 appraise the use of Cost-volume-profit analysis.
 explain the various elements of CVP analysis.
 perform Break-Even analysis.
 apply the break-even analysis for decision-making.
Introduction
Cost Volume Profit (CVP) analysis is one of the premier tools of management to take decisions and
fix a reasonable price and assess the level of profitability of the products/services. This is the only
costing tool that demarcates the fixed cost from the variable cost of the product/service to guide the
firm to know the minimal point of sales to equate production costs. It is a tool of analysis
highlighting the relationship between the firm's cost, the volume of sales, and profitability.
Meaning, assumptions, use, applications, and elements of CVP analysis are briefly discussed in the
present unit.
10.1 Marginal Cost and Marginal Costing

Marginal Cost
Marginal cost is a change in the total cost due to a change in the production level, i.e., either an
increase/decrease by one unit of product.
"Marginal cost is the amount at any given volume of output, by which aggregate costs are charged
if the volume of output is increased or decreased by one unit."
-- ICMA
Marginal Costing
Marginal Costing is defined as:
"The ascertainment of marginal cost and the effect on profit of changes in volume or type of output
by differentiating between fixed and variable costs."
In marginal costing, the change in the cost of operation is equivalent to variable cost due to fixed
cost components fixed irrespective of output level.

Notes
10.2 Cost-Volume-Profit (CVP) Analysis: Introduction

It establishes the relationship between costs, the volume of production/sales & profits. It shows
how operating income changes with changes in output level, selling prices, variable costs, or fixed
costs.
It is the study of the effects on future profit of changes in fixed cost, variable cost, sales price,
quantity and mix'. (CIMA)
Inter-relations
The cost-volume-profit (CVP) analysis helps management find out the relationship between costs
and revenues to profit. An undertaking aims to earn profit. Profit depends upon many factors, the
most important of which are the cost of manufacture and sales volume. Both these factors are
interdependent-volume of sales depending upon the volume production, which is related to costs.
Source: Author
Factors affecting cost are:
 The volume of production;
 Product-mix;
 Internal efficiency;
 Methods of production; and
 Size of the plant, etc.
Of all these, volume is perhaps the most significant single factor influencing costs, divided into
fixed costs and variable costs. Volume changes in a business are frequent, often necessitated by
outside factors over which management has no control. As costs do not always vary in proportion
to changes in output levels, management control of the volume factors presents a peculiar problem.
As profits are affected by the interplay of costs and volume, the management must have, at its
disposal, an analysis that can allow for a reasonably accurate presentation of the effect of a change
in any of these factors, which would have no profit performance. Cost-volume-profit analysis
furnishes a picture of the profit at various levels of activity.
Cost-Volume-Profit Analysis: Consideration
Analysis of cost-volume-profit involves consideration of the interplay of the following factors:
 The volume of sales;
 Selling price;
 Product mix of sales;
 Variable costs per unit; and
 Total fixed costs
Cost-Volume-Profit Analysis: Assumptions

Notes
The following are the basic assumptions of Cost-Volume-Profit analysis:

 All costs can be classified into Fixed cost and Variable cost.
 Revenue and cost functions are linear.
 Fixed costs, Selling Price and Variable cost per unit are known and constant.
 The sales mix is assumed to remain constant if more than one product is sold.
 The time value of money is ignored.
Cost-Volume-Profit Analysis: Objectives
The following are the objectives of Cost-Volume-Profit analysis:
 To forecast profit accurately.
 To set flexible budgets which indicate costs at various levels of activity.
 To assist in performance evaluation for control.
 To assist in formulating pricing policies.
 To know the amount of overhead costs that could be charged to product costs at various
operations levels.
Cost-Volume-Profit Analysis: Uses
 It helps in forecasting costs and profits as a result of a volume change.
 It helps fix a sales volume level to earn or cover a given revenue, return on capital
employed, or dividend rate.
 It assists in the determination of the effect of change in volume due to plant expansion or
acceptance of an order, with or without an increase in costs.
 It helps in determining the relative profitability of each product, line, project, or profit
plan.
 It assists in making an inter-firm comparison of profitability.
 It helps assess cash requirements at a desired volume of output with the help of cash
break-even charts.
Cost-Volume-Profit Analysis: Applications
Cost-Volume-Profit analysis helps the management to undertake the following decisions:
1. Profit planning
2. Evaluation of Performance
3. Make or Buy Decisions
4. Closure of a Department or Discontinuance of a Product
5. Maintaining a Desired Level of Profit
6. Offering Quotations
7. Accepting an Offer or Exporting below Normal Price
8. Alternative Use of Production Facilities
9. Problem of Key Factor
10. Selection of a Suitable Product Mix
Elements of CVP Analysis
The following are the critical elements of CVP analysis:
 Marginal cost equation
 Contribution Margin
 Profit-Volume Ratio

Notes
 Break-even point
 Margin of Safety
Marginal cost equation
As er know, Sales – Cost = Profit
or Sales – (Fixed cost + Variable Cost) = Profit
or Sales -Variable cost = Fixed Cost + Profit
It is known as the Marginal Cost Equation. We can convey it as under:
Sales – Variable cost = Fixed Cost + Profit

S–V=F+P
Contribution Margin
 It is the difference between Total Sales and Marginal cost/Variable Cost.
 It contributes towards fixed expenses and Profit.
Formulae:
a) Contribution = Total sales less Total variable costs
b) Contribution per unit = Selling price per unit less variable costs per unit
c) Contribution = Contribution per unit x number of units sold
d) Contribution = Fixed Cost + Profit
e) Contribution = Fixed Cost – Loss
Scenarios
1) Selling price containing profit:
Contribution = Fixed cost + Profit
2) Selling price at a cost:
Contribution = Fixed cost
3) Selling price at Loss:
Contribution = Fixed cost - Loss
Example:
Romeo disks manufacture one particular type of disk. It has provided you with the following
essential information, calculate Contribution per unit and Total Contribution.
Selling price per unit ₹30
Variable cost per unit ₹18
Units sold 15,000
Solution:
Contribution (in units) = Selling Price per unit – Variable Cost per unit
= ₹(30 - 18)
= ₹12
Total Contribution = Contribution per unit x Units sold
= ₹12*15000
= ₹1,80,000

Notes
Example:
Mango candies makes and sells a special type of Mango candy for kids. It has provided with you
the following information, Calculate Profit.
Contribution = ₹1,80,000
Fixed Cost = ₹1,16,000
Solution:
Profit = Contribution – Fixed Cost
= ₹1,80,000 - ₹1,16,000
= ₹64,000
Profit-Volume Ratio/ P/V Ratio
The ratio or percentage of contribution margin to sales is known as the P/V ratio. This ratio is
known as marginal income ratio, contribution to sales ratio, or variable profit ratio. P/V ratio,
usually expressed as a percentage, is the rate at which profits increase with the increase in volume.
It is used for studying the profitability of operations of the business.
P/V ratio = Marginal contribution/Sales
Or
Sales value - Variable cost/Sales value
Or
1 - Variable cost/Sales value
Or
Fixed cost + Profit/Sales value
Use of P/V ratio
 A comparison of P/V ratios of different products can be made to determine which product
is more profitable.
 The higher the P/V ratio, the more the profit will be, and the lower the P/V ratio, the
lesser the profit.
How can the P/V ratio be improved?
P/V ratio can be improved by:
(i) Increasing the selling price per unit.
(ii) Reducing direct and variable costs by effectively utilizing men, machines, and materials.
(iii) Switching the production to more profitable products showing a higher P/V ratio
Example:
Bob, the sugar candy seller, has provided you with the following information. You are required to
calculate P/V Ratio and Variable Cost from the same.
Contribution per unit ₹18
Solution:
P/V Ratio = (Contribution/Sales)*100
= (₹18/₹30)*100
= 60%
Variable Cost per unit= S.P-Contribution

Notes
= ₹30- ₹18
= ₹12
Variable Cost Ratio = 100-P/V Ratio
= 100-60
= 40%
Hence, V.C = 40%*S.P
= 40%*30 = ₹12
Break-even point
The break-even point in any business is that point at which the volume of sales or revenues exactly
equals total expenses or the point at which there is neither a profit nor loss under varying levels of
activity
 Point where Total sales = Total costs
 Point of No Profit and No Loss
 At this point, contribution = Fixed costs
Break-even Analysis
Break-even analysis examines the relationship between the firm's total revenue, total costs, and
total profits at various output levels. It is used to determine the sales volume required for the firm
to break even and the total profits and losses at other sales levels. The point at which total fixed and
variable costs are equal to total revenues is known as the break-even point. At the break-even point,
a business does not make a profit or loss. Therefore, the break-even point is often referred to as the
"no-profit" or "no-loss point."
The break-even analysis is essential to business owners and managers in determining how many
units (or revenues) are needed to cover fixed and variable expenses of the business.
A break-even analysis indicates at what level cost and revenue are in equilibrium.
- Martz, Curry, and Frank
Formulae:
a) Break-even point (in units)
b) Break-even point (in rupees)
Application of Break-even analysis

Break-even analysis is a very generalized approach for dealing with various questions associated
with profit planning and forecasting. Some of the essential practical applications of Break-even
analysis are:
a) What happens to overall profitability when a new product is introduced?
b) What level of sales is needed to cover all costs and to earn the desired rate of return?
c) What happens to overall profitability if a company purchases new capital equipment or
incurs higher or lower fixed or variable costs?
d) What happens to revenues and costs if the price of one of a company's products is
changed?
e) What are the revenue and cost implications of changing the process of production?
f) Between two alternative investments, which one offers the higher margin of profit
(safety)?
g) Should one make, buy or lease capital equipment?

Notes
h) It helps to determine the remaining/unused capacity of the company once break-even is

reached. It will help to show the maximum profit on a particular product/service that can
be generated.
i) It helps determine the impact on profit on changing automation from manual (a fixed cost
replaces a variable cost).
j) It helps to determine the change in profits if the price of a product is altered.
k) It helps to determine the amount of losses that could be sustained if there is a sales
downturn.
When is Break-even analysis used?
• Starting a new business
• Creating a new product
• Changing the business model
Starting a new business: To start a new business, a break-even analysis is a must. It helps decide
whether the idea of starting a new business is viable, but it will force the startup to be realistic
about the costs and provide a basis for the pricing strategy.
Creating a new product: In an existing business, the company should still perform a break-even
analysis before launching a new product—particularly if such a product will add a significant
expenditure.
Changing the business model: If the company is about to change the business model, like,
switching from wholesale business to retail business, then a break-even analysis must be
performed. The costs could vary considerably, and a break-even analysis will help in setting the
selling price.
Graphical Presentation of Break-even analysis
The following figure is showing the graphical presentation of the Break-even point.
In the above figure, total revenues and total costs are plotted on the vertical axis, whereas output or
sales per period are plotted on the horizontal axis. The slope of the TR curve refers to the constant
price at which the firm can sell its output. The TC curve indicates Total Fixed Costs (TFC) (The
vertical intercept) and a constant average variable cost (the slope of the TC curve). This is often the
case for many firms for small changes in output or sales. The firm breaks even (with TR=TC) at Q1
(point B in the figure) and incurs losses at smaller outputs while earning profits at higher output
levels.
Caution

Notes
Where the total cost line cuts the revenue line, that point turns into a Break-even point. At the
Break-even point, the company will neither incur loss nor earn profit.
Interpretation of Break-even Analysis

 Profit when Revenue > Total Variable cost + Total Fixed cost
 Break-even point when Revenue = Total Variable cost + Total Fixed cost
 Loss when Revenue < Total Variable cost + Total Fixed cost
Example:
From the following information, calculate break – even point in units and in rupees:
Output = 3000 units
Selling price per unit = ₹30
Variable price per unit = ₹20
Total fixed cost = ₹20000
Solution:
B.E.P (in units) = Total Fixed Cost/Contribution per unit
= 20000/10
= 2000 units
B.E.P (in ₹) = Total Fixed Cost/P/V Ratio
= 20000/33.33%
= ₹60,000
or
Break Even Sales X S.P/unit = 2000*30= ₹60,000
Example:
The sales and profit are given for two years:
Year Sales (₹) Profit (₹)
2019 1,40,000 15,000
2020 1,60,000 20,000
You are required to calculate :

a) P/V Ratio
b) Sales required to earn the profit of ₹40,000
c) Profit when sales are ₹120,000
Solution:
a) P/V Ratio
= (Change in Profit/Change in Sales)*100
= (5000/20000)*100
= 25%
b) Sales required to earn the profit of ₹40,000

Notes
Contribution = Sales*P/V ratio

= 1,60,000*25%
= ₹40000
Fixed Cost = Contribution - Profit
= 40,000-20,000 = ₹20,000
Desired Sales = (20,000+40,000)/25% = ₹2,40,000
c) Profit when sales are ₹1,20,000
Contribution = ₹1,20,000 x25%
= ₹30,000
Profit = Contribution – Fixed Cost
= ₹30,000 - ₹20,000 (calculated before)
= ₹10,000
Margin of Safety
The margin of safety is the difference between the actual sales and Break-even sales. Sales beyond
break-even volume bring in profits. Such sales represent a margin of safety. It is calculated as
follows:
a) Total Sales – Break-even sales
b)
c) × 100
The margin of safety may be improved by taking the following steps:

a) By lowering fixed costs.
b) By decreasing the variable costs to improve marginal contribution.
c) By increasing the volume of sales, if there is unused capacity.
d) By increasing the selling price, if market conditions permit, and
e) By changing the product mix to improve contribution.
Example:
From the following information, calculate:
Margin of safety
Particulars Amount (₹)
Total sales 360,000
Selling price per unit 100
Variable price per unit 50

