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LESSON ? 1.1

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ACCOUNTING ? AN INTRODUCTION

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1.1.1 INTRODUCTION

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Accounting is aptly called the language of business. This

designation is applied to accounting because it is the method of

communicating business information. The basic function of any

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language is to serve as a means of communication. Accounting duly

serves this function. The task of learning accounting is essentially

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the same as the task of learning a new language. But the

acceleration of change in business organization has contributed to

increasing the complexities in this language. Like other languages,

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it is undergoing continuous change in an attempt to discover better

means of communications. To enable the accounting language to

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convey the same meaning to all people as far as practicable it

should be made standard. To make it a standard language certain

accounting principles, concepts and standards have been developed

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over a period of time. This lesson dwells upon the different

dimensions of accounting, accounting concepts, accounting

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principles and the accounting standards.


1.1.2 OBJECTIVES

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After reading this lesson, the reader should be able to:

? Know the evolution of accounting
? Understand the definition of accounting

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? Comprehend the scope and function of accounting
? Ascertain the users of accounting information
? Know the specialised accounting fields
? Understand the accounting concepts and conventions
? Realise the need for accounting standards

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1.1.3 CONTENTS

1.1.3.1

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Evolution of Accounting

1.1.3.2

Book Keeping and Accounting

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1.1.3.3

Definition of Accounting

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1.1.3.4

Scope and Functions of Accounting

1.1.3.5

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Groups Interested in Accounting Information

1.1.3.6

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The Profession of Accounting

1.1.3.7

Specialised Accounting Fields

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1.1.3.8

Nature and Meaning of Accounting Principles

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1.1.3.9

Accounting Concepts

1.1.3.10

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Accounting Conventions

1.1.3.11

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Accounting Standards

1.1.3.12

Summary

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1.1.3.13

Key Words

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1.1.3.14

Self Assessment Questions

1.1.3.15

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Books for Further Reading

1.1.3.1

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EVOLUTION OF ACCOUNTING

Accounting is as old as money itself. It has evolved, as have medicine,

law and most other fields of human activity in response to the social and

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economic needs of society. People in all civilizations have maintained various

types of records of business activities. The oldest known are clay tablet records

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of the payment of wages in Babylonia around 600 B.C. Accounting was



2

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practiced in India twenty-four centuries ago as is clear from Kautilya's book

`Arthshastra' which clearly indicates the existence and need of proper

accounting and audit.

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For the most part, early accounting dealt only with limited aspects of the

financial operations of private or governmental enterprises. Complete

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accounting system for an enterprise which came to be called as "Double Entry

System" was developed in Italy in the 15th century. The first known description

of the system was published there in 1494 by a Franciscan monk by the name

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Luca Pacioli.

The expanded business operations initiated by the Industrial

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Revolution required increasingly large amounts of money which in turn

resulted in the development of the corporation form of organisations. As

corporations became larger, an increasing number of individuals and

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institutions looked to accountants to provide economic information about

these enterprises. For e.g. prospective investors and creditors sought

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information about a corporation's financial status. Government agencies

required financial information for purposes of taxation and regulation.

Thus accounting began to expand its function of meeting the needs of

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relatively few owners to a public role of meeting the needs of a variety

of interested parties.

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1.1.3.2

BOOK KEEPING AND ACCOUNTING

Book-keeping is that branch of knowledge which tells us how to

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keep a record of business transactions. It is considered as an art of

recording systematically the various types of transactions that occur in a

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business concern in the books of accounts. According to Spicer and

Pegler, "book-keeping is the art of recording all money transactions, so

that the financial position of an undertaking and its relationship to both

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its proprietors and to outside persons can be readily ascertained".



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3

Accounting is a term which refers to a systematic study of the principles

and methods of keeping accounts. Accountancy and book-keeping are

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related terms; the former relates to the theoretical study and the latter

refers to the practical work.

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1.1.3.3

DEFINITION OF ACCOUNTING

Before attempting to define accounting, it may be made clear that

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there is no unanimity among accountants as to its precise definition.

Anyhow let us examine three popular definitions on the subject:

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Accounting has been defined by the American Accounting

Association Committee as: ". . . the process of identifying, measuring

and communicating economic information to permit informed judgments

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and decisions by users of the information". This may be considered as a

good definition because of its focus on accounting as an aid to decision

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making.

The American Institute of Certified and Public Accountants

Committee on Terminology defined accounting as: "Accounting is the art

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of recording classifying and summarising, in a significant manner and in

terms of money, transactions and events which are, in part at least, of a

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financial character and interpreting the results thereof". Of all

definitions available, this is the most acceptable one because it

encompasses all the functions which the modern accounting system

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performs.

Another popular definition on accounting was given by American

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Accounting Principles Board in 1970, which defined it as: "Accounting

is a service society. Its function is to provide quantitative information,

primarily financial in nature, about economic entities that is useful in

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making economic decision, in making reasoned choices among

alternative courses of action". This is a very relevant definition in a

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present context of business units facing the situation of selecting the best

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among the various alternatives available. The special feature of this

definition is that it has designated accounting as a service activity.

1.1.3.4

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SCOPE AND FUNCTIONS OF ACCOUNTING

Individuals engaged in such areas of business as finance,

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production, marketing, personnel and general management need not be

expert accountants but their effectiveness is no doubt increased if they

have a good understanding of accounting principles. Everyone engaged

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in business activity, from the bottom level employee to the chief

executive and owner, comes into contact with accounting. The higher the

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level of authority and responsibility, the greater is the need for an

understanding of accounting concepts and terminology.

A study conducted in United States revealed that the most

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common background of chief executive officers in United States

Corporations was finance and accounting. Interviews with several

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corporate executives drew the following comments:

"...... my training in accounting and auditing practice has been

extremely valuable to me throughout". "A knowledge of accounting

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carried with it understanding of the establishment and maintenance of

sound financial controls- is an area which is absolutely essential to a

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chief executive officer".

Though accounting is generally associated with business, it is not

only business people who make use of accounting but also many

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individuals in non-business areas that make use of accounting data and

need to understand accounting principles and terminology. For e.g. an

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engineer responsible for selecting the most desirable solution to a

technical manufacturing problem may consider cost accounting data to

be the decisive factor. Lawyers want accounting data in tax cases and

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damages from breach of contract. Governmental agencies rely on an

accounting data in evaluating the efficiency of government operations

and for approving the feasibility of proposed taxation and spending

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programs. Accounting thus plays an important role in modern society

and broadly speaking all citizens are affected by accounting in some way

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or the other.

Accounting which is so important to all, discharges the following vital

functions:

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Keeping systematic records: This is the fundamental function of accounting.

The transactions of the business are properly recorded, classified and

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summarised into final financial statements ? income statement and the balance

sheet.

Protecting the business properties: The second function of accounting is to

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protect the properties of the business by maintaining proper record of various

assets and thus enabling the management to exercise proper control over them.

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Communicating the results: As accounting has been designated as the language

of business, its third function is to communicate financial information in respect

of net profits, assets, liabilities, etc., to the interested parties.

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Meeting legal requirements: The fourth and last function of accounting is to

devise such a system as will meet the legal requirements. The provisions of

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various laws such as the Companies Act, Income Tax Act, etc., require the

submission of various statements like Income Tax returns, Annual Accounts and

so on. Accounting system aims at fulfilling this requirement of law.

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It may be noted that the functions stated above are those of

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financial accounting alone. The other branches of accounting, about

which we are going to see later in this lesson, have their special

functions with the common objective of assisting the management in its

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6
task of planning, control and coordination of business activities. Of all

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the branches of accounting, management accounting is the most

important from the management point of view.

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As accounting is the language of business, the primary aim of

accounting, like any other language, is to serve as a means of

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communication. Most of the world's work is done through organisations

? groups of people who work together to accomplish one or more

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objectives. In doing its work, an organisation uses resources ? men,

material, money and machine and various services. To work effectively,

the people in an organisation need information about these sources and

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the results achieved through using them. People outside the organisation

need similar information to make judgments about the organisation.

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Accounting is the system that provides such information.



Any system has three features viz. input, processes and output.

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Accounting as a social science can be viewed as an information system

since it has all the three feature i.e., inputs (raw data), processes (men

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and equipment) and outputs (reports and information). Accounting

information is composed principally of financial data about business

transactions. The mere records of transactions are of little use in making

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"informed judgements and decisions". The recorded data must be sorted

and summarised before significant analysis can be prepared. Some of the

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reports to the enterprise manager and to others who need economic

information may be made frequently: other reports are issued only at

longer intervals. The usefulness of reports is often enhanced by various

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types of percentage and trend analyses. The "BASIC RAW

MATERIALS" of accounting are composed of business transactions

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data. Its "primary end products" are composed of various summaries,

analyses and reports.


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7



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The information needs of a business enterprise can be outlined

and illustrated with the help of the following chart:


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CHART SHOWING TYPES OF INFORMATION

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Information

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Nonquantitative Quantitative
Information

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Information

Accounting Non accounting

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Information Information



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Operating



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Financial



Management Cost

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Information

Accounting

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Accounting Accounting




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The chart clearly presents the different types of information that

might be useful to all sorts of individuals interested in the business

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enterprise. As seen from the chart, accounting supplies the quantitative

information. The special feature of accounting as a kind of a quantitative

information and as distinguished from other types of quantitative

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information is that it usually is expressed in monetary terms. In this

connection it is worthwhile to recall the definitions of accounting as

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given by the American Institute of Certified and Public Accountants and

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by the American Accounting Principles Board.



The types of accounting information may be classified into four

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categories: (1) Operating information, (2) Financial accounting

information (3) Management accounting information and (4) Cost

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accounting information.

Operating Information: By operating information, we mean the information

which is required to conduct the day-to-day activities. Examples of operating

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information are: Amount of wages paid and payable to employees, information

about the stock of finished goods available for sale and each one's cost and

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selling price, information about amounts owed to and owing by the business

enterprise, information about stock of raw materials, spare parts and accessories

and so on. By far the largest quantity of accounting information provides the raw

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data (input) for financial accounting, management accounting and cost

accounting.

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Financial Accounting: Financial accounting information is intended both for

owners and managers and also for the use of individuals and agencies external to

the business. This accounting is concerned with the recording of transactions for

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a business enterprise and the periodic preparation of various reports from such

records. The records may be for general purpose or for a special purpose. A

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detailed account of the function of financial accounting has been given earlier in

this lesson.

Management Accounting: Management accounting employs both historical and

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estimated data in assisting management in daily operations and in planning for

future operations. It deals with specific problems that confront enterprise

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managers at various organisational levels. The management accountant is

frequently concerned with identifying alternative courses of action and then

helping to select the best one. For e.g. the accountant may help the finance

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manager in preparing plans for future financing or may help the sales manager

in determining the selling price to be fixed on a new product by providing

suitable data. Generally management accounting information is used in three

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important management functions: (1) control (2) co-ordination and (3) planning.

Marginal costing is an important technique of management accounting which

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provides multi dimensional information that facilitates decision making. More

about it can be had in the Unit IV.

Cost Accounting: The Industrial Revolution in England posed a challenge to the

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development of accounting as a tool of industrial management. This necessitated

the development of costing techniques as guides to management action. Cost

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accounting emphasizes the determination and the control of costs. It is

concerned primarily with the cost of manufacturing processes. In addition one of

the principal functions of cost accounting is to assemble and interpret cost data,

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both actual and prospective, for the use of management in controlling current

operations and in planning for the future.

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All of the activities described above are related to accounting and

in all of them the focus is on providing accounting information to enable

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decisions to be made. More about cost accounting can be gained in

unit V

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1.1.3.5

GROUPS INTERESTED IN ACCOUNTING INFORMATION

There are several groups of people who are interested in the accounting

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information relating to the business enterprise. Following are some of them:

Shareholders: Shareholders as owners are interested in knowing the profitability

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of the business transactions and the distribution of capital in the form of assets

and liabilities. In fact, accounting developed several centuries ago to supply

information to those who had invested their funds in business enterprise.

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Management: With the advent of joint stock company form of organisation the

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gap between ownership and management widened. In most cases the

shareholders act merely as renters of capital and the management of the

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company passes into the hands of professional managers. The accounting

disclosures greatly help them in knowing about what has happened and what

should be done to improve the profitability and financial position of the

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enterprise.

Potential Investors: An individual who is planning to make an investment in a

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business would like to know about its profitability and financial position. An

analysis of the financial statements would help him in this respect.

Creditors: As creditors have extended credit to the company, they are much

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worried about the repaying capacity of the company. For this purpose they

require its financial statements, an analysis of which will tell about the solvency

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position of the company.

Government: Any popular Government has to keep a watch on big businesses

regarding the manner in which they build business empires without regard to the

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interests of the community. Restricting monopolies is something that is common

even in capitalist countries. For this, it is necessary that proper accounts are

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made available to the Government. Also, accounting data are required for

collection of sale-tax, income-tax, excise duty etc.

Employees: Like creditors, employees are interested in the financial statements

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in view of various profit sharing and bonus schemes. Their interest may further

increase when they hold shares of the companies in which they are employed.

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Researchers: Researchers are interested in interpreting the financial statements
of the concern for a given objective.
Citizens: Any citizen may be interested in the accounting records of business

enterprises including public utilities and Government companies as a voter and

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tax payer.



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1.1.3.6

THE PROFESSION OF ACCOUNTING

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Accountancy can very well be viewed as a profession with stature

comparable to that of law or medicine or engineering. The rapid

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development of accounting theory and techniques especially after the

late thirties of 20th century has been accompanied by an expansion of

the career opportunities in accounting and an increasing number of

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professionally trained accountants. Among the factors contributing to

this growth have been the increase in number, size and complexity of

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business enterprises, the imposition of new and increasingly complex

taxes and other governmental restrictions on business operations.

Coming to the nature of accounting function, it is no doubt a

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service function. The chief of accounting department holds a staff

position which is quite in contra distinction to the roles played by

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production or marketing executives who hold line authority. The role of

the accountant is advisory in character. Although accounting is a staff

function performed by professionals within an organization, the ultimate

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responsibility for the generation of accounting information, whether

financial or managerial, rests with management. That is why one of the

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top officers of many businesses is the Financial Controller. The

controller is the person responsible for satisfying other managers'

demands for management accounting information and for complying

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with the regulatory demands of financial reporting. With these ends in

view, the controller employs accounting professionals in both

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management and financial accounting. These accounting professionals

employed in a particular business firm are said to be engaged in private

accounting. Besides these there are also accountants who render

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accounting services on a fee basis through staff accountants employed by

them. These accountants are said to be engaged in public accounting.

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1.1.3.7

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SPECIALISED ACCOUNTING FIELDS

As in many other areas of human activity, a number of specialised

fields in accounting also have evolved besides financial accounting.

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Management accounting and Cost accounting are the result of rapid

technological advances and accelerated economic growth. The most

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important among them are explained below:

Tax Accounting: Tax accounting covers the preparation of tax returns and the

consideration of the tax implications of proposed business transactions or

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alternative courses of action. Accountants specialising in this branch of

accounting are familiar with the tax laws affecting their employer or clients and

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are upto date on administrative regulations and court decisions on tax cases.

International Accounting: This accounting is concerned with the special

problems associated with the international trade of multinational business

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organisations. Accountants specialising in this area must be familiar with the

influences that custom, law and taxation of various countries bring to bear on

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international operations and accounting principles.

Social Responsibility Accounting: This branch is the newest field of accounting

and is the most difficult to describe concisely. It owes its birth to increasing

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social awareness which has been particularly noticeable over the last three

decades or so. Social responsibility accounting is so called because it not only

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measures the economic effects of business decisions but also their social effects,

which have previously been considered to be unmeasurable. Social

responsibilities of business can no longer remain as a passive chapter in the text

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books of commerce but are increasingly coming under greater scrutiny. Social

workers and people's welfare organisations are drawing the attention of all

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concerned towards the social effects of business decisions. The management is

being held responsible not only for the efficient conduct of business as reflected


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13

by increased profitability but also for what it contributes to social well-being and

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progress.

Inflation Accounting: Inflation has now become a world-wide phenomenon.

The consequences of inflation are dire in case of developing and under-

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developed countries. At this juncture when financial statements or reports are

based on historical costs, they would fail to reflect the effect of changes in

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purchasing power or the financial position and profitability of the firm. Thus the

utility of the accounting records, not taking care of price level changes is

seriously lost. This imposes a demand on the accountants for adjusting financial

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accounting for inflation to know the real financial position and profitability of a

concern and thus emerged a future branch of accounting called Inflation

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accounting or Accounting for price level changes. It is a system of accounting

which regularly records all items in financial statements at their current values.

Human Resources Accounting: Human Resources Accounting is yet another

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new field of accounting which seeks to report and emphasise the importance of

human resources in a company's earning process and total assets. It is based on

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the general agreement that the only real long lasting asset which an organisation

possesses is the quality and calibre of the people working in it. This system of

accounting is concerned with, "the process of identifying and measuring data

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about human resources and communicating this information to interested

parties".

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1.1.3.8

NATURE AND MEANING OF ACCOUNTING PRINCIPLES

What is an accounting principle or concept or convention or

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standard? Do they mean the same thing? Or does each one have its own

meaning? These are all questions for which there is no definite answer

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because there is ample confusion and controversy as to the meaning and

nature of accounting principles. We do not want to enter into this


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14
controversial discussion because the reader may fall a prey to the

controversies and confusions and lose the spirit of the subject.

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The rules and conventions of accounting are commonly referred to

as principles. The American Institute of Certified Public Accountants

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have defined the accounting principle as, "a general law or rule adopted

or professed as a guide to action; a settled ground or basis of conduct or

practice". It may be noted that the definition describes the accounting

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principle as a general law or rule that is to be used as a guide to action.

The Canadian Institute of Chartered Accountants has defined accounting

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principles as, "the body of doctrines commonly associated with the

theory and procedure of accounting, serving as explanation of current

practices and as a guide for the selection of conventions or procedures

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where alternatives exist". This definition also makes it clear that

accounting principles serve as a guide to action.

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The peculiar nature of accounting principles is that they are man-

made. Unlike the principles of physics, chemistry etc. they were not

deducted from basic axiom. Instead they have evolved. This has been

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clearly brought out by the Canadian Institute of Chartered Accountants

in the second part of their definition on accounting principles: "Rules

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governing the foundation of accounting actions and the principles

derived from them have arisen from common experiences, historical

precedent, statements by individuals and professional bodies and

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regulation of governmental agencies". Since the accounting principles

are man made they cannot be static and are bound to change in response

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to the changing needs of the society. It may be stated that accounting

principles are changing but the change in them is permanent.

Accounting principles are judged on their general acceptability to

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the makers and users of financial statements and reports. They present a



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15

generally accepted and uniform view of the accounting profession in

relation to good accounting practice and procedures. Hence the name

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generally accepted accounting principles.

Accounting principles, rules of conduct and action are described

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by various terms such as concepts, conventions, doctrines, tenets,

assumptions, axioms, postulates, etc. But for our purpose we shall use all

these terms synonymously except for a little difference between the two

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terms ? concepts and conventions. The term "concept" is used to connote

accounting postulates i.e. necessary assumptions or conditions upon

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which accounting is based. The term convention is used to signify

customs or traditions as a guide to the preparation of accounting

statements.

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1.1.3.9

ACCOUNTING CONCEPTS

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The important accounting concepts are discussed hereunder:

Business Entity Concept: It is generally accepted that the moment a business

enterprise is started it attains a separate entity as distinct from the persons who

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own it. In recording the transactions of the business the important question is:



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How do these transactions affect the business enterprise? The question as

to how these transactions affect the proprietors is quite irrelevant. This concept

is extremely useful in keeping business affairs strictly free from the effect of

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private affairs of the proprietors. In the absence of this concept the private

affairs and business affairs are mingled together in such a way that the true

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profit or loss of the business enterprise cannot be ascertained nor its financial

position. To quote an example, if the proprietor has taken Rs.5000/- from the

business for paying house tax for his residence, the amount should be deducted

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from the capital contributed by him. Instead if it is added to the other business

expenses then the profit will be reduced by Rs.5000/- and also his capital more

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by the same amount. This affects the results of the business and also its financial



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position. Not only this, since the profit is lowered, the consequential tax

payment also will be less which is against the provisions of the Income-tax Act.

Going Concern Concept: This concept assumes that the business enterprise will

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continue to operate for a fairly long period in the future. The significance of this

concept is that the accountant while valuing the assets of the enterprise does not

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take into account their current resale values as there is no immediate expectation

of selling it. Moreover, depreciation on fixed assets is charged on the basis of

their expected life rather than on their market values. When there is conclusive

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evidence that the business enterprise has a limited life the accounting procedures

should be appropriate to the expected terminal date of the enterprise. In such

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cases, the financial statements could clearly disclose the limited life of the

enterprise and should be prepared from the `quitting concern' point of view

rather than from a `going concern' point of view.

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Money Measurement Concept: Accounting records only those transactions

which can be expressed in monetary terms. This feature is well emphasized in

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the two definitions on accounting as given by the American Institute of Certified

Public Accountants and the American Accounting Principles Board. The

importance of this concept is that money provides a common denomination by

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means of which heterogeneous facts about a business enterprise can be

expressed and measured in a much better way. For e.g. when it is stated that a

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business owns Rs.1,00,000 cash, 500 tons of raw material, 10 machinery items,

3000 square meters of land and building etc., these amounts cannot be added

together to produce a meaningful total of what the business owns. However, by

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expressing these items in monetary terms Rs.1,00,000 cash, Rs.5,00,000 worth

of raw materials, Rs,10,00,000 worth of machinery items and Rs.30,00,000

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worth of land and building ? such an addition is possible.



A serious limitation of this concept is that accounting does not

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take into account pertinent non-monetary items which may significantly



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17

affect the enterprise. For instance, accounting does not give information

about the poor health of the Chairman, serious misunderstanding

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between the production and sales manager etc., which have serious

bearing on the prospects of the enterprise. Another limitation of this

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concept is that money is expressed in terms of its value at the time a

transaction is recorded in the accounts. Subsequent changes in the

purchasing power of moneys are not taken into account.

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Cost Concept: This concept is yet another fundamental concept of accounting

which is closely related to the going-concern concept. As per this concept: (i) an

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asset is ordinarily entered in the accounting records at the price paid to acquire it

i.e., at its cost and (ii) this cost is the basis for all subsequent accounting for the

asset.

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The implication of this concept is that the purchase of an asset is

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recorded in the books at the price actually paid for it irrespective of its

market value. For e.g. if a business buys a building for Rs.3,00,000, the

asset would be recorded in the books at Rs.3,00,000 even if its market

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value at that time happens to be Rs.4,00,000. However, this concept does

not mean that the asset will always be shown at cost. This cost becomes

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the basis for all future accounting for the asset. It means that the asset

may systematically be reduced in its value by changing depreciation. The

significant advantage of this concept is that it brings in objectivity in the

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preparations and presentation of financial statements. But like the money

measurement concept this concept also does not take into account

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subsequent changes in the purchasing power of money due to

inflationary pressures. This is the reason for the growing importance of

inflation accounting.

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18
Dual Aspect Concept (Double Entry System): This concept is the core of

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accounting. According to this concept every business transaction has a dual

aspect. This concept is explained in detail below:

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The properties owned by a business enterprise are referred to as

assets and the rights or claims to the various parties against the assets are

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referred to as equities. The relationship between the two may be

expressed in the form of an equation as follows:

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Equities = Assets

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Equities may be subdivided into two principal types: the rights of

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creditors and the rights of owners. The rights of creditors represent debts of the

business and are called liabilities. The rights of the owners are called capital.

Expansion of the equation to give recognition to the two types of equities results

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in the following which is known as the accounting equation:



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Liabilities + Capital = Assets



It is customary to place `liabilities' before `capital' because creditors

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have priority in the repayment of their claims as compared to that of owners.

Sometimes greater emphasis is given to the residual claim of the owners by

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transferring liabilities to the other side of the equation as:




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Capital = Assets ? Liabilities

All business transactions, however simple or complex they are, result in

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a change in the three basic elements of the equation. This is well explained with

the help of the following series of examples:

(i)

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Mr.Prasad commenced business with a capital of Rs.3,000: The

result of this transaction is that the business, being a separate

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entity, gets cash-asset of Rs.30,000 and has to pay to Mr.Prasad

Rs.30,000 his capital. This transaction can be expressed in the

form of the equation as follows:

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19

Capital

=

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Assets

Prasad

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Cash

30,000

30,000

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(ii)

Purchased furniture for Rs.5,000: The effect of this transaction is

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that cash is reduced by Rs.5,000 and a new asset viz. furniture

worth Rs.5,000 comes in thereby rendering no change in the total

assets of the business. The equation after this transaction will be:

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Capital =

Assets

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Prasad

Cash + Furniture

30,000

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25,000 5,000

(iii)

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Borrowed Rs.20,000 from Mr.Gopal: As a result of this

transaction both the sides of the equation increase by Rs.20,000;

cash balance is increased and a liability to Mr.Gopal is created.

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The equation will appear as follows:

Liabilities + Capital

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=Assets

Creditiors

+

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Prasad Cash +

Furniture

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20,000



30,000 45,000

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5,000

(iv)

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Purchased goods for cash Rs.30,000: This transaction does not

affect the liabilities side total nor the asset side total. Only the

composition of the total assets changes i.e. cash is reduced by

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Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in.

The equation after this transaction will be as follows:

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Liabilities + Capital

=Asset

Creditors

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Prasad Cash + Stock + Furniture

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20,000

30,000

15,000 30,000 5,000

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(v)

Goods worth Rs.10,000 are sold on credit to Ganesh for

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Rs.12,000. The result is that stock is reduced by Rs.10,000 a new

asset namely debtor (Mr.Ganesh) for Rs.12,000 comes into


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20
picture and the capital of Mr.Prasad increases by Rs.2,000 as the

profit on the sale of goods belongs to the owner. Now the

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accounting equation will look as under:

Liabilities

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+ Capital

=Asset

Creditors

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Prasad

Cash +Debtors+Stock+ Furnitures

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20,000 32,000

15,000 12,000 20,000 5,000

(vi)

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Paid electricity charges Rs.300: This transaction reduces both the

cash balance and Mr.Prasad's capital by Rs.300. This is so

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because the expenditure reduces the business profit which in turn

reduces the equity. The equation after this will be:

Liabilities

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+ Capital

=Asset

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Creditors

+ Prasad

Cash +Debtors+Stock+ Furnitures

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20,000 31,700

14,700 12,000 20,000 5,000

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Thus it may be seen that whatever is the nature of transaction, the

accounting equation always tallies and should tally.

The system of recording transactions based on this concept is

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called double entry system.

Account Period Concept: In accordance with the going concern concept it is

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usually assumed that the life of a business is indefinitely long. But owners and

other interested parties cannot wait until the business has been wound up for

obtaining information about its results and financial position. For e.g. if for ten

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years no accounts have been prepared and if the business has been consistently

incurring losses, there may not be any capital at all at the end of the tenth year

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which will be known only at that time. This would result in the compulsory

winding up of the business. But if at frequent intervals information are made

available as to how things are going, then corrective measures may be suggested

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and remedial action may be taken. That is why, Pacioli wrote as early as in



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21

1494: `Frequent accounting makes for only friendship'. This need leads to the

accounting period concept.

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According to this concept accounting measures activities for a

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specified interval of time called the accounting period. For the purpose

of reporting to various interested parties one year is the usual accounting

period. Though Pacioli wrote that books should be closed each year

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especially in a partnership, it applies to all types of business

organisations.

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Periodic Matching of Costs and Revenues: This concept is based on the

accounting period concept. It is widely accepted that desire of making profit is

the most important motivation to keep the proprietors engaged in business

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activities. Hence a major share of attention of the accountant is being devoted

towards evolving appropriate techniques of measuring profits. One such

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technique is periodic matching of costs and revenues.



In order to ascertain the profits made by the business during a

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period, the accountant should match the revenues of the period with the

costs of that period. By `matching' we mean appropriate association of

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related revenues and expenses pertaining to a particular accounting

period. To put it in other words, profits made by a business in a

particular accounting period can be ascertained only when the revenues

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earned during that period are compared with the expenses incurred for

earning that revenue. The question as to when the payment was actually

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received or made is irrelevant. For e.g. in a business enterprise which

adopts calendar year as accounting year, if rent for December 1989 was

paid in January 1990, the rent so paid should be taken as the expenditure

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of the year 1989, revenues of that year should be matched with the costs

incurred for earning that revenue including the rent for December 1989,

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though paid in January 1990. It is on account of this concept that



22

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adjustments are made for outstanding expenses, accrued incomes,

prepaid expenses etc. while preparing financial statements at the end of

the accounting period.

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The system of accounting which follows this concept is called as

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mercantile system. In contrast to this there is another system of

accounting called as cash system of accounting where entries are made

only when cash is received or paid, no entry being made when a payment

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or receipt is merely due.

Realisation Concept: Realisation refers to inflows of cash or claims to cash like

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bills receivables, debtors etc. arising from the sale of assets or rendering of

services. According to Realisation concept, revenues are usually recognized in

the period in which goods were sold to customers or in which services were

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rendered. Sale is considered to be made at the point when the property in goods

passes to the buyer and he becomes legally liable to pay. To illustrate this point,

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let us consider the case of A, a manufacturer who produces goods on receipt of

orders. When an order is received from B, A starts the process of production and

delivers the goods to B when the production is complete. B makes payment on

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receipt of goods. In this example, the sale will be presumed to have been made

not at the time when goods are delivered to B. A second aspect of the

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Realisation concept is that the amount recognized as revenue is the amount that

is reasonably certain to be realized. However, lot of reasoning has to be applied

to ascertain as to how certain `reasonably certain' is ... Yet, one thing is clear,

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that is, the amount of revenue to be recorded may be less than the sales value of

the goods sold and services rendered. For e.g. when goods are sold at a discount,

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revenue is recorded not at the list price but at the amount at which sale is made.

Similarly, it is on account of this aspects of the concept that when sales are made

on credit though entry is made for the full amount of sales, the estimated amount

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of bad debts is treated as an expense and the effect on net income is the same as



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23

if the revenue were reported as the amount of sales minus the estimated amount

of bad debts.

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1.1.3.10 ACCOUNTING CONVENTIONS

Convention of Conservation: It is a world of uncertainity. So it is always better

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to pursue the policy of playing safe. This is the principle behind the convention

of conservatism. According to this convention the accountant must be very

careful while recognising increases in an enterprise's profits rather than

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recognising decreases in profits. For this the accountants have to follow the rule,

anticipate no profit, provide for all possible losses, while recording business

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transactions. It is on account of this convention that the inventory is valued `at

cost or market price whichever is less', i.e. when the market price of the

inventories has fallen below its cost price it is shown at market price i.e. the

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possible loss is provided and when it is above the cost price it is shown at cost

price i.e. the anticipated profit is not recorded. It is for the same reason that

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provision for bad and doubtful debts, provision for fluctuation in investments,

etc., are created. This concept affects principally the current assets.

Convention of full disclosure: The emergence of joint stock company form of

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business organisation resulted in the divorce between ownership and

management. This necessitated the full disclosure of accounting information

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about the enterprise to the owners and various other interested parties. Thus the

convention of full disclosure became important. By this convention it is implied

that accounts must be honestly prepared and all material information must be

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adequately disclosed therein. But it does not mean that all information that

someone desires are to be disclosed in the financial statements. It only implies

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that there should be adequate disclosure of information which is of considerable

value to owners, investors, creditors, Government, etc. In Sachar Committee

Report (1978) it has been emphasised that openness in company affairs is the

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best way to secure responsible behaviour. It is in accordance with this



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24
convention that Companies Act, Banking Companies Regulation Act, Insurance

Act etc., have prescribed proforma of financial statements to enable the

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concerned companies to disclose sufficient information. The practice of

appending notes relating to various facts on items which do not find place in

financial statements is also in pursuance to this convention. The following are

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some examples:

(a) Contingent liabilities appearing as a note

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(b) Market value of investments appearing as a note

(c) Schedule of advances in case of banking companies

Convention of Consistency: According to this concept it is essential that

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accounting procedures, practices and method should remain unchanged from

one accounting period to another. This enables comparison of performance in

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one accounting period with that in the past. For e.g. if material issues are priced

on the basis of FIFO method the same basis should be followed year after year.

Similarly, if depreciation is charged on fixed assets according to diminishing

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balance method it should be done in subsequent year also. But consistency never

implies inflexibility as not to permit the introduction of improved techniques of

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accounting. However if introduction of a new technique results in inflating or

deflating the figures of profit as compared to the previous methods, the fact

should be well disclosed in the financial statement.

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Convention of Materiality: The implication of this convention is that accountant

should attach importance to material details and ignore insignificant ones. In the

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absence of this distinction accounting will unnecessarily be overburdened with

minute details. The question as to what is a material detail and what is not is left

to the discretion of individual accountant. Further an item should be regarded as

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material if there is reason to believe that knowledge of it would influence the

decision of informed investor. Some examples of material financial information

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are: fall in the value of stock, loss of markets due to competition, change in the



25

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demand pattern due to change in government regulations, etc. Examples of

insignificant financial information are: rounding of income to nearest ten for tax

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purposes etc. Sometimes if it is felt that an immaterial item must be disclosed,

the same may be shown as footnote or in parenthesis according to its relative

importance.

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1.1.3.11 ACCOUNTING STANDARS

The information revealed by the published financial statements is

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of considerable importance to shareholders, creditors and other

interested parties. Hence it is the responsibility of the accounting

profession to ensure that the required information is properly presented.

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If the accountants present the financial information using their own

discretion and in their own way, the information may not be valid and

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hence may not serve the purpose. There is, therefore, the urgent need

that certain standard should be followed for drawing up the financial

statements so that there is the minimum possible ambiguity and

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uncertainty about the information contained in them. The International

Accounting Standards Committee (IASC) has undertaken this task of

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drawing up the standards.

The IASC was established in 1973. It has its headquarters at London. At

present, the IASC has two classes of membership:

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(a) Founder members, being the professional accounting bodies of the

following nine countries:

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Australia

Mexico

Canada Netherlands

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France

U.K.

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and

Ireland

Germany

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U.S.A.

Japan

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26
(b) Members being accounting bodies from countries other than the

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nine above which seek and are granted membership.

The need for an IAS Program has been attributed to three factors:

(a) The growth in international investment. Investors in international

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capital markets are to make decisions based on published accounting

which are based on accounting policies and which again vary from

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country to country. The International Accounting Statements will

help investors to make more efficient decisions.

(b) The increasing prominence of multinational enterprises. Such

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enterprises render accounts for the countries in which their

shareholders reside and in local country in which they operate,

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accounting standards will help to avoid confusion.

(c) The growth in the number of accounting standard setting bodies. It is

hoped that the IASC can harmonise these separate rule making

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efforts.

The objective of the IASC is `to formulate and publish in the

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public interest standards to be observed in the presentation of audited

financial statements and to promote their world-wide acceptance and

observance'. The formulation of standards will bring uniformity in

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terminology, procedure, method, approach and presentation of results.

The International Accounting Standards Board (IASB) replaced the

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IASC in 2001. Since then the IASB has amended some International

Accounting Standards, has proposed to replace some International

Accounting Standards with new International Financial Reporting

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Standards (IFRSs) and has adopted or proposed certain new IFRSs on

topics for which there was no previous International Accounting

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Standards. Since its inception the IASC has so far issued 41 International

Accounting Standards.


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27

INDIA AND ACCOUNTING STANDARDS

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The Institute of Chartered Accountants of India (ICAI) and the

Institute of Cost and Works Accountants of India (ICWAI) are associate

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members of the IASC. But the enforcement of the standards issued by

the IASC has been restricted in our country. Instead, the ICAI is drawing

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up its own standards. The Accounting Standards Board (ASB) which was

established by the council of the ICAI in 1977 is formulating accounting

standards so that such standards will be established by the council of the

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ICAI.



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The ICAI has issued a mandate to its members to adopt uniform

accounting system for the corporate sector w.e.f. 1-4-1991, in view of

the fact that the International Accounting Standards are being followed

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all over the world and so, the auditor of companies will now insist on

compliance of these mandatory accounting standards. As at 28-2-2005

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the ASB of ICAI has issued 29 Indian Accounting Standards.

1.1.3.12 SUMMARY

Accounting is rightly called the language of business. It is as old

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as money itself. It is concerned with the collecting, recording, evaluating

and communicating the results of business transactions. Initially meant

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to meet the needs of a relatively few owners, it gradually expanded its

functions to a public role of meeting the needs of a variety of interested

parties. Broadly speaking all citizens are affected by accounting in some

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way. Accounting as an information system possesses with accountants

engaged in private and public accounting. As in many other areas of

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human activity a number of specialised fields in accounting also have

evolved as a result of rapid changes in business and social needs.


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Accounting information should be made standard to convey the

same meaning to all interested parties. To make it standard, certain

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28
accounting principles, concepts, conventions and standards have been

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developed over a period of time. These accounting principles, by

whatever name they are called, serve as a general law or rule that is to be

used as a guide to action. Without accounting principles, accounting

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information becomes uncomparable, inconsistent and unreliable. An

accounting principle to become generally accepted should satisfy the

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criteria of relevance, objectivity and feasibility. The FASB (Financial

Accounting Standards Board) is currently the dominant body in the

development of accounting principles. The IASC is another professional

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body which is engaged in the development of the accounting standards.

The ICAI is an associate member of the IASC and the ASB started by the

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ICAI is formulating accounting standards in our country. The IASC and

ICAI both consider going concern, accrual and consistency as

fundamental accounting assumptions.

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1.1.3.13 KEY WORDS

Accounting: Language of business.

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Financial Accounting: Concerned with the recording of transactions for a

business enterprise and the periodic preparation of various reports from such

records

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Management Accounting: Accounting for internal management needs.

Cost Accounting: Accounting for determination and control of costs.

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Accounting Principle: The body of doctrines commonly associated with the

theory and procedure of accounting.

Accounting Concept: Accounting postulates i.e. necessary assumptions or

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conditions upon which accounting is based.

Accounting Conventions: Convention signifies the customs or traditions which

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serve as a guide to the preparation of accounting statements.



29

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Accounting Standard: Standards to be observed in the presentation of financial

statements.

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1.1.3.14 SELF ASSESSMENT QUESTIONS

1. Why is accounting called the language of business?

2. What are the functions of accounting?

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3. Accounting as a social science can be viewed as an information system.

Examine.

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4. Is accounting a staff function or line function? Explain the reasons.

5. Give an account of the various branches of accounting.

6. `Accounting is a service function'. Discuss the statement in the context of a

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modern manufacturing business.

7. Distinguish between Financial Accounting and Management Accounting.

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8. What are accounting concepts and conventions? Is there any difference

between them?

9. What is the significance of dual aspect concept?

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10. Write a short note on Accounting Standards.

11. What is the position in India regarding the formulation and enforcement of

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accounting standards?




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30
UNIT ? I

LESSON ? 1.2

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-------------------------------------------------------------------------------------------------

THE ACCOUNTING PROCESS

-------------------------------------------------------------------------------------------------

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1.2.1 INTRODUCTION



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During the accounting period the accountant records transactions

as and when they occur. At the end of each accounting period the

accountant summarises the information recorded and prepares the Trial

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Balance to ensure that the double entry system has been maintained. This

is often followed by certain adjusting entries which are to be made to

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account the changes that have taken place since the transactions were

recorded. When the recording aspect has been made as complete and

upto-date as possible the accountant prepares financial statements

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reflecting the financial position and the results of business operations.

Thus the accounting process consists of three major parts:

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(i)

the recording of business transactions during that period;

(ii)

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the summarizing of information at the end of the period, and

(iii)

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the reporting and interpreting of the summary information.

The success of the accounting process can be judged from the

responsiveness of financial reports to the needs of the users of

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accounting information. This lesson takes the readers into the

accounting process.

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1.2.2 OBJECTIVES



After reading this lesson the reader should be able to:

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? Understand the rules of debit and credit
? Pass journal entries
? Prepare ledger accounts

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31

? Prepare a trial balance

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? Make adjustment and closing entries
? Get introduced to tally package

1.2.3 CONTENTS

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1.2.3.1

The Account

1.2.3.2

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Debit ? Credit

1.2.3.3

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The Ledger

1.2.3.4

Journal

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1.2.3.5

The Trial Balance

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1.2.3.6

Closing Entries

1.2.3.7

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Adjustment Entries

1.2.3.8

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Preparation of Financial Statements

1.2.3.9

Introduction to Tally Package

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1.2.3.10

Summary

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1.2.3.11

Key Words

1.2.3.12

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Self Assessment Questions

1.2.3.13

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Books for Further Reading

1.2.3.1 THE ACCOUNT


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The transactions that takes place in a business enterprise during a

specific period may effect increases and decreases in assets, liabilities,

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capital, revenue and expense items. To make upto-date information

available when needed and to be able to prepare timely periodic financial

statements, it is necessary to maintain a separate record for each item.

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For e.g. it is necessary to have a separate record devoted exclusively to

recording increases and decreases in cash, another one to record

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increases and decreases in supplies, a third one on machinery, etc. The

type of record that is traditionally used for this purpose is called an

account. Thus an account is a statement wherein information relating to

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32
an item or a group of similar items are accumulated. The simplest form

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of an account has three parts:

(i)

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a title which gives the name of the item recorded in the account

(ii)

a space for recording increases in the amount of the item, and

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(iii)

a space for recording decreases in the amount of the item. This

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form of an account is known as a `T' account because of its

similarity to the letter `T' as illustrated below:

Title

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Left side

Right side

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(Debit side)

(Credit side)


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1.2.3.2 DEBIT CREDIT



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The left-hand side of any account is called the debit side and the

right-hand side is called the credit side. Amounts entered on the left

hand side of an account, regardless of the tile of the account are called

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debits and the amounts entered on the right hand side of an account are

called credits. To debit (Dr) an account means to make an entry on the

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left-hand side of an account and to credit (Cr) an account means to make

an entry on the right-hand side. The words debit and credit have no other

meaning in accounting, though in common parlance, debit has a negative

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connotation, while credit has a positive connotation.



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Double entry system of recording business transactions is

universally followed. In this system for each transaction the debit

amount must equal the credit amount. If not, the recording of

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transactions is incorrect. The equality of debits and credits is maintained

in accounting simply by specifying that the left side of asset accounts is

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to be used for recording increases and the right side to be used for

recording decreases; the right side of a liability and capital accounts is to


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33

be used to record increases and the left side to be used for recording

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decreases. The account balances when they are totaled, will then

conform to the two equations:

1.

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Assets = Liabilities + Owners' equity

2.

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Debits = Credits

From the above arrangement we can state that the rules of debits

and credits are as follows:

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-------------------------------------------------------------------------------------------------

Debit

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signifies

Credit

signifies

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-------------------------------------------------------------------------------------------------

1.

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Increase in asset accounts



1.

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Decrease in asset accounts

2.

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Decrease in liability accounts

2.

Increase in liability

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accounts
3.

Decrease in owners' equity

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3.

Increase in owners' equity

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accounts accounts
-------------------------------------------------------------------------------------------------



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From the rule that credit signifies increase in owners' equity and

debit signifies decrease in it, the rules of revenue accounts and expense

accounts can be derived. While explaining the dual aspect of the concept

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in the preceding lesson, we have seen that revenues increase the owners'

equity as they belong to the owners. Since owners' equity accounts

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increase on the credit side, revenue must be credits. So, if the revenue

accounts are to be increased they must be credited and if they are to be

decreased they must be debited. Similarly we have seen that expenses

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decrease the owners' equity. As owners' equity account decreases on the

debit side expenses must be debits. Hence to increase the expense

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accounts, they must be debited and to decrease it they must be credited.

From the above we can arrive at the rules for revenues and expenses as

follows:

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34
-------------------------------------------------------------------------------------------------



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Debit signifies


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Credit Signifies

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-------------------------------------------------------------------------------------------------

Increase

in

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expenses

Decrease in expenses

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Decrease in revenues

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Increase in revenues

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-------------------------------------------------------------------------------------------------

1.2.3.3 THE LEDGER


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A ledger is a set of accounts. It contains all the accounts of a specific

business enterprise. It may be kept in any of the following two forms:

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(i)

Bound Ledger and

(ii)

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Loose Leaf Ledger

A bound ledger is kept in the form of book which contains all the

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accounts. These days it is common to keep the ledger in the form of

loose-leaf cards. This helps in posting transactions particularly when

mechanized system of accounting is used.

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1.2.3.4 JOURNAL



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When a business transaction takes place the first record of it is

done in a book called journal. The journal records all the transactions of

a business in the order in which they occur. The journal may therefore be

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defined as a Chronological record of accounting transactions. It shows

names of accounts that are to be debited or credited, the amounts of the

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debits and credits and any additional but useful information about the

transaction. A journal does not replace but precedes the ledger. A

proforma of a journal is given in Illustration 1.

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35

Illustration 1:

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Journal

-------------------------------------------------------------------------------------------------

Date

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Particulars

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L.F.

Debit Credit

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-------------------------------------------------------------------------------------------------



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2005



Cash a/c (Dr)

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3



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30,000

August 2


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Sales a/c (Cr)

9

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30,000

-------------------------------------------------------------------------------------------------

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In the illustration 1 the debit entry is listed first, the debit amount

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appears in the left-hand amount column; the account to be credited

appears below the debit entry and the credit amount appears in the right

hand amount column. The data in the journal entry are transferred to the

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appropriate accounts in the ledger by a process known as posting. Any

entry in any account can be made only on the basis of a journal entry.

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The column L.F. which stands for ledger folio gives the page number of

accounts in the ledger wherein posting for the journal entry has been

made. After all the journal entries are posted in the respective ledger

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accounts, each ledger account is balanced by subtracting the smaller total

from the bigger total. The resultant figure may be either debit or credit

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balance and vice-versa.



Thus the transactions are recorded first of all in the journal and

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then they are posted to the ledger. Hence the journal is called the book of

original or prime entry and the ledger is the book of second entry. While

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the journal records transactions in a chronological order, the ledger

records transactions in an analytical order.


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36
1.2.3.5 THE TRIAL BALANCE



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The Trial Balance is simply a list of the account names and their

balance as of a given moment of time with debit balances in one column

and credit balances in another column. It is prepared to ensure that the

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mechanics of the recording and posting of the transaction have been

carried out accurately. If the recording and posting have been accurate

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then the debit total and credit total in the Trial Balance must tally

thereby evidencing that an equality of debits and credits has been

maintained. In this connection it is but proper to caution that mere

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agreement of the debt and credit total in the Trial Balance is not

conclusive proof of correct recording and posting. There are many errors

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which may not affect the agreement of Trial Balance like total omission

of a transaction, posting the right amount on the right side but of a

wrong account etc.

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The points which we have discussed so far can very well be

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explained with the help of the following simple illustration.

Illustration 2:


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January 1

- Started business with Rs.3,000

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January 2

- Bought goods worth Rs.2,000

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January 9

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- Received order for half of the goods from `G'



January 12

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- Delivered the goods, G invoiced Rs.1,300

January 15

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- Received order for remaining half of the total goods

purchased


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January 21

- Delivered goods and received cash Rs.1,200

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January 30

- G makes payment

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January 31

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- Paid salaries Rs.210

- Received interest Rs.50

Let us now analyse the transactions one by one.

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37

January 1 ? Started business with Rs.3,000: The two accounts involved are

cash and owners' equity. Cash, an asset increases and hence it has to be debited.

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Owners' equity, a liability also increases and hence it has to be credited.

January 2 ? Bought goods worth Rs.2,000: The two accounts affected by this

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transaction are cash and goods (purchases). Cash balance decreases and hence it

is credited and goods on hand, an asset, increases and hence it is to be debited.

January 9 ? Received order for half of the goods from `G': No entry is

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required as realisation of revenue will take place only when goods are delivered

(Realisation concept).

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January 12 ? Delivered the goods, `G' invoiced Rs.1,300: This transaction

affects two accounts ? Goods (Sales) a/c and Receivables a/c. Since it is a credit

transaction receivables increase (asset) and hence is to be debited. Sales

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decreases goods on hand and hence goods (Sales) a/c is to be credited. Since the

term `goods' is used to mean purchase of goods and sale of goods, to avoid

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confusion purchase of goods is simply shown as Purchases a/c and Sale of goods

as Sales a/c.

January 15 ? Received order for remaining half of goods: No entry.

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January 21 ? Delivered goods and received cash Rs.1,200: This transaction

affects cash a/c. Since cash is realized, the cash balance will increase and hence

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cash account is to be debited. Since the stock of goods becomes nil due to sale,

Sales a/c is to be credited (as asset in the form goods on hand has reduced due to

sales).

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January 30 - `G' makes Payment: Both the accounts affected by this transaction

are asset accounts ? cash and receivables. Cash balance increases and hence it is

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to be debited and receivables balance decreases and hence it is to be credited.

January 31 ? Paid Salaries Rs.210: Because of payment of salaries cash

balance decreases and hence cash account is to be credited. Salary is an expense

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38
and since expense has the effect of reducing owners' equity and as owners'

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equity account decreases on the debit side, expenses account is to be debited.

January 31 ? Received Interest Rs.50: The receipt of interest increases cash

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balance and hence cash a/c is to be debited. Interest being revenue which has the

effect of increasing the owners' equity, it has to be credited as owners' equity

account increases on the credit side.

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When journal entries for the above transaction are passed, they

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would be as follows:

-------------------------------------------------------------------------------------------------

Date

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Particulars

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L.F.

Debit Credit

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-------------------------------------------------------------------------------------------------

Jan.1

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Cash

a/c (Dr)

3,000

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Capital a/c


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3,000


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Jan.2

Purchase

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a/c

(Dr)

2,000

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Cash a/c


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--- Content provided by‍ FirstRanker.com ---

2,000

Jan.12

Receivables

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a/c (Dr)

1,300

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Sales

a/c 1,300


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Jan.21

Cash

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a/c (Dr)

1,200

Sales

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a/c 1,200

Jan.30

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Cash

a/c (Dr)

1,300

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Receivables

a/c 1,300

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Jan.31

Salaries

a/c

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(Dr)



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210

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Cash

a/c

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210

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Jan.31 Cash a/c



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(Dr)

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50



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Interest a/c

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50

-------------------------------------------------------------------------------------------------

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39


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Now the above journal entries are posted into respective ledger

accounts which in turn are balanced.

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-------------------------------------------------------------------------------------------------



Debit

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Cash a/c




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Debit

-------------------------------------------------------------------------------------------------

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Capital

a/c

3,000

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Purchase

a/c

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2,000

Sales

a/c 1,200

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Salaries

a/c

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--- Content provided by⁠ FirstRanker.com ---


210

Receivables

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a/c 1,300

Balance 3,340

Interest a/c

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50

-------

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-------



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5,550

5,500

-------------------------------------------------------------------------------------------------

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Capital a/c

Balance

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3,000

Cash

a/c 3,000

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Purchases a/c

Cash

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a/c 2,000

Balance

2,000

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Receivables a/c

Sales

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a/c 1,300

Cash

a/c 1,300

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Sales a/c

Balance 2,500

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Receivables

a/c 1,300

Cash

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a/c 1,200

-------

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-------



2,500

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2,500

-------

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-------



Salaries a/c

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Cash a/c



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210

Balance

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--- Content provided by‍ FirstRanker.com ---

210

Interest a/c

Balance

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50

Cash a/c


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50

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-------------------------------------------------------------------------------------------------



40

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Now a Trial Balance can be prepared and when prepared it would

appear as follows:

Trial Balance

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-------------------------------------------------------------------------------------------------



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Debit




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Credit

-------------------------------------------------------------------------------------------------

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Cash

3,340

Capital

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3,000

Purchases

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2,000

Sales

2,500

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Salaries

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210


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Interest

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50

-------

-------

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5,550

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5,550

-------------------------------------------------------------------------------------------------
1.2.3.6 CLOSING ENTRIES

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Periodically, usually at the end of the accounting period, all

revenue and expense account balances are transferred to an account

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called Income summary or Profit and Loss account and are then said to

be closed. (A detailed discussion on Profit and Loss account can be had

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in a subsequent lesson). The balance in the Profit and Loss account,

which is the net income or net loss for the period, is then transferred to

the capital account and thus the Profit and Loss account is also closed. In

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the case of corporation the net income or net loss is transferred to

retained earnings account which is a part of owners' equity. The entries

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which are passed for transferring these accounts are called as closing

entries. Because of this periodic closing of revenue and expense

accounts, they are called as temporary or nominal accounts whereas

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assets, liabilities and owners' equity accounts, the balances of which are

shown on the balance sheet and are carried forward from year to year are

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called as Permanent or Real accounts.



The principle of framing a closing entry is very simple. If an

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account is having a debit balance, then it is credited and the Profit and

Loss account is debited. Similarly if a particular account is having a

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41

credit balance, it is closed by debited it and crediting the Profit and Loss

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account.



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In our example Sales account and Interest account are revenues

and Purchases account and Salaries account are expenses. Purchases

account is an expense because the entire goods have been sold out in the

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accounting period itself and hence they become cost of goods sold out.

This aspect would become more clear when the reader proceeds to the

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lessons on Profit and Loss account. The closing entries would appear as

follows:

(1)

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Profit

and

--- Content provided by FirstRanker.com ---

Loss

a/c

(Dr)

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2,210

Salaries

--- Content provided by⁠ FirstRanker.com ---

a/c

(Cr)


--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

210

Purchases

a/c

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(Cr)

2,000

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(2)

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Sales

a/c (Dr)

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2,500

Profit

and

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Loss

a/c

--- Content provided by⁠ FirstRanker.com ---

(Cr)

2,500


--- Content provided by FirstRanker.com ---


(3)

Interest

--- Content provided by‌ FirstRanker.com ---

a/c

(Dr)


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





50

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Profit and Loss a/c


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(Cr)

50

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Now Profit and Loss a/c, Retained Earnings a/c and Balance Sheet

can be prepared which would appear as follows:

--- Content provided by‌ FirstRanker.com ---


Profit and Loss Account

Purchase

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a/c

2,000

Sales

--- Content provided by FirstRanker.com ---


a/c 2,500

Salaries a/c

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


210

Interest a/c

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50

Retained Earnings a/c

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340

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


-------

-------

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2,550

2,550

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-------

-------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


42
Retained Earnings a/c


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Balance



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340

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Profit and Loss a/c



--- Content provided by‌ FirstRanker.com ---

340

-------

-------

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340 340

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-------

-------


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Balance Sheet

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Cash

3,340

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Capital

3,000

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Retained

Earnings


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

340

-------

-------

--- Content provided by​ FirstRanker.com ---




3,340

--- Content provided by FirstRanker.com ---

3,340

-------

-------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

1.2.3.7 ADJUSTMENT ENTRIES



Because of the adopting of accrual accounting, after the

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preparation of Trial Balance, adjustments relating to the accounting

period have to be made in order to make the financial statements

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complete. These adjustments are needed for transactions which have not

been recorded but which affect the financial position and operating

results of the business. They may be divided into four kinds: two in

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relation to revenues and the other two in relation to expenses. The two in

relation to revenues are:

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(i) Unrecorded revenues: i.e. income earned for the period but not received in

cash. For e.g. interest for the last quarter of the accounting period is yet to be

received though fallen due. The adjustment entry to be passed is:

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Accrued

interest

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a/c

(Dr)

Interest

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a/c

(Cr)

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43

--- Content provided by‌ FirstRanker.com ---


(ii) Revenues received in advance: i.e. income relating to the next period

received in the current accounting period, e.g. rent received in advance. The

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adjustment entry is:




--- Content provided by FirstRanker.com ---


Rent a/c



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(Dr)

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--- Content provided by‍ FirstRanker.com ---



Rent received in advance a/c (Cr)

The two relating to expenses are:

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(i) Unrecorded expenses: i.e. expenses were incurred during the period but no

record of them as yet have been made, e.g. Rs.500 wages earned by an employee

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during the period remaining to be paid. The adjustment entry would be:

Wages

a/c

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(Dr)

Accrued

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wages

a/c

(Cr)

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(ii) Prepaid expenses: i.e., expenses relating to the subsequent period paid in

advance in the current accounting period. An example which is frequently cited

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is insurance paid in advance. The adjustment entry would be:

Prepaid

Insurance

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a/c

(Dr)

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Insurance

a/c

(Cr)

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

In the above four cases unrecorded revenues and prepaid expenses

are assets and hence debited (as debit may signify increase in assets) and

revenues received in advance and unrecorded expenses are liabilities and

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hence credited (as credit may signify increase in liabilities).



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Besides the above four adjustments, some more are to be done

before preparing the financial statements. They are:

1.

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Inventory at the end

2.

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Provision of Depreciation

3.

Provision for Bad Debts

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4.

Provision for Discount on receivables and payables

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5.

Interest on Capital and Drawings


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44
1.2.3.8 PREPARATION OF FINANCIAL STATEMENTS

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Now everything is set ready for the preparation of financial

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statements for the accounting period and as of the last day of the

accounting period. Generally Agreed Accounting Principles (GAAP)

require that three such reports be prepared:

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(i)

A Balance Sheet

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(ii)

A Profit and Loss Account (or) Income Statement

(iii)

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A Fund Flow Statement

A detailed discussion on these three financial statements follows

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in the succeeding lessons.

1.2.3.9 INTRODUCTION TO TALLY PACKAGE


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Today an increasingly large number of companies have adopted

mechanised accounting. The main reasons for this development are that:

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(i)

the size of firms have become very large resulting in manifold

increase in accounting data to be collected and processed.

--- Content provided by FirstRanker.com ---


(ii)

the requirements of modern management which want detailed

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analysis, in many ways, of the accounting and statistical

information for the efficient discharge of their duties.

(iii)

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collection of statistics not only for the firm's own use but also for

submission to various official authorities.

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In this context, the use of computers in accounting is worth

mentioning. Late 80's and early 90's was an era of Financial Accounting

Software. Many software developers offered separate Financial and

--- Content provided by FirstRanker.com ---


Inventory Softwares to take care of the needs of the concerns but users

wanted a single software that will take care of Production and Inventory

--- Content provided by‌ FirstRanker.com ---

Management i.e. they wanted a single software where if an invoice is

entered that will update Accounts as well as Inventory Information. Here

Tally comes in handy.

--- Content provided by‌ FirstRanker.com ---




45

--- Content provided by‍ FirstRanker.com ---

Tally is one of the acclaimed accounting software with large user

base in India and abroad, which is continuously growing. There is good

potential for Tally professionals even in small towns. Tally which is a

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vast software covers a lot of areas for various types of industries and

loaded with options. So, every organisation needs a hardcore Tally

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professional to exploit its full capabilities and functionality to implement

Tally. Tally which is a Financial and Inventory Management System is

developed in India using Tally Development Language. Tally has been

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created by Pentronics (P) Limited, Bangalore.

Features of Tally:

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(i)

Accounts without any account codes.

(ii)

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Maintains complete range of Books of Accounts, Final Accounts

like Balance Sheets, Profit and Loss Statements, Cash and Fund

--- Content provided by​ FirstRanker.com ---

Flows, Trial Balance and others.

(iii)

Provides option to post stock value from inventory directly to

--- Content provided by FirstRanker.com ---


Balance Sheet and Profit and Loss a/c as per the valuation

method specified by user. This greatly simplifies the procedure

--- Content provided by​ FirstRanker.com ---

and one gets the Final Accounts which is in tune with the stock

statements of the Inventory System.

(iv)

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Provides Multiple Reports in diverse formats.

(v)

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Various options for interest calculation.

(vi)

Allows accounts of multiple companies simultaneously.

--- Content provided by⁠ FirstRanker.com ---


(vii) Multiple currencies in the same transactions and viewing all

reports in one or more currency.

--- Content provided by⁠ FirstRanker.com ---

(viii) Unlimited budgets and periods, user definable security levels for

access control and audit capabilities to track malafide changes.

(ix)

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Allows Import and Export of data from or to other systems.

(x)

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Online Help.



46

--- Content provided by FirstRanker.com ---

(xi)

Backup and Restore of Data.

(xii) Facilitates printing of cheques, etc.

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1.2.3.10 SUMMARY



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The following steps are involved in the accounting process:

1. The first and the most important part of the accounting process is the

analysis of the transactions to decide which account is to be debited

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and which account is to be credited.

2. Next comes journalising the transactions i.e. recording the

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transactions in the journal.

3. The journal entries are posted into respective accounts in the ledger

and the ledger accounts are balanced.

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4. At the end of the accounting period, a trial balance is prepared to

ensure quality of debits and credits.

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5. Adjustment and closing entries are made to enable the preparation of

financial statements.

6. As a last step financial statements are prepared.

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These six steps taken sequentially complete the accounting

process during an accounting period and are repeated in each subsequent

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period.

1.2.3.11 KEY WORDS

Account: A statement wherein information relating to all items are accumulated.

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Debit: Signifies increase in asset accounts, decrease in liability accounts and

decrease in owners' equity accounts.

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Credit: Signifies decrease in asset accounts, increase in liability accounts and

increase in owners' equity accounts.

Ledger: A set of accounts of a specific business enterprise.

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Journal: A book of prime entry.

Trial Balance: A list of balances of accounts to ensure arithmetical accuracy.

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47

Closing Entries: Entries passed to transfer the revenue accounts to profit and

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loss a/c.

Adjustment Entries: Entries passed for transactions which are not recorded but

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which affect the financial position and operating results of the business.

1.2.3.12 SELF ASSESSMENT QUESTIONS

1. Explain the following:

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(a) A Journal

(b) An Account

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(c) A Ledger

2. Bring out the relationship between a journal and a ledger.

3. Explain the significance of Trial Balance.

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4. Why adjustment entries are necessary?

5. Narrate the rules of debit and credit.

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6. Distinguish nominal accounts from real accounts.

7. Explain the mechanism of balancing an account.

8. How and why closing entries are made?

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9. The following transactions relate to a business concern for the month of

December 2005. Journalise them, post into ledger accounts, balance and

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prepare the Trial Balance.

March 1 -

Started business with a capital of Rs.9,000

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March 2 -

Purchased furniture Rs.300

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March 3 -

Purchased goods Rs.6,000

March 11 -

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Received order for half-of goods from `C'

March 15 -

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Delivered goods, `C' invoiced Rs.4,000

March 17 -

Received order for the remaining half of goods

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March 21 -

Delivered goods, cash received Rs.3,800

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March 31 -

Paid wages Rs.300


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48
1.2.3.13 BOOKS FOR FURTHER READING

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1. M.A.Arulanandam & K.S.Raman: Advanced Accounts, Himalaya

Publishing House.

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2. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Vol.I, Sultan Chand,

New Delhi.

3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co. New

--- Content provided by‌ FirstRanker.com ---


Delhi.



--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






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49

UNIT-I

LESSON 1.3

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-------------------------------------------------------------------------------------------------

PREPARATION OF FINAL ACCOUNTS

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-------------------------------------------------------------------------------------------------


1.3.1 INTRODUCTION

--- Content provided by‌ FirstRanker.com ---



The primary objective of any business concern is to earn income.

Ascertainment of the periodic income of a business enterprise is perhaps the

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important objective of the accounting process. This objective is achieved by the

preparation of profit and loss account or the income statement. Profit and loss

--- Content provided by‌ FirstRanker.com ---

account is generally considered to be of greatest interest and importance to end-

users of accounting information. The profit and loss account enables all

concerned to find out whether the business operations have been profitable or

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not during a particular period. Usually the profit and loss account is

accompanied by the balance sheet as on the last date of the accounting period for

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which the profit and loss account is prepared. A balance sheet shows the

financial position of a business enterprise as of a specified moment of time. It

contains a list of the assets and liabilities and capital of a business entity as of a

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specified date, usually at the close of the last day of a month or a year. While the

profit and loss account is categorised as a flow report (for a particular period the

--- Content provided by​ FirstRanker.com ---

balance sheet is categorised as a status report as on a particular date).




--- Content provided by FirstRanker.com ---


1.3.2 OBJECTIVES



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After reading this lesson the reader should be able to:

? Understand the basic ideas of income and expense
? Prepare a profit and loss account/income statement in the proper

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format



50

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? Understand the basic ideas about a balance sheet
? Classify the different assets and liabilities
? Prepare a balance sheet in the proper format

1.3.3 CONTENTS

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1.3.3.1

Basic Ideas about Income and Expense

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1.3.3.2

Form and Presentation of Profit and Loss Account /

Income Statement

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1.3.3.3

Explanation of Items on the Income Statement

--- Content provided by⁠ FirstRanker.com ---

1.3.3.4

Statement of Retained Earnings

1.3.3.5

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Balance Sheet

1.3.3.6

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Form and Presentation of Balance Sheet

1.3.3.7

Listing of Items on the Balance Sheet

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1.3.3.8

Classification of Items in the Balance Sheet

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1.3.3.9

Summary

1.3.3.10

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Key Words

1.3.3.11

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Self Assessment Questions

1.3.3.12

Key to Self Assessment Questions

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1.3.3.13

Case Analysis

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1.3.3.14

Books for Further Reading

1.3.3.1 BASIC IDEAS ABOUT INCOME AND EXPENSE

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Profit and Loss account consists of two elements: One element is the

inflows that result from the sale of goods and services to customers which are

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called as revenues. The other element reports the outflows that were made in

order to generate those revenues; these are called as expenses. Income is the

amount by which revenues exceed expenses. The term `net income' is used to

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indicate the excess of all the revenues over all the expenses. The basic equation

is:

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Revenue ? Expenses = Net Income


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51



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This is in accordance with the matching concept.

Income and Owner's Equity: The net income of an accounting period increases

owner's equity because it belongs to the owner. To quote an example goods

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costing Rs.20,000 are sold on credit for Rs.28,000. The result is that stock is

reduced by Rs.20,000 and a new asset namely debtor for Rs.28,000 is created

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and the total assets increase by the difference Rs.8,000. Because of the dual

aspect concept we know that the equity side of the balance sheet would also

increase by Rs.8,000 and the increase would be in owner's equity because the

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profit on sale of goods belongs to the owner. It is clear from the above example

that income increases the owner's equity.

