Business Accounting
MBAO 0002
1
1,2,3
Prof. T. Gurusant
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Copyright © 2021 by GLA University, Mathura
For private circulation to GLA University Online Students.
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Kanchan Sharma
Kiran Chaudhary
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Prof. Jeevanandam J., Director – CDOE, GLA University
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CDOE Expert Committee
Dr. Nitin Seth
Dr. Deepak Tandan
Professor
Indian Institute of Foreign Trade, New Delhi
Professor
IMI, New Delhi
Dr. Manoj Kumar
Professor & Head
Department of Mathematics, Statistics and
computer Science,
College of Basic Sciences and Humanities
G B Pant University of Agriculture & Tech.
Pantnagar
Prof. Swati Agarwal
Dr. M L Agrawal
Associate Professor
Department of Economics, A K College,
Sikohabad
Dr. Akhilesh Tiwari
Associate Professor
School of Business Management,
Christ University, Delhi-NCR Campus
Dean
Jaipuria Institute of Management, Noida
Prof. Poonam Sharma
Professor
Jaipuria Institute of Management, Noida
Prof. Samar Sarabhai
Dean Academics
Jaipuria Institute of Management, Jaipur
Prof. Ravi Shankar
Professor
Management Dept, IIT Delhi
Dr. Sheetal Mundra
Associate Professor
JK Laxmipat University, Jaipur
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Syllabus
Objectives of the Course:
•
•
•
By the end of this course, the learner should be able to:
Understand the role and relevance of financial accounting in management.
Explore the various dimensions of financial accounting and their implications in
financial spectrum of a business entity.
ModuleI
ModuleII
ModuleIII
Overview of Financial Accounting: Role, Functions, Users,
Principles, Concept, Conventions, Accounting Cycle.
Preparation of Original Books of Entries: Preparation of Journal,
Ledger and Trial Balance. Preparation of Trading Account, Profit &
Loss Account, and Balance Sheet (With Basic Adjustment)
Preparation of Statement of Profit & Loss and Balance Sheet as per
Companies Act, 2013 without adjustment.
Introduction to Financial Analysis: Role, Types, Tools, Limitations
Ratio Analysis: Types of Ratios, Profitability Ratio, Turnover Ratio,
Financial Ratio: Computation & Analysis
Preparation and Interpretation of Fund flow Statement:
Concept of fund flow, Statement of Changes in Working Capital, Fund
from Operation, Fund Flow Statement
Preparation of Cash Flow Statement (As per AS 3)
Cash flow from Operating / Investing / Financing Activities
Direct or Indirect Method of preparation of Cash Flow Statement.
Introduction to Cost Accounting
Role of Cost Accounting in Decision Making, Scope, Nature, Functions,
Types of Cost, Cost Accounting and Financial Accounting.
Components and Preparation of Cost Sheet, Methods of Costing.
Introduction and Application to Management Accounting
Scope, Nature, Functions of Management Accounting in Managerial
Decision Making.
Break Even Analysis: Marginal Costing versus Absorption Costing,
Cost-Volume-Profit Analysis and P/V Ratio Analysis and their
implications, Concept and uses of Contribution and Breakeven Point
and their analysis, Margin of Safety, Angle of Incidence.
Budgeting and Budgetary Control: Concept of Budget, Budgeting
and Budgetary Control, Types of Budget, Static and Flexible
Budgeting, Preparation of Cash Budget, Sales Budget and Master
Budget, Advantages and Limitations of Budgetary Control. Zero Base
Budgeting
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Standard Costing and Variance Analysis: Concept of Standard Costs,
Establishing various Cost Standards, Calculation of Material Variance,
Labour Variance.
Recent Developments in Accounting:
Responsibility Accounting: Definition and Role, Centres of Control.
Accounting for Price Level Changes: Inflation Accounting. Methods
of Accounting for Changing Prices.
Concept of Transfer Pricing, Concept of Social Cost Benefit Analysis.
Further Additional Reference Readings:
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Tulsian, P. C. Financial Accounting. New Delhi: Pearson Education.
T.S. Grewal. Financial Accounting. Sultan Chand and Sons
Kishore, Ravi. M. Cost and Management Accounting. New Delhi: Taxman.
Jawahar Lal, Seema Srivastava. Cost Accounting. New Delhi: Tata Mc Graw
Hill
R.S.N. Pillai, Bagavathi. Management Accounting. New Delhi: S. Chand
Khan & Jain.Management Accounting. New Delhi: Tata McGraw Hill.
Reference Books:
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•
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Narayanaswami, R. Financial Accounting: Managerial Perspective. New Delhi:
Prentice Hall of India Private Limited.
Maheshwari, S. N., & Maheshwari, S. K. An Introduction to Accountancy. New
Delhi: Vikas Publishing House Pvt. Ltd.
Neelakantan,
Ramchandran&KakaniFinancial
Accounting
for
Management.Tata McGraw-Hill Publishing Company Limited, New Delhi.
Horngrene, Datar, & Foster. Introduction to Management Accounting.New
Delhi: Pearson Education.
Pandey, I. M. Management Accounting. New Delhi: Vikas Publication.
Suggested Journals:
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Indian Journal of Finance
The IUP Journal of Accounting Research and Audit Practices
The IUP Journal of Accounting Research & Audit Practices, IUP Publications,
Hyderabad.
Indian Journal of Finance, Satya Gilani Publication, New Delhi.
Learning Outcomes
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•
Students will be able to understand the role and relevance of financial
accounting in management.
Explore the various dimensions of financial accounting and their implications in
financial spectrum of a business entity.
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•
•
•
Students will be able to understand with cost records/statements and principles
underlying them and to develop their skills in understanding and appreciating
cost information.
Students will know the cost and management accounting mechanics, process
and system, but emphasis is laid on sound concepts and their managerial
implications.
Know the utility of cost information as a vital input for management information
and decision making process.
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Table of Contents
Module 1 ................................................................................................................. 10
Financial Accounting: .............................................................................................. 11
Introduction ............................................................................................................. 11
Origin And Growth Of Accounting ........................................................................... 11
Meaning Of Accounting ........................................................................................... 12
Distinction Between Book-Keeping And Accounting ............................................... 13
Distinction Between Accounting And Accountancy ................................................. 13
Nature Of Accounting.............................................................................................. 13
Objectives Of Accounting ........................................................................................ 15
Users Of Accounting Information ............................................................................ 17
Branches Of Accounting ......................................................................................... 19
Role Of Accounting ................................................................................................. 20
Limitations Of Financial Accounting ........................................................................ 21
Systems Of Accounting ........................................................................................... 22
Summary ................................................................................................................ 23
Keywords ...................................................................Error! Bookmark not defined.
1.ACCOUNTING CONCEPTS AND CONVENTIONS ............................................ 23
Introduction ............................................................................................................. 23
Meaning And Features Of Accounting Principles .................................................... 23
Accounting Principles.............................................................................................. 25
Accounting Concepts .............................................................................................. 26
Accounting Conventions ......................................................................................... 30
Accounting Standards ............................................................................................. 32
Summary ................................................................................................................ 33
Keywords ...................................................................Error! Bookmark not defined.
Accounting Process: Equation, Rules, Preparation of Journal And Ledger ............ 34
Introduction ............................................................................................................. 34
Accounting Equation ............................................................................................... 36
Rules Of Debit And Credit ....................................................................................... 39
Meaning And Format Of A Journal.......................................................................... 40
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Meaning of Journalising .......................................................................................... 41
Compound Journal Entries ..................................................................................... 43
Opening Entry ......................................................................................................... 44
Goods Account ....................................................................................................... 45
Ledger..................................................................................................................... 49
Relationship between Journal and Ledger .............................................................. 50
The accounting process in operation ...................................................................... 52
An accounting perspective: ..................................................................................... 65
Uses of technology ................................................................................................. 65
The use of ledger accounts ..................................................................................... 65
An ethical perspective: ............................................................................................ 74
Financial Deals, Inc................................................................................................. 74
An accounting perspective: ..................................................................................... 75
Uses of technology ................................................................................................. 75
Analyzing and using the financial results— Horizontal and vertical analyses ......... 76
An accounting perspective: ..................................................................................... 77
Business insight ...................................................................................................... 77
Understanding the learning objectives .................................................................... 77
Key terms ................................................................................................................ 78
Trial Balance ........................................................................................................... 79
INTRODUCTION .................................................................................................... 79
OBJECTIVES OF PREPARING TRIAL BALANCE ................................................. 80
LIMITATIONS OF TRIAL BALANCE....................................................................... 80
METHODS OF PREPARATION OF TRIAL BALANCE........................................... 81
ACCOUNTING ERRORS ....................................................................................... 83
STEPS FOR LOCATION OF ERRORS .................................................................. 86
SUMMARY ............................................................................................................. 87
KEYWORDS ........................................................................................................... 88
SELF ASSESSMENT QUESTIONS ....................................................................... 88
Preparation Of Final Accounts Of Non-Corporate ................................................... 89
OBJECTIVE ............................................................................................................ 89
TRADING ACCOUNT ............................................................................................. 90
Module 2 ................................................................................................................. 93
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Introduction and Application to Management Accounting ....................................... 94
Introduction and Definition ...................................................................................... 94
Scope of Management Accounting ......................................................................... 94
Nature of Management Accounting......................................................................... 95
Functions of Management Accounting .................................................................... 96
Break Even Analysis ............................................................................................... 97
Difference Between Marginal Costing and Absorption Costing ............................... 98
Comparison Chart ................................................................................................... 99
Cost-Volume-Profit Analysis and P/V Ratio Analysis and their implications ......... 100
Concept and uses of Contribution and Breakeven Point and their analysis .......... 104
Budgeting and Budgetary Control ......................................................................... 105
Module 3 ............................................................................................................... 113
Introduction and Application to Management Accounting ..................................... 114
Introduction ........................................................................................................... 114
Nature and Scope of Management Accounting: ................................................... 116
Break Even Analysis ............................................................................................. 118
What is a Break-Even Analysis? ........................................................................... 118
Components of Break-Even Analysis.................................................................... 118
Marginal Costing versus Absorption Costing ........................................................ 121
In summary ............................................................................................................. 125
Standard Costing and Variance Analysis .............................................................. 148
Standard Costing .................................................................................................. 148
Determination of Standard Costs .......................................................................... 149
Features of Standard Costing ............................................................................... 149
Ways of Developing Standards ............................................................................. 150
Variance Analysis ................................................................................................. 150
Recent Developments in Accounting and Responsibility Accounting: .................. 153
Accounting for Price Level Changes: .................................................................... 159
(b)
Method of Price Level Accounting # 2. Replacement Cost Accounting
Technique: ............................................................................................................ 170
(c)
Method of Price Level Accounting # 3. Current Value Accounting
Technique: ............................................................................................................ 172
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(d)
Method of Price Level Accounting # 4. Current Cost Accounting
Technique: ............................................................................................................ 173
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Module 1
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Financial Accounting:
Introduction
Accounting has rightly been termed as the language of the business. The basic
function of a language is to serve as a means of communication Accounting also
serves this function. It communicates the results of business operations to various
parties who have some stake in the business viz., the proprietor, creditors, investors,
Government and other agencies. Though accounting is generally associated with
business but it is not only business which makes use of accounting. Persons like
housewives, Government and other individuals also make use of an accounting. For
example, a housewife has to keep a record of the money received and spent by her
during a particular period. She can record her receipts of money on one page of her
"household diary" while payments for different items such as milk, food, clothing,
house, education etc. on some other page or pages of her diary in a chronological
order. Such a record will help her in knowing about:
(i)
(ii)
(iii)
The sources from which she received cash and the purposes for which it
was utilised.
Whether her receipts are more than her payments or vice-versa?
The balance of cash in hand or deficit, if any at the end of a period.
In case the housewife records her transactions regularly, she can collect valuable
information about the nature of her receipts and payments. For example, she can find
out the total amount spent by her during a period (say a year) on different items say
milk, food, education, entertainment, etc. Similarly, she can find the sources of her
receipts such as salary of her husband, rent from property, cash gifts from her
relatives, etc. Thus, at the end of a period (say a year) she can see for herself about
her financial position i.e., what she owns and what she owes. This will help her in
planning her future income and expenses (or making out a budget) to a great extent.
The need for accounting is all the more great for a person who is running a business.
He must know: (i) What he owns? (ii) What he owes? (iii) Whether he has earn a profit
or suffered a loss on account of running a business? (iv) What is his financial position
i.e. whether he will be in a position to meet all his commitments in the near future or
he is in the process of becoming a bankrupt.
Origin and Growth of Accounting
Accounting is as old as money itself. However, the act of accounting was not as
developed as it is today because in the early stages of civilisation, the number of
transactions to be recorded were so small that each businessman was able to record
and check for himself all his transactions. Accounting was practised in India twentythree centuries ago as is clear from the book named "Arthashastra" written by Kautilya,
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King Chandragupta's minister. This book not only relates to politics and economics,
but also explain the art of proper keeping of accounts. However, the modern system
of accounting based on the principles of double entry system owes it origin to Luco
Pacioli who first published the principles of Double Entry System in 1494 at Venice in
Italy. Thus, the art of accounting has been practised for centuries but it is only in the
late thirties that the study of the subject 'accounting' has been taken up seriously.
Meaning of Accounting
The main purpose of accounting is to ascertain profit or loss during a specified
period, to show financial condition of the business on a particular date and to have
control over the firm's property. Such accounting records are required to be maintained
to measure the income of the business and communicate the information so that it
may be used by managers, owners and other interested parties. Accounting is a
discipline which records, classifies, summarises and interprets financial information
about the activities of a concern so that intelligent decisions can be made about the
concern. The American Institute of Certified Public Accountants has defined the
Financial Accounting as "the art of recording, classifying and summarising in as
significant manner and in terms of money transactions and events which in part, at
least of a financial character, and interpreting the results thereof". American
Accounting Association defines accounting as "the process of identifying, measuring,
and communicating economic information to permit informed judgements and
decisions by users of the
information.
From the above the following attributes of accounting emerge:
(i) Recording: It is concerned with the recording of financial transactions in an orderly
manner, soon after their occurrence in the proper books of accounts.
(ii) Classifying: It Is concerned with the systematic analysis of the recorded data so
as to accumulate the transactions of similar type at one place. This function is
performed by maintaining the ledger in which different accounts are opened to which
related transactions are posted.
(iii) Summarising: It is concerned with the preparation and presentation of the
classified data in a manner useful to the users. This function involves the preparation
of financial statements such as Income Statement, Balance Sheet, Statement of
Changes in Financial Position, Statement of Cash Flow, Statement of Value Added.
(iv) Interpreting: Nowadays, the aforesaid three functions are performed by electronic
data processing devices and the accountant has to concentrate mainly on the
interpretation aspects of accounting. The accountants should interpret the statements
in a manner useful to action. The accountant should explain not only what has
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happened but also (a) why it happened, and (b) what is likely to happen under
specified conditions.
Distinction Between Book-Keeping and Accounting
Book-keeping is a part of accounting and is concerned with the recording of
transactions which is often routine and clerical in nature, whereas accounting performs
other functions as well, viz., measurement and communication, besides recording. An
accountant is required to have a much
higher level of knowledge, conceptual understanding and analytical skill than is
required of the book-keeper.
An accountant designs the accounting system, supervises and checks the work of the
book-keeper, prepares the reports based on the recorded data and interprets the
reports. Nowadays, he is required to take part in matters of management, control and
planning of economic resources.
Distinction Between Accounting and Accountancy
Although in practice Accountancy and Accounting are used interchangeably yet
there is a thin line of demarcation between them. The word Accountancy is used for
the profession of accountants - who do the work of accounting and are knowledgeable
persons. Accounting is concerned with recording all business transactions
systematically and then arranging in the form of various accounts and financial
statements. And it is a distinct discipline like economics, physics, astronomy etc. The
word accounting tries to explain the nature of the work of the accountants
(professionals) and the word Accountancy refers to the profession these people adopt.
Nature of Accounting
The various definitions and explanations of accounting has been propounded by
different accounting experts from time to time and the following aspects comprise the
nature of accounting:
i) Accounting as a service activity
Accounting is a service activity. Its function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions, in making reasoned choices among alternative courses
of action. It means that accounting collects financial information for the various users
for taking decisions and tackling business issues.
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Accounting in itself cannot create wealth though, if it produces information which is
useful to others, it may assist in wealth creation and maintenance.
(ii) Accounting as a profession
Accounting is very much a profession. A profession is a career that involve the
acquiring of a specialised formal education before rendering any service. Accounting
is a systematized body of knowledge developed with the development of trade and
business over the past century. The accounting education is being imparted to the
examinees by national and international recognised the
bodies like The Institute of Chartered Accountants of India (ICAI), New Delhi in India
and American Institute of Certified Public Accountants (AICPA) in USA etc. The
candidate must pass a vigorous examination in Accounting Theory, Accounting
Practice, Auditing and Business Law. The members of the professional bodies usually
have their own associations or organisations, where in they are
required to be enrolled compulsorily as Associate member of the Institute of Chartered
Accountants (A.C.A.) and fellow of the Institute of Chartered Accountants (F.C.A.). In
a way, accountancy as a profession has attained the stature comparable with that of
lawyer, medicine or architecture.
(iii) Accounting as a social force
In early days, accounting was only to serve the interest of the owners. Under the
changing business environment, the discipline of accounting and the accountant both
have to watch and protect the interests of other people who are directly or indirectly
linked with the operation of modern business. The society is composed of people as
customer, shareholders, creditors and investors. The accounting information/data is
to be used to solve the problems of the public at large such as determination and
controlling of prices. Therefore, safeguarding of public interest can better be facilitated
with the help of proper, adequate and reliable accounting information and as a result
of it the society at large is benefited.
(iv) Accounting as a language
Accounting is rightly referred the "language of business". It is one means of reporting
and communicating information about a business. As one has to learn a new language
to converse and communicate, so also accounting is to be learned and practised to
communicate business events.
A language and accounting have common features as regards rules and symbols.
Both are based and propounded on fundamental rules and symbols. In language these
are known as grammatical rules and in accounting, these are termed as accounting
rules. The expression, exhibition and presentation of accounting data such as a
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numerals and words and debits and credit are accepted as symbols which are unique
to the discipline of accounting.
(v) Accounting as science or art
Science is a systematised body of knowledge. It establishes a relationship of cause
and effect in the various related phenomenon. It is also based on some fundamental
principles. Accounting has its own principles e.g. the double entry system, which
explains that every transaction has two fold aspect i.e. debit and credit. It also lays
down rules of journalising. So we can say that accounting is a science. Art requires a
perfect knowledge, interest and experience to do a work efficiently. Art also teaches
us how to do a work in the best possible way by making the best use of the available
resources. Accounting is an art as it also requires knowledge, interest and experience
to maintain the books of accounts in a systematic manner. Everybody cannot become
a good accountant. It can be concluded from the above discussion that accounting is
an art as well as a science.
(vi) Accounting as an information system
Accounting discipline will be the most useful one in the acquisition of all the business
knowledge in the near future. You will realise that people will be constantly exposed
to accounting information in their everyday life. Accounting information serves both
profit-seeking business and non-profit organisations. The accounting system of a
profit-seeking organisation is an information system designed to provide relevant
financial information on the resources of a business and the effect of their use.
Information is relevant and valuable if the decision makers can use it to evaluate the
financial consequences of various alternatives. Accounting generally does not
generate the basic information (raw financial data), rather the raw financial data result
from the day to day transactions of the business. As an information system, accounting
links an information source or transmitter (generally the accountant), a channel of
communication (generally the financial statements) and a set of receivers (external
users).
Objectives of Accounting
The following are the main objectives of accounting:
1.To keep systematic records: Accounting is done to keep a systematic record
of financial transactions. In the absence of accounting there would have been
terrific burden on human memory which in most cases would have been
impossible to bear.
2.To protect business properties: Accounting provides protection to business
properties from unjustified and unwarranted use. This is possible on account of
accounting supplying the following information to the manager or the proprietor:
(i)
The amount of the proprietor's funds invested in the business.
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(ii)
(iii)
(iv)
How much the business have to pay to others?
How much the business has to recover from others?
How much the business has in the form of (a) fixed assets, (b) cash in
hand, (c) cash at bank, (d) stock of raw materials, work-in-progress and
finished goods?
Information about the above matters helps the proprietor in assuring that the funds
of the business are not necessarily kept idle or underutilised.
3.To ascertain the operational profit or loss: Accounting helps in ascertaining
the net profit earned or loss suffered on account of carrying the business. This is
done by keeping a proper record of revenues and expense of a particular period.
The Profit and Loss Account is prepared at the end of a period and if the amount
of revenue for the period is more than the expenditure incurred in earning that
revenue, there is said to be a profit. In case the expenditure exceeds the revenue,
there is said to be a loss.
Profit and Loss Account will help the management, investors, creditors, etc. in
knowing whether the business has proved to be remunerative or not. In case it
has not proved to be remunerative or profitable, the cause of such a state of
affairs will be investigated and necessary remedial steps will be taken.