Notes
Fixed cost 100,000
Solution:
Break Even Sales = 1,00,000/50 = 2000 units
Break Even sales (₹) = 2000*100= ₹2,00,000
Margin of Safety (₹) = Actual sales-Break even sales
= ₹3,60,000-₹2,00,000
= ₹1,60,000
Case Study
A Case Study on A Re-look at Break-Even Analysis
M/s Innovative Ventures Private Limited (a manufacturing company) currently manufactures
various products, and their product portfolio essentially comprises cosmetics and toiletries.
Their products particularly appeal to a select group of quality-conscious customers in the high-
income category. The superior quality of their products had been instrumental in positioning
their company as a dominant market player so far as their current product range is concerned.
Over the years, the said company had successfully applied a simple yet effective business model
which involves the following steps:
(a) Conduct a detailed market survey to identify the "gaps" that exist in the cosmetics and
toiletries sector coupled with a detailed analysis of prospective future demand that may emerge
in case such "gap" is addressed
(b) Innovate, design, develop & launch a product that would fulfill such "gap."
(c) Swiftly capture the market comprising target customers through aggressive advertising and
marketing clout.
Such marketing and operating strategies had proved to be highly influential over the years. The
same had been appropriately reflected in terms of impressive growth in the company's top line,
bottom line, and operating cash flows.
However, of late, the last two product launches failed to fetch the desired results. In fact, the
company had experienced adverse impact on their bottom line and operating cash flow
performances in these two instances. Naturally, these two product launches involved a
substantial quantum of initial investments, and the final outcome could not justify the
productivity of such investments. The company had undertaken a post mortem analysis of such
failures and tried its level best to identify the root causes that culminated in such dismal
performances. Such a post mortem study essentially hinted at the wrong estimation of
prospective future demand and the inability to visualize and mitigate a few operational risks
inherent in such investment options as the primary reasons for failure. Having burned their
fingers with these two product launch experiences, the company's senior management had
consciously decided to be more cautious in respect of future product launches.
Currently, Mr. Dasgupta (the company's CEO) is toying with another fresh proposal of a product
launch that essentially appears very attractive at first glance. However, he had already learned
from his past experiences that an investment proposal that looks very "rosy" at the inception
stage might result in disastrous consequences as well. Moreover, by this time, Mr. Dasgupta also
understands and appreciates that once a capital investment fails to deliver the desired results
and the venture translates into failure—the exit options become pretty limited, which in turn
magnifies the monetary losses making the situation even worse than anticipated.
Mr. Dasgupta distinctly recalls that the failure of the previous two product launches was
essentially attributed to the "over-estimation" of product prospects in terms of their market
demand, revenue and profit generation possibilities, etc. Because of the same, Mr. Dasgupta
contacted Ms. Bose (the Finance Manager) and requested her to develop a "worst-case" scenario
regarding the fresh proposal about the new product launch in consultation with the Production
and Marketing Divisions of the company. He had also clarified (to her) that this "worst-case"
scenario is required to counter the "overestimation" phenomenon that had occurred in the

Notes
previous two product launch circumstances that had adversely affected the final outcome. Ms.
Bose had since worked on the said proposal and developed such "worst-case" scenario (as per
the advice of the CEO) in consultation with the concerned personnel of various departments of
the company and her estimations are provided in Exhibit I (enclosed) for ready reference.
Mr. Dasgupta studied the "worst-case" scenario as developed by Ms. Bose (in-depth). He
commented that it appears that she had missed out on the "working capital investments" aspect
that may be specifically required in the instant case. However, Ms. Bose opined that the
"working capital investments" that may be specifically attributable to the case under review
might be regarded as "negligible" due to the following reasons:
(a) As the company intends to operate on a "cash and carry" basis so far as this new product is
concerned, the investment in debtors may be ignored altogether.
(b) So far as this new product is concerned, the production schedule would only be developed
based on orders received from prospective customers and, hence, the investments in finished
goods inventory would be negligible as well.
(c) Moreover, the raw material required for producing this new product is readily available from
suppliers. Hence, lead time in delivering raw material is not a crucial consideration in the instant
case. Therefore, the company would operate the "just-in-time" model so far as raw material
inventory management issues are concerned. Hence, there is no need to provide for investments
in raw material inventory in the proposal under review.
Mr. Dasgupta was pretty impressed (instead, convinced) with the arguments provided by Ms.
Bose, and they both agreed that the crucial parameter that needs to be thoroughly examined
before going ahead with the said product launch happens to be the "minimum average annual
market demand" of this new product. Thus, naturally, the next assignment to be undertaken is a
detailed market survey/demand analysis exercise to assess the prospective future demand of
such a new product in the market.
Ms. Bose commented that while the marketing team undertakes such market survey/demand
analysis assignment, she would simultaneously undertake a simple exercise of computing the
"break-even point (in units)" based on the "worst-case" financial estimates as already developed
by her. She explained that if the outcome of the market survey report finally suggests that the
"average annual market demand" of the product would exceed the "break-even level" (to be
computed by her, shortly) comfortably, the product launch (as currently being contemplated by
the CEO) is bound to succeed. Mr. Dasgupta naturally saw a lot of merit in the approach
suggested by Ms. Bose and requested her to undertake such a "break-even analysis" exercise. He
agreed that this exercise might aid in visualizing and ascertaining the crucial operating risk
exposure of the proposal under review.
Ms. Bose had since conducted a simple break-even analysis (based on the "worst-case" financial
estimates) and generated the "break-even" information as well. Such "break-even analysis" is
provided in Exhibit II (enclosed) for ready reference. Once Mr. Dasgupta observed that the new
product would break even at average annual demand of 7 lakh units, he instructed his
marketing team to undertake a detailed market survey/demand analysis exercise. He
specifically requested their team to spell out the minimum anticipated annual demand of the
product under a "worst-case scenario" as well. The marketing team duly conducted the market
survey, and critical information obtained from their report is provided as :
(a) Average Annual Market Demand would range between 9 to 10 lakhs units
(b) Even in the "worst-case scenario," annual demand would amount to 8 lakh units
Mr. Dasgupta was pleased with the outcome of the market survey report because he realized
that the new product launch is sure to succeed.
The evening before he was officially expected to give clearance to the new product launch
proposal, a relieved Mr. Dasgupta was attending an informal get-together where he happened to
meet one
Mr. Basak is a renowned freelance financial consultant by profession. In the conversation, Mr.
Dasgupta cited the above case facts to Mr. Basak while clarifying how he tried to visualize,
ascertain and address the risk exposure of a real-life project. The case facts naturally interested
Mr. Basak, and fortunately, Mr. Dasgupta still had the papers available with him in his attaché
case, which he readily shared with Mr. Basak. Mr. Basak studied the case related documents for

Notes
half an hour or so and commented:

"Mr. Dasgupta, I suggest that you give a second thought before clearing the proposal tomorrow
morning. Since you and your entire team had heavily stressed the worst-case scenario while
evaluating the proposal, I guess that possibility of such a scenario emerging may not be ruled
out altogether. I can tell you one thing for sure. In such a worst-case scenario, your project won't
break even at 7 lakh Units at all.
A conceptual limitation characterizes the break-even analysis conducted by your finance
manager because it happens to ignore one crucial—yet significant—"cost" concerning the project
under review. Therefore, the break-even figure of 7 lakh Units that your finance manager had
arrived at has distorted the reality. As per my guess, the actual break-even for this project (under
the worst-case scenario) is far higher than 7 lakh Units. Such break-even would exceed the
minimum market demand of 8 lakh units of the new product (under the worst-case scenario) as
captured in your market survey report."
List of Review Questions
(a) Do you agree with Mr. Basak that the break-even of 7 lakh Units as arrived at by the finance
manager depicts distorted reality?
(b) In case you agree with the views expressed by Mr. Basak, please clarify the conceptual
limitation that the break-even analysis is given in Exhibit II suffers from.
(c) Mr. Basak had also commented that the break-even analysis provided in Exhibit II actually
ignores one crucial—yet significant—"cost" concerning the project. What "cost" is he referring to?
(d) Suggest an alternative method of arriving at a more reliable break-even number and compute
such break-even sales (in units).
Exhibit I: New Product Launch—The Proposal (The "Worst-Case" Scenario— Estimated
Financials)
Capital Investment Required ₹20 Crores
Useful Life of the Capital Asset (Estimated Salvage Value—

ZERO) 10 Years
Depreciation Policy (As would be allowed by IT Authorities in the

instant case) Straight Line
Effective Tax Rate 35%
Mode of Financing of the above capital I investment Internal Accruals
Expected Returns of Equity Investors 18%
Selling Price Per Unit of this new product (Minimum) ₹500
Variable Cost Per Unit (Maximum) ₹400
Attributable Annual Fixed Cost—Other than Depreciation

(Maximum) ₹5 Crores
Subject to Market
Annual Average Market Demand of this New Product (In Units) Survey
Exhibit II: New Product Launch—Break-Even (Based on the "Worst-Case" Estimated Scenario)
Level of Operation— New

Product

Notes
4 lakh 7 lakh 9 lakh

units (₹ units (₹ units (₹
Details lakhs) lakhs) lakhs)
Revenue (@ ₹500) 2000 3500 4500
Variable Cost (@ ₹400) (1200) (2800) (3600)
Contribution 400 700 900
Attributable Fixed Costs (500) (500) (500)
Depreciation Charges (200) (200) (200)
Profit Before Tax (PBT) (300) 0 200
(Tax Charge)/Tax Savings 105 0 (70)
Profit After Tax (PAT) (195) 0 130
BE Level
Break-even Sales (in units) 7 lakhs units
Break-even Sales (in ₹) ₹3500 lakhs
Source: https://icmai.in/Knowledge-Bank/upload/case-study/2012/Case-Study.pdf
Summary
 Marginal costing is one of the essential tools of management to make decisions and fix an
appropriate price and assess the level of profitability.
 Marginal cost refers to a change that occurred in the total cost due to a slight change in the
quantity produced.
 The cost-volume-profit analysis is a tool to show the relationship between various
ingredients of profit planning.
 The crucial step in this analysis is the determination of the break-even point.
 BEP is defined as the sales level at which the total revenue equals total cost.
Keywords
Break-even Point (in units): The number of units sold at which the firm neither incurs a loss nor
earns a profit.
Break-even Point (in Volume): The level of sales in Rupees at which the firm neither incurs a loss
nor earns a profit.
Contribution: It is an amount of balance available after the deduction of variable cost from the
sales.
CVP analysis: It establishes the relationship between costs, the volume of production/sales &
profits. It shows how operating income changes with changes in output level, selling prices,
variable costs, or fixed costs.
Marginal Cost: Change occurred in the cost of operations due to a change in production level.
Margin of Safety: It is the difference between actual sales and break-even sales.

Notes
PV Ratio: It shows the relation between the contribution and sales. It can be calculated in absolute
terms or percentage.
SelfAssessment
1. CVP analysis establishes the relationship between:
A. Cost, Volume, and Profit
B. Cost, Value, and Profit
C. Cost, Volume, and Production
D. Cost, value, and Production
2. CVP analysis shows how operating income changes with changes in:
A. Output level
B. Selling prices
C. Variable costs, or fixed costs
D. All of above
3. The following is/are the assumption of CVP analysis:

A. All costs cannot be classified into Fixed cost and Variable cost.
B. Revenue and cost functions are non-linear.
C. Fixed costs, Selling Price and Variable cost per unit are known and constant.
D. Time Value of money is considered.
4. The following is not considered as the assumption of CVP analysis:

A. All costs can be classified into Fixed cost and Variable cost.
B. Revenue and cost functions are non-linear.
C. Fixed costs, Selling Price and Variable cost per unit are known and constant.
D. The sales mix is assumed to remain constant if more than one product is sold.
5. The following is/are the objective/s of CVP analysis:

A. To assist in formulating pricing policies.
B. To set flexible budgets which indicate costs at various levels of activity.
C. To assist in performance evaluation for control.
D. All of above
6. Bread Basket has started a business venture of making and selling loaves of bread in
Amritsar. It has incurred ₹ 1,00,000 as a fixed cost and ₹ 3,00,000 as the variable cost to
manufacture various types of bread in different quantities. The owner of Bread Basket is not
getting the financial position of his venture. Suggest him when his business will be reaching
its Break even.
A. When its revenue will equate to Fixed cost
B. When its revenue will equate to variable cost
C. When its revenue will equate to Total Cost

Notes
D. When its revenue will equate to Contribution
7. Loaf King has started a business venture of making and selling loaves of bread in Phagwara.
It has incurred ₹ 2,00,000 as a fixed cost and ₹ 5,00,000 as a variable cost to manufacture
various types of bread in different quantities. The owner of Loaf King is not getting the
financial position of his venture. Suggest him when his business will be reaching its Break
even.
A. When its revenue will be ₹2,00,000
B. When its revenue will be ₹5,00,000
C. When its revenue will be ₹7,00,000
D. When its revenue will be ₹3,75,000
8. The following is the correct Marginal cost Equation:

A. Sales – Variable Cost = Fixed Cost + Profit
B. Sales + Variable Cost = Fixed Cost – Profit
C. Sales + Variable Cost = Fixed Cost + Profit
D. Sales – Variable Cost = Fixed Cost + Loss
9. What will be the contribution per unit if the Selling price per unit ₹35, Variable cost per unit
₹15, and Fixed cost per unit ₹5?
A. ₹20
B. ₹15
C. ₹30
D. ₹35
10. P/V ratio can be improved by:

A. Decreasing the selling price per unit.
B. Increasing direct and variable costs by effectively utilizing men, machines, and materials.
C. Switching the production to more profitable products showing a higher P/V ratio
D. All of above
11. From the following information, calculate the break-even point in units: Output = 2000 units,
Selling price per unit = ₹40, Variable price per unit = ₹30, Total fixed cost = ₹20000
A. 2000 units
B. 1000 units
C. 3000 units
D. 1500 units
12. The margin of safety may be improved by taking the following step/s:
A. Increasing Fixed cost
B. Increasing Variable cost
C. Increasing Volume of Sales
D. Decreasing the selling Price

Notes
13. A company will be earning Profit when

A. Revenue > Total Variable cost + Total Fixed cost
B. Revenue = Total Variable cost + Total Fixed cost
C. Revenue < Total Variable cost + Total Fixed cost
D. Revenue < Total Variable cost – Total Fixed cost
14. Higher the P/V ratio of a product signifies:

A. More is the Profit per product
B. Less is the Profit per product
C. More is the Cost per product
D. More is the Volume per product
15. When Contribution = ₹ 2,80,000, Variable Cost = ₹ 1,80,000 and Fixed Cost = ₹ 2,16,000,
What will be Profit?
A. ₹64,000
B. ₹1,00,000
C. ₹36,000
D. ₹72,000

1. A 2. D 3. C 4. B 5. D
6. C 7. C 8. A 9. A 10. C
11. A 12. C 13. A 14. A 15. A
Review Questions
1. Illustrate the interrelation of Cost, Volume, and Profit through CVP analysis.
2. List the assumption of CVP analysis.
3. Explain the use and application of CVP analysis.
4. Explain the components of CVP analysis.
5. What is a break-even point? Give the assumptions and use of break-even analysis.
6. Explain the following terms:
a) Contribution
b) P/V ratio
c) Margin of Safety
7. Illustrate the graphic approach of BEP analysis.
8. M/S Sumitra ltd, has provided you with the following details.
Selling Price ₹125 per unit

Notes
Variable cost ₹50 per unit

Fixed Cost ₹500000
The number of units sold during the year was 14000.
You are required to calculate:
a) Contribution
b) P/V ratio
c) Break-even point in units
d) Break-even point in rupees
e) Margin of Safety in units
f) Margin of Safety in rupees.
g) Selling price per unit if break-even point is 18000 units.
8. Calculate variable cost and profit from the following information:
Sales 8000 units @ ₹10 per unit
Break-even sales 3000 units
Fixed Cost ₹6000
9. The following data is given:
Sales ₹800000
Variable Cost ₹480000
Fixed Cost ₹120000
Calculate:
a) Break-even point
b) New break-even point if the selling price is reduced by 10%
c) New break-even point if the variable cost is increased by 10%
d) New break-even point if the fixed cost is increased to ₹150000
10. The following information is given:
Sales = ₹2,00,000
Variable Cost = ₹1,20,000
Fixed Cost = ₹30,000
Calculate:
a) Break-even point
b) Margin of safety
11. The sales and Profit during last two years are given below:
Sales (₹) Profit (₹)
Year 2019 20,00,000 2,00,000
Year 2020 30,00,000 4,00,000
The fixed cost is ₹2,00,000. It remained the same in both years
Calculate
a) Break-even Point
b) Sales required to earn a profit of ₹5,00,000
12. Camay Soap ltd. made sales of ₹1,50,000 that produced a profit of ₹4,000 in 2020. It was able
to earn sales of ₹1,90,000 and a profit of ₹12,000 in 2021. Determine the BEP for Camay Soap ltd.