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Income Vs Receipts: Income of a period increases the owner's equity but it need

not result in increase in cash balance. Loss of a period decreases owner's equity

but it need not result in decrease in cash balance. Similarly increase in cash

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balance need not result in increased income and owner's equity and decrease in

cash balance need not denote loss and decrease in owner's equity. All these are

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due to the fact that income is not the same as cash receipt. The following

examples make clear the above point:

i)

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When goods costing Rs.20,000 are sold on credit for Rs.28,000 it

results in an income of Rs.8,000 but the cash balance does not

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increase.

ii)

When goods costing Rs.18,000 are sold on credit for Rs.15,000

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there is a loss of Rs.3,000 but there is no corresponding decrease

in cash.

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iii)

When a loan of Rs.5,000 is borrowed the cash balance increases

but there is no impact on income.

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iv)

When a loan of Rs.8,000 is repaid it decreases only the cash

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balance and not the income.




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52
Expenses: An expense is an item of cost applicable to an accounting period. It

represents economic resources consumed during the current period. When an

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expenditure is incurred the cost involved is either an asset or an expense. If the

benefits of the expenditure relate to further periods it is an asset. If not, it is an

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expense of the current period. Over the entire life of an enterprise, most

expenditures become expenses. But according to accounting period concept,

accounts are prepared for each accounting period. Hence we get the following

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four types of transactions relating to expenditure and expenses:

Expenditures that are also expenses: This is the simplest and most common

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type of transaction to account for. If an item is acquired during the year, it is

expenditure. If the item is consumed in the same year, then the expenditure

becomes expense. e.g. raw materials purchased are converted into saleable

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goods and are sold in the same year.

Assets that become expenses: When expenditures incurred result in benefits for

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the future period they become assets. When such assets are used in subsequent

years they become expenses of the year in which they are used. For e.g.

inventory of finished goods are assets at the end of a particular accounting year.

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When they are sold in the next accounting year they become expenses.

Expenditures that are not expenses: As already pointed out when the benefits

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of the expenditure relate to future periods they become assets and not expenses.

This applies not only to fixed assets but also to inventories which remain unsold

at the end of the accounting year. For e.g. the expenditure incurred on inventory

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remaining unsold is asset until it is sold out.

Expenses not yet paid: Some expenses would have been incurred in the

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accounting year but payment for the same would not have been made within the

accounting year. These are called accrued expenses and are shown as liabilities

at the year end.

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53

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1.3.3.2 FORM AND PRESENTATION OF PROFIT AND LOSS
ACCOUNT / INCOME STATEMENT

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In practice there is considerable variety in the format and degree of detail

used in income statements. The profit and loss account is usually prepared in

--- Content provided by FirstRanker.com ---

"T" shape. The following (Illustration-A) is the summarised profit and loss

account of Ali Akbar Ltd.

Illustration ? A:

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Ali Akbar Ltd

Profit and Loss Account for the year ended 31st March 2005

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(Rs. in `000)

-------------------------------------------------------------------------------------------------
Cost of goods sold

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78,686 Sales (less discount) 89,740

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Expenses (Schedule 17)



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33,804 Other income

39,947

Interest (Schedule 18)

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2,902 (Schedule 13)

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Director's Fees




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11

Depreciation

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2,094

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Provision for Taxation



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6,565

Net

Profit

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--- Content provided by‌ FirstRanker.com ---

5,625




--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

-----------



-----------

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--- Content provided by​ FirstRanker.com ---





1,29,687

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

1,29,687

-------------------------------------------------------------------------------------------------


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In the "T" shaped profit and loss account expenses are shown on the left

hand side i.e., the debit side and revenues are shown on the right hand side i.e.,

the credit side. Net profit or loss is the balancing figure.

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The profit and loss account can also be presented in the form of a

--- Content provided by FirstRanker.com ---

statement when it is called as income statement. There are two widely used

forms of income statement: single step form and multiple-step form.


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The single-step form of income statement derives its name from the fact

that the total of all expenses is deducted from the total of all revenues.

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Illustration ? A can be presented in the single-step form as given in

Illustration ? B.


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54
Illustration ? B:

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Ali Akbar Ltd

Income Statement for the year ended 31st March 2005

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(Rs. in `000)

-------------------------------------------------------------------------------------------------

Revenues

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Sales

(less

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discount)

89,740


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Other income (Schedule 13)

39,947

--- Content provided by FirstRanker.com ---

--------

1,29,687

Expenses

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Cost of goods sold

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78,686

--- Content provided by​ FirstRanker.com ---




Expenses (Schedule 17)

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33,804


--- Content provided by‍ FirstRanker.com ---


Director's Fees



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11

Interest

--- Content provided by​ FirstRanker.com ---


(Schedule

18)

--- Content provided by FirstRanker.com ---





2,902

--- Content provided by‍ FirstRanker.com ---


Depreciation



--- Content provided by⁠ FirstRanker.com ---



2,094


--- Content provided by FirstRanker.com ---


Provision for Taxation



--- Content provided by‌ FirstRanker.com ---

6,565

--------

1,24,062

--- Content provided by​ FirstRanker.com ---




----------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



5,625


--- Content provided by FirstRanker.com ---


----------



--- Content provided by‌ FirstRanker.com ---

-------------------------------------------------------------------------------------------------


The single-step form has the advantage of simplicity but it is inadequate

--- Content provided by⁠ FirstRanker.com ---

for analytical purpose.



The multi-step form income statement is so called because of its

--- Content provided by‌ FirstRanker.com ---


numerous sections, sub-sections and intermediate balances. Illustration ? C is a

typical proforma of multiple-step income statement.

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

55

Illustration ? C:

Proforma of a Multiple-step Income Statement

--- Content provided by​ FirstRanker.com ---



Gross

sales

--- Content provided by‌ FirstRanker.com ---


xxx

Less

--- Content provided by‌ FirstRanker.com ---

Sales

returns

xxx

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


-----

Net

--- Content provided by​ FirstRanker.com ---

Sales

xxx

Less Cost of goods sold

--- Content provided by​ FirstRanker.com ---



Raw materials cost


--- Content provided by⁠ FirstRanker.com ---


Opening stock of raw material



--- Content provided by FirstRanker.com ---

xxx



Add Purchase of raw material

--- Content provided by FirstRanker.com ---




xxx

--- Content provided by FirstRanker.com ---

Freight

xxx


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




-----

--- Content provided by​ FirstRanker.com ---

Raw

materials

available

--- Content provided by‍ FirstRanker.com ---


xxx



--- Content provided by⁠ FirstRanker.com ---

Less Closing stock of raw material

xxx


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-----

--- Content provided by⁠ FirstRanker.com ---

Raw

materials

consumed

--- Content provided by FirstRanker.com ---


xxx

Direct

--- Content provided by FirstRanker.com ---

Labour

Cost

xxx

--- Content provided by FirstRanker.com ---


Manufacturing

Expenses

--- Content provided by‌ FirstRanker.com ---

xxx




--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---


-----

Total

--- Content provided by⁠ FirstRanker.com ---

Production

Cost

xxx

--- Content provided by⁠ FirstRanker.com ---




Add Opening work-in-progress

--- Content provided by‍ FirstRanker.com ---



xxx


--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




-----

--- Content provided by‌ FirstRanker.com ---

Total



xxx

--- Content provided by⁠ FirstRanker.com ---




Less Closing work-in-progress

--- Content provided by⁠ FirstRanker.com ---



xxx


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-----

--- Content provided by​ FirstRanker.com ---



Cost of goods manufactured


--- Content provided by​ FirstRanker.com ---


xxx



--- Content provided by FirstRanker.com ---

Add Opening finished goods



xxx

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-----



Cost of goods available for sale

--- Content provided by FirstRanker.com ---




xxx

--- Content provided by‌ FirstRanker.com ---



Less Closing finished goods


--- Content provided by⁠ FirstRanker.com ---


xxx



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



-----

Cost

--- Content provided by FirstRanker.com ---


of

goods

--- Content provided by FirstRanker.com ---

sold

xxx


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-----

--- Content provided by‍ FirstRanker.com ---

Gross

Profit

xxx

--- Content provided by​ FirstRanker.com ---


Less Operating Expenses



--- Content provided by⁠ FirstRanker.com ---



Administrative

Expenses

--- Content provided by FirstRanker.com ---


xxx



--- Content provided by​ FirstRanker.com ---

Selling and Distribution Expenses



xxx

--- Content provided by FirstRanker.com ---


-----

xxx

--- Content provided by FirstRanker.com ---

Operating

Profit xxx


--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-----


--- Content provided by‌ FirstRanker.com ---


56
Add Non-operating Income


--- Content provided by⁠ FirstRanker.com ---

(Such as dividend received



profit on sale of assets etc.)

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



xxx


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



-----

Less Non-operating Expenses

--- Content provided by‌ FirstRanker.com ---



(Such as discount on issue of shares


--- Content provided by FirstRanker.com ---


written off, loss on sale of assets, etc.)



--- Content provided by‌ FirstRanker.com ---



xxx


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



-----

Profit (or) Earnings before Interest &

--- Content provided by​ FirstRanker.com ---

Tax

(EBIT)

xxx

--- Content provided by‍ FirstRanker.com ---


Less

Interest

--- Content provided by FirstRanker.com ---

xxx




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




-----

--- Content provided by⁠ FirstRanker.com ---

Profit (or) Earnings Before Tax (EBT)




--- Content provided by⁠ FirstRanker.com ---


xxx

Less Provision for Income-Tax

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


xxx



--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





-----

--- Content provided by​ FirstRanker.com ---


Net profit (or) Earnings After Tax (EAT)



--- Content provided by​ FirstRanker.com ---



xxx


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

-----

Earnings per share of Common Stock


--- Content provided by‍ FirstRanker.com ---




xxx

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


-----

-------------------------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---


The multiple-step form of Illustration `C' would be as given under

Illustration `D'.

--- Content provided by‌ FirstRanker.com ---

Illustration ? D:

Ali Akbar Ltd

Income Statement for the year ended 31st March 2005

--- Content provided by‍ FirstRanker.com ---


(Rs. in `000)

-------------------------------------------------------------------------------------------------
Net

--- Content provided by FirstRanker.com ---


Sales

89,740

--- Content provided by‌ FirstRanker.com ---

Less

Cost

of

--- Content provided by FirstRanker.com ---


goods

sold

--- Content provided by FirstRanker.com ---

78,686




--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

--------

Gross

Profit

--- Content provided by​ FirstRanker.com ---


11,054

Less Operating Expenses
Expenses

--- Content provided by‌ FirstRanker.com ---


(Schedule

17)

--- Content provided by⁠ FirstRanker.com ---

33,804



Director's Fee

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

11



Depreciation

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



2,094

35,909

--- Content provided by⁠ FirstRanker.com ---


---------



--- Content provided by‌ FirstRanker.com ---



----------


--- Content provided by‍ FirstRanker.com ---


Operating Loss



--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


(-) 24,855

Add Non-Operating

--- Content provided by FirstRanker.com ---

Income

Other

income

--- Content provided by‍ FirstRanker.com ---


(Schedule

13)

--- Content provided by​ FirstRanker.com ---

39,947

---------


--- Content provided by⁠ FirstRanker.com ---




Profit or Earnings before Int.& Tax

--- Content provided by‌ FirstRanker.com ---





15,092

--- Content provided by‍ FirstRanker.com ---




57

--- Content provided by⁠ FirstRanker.com ---

(EBIT)


Less Interest (Schedule 18)

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


2,902

---------

--- Content provided by​ FirstRanker.com ---





Net Profit or Earnings Before Tax (EBT)

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

12,190



Less

--- Content provided by FirstRanker.com ---


Provision

for

--- Content provided by FirstRanker.com ---

Taxation



6,565

--- Content provided by‌ FirstRanker.com ---


---------



--- Content provided by FirstRanker.com ---



Net Profit or Earnings After Tax (EAT)


--- Content provided by⁠ FirstRanker.com ---




5,625

--- Content provided by​ FirstRanker.com ---

---------



-------------------------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---



The advantage of multiple-step form of income statement over single-

step form and the "T" shaped profit and loss account is that there are a number

--- Content provided by‍ FirstRanker.com ---


of significant sub totals on the road to net income which lend themselves for

significant analysis.

--- Content provided by⁠ FirstRanker.com ---



Income statements prepared for use by the managers of an enterprise

usually contain more detailed information than that shown in the above

--- Content provided by​ FirstRanker.com ---


illustrations.

1.3.3.3 EXPLANATION OF ITEMS ON THE INCOME STATAEMENT

--- Content provided by⁠ FirstRanker.com ---

The heading of the income statement must show:

i)

the business enterprise to which it relates (Ali Akbar Ltd)

--- Content provided by FirstRanker.com ---


ii)

the name of the statement (income statement)

--- Content provided by​ FirstRanker.com ---

iii)

the time period covered (year ended 31st March of the relevant

year)

--- Content provided by FirstRanker.com ---


The income statement is generally followed by various schedules

that give detailed account of the items, listed on them. Information about

--- Content provided by‌ FirstRanker.com ---

these schedules are given against each item in the financial statements.

One important objective in reporting revenue on an income

statement is to disclose the major source of revenue and to separate it

--- Content provided by‌ FirstRanker.com ---


from miscellaneous sources. For most companies the major source of

revenue is the sale of goods and services.

--- Content provided by⁠ FirstRanker.com ---





58

--- Content provided by​ FirstRanker.com ---

Sales Revenue: An income statement often reports several separate items in the

sales revenue section, the net of which is the net sales figure. Gross sales is the

total invoice price of the goods sold or services rendered during the period. It

--- Content provided by‌ FirstRanker.com ---


should not include sales taxes or excise duties that may be charged to the

customers. Such taxes are not revenues but rather represent collections that the

--- Content provided by‌ FirstRanker.com ---

business makes on behalf of the government and are liabilities to the

government until paid. Similarly, postage, freight or other items billed to the

customers at cost are not revenues. These items do not appear in the sales figure

--- Content provided by⁠ FirstRanker.com ---


but instead are an offset to the costs the company incurs for them.



--- Content provided by​ FirstRanker.com ---

Sales returns and allowances represent the sales values of goods that

were returned by customers or allowance made to customers because the goods

were defective. The amount can be subtracted from the sales figure directly

--- Content provided by​ FirstRanker.com ---


without showing it as a separate item on the income statement. But it is always

better to show them separately.

--- Content provided by​ FirstRanker.com ---



Sometimes called as cash discounts sales discounts are the amount of

discounts allowed to customers for prompt payment. For e.g. if a business offers

--- Content provided by​ FirstRanker.com ---


a 3% discount to customers who pay within 7 days from the date of the invoice

and it sells Rs.30,000 of goods to a customer who takes advantage of this

--- Content provided by‌ FirstRanker.com ---

discount the business receives only Rs.29,100 in cash and records the balance

Rs.900 as sales discount. There is another kind of discount called as trade

discount which is given by the wholesaler or manufacturer to the retailers to

--- Content provided by‍ FirstRanker.com ---


enable them to sell at catalogue price and make a profit: e.g. List less 30 percent.

Trade discount does not appear in the accounting records at all.

--- Content provided by⁠ FirstRanker.com ---

Miscellaneous or Secondary Sources of Revenues: These are revenues earned

from activities not associated with the sale of the enterprise's goods and

services. Interest or dividends earned on marketable securities, royalties, rents

--- Content provided by​ FirstRanker.com ---


and gains on disposal of assets are examples of this type of revenues. For e.g. in

the case of Ali Akbar Ltd., its operating loss has been converted into net profit

--- Content provided by⁠ FirstRanker.com ---



59

only because of other income, other than sales revenue. Schedule 13 gives

--- Content provided by⁠ FirstRanker.com ---


details of other income earned by Ali Akbar Ltd.

Schedule 13 ? Other Income

--- Content provided by FirstRanker.com ---

(Rs.`000)



Income from Trade Investments

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

825



Interest on Bank Deposits & others

--- Content provided by‌ FirstRanker.com ---




1,042

--- Content provided by‌ FirstRanker.com ---



Profit on Sale of Investments


--- Content provided by‌ FirstRanker.com ---




456

--- Content provided by‌ FirstRanker.com ---



Profit on Sale of Inventories


--- Content provided by‍ FirstRanker.com ---




813

--- Content provided by FirstRanker.com ---

Miscellaneous

income


--- Content provided by‍ FirstRanker.com ---




2,394

--- Content provided by⁠ FirstRanker.com ---

Factory

charges

recovered

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

9,081

Bottle

deposits

--- Content provided by‍ FirstRanker.com ---


forfeited

25,336

--- Content provided by‌ FirstRanker.com ---

--------



39,947

--- Content provided by‌ FirstRanker.com ---

--------



Cost of Goods sold: When income is increased by the sale value of goods or

--- Content provided by FirstRanker.com ---


services sold, it is also decreased by the cost of these goods or services. The cost

of goods or services sold is called the cost of sales. In manufacturing firms and

--- Content provided by‌ FirstRanker.com ---

retailing business it is often called the cost of goods sold. The complexity of

calculation of cost of goods sold varies depending upon the nature of the

business. In the case of a trading concern which deals in commodities it is very

--- Content provided by​ FirstRanker.com ---


simple to calculate the most of goods sold and it is done as follows:

Opening

--- Content provided by‌ FirstRanker.com ---

Stock

xxx


--- Content provided by⁠ FirstRanker.com ---


Add:

Purchase

--- Content provided by⁠ FirstRanker.com ---

xxx

Freight

xxx

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

-----




--- Content provided by FirstRanker.com ---


Goods available for sale



--- Content provided by‌ FirstRanker.com ---

xxx



Less:

--- Content provided by FirstRanker.com ---


Closing

stock

--- Content provided by‍ FirstRanker.com ---

xxx




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


-----

Cost

--- Content provided by⁠ FirstRanker.com ---

of

goods

sold

--- Content provided by FirstRanker.com ---


xxx



--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



-----


--- Content provided by FirstRanker.com ---


The calculation becomes a complicated process in the case of

manufacturing concern, especially when a number of products are

--- Content provided by FirstRanker.com ---



60
manufactured because it involves the calculation of the work in progress and

--- Content provided by FirstRanker.com ---

valuation of inventory. The cost of goods sold in the case of Ali Akbar Ltd

would have been calculated as given in Illustration `E'.

Illustration E:

--- Content provided by FirstRanker.com ---


Cost of goods sold



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

(Rs. in `000)



Opening

--- Content provided by​ FirstRanker.com ---


stock



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


4,436

Raw

--- Content provided by‌ FirstRanker.com ---

materials

consumed

22,151

--- Content provided by⁠ FirstRanker.com ---


Packing

materials

--- Content provided by‌ FirstRanker.com ---

consumed

48,536

Excise

--- Content provided by‍ FirstRanker.com ---


Duty



--- Content provided by‍ FirstRanker.com ---



7,805

--------

--- Content provided by⁠ FirstRanker.com ---




82,928
Less: Closing stock

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---





4,242

--- Content provided by‌ FirstRanker.com ---


--------



--- Content provided by​ FirstRanker.com ---

Cost

of

goods

--- Content provided by‌ FirstRanker.com ---


sold

78,686

--- Content provided by‌ FirstRanker.com ---

--------



Gross Profit: The excess of sales revenue over cost of goods sold is gross

--- Content provided by⁠ FirstRanker.com ---


margin or gross profit. In the case of multiple-step income statement it is shown

as a separate item. Significant managerial decisions can be taken by calculating

--- Content provided by⁠ FirstRanker.com ---

the percentage of gross profit on sale. This percentage indicates the average

mark up obtained on products sold. The percentage varies widely among

industries, but healthy companies in the same industry tend to have similar gross

--- Content provided by‍ FirstRanker.com ---


profit percentages.

Operating Expenses: Expenses which are incurred for running the business and

--- Content provided by‍ FirstRanker.com ---

which are not directly related to the company's production or trading are

collectively called as operating expenses. Usually operating expenses include

administration expenses, finance expenses, depreciation and selling and

--- Content provided by⁠ FirstRanker.com ---


distribution expenses. Administration expenses generally include personnel

expenses also. However sometimes personnel expenses may be shown

--- Content provided by​ FirstRanker.com ---

separately under the heading Establishment Expenses.




--- Content provided by⁠ FirstRanker.com ---


61

Until recently most companies included expenses on research and

--- Content provided by FirstRanker.com ---

development as part of general and administrative expenses. But now-a-

days the Financial Accounting Standards Board (FASB) requires that this

amount should be shown separately. This is so because the expenditure

--- Content provided by⁠ FirstRanker.com ---


on research and development could provide an important clue as to how

cautious the company is in keeping its products and services upto date.

--- Content provided by​ FirstRanker.com ---

Operating profit: Operating profit is obtained when operating expenses are

deducted from gross profit.

Non-operating Expenses: These are expenses which are not related to the

--- Content provided by‌ FirstRanker.com ---


activities of the business e.g. loss on sale of asset, discount on shares written off

etc. These expenses are deducted from the income obtained after adding other

--- Content provided by​ FirstRanker.com ---

incomes to the operating profit. Other incomes or miscellaneous receipts have

already been explained. The resultant profit is called as Profit (or) Earning

before interest and tax (EBIT).

--- Content provided by⁠ FirstRanker.com ---


Interest Expenses: Interest expense arises when part of the expenses are met

from borrowed funds. The FASB requires separate disclosure of interest

--- Content provided by‌ FirstRanker.com ---

expense. This item of expense is deducted from income or earnings before

interest and tax. The resultant figure is profit (or) earnings before tax (EBT).

Income Tax: The provision for tax is estimated based on the quantum of profit

--- Content provided by FirstRanker.com ---


before tax. As per the corporate tax laws the amount of tax payable is

determined not on the basis of reported net profit but the net profit arrived at has

--- Content provided by⁠ FirstRanker.com ---

to be recomputed and adjusted for determining the tax liability. That is why the

liability is always shown as a provision.

Net Profit: This is the amount of profit finally available to the enterprise for

--- Content provided by‍ FirstRanker.com ---


appropriation. Net profits is reported not only in total but also per share of stock.

This per share amount is obtained by dividing the total amount of net profit by

--- Content provided by‍ FirstRanker.com ---

the number of shares outstanding. The net profit is usually referred to as profit

or earnings after tax. This profit could either be distributed as dividends to


--- Content provided by⁠ FirstRanker.com ---


62
shareholders or retained in the business. Just like gross profit percentage, net

profit percentage on sales can also be calculated which will be of great use for

--- Content provided by FirstRanker.com ---


managerial analysis.

1.3.3.4 STATEMENT OF RETAINED EARNINGS

--- Content provided by FirstRanker.com ---



The term retained earnings means the accumulated excess of earnings

over losses and dividends. The statement of retained earnings is generally

--- Content provided by‌ FirstRanker.com ---


included with almost any set of financial statements although it is not considered

to be one of the major financial statements. A typical statement of retained

--- Content provided by​ FirstRanker.com ---

earnings starts with the opening balance of retained earnings, the net income for

the period as an addition, the dividends as a deduction, and ends with the closing

balance of retained earnings. The statement may be prepared and shown on a

--- Content provided by‌ FirstRanker.com ---


separate sheet or included at the bottom of the income statement. The balance

shown by the income statement is transferred to the balance sheet through the

--- Content provided by‍ FirstRanker.com ---

statement of retained earnings after making necessary appropriations. This

statement thus links the income statement to the retained earning item on the

balance sheet. This statement can be prepared in `T' shape also when it is called

--- Content provided by‌ FirstRanker.com ---


as Profit and Loss Appropriation Account. Illustration `F' gives the statement of

retained earning of Ali Akbar Ltd.

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



63

Illustration ? F:

--- Content provided by‌ FirstRanker.com ---


Ali Akbar Ltd.

For the year ended 31st March 2005

--- Content provided by⁠ FirstRanker.com ---

(Rs. in `000)

-------------------------------------------------------------------------------------------------
Retained earnings at the beginning of the year

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


700



--- Content provided by‌ FirstRanker.com ---

Add:

Net

Income

--- Content provided by‍ FirstRanker.com ---


5,625



--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




-------

--- Content provided by FirstRanker.com ---

6,325


Less:

--- Content provided by‍ FirstRanker.com ---

Dividends

5,600

General

--- Content provided by​ FirstRanker.com ---


Reserve



--- Content provided by‍ FirstRanker.com ---





625

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





-------

--- Content provided by‍ FirstRanker.com ---

6,225




--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

-------

Retained earning at the end of the year


--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

100




--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

-------

-------------------------------------------------------------------------------------------------

1.3.3.5 BALANCE SHEET

--- Content provided by‌ FirstRanker.com ---




The balance sheet is basically a historical report showing the cumulative

--- Content provided by‍ FirstRanker.com ---

effect of past transactions. It is often described as a detailed expression of the

following fundamental accounting equation:


--- Content provided by⁠ FirstRanker.com ---


Assets = Liabilities + Owners' Equity (capital)

Assets are costs which represent expected future economic benefits to the

--- Content provided by‌ FirstRanker.com ---

business enterprise. However, the rights to assets have been acquired by the

enterprise as a result of past transactions.

Liabilities also result from past transactions: they represent obligations which

--- Content provided by‌ FirstRanker.com ---


require settlement in the future either by conveying assets or by performing

services. Implicit in these concepts of the nature of assets and liabilities is the

--- Content provided by⁠ FirstRanker.com ---

meaning of owners' equity as the residual interest in the assets of the enterprise.

1.3.3.6 FORM AND PRESENTATION OF A BALANCE SHEET


--- Content provided by​ FirstRanker.com ---


Two objectives are dominant in presenting information in a balance

sheet. One is clarity and readability; the other is disclosure of significant facts

--- Content provided by⁠ FirstRanker.com ---

within the framework of the basic assumptions of accounting. Balance sheet



64

--- Content provided by​ FirstRanker.com ---

classification, terminology and the general form of presentation should be

studied with these objectives in mind.


--- Content provided by‌ FirstRanker.com ---


It is proposed to explain the various aspects of the balance sheet with the

help of the following typical summarised balance sheet of an imaginary

--- Content provided by‌ FirstRanker.com ---

partnership firm:

Illustration A:

Sundaram & Sons

--- Content provided by⁠ FirstRanker.com ---


Balance Sheet as at 31st December 2005

-------------------------------------------------------------------------------------------------
Assets

--- Content provided by​ FirstRanker.com ---


Liabilities

&

--- Content provided by⁠ FirstRanker.com ---

Capital

-------------------------------------------------------------------------------------------------
Current

--- Content provided by​ FirstRanker.com ---

Assets

Current

Liabilities

--- Content provided by‌ FirstRanker.com ---


Cash

1,000

--- Content provided by⁠ FirstRanker.com ---

Bills

payable

7,000

--- Content provided by‌ FirstRanker.com ---


Bank

2,000

--- Content provided by‍ FirstRanker.com ---

Creditors

7,000

Marketable

--- Content provided by‌ FirstRanker.com ---


Securities

3,000

--- Content provided by​ FirstRanker.com ---

Outstanding

expenses

7,000

--- Content provided by‌ FirstRanker.com ---


Bills

Receivables

--- Content provided by‌ FirstRanker.com ---

3,000

Income

received

--- Content provided by⁠ FirstRanker.com ---


in



--- Content provided by​ FirstRanker.com ---

1,000

Debtors 10,000

advance

--- Content provided by​ FirstRanker.com ---


Less Provision

Provision

--- Content provided by‍ FirstRanker.com ---

for

Income

For Doubtful Debts

--- Content provided by FirstRanker.com ---


1,000 9,000

Tax

--- Content provided by⁠ FirstRanker.com ---



10,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



--------

Inventory

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



12,000

Total Current 32,000

--- Content provided by FirstRanker.com ---


Prepaid expenses



--- Content provided by​ FirstRanker.com ---



3,000

Liabilities

--- Content provided by‌ FirstRanker.com ---


---------

Long Term Liabilities

--- Content provided by‌ FirstRanker.com ---

Total current assets

33,000

Mortgage loan 20,000

--- Content provided by⁠ FirstRanker.com ---


Investments:



--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Owners' Equity

Long term securities

--- Content provided by‌ FirstRanker.com ---



3,000

S's capital

--- Content provided by FirstRanker.com ---


10,000

at costs

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

A's capital

15,000

Fixed Assets:

--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





U's capital

--- Content provided by‌ FirstRanker.com ---


20,000

Furniture & Fixtures

--- Content provided by‌ FirstRanker.com ---



1,000

General Reserve 10,000

--- Content provided by FirstRanker.com ---


Less: Accumulated Dep.

100 900

--- Content provided by‌ FirstRanker.com ---

Plant & Machinery 10,000
Less: Accumulated Dep.

2,000 8,000

--- Content provided by​ FirstRanker.com ---

Land

20,000

Buildings

--- Content provided by‌ FirstRanker.com ---


20,000

Intangile Assets
Patents

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

2,100




--- Content provided by⁠ FirstRanker.com ---




65

--- Content provided by‌ FirstRanker.com ---

Trade Marks



11,000

--- Content provided by‍ FirstRanker.com ---


Goodwill



--- Content provided by⁠ FirstRanker.com ---



9,000

Total

--- Content provided by‍ FirstRanker.com ---


Liabilities

&

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-----------

--- Content provided by⁠ FirstRanker.com ---

Owners' equit ----------

Total Assets


--- Content provided by‍ FirstRanker.com ---


1,07,000



--- Content provided by‌ FirstRanker.com ---



1,07,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



-----------


--- Content provided by​ FirstRanker.com ---




----------

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------

Conventions of preparing the Balance Sheet: There are two conventions of

preparing the balance sheet, the American and the English. According to the

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American convention assets are shown on the left hand side and the liabilities

and the owners' equity on the right hand side. Under the English convention just

--- Content provided by​ FirstRanker.com ---

the opposite is followed i.e. assets are shown on the right hand side and the

liabilities and owners' equity are shown on the left hand side. In the illustration

`A', the American convention has been followed.

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Forms of presenting the Balance Sheet: There are two forms of presenting the

balance sheet ? account form and report form. When the assets are listed on the

--- Content provided by​ FirstRanker.com ---

left hand side and liabilities and owners' equity on the right hand side we get the

account form of balance sheet. It is so called because it is similar to an account.

An alternative practice is the report form of balance sheet where the assets are

--- Content provided by‍ FirstRanker.com ---


listed at the top of the page and the liabilities and owners' equity are listed

beneath them. In illustration `A' we have followed the account form of balance

--- Content provided by​ FirstRanker.com ---

sheet. Now-a-days Joint Stock companies present Balance Sheet in the form of a

statement in the Annual Reports. To illustrate, the Balance Sheet of Ali Akbar

Ltd. Pondicherry as on 31-3-2005 is given below:

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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



66
Illustration `B':

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Ali Akbar Ltd.

Balance Sheet as at 31-3-2005

-------------------------------------------------------------------------------------------------

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--- Content provided by​ FirstRanker.com ---




Schedule

--- Content provided by‌ FirstRanker.com ---

2004-05 2003-04

Rs.'000 Rs.'000
-------------------------------------------------------------------------------------------------
I. SOURCES OF FUNDS

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1. SHAREHOLDERS' FUNDS
Capital



--- Content provided by⁠ FirstRanker.com ---

1




--- Content provided by FirstRanker.com ---


1,40,00



--- Content provided by‍ FirstRanker.com ---

1,40,00

Reserves and surplus 2


--- Content provided by​ FirstRanker.com ---




12,11,94

--- Content provided by​ FirstRanker.com ---



12,73,93

2. LOAN FUNDS

--- Content provided by FirstRanker.com ---

Secured loans

3


--- Content provided by‌ FirstRanker.com ---




2,45,15

--- Content provided by‌ FirstRanker.com ---



2,67,62

Unsecured loans

--- Content provided by​ FirstRanker.com ---


4



--- Content provided by‌ FirstRanker.com ---



-----


--- Content provided by​ FirstRanker.com ---


24

----------- -----------

--- Content provided by‍ FirstRanker.com ---



15,97,09 16,81,79


--- Content provided by‍ FirstRanker.com ---

----------- -----------



II. APPLICATION OF FUNDS

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1. FIXED ASSETS 5
Gross block



--- Content provided by​ FirstRanker.com ---



14,19,93

13,73,59

--- Content provided by⁠ FirstRanker.com ---


Less: Depreciation



--- Content provided by‍ FirstRanker.com ---



4,64,56

3,81,38

--- Content provided by FirstRanker.com ---


-----------



--- Content provided by​ FirstRanker.com ---



-----------

Net block

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



9,55,37

9,92,21

--- Content provided by‍ FirstRanker.com ---


Capital work-in-progress



--- Content provided by⁠ FirstRanker.com ---

--- 9,55,37

16,27 10,08,48

---------- -----------

--- Content provided by‍ FirstRanker.com ---




2. INVESTMENTS 6

--- Content provided by‌ FirstRanker.com ---





76,39

--- Content provided by​ FirstRanker.com ---




63,07

--- Content provided by‌ FirstRanker.com ---





3. CURRENT ASSETS

--- Content provided by‌ FirstRanker.com ---

LOANS AND ADVANCES
Inventories



--- Content provided by‌ FirstRanker.com ---

7



1,55,71

--- Content provided by​ FirstRanker.com ---


2,37,55

Sundry debtors

--- Content provided by⁠ FirstRanker.com ---

8



3,59,65

--- Content provided by⁠ FirstRanker.com ---


3,16,52

Cash and Bank balances

--- Content provided by‌ FirstRanker.com ---

9

69,52


--- Content provided by⁠ FirstRanker.com ---


74,55

Loans and advances 10

--- Content provided by⁠ FirstRanker.com ---

2,22,03

2,11,60

----------

--- Content provided by‌ FirstRanker.com ---




-----------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

8,06,91

8,40,22

Less: CURRENT

--- Content provided by FirstRanker.com ---

LIABILITIES

&

PROVISIONS

--- Content provided by‌ FirstRanker.com ---

Liabilities




--- Content provided by​ FirstRanker.com ---


11

1,85,58

--- Content provided by‍ FirstRanker.com ---

1,74,77

Provisions


--- Content provided by FirstRanker.com ---




12

--- Content provided by FirstRanker.com ---

56,00



55,21

--- Content provided by‍ FirstRanker.com ---


-----------



--- Content provided by FirstRanker.com ---



----------


--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





2,41,58

--- Content provided by‍ FirstRanker.com ---


2,29,98



--- Content provided by⁠ FirstRanker.com ---

67

NET CURRENT ASSETS

5,65,33

--- Content provided by​ FirstRanker.com ---


6,10,24



--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


---------- ---------



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


15,97,09

16,81,79

--- Content provided by‍ FirstRanker.com ---

----------




--- Content provided by FirstRanker.com ---


----------


Notes on the Accounts: Schedules 1 to 12 and 19 referred to above form an

--- Content provided by FirstRanker.com ---


integral part of the Balance Sheet.



--- Content provided by‍ FirstRanker.com ---

From the above balance sheet it would have been found that previous

years figures are also given. As per the Companies Act, 1956 it is mandatory for

the companies to give figures for the previous year also. Further one would have

--- Content provided by​ FirstRanker.com ---


noticed the "Schedule" column in the above balance sheet. The schedules

attached to the Balance Sheet give details of the respective items. For e.g.

--- Content provided by FirstRanker.com ---

schedule 3 gives details of the secured loan as given below:

Schedule 3 ? Secured Loans

Rs.

--- Content provided by​ FirstRanker.com ---


`000


2004-05 2003-04

--- Content provided by‍ FirstRanker.com ---

From Banker

Term Loan (Secured by charge on certain

17,00

--- Content provided by‌ FirstRanker.com ---


28,00

plant & machinery)

--- Content provided by‌ FirstRanker.com ---

Cash Credit-account (Secured by hypothecation

2,28,15

2,39,62

--- Content provided by​ FirstRanker.com ---


Of raw materials, stock-in-progress, finished
Goods, stocks and other current assets)


--- Content provided by‌ FirstRanker.com ---


---------

---------

--- Content provided by FirstRanker.com ---



2,45,15 2,67,62


--- Content provided by⁠ FirstRanker.com ---


--------- ---------

1.3.3.7 LISTING OF ITEMS ON THE BALANCE SHEET

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Assets in balance sheet are generally listed in two ways ? i) in the order

of liquidity or according to time i.e. in the order of the degree of ease with which

--- Content provided by​ FirstRanker.com ---


they can be converted into cash or ii) in the order of permanence or according to

purpose i.e., in the order of the desire to keep them in use. Some assets cannot

--- Content provided by‍ FirstRanker.com ---

be easily classified. For e.g. investments can be easily sold but the desire may be

to keep them. Investments may therefore be both liquid and semi-permanent that


--- Content provided by FirstRanker.com ---


68
is why they are shown as a separate item in the balance sheet. Liabilities can

also be grouped in two ways either in the order of urgency of payment or in the

--- Content provided by‍ FirstRanker.com ---


reverse order. The various assets and liabilities grouped in the two orders will

appear as follows:

--- Content provided by‍ FirstRanker.com ---

Order of Liquidity




--- Content provided by‍ FirstRanker.com ---



Assets

Liabilities

--- Content provided by​ FirstRanker.com ---



Cash

Bills

--- Content provided by‌ FirstRanker.com ---


payable

Bank

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




Creditors

--- Content provided by FirstRanker.com ---

Marketable

securities

Outstanding

--- Content provided by‌ FirstRanker.com ---


expenses

Debtors Income

--- Content provided by⁠ FirstRanker.com ---

received

in

advance

--- Content provided by‍ FirstRanker.com ---


Inventory

Provision

--- Content provided by‌ FirstRanker.com ---

for

income-tax

Prepaid

--- Content provided by FirstRanker.com ---


expenses

Mortgage

--- Content provided by‌ FirstRanker.com ---

loan

Investments

Debentures

--- Content provided by​ FirstRanker.com ---


Furniture

and

--- Content provided by⁠ FirstRanker.com ---

Fixtures

Owners'

equity

--- Content provided by‌ FirstRanker.com ---


Plant and Machinery
Land and Buildings
Patents
Trade Marks

--- Content provided by​ FirstRanker.com ---

Goodwill


Order of Permanence

--- Content provided by​ FirstRanker.com ---





Assets

--- Content provided by⁠ FirstRanker.com ---


Liabilities

Goodwill

--- Content provided by​ FirstRanker.com ---

Owner's

equity

Trade

--- Content provided by‍ FirstRanker.com ---


Marks

Debentures

--- Content provided by FirstRanker.com ---

Patents

Mortgage

loans

--- Content provided by​ FirstRanker.com ---


Land and Buildings



--- Content provided by FirstRanker.com ---

Provision for income-tax

Plant and Machinery


--- Content provided by​ FirstRanker.com ---


Income received in advance

Furniture and Fixtures

--- Content provided by⁠ FirstRanker.com ---



Outstanding expenses

Investments

--- Content provided by‌ FirstRanker.com ---


Creditors

Prepaid

--- Content provided by⁠ FirstRanker.com ---

expenses

Bills

payable

--- Content provided by‌ FirstRanker.com ---


Inventory
Debtors
Bills receivable
Marketable securities

--- Content provided by⁠ FirstRanker.com ---

Bank
Cash



--- Content provided by FirstRanker.com ---

69



Whatever is the order, it is always better to follow the same order for

--- Content provided by⁠ FirstRanker.com ---


both assets and liabilities. In the illustration `A' the order of liquidity has been

followed.

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1.3.3.8 CLASSIFICATION OF ITEMS IN THE BALANCE SHEET


Although each individual asset or liability can be listed separately on the

--- Content provided by​ FirstRanker.com ---

balance sheet, it is more practicable and more informative to summarise and

group related items into categories called as account classifications. The

classifications or group headings will vary considerably depending on the size of

--- Content provided by FirstRanker.com ---


the business, the form of ownership, the nature of its operations and the users of

the financial statements. For e.g. while listing assets, the order of liquidity is

--- Content provided by FirstRanker.com ---

generally used by sole traders, partnership firms and banks whereas joint stock

companies by law follow the order of permanence. As a generalisation which is

subject to many exceptions, the following classification of balance sheet items is

--- Content provided by⁠ FirstRanker.com ---


suggested as representative:

Assets

--- Content provided by FirstRanker.com ---

Current

Assets

Investments

--- Content provided by‍ FirstRanker.com ---


Fixed

Assets

--- Content provided by​ FirstRanker.com ---

Intangible

Assets


--- Content provided by FirstRanker.com ---


Other Assets

Liabilities

--- Content provided by FirstRanker.com ---

Current

Liabilities


--- Content provided by⁠ FirstRanker.com ---


Long term liabilities

Owners' Equity

--- Content provided by⁠ FirstRanker.com ---

Capital

Retained

earnings

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

70
Classification of Assets

Consumed Current Assets: Current assets are those which are reasonably

--- Content provided by​ FirstRanker.com ---

expected to be realised in cash or sold or consumed during the normal operating

cycle of the business enterprise or within one year, whichever is longer. By

operating cycle we mean the average period of time between the purchase of

--- Content provided by FirstRanker.com ---


goods or raw materials and the realisation of cash from the sale of goods or the

sale of products produced with the help of raw materials. Current assets

--- Content provided by​ FirstRanker.com ---

generally consist of cash, marketable securities, bills receivables, debtors,

inventory and prepaid expenses.

Cash: Cash consists of funds that are readily available for disbursement. It

--- Content provided by‍ FirstRanker.com ---


includes cash kept in the cash chest of the enterprise as also cash deposited on

call or current accounts with banks.

--- Content provided by‌ FirstRanker.com ---

Marketable Securities: These consist of investments that are both readily

marketable and are expected to be converted into cash within a year. These

investments are made with a view to earn some return on cash that otherwise

--- Content provided by‍ FirstRanker.com ---


would be temporarily idle.

Accounts Receivable: Accounts receivable consist of amounts owed to the

--- Content provided by⁠ FirstRanker.com ---

enterprise by its consumers. This represents amounts usually arising out of

normal commercial transactions. These amounts are listed in the balance sheet at

the amount due less a provision for portion that may not be collected. This

--- Content provided by FirstRanker.com ---


provision is called as provision for doubtful debts. Amounts due to the

enterprise by someone other than a consumer would appear under the heading

--- Content provided by FirstRanker.com ---

`other receivables' rather than `accounts receivables'. If the amounts due are

evidenced by written promises to pay, they are listed as bills receivables.

Accounts receivables are expected to be realised in cash.

--- Content provided by⁠ FirstRanker.com ---


Inventory: Inventory consists of i) goods that are held in stock for sale in the

ordinary course of business, ii) work-in-progress that are to be currently

--- Content provided by‌ FirstRanker.com ---

consumed in the production of goods or services to be available for sale.



71

--- Content provided by​ FirstRanker.com ---


Inventory is expected to be sold either for cash or on credit to customers to be

converted into cash. It may be noted in this connection that inventory relates to

--- Content provided by‍ FirstRanker.com ---

goods that will be sold in the ordinary course of business. A van offered for sale

by a van dealer is inventory. A van used by the dealer to make service calls is

not inventory; it is an item of equipment which is a fixed asset.

--- Content provided by‍ FirstRanker.com ---


Prepaid Expenses: These items represent expenses which are usually paid in

advance such as rent, taxes, subscriptions and insurance. For e.g. if rent for three

--- Content provided by⁠ FirstRanker.com ---

months for the building is paid in advance then the business acquires a right to

occupy the building for three months. This right to occupy is an asset. Since this

right will expire within a fairly short period of time it is a current asset.

--- Content provided by‌ FirstRanker.com ---


Long Term Investments: The distinction between a marketable security shown

under current asset and as an investment is entirely based on time factor. Those

--- Content provided by FirstRanker.com ---

investments like investments in shares, debentures, bonds etc. that will be

retained for more than one year or one operating cycle will appear under this

classification.

--- Content provided by‌ FirstRanker.com ---


Fixed Assets: Tangible assets used in the business that are of a permanent or

relatively fixed nature are called plant assets or fixed assets. Fixed assets include

--- Content provided by​ FirstRanker.com ---

furniture, equipment, machinery, building and land. Although there is no

standard criterion as to the minimum length of life necessary for classification as

fixed assets, they must be capable of repeated use and are ordinarily expected to

--- Content provided by‌ FirstRanker.com ---


last more than a year. However the asset need not actually be used continuously

or even frequently. Items of spare equipments held for use in the event of

--- Content provided by‌ FirstRanker.com ---

breakdown of regular equipment or for use only during peak periods of activity

are also included in fixed assets.


--- Content provided by⁠ FirstRanker.com ---


With the passage of time, all fixed assets with the exception of land lose

their capacity to render services. Accordingly the cost of such assets should be

--- Content provided by‌ FirstRanker.com ---

transferred to the related expense amounts in a systematic manner during their

expected useful life. This periodic cost expiration is called depreciation. While


--- Content provided by‍ FirstRanker.com ---


72
showing the fixed assets in the balance sheet the accumulated depreciation as on

the date of balance sheet, is deducted from the respective assets.

--- Content provided by‌ FirstRanker.com ---


Intangible Assets: While tangible assets are concrete items which have physical

existence such as buildings, machinery etc., intangible assets are those which

--- Content provided by FirstRanker.com ---

have no physical existence. They cannot be touched and felt. They derive their

value from the right conferred upon their owner by possession. Examples are:

goodwill, patents, copyrights and trademarks.

--- Content provided by‌ FirstRanker.com ---


Fictitious Assets: These items are not at all assets. Still they appear in the asset

side simply because of a debit balance in a particular account not yet written off

--- Content provided by‌ FirstRanker.com ---

? eg. debit balance in current account of partners, profit and loss account, etc.



Classification of Liabilities

--- Content provided by⁠ FirstRanker.com ---


Current Liabilities: When the liabilities of a business enterprise are due within

an accounting period or the operating cycle of the business, they are classified as

--- Content provided by‍ FirstRanker.com ---

current liabilities. Most of current liabilities are incurred in the acquisition of

materials or services forming part of the current assets. These liabilities are

expected to be satisfied either by the use of current assets or by the creation of

--- Content provided by‌ FirstRanker.com ---


other current liabilities. The one year time interval or current operating cycle

criterion applies to classifying current liabilities also. Current liabilities

--- Content provided by‍ FirstRanker.com ---

generally consists of bills payable, creditors, outstanding expenses, income-

received in advance, provision for income-tax etc.

Accounts payable: These amounts represent the claims of suppliers related to

--- Content provided by‍ FirstRanker.com ---


goods supplied or services rendered by them to the business enterprise for which

they have not yet been paid. Usually these claims are unsecured and are not

--- Content provided by FirstRanker.com ---

evidenced by any formal written acceptance or promise to pay. When the

enterprise gives a written promise to pay money to a creditor for the purchase of

goods or services used in the business or the money borrowed, then the written

--- Content provided by FirstRanker.com ---


promise is called as bills payable or notes payable. Amounts due to financial



--- Content provided by‍ FirstRanker.com ---

73

institutions which are suppliers of funds, rather than of goods or services are

termed as short-term loans or by some other name that describes the nature of

--- Content provided by⁠ FirstRanker.com ---


the debt instrument, rather than accounts payable.

Outstanding Expenses: These are expenses or obligations incurred in the

--- Content provided by FirstRanker.com ---

previous accounting period but the payment for which will be made in the next

accounting period. A typical example is wages or rent for the last month of the

accounting period remaining unpaid. It is usually paid in the first month of the

--- Content provided by⁠ FirstRanker.com ---


next accounting period and hence it is an outstanding expense.

Income received in advance: These amounts relate to the next accounting

--- Content provided by FirstRanker.com ---

period but received in the previous accounting period. This item of liability is

frequently found in the balance sheet of enterprises dealing in the publication of

newspapers and magazines.

--- Content provided by​ FirstRanker.com ---


Provision for Taxes: This is the amount owed by the business enterprise to the

Government for taxes. It is shown separately from other current liabilities both

--- Content provided by⁠ FirstRanker.com ---

because of the size and because the amount owed may not be known exactly as

on the date of balance sheet. The only thing known is the existence of liability

and not the amount.

--- Content provided by‍ FirstRanker.com ---


Long term liabilities: All liabilities which do not become due for payment in

one year and which do not require current assets for their payment are classified

--- Content provided by FirstRanker.com ---

as long-term liabilities or fixed liabilities. Long term liabilities may be classified

as secured loans or unsecured loans. When the long-term loans are obtained

against the security of fixed assets owned by the enterprise, they are called as

--- Content provided by‍ FirstRanker.com ---


secured or mortgage loans. When any asset is not attached to these loans they

are called as unsecured loans. Usually long-term liabilities include debentures

--- Content provided by⁠ FirstRanker.com ---

and bonds, borrowings from financial institutions and banks, public debts, etc.

Interest accrued on a particular secured long term loan, should be shown under

the appropriate sub-heading.

--- Content provided by⁠ FirstRanker.com ---




74

--- Content provided by FirstRanker.com ---


Contingent Liabilities: Contingent liabilities are those liabilities which may or

may not result in liability. They become liabilities only on the happening of a

--- Content provided by​ FirstRanker.com ---

certain event. Until then both the amount and the liability are uncertain. If the

event happens there is a liability; otherwise there is no liability at all. A very

good example for contingent liability is a legal suit pending against the business

--- Content provided by​ FirstRanker.com ---


enterprise for compensation. If the case is decided against the enterprise the

liability arises and in the case of favourable decision there is no liability at all.

--- Content provided by FirstRanker.com ---

Contingent liabilities are not taken into account for the purpose of totaling of

balance sheet.

Capital or Owners' Equity: As mentioned earlier, owners' equity is the residual

--- Content provided by‌ FirstRanker.com ---


interest in the assets of the enterprise. Therefore the owners' equity section of

the balance sheet shows the amount the owners have invested in the entity.

--- Content provided by FirstRanker.com ---

However, the terminology `owners' equity, varies with different forms of

organisations depending upon whether the enterprise is a joint stock company or

sole proprietorship / partnership concern.

--- Content provided by‍ FirstRanker.com ---


Sole Proprietorship / Partnership Concern: The ownership equity in a sole

proprietorship or partnership is usually reported in the balance sheet as a single

--- Content provided by‌ FirstRanker.com ---

amount for each owner rather than distinction between the owners initial

investment and the accumulated earnings retained in the business. For e.g. in a

sole-prorprietor's balance sheet for the year 2005, the capital account of the

--- Content provided by​ FirstRanker.com ---


owner may appear as follows:



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Rs.

--- Content provided by‌ FirstRanker.com ---




Owner's capital as on 1-1-2005

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


2,50,000



--- Content provided by‍ FirstRanker.com ---

Add: 2005 ? Profit




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

30,000

-----------


--- Content provided by​ FirstRanker.com ---


2,80,000


Less: 2005 ? Drawings

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





15,000

--- Content provided by‍ FirstRanker.com ---


-----------



--- Content provided by​ FirstRanker.com ---



Owner's capital as on 31-12-2005


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

2,65,000



75

--- Content provided by⁠ FirstRanker.com ---


Joint Stock Companies: In the case of joint stock companies, according to the

legal requirements, owners' equity is divided into two main categories. The first

--- Content provided by⁠ FirstRanker.com ---

category called share capital or contributed capital is the amount the owners

have invested directly in the business. The second category of owners' equity is

called retained earnings.

--- Content provided by⁠ FirstRanker.com ---




Share capital is the capital stock pre-determined by the company by the

--- Content provided by FirstRanker.com ---

time of registration. It may consist of ordinary share capital or preference share

capital or both. The capital stock is divided into units called as shares and that is

why the capital is called as share capital. The entire predetermined share capital

--- Content provided by‍ FirstRanker.com ---


called as authorised capital need not be raised at a time. That portion of

authorised capital which has been issued for subscription as on a date is referred

--- Content provided by⁠ FirstRanker.com ---

to as issued capital.



Retained earnings is the difference between the total earning to date and

--- Content provided by⁠ FirstRanker.com ---


the amount of dividends paid out to the shareholders to date. That is, the

difference represents that part of the total earnings that have been retained for

--- Content provided by‍ FirstRanker.com ---

use in the business. It may be noted that the amount of retained earnings on a

given date is the accumulated amount that has been retained in the business from

the beginning of the company's existence upto that date. The owners' equity

--- Content provided by⁠ FirstRanker.com ---


increases through retained earnings and decreases when retained earnings are

paid out in the form of dividends.

--- Content provided by​ FirstRanker.com ---

1.3.3.9 SUMMARY



The profit and loss account or income statement summarises the

--- Content provided by FirstRanker.com ---


revenues and expenses of a business enterprise for an accounting period. The

information on the income statement is regarded by many to be more important

--- Content provided by‌ FirstRanker.com ---

than information on the balance sheet because the income statement reports the

results of operations and enables to analyse the reasons for the enterprises'

profitability or loss thereof. A close relationship exists between income

--- Content provided by‌ FirstRanker.com ---


statement and balance sheet; the statement of retained earnings which is a



--- Content provided by⁠ FirstRanker.com ---

76
concomitant of income statement explains the change in retained earnings

between the balance sheets prepared at the beginning and the end of the period.

--- Content provided by​ FirstRanker.com ---

Balance sheet is one of the most important financial statements

which shows the financial position of a business enterprise as on a

particular date. It lists as on a particular date, usually at the close of the

--- Content provided by​ FirstRanker.com ---


accounting period, the assets and liabilities and capital of the enterprise.

An analysis of balance sheet together with profit and loss account will

--- Content provided by​ FirstRanker.com ---

give vital information about the financial position and operations of the

enterprise. The analysis becomes all the more useful and effective when

a series of balance sheets and profit and loss accounts are studied.

--- Content provided by FirstRanker.com ---


1.3.3.10 KEY WORDS

Income: Revenues ? Expenses.

--- Content provided by FirstRanker.com ---

Expense: Item of cost applicable to an accounting period.

Cost of goods sold: Opening stock + Purchase + Freight ? Closing stock.

Gross Profit: Excess of sales revenue over cost of goods sold.

--- Content provided by‍ FirstRanker.com ---


Operating Expenses: Expenses incurred for running the business.

Operating Profit: Gross profit ? Operating expenses.

--- Content provided by‍ FirstRanker.com ---

Non Operating Expenses: Expenses which are not related to the activities of the

business.

Net Profit: Amount of profit finally available to the enterprise for appropriation.

--- Content provided by‌ FirstRanker.com ---


Retained Earnings: The term retained earnings means the accumulated excess

of earnings over losses and dividends.

--- Content provided by FirstRanker.com ---

Status Report: Financial position on a particular date.

Flow Report: Financial position for a particular period.

Assets: Costs which represent expected future economic benefits to the business

--- Content provided by​ FirstRanker.com ---


enterprise.

Liabilities: Represent obligations which require settlement in the future.

--- Content provided by​ FirstRanker.com ---



77

Current Assets: Assets which are reasonably expected to be realised in cash or

--- Content provided by FirstRanker.com ---


sold or consumed during the normal operating cycle of the business enterprise or

within one year, whichever is longer.

--- Content provided by⁠ FirstRanker.com ---

Operating Cycle: The average period of time between the purchase of goods or

raw materials and the realisation of cash from the sale of goods.

Fixed Assets: Tangible assets used in the business that are of a permanent or

--- Content provided by FirstRanker.com ---


relatively fixed nature.

Intangible Assets: Those assets which have no physical existence.

--- Content provided by FirstRanker.com ---

Fictitious Assets: They are not assets but appear in the asset side simply because

of a debit balance in a particular account not yet written off.

Current Liabilities: Liabilities due within an accounting period or the operating

--- Content provided by⁠ FirstRanker.com ---


cycle of the business.

Long Term Liabilities: Liabilities that become due for payment after one year.

--- Content provided by⁠ FirstRanker.com ---

Contingent Liabilities: Items which become a liability only on the happening of

a certain event.

Capital or Owner's Equity: This is the residual interest in the assets of the

--- Content provided by‌ FirstRanker.com ---


enterprise.

1.3.3.11 SELF ASSESSMENT QUESTIONS

--- Content provided by FirstRanker.com ---

1. What is an expenditure? When does it become an expense?

2. What is income? How is it different from receipt?

3. Explain the following:

--- Content provided by‍ FirstRanker.com ---


(a) Gross Profit

(b) Operating Profit

--- Content provided by⁠ FirstRanker.com ---

(c) Earnings before interest and tax

(d) Earnings after tax

4. What is meant by Statement of Retained Earnings?

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

78
5. The following are the balances taken from the books of Meena Ltd on 31st

December 2005:

--- Content provided by⁠ FirstRanker.com ---

Stock

on

1-1-2005

--- Content provided by‌ FirstRanker.com ---


15,000

Debtors 5,000

--- Content provided by‌ FirstRanker.com ---

Wages




--- Content provided by​ FirstRanker.com ---


8,000

Creditors

--- Content provided by‍ FirstRanker.com ---

6,000

Sales

40,000

--- Content provided by‍ FirstRanker.com ---


P&L

a/c

--- Content provided by‍ FirstRanker.com ---



3,500

Returns inward

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

500 (Credit balance)

Purchases


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

6,000 Plant



18,000

--- Content provided by⁠ FirstRanker.com ---


Discounts earned



--- Content provided by FirstRanker.com ---



200 Cash in hand


--- Content provided by‌ FirstRanker.com ---


600

Salaries

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


800 Bank account



--- Content provided by FirstRanker.com ---

3,400

Rent


--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

2,000 Bad Debts Reserve

175

Discount allowed

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

250 Bad debts




--- Content provided by​ FirstRanker.com ---


150

General expenses

--- Content provided by‌ FirstRanker.com ---





1,300 Insurance

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

300

Dividend (interim)


--- Content provided by​ FirstRanker.com ---




575 Capital

--- Content provided by​ FirstRanker.com ---

12,000




--- Content provided by​ FirstRanker.com ---


Closing stock was valued at Rs.9,000. Rs.500 still due to labourers.

Insurance unexpired Rs.50. Provide for a Bad Debts Reserve of 5% and a

--- Content provided by‌ FirstRanker.com ---

Reserve for Discount at 1%. Prepare Trading and Profit and Loss Account as at

31st December 2005.

6. From the following figures relating to a leading software producing

--- Content provided by⁠ FirstRanker.com ---


company, prepare the Income statement for the year ended 30th June 2005.

1.

--- Content provided by‍ FirstRanker.com ---



Sales

20,17,69,212

--- Content provided by‌ FirstRanker.com ---


2.

Dividend received

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


1,06,755

3.

--- Content provided by​ FirstRanker.com ---

Costs of goods sold




--- Content provided by FirstRanker.com ---


5,86,88,675

4.

--- Content provided by‌ FirstRanker.com ---

Interest received




--- Content provided by‌ FirstRanker.com ---




18,76,661

--- Content provided by FirstRanker.com ---

5.

Manufacturing

expenses

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

5,38,56,719

6.

Selling expenses

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



81,81,822

7.

--- Content provided by⁠ FirstRanker.com ---


Administration

expenses

--- Content provided by⁠ FirstRanker.com ---





2,99,32,794

--- Content provided by‌ FirstRanker.com ---


8.

Managerial Remuneration

--- Content provided by‍ FirstRanker.com ---





1,78,200

--- Content provided by​ FirstRanker.com ---


9.

Excise duty

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


48,94,360

10.

--- Content provided by FirstRanker.com ---

Bad Debts




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

16,48,157

11.

Overseas Project expenses

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

58,35,260

12.

Interest

--- Content provided by​ FirstRanker.com ---


paid



--- Content provided by FirstRanker.com ---



5,69,16,495


--- Content provided by⁠ FirstRanker.com ---


79

13.

--- Content provided by‌ FirstRanker.com ---

Depreciation




--- Content provided by​ FirstRanker.com ---


2,33,40,163

14.

--- Content provided by‌ FirstRanker.com ---

Auditor's remuneration




--- Content provided by​ FirstRanker.com ---


71,488

15.

--- Content provided by⁠ FirstRanker.com ---

Increase

in

stocks

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

9,16,30,652

16.

Other income

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



94,13,004

17.

--- Content provided by‍ FirstRanker.com ---


Balance of profit brought forward



--- Content provided by⁠ FirstRanker.com ---

3,51,87,048




--- Content provided by⁠ FirstRanker.com ---


from previous year

18.

--- Content provided by FirstRanker.com ---

Proposed

dividend


--- Content provided by‌ FirstRanker.com ---




4,64,19,410

--- Content provided by FirstRanker.com ---

19.

Transfer to general reserve


--- Content provided by​ FirstRanker.com ---


30,62,608



--- Content provided by FirstRanker.com ---

Also prepare the statement of Retained Earnings.

7. Explain the following:

(a) Assets

--- Content provided by​ FirstRanker.com ---


(b) Liabilities

(c) Fictitious Assets

--- Content provided by‍ FirstRanker.com ---

(d) Income received in advance

(e) Investments

8. What are the two forms of presenting a balance sheet?

--- Content provided by​ FirstRanker.com ---


9. Explain Owner's equity. How is it to be presented in the Balance Sheet?

10. From the following Trail Balance extracted from the books of the General

--- Content provided by‌ FirstRanker.com ---

Traders Limited as on 31st December 2005, you are required to prepare

Trading and Profit and Loss Account and Balance Sheet:

Share Capital

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





Rs.

--- Content provided by FirstRanker.com ---


Rs.


20,000 shares of Rs.10 each

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





2,00,000

--- Content provided by​ FirstRanker.com ---


Stock on 1st

January

--- Content provided by‍ FirstRanker.com ---

2005

36,000

Sales

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



58,000

Salaries

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

5,250

Purchases

44,000

--- Content provided by​ FirstRanker.com ---


Sundry

Debtors

--- Content provided by FirstRanker.com ---

23,000

Wages


--- Content provided by​ FirstRanker.com ---




3,000

--- Content provided by⁠ FirstRanker.com ---

Calls

in

arrears

--- Content provided by‍ FirstRanker.com ---


21,500

Sundry

--- Content provided by⁠ FirstRanker.com ---

Creditors




--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



7,200

Postage and Telegrams

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

470



80

--- Content provided by⁠ FirstRanker.com ---

Advertisement

960

Preliminary expenses

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

7,500

Printing

and

--- Content provided by‍ FirstRanker.com ---


Stationery

640

--- Content provided by FirstRanker.com ---

Land and Buildings




--- Content provided by​ FirstRanker.com ---


65,000

General expenses

--- Content provided by​ FirstRanker.com ---





2,200

--- Content provided by‌ FirstRanker.com ---


Furniture



--- Content provided by​ FirstRanker.com ---





1,200

--- Content provided by⁠ FirstRanker.com ---


Repairs

650

--- Content provided by⁠ FirstRanker.com ---

Bad

Debts

910

--- Content provided by‍ FirstRanker.com ---


Rent

received

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

2,700

Machinery


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

30,000

Cash with bank


--- Content provided by‌ FirstRanker.com ---




24,100

--- Content provided by‌ FirstRanker.com ---

Cash in hand




--- Content provided by​ FirstRanker.com ---




1,520

--- Content provided by​ FirstRanker.com ---



-------------

-----------

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




2,67,900

--- Content provided by​ FirstRanker.com ---

2,67,900




--- Content provided by​ FirstRanker.com ---




-------------

--- Content provided by​ FirstRanker.com ---





-----------

--- Content provided by‍ FirstRanker.com ---




The stock on 31st December 2005 was Rs.49,000. Write off Rs.2,500 out of

--- Content provided by‌ FirstRanker.com ---

preliminary expenses. Depreciate machinery by 10 percent and furniture by 6

percent.


--- Content provided by‌ FirstRanker.com ---


11. The books of Aranarasu show the following balances as on 31st December

2005. You are required to prepare a Trading and Profit and Loss Account

--- Content provided by‍ FirstRanker.com ---

and Balance Sheet.

Stock on 1st January 2005


--- Content provided by‍ FirstRanker.com ---


67,000

Sales

--- Content provided by FirstRanker.com ---

5,24,600

Bills

payable

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


1,500

Purchases

--- Content provided by⁠ FirstRanker.com ---

4,88,000

Salaries and wages


--- Content provided by‌ FirstRanker.com ---




9,800

--- Content provided by‍ FirstRanker.com ---

Rent




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

1,100

Travelling expenses


--- Content provided by​ FirstRanker.com ---




2,600

--- Content provided by‌ FirstRanker.com ---

Sundry

creditors


--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

57,000

Postage and Telegrams


--- Content provided by⁠ FirstRanker.com ---


620

General charges

--- Content provided by​ FirstRanker.com ---





2,250

--- Content provided by‍ FirstRanker.com ---


Printing and Stationery



--- Content provided by⁠ FirstRanker.com ---

350

Capital

Account

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



75,000

Interest and Commission

--- Content provided by​ FirstRanker.com ---




2,200

--- Content provided by⁠ FirstRanker.com ---

Lighting charges




--- Content provided by‌ FirstRanker.com ---


175

Repairs

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

35

Sundry Receipts


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





175

--- Content provided by‌ FirstRanker.com ---




81

--- Content provided by FirstRanker.com ---

Furniture




--- Content provided by‍ FirstRanker.com ---




3,000

--- Content provided by‌ FirstRanker.com ---

Bills Receivable




--- Content provided by‌ FirstRanker.com ---


4,000

Bad Debts

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


475

Sundry debtors

--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


85,000

Aranarasu's

--- Content provided by​ FirstRanker.com ---

current

account


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

17,000

Cash with bank


--- Content provided by‌ FirstRanker.com ---




6,500

--- Content provided by​ FirstRanker.com ---

Cash in hand




--- Content provided by‌ FirstRanker.com ---




2,170

--- Content provided by⁠ FirstRanker.com ---



----------- -----------


--- Content provided by‍ FirstRanker.com ---




6,75,275 6,75,275

--- Content provided by​ FirstRanker.com ---



----------- -----------


--- Content provided by‍ FirstRanker.com ---




Depreciate furniture by 6 percent. Salaries and rent were outstanding Rs.1,100

--- Content provided by‍ FirstRanker.com ---

and Rs.100 respectively. Stock at 31st December 2005 was valued at Rs.70,350.