4.To ascertain the financial position of the business: The Profit and Loss
Account gives the amount of profit or loss made by the business during a particular
period. However, it is not enough. The businessman must know about his financial
position i.e. where he stands? what he owes and what he owns? This objective is
served by the Balance Sheet or Position Statement. The Balance Sheet is a
statement of assets and liabilities of the business on a particular date. It serves as
barometer for ascertaining the financial health of the business.
5.To facilitate rational decision making: Accounting these days has taken upon
itself the task of collection, analysis and reporting of information at the required
points of time to the required levels of authority in order to facilitate rational
decision-making. The American Accounting Association has also stressed this
point while defining the term accounting when it says that accounting is the process
of identifying, measuring and communicating economic information to permit
informed judgements and decisions by users of the information. Of course, this is
by no means an easy task. However, the accounting bodies all over the world and
particularly the International Accounting Standards Committee, have been trying
to grapple with this problem and have achieved success in laying down some basic
postulates on the basis of which the accounting statements have to be prepared.
6.Information System: Accounting functions as an information system for collecting
and communicating economic information about the business enterprise. This
information helps the management in taking appropriate decisions. This function,
as stated, is gaining tremendous importance these days.
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Users of Accounting Information
The basic objective of accounting is to provide information which is useful for persons
inside the organisation and for persons or groups outside the organisation. Accounting
is the discipline that provides information on which external and internal users of the
information may base decisions that result in the allocation of economic resources in
society.
I. External Users of Accounting Information: External users are those groups or
persons who are outside the organisation for whom accounting function is performed.
Following can be the various external users of accounting information:
1. Investors, Those who are interested in investing money in an organisation are
interested in knowing the financial health of the organisation of know how safe the
investment already made is and how safe their proposed investment will be. To know
the financial health, they need accounting information which will help them in
evaluating the past performance and future prospects of the
organisation. Thus, investors for their investment decisions are dependent upon
accounting information included in the financial statements. They can know the
profitability and the financial position of the organisation in which they are interested
to make that investment by making a study of the accounting information given in the
financial statements of the organisation.
2. Creditors. Creditors (i.e. supplier of goods and services on credit, bankers and other
lenders of money) want to know the financial position of a concern before giving loans
or granting credit. They want to be sure that the concern will not experience difficulty
in making their payment in time i.e. liquid position of the concern is satisfactory. To
know the liquid position, they need accounting information relating to current assets,
quick assets and current liabilities which is available in the financial statements.
3. Members of Non-profit Organisations. Members of non-profit organisations such as
schools, colleges, hospitals, clubs, charitable institutions etc. need accounting
information to know how their contributed funds are being utilised and to ascertain if
the organisation deserves continued support or support should be withdrawn keeping
in view the bad performance depicted by the accounting information and diverted to
another organisation. In knowing the performance of such organisations, criterion will
not be the profit made but the main criterion will be the service provided to the society.
4. Government. Central and State Governments are interested in the accounting
information because they want to know earnings or sales for a particular period for
purposes of taxation. Income tax returns are examples of financial reports which are
prepared with information taken directly from accounting records. Governments also
17
needs accounting information for compiling statistics concerning business which, in
turn helps in compiling national accounts.
5. Consumers. Consumers need accounting information for establishing good
accounting control so that cost of production may be reduced with the resultant
reduction of the prices of goods they buy. Sometimes, prices for some goods are fixed
by the Government, so it needs accounting information to fix reasonable prices so that
consumers and manufacturers are not exploited. Prices are fixed keeping in view fair
return to manufacturers on their investments shown in the accounting records.
6. Research Scholars. Accounting information, being a mirror of the financial
performance of a business organisation, is of immense value to the research scholars
who wants to make a study to the financial operations of a particular firm. To make a
study into the financial operations of a particular firm, the research scholar needs
detailed accounting information relating to purchases, sales, expenses, cost of
materials used, current assets, current liabilities, fixed assets, long term liabilities and
shareholders' funds which is available in the accounting records maintained by the
firm.
II. Internal Users of Accounting Information. Internal users of accounting
information are those persons or groups which are within the organisation. Following
are such internal users:
1. Owners. The owners provide funds for the operations of a business and they want
to know whether their funds are being properly used or not. They need accounting
information to know the profitability and the financial position of the concern in which
they have invested their funds. The financial statements prepared from time to time
from accounting records depicts them the profitability and the financial position.
2. Management. Management is the art of getting work done through others, the
management should ensure that the subordinates are doing work properly. Accounting
information is an aid in this respect because it helps a manager in appraising the
performance of the subordinates. Actual performance of the employees can be
compared with the budgeted performance they were expected to achieve and remedial
action can be taken if the actual performance is not upto the mark. Thus, accounting
information provides "the eyes and ears to management".
The most important functions of management are planning and controlling.
Preparation of various budgets, such as sales budget, production budget, cash
budget, capital expenditure budget etc., is an important part of planning function and
the starting point for the preparation of the budgets is the accounting information for
the previous year. Controlling is the function of seeing that programmes laid down in
various budgets are being actually achieved i.e. actual performance ascertained from
accounting is compared with the budgeted performance, enabling the manager to
exercise controlling case of weak performance. Accounting information is also helpful
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to the management in fixing reasonable selling prices. In a competitive economy, a
price should be based on
cost plus a reasonable rate of return. If a firm quotes a price which exceeds cost plus
a reasonable rate of return, it probably will not get the order. On the other hand, if the
firm quotes a price which is less than its cost, it will be given the order but will incur a
loss on account of price being lower than the cost. So, selling prices should always be
fixed on the basis of accounting data to get the reasonable margin of profit on sales.
3. Employees. Employees are interested in the financial position of a concern they
serve particularly when payment of bonus depends upon the size of the profits earned.
They seek accounting information to know that the bonus being paid to them is correct.
Branches of Accounting
To meet the ever-increasing demands made on accounting by different interested
parties such as owners, management, creditors, taxation authorities etc., the various
branches have come into existence. There are as follows:
1. Financial accounting. The object of financial accounting is to ascertain the results
(profit or loss) of business operations during the particular period and to state the
financial position (balance sheet) as on a date at the end of the period.
2. Cost accounting. The object of cost accounting is to find out the cost of goods
produced or services rendered by a business. It also helps the business in controlling
the costs by indicating avoidable losses and wastes.
3. Management accounting. The object of management accounting is to supply
relevant information at appropriate time to the management to enable it to take
decisions and effect control.
In this lesson we are concerned only with financial accounting. Financial
accounting is the oldest and other branches have developed from it. The objects of
financial accounting, as stated above, can be achieved only by recording the financial
transactions in a systematic manner according to a set of principles. The art of
recording financial transactions and events in a systematic manner in
the books of account are known as book-keeping. However, mere record of
transactions is not enough. The recorded information has to be classified, analysed
and presented in a manner in which business results and financial position can be
ascertained.
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Role of Accounting
Accounting plays an important and useful role by developing the information for
providing answers to many questions faced by the users of accounting information:
(1) How good or bad is the financial condition of the business?
(2) Has the business activity resulted in a profit or loss?
(3) How well the different departments of the business have performed in the past?
(4) Which activities or products have been profitable?
(5) Out of the existing products which should be discontinued and the production of
which commodities should be increased?
(6) Whether to buy a component from the market or to manufacture the same?
(7) Whether the cost of production is reasonable or excessive?
(8) What has been the impact of existing policies on the profitability of the business?
(9) What are the likely results of new policy decisions on future earning capacity of the
business?
(10) In the light of past performance of the business how should it plan for future to
ensure desired results?
Above mentioned are few examples of the types of questions faced by the users
of accounting information. These can be satisfactorily answered with the help of
suitable and necessary information provided by accounting.
Besides, accounting is also useful in the following respects:
(a) Increased volume of business results in large number of transactions and no
businessman can remember everything. Accounting records obviate the necessity of
remembering various transactions.
(b) Accounting records, prepared on the basis of uniform practices, will enable a
business to compare results of one period with another period.
(c) Taxation authorities (both income tax and sales tax) are likely to believe the facts
contained in the set of accounting books if maintained according to generally accepted
accounting principles.
(d) Accounting records, backed up by proper and authenticated vouchers, are good
evidence in a court of law.
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(e) If a business is to be sold as a going concern, then the values of different assets
as shown by the balance sheet helps in bargaining proper price for the business.
Limitations of Financial Accounting
Advantages of accounting discussed in this lesson do not suggest that accounting is
free from limitations. Any one who is using accounting information should be well
aware of its limitations also. Following are the limitations :
(a) Financial accounting permits alternative treatments
No doubt accounting is based on concepts and it follows "generally accepted
accounting principles", but there exist more than one principle for the treatment of any
one item. This permits alternative treatments within the framework of generally
accepted accounting principles. For example, the closing stock of a business may be
valued by any one of the following methods : FIFO (First-in-first-out); LIFO (Last-infirst-out); Average price, Standard price etc., Application of different methods will give
different results but the methods are generally accepted. So, the results are not
comparable.
(b) Financial accounting is Influenced by personal judgements
Inspite of the fact that convention of objectivity is respected in accounting but
to record certain events estimates have to be made which requires personal
judgement. It is very difficult to expect accuracy in future estimates and objectivity
suffers. For example, in order to determine the amount of depreciation to be charged
every year for the use of fixed asset it is required to estimate (a) future life of the asset,
and (b) scrap value of the asset. Thus in accounting we do not determine but measure
the income. In other words, the income disclosed by accounting is not authoritative but
approximation.
(c) Financial accounting ignores important non-monetary information
Financial accounting takes into consideration only those transactions and
events which can be described in money. The transactions and events, however
important, if non-monetary in nature are ignored i.e., not recorded. For example, extent
of competition faced by the business, technical innovations possessed by the
business, loyalty and efficiency of the employees etc. are the important matters in
which management of the business is highly interested but accounting is not tailored
to take note of such matters. Thus any user of financial information is, naturally,
deprived of vital information which is of non-monetary character.
(d) Financial accounting does not provide timely information
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Financial accounting is designed to supply information in the form of statements
(Balance Sheet and Profit and Loss Account) for a period, normally, one year. So the
information is, at best, of historical interest and only postmortem analysis of the past
can be conducted. The business requires timely information at frequent intervals to
enable the management to plan and take corrective action. For example, if a business
has budgeted that during the current year sales should be Rs. 12,00,000 then it
requires information – whether the sales in the first month of the year amounted to Rs.
1,00,000 or less or more? Traditionally, financial accounting is not supposed to supply
information at shorter intervals than one year.
(e) Financial accounting does not provide detailed analysis
The information supplied by the financial accounting is in reality aggregate of
the financial transactions during the course of the year. Of course, it enables to study
the overall results of the business activity during the accounting period. For proper
running of the business the information is required regarding the cost, revenue and
profit of each product but financial accounting does not provide such detailed
information product-wise. For example, if a business has earned a total profit of, say,
Rs. 5,00,000 during the accounting year and it sells three products namely petrol,
diesel and mobile oil and wants to know profit earned by each product. Financial
accounting is not likely to help him.
(f) Financial accounting does not disclose the present value of the business
In financial accounting the position of the business as on a particular date is
shown by a statement known as balance sheet. In balance sheet the assets are shown
on the basis of going concern concept. Thus, it is presumed that business has
relatively longer life and will continue to exist indefinitely, hence the asset values are
going concern values. The realised value of each asset if sold today can't be known
by studying the balance sheet.
Systems of Accounting
The following are the main systems of recording business transactions:
(a) Cash System. Under this system, actual cash receipts and actual cash payments
are recorded. Credit transactions are not recorded at all until the cash in actually
received or paid. The Receipts and Payments Account prepared in case of non-trading
concerns such as a charitable institution, a club, a school, a college, etc. and
professional men like a lawyer, a doctor, a chartered accountant etc. can be cited as
the best example of cash system. This system does not make a complete record of
financial transactions of a trading period as it does not record outstanding transactions
like outstanding expenses and outstanding incomes. The system being based on a
record of actual cash receipts and actual cash payments will not be able to disclose
22
correct profit or loss for a particular period and will not exhibit true financial position of
the business on a particular day.
(b) Mercantile (Accrual) system. Under this system all transactions relating to a period
are recorded in the books of account i.e., in addition to actual receipts and payments
of cash income receivable and expenses payable are also recorded. This system gives
a complete picture of the financial transactions of the business as it makes a record of
all transactions relating to a period. The system being based on a complete record of
the financial transactions discloses correct profit or loss for a particular period and also
exhibits true financial position of the business on a particular day.
Summary
Accounting can be understood as the language of financial decisions. It is an
ongoing process of performance measurement and reporting the results to decision
makers. The discipline of accounting can be traced back to very early times of human
civilization. With the advancement of industry, modern day accounting has become
formalized and structured. A person who maintains accounts is known as the account.
The information generated by accounting is used by various interested groups like,
individuals, managers, investors, creditors, government, regulatory agencies, taxation
authorities, employee, trade unions, consumers and general public. Depending upon
purpose and method, accounting can be broadly three types; financial accounting,
cost accounting and management accounting. Financial accounting is primarily
concerned with the preparation of financial statements. It is used on certain welldefined concepts and conventions and helps in framing broad financial policies.
However, it suffers from certain limitations.
Accounting concepts and conventions
Introduction
Accounting is often called the language of business because the purpose of
accounting is to communicate or report the results of business operations and its
various aspects to various users of accounting information. In fact, today, accounting
statements or reports are needed by various groups such as shareholders, creditors,
potential investors, columnist of financial newspapers, proprietors and others. In view
of the utility of accounting reports to various interested parties, it becomes imperative
to make this language capable of commonly understood by all. Account ing could
become an intelligible and commonly understood language if it is based on generally
accepted accounting principles. Hence, you must be familiar with the accounting
principles behind financial statements to understand and use them properly.
Meaning And Features Of Accounting Principles
For searching the goals of the accounting profession and for expanding
knowledge in this field, a logical and useful set of principles and procedures are to be
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developed. We know that while driving our vehicles, follow a standard traffic rules.
Without adhering traffic rules, there would be much chaos on the road. Similarly, some
principles apply to accounting. Thus, the accounting profession cannot reach its goals
in the absence of a set rules to guide the efforts of accountants and auditors. The rules
and principles of accounting are commonly referred to as the conceptual framework
of accounting. Accounting principles have been defined by the Canadian Institute of
Chartered Accountants as “The body of doctrines commonly associated with the
theory and procedure of accounting serving as an explanation of current practices and
as a guide for the selection of conventions or procedures where alternatives exists.
Rules governing the formation of accounting axioms and the principles derived from
them have arisen from common experience, historical precedent statements by
individuals and professional bodies and regulations of Governmental agencies”.
According to Hendriksen (1997), Accounting theory may be defined as logical
reasoning in the form of a set of broad principles that (i) provide a general frame of
reference by which accounting practice can be evaluated, and (ii) guide the
development of new practices and procedures. Theory may also be used to explain
existing practices to obtain a better understanding of them. But the most important
goal of accounting theory should be to provide a coherent set of logical principles that
form the general frame of reference for the evaluation and development of sound
accounting practices.
The American Institute of Certified Public Accountants (AICPA) has advocated
the use of the word” Principle” in the sense in which it means “rule of action”. It discuss
the generally accepted accounting principles as follows :
Financial statements are the product of a process in which a large volume of
data about aspects of the economic activities of an enterprise are accumulated,
analysed and reported. This process should be carried out in conformity with generally
accepted accounting principles. These principles represent the most current
consensus about how accounting information should be recorded, what information
should be disclosed, how it should be disclosed, and which financial statement should
be prepared. Thus, generally accepted principles and standards provide a common
financial language to enable informed users to read and interpret financial statements.
Generally accepted accounting principles encompass the conventions, rules
and procedures necessary to define accepted accounting practice at a particular
time....... generally accepted accounting principles include not only broad guidelines
of general application, but also detailed practices and procedures (Source: AICPA
Statement of the Accounting Principles Board No. 4, “Basic Concepts and Accounting
Principles underlying Financial Statements of Business Enterprises “, October, 1970,
pp 54-55) According to ‘Dictionary of Accounting’ prepared by Prof. P.N. Abroal,
“Accounting standards refer to accounting rules and procedures which are relating to
measurement, valuation and disclosure prepared by such bodies as the Accounting
Standards Committee (ASC) of a particular country”. Thus, we may define Accounting
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Principles as those rules of action or conduct which are adopted by the accountants
universally while recording accounting transactions. Accounting principles are manmade. They are accepted because they are believed to be useful. The general
acceptance of an accounting principle usually depends on how well it meets the
following three basic norms:
a) Usefulness b) Objectiveness, and c) Feasibility
A principle is useful to the extent that it results in meaningful or relevant information to
those who need to know about a certain business. In other words, an accounting rule,
which does not increase the utility of the records to its readers, is not accepted as an
accounting principles. A principle is objective to the extent that the information is not
influenced by the personal bias or Judgement of those who furnished it. Accounting
principle is said to be objective when it is solidly supported by facts. Objectivity means
reliability which also means that the accuracy of the information reported can be
verified. Accounting principles should be such as are practicable. A principle is feasible
when it can be implemented without undue difficulty or cost. Although these three
features are generally found in accounting principles, an optimum balance of three is
struck in some cases for adopting a particular rule as an accounting principle. For
example, the principle of making the provision for doubtful debts is found on feasibility
and usefulness though it is less objective. This is because of the fact that such
provisions are not supported by any outside evidence.
Accounting Principles
In dealing with the framework of accounting theory, we are confronted with a
serious problem arising from differences in terminology. A number of words and terms
have been used by different authors to express and explain the same idea or notion.
The various terms used for describing the basic ideas are: concepts, postulates,
propositions, assumptions, underlying principles, fundamentals, conventions,
doctrines, rules, axioms, etc. Each of these terms is capable of precise definition. But
the accounting profession has served to give them lose and overlapping meanings.
One author may describe the same idea or notion as a concept and another as a
convention and still another as postulate. For example, the separate business entity
idea has been described by one author as a concept and by another as conventions.
It is better for us not to waste our time to discuss the precise meaning of generic terms
as the wide diversity in these terms can only serve to confuse the learner. We do feel,
however, that some of these terms/ideas have a better claim to be called ‘concepts
‘while the rest should be called ‘conventions’. The term ‘Concept’ is used to connote
the accounting postulates, i.e., necessary assumptions and ideas which are
fundamental to accounting practice. In other words, fundamental accounting concepts
are broad general assumptions which underline the periodic financial statements of
business enterprises. The reason why some of these terms should be called concepts
is that they are basic assumptions and have a direct bearing on the quality of financial
accounting information. The term ‘convention’ is used to signify customs or tradition
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as a guide to the preparation of accounting statements. The following are the important
accounting concepts and conventions:
Accounting Concepts
Separate Business Entity Concept
Money Measurement Concept
Dual Aspect Concept
Going Concern Concept
Accounting Period Concept
Cost Concept
The Matching Concept
Accrual Concept
Realisation Concept
Accounting Conventions
Convention of Materiality
Convention of Conservatism
Convention of consistency
Accounting Concepts
The more important accounting concepts are briefly described as follows:
1. Separate Business Entity Concept. In accounting we make a distinction
between business and the owner. All the books of accounts records day to day
financial transactions from the view point of the business rather than from that of the
owner. The proprietor is considered as a creditor to the extent of the capital brought in
business by him. For instance, when a person invests Rs. 10 lakhs into a business, it
will be treated that the business has borrowed that much money from the owner and
it will be shown as a ‘liability’ in the books of accounts of business. Similarly, if the
owner of a shop were to take cash from the cash box for meeting certain personal
expenditure, the accounts would show that cash had been reduced even though it
does not make any difference to the owner himself. Thus, in recording a transaction
the important question is how does it affects the business? For example, if the owner
puts cash into the business, he has a claim against the business for capital brought
in.
In sofar as a limited company is concerned, this distinction can be easily
maintained because a company has a legal entity of its own. Like a natural person it
can engage itself in economic activities of buying, selling, producing, lending,
borrowing and consuming of goods and services. However, it is difficult to show this
distinction in the case of sole proprietorship and partnership. Nevertheless, accounting
still maintains separation of business and owner. It may be noted that it is only for
accounting purpose that partnerships and sole proprietorship are treated as separate
from the owner (s), though law does not make such distinction. Infact, the business
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entity concept is applied to make it possible for the owners to assess the performance
of their business and performance of those whose manage the enterprise.
The managers are responsible for the proper use of funds supplied by owners,
banks and others.
2. Money Measurement Concept. In accounting, only those business
transactions are recorded which can be expressed in terms of money. In other words,
a fact or transaction or happening which cannot be expressed in terms of money is not
recorded in the accounting books. As money is accepted not only as a medium of
exchange but also as a store of value, it has a very important advantage since a
number of assets and equities, which are otherwise different, can be measured and
expressed in terms of a common denominator.