Notes
13. There are two businesses, Dull ltd. and Youth ltd., selling identical products in the market. The
following are the budget figures related to a particular year.
Dull ltd. Youth ltd.
Sales 5 lakh 5 lakh
Variable cost 4 lakh 3.5 lakh
Fixed cots 0.5 lakh 1 lakh
Profit 0.5 lakh 0.5 lakh
You are requested to calculate BEP for the two businesses.
14. Mokash Pvt. Ltd. produces a simple article and sells it at 100 each. The cost of production is ₹
60 per unit and the fixed cost ₹40,000 per annum. Calculate:
(a) P.V(ratio)
(b) BEP (sales)
(c) Sales to earn a profit of ₹50,000
(d) Profit at a sale of ₹3,00,000
(e) New BEP when the Selling price is reduced by 10%
Further Readings
Hill Education.
University Press.
Web Links
 https://saylordotorg.github.io/text_managerial-accounting/s10-how-is-cost-
volume-profit-anal.html
 https://efinancemanagement.com/financial-analysis/cost-volume-profit-
analysis
 https://www.iedunote.com/cost-volume-profit-analysis
 https://researchleap.com/cost-volume-profit-analysis-decision-making-
manufacturing-industries-nigeria/
 https://corporatefinanceinstitute.com/resources/knowledge/modeling/brea
k-even-analysis/

Notes
Razia Sehdev, Lovely Professional University Unit 11: Decision Involving Alternative Choices
Unit 11: Decision Involving Alternative Choices

CONTENTS
Objectives
Introduction
11.1 Concept and Steps involved in Decision Making
11.2 Profit Planning
11.3 Key Factor
11.4 Determination of Sales Mix
11.5 Make or Buy decision
11.6 Exploration of New Markets
11.7 Continue or Discontinue a Product Line
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 explain the concept of decision making.
 discuss the various decisions that can be made through CVP analysis.
 assess the selling price per product or total sales to earn desired profit.
 compose a maximum profitable sales mix through CVP analysis.
 devise make or buy decisions and sales mix decisions when a key factor is given.
 devise decisions related to exploring new markets, continue or discontinue a product line,
make or buy decisions, and sales mix to maximize overall business profits.
Introduction
The need for decision making arises in business because a manager is faced with a problem and
alternative courses of action are available. A manager has to take different decisions like making or
buying, continuing or shutting down, deciding about the sales mix,etc., to make the maximum
profit. In deciding which option to choose, he will need all the information relevant to his decision;
he must have some criterion based on which he can choose the best alternative. Some of the factors
affecting the decision may not be expressed in monetary value. Hence, the manager will have to
make 'qualitative' judgements, e.g., deciding which of two personnel should be promoted to a
managerial position. A 'quantitative' decision, on the other hand, is possible when the various
factors, and relationships between them, are measurable.

Notes
11.1 Concept and Steps involved in Decision Making

The marginal cost helps management to make a decision involving consideration of cost and
revenue. Marginal costing furnishes information regarding additional costs to be incurred if an
additional activity is to be taken up or the saving in costs expected if an activity is given up. It can
be compared with the benefit expected from the proposed course of action, and thus the
management will be able to take the appropriate decision.
Decision-making describes the process by which a course of action is selected as the way to deal
with a specific problem. A decision involves the act of choice and the alternative chosen out of the
available alternatives.
"Decision-making is defined as the selection of a course of action from among alternatives."
- According to Heinz Weihrich and Horold Koontz
"Decision-making is a course of action which is consciously chosen for achieving the desired
results."
- Haynes and Masie
"Decision-making is the selection based on some criteria from two or more possible alternatives."
- George R. Terry
Following are the essential areas of decision-making or applications of marginal costing:
1. Profit Planning
2. Key factor
3. Determination of Sales mix
4. Make or buy decisions
5. Exploration of new markets
6. Continue or Discontinue a product line
7. Fixation of Price,
8. Decision to Accept a Bulk Order,
9. Closure of a Department or Discontinuing a Product,
10. Evaluation of Performance, and
11. Alternative course of action.
11.2 Profit Planning

Profit planning is an important management activity. It is concerned with maximising profit. Profit
planning necessitates management's understanding of the interrelationships between selling prices,
sales volume, variable costs, and fixed expenses. Through the cost-volume-profit analysis approach,
marginal costing assists management in determining the profit position at different stages of
operation. As a result, management may organise its activities at the optimal level to maximise
revenues.
Even management may be interested in preserving a certain level of profitability. The marginal
costing approach helps determine the amount of sales required to achieve the target level of
profitability.
Example
By making and selling 60,000 pieces, or 60 percent of the maximum capacity, a toy maker achieves
an average net profit of $2.50 per piece on a selling price of $14.30.His cost of sales is:

Notes
He estimates that his fixed costs will grow by 10% this year, while direct material and direct labour
prices would climb by 6% and 8%, respectively. However, he is unable to raise the selling price. In
this circumstance, he receives an offer for an order equivalent to 20% of his capacity. The worried
consumer is unique.
What is the minimal profit you propose for acceptance in order to guarantee the manufacturer a
total profit of $1,67,300?
Solution:
Example

Notes
Solution:
Total number of units to be made and sold to earn a contribution of ₹35,00,000

= Total Contribution/Contribution per unit
= ₹35,00,000/10 = 3,50,000 units

Notes
11.3 Key Factor

A critical factor is the component that limits a company's output and profit. Typically, sales are the
limiting issue. A company may be unable to sell as much as it produces. However, a company may
be able to sell all it produces, but output is restricted owing to a lack of supplies, labour, plant
capacity, or money.
In such a circumstance, a decision must be made about the product whose production should be
expanded, decreased, or discontinued. When there is no limiting constraint, the product with the
greatest P/V ratio is usually chosen.
When resources are few or restricted, the product will be chosen based on the contribution per unit
of a scarce component of production. In summary, restricted resources should be directed in
directions that maximise contribution per unit of limited resources.
Aside from manufacturing constraints, limiting considerations may include difficulties in
marketing the things produced. In this situation, the ordering of things produced will be
determined by the relative contribution per unit of the limiting factor of production. Nonetheless,
the number of units produced for a product receiving rank one will be limited to the number of
units per demand for that product. The manufacture of the second-ranked product will then begin,
but will be limited to sales demand if the balance of limiting factors is available.
Example
A company manufactures three products. The budgeted quantity, selling prices and unit cost are as
follows:
A B C
(₹) (₹) (₹)
Raw Materials (@ ₹20 per kg) 80 40 20
Direct Wages (@ ₹5 per kg) 5 15 10

Notes
Variable overheads 10 30 20
Fixed overheads 9 22 18
Budgeted production (units) 6,400 3,200 2,400
Selling price per unit (in ₹) 140 120 90
Required:
i) Present a statement of budgeted profit.
ii) Set an optional productmix and determine the profit if the supply of raw materials is restricted to
18,400 kg.
Solution:
(i) Statement of Budgeted Profit
A B C Total (₹)
Budgeted production (units) 6400 3200 2400
Selling price (₹) 140 120 90
Sales 896000 384000 216000 1496000
Raw Materials 512000 128000 48000
Direct Wages 32000 48000 24000
Variable overhead 64000 96000 48000
Total variable cost 608000 272000 120000 1000000
Contribution 288000 112000 96000 496000
Less: Fixed Cost 57600 70400 43200 171200
Profit 324800
(ii) When raw material is the key factor
A B C
Raw material per unit of output 4 Kg 2 Kg 1 Kg
Total raw material consumed (Kg) 25600 6400 2400

Notes
Contribution per kg of raw material 11.25 17.5 40
III II I
11.4 Determination of Sales Mix

In the market, the various companies offer dealerships to the individual intermediaries in
promoting the sale of products. Before reaching an agreement with the company to act as a dealer,
usually, every individual considers the profitability of the product mix offered by the firm. For
example, two different companies brought forth their advertisements in offering the dealership to
the individual trading firms viz. HCL and IBM.
The profitability under the dealership banner should be appropriately considered before takinga
decision. To make a rational decision, the firm should compare the profitability of both different
dealerships of two different giant industrial brands. The greater the share of the profitability in
volume will be selected and vice-versa.
Example
Solution:

Notes
As Sales mix (iii) is most Profitable, thus it should be opted by company.
11.5 Make or Buy decision

The firms, which are routinely in need of spares, accessories are bought from the outsiders instead
of any production or manufacturing, though the requirement is at regular intervals. Most
automobile manufacturers usually buy the components from outside instead of producing them on
their own. The MarutiUdyog Ltd. had given a contract to the Nettur Technical Training
Foundation, Bangalore, to design the panel tool and manufacture it regularly to the tune of the
orders.
The leading four-wheeler manufacturer in India is buying the panel from the NTTF on a contract
basis instead of manufacturing.
Did u know? Why don't they manufacture despite buying them from the NTTF?
The main reason for buying is cheaper than the production of an article.
However, there are certain prices and non-cost aspects that must be considered before making a
final selection.
1. The purchased component should be accessible anytime it is required, and at the same price, we
consider purchasing it.
2. If there is a variation in quality, specifications, etc., the component to be purchased must be
workable.
3. Labor issues should not arise if production is not carried out. The excess labour force should be
put to constructive use.
Example
A T.V. manufacturing company finds that while it costs to make component X, the same is available
in the market at ₹5.75 each, with all assurance of continued supply. The breakdown of cost is:
₹(per unit)
Materials 2.75
Labour 1.75
Variable Overheads 0.5
Depreciation and other fixed cost 1.25
Total 6.25
Should the company make or buy the component?

What should be your decision if the supplier offered the component at ₹4.85 each?

Notes
Solution:
Marginal Cost per unit of Component X
Materials 2.75
Labour 1.75
Variable Overheads 0.5
Total Variable Cost 5.00
a) The aforementioned component costs $5.75 apiece to acquire. Assume the corporation has
spare capacity that cannot be filled with more lucrative employment. In such scenario, it is
suggested that the aforesaid component be made in-house since the marginal cost of 5.00
apiece is cheaper than the purchase cost of 5.75.
b) If the purchase cost is 4.85, which is less than the marginal cost of 5.00, it is advised that
the component be purchased from the provider, since this results in a 0.15 savings per
component. As much as feasible, the available surplus capacity may be used for other
reasons.
11.6 Exploration of New Markets

A choice to sell products in a new market (whether Indian or international) should be made after
taking the following aspects into account:
I Does the company have enough excess capacity to handle the additional demand?
(ii) What price does the new market offer? In any event, it should be more than the product's
variable cost plus any extra expenses paid to fulfil the special needs of the new market.
(iii) Will the selling of items in the new market have an impact on the current market for the goods?
It is especially true when items are sold in a foreign market at a cheaper price than in the home
market. Before approving such a foreign buyer's order, it must be ensured that the commodities
supplied are not dumped on the local market.
Example
Solution:

Notes
The offer should be accepted since it includes an extra $1,80,000 investment. Because fixed
expenditures have already been recovered from the local market, the overall profit will grow by
$1,80,000. Furthermore, orders from local customers should not be accepted at 36 per unit or at any
rate less than the typical price, i.e., 45, since this would result in a general decrease in the product's
selling prices.
Note: Acceptance of the new order should not result in production exceeding current capacity,
since this would significantly increase certain fixed expenditures. If there is a significant rise in
fixed expenditures, the whole increased cost should be evaluated in addition to the higher income.
11.7 Continue or Discontinue a Product Line

As previously stated, the marginal costing approach aids in determining a product's profitability. It
offers information that shows us how much each product contributes to fixed costs and profit; the
product or department that contributes the least should be removed, save for a limited time. If the
management selects a product from the available options, the products that contribute the most
should be picked, while those that contribute the least should be abandoned.
Before choosing to discontinue a product line, the following reasons should be considered:
(i) The product's contribution;
(ii) capacity utilisation
(iii) The product's availability to replace the product that the company wishes to discontinue and
that currently accounts for a large share of total capacity.
(iv) Long-term market prospects for the product.
(v) The impact on other goods sales. In rare situations, the discontinuation of one product may
result in a significant drop in sales of other items, hurting the firm's total profitability.
Example
A manufacturer has planned his level of operation at 50% of his plant capacity of 30,000 units. His
expenses are estimated as follows if 50% of the plant capacity is utilized:
Raw Materials 8,280
Direct Wages 11,160
Variable overheads 3,960
Fixed overheads irrespective of capacity utilization 6,000

Notes
The expected selling price in the domestic market is₹ 2 per unit. The manufacturer recently
received a trade enquiry from an overseas organization interested in purchasing 6,000 units at a
price of ₹1.45 per unit.
As a professional management accountant, what would be your suggestion regarding acceptance or
rejection of the offer? Support your suggestion with relevant quantitative information.
Solution:
Profitability Statement
15000 units
(For 6000 units Total
domestic (For (21000
sale) export) units)
Per Unit Per Unit

Total (₹) (₹) Total (₹) (₹) Total (₹)
Sales 30000 2 8700 1.45 38700
Raw Materials 8,280 0.552 3312 0.552 11592
Direct Wages 11,160 0.744 4464 0.744 15624
Variable overheads 3,960 0.264 1584 0.264 5544
Total Variable Cost 23,400 1.56 9360 1.56 32760
Contribution 6,600 0.44 -660 -0.110 5940
Less: Fixed Cost 6,000 6000
Profit/Loss 600 -60
The company should reject the offer as it givesan overall loss worth ₹60 to the company.
Summary
 The marginal costing technique helps determine the most profitable relationship between
costs, prices and volume of business.
 Following are the critical areas of decision-making or applications of marginal costing:
 Fixation of Price,
 The decision to Make or Buy,
 Selection of a Profitable Product Mix,
 The decision to Accept a Bulk Order,
 Closure of a Department or Discontinuing a Product,
 Maintaining a Desired Level of Profit, and
 Evaluation of Performance