12. From the following balances relating to Software India Ltd. prepare the

--- Content provided by FirstRanker.com ---


Balance sheet as at 31st December 2005.

(a)

--- Content provided by FirstRanker.com ---

Equity

capital

36,42,58,510

--- Content provided by⁠ FirstRanker.com ---


(b)

Reserves and surplus

--- Content provided by FirstRanker.com ---



23,58,26,861

(c

--- Content provided by​ FirstRanker.com ---


)

Debentures

--- Content provided by‌ FirstRanker.com ---





1,03,36,000

--- Content provided by‍ FirstRanker.com ---


(d)

Secured

--- Content provided by⁠ FirstRanker.com ---

loans

21,27,57,441

(e)

--- Content provided by⁠ FirstRanker.com ---


Fixed

assets

--- Content provided by FirstRanker.com ---

37,07,93,048

(f)

Investments

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

5,94,80,459

(g)

Inventories

--- Content provided by‌ FirstRanker.com ---


20,78,28,095

(h)

--- Content provided by​ FirstRanker.com ---

Sundry

debtors 10,21,66,468

(i)

--- Content provided by⁠ FirstRanker.com ---


Cash and Bank balances



--- Content provided by⁠ FirstRanker.com ---

1,49,87,264

(j)

Other current assets

--- Content provided by‌ FirstRanker.com ---




57,75,568

--- Content provided by‌ FirstRanker.com ---

(k)

Loans and Advances


--- Content provided by FirstRanker.com ---


12,49,59,370

(l)

--- Content provided by​ FirstRanker.com ---

Current Liabilities




--- Content provided by⁠ FirstRanker.com ---


4,71,71,358

(m)

--- Content provided by⁠ FirstRanker.com ---

Provisions




--- Content provided by‍ FirstRanker.com ---


4,64,19,410

(n)

--- Content provided by​ FirstRanker.com ---

Miscellaneous expenditure

3,07,79,308


--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

The balance sheet may be prepared in account form and report form.




--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





82

--- Content provided by‍ FirstRanker.com ---

1.3.3.12 KEY TO SELF ASSESSMENT QUESTIONS (FOR
PROBLEMS ONLY)

Q.No.5:

--- Content provided by​ FirstRanker.com ---

Gross Profit: Rs.19,000; Net Profit: Rs.14,327; Profit carried to

Balance Sheet: Rs.17,252.

Q.No.6:

--- Content provided by‍ FirstRanker.com ---




Net Profit: Rs.6,12,52,151; Retained Earnings Balance:

--- Content provided by FirstRanker.com ---

Rs.4,69,57,182.

Q.No.10:

Gross Profit: Rs.24,000; Net Profit: Rs.10,048; Balance Sheet

--- Content provided by⁠ FirstRanker.com ---


Total: Rs.1,95,748.

Q.No.11:

--- Content provided by FirstRanker.com ---

Gross Profit: Rs.39,950; Net Profit: Rs.19,140; Balance Sheet

Total: Rs.1,70,840.

1.3.3.13 CASE ANALYSIS

--- Content provided by⁠ FirstRanker.com ---




To give a practical insight to the students about the various aspects of

--- Content provided by‌ FirstRanker.com ---

Profit and Loss Account and of a Balance Sheet we give the Financial

Statements as at 31st March 2005 of TT Limited a yarn manufacturing company:


--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





83

--- Content provided by FirstRanker.com ---


T T LIMITED

BALANCE SHEET AS AT 31ST MARCH, 2005

--- Content provided by‌ FirstRanker.com ---


Particulars

Schedule

--- Content provided by⁠ FirstRanker.com ---



Current Year

Previous Year

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Rs.



--- Content provided by‌ FirstRanker.com ---

Rs.

I. SOURCES OF FUNDS

1. Share Capital 1

--- Content provided by‍ FirstRanker.com ---


107490250.00



--- Content provided by‍ FirstRanker.com ---

107490250.00

Reserve & Surplus 2

202213218.39 190240718.95

--- Content provided by FirstRanker.com ---



2. LOAN FUNDS
Secured loans 3

--- Content provided by‌ FirstRanker.com ---

447855991.83




--- Content provided by⁠ FirstRanker.com ---


423528431.00

Unsecured loans 4

--- Content provided by⁠ FirstRanker.com ---

69532615.80 56901290.19


3. DEFERRED TAX
LIABILITY 42276806.36 43673781.36

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


-----------------

-----------------

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


869368882.38 821834471.50



--- Content provided by FirstRanker.com ---





----------------- -----------------

--- Content provided by​ FirstRanker.com ---



II. APPLICATION OF FUNDS
1. FIXED ASSETS
Gross Block 5 734104404.86

--- Content provided by⁠ FirstRanker.com ---




700390441.72

--- Content provided by FirstRanker.com ---

Less: Depreciation

217233181.41

184869109.73

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-----------------

-----------------

--- Content provided by‍ FirstRanker.com ---


Net Block



--- Content provided by⁠ FirstRanker.com ---

516871223.45

515521331.99

Capt. work in progress 4305600.00 521176823.45

--- Content provided by⁠ FirstRanker.com ---


0.00 515521331.99

/ Advances

--- Content provided by FirstRanker.com ---



-----------------


--- Content provided by‍ FirstRanker.com ---




-----------------

--- Content provided by‌ FirstRanker.com ---





2. Investments 6

--- Content provided by‍ FirstRanker.com ---




1591141.57 1591642.57

--- Content provided by⁠ FirstRanker.com ---

3. i.Current Assets,
Loans & Advances

510807958.00

--- Content provided by‌ FirstRanker.com ---





457861043.73

--- Content provided by⁠ FirstRanker.com ---


ii. Less: Current
Liabilities & Provisions 164207040.63


--- Content provided by FirstRanker.com ---




153139546.79

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


-----------------



--- Content provided by⁠ FirstRanker.com ---



-----------------

Net Current Assets 7

--- Content provided by FirstRanker.com ---


346600917.37



--- Content provided by⁠ FirstRanker.com ---



304721496.94

(i-ii)

--- Content provided by FirstRanker.com ---


-------------------

-------------------

--- Content provided by‌ FirstRanker.com ---



869368882.38


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



821834471.50

-----------------

--- Content provided by​ FirstRanker.com ---


-------------------



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





84

--- Content provided by​ FirstRanker.com ---

T T LIMITED

PROFIT & LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH,

2005

--- Content provided by‍ FirstRanker.com ---



Particulars Schedule

Current Year

--- Content provided by⁠ FirstRanker.com ---


Previous Year



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Rs.

--- Content provided by‌ FirstRanker.com ---





Rs.

--- Content provided by⁠ FirstRanker.com ---


INCOME
Sales


--- Content provided by FirstRanker.com ---




1656633139.30

--- Content provided by​ FirstRanker.com ---

1470167645.65

Less: Excise duty


--- Content provided by​ FirstRanker.com ---


9164920.45



--- Content provided by​ FirstRanker.com ---

59656449.44




--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-------------------



-------------------

--- Content provided by‌ FirstRanker.com ---


Net Sales

8

--- Content provided by‌ FirstRanker.com ---



1649235545.85


--- Content provided by⁠ FirstRanker.com ---


1410511196.21

Other Income 9

--- Content provided by‌ FirstRanker.com ---



3194055.78


--- Content provided by FirstRanker.com ---


9178442.33

Increase (Decrease) 10

--- Content provided by⁠ FirstRanker.com ---

23509662.45



22572632.64

--- Content provided by‍ FirstRanker.com ---


in stock



--- Content provided by‍ FirstRanker.com ---



-------------------


--- Content provided by​ FirstRanker.com ---


-------------------



--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


1675939264.08



--- Content provided by‌ FirstRanker.com ---

1442262271.18




--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

-------------------



------------------

--- Content provided by‍ FirstRanker.com ---


EXPENDITURE
Material

11

--- Content provided by‌ FirstRanker.com ---




1262208246.11

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1107760578.66

Manufacturing,


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Personnel, Admin. &
Selling Expenses etc.12

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308899137.99



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254353516.32

Financial expenses13 47902372.00

30855197.88

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Depre. on Fixed 34107486.97



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33127938.23

Assets
Less:Transferred from 2906557.05 31200929.92

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3657679.05 29470259.18

Revaluation Reserve ------------


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----------------



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-----------------



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----------------




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1650210686.02



1422439552.04

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------------------

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-----------------

PROFIT
Profit Before Tax

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25728578.06

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19822719.14

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Less: Provision for Taxation



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- for the year 2000000.00


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400000.00

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- Deferred Tax - 1396975.00

603025.00

4750084.00 5150084.00

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---------------- ----------------

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Add: Taxation Adjustment




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0.00



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2154911.83

Of Previous Years (net)

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85

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Profit After Taxation

25125553.06


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16827546.97

Add: Balance B/F from

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33458012.39

28831460.48

Previous Year

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----------------

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----------------


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





58583565.45

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--- Content provided by‌ FirstRanker.com ---

45659007.45




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-----------------

----------------

APPROPRIATION

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Dividend




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8599220.00



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8599220.00

Dividend Distribution Tax

1123810.56

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1101775.06

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Trf to General Reserve

10000000.00


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2500000.00

Balance Carried Forward

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38860534.88

33458012.19


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------------------

----------------

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--- Content provided by‍ FirstRanker.com ---





58583565.45

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--- Content provided by FirstRanker.com ---

45659007.45




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----------------

---------------

Earning per Share (equity shares, par value

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Rs.10 each) Basic & Diluted

2.34


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1.57

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-------------------------------------------------------------------------------------------------

1.3.3.14 BOOKS FOR FURTHER READING

1. M.A.Arulanandam and K.S.Raman: Advanced Accounts, Himalaya

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Publishing House.

2. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Vol.I, Sultan Chand &

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Sons, New Delhi.

3. S.P.Jain and K.L.Narang: Advanced Accounts, Kalyani Publishers.

4. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co. New

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Delhi.

5. Tulsian: Financial Accounting, Pearson Education.

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86
UNIT II

LESSON 2.1

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-----------------------------------------------------------------------------------------

CAPITAL AND REVENUE EXPENDITURE AND RECEIPTS

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-----------------------------------------------------------------------------------------
2.1.1 INTRODUCTION



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In the lessons under Unit-I pertaining to the preparation of Profit

and Loss Account the reader would have had an exposure to the concepts

relating to expenses, expenditure and incomes. The term expenditure is a

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broad term and it is classified into capital expenditure, revenue

expenditure and deferred revenue expenditure. All incomes are not

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receipts and all receipts are not incomes. For eg. under accrual or

mercantile system of accounting even income earned but not received is

treated as income. Similarly all receipts are not recognised as incomes.

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This lesson deals with the classification of capital and revenue

expenditure and receipts.

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2.1.2 OBJECTIVES



After reading this lesson the reader should be able to:

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(i)

Understand capital expenditure

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(ii)

Distinguish capital expenditure from revenue expenditure

(iii)

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Identify Capital receipts and Revenue receipts

2.1.3 CONTENTS

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2.1.3.1.

Capital Expenditure

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2.1.3.2.

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Revenue Expenditure



2.1.3.3.

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Distinction between Capital and Revenue Expenditure



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2.1.3.4.

Deferred Revenue Expenditure


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2.1.3.5.

Capital and Revenue Profits, Receipts and Losses

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2.1.3.6.

Illustrations

2.1.3.7.

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Summary



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87

2.1.3.8.

Key

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Words



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2.1.3.9.

Self Assessment Questions

2.1.3.10.

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Key to Self Assessment Questions

2.1.3.11.

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Case Analysis

2.1.3.12.

Books for Further Reading

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2.1.3.1 CAPITAL EXPENDITURE: Capital expenditure is that expenditure

the benefit of which is not fully consumed in one period but spread over periods

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i.e. the benefits are expected to accrue for a long time. Any expenditure which

gives the following outcomes is a capital expenditure:

(i)

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Increases the capacity of an existing asset.

(ii)

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Increases the life of an existing asset.

(iii)

Increases the earning capacity of the concern.

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(iv)

Results in the acquisition of a new asset.

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(v)

Decreases the cost of production.


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Following are the examples of capital expenditure:

(i)

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Expenditure resulting in the acquisition of fixed assets e.g. land,

building, machines, etc.

(ii)

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Expenditure resulting in extension or improvement of fixed assets

e.g. amount spent on increasing the seating accommodation in the

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picture hall.

(iii)

Expenditure in connection with installation of a fixed asset.

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(iv)

Expenditure incurred for acquiring the right to carry on a

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business e.g. patents, copyright, etc.

(v)

Major repairs and replacements of parts resulting in increased

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efficiency of a fixed asset.



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88

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An expenditure cannot be said to be a capital expenditure only because:

(i)

The amount is large.

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(ii)

The amount is paid in lump sum.

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(iii)

The amount is paid out of that fund which has been received out

of the sale of fixed asset.

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(iv)

The receiver of the amount is going to treat it for the purchase of

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fixed asset.

2.1.3.2 REVENUE EXPENDITURE: An expenditure which is consumed

during the current period and which affects the income of the current period is

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called revenue expenditure. Also an expenditure which merely seeks to maintain

the business of high assets in good working conditions is revenue expenditure.

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Following are the examples of revenue expenditure:

(i)

Expenses of administration, expenses incurred in manufacturing

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and selling products.

(ii)

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Replacements for maintaining the existing permanent assets.

(iii)

Costs of goods purchased for resale.

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(iv)

Depreciation on fixed assets, interest on loans for business, etc.

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2.1.3.3 DISTINCTION BETWEEN CAPITAL AND REVENUE
EXPENDITURE:
The proper distinction between capital and revenue as regard to expenditure,

payments, profits, receipts and losses is one of the fundamental principles of

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correct accounting. It is very essential that in all cases this distinction should be

rigidly observed and amounts rightly allocated between capital and revenue.

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Failure or neglect to discriminate between the two will falsify the whole of the

results of accounting. However the distinction is not always easy. In actual

practice there is a good deal of difference of opinion as to whether a particular

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item is capital or revenue expenditure. However the rules mentioned above may

serve as a guide for making distinction between capital and revenue expenditure.

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89


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2.1.3.4 DEFERRED REVENUE EXPENDITURE: A heavy expenditure of

revenue nature incurred for getting benefit over a number of years is classified

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as deferred revenue expenditure. In some cases the benefit of revenue

expenditure may be available for a period of two or three or even more years.

Such expenditure is to be written off over a period of two or three years and not

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wholly in the year in which it is incurred. For example a new firm may advertise

very heavily in the beginning to capture a position in the market. The benefit of

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this advertisement campaign will last quite a few years. It will be better to write

off the expenditure in three or four years and not only in the first year. Some

other examples of deferred revenue expenditure: Preliminary expenses,

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brokerage on issue of shares and debentures, exceptional repairs, discount on

issue of shares or debentures, expenses incurred in removing the business to

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more convenient premises, etc.

2.1.3.5 CAPITAL AND REVENUE PROFITS, RECEIPTS AND LOSSES:

Capital and Revenue Profits: Capital profit is a profit made on the sale of a

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fixed asset or a profit earned on getting capital for the business. For example if

the original cost of a fixed asset is Rs.50,00,000 and if it is sold for Rs.60,00,000

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then Rs.10,00,000 is capital profit. Similarly if the shares having an original cost

of Rs.4,000 are sold for Rs.5,000, the profit of Rs.1,000 thus made is capital

profit. Capital profits should not be transferred to the profit and loss account but

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should be transferred to capital reserve which would appear as a liability in the

balance sheet. Revenue profit, on the other hand, is a profit by trading, e.g. profit

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on sale of goods, income from investments, discount received, commission

earned, rent received, interest earned etc. Such profits are taken to profit and loss

account.

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Capital and Revenue Receipts: The distinction between capital receipts and

revenue receipts is also important. Money obtained from the sale of fixed assets

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90
of investments, issue of shares, debentures, money obtained by way of loans are

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examples of capital receipts. On the other hand revenue receipts are: cash from

sales, commission received, interest on investments, transfer fees, etc. Capital

receipts are shown in the balance sheet and revenue receipts in the profit and

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loss account.

Capital and Revenue Losses: Capital losses are those losses which occur at

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selling fixed assets or raising share capital. For e.g. if investments having an

original cost of Rs.20,000 are sold for Rs.16,000, there will be a capital loss of

Rs.4,000. Similarly when the shares of the face value of Rs.100 are issued for

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Rs.90, the amount of discount i.e. Rs.10 per share will be a capital loss. Capital

losses should not be debited to Profit and Loss Account but may be shown on

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the asset side of Balance Sheet. As and when capital profits arise, losses are met

against them. Revenue losses are those losses which arise during the normal

course of business i.e. in trading operations such as losses on the sale of goods.

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Such losses are debited to Profit and Loss Account.

2.1.3.6 ILLUSTRATIONS

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Illustration 1: State which of the following expenditures are capital in nature

and which are revenue in nature:

(i)

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Freight and cartage on the new machine Rs.150; erection charges

Rs.200.

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(ii)

A sum of Rs.10,000 on painting the new factory.

(iii)

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Fixtures of the book value of Rs.1,500 was sold off at Rs.600 and

new fixtures of the value of Rs.1,000 were acquired, cartage on

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purchase Rs.50.

(iv)

Rs.1,000 spent on repairs before using a second hand car

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purchased recently.



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91

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Solution:

(i)

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Capital expenditure to be debited to machinery account.

(ii)

Painting charges of new or old factory are maintenance charges

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and be charged to revenue. However, if felt proper painting

charges of new factory may be treated as deferred revenue

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expenditure. However, some say painting of new factory is

capital expenditure.

(iii)

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Loss of Rs.900 on the sale of fixtures be treated as revenue

expense but the cost of new fixture Rs.1,000 together with

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cartage Rs.50 be debited to fixture account as these are capital

expenditure.

(iv)

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Rs.1,000 being expense to bring the asset in usable condition is a

capital expenditure.

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Illustration 2:

(i)

The sum of Rs.30,000 has been spent on a machine as follows:

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Rs.20,000 for additions to increase the output; Rs.12,000 for

repairs necessitated by negligence and Rs.8,000 for replacement

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of worn-out parts.

(ii)

The sum of Rs.17,200 was spent on dismantling, removing and

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reinstalling in order to remove their works to more suitable

premises. Classify these expenses into capital and revenue.

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Solution:

(i)

Rs.20,000 spent on additions is to be capitalised but Rs.12,000

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and Rs.8,000 spent on repairs and replacement of worn-out parts

respectively are to be charged to revenue.

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(ii)

Rs.17,200 spent for removing to a more suitable premises is to be

charged to revenue as it does not increase efficiency and income.

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It, may, however be treated as deferred revenue at the most.



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92
2.1.3.7 SUMMARY

Final accounts are prepared from the balances appearing in the

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trial balance. All accounts appearing in the Trial Balance are taken to

either Trading and Profit and Loss Account or Balance Sheet. All

revenue expenditures and receipts are taken to Trading and Profit and

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Loss Account and all capital expenditures and receipts are taken to

Balance Sheet. It is therefore necessary to realise the importance of

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distinction between capital and revenue items.

2.1.3.8 KEY WORDS

Capital Expenditure: It is that expenditure the benefit of which is expected to

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accrue for a number of years.

Revenue Expenditure: It is that expenditure the benefit of which is consumed

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during the current year.

Capital Receipt: Moneys obtained from sale of fixed assets, issue of capital,

borrowing of loans, etc.

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Revenue Receipt: Cash from sales, commission received, etc. are examples of

revenue receipts.

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2.1.3.9 SELF ASSESSMENT QUESTIONS



State which of the following items should be charged to capital and

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which to revenue:

(i)

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Rs.6,000 paid for removal of stock to new site.

(ii)

Rs.2,000 paid for the erection of a new machine.

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(iii)

Rs.2,500 paid on the repairing of new factory.

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(iv)

A car engine's rings and pistons were changed at a cost of

Rs.15,000; this resulted in improvement of petrol consumption to

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12 km per litre; earlier it had fallen from 15 km to 8 km.



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93

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2.1.3.10 KEY TO SELF ASSESSMENT QUESTIONS

(i)

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Deferred Revenue Expenditure.

(ii)

Capital Expenditure.

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(iii)

Capital Expenditure.

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(iv)

Revenue Expenditure.

2.1.3.11 CASE ANALYSIS

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Raja Ram Ltd., for which you are the Accounts Manager, has removed

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the works factory to a more suitable site. During the removal process the

following stream of expenditure were incurred:

(i)

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A sum of Rs.47,500 was spent on dismantling, removing and reinstalling

plant, machinery and fixtures.

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(ii)

The removal of stock from old works to new works cost Rs.5,000.

(iii)

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Plant and machinery which stood in books at Rs.7,50,000 included a

machine at a book value of Rs.15,000. This being obsolete was sold off

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for Rs.5,000 and was replaced by a new machine which costs Rs.24,000.

(iv)

The fixtures and furniture appeared in the books at Rs.75,000. Of these

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some portion of the book value of Rs.15,000 was discarded and sold off

for Rs.16,000 and new furniture of the value of Rs.12,000 was acquired.

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(v)

A sum of Rs.11,000 was spent on painting the new factory.

Your accounts clerk has come to you seeking your help to classify the

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above expenditure as to capital expenditure and revenue expenditure. Advise

him.

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Solution:

(i)

Rs.47,500 will have to be treated as revenue expenditure. It may be

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treated as deferred revenue expenditure item and spread over a term of

years say four to five years.

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94
(ii)

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The cost of removal of stock from the old works to the new works does

not either add to the value of the profit earning capacity of the asset and

as such it should be treated as an item of revenue expenditure.

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(iii)

Rs.10,000 the difference between the book value of the machine sold and

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the amount realised on sale, will have to be charged off to revenue as

depreciation. Rs.24,000, the cost of new machine, will have to be

capitalised.

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(iv)

Rs.1,000 the difference between the book value of the fixtures and

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fittings discarded and the amount realised there from will be treated as

capital profit and therefore be credited to capital revenue account.

Rs.12,000 the cost of new furniture, will be capitalised.

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(v)

A sum of Rs.11,000 spent on painting a new factory is capital

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expenditure and will be added to the cost of factory building as it is all to

the new factory.

2.1.3.12 BOOKS FOR FURTHER READING

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1. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Sultan Chand

& Sons, New Delhi.

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2. S.P.Jain and K.L.Narang: Advanced Accountancy, Kalyani

Publishers, New Delhi.

3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co.,

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New Delhi.

4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.

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5. Warren Reeve Fess: Financial Accounting, Thomson, South Westem.




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95

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UNIT-II



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LESSON 2.2

-----------------------------------------------------------------------------------------

DEPRECIATION

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-----------------------------------------------------------------------------------------

2.2.1 INTRODUCTION

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With the passage of time, all fixed assets lose their capacity to

render services, the exceptions being land and antics. Accordingly a

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fraction of the cost of the asset is chargeable as an expense in each of the

accounting periods in which the asset renders services. The accounting

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process for this gradual conversion of capitalised cost of fixed assets

into expense is called depreciation. This lesson explains the different

aspects of depreciation.

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2.2.2 OBJECTIVES

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After reading this lesson the reader should be able to:

(i)

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Understand the meaning of depreciation.

(ii)

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Know the causes of depreciation.

(iii)

Appreciate the need for depreciation accounting.

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(iv)

Evaluate the methods of depreciation.

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2.2.3 CONTENTS

2.2.3.1.

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Meaning of Depreciation

2.2.3.2.

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Causes of Depreciation

2.2.3.3.

Need for Depreciation Accounting

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2.2.3.4.

Methods of Depreciation

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2.2.3.5.

Straight Line Method of Depreciation

2.2.3.6.

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Diminishing Balance Method of Depreciation



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96
2.2.3.7.

Annuity Method of Depreciation

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2.2.3.8.

Summary

2.2.3.9.

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Key Words

2.2.3.10.

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Self Assessment Questions

2.2.3.11.

Key to Self Assessment Questions

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2.2.3.12.

Case Analysis

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2.2.3.13.

Books for Further Reading

2.2.3.1 MEANING OF DEPRECIATION

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In common parlance depreciation means a fall in the quality or

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value of an asset. But in accounting terminology, the concept of

depreciation refers to the process of allocating the initial or restated

input valuation of fixed assets to the several periods expected to benefit

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from their acquisitions and use. Depreciation accounting is a system of

accounting which aims to distribute the cost or other basic value of

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tangible capital assets, less salvage (if any), over the estimated useful

life of the unit (which may be a group of assets) in a systematic and

rational manner. It is a process of allocation, not of valuation.

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The International Accounting Standards Committee (IASC) (now

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International Accounting Standards Board) defines depreciation as

follows: Depreciation is the allocation of the depreciable amount of an

asset over the estimated useful life. The useful life is in turn defined as

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the period over which a depreciable asset is expected to be used by the

enterprise. The depreciable amount of a depreciable asset is its historical

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cost in the financial statements, less the estimated residual value.

Residual value or salvage value is the expected recovery or sales value

of the asset at the end of its useful life.

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2.2.3.2 CAUSES OF DEPRECIATION



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97



Among other factors, the two main factors that contribute to the decline

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in the usefulness of fixed assets are deterioration and obsolescence.

Deterioration is the physical process wearing out whereas obsolescence refers to

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loss of usefulness due to the development of improved equipment or processes,

changes in style or other causes not related to the physical conditions of the

asset. The other causes of depreciation are:

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(i)

Efflux of time ? mere passage of time will cause a fall in the

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value of an asset even if it is not used.

(ii)

Accidents ? an asset may reduce in value because of meeting

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with an accident.

(iii)

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Fall in market price ? a sudden fall in the market price of the

asset reduces its value even if it remains brand new.


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2.2.3.3 NEED FOR DEPRECIATION ACCOUNTING



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The need for depreciation accounting arises on three grounds:

(i)

To Calculate Proper Profit: According to matching concept of

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accounting, profit of any year can be calculated only when all costs of

earning revenues have been properly charged against them. Asset is an

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important tool in earning revenues. The fall in the book value of assets

reflects the cost of earning revenues from the use of assets in the current

year and hence like other costs like wages, salary, etc., it must also be

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provided for proper matching of revenues with expenses.



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(ii)

To Show True Financial Position: The second ground for providing

depreciation is that it should result in carrying forward only that part of

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asset which represents the unexpired cost of expected future service. If

the depreciation is not provided then the asset will appear in the balance

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sheet at the overstated value.



98

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(iii)

To Make Provision for Replacement of Assets: If no change were made

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for depreciation, profits of the concern would be more to that extent. By

making an annual charge for depreciation, a concern would be

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accumulating resources enough to enable it to replace an asset when

necessary. Replacement, thus, does not disturb the financial position of

the concern.

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2.2.3.4 METHODS OF DEPRECIATION



The amount of depreciation of a fixed asset is determined taking into

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account the following three factors: its original cost, its recoverable cost at the

time it is retired from service and the length of its life. Out of these three factors

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the only factor which is accurately known is the original cost of the asset. The

other two factors cannot be accurately determined until the asset is retired. They

must be estimated at the time the asset is placed in service. The excess of cost

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over the estimated residual value is the amount that is to be recorded as

depreciation expense during the assets life-time. There are no hard and fast rules

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for estimating either the period of usefulness of an asset or its residual value at

the end of such period. Hence these two factors, which are inter-related are

affected to a considerable extent by management policies.

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Let the reader consider the following example: A machine is

purchased for Rs.1,00,000 with an estimated life of five years and

estimated residual value of Rs.10,000. The objective of depreciation

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accounting is to charge this net cost of Rs.90,000 (original cost ?

residual value) as an expense over the 5 year period. How much should

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be charged as an expense each year? To give an answer to this question a



99

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number of methods of depreciation are available. In this lesson three

such methods viz. straight line method, diminishing balance method and

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annuity method are discussed.



2.2.3.5 STRAIGHT LINE METHOD OF DEPRECIATION

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This method which is also known as `fixed installment system', provides

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for equal amount of depreciation every year. Under this method, the cost of

acquisition plus the installation charges, minus the scrap value, is spread over

the estimated life of the asset to arrive at the annual charge. In other words, this

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method writes off a fixed percentage, say 20%, of the original cost of the asset

every year in such a way that the asset is reduced to nil or scrap value at the end

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of its life.

Evaluation: The chief merit of this method is that it is easy to calculate

depreciation, and hence, it is simple. Depreciation charge is constant from year

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to year, regardless of the extent of use of the asset. This method can be

employed in the case of assets like furniture and fixtures, short leases, etc.,

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which involve little capital outlay, or which have no residual value. This method

is criticised on the ground that the depreciation charge remaining the same every

year, cost of repairs and maintenance would be increasing as the asset becomes

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older. The efficiency of the asset declining, it is unfair to charge the same

amount of depreciation every year.

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2.2.3.6 DIMINISHING BALANCE METHOD



This method which is also known as the, `reducing installment system',

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or `written down value method', applies depreciation as a fixed percentage to

the balance of the net cost of the asset not yet allocated at the end of the

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previous accounting period. The percentage of depreciation is so fixed that,

theoretically, the balance of the unallocated cost at the end of the estimated

useful life of the asset should be equal to the estimated residual value.

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100
Evaluation: Unlike the fixed installment system, depreciation under this method

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is not fixed, but gradually decreasing. As such, in the initial periods the amount

will be much higher, but negligible in the later period of the asset. Thus this

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method tends to offset the amount of depreciation on the one hand and repairs

and maintenance on the other. This method is also simple, although the

calculation of depreciation is a bit complicated. Further as and when additions

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are made to the asset, fresh calculations do not become necessary. This method

is best suited to assets such as plant and machinery which have a long life.

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Entries Required: The entry to be made on writing off depreciation under any

method is:

Depreciation

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a/c

.....

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Dr




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To Asset a/c

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The depreciation account goes to the debit of the Profit and Loss

Account. The entry for this is:

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Profit and Loss a/c ...

Dr

To

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Depreciation

a/c

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The asset appears at its reduced value in the Balance Sheet.

Illustration 1: On 1-1-2003, machinery was purchased for Rs.3,00,000.

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Depreciation at the rate of 10% has to be written off. Write up the machinery

account for three years under:

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(i)

Straight Line Method (SLM) and

(ii)

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Written Down Value Method (WDV)

Solution:

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101

Machinery Account


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Date

Particulars

SLM

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WDV

Date

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Particulars

SLM

WDV

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--- Content provided by‌ FirstRanker.com ---






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1-1-2003

To Bank a/c

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3,00,000

3,00,000

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31-12-2003 By Depreciation

30,000

30,000

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--- Content provided by‍ FirstRanker.com ---






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31-12-2003 By Balance c/d

2,70,000

2,70,000

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--- Content provided by FirstRanker.com ---

-----------

----------


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-----------

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-----------




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3,00,000

3,00,000

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3,00,000

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3,00,000



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-----------

----------

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--- Content provided by⁠ FirstRanker.com ---

-----------

-----------


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--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






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1-1-2004

To Balance b/d 2,70,000

2,70,000

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31-12-2004 By Depreciation

30,000

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27,000




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--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


31-12-2004 By Balance c/d

2,40,000

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2,43,000




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-----------

----------

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-----------

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-----------



--- Content provided by‍ FirstRanker.com ---



2,70,000

2,70,000

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--- Content provided by FirstRanker.com ---

2,70,000

2,70,000


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-----------

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----------




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-----------

-----------

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To Balance b/d


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--- Content provided by‌ FirstRanker.com ---





1-1-2005

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2,40,000

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2,43,000

31-12-2005 By Depreciation

30,000

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24,300



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--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



31-12-2005 By Balance c/d

2,10,000

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2,18,700



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-----------

----------

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-----------

-----------

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2,40,000

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2,43,000

2,40,000

--- Content provided by‌ FirstRanker.com ---

2,43,000



To Balance b/d -----------

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----------

-----------

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-----------




--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



1-1-2006

2,10,000

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2,18,700



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From the above illustration it can be seen that under SLM method each

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year depreciation is calculated at 10% on original cost of asset i.e. on

Rs.3,00,000, while under WDV method each year depreciation is calculated at

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10% on the written down value i.e. for eg. in the 2nd year depreciation is

calculated at 10% on Rs.2,70,000 and so on.

Illustration 2: On 1-1-2002, machinery was purchased for Rs.30,000.

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Depreciation at the rate of 10% on original cost was written off during the first

two years. For the next two years 15% was written off the diminishing balance

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of the amount. The machinery was sold for Rs.15,000. Write up the machinery

account for four years and close the same.


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102
Machinery Account

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Rupees

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--- Content provided by⁠ FirstRanker.com ---

Rupees




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--- Content provided by‌ FirstRanker.com ---





1-1-2002

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To Bank 30,000

31-12-2002 By Depreciation

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3,000



a/c

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--- Content provided by FirstRanker.com ---

(10% on 30,000)




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--- Content provided by FirstRanker.com ---

31-12-2002 By Balance c/d

27,000


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--------

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--------

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--- Content provided by​ FirstRanker.com ---

30,000




--- Content provided by⁠ FirstRanker.com ---


30,000



--- Content provided by⁠ FirstRanker.com ---



--------


--- Content provided by FirstRanker.com ---




--------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



1-1-2003


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27,000

31-12-2003 By Depreciation

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3,000



To

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--- Content provided by‍ FirstRanker.com ---

(10% on 30,000)




--- Content provided by⁠ FirstRanker.com ---


Balance



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31-12-2003 By Balance c/d

24,000


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b/d

--------

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--------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

27,000




--- Content provided by‌ FirstRanker.com ---


27,000



--- Content provided by⁠ FirstRanker.com ---



--------


--- Content provided by‌ FirstRanker.com ---




--------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



1-1-2004


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24,000

31-12-2004 By Depreciation

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3,600




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

(15% on 24,000)




--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

31-12-2004 By Balance c/d

20,400


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To

--------

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--------

--- Content provided by⁠ FirstRanker.com ---




Balance

--- Content provided by‍ FirstRanker.com ---

24,000




--- Content provided by‍ FirstRanker.com ---


24,000



--- Content provided by‌ FirstRanker.com ---

b/d

--------


--- Content provided by‍ FirstRanker.com ---




--------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



1-1-2005


--- Content provided by⁠ FirstRanker.com ---


20,400

31-12-2005 By Depreciation

--- Content provided by‍ FirstRanker.com ---

3,060




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

(15% on 20,400)




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

31-12-2005 By Bank sale

15,000


--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



31-12-2005 By Profit&Loss

2,340

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To

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--------

a/c(loss on sale)

--------

--- Content provided by‍ FirstRanker.com ---




Balance

--- Content provided by‍ FirstRanker.com ---

20,400

20,400


--- Content provided by‌ FirstRanker.com ---


b/d

--------

--- Content provided by​ FirstRanker.com ---

--------




--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



103

Illustration 3: A company whose accounting year is the calendar year

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purchased on 1-1-2003 a machinery for Rs.40,000. It purchased further

machinery on 1-10-2003 for Rs.20,000 and on 1st July 2005 for Rs.10,000.

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On 1-7-2006, one-fourth of the machinery installed on 1-1-2003 became

obsolete and was sold for Rs.6,800. Show the machinery account for all

the 3 years under fixed installment system. Depreciation is to be provided

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at 10%p.a.

Machinery Account

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





2003

--- Content provided by‍ FirstRanker.com ---




Rupees

--- Content provided by​ FirstRanker.com ---

2003

By Depreciation

Rupees

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Jan 1

--- Content provided by‌ FirstRanker.com ---

To Bank-Purchase

40,000

Dec 31

--- Content provided by​ FirstRanker.com ---


-on Rs.40000 for 1 year

4,000

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

-on Rs.20000 for 3 month

500


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Oct 10

To Bank-Purchase

--- Content provided by⁠ FirstRanker.com ---

20,000

Dec 31

By Balance c/d

--- Content provided by‌ FirstRanker.com ---


55,500



--- Content provided by FirstRanker.com ---



--------


--- Content provided by‍ FirstRanker.com ---




--------

--- Content provided by FirstRanker.com ---





60,000

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

60,000




--- Content provided by⁠ FirstRanker.com ---


--------



--- Content provided by⁠ FirstRanker.com ---



--------

2004

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

2004

By Depreciation


--- Content provided by‍ FirstRanker.com ---


Jan 1

To Balance b/d

--- Content provided by⁠ FirstRanker.com ---

55,500

Dec 31

-on Rs.40000 for 1 year

--- Content provided by‌ FirstRanker.com ---


4,000



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

July 1

To Bank-Purchase

10,000

--- Content provided by‍ FirstRanker.com ---




-on Rs.20000 for 1 year

--- Content provided by FirstRanker.com ---

2,000




--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



-on Rs.10000 for 6 month

500

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Dec 31

--- Content provided by⁠ FirstRanker.com ---


By Balance c/d

59,000

--- Content provided by‌ FirstRanker.com ---





--------

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

--------




--- Content provided by‌ FirstRanker.com ---


65,500



--- Content provided by⁠ FirstRanker.com ---



65,500


--- Content provided by⁠ FirstRanker.com ---




--------

--- Content provided by‍ FirstRanker.com ---





--------

--- Content provided by‌ FirstRanker.com ---


2005



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Jan 1

--- Content provided by⁠ FirstRanker.com ---

To Balance b/d

59,000

2005

--- Content provided by‍ FirstRanker.com ---


By Depreciation



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


July 1

On machine sold

--- Content provided by‌ FirstRanker.com ---

500




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

July 1

By Bank-Sale

6,800

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





July 1

--- Content provided by FirstRanker.com ---


By P&L a/c (loss on sale)

700

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Dec 31

--- Content provided by‍ FirstRanker.com ---

By Depreciation




--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-on Rs.30000 for 1 year

3,000


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

-on Rs.20000 for 1 year

2,000


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


104



--- Content provided by​ FirstRanker.com ---




-on Rs.10000 for 1 year

--- Content provided by‍ FirstRanker.com ---

1,000




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




By Balance c/d

--- Content provided by​ FirstRanker.com ---

45,000




--- Content provided by​ FirstRanker.com ---


--------

--------

--- Content provided by​ FirstRanker.com ---





59,000

--- Content provided by⁠ FirstRanker.com ---


59,000



--- Content provided by‌ FirstRanker.com ---



--------

--------

--- Content provided by​ FirstRanker.com ---


2006



--- Content provided by‍ FirstRanker.com ---





Jan 1

--- Content provided by⁠ FirstRanker.com ---


To Balance b/d

45,000

--- Content provided by FirstRanker.com ---


Working Notes ? Loss on sale of machinery

Original cost of machinery on 1-1-2003: 4000 x ? =

--- Content provided by FirstRanker.com ---

10,000

Less Depreciation for 2003 at 10%


--- Content provided by‍ FirstRanker.com ---


1,000

--------
Book

--- Content provided by FirstRanker.com ---


value

on

--- Content provided by​ FirstRanker.com ---

1-1-2004




--- Content provided by‍ FirstRanker.com ---


9,000

Less Depreciation for 2004 at 10% on 10,000

--- Content provided by FirstRanker.com ---

1,000

--------


--- Content provided by‌ FirstRanker.com ---


Book

value

--- Content provided by‌ FirstRanker.com ---

on

1-1-2005


--- Content provided by‍ FirstRanker.com ---


8,000

Less Depreciation upto 1-7-2005 at 10% on 10000 500
--------

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---



Book value on date of sale


--- Content provided by​ FirstRanker.com ---




7,500

--- Content provided by⁠ FirstRanker.com ---

Less

Sale

proceeds

--- Content provided by​ FirstRanker.com ---




6,800

--- Content provided by​ FirstRanker.com ---

--------



Loss

--- Content provided by⁠ FirstRanker.com ---


on

sale

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




700

--- Content provided by‌ FirstRanker.com ---

--------




--- Content provided by​ FirstRanker.com ---

2.2.3.7 ANNUITY METHOD OF DEPRECIATION



Under the first two methods of depreciation the interest aspect has been

--- Content provided by⁠ FirstRanker.com ---


ignored. Under this method, the amount spent on the acquisition of an asset is

regarded as investment which is assumed to earn interest at a certain rate. Every

--- Content provided by FirstRanker.com ---

year the asset is debited with the amount of interest and credited with the

amount of depreciation. This interest is calculated on the debit balance of the

asset account at the beginning of the year. The amount to be written off as

--- Content provided by FirstRanker.com ---


depreciation is calculated from the annuity table an extract of which is given

below:

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


105

Years 3% 3.5% 4% 4.5%

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5%




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3 0.353530 0.359634 0.360349 0.363773 0.367209


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4 0.269027 0.272251 0.275490 0.278744 0.282012

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5 0.218355 0.221481 0.224627 0.227792 0.230975

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The amount to be written off as depreciation is ascertained from

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the annuity table and the same depends upon the rate of interest and the

period over which the asset is to be written off. The rate of interest and

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the amount of depreciation would be adjusted in such a way that at the

end of its working life, the value of the asset would be reduced to nil or

its scrap value.

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Evaluation: This method has the merit of treating purchase of an asset as an

investment within the business, and the same is supposed to earn interest.

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However, calculations become difficult when additions are made to the asset.

The method is suitable only for long leases and other assets to which additions

are not usually made and as such in case of machinery this method is not found

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suitable.

Illustration 4: A lease is purchased for a term of 4 years by payment of

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Rs.1,00,000. It is proposed to depreciate the lease by annuity method charging

4% interest. If annuity of Re.1 for 4 years at 4% is 0.275490, show the lease

account for the full period.

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Amount of annual depreciation = Rs.1,00,000 x Re.0.275490

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=

Rs.27,549

Lease Account

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1st year To Bank

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100000.00

1st year By Depreciation 27549.00

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To Interest at 4% 4000.00

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By Balance c/d

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76451.00




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--------------



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-------------


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104000.00

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104000.00

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--------------




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-------------



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2nd

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To Balance b/d

76451.00

2nd

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By Depreciation 27549.00

year

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year

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To Interest at 4% 3058.04


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By Balance c/d

51960.04

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--------------

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-------------




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79509.04



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79509.04


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--------------

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-------------

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3rd year To Balance b/d

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51960.04

3rd year By Depreciation 27549.00


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To Interest at 4% 2078.40

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By Balance c/d

26489.44

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--------------




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-------------



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54038.44


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54038.44

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4th year To Balance b/d

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26489.44

4th year By Depreciation 27549.00

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To Interest at 4% 1059.56




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(adjusted)

-------------

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-------------



27549.00

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27549.00



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-------------


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2.2.3.8 SUMMARY



Though depreciation to a common man means a fall in the value of an

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asset actually it is not a process of valuation. It is a process of cost allocation.

Through depreciation accounting the cost of a tangible asset less salvage value,

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if any, is distributed over the estimated useful life of the asset. Depreciation is to

be accounted to know the true profit earned by the concern, to exhibit a true and

fair view of the state of assets of the concern and to provide funds for

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replacement of the asset when it is worn out. Among the number of methods of

depreciation available three methods, viz. straight line method, diminishing

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balance method and annuity method are discussed.

2.2.3.9 KEY WORDS

Depreciable Asset: It is that asset on which depreciation is written off.

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107

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Depreciation: It is the allocation of the depreciable amount of an asset over the

estimated useful life.

Useful Life: It is the period over which a depreciable asset is expected to be

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used by the enterprise.

Depreciable Amount: The depreciable amount of a depreciable asset is its

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historical cost less estimated residual value.

Residual Value: It is the expected recovery or sales value of an asset at the end

of its useful life.

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2.2.3.10 SELF ASSESSMENT QUESTIONS

Question 1: A manufacturing concern, whose books are closed on 31st March,

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purchased machinery for Rs.1,50,000 on 1st April 2002. Additional machinery

was acquired for Rs.40,000 on 30th September 2003 and for Rs.25,000 on 1st

April 2005. Certain machinery which was purchased for Rs.40,000 on 30th

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September 2003 was sold for Rs.34,000 on 30th September 2005. Give the

machinery account for the year ending 31st March 2006 taking into account

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depreciation at 10% p.a. on the written down value.

Question 2: A seven years lease has been purchased for a sum of Rs.60,000 and

it is proposed to depreciate it under the annuity method charging 4% interest.

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Reference to the annuity table indicates that the required result will be brought

about by charging annually Rs.9996.55 to depreciation account. Show how the

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lease account will appear in each of the seven years.

Question 3: Examine the need for providing depreciation.


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2.2.3.11 KEY TO SELF ASSESSMENT QUESTIONS

Question 1: Machinery Account

2005 To Balance b/d

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1,43,550

2005 By Depreciation

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1,710


April 1 To Bank

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25,000

Sep 30

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By Bank 34,000



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108
Sep 30 To P&L a/c 1,510

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2006 By Depreciation

13,435


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Profit on sale



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Mar 31

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By Balance c/d 1,20,915




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-----------

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-----------

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1,70,060

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1,70,060


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-----------



-----------

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Question 2: Interest for seven years:
1st year: Rs.2,400; 2nd year: Rs.2,096.14; 3rd year: Rs.1,780.12; 4th year:
Rs.1,451.46; 5th year: Rs.1,109.66; 6th year: Rs.754.19; 7th year: Rs.384.28.

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2.2.3.12 CASE ANALYSIS



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Pondicherry Roadways Ltd which depreciates its machinery at 10% p.a.

on written down value desires to change the basis to straight line method, the

rate remaining the same. The decision is taken on 31st December 2005 to be

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effective from 1st January 2003.

On

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1st January 2005 the balance in the machinery account is

Rs.29,16,000.

On

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1st July 2005 a part of machinery purchased on 1st January 2003 for

Rs.2,40,000 was sold for Rs.1,35,000. On the same day a new machine is

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purchased for Rs.4,50,000 and installed at a cost of Rs.24,000.



Analyse the above case and answer the following questions:

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(i)

What was the loss incurred on the machine sold?

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(ii)

What was the book value of unsold machinery on 1-1-2003.

(iii)

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What would be the additional depreciation due to change in

method?

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(iv)

What should be the depreciation to be charged for 2005?

Answers:

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(i)

Rs.49,680

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(ii)

Rs.33,60,000

(iii)

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Rs.33,600

(iv)

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Rs.3,59,700




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109

2.2.3.13 BOOKS FOR FURTHER READING

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1. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Sultan Chand & Sons,

New Delhi.

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2. S.P.Jain and K.L.Narang: Advanced Accountancy, Kalyani Publishers, New

Delhi.

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3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co., New

Delhi.

4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.

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5. Warren Reeve Fess: Financial Accounting, Thomson, South Westam.



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110
UNIT-III

LESSON 3.1

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-------------------------------------------------------------------------------------------------

ANALYSIS AND INTREPRETATION OF FINANCIAL STATEMENTS

-------------------------------------------------------------------------------------------------

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3.1.1 INTRODUCTION



Financial statements by themselves do not give the required

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information both for internal management and for outsiders. They are

passive statements showing the results of the business i.e. profit or loss

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and the financial position of the business. They will not disclose any

reasons for dismal performance of the business if it is so. What is wrong

with the business, where it went wrong, why it went wrong, etc. are

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some of the questions for which no answers will be available in the

financial statements. Similarly no information will be available in the

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financial statements about the financial strengths and weaknesses of the

concern. Hence to get meaningful information from the financial

statements which would facilitate vital decisions to be taken, financial

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statements must be analysed and interpreted. Through the analysis and

interpretation of financial statements full diagnosis of the profitability

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and financial soundness of the business is made possible. The term

`analysis of financial statements' means methodical classification of the

data given in the financial statements. The term `interpretation of

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financial statements' means explaining the meaning and significance of

the data so classified. A number of tools are available for the purpose of

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analysing and interpreting the financial statements. This lesson discusses

in brief tools like common size statement, trend analysis, etc., and gives

a detailed discussion on ratio analysis.

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111

3.1.2 OBJECTIVES

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After reading this lesson the reader should be able to:

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? Realise the limitations of financial statements
? Appreciate the need for analysis and interpretation of financial

statements

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? Understand the nature and types of financial analysis
? Know the various tools of financial analysis
? Understand the meaning of ratio analysis
? Appreciate the significance of ratio analysis
? Understand the calculation of various kinds of ratios

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? Calculate the different ratios from the given financial statements
? Interpret the calculated ratios

3.1.3 CONTENTS

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3.1.3.1

Nature of Financial Analysis

3.1.3.2

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Types of Financial Analysis

3.1.3.3

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Tools of Financial Analysis

3.1.3.4

Illustrations

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3.1.3.5

Meaning and Nature of Ratio Analysis

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3.1.3.6

Capital Structure or Leverage Ratios

3.1.3.7

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Fixed Assets Analysis

3.1.3.8

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Analysis of Turnover or Analysis of Efficiency

3.1.3.9

Analysis of Liquidity Position

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3.1.3.10

Analysis of Profitability

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3.1.3.11

Analysis of Operational Efficiency

3.1.3.12

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Ratios from Shareholders Point of View

3.1.3.13

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Illustrations

3.1.3.14

Summary

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3.1.3.15

Key Words

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112
3.1.3.16

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Self Assessment Questions

3.1.3.17

Key to Self Assessment Questions

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3.1.3.18

Case Analysis

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3.1.3.19

Books for Further Reading

3.1.3.1 NATURE OF FINANCIAL ANALYSIS

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The focus of financial analysis is on the key figures contained in the

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financial statements and the significant relationship that exists between them.

"Analysing financial statements is a process of evaluating the relationship

between the component parts of the financial statements to obtain a better

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understanding of a firm's position and performance".



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The type of relationship to be investigated depends upon the

objective and purpose of evaluation. The purpose of evaluation of

financial statements differs among various groups: creditors,

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shareholders, potential investors, management and so on. For example,

short-term creditors are primarily interested in judging the firm's ability

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to pay its currently-maturing obligations. The relevant information for

them is the composition of the short-term (current) liabilities. The

debenture-holders or financial institutions granting long-term loans

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would be concerned with examining the capital structures, past and

projected earnings and changes in the financial position. The

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shareholders as well as potential investors would naturally be interested

in the earnings per share and dividends per share as these factors are

likely to have a significant bearing on the market price of shares. The

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management of the firms, in contrast, analyses the financial statements

for self-evaluation and decision making.

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The first task of the financial analyst is to select the information

relevant to the decision under consideration from the total information

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contained in the financial statements. The second step involved in



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113

financial analysis is to arrange the information in such a way as to

highlight significant relationships. The final step is the interpretation and

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drawing of inferences and conclusions. In brief, financial analysis is the

process of selection, relation and evaluation.

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3.1.3.2 TYPES OF FINANCIAL ANALYSIS



Financial analysis may be classified on the basis of parties who

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are undertaking the analysis and on the basis of methodology of analysis.

On the basis of the parties who are doing the analysis, financial analysis

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is classified into external analysis and internal analysis.

External Analysis: When the parties external to the business like creditors,

investors, etc. do the analysis, the analysis is known as external analysis. This

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analysis is done by them to know the credit-worthiness of the concern, its

financial viability, its profitability, etc.

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Internal Analysis: This analysis is done by persons who have control over the

books of accounts and other information of the concern. Normally this analysis

is done by management people to enable them to get relevant information to

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take vital business decision.



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On the basis of methodology adopted for analysis, financial

analysis may be either horizontal analysis or vertical analysis.

Horizontal Analysis: When financial statements of a number of years are

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analysed, then the analysis is known as horizontal analysis. In this type of

analysis figures of the current year are compared with the standard or base year.

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This type of analysis will give an insight into the concern's performance over a

period of years. This analysis is otherwise called as dynamic analysis as it

extends over a number of years.

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Vertical Analysis: This type of analysis establishes a quantitative relationship of

the various items in the financial statements on a particular date. For e.g. the

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ratios of various expenditure items in terms of sales for a particular year can be



114

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calculated. The other name for this analysis is `static analysis' as it relies upon

one year figures only.

3.1.3.3 TOOLS OF FINANCIAL ANALYSIS

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The following are the important tools of financial analysis which can be

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appropriately used by the financial analysts:

1. Common-size financial statements

2. Comparative financial statements

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3. Trend percentages

4. Ratio analysis

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5. Funds Flow analysis

6. Cash Flow analysis

Common-size Financial Statements: In this type of statements figures in the

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original financial statements are converted into percentages in relation to a

common base. The common base may be sales in the case of income statements

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(profit and loss account) and total of assets or liabilities in the case of balance

sheet. For e.g. in the case of common-size income statement, sales of the

traditional financial statement are taken as 100 and every other item in the

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income statement is converted into percentages with reference to sales. Similarly

in the case of common-size balance sheet, the total of asset/liability side will be

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taken as 100 and each individual asset/liability is converted into relevant

percentages.

Comparative Financial Statements: This type of financial statements are ideal

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for carrying out horizontal analysis. Comparative financial statements are so

designed to give them perspective to the review and analysis of the various

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elements of profitability and financial position displayed in such statements. In

these statements figures for two or more periods are compared to find out the

changes both in absolute figures and in percentages that have taken place in the

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115

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latest year as compared to the previous year(s). Comparative financial

statements can be prepared both for income statement and balance sheet.

Trend Percentages: Analysis of one year figures or analysis of even two years

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figures will not reveal the real trend of profitability or financial stability or

otherwise of any concern. To get an idea about how consistent is the

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performance of a concern, figures of a number of years must be analysed and

compared. Here comes the role of trend percentages and the analysis which is

done with the help of these percentages is called as Trend Analysis.

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Trend analysis is a useful tool for the management since it

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reduces the large amount of absolute data into a simple and easily

readable form. The trend analysis is studied by various methods. The

most popular forms of trend analysis are year to year trend change

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percentage and index-number trend series. The year to year trend change

percentage would be meaningful and manageable where the trend for a

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few years, say a five year or six year period is to be analysed.



Generally trend percentage are calculated only for some important

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items which can be logically related with each other. For e.g. trend ratio

for sales, though shows a clear-cut increasing tendency, becomes

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meaningful in the real sense when it is compared with cost of goods sold

which might have increased at a lower level.

Ratio Analysis: Of all the tools of financial analysis available with a financial

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analyst the most important and the most widely used tool is ratio analysis.

Simply stated ratio analysis is an analysis of financial statements done with the

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help of ratios. A ratio expresses the relationship that exists between two

numbers and in financial statement analysis a ratio shows the relationship

between two interrelated accounting figures. Both the accounting figures may be

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taken from the balance sheet and the resulting ratio is called a balance sheet ratio

or both the figures may be taken from profit and loss account when the resulting

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116
ratio is called as profit and loss account ratio and composite ratio is that ratio

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which is calculated by taking one figure from profit and loss account and the

other figure from balance sheet. A detailed discussion on ratio analysis is made

available in the pages to come.

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Funds Flow Analysis: The purpose of this analysis is to go beyond and behind

the information contained in the financial statements. Income statement tells the

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quantum of profit earned or loss suffered for a particular accounting year.

Balance sheet gives the assets and liabilities position as on a particular date. But

in an accounting year a number of financial transactions take place which have a

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bearing on the performance of the concern but which are not revealed by the

financial statements. For e.g. a concern collects finance through various sources

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and uses them for various purposes. But these details could not be known from

the traditional financial statements. Funds flow analysis gives an opening in this

respect. All the more, funds flow analysis reveals the changes in working capital

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position. If there is an increase in working capital what resulted in the increase

and if there is a decrease in working capital what caused the decrease, etc. will

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be made available through funds flow analysis.

Cash Flow Analysis: While funds flow analysis studies the reasons for the

changes in working capital by analysing the sources and application of funds

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cash flow analysis pays attention to the changes in cash position that has taken

place between two accounting periods. These reasons are not available in the

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traditional financial statements. Changes in the cash position can be analysed

with the help of a statement known as cash flow statement. A cash flow

statement summarises the change in cash position of the concern. Transactions

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which increase the cash position of the concern are labelled as `inflows' of cash

and those which decrease the cash position as `outflows' of cash.

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117

3.1.3.4 ILLUSTRATIONS

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Illustration 1: From the following Profit and Loss Accounts and the Balance

Sheets of Murugan Ltd. for the year ended 31st December, 2004 and 2005, you

are required to prepare a comparative income statement and a comparative

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balance sheet.

PROFIT AND LOSS ACCOUNT

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(Rs. in `000)

--------------------------------------------------------------------------------------------------------------------
2004

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2005

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2004

2005

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--------------------------------------------------------------------------------------------------------------------

To Cost of goods sold


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6,000 7,500 By Net Sales

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8,000 10,000


To Operating expenses:

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Administrative expenses

200

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200



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Selling expenses



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300

400


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To

Net

profit

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1,500



--- Content provided by‌ FirstRanker.com ---

1,900

------------------

------------------

--- Content provided by​ FirstRanker.com ---




8,000

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


10,000

8,000

--- Content provided by‍ FirstRanker.com ---

10,000

------------------

------------------

--- Content provided by FirstRanker.com ---




--------------------------------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---


BALANCE SHEET AS ON 31ST DECEMBER

(Rs. in `000)

--- Content provided by‍ FirstRanker.com ---

--------------------------------------------------------------------------------------------------------------------

Liabilities


--- Content provided by​ FirstRanker.com ---


2004

2005

--- Content provided by FirstRanker.com ---

Assets

2004

2005

--- Content provided by⁠ FirstRanker.com ---


-------------------------------------------------------------------------------------------------------------------

Bills payable

--- Content provided by‍ FirstRanker.com ---





500

--- Content provided by⁠ FirstRanker.com ---


750

Cash

--- Content provided by⁠ FirstRanker.com ---



1,000

1,400

--- Content provided by‌ FirstRanker.com ---


Sundry

creditors

--- Content provided by‌ FirstRanker.com ---

1,500

2,000

Debtors

--- Content provided by‍ FirstRanker.com ---


2,000

3,000

--- Content provided by⁠ FirstRanker.com ---

Tax

payable

1,000

--- Content provided by⁠ FirstRanker.com ---


1,500

Stock

--- Content provided by​ FirstRanker.com ---

2,000

3,000

6%

--- Content provided by⁠ FirstRanker.com ---


Debentures

1,000

--- Content provided by​ FirstRanker.com ---

1,500

Land

1,000

--- Content provided by‌ FirstRanker.com ---


1,000

6%

--- Content provided by‌ FirstRanker.com ---

Preference

capital

3,000 3,000 Building

--- Content provided by‍ FirstRanker.com ---


3,000

2,700

--- Content provided by‍ FirstRanker.com ---

Equity

capital

4,000

--- Content provided by⁠ FirstRanker.com ---


4,000

Plant

--- Content provided by​ FirstRanker.com ---

3,000

2,700

Reserves

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

2,000 2,450 Furniture

1,000

1,400

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



---------------------------

---------------------------

--- Content provided by FirstRanker.com ---




13,000 15,200

--- Content provided by​ FirstRanker.com ---



13,000 15,200

Solution:

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

118
MURUGAN LIMITED

COMPARATIVE INCOME STATEMENT

--- Content provided by​ FirstRanker.com ---

For the Years ended 31st December, 2004 and 2005

(Rs.

in `000)

--- Content provided by‍ FirstRanker.com ---


------------------------------------------------------------------------------------------------



--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





Absolute % increase

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




increase or or decrease

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



decrease in

in

--- Content provided by FirstRanker.com ---


2004

2005

--- Content provided by⁠ FirstRanker.com ---

2005 2005

------------------------------------------------------------------------------------------------
Net

--- Content provided by⁠ FirstRanker.com ---

Sales

8,000

10,000

--- Content provided by‍ FirstRanker.com ---


+2,000

+25

--- Content provided by FirstRanker.com ---


Cost of goods sold

6,000

--- Content provided by FirstRanker.com ---

7,500

+1,500

+25

--- Content provided by⁠ FirstRanker.com ---


--------------------------------------
Gross profit

2,000

--- Content provided by FirstRanker.com ---


2,500

+ 500

--- Content provided by FirstRanker.com ---

+25

--------------------------------------
Operating Expenses:
Administrative exp. 200

--- Content provided by⁠ FirstRanker.com ---


200

---

--- Content provided by FirstRanker.com ---



---


--- Content provided by‍ FirstRanker.com ---

Selling expenses

300

400

--- Content provided by⁠ FirstRanker.com ---


+ 100

+33.33

--- Content provided by​ FirstRanker.com ---

--------------------------------------
Total Operating

500

--- Content provided by‌ FirstRanker.com ---

600

+ 100

+20

--- Content provided by FirstRanker.com ---


Expenses --------------------------------------
Operating profit

1,500

--- Content provided by FirstRanker.com ---


1,900

+ 400

--- Content provided by⁠ FirstRanker.com ---

+26.67

------------------------------------------------------------------------------------------------

MURUGAN LIMITED

--- Content provided by‌ FirstRanker.com ---


COMPARATIVE BALANCE SHEET

As on 31st December, 2004 and 2005

--- Content provided by​ FirstRanker.com ---

-----------------------------------------------------------------------------------------------




--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Absolute

--- Content provided by‌ FirstRanker.com ---



%


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


increase



--- Content provided by FirstRanker.com ---

increase




--- Content provided by‌ FirstRanker.com ---


ASSETS



--- Content provided by⁠ FirstRanker.com ---



or


--- Content provided by⁠ FirstRanker.com ---




or

--- Content provided by‌ FirstRanker.com ---

decrease decrease
2004

2005

--- Content provided by⁠ FirstRanker.com ---

in

2005 in

2005

--- Content provided by FirstRanker.com ---


-----------------------------------------------------------------------------------------------
Current Assets
Cash

--- Content provided by⁠ FirstRanker.com ---

1,000

1,400


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

400

+40

Debtors 2,000

--- Content provided by FirstRanker.com ---


3,000

1,000

--- Content provided by⁠ FirstRanker.com ---

+50

Stock

2,000

--- Content provided by‌ FirstRanker.com ---


3,000

1,000

--- Content provided by​ FirstRanker.com ---

+50

--------------------------------------------------------------------


--- Content provided by⁠ FirstRanker.com ---



119

Total

--- Content provided by‌ FirstRanker.com ---

current
assets 5,000



--- Content provided by FirstRanker.com ---

7,400

2,400


--- Content provided by‌ FirstRanker.com ---


+48

--------------------------------------------------------------------
Fixed Assets

--- Content provided by FirstRanker.com ---

Land 1,000



1,000

--- Content provided by FirstRanker.com ---


---



--- Content provided by‌ FirstRanker.com ---



---

Building 3,000

--- Content provided by‌ FirstRanker.com ---




2,700

--- Content provided by FirstRanker.com ---

- 300



-10%

--- Content provided by FirstRanker.com ---


Plant 3,000



--- Content provided by⁠ FirstRanker.com ---

2,700

- 300


--- Content provided by FirstRanker.com ---


-10%

Furniture 1,000

--- Content provided by​ FirstRanker.com ---



1,400

+400

--- Content provided by‍ FirstRanker.com ---




+40%

--- Content provided by‍ FirstRanker.com ---



--------------------------------------------------------------------------

Total Fixed

--- Content provided by​ FirstRanker.com ---

Assets 8,000



7,800

--- Content provided by​ FirstRanker.com ---


- 200



--- Content provided by FirstRanker.com ---

- 2.5



--------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---


Total
Assets 13,000

15,200

--- Content provided by‌ FirstRanker.com ---


2,200



--- Content provided by‌ FirstRanker.com ---

+17%

------------------------------------------------------------------------------------------------
Liabilities
& Capital

--- Content provided by⁠ FirstRanker.com ---

Current
Liabilities:
Bills
payable 500

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


750

+250

--- Content provided by⁠ FirstRanker.com ---

+50%

Sundry
Creditors 1,500

--- Content provided by‍ FirstRanker.com ---



2,000

+500

--- Content provided by⁠ FirstRanker.com ---


+33.33%

Taxes
Payable 1,000

--- Content provided by‍ FirstRanker.com ---




1,500

--- Content provided by‍ FirstRanker.com ---

+500



+50%

--- Content provided by‌ FirstRanker.com ---




----------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---

Total
current 3,000



--- Content provided by​ FirstRanker.com ---

4,250 +1,250




--- Content provided by‌ FirstRanker.com ---


+41.66%

Liabilities
------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---


Long term
liabilities
6%

--- Content provided by⁠ FirstRanker.com ---

Debentures1,000

1,500

+500

--- Content provided by​ FirstRanker.com ---


+50%

------------------------------------------------------------------------
Total

--- Content provided by FirstRanker.com ---

Liabilities 4,000

5,750 +1,750


--- Content provided by⁠ FirstRanker.com ---




+43.75%

--- Content provided by⁠ FirstRanker.com ---

-------------------------------------------------------------------------
Capital & Reserves:
6% Pref. Capital 3,000

3,000

--- Content provided by⁠ FirstRanker.com ---


----



--- Content provided by‍ FirstRanker.com ---



----

Equity Capital 4,000

--- Content provided by​ FirstRanker.com ---


4,000

----

--- Content provided by⁠ FirstRanker.com ---





----

--- Content provided by‌ FirstRanker.com ---




120
Reserves

--- Content provided by‌ FirstRanker.com ---


2,000

2,450

--- Content provided by FirstRanker.com ---





450

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

22.5

-------------------------------------------------------------------------
Total
Shareholder's 9,000

--- Content provided by​ FirstRanker.com ---


9,450

450

--- Content provided by​ FirstRanker.com ---



5%

Funds

--- Content provided by⁠ FirstRanker.com ---


-------------------------------------------------------------------------

Total
Liabilities & 13,000 15,200 2,200

--- Content provided by‌ FirstRanker.com ---




17%

--- Content provided by​ FirstRanker.com ---

Capital
------------------------------------------------------------------------------------------------

Illustration 2: From the data given in Illustration 1 prepare Common-size
Income Statement and Balance Sheet.