We must realise that this concept imposes two limitations. Firstly, there are
several facts which though very important to the business, cannot be recorded in the
books of accounts because they cannot be expressed in money terms. For example,
general health condition of the Managing Director of the company, working conditions
in which a worker has to work, sales policy pursued by the enterprise, quality of product
introduced by the enterprise, though exert a great influence on the productivity and
profitability of the enterprise, are not recorded in the books. Similarly, the fact that a
strike is about to begin because employees are dissatisfied with the poor working
conditions in the factory will not be recorded even though this event is of great concern
to the business. You will agree that all these have a bearing on the future profitability
of the company. Secondly, use of money implies that we assume stable or constant
value of rupee. Taking this assumption means that the changes in the money value in
future dates are conveniently ignored. For example, a piece of land purchased in 1990
for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at the
same price, although the first purchased in 1990 may be worth two times higher than
the value recorded in the books because of rise in land values. Infact, most
accountants know fully well that purchasing power of rupee does change but very few
recognise this fact in accounting books and make allowance for changing price level.
3. Dual Aspect Concept. Financial accounting records all the transactions and
events involving financial element. Each of such transactions requires two aspects to
be recorded. The recognition of these two aspects of every transaction is known as a
dual aspect analysis. According to this concept every business transactions has dual
effect. For example, if a firm sells goods of Rs. 10,000 this transaction involves two
aspects. One aspect is the delivery of goods and the other aspect is immediate receipt
of cash (in the case of cash sales). Infact, the term ‘double entry’ book keeping has
come into vogue because for every transaction two entries are made. According to
this system the total amount debited always equals the total amount credited. It follows
from ‘dual aspect concept’ that at any point in time owners’ equity and liabilities for any
27
accounting entity will be equal to assets owned by that entity. This idea is fundamental
to accounting and could be expressed as the following equalities:
Assets = Liabilities + Owners Equity ...............(1)
Owners Equity = Assets - Liabilities ...............(2)
The above relationship is known as the ‘Accounting Equation’. The term Owners
Equity’ denotes the resources supplied by the owners of the entity while the term
‘liabilities’ denotes the claim of outside parties such as creditors, debenture-holders,
bank against the assets of the business. Assets are the resources owned by a
business. The total of assets will be equal to total of liabilities plus owners capital
because all assets of the business are claimed by either owners or outsiders.
4. Going Concern Concept. Accounting assumes that the business entity will
continue to operate for a long time in the future unless there is good evidence to the
contrary. The enterprise is viewed as a going concern, that is, as continuing in
operations, at least in the foreseeable future. In
other words, there is neither the intention nor the necessity to liquidate the particular
business venture in the predictable future. Because of this assumption, the accountant
while valuing the assets do not take into account forced sale value of them. Infact, the
assumption that the business is not expected to be liquidated in the foreseeable future
establishes the basis for many of the valuations and allocations in accounting. For
example, the accountant charges depreciation of fixed assets values. It is this
assumption which underlies the decision of investors to commit capital to enterprise.
Only on the basis of this assumption can the accounting process remain stable and
achieve the objective of correctly reporting and recording on the capital invested, the
efficiency of management, and the position of the enterprise as a going concern.
However, if the accountant has good reasons to believe that the business, or some
part of it is going to be liquidated or that it will cease to operate (say within six-month
or a year), then the resources could be reported at their current values. If this concept
is not followed, International Accounting Standard requires the disclosure of the fact
in the financial statements together with reasons.
5. Accounting Period Concept. This concept requires that the life of the
business should be divided into appropriate segments for studying the financial results
shown by the enterprise after each segment. Although the results of operations of a
specific enterprise can be known precisely only after the business has ceased to
operate, its assets have been sold off and liabilities paid off, the knowledge of the
results periodically is also necessary. Those who are interested in the operating results
of business obviously cannot wait till the end. The requirements of these parties force
the businessman ‘to stop’ and ‘see back’ how things are going on. Thus, the
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accountant must report for the changes in the wealth of a firm for short time periods.
A year is the most common interval on account of prevailing practice, tradition and
government requirements. Some firms adopt financial
year of the government, some other calendar year. Although a twelve month period is
adopted for external reporting, a shorter span of interval, say one month or three month
is applied for internal reporting purposes. This concept poses difficulty for the process
of allocation of long term costs. All the revenues and all the cost relating to the year in
operation have to be taken into account while matching the earnings and the cost of
those earnings for the any accounting period. This holds good irrespective of whether
or not they have been received in cash or paid in cash. Despite the difficulties which
stem from this concept, short term reports are of vital importance to owners,
management, creditors and other interested parties. Hence, the accountants have no
option but to resolve such difficulties.
6. Cost Concept. The term ‘assets’ denotes the resources land building,
machinery etc. owned by a business. The money values that are assigned to assets
are derived from the cost concept. According to this concept an asset is ordinarily
entered on the accounting records at the price paid to acquire it. For example, if a
business buys a plant for Rs. 5 lakh the asset would be recorded in the books at Rs.
5 lakh, even if its market value at that time happens to be Rs. 6 lakh. Thus, assets are
recorded at their original purchase price and this cost is the basis for all subsequent
accounting for the business. The assets shown in the financial statements do not
necessarily indicate their present market values. The term ‘book value’ is used for
amount shown in the accounting records. The cost concept does not mean that all
assets remain on the accounting records at their original cost for all times to come.
The asset may systematically be reduced in its value by charging ‘depreciation’, which
will be discussed in detail in a subsequent lesson. Depreciation have the effect
of reducing profit of each period. The prime purpose of depreciation is to allocate the
cost of an asset over its useful life and not to adjust its cost. However, a balance sheet
based on this concept can be very misleading as it shows assets at cost even when
there are wide difference between their costs and market values. Despite this limitation
you will find that the cost concept meets all the three basic norms of relevance,
objectivity and feasibility.
7. The Matching concept. This concept is based on the accounting period
concept. In reality we match revenues and expenses during the accounting periods.
Matching is the entire process of periodic earnings measurement, often described as
a process of matching expenses with revenues.
In other words, income made by the enterprise during a period can be measured only
when the revenue earned during a period is compared with the expenditure incurred
for earning that revenue. Broadly speaking revenue is the total amount realised from
the sale of goods or provision of services together with earnings from interest,
29
dividend, and other items of income. Expenses are cost incurred in connection with
the earnings of revenues. Costs incurred do not become expenses until the goods or
services in question are exchanged. Cost is not synonymous with expense since
expense is sacrifice made, resource consumed in relation to revenues earned during
an accounting period. Only costs that have expired during an accounting period are
considered as expenses. For example, if a commission is paid in January, 2002, for
services enjoyed in November, 2001, that commission should be taken as the cost for
services rendered in November 2001. On account of this concept, adjustments are
made for all prepaid expenses, outstanding expenses, accrued income, etc, while
preparing periodic reports.
8. Accrual Concept. It is generally accepted in accounting that the basis of
reporting income is accrual. Accrual concept makes a distinction between the receipt
of cash and the right to receive it, and the payment of cash and the legal obligation to
pay it. This concept provides a guideline to
the accountant as to how he should treat the cash receipts and the right related
thereto. Accrual principle tries to evaluate every transaction in terms of its impact on
the owner’s equity. The essence of the accrual concept is that net income arises from
events that change the owner’s equity in a specified period and that these are not
necessarily the same as change in the cash position of the business. Thus it helps in
proper measurement of income.
9. Realisation Concept. Realisation is technically understood as the process
of converting non-cash resources and rights into money. As accounting principle, it is
used to identify precisely the amount of revenue to be recognised and the amount of
expense to be matched to such revenue
for the purpose of income measurement. According to realisation concept revenue is
recognised when sale is made. 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. This
implies that revenue is generally realised when
goods are delivered or services are rendered. The rationale is that delivery validates
a claim against the customer. However, in case of long run construction contracts
revenue is often recognised on the basis of a proportionate or partial completion
method. Similarly, in case of long run instalment
sales contracts, revenue is regarded as realised only in proportion to the actual cash
collection. In fact, both these cases are the exceptions to the notion that an exchange
is needed to justify the realisation of revenue.
Accounting Conventions
1. Convention of Materiality. Materiality concept states that items of small
significance need not be given strict theoretically correct treatment. Infact, there are
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many events in business which are insignificant in nature. The cost of recording and
showing in financial statement such events may not be well justified by the utility
derived from that information. For example, an ordinary calculator costing Rs. 100 may
last for ten years. However, the effort involved in allocating its cost over the ten year
period is not worth the benefit that can be derived from this operation. The cost
incurred on calculator may be treated as the expense of the period in which it is
purchased. Similarly, when a statement of outstanding debtors is prepared for sending
to top management, figures may be rounded to the nearest ten or hundred. This
convention will unnecessarily overburden an accountant with more details in case he
is unable to find an objective distinction between material and immaterial events. It
should be noted that an item material for one party may be immaterial for another.
Actually, there are no hard and fast rule to draw the line between material and
immaterial events and hence, It is a matter of judgement and common sense. Despite
this limitation, It is necessary to disclose all material information to make the financial
statements clear and understandable. This is required as per IAS-1 and also reiterated
in IAS-5. As per IAS-1, materiality should govern the selection and application of
accounting policies.
2. Convention of Conservatism. This concept requires that the accountants
must follow the policy of ‘’playing safe” while recording business transactions and
events. That is why, the accountant follows the rule anticipate no profit but provide for
all possible losses, while recording the business events. This rule means that an
accountant should record lowest possible value for assets and revenues, and the
highest possible value for liabilities and expenses. According to this concept, revenues
or gains should be recognised only when they are realised in the form of cash or assets
(i.e. debts) the ultimate cash realisation of which can be assessed with reasonable
certainty. Further, provision must be made for all known liabilities, expenses and
losses, Probable losses regarding all contingencies should also be provided for.
‘Valuing the stock in trade at market price or cost price whichever is less’, ‘making the
provision for doubtful debts on debtors in anticipation of actual bad debts’, ‘adopting
written down value method of depreciation as against straight line method’, not
providing for discount on creditors but providing for discount on debtors’, are some of
the examples of the application of the convention of conservatism. The principle of
conservatism may also invite criticism if not applied cautiously. For example, when the
accountant creates secret reserves, by creating excess provision for bad and doubtful
debts, depreciation, etc. The financial statements do not present a true and fair view
of state of affairs. American Institute of Certified Public Accountant have also indicated
that this concept needs to be applied with much more caution and care as over
conservatism may result in misrepresentation.
4. Convention of Consistency. The convention of consistency requires that
once a firm decided on certain accounting policies and methods and has used these
for some time, it should continue to follow the same methods or procedures for all
subsequent similar events and transactions unless it has a sound reason to do
31
otherwise. In other worlds, accounting practices should remain unchanged from one
period to another. For example, if depreciation is charged on fixed assets according
to straight line method, this method should be followed year after year. Analogously,
if stock is valued at ‘cost or market price whichever is less’, this principle should be
applied in each subsequent year. However, this principle does not forbid introduction
of improved
accounting techniques. If for valid reasons the company makes any departure from
the method so far in use, then the effect of the change must be clearly stated in the
financial statements in the year of change. The application of the principle of
consistency is necessary for the purpose of comparison. One could draw valid
conclusions from the comparison of data drawn from financial statements of one year
with that of the other year. But the inconsistency in the application of accounting
methods might significantly affect the reported data.
Accounting Standards
The accounting concepts and conventions discussed in the foregoing pages are the
core elements in the theory of accounting. These principles, however, permit a variety
of alternative practices to co-exist. On account of this the financial results of different
companies can not be compared and evaluated unless full information is available
about the accounting methods which have been used. The lack of uniformity among
accounting practices have made it difficult to compare the financial results of different
companies. It means that there should not be too much discretion to companies
and their accountants to present financial information the way they like. In other words,
the information contained in financial statements should conform to carefully
considered standards. Obviously, accounting standards are needed to :
•
•
•
•
provide a basic framework for preparing financial statements to be uniformly
followed by all business enterprises,
make the financial statements of one firm comparable with the other firm and
the financial statements of one period with the financial statements of another
period of the same firm,
make the financial statements credible and reliable, and
create general sense of confidence among the outside users of financial
statements.
In this context unless there are reasonably appropriate standards, neither the purpose
of the individual investor nor that of the nation as a whole can be served. In order to
harmonise accounting policies and to evolve standards the need in the USA was felt
with the establishment of Securities
32
and Exchange Commission (SEC) in 1933. In 1957, a research-oriented organisation
called Accounting Principles Boards (APB) was formed to spell out the fundamental
accounting principles. After this the Financial Accounting Standards Board (FASB)
was formed in 1973, in USA. At the international level, the need for standardisation
was felt and therefore, an International Congress of accountants was organised in
Sydney, Australia in 1972 to ensure the desired level of uniformity in accounting
practices. Keeping this in view, International Accounting Standards Committee (IASC)
was formed and was entrusted with the responsibility of formulating international
standards.
In order to harmonise varying accounting policies and practices, the Institute of
Chartered Accountants of India (ICAI) formed the Accounting Standards Board (ASB)
in April, 1977. ASB includes representatives from industry and government. The main
function of the ASB is to formulate accounting standards. This Board of the Institute of
Chartered Accountants of
India has so far formulated around 27 Accounting Standards; the list of these
accounting standards is furnished. Regarding the position of Accounting standards in
India, it has been stated that the standards have been developed without first
establishing the essential theoretical framework. As a result, accounting standards
lack direction and coherence. This type of limitation also existed in UK and USA but it
was remedied long back.
Hence, there is an emergent need to make an attempt to develop a conceptual
framework and also revise suitably the Indian Accounting Standards to reduce the
number of alternative treatments.
Summary
Accounting principles have been defined as the body of doctrines commonly
associated with the theory and procedure of accounting serving as an explanation of
current practices and as a guide for the selection of conventions or procedures where
alternatives exists. Rules governing the formation of accounting axioms and the
principles derived from them have arisen from common experience, historical
precedent statements by individuals and professional bodies and regulations of
governmental agencies. The general acceptance of an accounting principle usually
depends on how well it meets the following three basic norms: a) Usefulness b)
Objectiveness, and c) Feasibility
The various terms used for describing the basic ideas are: concepts, postulates,
propositions, assumptions, underlying principles, fundamentals, conventions,
doctrines, rules, axioms, etc. Some of these terms/ideas have a better claim to be
called ‘concepts ‘ while the rest should be called ‘conventions’. The term ‘Concept’ is
used to connote the accounting postulates, i.e., necessary assumptions and ideas
33
which are fundamental to accounting practice. In other words, fundamental accounting
concepts are broad general assumptions which underline the periodic financial
statements of business enterprises. The term ‘convention’ is used to signify customs
or tradition as a guide to the preparation of accounting statements. The important
accounting concepts and conventions include Separate Business Entity Concept,
Money Measurement Concept, Dual Aspect Concept, Going Concern Concept,
Accounting Period Concept, Cost Concept, The Matching Concept,
Accrual Concept, Realisation Concept, Convention of Materiality, Convention of
Conservatism and Convention of consistency. In order to harmonise accounting
policies and to evolve standards ‘International Accounting Standards Committee’ was
formed and was entrusted with the responsibility of formulating international
standards. Similarly, the Institute of Chartered Accountants of India (ICAI) formed the
Accounting Standards Board in April, 1977 which has issued as many as 29
accounting standards over the years.
Accounting
Process:
Equation,
Rules,
Preparation of Journal And Ledger
Introduction
Any economic transaction or event of a business which can be expressed in
monetary terms should be recorded. Traditionally, accounting is a method of
collecting, recording, classifying, summarizing, presenting and interpreting financial
data of an economic activity. The series of business transactions occurs during the
accounting period and its recording is referred to an accounting process/mechanism.
An accounting process is a complete sequence of accounting procedures which are
repeated in the same order during each accounting period. Therefore, accounting
process involves the following steps:
Identification of Transaction: In accounting, only financial transactions are recorded.
A financial transaction is an event which can be expressed in terms of money and
which brings change in the financial position of a business enterprise. An event is an
incident or a happening which may or may not bring any change in the financial
position of a business enterprise. Therefore, all transactions are events but all events
are not transactions. A transaction is a complete action, to an expected or possible
future action. In every transaction, there is movement of value from one source to
another. For example, when goods are purchased for cash, there is a movement of
goods from the seller to the buyer and a movement of cash from buyer to the seller.
Transactions may be external (between a business entity and a second party, e.g.,
34
goods sold on credit to Hari or internal (do not involve second party, e.g., depreciation
charged on the machinery).
Illustration
State with reasons whether the following events are transactions or not to Mr. Nikhil,
Proprietor, Delhi Computers
(i) Mr. Nikhil started business with capital (brought in cash)Rs. 40,000.
(ii) Paid salaries to staff Rs. 5,000.
(iii) Purchased machinery for Rs. 20,000 in cash.
(iv) Placed an order with Sen & Co. for goods for Rs. 5,000.
(v) Opened a Bank account by depositing Rs. 4,000.
(vi) Received pass book from bank.
(vii) Appointed Sohan as Manager on a salary of Rs. 4,000 per month.
(viii)Received interest from bank Rs. 500.
(ix) Received a price list from Lalit.
Solution:
Here, each event is to be considered from the view point of Mr. Nikhil's business.
Those events which will change the financial position of the business of Mr. Nikhil,
should be regarded as transaction.
(i) It is a transaction, because it changes the financial position of Mr. Nikhil's business.
Cash will increase by Rs. 40,000 and Capital will increase by Rs. 40,000.
(ii) It is a transaction, because it changes the financial position of Mr. Nikhil's business.
Cash will decrease by Rs. 5,000 and Salaries (expenses) will increase by Rs. 5,000
(iii) It is a transaction, because it changes the financial position of Mr. Nikhil's business.
Machinery comes in and cash goes out.
(iv) It is not a transaction, because it does not change the financial position of the
business.
(v) It is a transaction, because it changes the financial position of the business. Bank
balance will increase by Rs. 4,000 and cash balance will decrease by Rs. 4,000.
(vi) It is also not a transaction, because it does not change the financial position of Mr.
Nikhil.
(vii) It is also not a transaction, because it does not change the financial position of Mr.
Nikhil.
35
(viii) It is a transaction, because it changes the financial position of Mr. Nikhil's
business.
(ix) It is not a transaction, because it does not change the financial position of the
business of Mr. Nikhil.
Recording the transaction: Journal is the first book of original entry in which all
transactions are recorded event-wise and date-wise and presents a historical record
of all monetary transactions. Journal may further be divided into sub-journals as well.
Classifying: Accounting is the art of classifying business transactions. Classification
means statement setting out for a period where all the similar transactions relating to
a person, a thing, expense, or any other subject are grouped together under
appropriate heads of accounts.
Summarising: Summarising is the art of making the activities of the business
enterprise as classified in the ledger for the use of management or other user groups
i.e. sundry debtors, sundry creditors etc. Summarisation helps in the preparation of
Profit and Loss Account and Balance sheet for a particular financial year.
Analysis and Interpretation: The financial information or data is recorded in the
books of account must further be analysed and interpreted so to draw meaningful
conclusions. Thus, analysis of accounting information will help the management to
assess in the performance of business operation and forming future plans also.
Presentation or reporting of financial information: The end users of accounting
statements must be benefited from analysis and interpretation of data as some of
them are the "share holders" and other one the "stake holders”. Comparison of past
and present statements and reports, use of ratios and trend analysis are the different
tools of analysis and interpretation. From the above discussion one can conclude
that accounting is an art which starts and includes steps right from recording of
business transactions of monetary character to the communicating or reporting the
results thereof to the various interested parties. For this purpose, the transactions
are classified into various accounts, the description of which follows in the next
section.
Accounting Equation
Dual concept states that 'for every debit, there is a credit'. Every transaction should
have two-sided effect to the extent of same amount. This concept has resulted in
accounting equation which states that at any point of time assets of any entity must
be equal (in monetary terms) to the total of owner's equity and outsider's liabilities. In
other words, accounting equation is a statement of equality between the assets and
the sources which finance the assets and is expressed as :
Assets = Sources of Finance
36
Assets may be tangible e.g. land, building, plant, machinery, equipment, furniture,
investments, cash, bank, stock, debtors etc. or intangible e.g. patent rights, trade
marks, goodwill etc., Sources include internal i.e. capital provided by the owner and
external i.e. liabilities. Liabilities are the obligations of the business to
others/outsiders. The above equation gets expanded.
Assets = Liabilities + Capital
All transactions of a business can be referred to this equation:
Assets = Liabilities + Owner's equity
To further explain the transaction of revenues, expenses, losses and gains,
the equation can be expanded thus:
Assets + Expenses = Liabilities + Revenue + Owner's equity
or
Assets = Liabilities + (Revenue – Expenses) + Owner's equity
or
Assets = Liabilities + Owner's equity + Owner's equity
(income) which ultimately becomes
Assets = Liabilities + Owner's equity
Let us consider the facts of the following case, step by step, to understand as
to how the equation remains true even in changed circumstances.
Illustration
1. Commenced business with cash Rs. 50,000
2. Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000
3. Sold goods for cash Rs. 40,000 costing Rs. 30,000
4. Rent paid Rs. 500
5. Bought furniture Rs. 5,000 on credit
6. Bought refrigerator for personal use Rs. 5,000
Solution:
1. Business receives cash Rs. 50,000 (asset) and it owes Rs. 50,000 to the
proprietor as his capital i.e. equity.