Notes
Keywords
Self Assessment
1. An increase in fixed cost results in:
A. Increase in Margin of Safety
B. Increase in profit/volume ratio
C. Increase in the break-even point
D. Increase in contribution
2. Calculate Margin of Safety of Teddy Bar limited when its profit is ₹50,000; Contribution is ₹
70,000 and Sales are ₹7,00,000.
A. ₹7,00,000
B. ₹2,00,000
C. ₹5,00,000
D. ₹2,00,000
3. "Blackberry" has a P/V ratio of 20%. It can earn actual sales of ₹37,500. It has calculated its
Break Sales as ₹30,000. Calculate its variable cost.
A. ₹24,000
B. ₹30,000
C. ₹7,500
D. ₹6,000
4. Revlon ltd. has provided you with the following information about its one lipstick
brand,"Revlon Ultra HD Matte". Calculate the "Revlon Ultra HD Matte" break-even point.
Sales ₹2,00,000, Contribution ₹80,000, and Fixed Cost ₹30,000
A. ₹75,000
B. ₹50,000
C. ₹88,000
D. ₹82,500
5. Hero Cycle is in the business of manufacturing and selling Kids Cycles. Its sales were ₹
2,40,000, and Contribution was ₹ 60,000. It was able to earn a profit of ₹ 16,000. Calculate
Fixed Cost of Hero Cycle.
A. ₹22,000
B. ₹76,000

Notes
C. ₹44,000
D. ₹60,000
6. "Raymond" textile is selling its silk cloth per meter at ₹ 5,000. The Contribution margin per
meter is ₹1,000. Calculate Contribution margin ratio:
A. 12%
B. 20%
C. 5%
D. 15%
7. "Arvind Mills"sells its silk cloth per meter at ₹8,000. The Contribution margin per meter is ₹
2,000. Calculate Contribution margin ratio:
A. 75%
B. 25%
C. 20%
D. 40%
8. Calculate the Break-even Point of Hyundai Verna Ltd. when its Margin of Safety is 60%, and
Actual Sales are ₹15,0000.
A. ₹60,000
B. ₹90,000
C. ₹2,10,000
D. ₹1,50,000
9. Bikes Freek is in the business of manufacturing and selling Kids Cycles. Its sales were ₹
2,40,000 and ₹2,80,000 in 2019 and 2020 respectively. It was able to earn a profit of ₹16,000
and ₹26,000 in 2019 and 2020, respectively. Calculate Profit Volume ratio of Bikes Freek.
A. 40%
B. 25%
C. 6.67%
D. 9.28%
10. Calculate Margin of Safety of Hyundai Ltd. when its Break-even point is 60%, and Actual
Sales are ₹1,20,000.
A. ₹48,000
B. ₹72,000
C. ₹36,000
D. ₹1,20,000
11. Havmor ice cream parlour is making four types. It is using the same ingredients (material) to
make all four types of icecream. Identify which icecream should be given the least priority
for manufacturing if materials are in short supply from the following data:

Notes
Offerings Contribution per P/V ratio (in Contribution

scoop %) per Material
usage per
scoop
Blue Berry 15 5 7.5
Honey Almond 10 8 10
Fig Almond 20 10 5
Banana Roast 18 9 6
A. Blue Berry
B. Honey Almond
C. Fig Almond
D. Banana Roast
12. Starbucks at Jalandhar offers various types of coffees. Look at the data given below and
suggest manager which coffee should get produced and sold more to maximize profits from
business:
Coffee Types Contribution per Cup of Coffee Profit Volume Ratio

(in %)
Freshly Brewed ₹90 15

Coffee
Crème ₹115 14
Frappuccino
Expresso ₹80 16
Coffee ₹105 18
Frappuccino
A. Freshly Brewed Coffee

B. Crème Frappuccino
C. Expresso
D. Coffee Frappuccino
13. Café Coffee day Ludhiana has provided you with the following data. The manager is under
pressure to answer the owner of reduced profits from the business. Suggest to him with the
help of given data, what should be done to increase the Business profits.
Sales Mix Actual Daily Daily Potential Profit

(Components) production/Sales Demand (in Volume
Volume (in units) units) Ratio (in
%)
Café Americano 30 30 12
Café Frappe 24 24 15

Notes
Café Latte 18 30 24
A. Increasing the selling price of individual offerings

B. Reducing the variable cost
C. Reduce the fixed cost
D. Change the sales mix
14. Amul ice cream parlour is making four types. It is using the same ingredients (material) to
make all four types of icecream. Identify which icecream should be manufactured as per its
maximum demand if materials are in short supply from the following data:
Offerings Contribution per P/V ratio (in %) Material usage

scoop per scoop
Blue Berry 15 5 2
Honey Almond 10 8 1
Fig Almond 20 10 4
Banana Roast 18 9 3
A. Blue Berry
B. Honey Almond
C. Fig Almond
D. Banana Roast
15. Kissan Jam Ltd. offers four different products to its customers. Details (per unit) are set out
below:
Mixed Fruit Pineapple Mango Jam Orange Jam

Jam (₹) Jam (₹) (₹) (₹)
Selling Price 40 65 85 100
Variable (20) (30) (45) (70)

Costs
Fixed Cost (10) (10) (25) (25)
Machine 3 7 10 10
Hours
The business can make and sell as many of each product as is possible. However, machine
availability limits the ability of the business to produce the products. Which product should
the business produce to maximize profits?
A. Mixed Fruit Jam
B. Pineapple Jam
C. Mango Jam
D. Orange Jam

Notes
1. C 2. C 3. B 4. A 5. C
6. B 7. B 8. A 9. B 10. A
11. C 12. D 13. D 14. B 15. A
Review Questions
1. Souvenir Ltd. manufactures medals for winners of athletic events and other contests. Its
manufacturing plant can produce 10,000 medals each month. The company has current production
and sales level of 7,500 medals per month. The current domestic market price of the medal is ₹150.
The cost data for March 2020 is as under:
(₹)
Raw materials 2,62,500
Direct wages 3,00,000
Variable costs (that vary with number of batches):
Set-ups cost (160 batches x 500 per batch) 75,000
Fixed cost
Manufacturing cost 2,75,000
Marketing cost 1,75,000
Souvenir Ltd. has received a particular one-time only order for 2,500 medals at₹ 100 per medal.
Souvenir Ltd. makes medals for its existing customers in a batch size of 50 medals (150 batches x 50
medals per batch = 7,500 medals).
The particular order for 2,500 medals requires Souvenir Ltd. to manufacture the medals in 25
batches of 100 each. Should Souvenir Ltd. accept aparticular/special order?
2. The following is the trading summary of a manufacturing concern that makes two products, X
and Y.
Trading Summary
For the fourmonths 30th April 2013
X (₹) Y (₹) Total (₹)
Sales 10,000 4,000 14,000
Less: Cost of Sales

Notes
Direct Cost
Labour 3000 1000
Material 1500 4500 1000 2000 6500
Indirect Costs
Variable Expenses 2000 1000 3000
Fixed Expenses
Common to both X and Y 1250 1250 2500
Profit 2250 -250 2000
*These costs tend to vary in direct proportion to physical output.

** These costs tend to remain constant irrespective of the physical outputs of X and Y.
It has been the practice of the concern to allocate these costs equally between X and Y. The Board
has made the following proposals of Directors for your consideration as a financial adviser:
(i) Discontinue Product -Y.
(ii) As an alternative to (i), reduce the price of Y by 20 per cent. It is estimated that the
demand will then increase by 40 per cent.
Required:
Recommend the proposals to be taken after evaluating each of these two proposals.
3. A refrigerator manufacturer purchases a certain component @ ₹50 per unit. If he manufactures
the same product, he has to incur a fixed cost of ₹ 20,000, and the variable cost per unit is ₹40.
When can the manufacturer make it on his own, or when he can buy from outside?
When the requirement is ₹5,000 units, will you advise to make or buy?
4. The following particulars are obtained from costing records of a factory:
Per unit of Product A Per unit of Product B

Particulars (₹) (₹)
Direct Material ₹20 per Kg 80 320
Direct Labor @ ₹10 per hr 100 200
Variable overhead 40 80
Selling price 400 1000
Total fixed overheads ₹30,000
5. From the following data, which product would you recommend to be manufactured in a factory,
time is the key factor?
Per unit of Product A Per unit of Product B

Particulars (₹) (₹)
Direct Material 24 14

Notes
Direct Labor @ ₹1 per hr 2 3
Variable overhead ₹2 per hr 4 6
Selling price 100 110
The standard time to produce 2 hours 3 Hours
6. Examine the various kinds of managerial decisions.

7. A factory engaged in manufacturing plastic buckets works at 40% capacity and produces 10,000
buckets per annum.
The present cost break up for the bucket is as under
Material ₹10
Labour ₹3
Overheads ₹5(60% fixed)
The selling price is ₹20 per bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90% capacity, the
selling price falls by 5%, accompanied by a similar fall in material prices.
You are required to calculate the profit at 50% and 90% capacities and also calculate the break-even
point for the same capacity productions.
8. A confectioner of sweets markets three products, all of which require sugar. His average monthly
sales, cost of sales and sugar consumption are as follows:
Products X Y Z Total
Sales (₹) 10,000 12,000 8,000 30,000
Variable cost of sales

(₹) 6,000 8,000 5,600 19,600
Sugar needed (Kg.) 500 800 240 1,540
Due to government restrictions, his sugar quota has been reduced to 1,405 Kg, per month. Suggest
an appropriate product mix.
9. The management of a company findsfinds that
that while
while the
the cost
cost of
of making
making aa component
component part
part is
is ₹10, the
same is available in the market at ₹9 with an assurance of continuous supply. Suggest whether to
make or buy this part. Also, give your views in case the supplier reduces the price from ₹9 to ₹8.
The cost information is as follows:
Material ₹3.50
Direct labour ₹4.00
Other variable expenses ₹1.00
Fixed expenses ₹1.50
Total ₹10.00
Further Readings
1. Khan, M.Y., & Jain, P.K. (2017). Management Accounting, 7th Edition, McGraw Hill
Education.
2. Shah, Paresh. (2019). Financial Accounting for Management, 3rd Edition, Oxford

Notes
University Press.
3. Maheshwari, S.N., Maheshwari, Sharad. K., &Maheshwari, Suneel. K. (2018). A Textbook
of Accounting for Management, 4th Edition, Vikas Publishing House.
4. Gupta, Ambrish. (2018). Financial Accounting for Management: An Analytical
5. Goyal, V.K. (2010). Financial Accounting, 3rd Edition, Excel Books, New Delhi.
6. Lanen, N. William., Anderson, W. Shannon., & Mather, W. Michael. (2010)
7. Belverd E., Needles. Accounting for Decision Making, Cengage Learning.
Web Links
https://www.accountingnotes.net/cost-accounting/marginal-costing/11-main-areas-of-
marginal-costing-cost-accounting/6167
https://www.economicsdiscussion.net/cost-accounting/applications-of-marginal-
costing/31695
https://icmai.in/upload/Students/Syllabus2016/Archive/Inter/Paper-10.pdf
https://www.eirc-
icai.org/mybackoffice/background_Material/Marginal%20Costing%20&%20Others.pdf

Notes
Razia Sehdev, Lovely Professional University Unit #: Unit Name
Unit 12: Transfer Pricing
CONTENTS
Objectives
Introduction
12.1 Meaning and Importance
12.2 Advantages and Limitations
12.3 Methods of Calculating Transfer Price
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 explain the concept and purpose of transfer pricing.
 calculate transfer price as per the various methods of transfer pricing.
 review the methods of transfer pricing.
Introduction
Transfer pricing refers to the rules and methods for pricing transactions within and between
enterprises under common ownership or control in taxation and accounting. Tax authorities in
many countries can adjust intra-group transfer prices that differ from what would have been
charged by unrelated enterprises dealing at arm's length (the arm's-length principle) due to the
potential of cross-border controlled transactions to distort taxable income.
The OECD and World Bank suggest intra-group pricing rules based on the arms-length principle,
and 19 of the 20 members of the G20 have followed similar measures through bilateral treaties and
domestic regulations, legislation, or administrative practice.
Transfer pricing rules wherever adopted allow tax authorities to adjust prices for most cross-border
intra-group transactions, including transfers of tangible or intangible property, services, and loans.
In the present unit, meaning, importance, pros & cons, and transfer pricing methods are briefly
discussed.
Did You Know?

What is an Arm's Length Transaction?
An arm's length transaction, also known as the arm's length principle (ALP), indicates a transaction
between two independent parties in which both parties act in their own self-interest.Both buyer and
seller are independent, possess equal bargaining power, are not under pressure or duress from the
opposing party, and are acting in their own self-interest to attain the most beneficial deal.
Did You Know?

What is a related party Transaction?

Notes
It refers to a deal or arrangement between two parties joined by a preexisting business relationship
or common interest.Companies often seek business deals with parties with whom they are familiar
or have a common interest.
Although related-party transactions are legal, they may create conflicts of interest or lead to other
illegal situations.
12.1 Meaning and Importance

Transfer Pricing: Meaning
It is an accounting practice representing the price that one division in a company charges another
division for goods and services provided.
Transfer pricing allows for the establishment of prices for the goods and services exchanged
between divisions, departments, subsidiaries, affiliates, or commonly controlled companies that
are part of the same larger enterprise.
Transfer pricing can also be applied to intellectual property such as research, patents, and royalties.
Transfer Pricing and Tax Liabilities
Multinational companies (MNC) are legally allowed to use the transfer pricing method for
allocating earnings among their various subsidiary and affiliate companies that are part of
the parent organization. However, companies can also use (or misuse) this practice by altering their
taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that
companies can shift tax liabilities to low-cost tax jurisdictions.
Companies use inter-company transfer pricing to reduce the tax burden of the parent company.
Example
Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging
lower prices (increasing profits) for low-tax countries.
Ideal Transfer Pricing
The ideal transfer price allows each division manager to make decisions that maximize the
company's profit while attempting to maximize the division's profit.
Transactions subject to Transfer pricing
The following are some of the typical international transactions which are governed by the transfer
pricing rules:
 Sale of finished goods
 Purchase of raw material
 Purchase of fixed assets
 Sale or purchase of machinery etc.
 Sale or purchase of Intangibles
 Reimbursement of expenses paid/received
 IT-enabled services
 Support services
 Software Development services
 Technical Service fees
 Management fees
 Royalty fee
 Corporate Guarantee fees
 Loan received or paid

Notes
Unit #: Unit Name
Transfer Pricing: Purpose and Importance

 Performance evaluation of individual divisions, subsidiaries, associates: Transfer
pricing assists in generating separate profit for each division and enabling performance
evaluation of each division separately.
 Allocation of company's resources: Transfer prices would affect not just the reported
profitsof every centre but also affect the allocation of a company's resources (Cost incurred
by one centre will be considered the resources utilized by them).
Why do organizations need to understand Transfer Pricing?
 For Accounting and Reporting purpose
 For compliance requirements
 For Tax management
 For allocating revenues and expenses
For Accounting and Reporting purpose:
For management accounting and reporting, multinational companies (MNCs) have little discretion
while defining how to distribute the profits and expenses to the subsidiaries located in various
countries.
For compliance requirements:
A business having cross-border intercompany transactions must understand the transfer pricing
concept, particularly for the compliance requirements as per law, and eliminate the risks of non-
compliance.
For Tax management:
Most companies use transfer pricing to manage their tax liabilities. Companies use inter-company
transfer pricing to reduce the tax burden of the parent company.
For allocating revenues and expenses:
Sometimes, a company's subsidiary might be divided into segments or might be accounted for as a
standalone business. In these cases, transfer pricing helps allocate revenue and expenses to such
subsidiaries in the proper manner.
12.2 Advantages and Limitations