--- Content provided by‌ FirstRanker.com ---



MURUGAN LIMITED

COMMON-SIZE INCOME STATEMENT

--- Content provided by‍ FirstRanker.com ---


For the years ended 31st December 2004 and 2005

-----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---

(Figures in percentages)
2004

2005

--- Content provided by‍ FirstRanker.com ---

------------------------------------------------------------------------------------------------
Net

sales

--- Content provided by‌ FirstRanker.com ---

100

100

Cost

--- Content provided by‌ FirstRanker.com ---


of

goods

--- Content provided by‌ FirstRanker.com ---

sold



75

--- Content provided by​ FirstRanker.com ---




75

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





-----------------------

--- Content provided by​ FirstRanker.com ---


Gross

profit

--- Content provided by‍ FirstRanker.com ---



25


--- Content provided by⁠ FirstRanker.com ---


25



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



-----------------------

Operating Expenses:

--- Content provided by​ FirstRanker.com ---

Administrative

Expenses

2.50

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

2

Selling

Expenses

--- Content provided by‍ FirstRanker.com ---


3.75



--- Content provided by FirstRanker.com ---



4


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




-----------------------

--- Content provided by⁠ FirstRanker.com ---

Total

operating

expenses

--- Content provided by‌ FirstRanker.com ---


6.25



--- Content provided by‍ FirstRanker.com ---



6


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




------------------------

--- Content provided by​ FirstRanker.com ---

Operating

Profit 18.75


--- Content provided by FirstRanker.com ---


19

---------------------
------------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



121

MURUGAN LIMITED

--- Content provided by‍ FirstRanker.com ---


COMMON-SIZE INCOME STATEMENT

As on 31st December 2004 and 2005

--- Content provided by⁠ FirstRanker.com ---

------------------------------------------------------------------------------------------------
2004

2005

--- Content provided by‍ FirstRanker.com ---





Assets

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



%


--- Content provided by FirstRanker.com ---




%

--- Content provided by‍ FirstRanker.com ---



100


--- Content provided by⁠ FirstRanker.com ---


100

------------------------------------------------------------------------------------------------
Current Assets:

--- Content provided by‌ FirstRanker.com ---

Cash




--- Content provided by⁠ FirstRanker.com ---


7.70



--- Content provided by FirstRanker.com ---



9.2

Debtors 15.38

--- Content provided by‍ FirstRanker.com ---


19.74

Stock

--- Content provided by‍ FirstRanker.com ---

15.38

19.74

----------------------------------

--- Content provided by​ FirstRanker.com ---

Total

current

assets

--- Content provided by FirstRanker.com ---


38.46

48.69

--- Content provided by‍ FirstRanker.com ---

----------------------------------
Fixed Assets:
Building 23.07

17.76

--- Content provided by FirstRanker.com ---


Plant

23.07

--- Content provided by​ FirstRanker.com ---

17.76

Furniture


--- Content provided by‍ FirstRanker.com ---




7.70

--- Content provided by‍ FirstRanker.com ---





9.21

--- Content provided by​ FirstRanker.com ---


Land



--- Content provided by‍ FirstRanker.com ---



7.70


--- Content provided by​ FirstRanker.com ---




6.58

--- Content provided by⁠ FirstRanker.com ---

----------------------------------
Total

fixed

--- Content provided by​ FirstRanker.com ---

assets

61.54

51.31

--- Content provided by​ FirstRanker.com ---


----------------------------------
Total

assets

--- Content provided by FirstRanker.com ---


100

100

--- Content provided by⁠ FirstRanker.com ---

------------------------------------------------------------------------------------------------
2004

2005

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





%

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

%

Liabilities

and

--- Content provided by‌ FirstRanker.com ---


Capital



--- Content provided by FirstRanker.com ---

100



100

--- Content provided by​ FirstRanker.com ---


------------------------------------------------------------------------------------------------
Current Liabilities:


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



Bills

payable

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

3.84




--- Content provided by‍ FirstRanker.com ---


4.93

Sundry

--- Content provided by​ FirstRanker.com ---

creditors

11.54

13.16

--- Content provided by​ FirstRanker.com ---


Taxes

payable

--- Content provided by FirstRanker.com ---





7.69

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

9.86

----------------------------------
Total

--- Content provided by​ FirstRanker.com ---

current

liabilities 23.07

27.95

--- Content provided by‌ FirstRanker.com ---


---------------------------------
Long-term Liabilities:
6%

--- Content provided by⁠ FirstRanker.com ---

Debentures



7.69

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

9.86

Capital & Reserves:
6%

--- Content provided by‌ FirstRanker.com ---

Preference

share

capital

--- Content provided by⁠ FirstRanker.com ---


23.10

19.72

--- Content provided by FirstRanker.com ---

Equity

share

capital

--- Content provided by⁠ FirstRanker.com ---


30.76

26.32

--- Content provided by​ FirstRanker.com ---

Reserves:

15.38

16.15

--- Content provided by‌ FirstRanker.com ---




122
---------------------------------

--- Content provided by‌ FirstRanker.com ---

Total

shareholders

funds

--- Content provided by⁠ FirstRanker.com ---


76.93

72.05

--- Content provided by⁠ FirstRanker.com ---

----------------------------------
Total

Liabilities

--- Content provided by​ FirstRanker.com ---

and

Capital

100

--- Content provided by FirstRanker.com ---


100

-----------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---

Illustration 3: From the following data relating to the assets side of the Balance

Sheet of Thirumal Limited for the period 31st December 2002 to 31st December

2005, you are required to calculate the trend percentages taking 2002 as the base

--- Content provided by‌ FirstRanker.com ---


year.

(Rupees in Thousands)

--- Content provided by⁠ FirstRanker.com ---

-----------------------------------------------------------------------------------------------
Assets

As

--- Content provided by⁠ FirstRanker.com ---

on

31st December

2002

--- Content provided by‌ FirstRanker.com ---


2003



--- Content provided by⁠ FirstRanker.com ---





2004

--- Content provided by⁠ FirstRanker.com ---


2005

-----------------------------------------------------------------------------------------------
Cash

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

1,000

1,200

800

--- Content provided by FirstRanker.com ---


1,400

Debtors 2,000

--- Content provided by​ FirstRanker.com ---

2,500




--- Content provided by‍ FirstRanker.com ---


3,250

4,000

--- Content provided by FirstRanker.com ---

Stock in Trade



3,000

--- Content provided by‌ FirstRanker.com ---


4,000

3,500

--- Content provided by‍ FirstRanker.com ---

5,000

Other current assets

500

--- Content provided by FirstRanker.com ---


750

1,250

--- Content provided by⁠ FirstRanker.com ---

1,500

Land

4,000

--- Content provided by‍ FirstRanker.com ---


5,000



--- Content provided by​ FirstRanker.com ---



5,000

5,000

--- Content provided by FirstRanker.com ---


Building



--- Content provided by FirstRanker.com ---



8,000 10,000

12,000 15,000

--- Content provided by⁠ FirstRanker.com ---


Plant



--- Content provided by FirstRanker.com ---

10,000 10,000

12,000 15,000

-------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


28,500 33,450

37,800 46,900

--- Content provided by‌ FirstRanker.com ---

-------------------------------------------------------------------------------------------------

Solution:

COMPARATIVE BALANCE SHEET

--- Content provided by‌ FirstRanker.com ---


As on December 31, 2002-2005

-------------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





December 31

--- Content provided by​ FirstRanker.com ---




Trend

--- Content provided by⁠ FirstRanker.com ---

Percentages




--- Content provided by‍ FirstRanker.com ---




(Rs. in thousands)

--- Content provided by‌ FirstRanker.com ---

Base year 2002

Assets

---------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

2002 2003 2004 2005 2002 2003 2004 2005

-------------------------------------------------------------------------------------------------
Current Assets:
Cash 1,000 1,200 800 1,400 100 120

--- Content provided by⁠ FirstRanker.com ---


080

140

--- Content provided by​ FirstRanker.com ---

Debtors 2,000 2,500 3,250

4,000 100 125

163

--- Content provided by‍ FirstRanker.com ---


200



--- Content provided by​ FirstRanker.com ---



123

Stock-in

--- Content provided by‌ FirstRanker.com ---

-trade 3,000

4,000 3,500

5,000 100 133

--- Content provided by‌ FirstRanker.com ---


117

167

--- Content provided by‌ FirstRanker.com ---

Other
current
assets 500

750 1,250

--- Content provided by FirstRanker.com ---


1,500 100 150

250

--- Content provided by⁠ FirstRanker.com ---

300



--------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---


Total
Current
assets 6 ,500

--- Content provided by⁠ FirstRanker.com ---

8,450 8,800

11,900 100 130

135

--- Content provided by FirstRanker.com ---


183

----------------------------------------------------------------------------------------
Fixed Assets:

--- Content provided by FirstRanker.com ---

Land 4,000

5,000 5,000

5,000 100 125

--- Content provided by‌ FirstRanker.com ---


125

125

--- Content provided by⁠ FirstRanker.com ---

Building 8,000 10,000 12,000

15,000 100 125

150

--- Content provided by‍ FirstRanker.com ---


187.5

Plant 10,000

--- Content provided by⁠ FirstRanker.com ---

10,000 12,000 15,000 100 100

120

150

--- Content provided by⁠ FirstRanker.com ---


----------------------------------------------------------------------------------------
Total
Fixed
Assets 22,000 25,000 29,000

--- Content provided by​ FirstRanker.com ---


35,000 100 114

132

--- Content provided by​ FirstRanker.com ---

159

-------------------------------------------------------------------------------------------------

3.1.3.5 MEANING AND NATURE OF RATIO ANALYSIS

--- Content provided by⁠ FirstRanker.com ---




Ratio expresses numerical relationship between two numbers. In the

--- Content provided by​ FirstRanker.com ---

words of Kennedy and McMullen, "The relationship of one item to another

expressed in simple mathematical form is known as a ratio". Thus, the ratio is a

measuring device to judge the growth, development and present condition of a

--- Content provided by⁠ FirstRanker.com ---


concern. It plays an important role in measuring the comparative significance of

the income and position statement. Accounting ratios are expressed in the form

--- Content provided by‍ FirstRanker.com ---

of time, proportion, percentage, or per one rupee. Ratio analysis is not only a

technique to point out relationship between two figures but also points out the

devices to measure the fundamental strengths or weaknesses of a concern. As

--- Content provided by​ FirstRanker.com ---


James C.Van Horne observes: "To evaluate the financial condition and

performance of a firm, the financial analyst needs certain yardsticks. One of the

--- Content provided by⁠ FirstRanker.com ---

yardsticks frequently used is a ratio. The main purpose of ratio analysis is to

measure past performance and project future trends. It is also used for inter-firm

and intra-firm comparison as a measure of comparative productivity. The

--- Content provided by‍ FirstRanker.com ---




124
significance of the various components of financial statements can be judged

--- Content provided by⁠ FirstRanker.com ---


only by ratio analysis. The financial analyst X-Rays the financial conditions of a

concern by the use of various ratios and if the conditions are not found to be

--- Content provided by‍ FirstRanker.com ---

favourable, suitable steps can be taken to overcome the limitations. The main

objectives of ratio analysis are:

(i)

--- Content provided by‌ FirstRanker.com ---


to simplify the comparative picture of financial statements.

(ii)

--- Content provided by‌ FirstRanker.com ---

to assist the management in decision making.

(iii)

to guage the profitability, solvency and efficiency of an

--- Content provided by⁠ FirstRanker.com ---


enterprise, and

(iv)

--- Content provided by⁠ FirstRanker.com ---

to ascertain the rate and direction of change and future

potentiality.

Financial ratios may be categorised in various ways. Van Horne has

--- Content provided by⁠ FirstRanker.com ---


divided financial ratios into four categories, viz., liquidity, debt, profitability and

coverage ratios. The first two types of ratios are computed from the balance

--- Content provided by‌ FirstRanker.com ---

sheet. The last two are computed from the income statement and, sometimes,

from both the statements. For the purpose of analysis the present lesson gives a

detailed description of ratios, the formula used for their computation and their

--- Content provided by⁠ FirstRanker.com ---


significance. The ratios have been categorised under the following headings:-

(i)

--- Content provided by⁠ FirstRanker.com ---

Ratios for analysis of Capital Structure or Leverage.

(ii)

Ratios for Fixed Assets Analysis.

--- Content provided by FirstRanker.com ---


(iii)

Ratios for Analysis of Turnover.

--- Content provided by‍ FirstRanker.com ---

(iv)

Ratios for Analysis of Liquidity Position.

(v)

--- Content provided by‍ FirstRanker.com ---


Ratios for Analysis of Profitability.

(vi)

--- Content provided by‌ FirstRanker.com ---

Ratios for Analysis of Operational Efficiency.

3.1.3.6 CAPITAL STRUCTURE OR LEVERAGE RATIOS


--- Content provided by​ FirstRanker.com ---


Financial strength indicates the soundness of the financial resources of

an organisation to perform its operations in the long run. The parties associated

--- Content provided by⁠ FirstRanker.com ---

with the organisation are interested in knowing the financial strength of the



125

--- Content provided by‍ FirstRanker.com ---


organisation. Financial strength is directly associated with the operational ability

of the organisation and its efficient management of resources. The financial

--- Content provided by‌ FirstRanker.com ---

strength analysis can be made with the help of the following ratios:

(1) Debt-Equity Ratio

(2) Capital Gearing Ratio

--- Content provided by‍ FirstRanker.com ---


(3) Financial Leverage

(4) Proprietary Ratio and

--- Content provided by​ FirstRanker.com ---

(5) Interest Coverage.

Debt-Equity Ratio: The debt-equity ratio is determined to ascertain the

soundness of the long-term financial policies of the company. This ratio

--- Content provided by‍ FirstRanker.com ---


indicates the proportion between the shareholders' funds (i.e. tangible net-

worth) and the total borrowed funds. Ideal ratio is 1. In other words, the investor

--- Content provided by‌ FirstRanker.com ---

may take debt equity ratio as quite satisfactory if shareholders' funds are equal

to borrowed funds. However, creditors would prefer a low debt-equity ratio as

they are much concerned about the security of their investment. This ratio can be

--- Content provided by‌ FirstRanker.com ---


calculated by dividing the total debt by shareholders' equity. For the purpose of

calculation of this ratio, the term shareholders' equity includes share capital,

--- Content provided by⁠ FirstRanker.com ---

reserves and surplus and borrowed funds which includes both long-term funds

and short-term funds.


--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Debt

--- Content provided by‍ FirstRanker.com ---

DEBT-EQUITY

RATIO

=

--- Content provided by FirstRanker.com ---


-----------



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





Equity

--- Content provided by‌ FirstRanker.com ---




A high ratio indicates that the claims of creditors are higher as compared

--- Content provided by‍ FirstRanker.com ---

to owners' funds and a low debt-equity ratio may result in a higher claim of

equity.

Capital Gearing Ratio: This ratio establishes the relationship between the fixed

--- Content provided by‍ FirstRanker.com ---


interest-bearing securities and equity shares of a company.



--- Content provided by⁠ FirstRanker.com ---





126

--- Content provided by​ FirstRanker.com ---

It is calculated as follows:




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Fixed

Interest-bearing

securities

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Capital Gearing Ratio = ---------------------------------------




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Equity Shareholders' Funds


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Fixed-interest bearing securities carry with them the fixed rate of

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dividend or interest and include preference share capital and debentures.

A firm is said to be highly geared if the lion's share of the total capital is

in the form of fixed interest-bearing securities or this ratio is more than

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one. If this ratio is less than one, it is said to be low geared. If it is

exactly one, it is evenly geared. This ratio must be carefully planned as

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it affects the firm's capacity to maintain a uniform dividend policy

during difficult trading periods that may occur. Too much capital should

not be raised by way of debentures, because debentures do not share in

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business losses.

Financial Leverage Ratio: Financial leverage results from the presence of fixed

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financial charges in the firm's income stream. These fixed charges do not vary

with the earnings before interest and tax (EBIT) or operating profits. They have

to be paid regardless of the amount of earnings before interest and taxes

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available to pay them. After paying them, the operating profits (EBIT) belong to

the ordinary shareholders. Financial leverage is concerned with the effects of

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changes in earnings before interest and taxes on the earnings available to equity

holders. It is defined as the ability of a firm to use fixed financial charges to

magnify the effects of changes in EBIT on the firm's earning per share.

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Financial leverage and trading on equity are synonymous terms. The EBIT is

calculated by adding back the interest (interest on loan capital + interest on long

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term loans + interest on other loans) and taxes to the amount of net profit.

Financial leverage ratio is calculated by dividing EBIT by EBT (earnings before


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127

tax). Neither a very high leverage nor a very low leverage represents a sound

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picture. (EBIT ? EBT).

Proprietary Ratio: This ratio establishes the relationship between the

proprietors' funds and the total tangible assets. The general financial strength of

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a firm can be understood from this ratio. The ratio is of particular importance to

the creditors who can find out the proportion of shareholders' funds in the

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capital assets employed in the business. A high ratio shows that a concern is less

dependent on outside funds for capital. A high ratio suggests sound financial

strength of a firm due to greater margin of owners' funds against outside sources

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of finance and a greater margin of safety for the creditors. A low ratio indicates

a small amount of owners' funds to finance total assets and more dependence on

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outside funds for working capital. In the form of formula this ratio can be

expressed as:-


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Net

Worth


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Proprietary Ratio

= ---------------

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Total

Assets


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Interest Coverage: This ratio measures the debt servicing capacity of a firm in

so far as fixed interest on long-term loan is concerned. It is determined by

dividing the operating profits or earnings before interest and taxes (EBIT) by the

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fixed interest charges on loans. Thus,



--- Content provided by‌ FirstRanker.com ---






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EBIT

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Interest

Coverage

=

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----------



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Interest



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It should be noted that this ratio uses the concept of net profits

before taxes because interest is tax-deductible so that tax is calculated

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after paying interest on long-term loans. This ratio, as the name suggests,

shows how many times the interest charges are covered by the EBIT out

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of which they will be paid. In other words, it indicates the extent to

which a fall in EBIT is tolerable in the sense that the ability of the firm


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128
to service its debts would not be adversely affected. From the point of

view of creditors, the larger the coverage, the greater the ability of the

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firm to handle fixed-charge liabilities and the more assured the payment

of interest to the creditors. However, too high a ratio may imply unused

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debt capacity. In contrast, a low ratio is danger signal that the firm is

using excessive debt and does not have the ability to offer assured

payment of interest to the creditors.

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3.1.3.7 FIXED ASSETS ANALYSIS



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The successful operation of a business generally requires some

assets of fixed character. These assets are used primarily in producing

goods and in operating the business. With the help of these, raw

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materials are converted into finished products. Fixed assets are not

meant for sale and are kept as a rule permanently in the business in order

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to carry on day-to-day operations.



Analysis of fixed assets is very important from investors' point of

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view because investors are more concerned with long term assets. Fixed

assets are property of non-current nature which are acquired to provide

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facilities to carry on business. They include land, building, equipment,

furniture, etc. They are generally shown in balance sheet by aggregating

them into groups of gross block as reduced by the accumulated amount

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of depreciation till date. Investment in fixed assets is of a permanent

nature and therefore should be financed by owners' funds (permanent

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sources of funds). The owners' funds should be sufficient to provide for

fixed assets. Fixed assets are generally financed by owners' equity and

long-term borrowings. The long-term borrowings are in the form of long-

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term loans and of almost permanent nature. Under such a situation it

becomes more or less irrelevant to relate the fixed assets with only the

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129

owners' equity. Therefore, the analysis of the source of financing of

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fixed assets has been done with the help of the following ratios:-

(a)

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Fixed Assets to Net Worth

(b)

Fixed Assets to Long-term Funds

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Fixed Assets to Net Worth: In the words of Anil B.Roy Choudhary, "this ratio

indicates the relationship between Net Worth (i.e. shareholders' funds) and

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investments in net fixed assets (i.e. Gross Block minus depreciation)".



The higher the ratio the lesser would be the protection to

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creditors. If the ratio is less than 1, it indicates that the net worth

exceeds fixed assets. It will further indicate that the working capital is

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partly financed by shareholders' funds. If the ratio exceeds 1, it would

mean that part of the fixed assets has been provided by creditors. The

formula for derivation of this ratio is:-

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Net Fixed Assets



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Fixed Assets to Net Worth Ratio

= ------------------------

Net Worth

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Fixed Assets to Long-term Funds: This ratio establishes the relationship

between the fixed assets and long-term funds and it is obtained by the formula:

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--- Content provided by​ FirstRanker.com ---






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Fixed Assets

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FIXED ASSET RATIO

=

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------------------------



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Long-term Funds




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The ratio should be less than one. If it is less than one, it shows

that a part of the working capital has been financed through long-term

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funds. This is desirable because a part of working capital termed as "core

working capital" is more or less of a fixed nature. The ideal ratio is 0.67.


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If this ratio is more than one, it indicates that a part of current

liability is invested in long-term assets. This is a dangerous position.

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Fixed assets include "net fixed assets" i.e. original cost less depreciation



130

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to date and trade investments including shares in subsidiaries. Long-term

funds include share capital, reserves and long-term borrowings.

3.1.3.8 ANALYSIS OF TURNOVER (OR) ANALYSIS OF EFFICIENCY

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Turnover ratios also referred to as Activity Ratios are concerned

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with measuring the efficiency in asset management. Sometimes, these

ratios are also called as efficiency ratios or asset utilisation ratios. The

efficiency with which the assets are used would be reflected in the speed

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and rapidity with which assets are converted into sales. The greater the

rate of turnover or conversion, the more efficient the

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utilisation/management, other things being equal. For this reason such

ratios are also designated as turnover ratios. Turnover is the primary

mode for measuring the extent of efficient employment of assets by

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relating the assets to sales. An activity ratio may, therefore, be defined

as a test of the relationship between sales (more appropriately with cost

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of sales) and the various assets of a firm. Depending upon the various

types of assets, there are various types of activity ratios. Some of the

more widely used turnover ratios are:-

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(1)

Fixed Assets Turnover Ratio

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(2)

Current Assets Turnover Ratio

(3)

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Working Assets Turnover Ratio

(4)

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Inventory (or stock) Turnover Ratio

(5)

Debtors Turnover Ratio

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(6)

Creditors Turnover Ratio

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Fixed Assets Turnover Ratio: The Fixed Assets Turnover Ratio measures the

efficiency with which the firm is utilising its investment in fixed assets, such as

land, building, plant and machinery, furniture, etc. It also indicates the adequacy

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of sales in relation to investment in fixed assets. The fixed assets turnover ratio



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131

is sales divided by the net fixed assets (i.e., the depreciated value of fixed

assets).

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--- Content provided by FirstRanker.com ---






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Sales



Fixed Assets Turnover Ratio =

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-----------------------



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Net

Fixed

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Assets



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The turnover of fixed assets can provide a good indicator for

judging the efficiency with which fixed assets are utilised in the firm. A

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high fixed assets turnover ratio indicates efficient utilisation of fixed

assets in generating operating revenue. A low ratio signifies idle

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capacity, inefficient utilisation and management of fixed assets.

Current Assets Turnover Ratio: The current assets turnover ratio ascertains the

efficiency with which current assets are used in a business. Professor Guthmann

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observes that "current assets turnover is to give an overall impression of how

rapidly the total investment in current assets is being turned". This ratio is

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strongly associated with efficient utilisation of costs, receivables and inventory.

A higher value of this ratio indicates greater circulation of current assets while a

low ratio indicates a stagnation of the flow of current assets. The formula for the

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computation of current assets turnover ratio is:



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--- Content provided by FirstRanker.com ---






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Sales

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Current Assets Turnover Ratio = ---------------------

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--- Content provided by​ FirstRanker.com ---


Current

Assets

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Working Capital Turnover Ratio: This ratio shows the number of times

working capital is turned-over in a stated period. Working capital turnover ratio

reflects the extent to which a business is operating on a small amount of working

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capital in relation to sales. The ratio is calculated by the following formula:-

Sales

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Working Capital Turnover Ratio = ---------------------------


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Net

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Working

Capital


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132

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The higher the ratio, the lower is the investment in working

capital and greater are the profits. However, a very high turnover of

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working capital is a sign of over trading and may put the firm into

financial difficulties. On the other hand, a low working capital turnover

ratio indicates that working capital is not efficiently utilised.

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Inventory Turnover Ratio: The inventory turnover ratio, also known as stock

turnover ratio normally establishes the relationship between cost of goods sold

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and average inventory. This ratio indicates whether investment in inventory is

within proper limit or not. In the words of S.C.Kuchal, "this relationship

expresses the frequency with which average level of inventory investment is

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turned over through operations". The formula for the computation of this ratio

may be expressed thus:

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Cost of Goods Sold



Inventory Turnover Ratio

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=

-----------------------------

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--- Content provided by​ FirstRanker.com ---






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Average Inventory


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In general, a high inventory turnover ratio is better than a low

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ratio. A high ratio implies good inventory management. A very high

ratio indicates under-investment in, or very low level of inventory which

results in the firm being out of stock and incurring high stock-out cost. A

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very low inventory turnover ratio is dangerous. It signifies excessive

inventory or over-investment in inventory. A very low ratio may be the

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results of inferior quality goods, over-valuation of closing inventory,

stock of unsaleable/obsolete goods.

Debtors Turnover Ratio and Collection Period: One of the major activity ratios

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is the receivables or debtors turnover ratio. Allied and closely related to this is

the average collection period. It shows how quickly receivables or debtors are

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converted into cash. In other words, the debtors turnover ratio is a test of the

liquidity of the debtors of a firm. The liquidity of a firm's receivables can be


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133

examined in two ways: (i) debtors/receivables turnover and (ii) average

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collection period. The debtors turnover shows the relationship between credit

sales and debtors of a firm. Thus,


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--- Content provided by​ FirstRanker.com ---






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Net Credit Sales



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Debtors Turnover Ratio

= -------------------------


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Average

Debtors


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Net credit sales consists of gross credit sales minus returns if any,

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from the customers. Average debtors is the simple average of debtors at

the beginning and at the end of the year.


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The second type of ratio measuring the liquidity of a firm's

debtors is the average collection period. This ratio is, in fact, inter-

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related with and dependent upon, the receivables turnover ratio. It is

calculated by dividing the days in a year by the debtors turnover. Thus,


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Days

in

year

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Average Collection Period = ---------------------

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Debtors

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turnover



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This ratio indicates the speed with which debtors/accounts

receivables are being collected. The higher the turnover ratio and shorter

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the average collection period, the better the trade credit management and

better the liquidity of debtors. On the other hand, low turnover ratio and

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long collection period reflects that payments by debtors are delayed. In

general, short collection period (high turnover ratio) is preferable.

Creditors' Turnover Ratio and Debt Payment Period: Creditors' turnover ratio

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indicates the speed with which the payments for credit purchases are made to the

creditors. This ratio can be computed as follows:-

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--- Content provided by‌ FirstRanker.com ---


Average

Accounts

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Payable



Creditors' Turnover Ratio

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=

-----------------------------------

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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



Net Credit Purchases


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134

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The term accounts payable include trade creditors and bills

payable. A high ratio indicates that creditors are not paid in time while a

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low ratio gives an idea that the business is not taking full advantage of

credit period allowed by the creditors.


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Sometimes, it is also required to calculate the average payment

period or average age of payables or debt period enjoyed to indicate the

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speed with which payments for credit purchases are made to creditors. It

is calculated as:


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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Days in a year

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Average age of payables

=

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-----------------------------------



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Creditors'

Turnover

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Ratio



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Both the creditors' turnover ratio and the debt payment period

enjoyed ratio indicate about the promptness or otherwise in making

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payment for credit purchases. A higher creditors' turnover ratio or lower

credit period enjoyed ratio signifies that the creditors are being paid

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promptly.

3.1.3.9 ANALYSIS OF LIQUIDITY POSITION


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The liquidity ratios measure the ability of a firm to meet its short-term

obligations and reflect the short-term financial strength/solvency of a firm. The

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term liquidity is described as convertibility of assets ultimately into cash in the

course of normal business operations and the maintenance of a regular cash

flow. A sound liquid position is of primary concern to management from the

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point of view of meeting current liabilities as and when they mature as well as

for assuring continuity of operations. Liquidity position of a firm depends upon

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the amount invested in current assets and the nature of current assets. The under

mentioned ratios are used to measure the liquidity position:-

(1)

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Current Ratio

(2)

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Liquid (or) Quick Ratio



135

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(3)

Cash to Current Assets Ratio

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(4)

Cash to Working Capital Ratio


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Current Ratio: The most widely used measure of liquid position of an enterprise

is the current ratio, i.e., the ratio of the firm's current assets to current liabilities.

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It is calculated by dividing current assets by current liabilities:




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Current Assets

Current

Ratio

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=

-----------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




Current Liabilities

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The current assets of a firm represent those assets which can be in the

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ordinary course of business, converted into cash within a short period of time,

normally not exceeding one year and include cash and bank balance, marketable

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securities, inventory of raw materials, semi-finished (work-in-progress) and

finished goods, debtors net of provision for bad and doubtful debts, bills

receivable and pre-paid expenses. The current liabilities defined as liabilities

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which are short-term maturing obligations to be met, as originally contemplated,

within a year, consist of trade creditors, bills payable, bank credit, provision for

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taxation, dividends payable and outstanding expenses. N.L.Hingorani and others

observe: "Current Ratio is a tool for measuring the short-term stability or ability

of the company to carry on its day-to-day work and meet the short-term

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commitments earlier". Generally 2:1 is considered ideal for a concern i.e.,

current assets should be twice of the current liabilities. If the current assets are

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two times of the current liabilities, there will be no adverse effect on business

operations when the payment of current liabilities is made. If the ratio is less

than 2, difficulty may be experienced in the payment of current liabilities and

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day-to-day operations of the business may suffer. If the ratio is higher than 2, it

is very comfortable for the creditors but, for the concern, it indicates idle funds

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and lack of enthusiasm for work.



136

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Liquid (or) Quick Ratio: Liquid (or) Quick ratio is a measurement of a firm's

ability to convert its current assets quickly into cash in order to meet its current

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liabilities. It is a measure of judging the immediate ability of the firm to pay-off

its current obligations. It is calculated by dividing the quick assets by current

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liabilities:




--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Quick Assets

Liquid

Ratio

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=

------------------------

--- Content provided by‍ FirstRanker.com ---



Current

Liabilities

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

The term quick assets refers to current assets which can be

converted into cash immediately or at a short notice without diminution

of value. Thus quick assets consists of cash, marketable securities and

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accounts receivable. Inventories are excluded from quick assets because

they are slower to convert into cash and generally exhibit more

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uncertainty as to the conversion price.



This ratio provides a more stringent test of solvency. 1:1 ratio is

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considered ideal ratio for a firm because it is wise to keep the liquid

assets atleast equal to the current liabilities at all times.

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Cash to Current Assets Ratio: Efficient management of the inflow and outflow

of cash plays a crucial role in the overall performance of a business. Cash is the

most liquid form of assets which safeguards the security interest of a business.

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Cash including bank balances plays a vital role in the total net working capital.

The ratio of cash to working capital signifies the proportion of cash to the total

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net working capital and can be calculated by dividing the cash including bank

balance by the working capital. Thus,


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Cash



Cash to Working Capital Ratio = ------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Working Capital




--- Content provided by⁠ FirstRanker.com ---


137



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Cash is not an end in itself, it is a means to achieve the end.

Therefore, only a required amount of cash is necessary to meet day-to-

day operations. A higher proportion of cash may lead to shrinkage of

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profits due to idleness of resources of a firm.

3.1.3.10 ANALYSIS OF PROFITABILITY

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Profitability is a measure of efficiency and control. It indicates the

efficiency or effectiveness with which the operations of the business are carried

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on. Poor operational performance may result in poor sales and therefore low

profits. Low profitability may be due to lack of control over expenses resulting

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in low profits. Profitability ratios are employed by management in order to

assess how efficiently they carry on business operations. Profitability is the main

base for liquidity as well as solvency. Creditors, banks and financial institutions

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are interested in profitability ratios since they indicate liquidity or capacity of

the business to meet interest obligations and regular and improved profits

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enhance the long term solvency position of the business. Owners are interested

in profitability for they indicate the growth and also the rate of return on their

investments. The importance of measuring profitability has been stressed by

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Hingorani, Ramanathan and Grewal in these words: "A measure of profitability

is the overall measure of efficiency".

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An appraisal of the financial position of any enterprise is

incomplete unless its overall profitability is measured in relation to the

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sales, assets, capital employed, net worth and earnings per share. The

following ratios are used to measure the profitability position from

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various angles:

(1)

Gross Profit Ratio

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(2)

Net Profit Ratio

--- Content provided by FirstRanker.com ---

(3)

Return on Capital Employed

(4)

--- Content provided by‍ FirstRanker.com ---


Operating Ratio



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138
(5)

Operating Profit Ratio

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(6)

Return on Owners' Equity

(7)

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Earnings Per Share

(8)

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Dividend Pay Out Ratio

Gross Profit Ratio: The Gross Profit Ratio or Gross Profit Margin Ratio

expresses the relationship of gross profit on sales / net sales. B.R.Rao opines that

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"gross profit margin ratio indicates the gross margin of profits on the net sales

and from this margin only, all expenses are met and finally net income

--- Content provided by​ FirstRanker.com ---

emerges". The basic components for the computation of this ratio are gross

profits and net sales. `Net Sales' means total sales minus sales returns and `gross

profit' means the difference between net sales and cost of goods sold. The

--- Content provided by FirstRanker.com ---


formula used to compute Gross Profit Ratio is:



--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Gross Profit

--- Content provided by FirstRanker.com ---

Gross

Profit

Ratio

--- Content provided by‌ FirstRanker.com ---


= ------------------ x 100



--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Sales

--- Content provided by​ FirstRanker.com ---




Gross profit ratio indicates to what extent the selling prices of

--- Content provided by FirstRanker.com ---

goods per unit may be reduced without incurring losses on operations. A

low gross profit ratio will suggest decline in business which may be due

to insufficient sales, higher cost of production with the existing or

--- Content provided by⁠ FirstRanker.com ---


reduced selling price or the alround inefficient management. A high

gross profit ratio is a sign of good and effective management.

--- Content provided by FirstRanker.com ---

Net Profit Ratio: Net profit is a good indicator of the efficiency of a firm. Net

profit ratio or net profit margin ratio is determined by relating net income after

taxes to net sales. Net profit here is the balance of profit and loss account which

--- Content provided by‌ FirstRanker.com ---


is arrived at after considering all non-operating incomes such as interest on

investments, dividends received, etc. and non-operating expenses like loss on

--- Content provided by​ FirstRanker.com ---

sale of investments, provisions for contingent liabilities, etc. This ratio indicates

net margin earned on a sale of Rs.100. The formula for calculating the ratio is:


--- Content provided by‍ FirstRanker.com ---




139

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Net Profit




--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Net Profit Ratio

=

---------------- x 100

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Sales



--- Content provided by​ FirstRanker.com ---


This ratio is widely used as a measure of overall profitability and

is very useful for proprietors. A higher ratio indicates better position.

--- Content provided by‌ FirstRanker.com ---

Return on Capital Employed: The prime objective of making investments in

any business is to obtain satisfactory return on capital invested. Hence, the

return on capital employed is used as a measure of success of a business in

--- Content provided by‍ FirstRanker.com ---


realising this objective. Otherwise known as Return on Investments, this is the

overall profitability ratio. It indicates the percentage of return on capital

--- Content provided by‍ FirstRanker.com ---

employed in the business and it can be used to show the efficiency of the

business as a whole. The formula for calculating the ratio is:


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Operating Profit


--- Content provided by‌ FirstRanker.com ---


Return on Capital Employed = -------------------------- x 100



--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---


Capital

Employed

--- Content provided by‌ FirstRanker.com ---




The term "Capital Employed" means [Share capital + Reserves

--- Content provided by⁠ FirstRanker.com ---

and Surplus + Long Term Loans] minus [Non-business assets +

Fictitious assets] and the term "Operating Profit" means profit before

interest and tax. The term `interest' means interest on long-term

--- Content provided by FirstRanker.com ---


borrowings. Non-trading income should be excluded for the above

purpose. A higher ratio indicates that the funds are invested profitably.

--- Content provided by FirstRanker.com ---

Operating Ratio: This ratio establishes the relationship between total operating

expenses and sales. Total operating expenses includes cost of goods sold plus

other operating expenses. A higher ratio indicates that operating expenses are

--- Content provided by‌ FirstRanker.com ---


high, as such profit margin is less and therefore lower the ratio better is the

position. The operating ratio is an index of the efficiency of the conduct of

--- Content provided by FirstRanker.com ---

business operations. An ideal norm for this ratio is between 75% to 85% in a

manufacturing concern. The formula for calculating the operating ratio is thus:


--- Content provided by‍ FirstRanker.com ---


140



--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



Cost of goods sold + Operating experience


--- Content provided by‌ FirstRanker.com ---


Operating Ratio =

----------------------------------------------------- x 100

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





Sales

--- Content provided by FirstRanker.com ---



Operating Profit Ratio: This ratio indicates net-margin earned on a sale of

Rs.100. It is calculated as follows:

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


Net Operating Profit



--- Content provided by​ FirstRanker.com ---

Operating Profit Ratio =

------------------------- x 100


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Sales



--- Content provided by FirstRanker.com ---



The operating profit ratio helps in determining the efficiency with

which affairs of the business are being managed. An increase in the ratio

--- Content provided by‍ FirstRanker.com ---


over the previous period indicates improvement in the operational

efficiency of the business provided the gross profit ratio is constant.

--- Content provided by‍ FirstRanker.com ---

Operating profit is estimated without considering non-operating income

such as profit on sale of fixed assets, interest on investments and non-

operating expenses such as loss on sale of fixed assets. This is thus, an

--- Content provided by⁠ FirstRanker.com ---


effective tool to measure the profitability of a business concern.

Return on Owners' Equity (or) Shareholders' Fund (or) the Net Worth:

--- Content provided by‌ FirstRanker.com ---

The ratio of return on owners' equity is a valuable measure for judging the

profitability of an organisation. This ratio helps the shareholders of a firm to

know the return on investment in terms of profits. Shareholders are always

--- Content provided by​ FirstRanker.com ---


interested in knowing as to what return they earned on their invested capital

since they bear all the risk, participate in management and are entitled to all the

--- Content provided by​ FirstRanker.com ---

profits remaining after all outside claims including preference dividend are met

in full. This ratio is computed as a percentage by using the formula:

Net

--- Content provided by‍ FirstRanker.com ---


Profit

after

--- Content provided by‍ FirstRanker.com ---

interest

and

tax

--- Content provided by‌ FirstRanker.com ---




Return on Owners' Equity = ------------------------------------------ x 100

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Owners'

Equity

--- Content provided by‍ FirstRanker.com ---

(Net

Worth)


--- Content provided by​ FirstRanker.com ---




141

--- Content provided by‍ FirstRanker.com ---



This is the single most important ratio to judge whether the firm

has earned a satisfactory return for its equity-shareholders or not. A

--- Content provided by⁠ FirstRanker.com ---


higher ratio indicates the better utilisation of owners' fund and higher

productivity. A low ratio may indicate that the business is not very

--- Content provided by‍ FirstRanker.com ---

successful because of inefficient and ineffective management and over

investment in assets.

Earnings Per Share (EPS): The profitability of a firm from the point of view of

--- Content provided by‍ FirstRanker.com ---


the ordinary shareholders is analysed through the ratio `EPS'. It measures the

profit available to the equity shareholders on a per share basis, i.e. the amount

--- Content provided by​ FirstRanker.com ---

that they can get on every share held. It is calculated by dividing the profits

available to the shareholders by the number of the outstanding shares. The

profits available to the ordinary shareholders are represented by net profit after

--- Content provided by FirstRanker.com ---


taxes and preference dividend.



--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Net profit after tax ? Preference Dividend



--- Content provided by‍ FirstRanker.com ---

Earnings Per Share = ----------------------------------------------------

Number

of

--- Content provided by‌ FirstRanker.com ---


Equity

Shares

--- Content provided by FirstRanker.com ---




This ratio is an important index because it indicates whether the

--- Content provided by‌ FirstRanker.com ---

wealth of each shareholder on a per-share basis has changed over the

period. The performance and prospects of the firm are affected by EPS.

If EPS increases, there is a possibility that the company may pay more

--- Content provided by‌ FirstRanker.com ---


dividend or issue bonus shares. In short, the market price of the share of

a firm will be affected by all these factors.

--- Content provided by⁠ FirstRanker.com ---

Dividend Pay Out Ratio: This ratio measures the relationship between the

earnings belonging to the ordinary shareholders and the dividend paid to them.

In other words, the dividend pay out ratio shows what percentage share of the

--- Content provided by⁠ FirstRanker.com ---


net profits after taxes and preference dividend is paid out as dividend to the

equity shareholders. It can be calculated by dividing the total dividend paid to

--- Content provided by‍ FirstRanker.com ---

the owners by the earnings available to them. The formula for computing this

ratio is:


--- Content provided by FirstRanker.com ---


142


Dividend

--- Content provided by​ FirstRanker.com ---


per

equity

--- Content provided by⁠ FirstRanker.com ---

share



Dividend payout ratio =

--- Content provided by​ FirstRanker.com ---


---------------------------------



--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Earnings per share




--- Content provided by‍ FirstRanker.com ---

This ratio is very important from shareholder's point of view as

its tells him that if a firm has used whole, or substantially the whole of

its earnings for paying dividend and retained nothing for future growth

--- Content provided by‍ FirstRanker.com ---


and expansion purposes, then there will be very dim chances of capital

appreciation in the price of shares of such firms. In other words, an

--- Content provided by​ FirstRanker.com ---

investor who is more interested in capital appreciation must look for a

firm having low payout ratio.

3.1.3.11 ANALYSIS OF OPERATIONAL EFFICIENCY

--- Content provided by⁠ FirstRanker.com ---




The operational efficiency of an organisation is its ability to

--- Content provided by FirstRanker.com ---

utilise the available resources to the maximum extent. Success or failure

of a business in the economic sense is judged in relation to expectations,

returns on invested capital and objectives of the business concern. There

--- Content provided by​ FirstRanker.com ---


are many techniques available for evaluating financial as well as

operational performance of a firm. The two important techniques adopted

--- Content provided by⁠ FirstRanker.com ---

in this study are:

1. Turnover to Capital Employed or Return on Investment (ROI)

2. Financial Operations Ratio

--- Content provided by⁠ FirstRanker.com ---


Turnover to Capital Employed: This is the ratio of operating revenue to capital

employed. This is one of the important ratios to find out the efficiency with

--- Content provided by FirstRanker.com ---

which the firms are utilising their capital. It signifies the number of times the

total capital employed was turned into sales volumes. The term capital employed

includes total assets minus current liabilities. The ratio for calculating turnover

--- Content provided by‌ FirstRanker.com ---


to capital employed (in percentage) is:



--- Content provided by FirstRanker.com ---



Operating

Revenue

--- Content provided by‌ FirstRanker.com ---




Turnover to capital employed = --------------------------- x 100

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Capital

Employed

--- Content provided by‌ FirstRanker.com ---





143

--- Content provided by​ FirstRanker.com ---


The higher the ratio, the better is the position.

Financial Operations Ratio: The efficiency of the financial management of a

--- Content provided by​ FirstRanker.com ---

firm is calculated through financial operations ratio. This ratio is a calculating

device of the cost and the return of financial charges. This ratio signifies a

relationship between net profit after tax and operating profit. The formula for the

--- Content provided by FirstRanker.com ---


computation of this ratio is:



--- Content provided by​ FirstRanker.com ---





Net

--- Content provided by⁠ FirstRanker.com ---


Profit

after

--- Content provided by​ FirstRanker.com ---

tax



Financial Operations Ratio = --------------------------- x 100

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Operating

Profit

--- Content provided by​ FirstRanker.com ---




Here, the term "operating profit" means sales minus operating

--- Content provided by‍ FirstRanker.com ---

expenses. A higher ratio indicates the better financial performance of the

firm.

3.1.3.12 RATIOS FROM SHAREHOLDERS' POINT OF VIEW

--- Content provided by‍ FirstRanker.com ---


1. Preference Dividend Cover: This ratio expresses Net Profit after tax as so

many times of Preference Dividend Payable. This is calculated as:

--- Content provided by‍ FirstRanker.com ---

Net Profit after tax
---------------------------
Preference Dividend


--- Content provided by FirstRanker.com ---


2. Equity Dividend Cover: This ratio gives information about net profit available

to equity shareholders. This ratio expresses profit as number of times of equity

--- Content provided by‌ FirstRanker.com ---

dividend payable. This ratio is calculated using the following formula:




--- Content provided by⁠ FirstRanker.com ---


Net Profit After Tax ? Preference Dividend

--------------------------------------------------------

--- Content provided by​ FirstRanker.com ---


Equity

Dividend

--- Content provided by​ FirstRanker.com ---


3. Dividend Yield on Equity Shares or Yield Ratio: This ratio interprets
dividend as a percentage of Market Price Per Share. It is calculated at:


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Dividend Per Share

-------------------------------- x 100


--- Content provided by‍ FirstRanker.com ---



Market Price Per Share


--- Content provided by‌ FirstRanker.com ---




144
4. Price Earning Ratio: This ratio tells how many times of earnings per share is

--- Content provided by‌ FirstRanker.com ---

the market price of the share of a company. The formula to calculate this ratio is:




--- Content provided by‌ FirstRanker.com ---





Market Price Per Share

--- Content provided by​ FirstRanker.com ---


---------------------------------



--- Content provided by‍ FirstRanker.com ---


Earnings Per Share


3.1.3.13 ILLUSTRATIONS

--- Content provided by‍ FirstRanker.com ---


Illustration 4: The following are the financial statements of Yesye Limited for

the year 2005.

--- Content provided by FirstRanker.com ---

BALANCE SHEET AS AT 31-12-2005

------------------------------------------------------------------------------------------------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



Rs.


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Rs.

Equity Share capital

1,00,000

--- Content provided by‌ FirstRanker.com ---


Fixed Assets

1,50,000

--- Content provided by‌ FirstRanker.com ---

General Reserve



90,000

--- Content provided by‌ FirstRanker.com ---


Stock



--- Content provided by‍ FirstRanker.com ---

42,500

Profit & Loss Balance

7,500

--- Content provided by​ FirstRanker.com ---


Debtors



--- Content provided by‍ FirstRanker.com ---

19,000

Sundry Creditors


--- Content provided by​ FirstRanker.com ---


35,000

Cash

--- Content provided by FirstRanker.com ---



61,000

6% Debentures

--- Content provided by​ FirstRanker.com ---




30,000 Proposed Dividends 10,000

--- Content provided by⁠ FirstRanker.com ---





----------

--- Content provided by‍ FirstRanker.com ---


----------



--- Content provided by⁠ FirstRanker.com ---

2,72,500 2,72,500
-----------------------------------------------------------------------------------------------



--- Content provided by FirstRanker.com ---

TRADING AND PROFIT AND LOSS ACCOUNT

for the year ended 31-12-2005

-----------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Rs.

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Rs.

To Cost of goods sold

1,80,000

--- Content provided by​ FirstRanker.com ---


By Sales



--- Content provided by‌ FirstRanker.com ---

3,00,000

To Gross profit c/d


--- Content provided by‌ FirstRanker.com ---


1,20,000



--- Content provided by⁠ FirstRanker.com ---





---------- ----------

--- Content provided by‍ FirstRanker.com ---




3,00,000 3,00,000
---------- ----------

--- Content provided by​ FirstRanker.com ---




To expenses

--- Content provided by⁠ FirstRanker.com ---



1,00,000

By Gross profit b/d 1,20,000

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

To Net Profit



20,000

--- Content provided by‍ FirstRanker.com ---




---------- ----------

--- Content provided by FirstRanker.com ---



1,20,000 1,20,000
----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---



145

You are required to compute the following:

--- Content provided by​ FirstRanker.com ---


1) Current ratio

2) Acid Test ratio

--- Content provided by‍ FirstRanker.com ---

3) Gross Profit ratio

4) Debtors' Turnover ratio

5) Fixed Assets to net tangible worth

--- Content provided by⁠ FirstRanker.com ---


6) Turnover to fixed assets

Solution:

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Current Assets

1) Current Ratio


--- Content provided by⁠ FirstRanker.com ---


=

----------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




Current

--- Content provided by‍ FirstRanker.com ---

Liabilities


1,22,500
=

--- Content provided by FirstRanker.com ---


-----------



--- Content provided by​ FirstRanker.com ---





45,000

--- Content provided by‍ FirstRanker.com ---



=

2.7:1.

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---



Quick Assets

2) Acid Test Ratio

--- Content provided by FirstRanker.com ---




= --------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Quick

--- Content provided by​ FirstRanker.com ---

Liabilities




--- Content provided by​ FirstRanker.com ---



80,000

=

--- Content provided by FirstRanker.com ---


-----------



--- Content provided by⁠ FirstRanker.com ---





45,000

--- Content provided by⁠ FirstRanker.com ---



=

1.8:1.

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Gross Profit

3) Gross Profit Ratio =

--- Content provided by⁠ FirstRanker.com ---

---------------------- x 100




--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Sales


1,20,000
=

--- Content provided by‌ FirstRanker.com ---


-----------

x

--- Content provided by​ FirstRanker.com ---

100

3,00,000


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



=

40%

--- Content provided by‍ FirstRanker.com ---




146

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





Net Sales

--- Content provided by​ FirstRanker.com ---


4) Debtors' Turnover =

-----------------------

--- Content provided by FirstRanker.com ---

Ratio




--- Content provided by‍ FirstRanker.com ---


Average Debtors


3,00,000

--- Content provided by‌ FirstRanker.com ---

=

-----------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

19,000


=

--- Content provided by‌ FirstRanker.com ---

15.78

times.


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


No. of days in the year

Collection Period

--- Content provided by‍ FirstRanker.com ---



=

-----------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





Debtors'

--- Content provided by FirstRanker.com ---


Turnover



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



365

=

--- Content provided by‌ FirstRanker.com ---


-----------



--- Content provided by⁠ FirstRanker.com ---





15.78

--- Content provided by‌ FirstRanker.com ---



=

23

--- Content provided by‍ FirstRanker.com ---


days



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





Fixed Assets

--- Content provided by‍ FirstRanker.com ---


5) Fixed Asset to Net Tangible Worth = ----------------------- x 100



--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Proprietor's Fund


1,50,000

--- Content provided by FirstRanker.com ---


=

-----------

--- Content provided by​ FirstRanker.com ---



x

100

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

1,97,500



=

--- Content provided by⁠ FirstRanker.com ---


76%



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Net Sales

--- Content provided by‍ FirstRanker.com ---

6) Turnover to Fixed Assets

=

------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Fixed Assets

3,00,000

=

--- Content provided by‍ FirstRanker.com ---


-----------



--- Content provided by⁠ FirstRanker.com ---

1,50,000




--- Content provided by‌ FirstRanker.com ---




=

--- Content provided by‌ FirstRanker.com ---

2 times



147

--- Content provided by FirstRanker.com ---


Illustration 5: From the following details prepare a statement of proprietary

fund with as many details as possible.

--- Content provided by FirstRanker.com ---

1)

Stock

Velocity

--- Content provided by‍ FirstRanker.com ---


6

2)

--- Content provided by⁠ FirstRanker.com ---

Capital

Turnover

Ratio

--- Content provided by FirstRanker.com ---


2



--- Content provided by⁠ FirstRanker.com ---



3) Fixed Assets Turnover Ratio


--- Content provided by FirstRanker.com ---


4



--- Content provided by FirstRanker.com ---



4) Gross Profit Turnover Ratio


--- Content provided by FirstRanker.com ---


20%

5)

--- Content provided by‍ FirstRanker.com ---

Debtors'

Velocity

2

--- Content provided by‌ FirstRanker.com ---


months

6)

--- Content provided by​ FirstRanker.com ---

Creditors'

Velocity

73

--- Content provided by​ FirstRanker.com ---


days

Gross profit was Rs.60,000. Reserves and surplus amount to 20,000. Closing

--- Content provided by⁠ FirstRanker.com ---

stock was Rs.5,000 in excess of opening stock.

Solution:

1. Calculation of Sales

--- Content provided by‌ FirstRanker.com ---


Gross Profit

Gross Profit Ratio

--- Content provided by FirstRanker.com ---

= ---------------




--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---





Sales

--- Content provided by FirstRanker.com ---




=

--- Content provided by⁠ FirstRanker.com ---

20%


Rs.60,000

--- Content provided by​ FirstRanker.com ---



20

---------------

--- Content provided by⁠ FirstRanker.com ---


=

--------

--- Content provided by​ FirstRanker.com ---

Sales




--- Content provided by FirstRanker.com ---


100



--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





1

--- Content provided by‌ FirstRanker.com ---




=

--- Content provided by‍ FirstRanker.com ---

---




--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



5


--- Content provided by​ FirstRanker.com ---

Sales:

Rs.3,00,000


--- Content provided by FirstRanker.com ---

2. Calculation of Sundry Debtors

Debtors

Debtors' Velocity

--- Content provided by FirstRanker.com ---


=

------------ x 12 months

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Sales

Let

Debtors

--- Content provided by FirstRanker.com ---


be

x

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





x

--- Content provided by‍ FirstRanker.com ---


2 =

-----------

--- Content provided by FirstRanker.com ---

x

12

3,00,000

--- Content provided by‌ FirstRanker.com ---




148

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




x

--- Content provided by FirstRanker.com ---





1

--- Content provided by‍ FirstRanker.com ---


-------------

=

--- Content provided by‍ FirstRanker.com ---

---




--- Content provided by⁠ FirstRanker.com ---




3,00,000

--- Content provided by‍ FirstRanker.com ---



6


--- Content provided by‌ FirstRanker.com ---

x =

Rs.50,000


--- Content provided by‍ FirstRanker.com ---

Debtors:

Rs.50,000


--- Content provided by‌ FirstRanker.com ---


It is assumed that all sales are credit sales.


3. Calculation of Stock

--- Content provided by‌ FirstRanker.com ---


Cost of goods sold

Stock Turnover Ratio

--- Content provided by⁠ FirstRanker.com ---



=

---------------------------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Average stock

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


=

6

--- Content provided by⁠ FirstRanker.com ---

Cost of goods sold



=

--- Content provided by FirstRanker.com ---


Sales ? Gross Profit



--- Content provided by‍ FirstRanker.com ---

=

Rs.3,00,000

?

--- Content provided by FirstRanker.com ---


Rs.60,000



--- Content provided by FirstRanker.com ---

=

Rs.2,40,000


--- Content provided by‍ FirstRanker.com ---




Rs.2,40,000

--- Content provided by FirstRanker.com ---



------------------

=

--- Content provided by‍ FirstRanker.com ---


6



--- Content provided by⁠ FirstRanker.com ---

Average

Stock


--- Content provided by‍ FirstRanker.com ---


Rs.2,40,000

Average Stock

--- Content provided by‍ FirstRanker.com ---





= ---------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



6


--- Content provided by​ FirstRanker.com ---



=

Rs.40,000

--- Content provided by​ FirstRanker.com ---





Opening

--- Content provided by⁠ FirstRanker.com ---


stock

+

--- Content provided by​ FirstRanker.com ---

Closing

stock

Average

--- Content provided by​ FirstRanker.com ---


Stock

=

--- Content provided by FirstRanker.com ---

--------------------------------------




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




2

--- Content provided by‌ FirstRanker.com ---

Let opening stock be Rs.x.


Then closing stock will be x + 5,000

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

x + x + 5,000

----------------

=

--- Content provided by FirstRanker.com ---


40,000



--- Content provided by FirstRanker.com ---



2


--- Content provided by‍ FirstRanker.com ---





2x + 5,000

--- Content provided by FirstRanker.com ---




------------

--- Content provided by⁠ FirstRanker.com ---

=

40,000


--- Content provided by​ FirstRanker.com ---




2

--- Content provided by‌ FirstRanker.com ---





149

--- Content provided by‍ FirstRanker.com ---


Cross multiplying

2x

--- Content provided by⁠ FirstRanker.com ---

+

5,000

=

--- Content provided by‍ FirstRanker.com ---


80,000

2x

--- Content provided by‌ FirstRanker.com ---

=

80,000

?

--- Content provided by‌ FirstRanker.com ---


5,000

=

--- Content provided by‍ FirstRanker.com ---

75,000


x =

--- Content provided by⁠ FirstRanker.com ---

37,500



Opening stock Rs.37,500

--- Content provided by FirstRanker.com ---

Closing stock Rs.42,500


4. Calculation of Creditors

--- Content provided by⁠ FirstRanker.com ---

Total Creditors

Creditors' velocity


--- Content provided by FirstRanker.com ---


=

------------------------------ x 365

--- Content provided by‍ FirstRanker.com ---

days




--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Credit Purchases




--- Content provided by​ FirstRanker.com ---

=

73

days

--- Content provided by​ FirstRanker.com ---



Purchase

= Cost of goods + Closing Stock ? Opening stock

--- Content provided by FirstRanker.com ---


=

Rs.2,40,000

--- Content provided by‌ FirstRanker.com ---

+

42,500

?

--- Content provided by‌ FirstRanker.com ---


37,500



--- Content provided by​ FirstRanker.com ---

=

Rs.2,45,000


--- Content provided by⁠ FirstRanker.com ---

Let the creditors be x


x

--- Content provided by‍ FirstRanker.com ---



-------------- x 365


--- Content provided by‌ FirstRanker.com ---


=

73

--- Content provided by⁠ FirstRanker.com ---



2,45,000


--- Content provided by⁠ FirstRanker.com ---

365

x

=

--- Content provided by⁠ FirstRanker.com ---




2,45,000

--- Content provided by‍ FirstRanker.com ---

x

73


--- Content provided by‌ FirstRanker.com ---

2,45,000

x

73

--- Content provided by⁠ FirstRanker.com ---


x =

----------------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



365


--- Content provided by‍ FirstRanker.com ---


Creditors

=

--- Content provided by‍ FirstRanker.com ---

Rs.49,000


5. Calculation of Fixed Assets

--- Content provided by FirstRanker.com ---

Costs of goods sold

Fixed Assets Turnover Ratio = -----------------------------


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



Fixed Assets


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

=

4


--- Content provided by‌ FirstRanker.com ---


150

Let Fixed assets be x

--- Content provided by‌ FirstRanker.com ---

2,40,000
---------- =

4

--- Content provided by​ FirstRanker.com ---





x

--- Content provided by⁠ FirstRanker.com ---


x =

60,000

--- Content provided by‍ FirstRanker.com ---


Fixed

Assets

--- Content provided by FirstRanker.com ---

=

Rs.60,000


--- Content provided by FirstRanker.com ---


6. Shareholders' Fund

Cost of goods sold

--- Content provided by‍ FirstRanker.com ---

Capital Turnover Ratio



=

--- Content provided by​ FirstRanker.com ---


----------------------- =

2

--- Content provided by‌ FirstRanker.com ---





Proprietary

--- Content provided by‌ FirstRanker.com ---


Fund

2,40,000

--- Content provided by‍ FirstRanker.com ---

--------------------- = 2
Proprietary

Fund

--- Content provided by⁠ FirstRanker.com ---


Proprietary

Fund

--- Content provided by FirstRanker.com ---

=

Rs.1,20,000

Shareholders' fund includes Share capital, Profit & Reserve.

--- Content provided by‌ FirstRanker.com ---




Share Capital

--- Content provided by‌ FirstRanker.com ---

=

Shareholders' Fund ? (Profit + Reserve)


--- Content provided by‌ FirstRanker.com ---

=

Rs.1,20,000

?

--- Content provided by⁠ FirstRanker.com ---


Rs.80,000


=

--- Content provided by⁠ FirstRanker.com ---


Rs.40,000


7. Calculation of Bank Balance

--- Content provided by FirstRanker.com ---


Shareholders' Fund + Current Liabilities = Fixed Assets + Current Assets



--- Content provided by⁠ FirstRanker.com ---

Rs.1,20,000 + 49,000 =

Rs.60,000 + Current Assets


--- Content provided by‍ FirstRanker.com ---

Current

Assets

=

--- Content provided by​ FirstRanker.com ---


Rs.1,09,000



--- Content provided by FirstRanker.com ---

Current Assets

=

Stock + Debtors + Bank Balance

--- Content provided by‍ FirstRanker.com ---




Bank Balance

--- Content provided by⁠ FirstRanker.com ---

=

Current Assets ? (Stock + Debtors)

=

--- Content provided by​ FirstRanker.com ---


Rs.1,09,000

?

--- Content provided by FirstRanker.com ---

(42,500

+

50,000)

--- Content provided by‍ FirstRanker.com ---


=

Rs.1,09,000

--- Content provided by FirstRanker.com ---

?

92,500

=

--- Content provided by‌ FirstRanker.com ---


Rs.16,500



--- Content provided by FirstRanker.com ---




151

--- Content provided by FirstRanker.com ---

Balance Sheet as on ...

-----------------------------------------------------------------------------------------------


--- Content provided by FirstRanker.com ---


Liabilities



--- Content provided by‌ FirstRanker.com ---

Rs.

Assets


--- Content provided by FirstRanker.com ---


Rs.

-----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---

Share capital

40,000

Fixed Assets

--- Content provided by‍ FirstRanker.com ---




60,000

--- Content provided by FirstRanker.com ---

Reserves & Surplus 20,000

Current Assets:

Profit

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

60,000 Stock

42,500

Current liabilities

--- Content provided by‌ FirstRanker.com ---


49,000

Debtors

--- Content provided by​ FirstRanker.com ---

50,000

Bank

16,500

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



1,09,000

----------

--- Content provided by⁠ FirstRanker.com ---


-- - ----------



--- Content provided by‍ FirstRanker.com ---



1,69,000


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

1,69,000

-----------------------------------------------------------------------------------------------

Illustration 6: The following data is furnished:

--- Content provided by FirstRanker.com ---


a)

Working

--- Content provided by⁠ FirstRanker.com ---

capital

Rs.45,000

b)

--- Content provided by FirstRanker.com ---


Current

ratio 2.5

--- Content provided by‌ FirstRanker.com ---

c)

Liquidity

ratio

--- Content provided by FirstRanker.com ---


1.5



--- Content provided by‍ FirstRanker.com ---



d) Proprietary ratio ? (Fixed assets

to

--- Content provided by‍ FirstRanker.com ---


proprietary

funds)

--- Content provided by FirstRanker.com ---

0.75

e)

Overdraft

--- Content provided by‍ FirstRanker.com ---


Rs.10,000

f)

--- Content provided by FirstRanker.com ---

Retained

earnings

Rs.30,000

--- Content provided by‌ FirstRanker.com ---


There are no long term loans and fictitious assets.
Find

out:

--- Content provided by FirstRanker.com ---


1)

Current assets

--- Content provided by​ FirstRanker.com ---

2)

Current liabilities

3)

--- Content provided by‌ FirstRanker.com ---


Fixed assets

4)

--- Content provided by​ FirstRanker.com ---

Quick assets

5)

Quick liabilities

--- Content provided by⁠ FirstRanker.com ---


6)

Stock

--- Content provided by‍ FirstRanker.com ---

7)

Equity


--- Content provided by FirstRanker.com ---

Solution:

Current Assets

Current

--- Content provided by‌ FirstRanker.com ---


assets

2.5

--- Content provided by​ FirstRanker.com ---

Current

liability 1.0

---

--- Content provided by FirstRanker.com ---




Working

--- Content provided by‍ FirstRanker.com ---

capital 1.5



152

--- Content provided by‌ FirstRanker.com ---




If working capital is 1.5, current asset will be 2.5.

--- Content provided by⁠ FirstRanker.com ---




If working capital is Rs.45,000, current assets will be Rs.75,000

--- Content provided by‍ FirstRanker.com ---


Current

Assets

--- Content provided by⁠ FirstRanker.com ---

=

Rs.75,000


--- Content provided by‌ FirstRanker.com ---

Current Liability
Current

Liability

--- Content provided by FirstRanker.com ---

=

Current assets ? Working capital

=

--- Content provided by⁠ FirstRanker.com ---


Rs.75,000

?

--- Content provided by FirstRanker.com ---

Rs.45,000

=

Rs.30,000

--- Content provided by‌ FirstRanker.com ---



Fixed Assets


--- Content provided by‍ FirstRanker.com ---

Shareholders' Fund+ Current Liabilities = Fixed Assets + Current Assets




--- Content provided by⁠ FirstRanker.com ---

Shareholders' Fund=Fixed assets + Current assets ? Current Liabilities


=

--- Content provided by​ FirstRanker.com ---

Fixed

assets

+

--- Content provided by​ FirstRanker.com ---


Rs.75,000

?

--- Content provided by‌ FirstRanker.com ---

Rs.30,000


=

--- Content provided by‍ FirstRanker.com ---

Fixed

assets

+

--- Content provided by FirstRanker.com ---


Rs.45,000


Let the shareholders' fund be x, fixed assets will be ? x

--- Content provided by‌ FirstRanker.com ---


x =

Rs.

--- Content provided by​ FirstRanker.com ---

?

x

+

--- Content provided by​ FirstRanker.com ---


Rs.45,000


?

--- Content provided by‌ FirstRanker.com ---


x

=

--- Content provided by FirstRanker.com ---

Rs.45,000


x =

--- Content provided by FirstRanker.com ---

Rs.1,80,000


?