Assets (=)
Cash Rs. 50,000
Liabilities (+)
Nil
Owner's equity
Capital Rs. 50,000
(2) Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000. Business
has acquired asset namely – goods worth Rs. 50,000 and another asset
namely = cash has decreased by Rs. 20,000 while liability– creditors have
been created of Rs. 30,000.
Assets (=)
Cash
30,000
Goods
50,000
Liabilities (+)
Creditors 30,000
Owner's equity
Capital
50,000
37
80,000
30,000
50,000
(3) Sold goods for cash Rs. 40,000 costing Rs. 30,000
This transaction has resulted in decrease of goods by Rs. 30,000 and
increase in cash by Rs. 40,000 thus Increasing equity by Rs. 10,000
Assets (=)
Cash
70,000
Goods
20,000
90,000
Liabilities (+)
Creditors 30,000
Owner's equity
Capital
60,000
30,000
60,000
(4) Rent paid Rs. 500
This transaction has resulted in an expenditure of Rs. 500 effecting decrease
of cash and equity by Rs. 500 each.
Assets (=)
Cash
69,500
Goods
20,000
89,500
Liabilities (+)
Creditors
30,000
Owner's equity
Capital
59,500
30,000
59,500
(5) Bought furniture on credit Rs. 5,000
This transaction results in acquiring an asset namely furniture worth
Rs. 5,000 and increasing creditors by Rs. 5,000
Assets (=)
Cash
Goods
Furniture
69,500
20,000
5,000
94,500
Liabilities (+)
Creditors
35,000
Owner's equity
Capital
59,500
59,500
35,000
(6) Bought refrigerator for personal use Rs. 5,000.
This transaction will have the effect of reducing both cash as well as capital by
Rs. 5,000 each.
Assets (=)
Cash
Goods
Furniture
69,500
20,000
5,000
89,500
Liabilities (+)
Creditors
35,000
Owner's equity
Capital
59,500
35,000
59,500
54,500
38
Account
An account is a summary of the relevant transactions at one place relating to a
particular head. It records not only the amount of transaction but also their effect and
direction.
Classification of Accounts
The classification of accounts is given as follows :
1. Personal Accounts : Accounts which are related to individuals, firms, companies,
co-operative societies, banks, financial institutions are known as personal accounts.
The personal accounts may further be classified into three categories :
(i) Natural Personal Accounts : Accounts of individuals (natural persons) such as
Akhils' A/c, Rajesh's A/c, Sohan's A/c are natural personal accounts.
(ii) Artificial Personal Accounts : Accounts of firms, companies, banks, financial
institutions such as Reliance Industries Ltd., Lions Club, M/s Sham & Sons, Punjab
National Bank, National College are artificial personal accounts.
(iii) Representative Personal Accounts : The accounts recording transactions
relating to limited expenses and incomes are classified as nominal accounts. But in
certain cases (due to the matching concept of accounting) the amount on a particular
date, is payable to the individuals or recoverable from individuals. Such amount (i)
relates to the particular head of expenditure or income and (ii) represents persons to
whom it is payable or from whom it is recoverable. Such accounts are classified as
representative personal account e.g., Wages outstanding account, Pre-paid insurance
account etc.
2. Real Accounts : Real accounts are the accounts related to assets/properties.
These may be classified into tangible real account and intangible real account. The
accounts relating to tangible assets (which can be touched, purchased and sold) such
as building, plant, machinery, cash, furniture etc. are classified as tangible real
accounts. Intangible real accounts (which do not have physical shape) are the
accounts related to intangible assets such as goodwill, trademarks, copyrights, patents
etc.
3. Nominal Accounts : The accounts relating to income, expenses, losses and gains
are classified as nominal accounts. For example Wages Account, Rent Account,
Interest Account, Salary Account, Bad Debts Accounts, Purchases;
Account etc. fall in the category of nominal accounts.
Rules Of Debit And Credit
Basically, debit means to enter an amount to the left side of an account and
credit means to enter an amount to the right side of an account. In the abbreviated
form Dr. stands for debit and Cr. stands for credit. Both debit and credit may represent
either increase or decrease depending upon the nature of an account.
39
The Rules for Debit and Credit are given below:
Types of Accounts
Rules for Debit
Rules for Credit
(a) For Personal
Debit the receiver
Credit the giver
Accounts
Debit what comes in
Credit what goes out
(b) For Real Accounts Debit all expenses and
Credit all incomes and
(c) For Nominal
losses
gains
Accounts
Illustration: How will you classify the following into personal, real and nominal
accounts ?
(i) Investments
(ii) Freehold Premises
(iii) Accrued Interest to Ram
(iv) Haryana Agro Industries Corporation
(v) Janata Mechanical Works
(vi) Salary Account
(vii) Loose Tools Accounts
(viii)Purchases Account
(ix) Corporation Bank Ltd.
(x) Capital Account
(xi) Brokerage Account
(xii) Toll Tax Account
(xiii) Dividend Received Account
(xiv) Royalty Account
(xv) Sales Account
Solution :
Real Account : (i), (ii), (vii), (viii), (xv)
Nominal Account : (vi), (xi), (xii), (xiii), (xiv)
Personal Account : (iii), (iv), (v), (ix), (x)
Meaning And Format Of A Journal
Journal is a historical record of business transactions or events. The word
journal comes from the French word "Jour" meaning "day". It is a book of original or
prime entry written up from the various source documents. Journal is a primary book
for recording the day to day transactions in a chronological order i.e. in the order in
which they occur. The journal is a form of diary for business transactions. This is also
called the book of first entry since every transaction is recorded firstly in the journal.
The format of a journal is shown as follows:
Date
Particulars
Journal
L.F.
Debit
Credit
40
(Rs.)
(Rs.)
(a) Date Column: This column shows the date on which the transaction is recorded.
The year and month are written once, till they change.
(b) Particular Column: Under this column, first the names of the accounts to be debited,
then the names of the accounts to be credited and lastly, the narration (i.e. a brief
explanation of the transaction) are entered.
(c) L.F., i.e. Ledger Folio Column: Under this column, the ledger page number
containing the relevant account is entered at the time of posting.
(d) Debit amount Column: Under this column, the amount to be debited is entered.
(e) Credit amount Column: Under this column, the amount to be credited is entered.
Meaning of Journalising
The process of recording a transaction in the journal is called journalising. The various
steps to be followed in journalising business transactions are given below:
Step 1 Ascertain what accounts are involved in a transaction.
Step 2 Ascertain what is the nature of the accounts involved.
Step 3 Ascertain which rule of debit and credit is applicable for each of the accounts
involved.
Step 4 Ascertain which account is to be debited and which is to be credited.
Step 5 Record the date of transaction in the 'Date column'.
Step 6 Write the name of the account to be debited, very close to the left hand side
i.e. the line demarcating the 'Date column' and the 'Particulars column') along
with the abbreviation 'Dr.' on the same line against the name of the account in
the 'Particulars column' and the amount to be debited in the 'Debit Amount
column' against the name of the account.
Step 7 Write the name of the account to be credited in the next line preceded by the
word 'To' at a few spaces towards right in the 'Particulars column' and the amount
to be credited in the 'Credit Amount column' against the name of the account.
Step 8 Write 'Narration' (i.e. a brief description of the transaction) within brackets in
the next line in the 'Particulars column'.
Step 9 Draw a line across the entire 'Particulars column' to separate one Journal Entry
from the other.
Advantages of Journal
The transactions are recorded in journal as and when they occur so the chances of
error are minimized.
It helps in preparation of ledger.
Any transfer from one account to another account is made through Journal.
The entry recorded in journal are self-explanatory as it includes narration also.
It can record any such transaction which cannot be entered in any other books of
account.
41
Every transaction is recorded in chronological order (date wise) so the chances of
manipulations are reduced.
Journal shows all information in respect of a transaction at one place.
The closing balances of previous year of accounts related to assets and liabilities can
be brought forward to the next year by passing journal entry in journal.
Illustration: From the following transactions of Nikhil, find out the nature of accounts
and also state which account should be debited and which should be credited :
i) Rent paid
ii) Interest received
iii) Purchased furniture for cash
iv) Machinery sold in cash
v) Outstanding salaries
vi) Paid to Surinder
Solution :
Illustration: Journalise the following transactions:
2005
Jan. 1
Mohan started business with cash
80,000
Jan. 6
Purchased goods from Ram on credit
30,000
Jan. 8
Sold goods on cash
6,000
Rs.
42
Jan. 15
8,000
Jan. 18
6,500
Jan. 20
1,000
Date
2005
‘’6
‘’8
‘’15
‘’18
‘’20
Bought Furniture from Yash for cash
Paid Salary to manager
Paid Rent to land lord in cash
Particulars
Cash Account
To Mohan's Capital Account
(Being business started with
cash)
Purchases Account
To Ram's Account
(Being purchase on credit)
Cash Account
To Sales Account
(Being sold goods for cash)
Furniture Account
To Cash Account
(Being bought furniture for
cash)
Salary Account
To Cash Account
(Being salary paid to
manager)
Rent Account
To Cash Account
(Being rent paid to land lord)
L.F.
Dr.
Debit
80,000
Credit
80,000
Dr.
30,000
30,000
Dr.
6,000
6,000
Dr.
8,000
8,000
Dr.
6,500
6,500
Dr.
1,000
1,000
Compound Journal Entries
When more than two accounts are involved in a transaction and the transaction is
recorded by means of a single journal entry instead of passing several journal entries,
such single journal entry is termed as 'Compound Journal Entry'.
Illustration : Journalise the following :
2005
Nov. 1
6
8
Paid to Arun Rs. 5,250 discount allowed by him Rs.50
Received from Somesh Rs. 1,900 and from Komesh Rs. 400
Goods purchased for cash
Rs. 4,000
Furniture purchased for cash
Rs. 3,000
43
Paid cash to Raman
Paid Salary in cash
Paid Rent in cash
Rs. 2,090
Rs. 7,600
Rs. 1,400
Solution:
Opening Entry
A journal entry by means of which the balances of various assets, liabilities and
capital appearing in the balance sheet of previous accounting period are brought
forward in the books of the current accounting period, is known as 'Opening Entry'.
While passing an opening entry, all assets accounts (individually) are debited and all
liabilities accounts (individually) are credited and the Net worth (i.e. excess of assets
over liabilities) is credited to Proprietor's Capital Account (in case of a proprietary
concern) or Partners' Capital Accounts (in case of a partnership concern).
Illustration: On 1st April 2006, Singh's assets and liabilities stood as follows:
Assets: Cash Rs. 6,000; Bank Rs. 17,000; Stock Rs. 3,000; Bills Receivable
Rs.7,000; Debtors Rs. 3,000; Building Rs.70,000; Investments Rs. 30,000;
Furniture Rs. 4,000
Liabilities:
Bills payable Rs. 5000, Creditors Rs. 9000, Ram's Loan Rs.13000
Pass an opening Journal entry.
44
Goods Account
In accounting the meaning of goods is restricted to only those articles which are
purchased by a businessman with an intention to sell it. For example, if a
businessman purchased typewriter, it will be goods for him if he deals in typewriter
but if he deals in other business say clothes then typewriter will be asset for him and
clothes will be goods.
Sub-Division of Goods Accounts
The goods account is not opened in accounting books. In place of goods account the
following accounts are opened in the books of accounts :
Purchases Account : This is opened for goods purchased on cash and credit.
Sales Account : This account is opened for the goods sold on cash and credit.
Purchase Returns Account or Return Outward Account : This account is opened
for the goods returned to suppliers.
Sales Returns Account or Return Inward Account : This account is opened for
the goods returned by customers.
IMPORTANT CONSIDERATIONS FOR RECORDING THE BUSINESS
TRANSACTIONS
1. Trade Discount
Trade discount is usually allowed on the list price of the goods. It may be
allowed by producer to wholesaler and by wholesaler to retailer for purchase of goods
in large quantity. It is not recorded in the books of account and entry is made only with
45
the net amount paid or received. For example, purchased goods of list price Rs. 8,000
at 15% trade discount from X. In this case the following entry will be passed:
Rs.
6,800
Purchases Account
Dr.
To X
(Being goods purchased at 15%
trade discount less list price)
Rs.
6,800
2. Cash Discount
Cash discount is a concession allowed by seller to buyer to encourage him to
make early cash payment. It is a Nominal Account. The person who allows discount,
treat it as an expense and debits in his books and it is called discount allowed and the
person who receives discount, treat it as an income and it is called discount received
and credited in his books of account as "Discount Received Account." For example, X
owes Rs. 6,000 to Y. He pays Rs. 5,950 in full settlement against the amount due. In
the books of X, the journal entry will be:
Y
Dr.
Rs.
6,000
Rs.
To Cash Account
To Discount Received account
(Being Cash paid and discount received)
In the books of Y
Cash Account
Dr.
Discount Allowed Account Dr.
To X
(Being cash received and discount allowed)
5,950
50
Rs.
Rs.
5,950
50
6,000
3. Goods distributed as free samples
Sometimes business distribute goods as free samples for the purpose of
advertisement. In this case, Advertisement Account is debited and Purchases Account
is credited. For example, goods costing Rs. 8000 were distributed as free sample. To
record this transaction following entry will be passed :
Rs.
Rs.
Advertisement Account
Dr.
8,000
To Purchases Account
8,000
4. Interest on capital
46
Interest paid on capital is an expense. Therefore, interest account should be debited.
On the other hand, the capital of the business increases. So, the capital account
should be credited. The entry will be as follows:
Interest on Capital Account
Dr.
To Capital Account
5.Interest charged on Drawings
If the interest is charged on drawings then it will be an increase in the income of
business, so interest on drawings will be credited. On the other hand there will be
increase in drawings or decrease in Capital. So Drawings Account will be debited. To
record this, following entry will be passed :
Drawing Account/Capital Account
Dr.
To Interest on Drawing Account
6. Depreciation charged on Fixed Assets
Depreciation is the gradual, permanent decrease in the value of an asset due to wear
and tear and many other causes. Depreciation is an expense so the following entry
will be passed :
Depreciation Account
Dr.
To Asset Account
7. Bad Debts
Sometimes a debtor of business fails to pay the amount due from him. Reasons may
be many e.g. he may become insolvent or he may die. Such irrecoverable amount is
a loss to the business. To record this following entry will be passed :
Bad Debts Account
Dr.
To Debtor's Account
8. Bad Debts Recovered
When any amount becomes irrecoverable from any costumer or debtor his account is
closed in the books. If in future any amount is recovered from him then his personal
account will not be credited because that does not exist in the books. So the following
entry is passed :
Cash Account
Dr.
To Bad Debts Recovered Account
9. Purchase and Sale of investment
When business has some surplus money it may invest this amount is shares,
debentures or other types of securities. When these securities are purchased, these
are recorded at the purchase price paid. At the time of sale of investment the sale
price of an investment is recorded in the books of accounts. The following entry is
passed to record the purchase of investment :
Investment Account
Dr.
To Cash Account
In case of sale of these securities the entry will be :
Cash Account
Dr.
To Investment Account
10. Loss of Goods by Fire/Accident/theft
47
A business may suffer loss of goods on account of fire, theft or accident. It is a
business loss and a nominal account. It also reduces the goods at cost price, and
increases the loss/expenses of the business. The entry will be passed as :
Loss by fire/Accident/theft Account
Dr.(for loss)
Insurance Company Account
Dr. (for insurance claim
admitted)
To Purchases Account
11. Income Tax Paid
Income Tax paid should be debited to Capital Account or Drawings Account
and credited to Cash Account in case of sole proprietorship and partnership firms. The
reason behind this is that income tax is a personal expense for the sole trader and
partners because it is paid on income of proprietor. The entry will be as follows:
Capital Account/Drawing Account
Dr.
To Cash Account
12. Bank Charges
Bank provide various services to their customers. Bank deducts some charges
by debiting the account of customers. It is an expense for the business. To record this,
Bank charges account is debited and bank account is credited in the books of
customer.
13. Drawings Account
It is a personal account of the proprietor. When the businessman withdraws
cash or goods from the business for his personal/domestic use it is called as
'drawings'. Drawings reduce the capital as well as goods/cash balance of the business.
The journal entry is:
Drawings Account Dr.
To Cash Account
To Purchases Account
14. Personal expenses of the proprietor
When the private expenses such as life insurance premium, income tax, home
telephone bill, tuition fees of the son of the proprietor etc. are paid out of the cash or
bank account of business it should be debited to the Drawings Account of the
proprietor.
15. Sale of Asset/Property
When the asset of a business is sold, there may occur a profit or loss on its
sale. Its journal entry is :
(i) In case there is a profit on sale of Property/Assets
48
Cash/Bank Account
To Asset/Property Account
To Profit on sale of Asset Account
(ii) In case of a loss on sale of asset
Cash/Bank Account
Loss on sale of Asset Account
To Asset Account
Dr.
Dr.
Dr.
16. Amount paid or Received on behalf of customer
When the business entity pays the amount on behalf of old reputed customers such
as carriage in anticipation of recovering the same later on, carriage account should
not be opened because carriage is not the expense of the seller. It should be
debited/charged to customer's Personal account.
When the business entity receives the amount on behalf of customers from the third
party as mutually settled between the third party and the customer, the account of the
third party/person making the payment should not be opened in the books of the
receiving entity. The journal entry in the books of the entity is :
Cash/Bank Account
Dr.
To Customer/Debtor's Account
17. Amount paid on behalf of creditors
When the creditors/supplier instructs the business entity to make payment on
their behalf, the amount so paid should be debited to creditors account and liability of
the business will decrease accordingly.
18. The events affecting business but they do not involve any transfer/exchange of
money for the time being, they would not be recorded in the financial books.
19. Paid wages/installation charges for erection of machinery
Wages and installation charges are the expenses of nominal nature. But for
erection of machinery no separate account should be opened for such expenses
because these expenses are of capital nature and it will be merged/debited to the cost
of assets i.e. machinery. The journal entry is:
Machinery Account
Dr.
To Cash/Bank Account
(Being wages/installation charges paid
for the erection of machinery)
Ledger
Journal is a daily record of all business transactions. In the journal all transactions
relating to persons, expenses, assets, liabilities and incomes are recorded. Journal
49
does not give a complete picture of the fundamental elements of book keeping i.e.
properties, liabilities, proprietorship accounts and expenses and incomes at a glance
and at one place. Business transactions being recurring in nature, a number of
entries are made for a particular type of transactions such as
sales, purchases, receipts and payments of cash, expenses etc., throughout the
accounting year. The entries are therefore scattered over in the Journal. In fact, the
whole Journal will have to be gone through to find out the combined effect of various
transactions on a particular account. In case, at any time, a businessman wants to
now:
i) How much he has to pay to the suppliers/creditors of goods?
ii) How much he has to receive from the customers?
iii) What is the total amount of purchases and sales made during a particular period?
iv) How much cash has been spent/incurred on various items of expenses such as
salaries, rent, carriage, stationery etc.
v) What is the amount of profit or loss made during a particular period?
vi) What is the financial position of the unit on a particular date?
The above-mentioned information cannot be easily gathered from the journal
itself because the details of such information is scattered all over the journal. It is
thus of dire need to get a summarised/grouped record of all the transactions relating
to a particular person, or a thing or an expenditure to take managerial decisions. The
mechanics of collecting, assembling and summarising
all transactions of similar nature at one place can better be served by a book known
as 'ledger' i.e. a classified head of accounts.
Ledger is a principal book of accounts of the enterprise. It is rightly called as
the 'King of Books'. Ledger is a set of accounts. Ledger contains the various
personal, real and nominal accounts in which all business transactions of the entity
are recorded. The main function of the ledger is to classify and summarise all the
items appearing in Journal and other books of original entry under appropriate
head/set of accounts so that at the end of the accounting period, each account
contains the complete information of all transaction relating to it. A ledger therefore is
a collection of accounts and may be defined as a summary statement of all the
transactions relating to a person, asset, expense or income which have taken place
during a given period of time and shows their net effect.
Relationship between Journal and Ledger
Journal and Ledger are the most useful books kept by a business entity. The
points of distinction between the two are given below:
1. The journal is a book of original entry whereas the ledger is the main book of
account.
2. In the journal business transactions are recorded as and when they occur
i.e. date-wise. However, posting from the journal is done periodically, may be
weekly, fortnightly as per the convenience of the business.
50
3. The journal does not disclose the complete position of an account. On the
other hand, the ledger indicates the position of each account debit wise or credit
wise, as the case may be. In this way, the net position of each account is known
immediately.
4. The record of transactions in the journal is in the form of journal entries
whereas the record in the ledger is in the form of an account.
Utility of a Ledger
The main utilities of a ledger are summarised as under:
(a) It provides complete information about all accounts in one book.
(b) It enables the ascertainment of the main items of revenues and expenses
(c) It enables the ascertainment of the value of assets and liabilities.
(d) It facilitates the preparation of Final Accounts.
Format of a Ledger Account
A ledger account can be prepared in any one of the following two forms:
A ledger (general ledger) is the complete collection of all the accounts of a company. The
ledger may be in loose-leaf form, in a bound volume, or in computer memory.
Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and
stockholders' equity) and (2) income statement accounts (revenues and expenses). The terms
real accounts and permanent accounts also refer to balance sheet accounts. Balance sheet
accounts are real accounts because they are not subclassifications or subdivisions of any
other account. They are permanent accounts because their balances are not transferred (or
closed) to any other account at the end of the accounting period. Income statement accounts
and the Dividends account are nominal accounts because they are merely subclassifications
51
of the stockholders' equity accounts. Nominal literally means "in name only". Nominal
accounts are also called temporary accounts because they temporarily contain revenue,
expense, and dividend information that is transferred (or closed) to the Retained Earnings
account at the end of the accounting period.
The chart of accounts is a complete listing of the titles and numbers of all the accounts in
the ledger. The chart of accounts can be compared to a table of contents. The groups of
accounts usually appear in this order: assets, liabilities, stockholders' equity, dividends,
revenues, and expenses.
Individual accounts are in sequence in the ledger. Each account typically has an
identification number and a title to help locate accounts when recording data. For example, a
company might number asset accounts, 100-199; liability accounts, 200-299; stockholders'
equity accounts and Dividends account, 300-399; revenue accounts, 400-499; and expense
accounts, 500-599. We use this numbering system in this text. The uniform chart of accounts
used in the first 11 chapters appears in a separate file at the end of the text. You should print
that file and keep it handy for working certain problems and exercises. Companies may use
other numbering systems. For instance, sometimes a company numbers its accounts in
sequence starting with 1, 2, and so on. The important idea is that companies use some
numbering system.
Now that you understand how to record debits and credits in an account and how all
accounts together form a ledger, you are ready to study the accounting process in operation.
The accounting process in operation
MicroTrain Company is a small corporation that provides on-site personal computer
software training using the clients' equipment. The company offers beginning through
advanced training with convenient scheduling. A small fleet of trucks transports personnel and
teaching supplies to the clients' sites. The company rents a building and is responsible for
paying the utilities.
We illustrate the capital stock transaction that occurred to form the company (in November)
and the first month of operations (December). The accounting process used by this company
is similar to that of any small company. The ledger accounts used by MicroTrain Company are:
Acct. Account Title Description
No.
100 Cash
Bank deposits and cash on hand.
103 Accounts
Amounts owed to the company by
Receivable
customers.
107 Supplies on Hand Items such as paper, envelopes, writing
materials, and other materials used in
performing
training
services
for
customers or in doing administrative
Assets
and clerical office work.
108 Prepaid Insurance Insurance policy premiums paid in
advance of the periods for which the
insurance coverage applies.
112 Prepaid Rent
Rent paid in advance of the periods for
which the rent payment applies.
150 Trucks
Trucks used to transport personnel and
training supplies to clients' locations.
200 Accounts Payable Amounts owed to creditors for items
52
Liabilities 216 Unearned Service
Fees
Stockhol
ders'
equity
Dividend
s
Revenue
s
300 Capital
Stock
310 Retained Earnings
320 Dividends
400 Service Revenue
505 Advertising
Expense
506 Gas
and
Expense
Oil
purchased
from them.
Amounts received from customers
before the training services have been
performed for them.
The stockholders' investment in the
business. The earnings retained in the
business.
The amount of dividends declared to
stockholders.
Amounts earned by performing training
services for customers.
The cost of advertising incurred in the
current period.
The cost of gas and oil used in trucks in
the
current period.
Expense
s
]
507 Salaries Expense The amount of salaries incurred in the
current period.
511 Utilities Expense The cost of utilities incurred in the
current period.
Notice the gaps left between account numbers (100, 103, 107, etc.). These gaps allow the
firm to later add new accounts between the existing accounts.
To begin, a transaction must be journalized. Journalizing is the process of entering the
effects of a transaction in a journal. Then, the information is transferred, or posted, to the
proper accounts in the ledger. Posting is the process of recording in the ledger accounts the
information contained in the journal. We explain posting in more detail later in the chapter.
In the following example, notice that each business transaction affects two or more
accounts in the ledger. Also note that the transaction date in both the general journal and the
general ledger accounts is the same. In the ledger accounts, the date used is the date that the
transaction was recorded in the general journal, even if the entry is not posted until several
days later. Our example shows the journal entries posted to T-accounts. In practice, firms post
journal entries to ledger accounts, as we show later in the chapter.
Accountants use the accrual basis of accounting. Under the accrual basis of accounting,
they recognize revenues when the company makes a sale or performs a service, regardless
of when the company receives the cash. They recognize expenses as incurred, whether or
not the company has paid out cash. Chapter 3 discusses the accrual basis of accounting in
more detail.
In the following MicroTrain Company example, transaction 1 increases (debits) Cash and
increases (credits) Capital Stock by USD 50,000. First, MicroTrain records the transaction in
the general journal; second, it posts the entry to the accounts in the general ledger.
Transaction 1:2010 Nov. 28 Stockholders invested $50,000 and formed MicroTrain
Company.
General Journal
Date
Account Titles and Explanation
Pos Debit
Credit
t.
53
2010
Nov.
2 Cash (+A)
8
Capital Stock (+SE)
Stockholders invested
business.
Ref
.
100
300
$50,000
cash
5000 0
5 0000
in
General Ledger
Cash
Acct. No. 100
Capital Stock
(Dr.)
(Cr.)
(Dr.)
Acct. No. 300
(Cr.)
2010
2010
Nov. 28 50,000
Nov. 28 50,000
No other transactions occurred in November. The company prepares financial statements
at the end of each month. Exhibit 5 shows the company's balance sheet at 2010 November
30.
The balance sheet reflects ledger account balances as of the close of business on 2010
November 30. These closing balances are the beginning balances on 2010 December 1. The
ledger accounts show these closing balances as beginning balances (Beg. bal.).
Now assume that in December 2010, MicroTrain Company engaged in the following
transactions. We show the proper recording of each transaction in the journal and then in the
ledger accounts (in T-account form), and describe the effects of each transaction.
MICROTRAIN COMPANY Balance Sheet 2010 November 30
Assets
Liabilities and Stockholders' Equity
Cash
$50,000
Stockholders' equity:
Capital stock
$50,000
Total Assets
$50,000
Total liabilities and stockholders'
equity
$50,000
Exhibit 9: Balance sheet
Transaction 2: Dec. 1 Paid cash for four small trucks, $40,000.
General Journal
Date
2010
Dec.
Account Titles and Explanation
1 Trucks (+A)
Cash (-A)
Pos Debit
Credit
t.
Ref
.
150 4 0 0 0 0 (A
)
100
4 0 0 0 0 (B
)
To record the purchase of four trucks.
General Ledger
Trucks
(Dr.)
Acct. No. 150
(Cr.)
54
2010 Dec. (A)40,0
1
00
Cash
(Dr.)
Acct. No. 100
(Cr.)
2010
50,000 2010
(B)40
Dec. 1 Beg.
Dec. 1 ,000
bal.
Transaction 3: Dec. 1 Paid cash for insurance on the trucks to cover a one-year period
from this date.
General Journal
Date
2010
Dec.
Account Titles and Explanation
1 Prepaid Insurance (+A)
Pos Debit
t.
Ref
.
108
2400
Cash (-A)
100
Purchased truck insurance to cover a one-year
period.
(Dr)
2010
Dec. 1
Credit
2400
General Ledger
Prepaid
Insurance
Acct. No. 108
(Cr)
2,400
Cash
(Dr)
Acct. No. 100
(Cr.)
2010
50,00 2010
40,000
Dec.
10
Dec.
1 2,40
Beg. Bal
Dec. 1
Effects of transaction
An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by
USD 2,400. The debit is to Prepaid Insurance rather than Insurance Expense because the
policy covers more than the current accounting period of December (insurance policies are
usually paid one year in advance). As you will see in Chapter 3, prepaid items are expensed
as they are used. If this insurance policy was only written for December, the entire USD 2,400
debit would have been to Insurance Expense.
Transaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period
from this date.
General Journal
Date
Account Titles and Explanation
Pos Debit
t.
Credit
55
2010
Dec.
Ref
.
112
1 Prepaid Rent (+A)
Cash (-A)
Paid three months' rent on a building.
(Dr.)
2010
100
1200
1200
General Ledger
Prepaid Rent
Acct. No. 112
(Cr)
Dec. 1
1,200
(Dr.)
2010
Cash
Acct. No. 100
2010
Dec. 1 Beg. 50,00 Dec. 1
Bal.
0
Dec. 1
Dec. 1
(Cr.)
40,000
2,400
1,200
Effects of transaction
An asset, prepaid rent, increases (debited); and another asset, cash, decreases (credited)
by USD 1,200. The debit is to Prepaid Rent rather than Rent Expense because the payment
covers more than the current month. If the payment had just been for December, the debit
would have been to Rent Expense.
Transaction 5: Dec. 4 Purchased $1,400 of training supplies on account to be used
over the next several months.
General Journal
Date
Account Titles and Explanation
Pos Debit
Credit
t.
Ref
.
2010 4 Supplies on Hand (+A)
107
1400
Dec.
Accounts Payable (+L)
200
1400
To record the purchases of training supplies for
future use.
(Dr.)
2010
General Ledger
Supplies on Hand
Acct. No. 107
(Cr)
56
Dec. 4
1,400
(Dr.)
Accounts Payable
Acct. No. 200
2010
Dec. 4
(Cr.)
1,400
Effects of transaction
An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases
(credited) by USD 1,400. The debit is to Supplies on Hand rather than Supplies Expense
because the supplies are to be used over several accounting periods.
In each of the three preceding entries, we debited an asset rather than an expense. The
reason is that the expenditure applies to (or benefits) more than just the current accounting
period. Whenever a company will not fully use up an item such as insurance, rent, or
supplies in the period when purchased, it usually debits an asset. In practice, however,
sometimes the expense is initially debited in these situations.
Companies sometimes buy items that they fully use up within the current accounting period.
For example, during the first part of the month a company may buy supplies that it intends
to consume fully during that month. If the company fully consumes the supplies during the
period of purchase, the best practice is to debit Supplies Expense at the time of purchase
rather than Supplies on Hand. This same advice applies to insurance and rent. If a company
purchases insurance that it fully consumes during the current period, the company should
debit Insurance Expense at the time of purchase rather than Prepaid Insurance. Also, if a
company pays rent that applies only to the current period, Rent Expense should be debited
at the time of purchase rather than Prepaid Rent. As illustrated in Chapter 3, following this
advice simplifies the procedures at the end of the accounting period.
Transaction 6: Dec. 7 Received $4,500 from a customer in payment for future training
services.
General Journal
Date
Account Titles and Explanation
Pos Debit
Credit
t.
Ref
.
2010 7 Cash (+A)
100
4500
Dec.
Unearned Service Fees (+L)
216
4500
To record the receipt of cash from a customer in
payment
for future training services.
General Ledger
Cash
57
(Dr.)
2010
Dec.
1
Dec.
7
Acct. No. 100
2010
Beg
Bal Dec. 1
50,000
4,500
Dec. 1
(Cr)
40,000
2,400
Dec. 1
1,200
Unearned Service Fees
(Dr.) Acct. No. 216
(Cr.)
2010
Dec. 7
4,500
Effects of transaction
An asset, cash, increases (debited); and a liability, unearned service revenue, increases
(credited) by USD 4,500. The credit is to Unearned Service Fees rather than Service Revenue
because the USD 4,500 applies to more than just the current accounting period. Unearned
Service Fees is a liability because, if the services are never performed, the USD 4,500 will
have to be refunded. If the payment had been for services to be provided in December, the
credit would have been to Service Revenue.
Transaction 7: Dec. 15 Performed training services for a customer for cash, $5,000.
General Journal
Date
2010
Dec.
Account Titles and Explanation
1 Cash (+A)
5
Service Revenue (+SE)
Pos Debit
t.
Ref
.
100
5000
400
Credit
5000
To record the receipt of cash for performing
training
services for a customer.
General Ledger
Cash
(Dr.)
2010
Acct. No. 100
2010
Dec. 1 Beg Bal. Dec. 1
50,000
Dec. 7
4,500 Dec. 1
Dec. 15
5,000 Dec. 1
(Cr)
40,000
2,400
1,200
58
Service Revenue
(Dr.)
Acct. No. 400
2010
Dec. 15
(Cr.)
5,000
Effects of transaction
An asset, cash, increases (debited); and a revenue, service revenue, increases (credited) by
USD 5,000.
Transaction 8: Dec. 17 Paid the $1,400 account payable resulting from the transaction
of December 4.
General Journal
Date
Account Titles and Explanation
Pos Debit
Credit
t.
Ref.
2010 1 Accounts Payable (-L)
200
14 00
Dec. 7
Cash (-A)
100
1400
Paid the account payable arising from the
purchase of
Supplies on December 4.
General Ledger
Accounts Payable
(Dr.
)
201
0
De 17
c.
Acct. No. 200
(Cr)
2010
1,400
Dec. 4
1,400
Cash
(Dr.
)
201
0
De
c.
De
c.
De
c.
Acct. No. 100
(Cr.)
2010
1 Beg Bal. Dec. 1
50,000
7
4,500 Dec. 1
40,000
15
1,200
5,000 Dec. 1
2,400
Dec 17
1,400
Effects of transaction
A liability, accounts payable, decreases (debited); and an asset, cash, decreases (credited)
by USD 1,400.
59
Transaction 9: Dec. 20 Billed a customer for training services performed, $5,700.
General Journal
Date
2010
Dec.
Account Titles and Explanation
2 Accounts Receivable (+A)
0
Service Revenue (+SE)
Pos Debit
t.
Ref.
103
57 00
400
Credit
5700
To record the performance of training services
on account
for which a customer was billed.
(Dr.)
2010
General Ledger
Accounts
Receivable
Acct. No. 103
Dec. 20 5,700
Service Revenue
(Dr.)
Acct. No. 400
2010
Dec. 15
(Cr)
(Cr.)
5,000
Dec. 20 5,700
Effects of transaction
An asset, accounts receivable, increases (debited); and a revenue, service revenue,
increases (credited) by USD 5,700.
Transaction 10: Dec. 24 Received a bill for advertising in a local newspaper
in December, $50.
General Journal
Date
2010
Dec.
Account Titles and Explanation
Pos Debit
t.
Ref.
505
2 Advertising Expense (-SE)
4
Accounts Payable (+L)
200
Received a bill for advertising for the month of
December.
Cre
dit
50
50
General Ledger
60
Advertising
Expense
Acct. No. 505
(Dr.
(Cr)
)
201
0
Dec 24 50
.
(Dr.
Accounts Payable (Cr.)
)
Acct. No. 200
201
2010
0
Dec 17 1,400
Dec. 4 1,400
.
Dec. 24
50
Effects of transaction
An expense, advertising expense, increases (debited); and a liability, accounts payable,
increases (credited) by USD 50. The reason for debiting an expense rather than an asset is
because all the cost pertains to the current accounting period, the month of December.
Otherwise, Prepaid Advertising (an asset) would have been debited.
Transaction 11: Dec. 26 Received $500 on accounts receivable from a customer.
General Journal
Date
2010
Dec.
Account Titles and Explanation
2 Cash (+A)
6
Accounts Receivable (-A)
Pos Debit
t.
Ref.
100
5 00
103
Credit
500
Received $500 from a customer on accounts
receivable
General Ledger Cash
(Dr.)
Acct. No. 100
(Cr)
2010
2010
Dec. 1 Beg Bal. Dec. 1
40,000
50,000
Dec. 7
4,500 Dec. 1
2,400
Dec. 15
5,000 Dec. 1
1,200
Dec. 26
500 Dec. 17
1,400
Accounts
Receivable
(Dr.)
Acct. N o. 103
(Cr.)
2010
2010
Dec. 20
5,700 Dec. 26
500
Effects of transaction
61
One asset, cash, increases (debited); and another asset, accounts receivable, decreases
(credited) by USD 500.
Transaction 12: Dec. 28 Paid salaries of $3,600 to training personnel for the first four
weeks of December.
(Payroll and other deductions are to be ignored since they have not yet been
discussed.)
General Journal
Date
2010
Dec.
(Dr.)
2010
Dec.
28
(Dr.)
2010
Dec.
1
Dec.
7
Dec.
15
Dec.
26
Account Titles and Explanation
Pos Debit
t.
Ref.
507
36 00
2 Salaries Expense (-SE)
8
Cash (-A)
100
Paid training personnel salaries for the first four
weeks of
December.
Cre
dit
3600
General Ledger
Salaries Expense
Acct. No. 507
(Cr)
3,600
Cash
Acct. No. 100
2010
50,000 Dec. 1
(Cr.)
40,000
4,500
Dec. 1
2,400
5,000
Dec. 1
1,200
500
Dec. 17
1,400
Dec. 28 3,600
Effects of transaction
An expense, salaries expense, increases (debited); and an asset, cash, decreases
(credited) by USD 3,600.
Transaction 13: Dec. 29 Received and paid the utilities bill for December, $150.
General Journal
Date
2010
Dec.
Account Titles and Explanation
2 Utilities Expense (-SE)
9
Pos Debit
t.
Ref.
511
1 50
Credit
62
Cash (+A)
100
150
Paid the utilities bill for December.
(Dr.)
2010
Dec.
29
General Ledger
Utilities Expense
Acct. No. 511
(Cr)
150
Cash
(Dr.)
Acct. No. 100
(Cr.)
2010
2010
Dec.
50,000 Dec.
40,000
1
1
Dec.
4,500
Dec.
2,400
7
1
Dec.
5,000
Dec.
1,200
15
1
Dec.
500
Dec.
1,400
26
17
Dec.
3,600
28
Dec. 29 150
Effects of transaction
An expense, utilities expense, increases (debited); and an asset, cash, decreases
(credited) by USD 150.
Transaction 14: Dec. 30 Received a bill for gas and oil used in the trucks for December,
$680.
General Journal
Date
2010
Dec.
Account Titles and Explanation
3 Gas and Oil Expense (-SE)
0
Accounts Payable (+L)
Pos Debit
t.
Ref.
506
6 80
200
Credit
680
Received a bill for gas and oil used in the trucks
for
December.
General Ledger
63
Gas
and
Expense
Acct. No. 506
(Dr.)
2010
Dec.
30
Oil
(Cr)
680
(Dr.)
2010
Dec.
17
Accounts Payable
Acct. No. 200
2010
(Cr.)
1,400
Dec. 4
1,400
Dec.24
50
Dec. 30
680
Effects of transaction
An expense, gas and oil expense, increases (debited); and a liability, accounts payable,
increases (credited) by USD 680.
Transaction 15: Dec. 31 A dividend of $3,000 was paid to stockholders.
General Journal
Date
2010
Dec.
Account Titles and Explanation
3 Dividends (-SE)
1
Cash (-A)
Pos Debit
t.
Ref.
320
30 00
100
Credit
3000
Dividends were paid to stockholders.
(Dr.)
2010
Dec. 31
General Ledger
Dividends
Acct. No. 320
(Cr)
3,000
Cash
(Dr.)
Acct. No. 100
2010
2010
Dec. 1 Beg 50,00 Dec. 1
Bal.
0
Dec. 7
4,500 Dec. 1
Dec. 15
5,000 Dec. 1
Dec. 26
500 Dec. 17
(Cr.)
40,000
2,400
1,200
1,400
64
Dec. 28 3,600
Dec. 29 150
Dec. 31 3,000
Effects of transaction
The Dividends account increases (debited); and an asset, cash, decreases (credited) by
USD 3,000.
Transaction 15 concludes the analysis of the MicroTrain Company transactions. The next
section discusses and illustrates posting to ledger accounts and cross-indexing.
An accounting perspective:
Uses of technology
The concept of the Internet dates to the 1960s when the military tied together
several computers forming a "network" that allowed users to communicate with
each other instantaneously on their computers over many miles.
Then universities and scientific institutions connected to the network to meet their
research and communication needs. More and more organizations hooked up to
the network over time. Today many companies seek customers and employees
over the Internet. Students and faculty use the Internet to perform research,
communicate with their colleagues (using e-mail), and search distant libraries.
Accountants in practice are heavy users of the Internet to locate company data,
tax regulations, and almost any other information they need. You will find that
learning to use the Internet effectively is essential to your future success.
The use of ledger accounts
A journal entry is like a set of instructions. The carrying out of these instructions is known as
posting. As stated earlier, posting is recording in the ledger accounts the information
contained in the journal. A journal entry directs the entry of a certain dollar amount as a debit
in a specific ledger account and directs the entry of a certain dollar amount as a credit in a
specific ledger account. Earlier, we posted the journal entries for MicroTrain Company to Taccounts. In practice, however, companies post these journal entries to ledger accounts.
Using a new example, Jenks Company, we illustrate posting to ledger accounts. Later, we
show you how to post the MicroTrain Company journal entries to ledger accounts.
In Exhibit 10, the first journal entry for the Jenks Company directs that USD 10,000 be posted
in the ledger as a debit to the Cash account and as a credit to the Capital Stock account. We
post the debit in the general ledger Cash account by using the following procedure: Enter in
the Cash account the date, a short explanation, the journal designation ("G" for general
journal) and the journal page number from which the debit is posted, and the USD 10,000 in
the Debit column. Then, enter the number of the account to which the debit is posted in the
Posting Reference column of the general journal. Post the credit in a similar manner but as a
credit to Account No. 300. The arrows in Exhibit 10 show how these amounts were posted to
the correct accounts.