Transfer Pricing: Advantages
 Cost-saving for Departments
 Transparency
 Reducing Tax liabilities
Cost-saving for Departments
Transfer pricing results in cost savings as far departments are concerned because transfer price is
usually lower than the market price of the product, hence for example, if the multinational
company produces batteries as well as mobiles, then the mobile division can purchase batteries
from the battery division of the company resulting in cost savings for mobile division of the
company.
Transparency
It makes dealings between various departments transparent. In the absence of a transfer price
mechanism, departmental heads will charge prices arbitrarily, resulting in them exploiting the
department that needs the product and thus creating animosity between departments that, in the
long term, can cause irreversible damage to the company.
Reducing Tax liabilities

Notes
Using transfer pricing methods, companies reduce income taxes in countries with comparatively
high tax charges by overpricing goods they transfer to countries where they can leverage lower tax
rates. In this way, business entities successfully earn higher profit margins.
Transfer Pricing: Limitations
 Complicated Process
 Animosity between Departments
 Difficult to set transfer pricing policies for intangibles.
 Determining Arm's Length Price of Transactions.
Complicated Process
The most significant disadvantage of transfer price is that it is a complicated process. Unlike market
price determined by the demand and supply of the good transfer price, market forces alone rather
than many other variables come into play, making this process complicated and questionable.
Animosity between Departments
It can create an unnecessary rift between the departments because departments that supply goods
to other departments will feel that they are sacrificing their profit by not selling their products to
the market as market rates are higher than transfer price.
Animosity between Departments
In simple words, suppose you own a home. Due to some reason, for six months you have to give
that home on a rent to your relative or friend then you will be taking less rent than market rent, the
mechanism of transfer price is somewhat similar and hence can cause anger as well frustration in
the company.
Difficult to set transfer pricing policies for intangibles
To decide the right amount while determining the pricing policy for intangibles like services is a
daunting task.
Determining Arm's Length Price of Transactions
Sometimes, it is impossible to find uncontrolled independent transactions used to determine Arm's
Length Price, and it becomes practically impossible to decide on ALP.
12.3 Methods of Calculating Transfer Price

 Market-based Transfer Pricing
 Cost-based Transfer Pricing
 Negotiated Transfer Pricing
Market-Based Price
 When the outside market for the good is well-defined, competitive, and stable, firms
often use the market price as an upper bound for the transfer price
 Transfers are made based on Market price.
Applicable
When the outside market for the good is well-defined, active, competitive, and stable, firms often
use the market price as an upper bound for the transfer price
Concerns to Use Market Price
 When the outside market is neither competitive nor stable.
 If competitors are selling at distress prices or are engaged in any of a variety of "special"
pricing strategies (e.g., price discrimination, product tie-ins, or entry deterrence), internal
decision-making may be distorted.
 Reliance on market prices makes it difficult to protect "infant" segments.

Notes
Unit #: Unit Name
Cost-based Transfer Pricing

 In the absence of an established market price, many companies base the transfer price on
the production cost of the supplying division.
 Goods and Services are transferred based onthe Cost of production.

Advantage
It is a convenient and straightforward method of deciding transfer prices.
Disadvantage
 It may distort the Profit figure.
 It may prove inappropriate in case of inefficiencies of transferring department.
Cost-based Transfer Pricing: Methods
1. Full Cost
2. Cost-plus
3. Variable Cost plus Lump Sum charge
4. Variable Cost plus the Opportunity cost
5. Dual Transfer Prices
1. Full Cost
It is a popular transfer price because of its clarity and convenience and because it is often viewed as
a satisfactory approximation of outside market prices.
Caution: Total actual costs can include inefficiencies; thus, its usage for transfer pricing
often fails to provide an incentive to control such inefficiencies.
The use of total standard costs may minimize the inefficiencies mentioned above.
2. Cost-plus markup
It overcomes the shortcoming of the Cost Price Method.
Example: Cost-plus a margin of profit (say 15% of the Cost)
Advantage
It is a simple and convenient method.
Disadvantage
Inefficiencies are also transferred from one centre to another.
3. Variable Cost plus a Lump Sum Charge
The transfer price could be set equal to (standard) variable cost plus a lump-sum periodical charge
covering the supplying division's related fixed costs to motivate the buying division for making
appropriate purchasing decisions.
4. Variable Cost plus Opportunity Cost
Minimum Transfer Price = Incremental Cost + Opportunity Cost.
For internal decision-making purposes, a transfer price should be at least as large as the sum of:
• cash outflows that are directly associated with the production of the transferred goods; and
• the contribution margin foregone by the firm as a whole if the goods are transferred internally.
5. Dual Transfer Prices

Notes
Some companies adopt a dual transfer pricing system to avoid some of the problems associated
with the above schemes. For example:
Charge the buyer for the variable cost. The objective is to motivate the manager of the buying
division to make optimal (short-term) decisions.
Credit the seller at a price that allows for a normal profit margin. This facilitates a "fair" evaluation
of the selling division's performance.
Negotiated Price
Price arrived at after negotiations
Here, the firm does not specify rules for the determination of transfer prices. Divisional managers
are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is
typically combined with free sourcing. In some companies, though, headquarters reserves the right
to mediate the negotiation process and impose an "arbitrated" solution.
A manufacturing company had two departments A and B. Dept. A transfers most of its
production to Dept. B. The product's variable cost is ₹15 per unit, and the fixed cost is ₹ 7.5 per
unit. The Market price of the product is ₹27.5. Dept. B has to incur an extra processing cost of ₹25,
and the final product is sold in the market at ₹55 per unit.
Examine the profits of transferring to B when Transfer Pricing methods will be at:
1. Total Cost
2. Total cost plus 25% of the cost
3. Market-based price
4. The standard price is ₹23.5 per unit
5. Negotiated price is ₹24
Solution:
1. Total Cost method
Selling price per unit ₹ 55

Transfer price (15+7.5) ( ₹ 22.5)
Additional cost ( ₹ 25)
Gross profit per unit ₹ 7.5
2. Cost-plus mark up of 25%

Transfer price (15+7.5+5.625) (₹28.13)
Additional cost (₹25)
Gross profit per unit ₹1.87
3. Market transfer Price
Selling price per unit ₹ 55

Transfer price (27.5) (₹27.5)
4. Standard price method

Transfer price (23.5) (₹23.5)

Notes
Unit #: Unit Name
5. Negotiated transfer price

Transfer price (24) (₹24)
Gross profit per unit ₹6
Selection of Transfer Pricing Method
The following general criteria should be kept in mind while determining the transfer price:
 The transfer price should compensate the transferring division and charge the buying
division with the value of goods/services exchanged.
 The transfer price should be objectively determinable.
 The transfer price should providethe basis forprofit centre evaluation.
 It should contribute to the congruence between the goals of the division and the goals of
the organization.
 It should maximize the efforts towards the achievement of organizational goals.
Case Study
India vs. M/s Redington (India) Limited, December 2020
Redington India Limited (RIL) established a wholly-owned subsidiary Redington Gulf (RG), in
the Jebel Ali Free Zone of the UAE in 2004. The subsidiary was responsible for the Redington
group's business in the Middle East and Africa. Four years later, in July 2008, RIL set up a
wholly-owned subsidiary company in Mauritius, RM. In turn, this company set up its wholly-
owned subsidiary in the Cayman Islands (RC) – a step-down subsidiary of RIL. On 13 November
2008, RIL transferred its entire shareholding in RG to RC without consideration. Within a week
after the transfer, a 27% shareholding in RC was sold by RG to a private equity fund Investcorp,
headquartered in the Cayman Islands, for a price of ₹325.78 Crores.
RIL claimed that the transfer of its shares in RG to RC was a gift and, therefore, exempt from
capital gains taxation in India. It was also claimed that transfer pricing provisions were not
applicable as income was exempt from tax.
The Indian tax authorities disagreed and found that the transfer of shares was a taxable
transaction, as the three defining requirements of a gift were not met – that the transfer should
be (i) voluntary, (ii) without consideration and that (iii) the property so transferred should be
accepted by the donee. The tax authorities also relied on the documents for the transfer of shares,
the CFO statement, and the law dealing with property transfer. The tax authorities determined
the arm's length price using the comparable uncontrolled price method – referring to the pricing
of the shares transferred to Investcorp.
In the tax assessment, the authorities had also denied deductions for trademark fees paid by RIL
to a Singapore subsidiary to use the "Redington" name. The tax authorities had also imputed a
fee for RIL providing guarantees in favour of its subsidiaries.
RIL disagreed with the assessment and brought the case before the Dispute Resolution Panel
(DRP) who ruled in favour of the tax authorities. The case was then brought before the Income
Tax Appellate Tribunal (ITAT) who ruled in favour of RIL. ITAT's ruling was then brought
before the High Court by the tax authorities.
The decision of the High Court
The High Court ruled that transferring shares in RG by RIL to its step-down subsidiary (RC) as
part of corporate restructuring could not be qualified as a gift. Extraneous considerations had
compelled RIL to make the transfer of shares, thereby rendering the transfer involuntary. The
entire transaction was structured to accommodate a third-partyinvestor, who had put certain
conditions before effecting the transfer. According to the Court, the transfer of shares was a
circular transaction to avoid payment of taxes.
"Thus, if the chain of events is considered, it is clear that the incorporation of the company in

Notes
Mauritius and Cayman Islands just before the transfer of shares is undoubtedly a means to avoid
taxation in India, and the said two companies had been used as conduits to avoid income tax"
observed the Court.
The High Court also disallowed deductions for trademark fees paid by RIL to a Singapore
subsidiary. The Court stated it was illogical for a subsidiary company to claim a Trademark fee
from its parent company (RIL), especially when there was no documentation to show that the
subsidiary was the trademark owner. It was also noted that RIL had been using the trademark in
question since 1993 – long before the subsidiary in Singapore was established in 2005.
Regarding the guarantees, the Court concluded these were financial services provided by RIL to
its subsidiaries for which a remuneration (fee/commission) was required.
Source:https://tpcases.com/india-vs-m-s-redington-india-limited-december-2020-high-court-of-
madras-case-no-t-c-a-nos-590-591-of-2019/
Summary
 Transfer pricing can be defined as the price charged by one enterprise division from
another division of the same enterprise.
 It may not appear significant in the small or centralized enterprise. However, it is of
immense significance when the scale of an industry is raised or decentralized enterprise.
 Any transaction on transfer pricing happens whenever two companies are part of the
same multinational group trade. For example, when a US-based subsidiary of Pepsico
buys something from a Germany-based subsidiary of Pepsico. When the parties establish a
price for the transaction, this is transfer pricing.
 Transfer pricing is not, in itself, illegal or necessarily abusive. Unlawful or abusive is
transfer mispricing, also known as transfer pricing manipulation or abusive transfer
pricing.
 It is of immense use for tax management for multinational companies.
 It can result in shifting profits from high tax jurisdictions to low tax jurisdictions.
 Transfer pricing can be determined through market-based pricing methods, cost-based
pricing methods, or negotiated pricing methods.
 There could be differences in opinions among divisional organizational managers
concerning how to transfer price needs to be set.
 The transfer pricing issue in a multinational setup is very complicated.
Keywords
Arm's Length Price: It is a price that is fixed by the associated enterprises as if they had set the
price between unassociated enterprises entering into the transaction.
Cost-based Transfer Pricing: In the absence of an established market price, many companies base
the transfer price on the production cost of the supplying division.
Market-based Transfer Pricing: When the outside market for the good is well-defined,
competitive, and stable, firms often use the market price as an upper bound for the transfer price.
Negotiated Transfer Pricing: The firm does not specify rules for the determination of transfer
prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price.
Transfer pricing: It refers to the value attached to transfers of goods, services, and technology
between related entities located in different territories.
Self Assessment
1. What is the main reason for shifting profits from one country to another country?

Notes
Unit #: Unit Name
A. To avoid double taxation

B. To benefit from investment opportunities
C. To benefit from a difference in tax rates
D. To increase overall pre-tax profits
2. Transfer Pricing plays a significant role in Accounting of:

A. Arm's Length transactions
B. Related party transactions
C. Both Arm's Length and Related Party transactions
D. None of above
3. Transfer pricing is due to:
A. Related party transactions
B. A way for International marketers to reduce tax liabilities
C. International marketers transferring goods and services in their organization between
different countries
D. All of above
4. ………………………………. indicates a transaction between two independent parties in which

both parties are acting in their own self-interest.
A. Transaction
B. Related Party Transaction
C. Arm's Length Transaction
D. Exchange of value
5. The ideal transfer price allows each division manager to make decisions that will
………………………………………..
A. maximize the company's profit
B. maximize division's profit
C. maximize the company's profit while attempting to maximize the division's profit
D. maximize the company's profit while trying to minimize the division's profit
6. Why Organizations Need to Understand Transfer Pricing?

A. For Accounting and Reporting purpose
B. For compliance requirements
C. For Tax management
D. All of above
7. Which method helps fix transfer price when a competitive external market exists for the
transferred product?
A. Market Price
B. Cost Price
C. Cost Plus Margin Price

Notes
D. Negotiated Price
8. When Cost alone is used for transfer pricing, the selling division cannot profit from the goods
transferred. This is a disincentive to the selling division. To overcome this problem, which
method should be used to fix the transfer price?
A. Absorption cost
B. Cost Price
D. Marginal Cost
9. A price which is set post negotiations by heads of both (Transferor and Transferred) division
is termed as:
A. Market Price
B. Cost Price
D. Negotiated Price
10. If actual costs are used as the basis for the transfer, any variances or inefficiencies in the
selling division are passed along to the buying division. To promote responsibility in the
selling division and to isolate variances within divisions, which costs are usually used as a
basis for transfer pricing in cost-based systems?
A. Cost Price
B. Cost Plus Margin Price
C. Marginal Cost
D. Standard Cost
11. The "Pedal" division of 'Avon Cycles' manufactures one type of Pedals which is sold to
external customers for ₹50 each. Its fixed Cost per Pedal is ₹10.50, and its variable cost is ₹
22.50. Avon's top management asks the Pedal division to transfer 10,000 Pedals to another
division within the company. Which of the following amount will be set as transfer price if
the transfer is made at the 'actual cost' of the Pedal division?
A. ₹50
B. ₹10.50
C. ₹22.50
D. ₹33
the transfer is made at 'Variable cost' of the Pedal division?
A. ₹70
B. ₹30.50
C. ₹22.50
D. ₹53

Notes
Unit #: Unit Name
the transfer is made at 'Market Price' of the Pedal division?
A. ₹60
B. ₹20.50
C. ₹12.50
D. ₹80.50
14. Setting transfer price as per the following method can include inefficiencies; thus, its usage
for transfer pricing often fails to provide an incentive to control such inefficiencies.
A. Full Cost
B. Standard Cost
C. Opportunity cost
D. Variable cost-plus opportunity cost
15. Minimum Transfer Price is set by adding Incremental Cost and Opportunity Cost as per the
following method:
A. Variable Cost-Plus Opportunity Cost
B. Dual Transfer Prices
C. Variable Cost Plus a Lump Sum Charge
D. Cost-Plus Mark Up

1. C 2. B 3. D 4. C 5. C
6. D 7. A 8. C 9. D 10. D
11. D 12. C 13. A 14. A 15. A
Review Questions
1. What is the transfer price?
2. Explain the meaning and importance of transfer pricing.
3. Illustrate the use of transfer pricing in tax management by multinational corporations.
4. Explain the market-based transfer pricing method with its advantages and disadvantages.
5. Examine the cost-based transfer pricing method with its pros and cons.
6. What is the need forIntracompany transfer pricing? Discuss the significant techniques for transfer
pricing and outline the circumstances in which each may be used with an advantage.
7. What is the transfer price? What are the different types of transfer prices? Discuss the usefulness
and appropriateness of the different kinds of transfer prices under different circumstances.