--- Content provided by​ FirstRanker.com ---

x

=

Rs.1,35,000

--- Content provided by‍ FirstRanker.com ---



Fixed

assets

--- Content provided by​ FirstRanker.com ---


=

Rs.1,35,000

--- Content provided by‍ FirstRanker.com ---




Shareholders Funds

--- Content provided by FirstRanker.com ---

=

Rs.1,35,000 + Rs.45,000


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





=

--- Content provided by⁠ FirstRanker.com ---


Rs.1,80,000

Stock

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


Quick assets

Liquid

--- Content provided by​ FirstRanker.com ---

ratio

=

-------------------

--- Content provided by​ FirstRanker.com ---


Quick

liabilities

--- Content provided by‍ FirstRanker.com ---




Quick assets

--- Content provided by​ FirstRanker.com ---



=

Current assets ? Stock

--- Content provided by FirstRanker.com ---




153

--- Content provided by FirstRanker.com ---



Quick liabilities


--- Content provided by‌ FirstRanker.com ---


=

Current liabilities ? Bank overdraft

--- Content provided by‌ FirstRanker.com ---

Let the value of stock be x.



Quick assets

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Rs.75,000 ? x

-------------------- = ---------------------


--- Content provided by​ FirstRanker.com ---

Quick liabilities




--- Content provided by‍ FirstRanker.com ---


30,000 ? 10,000



--- Content provided by‍ FirstRanker.com ---


75,000

-

--- Content provided by⁠ FirstRanker.com ---

x

=

-------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

=

1.5


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

20,000

Cross multiplying


--- Content provided by‍ FirstRanker.com ---




75,000 ? x

--- Content provided by‍ FirstRanker.com ---



=

20,000 x 1.5

--- Content provided by‌ FirstRanker.com ---


75,000

?

--- Content provided by FirstRanker.com ---

x

=

30,000

--- Content provided by​ FirstRanker.com ---


x =

45,000

--- Content provided by‌ FirstRanker.com ---

Stock

=

Rs.45,000

--- Content provided by FirstRanker.com ---


Quick

Assets

--- Content provided by⁠ FirstRanker.com ---

=

Rs.75,000

?

--- Content provided by​ FirstRanker.com ---


Rs.45,000

=

--- Content provided by​ FirstRanker.com ---

Rs.30,000

Quick

Liabilities

--- Content provided by⁠ FirstRanker.com ---


=

Rs.20,000

--- Content provided by FirstRanker.com ---


Equity



--- Content provided by‌ FirstRanker.com ---

Shareholders' Fund =

Equity + Retained earnings


--- Content provided by FirstRanker.com ---


Shareholders' Fund =

Rs.1,80,000 (as calcualted)

--- Content provided by​ FirstRanker.com ---



Retained earnings

=

--- Content provided by​ FirstRanker.com ---


Rs.30,000 (as given)

Equity

--- Content provided by‍ FirstRanker.com ---

=

Rs.1,50,000


--- Content provided by⁠ FirstRanker.com ---

Illustration 7: From the following balance sheet of Dinesh Limited calculate (i)
Current ratio (ii) Liquid ratio (iii) Debt-equity ratio (iv) Proprietary ratio, and (v)
Capital gearing ratio.

Balance Sheet of Dinesh Limited as on 31-12-2005

--- Content provided by‍ FirstRanker.com ---


-----------------------------------------------------------------------------------------------


Liabilities

--- Content provided by‍ FirstRanker.com ---




Rs.

--- Content provided by‍ FirstRanker.com ---

Assets

Rs.

-----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---

Equity share capital

10,00,000

Goodwill

--- Content provided by​ FirstRanker.com ---




5,00,000

--- Content provided by‍ FirstRanker.com ---

6% preference capital

5,00,000

Plant & Machinery 6,00,000

--- Content provided by‌ FirstRanker.com ---


Reserves



--- Content provided by⁠ FirstRanker.com ---



1,00,000

Land & Buildings

--- Content provided by⁠ FirstRanker.com ---


7,00,000

Profit & Loss a/c

--- Content provided by‍ FirstRanker.com ---



4,00,000

Furniture

--- Content provided by FirstRanker.com ---




1,00,000

--- Content provided by‌ FirstRanker.com ---

Tax

provision


--- Content provided by‍ FirstRanker.com ---




1,76,000

--- Content provided by‍ FirstRanker.com ---

Stock

6,00,000

Bills payable

--- Content provided by FirstRanker.com ---




1,24,000

--- Content provided by‌ FirstRanker.com ---

Bills receivables

30,000

Bank overdraft

--- Content provided by​ FirstRanker.com ---




20,000

--- Content provided by FirstRanker.com ---

Sundry debtors

1,50,000


--- Content provided by‍ FirstRanker.com ---




154
Sundry creditors

--- Content provided by‍ FirstRanker.com ---




80,000

--- Content provided by​ FirstRanker.com ---

Bank account

2,00,000

12% debentures

--- Content provided by‌ FirstRanker.com ---




5,00,000

--- Content provided by⁠ FirstRanker.com ---

Short term investment 20,000

------------

-----------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


29,00,000



--- Content provided by FirstRanker.com ---



29,00,000

-----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



Current Assets

(i) Current

--- Content provided by​ FirstRanker.com ---


=

------------------------

--- Content provided by‍ FirstRanker.com ---

ratio



Current Liabilities

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Stock + Bills receivables + Debtors + Bank + S.T. Investments

=

----------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

S.Creditors + Bills Payable + Bank O.D. + Tax Provision


10,00,000
=

--- Content provided by‌ FirstRanker.com ---


------------

=

--- Content provided by‌ FirstRanker.com ---

2.5

:

1.

--- Content provided by⁠ FirstRanker.com ---




4,00,000

--- Content provided by‌ FirstRanker.com ---


Interpretation: The current ratio in the said firm is 2.5:1 against a standard ratio
of 2:1. It is a good sign of liquidity. However, the stock is found occupying 60
percent of current assets which may not be easily realisable.

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Current Assets ? Stocks

(ii) Liquid ratio


--- Content provided by⁠ FirstRanker.com ---


=

--------------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Current Liabilities




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Liquid

Assets

--- Content provided by​ FirstRanker.com ---

=

------------------------

Current

--- Content provided by‌ FirstRanker.com ---


Liabilities


4,00,000

--- Content provided by‌ FirstRanker.com ---

=

----------


--- Content provided by‌ FirstRanker.com ---


4,00,000

=

--- Content provided by‍ FirstRanker.com ---

1:1.




--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


155

Interpretation: The standard for quick ratio is 1:1. The calculated ratio in case
of Dinesh Limited is also 1:1. The above two ratios show the safety in respect of

--- Content provided by FirstRanker.com ---

liquidity in the said firm.

Long

term

--- Content provided by⁠ FirstRanker.com ---


Debt

(iii) Debt Equity ratio =

--- Content provided by FirstRanker.com ---

-------------------------------------




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Equity Shareholders' Fund



Debentures

--- Content provided by​ FirstRanker.com ---




= ----------------------------------------------------------------------------
Equity capital + Preference capital + Reserves + Profit & Loss a/c

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


5,00,000

=

--- Content provided by⁠ FirstRanker.com ---

----------------------------------------------------------------




--- Content provided by FirstRanker.com ---




10,00,000 + 5,00,000 + 1,00,000 + 4,00,000

--- Content provided by‍ FirstRanker.com ---


=

1:4.

--- Content provided by‌ FirstRanker.com ---


Interpretation: Debt-equity ratio indicates the firm's long term solvency. It can
be observed that the firm's long term loans are constituting 25 percent to that of
the owners' fund. Although such a low ratio indicates better long term solvency,
the less use of debt in capital structure may not enable the firm to gain from the

--- Content provided by‌ FirstRanker.com ---

full stream of leverage effects.




--- Content provided by⁠ FirstRanker.com ---




Proprietors'

--- Content provided by​ FirstRanker.com ---

Funds

(iv) Proprietary ratio =

---------------------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





Total assets

--- Content provided by FirstRanker.com ---



20,00,000
=

--- Content provided by‍ FirstRanker.com ---

------------

=

20:29

--- Content provided by‌ FirstRanker.com ---


29,00,000

Interpretation: Out of total assets, seven-tenths are found financed by owners'
funds. In other words a large majority of long term funds are well invested in

--- Content provided by‍ FirstRanker.com ---

various long term assets in the firm.




--- Content provided by FirstRanker.com ---


Owners'

resources

--- Content provided by​ FirstRanker.com ---

(v) Capital gearing ratio

=

-------------------------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Fixed-interest bearing resources



--- Content provided by‍ FirstRanker.com ---





156

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Equity Share Capital + Reserves + P&L A/c

--- Content provided by‍ FirstRanker.com ---

=

--------------------------------------------------------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



Preference Capital + Debentures


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




10,00,000 + 1,00,000 + 4,00,000

--- Content provided by‍ FirstRanker.com ---

=

--------------------------------------------


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

5,00,000

+

5,00,000

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


15,00,000

=

--- Content provided by‌ FirstRanker.com ---

---------------

=

1.5:1.

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



10,00,000


--- Content provided by​ FirstRanker.com ---

Interpretation: Keeping Rs.15 lakhs of equity funds as security, the firm is
found to have mobilised Rs.10 lakhs from fixed interest bearing sources. It
indicates that the capital structure is low geared.

Illustration 8: The following are the balance sheet and profit and loss account of

--- Content provided by​ FirstRanker.com ---

Sundara Products Limited as on 31st December 2005.


Profit and Loss Account

--- Content provided by FirstRanker.com ---


To opening stock



--- Content provided by FirstRanker.com ---

1,00,000

By Sales


--- Content provided by‍ FirstRanker.com ---


8,50,000

Purchases

--- Content provided by‌ FirstRanker.com ---

5,50,000 Closing

stock

1,50,000

--- Content provided by‍ FirstRanker.com ---


Direct expenses



--- Content provided by FirstRanker.com ---

15,000



Gross

--- Content provided by FirstRanker.com ---


profit

3,35,000

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


------------



--- Content provided by‌ FirstRanker.com ---



------------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

10,00,000




--- Content provided by​ FirstRanker.com ---


10,00,000



--- Content provided by⁠ FirstRanker.com ---





------------

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---

------------

To Admn. expenses

50,000

--- Content provided by FirstRanker.com ---


By Gross profit

3,35,000

--- Content provided by‌ FirstRanker.com ---

Office establishment

1,50,000

Non-operating income 15,000

--- Content provided by⁠ FirstRanker.com ---


Financial expenses



--- Content provided by​ FirstRanker.com ---

50,000

Non-Operating


--- Content provided by‌ FirstRanker.com ---

Expenses/losses

50,000

Net profit

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

50,000

-----------

-----------

--- Content provided by‍ FirstRanker.com ---




3,50,000 3,50,000
-----------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

157

Balance Sheet

-----------------------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---

Liabilities




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Rs.

Assets

Rs.

--- Content provided by‍ FirstRanker.com ---


-----------------------------------------------------------------------------------------------
Equity share capital


--- Content provided by‌ FirstRanker.com ---




Land & Buildings

--- Content provided by⁠ FirstRanker.com ---

1,50,000

(2000 @ 100)


--- Content provided by FirstRanker.com ---


2,00,000

Plant & Machinery 1,00,000

--- Content provided by‌ FirstRanker.com ---

Reserves

1,50,000 Stock

in

--- Content provided by‌ FirstRanker.com ---


trade

1,50,000

--- Content provided by‍ FirstRanker.com ---

Current Liabilities



1,50,000

--- Content provided by FirstRanker.com ---


Sundry Debtors

1,00,000

--- Content provided by‌ FirstRanker.com ---

P&L a/c Balance



50,000

--- Content provided by⁠ FirstRanker.com ---


Cash & Bank

50,000

--- Content provided by‌ FirstRanker.com ---

---------- -----------



5,50,000 5,50,000

--- Content provided by FirstRanker.com ---

---------- -----------



-----------------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---

Calculate turnover ratios.

Solution:
(i)

--- Content provided by​ FirstRanker.com ---

Share capital to turnover ratio

Sales

= ----------------------------------

--- Content provided by‌ FirstRanker.com ---



Total Capital Employed


--- Content provided by‌ FirstRanker.com ---


Sales

= ---------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---


Equity + Reserve + P & L a/c Balance


8,50,000

--- Content provided by‍ FirstRanker.com ---

= ----------



4,00,000

--- Content provided by⁠ FirstRanker.com ---


= 2.13

times.

--- Content provided by​ FirstRanker.com ---


Interpretation: This turnover ratio indicates that the firm has actually converted
its share capital into sales for about 2.13 times. This ratio indicates the
efficiency in use of capital resources and a high turnover ratio ensures good
profitability on operations on an enterprise.

--- Content provided by⁠ FirstRanker.com ---


(ii)

Fixed Asset's Turnover Ratio

--- Content provided by⁠ FirstRanker.com ---

Sales

= ----------------------------


--- Content provided by FirstRanker.com ---

Total Fixed Assets




--- Content provided by⁠ FirstRanker.com ---




158
Sales

--- Content provided by‌ FirstRanker.com ---


= ------------------------------------


Land + Plant & Machinery

--- Content provided by‍ FirstRanker.com ---



8,50,000
= ----------

--- Content provided by‌ FirstRanker.com ---



2,50,000

= 3.4

--- Content provided by FirstRanker.com ---


times.


Interpretation: Although fixed assets are not directly involved in the process of

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generating sales, these are said to back up the production process. A ratio of 3.4
times indicates the efficient utilisation of various fixed assets in this
organisation.

(iii)

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Net Working Capital Turnover:



--- Content provided by‌ FirstRanker.com ---

Sales

= ----------------------------


--- Content provided by‌ FirstRanker.com ---

Net Working Capital



Sales

--- Content provided by⁠ FirstRanker.com ---


= -----------------------------------------------


Current Assets ? Current Liabilities

--- Content provided by‌ FirstRanker.com ---





8,50,000

--- Content provided by​ FirstRanker.com ---


= -----------------------


3,00,000 ? 1,50,000

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= 5.67

times.

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Interpretation: Net working capital indicates the excess of current assets
financed by permanent sources of capital. An efficient utilisation of such funds
is of prime importance to ensure sufficient profitability along with greater

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liquidity. A turnover ratio of 5.7 times is really appreciable.
(iv)

Average Collection Period:

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Credit Sales

Debtor's turnover

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=

-----------------------

--- Content provided by⁠ FirstRanker.com ---





Average

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Debtors


Assuming that 80% of the sales of 8,50,000 as credit sales:

--- Content provided by​ FirstRanker.com ---




159

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6,80,000
=

----------

--- Content provided by​ FirstRanker.com ---




1,00,000

--- Content provided by‍ FirstRanker.com ---

=

6.8

times

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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


Average collection period



--- Content provided by‌ FirstRanker.com ---

360

days

= ---------------------------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Debtors'

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Turnover



--- Content provided by‍ FirstRanker.com ---




360

--- Content provided by​ FirstRanker.com ---

=

-------


--- Content provided by⁠ FirstRanker.com ---




6.8

--- Content provided by‌ FirstRanker.com ---


=

53

--- Content provided by‍ FirstRanker.com ---

days


Interpretation: Average collection period indicates the time taken by a firm in
collecting its debts. The calculated ratio shows that the realisation of cash on

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credit sales is taking an average period of 53 days. A period of roughly two
months indicate that the credit policy is liberal and needs a correction.

(v)

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Stock Turnover Ratio

Cost of goods sold

= ---------------------------

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Average stock


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Sales ? Gross Profit

= ------------------------------------------------

--- Content provided by FirstRanker.com ---


(Opening stock + Closing stock) + 2


5,15,000

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= ----------



1,25,000

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= 4.12

times.

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--- Content provided by FirstRanker.com ---




160
Interpretation: Stock velocity indicates the firm's efficiency and profitability.

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The stock turnover ratio shows that on an average inventory balances are cleared
once in 3 months. Since there is no standard for this ratio, the period of
operating cycle of this firm is to be compared with the industry average for
better interpretation.

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Illustration 9: Comment on the performance of Arasu Limited from the ratios
given below:
Industry

Average

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Ratios

of

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Ratios




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


Arasu

Ltd.

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1.

Current

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ratio

2:1

2.5:1

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2.

Debt-equity

--- Content provided by‌ FirstRanker.com ---

ratio

2:1

1:1

--- Content provided by​ FirstRanker.com ---


3.

Stock

--- Content provided by FirstRanker.com ---

turnover

ratio

9.5

--- Content provided by​ FirstRanker.com ---


3.5



--- Content provided by FirstRanker.com ---

4.

Net profit margin ratio

23.5%

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15.1%

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Solution:

(i) Current ratio: The ratio indicates the liquidity position of a firm. The ability

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of a firm in meeting its current liabilities could be understood by this ratio. The

calculated results show that the liquidity in Arasu Limited is even greater than

industry average, showing the safety. However, excess liquidity locks up the

--- Content provided by‍ FirstRanker.com ---


capital in unnecessary current assets.

(ii) Debt-equity ratio: It is an indicator of a firm's solvency in terms of its ability

--- Content provided by​ FirstRanker.com ---

to repay long term loans in time. The calculated ratio shows better solvency of

1:1 indicating that for every one rupee of debt capital, to repay one rupee of

equity base exists in Arasu Ltd. However, this ratio is not likely to ensure the

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leverage benefits that a firm gains by using higher dose of debt.

(iii) Stock turnover ratio: Stock velocity is an indicator of a firm's activeness. It

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directly influences the profitability of a firm. The calculated ratio for Arasu Ltd.

is very poor when compared to industry average. This poor ratio indicates the

inefficient use of capacities, consequently, the likely low profitability.

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(iv) Net Profit margin ratio: Although the firms in a particular industry could

sell the product more or less at same price, the net profits differ among firms due

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to their cost of production, excessive administrative and establishment expenses



161

--- Content provided by​ FirstRanker.com ---


etc. This picture is found true in case of Arasu Ltd. A poor profitability of 15.1%

compared to an industry average of 23.5% may be due to low stock turnover,

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inefficiency in management, excess overhead cost and excessive interest

burdens.

3.1.3.14 SUMMARY

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Financial statements by themselves do not give the required

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information both for internal management and for outsiders. They must

be analysed and interpreted to get meaningful information about the

various aspects of the concern. Analysing financial statements is a

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process of evaluating the relationship between the component parts of

the financial statements to obtain a proper understanding of a firm's

--- Content provided by​ FirstRanker.com ---

performance. Financial analysis may be external or internal analysis or

horizontal or vertical analysis. Financial analysis can be carried out

through a number of tools like Ratio analysis, Funds flow analysis, Cash

--- Content provided by FirstRanker.com ---


flow analysis etc. Among the various tools available for their analysis,

ratio analysis is the most popularly used tool. The main purpose of ratio

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analysis is to measure past performance and project future trends. It is

also used for inter-firm and intra-firm comparison as a measure of

comparative productivity. The financial analyst X-rays the financial

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conditions of a concern by the use of various ratios and if the conditions

are not found to be favourable, suitable steps can be taken to overcome

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the limitations.

3.1.3.15 KEY WORDS

Analysis: Analysis means methodical classification of the data given in the

--- Content provided by​ FirstRanker.com ---


financial statements.

Interpretation: Interpretation means explaining the meaning and significance of

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the data so classified.

Financial Statements: Income statement and Balance sheet.


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162
Ratio: The relationship of one item to another expressed in simple mathematical

form is known as a ratio.

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Ratio Analysis: This process of computing, determining and presenting the

relationship of items and groups of items in financial statements.

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Financial Leverage: The ability of a firm to use fixed financial charges to

magnify the effects of changes in EBIT on the firm's earnings per share.

Net Worth: Proprietors' funds ? Intangible Assets ? Fictitious Assets.

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Debt: Both long term and short term liabilities.

Operating Profit: Gross Profit ? Operating expenses.

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Equity: Proprietors' fund.

Capital Employed: Net worth + long term liabilities.

3.1.3.16 SELF ASSESSMENT QUESTIONS

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1. Explain the meaning of the term `Financial Statements'. State their nature

and limitations.

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2. Explain the different types of financial analysis.

3. Explain the various tools of financial analysis.

4. Justify the need for analysis and interpretation of financial statements.

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5. Collect the annual reports of any public limited company for a period of 5

years. Calculate the trend percentages and prepare a report.

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6. What is meant by Ratio Analysis? Explain its significance in the analysis

and interpretation of financial statements.

7. Explain the importance of Ratio analysis in making comparisons between

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firms.

8. How the ratios are broadly classified? Explain how ratios are calculated

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under each classification.

9. What are the limitations of Ratio Analysis?

10. From the below given Summary Balance Sheet calculate current ratio and

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long term solvency ratio.



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163

Balance Sheet as on 31st December 2005

-----------------------------------------------------------------------------------------------

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Liabilities

Rs.

Assets

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Rs.

-----------------------------------------------------------------------------------------------
Share

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capital

4,00,000 Fixed

--- Content provided by FirstRanker.com ---

assets

4,00,000

Long term loans

--- Content provided by FirstRanker.com ---




2,00,000

--- Content provided by​ FirstRanker.com ---

Current assets

4,00,000

Current liabilities

--- Content provided by​ FirstRanker.com ---




2,00,000

--- Content provided by⁠ FirstRanker.com ---

---------- -----------



8,00,000 8,00,000

--- Content provided by⁠ FirstRanker.com ---

-----------------------------------------------------------------------------------------------

11. From the following trading and profit and loss account and balance sheet

calculate (i) stock turnover ratio (ii) debtors' velocity (iii) sales to working

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capital (iv) sales to total capital employed (v) return on investment (vi)

current ratio (vii) net profit ratio and (viii) operating ratios.

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Trading and Profit and Loss Account

-----------------------------------------------------------------------------------------------


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Rs.




--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Rs.

To Opening stock

1,00,000

--- Content provided by⁠ FirstRanker.com ---


By Sales



--- Content provided by⁠ FirstRanker.com ---



10,00,000

Purchase

--- Content provided by​ FirstRanker.com ---




5,50,000

--- Content provided by FirstRanker.com ---

Closing stock



1,50,000

--- Content provided by⁠ FirstRanker.com ---


Gross profit

5,00,000

--- Content provided by​ FirstRanker.com ---

-----------

------------


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

11,50,000




--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

11,50,000




--- Content provided by‍ FirstRanker.com ---


-----------



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


------------

Gross

--- Content provided by‍ FirstRanker.com ---

Profit




--- Content provided by FirstRanker.com ---


5,00,000

Admn. Expenses

--- Content provided by‍ FirstRanker.com ---

1,50,000

Interest


--- Content provided by‌ FirstRanker.com ---


30,000

Selling expenses

--- Content provided by‍ FirstRanker.com ---

1,20,000

Net profit


--- Content provided by​ FirstRanker.com ---


2,00,000

---------- ------------

--- Content provided by FirstRanker.com ---



5,00,000


--- Content provided by​ FirstRanker.com ---


5,00,000

-----------------------------------------------------------------------------------------------

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164
Balance Sheet

--- Content provided by​ FirstRanker.com ---

-----------------------------------------------------------------------------------------------

Share capital

10,00,000

--- Content provided by​ FirstRanker.com ---


Land & Building



--- Content provided by‍ FirstRanker.com ---

5,00,000

Profit & Loss a/c

2,00,000

--- Content provided by‌ FirstRanker.com ---


Plant & Machinery

3,00,000

--- Content provided by​ FirstRanker.com ---

S.Creditors




--- Content provided by‌ FirstRanker.com ---


2,50,000

Stock

--- Content provided by FirstRanker.com ---

1,50,000

Bills payable

1,50,000

--- Content provided by‍ FirstRanker.com ---


Debtors'



--- Content provided by⁠ FirstRanker.com ---



1,50,000

Bills

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receivable 1,25,000

Cash

--- Content provided by‍ FirstRanker.com ---

in

hand

1,75,000

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Furniture

2,00,000

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


------------



--- Content provided by‍ FirstRanker.com ---





------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



16,00,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

16,00,000

-----------------------------------------------------------------------------------------------
12. Triveni Engineering Limited has the following capital structure:

--- Content provided by‌ FirstRanker.com ---



9% Preference shares of Rs.100 each


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10,00,000

--- Content provided by FirstRanker.com ---

Equity shares of Rs.10 each




--- Content provided by‌ FirstRanker.com ---




40,00,000

--- Content provided by‌ FirstRanker.com ---



------------


--- Content provided by⁠ FirstRanker.com ---




50,00,000

--- Content provided by‌ FirstRanker.com ---



------------


--- Content provided by FirstRanker.com ---


The following information relates to the financial year just ended:

Profit

--- Content provided by‌ FirstRanker.com ---

after

taxation

22,00,000

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Equity Dividend paid



--- Content provided by⁠ FirstRanker.com ---

20%

Market price of Equity shares

Rs.20 each

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You are required to find

(a) Dividend yield on equity shares

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(b) The cover for preference and equity dividend
(c) Earnings per share
(d) P/E ratio


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3.1.3.17 KEY TO SELF ASSESSMENT QUESTIONS (For Problems only)

Q.No.10:

Current ratio: 2:1; Debt equity ratio: 1:2 or 1:1.

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Q.No.11:

(i) 4 times; (ii) 100 days; (iii) 5 times; (iv) 0.83 times; (v)

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19.17%; (vi) 1.5:1; (vii) 20%; (viii) 77%.


Q.No.12:

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(a) 10%; (b) 24.4 times and 2.6 times (c) Rs.5.275; (d) 3.8 times.




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165


3.1.3.18 CASE ANALYSIS

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--- Content provided by‌ FirstRanker.com ---

The following figures are extracted from the Balance Sheets of a

Company:


--- Content provided by FirstRanker.com ---


2002-03 2003-04 2004-05



--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Rs.

--- Content provided by​ FirstRanker.com ---

Rs.

Rs.

Assets

--- Content provided by FirstRanker.com ---


Buildings



--- Content provided by‍ FirstRanker.com ---





12,000

--- Content provided by FirstRanker.com ---


10,000

20,000

--- Content provided by FirstRanker.com ---

Plant and Equipment



10,000

--- Content provided by‌ FirstRanker.com ---


15,000

10,000

--- Content provided by‌ FirstRanker.com ---

Stock




--- Content provided by​ FirstRanker.com ---




50,000

--- Content provided by⁠ FirstRanker.com ---

50,000

70,000

Debtors

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



30,000

50,000

--- Content provided by‍ FirstRanker.com ---


60,000

-----------------------------------------------
1,02,000 1,25,000 1,60,000

--- Content provided by​ FirstRanker.com ---

-----------------------------------------------

Liabilities

Paid up Capital (Rs.10 shares ?

--- Content provided by​ FirstRanker.com ---


56,000

56,000

--- Content provided by‍ FirstRanker.com ---

56,000

Rs.7-50 paid up)
Profit & Loss A/c

--- Content provided by FirstRanker.com ---





10,000

--- Content provided by⁠ FirstRanker.com ---


13,000

15,000

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Trade Creditors




--- Content provided by⁠ FirstRanker.com ---


11,000

26,000

--- Content provided by​ FirstRanker.com ---

39,000

Bank


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

25,000

30,000

50,000

--- Content provided by‍ FirstRanker.com ---


----------------------------------------------
1,02,000 1,25,000 1,60,000
----------------------------------------------

--- Content provided by⁠ FirstRanker.com ---

Sales

1,00,000 1,50,000 1,50,000

Gross Profit

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

25,000

30,000

25,000

--- Content provided by⁠ FirstRanker.com ---


Net Profit



--- Content provided by​ FirstRanker.com ---





5,000

--- Content provided by‍ FirstRanker.com ---


7,000

5,000

--- Content provided by​ FirstRanker.com ---

Dividend Paid




--- Content provided by‌ FirstRanker.com ---


4,000

4,000

--- Content provided by‍ FirstRanker.com ---

3,000




--- Content provided by FirstRanker.com ---


The opening stock at the beginning of the year 2002-03 was

Rs.4,000. As a financial analyst comment on the comparative short-term,

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166
activity, solvency, profitability and financial position of the company

--- Content provided by‍ FirstRanker.com ---

during the three year period.

Solution:


--- Content provided by⁠ FirstRanker.com ---


To test the short-term solvency the following ratios are calculated for

three years:

--- Content provided by‌ FirstRanker.com ---

i.

Current Ratio and

ii.

--- Content provided by FirstRanker.com ---


Quick Ratio


(i) Current Ratio:

--- Content provided by‌ FirstRanker.com ---


2002-03 2003-04 2004-05



--- Content provided by​ FirstRanker.com ---

Current Assets



80,000

--- Content provided by‌ FirstRanker.com ---


1,00,000

1,30,000

--- Content provided by​ FirstRanker.com ---

------------------------

-------- ----------- -----------

Current Liabilities

--- Content provided by​ FirstRanker.com ---




36,000

--- Content provided by‌ FirstRanker.com ---

56,000

89,000

2.22:1

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

1.80:1



1.46:1

--- Content provided by‍ FirstRanker.com ---


(ii) Quick Ratio:

2002-03 2003-04 2004-05

--- Content provided by‍ FirstRanker.com ---





Quick Assets (Debtors)

--- Content provided by⁠ FirstRanker.com ---


30,000

50,000

--- Content provided by‌ FirstRanker.com ---

60,000

--------------------------------- --------

--------

--- Content provided by‌ FirstRanker.com ---


--------



--- Content provided by‌ FirstRanker.com ---

Quick Liabilities (Creditors) 11,000

26,000

39,000

--- Content provided by‌ FirstRanker.com ---




2.7:1

--- Content provided by⁠ FirstRanker.com ---



1.9:1


--- Content provided by‌ FirstRanker.com ---


1.5:1



--- Content provided by​ FirstRanker.com ---

As the standard for Current Ratio is 2:1 the working capital position of

the company has weakened in the 2nd year and 3rd year. However the Quick

Ratio for all the three years is well above the standard of 1:1. Thus it can be said

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that the short term solvency position of the company shows a mixed trend.

Activity Ratios: To test the operational efficiency of the company the following

--- Content provided by⁠ FirstRanker.com ---

ratios are calculated. Debtors Turnover Ratio and Inventory Turnover Ratio.




--- Content provided by‌ FirstRanker.com ---


167

Debtors Turnover Ratio:

--- Content provided by‍ FirstRanker.com ---

2002-03 2003-04 2004-05



Sales

--- Content provided by FirstRanker.com ---


1,00,000 1,50,000 1,50,000

-------------------- ---------- ----------

--- Content provided by‍ FirstRanker.com ---

----------



Average Debtors

--- Content provided by⁠ FirstRanker.com ---




30,000

--- Content provided by​ FirstRanker.com ---

40,000

55,000


--- Content provided by​ FirstRanker.com ---


3.33

times

--- Content provided by​ FirstRanker.com ---

3.75

times

2.73

--- Content provided by‍ FirstRanker.com ---


times



--- Content provided by FirstRanker.com ---



The sales as a number of times of debtors has improved in the

year 2003-04 but has deteriorated in the year 2004-05.

--- Content provided by​ FirstRanker.com ---




Inventory Turnover Ratio:

--- Content provided by⁠ FirstRanker.com ---

2002-03 2003-04 2004-05




--- Content provided by‍ FirstRanker.com ---




Cost of Goods Sold (Sales ? G.P.) 75,000

--- Content provided by FirstRanker.com ---

1,20,000

1,25,000

----------------------------------------- ---------

--- Content provided by​ FirstRanker.com ---


----------

----------

--- Content provided by‍ FirstRanker.com ---





O.S + C.S

--- Content provided by‌ FirstRanker.com ---


27,000

50,000

--- Content provided by⁠ FirstRanker.com ---

60,000

Average Stock (--------------)


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





2

--- Content provided by​ FirstRanker.com ---


2.78 times

2.40 times

--- Content provided by‌ FirstRanker.com ---

2.08 times



Though there is no standard for Inventory Turnover Ratio, higher

--- Content provided by‍ FirstRanker.com ---


the ratio better is the activity level of the concern. From this angle the

Ratio has come down gradually during the three year period indicating

--- Content provided by⁠ FirstRanker.com ---

slow moving of stock.

Profitability Ratios: To analyse the profitability position of the company Gross

Profit Ratio and Net Profit Ratio are calculated.

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



168
Gross Profit Ratio:

--- Content provided by​ FirstRanker.com ---

2002-03 2003-04 2004-05



Gross Profit

--- Content provided by‌ FirstRanker.com ---




25,000

--- Content provided by​ FirstRanker.com ---

30,000

25,000

-------------- x 100

--- Content provided by⁠ FirstRanker.com ---


-----------

---------- ----------

--- Content provided by FirstRanker.com ---



Sales


--- Content provided by‍ FirstRanker.com ---




1,00,000

--- Content provided by⁠ FirstRanker.com ---

1,50,000

1,50,000


--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




25% 20% 16.7%

--- Content provided by⁠ FirstRanker.com ---

Net Profit Ratio:

2002-03 2003-04 2004-05


--- Content provided by FirstRanker.com ---



Net Profit


--- Content provided by FirstRanker.com ---




5,000

--- Content provided by​ FirstRanker.com ---

7,000

5,000

------------

--- Content provided by‍ FirstRanker.com ---


x

100 ---------- ---------- ----------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Sales

--- Content provided by‌ FirstRanker.com ---

1,00,000 1,50,000 1,50,000




--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




5% 4.7%

--- Content provided by​ FirstRanker.com ---

3.3%




--- Content provided by‌ FirstRanker.com ---

The profitability ratios show that there is steady decline in the

profitability of the concern during the period. One reason for this

declining profitability among others, is the low and decreasing inventory

--- Content provided by⁠ FirstRanker.com ---


turnover ratio.

Financial Position: Here the long term solvency position of the concern is

--- Content provided by‌ FirstRanker.com ---

analysed by calculating Debt/Equity Ratio and Debt/Asset Ratio.

Debt/Equity Ratio:

2002-03 2003-04 2004-05

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Debt



36,000

--- Content provided by FirstRanker.com ---


56,000

89,000

--- Content provided by⁠ FirstRanker.com ---

---------



--------

--- Content provided by FirstRanker.com ---


--------

--------

--- Content provided by‍ FirstRanker.com ---



Equity


--- Content provided by⁠ FirstRanker.com ---


66,000

69,000

--- Content provided by⁠ FirstRanker.com ---

71,000



0.545:1 0.812:1 1.254:1

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

169

Debt/Asset Ratio:

2002-03 2003-04 2004-05

--- Content provided by‍ FirstRanker.com ---





Debt

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

36,000

56,000

89,000

--- Content provided by​ FirstRanker.com ---


---------

---------- ----------- -----------

--- Content provided by​ FirstRanker.com ---



Assets

1,02,000 1,25,000

--- Content provided by​ FirstRanker.com ---


1,61,000



--- Content provided by‍ FirstRanker.com ---



0.35:1


--- Content provided by‌ FirstRanker.com ---


0.448:1



--- Content provided by‌ FirstRanker.com ---

0.556:1



Debt Equity Ratio expresses the existence of Debt for every Re.1 of

--- Content provided by‍ FirstRanker.com ---


Equity. From this standpoint the share of debt in comparison to equity is

increasing year after year and in the last year the debt is even more than equity.

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Debt Asset Ratio gives how much of assets have been acquired using debt funds.

The calculation of this ratio reveals that in the 1st year 35% of assets were

purchased using debt funds which has increased to 44.8% in the 2nd year and

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55.6% in the 3rd year. Thus both the ratios reveal that the debt component in the

capital structure is increasing which has for reaching consequences.

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3.1.3.19 BOOKS FOR FURTHER READING

1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.

2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.

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3. J.Made Gowda: Management Accounting, Himalaya Publishing House.

4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.

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5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting for Management,

S.Chand & Co. New Delhi.


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170
UNIT-III

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LESSON 3.2

-----------------------------------------------------------------------------------------------

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FUNDS FLOW ANALYSIS AND CASH FLOW ANALYSIS

------------------------------------------------------------------------------------------------


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3.2.1 INTRODUCTION



At the end of each accounting period, preparation and presentation of

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financial statements are undertaken with an objective of providing as much

information as possible for the public. The Balance Sheet presents a snapshot

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picture of the financial position at a given point of time and the Income

Statement shows a summary of revenues and expenses during the accounting

period. Though these are significant statements especially in terms of the

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principal goals of the enterprise, yet there is a need for one more statement

which will indicate the changes and movement of funds between two balance

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sheet dates which are not clearly mirrored in the Balance Sheet and Income

Statement. That statement is called as Funds Flow Statement. The analysis

which studies the flow and movement of funds is called as Funds Flow Analysis.

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Similarly one more statement has to be prepared known as Cash Flow

Statement. This requires the doing of Cash Flow Analysis. The focus of Cash

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Flow Analysis is to study the movement and flow of cash during the accounting

period. This lesson deals at length both the analyses.

3.2.2 OBJECTIVES

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After reading this lesson, the reader should be able to

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? Understand the concept of funds and flow;
? Evaluate the changes in working capital in an organisation;
? Ascertain the sources and uses of funds from a given financial

statement;

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? Prepare Fund Flow Statement.



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171

? Understand the concepts of Cash and Cash Flow.
? Understand the Cash Flow Analysis.
? Prepare Cash Flow Statement.

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3.2.3 CONTENTS

3.2.3.1

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Concept of Funds

3.2.3.2.

Flow of Funds

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3.2.3.3

Importance and Utility of Funds Flow Analysis

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3.2.3.4

Preparation of Funds Flow Statement

3.2.3.5

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Illustrations

3.2.3.6

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Meaning of Concepts of Cash, Cash Flow and Cash Flow

Analysis

3.2.3.7

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Cash Flow Statement

3.2.3.8

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Calculation of Cash from Operations

3.2.3.9

Utility of Cash Flow Analysis

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3.2.3.10 Cash Flow Analysis Vs Funds Flow Analysis

3.2.3.11 Illustrations

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3.2.3.12 Summary

3.2.3.13 Key Words

3.2.3.14 Self Assessment Questions

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3.2.3.15 Key to Self Assessment Questions

3.2.3.16 Case Analysis

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3.2.3.17 Books for Further Reading

3.2.3.1 CONCEPT OF FUNDS


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How are funds defined? Perhaps the most ambiguous aspect of funds

flow statement is understanding what is meant by funds. Unfortunately there is

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no general agreement as to precisely how funds should be defined. To a lay man

the concept of funds means `cash'. According to a few, `funds' mean `net

current monetary assets' arrived at by considering current assets (cash +

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172
marketable securities + short term receivables) minus short term obligations. A

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third view, which is the most acceptable one, is that concept of funds means

`Working Capital' and in this lesson the term `funds' is used in the sense of

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Working Capital.

WORKING CAPITAL CONCEPT OF FUNDS


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The excess of an enterprise's total current assets over its total current

liabilities at some point of time may be termed as its net current assets or

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Working Capital. To illustrate let us assume that on the balance sheet date the

total current assets of an enterprise are Rs.3,00,000 and its total current

liabilities are Rs.2,00,000. It working capital on that date will be Rs.3,00,000 ?

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Rs.2,00,000 = Rs.1,00,000. It follows from the above that any increase in total

current assets or any decrease in total current liabilities will result in a change in

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working capital.

3.2.3.2 FLOW OF FUNDS


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The term `flow' means change and therefore, the term `flow of funds'

means `change in funds' or `change in working capital'. According to

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Manmohan and Goyal, "the flow of funds" refers to movement of funds

described in terms of the flow in and out of the working capital area. In short,

any increase or decrease in Working Capital means `flow of funds'.

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Many transactions which take place in a business enterprise may increase

its working capital, may decrease it or may not effect any change in it. Let us

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consider the following examples.

(i) Purchased machinery for Rs.3,00,000: The effect of this transaction is that

working capital decreases by 3,00,000 as cash balance is reduced. This change

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(decrease) in working capital is called as application of funds. Here the accounts

involved are Current Assets (Cash a/c) and Fixed Asset (Machinery a/c).

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173

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(ii) Issue of share capital of Rs.10,00,000: This transaction will increase the

working capital as cash balance increases. This change (increase) in working

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capital is called as source of funds. Here the two accounts involved are current

assets (Cash a/c) and Long-Term Liability (Share Capital a/c).

(iii) Sold plant for Rs.3,00,000: This transaction will have the effect of

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increasing the working capital by Rs.3,00,000 as the cash balance increases by

Rs.3,00,000. It is a source of funds. Here the accounts involved are current

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assets (Cash a/c) and Fixed Assets (Plant a/c).

(iv) Redeemed debentures worth Rs.1,00,000: This transaction has the effect of

reducing the working capital, as the redemption of debentures results in

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reduction in cash balance. Hence this is an example of application of funds. The

two accounts affected by this transaction are Current Assets (Cash a/c) and

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Long-Term Liability (Debenture a/c).

(v) Purchased inventory worth Rs.10,000: This transaction results in decrease in

cash by Rs.10,000 and increase in stock by Rs.10,000 thereby keeping the total

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current assets at the same figure. Hence there will be no change in the Working

Capital (There is no flow of funds in this transaction). Both the accounts

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affected are Current Assets.

(vi) Notes payables drawn by creditors accepted for Rs.30,000: The effect of

this transaction on Working Capital is Nil as it results in increase in notes

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payable (a current liability) and decreases the creditors (another current

liability). Since there is no change in total current liabilities there is no flow of

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funds.

(vii) Building purchased for Rs.30,00,000 and payment is made by shares:

This transaction will not have any impact on working capital as it does not result

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in any change either in the current asset or in the current liability. Hence there is

no flow of funds. The two accounts affected are Fixed Assets (Building a/c) and

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Long Term Liabilities (Capital a/c).



174

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From the above series of examples, we arrive at the following rules on

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flow of funds.

I. There will be flow of funds only when there is a cross-transaction i.e., only

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when the transaction involves:

(i) Current Assets and Fixed Assets e.g., Purchase of Machinery for Cash

(application of funds) or Sale of Plant for a Cash (Source of funds).

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(ii) Current assets and capital, e.g., Issue of Shares (Source of funds).
(iii) Current Assets and Long Term Liabilities, e.g., Redemption of

Debentures in Cash (Application of Funds).

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(iv) Current Liabilities and Long-Term Liabilities, e.g., Creditors paid off in

Debentures or Shares (Source of funds).

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(v) Current Liabilities and Fixed Assets, e.g., Building transferred to

creditors in satisfaction of their claims (Source of funds).


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II. There will be no flow of funds when there is no cross transaction i.e., when

the transaction invoves:

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(i)

Current Assets and Current Assets, e.g., Inventory Purchased for
Cash.

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(ii)

Current Liabilities and Current Liabilities, e.g., Notes Payables
issued to Creditors.

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(iii)

Current Assets and Current Liabilities, e.g., Payments made to
Creditors.

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(iv)

Fixed Assets and Long Term Liabilities, e.g., Building purchased
and payment made in Shares or Debentures.

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(A) Sources and Application of Funds: The following are the main sources of

funds:

(i) Funds from Operations: The operations of the business generate revenue and

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entail expenses. Revenues augment working capital and expenses, other than

depreciation and other amortizations. The following adjustments will be

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required in the figures of net profit for finding out the real funds from

operations:


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175

-------------------------------------------------------------------------------------------------

Funds From Operations

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-------------------------------------------------------------------------------------------------
Net

Profit

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for

the

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year

x x x


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Add*: Depreciation of Fixed Assets

x


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x



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x



Preliminary expenses, goodwill, etc.

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Written

off

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x x x



Loss on sale of Fixed Assets

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x



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x



x

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Transfers

to

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Reserve

x x x

Less: Profit on sale or revaluation

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x



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x



x

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Dividends

received,

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etc.

x x x

Funds

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from

Operations x x x

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-------------------------------------------------------------------------------------------------
* These items are added as they do not result in outflow of funds. In case of `Net
Loss' for the year these items will be deducted.
-------------------------------------------------------------------------------------------------

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(ii) Issue of Share Capital: An issue of share capital results in an Inflow of
Funds.
(iii) Long-Term Borrowings: When a long-term loan is taken there is an
increase in working capital because of cash inflow. A short term loan, however,
does not increase the working capital because a short-term loan increases the

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current assets (cash) and the current liability (short term loan) by the same
amount, leaving the size of working capital unchanged.
(iv) Sale of Non-Current Assets: When a Fixed Asset or a Long-Term
Investment or any other Non-Current Asset is sold, there will be inflow
represented by cash or short-term receivables.

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(B) Uses of Funds: The following are the main uses of funds:


(i) Payment of Dividend: The transaction results in decrease in working capital

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owing to outflow of cash.

(ii) Repayment of Long-term Liability: The repayment of long-term loan
involves cash outflow and hence it is use of working capital. The repayment of a
current liability does not affect the amount of working capital because it entails

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an equal reduction in Current Liabilities and Current Assets.

(iii) Purchase of Non-Current Assets: When a firm purchases Fixed Assets or
other non-current assets, and if it pays cash or incurs a short-term debt, its
working capital decreases. Hence it is a use of funds.

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176
3.2.3.3 IMPORTANCE AND UTILITY OF FUNDS FLOW ANALYSIS

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Funds flow analysis provides an insight into the movement of funds and

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helps in understanding the change in the structure of assets, liabilities and

owners' equity. This analysis helps financial managers to find answers to

questions like:

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(i)

How far capital investment has been supported by long term
financing?

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(ii)

How far short-term sources of financing have been used to
support capital investment?

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(iii)

How much funds have been generated from the operations of a
business?

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(iv)

To what extent the enterprise has relied on external sources of
financing?

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(v)

What major commitments of funds have been made during the
year?

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(vi)

Where did profits go?

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(vii) Why were dividends not larger?
(viii) How was it possible to distribute dividends in excess of current

earnings or in the presence of a net loss during the current
period?

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(ix)

Why are the current assets down although the income is up?

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(x)

Has the liquidity position of the firm improved?

(xi)

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What accounted for an increase in net current assets despite a net
loss for the period?

(xii) How was the increase in working capital financed?

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3.2.3.4 PREPARATION OF FUNDS FLOW STATEMENT

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Two statements are involved in Funds Flow Analysis.

(i)

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Statement or Schedule of Changes in Working Capital

(ii)

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Statement of Funds Flow


(A) Statement of Changes in Working Capital: This statement when prepared

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shows whether the working capital has increased or decreased during two

Balance Sheet dates. But this does not give the reasons for increase or decrease

in working capital. This statement is prepared by comparing the current assets

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and the current liabilities of two periods. It may be shown in the following form:



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177



Schedule of Changes in Working Capital (Proforma)

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Items

As on

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As on

Change

Increase Decrease

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Current Assets



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Cash Balances
Bank Balnces
Marketable Securities
Stock in Trade

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Pre-paid Expenses


Current Liabilities

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Bank Overdraft
Outstanding Expenses
Accounts Payable
Provision for Tax
Dividend

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Increase / Decrease in




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Working Capital




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Any increase in current assets will result in increase in Working Capital

and any decrease in Current Assets will result in decrease in Working Capital.

Any increase in current liability will result in decrease in working capital and

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any decrease in current liability will result in increase in working capital.

(B) Funds Flow Statement: Funds Flow Statement is also called as Statement of

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Changes in Financial Position or Statement of Sources and Applications of

Funds or where got, where gone statement. The purpose of the funds flow

statement is to provide information about the enterprise's investing and

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financing activities. The activities that the funds flow statement describes can be

classified into two categories:

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(i)

activities that generate funds, called Sources, and

(ii)

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activities that involve spending of funds, called Uses.



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178
When the funds generated are more than funds used, we get an

increase in working capital and when funds generated are lesser than the

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funds used, we get decrease in working capital. The increase or decrease

in working capital disclosed by the schedule of changes in working

capital should tally with the increase or decrease disclosed by the Funds

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Flow Statement.

The Funds Flow Statement may be prepared either in the form of a

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statement or in `T' shape form. When prepared in the form of the

statement it would appear as follows:

Funds Flow Statement

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-----------------------------------------------------------------------------------------------
Sources of Funds
Issues

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of

Shares x x x

Issue

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of

Debentures

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x x x

Long

term

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borrowings x x x

Sale

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of

Fixed

Assets

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x x x

*Operating

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Profit



(Funds

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from

Operations)

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x x x

-------------------------------------------------
Total

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Sources

x x x

-------------------------------------------------

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Application of Funds


Redemption of Redeemable

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Preference

shares

x x x

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Redemption

of

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Debentures

x x x


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Payments for other long-term loans x



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x



x

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Purchase

of

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fixed

assets

x x x

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* Operation loss (Funds lost from x



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x



x

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Operations)

---------------------------------------

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Total

uses

x x x

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---------------------------------------

Net increase / decrease in working capital
(Total Sources ? Total uses)

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------------------------------------------------------------------------------------------------


When prepared in `T' shape form, the Funds Flow Statement would

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appear as follows:



179

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Funds Flow Statement

------------------------------------------------------------------------------------------------

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Sources

of

Funds

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Application

of

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Funds

------------------------------------------------------------------------------------------------

* Funds from operation

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x x x *Funds lost in operations



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x x x

Issue of shares


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x x x Redemption of Preference



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Shares




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x x x

Issue of Debentures

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x x x Redemption of Debentures

x x x

Long-term borrowings

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x x x Payment of other long-term



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Loans x

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x

x

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Sale of fixed assets

x x x Purchase of fixed assets


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x x x

* Decrease in working

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Payment of dividend, tax,

capital

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--- Content provided by FirstRanker.com ---

x x x etc.




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x x x

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Increase

in

working

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capital

x

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x

x


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------

------

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------------------------------------------------------------------------------------------------
*Only one figure will be there.

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It may be seen from the proforma that in the Funds Flow Statement

preparation, current assets and current liabilities are ignored. Attention is given

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only to change in fixed assets and fixed liabilities.

In this connection an important point about provision for taxation and

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proposed dividend is worth mentioning. These two may either be treated as

current liability or long-term liability. When treated as current liabilities they

will be taken to `schedule of changes in working capital' and thereafter no

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adjustment is required anywhere. If they are treated as long-term liabilities there

is no place for them in the schedule of changes in working capital. The amount

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of tax provided and dividend proposed during the current year will be added to

net profits to find the funds from operations. The amount of actual tax and

dividend paid will be shown as application of funds in the Funds Flow

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Statement. In this lesson, we have taken them as Current Liabilities.



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180

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3.2.3.5 ILLUSTRATIONS

Illustration 1: The mechanism of preparation of Funds Flow Statement is

proposed to be explained with the help of Annual Reports for the years 2003-04

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and 2004-05 pertaining to Arasu Limited.

ARASU LIMITED

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Balance Sheet as at 31st March 2005

Rs.`000

-------------------------------------------------------------------------------------------------

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2004-05 2003-04
-------------------------------------------------------------------------------------------------
I. Source of Funds
1.

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Share

Capital 1,40,00 1,40,00

2.

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Reserves

and

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Surplus

2,77,84 2,30,62

---------

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---------



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4,17,84 3,70,62

---------

---------

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II. Application of Funds
1. Fixed Assets

4,83,15

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4,61,23

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Less: Dep. Provision 2,57,85 2,25,30

2,27,36

2,33,87

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---------


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---------

2. Investments

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20,25

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20,30

3. Current Assets, Loans
and Advances
Inventories

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1,52,83



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1,92,54

Debtors


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51,41

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64,29

Cash and Bank

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1,40,80



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18,46

Loans & Advances

17,82

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14,73

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---------



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---------




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3,62,86

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2,90,02


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---------



---------

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Less: Current Liabilities
&

Provisions

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Liabilities



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89,81


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76,70

Provisions

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100,76


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96,87

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---------

---------


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1,90,57 1,73,57
---------

---------

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--- Content provided by⁠ FirstRanker.com ---





181

--- Content provided by FirstRanker.com ---


Net

Current

--- Content provided by FirstRanker.com ---

Assets

1,72,29 1,16,45

---------

--- Content provided by‌ FirstRanker.com ---


---------



--- Content provided by⁠ FirstRanker.com ---

(Working

Capital)

4,17,84 3,70,62

--- Content provided by​ FirstRanker.com ---


---------

---------

--- Content provided by‍ FirstRanker.com ---

-------------------------------------------------------------------------------------------------


Profit and Loss Account

--- Content provided by‍ FirstRanker.com ---

for the year ended 31st March 2005

Rs.`000

-------------------------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---

2004-05 2003-04
-------------------------------------------------------------------------------------------------
Income
Sales

--- Content provided by‍ FirstRanker.com ---

4,94,19 5,36,63

Other

income

--- Content provided by⁠ FirstRanker.com ---


2,35,73 2,57,64

------------------------------------
7,29,92 7,94,27

--- Content provided by‌ FirstRanker.com ---



------------------------------------

Expenditure

--- Content provided by​ FirstRanker.com ---



Opening Stock


--- Content provided by⁠ FirstRanker.com ---




20,45

--- Content provided by‍ FirstRanker.com ---



25,59


--- Content provided by‍ FirstRanker.com ---


Raw materials consumed



--- Content provided by​ FirstRanker.com ---

87,35



95,67

--- Content provided by FirstRanker.com ---


Packing

materials

--- Content provided by‌ FirstRanker.com ---

consumed

2,87,78 3,29,04


--- Content provided by‍ FirstRanker.com ---


Excise Duty



--- Content provided by⁠ FirstRanker.com ---



23,90


--- Content provided by⁠ FirstRanker.com ---


27,26

Expenses

--- Content provided by FirstRanker.com ---

1,65,38 1,29,94



Directors' Fees

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

11



10

--- Content provided by‌ FirstRanker.com ---




Interest

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


94



--- Content provided by⁠ FirstRanker.com ---

5,69

Depreciation


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

30,49




--- Content provided by⁠ FirstRanker.com ---


39,98

-------------------------------------
6,16,40 6,53,27

--- Content provided by⁠ FirstRanker.com ---



Less: Closing Stock


--- Content provided by‌ FirstRanker.com ---


19,06



--- Content provided by​ FirstRanker.com ---

20,45

------------------------------------
5,97,34 6,32,82
------------------------------------

--- Content provided by​ FirstRanker.com ---

Profit

before

Taxation

--- Content provided by‌ FirstRanker.com ---


1,32,58 1,61,45



--- Content provided by‍ FirstRanker.com ---

Provision for Income-tax



(64,36)

--- Content provided by⁠ FirstRanker.com ---




(82,40)

--- Content provided by⁠ FirstRanker.com ---

------------------------------------




--- Content provided by FirstRanker.com ---





68,22

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

79,05



Profit brought forward from

--- Content provided by⁠ FirstRanker.com ---




Previous year

--- Content provided by​ FirstRanker.com ---





12

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

1




--- Content provided by FirstRanker.com ---


------------------------------------



--- Content provided by​ FirstRanker.com ---

Balance




--- Content provided by​ FirstRanker.com ---




68,34

--- Content provided by‌ FirstRanker.com ---



79,06


--- Content provided by‌ FirstRanker.com ---




182

--- Content provided by⁠ FirstRanker.com ---


Provision for Taxation



--- Content provided by⁠ FirstRanker.com ---

Relating to Earlier Year




--- Content provided by⁠ FirstRanker.com ---


----

(46,27)

--- Content provided by‍ FirstRanker.com ---

Miscellaneous

Expenditure

Written

--- Content provided by​ FirstRanker.com ---


off



--- Content provided by‍ FirstRanker.com ---





----

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

(15,67)

---------------------------------


--- Content provided by⁠ FirstRanker.com ---

Balance available for



Appropriation

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



68,34

17,12

--- Content provided by​ FirstRanker.com ---


---------------------------------

Appropriations

--- Content provided by⁠ FirstRanker.com ---



General Reserve


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

47,25

3,00


--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Proposed Reserve for Appropriation

21,00

14,00

--- Content provided by‍ FirstRanker.com ---




---------------------------------

--- Content provided by FirstRanker.com ---





68,25

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



17,00

---------------------------------

--- Content provided by‌ FirstRanker.com ---



Balance carried over to next year


--- Content provided by​ FirstRanker.com ---


9

12

--- Content provided by‌ FirstRanker.com ---

-------------------------------------------------------------------------------------------------


For the above financial statements, Funds Flow Statement is prepared as

--- Content provided by FirstRanker.com ---

follows with necessary workings:

I. Calculation of Funds from Operations for the year 2004-05

(Rs.`000)

--- Content provided by‍ FirstRanker.com ---


Balance of Profit carried over to next year



--- Content provided by FirstRanker.com ---





9

--- Content provided by‍ FirstRanker.com ---


Add:



--- Content provided by FirstRanker.com ---

Provision

for

Depreciation

--- Content provided by FirstRanker.com ---


30,49

Transfer

--- Content provided by​ FirstRanker.com ---

to

General

Reserves

--- Content provided by⁠ FirstRanker.com ---


47,25



--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




-------

--- Content provided by​ FirstRanker.com ---

77,83
Less: Balance of Profit brought forward from previous year



--- Content provided by FirstRanker.com ---

12




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-------

Funds

--- Content provided by FirstRanker.com ---


from

operations 77,71

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-------

Note: Provision for income-tax and proposed dividend are taken as current

liabilities. Hence they are not added here. They will be taken to Schedule of

--- Content provided by FirstRanker.com ---


Changes in Working Capital.

II. Fixed Assets: From a perusal of schedule relating to `Fixed Assets' in the

--- Content provided by‍ FirstRanker.com ---

annual report, it is ascertained that there was a sale of fixed assets amounting to

Rs.16,62,000 and purchase of fixed assets to the tune of Rs.38,54,000. These


--- Content provided by⁠ FirstRanker.com ---


183

will be shown as source and application of funds respectively. (In examination

--- Content provided by‌ FirstRanker.com ---

problems information about, sale and purchase of assets can be ascertained by

preparing respective Asset Accounts).

III. Investments: A similar perusal of schedule relating to `investments' gives

--- Content provided by‍ FirstRanker.com ---


information that there was a redemption of investment amounting to Rs.5,000

which is a source of fund.

--- Content provided by‍ FirstRanker.com ---



Now the Schedule of Changes in Working Capital and Funds Flow

Statement are prepared.

--- Content provided by⁠ FirstRanker.com ---


ARASU LIMITED

Schedule of Changes in Working Capital 2004-05

--- Content provided by⁠ FirstRanker.com ---

(Rs.`000)

-------------------------------------------------------------------------------------------------
2003-04 2004-05 Increase Decrease
-------------------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---

Current Assets


Inventories

--- Content provided by⁠ FirstRanker.com ---

1,92,54

1,52,83

---

--- Content provided by FirstRanker.com ---


39,71



--- Content provided by‍ FirstRanker.com ---

Debtors

64,29

51,41

--- Content provided by⁠ FirstRanker.com ---


---

12,88

--- Content provided by‍ FirstRanker.com ---



Cash and Bank 18,46

1,40,80

--- Content provided by⁠ FirstRanker.com ---


1,22,34

---

--- Content provided by⁠ FirstRanker.com ---



Loans and
Advances 14,73

--- Content provided by⁠ FirstRanker.com ---

17,82

3,09

---

--- Content provided by‌ FirstRanker.com ---




----------------------------

--- Content provided by​ FirstRanker.com ---

(A) Total of
Current Assets 2,90,02

3,62,86

--- Content provided by‌ FirstRanker.com ---

-----------------------------
Current Liabilities


Creditors

--- Content provided by‍ FirstRanker.com ---


75,43

88,81

--- Content provided by FirstRanker.com ---

---

13,38

Unpaid

--- Content provided by​ FirstRanker.com ---




dividend

--- Content provided by​ FirstRanker.com ---

1,27

1,00

27

--- Content provided by FirstRanker.com ---


---



--- Content provided by FirstRanker.com ---

Provision for

Tax

82,87

--- Content provided by​ FirstRanker.com ---


79,76

3,11

--- Content provided by FirstRanker.com ---

---

Proposed


--- Content provided by‍ FirstRanker.com ---


Dividend

14,00

--- Content provided by FirstRanker.com ---

21,00

---

7,00

--- Content provided by FirstRanker.com ---


-----------------------------
(B) Total of Current 1,73,57

1,90,57

--- Content provided by​ FirstRanker.com ---


Liabilities

-----------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


184
Working
Capital (A)-(B)

--- Content provided by​ FirstRanker.com ---

1,16,45

1,72,29

---

--- Content provided by FirstRanker.com ---


---

Increase in Working
Capital

--- Content provided by‍ FirstRanker.com ---




55,84

--- Content provided by‌ FirstRanker.com ---

---

---

55,84

--- Content provided by⁠ FirstRanker.com ---


----------------------------------------------------------------
1,72,29 1,72,29 1,28,81 1,28,81
------------------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---


ARASU LIMITED

Funds Flow Statement 2004-04

--- Content provided by⁠ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Sources Applications
-------------------------------------------------------------------------------------------------


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Rs.



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Rs.

--- Content provided by‍ FirstRanker.com ---


Funds from Operations

77,71 Purchase of Fixed Assets

--- Content provided by⁠ FirstRanker.com ---



38,54

Sale of Fixed Assets

--- Content provided by​ FirstRanker.com ---


16,62 Increase in Working Capital

55,84

--- Content provided by FirstRanker.com ---

Redemption of Investment 5
-------

-------

--- Content provided by‍ FirstRanker.com ---



94,38

94,38

--- Content provided by‌ FirstRanker.com ---


-------------------------------------------------------------------------------------------------


It may be seen from the above statement that Sources amount to

--- Content provided by‌ FirstRanker.com ---


Rs.94,38,000 and Applications amount to Rs.38,54,000, thereby resulting in an
increase in Working Capital amounting to Rs.55,84,000. This figure tallies with
the increase in working capital as shown by the Schedule of Changes in
Working Capital.

--- Content provided by FirstRanker.com ---

Illustration 2: The Balance Sheet of Mathi Limited for two years were as
follows:
-------------------------------------------------------------------------------------------------
Liabilities

--- Content provided by⁠ FirstRanker.com ---

Assets

-------------------------------------------------------------------------------------------------


--- Content provided by FirstRanker.com ---





2004 2005

--- Content provided by⁠ FirstRanker.com ---




2004 2005

--- Content provided by FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Share Capital

40,000 60,000

--- Content provided by‌ FirstRanker.com ---

Land &

27,700 56,600


--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Buildings

Share Premium

--- Content provided by‍ FirstRanker.com ---

4,000 6,000

Plant &

17,800 25,650

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Machinery

--- Content provided by FirstRanker.com ---

General Reserve

3,000 4,500

Furniture

--- Content provided by‌ FirstRanker.com ---


1,200 750

Profit & Loss A/c

--- Content provided by FirstRanker.com ---

9,750 10,400

Stock

11,050 13,000

--- Content provided by FirstRanker.com ---


5% Debentures

--- 13,000

--- Content provided by FirstRanker.com ---

Debtors

18,250 19,550


--- Content provided by‌ FirstRanker.com ---





185

--- Content provided by‌ FirstRanker.com ---



Creditors


--- Content provided by⁠ FirstRanker.com ---


16,750 18,200

Bank

--- Content provided by‌ FirstRanker.com ---

2,400 2,000

Provision for

4,900 5,450

--- Content provided by​ FirstRanker.com ---


Taxation



--- Content provided by​ FirstRanker.com ---

-----------------------

------------------------


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

78,400 1,17,550



78,400 1,17,550

--- Content provided by‌ FirstRanker.com ---


-------------------------------------------------------------------------------------------------

Additional Information

--- Content provided by‌ FirstRanker.com ---

Depreciation written off during the year was:

Plant

and

--- Content provided by‍ FirstRanker.com ---


Machinery



--- Content provided by​ FirstRanker.com ---

Rs.6,400




--- Content provided by FirstRanker.com ---




Furniture

--- Content provided by‌ FirstRanker.com ---

Rs.200

Prepare: A Schedule of Changes in Working Capital and A Statement of Sources

and Application of Funds.

--- Content provided by​ FirstRanker.com ---




Schedule of Changes in Working Capital

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------




--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





Working Capital

--- Content provided by FirstRanker.com ---


2004

2005

--- Content provided by​ FirstRanker.com ---

Increase Decrease




--- Content provided by​ FirstRanker.com ---




Rs.

--- Content provided by‍ FirstRanker.com ---



Rs.

Rs.

--- Content provided by‌ FirstRanker.com ---


Rs.

-------------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---

Current Assets

Stock

11,050

--- Content provided by‌ FirstRanker.com ---


13,000

1,950

--- Content provided by​ FirstRanker.com ---



Debtors 18,250

19,550

--- Content provided by‌ FirstRanker.com ---


1,300



--- Content provided by‌ FirstRanker.com ---

Bank




--- Content provided by​ FirstRanker.com ---


2,400 2,000



--- Content provided by⁠ FirstRanker.com ---

400

-----------------------
(A)

--- Content provided by​ FirstRanker.com ---

31,700

34,550

-----------------------

--- Content provided by‍ FirstRanker.com ---


Current Liabilities

Creditors

--- Content provided by⁠ FirstRanker.com ---

16,750

18,200

1,450

--- Content provided by​ FirstRanker.com ---




Provision for Taxation

--- Content provided by‌ FirstRanker.com ---

4,900 5,450



550

--- Content provided by FirstRanker.com ---


-----------------------
(B)

21,650

--- Content provided by FirstRanker.com ---


23,650

-----------------------
Working Capital (A) ? (B)

--- Content provided by‍ FirstRanker.com ---


10,050 10,900

Increase in Working Capital

--- Content provided by​ FirstRanker.com ---

850




--- Content provided by‌ FirstRanker.com ---


850

----------------------------------------------------
10,900

--- Content provided by‍ FirstRanker.com ---


10,900



--- Content provided by‌ FirstRanker.com ---

3,250

3,250

----------------------------------------------------

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------



186

--- Content provided by⁠ FirstRanker.com ---

Calculation of Funds from Operations


Profit and Loss a/c as on 31-12-2005

--- Content provided by FirstRanker.com ---





10,400

--- Content provided by​ FirstRanker.com ---


Add:

Transfer

--- Content provided by‍ FirstRanker.com ---

to

Reserve


--- Content provided by​ FirstRanker.com ---




1,500

--- Content provided by FirstRanker.com ---



Depreciation ?