Exhibit 10 shows the ledger account. In contrast to the two-sided T-account format shown so
far, the three-column format has columns for debit, credit, and balance. The three-column form
has the advantage of showing the balance of the account after each item has been posted. In
addition, in this chapter, we indicate whether each balance is a debit or a credit. In later
chapters and in practice, the nature of the balance is usually not indicated since it is
65
understood. Also, notice that we give an explanation for each item in the ledger accounts.
Often accountants omit these explanations because each item can be traced back to the
general journal for the explanation.
Posting is always from the journal to the ledger accounts. Postings can be made (1) at the
time the transaction is journalized; (2) at the end of the day, week, or month; or (3) as each
journal page is filled. The choice is a matter of personal taste. When posting the general
journal, the date used in the ledger accounts is the date the transaction was recorded in the
journal, not the date the journal entry was posted to the ledger accounts.
Frequently, accountants must check and trace the origin of their transactions, so they provide
cross-indexing. Cross-indexing is the placing of (1) the account number of the ledger account
in the general journal and (2) the general journal page number in the ledger account. As shown
in Exhibit 10, the account number of the ledger account to which the posting was made is in
the Posting Reference column of the general journal. Note the arrow from Account No. 100 in
the ledger to the 100 in the Posting Reference column beside the first debit in the general
journal. Accountants place the number of the general journal page from which the entry was
posted in the Posting Reference column of the ledger account. Note the arrow from page 1 in
Exhibit 10 the general journal to G1 in the Posting Reference column of the Cash account in
the general ledger. The notation "G1" means general journal, page 1. The date of the
transaction also appears in the general ledger. Note the arrows from the date in the general
journal to the dates in the general ledger.
Page 1
JENKS COMPANY
General Journal
Date
Account Titles and Explanation
Post Debit
Credit
.
Ref.
2010 1( Cash (+A)
(C)1 1 0 0 0 0 (A
Jan.
B)
00
)
Capital Stock (+SE)
300
1 0 0 0 0 (D
)
Stockholders invested $10,000 cash in the
business.
5
:-
Cash (+A)
Notes Payable (+L)
Borrowed $5,000 from the bank on a note.
100
201
50 00
500 0
General Ledger Cash
Explanation
2010 - (B Stockholders investment
Jan.
)1
5 Bank loan
Pos Debt
t
Ref.
G1 (A 1 0 0 0 0
)
G1
5 0 00
Credit
Account
100(C)
Balance
No
1 0 0 0 0 Dr
1 5 0 0 0 Dr
66
Notes
Account No. 201
Date
2010
Jan.
Explanation
5
Borrowed cash
Capital
Account No. 300
Explanation
(B Cash from stockholders
2010 "
)1
Jan.
Payable
Pos Debt
t
Ref.
G1
Credit
50 00
Balance
5 0 0 0 Cr
Stock
Pos Debt
t
Ref.
G1
Credit
(1 00 00
D
)
Balance
1 0 0 0 0 Cr
Exhibit 10: General journal and general ledger; posting and cross-indexing
Cross-indexing aids the tracing of any recorded transaction, either from general journal to
general ledger or from general ledger to general journal. Normally, they place cross-reference
numbers in the Posting Reference column of the general journal when the entry is posted. If
this practice is followed, the cross-reference numbers indicate that the entry has been posted.
MICROTRAIN COMPANY
General Journal
Page1
Date
2010
Nov.
Dec
Account Titles and Explanation
2 Cash (+A)
8
Capital Stock (+SE)
Stockholders invested $50,000 cash in the
business.
1 Truck (+A)
Cash (-A)
To record the purchase of four trucks.
Pos Debit
t.
Ref.
100
5 00 0 0
*
300
150
100
4 00 0 0
1 Prepaid Insurance (+A)
108
Cash (-A)
100
Purchased truck insurance to cover a one-year
period.
24 0 0
1 Prepaid Rent (+A)
12 0 0
112
Credit
500 00
400 00
24 00
67
Cash (-A)
Paid three months' rent on a building.
100
12 00
4 Supplies on Hand (+A)
107
Accounts Payable (+L)
200
To record the purchase of training supplies for
future use.
14 0 0
7 Cash (+A)
100
Unearned Service Fees (+L)
216
To record the receipt of cash from a customer in
payment
for future training services.
45 0 0
1 Cash (+A)
100
5
Service Revenue (+SE)
400
To record the receipt of cash for performing
training
services for a customer.
50 0 0
1 Accounts Payable (-L)
200
7
Cash (-A)
100
Paid the account payable arising from the
purchase of
supplies on December 4.
14 0 0
14 00
45 00
50 00
14 00
General Journal
Page 2
Date
2010
Dec.
Account Titles and Explanation
Pos Debit
t.
Ref.
103
57 0 0
2 Accounts Receivable (+A)
0
Service Revenue (+SE)
400
To record the performance of training services
on account
for which a customer was billed.
2 Advertising Expense (-SE)
505
4
Accounts Payable (+L)
200
Received a bill for advertising for the month of
December.
Credit
57 00
50
50
68
2 Cash (+A)
100
6
Accounts Receivable (-A)
103
Received $500 from a customer on accounts
receivable.
500
2 Salaries Expense (-SE)
507
8
Cash (-A)
100
Paid training personnel salaries for the first four
weeks
of December.
36 0 0
2 Utilities Expense (-SE)
9
Cash (-A)
Paid the utilities bill for December.
511
36 00
150
100
3 Gas and Oil Expense (-SE)
506
0
Accounts Payable (-A)
200
Received a bill for gas and oil used in the trucks
for
December.
3 Dividends (-SE)
1
Cash (-A)
Dividends were paid to stockholders.
5 00
320
100
1 50
680
6 80
30 0 0
30 00
Exhibit 11: General journal (after posting)
To understand the posting and cross-indexing process, trace the entries from the general
journal to the general ledger. The ledger accounts need not contain explanations of all the
entries, since any needed explanations can be obtained from the general journal.
Look at Exhibit 11 to see how all the November and December transactions of MicroTrain
Company would be journalized. As shown in Exhibit 11, you skip a line between journal entries
to show where one journal entry ends and another begins. This procedure is standard practice
among accountants. Note that no dollar signs appear in journals or ledgers. When amounts
are in even dollar amounts, accountants leave the cents column blank or use zeros or a dash.
When they use lined accounting work papers, commas or decimal points are not needed to
record an amount. When they use unlined paper, they add both commas and decimal points.
Next, observe Exhibit 12, the three-column general ledger accounts of MicroTrain Company
after the journal entries have been posted. Each ledger account would appear on a separate
page in the ledger. Trace the postings from the general journal to the general ledger to make
sure you know how to post journal entries.
All the journal entries illustrated so far have involved one debit and one credit; these journal
entries are called simple journal entries. Many business transactions, however, affect more
69
than two accounts. The journal entry for these transactions involves more than one debit
and/or credit. Such journal entries are called compound journal entries.
As an illustration of a compound journal entry, assume that on 2011 January 2, MicroTrain
Company purchased USD 8,000 of training equipment from Wilson Company. See below.
MICROTRAIN COMPANY
General Ledger
Cash
Account No. 100
Date
2010
Dec.
Explanation
Pos Debit
t
Ref.
1 Beginning balance*
1 Trucks
G1
4 00 0 0
1 Prepaid insurance
G1
24 0 0
1 Prepaid rent
G1
12 0 0
7 Unearned service fees
G1
4500
1
5
1
7
2
6
2
8
2
9
3
1
Service revenue
G1
5000
Paid account payable
G1
Collected account receivable
G2
Salaries
G2
36 0 0
Utilities
G2
150
Dividends
G2
30 0 0
Accounts Receivable
Date
2010
Dec.
Credit
Explanation
2 Service revenue
0
2 Collections
6
Supplies on Hand
14 0 0
500
Balance
5 000 0D
r
1 000 0D
r
760 0D
r
640 0D
r
1 090 0D
r
1 590 0D
r
1 450 0D
r
1 500 0D
r
1 140 0D
r
1 125 0D
r
825 0D
r
Account No. 103
Pos Debit
t
Ref.
G2
5700
G2
Credit
500
Balance
570 0D
r
520 0D
r
Account No. 107
70
Date
2010
Dec.
Explanation
4 Purchased on account
Prepaid Insurance
Date
2010
Dec.
Explanation
1 One-year policy on trucks
General Ledger
Prepaid Rent
Date
Explanation
2010
Dec.
1 Three-month payment
Trucks
Date
2010
Dec.
2010
Dec.
Explanation
1 Paid cash
Explanation
4 Supplies
1 Paid for supplies
7
2 Advertising
4
3 Gas and oil
0
Unearned Service Fees
Date
Credit
Balance
140 0D
r
Account No. 108
Pos Debit
t
Ref.
G1
2400
Page 1
Account No. 112
Pos Debit
t
Ref.
G1
1200
Credit
Balance
240 0D
r
Credit
Balance
120 0D
r
Account No. 150
Accounts Payable
Date
Pos Debit
t
Ref.
G1
1400
Explanation
Pos Debit
t
Ref.
G1
40000
Credit
Balance
4 000 0D
r
Account No. 200
Pos Debit
t
Ref.
G1
Credit
Balance
14 0 0
140 0C
r
- 0-
G2
50
G2
68)
5 0C
r
73 0C
r
G1
1400
Account No. 216
Pos Debit
Credit
Balance
71
2010
Dec.
7 Received cash
t
Ref.
G1
45 0 0
Capital Stock
Account No. 300
Date
Pos Debit
t
Ref.
2010
Dec.
Explanation
1 Beginning balance
General Ledger
Dividends
Date
Explanation
2010
Dec.
Credit
3 Cash
1
Page 3
Account No. 320
Pos Debt
t
Ref.
G2
3000
Account No. 400
Date
Explanation
2010
Dec.
1 Cash
5
2 On account
0
Pos Debt
t
Ref.
G1
Date
Explanation
2010
Dec.
2 On account
4
Gas and Oil Expense
Date
Explanation
2010
Dec.
3 On account
0
Balance
5 000 0C
r
Service Revenue
Advertising Expense
450 0C
r
Credit
Balance
300 0D
r
Credit
50 0 0
G2
57 0 0
Balance
500 0C
r
1 070 0C
r
Account No. 505
Pos Debt
t
Ref.
G2
Credit
50
Balance
5 0D
r
Account No. 506
Pos Debt
t
Ref.
G2
680
Credit
Balance
68 0D
r
72
Salaries Expense
Date
2010
Dec.
Explanation
2 Cash paid
8
Account No. 507
Pos Debt
t
Ref.
G2
3600
Utilities Expense
Account No. 511
Date
Pos Debt
t
Ref.
G2
150
2010
Dec.
Explanation
2 Cash paid
9
Credit
Balance
360 0D
r
Credit
Balance
15 0D
r
Exhibit 12: General ledger - Extended illustration
MICROTRAIN COMPANY
Trial Balance
December 31, 2010
Ac
ct.
No. Account Title
Debits
Credits
100 Cash
$ 8,250
103 Accounts Receivable
5,200
107 Supplies on Hand
1,400
108 Prepaid Insurance
2,400
112 Prepaid Rent
1,200
150 Trucks
40,000
200 Accounts Payable
$ 730
216 Unearned Service Fees
4,500
300 Capital Stock
50,000
320 Dividends
3,000
400 Service Revenue
10,700
505 Advertising Expense
50
506 Gas and Oil Expense
680
507 Salaries Expense
3,600
511 Utilities Expense
150
Exhibit 13: Trail balance
MicroTrain paid USD 2,000 cash with the balance due on 2011 March 3. The general journal
entry for MicroTrain Company is:
Debit Credit
201
1
Jan. 2 Equipment (+A)
8,000
Cash (-A)
2,000
Accounts Payable (+L)
6,000
73
Training equipment purchased from
Wilson Company.
Note that the firm credits two accounts, Cash and Accounts Payable, in this one entry.
However, the dollar totals of the debits and credits are equal.
Periodically, accountants use a trial balance to test the equality of their debits and credits. A
trial balance is a listing of the ledger accounts and their debit or credit balances to determine
that debits equal credits in the recording process. The accounts appear in this order: assets,
liabilities, stockholders' equity, dividends, revenues, and expenses. Within the assets
category, the most liquid (closest to becoming cash) asset appears first and the least liquid
appears last. Within the liabilities, those liabilities with the shortest maturities appear first.
Study Exhibit 13, the trial balance for MicroTrain Company. Note the listing of the account
numbers and account titles on the left, the column for debit balances, the column for credit
balances, and the equality of the two totals.
When the trial balance does not balance, try re-totaling the two columns. If this step does not
locate the error, divide the difference in the totals by 2 and then by 9. If the difference is divisible
by 2, you may have transferred a debit-balanced account to the trial balance as a credit, or a
credit-balanced account as a debit. When the difference is divisible by 2, look for an amount
in the trial balance that is equal to one-half of the difference. Thus, if the difference is USD
800, look for an account with a balance of USD 400 and see if it is in the wrong column.
If the difference is divisible by 9, you may have made a transposition error in transferring a
balance to the trial balance or a slide error. A transposition error occurs when two digits are
reversed in an amount (e.g. writing 753 as 573 or 110 as 101). A slide error occurs when you
place a decimal point incorrectly (e.g. USD 1,500 recorded as USD 15.00). Thus, when a
difference is divisible by 9, compare the trial balance amounts with the general ledger account
balances to see if you made a transposition or slide error in transferring the amounts.
An ethical perspective:
Financial Deals, Inc.
Larry Fisher was captain of the football team at Prestige University. Later, he
earned a master's degree in business administration with a concentration in
accounting.
Upon graduation, Larry accepted a position with Financial Deals, Inc., in the
accounting and finance division. At first, things were going smoothly. He was tall,
good looking, and had an outgoing personality. The president of the company took
a liking to him. However, Larry was somewhat bothered when the president started
asking him to do some things that were slightly unethical. When he protested
mildly, the president said: "Come on, son, this is the way the business world works.
You have great potential if you don't let things like this get in your way."
As time went on, Larry was asked to do things that were more unethical, and finally
he was performing illegal acts. When he resisted, the president appealed to his
loyalty and asked him to be a team player. The president also promised Larry great
wealth sometime in the future. Finally, when he was told to falsify some financial
statements by making improper entries and to sign some documents containing
material errors, the president supported his request by stating: "You are in too
deep now to refuse to cooperate. If I go down, you are going with me." Through
various company schemes, Larry had convinced some friends and relatives to
74
invest about USD 10 million. Most of this would be lost if the various company
schemes were revealed.
Larry could not sleep at night and began each day with a pain in his stomach and
by becoming physically ill. He was under great strain and believed that he could
lose his mind. He also heard that the president had a shady past and could
become violent in retaliating against his enemies. If Larry blows the whistle, he
believes he will go to prison for his part in the schemes. (Note: This scenario is
based on an actual situation with some facts changed to protect the guilty.)
If you still cannot find the error, it may be due to one of the following causes:
• Failing to post part of a journal entry.
• Posting a debit as a credit, or vice versa.
• Incorrectly determining the balance of an account.
• Recording the balance of an account incorrectly in the trial balance.
• Omitting an account from the trial balance.
• Making a transposition or slide error in the accounts or the journal.
Usually, you should work backward through the steps taken to prepare the trial balance.
Assuming you have already re-totaled the columns and traced the amounts appearing in the
trial balance back to the general ledger account balances, use the following steps: Verify the
balance of each general ledger account, verify postings to the general ledger, verify general
journal entries, and then review the transactions and possibly the source documents.
The equality of the two totals in the trial balance does not necessarily mean that the accounting
process has been error-free. Serious errors may have been made, such as failure to record a
transaction, or posting a debit or credit to the wrong account. For instance, if a transaction
involving payment of a USD 100 account payable is never recorded, the trial balance totals
still balance, but at an amount that is USD 100 too high. Both cash and accounts payable
would be overstated by USD 100.
You can prepare a trial balance at any time—at the end of a day, a week, a month, a quarter,
or a year. Typically, you would prepare a trial balance before preparing the financial
statements.
An accounting perspective:
Uses of technology
The computers of persons in a given department or building are frequently
connected in a Local Area Network (LAN). These persons can then access
simultaneously the programs and databases stored in the LAN and can
communicate with all other persons in the LAN through email. A more advanced
type of computer network is called Client/Server Computing. Under this structure,
any computer in the network can be used to update the information stored
elsewhere in the network. For example, accounting information stored in one
computer could be updated by authorized persons from a number of other
computers in the system. The use of networks is designed to improve efficiency
and to reduce software and hardware costs.
75
Analyzing and using the financial results— Horizontal and vertical analyses
The calculation of dollar and/or percentage changes from one year to the next in an item on
financial statements is horizontal analysis. For instance, in the following data taken from the
2000 annual report of Hewlett-Packard Company, the amount of inventory increased by USD
836 million from 1999 October 31, to 2000 October 31. This amount represented a 17 per cent
increase. To find the amount of the increase or decrease, subtract the 1999 amount from the
2000 amount. To find the percentage change, divide the increase or decrease by the 1999
amount.
Knowing the dollar amount and percentage of change in an amount is much more meaningful
than merely knowing the amount at one point in time. By analyzing the data, we can see that
cash and cash equivalents declined in 2000. Their decline at least partially explains the
increases in some of the other current assets. We can also see that the company invested in
property, plant and equipment. Any terms in Hewlett-Packard's list of assets that you do not
understand are explained in later chapters. At this point, all we want you to understand is the
nature of horizontal and vertical analyses.
Vertical analysis shows the percentage that each item in a financial statement is of some
significant total such as total assets or sales. For instance, in the Hewlett-Packard data we
can see that cash and cash equivalents were 15.3 per cent of total assets as of 1999 October
31, and had declined to 10.0 per cent of total assets by 2000 October 31. Total current assets
(cash plus other amounts that will become cash or be used up within one year) increased from
61.3 per cent of total assets to 68.3 per cent during 2000. Long-term investments and other
non-current assets accounted for 18.4 per cent of total assets as of 2000 October 31.
Increase or Percent of
(Decrease)
Total Assets
2000
over October 31
1999
2000 1999 Dollar Perce 2000 1999
s
nt
Assets (in millions)
Current assets:
Cash and cash equivalents $ 3,415 $ 5,411 $
-37% 10.0% 15.3
(1,996
%
)
Short-term investments
592
179
413
231% 1.7% 0.5%
Accounts receivable
6,394 5,958 436
7%
18.8% 16.9
%
Financing receivables
2,174 1,889 285
15% 6.4% 5.4%
Inventory
5,699 4,863 836
17% 16.8% 13.8
%
Other current assets
4,970 3,342 1,628 49% 14.6% 9.5%
Total current assets
$
$
$
7%
68.3% 61.3
23,244 21,642 1,602
%
Property,
plant
and
equipment:
Property,
plant
and 4,500 4,333 167
4%
13.2% 12.3
equipment, net
%
Long-term investments
76
and
other non-current assets 6,265
9,322
(3,057 -33% 18.4% 26.4
)
%
Total assets
$
$
$
-4%
100.0 100.0
34,009 35,297 (1,288
%
%
)
Management performs horizontal and vertical analyses along with other forms of analysis
to help evaluate the wisdom of its past decisions and to plan for the future. Other data would
have to be examined before decisions could be made regarding the assets shown. For
instance, if you discovered the liabilities that would have to be paid within a short time by
Hewlett-Packard were more than USD 30 billion, you might conclude that the company is short
of cash even though current assets increased substantially during 2000. We illustrate
horizontal and vertical analyses to a much greater extent later in the text.
An accounting perspective:
Business insight
Many companies have been restructuring their organizations and reducing the
number of employees to cut expenses. General Motors, AT&T, IBM, and numerous
other companies have taken this action. One could question whether companies
place as much value on their employees as in the past. In previous years it was
common to see the following statement in the annual reports of companies: "Our
employees are our most valuable asset". Companies are not permitted to show
employees as assets on their balance sheets. Do you think they should be allowed
to do so?
What you have learned in this chapter is basic to your study of accounting. The entire
process of accounting is based on the double-entry concept. Chapter 3 explains that
adjustments bring the accounts to their proper balances before accurate financial statements
are prepared.
Understanding the learning objectives
An account is a storage unit used to classify and summarize money measurements of
business activities of a similar nature.
• A firm sets up an account whenever it needs to provide useful information about a
particular business item to some party having a valid interest in the business.
• A T-account resembles the letter T.
• Debits are entries on the left side of a T-account.
• Credits are entries on the right side of a T-account.
• Debits increase asset, expense, and Dividends accounts.
• Credits increase liability, stockholders' equity, and revenue accounts.
• Analyze transactions by examining source documents.
• Journalize transactions in the journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance of the accounts and complete the work sheet.
• Prepare financial statements.
• Journalize and post adjusting entries.
• Journalize and post closing entries. Prepare a post-closing trial balance.