Notes
Further Readings
Education.
University Press.
3. Maheshwari, S.N., Maheshwari, Sharad. K., & Maheshwari, Suneel. K. (2018). A
Web Links
https://www.icsi.edu/media/website/CostAndManagementAccounting.pdf
https://icmai.in/TaxationPortal/Publication/Books/Intl-Tax-Transfer-Pricing.pdf
https://tpcases.com/pop-pages/india-2/

Notes
Razia Sehdev, Lovely Professional University Unit 13: Activity – Based Costing
Unit 13: Activity-Based Costing

CONTENTS
Objectives
Introduction
13.1 Background, Concept, and Pre-requisites
13.2 Activity-Based Costing versus Traditional Costing
13.3 Steps Involved in Activity Based Costing
13.4 Determination of Cost under ABC
13.5 Benefits and Limitations
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 discuss the problems of the traditional costing system.
 explain the activity-based costing system.
 compare traditional and activity-based costing.
 execute the five steps of activity-based costing to determine product costs.
 discuss the benefits and limitations of activity-based costing.
 comment on the importance and use of activity-based costing in the complex business
environment.
Introduction
The main objective of any costing system is to determine the cost of a product or service
scientifically. For facilitating the calculation, costs are divided into direct and indirect. Direct costs
are the costs that are traceable to the products/services offered. On the other hand, indirect costs,
also called 'overheads,' are not traceable to the products/services. Hence these costs are first
identified, classified, allocated, apportioned wherever allocation is not possible, reapportioned, and
finally absorbed in the products/services. Charging the direct costs to the products is
comparatively a simple procedure and can be done with remarkable accuracy. However, the
indirect costs present problems in charging them to the products, and there is a possibility of
distortion of costs though charging them is pretty logical. It is one of the limitations of the
traditional costing system. For example, one of the methods of absorption of overheads is direct
labor cost. This method is quite satisfactory when the overhead costs of indirect activities are a
small percentage compared to the direct labor component in the actual making of products.
However, the increased technology and automation have considerably reduced direct labor, so the
indirect activities have assumed greater importance. Therefore, using direct labor to absorb the
overheads can lead to distortions in the costs. Distortions in the costs resulting in incorrect cost
calculations may lead to following wrong decisions.

Notes
 Errors in fixation of selling prices.

 Wrong decisions regarding deciding of product mix.
 Ignoring customer orientation.
 Missing of profitable opportunities.
To overcome the limitations of traditional costing systems, activity-based Costing has been
introduced. Before we proceed to the other aspects of Activity-based Costing, let us see the
limitations of the traditional costing system. A brief mention of the same has already been made in
the above paragraph. Some more points are discussed below.
13.1 Background, Concept, and Pre-requisites
As per the traditional costing system, Material cost, labor cost, and overhead constitute the total
cost of a product or service. Overheads are allocated to the products on volume-based measures,
e.g., labor hours, machine hours, units produced.
Limitations of Traditional costing system
 Focuses upon product costing by tracing costs to the product and allocating costs through
cost centers.
 Methods of Allocation are inadequate to prorate common costs.
 It can result in cost distortion, i.e., either under-costing of product or over-costing of
product.
The traditional costing system's above limitations are overcome by the Activity-Based Costing
(ABC) system. Let's discuss how through the following case:
Case Study
Mr. John sold 100 Pizza and 100 burgers at his 'Fast food joint' in October.
He purchased the pizza base for ₹20 per unit and Bun for ₹10 per unit.
There is an electricity bill of ₹2,000 for October.
 What will be the cost of 100 pizzas and 100 burgers?
Solution:
As per the traditional costing system, the total cost will be calculated as follows:
Pizza (100 Burger (100

Description
units) in (₹) units) in (₹)
Material cost 2,000 1,000
Electricity bill (₹2000 /200 units)*100

1,000 1,000
units
Total cost 3,000 2,000
Point of Discussion

Notes
Unit 13: Activity – Based Costing
 Is it fair to allocate electricity bills equally to Pizzas and Burgers based on the number of
units produced?
Solution: No, it will distort the costing results as it has over-priced the burgers and underpriced
the Pizzas. Let's check how?
Assume that 800 units of electricity are used to make 100 Pizzas and 200 units of electricity are
used to make100 burgers.
In such a case, it is the direct inference that the traditional costing system has distorted the
costing results. Thus, it is activity-based costing (ABC) system that will provide a better
alternative. Let's discuss how costing results are improved through an activity-based costing
system.
As per the ABC system, Apportionment of Electricity Cost will be based on electricity units
consumed for each product, and the total cost of 100 Pizzas and 100 Burgers will be calculated as
follows:
Description Pizza (100 units) in (₹) Burger (100 units) in (₹)
Material cost 2,000 1,000
(₹2000*800/1000) (₹2000*200/1000)
Electricity bill
=1600 =400
Total cost 3,600 1,400
Point of Discussion
 Is it a fair apportionment of electricity based on consumption of units by both products?
Solution: Definitely yes, as it has not resulted in cost distortion of Pizzas and Burgers. Neither of
them is underpriced or overpriced.
Activity-Based Costing System (ABC): Concept
Activity-Based Costing System (ABC): Key terms

Activity
An activity is an event, task, or unit of work with a specified purpose.
Examples
Designing products, setting up machines, operating machines, and distributing products.
More informally, activities are verbs; they are things that a firm does.
Cost Object
A cost object is an item for which a cost is compiled.
Examples
A product, product line, service, project, customer, distribution channel, or activity.
Cost objects are used in activity-based costing analyses as the focal point of cost accumulations.
A close review of cost objects is also helpful in managing costs throughout an organization.

Notes
Cost Driver
A cost driver is any factor or activity with a direct cause and effect relationship with the resources
consumed.
Examples
Business functions Cost Drivers
Distribution  Number of units distributed

 Number of customers
Marketing  Number of advertisements

 Number of sales personnel
 Sales revenue
Research and Development  Number of research projects

 Personnel hours on a project
Customer Service  Number of service calls

 Number of products serviced
 Hours spent on servicing products
Design of products, services, and procedures  Number of products in design

 Number of parts per product
 Number of engineering hours
Activity-Based Costing (ABC): Meaning and Definition

 A costing methodology for more precisely allocating overhead costs by assigning them to
activities.
 Once costs are assigned to activities, the costs can be assigned to the cost objects that use
those activities.
 The system can be employed for the targeted reduction of overhead costs.
 ABC works best in complex environments, where there are many machines and products
and tangled processes that are not easy to sort out.
 Conversely, it is of less use in a streamlined environment where production processes are
abbreviated.
Activity-Based Costing (ABC): Rationale

Notes
13.2 Activity-Based Costing versus Traditional Costing
Case Study
Bira Co. produces fizzy drinks and expects to produce 20,000 beverages in July. For July, direct
labour hours are anticipated to be 900, direct machine hours are estimated to be 600, and overheads

Notes
are estimated to be $6,000. These expenses are broken down into three categories: $1,000 for direct
supervision for 350 machine hours, $3,500 for logistics for 540 direct labour hours, and $1,500 for 30
production set-ups.
Required: Calculate and compare overhead rates using the standard costing method and the
activity-based costing approach.
Solution:
Activity-Based Costing: Pre-Requisites

 Formation of Cost Pools
 Identification of Activities
 Identification of Cost Object
 Determination of Cost drivers

Notes
Did you know? What is a cost pool?

Activity cost pools are groups of individual costs influenced by the same cost drivers, which control
the amount of costs incurred. It represents a group of various cost items. It consists of costs that
have the exact cause and effect relationship—for example, machine set-up.
Did you know? What is Activity-based Management?

Activity-based Management is a tool of management that involves analyzing and costing activities
to improve efficiency and effectiveness. Though it is closely related to Activity-based Costing, it still
differs from its primary goal. The activity-based Costing focuses on activities with the object of
measuring the cost of products/services. It tries to compute the cost as accurately as possible. On
the other hand, activity-based Management focuses on managing the activities themselves. In
activity-based Costing, resources are traced to the activities to compute the costs, while in activity-
based Management, resources are traced to activities for evaluation of the activities themselves. In
other words, efforts are made to improve the activities further. Thus, activity-based Management is
a set of actions that management can take, based on information from an activity-based costing
system, to increase/improve profitability.
13.3 Steps Involved in Activity Based Costing

Step 1. Identify activities required to manufacture products.
The company must conduct a thorough examination of each responsibility center's operational
procedures. Each process may have one or more actions that must be completed in order to create
an outcome.
Step 2: Identify the Overhead Cost Drivers.
It entails tracing expenses back to cost items in order to discover why the cost arose. Costs are
classified into three types:
i. Direct - expenses that may be linked back to a single output. For instance, the wood and paint
required to construct a chair.
ii. Indirect - expenses that cannot be assigned to a single output, i.e. they benefit two or more
outputs but not all outputs—for example, maintenance or storage costs.
iii. General/administration – costs that cannot be associated with any product or service. These
expenditures are likely to be constant regardless of output—for example, administrative wages,
security costs, or depreciation.
Step 3. Allocation of overhead cost to cost pools.
Relate the overheads to the activities, both support and primary, that cause them. It creates 'cost
pools' or 'cost buckets.' It will be done using resource cost drivers that reflect causality.
Step 4. Calculate a predetermined overhead rate for each activity.
Calculate activity cost driver rates for each activity, just as an overhead absorption rate would be
calculated in the traditional system.
13.4 Determination of Cost under ABC

Let's take a small case to understand the steps mentioned above and determine overhead cost
accordingly:
Case Study
Assume that a company manufactures circuits and management decides to install an ABC
system. Management decides that all overhead costs only have three cost drivers—
 Direct labor hours

Notes
 Machine hours
 Number of purchase orders
The management provided further following overhead costs incurred to manufacture circuits.
General Ledger
Payment of Payroll taxes ₹1,000
Machine maintenance ₹500
Purchasing Dept. labor paid ₹4,000
Fringe benefits ₹2,000
Purchasing Dept. Supplies ₹250
Equipment depreciation ₹750
Electricity bill paid ₹1,250
Unemployment insurance ₹1,500
Total ₹11,250
Let's implement the ABC system and calculate overhead rates and cost accordingly.
Solution:
Step 1: Identification of main activities
Step-2: Determination of Overhead Cost Drivers

Management decides that all overhead costs only have three cost drivers—
 Direct labor hours
 Machine hours
 Number of purchase orders
Base Product A Product B Total

Notes
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 50 50 100
Step-3: Allocation of overhead cost to cost pools

a) Direct Labour
Payroll Taxes ₹1,000
Fringe Benefits ₹2,000
Unemployment insurance ₹1,500
Total ₹4,500
b) Machine Hours
Machine Maintenance ₹500
Equipment depreciation ₹750
Electricity ₹1,250
Total ₹2,500
c) Number of Purchase orders
Purchasing Dept. Labor ₹4,000
Purchasing Dept. Supplies ₹250
Total ₹4,250
Step-4: Allocation of cost as per activity cost driver rate
Base Product A (₹) Product B (₹)
(4500*400/1000) (4500*600/1000)
Direct labor hours (400:600)
=1800 =2700
(2500*100/250) (2500*150/250)
Machine hours(100:150)
=1000 =1500
(4250*50/100) (4250*50/100)
Purchase orders(50:50)
=2125 =2125
Total 4925 6325
The actual overhead allocated was ₹4,925 + ₹6,325 = ₹11,250 overhead applied.
Now, Let's see what if we had allocated the overhead in this company using traditional cost
accounting allocation.
Let's assume the base is direct labor hours

Notes
 What would be the amount allocated to each product?

The total amount of overhead is ₹11,250. Total direct labor hours are 1,000 and it is used for
allocation purpose.
Allocating overhead using direct labor hours only under traditional costing:
Product A: ₹11,250 x 400 hours / 1000 hours = ₹4,500
Product B: ₹11,250 x 600 hours / 1000 hours = ₹6,750
Total overhead applied ₹4500 +₹6750 = ₹11,250
Let’s compare the overheads cost allocation as per traditional and activating based costing as
follows:
Product A Product B Total
Traditional Method ₹4,500 ₹6,750 ₹11,250
Activity Based Costing ₹4,925 ₹6,325 ₹11,250
Difference -₹425 ₹425 -0-
Point of Discussion from above comparison.

 Which costing system is more accurate or Why?
13.5 Benefits and Limitations

Benefits of ABC system
 It is a more realistic product cost- based on a cause-and-effect relationship.
 It helps in making better pricing decisions and making better pricing policies by supplying
accurate cost information.
 It is a relatively more realistic approach as overhead allocation is done on a logical basis.
 It assists in better control of costs as it focuses on controlling unit cost rather than just total
cost.
 It provides greater cost efficiency as it helps to identify non-value-added activities which
facilitate cost reduction.
 It is very much helpful for an organization with multiple products.
 It highlights problem areas that require the attention of the management.
Limitations of ABC system
Though this system is quite adequate, it suffers from some limitations. These limitations are given
below:
 Activity-based costing is a complex system and requires a lot of records and tedious
calculations.
 For small organizations, a traditional cost accounting system may be more beneficial than
Activity-based Costing due to the simplicity of operation of the former.
 Sometimes it isn't easy to attribute costs to single activities as some costs support several
activities.
 There is a need for trained professionals who are limited in number.
 This system will be successful if there is total support from the top management.