Plant & Machinery

--- Content provided by​ FirstRanker.com ---


6,400

Furniture

--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

200

---------


--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

18,500




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Less: P&L a/c as on 1-1-2005

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


9,750

---------

--- Content provided by⁠ FirstRanker.com ---



Funds

from

--- Content provided by⁠ FirstRanker.com ---


Operations



--- Content provided by FirstRanker.com ---

8,750

---------

Land & Building A/c

--- Content provided by‌ FirstRanker.com ---


-------------------------------------------------------------------------------------------------
To Balance b/d


--- Content provided by‍ FirstRanker.com ---


27,700

By Balance c/d

--- Content provided by⁠ FirstRanker.com ---

56,600

To Bank Purchase


--- Content provided by FirstRanker.com ---


28,900

(Balancing figure)

--- Content provided by FirstRanker.com ---



--------

---------

--- Content provided by⁠ FirstRanker.com ---




56,600

--- Content provided by​ FirstRanker.com ---

56,600

--------

---------

--- Content provided by‌ FirstRanker.com ---




-------------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---

Plant & Machinery A/c
-------------------------------------------------------------------------------------------------
To Balance b/d


--- Content provided by‌ FirstRanker.com ---


17,800

By Depreciation

--- Content provided by‌ FirstRanker.com ---

6,400

To Bank Purchase


--- Content provided by‌ FirstRanker.com ---


14,250

By Balance c/d

--- Content provided by‍ FirstRanker.com ---

25,650

(Balancing figure)


--- Content provided by‍ FirstRanker.com ---


--------

---------

--- Content provided by​ FirstRanker.com ---



32,050

32,050

--- Content provided by FirstRanker.com ---


--------

---------

--- Content provided by​ FirstRanker.com ---



-------------------------------------------------------------------------------------------------

Furniture A/c

--- Content provided by⁠ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
To Balance b/d



--- Content provided by FirstRanker.com ---

1,200

By Depreciation

200

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




By Bank ? Sale

--- Content provided by‌ FirstRanker.com ---

250

(Balancing

figure)

--- Content provided by⁠ FirstRanker.com ---


By

Balance

--- Content provided by FirstRanker.com ---

c/d




--- Content provided by‍ FirstRanker.com ---




750

--- Content provided by‌ FirstRanker.com ---

-------




--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


-------



--- Content provided by FirstRanker.com ---

1,200




--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


1,200

-----------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---



187

Statement of Sources and Application of Funds

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Sources



--- Content provided by​ FirstRanker.com ---

Rs.




--- Content provided by​ FirstRanker.com ---


Applications Rs.

-------------------------------------------------------------------------------------------------
Funds from Operations

--- Content provided by FirstRanker.com ---


8,750

Purchase of Land & 28,900

--- Content provided by FirstRanker.com ---

Share Capital

20,000

Buildings

--- Content provided by FirstRanker.com ---


Share Premium



--- Content provided by​ FirstRanker.com ---

2,000

Purchase of Plant & 14,250

Debentures

--- Content provided by⁠ FirstRanker.com ---




13,000

--- Content provided by​ FirstRanker.com ---

Increase in working 850

Sale of Furniture


--- Content provided by‍ FirstRanker.com ---


250

capital

--- Content provided by‌ FirstRanker.com ---

---------

--------


--- Content provided by‍ FirstRanker.com ---


44,000

44,000

--- Content provided by FirstRanker.com ---

--------

--------


--- Content provided by⁠ FirstRanker.com ---


-------------------------------------------------------------------------------------------------

3.2.3.6 MEANING OF CONCEPTS OF CASH, CASH FLOW AND
CASH FLOW ANALYSIS

--- Content provided by⁠ FirstRanker.com ---





While explaining the concept of `fund' it was mentioned that in a

--- Content provided by‍ FirstRanker.com ---


narrower sense the term `fund' is also used to denote cash. The term `cash' in

the context of cash flow analysis stands for cash and bank balances. Cash flow

--- Content provided by​ FirstRanker.com ---

refers to the actual movement of cash in and out of an organisation. When cash

flows into the organisation it is called cash inflow or positive cash flow. In the

same way when cash flows out of the organisation, it is called cash outflow or

--- Content provided by​ FirstRanker.com ---


negative cash flows. Cash flow analysis is an analysis based on the movement of

cash and bank balances. Under cash flow analysis, all movements of cash would

--- Content provided by FirstRanker.com ---

be considered.

3.2.3.7 CASH FLOW STATEMENT


--- Content provided by‍ FirstRanker.com ---


A cash flow statement is a statement depicting changes in cash position

from one period to another i.e. the result of cash flow analysis is given in the

--- Content provided by‍ FirstRanker.com ---

cash flow statement. For example if the cash balance of a concern as per its

Balance Sheet as on 31st March 2004 is Rs.90,000 and the cash balance as per its

Balance Sheet as on 31st March 2005 is Rs.1,20,000, there has been an inflow of

--- Content provided by​ FirstRanker.com ---


cash of Rs.30,000 in the year 2004-05 as compared to the year 2003-04. The



--- Content provided by FirstRanker.com ---

188
cash flow statement explain the reasons for such inflows or outflows of cash as

the case may be.

--- Content provided by FirstRanker.com ---



Normally the following are principal sources of inflows of cash:

(i)

--- Content provided by‍ FirstRanker.com ---


Issue of shares and debentures for cash

(ii)

--- Content provided by⁠ FirstRanker.com ---

Sale of fixed assets and investments for cash

(iii)

Borrowings from banks and other financial institution

--- Content provided by⁠ FirstRanker.com ---


(iv)

Cash from operations

--- Content provided by‌ FirstRanker.com ---

Outflows of cash generally include:

(i)

Redemption of shares and debentures by cash

--- Content provided by‌ FirstRanker.com ---


(ii)

Purchase of fixed assets and investments by cash

--- Content provided by‌ FirstRanker.com ---

(iii)

Repayment of loans

(iv)

--- Content provided by​ FirstRanker.com ---


Cash lost in operations



--- Content provided by⁠ FirstRanker.com ---

The following is the format of a cash flow statement:

Cash Flow Statement for the year ending say 31st March 2005

-------------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---


Balance as on 1-4-2004



--- Content provided by​ FirstRanker.com ---



Balance as on 1-4-2004


--- Content provided by​ FirstRanker.com ---


Cash in hand

x x x

--- Content provided by FirstRanker.com ---

Bank overdraft (if any)

x x x


--- Content provided by‍ FirstRanker.com ---


Cash at Bank

x x x

--- Content provided by⁠ FirstRanker.com ---



Add: Cash

Inflows:

--- Content provided by FirstRanker.com ---


Cash Outflows:

Here

--- Content provided by‍ FirstRanker.com ---

the

items

mentioned

--- Content provided by⁠ FirstRanker.com ---


Here

the

--- Content provided by‌ FirstRanker.com ---

items

mentioned

as sources of cash inflows

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

as outflows of cash above

above will be recorded


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

will be recorded


Balance as on 31-3-2005

--- Content provided by‌ FirstRanker.com ---



Balance as on 31-3-2005


--- Content provided by⁠ FirstRanker.com ---


Bank overdraft (if any)x x x



--- Content provided by FirstRanker.com ---

Cash in hand

x x x


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Cash at Bank

--- Content provided by⁠ FirstRanker.com ---

x x x

------

------

--- Content provided by​ FirstRanker.com ---




x

--- Content provided by‍ FirstRanker.com ---

x

x


--- Content provided by‌ FirstRanker.com ---


x

x

--- Content provided by‌ FirstRanker.com ---

x



------

--- Content provided by FirstRanker.com ---


------

-------------------------------------------------------------------------------------------------
The Accounting Standard 3 issued by the Institute of Chartered Accountants of

--- Content provided by​ FirstRanker.com ---


India requires the companies to prepare Cash Flow Statement and present them

as part of their Annual Reports.

--- Content provided by⁠ FirstRanker.com ---





189

--- Content provided by​ FirstRanker.com ---


3.2.3.8 CALCULATION OF CASH FROM OPERATIONS



--- Content provided by FirstRanker.com ---

The important step in the preparation of cash flow statement is the

calculation of cash from operations. It is calculated as follows:


--- Content provided by⁠ FirstRanker.com ---


The first step in the calculation of cash from operations is the calculation

of funds from operations (which is already explained in the lesson on Funds

--- Content provided by​ FirstRanker.com ---

Flow Analysis). To the funds from operations the decrease in current assets and

increase in current liabilities will be added (except cash, Bank and Bank O.D.).

From the added total increase in current assets and decrease in current liabilities

--- Content provided by​ FirstRanker.com ---


will be deducted (except cash, Bank and Bank O.D.). The resultant figure is cash

from operations (Refer Illustration 3).

--- Content provided by​ FirstRanker.com ---

Proforma of Cash from Operations Statement

Funds from Operations or Funds lost from operations


--- Content provided by FirstRanker.com ---


x x x x

Add:

--- Content provided by⁠ FirstRanker.com ---

Decrease

in

current

--- Content provided by FirstRanker.com ---


assets

x

--- Content provided by‍ FirstRanker.com ---

x

x

x

--- Content provided by⁠ FirstRanker.com ---


Increase

in

--- Content provided by‌ FirstRanker.com ---

current

liabilities

x

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x

x

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x




--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






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--------


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x x x x


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--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



--------

Less: Inecrease in current assets

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--- Content provided by FirstRanker.com ---

x x x



Decrease in current liabilities

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x x x

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------

x

x

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x

x

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--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

--------

Cash from operations or cash lost from operations


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--------



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As in the case of Fund Flow Analysis here also we assume Provision for

Taxation and Proposed Dividend as current liabilities.

3.2.3.9 UTILITY OF CASH FLOW ANALYSIS

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Cash flow analysis yields the following advantages:

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(i)

It is very helpful in understanding the cash position of the firm.

This would enable the management to plan and coordinate the

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financial operations properly.



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190
(ii)

Since it provides information about cash which would be

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available from operations the management would be in a position

to plan repayment of loans, replacement of assets, etc.

(iii)

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It throws light on the factors contributing to the reduction of cash

balance inspite of increase in income and vice versa.

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(iv)

A comparison of the cash flow statement with the cash budget for

the same period helps in comparing and controlling cash inflows

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and cash outflows.

However cash flow analysis is not without limitations. The cash

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balance as disclosed by the cash flow statement may not represent the

real liquid position of the business since it can be easily influenced by

postponing purchases and other payments. Further cash flow statement

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cannot replace the income statement or funds flow statement. Each of

them has a separate function to perform.

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3.2.3.10 CASH FLOW ANALYSIS Vs FUNDS FLOW ANALYSIS

(i)

A cash flow statement is concerned only with the changes in cash

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position while funds flow analysis is concerned with changes in

working capital position between two balance sheet dates.

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(ii)

Cash flow analysis is a tool of short-term financial analysis while

the funds flow analysis is comparatively a long-term one.

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(iii)

Cash is part of working capital and therefore an improvement in

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cash position results in improvement in the funds position but not

vice versa. In other words "inflows of cash" results in "inflow of

funds" but inflow of funds may not necessarily result in "inflow

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of cash".

(iv)

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In funds flow analysis, the changes in various current assets and

current liabilities are shown in a separate statement called

schedule of changes in working capital in order to ascertain the

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191

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net increase or decrease in working capital. But in cash flow

analysis, such changes are adjusted to funds from operations in

order to ascertain cash from operations.

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3.2.3.11 ILLUSTRATIONS

Illustration 3: From the following balances calculate cash from operations:

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--- Content provided by‌ FirstRanker.com ---

December

31


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2004

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--- Content provided by​ FirstRanker.com ---


2005

Profit and Loss A/c Balance

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75,000

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1,55,000

Debtors

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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

45,000

42,000

Creditors

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--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


20,000

26,000

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Bills Receivable




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--- Content provided by‍ FirstRanker.com ---

12,000

15,000

Cash in hand

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--- Content provided by​ FirstRanker.com ---





2,500

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3,000

Prepaid expenses

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--- Content provided by⁠ FirstRanker.com ---




1,600

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1,400

Bills Payable


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18,000

16,000

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Cash at Bank



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8,000

10,000

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Outstanding expenses




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1,200

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1,600

Income received in advance


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250 300

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Outstanding Income




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800 900

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Additional information:

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(i)

Depreciation written off during the year Rs.10,000

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(ii)

Transfer to General Reserve Rs.10,000

Calculation of Funds from Operations

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Rs.

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Profit & Loss A/c as on 31st

December

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2005

1,55,000

Add:

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Depreciation



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10,000

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Transfer

to

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General

Reserve


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--- Content provided by​ FirstRanker.com ---

10,000

-----------


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1,75,000
Less: P & L a/c as on 1st January 2005


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--- Content provided by‍ FirstRanker.com ---

75,000

-----------


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Funds

from

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Operations 1,00,000

-----------


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192
Calculation of Cash from Operations

Funds

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from

Operations 1,00,000

Add: Decrease in Current Assets

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Decrease

in

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Debtors




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--- Content provided by‌ FirstRanker.com ---



3,000


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Decrease in Prepaid Expenses



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200

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--- Content provided by⁠ FirstRanker.com ---

Increase in Current Liabilities

Increase

in

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Creditors



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6,000

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Increase in Outstanding Expenses


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400



Increase in Income Received in Advance

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--- Content provided by⁠ FirstRanker.com ---

50

-----------


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1,09,650
Less: Increase in Current Assets

Increase

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in

Bills

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Receivables

3,000


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Increase in Outstanding Income



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100



Decrease in Current Liabilities

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Decrease

in

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Bills

Payable

2,000

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-------



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--- Content provided by‍ FirstRanker.com ---




5,100

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-----------



Cash

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from

Operations

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1.04,550

-----------
Note: Decrease in current assets means current assets are converted into cash
and increase in current liabilities results in further generation of cash. Hence

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they are added. Increase in current assets and decrease in current liabilities result
in outflow of cash. Hence they are deducted.


Illustration 4: Balance Sheets of Somy Thomas as on 1-1-2005 and 31-12-2005

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were as follows:
-------------------------------------------------------------------------------------------------

Liabilities

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2004

2005

Assets

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2004

2005

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--- Content provided by FirstRanker.com ---


Rs.

Rs.

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Rs.

Rs.

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-------------------------------------------------------------------------------------------------
Credits

40,000

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44,000

Cash

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10,000



7,000

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Bills payable

25,000

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---

Debtors

30,000 50,000

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Loans from Bank

40,000

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50,000 Stock

35,000 25,000


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193


Capital 1,25,000 1,53,000 Machinery

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80,000 55,000




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Land

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40,000 50,000



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Building

35,000 60,000


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-----------------------------

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-------------------------


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2,30,000 2,47,000

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2,30,000 2,47,000




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------------------------------

--------------------------

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-------------------------------------------------------------------------------------------------



During the year, a machine costing Rs.10,000 (accumulated depreciation

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Rs.3,000) was sold for Rs.5,000. The provision for depreciation against
machinery as on 1-1-2005 was Rs.25,000 and 31-12-2005 it was Rs.40,000. Net
profit for the year 2005 amounted to Rs.45,000. Prepare Cash Flow Statement.

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Calculation of Cash from Operations




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--- Content provided by FirstRanker.com ---




Rs.

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Net Profit for the year 2005


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45,000

Add: Addition to Provision for Depreciation


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18,000



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Loss of Sale of Machinery




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2,000

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---------



Funds

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from

Operations

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65,000

Add:

Decrease

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in

Stock

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10,000

Increase

in

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Creditors



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4,000

--------

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79,000
Less: Increase

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in

Debtors

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20,000



Decrease in Bills Payable

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25,000

--------

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45,000

--------


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Cash

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from

Operations

34,000

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--------



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194

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Capital A/c

-------------------------------------------------------------------------------------------------

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To Drawings

17,000

By Balance b/d

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1,25,000

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(Balancing figure)
To Balance c/d

1,53,000

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By Net Profit for the year

45,000

---------- ----------

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1,70,000 1,70,000
---------- ----------

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-------------------------------------------------------------------------------------------------

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Machinery A/c

-------------------------------------------------------------------------------------------------
To Balance b/d

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1,05,000

By Bank Sale

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5,000

(80000 + 25000)

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--- Content provided by​ FirstRanker.com ---


By Provision for Dep. 3,000



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--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

By P&L a/c ? Loss 2,000

By

Balance

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c/d



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95,000

---------- (55000 + 40000)

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----------

1,05,000 1,05,000
---------- ----------

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-------------------------------------------------------------------------------------------------

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Provision for Depreciation A/c

-------------------------------------------------------------------------------------------------

To Machinery a/c

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3,000

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By Balance b/d

25,000

(Dep. on machinery sold)

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--- Content provided by FirstRanker.com ---

By P&L a/c




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To Balance c/d



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40,000

Dep. for the current year 18,000


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--------


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

--------




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

43,000




--- Content provided by‌ FirstRanker.com ---




43,000

--- Content provided by‌ FirstRanker.com ---

--------




--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




--------

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-------------------------------------------------------------------------------------------------


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--- Content provided by​ FirstRanker.com ---


195



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Cash Flow Statement

-------------------------------------------------------------------------------------------------
Cash as on 1-1-2005 10,000
Add:

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Inflows Cash

Outflows:

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Cash

from

Operations

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34,000

Drawings

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17,000

Loan from Bank


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10,000

Purchase of Land

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10,000

Sale of Machinery


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5,000

Purchase of Building 25,000

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Cash

as

on

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31-12-2005

7,000

--- Content provided by‌ FirstRanker.com ---

--------

--------


--- Content provided by⁠ FirstRanker.com ---


59,000

59,000

--- Content provided by‌ FirstRanker.com ---

--------

--------


--- Content provided by FirstRanker.com ---


-------------------------------------------------------------------------------------------------

3.2.3.12 SUMMARY

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A funds flow statement officially called a statement of changes in

financial position, provides information about an enterprise's investing and

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financing activities during the accounting period. Though there are many

concepts of funds, the working capital concept of funds has been used in this

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lesson. Flow of funds results only when there is a cross transaction i.e. only

when a transaction involves a fixed asset or liability and a current asset or

liability. The main sources of funds are: funds from operations, issue of shares

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and debentures and sale of non-current assets. The main uses of funds are

repayment of long-term liabilities including redemption of preference shares and

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debentures, purchase of non-current assets and payment of dividends. Funds

flow statement helps the financial analyst in having a more detailed analysis and

understanding of changes in the distribution of sources between two balance

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sheet dates. In addition to funds flow statement concerns are also preparing cash

flow statement which is the outcome of cash flow analysis. Cash flow analysis is

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based on the movement of cash and bank balances and the cash flow statement

is a statement depicting changes in cash position from one period to another

period.

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196
3.2.3.13 KEY WORDS

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Working Capital: Working capital is that part of capital used for the purposes of

day-to-day operations of a business.

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Fund: Fund refers to the long term capital used for financing current assets. It

can be ascertained by finding the difference between Current Assets and Current

Liabilities.

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Flow of Funds: Flow refers to transactions which change the size of fund in an

organisation. The flow transactions are divided into uses and sources. While the

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former refers to those transactions which reduce the funds, the latter increases

the size of fund.

Cash: Cash refers to cash and bank balances.

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Cash Flow: Cash flow refers to the actual movement of cash in and out of an

organisation.

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3.2.3.14 SELF ASSESSMENT QUESTIONS

1. What do you mean by working capital concept of funds?
2. Explain the significance of funds flow analysis and cash flow analysis.
3. Distinguish between schedule of changes in working capital and funds flow

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statement.

4. Distinguish between cash flow analysis and funds flow analysis.
5. Shyam and Company has the following information for the year ending 31st

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March 2005:

Sales

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Rs.5,000

Depreciation


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Rs. 450

Other operating expenses

--- Content provided by FirstRanker.com ---

Rs.4,100




--- Content provided by‌ FirstRanker.com ---




You are required to:
(i)

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Estimate the amount of funds generated during the year.

(ii)

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If the amount of depreciation increases to Rs.9,000 what would
be its effect on funds generated during the year.

(iii)

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Under what circumstances can the funds from operation be zero?




--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

197

6. From the following balance sheets of Damodar Ltd as on 31st December

2004 and 2005 you are required to prepare:

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(i)

A schedule of changes in working capital

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(ii)

A funds flow statement
Assets

--- Content provided by FirstRanker.com ---





2004

--- Content provided by‌ FirstRanker.com ---


2005


Goodwill

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12,000

12,000

--- Content provided by‌ FirstRanker.com ---

Building 40,000

36,000

Plant

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37,000

36,000

--- Content provided by⁠ FirstRanker.com ---

Investments

10,000

11,000

--- Content provided by‌ FirstRanker.com ---


Stock

30,000

--- Content provided by FirstRanker.com ---

23,400



Bills Receivable

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

2,000

3,200

Debtors 18,000

--- Content provided by​ FirstRanker.com ---


19,000



--- Content provided by FirstRanker.com ---

Cash at Bank



6,600

--- Content provided by‍ FirstRanker.com ---


15,200



--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-----------------------------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

1,55,600 1,55,800




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-----------------------------------


--- Content provided by⁠ FirstRanker.com ---

Liabilities




--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

2004

2005


--- Content provided by‌ FirstRanker.com ---

Share

capital

1,00,000 1,00,000

--- Content provided by​ FirstRanker.com ---




General Reserve

--- Content provided by​ FirstRanker.com ---





14,000

--- Content provided by⁠ FirstRanker.com ---


18,000



--- Content provided by‍ FirstRanker.com ---

Creditors




--- Content provided by FirstRanker.com ---




8,000

--- Content provided by FirstRanker.com ---

5,400



Bills Payable

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

1,200

800


--- Content provided by‌ FirstRanker.com ---


Provision for Taxation



--- Content provided by FirstRanker.com ---

16,000

18,000


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Provision for doubtful debts 400

600

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Profit & Loss A/c


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16,000

--- Content provided by⁠ FirstRanker.com ---

13,000

---------------------------------
1,55,600 1,55,800

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Additional information:

(i)

Depreciation charged on plant was Rs.4,000 and on building

--- Content provided by​ FirstRanker.com ---

Rs.4,000.

(ii)

Provision for taxation Rs.19,000.

--- Content provided by⁠ FirstRanker.com ---


(iii)

Interim dividend of Rs.8,000 was paid during the year 2005.

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


198
7. The financial position of Subhulakshmi Ltd on 1-1-2005 and 31-12-2005

was as follows:

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-------------------------------------------------------------------------------------------------

Liabilities

--- Content provided by⁠ FirstRanker.com ---

2004 2005

Assets 2004

2005

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



Rs. Rs. Rs. Rs.

-------------------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---

Current Liabilities



72,000 82,000

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Cash 8,000 7,200

Loan from Rosary

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40,000

--- Content provided by‌ FirstRanker.com ---


Debtors 70,000 76,800

Ltd.

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Stock 50,000 44,000

Loan from Gayatri

--- Content provided by FirstRanker.com ---




60,000 50,000

--- Content provided by‌ FirstRanker.com ---

Land 40,000 60,000

Ltd.

Buildings

--- Content provided by​ FirstRanker.com ---


1,00,000

1,10,000

--- Content provided by‍ FirstRanker.com ---

Capital & Reserves 2,96,000 2,98,000

Machinery 1,60,000 1,72,000

----------------------

--- Content provided by‍ FirstRanker.com ---


-------------------------



--- Content provided by‍ FirstRanker.com ---





4,28,000 4,70,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

4,28,000 4,70,000

----------------------

-------------------------

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-------------------------------------------------------------------------------------------------


During the year Rs.52,000 were paid as dividends. The provision for

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depreciation against machinery as on 1-1-2005 was Rs.54,000 and on 31-12-
2005 was Rs.72,000. Prepare a Cash Flow Statement.

3.2.3.15 KEY TO SELF ASSESSMENT QUESTIONS (FOR

--- Content provided by‍ FirstRanker.com ---

PROBLEMS ONLY)

Q.No.5:

(i) Rs.900; (ii) Rs.900; (iii) When other operating expenses are

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increased to Rs.5,000 or sales decreased to Rs.4,100 without any
decrease in other operating expenses.

Q.No.6:

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Increase in working capital Rs.5,000; Funds from Operations
Rs.17,000.

Q.No.7:

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Funds from Operations Rs.72,000; Cash from Operations

Rs.81,200.


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3.2.3.16 CASE ANALYSIS



Given below are the Balance Sheets of Bharathy Ltd for a period of three

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years as at 31st March each. Rs. in Lakhs



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2003 2004

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2005

Liabilities

Share capital in equity shares of Rs.10 each

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30

35

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35

General

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Reserve

10

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15

18

Surplus

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5



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8



9

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199

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13%

Debentures

10

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5

--- Content provided by‌ FirstRanker.com ---

10

Bank

Credit

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5

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10

15

Trade

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Creditors 10

12

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15

Income

Tax

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Provision



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8

11

14

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Proposed

Dividend

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6

10.5

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14

----------------------------------
84

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106.5

130

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----------------------------------

Assets

Plant

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and

Machinery

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45

55

70

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Investments

10

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15

20

Stock

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12

15

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15

Debtors 14

15

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12

Cash

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and

Bank

3

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6.5

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13

----------------------------------
84

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106.5

130

----------------------------------

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Other Details:

(a) Depreciation provided in the books:

2002-03: Rs.6 lakhs; 2003-04: Rs.8 lakhs; 2004-05: Rs.10 lakhs

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(b) A part of the Debentures was converted into equity at par in September

2003.

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(c) There was no sale of fixed assets during the period.


As you are the Management Accountant of the concern, the management
seeks your advice on the liquidity position of the company. Analyse the case

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and advice the management using Funds Flow Analysis.

Hint: (i)

Calculate Funds from Operations.

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(ii)

Prepare Schedule of Changes in Working Capital.

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(iii)

Prepare Funds Flow Statement.

(iv)

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Calculate Current Ratio and Liquidity Ratio.

Based on the above workings suitable advice may be given to the
management.

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200
3.2.3.17 BOOKS FOR FURTHER READING

1. James Jimbalvo: Management Accounting, John Wiley & Sons.

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2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.,

New Delhi.

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3. J.Made Gowda: Management Accounting, Himalaya Publishing House,

Delhi.

4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons, New

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Delhi.

5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting for Management,

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S.Chand & Co., New Delhi.




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201

UNIT IV

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LESSON 4.1

--------------------------------------------------------------------------------------

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MARGINAL COSTING

--------------------------------------------------------------------------------------
4.1.1 INTRODUCTION

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Marginal costing is a technique of costing. This technique of

costing uses the concept `Marginal Cost'. Marginal cost is the change in

the total cost of production as a result of change in the production by one

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unit. Thus marginal cost is nothing but variable cost. In marginal costing

technique only variable costs are considered while calculating the cost of

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the product, while fixed costs are charged against the revenue of the

period. The revenue arising from the excess of sales over variable costs

is known as `contribution'. Using contribution as a vital tool, marginal

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costing helps to a great extent in the managerial decision making

process. This unit deals with the various aspects of marginal costing.

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4.1.2 OBJECTIVES

After reading this lesson, the reader should be able to:

? Know the meaning of marginal cost.

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? Understand the various elements of marginal costing technique.
? Appreciate the importance of marginal costing as a decision making

tool.

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? Realise the advantages and disadvantages of marginal costing.
? Apply marginal costing technique under appropriate situations.

4.1.3 CONTENTS

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4.1.3.1

Various Elements of Marginal Costing

4.1.3.2

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Benefits of Marginal Costing

4.1.3.3

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Application of Marginal Costing

4.1.3.4

Limitations of Marginal Costing

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202
4.1.3.5

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Additional Illustrations

4.1.3.6

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Summary

4.1.3.7

Key Words

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4.1.3.8

Self Assessment Questions

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4.1.3.9

Key to Self Assessment Questions

4.1.3.10

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Case Analysis

4.1.3.11

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Books for Further Reading

4.1.3.1 VARIOUS ELEMENTS OF MARGINAL COSTING


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According to the Institute of Cost and Management Accountants

(ICMA), London, Marginal Cost is `the amount at any given volume of

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output by which aggregate costs are changed if the volume of output is

increased or decreased by one unit'. Thus marginal cost is the added cost

of an extra unit of output.

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MC = Direct Material + Direct Labour + Other Variable Costs



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= Total Cost ? Fixed Cost.

Contribution


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The difference between selling price and variable cost (or marginal cost)

is known as `Contribution' or `Gross Margin'. It may be considered as some sort

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of fund from out of which all fixed costs are met. The difference between

contribution and fixed cost represents either profit or loss, as the case may be.

Contribution is calculated thus:

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Contribution

=

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Selling price ? Variable cost



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=

Fixed Cost + Profit or ? Loss

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It is clear from the above equation that profit arises only when

contribution exceeds fixed costs. In other terms, the point of `no profit no loss'

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will be at a level where contribution is equal to fixed costs.



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203

Marginal Cost Equation


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The algebric expression of contribution is known as Marginal Cost

Equation. It can be expressed thus:

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S ? V

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= F + P



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S ? V

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= C



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C

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= F + P and in case of loss



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C

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= F ? L


Where

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S = Sales



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V = Variable Cost

C

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=

Contribution

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F = Fixed Cost

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P

=

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Profit

L

=

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Loss

Profit Volume Ratio (P/V Ratio)

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The profitability of business operations can be found out by calculating

the P/V Ratio. It shows the relationship between contribution and sales and is

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usually expressed in percentage. It is also known as `marginal-income ratio',

`contribution-sales ratio' or `variable-profit ratio'. P/V Ratio thus is the ratio of

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contribution to sales, and is calculated thus:



P/V Ratio

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=

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Contribution

-----------------
Sales

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C S ? V F + P

=

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---

or

---------

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or

--------

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--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

S S S




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Variable Costs

=

1

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-



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---------------------

Sales


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The ratio can also be shown by comparing the change in

contribution to change in sales, or change in profit to change in sales.

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Any increase in contribution, obviously, would mean increase in profit,

as fixed expenses are assumed to be constant at all levels of production.


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204



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Change

in

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Contribution

P/V Ratio


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=

-------------------------------

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Change in Sales




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Change

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in

Profit

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=

------------------------


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--- Content provided by‌ FirstRanker.com ---

Change

in

Sales

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--- Content provided by FirstRanker.com ---

The importance of P/V Ratio lies in its use for evaluating the

profitability of alternative products, proposals or schemes. A higher ratio

shows greater profitability. Management should, therefore, try to

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increase P/V ratio by widening the gap between the selling price and the

variable costs. This can be achieved by increasing sale price, reducing

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variable costs or switching over to more profitable products.

Break-even or Cost-Volume-Profit Analysis


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Break-even analysis is a specific method of presenting and

studying the inner relationship between costs, volume and profits.

(Hence, the name C-V-P Analysis). It is an important tool of financial

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analysis whereby the impact on profit of the changes in volume, price,

costs and mix can be found out with a certain amount of accuracy. A

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business is said to break even when its total sales are equal to its total

costs. It is a point of no profit or no loss. At this point contribution is

equal to fixed costs. Break-even point, can be calculated thus:

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Fixed Cost

B.E.P. (in Units)

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=

--------------------------

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--- Content provided by⁠ FirstRanker.com ---




Contribution per unit

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--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Fixed Cost

=

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---------------------------------------------

Selling

price/unit

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?

Marginal

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cost/unit




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Fixed Cost

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B.E.P. (Sales) = ------------------------- x Selling price/unit

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--- Content provided by​ FirstRanker.com ---


Contribution per unit



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205




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Fixed Cost

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=

------------------------- x Total Sales


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Total

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Contribution




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--- Content provided by‍ FirstRanker.com ---




F x S

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or

=

----------

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--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---


S ? V



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--- Content provided by‌ FirstRanker.com ---


Fixed Cost



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or


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=

----- ------------------------------

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--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Variable cost per unit




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--- Content provided by⁠ FirstRanker.com ---



1 - ----------------------------


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Selling

price

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per

unit


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Fixed

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Cost

or

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=


--- Content provided by​ FirstRanker.com ---


---------------



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--- Content provided by‍ FirstRanker.com ---




P/V Ratio

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At break-even point the desired profit is zero. Where the volume

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of output or sales is to be calculated so as to earn a desired amount of

profit, the amount of desired profits has to be added to the fixed cost

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given in the above formula.

Units to earn a desired profit


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--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Fixed Cost + Desired Profit

=

--- Content provided by⁠ FirstRanker.com ---

------------------------------------




--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





Contribution per unit

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Sales to earn a desired profit

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--- Content provided by FirstRanker.com ---

Fixed

Cost

+

--- Content provided by‍ FirstRanker.com ---


Desired

Profit

--- Content provided by‍ FirstRanker.com ---

=

------------------------------------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


P/V

Ratio

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Cash Break-even Point


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It is the level of output or sales where the cash inflow will be

equivalent to cash needed to meet immediate cash liabilities. To this end,

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206
fixed costs have to be divided into two parts (i) fixed cost which do not

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need immediate cash outlay (depreciation etc.) and (ii) fixed cost which

need immediate cash outlay (rent etc.). Cash break-even point can be

calculated thus:

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Cash Break-even Point (of output)

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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Cash fixed costs

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=

-----------------------------------

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Cash



contribution

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per

unit

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Composite Break-even Point


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Where a firm is dealing with several products, a composite break-

even point can be calculated using the following formula:

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Composite Break-even point (Sales)




--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


Cash fixed costs

=

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----------------------------------




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--- Content provided by‍ FirstRanker.com ---





Composite P/V Ratio

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Total

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Fixed

Costs

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x

Total

Sales

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or

=

--- Content provided by‍ FirstRanker.com ---

--------------------------------------

Total

Contribution

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--- Content provided by⁠ FirstRanker.com ---


Total

Contribution

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or

=

------------------------- x 100

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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Total Sales

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Margin of Safety



Total sales minus the sales at break-even point is known as the

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margin of safety. Lower break-even point means a higher margin of

safety. Margin of safety can also be expressed as a percentage of total

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sales. The formula is:



Margin of Safety

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=

--- Content provided by⁠ FirstRanker.com ---

Total Sales ? Sales at B.E.P.




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Profit

or


--- Content provided by‌ FirstRanker.com ---


=

------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

P/V

Ratio


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207

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



Margin of Safety


--- Content provided by⁠ FirstRanker.com ---


Margin of Safety



--- Content provided by‌ FirstRanker.com ---

=

----------------------- x 100


--- Content provided by⁠ FirstRanker.com ---


(as a percentage)



--- Content provided by‍ FirstRanker.com ---



Total Sales


--- Content provided by⁠ FirstRanker.com ---



Higher margin of safety shows that the business is sound and

when sales substantially come down, (but not below break even sales)

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profit might be earned by the business. Lower margin of safety, as

pointed out earlier, means that when sales come down slightly profit

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position might be affected adversely. Thus, margin of safety can be used

to test the soundness of a business. In order to improve the margin of

safety a business can increase selling prices (without affecting demand,

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of course) reducing fixed or variable costs and replacing unprofitable

products with profitable one.

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Illustration 1: Beta Manufacturers Ltd. has supplied you the following

information in respect of one of its products:

Total

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fixed

costs

--- Content provided by​ FirstRanker.com ---

18,000

Total

variable

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costs

30,000

--- Content provided by⁠ FirstRanker.com ---

Total

sales

60,000

--- Content provided by FirstRanker.com ---


Units

sold

--- Content provided by‍ FirstRanker.com ---

20,000



Find out (a) contribution per unit, (b) break-even point, (c) margin

--- Content provided by​ FirstRanker.com ---


of safety, (d) profit, and (e) volume of sales to earn a profit of

Rs.24,000.

--- Content provided by‍ FirstRanker.com ---

Solution:

60,000


--- Content provided by​ FirstRanker.com ---

Selling price per unit =

--------

= Rs.3

--- Content provided by​ FirstRanker.com ---


20,000

30,000

--- Content provided by FirstRanker.com ---


Variable cost per unit =

--------

--- Content provided by⁠ FirstRanker.com ---

= Rs.1.50

20,000


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208
(a)

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Contribution per unit =

Selling price per unit ? Variable

--- Content provided by‌ FirstRanker.com ---

cost per Unit
=

R.s3

--- Content provided by FirstRanker.com ---

?

Rs.1.50

=

--- Content provided by FirstRanker.com ---


Rs.1.50



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Total Fixed Cost

--- Content provided by FirstRanker.com ---


(b) Break-even

point = -------------------------------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Contribution per unit


Rs.18,000
=

--- Content provided by‍ FirstRanker.com ---


-------------



--- Content provided by FirstRanker.com ---



Rs.1.50


--- Content provided by‌ FirstRanker.com ---

=

12,000

units

--- Content provided by‍ FirstRanker.com ---



(c)

Margin of Safety

--- Content provided by​ FirstRanker.com ---


=

Units sold ? Break-even point

--- Content provided by FirstRanker.com ---

=

20,000

?

--- Content provided by‌ FirstRanker.com ---


12,000

=

--- Content provided by​ FirstRanker.com ---

8,000

units

(or)

--- Content provided by​ FirstRanker.com ---


Rs.24,000


(d)

--- Content provided by‌ FirstRanker.com ---


Profit



--- Content provided by‍ FirstRanker.com ---

= Units sold x Contribution per unit

2Fixed Cost

=

--- Content provided by‍ FirstRanker.com ---


20,000

x

--- Content provided by​ FirstRanker.com ---

Rs.1.50

2Rs.18,000

=

--- Content provided by‍ FirstRanker.com ---


Rs.12,000


(e)

--- Content provided by‍ FirstRanker.com ---


Volume of Sales to earn a profit of Rs.24,000



--- Content provided by​ FirstRanker.com ---

Fixed Cost + Desired Profit

= --------------------------------------


--- Content provided by⁠ FirstRanker.com ---

Contribution per unit




--- Content provided by​ FirstRanker.com ---

18,000 + 24,000

= ----------------------
1.50

--- Content provided by FirstRanker.com ---

= 28,000

units


--- Content provided by​ FirstRanker.com ---


Illustration 2: Calculate `Margin of Safety' from the following data:

-------------------------------------------------------------------------------------
Particulars

--- Content provided by FirstRanker.com ---


Mary

&

--- Content provided by‍ FirstRanker.com ---

Co.

Geetha

&

--- Content provided by⁠ FirstRanker.com ---


Co.

--------------------------------------------------------------------------------------
Sales

--- Content provided by FirstRanker.com ---




1,00,000 1,00,000

--- Content provided by‍ FirstRanker.com ---

Cost




--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

80,000

80,000


--- Content provided by‌ FirstRanker.com ---


209

Fixed ? Mary & Co. 30,000

--- Content provided by‌ FirstRanker.com ---


Geetha & Co. 50,000


Variable ? Mary & Co. 50,000

--- Content provided by​ FirstRanker.com ---



Geetha & Co. 30,000


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



---------- -----------


--- Content provided by‌ FirstRanker.com ---


Profit



--- Content provided by⁠ FirstRanker.com ---

20,000 20,000

----------

----------

--- Content provided by​ FirstRanker.com ---


--------------------------------------------------------------------------------------


Solution:

--- Content provided by​ FirstRanker.com ---


--------------------------------------------------------------------------------------
Particulars


--- Content provided by‌ FirstRanker.com ---




Mary& Co.

--- Content provided by‍ FirstRanker.com ---

Geetha & Co.

--------------------------------------------------------------------------------------
Actual

--- Content provided by‍ FirstRanker.com ---

Sales




--- Content provided by‍ FirstRanker.com ---


1,00,000 1,00,000

Less: Sales at Break-even point

--- Content provided by‍ FirstRanker.com ---

60,000



71,429

--- Content provided by‌ FirstRanker.com ---




----------

--- Content provided by‌ FirstRanker.com ---

----------

Marginal of Safety


--- Content provided by‍ FirstRanker.com ---




40,000

--- Content provided by​ FirstRanker.com ---



28,571


--- Content provided by‍ FirstRanker.com ---


----------



--- Content provided by​ FirstRanker.com ---

----------

Fixed

Cost

--- Content provided by​ FirstRanker.com ---


Break-even Sales

= ----------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




P/V Ratio

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





Sales ? Variable Cost

--- Content provided by​ FirstRanker.com ---


P/V Ratio



--- Content provided by‌ FirstRanker.com ---

= ----------------------------




--- Content provided by‌ FirstRanker.com ---




Sales

--- Content provided by​ FirstRanker.com ---

Therefore

P/V Ratio


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



1,00,000

1,00,000

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




- 50,000

--- Content provided by⁠ FirstRanker.com ---



- 30,000


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


----------

----------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



50,000

70,000

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





50%

--- Content provided by‍ FirstRanker.com ---




70%

--- Content provided by⁠ FirstRanker.com ---


Break-even Sales



--- Content provided by⁠ FirstRanker.com ---





30,000

--- Content provided by‌ FirstRanker.com ---




50,000

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



----------

----------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




50%

--- Content provided by‌ FirstRanker.com ---



70%


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



60,000


--- Content provided by⁠ FirstRanker.com ---


71,429

--------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---



210


--- Content provided by‍ FirstRanker.com ---

Illustration 3: From the following particulars, find out the selling price per unit

if B.E.P. is to be brought down to 9,000 units.


--- Content provided by​ FirstRanker.com ---


Variable cost per units Rs.75



--- Content provided by FirstRanker.com ---

Fixed expenses Rs.2,70,000



Selling price per unit Rs.100

--- Content provided by​ FirstRanker.com ---




Solution:

--- Content provided by‌ FirstRanker.com ---



Let us assume that the contribution per unit at B.E.P. sales of

9,000 is x.

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



Fixed Cost

B.E.P.

--- Content provided by​ FirstRanker.com ---


=

------------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Contribution per unit




--- Content provided by‍ FirstRanker.com ---



Contribution per unit is not known. Therefore,


--- Content provided by FirstRanker.com ---





2,70,000

--- Content provided by‍ FirstRanker.com ---


9,000

units

--- Content provided by‌ FirstRanker.com ---

=

-------------


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





x

--- Content provided by‌ FirstRanker.com ---



9,000


--- Content provided by FirstRanker.com ---


x =

2,70,000

--- Content provided by‍ FirstRanker.com ---


x =

30

--- Content provided by⁠ FirstRanker.com ---



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

price should be Rs.105, i.e. Rs.75 + Rs.30.

--- Content provided by‌ FirstRanker.com ---


4.1.3.2 BENEFITS OF MARGINAL COSTING



--- Content provided by⁠ FirstRanker.com ---

The technique of marginal costing is of immense use to the management

in taking various decisions, as explained below:

1. How much to produce? Marginal costing helps in finding out the level of

--- Content provided by FirstRanker.com ---


output which is most profitable for running a concern. This, in turn, helps in

utilising plant capacity in full, and realise maximum profits. By determining

--- Content provided by​ FirstRanker.com ---

the most profitable relationships between cost, price and volume, marginal

costing helps a business determine most competitive prices for its products.


--- Content provided by⁠ FirstRanker.com ---


211

2. What to produce? By applying marginal costing techniques, the most

--- Content provided by FirstRanker.com ---

suitable production line could be determined. The profitability of various

products can be compared and those products which languish behind and

which do not seem to be feasible (in view of their inability to recover

--- Content provided by​ FirstRanker.com ---


marginal costs), may be eliminated from the production line by using

marginal costing. It, thus, helps in selecting an optimum mix of products,

--- Content provided by‌ FirstRanker.com ---

keeping the capacity and resource constraints in mind. It will also serve as a

guide in arriving at the price for new products.

3. Whether to produce or procure? The marginal cost of producing an article

--- Content provided by FirstRanker.com ---


inside the factory serves as a useful guide while arriving at make or buy

decisions. The costs of manufacturing can be compared with the costs of

--- Content provided by‌ FirstRanker.com ---

buying outside and a suitable decision can be arrived at easily.

4. How to produce? In case a particular product can be produced by two or

more methods, ascertaining the marginal cost of producing the product by

--- Content provided by⁠ FirstRanker.com ---


each method will help in deciding as to which method should be allowed.

The same is true in case of decisions to use machine power in place of

--- Content provided by​ FirstRanker.com ---

manual labour.

5. When to produce? In periods of trade depression, marginal costing helps in

deciding whether production in the plants should be suspended temporarily

--- Content provided by FirstRanker.com ---


or continued in spite of low demand for the firm's products.

6. At what cost to produce? Marginal costing helps in determining the no-

--- Content provided by‍ FirstRanker.com ---

profit-no-loss point. The efficiency and economy of various products, plants,

departments can also be determined. This helps in profit planning as well as

cost control.

--- Content provided by FirstRanker.com ---


4.1.3.3 APPLICATION OF MARGINAL COSTING



--- Content provided by‍ FirstRanker.com ---

Marginal costing technique helps management in several ways.

These are discussed below:


--- Content provided by‌ FirstRanker.com ---


212
1. Profit Planning

There are four important ways of improving the profit performance of a

--- Content provided by​ FirstRanker.com ---


business: (i) increasing the volume, (ii) increasing the selling price, (iii)

decreasing variable cost, and (iv) decreasing fixed costs. Profit planning is the

--- Content provided by⁠ FirstRanker.com ---

planning of future operations so as to attain maximum profit. The contribution

ratio shows the relative profitability of various sectors of business whenever

there is a change in the selling price, variable cost etc.

--- Content provided by⁠ FirstRanker.com ---


Illustration 4: Two businesses P Ltd. and Q Ltd. sell the same type of product

in the same type of market. Their budgeted profit and loss accounts for the

--- Content provided by⁠ FirstRanker.com ---

coming year are as under:

--------------------------------------------------------------------------------------


--- Content provided by​ FirstRanker.com ---



P

Ltd.

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Q

Ltd.

--------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---

Sales

1,50,000 1,50,000


--- Content provided by‍ FirstRanker.com ---

Less: Variable costs 1,20,000



1,00,000

--- Content provided by‍ FirstRanker.com ---





Fixed costs

--- Content provided by FirstRanker.com ---


15,000

1,35,000 35,000 1,35,000

--- Content provided by‌ FirstRanker.com ---

---------- ----------



Budget Net Profit

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

15,000



15,000

--- Content provided by​ FirstRanker.com ---


---------- ----------



--- Content provided by FirstRanker.com ---

--------------------------------------------------------------------------------------


You are required to:

--- Content provided by⁠ FirstRanker.com ---

i)

Calculate the break-even point for each business

ii)

--- Content provided by​ FirstRanker.com ---


Calculate the sales volume at which each business will earn
Rs.5,000 profit.


--- Content provided by⁠ FirstRanker.com ---

iii)

State which business is likely to earn greater profit in conditions

of:

--- Content provided by‍ FirstRanker.com ---


(a) heavy demand for the product

(b) low demand for the product, and,

--- Content provided by‌ FirstRanker.com ---

briefly give your argument also.




--- Content provided by‍ FirstRanker.com ---


213

Solution:

--- Content provided by‍ FirstRanker.com ---

(i)

For calculating the break-even points, P/V ratio of P Ltd. and Q Ltd.,
should be calculated:

--- Content provided by‍ FirstRanker.com ---

P/V

Ratio

=

--- Content provided by​ FirstRanker.com ---


Contribution

/

--- Content provided by‍ FirstRanker.com ---

Sales




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Fixed Expenses + Profit

=

--- Content provided by​ FirstRanker.com ---

------------------------------




--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

Sales




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




15,000 + 15,000

--- Content provided by​ FirstRanker.com ---

1

P/V Ratio of P


--- Content provided by​ FirstRanker.com ---


=

---------------------

--- Content provided by​ FirstRanker.com ---

= --- = 20%




--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



1,50,000 5


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---


35,000 + 15,000

1

--- Content provided by‍ FirstRanker.com ---

P/V Ratio of Q



=

--- Content provided by FirstRanker.com ---


----------------------

= --- = 33 1/3%

--- Content provided by‍ FirstRanker.com ---

1,50,000




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

3




--- Content provided by​ FirstRanker.com ---



Fixed

expenses

--- Content provided by‌ FirstRanker.com ---


Break-even point



--- Content provided by‍ FirstRanker.com ---

= --------------------




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



P/V Ratio


--- Content provided by FirstRanker.com ---





15,000

--- Content provided by‍ FirstRanker.com ---


P

Ltd.

--- Content provided by⁠ FirstRanker.com ---

=

-----------

=

--- Content provided by FirstRanker.com ---


Rs.75,000



--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


1/5



--- Content provided by FirstRanker.com ---




35,000

--- Content provided by FirstRanker.com ---

Q

Ltd.

=

--- Content provided by​ FirstRanker.com ---


-----------

=

--- Content provided by⁠ FirstRanker.com ---

Rs.1,05,000




--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

1/3


(ii)

--- Content provided by​ FirstRanker.com ---

Sales volume to earn a desired profit (Rs.5000):



Fixed Expenses + Desired Profit

--- Content provided by⁠ FirstRanker.com ---


Formula = ----------------------------------------



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



P/V Ratio


--- Content provided by‌ FirstRanker.com ---

15,000

+

5,000

--- Content provided by⁠ FirstRanker.com ---


P Ltd.

=

--- Content provided by FirstRanker.com ---

-------------------

= Rs.1,00,000


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



1/5


--- Content provided by​ FirstRanker.com ---





214

--- Content provided by‌ FirstRanker.com ---

35,000

+

5,000

--- Content provided by FirstRanker.com ---


Q Ltd.

=

--- Content provided by​ FirstRanker.com ---

-------------------

= Rs.1,20,000


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



1/3


--- Content provided by FirstRanker.com ---


(iii)

(a) In conditions of heavy demand, a concern with larger P/V ratio can

--- Content provided by​ FirstRanker.com ---

earn greater profits because of greater contribution. Thus, Q Ltd. is likely

to earn greater profit.

(b) In conditions of low demand, a concern with lower break-even

--- Content provided by‌ FirstRanker.com ---


point is likely to earn more profits because it will start earning profits at

a lower level of sales. In this case, P Ltd. will start earning profits when

--- Content provided by⁠ FirstRanker.com ---

its sales reach a level of Rs.75,000, whereas Q Ltd. will start earning

profits when its sales reach Rs.1,05,000. Therefore, in case of low

demand, break-even point should be reached as early as possible so that

--- Content provided by‌ FirstRanker.com ---


the concern may start earning profits.

2. Introduction of a New Product

--- Content provided by‍ FirstRanker.com ---

Sometimes, a product may be added to the existing lines of products with a

view to utilise idle facilities, to capture a new market or for any other purpose.

The profitability of this new product has to be found out initially. Usually, the

--- Content provided by⁠ FirstRanker.com ---


new product will be manufactured if it is capable of contributing something

toward fixed costs and profit after meeting its variable costs.

--- Content provided by‌ FirstRanker.com ---

Illustration 5: A concern manufacturing Product X has provided the following

information:


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Rs.

--- Content provided by FirstRanker.com ---



Sales

75,000

--- Content provided by​ FirstRanker.com ---


Direct

materials 30,000

--- Content provided by FirstRanker.com ---

Direct

labour

10,000

--- Content provided by⁠ FirstRanker.com ---


Variable

overhead

--- Content provided by‌ FirstRanker.com ---

10,000

Fixed

overhead 15,000

--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

215



In order to increase its sales by Rs.25,000, the concern wants to

--- Content provided by FirstRanker.com ---


introduce the Product Y, and estimates the costs in connection therewith

as under:

--- Content provided by‌ FirstRanker.com ---

Direct

materials 10,000

Direct

--- Content provided by​ FirstRanker.com ---


labour



--- Content provided by​ FirstRanker.com ---



8,000


--- Content provided by​ FirstRanker.com ---


Variable overhead



--- Content provided by⁠ FirstRanker.com ---

5,000



Fixed overhead

--- Content provided by⁠ FirstRanker.com ---




NIL

--- Content provided by‌ FirstRanker.com ---





Advise whether the Product Y will be profitable or not.

--- Content provided by⁠ FirstRanker.com ---


Solution:

Marginal Cost Statement

--- Content provided by FirstRanker.com ---

(in Rupees)

-------------------------------------------------------------------------------------------------


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




X

--- Content provided by FirstRanker.com ---

Y

Total

-------------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---

Sales




--- Content provided by‌ FirstRanker.com ---


75,000

25,000 1,00,000

--- Content provided by⁠ FirstRanker.com ---

Less: Marginal

costs:


--- Content provided by‍ FirstRanker.com ---


Direct materials



--- Content provided by FirstRanker.com ---

30,000

10,000

40,000

--- Content provided by​ FirstRanker.com ---




Direct labour

--- Content provided by⁠ FirstRanker.com ---



10,000

8,000

--- Content provided by​ FirstRanker.com ---


18,000



--- Content provided by FirstRanker.com ---

Variable overhead



10,000

--- Content provided by⁠ FirstRanker.com ---


5,000

15,000

--- Content provided by​ FirstRanker.com ---





---------

--- Content provided by⁠ FirstRanker.com ---


--------



--- Content provided by FirstRanker.com ---



--------


--- Content provided by​ FirstRanker.com ---




50,000

--- Content provided by‍ FirstRanker.com ---

23,000




--- Content provided by‌ FirstRanker.com ---


73,000



--- Content provided by FirstRanker.com ---





--------

--- Content provided by​ FirstRanker.com ---


--------- -------



--- Content provided by​ FirstRanker.com ---

Contribution



25,000

--- Content provided by​ FirstRanker.com ---


2,000

27,000

--- Content provided by⁠ FirstRanker.com ---

Fixed

cost


--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

15,000




--- Content provided by‌ FirstRanker.com ---


----------



--- Content provided by‍ FirstRanker.com ---

Profit




--- Content provided by⁠ FirstRanker.com ---




12,000

--- Content provided by‍ FirstRanker.com ---





----------

--- Content provided by‍ FirstRanker.com ---




-------------------------------------------------------------------------------------------------
Commentary: If product Y is introduced, the profitability of product X is not

--- Content provided by​ FirstRanker.com ---


affected in any manner. On the other hand, product Y provides a contribution of

Rs.2,000 towards fixed cost and profit. Therefore, Y should be introduced.

--- Content provided by FirstRanker.com ---

3. Level of Activity Planning

Marginal costing is of great help while planning the level of activity. Maximum

contribution at a particular level of activity will show the position of maximum

--- Content provided by⁠ FirstRanker.com ---


profitability.



--- Content provided by‌ FirstRanker.com ---

216
Illustration 6: Following is the cost structure of Sundaram Corporation,

Pondicherry, manufacturers of Colour TVs.

--- Content provided by⁠ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Level of Activity



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

50%

70%

90%

--- Content provided by‍ FirstRanker.com ---


-------------------------------------------------------------------------------------------------
Output (in units )


--- Content provided by⁠ FirstRanker.com ---


200



--- Content provided by‌ FirstRanker.com ---

280

360

Cost (in Rs.)

--- Content provided by⁠ FirstRanker.com ---



Materials


--- Content provided by‌ FirstRanker.com ---


10,00,000 14,00,000

18,00,000

--- Content provided by‍ FirstRanker.com ---



Labour

3,00,000 4,20,000 5,40,000

--- Content provided by‌ FirstRanker.com ---




Factory overhead

--- Content provided by‍ FirstRanker.com ---

5,00,000 6,00,000

7,00,000


--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



------------ ------------ ------------

Factory Cost

--- Content provided by⁠ FirstRanker.com ---




18,00,000 24,20,000

--- Content provided by‌ FirstRanker.com ---

30,40,000




--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

------------ ------------ ------------

-------------------------------------------------------------------------------------------------

In view of the fact that there will be no increase in fixed costs and import

--- Content provided by FirstRanker.com ---


license for the picture tubes required in the manufacture of its TVs has been

obtained, the Corporation is considering an increase in production to its full

--- Content provided by FirstRanker.com ---

installed capacity.

The management requires a statement showing all details of production costs

at 100% level of activity.

--- Content provided by‍ FirstRanker.com ---


Solution:

Marginal Cost Statement
-------------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---

(At 100% level of activity




--- Content provided by⁠ FirstRanker.com ---


Total Cost

Cost per unit

--- Content provided by‌ FirstRanker.com ---

with 400 units)




--- Content provided by‌ FirstRanker.com ---




Rs.

--- Content provided by​ FirstRanker.com ---



Rs.

-------------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---

Materials




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

20,00,000



5,000

--- Content provided by FirstRanker.com ---


Labour



--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


6,00,000



--- Content provided by‍ FirstRanker.com ---

1,500

Variable Factory Overhead

5,00,000

--- Content provided by FirstRanker.com ---




1,250

--- Content provided by‌ FirstRanker.com ---

------------




--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---



-------

Marginal Factory Cost

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

31,00,000



7,750

--- Content provided by FirstRanker.com ---


Fixed Factory Overhead



--- Content provided by‍ FirstRanker.com ---



2,50,000


--- Content provided by‌ FirstRanker.com ---


625

------------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-------



Total Factory Cost

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



33,50,000


--- Content provided by‍ FirstRanker.com ---


8,375

------------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

-------




--- Content provided by FirstRanker.com ---


217



--- Content provided by​ FirstRanker.com ---

Thus, the marginal factory cost per unit is Rs.7,750 and the total

production cost per unit is Rs.8,375.

Commentary:

--- Content provided by‍ FirstRanker.com ---


(i)

Calculation of Variable Factory Overheads per unit:

--- Content provided by FirstRanker.com ---



Rs.6,00,000 ? Rs.5,00,000

= --------------------------------- =

--- Content provided by‍ FirstRanker.com ---


Rs.1,250



--- Content provided by‌ FirstRanker.com ---



80 units


--- Content provided by‍ FirstRanker.com ---

(ii)

Calculation of Fixed Factory Overheads:


--- Content provided by​ FirstRanker.com ---


Factory overheads ? (No. of units at certain level of activity x Variable
Factory Overheads per unit).


--- Content provided by‍ FirstRanker.com ---


Therefore Rs.5,00,000 ? (200 units x 1,250)
Therefore Rs.5,00,000 ? Rs.2,50,000 = Rs.2,50,000
The amount can be verified by making calculation at any other level of activity.

--- Content provided by​ FirstRanker.com ---

(iii)

Variable Factory Overheads at 100% level of activity:
400 units x 1,250 = Rs.5,00,000

--- Content provided by⁠ FirstRanker.com ---

4. Key Factor

A concern would produce and sell only those products which offer maximum

profit. This is based on the assumption that it is possible to produce any quantity

--- Content provided by‌ FirstRanker.com ---


without any difficulty and sell likewise. However, in actual practice, this seems

to be unrealistic as several constraints come in the way of manufacturing as well

--- Content provided by​ FirstRanker.com ---

as selling. Such constraints that come in the way of management's efforts to

produce and sell in unlimited quantities are called `key factors' or `limiting

factors'. The limiting factors may be materials, labour, plant capacity, or

--- Content provided by⁠ FirstRanker.com ---


demand. Management must ascertain the extent of the influence of the key

factor for ensuring maximisation of profit. Normally, when contribution and key

--- Content provided by‌ FirstRanker.com ---

factors are known, the relative profitability of different products or processes

can be measured with the help of the following formula:


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Contribution




--- Content provided by⁠ FirstRanker.com ---




Profitability = -----------------------

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Key

--- Content provided by FirstRanker.com ---

Factor



218

--- Content provided by​ FirstRanker.com ---

Illustration 7: From the following data, which product would you recommend
to be manufactured in a factory, time, being the key factor?
-------------------------------------------------------------------------------------------------


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

Per unit of

Per unit of

Product

--- Content provided by‌ FirstRanker.com ---


X



--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


Product

Y

--- Content provided by‌ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Direct Material



--- Content provided by⁠ FirstRanker.com ---





24

--- Content provided by​ FirstRanker.com ---




14

--- Content provided by FirstRanker.com ---

Direct labour at Re.1 per hour



2

--- Content provided by​ FirstRanker.com ---




3

--- Content provided by‌ FirstRanker.com ---

Variable overhead at Rs.2 per hour 4



6

--- Content provided by FirstRanker.com ---


Selling price



--- Content provided by FirstRanker.com ---





100

--- Content provided by⁠ FirstRanker.com ---


110

Standard time to produce

--- Content provided by‍ FirstRanker.com ---





2 hours

--- Content provided by‌ FirstRanker.com ---




3 hours

--- Content provided by FirstRanker.com ---

-------------------------------------------------------------------------------------------------


Solution:

--- Content provided by FirstRanker.com ---

-------------------------------------------------------------------------------------------------




--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Per unit of Per unit of



--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




Product X

--- Content provided by FirstRanker.com ---

Product Y




--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





(Rs.)

--- Content provided by FirstRanker.com ---


(Rs.)

-------------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---


Selling price



--- Content provided by‍ FirstRanker.com ---



100


--- Content provided by​ FirstRanker.com ---


110

Less: Marginal

--- Content provided by‌ FirstRanker.com ---

Cost:



Direct materials

--- Content provided by⁠ FirstRanker.com ---


24



--- Content provided by FirstRanker.com ---

14



Direct labour

--- Content provided by FirstRanker.com ---


2

3

--- Content provided by‍ FirstRanker.com ---



Variable overhead

4

--- Content provided by‍ FirstRanker.com ---


30 6

23

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




--

--- Content provided by‌ FirstRanker.com ---

--- -- ----



Contribution

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

70



87

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




---

--- Content provided by‍ FirstRanker.com ---



----


--- Content provided by​ FirstRanker.com ---

Standard

time

to

--- Content provided by‌ FirstRanker.com ---


produce

2

--- Content provided by​ FirstRanker.com ---

hours

3

hours

--- Content provided by⁠ FirstRanker.com ---



Contribution

per

--- Content provided by​ FirstRanker.com ---


hour

70/2

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


87/3


=

--- Content provided by‍ FirstRanker.com ---


Rs.35 =

Rs.29

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-------------------------------------------------------------------------------------------------


Contribution per hour of Product X is more than that of Product Y

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by Rs.6. Therefore, Product X is more profitable and is recommended to

be manufactured.


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219

5. Make of Buy Decisions

A company might be having unused capacity which may be utilized for making

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component parts or similar items instead of buying them from the market. In

arriving at such a `make or buy' decision, the cost of manufacturing component

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parts should be compared with price quoted in the market. If the variable costs

are lower than the purchase price, the component parts should be manufactured

in the factory itself. Fixed costs are excluded on the assumption that they have

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been already incurred, and the manufacturing of components involves only

variable cost. However, if there is an increase in fixed costs and any limiting

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factor is operating while producing components etc. that should also be taken

into account. Consider the following illustration, throwing light on these aspects.


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Illustrations 8: You are the Management Accountant of XYZ Co. Ltd. The

Managing Director of the company seeks your advice on the following problem:

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The company produces a variety of products each having a number of computer

parts. Product "B" takes 5 hours to produce on machine No.99 working at full

capacity. "B" has a selling price of Rs.50 and a marginal cost, Rs.30 per unit.

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"A-10" a component part could be made on the same machine in 2 hours for

marginal cost of Rs.5 per unit. The supplier's price is Rs.12.50 per unit. Should

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the company make or buy "A-10"?

Assume that machine hour is the limiting factor.


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Solution:



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In this problem the cost of new product plus contribution lost during the

time for manufacturing "A-10" should be compared with the supplier's price to

arrive at a decision.

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--- Content provided by⁠ FirstRanker.com ---


220



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





Rs.

--- Content provided by‌ FirstRanker.com ---




"B" ? Selling price

--- Content provided by‍ FirstRanker.com ---





50.00

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Marginal

cost

--- Content provided by‌ FirstRanker.com ---

30.00

-------


--- Content provided by​ FirstRanker.com ---


20.00
-------


--- Content provided by FirstRanker.com ---


It takes 5 hours to produce one unit of "B".



--- Content provided by⁠ FirstRanker.com ---

Therefore Contribution earned per hour on Machine No.99 is

Rs.20/5 =

Rs.4

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"A-10" takes two hours to be manufactured on machine which is

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producing "B".



Real cost of "A-10" to the company = Marginal cost of "A-10"

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plus contribution lost for using the machine for "A-10".

Rs.5

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+

Rs.8

=

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Rs.13



--- Content provided by​ FirstRanker.com ---

This is more than the seller's price of Rs.12.50 and so it is

advisable for the company to buy the product from outside.


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Illustration 9: A T.V. manufacturing company finds that while it costs Rs.6.25

to make each component X, the same is available in the market at Rs.4.85 each,

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with an assurance of continued supply. The break down of cost is:




--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Rs.

--- Content provided by FirstRanker.com ---


Materials

2.75

--- Content provided by⁠ FirstRanker.com ---

Each

Labour

1.75

--- Content provided by FirstRanker.com ---


Each

Other

--- Content provided by‍ FirstRanker.com ---

variables 0.50

Each


--- Content provided by​ FirstRanker.com ---


Depreciation and other fixed costs



--- Content provided by⁠ FirstRanker.com ---

1.25

Each


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

-----

6.25


--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





-----

--- Content provided by FirstRanker.com ---




Should you make or buy?

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221

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Solution:



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Variable cost of manufacturing is Rs.5; (Rs.6.25 ? Rs.1.25) but the

market price is Rs.4.85. If the fixed cost of Rs.1.25 is also added, it is not

profitable to make the component. Because there is a saving of Rs.0.15 even in

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variable cost, it is profitable to procure from outside.

6. Suitable Product Mix/Sales Mix

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Normally, a business concern will select the product mix which gives the

maximum profit. Product mix is the ratio in which various products are

produced and sold. The marginal costing technique helps management in taking

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appropriate decisions regarding the product mix, i.e., in changing the ratio of

product mix so as to maximise profits. The technique not only helps in dropping

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unprofitable products from the mix but also helps in dropping unprofitable

departments, activities etc. Consider the following illustrations:

Illustration 10: (Product Mix)

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The following figures are obtained from the accounts of a departmental

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store having four departments.

Departments

(figures in Rs.)