•
77
•A
journal contains a chronological record of the transactions of a business. An example
of a general journal is shown in Exhibit 11. Journalizing is the process of entering a
transaction in a journal.
• Posting is the process of transferring information recorded in the journal to the proper
places in the ledger.
•
Cross-indexing is the placing of (1) the account number of the ledger account in the
general journal and (2) the general journal page number in the ledger account.
•
An example of cross-indexing appears in Exhibit 10.
•
A trial balance is a listing of the ledger accounts and their debit or credit balances.
•
If the trial balance does not balance, an accountant works backward to discover the
error.
•
A trial balance is shown in Exhibit 13.
•
Horizontal analysis involves calculating the dollar and/or percentage changes in an
item from one year to the next.
• Vertical analysis shows the percentage that each item in a financial statement is of some
significant total.
Key terms
Account A part of the accounting system used to classify and summarize the increases,
decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue,
and expense. The three-column account is normally used. It contains columns for debit, credit,
and balance.
Accounting cycle A series of steps performed during the accounting period (some throughout
the period and some at the end) to analyze, record, classify, summarize, and report useful
financial information for the purpose of preparing financial statements.
Accrual basis of accounting Recognizes revenues when sales are made or services are
performed, regardless of when cash is received. Recognizes expenses as incurred, whether
or not cash has been paid out.
Business transactions Measurable events that affect the financial condition of a business.
Chart of accounts The complete listing of the account titles and account numbers of all of
the accounts in the ledger; somewhat comparable to a table of contents.
Compound journal entry A journal entry with more than one debit and/or credit.
Credit The right side of any account; when used as a verb, to enter a dollar amount on the
right side of an account; credits increase liability, stockholders' equity, and revenue accounts
and decrease asset, expense, and Dividends accounts.
Credit balance The balance in an account when the sum of the credits to the account exceeds
the sum of the debits to that account.
Cross-indexing The placing of (1) the account number of the ledger account in the general
journal and (2) the general journal page number in the ledger account.
Debit The left side of any account; when used as a verb, to enter a dollar amount on the left
side of an account; debits increase asset, expense, and Dividends accounts and decrease
liability, stockholders' equity, and revenue accounts.
Debit balance The balance in an account when the sum of the debits to the account exceeds
the sum of the credits to that account.
Double-entry procedure The accounting requirement that each transaction must be recorded
by an entry that has equal debits and credits.
78
Horizontal analysis The calculation of dollar and/or percentage changes in an item on the
financial statements from one year to the next.
Journal A chronological (arranged in order of time) record of business transactions; the
simplest form of journal is the two-column general journal.
Journal entry Shows all of the effects of a business transaction as expressed in debit(s) and
credit(s) and may include an explanation of the transaction.
Journalizing A step in the accounting recording process that consists of entering the effects
of a transaction in a journal.
Ledger The complete collection of all of the accounts of a company; often referred to as the
general ledger.
Nominal accounts See temporary accounts.
Note An unconditional written promise to pay to another party the amount owed either when
demanded or at a certain specified date.
Permanent accounts (real accounts) Balance sheet accounts; their balances are not
transferred (or closed) to any other account at the end of the accounting period.
Posting Recording in the ledger accounts the information contained in the journal.
Real accounts See permanent accounts.
Simple journal entry An entry with one debit and one credit.
T-account An account resembling the letter T, which is used for illustrative purposes only.
Debits are entered on the left side of the account, and credits are entered on the right side of
the account.
Temporary accounts (nominal accounts) They temporarily contain the revenue, expense,
and dividend information that is transferred (or closed) to a stockholders' equity account
(Retained Earnings) at the end of the accounting period.
Trial balance A listing of the ledger accounts and their debit or credit balances to determine
that debits equal credits in the recording process.
Vertical analysis Shows the percentage that each item in a financial statement is of
some significant total such as total assets or sales.
Trial Balance
INTRODUCTION
A Trial Balance is a two-column schedule listing the titles and balances of all the
accounts in the order in which they appear in the ledger. The debit balances are listed
in the left-hand column and the credit balances in the right-hand column. In the case
of the General Ledger, the totals of the two columns should agree. We, now, know the
fundamental principle of double entry system of accounting where for every debit,
there must be a corresponding credit. Therefore, for every debit or a series of debits
given to one or several accounts, there is a corresponding credit or a series of credits
of an equal amount given to some other account or accounts and viceversa. Hence,
according to this principle, the sum total of debit amounts must equal the credit
amounts of the ledger at any date. If the various accounts in the ledger are balanced,
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then the total of all debit balances must be equal to the total of all credit balances. If
the same is not true then the books of accounts are arithmetically inaccurate. It is,
therefore, at the end of the financial year or at any other time, the balances of all the
ledger accounts are extracted and are recorded in a statement known as Trial Balance
and finally totalled up to see whether the total of debit balances is equal to the total of
credit balances. A Trial Balance may thus be defined as a statement of debit and credit
totals or balances extracted from the various accounts in the ledger books with a view
to test the arithmetical accuracy of the books. The agreement of the Trial Balance
reveals that both the aspects of each transaction have been recorded and that the
books are arithmetically accurate. If both the sides of Trial Balance do not agree to
each other, it shows that there are some errors, which must be
detected and rectified if the correct final accounts are to be prepared.Thus, Trial
Balance forms a connecting link between the ledger accounts and the final accounts.
OBJECTIVES OF PREPARING TRIAL BALANCE
The following are the main objectives of preparing the trial balance:
(i) To check the arithmetical accuracy of books of
accounts: According to the principle of double entry system of book-keeping, every
business transaction has two aspects, debit and credit. So, the agreement of the trial
balance is a proof of the arithmetical accuracy of the books of accounts. However, it
is not a conclusive evidence of their
accuracy as their may be certain errors, which the Trial Balance may not be able to
disclose.
(ii) Helpful in preparing final accounts: The trial balance records the balances of all
the ledger accounts at one place which helps in the preparation of final accounts, i.e.
Trading and Profit and Loss Account and Balance Sheet. But, unless the trial balance
agrees, the final accounts
cannot be prepared. So, if the trial balance does not agree, errors are located and
necessary corrections are made at the earliest, so that there may not be unnecessary
delay in the preparation of the final accounts.
(iii) To serve as an aid to the management: By comparing the trial balances of
different years changes in figures of certain important items such as purchases, sales,
debtors etc. are ascertained and their analysis is made for taking managerial
decisions. So, it serves as an aid to the management.
LIMITATIONS OF TRIAL BALANCE
The following are the main limitations of the Trial Balance:
Trial Balance can be prepared only in those concerns where double entry system of
accounting is adopted.
Though trial balance gives arithmetic accuracy of the books of accounts but there are
certain errors, which are not disclosed by the trial balance. That is why it is said that
trial balance is not a conclusive proof of the accuracy of the books of accounts.
If trial balance is not prepared correctly then the final accounts prepared will not reflect
the true and fair view of the state of affairs of the business. Whatever conclusions and
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decisions are made by the various groups of persons will not be correct and will
mislead such persons.
METHODS OF PREPARATION OF TRIAL BALANCE
A trial balance can be prepared by the following two methods:
1. Total method: In this method, the debit and credit totals of each account are shown
in the two amount columns (one for the debit total and the other for the credit total).
2. Balance Method: In this method, the difference of each amount is extracted. If debit
side of an account is bigger in amount than the credit side, the difference is put in the
debit column of the Trial Balance and if the credit side is bigger, the difference is written
in the credit column of the
Trial Balance.
A specimen of the Trial Balance is given as follows:
Of the two methods of the trial balance preparation, the second is usually used in
practice because it facilitates the preparation of the final accounts.
Illustration : The following Trial Balance has been prepared wrongly. You are asked
to prepare the Trial Balance correctly.
Name of Accounts
Cash in hand
Purchases returns
Wages
Establishment
expenses
Sales returns
Capital
Carriage outwards
Discount received
Commission earned
Debit
Balance (Rs.)
Credit
Balance (Rs.)
7,000
8,000
8,000
12,000
7,000
22,000
2,000
1,200
800
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Machinery
Stock
Debtors
Creditors
Sales
Purchases
Bank overdraft
Manufacturing
expenses
Loan from Ashok
Carriage inward
Interest on investments
Total
20,000
10,000
8,000
12,000
44,000
1,28,000
1,14,000
14,000
14,000
1,000
2,17,000
1,000
2,17,000
Solution: Correct Trial Balance as on …….
Name of Accounts
Cash in hand
Purchases returns
Wages
Establishment
expenses
Sales returns
Capital
Carriage outwards
Discount received
Commission earned
Machinery
Stock
Debtors
Creditors
Sales
Purchases
Bank overdraft
Manufacturing
expenses
Loan from Ashok
Carriage inward
Interest on investments
Total
Debit
Balance (Rs.)
7,000
Credit
Balance (Rs.)
8,000
8,000
12,000
7,000
2,000
22,000
1,200
800
20,000
10,000
8,000
12,000
44,000
1,28,000
1,14,000
14,000
14,000
1,000
2,17,000
1,000
2,17,000
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ACCOUNTING ERRORS
If the two sides of a trial balance agree it is a prima facie evidence of the arithmetical
accuracy of the entries made in the Ledger. But even if the trial balance agrees, it does
not necessarily mean that the accounting records are free from all errors, because
there are certain types of errors, which are not revealed by a Trial Balance. Therefore,
a Trial Balance should not be regarded as a conclusive proof of accuracy of accounts.
In accounting an error is a mistake committed by the book-keeper
(Accountant/Accounts Clerk) while recording or maintaining the books of accounts. An
error is an innocent and non-deliberate act or lapse on the part of the persons involved
in recording business transactions. It
may occur while the transactions are originally recorded in the books of original entries
i.e. Journal, Purchase Book, Sales Book, Purchase Return Book, Sales Return Book,
Bills Receivable Book, Bills Payable Book and Cash Book, or while the ledger
accounts are posted or balanced or even when the trial balance is prepared. These
errors may affect the arithmetical accuracy of the trial balance or may defeat the very
purpose of accounting. These errors can be classified as follows:
1. Clerical errors
2. Errors of Principle
A brief description of the above errors is given below:
(a) Clerical errors
Clerical errors are those errors, which are committed by the clerical staff during
the course of recording business transactions in the books of accounts. These errors
are:
1. Errors of omission
2. Errors of commission
3. Compensating errors
4. Errors of duplication
Errors of omission: When business transaction is either completely or partly omitted
to be recorded in the books of prime entry it is called an ‘error of omission’. When a
business transaction is omitted completely, it is called a ‘complete error of omission”,
and when a business transaction is partly omitted, it is called a “partial error of
omission”. A complete error of omission does not affect the agreement of trial balance
whereas a partial error of omission may or may not affect the agreement of trial
balance.
Omission of recording a business transaction either completely or partly, omission of
ledger posting, omission of casting and balancing of an account and omission of
carrying forward are some examples of the errors of omission.
An example of a complete error of omission is goods purchased or sold may not be
recorded in the purchase book or sales book at all. This error will not affect the trial
balance. An example of a partial error of omission is goods purchased for Rs. 5,500
recorded in Purchase Book for Rs. 550. This is a partial error of omission. This error
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will also not affect the agreement of trial balance. Another example of a partial error of
omission is that if goods purchased for Rs. 5,500 is recorded in the Purchase Book for
Rs. 5,500 but the personal account of the supplier is not posted with any amount on
the credit side in the ledger, it is a partial error of omission and it will affect the
agreement of trial
balance.
Error of commission: Such errors are generally committed by the clerical staff due
to their negligence during the course of recording business transactions in the books
of accounts. Though, the rules of debit and credit are followed properly yet some
mistakes are committed. These mistakes may be due to wrong posting of a business
transaction either to a wrong account or on the wrong side of an account, or due to
wrong casting (addition) i.e. over-casting or under-casting or due to wrong balancing
of the accounts in the ledger.
Compensating errors: Compensating errors are those errors, which cancel or
compensate themselves. These errors arise when an error is either compensated or
counter-balanced by another error or errors so that of the other on the debit or credit
side neutralizes the adverse effect of one on credit side or debit side. For example,
overposting on one side may be compensated by under posting of an equal amount
on the same side of the same account or over posting of one side of an account may
be compensated by an equal overprinting on the opposite side of some other account.
But these errors do not affect the trial balance.
Errors of duplication: When a business transaction is recorded twice in the prime
books and posted in the Ledger in the respective accounts twice, the error is known
as the ‘Error of Duplication’. These errors do not affect the trial balance.
(b) Errors of principle
When a business transaction is recorded in the books of original entries by
violating the basic/fundamental principles of accountancy it is called an error of
principle. Some examples of these errors are:
When revenue expenditure is treated as capital expenditure or vice-versa, e.g.
building purchased is debited to the purchase account instead of the building
account.
Revenue expenses debited to the personal account instead of the expenses
account, e.g. salary paid to Mr. Ashok, a clerk, for the month of June, debited
to Ashok’s account instead of salary account. These errors do not affect the
Trial Balance.
(i)
The disagreement of the Trial Balance will disclose the following errors:
An item omitted to be posted from a subsidiary book into the Ledger i.e. a
purchase of Rs. 6,000 from Satpal omitted to be credited to his account. As a
result of this error, the figure of sundry creditors to be shown in the Trial Balance
will reduce by Rs. 6,000 and the total of the credit side of the Trial Balance will
be Rs. 6,000 less as compared to the debit side of the Trial Balance.
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(ii)
Posting of wrong amount to a ledger account i.e. credit sale of Rs. 12,000 to
Nisha wrongly posted to her account as Rs. 1,200. The effect of this error will
be that the figure of sundry debtors will reduce by Rs. 10,800 and the total of
the debit side of the Trial Balance will be Rs. 10,800 less than the total of the
credit side of the Trial Balance.
(iii) Posting an amount to the wrong side of the ledger account i.e. Rs. 150 discount
allowed to a customer wrongly posted to the credit instead of the debit of the
Discount Account. As a result of this error, the credit side of the Trial Balance
will exceed by Rs. 300 (double the amount of the error).
(iv) Wrong additions or balancing of ledger account, i.e. while balancing Capital
Account at the end of the financial year, credit balance of Rs. 1,89,000 wrongly
taken as Rs. 1,79,000. As a result of this error, the credit total of the Trial
Balance will be short by Rs. 10,000.
(v)
Wrong totalling of subsidiary books, i.e. Sales Book is overcast by Rs. 1,000.
As a result of this error, Credit side of the Trial Balance will be excess by Rs.
1,000 because Sales Account will appear at a higher figure on the credit side
of the Trial Balance.
(vi) An item in the subsidiary book posted twice to a ledger account, i.e. a payment
of Rs. 9,000 to a creditors posted twice to his account.
(vii) Omission of a balance of an account in the Trial Balance, i.e. cash and bank
balances may have been omitted to be included in the Trial Balance.
(viii) Balance of some account wrongly entered in the Trial Balance i.e. a balance of
Rs. 614 in Stationery Account wrongly entered as Rs. 416 in the Trial Balance.
(ix) Balance of some account written to the wrong side of the Trial Balance, i.e.,
balance of Commission Earned Account wrongly shown to the debit side
instead of the credit side of the Trial Balance.
(x) An error in the totalling of the Trial Balance will bring the disagreement of the
Trial Balance.
Illustration : Ramniwas, a book-keeper, taking out a trial balance as on 31st March
2005, found that its debit and credit columns did not agree. He proceeded to check
the entries and discovered the following errors:
1. A credit sale of Rs. 1,000 to Ajay had been correctly entered in the Sales Book but
Ajay’s Account had been debited with Rs. 100 only.
2. The total of the Bills Payable Book Rs. 5,000 had been posted to the credit of Bills
Receivable Account.
3. Rs. 2,500 paid to Ram had been wrongly posted to Shyam.
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4. Rs. 100 owing by a customer had been omitted from the list of debtors.
5. The discount column of the Cash Book representing discount allowed to customer
has been over-added by Rs. 10.
6. Goods worth Rs. 100 taken by the proprietor omitted to be recorded in the books.
7. Depreciation on furniture Rs. 100, had not been posted to Depreciation Account.
8. The total of Sales Book had been added Rs. 1,000 short. Which of the above errors
caused the totals of the Trial Balance to disagree and by how much did the totals
differ?
Solution: The effect of the above noted errors on the Trial Balance will be as follows:
1. Ajay’s account has been given fewer debits for Rs. 900, so the debit side of the Trial
Balance would be short by s. 900.
2. This error will not affect the agreement of the Trial Balance because the posting of
the Bills Payable Book has been made to the correct side but in the wrong Account.
The credit given to Bills Receivable Account instead of Bills Payable Account does not
affect the agreement of the Trial Balance.
3. This error will not affect the agreement of the Trial Balance because the amount
paid has been posted to right side through to a wrong account.
4. Sundry debtors have been shown in the Trial Balance with a less amount of Rs.
100, so debit side of the Trial Balance is short by Rs. 100.
5. Discount Account has been given an excess debit of Rs. 10 so debit side of the Trial
Balance exceeds by Rs. 10.
6. This error will have no affect on the agreement of the Trial Balance because the
dual aspect of the entry has been omitted i.e., neither of the two accounts involved in
this transaction has been given debit or credit.
7. Depreciation of furniture has not been debited to Depreciation Account, so debit
side of the Trial Balance will be short by Rs. 100.
8. Sales Account has been given less credit for Rs. 1,000, so credit side of the Trial
Balance would be short by Rs. 1,000. The combined affect of all the errors is that the
credit side of the Trial Balance would exceed the debit side by Rs. 90.
STEPS FOR LOCATION OF ERRORS
Whenever a Trial Balance disagrees, the following steps should be taken to locate the
causes of the difference:
1. Recheck the total of the Trial Balance and ascertain the exact amount
difference in the Trial Balance.
2. Divide the difference of the Trial Balance by two and find out if there is any
balance of the same amount in the Trial Balance. It may be that such a balance
might have been recorded on the wrong side of the Trial Balance, thus causing
a difference of double the amount.
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3. If the mistake is not located by the above steps, the difference in the Trial
Balance should be divided by 9. If the difference is evenly divisible by 9, the
error may be due to transposition or transplacement of figures. A transposition
occurs when 57 is written as 75, 197 as 791 and so on. A transplacement takes
place when the digits of the numbers are moved to the left or right e.g. when
Rs. 5,694 is written as Rs. 56.94 or s. 569.40. If there is a transposition or
transplacement of figures, the search can be narrowed down to numbers where
these errors might have been made.
4. See that the balances of all accounts including cash and bank balances have
been included in the Trial Balance.
5. See that the opening balances have been correctly brought forward in the
current year’s books.
6. If the difference is of a large amount, compare the Trial Balance of the current
year with that of the previous year and see that the figures under similar head
of account are approximately the same as those of the previous year and
whether their balances fall on the same side of the Trial Balance. If the
difference between the previous year figures and the current year figures is
large one, establish the causes of difference.
7. If the above listed steps fail to detect the errors, check your work as follows:
(i) Check the totals of the subsidiary books paying particular attention to carry
forwards.
(ii) Check the posting made from the Journal or subsidiary books in the ledger.
(iii) Re-check the balances extracted from ledger.
(iv) Re-cast the list of balances.
If all the efforts fail to locate the errors, all the books of primary entry (subsidiary books)
must be cast, and, if necessary, the postings to the ledger should be re-checked.
SUMMARY
As air, food and water are indispensable to life, Trial Balance is indispensable
to accounting. It serves as a lubricant for the smooth movement and completion of the
accounting cycle. Moreover, it forms a useful connecting link between ledger accounts
and final accounts. The agreement of a Trial Balance is not a conclusive proof as to
the absolute accuracy of the books. It only gives an indication of the arithmetical
accuracy. Even if both the sides of trial Balance agree to each other yet there may be
some errors in the books of accounts.
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KEYWORDS
Trial Balance: A Trial Balance is a statement of debit and credit balances extracted
from all the ledgers with a view to ascertain arithmetical accuracy of posting of all
transactions into the respective ledgers.
Clerical Errors: Those errors which are committed by the clerical staff during the
course of recording business transactions in the books of accounts is known as clerical
errors.
Compensating Errors: Compensating errors are those errors which cancel or
compensate themselves.
Errors of Principle: When a transaction is recorded in the books of accounts by
violating the basic principle of accounting, it is called an error of principle.
SELF ASSESSMENT QUESTIONS
1. What do you mean by a Trial Balance? Discuss the objectives and methods of
preparing a Trial Balance.
2. Is the agreement of Trial Balance a conclusive proof of the accuracy of books of
accounts? If not, what are the errors, which remain undetected by the Trial Balance?
3. In case of disagreement of the Trial Balance in what order you would follow to locate
the errors?
4. The cashbook of Mr. Sheru shows Rs. 8,364 as bank balance on 31st December
2005. But you find that this does not agree with the balance as shown by passbook.
On scrutiny you find the following discrepancies:
(a) On 15th Dec. 2005 the payment side of cashbook was undercast by Rs.
100.
(b) A cheque for Rs. 131 issued on 25th December 2005 was taken in cash
column.
(c) One deposit of Rs. 150 was recorded in cash book as if there is not bank
column therein.