Notes
 A substantial investment of time and money is required for the implementation of this
system.
 It is relativelyexpensive to use.
 It is a time-consuming system.
 Some arbitrary allocations may continue in the activity-based costing system as well.
Summary
 The main objective of any costing system is to determine the cost of a product or service
scientifically. For facilitating the calculation, costs are divided into direct and indirect.
Direct costs are the costs that are traceable to the products/services offered. On the other
hand, indirect costs, also called 'overheads,' are not traceable to the products/services.
 To overcome the limitations of traditional costing systems, activity-based costing has been
introduced.
 Activity-based Costing is cost attribution to cost units based on the benefit received from
indirect activities, e.g., ordering, setting up, assuring quality.
 It is very much valuable for the organization with multiple products.
 Activity-based budgeting is different from traditional budgeting in the sense that it
provides a strong link between the objectives of the organization and the objectives of a
particular activity
 The limitations of the ABC system are that it is very costly and cannot be applied to all
companies.
 The ABC system as a costing tool to manage costs at the activity level is known as
Activity-Based Cost Management (ABM). ABM is a discipline that focuses on the efficient
and effective management of activities as the route to continuously improving the value
received by customers. It utilizes cost information gathered through ABC.
Keywords
 Resource cost driver: it is a measure of the quantity of resources consumed by an activity.

It is used to assign the cost of a resource to an activity or cost pool.
 Activity cost driver: It measures the frequency and intensity of demand placed on
activities by cost objects. It is used to assign activity costs to cost objects.
Cost Object: It is an item for which cost measurement is required—for example, a product, a
service, or a customer.
Cost Pool: It represents a group of various cost items. It consists of costs that have the same cause
and effect relationship—for example, machine set-up.
Self Assessment
1. Activity-based costing:

Notes
A. Uses a plant-wide overhead rate to assign overhead

B. Is not expensive to implement
C. Typically allocates overhead costs to the products based on consumed activities
D. Uses multiple activity rates
2. A/An ……………. is any factor or activity with a direct cause and effect relationship with the
resources consumed.
A. Cost Driver
B. Cost unit
C. Cost Activity
D. Cost Pool
3. A "project" will be treated as following as per Activity Based Costing system.

A. Cost Driver
B. Cost Object
C. Cost Activity
D. Cost Pool
4. ITC has the total purchase requisition cost of Tobacco worth ₹ 3,00,000. It is one of the
critical'activities' while producing"Gold Flake," its oldest Cigarette brand. Identify which of
the following will serve as the most appropriate 'cost driver' for this activity?
A. Number of machines set-ups
B. Number of times orders placed
C. Direct labor hours
D. Number of customers served
5. Which of the following characteristics would indicate that a company would benefit from
switching to activity-based costing?
A. Only one homogenous product is produced continuously
B. The existing cost system is reliable and predictable
C. Overhead costs are high and increasing with no apparent reason
D. The costs of implementing ABC outweigh the benefits
6. Which of the following is a limitation of activity-based costing?

A. Each significant activity accumulates costs
B. A variety of activity measures are used
C. All costs in an activity cost pool pertain to a single activity
D. Activity-based costing relies on the assumption that the cost in each cost pool is strictly
proportional to its cost measure
7. Ola Cabs has built its business on one basic principle: "Providing best customer care service" to
its customers. Thus, it invests ₹ 11 lakhs on average basis each year to provide instant

Notes
customer care services to its customers. Identify which of the following will act as the most
appropriate 'cost driver' for this activity?
A. Number of Service Calls
B. Number of Research Projects
C. Number of Advertisements
D. Sales revenue
8. ……………. refers to an event that incurs cost.

A. Cost Driver
B. Cost Pool
C. Activity
D. Cost Object
9. ………………… represents a group of various individual cost items. It consists of costs that
have the same cause-effect relationship.
A. Cost Driver
B. Cost Pool
C. Activity
D. Cost Object
10. The following is/are the pre-requisites of implementing an activity-based costing system.
A. Identification of Activities
B. Identification of Cost Object
C. Determination of Cost drivers
D. All of above
11. Identify which of the following will act as the most appropriate 'cost driver' for the "Design of
Product" activity?
A. Personnel Hours on a Project
B. Number of parts per product
C. Hours spent on servicing products
D. Number of customers
12. Identify which of the following will act as the most appropriate 'cost driver' for the
"Distribution" activity?
13. Identify which of the following will act as the most appropriate 'cost driver' for the "Research
and Development" activity?

Notes

14. Identify which of the following will act as the most appropriate 'cost driver' for the "Customer
Care" activity?
15. Amul has gained the top-of-the-mind positioning because it is the first brand that comes to
mind when talking of Ice cream, milk, cheese, butter, or any other milk-based products. It
invests a reasonably good amount in the marketing and positioning of its brand and
products each year. Identify which of the following will act as the most appropriate 'cost
driver' for its marketing activities?
A. Number of Service Calls
B. Number of Research Projects
C. Number of Advertisements
D. Sales revenue

l. C 2. A 3. B 4. B 5. C
6. D 7. A 8. C 9. B 10. D
11. B 12. D 13. A 14. C 15. C
Review Questions
1. What is activity-based costing? Why is it needed?
2. Discuss the steps in applying activity-based costing in a manufacturing company.
3. Differentiate between traditional costing and activity-based costing.
4. Discuss the limitations of the traditional costing system.
5. Give the pre-requisites of the activity-based costing system.
6. What are the benefits of activity-based costing?
7. Enumerate the limitations of activity-based costing.
Further Readings
Education.

Notes
University Press.
3. Maheshwari, S.N., Maheshwari, Sharad. K., &Maheshwari, Suneel. K. (2018). A
Web Links
https://resource.cdn.icai.org/62025bos50397cp5.pdf
https://www.termscompared.com/difference-between-activity-based-costing-and-
traditional-costing/
https://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_co
sting_nov08.pdf.pdf
https://www.cimaglobal.com/Documents/Thought_leadership_docs/6Activity-based-
costing-China.pdf

Notes
Razia Sehdev, Lovely Professional University Unit 14: Responsibility Accounting
Unit 14: Responsibility Accounting

CONTENTS
Objectives
Introduction
14.1 Meaning and Definition of Responsibility Accounting
14.2 Pre-requisites or Essential Features of Responsibility Accounting
14.3 Types of Responsibility Centres
14.4 Principles of Responsibility Accounting/Steps involved in implementing Responsibility
Accounting
14.5 Advantages of Responsibility Accounting
14.6 Limitations of Responsibility Accounting
Summary
Keywords
Self Assessment
Answer for Self Assessment
Review Questions
Further Readings
Objectives
• explain the meaning and features of responsibility accounting.
• appraise the importance of responsibility accounting.
• review the pre-requisites to implement the responsibility accounting for
controlling purposes.
• categorize the various Responsibility Centers as per their types.
• assess the steps involved in implementing responsibility accounting in an
organization.
• review the advantages and limitations of responsibility accounting.
Introduction
Expediting and aiding managerial control is the primary function of management and cost
accounting. Management does use various control devices and systems such as Budgetary Control,
Standard Costing (Various Analysis), and so on to perform this vital function. Responsibility
accounting is one of the most influential and useful managerial control devices among other control
systems. Responsibility accounting has gained tremendous importance and is described as a
modern approach to managerial control and reporting. The reason behind the same is responsibility
accounting focuses on measuring and evaluating the performance of individual divisions,
departments, and products of an organization. At the same time, other traditional control systems
emphasize the performance evaluation of an organization as a whole. The underlying principle of
responsibility accounting technique says accomplishing budgeted or targeted performances is the
human responsibility, not of control systems. As it is the human, who uses those control systems as
per their discretion for controlling function. Responsibility accounting uses budgetary control and
variance analysis for control purposes. Under Responsibility accounting, the target performance for
individual responsibility centre’s head is set using either budgeting or standard costing. Thus,
Responsibility accounting, Budgetary control, and Variance analysis are closely related techniques.

Notes
The use of Responsibility accounting as a control device is closely related to the organization size. It
has high relevance in large, diversified organizations or conglomerates which deal in multiple
unrelated businesses and geographical segments like Hindustan Unilever limited., Johnson &
Johnson, ITC limited, Tata group, Reliance Industries limited, and so on. In such big, diversified
companies, it is relatively difficult to directly control the operations of all business and
geographical divisions by head office compared to small organizations that are run and controlled
by a single individual with centralized decision-making authority. Hence, it is appropriate for big
companies to decentralize their organizational structure and authorize all divisional or functional
managers to operate their divisions independently. Under responsibility accounting control
system, these divisional managers will be wholly solely personally responsible for the performance
of the divisions they are heading.
Example: Let us take an example of Hindustan Unilever Limited, which is in the business of
Personal care, Homecare, Refreshments, Food, and others. In implementing responsibility
accounting to such a business model, each business segment manager may be asked to operate the
segment business like a small independent business. Thus, each business segment will be regarded
as a separate responsibility centre. In this way, the number of responsibility centres will be
identified and created for each business segment. These responsibility centres should focus on
enhancing the organization's long-term profitability as a whole by coordinating with the activities
of other responsibility centres simultaneously.
14.1 Meaning and Definition of Responsibility Accounting

Responsibility accounting is a control system where individual persons are assigned responsibility
for controlling costs. These individuals are given proper authority so that they can keep up their
performance as per predetermined standards. They will be personally responsible for their quick
heads in case they fail to achieve predetermined performance. Thus, Responsibility accounting
emphasized humans despite systems. The rationale behind responsibility accounting is to hold
individuals for those costs which are significantly controllable in their hands. Further, managers
should be given credit only for those revenues which are a result of their actions.
As per the above definition, it is required to divide the organization into various responsibility
centres and make each responsibility centre responsible for its own cost to use responsibility
accounting as a managerial control system. Measuring and reporting each responsibility centre's
performance regularly is another essential for a successful responsibility accounting system.

Notes
As per the above definition, Responsibility accounting is an accounting system in which cost data
are reported to managers who are in-charge of various cost centres. In this system, budgets are
prepared, and actual performance is recorded and reported.
Example: You are working as a production manager of Soaps Segment of Hindustan Unilever
Limited. Being in the production manager's capacity, if you prepare the production cost budget of
your department for the upcoming quarter, you will be made personally responsible for keeping
the production cost under a set budget. You will be given all detailed information of each cost that
will be incurred by your department. In case the actual production cost goes higher than the
budgeted cost, you will be required to find reasons for such adverse variance in production cost
and take required corrective measures. You will also be required to report such unfavourable
variance to the top management and present the reasons for the same, along with corrective actions
that you are proposing to bring the production cost under control.
14.2 Pre-requisites or Essential Features of Responsibility Accounting
Planned and Actual Information or Use of Budgeting:

A successful responsibility accounting system needs planned as well as actual financial
information. The use of Budgeting is the foremost essential requirement for effective
implementation of the Responsibility accounting system as planned, or predetermined performance
for individual responsibility centres will be conveyed to each level of management through
budgets. The use of various types of budgets such as flexible budgets, fixed budgets, cash budgets,
master budgets, and profit planning are all incorporated into one overall responsibility accounting
system.
Identification of Responsibility Centres:
Responsibility accounting cannot be executed without the identification of responsibility centres.
The responsibility centres can be described as the sphere of authority or decision points in an
organization. The number, scope of responsibility, and authority of each responsibility centres
depend upon the size of an organization. As discussed earlier, generally, one person or a small
number of persons, who are usually the owners, may manage or control the entire organization in
the case of small and micro business firms. But large business firms usually decentralize themselves
into the meaningful unit, divisions, business or geographical segments or departments. These sub-
units or divisions of the organization are called responsibility centres. A responsibility centre is
then put under the direct independent control of an individual who is personally responsible for
controlling activities and performance of that sub-unit of the organization.
The scope or area of work of a responsibility centre may be very narrow or wide. It can be a very
small sub-unit of the organization, or it may be a very big division of the organization. The
companies usually follow a general guideline to identify responsibility centres which state that to
represent one division, machine or unit as a responsibility centre then it has to be confirmed that

Notes
the respective unit of the organization should be separable, identifiable for operating purposes, and
it is possible to measure its performance effectively.
Relationship between Organization Structure and Responsibility Accounting System:

A sound organizational structure with clear-cut lines of authority—responsibility relationships is a
pre-requisite for setting up an effective and successful responsibility accounting system. Further,
the responsibility accounting system must be designed in such a way as it must suit the
organizational structure. Organization structure and responsibility accounting should run as
parallel to each other.
The following Chart is showcasing the relationship between organization structure and
responsibility centres:
Source:https://www.yourarticlelibrary.com/accounting/responsibility-accounting/responsibility-
accounting-meaning-features-and-steps-for-achieving-
goals/67700#:~:text=Responsibility%20Accounting%20is%20a%20system,to%20keep%20up%20the
ir%20performance.
Once various responsibility centres are identified, and authority-responsibility relationships are
established, the next essential to follow is assigning costs and revenues to individuals. It is the
requirement of an effective responsibility accounting system as a control device that only those
costs and revenues over which an individual has a definite control can be and should be assigned to
him for evaluating his performance. Unlike the traditional costing system, which classifies and
accumulates the various costs as per function, responsibility accounting classifies and accumulates

Notes
the various costs as per controllability. It makes a clear distinction between controllable and
uncontrollable costs.
Transfer Pricing Policy:

In decentralized enterprises, it is a routine and frequent exercise to transfer goods and services of
one organization's division to another. Thus, it is required to determine the price at which the
transfer should be made to accurately assign costs and revenues to both divisions in such
situations. As studied earlier, the transfer price will be a source of revenue for transferring division,
and it will be a cost element for buying or transferred division. Hence, for the successful
implementation of the responsibility accounting system, formulating a proper transfer pricing
policy is an essence.
Source: https://www.yourarticlelibrary.com/accounting/responsibility-
accounting/responsibility-accounting-meaning-features-and-steps-for-achieving-
goals/67700#:~:text=Responsibility%20Accounting%20is%20a%20system,to%20keep%20up%20the
ir%20performance.
Participative Management:
The participative or democratic style of management makes the responsibility accounting system
more effective. When plans are made, or budgets/ standards are determined as per the mutual

Notes
consent of heads and subordinates, it motivates the subordinates to give their best for achieving
that predetermined and self-imposed fixed performance.
Responsibility Centres
A responsibility centre is a point in an organization where the control over revenue or expense is
located, e.g., division, department or a single machine. As discussed earlier, it is the area of
authority or decision points or division in an organization for which a manager is held responsible.
In simple words, when large companies divide themselves into various manageable and meaning
sub-units, divisions, departments, business segments, geographical segments or others for
exercising effective control over its operations, then these created sub-units, divisions, departments
or segments are termed as responsibility centres. It acts like a small business to attain the goals of a
large organization. For successfully achieving the vision, mission and goals of a large organization,
it is required to coordinate the activities of all its responsibility centres. Responsibility centres can
be found in small and large organizations.
"A responsibility centre is a specific unit in an organization assigned to a manager who is held
responsible for its operations and resources."
- Deakin and Mather
"A responsibility centre is a segment of the organization, where an individual manager is held
responsible for its segments' performance."
- CIMA
14.3 Types of Responsibility Centres

Companies can identify the following four types of Responsibility Centres to exercise effective
managerial control.
1. Cost Centre or Expense Centre
2. Revenue Centre
3. Profit Centre
4. Investment Centre
Cost Centre or Expense Centre
It is a business segment that incurs only expenses or costs but does not generate revenue. It is a sub-
unit of the organization that has control over inputs and their cost only. It has no control over
revenues and investments. Thus, the manager of a cost centre is only responsible for the costs that
are under his direct and significant control, not for its revenues and investments. The evaluation of
a manager's performance for cost Centres is based on his or her ability to meet budgeted goals for
controllable costs.
Examples:Production department, Repairs & Maintenance department, Accounting

department, Legal department, Service department etc.