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-------------------------------------------------------------------------------------------------
Particulars

A

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B

--- Content provided by​ FirstRanker.com ---

C



D

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Total

-------------------------------------------------------------------------------------------------
Sales

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5,000

8,000

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6,000

7,000

26,000

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-------

-------

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-------

-------

---------

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Marginal cost 5,500

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6,000

2,000

2,000 15,500

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Fixed cost

500

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4,000

1,000

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1,000 6,500

(apportioned) -------

------- -------

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-------

---------

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Total cost

6,000 10,000

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3,000

3,000 22,000

-------

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-------

-------

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-------

---------

Profit/Loss(-) 1,000 (-) 2,000

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3,000

4,000 4,000

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-------------------------------------------------------------------------------------------------



222

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On the above basis, it is decided to close down Dept. B immediately, as the loss

shown is the maximum. After that Dept. A will be discarded. What is your

advice to the management?

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Statement of Comparative Profitability

Departments

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-------------------------------------------------------------------------------------------------
Particulars

A

--- Content provided by‍ FirstRanker.com ---



B

C

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D

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Total

-------------------------------------------------------------------------------------------------
Sales

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5,000

8,000

6,000

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7,000

26,000

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Less:
Marginal cost 5,500

6,000

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2,000

2,000 15,500

-------

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-------

-------

--- Content provided by​ FirstRanker.com ---

-------

---------


--- Content provided by‍ FirstRanker.com ---


Contribution (-) 500

2,000

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4,000

5,000 10,500


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-------

-------

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-------

-------

---------

--- Content provided by‌ FirstRanker.com ---


Fixed cost



--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

6,500



---------

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Profit



--- Content provided by​ FirstRanker.com ---





4,000

--- Content provided by‍ FirstRanker.com ---


---------



--- Content provided by FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Commentary: From the above, it is clear that the contribution of Dept. A is

negative and should be discarded immediately. As Dept. B provides Rs.2,000

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towards fixed costs and profits, it should not be discarded.

Illustration 11 (Sales Mix):


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Present the following information to show to the management: (a)

the marginal product cost and the contribution per unit; (b) the total

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contribution and profits resulting from each of the following mixtures:

-------------------------------------------------------------------------------------------------


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--- Content provided by‌ FirstRanker.com ---


Product

Per

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Unit

(Rs.)

-----------------------------------------------------------------------------------------

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Direct Materials


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A

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10

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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




B

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9

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Direct

wages

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A



3

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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




B

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2

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Fixed expenses Rs.800

-----------------------------------------------------------------------------------------

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Variable expenses are allocated to products as 100% of direct wages.



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223




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--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




Rs.

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Sales price

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--- Content provided by FirstRanker.com ---

A



20

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--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




B

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15

Sales mixtures:

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(i)

1000 units of product A and 2000 units of B

(ii)

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1500 units of product A and 1500 units of B

(iii)

--- Content provided by‌ FirstRanker.com ---

2000 units of product A and 1000 units of B


Solution:
-------------------------------------------------------------------------------------------------

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(a) Marginal cost statement



A

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B

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-------------------------------------------------------------------------------------------------
- Direct

materials 10

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9

Direct

wages

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3

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2

Variable

overheads

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(100%)



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3

2


--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


---

---

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Marginal cost


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16

--- Content provided by​ FirstRanker.com ---

13



Sales price

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--- Content provided by‍ FirstRanker.com ---



20

15

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




---

--- Content provided by‌ FirstRanker.com ---

---

Contribution


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4

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2

-------------------------------------------------------------------------------------------------

-------------------------------------------------------------------------------------------------

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1000

A+ 1500

A+ 2000

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A+

(b) Sales mix

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2000 B



1500 B

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1000B

choice

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(i)


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(ii)

(iii)

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------




--- Content provided by FirstRanker.com ---

(Rs.)




--- Content provided by⁠ FirstRanker.com ---


(Rs.)



--- Content provided by​ FirstRanker.com ---



(Rs.)

-------------------------------------------------------------------------------------------------

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Total sales


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(1000 x 20 + (1500 x 20 + (2000 x 20 +



--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


2000 x 15) = 1500 x 15) = 1000 x 15) =

50,000

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52,500

55,000


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--- Content provided by FirstRanker.com ---




(1000 x 16 + (1500 x 16 + (2000 x 16 +

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




2000 x 13) = 1500 x 13) = 1000 x 13) =

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Less: Marginal cost

42,000

43,500

--- Content provided by⁠ FirstRanker.com ---


45,000

------------------------------------------------------------

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Contribution

8,000

--- Content provided by​ FirstRanker.com ---

9,000

10,000

Less: Fixed costs

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800 800

--- Content provided by⁠ FirstRanker.com ---

800

------------------------------------------------------------
Profit

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7,200


--- Content provided by FirstRanker.com ---


8,200



--- Content provided by FirstRanker.com ---

9,200

-----------------------------------------------------------------------------------------


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224


Therefore sales mixture (iii) will give the highest profit; and as

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such, mixture (iii) can be adopted.

7. Pricing Decisions

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Marginal costing techniques help a firm to decide about the prices of various

products in a fairly easy manner. Let's examine the following cases:

(i)

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Fixation of selling price



--- Content provided by​ FirstRanker.com ---

Illustration 12: P/V ratio is 60% and the marginal cost of the product is Rs.50.

What will be the selling price?

Solution:

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


S ? V



--- Content provided by​ FirstRanker.com ---

V C

P/V

ratio

--- Content provided by⁠ FirstRanker.com ---


=

----------

--- Content provided by​ FirstRanker.com ---

= 1 - -----

= -----


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





S S S

--- Content provided by⁠ FirstRanker.com ---





Variable cost

--- Content provided by​ FirstRanker.com ---




40

--- Content provided by‍ FirstRanker.com ---



----------------

=

--- Content provided by‍ FirstRanker.com ---


40% or ------



--- Content provided by‌ FirstRanker.com ---

Sales




--- Content provided by⁠ FirstRanker.com ---


100



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

50 50 x 100



Selling price = -------

--- Content provided by​ FirstRanker.com ---


= -------------- = Rs.125



--- Content provided by⁠ FirstRanker.com ---





40% 40

--- Content provided by FirstRanker.com ---



(ii)

Reducing Selling Price

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Illustration 13: The price structure of a cycle made by the Visu Cycle Co. Ltd.
is as follows:

--- Content provided by⁠ FirstRanker.com ---





Per Cycle

--- Content provided by‍ FirstRanker.com ---




Materials

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


60

Labour

--- Content provided by FirstRanker.com ---

20

Variable

overheads

--- Content provided by‌ FirstRanker.com ---


20



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


-----



--- Content provided by FirstRanker.com ---

Fixed overheads



100

--- Content provided by‌ FirstRanker.com ---




Profit

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


50

Selling

--- Content provided by⁠ FirstRanker.com ---

price

50


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


-----



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




200

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-----


--- Content provided by​ FirstRanker.com ---


225

This is based on the manufacture of one lakh cycles per annum.

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The company expects that due to competition they will have to reduce selling

prices, but they want to keep the total profits intact. What level of production

will have to be reached, i.e., how many cycles will have to be made to get the

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same amount of profits, if:

(a) the selling price is reduced by 10%?

--- Content provided by​ FirstRanker.com ---

(b) the selling price is reduced by 20%?

Solution:


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




(Rs.)

--- Content provided by‍ FirstRanker.com ---



(Rs.)


--- Content provided by⁠ FirstRanker.com ---


Existing profit

=

--- Content provided by⁠ FirstRanker.com ---

1,00,000 x 50 =

50,00,000


--- Content provided by​ FirstRanker.com ---


Total fixed overheads =

1,00,000 x 50 =

--- Content provided by⁠ FirstRanker.com ---

50,00,000


(a) Selling price is reduced by 10% and to get the existing profit of Rs.50 lakhs.

--- Content provided by​ FirstRanker.com ---

New selling price




--- Content provided by‍ FirstRanker.com ---


=

200 ? 10% of Rs.200

--- Content provided by⁠ FirstRanker.com ---

=

200

?

--- Content provided by FirstRanker.com ---


20 =Rs.180


New contribution

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

=

180 ? 100

=Rs.80 per unit

--- Content provided by‍ FirstRanker.com ---



Total sales (units)


--- Content provided by‌ FirstRanker.com ---




=

--- Content provided by⁠ FirstRanker.com ---

F + P/Contribution per unit




--- Content provided by​ FirstRanker.com ---



5,00,000

+

--- Content provided by FirstRanker.com ---


5,00,000

=

--- Content provided by FirstRanker.com ---

---------------------------




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


80


=

--- Content provided by FirstRanker.com ---


1,25,000

cycles

--- Content provided by FirstRanker.com ---


are to be obtained and sold to earn the existing profit of Rs.5,00,000.

(b) Selling price reduced by 20% and to get the existing profit of Rs.5,00,000.

--- Content provided by FirstRanker.com ---

New selling price




--- Content provided by‌ FirstRanker.com ---


=

200 ? 20% of Rs.200

--- Content provided by FirstRanker.com ---

=

200

?

--- Content provided by⁠ FirstRanker.com ---


40 =

Rs.160

--- Content provided by⁠ FirstRanker.com ---


New contribution



--- Content provided by​ FirstRanker.com ---



=

S ? V

--- Content provided by‍ FirstRanker.com ---




=

--- Content provided by​ FirstRanker.com ---

160 ? 100 = Rs.80 per unit


Total sales (units)

--- Content provided by⁠ FirstRanker.com ---





=

--- Content provided by‍ FirstRanker.com ---


F + P/Contribution per unit



--- Content provided by FirstRanker.com ---

226




--- Content provided by FirstRanker.com ---


5,00,000

+

--- Content provided by FirstRanker.com ---

5,00,000

=

---------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

60


=

--- Content provided by FirstRanker.com ---

1,66,667

cycles


--- Content provided by FirstRanker.com ---


are to be produced and sold to earn the existing profit of Rs.50 lakhs.

(iii)

--- Content provided by​ FirstRanker.com ---

Pricing during Recession:

Illustration 14: SSA Company is working well below normal capacity due to

recession. The directors of the company have been approached with an enquiry

--- Content provided by⁠ FirstRanker.com ---


for special job. The costing department estimated the following in respect of the

job.

--- Content provided by‌ FirstRanker.com ---

Direct

materials Rs.10,000

Direct

--- Content provided by⁠ FirstRanker.com ---


labour

500

--- Content provided by​ FirstRanker.com ---

hours

@

Rs.2

--- Content provided by‌ FirstRanker.com ---


per

hour

--- Content provided by​ FirstRanker.com ---



Overhead costs: Normal recovery rates

Variable Re.0.50

--- Content provided by​ FirstRanker.com ---


per

hour

--- Content provided by‌ FirstRanker.com ---

Fixed

Re.1.00

per

--- Content provided by⁠ FirstRanker.com ---


hour



--- Content provided by‍ FirstRanker.com ---



The directors ask you to advise them on the minimum price to be

charged. Assume that there are no production difficulties regarding the

--- Content provided by‌ FirstRanker.com ---


job.

Solution:

--- Content provided by⁠ FirstRanker.com ---



Calculation of Marginal cost:


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

(Rs.)

Direct

materials 10,000

--- Content provided by⁠ FirstRanker.com ---




Direct labour

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




1,000

--- Content provided by FirstRanker.com ---



Variable overhead @ Re.0.50 per hour

250

--- Content provided by FirstRanker.com ---


---------
Marginal

cost

--- Content provided by⁠ FirstRanker.com ---


11,250

---------

--- Content provided by⁠ FirstRanker.com ---



Commentary: Here the minimum price to be quoted is Rs.11,250 which is the

marginal cost. By quoting so, the company is sacrificing the recovery of the

--- Content provided by​ FirstRanker.com ---


profit and the fixed-costs. The fixed costs will continue to be incurred even if



--- Content provided by​ FirstRanker.com ---

227

the company does not accept the offer. So any price above Rs.11,250 is

welcome.

--- Content provided by⁠ FirstRanker.com ---


8. Accepting Foreign Order

Marginal costing technique can also be used to take a decision as to whether

--- Content provided by FirstRanker.com ---

to accept a foreign offer or not. The speciality of this situation is that normally

foreign order is requiring the manufacturer to supply the product at a price lower

than the inland selling price. Here the decision is taken by comparing the

--- Content provided by‍ FirstRanker.com ---


marginal cost of the product with the foreign price offered. If the foreign order

offers a price higher than the marginal cost then the offer can be accepted

--- Content provided by‌ FirstRanker.com ---

subject to availability of sufficient installed production capacity. The following

illustration highlights this decision:

Illustration 15: Due to industrial depression, a plant is running at present at

--- Content provided by‌ FirstRanker.com ---


50% of the capacity. The following details are available:



--- Content provided by‌ FirstRanker.com ---

Cost of Production per unit




--- Content provided by​ FirstRanker.com ---


(Rs.)

Direct

--- Content provided by FirstRanker.com ---

materials

2


--- Content provided by‍ FirstRanker.com ---




Direct labour

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




1

--- Content provided by‌ FirstRanker.com ---

Variable

overhead

3

--- Content provided by‌ FirstRanker.com ---


Fixed

overhead 2

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


---



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


8



--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





---

--- Content provided by‍ FirstRanker.com ---


Production

per

--- Content provided by​ FirstRanker.com ---

month

20,000

units

--- Content provided by‌ FirstRanker.com ---


Total

cost

--- Content provided by‌ FirstRanker.com ---

of

production

Rs.1,60,000

--- Content provided by‌ FirstRanker.com ---


Sale

price

--- Content provided by‍ FirstRanker.com ---

Rs.1,40,000

--------------


--- Content provided by‌ FirstRanker.com ---


Loss

Rs.

--- Content provided by⁠ FirstRanker.com ---





20,000

--- Content provided by FirstRanker.com ---


--------------



--- Content provided by‍ FirstRanker.com ---



An exporter offers to buy 5000 units per month at the rate of

Rs.6.50 per unit and the company is hesitant to accept the order for fear

--- Content provided by FirstRanker.com ---


of increasing its already large operating losses. Advise whether the

company should accept or decline this offer.

--- Content provided by FirstRanker.com ---

Solution:



228

--- Content provided by​ FirstRanker.com ---



At present the selling price per unit is Rs.7/- and the marginal cost per

unit is Rs.6/- (Material Rs.2 + Labour Re.1 + Variable overhead Rs.3). The

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foreign order offers a price of Rs.6.50 and there is ample production capacity

(50%) available. Since the foreign offer is at a price higher than marginal cost

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the offer can be accepted. This is proved hereunder:




--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




(Rs.)

--- Content provided by‌ FirstRanker.com ---




Marginal cost of 5000 units = 5000 x 6

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=

30,000


--- Content provided by⁠ FirstRanker.com ---


Sale price of 5000 units

= 5000 x 6.50

--- Content provided by FirstRanker.com ---

=

32,500


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



--------

Profit

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

2,500




--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

--------


Thus by accepting the foreign order the present loss of Rs.20,000

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would be reduced to Rs.17,500 i.e., Rs.20000 loss ? Rs.2,500

profit.


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4.1.3.4 LIMITATIONS OF MARGINAL COSTING



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Marginal costing has the following limitations:

1.Difficulty in Classification: In marginal costing, costs are segregated into

fixed and variable. In actual practice, this classification scheme proves to be

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superfluous in that, certain costs may be partly fixed and partly variable and

certain other costs may have no relation to volume of output or even with the

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time. In short, the categorisation of costs into fixed and variable elements is a

difficult and tedious job.

2.Difficulty in Application: The marginal costing technique cannot be applied in

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industries where large stocks in the form of work-in-progress (job and

contracting firms) are maintained.

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3.Defective Inventory Valuation: Under marginal costing, fixed costs are not

included in the value of finished goods and work in progress. As fixed costs are

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229

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also incurred, these should form part of the cost of the product. By eliminating

fixed costs from finished stock and work-in-progress, marginal costing

techniques present stocks at less than their true value. Valuing stocks at

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marginal cost is objectionable because of other reasons also:

1. In case of loss by fire, full loss cannot be recovered from the

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insurance company.

2. Profits will be lower than that shown under absorption costing and

hence may be objected to by tax authorities.

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3. Circulating assets will be understated in the balance sheet.

4.Wrong Basis for Pricing: In marginal costing, sales prices are arrived at on

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the basis of contribution alone. This is an objectionable practice. For example, in

the long run, the selling price should not be fixed on the basis of contribution

alone as it may result in losses or low profits. Other important factors such as

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fixed costs, capital employed should also be taken into account while fixing

selling prices. Further, it is also not correct to lay more stress on selling

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function, as is done in marginal costing, and relegate production function to the

backgroud.

5.Limited Scope: The utility of marginal costing is limited to short-run profit

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planning and decision-making. For decisions of far-reaching importance, one is

interested in special purpose cost rather than variable cost. Important decisions

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on several occasions, depend on non-cost considerations also, which are

thoroughly discounted in marginal costing.


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In view of these limitations, marginal costing needs to be applied

with necessary care and caution. Fruitful results will emerge only when

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management tries to apply the technique in combination with other

useful techniques such as budgetary control and standard costing.


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4.1.3.5 ADDITIONAL ILLUSTRATIONS



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230
Illustration 16: From the following information, find out the amount of profit

earned during the year, using marginal cost equation:

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Fixed

cost

Rs.5,00,000

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Variable

cost

--- Content provided by‌ FirstRanker.com ---

Rs.10

per

unit

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Selling

price

--- Content provided by FirstRanker.com ---

Rs.15

per

unit

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Output

level

--- Content provided by⁠ FirstRanker.com ---

1,50,000

units


--- Content provided by⁠ FirstRanker.com ---

Solution:
Contribution

=

--- Content provided by FirstRanker.com ---

Selling

price ? Variable cost


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





=

--- Content provided by‌ FirstRanker.com ---


(1,50,000 x 15) ? (1,50,000 x 10)

=

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Rs.22,50,000

?

Rs.15,00,000

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=

Rs.7,50,000

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Contribution

=

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Fixed

cost

+

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Profit

Rs.7,50,000

--- Content provided by‍ FirstRanker.com ---

=

5,00,000

+

--- Content provided by‌ FirstRanker.com ---


Profit

Profit

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=

7,50,000

?

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5,00,000



--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

=

(C ? F)

Profit

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=

Rs.2,50,000

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Illustration 17: Determine the amount of fixed costs from the following details,
using the marginal cost equation.
Sales

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Rs.2,40,000



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Direct materials




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Rs. 80,000

Direct

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labour

Rs.


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50,000

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Variable overheads


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Rs. 20,000

Profit

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Rs.


--- Content provided by‌ FirstRanker.com ---




50,000

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Solution:


Marginal costing equation

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=

S ? V = F + P

=

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2,40,000

?

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1,50,000




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





=

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F + P

=

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90,000

=

F

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+

50,000

--- Content provided by‍ FirstRanker.com ---

F

=

90,000

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?

50,000

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F

=

Rs.40,000

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Illustration 18:

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231


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Sales 10,000 units @ Rs.25 per unit



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Variable cost Rs.15 per unit

Fixed

costs

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Rs.1,00,000



--- Content provided by‌ FirstRanker.com ---

Find out the sales for earning a profit of Rs.50,000


Solution:

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Sales to earn a profit of Rs.50,000


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(Fixed

cost

--- Content provided by⁠ FirstRanker.com ---


+

Profit)

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Sales

=

----------------------------------

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--- Content provided by​ FirstRanker.com ---





Sales ? Variable Cost

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--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

1,00,000 + 50,000 x 2,50,000

=

-------------------------------------

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--- Content provided by⁠ FirstRanker.com ---





2,50,000 ? 1,50,000

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--- Content provided by FirstRanker.com ---


1,50,000

x

--- Content provided by⁠ FirstRanker.com ---

2,50,000

=

---------------------------

--- Content provided by⁠ FirstRanker.com ---


1,00,000

=

--- Content provided by⁠ FirstRanker.com ---

Rs.3,75,000


Illustration 19: The records of RAM Ltd., which has three departments give the
following figures:

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-------------------------------------------------------------------------------------------------
Dept.

A Dept.

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B Dept.

C Total


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--- Content provided by​ FirstRanker.com ---



(Rs.) (Rs.)

(Rs.) (Rs.)

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-------------------------------------------------------------------------------------------------


Sales

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12,000

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18,000

20,000 50,000

-------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---



Marginal cost

13,000

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6,000

15,000 34,000

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Fixed cost


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1,000

4,000

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10,000 15,000

-------------------------------------------------------------


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Total cost



14,000 10,000

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25,000 49,000



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Profit/Loss



-2,000 +8,000

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-5,000 1,000

-------------------------------------------------------------------------------------------------

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The management wants to discontinue product C immediately as it

gives the maximum loss. How would you advise the management?

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Solution:



232

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Marginal Cost Statement
-------------------------------------------------------------------------------------------------
Particulars


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A

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B


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C



--- Content provided by⁠ FirstRanker.com ---

Total

(Rs.)

(Rs.)

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(Rs.)

(Rs.)

--- Content provided by​ FirstRanker.com ---

-------------------------------------------------------------------------------------------------


Sales

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12,000

18,000

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20,000 50,000

Less: Marginal cost

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13,000

6,000

15,000 34,000

--- Content provided by‌ FirstRanker.com ---


-------------------------------------------------------------


Contribution

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-1,000

12,000

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5,000 16,000



Fixed cost

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




15,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




-------

--- Content provided by⁠ FirstRanker.com ---



Profit


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


1,000



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




-------

--- Content provided by‍ FirstRanker.com ---

-------------------------------------------------------------------------------------------------




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Here department A gives negative contribution, and as such it can

be given up. Department C gives a contribution of Rs.5,000. If

department C is closed, then it may lead to further loss. Therefore, C

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should be continued.

4.1.3.6 SUMMARY

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Marginal costing is an important technique of costing where only

variable costs are considered while calculating the cost of the product. It

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is a technique of presenting cost information and can be used with other

methods of costing (such as job costing, contract costing, etc). This

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technique can be applied while taking decisions relating to profit

planning, introducing a new product, level of activity planning,

allocating scarce factors to profitable channels, make or buy decisions,

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suitable production/sales mix, fixing prices for products, etc. However

this technique is not without limitations.

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4.1.3.7 KEY WORDS



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233

Marginal Costing: The change in total cost because of change in total output by

one unit which is otherwise called as variable cost.

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Contribution: The excess of selling price over variable cost.

Profit Volume Ratio: It shows the relationship between contribution and sales.

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Break Even Point: It is that point of sales at which there is no profit or no loss

i.e. where total revenues and total costs are equal.

Margin of Safety: Excess of actual sales over break-even sales.

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Marginal Cost Equation:



--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




S ? V =

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C




--- Content provided by‍ FirstRanker.com ---


C

=

--- Content provided by FirstRanker.com ---

F + P

4.1.3.8 SELF ASSESSMENT QUESTIONS

1. Define Marginal Cost.

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2. What is meant by Contribution? Explain its significance.

3. Explain the following:

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(i)

Profit Volume Ratio

(ii)

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Break Even Point

(iii)

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Margin of Safety

4. Explain how marginal costing technique is useful as a decision making tool.

5. Critically evaluate marginal costing technique.

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6. Break-down of cost per unit at an activity level of 10,000 units of a company

is as follows:

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Rs.

Raw

materials 10

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Direct

expenses 8

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Chargeable

expenses


--- Content provided by‍ FirstRanker.com ---


2

Variable

--- Content provided by​ FirstRanker.com ---

overheads



4

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Fixed

overheads

--- Content provided by​ FirstRanker.com ---

6

---
Total

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cost

per

unit

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30



--- Content provided by‍ FirstRanker.com ---

234
Selling

price

--- Content provided by‍ FirstRanker.com ---

32

---


--- Content provided by​ FirstRanker.com ---


Profit

per

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unit



2

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---



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How many units must be sold to break-even?

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7. Tamarai Ltd., gives you the following information:


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Sales

Profit

Rs.

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Rs.

Period

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I 1,50,000 20,000

Period

II 1,70,000 25,000

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Calculate:

(a) The P/V Ratio.
(b) The Profit when sales are Rs.2,50,000

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(c) The sales required to earn a profit of Rs.40,000
(d) The break-even point.


8. Production costs of Selvi Enterprises Limited are as follows:

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-------------------------------------------------------------------------------------------------
Level

of

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Activity

-------------------------------------------------------------------------------------------------

Output

--- Content provided by⁠ FirstRanker.com ---


(in

%ge) 60%

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70%

80%


--- Content provided by FirstRanker.com ---

Output

(in

units)

--- Content provided by‍ FirstRanker.com ---


1,200

1,400

--- Content provided by‍ FirstRanker.com ---

1,600




--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



------------------------------------------------


--- Content provided by FirstRanker.com ---


Direct materials



--- Content provided by‌ FirstRanker.com ---

24,000 28,000 32,000



Direct labour

--- Content provided by‌ FirstRanker.com ---




7,200

--- Content provided by‌ FirstRanker.com ---

8,400

9,600


--- Content provided by​ FirstRanker.com ---


Factory overheads

12,800 13,600 14,400

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

------------------------------------------------



Works Cost

--- Content provided by‌ FirstRanker.com ---




44,000 50,000 56,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

------------------------------------------------

-------------------------------------------------------------------------------------------------

A proposal to increase production to 90% level of activity is

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under consideration of the management. The proposal is not expected to

involve any increase in fixed factory overheads.

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[Hint: Fixed factory overheads Rs.8,000]




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235

9. The following expenses are incurred in the manufacture of 1,000 units of a

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product in the manufacture of which a factory specialises:

Raw

materials

--- Content provided by‌ FirstRanker.com ---


2,800

Wages

--- Content provided by​ FirstRanker.com ---

1,900

Overhead Charges (Rs.4,000 fixed)

4,200

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

10,000 units of the product can be absorbed by the home market where

the selling price is Rs.9 per unit. There is a demand for 50,000 units of

the product in a foreign market if it can be offered at Rs.8.20 per unit. If

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this is done, what will be the total profit or loss made by the

manufacturer.

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10. The following data are obtained from the records of a factory:




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Rs.

Rs.

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Sales 4000 units @ Rs.25 each

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



1,00,000


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Less: Marginal Cost

Materials

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consumed

40,000

Labour

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charges 20,000

Variable

--- Content provided by‍ FirstRanker.com ---

overheads

12,000

--------

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

72,000




--- Content provided by FirstRanker.com ---


Fixed cost



--- Content provided by⁠ FirstRanker.com ---





18,000

--- Content provided by​ FirstRanker.com ---


90,000

---------

--- Content provided by‍ FirstRanker.com ---

---------

Profit


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

10,000




--- Content provided by‌ FirstRanker.com ---


---------



--- Content provided by​ FirstRanker.com ---

It is proposed to reduce the selling price by 20%. What extra units

should be sold to obtain the same amount of profit as above?

4.1.3.9 KEY TO SELF ASSESSMENT QUESTIONS

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(For Problems only)


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Q.No.6:

7500 units.


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Q.No.7:

(a) 25%; (b) Rs.45,000; (c) Rs.2,30,000; (d) Rs.70,000.


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236
Q.No.8:

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Prime cost Rs.46,800; Marginal cost Rs.54,000; Works cost
Rs.62,000.


--- Content provided by FirstRanker.com ---

Q.No.9:

Profit Rs.2,02,000.


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Q.No.10:

10,000 units.


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4.1.3.10 CASE ANALYSIS


The cost per unit of the three products X, Y and Z of a concern is

--- Content provided by⁠ FirstRanker.com ---


as follows:



--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

X Y

Z


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





(Rs.)

--- Content provided by‍ FirstRanker.com ---


(Rs.)

(Rs.)

--- Content provided by⁠ FirstRanker.com ---




Direct material

--- Content provided by⁠ FirstRanker.com ---



6

7

--- Content provided by​ FirstRanker.com ---


6



--- Content provided by‌ FirstRanker.com ---

Direct labour

10

8

--- Content provided by‍ FirstRanker.com ---


9



--- Content provided by‍ FirstRanker.com ---

Variable expenses



4

--- Content provided by FirstRanker.com ---


5

3

--- Content provided by‌ FirstRanker.com ---



Fixed expenses


--- Content provided by‍ FirstRanker.com ---


3

3

--- Content provided by FirstRanker.com ---

2



----------------------------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


23 23 20



--- Content provided by​ FirstRanker.com ---

Profit




--- Content provided by⁠ FirstRanker.com ---


9

7

--- Content provided by​ FirstRanker.com ---

6



-----------------------------------------------

--- Content provided by‍ FirstRanker.com ---




Selling price

--- Content provided by​ FirstRanker.com ---



32 30

26

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

-----------------------------------------------



No. of units produced

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10,000

5,000

--- Content provided by‍ FirstRanker.com ---

8,000



Production arrangements are such that if one product is given up, the

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production of the others can be raised by 50%. The Directors propose that Z

should be given up because the contribution in that case is the lowest.

--- Content provided by‌ FirstRanker.com ---

Analyse the case and give your opinion.

Solution:
Statement of Projected Profitability with Products X and Y
-----------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



X


--- Content provided by​ FirstRanker.com ---


Y

-----------------------------------------------------------------------------------------
Production

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(in

units)

--- Content provided by‍ FirstRanker.com ---

10000

5000

Add 50% increase (proposed)

--- Content provided by​ FirstRanker.com ---




5000

--- Content provided by⁠ FirstRanker.com ---

2500



-------------------------

--- Content provided by⁠ FirstRanker.com ---




15000

--- Content provided by‌ FirstRanker.com ---

7500

---------------------------


--- Content provided by‌ FirstRanker.com ---


237

Selling price per unit

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---


32



--- Content provided by​ FirstRanker.com ---

30



--------------------------

--- Content provided by⁠ FirstRanker.com ---


Less: Variable cost per unit
Materials

6

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





7

--- Content provided by‌ FirstRanker.com ---


Labour

10

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

8



Variable expenses

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



4


--- Content provided by‍ FirstRanker.com ---


5



--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



-------------------------
20

--- Content provided by⁠ FirstRanker.com ---

20

-------------------------

Contribution per unit

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

12 10

Total Contribution
X

--- Content provided by​ FirstRanker.com ---

15000

units

x

--- Content provided by‍ FirstRanker.com ---


Rs.12

=

--- Content provided by‌ FirstRanker.com ---

Rs.1,80,000




--- Content provided by​ FirstRanker.com ---


Y

7500 units x Rs.10

--- Content provided by FirstRanker.com ---

=

Rs. 75,000

--------------

--- Content provided by​ FirstRanker.com ---




Rs.2,55,000

--- Content provided by‍ FirstRanker.com ---

Less: Fixed Cost
X

10000

--- Content provided by​ FirstRanker.com ---

x

3

=

--- Content provided by FirstRanker.com ---


30000



--- Content provided by FirstRanker.com ---



Y

5000 x 3

--- Content provided by​ FirstRanker.com ---


=

15000

--- Content provided by‍ FirstRanker.com ---





Z

--- Content provided by‍ FirstRanker.com ---


8000 x 2

=

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16000

Rs. 61,000

-------

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--------------



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Projected

Profit =

Rs.1,94,000

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--------------



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Statement of Present Profit with Products X, Y and Z




--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



Rs.


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Product X

=

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10000 units x Rs.9

=

90,000

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Product Y

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=

5000 units x Rs.7 =

35,000

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Product Z

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=

8000 units x Rs.6

=

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48,000



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



------------


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




1,73,000

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--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





----------

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Since by discontinuing Product Z and increasing the production of

Products X and Y the profit increases from Rs.1,73,000 to Rs.1,94,000.

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The Directors proposal may be implemented.




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238

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4.1.3.11 BOOKS FOR FURTHER READING



1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New Delhi.

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2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.

3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.

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4. S.N.Maheswari: Management Accounting and Financial Control, Sultan

Chand & Sons.

5. V.K.Saxena and C.D.Vashist: Advanced Cost and Management Accounting,

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Sultan Chand & Sons, New Delhi.



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239

UNIT-IV

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LESSON 4.2

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-------------------------------------------------------------------------------------------------

COST VOLUME PROFIT ANALYSIS

-------------------------------------------------------------------------------------------------

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4.2.1 INTRODUCTION



The cost of a product consists of two items: fixed cost and

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variable cost. Fixed costs are those which remain the same in total

amount regardless of changes in volume. Variable costs are those which

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vary in total amount as the volume of production increases or decreases.

As a result, at different levels of activity, the cost structure of a firm

changes. The effect on profit on account of such variations is studied

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through break even analysis or cost-volume-profit analysis. This lesson

deals with the various concepts, tools and techniques of cost-volume-

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profit analysis.

4.2.2 OBJECTIVES


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After reading this lesson, the reader should be able to:

? Understand the meaning of cost-volume-profit analysis.
? Apply cost-volume-profit analysis while taking decisions.

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? Construct the break-even chart.
? Evaluate the advantages and limitations of break-even analysis.

4.2.3 CONTENTS

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4.2.3.1

Meaning of Cost-Volume-Profit Analysis

4.2.3.2

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Application of Cost-Volume-Profit Analysis

4.2.3.3

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Break Even Chart

4.2.3.4

Consultation of Break Even Chart

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4.2.3.5

Profit Volume Graph

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4.2.3.6

Advantages and Limitations of Break Even Analysis


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240
4.2.3.7

Summary

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4.2.3.8

Key Words

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4.2.3.9

Self Assessment Questions

4.2.3.10

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Key to Self Assessment Questions

4.2.3.11

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Case Analysis

4.2.3.12

Books for Further Reading

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4.2.3.1 MEANING OF COST-VOLUME-PROFIT ANALYSIS



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Cost-volume-profit (CVP) analysis focuses on the way cost and

profit change when volume changes. It is, broadly speaking, that system

of analysis which determines the probable profit at any level of activity.

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This technique is generally used to analyse the incremental effect of

volume on costs, revenues and profits. At what volume of operations are

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costs and revenues equal? What volume of output or sales would be

necessary to earn a profit of say Rs.2 lakhs? How much profit will be

earned at a volume of, say 10,000 units? What will happen if there is a

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reduction of 10 percent in the selling price? Questions like these are

sought to be answered through CVP analysis. This detailed analysis will

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help the management to know the profit levels at different activity levels

of production and sales and various types of costs involved in it.

4.2.3.2 APPLICATION OF COST-VOLUME-PROFIT ANALYSIS

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CPV analysis helps in:

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? forecasting the profit in an accurate manner
? preparing the flexible budgets at different levels of activity
? fixing prices for products


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241

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Illustration 1: (Profit Planning) Based on the following information, find out

the break even point, the sales needed for a profit of Rs.6,00,000 and the profit if

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4,00,000 units are sold at Rs.6 per unit.

Units

of

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output 5,00,000

Fixed

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costs

Rs.7,50,000

Variable

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cost

per

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unit

Rs.

2

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Selling

price

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per

unit

Rs.

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5

Solution:

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(1) Break-even point (of sales)

Fixed costs

=

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-------------------------- x Selling price per unit



--- Content provided by​ FirstRanker.com ---

Contribution

per

unit

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--- Content provided by‍ FirstRanker.com ---


7,50,000



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=

-------------- x 5

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=

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Rs.12,50,000




--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

3

(2) Sales needed for a profit of Rs.6,00,000

FC + Desired Profit

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Sales



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=

--------------------------


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--- Content provided by FirstRanker.com ---





P/V Ratio

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--- Content provided by‍ FirstRanker.com ---


7,50,000

+

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6,00,000

=

---------------------------

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--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




3/5

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--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

5




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

=

13,50,000 x -----


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--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




3

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=

Rs.22,50,000

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[or]




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22,50,000

=

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---------------



--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




(SP) 5

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=

4,50,000

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units




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242
(3) Profit on sale of 4,00,000 units at Rs.6 per unit

Sales

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=

4,00,000

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units

=

4,00,000

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x

Rs.6

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=

Rs.24,00,000


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Sales ? V. Cost

=

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Contribution



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24 lakhs ? (4 lakhs x 2 per unit)

=

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16,00,000

C

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?

FC

=

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Profit

16,00,000

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?

7,50,000

=

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Rs.8,50,000

[or]

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--- Content provided by‍ FirstRanker.com ---

Unit sales x Contribution per unit ? FC




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4 lakhs x Rs.4 =

16 lakhs ? 7,50,000 = 8,50,000

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Illustration 2: (Pricing) A company is considering a reduction in the price of

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its product by 10% because it is felt that such a step may lead to a greater

volume of sales. It is anticipated that there will be no change in total fixed costs

or variable costs per unit. The directors wish to maintain profit at the present

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level.



--- Content provided by FirstRanker.com ---

You are given the following information:

Sales

(15,000

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units)

Rs.3,00,000

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Variable

cost

Rs.13

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per

unit

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Fixed

cost

Rs.60,000

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From the above information, calculate P/V ratio and the amount of

sales required to maintain profit at the present level after reduction of

selling price by 10%.

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Solution:



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--- Content provided by‌ FirstRanker.com ---


S ? V

3,00,000? (15,000 x 13)

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P/V Ratio

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= ----------

= -------------------------------

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--- Content provided by‌ FirstRanker.com ---




S

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3,00,000

=

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0.35

or

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35%




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After reduction of price by 10% it will be Rs.18 (original price per unit =

Rs.20).


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243



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Present profit level



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=

(35% of 3,00,000) ? 60,000

=

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Rs.45,000



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P/V ratio after price reduction



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--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

S ? V 18 ? 13 5

=

--------

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--- Content provided by‍ FirstRanker.com ---





=

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---------- = ---- %



--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

S 18 18




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To earn the same profit level

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



F + Desired Profit

=

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-------------------------



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



P/V Ratio


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--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





18

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=

1,05,000

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x

------


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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






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5


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=

Rs.3,78,000


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Illustration 3: From the following data, calculate the break-even point.



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First

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year

Second

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year



Sales

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80,000


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90,000

Profit

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Rs.10,000

Rs.14,000


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Solution:




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Fixed costs

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BEP

Sales

=

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---------------



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--- Content provided by‌ FirstRanker.com ---




P/V Ratio

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Change

in

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profit

P/V

Ratio

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=

-------------------- x 100

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--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Change in sales




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4,000

=

---------

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x

100

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=

40%

10,000

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Fixed cost

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=

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Contribution ? Profit




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244



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40

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--- Content provided by​ FirstRanker.com ---





=

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80,000 x ------ - Rs.10,000



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--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

100




--- Content provided by‌ FirstRanker.com ---

=

32,000

?

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10,000


=

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22,000


22,000

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x

100

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BEP

Sales

=

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---------------- =

Rs.55,000

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--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



40


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Illustration 4: A company is considering expansion. Fixed costs amount to

Rs.4,20,000 and are expected to increase by Rs.1,25,000 when plant expansion

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is completed. The present plant capacity is 80,000 units a year. Capacity will

increase by 50 percent with the expansion. Variable costs are currently Rs.6.80

per unit and are expected to go down by Re.0.40 per unit with the expansion.

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The current selling price is Rs.16 per unit and is expected to remain the same

under either alternative. What are the break-even points under either

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alternatives? Which alternative is better and why?



Solution:

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Computation of BEP under two alternatives

-----------------------------------------------------------------------------------------------
Items

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Currently

After

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the

expansion


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--- Content provided by‍ FirstRanker.com ---





Rs.

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--- Content provided by‍ FirstRanker.com ---



Rs.

-----------------------------------------------------------------------------------------------

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Fixed

costs

4,20,000 5,45,000

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Capacity



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


80,000 units 1,20,000 units

Variable

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cost

per

unit

--- Content provided by FirstRanker.com ---


6.80

6.40

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Contribution

margin

per

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unit

9.20

--- Content provided by​ FirstRanker.com ---

9.60

Selling

price

--- Content provided by​ FirstRanker.com ---


per

unit

--- Content provided by⁠ FirstRanker.com ---

16

16


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

245



4,20,000

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5,45,000

BEP =

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------------

-----------

9.20

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9.60



--- Content provided by​ FirstRanker.com ---

=

45,652

units

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=

56,771

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units

-----------------------------------------------------------------------------------------------


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Assuming that the whole production can be sold, the profit under

the two alternatives will be:

-----------------------------------------------------------------------------------------------

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Items

Currently

After

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the

expansion

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-----------------------------------------------------------------------------------------------
Sales

12,80,000

--- Content provided by FirstRanker.com ---

19,20,000

-

Variable

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cost



--- Content provided by‌ FirstRanker.com ---

5,44,000

7,68,000

------------ ------------

--- Content provided by‌ FirstRanker.com ---




Contribution

--- Content provided by​ FirstRanker.com ---



7,36,000 11,52,000

-

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Fixed

cost

--- Content provided by⁠ FirstRanker.com ---



4,20,000

5,45,000

--- Content provided by⁠ FirstRanker.com ---


------------ ------------



--- Content provided by‌ FirstRanker.com ---



3,16,000


--- Content provided by⁠ FirstRanker.com ---


6,07,000

------------ ------------

--- Content provided by‍ FirstRanker.com ---



-----------------------------------------------------------------------------------------------


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It is obvious from the above calculations that the profits will be

almost double after the expansion. Hence, the alternative of expansion is

to be preferred.

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Illustration 5: A factory engaged in manufacturing plastic buckets is working at

40% capacity and produces 10,000 buckets per annum:

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Rs.

--- Content provided by⁠ FirstRanker.com ---

Material 10

Labour

cost

--- Content provided by​ FirstRanker.com ---


3

Overheads

--- Content provided by‌ FirstRanker.com ---

5

(60%

fixed)

--- Content provided by​ FirstRanker.com ---




The selling price is Rs.20 per bucket.

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If it is decided to work the factory at 50% capacity, the selling

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price falls by 3%. At 90% capacity the selling price falls by 5%,

accompanied by a similar fall in the prices of material.

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You are required to calculate the profit at 50% and 90% capacities

and also the break-even points for the same capacity productions.

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246

--- Content provided by​ FirstRanker.com ---


Solution:



--- Content provided by‌ FirstRanker.com ---

Statement showing profit and break-even point at different

capacity levels:


--- Content provided by‌ FirstRanker.com ---

Capacity level

50%

90%

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Production

(units)

--- Content provided by‌ FirstRanker.com ---

12,500

22,500

-------------------------------------------------------------------------------------------------

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Per unit

Total Perunit

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Total



--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Rs.

--- Content provided by FirstRanker.com ---

Rs. Rs.

Rs.

-------------------------------------------------------------------------------------------------

--- Content provided by‌ FirstRanker.com ---

(a)

Sales


--- Content provided by‌ FirstRanker.com ---




19.40

--- Content provided by​ FirstRanker.com ---

2,42,500 19.00 4,27,500

Variable

cost

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Materials




--- Content provided by‍ FirstRanker.com ---


10.00

1,25,000 9.50 2,13,750

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Wages


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3.00

--- Content provided by​ FirstRanker.com ---

37,500 3.00 67,500



Variable overhead

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2.00

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25,000 2.00 45,000

----------------------------------------------------
(b)

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Total variable cost



15.00

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1,87,500 14.50 3,26,250

----------------------------------------------------
(c)

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Contribution (S-V)



--- Content provided by​ FirstRanker.com ---

4.40

55,000 4.50 1,01,250


--- Content provided by⁠ FirstRanker.com ---


or (a ? b)



--- Content provided by‍ FirstRanker.com ---

Less Fixed cost




--- Content provided by⁠ FirstRanker.com ---




30,000

--- Content provided by⁠ FirstRanker.com ---

30,000




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


----------

----------

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





25,000

--- Content provided by​ FirstRanker.com ---


71,250



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



----------

----------

--- Content provided by‍ FirstRanker.com ---


-------------------------------------------------------------------------------------------------
Break-even

points

--- Content provided by⁠ FirstRanker.com ---


at

50%

--- Content provided by‌ FirstRanker.com ---

at

90%


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Fixed costs

Units

--- Content provided by‍ FirstRanker.com ---

=

---------------------------


--- Content provided by FirstRanker.com ---




Contribution

--- Content provided by​ FirstRanker.com ---

per

unit


--- Content provided by‌ FirstRanker.com ---



30,000

30,000

--- Content provided by⁠ FirstRanker.com ---


=

---------- = 6818 ---------- = 6667

--- Content provided by FirstRanker.com ---

4.40

4.50


--- Content provided by‌ FirstRanker.com ---


Sales value



--- Content provided by⁠ FirstRanker.com ---

= Rs.1,32,269 = Rs.1,26,667




--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



247

Illustration 6:

--- Content provided by‍ FirstRanker.com ---


Calculate:

(i)

--- Content provided by‍ FirstRanker.com ---

The amount of fixed expenses

(ii)

The number of units to break-even

--- Content provided by⁠ FirstRanker.com ---


(iii)

The number of units to earn a profit of Rs.40,000

--- Content provided by​ FirstRanker.com ---

The selling price can be assumed as Rs.10.

The company sold in two successive periods 9,000 units and 7,000 units

and has incurred a loss of Rs.10,000 and earned Rs.10,000 as profit respectively.

--- Content provided by‌ FirstRanker.com ---


Solution:

Sales

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Profit/Loss

I 7,000

-

--- Content provided by​ FirstRanker.com ---


10,000

II

--- Content provided by​ FirstRanker.com ---

9,000

+10,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





-------

--- Content provided by​ FirstRanker.com ---


----------

2,000

--- Content provided by⁠ FirstRanker.com ---





20,000

--- Content provided by​ FirstRanker.com ---


(Change)



--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



units Rs.


--- Content provided by‍ FirstRanker.com ---


units Rs.

(i) Contribution

--- Content provided by‍ FirstRanker.com ---

=

9,000 x 10= 90,000 7,000 x 10

= 70,000

--- Content provided by⁠ FirstRanker.com ---





Profit/Loss

--- Content provided by FirstRanker.com ---


=

Rs. -10,000

--- Content provided by⁠ FirstRanker.com ---

Rs.+10,000




--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

---------



----------

--- Content provided by‍ FirstRanker.com ---


Fixed Cost

=

--- Content provided by​ FirstRanker.com ---



80,000


--- Content provided by‌ FirstRanker.com ---


80,000

---------

--- Content provided by FirstRanker.com ---



----------


--- Content provided by​ FirstRanker.com ---




(Contribution = Fixed cost + Profit)

--- Content provided by​ FirstRanker.com ---



Rs.20,000

(ii) Contribution

--- Content provided by FirstRanker.com ---


=

--------------- = Rs.10 per unit

--- Content provided by‌ FirstRanker.com ---





2,000

--- Content provided by‌ FirstRanker.com ---


units



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

FC

Rs.80,000

BEP

--- Content provided by‍ FirstRanker.com ---


=

---------

--- Content provided by⁠ FirstRanker.com ---

=

------------- = 8,000

units

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---





C

--- Content provided by‍ FirstRanker.com ---


Rs.10


(iii)

--- Content provided by‍ FirstRanker.com ---


The No. of units to earn a profit of Rs.40,000



--- Content provided by⁠ FirstRanker.com ---

F + Desired Profit



80,000 + 40,000

--- Content provided by​ FirstRanker.com ---


----------------------- = ---------------------
C per unit


--- Content provided by⁠ FirstRanker.com ---


10


=

--- Content provided by⁠ FirstRanker.com ---


12,000

units

--- Content provided by FirstRanker.com ---



248
Illustration 7:

--- Content provided by‍ FirstRanker.com ---



From the following data calculate:

(i)

--- Content provided by FirstRanker.com ---


P/V ratio

(ii)

--- Content provided by⁠ FirstRanker.com ---

Profit when sales are Rs.20,000

(iii)

Net break-even if selling price is reduced by 20%

--- Content provided by‍ FirstRanker.com ---


Fixed expenses Rs.4,000

Break-even point 10,000

--- Content provided by​ FirstRanker.com ---


Solution:



--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Fixed expenses

(i) Break-even

--- Content provided by FirstRanker.com ---

Sales = --------------------




--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





P/V ratio

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Fixed

--- Content provided by FirstRanker.com ---

expenses



or P/V ratio

--- Content provided by⁠ FirstRanker.com ---




= ----------------------

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



Break-even sales


--- Content provided by⁠ FirstRanker.com ---



4,000

=

--- Content provided by FirstRanker.com ---


--------

=

--- Content provided by​ FirstRanker.com ---

40%



10,000

--- Content provided by⁠ FirstRanker.com ---


(ii)

Profit when sales are Rs.20,000

--- Content provided by‌ FirstRanker.com ---



Profit


--- Content provided by‌ FirstRanker.com ---


=

Sales x P/V ratio ? Fixed expenses

--- Content provided by FirstRanker.com ---

=

Rs.20,000

x

--- Content provided by‌ FirstRanker.com ---


40%

- Rs.4,000

--- Content provided by⁠ FirstRanker.com ---

=

Rs.8,000

?

--- Content provided by FirstRanker.com ---


Rs.4,000

=

--- Content provided by‌ FirstRanker.com ---

Rs.4,000



(iii)

--- Content provided by FirstRanker.com ---


New break-even point if selling price is reduced by 20%



--- Content provided by‍ FirstRanker.com ---

If selling price is Rs.100, now it will be Rs.80
V. cost per unit

= Rs.60 (i.e., 100 ? 40% old P/V ratio)

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





249

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



80 ? 60

New P/V ratio =

--- Content provided by‌ FirstRanker.com ---


----------

=

--- Content provided by‌ FirstRanker.com ---

25%




--- Content provided by‍ FirstRanker.com ---




80

--- Content provided by FirstRanker.com ---


4,000
Break-even point will be

=

--- Content provided by FirstRanker.com ---


------- = Rs.16,000



--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




25%

--- Content provided by FirstRanker.com ---

Illustration 8:



From the following data calculate:

--- Content provided by‍ FirstRanker.com ---


(i)

Break-even point in amount of sales in rupees.

--- Content provided by​ FirstRanker.com ---

(ii)

Number of units that must be sold to earn a profit of Rs.60,000

per year.

--- Content provided by⁠ FirstRanker.com ---


(iii)

How many units must be sold to earn a net profit of 15% of

--- Content provided by‌ FirstRanker.com ---

sales?

Sales

Price

--- Content provided by‍ FirstRanker.com ---


Rs.20

per

--- Content provided by⁠ FirstRanker.com ---

unit

Variable manufacturing costs Rs.11 per unit
Variable selling costs

--- Content provided by‌ FirstRanker.com ---

Rs.3 per unit

Fixed factory overheads

Rs.5,40,000

--- Content provided by⁠ FirstRanker.com ---


Fixed selling costs



--- Content provided by FirstRanker.com ---

Rs.2,52,000

Solution:
------------------------------------------------------------------------------------------------
(i)

--- Content provided by⁠ FirstRanker.com ---


Items

Per

--- Content provided by FirstRanker.com ---

unit

Total

fixed

--- Content provided by‍ FirstRanker.com ---


cost:



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Rs.

--- Content provided by​ FirstRanker.com ---





Rs.

--- Content provided by FirstRanker.com ---


-------------------------------------------------------------------------------------------------
-
Sales

--- Content provided by‌ FirstRanker.com ---

price

20

Factory

--- Content provided by⁠ FirstRanker.com ---


overheads

5,40,000

--- Content provided by⁠ FirstRanker.com ---

Variable

costs

Selling

--- Content provided by​ FirstRanker.com ---


costs

2,52,000

--- Content provided by​ FirstRanker.com ---

----------



Manufacturing

--- Content provided by​ FirstRanker.com ---


11

7,92,000

--- Content provided by⁠ FirstRanker.com ---

Selling



3

--- Content provided by‌ FirstRanker.com ---


14

--

--- Content provided by⁠ FirstRanker.com ---

---




--- Content provided by‍ FirstRanker.com ---


Contribution per unit

6

--- Content provided by‍ FirstRanker.com ---

-------------------------------------------------------------------------------------------------
Fixed

costs

--- Content provided by​ FirstRanker.com ---

7,92,000

BEP

=

--- Content provided by‍ FirstRanker.com ---


------------------------- =

------------

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Contribution per unit

--- Content provided by‍ FirstRanker.com ---

6




--- Content provided by⁠ FirstRanker.com ---


250
=

1,32,000

--- Content provided by​ FirstRanker.com ---


units



--- Content provided by‍ FirstRanker.com ---


Total sales

=

--- Content provided by FirstRanker.com ---

1,32,000 x Rs.20

=

26,40,000

--- Content provided by⁠ FirstRanker.com ---





Fixed cost + Desired Profit

--- Content provided by‌ FirstRanker.com ---




7,92,000 + 60,000

--- Content provided by‌ FirstRanker.com ---

(ii) -----------------------------------

=

-----------------------

--- Content provided by‌ FirstRanker.com ---




Contribution per unit

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


6


8,52,000

--- Content provided by‍ FirstRanker.com ---

=

-----------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


6


=

--- Content provided by‍ FirstRanker.com ---


1,42,000

units

--- Content provided by‍ FirstRanker.com ---

(iii)

Let the no. of units sold be x.


--- Content provided by‌ FirstRanker.com ---



Marginal cost equation:

=

--- Content provided by⁠ FirstRanker.com ---


S

?

--- Content provided by‍ FirstRanker.com ---

V

=

F

--- Content provided by‍ FirstRanker.com ---


+

P

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


=

20x ? 14x

--- Content provided by‍ FirstRanker.com ---

=

F + 15% of sales


--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

=

20 x ? 14 x

=

--- Content provided by⁠ FirstRanker.com ---


7,92,000 + 15% of 20x

=

--- Content provided by​ FirstRanker.com ---

6

x

=

--- Content provided by FirstRanker.com ---


7,92,000

+

--- Content provided by‍ FirstRanker.com ---

3

x


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

=

6 x ? 3 x

=

--- Content provided by‌ FirstRanker.com ---


7,92,000

=

--- Content provided by‍ FirstRanker.com ---

3

x

=

--- Content provided by⁠ FirstRanker.com ---


7,92,000


7,92,000

--- Content provided by FirstRanker.com ---



x = no. of units


--- Content provided by FirstRanker.com ---




=

--- Content provided by‍ FirstRanker.com ---

----------




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





3

--- Content provided by​ FirstRanker.com ---



=

2,64,000

--- Content provided by​ FirstRanker.com ---



2,64,000

x

--- Content provided by⁠ FirstRanker.com ---


Rs.20

x

--- Content provided by FirstRanker.com ---

15

Profit

=

--- Content provided by​ FirstRanker.com ---


---------------------------

=

--- Content provided by‌ FirstRanker.com ---

Rs.7,92,000




--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



100


--- Content provided by​ FirstRanker.com ---


4.2.3.3 BREAK-EVEN CHART



--- Content provided by​ FirstRanker.com ---

The break-even point can also be shown graphically through the

break-even chart. The break-even chart `shows the profitability or

otherwise of an undertaking at various levels of activity and as a result

--- Content provided by FirstRanker.com ---


indicates the point at which neither profit nor loss is made'. It shows the

relationship, through a graph, between cost, volume and profit. The

--- Content provided by FirstRanker.com ---



251

break-even point lies at the point of intersection between the total cost

--- Content provided by‍ FirstRanker.com ---


line and the total sales line in the chart. In order to construct the break-

even chart, the following assumptions are made:

--- Content provided by​ FirstRanker.com ---

Assumptions of Break-even chart

1. Fixed costs will remain constant and do not change with the level of

activity.

--- Content provided by‌ FirstRanker.com ---


2. Costs are bifurcated into fixed and variable costs. Variable costs

change according to the volume of production.

--- Content provided by‍ FirstRanker.com ---

3. Prices of variable cost factors (wage rates, price of materials,

suppliers etc.) will remain unchanged so that variable costs are truly

variable.

--- Content provided by​ FirstRanker.com ---


4. Product specifications and methods of manufacturing and selling will

not undergo a change.

--- Content provided by​ FirstRanker.com ---

5. Operating efficiency will not increase or decrease.

6. Selling price remains the same at different levels of activity.

7. Product mix will remain unchanged.

--- Content provided by FirstRanker.com ---


8. The number of units of sales will coincide with the units produced,

and hence, there is no closing or opening stock.

--- Content provided by⁠ FirstRanker.com ---

4.2.3.4 CONSTRUCTION OF BREAK-EVEN CHART



The following steps are required to be taken while constructing the

--- Content provided by‌ FirstRanker.com ---


break-even chart:

1. Sales volume is plotted on the X-axis. Sales volume can be shown in

--- Content provided by‌ FirstRanker.com ---

the form of rupees, units or as a percentage of capacity. A horizontal

line is drawn spacing equal distances showing sales at various

activity levels.

--- Content provided by⁠ FirstRanker.com ---


2. Y axis represents revenues, fixed and variable costs. A vertical line is

also spaced in equal parts.

--- Content provided by⁠ FirstRanker.com ---



252


--- Content provided by⁠ FirstRanker.com ---

3. Draw the sales line from point O onwards. Cost lines may be drawn

in two ways (i) Fixed cost line is drawn parallel to X axis and above

it variable cost line is drawn from zero point of fixed cost line. This

--- Content provided by⁠ FirstRanker.com ---


line is called the Total cost line (Fig.1) (ii) In the second method the

variable cost line is drawn from point O and above this, fixed cost

--- Content provided by​ FirstRanker.com ---

line is depicted running parallel to the variable cost line. This line

may be called Total cost line. (Fig.2)

4. The point at which the total cost cuts across the sales line is the

--- Content provided by‍ FirstRanker.com ---


break-even point and volume at this point is break-even volume.

5. The angle of incidence is the angle between sales and the total cost

--- Content provided by⁠ FirstRanker.com ---

line. It is formed at the intersection of the sales and the total cost line,

indicating the profit earning capacity of a firm. The wider the angle

the greater is the profit and vice versa. Usually, the angle of

--- Content provided by‍ FirstRanker.com ---


incidence and the margin of safety are considered together to show

that a wider angle of incidence coupled with a high margin of safety

--- Content provided by⁠ FirstRanker.com ---

would indicate the most suitable conditions.

Illustration 9: From the following information, prepare a break-even chart

showing the break-even point.

--- Content provided by FirstRanker.com ---


Budget

output

--- Content provided by⁠ FirstRanker.com ---

....

80,000

units

--- Content provided by‌ FirstRanker.com ---


Fixed

expenses ....

--- Content provided by‌ FirstRanker.com ---

Rs.4,00,000



Selling price per unit

--- Content provided by FirstRanker.com ---


....



--- Content provided by​ FirstRanker.com ---

Rs.20



Variable cost per unit

--- Content provided by‌ FirstRanker.com ---


....



--- Content provided by‍ FirstRanker.com ---

Rs.10




--- Content provided by⁠ FirstRanker.com ---


253

Solution:

--- Content provided by FirstRanker.com ---


Total costs and sales at varying levels of output:

-------------------------------------------------------------------------------------------------
Output

--- Content provided by‌ FirstRanker.com ---


Variable Fixed



--- Content provided by‌ FirstRanker.com ---

Total

Sales

(units)

--- Content provided by‍ FirstRanker.com ---


Cost

Cost

--- Content provided by FirstRanker.com ---



Cost


--- Content provided by‍ FirstRanker.com ---




Rs.

--- Content provided by‌ FirstRanker.com ---



Rs.

Rs.

--- Content provided by‍ FirstRanker.com ---


Rs.

-------------------------------------------------------------------------------------------------
@

--- Content provided by FirstRanker.com ---


10

P.U.

--- Content provided by​ FirstRanker.com ---



@

20

--- Content provided by⁠ FirstRanker.com ---


P.U.

20,000

--- Content provided by FirstRanker.com ---

2,00,000 4,00,000 6,00,000



4,00,000

--- Content provided by FirstRanker.com ---


40,000

4,00,000 4,00,000 8,00,000

--- Content provided by​ FirstRanker.com ---



8,00,000

60,000

--- Content provided by‌ FirstRanker.com ---


6,00,000



--- Content provided by‍ FirstRanker.com ---

4,00,000 10,00,000 12,00,000

80,000

8,00,000

--- Content provided by⁠ FirstRanker.com ---




4,00,000 12,00,000 16,00,000

--- Content provided by FirstRanker.com ---

-------------------------------------------------------------------------------------------------




--- Content provided by FirstRanker.com ---



Fig. 1


--- Content provided by​ FirstRanker.com ---




254

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


Fig. 2



--- Content provided by⁠ FirstRanker.com ---

255

First Method (Fig.1)


--- Content provided by FirstRanker.com ---

Fixed cost line runs parallel to X-axis. Total cost line is drawn at

Rs.4 lakhs on Y-axis and runs upward. Sales line drawn from point O.


--- Content provided by‌ FirstRanker.com ---

B.E.P. is at 40,000 units, i.e., Rs.8,00,000




--- Content provided by⁠ FirstRanker.com ---



M/S =

Sales ? B.E. Volume

--- Content provided by‌ FirstRanker.com ---


=

80,000

--- Content provided by‍ FirstRanker.com ---

?

40,000

=

--- Content provided by​ FirstRanker.com ---


40,000

Units

--- Content provided by​ FirstRanker.com ---

(i.e.

Rs.8,00,000)

Alternative Method (Fig.2)

--- Content provided by‍ FirstRanker.com ---




Variable cost line starts from point O and runs upward. Total cost

--- Content provided by FirstRanker.com ---

line is drawn parallel to V.C.line from Rs.4 lakhs point on Y-axis. Total

cost and sales line cut each other at 40,000 units (i.e., Rs.8,00,000 sales).

This is the Break-even point.

--- Content provided by⁠ FirstRanker.com ---


Cash Break-Even Chart



--- Content provided by‍ FirstRanker.com ---

This chart is prepared to show the cash need of a concern. Fixed

expenses are to be classified as those involving cash payments and those

not involving cash payments like depreciation. As the cash break-even

--- Content provided by⁠ FirstRanker.com ---


chart is designed to include only actual payments and not expenses

incurred, any time lag in the payment of items included under variable

--- Content provided by‍ FirstRanker.com ---

costs must be taken into account. Equal care must be shown on the

period of credit allowed to the debtors for the purpose of calculating the

amount of cash to be received from them, during a particular period.

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



256


--- Content provided by​ FirstRanker.com ---



Illustration 10: The following information is available in respect of

Graphics Ltd. Ghaziabad, for the budget period.

--- Content provided by‌ FirstRanker.com ---




Sales 10,000 units at Rs.10 per unit.

--- Content provided by FirstRanker.com ---



Variable costs Rs.4 per unit.


--- Content provided by⁠ FirstRanker.com ---


Fixed costs Rs.25,000 including depreciation of Rs.5,000



--- Content provided by⁠ FirstRanker.com ---

Preference Dividend to be paid Rs.5,000



Taxes to be paid Rs.5,000

--- Content provided by‌ FirstRanker.com ---




It may be assumed that there are no lags in payment. Prepare a

--- Content provided by FirstRanker.com ---

cash break-even chart.



Fig.3.

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



257

4.2.3.5 PROFIT VOLUME GRAPH

--- Content provided by‌ FirstRanker.com ---




This graph (called profit graph) gives a pictorial representation of

--- Content provided by FirstRanker.com ---

cost-volume profit relationship. In this graph X axis represents sales.

However, the sales line bisects the graph horizontally to form two areas.

The ordinate above the zero sales line, shows the profit area, and the

--- Content provided by‍ FirstRanker.com ---


ordinate below the zero sales line indicates the loss or the fixed cost

area. The profit-volume-ratio line is drawn from the fixed cost point

--- Content provided by FirstRanker.com ---

through the break-even point to the point of maximum profit. In order to

construct this graph, therefore, data on profit at a given level of activity,

the break-even point and the fixed costs are required.

--- Content provided by‍ FirstRanker.com ---


Illustration 11: Draw the profit volume graph and find out P/V ratio

with the following information:

--- Content provided by‌ FirstRanker.com ---



Output 3,000 units


--- Content provided by​ FirstRanker.com ---


Volume of sales Rs.7,500

Variable

--- Content provided by FirstRanker.com ---

cost

Rs.1,500

Fixed

--- Content provided by‌ FirstRanker.com ---


cost

Rs.1,500

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


258



--- Content provided by‍ FirstRanker.com ---


Solution:



--- Content provided by‍ FirstRanker.com ---

In the above graph, the profit is Rs.1,500. The fixed cost is

Rs.1,500. PQ represents sales line at point Positive, which is the break

even point i.e., Rs.3,750. The P/V ratio can easily be found out with the

--- Content provided by‌ FirstRanker.com ---


help of this graph as follows:



--- Content provided by‍ FirstRanker.com ---

F

x

S

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


1,500 x 7,500

Sales at B.E.P.

--- Content provided by‍ FirstRanker.com ---

=

---------

=

--- Content provided by FirstRanker.com ---


----------------- Rs.3,750



--- Content provided by​ FirstRanker.com ---

S

?

V

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


7,500 ? 4,500


Margin of safety

--- Content provided by‍ FirstRanker.com ---


=

7,500 ? 3,750

--- Content provided by⁠ FirstRanker.com ---

=

3,750


--- Content provided by FirstRanker.com ---


259



--- Content provided by FirstRanker.com ---





S

--- Content provided by FirstRanker.com ---


?

V 7,500

--- Content provided by⁠ FirstRanker.com ---

?

4,500

P/V

--- Content provided by⁠ FirstRanker.com ---


Ratio

= --------- = -----------------

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




S

--- Content provided by‍ FirstRanker.com ---



7,500


--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



2


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

=

--- or 0.4 or 40%


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



5


--- Content provided by FirstRanker.com ---


( Use Fig.4)



--- Content provided by‌ FirstRanker.com ---

4.2.3.6 ADVANTAGES AND LIMITATIONS OF BREAK-EVEN

ANALYSIS


--- Content provided by⁠ FirstRanker.com ---


The break-even analysis is a simple tool employed to graphically

represent accounting data. The data revealed by financial statements and

--- Content provided by‍ FirstRanker.com ---

reports are difficult to understand and interpret. But when the same are

presented through break-even charts, it becomes easy to understand

them.

--- Content provided by​ FirstRanker.com ---


Break-even Charts help in:

1. Determining total cost, variable cost and fixed cost at a given

--- Content provided by⁠ FirstRanker.com ---

level of activity.

2. Finding out break-even output or sales.

3. Understanding the cost, volume, profit relationship.

--- Content provided by⁠ FirstRanker.com ---


4. Making inter-firm comparisons.

5. Forcasting profits.

--- Content provided by⁠ FirstRanker.com ---

6. Selecting the best product mix.

7. Enforcing cost control.

On the negative side, break-even analysis suffers from the

--- Content provided by‌ FirstRanker.com ---


following limitations:

1. It is very difficult if not impossible to segregate costs into

--- Content provided by‌ FirstRanker.com ---

fixed and variable components. Further, fixed costs do not



260

--- Content provided by‍ FirstRanker.com ---

always remain constant. They have a tendency to rise to some

extent after production reaches a certain level. Likewise,

variable costs do not always vary proportionately. Another

--- Content provided by‍ FirstRanker.com ---


false assumption is regarding the sales revenue, which does

not always change proportionately. As we all know selling

--- Content provided by​ FirstRanker.com ---

prices are often lowered down with increased production in an

attempt to boost up sales revenue. The break even analysis

also does not take into account the changes in the stock

--- Content provided by⁠ FirstRanker.com ---


position (it is assumed, erroneously though, that stock changes

do not affect the income) and the conditions of growth and

--- Content provided by‌ FirstRanker.com ---

expansion in an organisation.

2. The application of break-even analysis to a multiproduct firm

is very difficult. A lot of complicated calculations are

--- Content provided by‍ FirstRanker.com ---


involved.

3. The break-even point has only limited importance. At best it

--- Content provided by‍ FirstRanker.com ---

would help management to indulge in cost reduction in times

of dull business. Normally, it is not the objective of business

to break-even, because no business is carried on in order to

--- Content provided by‍ FirstRanker.com ---


break-even. Further the term BEP indicates precision or

mathematical accuracy of the point. However, in actual

--- Content provided by‍ FirstRanker.com ---

practice, the precise break-even volume cannot be determined

and it can only be in the nature of a rough estimate. Therefore,

critics have pointed out that the term `break-even area' should

--- Content provided by‌ FirstRanker.com ---


be used in place of BEP.

4. Break-even analysis is a short-run concept, and it has a limited

--- Content provided by‌ FirstRanker.com ---

application in the long range planning.




--- Content provided by‌ FirstRanker.com ---


261

Despite these limitations, break-even analysis has some practical

--- Content provided by‍ FirstRanker.com ---

utility in that it helps management in profit planning. According to

Wheldon, `if the limitations are accepted, and the chart is considered as

being an instantaneous photograph of the present position and possible

--- Content provided by‍ FirstRanker.com ---


trends, there are some very important conclusions to be drawn from such

a chart'.

--- Content provided by FirstRanker.com ---

4.2.3.7

SUMMARY

Cost-Volume-Profit Analysis is a technique of analysis to study

--- Content provided by‌ FirstRanker.com ---


the effects of cost and volume variations on profit. It determines the

probable profit at any level of activity. It helps in profit planning,

--- Content provided by​ FirstRanker.com ---

preparation of flexible budgets, fixation of selling prices for products,

etc.

The break-even point is generally depicted through the break-even

--- Content provided by‌ FirstRanker.com ---


chart. The chart shows the profitability of an undertaking at various

levels of activity. It brings out the relationship between cost, volume and

--- Content provided by‍ FirstRanker.com ---

profit clearly. On the negative side, the limitations of break-even

analysis are: difficulty in segregating costs into fixed and variable

components, difficulty in applying the technique to multi-product firms,

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short-term orientation of the concept etc.

4.2.3.8

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KEY WORDS

Cost-Volume-Profit Analysis: It is that system of analysis which

determines the probable profit at any level of activity.

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Profit Planning: Estimating the profit as accurately as possible.

Pricing: Fixing prices for products.

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Break-Even Chart: It is that chart which shows the BEP graphically.

Cash Break-Even Chart: This chart shows the cash need of a concern.

Profit-Volume Graph: This chart gives a pictorial representation of cost-

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volume-profit analysis.




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262
4.2.3.9

SELF ASSESSMENT QUESTIONS

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1. What is meant by Cost-Volume-Profit Analysis? Explain its

application in managerial decision making.

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2. How would you construct a Break-Even Chart?

3. Make an evaluation of Break-Even Analysis.

4. You are given the following data for the year 1989 of X

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Company.

Rs.

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%

Variable

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costs 6,00,000

60

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Fixed

costs

3,00,000

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30

Net

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Profit

1,00,000

10

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--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



-----------

-----

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Total sales



10,00,000

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100



--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





-----------

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-----



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Find out

(a) Break-even point
(a)

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P/V Ratio, and

(b)

Margin of Safety Ratio

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Also draw a break-even chart indicating contribution.

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5. A firm is selling X product, whose variable cost per unit is

Rs.10 and fixed cost is Rs.6,000. It has sold 1,000 articles

during one month at Rs.20 per unit. Market research shows

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that there would be a great demand for the product if the price

can be reduced. If the price can be reduced to Rs.12.50 per

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unit, it is expected that 5,000 articles can be sold in the

expanded market. The firm has to take a decision whether to

produce and sell 1,000 units at the rate of Rs.20 or to produce

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and sell for the growing demand of 5,000 units at the rate of

Rs.12.50. Give your advice to the management in taking

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decision.



263

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6. A publishing firm sells a popular novel at Rs.15 each. At

current sales of 20,000 books, the firm breaks even. It is

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estimated that if the author's royalties were reduced, the

variable cost would drop by Rs.1.00 to Rs.7.00 per book.

Assume that the royalties were reduced by Rs.1.00, that the

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price of the book is reduced to Rs.12 and that this price

reduction increases sales from 20,000 to 30,000 books. What

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are the publisher's profits, assuming that fixed costs do not

change?

7. An analysis of a Manufacturing Co. led to the following

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information:

Variable cost

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Fixed cost

Cost Element

(% of sales)

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Rs.



--- Content provided by​ FirstRanker.com ---

Direct

material

32.8

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Direct

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labour

28.4

Factory

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overheads

12.6

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1,89,900

Distribution

overheads

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4.1

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58,400

General

administration

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overheads 1.1

66,700

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Budgeted

sales

Rs.18,50,000

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--- Content provided by‌ FirstRanker.com ---



You are required to determine:

(a) the break-even sales volume

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(b) the profit at the budgeted sales volume
(c) the profit if actual sales

(i)

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drop by 80%

(ii)

increase by 5% from budgeted sales.

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4.2.3.10 KEY TO SELF ASSESSMENT QUESTIONS

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(For Problems Only)

Q.No.4:

(a) Rs.7,50,000; (b) 40%; (c) 25%

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Q.No.5:

The proposal is profitable

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Q.No.6:

Rs.10,000


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264


Q.No.7:

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(a) Rs.15,000; (b) Rs.73,000; (c) (i) Rs.34,650; (ii)

Rs.9,925

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4.2.3.11 CASE ANALYSIS

The Directors of Anandam Ltd. provide you the following data

relating to the cylce chain manufactured by them:

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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






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Rs.

Sales 4,000 units @Rs.50 each


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2,00,000

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Production cost details:




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Rs.

Materials

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consumed



80,000

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Labour

cost

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40,000

Variable

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overheads



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20,000

Fixed

overheads

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30,000 1,70,000

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--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



---------- ----------

Profit

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--- Content provided by⁠ FirstRanker.com ---

30,000

----------


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They require you to answer their following queries:

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(i)

The number of units by selling which the company will be
at break-even.

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(ii)

The sales needed to earn a profit of 20% on sales.

(iii) The extra units which would be sold to obtain the present

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profit if it is proposed to reduce the selling price by 20%

Solution:

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(i)

Break Even units:

Fixed cost

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Rs.30,000

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--------------------------

=

-------------- = 2000 units

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Contribution per unit



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Rs.15



(ii)

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Sales to earn 20% on sales

Let the units to be sold to earn 20% be x. Therefore sales will be

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50x and profit is 20% of 50x i.e. 10x.



Now the total sales should be Fixed Cost + Variable cost + Profit

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is



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265




--- Content provided by FirstRanker.com ---


50x

=

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30000 + 35x + 10x

5x

=

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30000

x =

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6000

units

Therefore sales required is 6000 units x Rs.50 = Rs.3,00,000

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(iii) Extra units to be sold if selling price is reduced by 20%.

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Present

selling

price

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Rs.50

Less

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20%

Rs.10

-------

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New

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selling

price

Rs.40

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Less Variable cost



--- Content provided by⁠ FirstRanker.com ---



Rs.35

-------

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--- Content provided by‍ FirstRanker.com ---

Contribution




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Rs. 5

-------

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--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





Fixed cost + Target Profit

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Units to be sold



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=

-------------------------------


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--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Contribution



--- Content provided by‌ FirstRanker.com ---

30,000

+

30,000

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=

--------------------

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=

12000

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units



--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




5

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Extra units to be sold

=12000 ? 4000

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=

8000 units


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4.2.3.12 BOOKS FOR FURTHER READING

1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New

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Delhi.

2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting and Financial Control,

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Sultan Chand & Sons.

5. V.K.Saxena and C.D.Vashist: Advanced Cost and Management

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Accounting, Sultan Chand & Sons, New Delhi.

UNIT ? V

LESSON ? 5

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------------------------------------------------------------------------------------------------

COST ACCOUNTING

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------------------------------------------------------------------------------------------------



266

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5.1 INTRODUCTION


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Accounting can no longer be considered a mere language of

business. The need for maintaining the financial chastity of business

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operations, ensuring the reliability of recorded experience resulting from

these operations and conducting a frank appraisal of such experiences

has made accounting a prime activity along with such other activities as

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marketing, production and finance. Accounting may be broadly classified

into two categories ? accounting which is meant to serve all parties

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external to the operating responsibility of the firms and the accounting,

which is designed to serve internal parties to take care of the operational

needs of the firm. The first category, which is conventionally referred to

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as "Financial Accounting", looks to the interest of those who have

primarily a financial stake in the organisation's affairs ? creditors,

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investors, employees etc. On the other hand the second category of

accounting is primarily concerned with providing information relating to

the conduct of the various aspects of a business like cost or profit

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associated with some portions of business operations to the internal

parties viz. management. This category of accounting is divided into:

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"Management Accounting" and "Cost Accounting". This section deals

with cost accounting.

5.2 OBJECTIVES

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After reading this lesson, the reader should be able to:

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- Understand the different dimensions of cost accounting.

- Distinguish cost accounting from financial accounting.

- Appreciate the utility of cost accounting.

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- Apply the various bases of classification of costs.

- Prepare a cost sheet or tender or quotations.

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267

5.3 CONTENTS

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5.3.1

Meaning of Cost Accounting

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5.3.2

Distinction Between Financial Accounting and Cost

Accounting

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5.3.3

Utility of Cost Accounting

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5.3.4

Distinction Between Costing and Cost Accounting

5.3.5

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Classification of Cost

5.3.6

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Cost Sheet

5.3.7

Illustrations

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5.3.8

Summary

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5.3.9

Key Words

5.3.10

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Self Assessment Questions

5.3.11

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Key to Self Assessment Questions

5.3.12

Case Analysis

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5.3.13

Books for Further Reading

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5.3.1 MEANING OF COST ACCOUNTING



Cost Accounting developed as an advanced phase of accounting

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science is trying to make up the deficiencies of financial accounts and is

essentially a creation of the twentieth century. Cost accounting accounts

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for the costs of a product, a service or an operation. It is concerned with

actual costs incurred and the estimation of future costs. Cost accounting

is a conscious and rational procedure used by accountants for

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accumulating costs and relating such costs to specific products or

departments for effective management action. Cost accounting through

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its marginal costing technique helps the management in profit planning

and through its another technique i.e. standard costing facilitates cost

control. In short cost accounting is a management information system

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268
which analyses past, present and future data to provide the basis for

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managerial decision making.


5.3.2 DISTINCTION BETWEEN FINANCIAL ACCOUNTING AND

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COST ACCOUNTING




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Though there is much common ground between Financial Accounting

and Cost Accounting and though in fact cost accounting is an outgrowth of

financial accounting yet the emphasis differs. Firstly financial accounting is

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more attached with reporting the results of business to persons other than

internal management ? government, creditors, investors, researchers, etc. Cost

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accounting is an internal reporting system for an organisation's own

management for decision making. Secondly financial accounting data is

historical in nature and its periodicity of reporting is much wider. Cost

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accounting is more concerned with short-term planning and its reporting period

much lesser than financial accounting. It not only deals with historic data but

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also futuristic in approach. Thirdly in financial accounting the major emphasis in

cost classification is based on the type of transaction e.g. salaries, repairs,

insurance, stores, etc. But in cost accounting the major emphasis is on functions,

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activities, products, processes and on internal planning and control and

information needs of the organisation.

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5.3.3 UTILITY OF COST ACCOUNTING



A properly installed cost accounting system will help the management in

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the following ways:

- The analysis of profitability of individual products, services or jobs.

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- The analysis of profitability of different departments or operations.

- It locates differences between actual results and expected results.

- It will assist in setting the prices so as to cover costs and generate an

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acceptable level of profit.



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269

- Cost accounting data generally serves as a base to which the tools and

techniques of management accounting can be applied to make it more

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purposeful and management oriented.

- The effect on profits of increase or decrease in output or shutdown of a

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product line or department can be analysed with by adoption of efficient cost

accounting system.

5.3.4 DISTINCTION BETWEEN COSTING AND COST ACCOUNTING

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Costing is the technique and process of ascertaining costs. It tries to find

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out the cost of doing something, i.e., the cost of manufacturing an article,

rendering a service, or performing a function. Cost Accounting is a broader

term, in that it tries to determine the costs through a formal system of accounting

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(unlike costing which can be performed even through informal means). Stated

precisely Cost Accounting is a formal mechanism by means of which costs of

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products and services are ascertained and controlled. The Institute of Cost and

Management Accountants, U.K. define Cost Accounting as: The application of

accounting and costing principles, methods and techniques in the ascertainment

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of costs and the analysis of savings and/or excesses as compared with previous

experience or with standards. It, thus, includes three things:

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? Cost Ascertainment: Finding out the specific and precise total and unit costs

of products and services.

? Cost Presentation: Reporting cost data to various levels of management with

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a view to facilitate decision making.

? Cost Control: This consists of estimating costs for production and activities

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for the future, and keeping them within proper limits. Budgets and standards

are employed for this purpose.

Cost Accounting also aims at cost reduction, i.e., achieving a permanent and real

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reduction in cost by improving the standards. Cost Accountancy is a

comprehensive term that implies the `application of costing and cost accounting

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270
principles, methods and techniques to the science, art and practice of cost

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control'. It seeks to control costs and ascertain the profitability of business

operations.

5.3.5 CLASSIFICATION OF COST

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In the process of cost accounting, costs are arranged and rearranged in

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various classifications. The term `classification' refers to the process of

grouping costs according to their common characteristics. The different bases of

cost classification are:

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1. By nature or elements (materials, labour and overheads)
2. By time (historical, pre-determined)
3. By traceability to the product (direct, indirect)
4. By association with the product (product, period)

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5. By changes in activity or volume (fixed, variable, semi-variable)
6. By function (manufacturing, administrative, selling, research and

development, pre-production)

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7. By relationship with the accounting period (capital, revenue)
8. By controllability (controllable, non-controllable)
9. By analytical/decision-making purpose (opportunity, sunk, differential, joint,

common, imputed, out-of-pocket, marginal, uniform, replacement)

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10. By other reasons (conversion, traceable, normal, avoidable, unavoidable,

total)

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1. Elements of Cost

The elements of costs are the essential part of the cost. There are, broadly,

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three elements of cost, as explained below:

(A) Material

The substance from which the produce is made is called material. It can be

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direct as well as indirect.

i) Direct Material: It refers to those materials which become an integral part of

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the final product and can be easily traceable to specific physical units. Direct

materials, thus, include:

1. All materials specifically purchased for a particular job or process.

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2. Components purchased or produced.



271

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3. Primary packing materials (e.g., carton, wrapping, card-board boxes

etc.).

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4. Material passing from one process to another.


ii) Indirect Material: All materials which are used for purpose ancilliary to the

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business and which cannot conveniently be assigned to specific physical units

are known as `indirect materials'. Oil, grease, consumable stores, printing and

stationery material etc. are a few examples of indirect materials.

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(B) Labour

In order to convert materials into finished products, human effort is

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required. Such human effort is known as labour. Labour can be direct as well as

indirect.

i) Direct Labour: It is defined as the wages paid to workers who are engaged in

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the production process and whose time can be conveniently and economically

traceable to specific physical units. When a concern does not produce but

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instead renders a service, the term direct labour or wages refers to the cost of

wages paid to those who directly carry out the service, e.g., wages paid to driver,

conductor etc. of a bus in transport service.

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ii) Indirect Labour: Labour employed for the purpose of carrying out tasks

incidental to goods produced or services provided is called indirect labour or

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indirect wages. In short, wages which cannot be directly identified with a job,

process or operation, are generally treated as indirect wages. Examples of

indirect labour are: wages of store-keepers, foremen, supervisors, inspectors,

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internal transportmen etc.



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(C) Expenses

Expenses may be direct or indirect.

i) Direct Expenses: These are expenses which can be directly, conveniently and

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wholly identifiable with a job, process or operation. Direct expenses are also

known as chargeable expenses or productive expenses. Examples of such

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272
expenses are: cost of special layout, design or drawings, hire of special

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machinery required for a particular contract, maintenance cost of special tools

needed for a contract job, etc.

ii) Indirect Expenses: Expenses which cannot be charged to production directly

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and which are neither indirect materials nor indirect wages are known as indirect

expenses. Examples are rent, rates and taxes, insurance, depreciation, repairs

--- Content provided by​ FirstRanker.com ---

and maintenance, power, lighting and heating etc.



The above elements of cost may be shown by means of a chart:

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ELEMENT OF COST



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Materials

Labour

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Expenses



--- Content provided by‌ FirstRanker.com ---





Direct

--- Content provided by FirstRanker.com ---


Indirect

Direct

--- Content provided by‍ FirstRanker.com ---

Indirect

Direct Indirect


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1. Overheads



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The term overheads includes, indirect material, indirect labour

and indirect expenses, explained in the preceding paragraphs. Overheads

may be incurred in the factory, office or selling and distribution

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departments/divisions in an undertaking. Thus overheads may be of three

types: factory overheads, office and administrative overheads and selling

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and distribution overheads. This classification of overheads may be

shown thus:

Classification of Overheads

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273

--- Content provided by‌ FirstRanker.com ---

Overheads




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Factory



--- Content provided by FirstRanker.com ---



Office Selling and Distribution


--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indir
Material Labour Exp Mat Lab. Exp. Mat. Lab Exp


2. Cost Classification by Time

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On the basis of the time of computing costs, they can be classified

into historical and pre-determined costs.

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i) Historical Costs: These costs are computed after they are incurred. Such costs

are available only after the production of a particular thing is over.

ii) Pre-determined Costs: These costs are computed in advance of production on

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the basis of a specification of all factors influencing cost. Such costs may be:

1. Estimated costs: Estimated costs are based on a lot of guess work.

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They try to ascertain what the costs will be, based on certain factors.

They are less accurate as only past experience is taken into account

primarily, while computing them.

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2. Standard costs: Standard costs is a pre-determined cost based on a

technical estimate for material, labour and other expenses for a

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selected period of time and for a prescribed set of working

conditions. It is more scientific in nature and the object is to find out

what the costs should be.

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3. Cost Classification by Traceability

As explained previously, costs which can be easily traceable to a product are

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called direct costs. Indirect costs cannot be traced to a product or activity. They



274

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are common to several products (e.g., salary of a factory manager, supervisor

etc.) and they have to be apportioned to different products on some suitable

basis. Indirect costs are also called `overheads'.

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4. Cost Classification by Association with Product

Costs can also be classified (on the basis of their association with products)

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as product costs and period costs.

1. Product Costs: Product costs are traceable to the product and include

direct material, direct labour and manufacturing overheads. In other

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words, product cost is equivalent to factory cost.

2. Period Costs: Period costs are charged to the period in which they

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are incurred and are treated as expenses. They are incurred on the

basis of time, e.g., rent, salaries, insurance etc. They cannot be

directly assigned to a product, as they are incurred for several

--- Content provided by‌ FirstRanker.com ---


products at a time (generally).

5. Cost Classification by Activity/Volume

--- Content provided by​ FirstRanker.com ---

Costs are also classified into fixed, variable and semi-variable on the basis of

variability of cost in the volume of production.

1. Fixed Cost: Fixed cost is a cost which tends to be unaffected by

--- Content provided by⁠ FirstRanker.com ---


variations in volume of output. Fixed cost mainly depends on the

passage of time and does not vary directly with the volume of output.

--- Content provided by FirstRanker.com ---

It is also called period cost, e.g., rent, insurance, depreciation of

buildings etc. It must be noted here that fixed costs remain fixed upto

a certain level only. These costs may also vary after a certain

--- Content provided by FirstRanker.com ---


production level.

2. Semi-Variable Cost: These costs are partly fixed and partly variable.

--- Content provided by​ FirstRanker.com ---

Because of the variable element, they fluctuate with volume and

because of the fixed element, they do not change in direct proportion

to output. Semi-variable or semi-fixed costs change in the same

--- Content provided by FirstRanker.com ---




275

--- Content provided by⁠ FirstRanker.com ---

direction as that of the output but not in the same proportion. For

example, the expenditure on maintenance is to a great extent fixed if

the output does not change significantly. Where, however, the

--- Content provided by‍ FirstRanker.com ---


production rises beyond a certain limit, further expenditure on

maintenance will be necessary although the increase in the

--- Content provided by‌ FirstRanker.com ---

expenditure will not be in proportion to the rise in output. Other

examples in this regard are: depreciation, telephone rent, repairs etc.

3. Variable Cost: Cost which tends to vary directly with volume of

--- Content provided by⁠ FirstRanker.com ---


outputs is called `variable cost'. It is a direct cost. It includes direct

material, direct labour, direct expenses etc. It should be noted here

--- Content provided by⁠ FirstRanker.com ---

that the variable cost per unit is constant but the total cost changes

corresponding to the levels of output. It is always expressed in terms

of units, not in terms of time.

--- Content provided by‍ FirstRanker.com ---


6. Cost Classification by Function

On the basis of the functions carried out in a manufacturing concern,

--- Content provided by FirstRanker.com ---

costs can be classified into four categories:

1. Manufacturing/Production Cost: It is the cost of operating the

manufacturing division of an enterprise. It is defined as the cost of

--- Content provided by​ FirstRanker.com ---


the sequence of operations which begin with supplying materials,

services and ends with the primary packing of the product.

--- Content provided by‌ FirstRanker.com ---

2. Administrative/Office Cost: It is the cost of formulating the policy,

directing the organisation and controlling the operations of an

undertaking, which is not directly related to production, selling,

--- Content provided by‍ FirstRanker.com ---


distribution, research or development. Administration cost, thus,

includes all office expenses; remuneration paid to managers,

--- Content provided by‌ FirstRanker.com ---

directors, legal expenses, depreciation of office premises etc.

3. Selling Cost: Selling cost is the cost of seeking to create and

stimulate demand e.g., advertisements, show room expenses, sales

--- Content provided by‌ FirstRanker.com ---




276
promotion expenses, discounts to distributors, free repair and

--- Content provided by‍ FirstRanker.com ---


servicing expenses, etc.

4. Distribution Cost: It is the cost of the sequence of operations which

--- Content provided by⁠ FirstRanker.com ---

begins with making the packed product, available for despatch and

ends with making the reconditioned returned empty package, if any,

available for re-use. Thus, distribution cost includes all those

--- Content provided by‌ FirstRanker.com ---


expenses concerned with despatching and delivering finished

products to customers, e.g., warehouse rent, depreciation of delivery

--- Content provided by‍ FirstRanker.com ---

vehicles, special packing, loading expenses, carriage outward,

salaries of despatch clerks, repairing of empties for re-use, etc.

5. Research and Development Cost: It is the cost of discovering new

--- Content provided by‌ FirstRanker.com ---


ideas, processes, products by experiment and implementing such

results on a commercial basis.

--- Content provided by FirstRanker.com ---

6. Pre-Production Cost: Expenses incurred before a factory is started

and expenses involved in introducing a new product are pre-

production costs. They are treated as deferred revenue expenditure

--- Content provided by⁠ FirstRanker.com ---


and charged to the cost of future production on some suitable basis.

7. Cost Classification by Relationship with Accounting Period

--- Content provided by​ FirstRanker.com ---

On the basis of controllability, costs can be classified as controllable or

uncontrollable.

1. Controllable Cost: A Cost which can be influenced by the action of a

--- Content provided by⁠ FirstRanker.com ---


specified member of an undertaking is a controllable cost, e.g., direct

materials, direct labour etc.

--- Content provided by​ FirstRanker.com ---

2. Uncontrollable Cost: A cost which cannot be influenced by the

action of a specified member of an undertaking is an uncontrollable

cost, e.g., rent, rates, taxes, salary, insurance etc.

--- Content provided by⁠ FirstRanker.com ---


The term controllable cost is often used in relation to variable cost and

the term uncontrollable cost in relation to fixed cost. It should be noted here that

--- Content provided by FirstRanker.com ---



277

a controllable cost can be controlled by a person at a given organisation level

--- Content provided by​ FirstRanker.com ---


only. Sometimes two or more individuals may be involved in controlling such a

cost.

--- Content provided by FirstRanker.com ---

8. Cost Classification by Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes for

which they are put to use, in the following ways:

--- Content provided by‍ FirstRanker.com ---


1. Opportunity Cost: It is the value of the benefit sacrificed in favour of

choosing a particular alternative or action. It is the cost of the best

--- Content provided by​ FirstRanker.com ---

alternative foregone. If an owned building, for example, is proposed

to be used for a new project, the likely revenue which the building

could fetch, when rented out, is the opportunity cost which should be

--- Content provided by‍ FirstRanker.com ---


considered while evaluating the profitability of the project.

2. Sunk Cost: A cost which was incurred or sunk in the past and is not

--- Content provided by FirstRanker.com ---

relevant for decision-making is a sunk cost. It is only historical in

nature and is irrelevant for decision-making. It may also be defined

as the difference between the purchase price of an asset and its

--- Content provided by FirstRanker.com ---


salvage value.

3. Differential Cost: The difference in total costs between two

--- Content provided by‌ FirstRanker.com ---

alternatives is called as differential cost. In case the choice of an

alternative results in increase in total cost, such increase in costs is

called `incremental cost'. If the choice results in decrease in total

--- Content provided by​ FirstRanker.com ---


costs, the resulting decrease is known as decremental cost.

4. Joint Cost: Whenever two or more products are produced out of one

--- Content provided by⁠ FirstRanker.com ---

and the same raw material or process, the cost of material purchased

and the processing are called joint costs. Technically speaking, joint

cost is that cost which is common to the processing of joint products

--- Content provided by FirstRanker.com ---


or by-products upto the point of split-off or separation.



--- Content provided by FirstRanker.com ---

278
5. Common Cost: Common cost is a cost which is incurred for more

than one product, job territory or any other specific costing object. It

--- Content provided by FirstRanker.com ---

cannot be treated to individual products and, hence, apportioned on

some suitable basis.

6. Imputed Cost: This type of cost is neither spent nor recorded in the

--- Content provided by‌ FirstRanker.com ---


books of account. These costs are not actually incurred (hence known

as hypothetical or notional costs) but are considered while making a

--- Content provided by‌ FirstRanker.com ---

decision. For example, in accounting, interest and rent are recognised

only as expenditure when they are actually paid. But in costing they

are charged on a notional basis while ascertaining the cost of a

--- Content provided by‌ FirstRanker.com ---


product.

7. Out-of-pocket Cost: It is the cost which involves current or future

--- Content provided by FirstRanker.com ---

expenditure outlay, based on managerial decisions. For example a

company has its own trucks for transporting goods from one place to

another. It seeks to replace these by employing public carriers of

--- Content provided by⁠ FirstRanker.com ---


goods. While making this decision, management can ignore

depreciation, but not the out-of-pocket costs in the present situation,

--- Content provided by‍ FirstRanker.com ---

i.e., fuel, salary to drivers and maintenance paid in cash.

8. Marginal Cost: It is the aggregate of variable costs, i.e., prime cost

plus variable overheads.

--- Content provided by‌ FirstRanker.com ---


9. Replacement Cost: It is the cost of replacing a material or asset in the

current market.

--- Content provided by‍ FirstRanker.com ---

5.3.6 COST SHEET

Cost sheet is a statement presenting the items entering into cost of

products or services. It shows the total cost components by stages and cost per

--- Content provided by FirstRanker.com ---


unit of output during a period. It is usually prepared to meet three objectives: to

provide the classification of costs in a summarised form, to prepare estimates of

--- Content provided by FirstRanker.com ---



279

costs for future use and to facilitate a comparative study of costs with previous

--- Content provided by FirstRanker.com ---


cost sheets to know the cost trends.



--- Content provided by​ FirstRanker.com ---

The layout of a typical cost sheet is provided below:



Specimen Cost Sheet

--- Content provided by​ FirstRanker.com ---


Particulars

Total

--- Content provided by‍ FirstRanker.com ---

Cost

Cost

per

--- Content provided by‌ FirstRanker.com ---


unit

Direct Materials

--- Content provided by‍ FirstRanker.com ---



Opening stock of materials


--- Content provided by‍ FirstRanker.com ---


Add Purchases of materials



--- Content provided by‍ FirstRanker.com ---

Less Closing stock of materials
(a) Materials consumed

Direct Wages

--- Content provided by‌ FirstRanker.com ---

Direct Expenses

------

------

--- Content provided by⁠ FirstRanker.com ---


PRIME COST

Add Factory Overheads

--- Content provided by‌ FirstRanker.com ---



Factory rent, rates, taxes

Fuel-power

--- Content provided by⁠ FirstRanker.com ---


and

water

--- Content provided by⁠ FirstRanker.com ---



Lighting and Heating

Indirect

--- Content provided by​ FirstRanker.com ---


wages

Depreciation,

--- Content provided by FirstRanker.com ---

Repairs



Salaries of Works Manager etc.

--- Content provided by‌ FirstRanker.com ---


Indirect

Materials

--- Content provided by⁠ FirstRanker.com ---



Drawing office and works office expenses


--- Content provided by⁠ FirstRanker.com ---


Depreciation on factory land and building



--- Content provided by‍ FirstRanker.com ---

Less Scrap value

Defective

work

--- Content provided by FirstRanker.com ---




Add Work in progress (opening)

--- Content provided by⁠ FirstRanker.com ---



Less Work in progress (closing)


--- Content provided by‍ FirstRanker.com ---




------

--- Content provided by​ FirstRanker.com ---


WORKS COST

Add Office/Administration overheads

--- Content provided by‍ FirstRanker.com ---


Office rent, insurance, lighting, cleaning



--- Content provided by‍ FirstRanker.com ---

Office salaries, telephone, law and

audit

expenses

--- Content provided by​ FirstRanker.com ---




280
General

--- Content provided by⁠ FirstRanker.com ---


Manager's

salary

--- Content provided by​ FirstRanker.com ---

Printing

and

stationery

--- Content provided by‌ FirstRanker.com ---


Maintenance,

repairs, upkeep of office bldg

--- Content provided by‌ FirstRanker.com ---



Bank charges and miscellaneous expenses

------

--- Content provided by​ FirstRanker.com ---



COST OF PRODUCTION


--- Content provided by‍ FirstRanker.com ---


Add Opening stock of finished goods



--- Content provided by‌ FirstRanker.com ---

Less Closing stock of finished goods



------

--- Content provided by​ FirstRanker.com ---



COST OF GOODS SOLD

Add Selling and Distribution Overheads

--- Content provided by⁠ FirstRanker.com ---



Showroom expenses, salesmen's salaries


--- Content provided by​ FirstRanker.com ---


& commission, bad debts, discounts, warehouse



--- Content provided by⁠ FirstRanker.com ---

rent, carriage outwards, advertising, delivery



expenses, samples and free gifts etc.

--- Content provided by‍ FirstRanker.com ---



COST OF SALES

Add Net Profit or deduct net loss:

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



------

SALES ------

--- Content provided by⁠ FirstRanker.com ---


Treatment of Certain Items in the Cost Sheet:

(a)

--- Content provided by FirstRanker.com ---

Computation of Profit: Profit may be calculated either as a
percentage of cost or selling price.

Example:

--- Content provided by⁠ FirstRanker.com ---

Profit as a percentage of cost:

Factory

cost

--- Content provided by‍ FirstRanker.com ---


5,700

Administration

--- Content provided by​ FirstRanker.com ---

overhead




--- Content provided by FirstRanker.com ---




600

--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


-------

Total

--- Content provided by‍ FirstRanker.com ---

cost

6,300


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

-------




--- Content provided by‍ FirstRanker.com ---


Profit 10% on cost



--- Content provided by​ FirstRanker.com ---





630

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



-------

Selling

--- Content provided by‌ FirstRanker.com ---


price

6,930

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


-------



--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




Percent

--- Content provided by‍ FirstRanker.com ---





So Profit

--- Content provided by FirstRanker.com ---


= Cost -------------



--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




100

--- Content provided by​ FirstRanker.com ---




Example: Profit as a percentage of selling price. Here the percentage is on

--- Content provided by⁠ FirstRanker.com ---

selling price. Selling price includes cost + profit.



281

--- Content provided by FirstRanker.com ---



Sales

price

--- Content provided by‌ FirstRanker.com ---


=

100

--- Content provided by‌ FirstRanker.com ---

Less

Profit

=

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

10




--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




----

--- Content provided by FirstRanker.com ---

Cost

price

=

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

90




--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




----

--- Content provided by‍ FirstRanker.com ---



This profit of Rs.10 is on Rs.90 which is the cost price. So it is 1/9th of

cost price. In the above example,

--- Content provided by FirstRanker.com ---

Total

Cost

=

--- Content provided by⁠ FirstRanker.com ---


6,300



--- Content provided by FirstRanker.com ---

Profit on 10% on SP




--- Content provided by⁠ FirstRanker.com ---


=

700

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---


-------

Selling

--- Content provided by FirstRanker.com ---

price

7,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



-------


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Cost x percent

--- Content provided by‌ FirstRanker.com ---

So Sale price



=

--- Content provided by⁠ FirstRanker.com ---


-------------------



--- Content provided by⁠ FirstRanker.com ---



100

?

--- Content provided by⁠ FirstRanker.com ---


percent



--- Content provided by​ FirstRanker.com ---




6,300

--- Content provided by‌ FirstRanker.com ---

x

100


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


=

-----------------

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




100

--- Content provided by‌ FirstRanker.com ---

-

10


--- Content provided by⁠ FirstRanker.com ---

=

7,000


--- Content provided by​ FirstRanker.com ---


(b)

Treatment of Stock: The term `Stock' includes three items: raw

--- Content provided by​ FirstRanker.com ---

materials, work in progress and finished goods. The value of raw

materials is arrived at in the following manner:


--- Content provided by FirstRanker.com ---




Opening stock of raw material

--- Content provided by‌ FirstRanker.com ---

Add Purchases

Add Expenses involved in the purchases of raw material

Less Closing stock of raw materials

--- Content provided by​ FirstRanker.com ---


Work-in-progress represents the quantity of semi-finished goods at the

time of the preparation of the cost sheet. It represents cost of materials, labour

--- Content provided by FirstRanker.com ---

and manufacturing expenses to-date. Work-in-progress may be shown in the

cost sheet either immediately after the prime cost or after the calculation of the


--- Content provided by‍ FirstRanker.com ---


282
factory overheads, as shown in the Specimen Cost Sheet. Finally, in respect of

stock of finished goods, adjustments have to be made where opening and closing

--- Content provided by⁠ FirstRanker.com ---


stock of finished goods are given. This is done, as shown in the Specimen Cost

Sheet, by adding opening stock of finished goods to the cost of production

--- Content provided by FirstRanker.com ---

arrived at on the basis of current figures and reducing the closing stock of

finished goods from this total. Let's explore these aspects more clearly through

the following illustrations:

--- Content provided by⁠ FirstRanker.com ---


Tenders and Quotations While preparing tenders or quotation manufacturers

or contractors have to look into the figures pertaining to the previous year as

--- Content provided by‌ FirstRanker.com ---

shown in the cost sheet for that period. These figures have to be suitably

modified in the light of changes expected in the prices of materials, labour, etc.,

and submit the tender or quotation accordingly.

--- Content provided by⁠ FirstRanker.com ---


5.3.6 ILLUSTRATIONS

Illustration 1: Prepare the cost sheet to show the total cost of production

--- Content provided by FirstRanker.com ---

and cost per unit of goods manufactured by a company for the month of

July 2005. Also find out the cost of sales.


--- Content provided by‍ FirstRanker.com ---


Stock of raw materials 1-7-2005



--- Content provided by​ FirstRanker.com ---



3,000

Raw

--- Content provided by‌ FirstRanker.com ---


materials

purchased

--- Content provided by‍ FirstRanker.com ---

28,000



Stock of raw materials 31-7-2005

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

4,500

Manufacturing

wages

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

7,000

Depreciation

of

--- Content provided by​ FirstRanker.com ---


plant



--- Content provided by​ FirstRanker.com ---



1,500


--- Content provided by⁠ FirstRanker.com ---


Loss on sale of a part of plant



--- Content provided by​ FirstRanker.com ---



300

Factory

--- Content provided by FirstRanker.com ---


rent

and

--- Content provided by​ FirstRanker.com ---

rates




--- Content provided by‌ FirstRanker.com ---


3,000

Office

--- Content provided by​ FirstRanker.com ---

rent




--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---



500


--- Content provided by​ FirstRanker.com ---


General expenses



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


400



--- Content provided by⁠ FirstRanker.com ---

Discount on sales




--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

300



Advertisement expenses to be fully charged

--- Content provided by​ FirstRanker.com ---


600

Income-tax

--- Content provided by FirstRanker.com ---

paid



2,000

--- Content provided by⁠ FirstRanker.com ---




283

--- Content provided by⁠ FirstRanker.com ---



The number of units produced during July, 2005 was 3,000.


--- Content provided by​ FirstRanker.com ---


The stock of finished goods was 200 and 400 units on 1-7-2005 and

31-7-2005 respectively. The total cost of units on hand on 1-7-2005 was

--- Content provided by FirstRanker.com ---

Rs.2,800. All these have been sold during the month.

Output 3,000 units.

Cost Sheet for the year ended 31-7-2005

--- Content provided by⁠ FirstRanker.com ---

-----------------------------------------------------------------------------------------------


Particulars

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




Total Cost Per Unit Cost

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





Rs.

--- Content provided by⁠ FirstRanker.com ---


Rs.

-----------------------------------------------------------------------------------------------
Raw

--- Content provided by‍ FirstRanker.com ---


materials

consumed

--- Content provided by​ FirstRanker.com ---





Opening stock

--- Content provided by⁠ FirstRanker.com ---




3,000

--- Content provided by​ FirstRanker.com ---



Add Purchases


--- Content provided by⁠ FirstRanker.com ---


28,000



--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




---------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

31,000

Less Closing stock


--- Content provided by FirstRanker.com ---




4,500

--- Content provided by FirstRanker.com ---

26,500

8.83


--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





--------

--- Content provided by⁠ FirstRanker.com ---


Direct

wages

--- Content provided by‍ FirstRanker.com ---





7,000

--- Content provided by​ FirstRanker.com ---


2.33



--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





-------- -------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

Prime Cost




--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

33,500 11.16


Factory Overheads:
Depreciation

--- Content provided by‌ FirstRanker.com ---


1,500

Factory

--- Content provided by⁠ FirstRanker.com ---

rent

3,000


--- Content provided by‍ FirstRanker.com ---


4,500

1.50

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



-------

------- -------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





Factory Cost

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

38,000 12.66


Office and Administrative Overheads:
Office

--- Content provided by FirstRanker.com ---


rent



--- Content provided by⁠ FirstRanker.com ---



500


--- Content provided by FirstRanker.com ---


General expenses



--- Content provided by​ FirstRanker.com ---



400

900

--- Content provided by FirstRanker.com ---


0.30



--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

------ -------- -------




--- Content provided by‌ FirstRanker.com ---


Cost of Production



--- Content provided by FirstRanker.com ---



38,900 12.96


--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




-------- --------

--- Content provided by‌ FirstRanker.com ---

Statement of Cost of Sales




--- Content provided by​ FirstRanker.com ---

Cost of production




--- Content provided by‍ FirstRanker.com ---


38,900



--- Content provided by​ FirstRanker.com ---



Add: Opening stock of

finished

--- Content provided by‌ FirstRanker.com ---


goods

2,800

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---





---------

--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

41,700



284

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Less: Closing stock of finished


--- Content provided by​ FirstRanker.com ---




goods (400 x Rs.12.96)

--- Content provided by‍ FirstRanker.com ---





5,184

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

--------

Cost of Production of Goods Sold


--- Content provided by​ FirstRanker.com ---




36,516

--- Content provided by​ FirstRanker.com ---


Add: Selling and Distribution overhead:
Discount

on

--- Content provided by‍ FirstRanker.com ---


sales

300

--- Content provided by⁠ FirstRanker.com ---

Advertisement

expenses

600

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

900




--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





----

--- Content provided by‌ FirstRanker.com ---


--------



--- Content provided by‌ FirstRanker.com ---



Cost of Sales


--- Content provided by‍ FirstRanker.com ---




37,416

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





--------

--- Content provided by FirstRanker.com ---


-----------------------------------------------------------------------------------------------



--- Content provided by FirstRanker.com ---


Illustration 2: From the following particulars, prepare a cost sheet for
the year ending 31-12-2005.


--- Content provided by‌ FirstRanker.com ---

Opening stock of raw materials (1-1-2005)

50,000

Purchases

--- Content provided by​ FirstRanker.com ---


of

raw

--- Content provided by FirstRanker.com ---

materials

1,60,000


--- Content provided by⁠ FirstRanker.com ---


Closing stock of raw materials (31-12-2005)

80,000

--- Content provided by⁠ FirstRanker.com ---

Wages

?

Productive

--- Content provided by FirstRanker.com ---


1,50,000

General

--- Content provided by‍ FirstRanker.com ---





20,000

--- Content provided by‍ FirstRanker.com ---


Chargeable

expenses

--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


40,000



--- Content provided by FirstRanker.com ---

Rent, rates and taxes ? Factory




--- Content provided by FirstRanker.com ---


10,000



--- Content provided by‌ FirstRanker.com ---

Rent, rates and taxes ? Office




--- Content provided by​ FirstRanker.com ---


1,000



--- Content provided by​ FirstRanker.com ---

Depreciation on plant and machinery



3,000

--- Content provided by‍ FirstRanker.com ---




Salary ? Office

--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




5,000

--- Content provided by​ FirstRanker.com ---



Salary ? Travellers


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---



4,000


--- Content provided by⁠ FirstRanker.com ---


Printing and stationery



--- Content provided by‌ FirstRanker.com ---





1,000

--- Content provided by​ FirstRanker.com ---




Office cleaning and lighting

--- Content provided by⁠ FirstRanker.com ---





800

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

Repairs and renewals (factory)




--- Content provided by FirstRanker.com ---


6,400



--- Content provided by FirstRanker.com ---

Other factory expenses




--- Content provided by⁠ FirstRanker.com ---




5,000

--- Content provided by‍ FirstRanker.com ---



Management expenses (including managing

Director's

--- Content provided by​ FirstRanker.com ---


fees)



--- Content provided by​ FirstRanker.com ---



24,000


--- Content provided by FirstRanker.com ---


Travelling expenses of salesmen



--- Content provided by⁠ FirstRanker.com ---



2,200


--- Content provided by‌ FirstRanker.com ---


285



--- Content provided by FirstRanker.com ---

Showroom expenses and samples




--- Content provided by‌ FirstRanker.com ---


2,000



--- Content provided by FirstRanker.com ---

Carriage and freight ? Outwards




--- Content provided by‌ FirstRanker.com ---


2,000



--- Content provided by FirstRanker.com ---

Carriage and freight ? Inwards




--- Content provided by⁠ FirstRanker.com ---


9,000



--- Content provided by‍ FirstRanker.com ---

Octroi on purchases




--- Content provided by​ FirstRanker.com ---




1,000

--- Content provided by⁠ FirstRanker.com ---



Advertisement


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



30,000

Sales

--- Content provided by⁠ FirstRanker.com ---




4,60,000

--- Content provided by⁠ FirstRanker.com ---



Management expenses should be allocated in the ratio of 2:1:3 on

factory, office and sales departments.

--- Content provided by‍ FirstRanker.com ---




Solution:

--- Content provided by​ FirstRanker.com ---

Statement of Cost and Profit for 2005

-----------------------------------------------------------------------------------------------


--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---




Rupees

--- Content provided by⁠ FirstRanker.com ---

Rupees

Materials consumed
Opening

--- Content provided by‌ FirstRanker.com ---

stock




--- Content provided by FirstRanker.com ---




50,000

--- Content provided by FirstRanker.com ---

Add

Purchases

1,60,000

--- Content provided by⁠ FirstRanker.com ---




Add Carriages Freight inwards

--- Content provided by​ FirstRanker.com ---



9,000


--- Content provided by​ FirstRanker.com ---


Add Octroi on purchases



--- Content provided by⁠ FirstRanker.com ---



1,000

-----------

--- Content provided by‍ FirstRanker.com ---

2,20,000


Less closing stock

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


80,000

-----------
Cost

--- Content provided by‌ FirstRanker.com ---


of

materials

--- Content provided by‌ FirstRanker.com ---

used

1,40,000

Productive

--- Content provided by‌ FirstRanker.com ---


wages

1,50,000

--- Content provided by FirstRanker.com ---

Chargeable

expenses


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

40,000

-----------


--- Content provided by FirstRanker.com ---



Prime Cost

3,30,000

--- Content provided by‌ FirstRanker.com ---


Factory Expenses
General

wages

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

20,000



Rent, rates and taxes

--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

10,000



Depreciation on plant and machinery

--- Content provided by‌ FirstRanker.com ---


3,000



--- Content provided by‍ FirstRanker.com ---

Repairs and renewals




--- Content provided by​ FirstRanker.com ---


6,400



--- Content provided by‌ FirstRanker.com ---

Other factory expenses




--- Content provided by‍ FirstRanker.com ---


5,000



--- Content provided by‍ FirstRanker.com ---

Management expenses: 1/6 of Rs.24,000

8,000

52,400

--- Content provided by‌ FirstRanker.com ---




286
---------

--- Content provided by‍ FirstRanker.com ---


-----------



--- Content provided by FirstRanker.com ---



Factory Cost


--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

3,82,400

Administrative expenses


--- Content provided by​ FirstRanker.com ---

Rent, rates and taxes




--- Content provided by FirstRanker.com ---


1,000

Salary

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


5,000



--- Content provided by‍ FirstRanker.com ---

Printing and stationery




--- Content provided by⁠ FirstRanker.com ---


1,000



--- Content provided by‌ FirstRanker.com ---

Cleaning and lighting




--- Content provided by​ FirstRanker.com ---


800



--- Content provided by⁠ FirstRanker.com ---

Management expenses:1/6 of Rs.24,000

4,000

11,800

--- Content provided by‍ FirstRanker.com ---


----------



--- Content provided by⁠ FirstRanker.com ---





Cost of Production

--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



3,94,200

Selling and Distribution expenses

--- Content provided by⁠ FirstRanker.com ---

Advertising




--- Content provided by‌ FirstRanker.com ---




4,000

--- Content provided by‍ FirstRanker.com ---



Show-room expenses and samples

2,000

--- Content provided by⁠ FirstRanker.com ---


Traveller's

salary

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


4,000



--- Content provided by⁠ FirstRanker.com ---

Salesmen's travelling expense



2,200

--- Content provided by‍ FirstRanker.com ---




Carriage outwards and freight

--- Content provided by‍ FirstRanker.com ---



2,000


--- Content provided by‍ FirstRanker.com ---


Management expenses: 3/6 of Rs.24,000

12,000

--- Content provided by⁠ FirstRanker.com ---

26,200

----------


--- Content provided by​ FirstRanker.com ---



Cost of Sales

4,20,400

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



Sales

4,60,000

--- Content provided by​ FirstRanker.com ---


----------



--- Content provided by‌ FirstRanker.com ---




Profit

--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


39,600

----------

--- Content provided by⁠ FirstRanker.com ---



-----------------------------------------------------------------------------------------------


--- Content provided by⁠ FirstRanker.com ---




Illustration 3: The following particulars relate to a company for a period of

--- Content provided by⁠ FirstRanker.com ---

three months:

Raw

materials

--- Content provided by‌ FirstRanker.com ---


(1-1-2005)

55,000

--- Content provided by‌ FirstRanker.com ---

Raw

materials

(31-3-2005)

--- Content provided by FirstRanker.com ---


35,000

Factory

--- Content provided by FirstRanker.com ---

wages

80,000

Materials

--- Content provided by‍ FirstRanker.com ---


purchased

60,000

--- Content provided by⁠ FirstRanker.com ---



Sales


--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

1,54,000

Indirect

expenses

--- Content provided by FirstRanker.com ---


10,000



--- Content provided by⁠ FirstRanker.com ---

Stock of finished goods (1-1-2005)

NIL


--- Content provided by FirstRanker.com ---


Stock of finished goods (31-3-2005)

30,000

--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


287



--- Content provided by⁠ FirstRanker.com ---

No. of units produced during the period was 2,000.




--- Content provided by‍ FirstRanker.com ---

Prepare a statement of cost for the period and compute the price to

be quoted for 500 units in order to realise the same of profit as for the
period under review, assuming no alternation in wages and cost of
materials.

--- Content provided by FirstRanker.com ---



Solution:

Statement of Cost for the period ending 31-3-2005

--- Content provided by⁠ FirstRanker.com ---




Output 2,000 units

--- Content provided by‍ FirstRanker.com ---

-----------------------------------------------------------------------------------------------




--- Content provided by‌ FirstRanker.com ---

Particulars




--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

Amount

Rs.


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Rs.


--- Content provided by FirstRanker.com ---


-----------------------------------------------------------------------------------------------
Opening stock of raw materials


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

55,000

Add:

Purchases 60,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---

----------




--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---


1,15,000

Less: Closing stock of raw

--- Content provided by​ FirstRanker.com ---

materials



35,000

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

----------

Raw

materials

--- Content provided by‍ FirstRanker.com ---


consumed



--- Content provided by FirstRanker.com ---





80,000

--- Content provided by FirstRanker.com ---

Factory

wages


--- Content provided by FirstRanker.com ---




80,000

--- Content provided by‌ FirstRanker.com ---

----------



Prime

--- Content provided by‌ FirstRanker.com ---


cost

1,60,000

--- Content provided by‌ FirstRanker.com ---

Indirect

expenses


--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

10,000

----------


--- Content provided by‍ FirstRanker.com ---


Cost

of

--- Content provided by‌ FirstRanker.com ---

production

1,70,000

Less: Closing stock of finished goods

--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



30,000

----------

--- Content provided by FirstRanker.com ---




Cost

--- Content provided by​ FirstRanker.com ---

of

goods

sold

--- Content provided by⁠ FirstRanker.com ---


1,40,000


14,000 x 100

--- Content provided by‍ FirstRanker.com ---

Profit ( -------------------- ) = 10% of cost
1,40,000



--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---




14,000

--- Content provided by FirstRanker.com ---

----------



Sales

--- Content provided by‍ FirstRanker.com ---


1,54,000

----------

--- Content provided by‍ FirstRanker.com ---



-----------------------------------------------------------------------------------------------


--- Content provided by‍ FirstRanker.com ---



288
Tender statement showing quotations for 500 units
-----------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---

Particulars

Amount


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



Rupees

-----------------------------------------------------------------------------------------------

--- Content provided by​ FirstRanker.com ---


80,000 x 500
Materials consumed ( ---------------- )
2,000

--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




20,000

--- Content provided by‌ FirstRanker.com ---





80,000 x 500

--- Content provided by‌ FirstRanker.com ---


Wages ( -----------------)



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


20,000

2,000

--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by FirstRanker.com ---



----------

Prime

--- Content provided by​ FirstRanker.com ---


cost



--- Content provided by‌ FirstRanker.com ---



40,000


--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

10,000 x 500



Add: Indirect expenses ( ----------------- )

--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



2,500


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

2,000




--- Content provided by‌ FirstRanker.com ---




----------

--- Content provided by​ FirstRanker.com ---

Cost

of

production

--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

42,500

Add: Profit (10% of cost of production)


--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

4,250

----------


--- Content provided by​ FirstRanker.com ---


Price

to

--- Content provided by‍ FirstRanker.com ---

be

quoted


--- Content provided by​ FirstRanker.com ---




46,750

--- Content provided by​ FirstRanker.com ---

----------



-----------------------------------------------------------------------------------------------

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---


Illustration 4: The following information has been taken from a factory:



--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---





Rupees

--- Content provided by​ FirstRanker.com ---


Materials

50,000

--- Content provided by‌ FirstRanker.com ---

Direct

wages

40,000

--- Content provided by​ FirstRanker.com ---


Factory

overheads

--- Content provided by‍ FirstRanker.com ---

30,000

Administration

overheads

--- Content provided by FirstRanker.com ---


20,000



--- Content provided by⁠ FirstRanker.com ---

You are required to fix the selling price of a machine costing Rs.4,200 in

materials and Rs.3,000 in wages so that it yields a profit of 25% on selling price.

Solution:

--- Content provided by‌ FirstRanker.com ---




289

--- Content provided by⁠ FirstRanker.com ---

Statement of Cost



Rupees

--- Content provided by‌ FirstRanker.com ---


Materials

50,000

--- Content provided by​ FirstRanker.com ---

Direct

wages

40,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by FirstRanker.com ---

----------

Prime

Cost

--- Content provided by FirstRanker.com ---


90,000

Factory

--- Content provided by‌ FirstRanker.com ---

overheads

30,000


--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---




----------

--- Content provided by FirstRanker.com ---



Works Cost


--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

1,20,000

Administration

Overheads

--- Content provided by⁠ FirstRanker.com ---


20,000



--- Content provided by‌ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---



----------


--- Content provided by⁠ FirstRanker.com ---




Cost of Production

--- Content provided by​ FirstRanker.com ---





1,40,000

--- Content provided by‍ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---

----------

Percentage of factory overheads to direct wages:


--- Content provided by⁠ FirstRanker.com ---


30,000



--- Content provided by​ FirstRanker.com ---

------------ x 100 = 75%



40,000

--- Content provided by⁠ FirstRanker.com ---



Percentage of office overheads to works cost:


--- Content provided by FirstRanker.com ---


20,000

-------------- x 100 = 16.67%

--- Content provided by‌ FirstRanker.com ---


1,20,000



--- Content provided by FirstRanker.com ---




Tender or Quotation

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Rupees

Materials

--- Content provided by​ FirstRanker.com ---

4,200

Wages

3,000

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



-------

Prime

--- Content provided by FirstRanker.com ---


Cost

7,200

--- Content provided by‍ FirstRanker.com ---



Factory overheads - 75% of wages


--- Content provided by‌ FirstRanker.com ---


2,250



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---





-------

--- Content provided by‌ FirstRanker.com ---


Works

Cost

--- Content provided by FirstRanker.com ---

9,450




--- Content provided by​ FirstRanker.com ---

Administration overheads ? 16.67% on



290

--- Content provided by​ FirstRanker.com ---

Works

cost

1,575

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---

--------




--- Content provided by​ FirstRanker.com ---


Cost of Production



--- Content provided by‌ FirstRanker.com ---



11,025


--- Content provided by‌ FirstRanker.com ---


Profit 25% on selling price or



--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---


33 1/3



--- Content provided by‌ FirstRanker.com ---

33 1/3% on cost 11,025

x

-----------

--- Content provided by​ FirstRanker.com ---


3,675

100

--- Content provided by‍ FirstRanker.com ---

---------

Estimated Selling Price


--- Content provided by‌ FirstRanker.com ---




14,700

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



---------

5.3.8 SUMMARY

--- Content provided by‍ FirstRanker.com ---


Traditional accounting or financial accounting can no longer serve the purposes

of all concerned. Especially the internal organs of the business concerns, namely

--- Content provided by⁠ FirstRanker.com ---

managements, want a lot of analytical information which could not be provided

by the financial accounting. Hence to serve the needs of management two more

kinds of accounts ? Management Accounting and Cost Accounting have

--- Content provided by⁠ FirstRanker.com ---


evolved. Simply stated, management accounting serves the needs of

management and cost accounting tries to determine the costs through a formal

--- Content provided by​ FirstRanker.com ---

system of accounting. Costs can be classified on various bases and cost sheet is

a statement presenting the items entering into cost of products or services.

5.3.9 KEY WORDS

--- Content provided by FirstRanker.com ---


Direct Expenses: Expenses that can easily be identified with a particular

product.

--- Content provided by‍ FirstRanker.com ---

Indirect Expenses: Expenses which cannot be easily identified with a particular

product.

Overheads: Total of all indirect expenses.

--- Content provided by⁠ FirstRanker.com ---


Works Cost: Prime cost + Factory overheads.

Cost of Production: Works cost + Administration overheads.

--- Content provided by‍ FirstRanker.com ---

Cost of Sales: Cost of production + Selling and distribution overheads.

Cost Sheet: A statement which is prepared to ascertain the cost of sales.

Tenders: A statement which quotes the price for a particular job or level of

--- Content provided by​ FirstRanker.com ---


production activity.



--- Content provided by⁠ FirstRanker.com ---

291

5.3.10 SELF ASSESSMENT QUESTIONS

1. What are the limitations of financial accounting?

--- Content provided by‌ FirstRanker.com ---


2. Justify the need for cost accounting.

3. Explain the various bases for classification of costs.

--- Content provided by​ FirstRanker.com ---

4. What are the differences between a `Cost Sheet' and `Tender'.

5. Prepare a cost sheet for the production of 100 units of an article using

imaginary figures.

--- Content provided by‌ FirstRanker.com ---


6. Prepare a statement of cost showing:

(a) Value of materials consumed

--- Content provided by‍ FirstRanker.com ---

(b) Total Cost of Production

(c) Cost of Goods Sold and

(d) The amount of Profit

--- Content provided by​ FirstRanker.com ---


From the following details relating to a Toy manufacturing concern:



--- Content provided by​ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Rupees



--- Content provided by‌ FirstRanker.com ---

Opening Stock: Raw materials




--- Content provided by​ FirstRanker.com ---


25,000



--- Content provided by‍ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---


Finished goods



--- Content provided by⁠ FirstRanker.com ---

20,000



Raw materials purchased

--- Content provided by⁠ FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



2,50,000


--- Content provided by FirstRanker.com ---


Wages paid to labourers



--- Content provided by​ FirstRanker.com ---





1,00,000

--- Content provided by FirstRanker.com ---


Closing

Stock:

--- Content provided by FirstRanker.com ---

Raw

materials


--- Content provided by‍ FirstRanker.com ---




20,000

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---




Finished goods

--- Content provided by‍ FirstRanker.com ---



25,000


--- Content provided by‌ FirstRanker.com ---


Chargeable expenses



--- Content provided by​ FirstRanker.com ---





10,000

--- Content provided by‍ FirstRanker.com ---




Rent, rates and taxes (Factory)

--- Content provided by‌ FirstRanker.com ---





25,000

--- Content provided by‌ FirstRanker.com ---




Motive power

--- Content provided by‍ FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---




10,000

--- Content provided by FirstRanker.com ---



Factory heating and lighting


--- Content provided by⁠ FirstRanker.com ---




10,000

--- Content provided by FirstRanker.com ---

Factory

insurance

5,000

--- Content provided by‌ FirstRanker.com ---


Experimental

expenses 2,500

--- Content provided by⁠ FirstRanker.com ---



Waste materials in Factory


--- Content provided by⁠ FirstRanker.com ---




1,000

--- Content provided by‌ FirstRanker.com ---



Office Salaries


--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---



20,000

Printing

--- Content provided by‌ FirstRanker.com ---


and

Stationery 1,000

--- Content provided by⁠ FirstRanker.com ---



Salesmen's salary


--- Content provided by‍ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---



10,000


--- Content provided by​ FirstRanker.com ---


Commission to Travelling Agents



--- Content provided by FirstRanker.com ---



5,000

Sales

--- Content provided by‌ FirstRanker.com ---






--- Content provided by FirstRanker.com ---






--- Content provided by‌ FirstRanker.com ---






--- Content provided by​ FirstRanker.com ---

5,00,000



7.

--- Content provided by‌ FirstRanker.com ---


Kolam Products Ltd. produces a stabilizer that sells for Rs.300. An

increase of 15% in the cost of materials and 10% in the cost of labour is

--- Content provided by FirstRanker.com ---



292
anticipated. If the only figures available are those given below, what must be the

--- Content provided by⁠ FirstRanker.com ---

selling price to give the same percentage of gross profit as before?

(a) Material costs have been 45% of cost of sales

(b) Labour costs have been 40% of cost of sales

--- Content provided by‍ FirstRanker.com ---


(c) Overhead costs have been 15% of the sales

(d) The anticipated increased costs in relation to the present sale

--- Content provided by‌ FirstRanker.com ---

price would cause a 35% decrease in the amount of present gross

profit.

5.3.11 KEY TO SELF ASSESSMENT QUESTIONS (FOR PROBLEMS

--- Content provided by‌ FirstRanker.com ---

ONLY)


6.

--- Content provided by⁠ FirstRanker.com ---

Materials used Rs.2,55,000; Prime Cost Rs.3,65,000; Works Cost

Rs.4,18,500; Cost of Production Rs.4,39,500; Cost of Sales Rs.4,49,500

and Profit Rs,50,500.

--- Content provided by⁠ FirstRanker.com ---




7.

--- Content provided by‌ FirstRanker.com ---

Selling Price: Rs.332.25.




--- Content provided by FirstRanker.com ---




5.3.12 CASE ANALYSIS

--- Content provided by FirstRanker.com ---



A small scale manufacturer produces an article at the operated capacity

of 10,000 units while the normal capacity of his plant is 14,000 units. Working

--- Content provided by⁠ FirstRanker.com ---


at a profit margin of 20% on sales realisation, he has formulated his budget as

under:

--- Content provided by​ FirstRanker.com ---

10,000 units

14,000 units


--- Content provided by‌ FirstRanker.com ---






--- Content provided by⁠ FirstRanker.com ---





Rs.

--- Content provided by⁠ FirstRanker.com ---




Rs.

--- Content provided by FirstRanker.com ---



Sales

Realisation

--- Content provided by‍ FirstRanker.com ---


2,00,000 2,80,000



--- Content provided by​ FirstRanker.com ---

Variable overheads

50,000


--- Content provided by​ FirstRanker.com ---


70,000



--- Content provided by FirstRanker.com ---

Semi-variable overheads

20,000


--- Content provided by FirstRanker.com ---


22,000



--- Content provided by⁠ FirstRanker.com ---

293



Fixed overheads

--- Content provided by⁠ FirstRanker.com ---




40,000

--- Content provided by⁠ FirstRanker.com ---



40,000


--- Content provided by FirstRanker.com ---




He gets an order for a quantity equivalent to 20% of the operated

--- Content provided by FirstRanker.com ---

capacity and even on this additional production profit margin is desired
at the same percentage on sales realisation as for production to operated
capacity. As you are a cost manager he approached you to advise him as
to what should be the minimum price to realise this objective.

--- Content provided by‍ FirstRanker.com ---

Solution:

Computation of Prime Cost


--- Content provided by‍ FirstRanker.com ---




Profit margin is 20% on sale

--- Content provided by​ FirstRanker.com ---



Therefore cost of sale, 80% of

Rs.2,00,000

--- Content provided by⁠ FirstRanker.com ---


i.e. 1,60,000

Variable

--- Content provided by FirstRanker.com ---

overheads

50,000

Semi-variable

--- Content provided by FirstRanker.com ---


overheads

20,000

--- Content provided by⁠ FirstRanker.com ---



Fixed

overhead 40,000

--- Content provided by​ FirstRanker.com ---


1,10,000



--- Content provided by FirstRanker.com ---






--- Content provided by‍ FirstRanker.com ---






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--------

----------

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Prime

Cost

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50,000

----------

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Since an additional production of 4000 units requires an increase

of Rs.2000 in semi-variable expenses, an additional production of 2000

units will require an increase of Rs.1000 in semi-variable expenses:

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Differential Cost of Production of 2000 extra units

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10000 12000 Differential Cost

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units units for 2000 units




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Rs. Rs.

Rs.

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Prime

cost

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50,000

60,000

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10,000

Variable

overheads

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50,000

60,000

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10,000



Semi-variable overheads

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20,000

21,000

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1,000



Fixed overheads

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40,000

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40,000

---


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-------------------------------------------------


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1,60,000 1,81,000

21,000

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The different cost for 1 unit is Rs.21000 ? 2000 units i.e. Rs.10-50. Profit

margin required is 20% on sale or 25%on cost. Hence the minimum

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selling price = Rs.10.50 + Rs.2.625 = Rs.13.125.

5.3.13 BOOKS FOR FURTHER READING

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1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New

Delhi.

2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.

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3. Jawaharlal: Advanced Management Accounting, S.Chand & Co., New Delhi.

4. Lall Nigam & Sharma: Advanced Cost Accounting, Himalaya Publishing

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House.

5. Vashist & Saxena: Advanced Cost Accounting, Sultan Chand & Sons.


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295

This post was last modified on 14 March 2022