Notes
Note: As the contribution of accounting, legal, repairs, and maintenance or service

department cannot be measured in monetary terms, and they incur only expenses so, they will be
termed as expense or cost centres. Sometimes, it is either not feasible or necessary to measure the
output of some responsibility centres; then such centres are also treated as cost centres.
Caution:The production department does produce output, but that output is not sold to
external customers by the production department itself. However, its output is transferred to the
sales department to sell the products to ultimate customers. That is the reason behind creating the
production department as a cost centre. The manager of a production department will be
responsible for costs that its department will incur to produce the budgeted number of units.
Task:You are the manager of the Finishing Department of Fox Manufacturing Company. You
have been provided with all types of costs that have been incurred by your department in January
2020. As you have to report your department's performance to Top management, you have
prepared a performance report of your department as follows to be presented to Top management.
Source: Author
Being a Departmental head, you would be required to:
a) provide reasons to top management for adverse or unfavourable variance in the various
controllable cost incurred by your department?
b) give corrective measures to avoid such avoidable variance in the future.
Revenue Centre
A business segment where the manager has control over generating or earning revenues only and
does not control the cost of products/service or the investment made in the responsibility centre.
Examples: Sales Department, Reservation Department, Ticket Counters, Valet Parking

Division for Hotels.
Note: The managers of aforesaid departments will be just focused on increasing the number of
units sold or their customer base. Thus, they are responsible for only maximizing the revenues of
their centres. That is why these centres are termed Revenue centres.
Profit Centre
It is a sub-unit of the business that has control over both revenues and costs, i.e., inputs and outputs
but has no control over investment funds. The difference between the revenue earned and costs
incurred will be a profit if it is a positive figure, and it will be a loss if it is a negative figure. Hence,
the managers of profit centres are responsible for both earned revenues and incurred costs. The

Notes
profit centre may earn revenue by selling its output to internal customers (other sub-divisions of
the organization) or external customers. If the output is sold to external customers, then the
revenue will be measured at the selling price. However, if the output is transferred to internal
customers, then the revenue will be measured as per the decided transfer pricing policy. In such a
case, even it is the discretion of management to treat such a centre as a Profit centre or not.
Generally, If the transfer is made on cost price, then such transferring division is not termed as a
Profit centre. The income statement of the Profit Centre is used as a control device. It is the
responsibility of the manager of the profit centre to achieve budgeted profit by increasing revenues
and controlling costs simultaneously. The managers of such centres always aim to maximize the
profits of their centres by taking decisions related to production volume, production techniques,
sales mix, setting sale price, make or buy decision, credit policy, promotion and marketing strategy
etc.
"It is a part of a business accountable for costs and revenues. It may be called a business centre,
business unit, or strategic business unit."
- CIMA
Examples:
• Individual shops in a retail chain.
• Local branches in a regional or nationwide distribution business.
• A geographical region – e.g., a country (for multinationals) or region within a country.
• Individual divisions, departments, or products.
Investment Centre
It is a business unit in a firm that can utilize capital to contribute directly to a company's
profitability. Companies evaluate the performance of an investment centre according to the
revenues it brings in through investments in capital assets compared to the overall expenses. In
simple words, it is a business segment in which a manager has control over costs, revenues as well
as investment. The manager can control or significantly influence the investment funds available
for use. Thus, the manager of the investment centre is responsible for earning a good rate of return
on the assets employed in his or her investment centre by taking optimum utilization of such assets.
They are accountable for making decisions related to capital investment, working capital
management, capital structure etc.
"It is a profit centre whose performance is measured by its return on capital employed."
- CIMA
Example:
Lakme Lever Private Limited (LLPL) is a 100% subsidiary of Hindustan Unilever Limited. It is
engaged in Salons Business and also operates a manufacturing unit that carries out job work
operations for Hindustan Unilever Limited, manufacturing toilet soaps, bathing bars and detergent
bars. Here, LLPL is an investment centre of HUL. PushkarajShenai, CEO of LLPL, will be
responsible for its operation Costs and Revenues. He also has control over the investments in terms
of assets in LLPL, and hence, he will be accountable for earning a fair amount of return on
investment that he has decided to put in the business of LLPL.
The performance of an Investment Centre is evaluated on its earned Return on Investment (ROI).
ROI is considered as a superior measure to any other performance measurement for performance
evaluation as it shows the effectiveness of the manager in utilizing the assets at his or her disposal.

Notes
Caution:Performance evaluation of investment centres may become difficult if certain assets

are being used by more than one investment centre or in such a situation where the assets have one
centre but are used by other responsibility centres.
14.4 Principles of Responsibility Accounting/Steps involved in

implementing Responsibility Accounting
The following steps are involved in the effective execution of Responsibility accounting as a
managerial control system.
Identification of responsibility centres
Responsibility centres are identified by dividing the organization into various meaningful sub-unit.
Then, the various identified responsibility centres are put under the charge of one individual
head/manager. The managers are accountable for the performance of their responsibility centres.
Fixation of Targets for each responsibility centre
Budgeted performance/targets/goals are determined for each responsibility centre in consultation
with their respective managers so that they and their team will be motivated to achieve self-
determined targeted performance. Once targets are fixed, they are communicated to the concerned
responsibility centres' managers and a higher level of management.
Making a comparison between actual and target performance
The actual performance of each responsibility centre is observed and recorded on a regular basis.
The performance reports are prepared in which actual performance is compared with a target
performance. These reports are then communicated to the executive concerned. It helps in assessing
the work of these centres.
Analyzing the variance in performance
If the actual performance of a responsibility centre is below the standard set, then the
unfavourable/adverse variances are conveyed to the top management. The responsible manager's
name is also conveyed along with the variance report so that the responsibility of such low
performance may be fixed.
Taking corrective measures
Timely action is taken to take necessary corrective measures so that the work does not suffer in
future. The directions of the top-level management are communicated to the concerned
responsibility centre so that corrective measures are initiated at the earliest.
Exclusion of uncontrollable cost
Only those costs and revenues over which an individual manager has definite control can be
attributed to him for evaluating his performance while making performance reports.
14.5 Advantages of Responsibility Accounting

• It establishes a sound mechanism for control.
• It forces the management to consider the organizational structure and examines who is
responsible for what, and fix the delegation of power.
• It encourages Budgeting with which actual achievement can be compared.
• It increases the interest and awareness of the officers as they are called upon to explain the
deviations for which they are responsible.
• The exclusion of items that are beyond the scope of the individual's responsibility
simplifies the structure of the reports and facilitates promptness in reporting.

Notes
14.6 Limitations of Responsibility Accounting

• Adherence to the pre-requisites for a successful responsibility accounting system is a
difficult task.
• The traditional way of classification of expenses needs to be subjected to a further analysis
which becomes difficult.
• Certain managers may require additional classification, particularly if the responsibility
reports are different from routine reports at the time of introducing the system as a control
device. Thus, it will increase the time and finance cost for the organization.
• It may result in inter-departmental conflicts.
Task: Analyze different Centres of a food chain of your choice and categorize them into
various types of responsibility Centres.
Summary
Responsibility accounting is a control system where individual persons are assigned responsibility
for controlling costs. These individuals are given proper authority so that they can keep up their
performance as per predetermined standards. They will be personally responsible for their
immediate heads in case they fail to achieve predetermined performance. It is of immense use for
large diversified companies as it is difficult the exercise direct control over the operations of several
divisions through Head office. So, such large companies divide themselves into various sub-units
known as responsibility centres. These responsibility centres are put under the control of a single
individual manager who is personally responsible for the performance of assigned responsibility
centres. The companies have to follow certain pre-requisites for effective implementation of
responsibility accounting as a managerial control system. An effective responsibility accounting
system requires a clear organizational structure, use of budgetary control and a proper
management reporting system. Management should positively use responsibility accounting as a
source of motivating employees to achieves targets rather than as a punishment tool. Then only, it
can be proved as an effective and successful control device.
Keywords
Cost Centre: A business segment that has control over the incurrence of costs. The manager of the
cost centre is solely responsible for the incurrence of certain costs—for example, the paint
department in an automobile company.
Investment Centre: A business unit where the unit manager has the responsibility and the
authority to make decisions that affect not only costs and revenues but also the assets invested in
the centre. A typical investment centre is a subsidiary entity, for whose financial performance and
position, the subsidiary's CEO is responsible.
Profit Centre: A business segment that is responsible for both revenues and expenses, which result
in profits and losses. A typical profit centre is a product line, for which a product manager is
responsible.
Responsibility Accounting: It is a system of control where responsibility is assigned to a single
person for the control of costs.
Responsibility Centre: A responsibility centre is a segment of the organization where an individual
manager is held responsible for its segments' performance.
Revenue Centre: A business division that is solely responsible for generating sales. For example,
the reservation department in an airline.
SelfAssessment
1. Which of the following statements are true about responsibility accounting?
A. Responsibility accounting results in inter-departmental conflicts

Notes
B. In the responsibility centre, more focus is paid on products, processes or jobs

C. No focus is paid on controlling costs
D. Managers are responsible for the total cost of their centres
2. Which of the following is a responsibility centre?

A. Expense centre
B. Profit centre
C. Investment centre
D. All of the above
3. The responsibility centres, for control purposes, may be classified into _____ types.
A. Five
B. Three
C. Four
D. Two
4. In responsibility cost accounting, the costs in focus are:

A. Controllable costs
B. Uncontrollable costs
C. Both A and B
5. The area of focus on responsibility centre is

A. Quantum of sales
B. Quantum of production
C. Optimum utilization of resources
D. All of the above
6. An underlying concept of budgeting and standard cost systems is
A. The concept of statistical control limits
B. The concept of continuous improvement
C. The concept of quality at the source
D. The concept of responsibility accounting
7. Which type of responsibility centre has the greatest amount of autonomy?

A. A revenue centre
B. A cost centre
C. A profit centre
D. An investment centre
8. Responsibility accounting is not useful in following the principle of management by

exception.

Notes
A. True
B. False
9. In cost centres, managers have no revenue responsibilities.

A. True
B. False
10. Which of the following correctly describes a cost centre?
A. A business segment whose manager has control over costs but not over revenue or
investment funds
B. A business segment whose manager has control over both cost and revenue, but not
investment funds
C. A business segment whose manager has control over cost, revenue and investments
D. All of the above
11. A business division that is solely responsible for generating sales:

A. A revenue centre
B. A cost centre
C. A profit centre
12. _____________ is a system of control where responsibility is assigned to single person for the
control of costs.
A. Responsibility Centre
B. Responsibility Accounting
C. Management by Exception
D. Performance Reporting
13. Which of the following is/are pre-requisite of implementing responsibility accounting?

A. Performance reporting
B. Management by exception
C. Identification of responsibility centres
D. All of the above
14. The objective of responsibility accounting should not be to place blame; rather, it should
evaluate the performance and provide genuine feedback to improve future operations.
A. True
B. False
15. ___________ is the centre, the manager of which has control over its costs and revenues but
not over its investment.
A. A revenue centre
B. A cost centre
C. A profit centre

Notes
Answer for SelfAssessment

l. A 2. D 3. C 4. A 5. C
6. D 7. D 8. D 9. A 10. A
11. A 12. B 13. D 14. A 15. C
Review Questions
Q1 What do you mean by Responsibility Accounting?
Q2 Explain the pre-requisites of executing responsibility accounting in an organization.
Q3 State the steps of implementing a responsibility accounting system in an organization.
Q4 What do you mean by responsibility centres?
Q5 Explain the various types of responsibility centres.
Q6 Give the advantages of using a responsibility accounting system.
Q7 List the limitation of the responsibility accounting system.
Further Readings
1. M.N. Arora, Cost and Management Accounting, 8th Edition, Vikas Publishing
House (P) Ltd.
2. Shashi K. Gupta and R.K. Sharma, Financial Management (Theory and Practice),
8thEdition, Kalyani Publishers.
Web Links
1. https://www.accountingtools.com/articles/what-is-a-responsibility-center.html
2. https://www.wallstreetmojo.com/responsibility-accounting/
3. https://www.vedantu.com/commerce/responsibility-accounting
4. https://www.yourarticlelibrary.com/accounting/responsibility-
accounting/responsibility-accounting-meaning-features-and-steps-for-achieving-
goals/67700#:~:text=Responsibility%20Accounting%20is%20a%20system,to%20keep%20u
p%20their%20performance.
5. https://efinancemanagement.com/budgeting/responsibility-accounting

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Financial Reporting, Statements

Unit 1: Introduction to Accounting 1

Unit 2: Corporate Financial Statements 43

Unit 3: Ratio Analysis 57

Unit 4: Financial Statement Analysis 79

Unit 5: Artificial Intelligence and Analysis 99

Unit 6: Cash Flow Statement 111

Unit 7: Basic aspects of Cost Accounting 126

Unit 8: Budgetary Control 146

Unit 10: Marginal Costing and Profit Planning 178

Unit 13: Activity-Based Costing 227

Unit 14: Responsibility Accounting 242

Unit 01: Introduction to Accounting

 Explain the meaning of Accounting.

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Accounting is not an equivalent function to book-keeping. Accounting is broader in scope

1.1 Meaning of Accounting

1.2 Definition of Accounting

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1.3 Characteristics of Accounting

1.4 Branches of Accounting

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Identifying: Only Business-related transactions have a place in the books of accounts.

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Accounting Process Explanation of the steps

Identify The transaction "identified" was the purchase of a printer.

Measure The cost of the printer was "measured" as ₹5000.

Record The transaction was "recorded" in Journal systematically as

Classify The transaction was then moved to the Ledger

Summarize Here the ledger balance was "summarized" and converted

Analyze The purchase manager "analyzed" the financial statements at

Communicate Interpretation inferred from the analysis in the above step

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To maintain a systematic record of business transactions:

To ascertain the financial position:

To assist the management:

To provide information to various users:

1.6 Users of Accounting Information

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Decisions related to whether the company should-

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Media, NGOs, and Business consultants/analysts are also users of accounting

1.7 Advantages of Accounting

Preparation of financial statements

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Evidence in legal matters

Provides information to related parties

Provides information about related party transactions

Helps in taxation matters

1.8 Limitations of Accounting

Measurability: Ignores the qualitative elements

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Ignores Price Level Changes

The danger of Window Dressing

Varied Accounting Policies

1.9 Accounting Terminology

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Cash, Property, Buildings, Equipment, Furniture, Inventory

Patents, Goodwill, Copyrights, Trademark