(d) On 18th Dec. 2005 the debit balance of Rs. 1,526 as on the previous day
was brought forward as credit balance.
(e) Of the total cheques amounting to Rs. 11,514 drawn in last week of
December 2005, cheques aggregating Rs. 7,815 encashed in December.
(f) Dividends of Rs. 250 collected by bank and subscription of Rs. 200 paid by
it were not recorded in cash book.
(g) One outgoing cheque of Rs. 350 was recorded twice in the cash book.
5. From the following Trial Balance (containing obvious errors) prepare a correct Trial
Balance:
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Preparation Of Final Accounts Of Non-Corporate
OBJECTIVE
This lesson will make you familiar with preparation of
* Trading Account.
* Manufacturing Account.
* Profit and Loss Account.
* Balance Sheet.
* Final accounts giving effect to adjustments.
INTRODUCTION
The transactions of a business enterprise for the accounting period are first
recorded in the books of original entry, then posted therefrom into the ledger and
lastly tested as to their arithmetical accuracy with the help of trial balance. After the
preparation of the trial balance, every businessman
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is interested in knowing about two more facts. They are : (i) Whether he has earned
a profit or suffered a loss during the period covered by the trial balance, and (ii)
Where does he stand now? In other words, what is his financial position?
For the above said purposes, the businessman prepares financial statements for his
business i.e. he prepares the Trading and Profit and Loss Account and Balance
Sheet at the end of the accounting period. These financial statements are popularly
known as final accounts. The preparation of financial statements depends upon
whether the business concern is a trading concern or manufacturing concern. If the
business concern is a trading concern, it has to prepare the following accounts along
with the
Balance Sheet :
(i) Trading Account; and
(ii) Profit and Loss Account.
But, if the business concern is a manufacturing concern, it has to prepare the
following accounts along with the Balance Sheet:
(i) Manufacturing Account;
(ii) Trading Account ; and
(iii) Profit and Loss Account.
Basically, two types of statements are prepared namely "Income Statement" and
'Position Statement". The Income Statement is generally known as Profit and Loss
Account. This Profit and Loss Account is further sub-divided either into three parts or
two parts according to the nature of
the business. As stated above, if the concern is a manufacturing one, the Profit and
Loss Account is divided into three sub-sections viz, Manufacturing Account, Trading
Account and Profit and Loss Account. On the other hand, if it is a trading concern,
then this account is divided into two sub-sections, namely Trading Account and Profit
and Loss Account. The second statement i.e. the "Position Statement" which is
popularly known as the "Balance Sheet" is prepared by every type of business
concern. The Balance Sheet is a statement which shows the position of the assets,
liabilities and capital in money terms, of an accounting entity as on a given date. A
Balance Sheet is a formal representation of the accounting equation indicating that
the assets are always equal, in value, to the liabilities plus capital. Trading Account is
prepared to know the Gross Profit or Gross Loss.
Profit and Loss Account discloses net profit or net loss of the business. Balance
sheet shows the financial position of the business on a given date. For preparing
final accounts, certain accounts representing incomes or expenses are closed either
by transferring to Trading Account or Profit and
Loss Account. Any Account which cannot find a place in any of these two accounts
goes to the Balance Sheet.
TRADING ACCOUNT
After the preparation of trial balance, the next step is to prepare Trading Account.
Trading Account is one of the financial statements which shows the result of buying
and selling of goods and/or services during an accounting period. The main objective
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of preparing the Trading Account is to ascertain gross profit or gross loss during the
accounting period. Gross Profit is said to have been made when the sale proceeds
exceed the cost of goods sold. Conversely, when sale proceeds are less than the
cost of goods sold, gross loss is incurred. For the purpose of calculating cost of
goods sold, we have to take into consideration opening stock, purchases, direct
expenses on purchasing or manufacturing the goods and closing stock. The balance
of this account i.e. gross profit or gross loss is transferred to the Profit and Loss
Account.
Format of Trading Account
A Trading Account is prepared in "T" form just like every other
account. Though it is an account, yet it is not exactly an ordinary ledger
4
account. It is one of the accounts which are prepared only once in an
accounting period to ascertain the gross profit or gross loss of the business.
As it is prepared once in a year, columns for date and journal folio are not
provided. While preparing a Trading Account, an important point that must
be kept in mind is that a closing journal entry is to be recorded in the journal
proper. At the end of every accounting period, items of revenue and direct
expenses are closed by transferring their respective balances to the Trading
Account. The format of a Trading Account and the usually appearing entries
therein are shown below :
TRADING ACCOUNT
For the year ended 31st March, 2006
When it comes to financial statement analysis, you can use ratio analysis formulas
to interpret the data presented in financial statements (balance sheet, profit and
loss) in a better manner. In this article, we start with the meaning and definition of
ratio analysis, and then move on to examples of various financial ratios, before
concluding with a summary of their limitations.
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e-Exercises to check your understanding
https://myglaonline.com/mod/quiz/view.php?id=789
https://myglaonline.com/mod/quiz/view.php?id=790
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Module 2
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Introduction and Application to
Management Accounting
Introduction and Definition
Management gurus often say that when all is said and done, accounting is really
about investigating where scarce financial resources are really going, so that their
allocation and their use can be improved.
Business managers are almost always caught in a dilemma over which of their
company activities show the most promise and deserve to be provided funds, and
which do not.
Management accounting provides them the answers to these questions, equipping
them with information that helps them decide what products to develop and sell, and
how, where, and when to sell them.
“Management accounting, or managerial accounting, is, by definition, the
process of identifying, analysing, recording, and presenting financial
information that can be used internally by managers for planning, decisionmaking, and operational control.”
Scope of Management Accounting
Management accounting provides answers to typical questions that managers seek
answers to. Here are examples of such questions:
•
•
•
•
Which products bring in the maximum revenues and which products are the
most expensive to produce?
What is the increase in the labour wage component in the price of a particular
product?
What should be the ideal initial retail price of a new product?
How much in sales does each rupee spent on marketing bring?
By facilitating planning (or strategy formulation), decision-making, and operational
control, management accounting tells them what products to manufacture, where to
manufacture them, and when.
It helps managers to predict future events in the light of past experiences and evolve
short- and long-term policies.
It enables them to determine the resources, including labour, raw materials, and
equipment, required for making their products successful in the marketplace.
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It assists them in calculating the profit margins of products and even in finding out
which departments and which managers have performed effectively and which have
not.
In a nutshell, management accounting adopts crucial accounting, finance, and
management approaches required to take a successful business forward.
In practice, management accounting increase knowledge within a business entity
and, by doing so, reduces risks in decision-making.
Managers study the details of accountants’ reports on costs and revenues, and see
whether specific, individual targets have been met. If not, they can take corrective
action.
They can also compare overheads, productivity figures, hourly labour costs, and
wastage, between departments and between time periods, for example.
Managerial accounting, therefore, is concerned primarily with many basic functions
such as management planning, cost determination, cost control, and performance
evaluation.
Nature of Management Accounting
The term management accounting is composed of 'management' and 'accounting'.
The word 'management' here does not signify only the top management but the entire
personnel charged with the authority and responsibility of operating an enterprise. The
task of management accounting involves furnishing accounting information to the
management, which may base its decisions on it. It is through management
accounting that the management gets the tools for an analysis of its administrative
action and can lay suitable stress on the possible alternatives in terms of costs, prices
and profits, etc. but it should be understood that the accounting information supplied
to management is not the sole basis for managerial decisions. Along with the
accounting information, management takes into consideration or
weighs other factors concerning actual execution. For reaching a final decision,
management has to apply its common sense, foresight, knowledge and experience of
operating an enterprise, in addition to the information that is already has.
The word 'accounting' used in this phrase should not lead us to believe that it is
restricted to a mere record of business transactions i.e., book keeping only. It has
indeed a 'macro-economic approach'. As it draws its raw material from several other
disciplines like costing, statistics, mathematics, financial
accounting, etc., it can be called an interdisciplinary subject, the scope of which is not
clearly demarcated. Other fields of study, which can be covered by management
accounting, are political science, sociology, psychology, management, economics,
statistics, law, etc. A knowledge of political science helps to understand authority
relationship and responsibility identification in an organization. A study of sociology
helps to understand the behaviour of man in groups. Psychology enables us to know
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the mental make-up of employers and employees. A knowledge of these subjects
helps to increase motivation, and to control the actions of the people who are ultimately
responsible for costs. This builds a better employer-employee relationship and a
sound morale. The subject of management reveals the processes involved in the art
of managing, a knowledge of economics assists in the determination of optimum
output in the forecasting of sales and production, etc., and also makes it possible to
analyze management action in terms of cost revenues, profits, growth, etc. It is with
the help of statistics that this information is presented to the management in a form
that can be assimilated. The subject of management accounting also encompasses
the subject of law, knowledge of which is necessary to find out if the management
action is ultra-vires or not. It is, therefore, a wide and diverse subject. Management
accounting has no set principles such as the double entry system of bookkeeping. In
place of generally accepted accounting principles, the philosophy of cost benefit
analysis is the core guide of this discipline. It says that no accounting system is good
or bad but is can be considered desirable so long as it brings incremental benefits in
excess of its incremental costs. Applying management accounting principles to
financial matters can arrive at no single perfect solution. It is, therefore, an inexact
science, which uses its own conventions rather than standardized principles. The facts
to be studied here can be interpreted in different ways and the precision of the
inferences depends upon the skill, judgement and common sense of different
management accountants. It occupies a middle position between a fully matured and
an infant subject. Since management accounting is managerially oriented, its data is
selective in nature. It focuses on potential opportunities rather than opportunities lost.
The data is operative in nature catering to the operational needs of a firm. It details
events, monetary and non-monetary. The nature of data, the form of presentation and
its duration are mainly determined by managerial needs. It is quite frequently reported
as it is meant for internal uses and managerial control. An accountant should look at
his enterprise from the management's point of view. Whenever he fails to do that, he
ceases to be a management accountant. Management accounting is highly sensitive
to management needs. However, it assists the management and does not replace it.
It represents a service phase of management rather than a service to management
from management accountant. It is rather highly personalized service. Finally, it can
be said that the management accounting serves as a management information system
and so enables the management to manage better.
Functions of Management Accounting
1. Management Accounting also provides qualitative information:
Management Accounting not only record & present financial data but it also express
some information which may not be capable of being measured in monetary terms.
Such information is generally colleted through special surveys, engineering records &
statistical compilations.
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2. Management Accounting facilitates controls:
With the help of mgmt accounting the objectives are formulated & then translated into
specific goals for the attainment in a specified period of time. The organisation has to
accomplish these goals following the plan of action decided by the top management
such planning facilitates control owner the activities & suggest the areas of
improvement.
3. Management Accounting sever as means of communication:
Management Accounting provides inform to various levels of mgmt upward, downward
& outward though the organisation.
4. Modification & presentation of Data:
In management accounting, the presentation of the data changes according to the
informational needs of particulars management. Modification means changes in the
presentation format according to the needs not the manipulation of the data.
Break Even Analysis
A breakeven analysis is used to determine how much sales volume your business
needs to start making a profit. The breakeven analysis is especially useful when you're
developing a pricing strategy, either as part of a marketing plan or a business plan.
To conduct a breakeven analysis, use this formula:
Fixed Costs divided by (Revenue per unit - Variable costs per unit)
Fixed costs are costs that must be paid whether or not any units are produced. These
costs are "fixed" over a specified period of time or range of production.
Variable costs are costs that vary directly with the number of products produced. For
instance, the cost of the materials needed and the labour used to produce units isn't
always the same.
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For example, suppose that your fixed costs for producing 100,000 widgets were
Rs.30,000 a year.
Your variable costs are Rs.2.20 materials, Rs.4.00 labour, and Rs.0.80 overhead, for
a total of Rs.7.00.
If you choose a selling price of $12.00 for each widget, then:
Rs.30,000 divided by (Rs.12.00 - 7.00) equals 6000 units.
This is the number of widgets that have to be sold at a selling price of Rs.12.00 before
your business will start to make a profit.
Limitations
Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you
nothing about what sales are actually likely to be for the product at these various
prices.
It assumes that fixed costs (FC) are constant. Although, this is true in the short run, an
increase in the scale of production is likely to cause fixed costs to rise.
It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales. (i.e. linearity)
Difference Between Marginal Costing and
Absorption Costing
There are two alternative approaches for the valuation of inventory; they are
Marginal Costing and Absorption Costing. In marginal costing, marginal cost is
determined by bifurcating fixed cost and variable cost. Only variable costs are
charged to operation, whereas the fixed cost are excluded from it and are charged to
profit and loss account for the period.
Conversely, Absorption costing or otherwise known as full costing, is a costing
technique in which all costs, whether fixed or variable are absorbed by the total units
produced. It is aminly used for reporting purposes, i.e. for financial and tax reporting.
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There are many who say marginal costing is better, while others prefer absorption
costing. So, one should know the difference between marginal costing and
absorption costing to reach at conclusion, as to which one to be preferred over the
other.
Comparison Chart
BASIS FOR
COMPARISON
MARGINAL COSTING
ABSORPTION COSTING
Meaning
A decision-making technique
for ascertaining the total cost
of production is known as
Marginal Costing.
Apportionment of total costs to the
cost center in order to determine
the total cost of production is known
as Absorption Costing.
Cost Recognition
The variable cost is
considered as product cost
while fixed cost is considered
as period costs.
Both fixed and variable cost is
considered as product cost.
Classification of
Overheads
Fixed and Variable
Production, Administration and
Selling & Distribution
Profitability
Profitability is measured by
Profit Volume Ratio.
Due to the inclusion of fixed cost,
profitability gets affected.
Cost per unit
Variances in the opening and
closing stock does not
influence the cost per unit of
output.
Variances in the opening and
closing stock affects the cost per
unit.
Highlights
Contribution per unit
Net Profit per unit
Cost data
Presented to outline total
contribution of each product.
Presented in conventional way.
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Definition of Marginal Costing
Marginal Costing, also known as Variable Costing, is a costing method whereby
decisions can be taken regarding the ascertainment of total cost or the determination
of fixed and variable cost to find out the best process and product for production, etc.
It identifies the Marginal Cost of production and shows its impact on profit for the
change in the output units. Marginal cost refers to the movement in the total cost, due
to the production of an additional unit of output.
In marginal costing, all the variable costs are regarded as product related costs while
fixed costs are assumed as period costs. Therefore, fixed cost of production is posted
to the Profit & Loss Account. Moreover, fixed cost is also not given relevance while
determining the selling price of the product or at the time of valuation of closing stock
(whether it is finished goods or Work in Progress).
Definition of Absorption Costing
Absorption Costing is a method for inventory valuation whereby all the manufacturing
expenses are allocated to the cost centres to recognise the total cost of production.
These manufacturing expenses include all fixed as well as variable costs. It is the
traditional method for cost ascertainment, also known by the name Full Absorption
Costing.
In an absorption costing system, both the fixed and variable costs are regarded as
product related cost. In this method, the objective of the assignment of the total cost
to cost centre is to recover it from the selling price of the product.
On the basis of function, the expenses are divided into Production, Administration and
Selling & Distribution. The following are the types of Absorption Costing:
•
•
•
Activity Based Costing
Job Costing
Process Costing
Cost-Volume-Profit Analysis and P/V Ratio Analysis
and their implications
Cost-Volume-Profit (CVP) Analysis is also known as Break–Even Analysis. Every
business organization works to maximize its profits. With the help of CVP analysis, the
management studies the co-relation of profit and the level of production.
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CVP analysis is concerned with the level of activity where total sales equals the total
cost and it is called as the break-even point. In other words, we study the sales value,
cost and profit at different levels of production. CVP analysis highlights the relationship
between the cost, the sales value, and the profit.
Assumptions
Let us go through the assumptions for CVP analysis:
• Variable costs remain variable and fixed costs remain static at every level of
production.
• Sales volume does not affect the selling price of the product. We can assume
the selling price as constant.
• At all level of sales, the volume, material, and labor costs remain constant.
• Efficiency and productivity remains unchanged at all the levels of sales volume.
• The sales-mix at all level of sales remains constant in a multi-product situation.
• The relevant factor which affects the cost and revenue is volume only.
• The volume of sales is equal to the volume of production.
Marginal Cost Equation
Equations for elements of cost are as follows:
Sales = Variable costs + Fixed Expenses ± Profit /Loss
Or
Sales – Variable Cost = Fixed Expenses ± Profit /Loss
Or
Sales – Variable Cost = Contribution
It is necessary to understand the following four concepts, their calculations, and
applications to know the mathematical relation between cost, volume, and profit:
•
•
•
•
Contribution
Profit Volume Ratio (P/V Ratio or Contribution/Sales (C/S))
Break-Even Point
Margin of Safety
Contribution
Contribution = Sales – Marginal Cost
We have already discussed contribution in Marginal Costing topic above.
Profit-Volume Ratio
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Profit / Volume (P/V) ratio is calculated while studying the profitability of operations of
a business and to establish a relation between Sales and Contribution. It is one of the
most important ratios, calculated as under:
The P/V Ratio shares a direct relation with profits. Higher the P/V ratio, more the profit
and vice-a-versa.
Break-Even Point
When the total cost of executing business equals to the total sales, it is called breakeven point. Contribution equals to the fixed cost at this point. Here is a formula to
calculate break-even point:
Composite Break Even Point
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A company may have different production units, where they may produce the same
product. In this case, the combined fixed cost of each productions unit and the
combined total sales are taken into consideration to find out BEP.
•
•
Constant Product - Mix Approach In this approach, the ratio is constant for the
products of all production units.
Variable Product - Mix Approach In this approach, the preference of products
is based on bigger ratio.
Margin of Safety
Excess of sale at BEP is known as margin of safety. Therefore,
Margin of safety = Actual Sales − Sales at BEP
Margin of safety may be calculated with the help of the following formula:
Break-Even Chart
Break-Even Chart is the most useful graphical representation of marginal costing. It
converts accounting data to a useful readable report. Estimated profits, losses, and
costs can be determined at different levels of production. Let us take an example.
Example
Calculate break-even point and draw the break-even chart from the following data:
Fixed Cost = Rs 2,50,000
Variable Cost
= Rs 15 per unit
Selling Price = Rs 25 per unit
Production level in units 12,000, 15,000, 20,000, 25,000, 30,000, and 40,000.
Solution:
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At production level of 25,000 units, the total cost will be Rs 6,25,000.
(Calculated as (25000 × 14) + 2,50000)
Statement showing Profit & Margin of safety at different level of production Break Even
Sale = Rs 6,25,000 (25,000 x 25)
Production
(In Units)
Total Sale
Total Cost
Profit
(In Rs)
(In Rs)
(Sales Cost)
Margin of safety
(Profit/Contribution
per unit)
(In Rs)
(In Units)
12000
3,00,000
4,30,000
-1,30,000
15000
3,75,000
4,75,000
-1,00,000
20000
5,00,000
5,50,000
-50,000
25000
6,25,000
6,25,000
(B.E.P)
(B.E.P)
30000
7,50,000
7,00,000
50,000
5,000
40000
10,00,000
8,50,000
1,50,000
15,000
Concept and uses of Contribution and Breakeven
Point and their analysis
Break-even analysis entails the calculation and examination of the margin of safety for
an entity based on the revenues collected and associated costs. Analyzing different
price levels relating to various levels of demand a business uses break-even analysis
to determine what level of sales are necessary to cover the company's total fixed costs.
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A demand-side analysis would give a seller significant insight regarding selling
capabilities.
How Break-Even Analysis Works
Break-even analysis is useful in the determination of the level of production or a
targeted desired sales mix. The study is for management’s use only, as the metric and
calculations are not necessary for external sources such as investors, regulators or
financial institutions. This type of analysis depends on a calculation of the break-even
point (BEP). The break-even point is calculated by dividing the total fixed costs of
production by the price of a product per individual unit less the variable costs of
production. Fixed costs are those which remain the same regardless of how many
units are sold.
Break-even analysis looks at the level of fixed costs relative to the profit earned by
each additional unit produced and sold. In general, a company with lower fixed costs
will have a lower break-even point of sale. For example, a company with $0 of fixed
costs will automatically have broken even upon the sale of the first product assuming
variable costs do not exceed sales revenue. However, the accumulation of variable
costs will limit the leverage of the company as these expenses come from each item
sold.
Budgeting and Budgetary Control
A budget is an instrument of management used as an aid in the planning, programming
and control of business activity. A budget may be defined as a financial and/or
quantitative statement, prepared and approved prior to a defined period of time, of the
policy to be pursued during that period for the purpose of attaining a given objective.
It may include income, expenditure and employment of capital.
Based upon this definition, a recreation budget of a person for one fine evening may
look as:
The budget is a statement showing the way the person plans to spend Rs. 121.50.
Thus budget is a written plan of action. A budget is used for cost control purposes and
it is one of the most important overall control devices employed by management. A
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budget represents the financial requirements of different sections of the business
during a given period to achieve an estimated profit based upon a given volume of
sales.
A budget is based upon past statistical data and it predicts the estimated labour, sales,
production and other management requirements for future, i.e., for a definite budgetary
period (of time). A budget can be thought of as an overall plan for the operation of the
business in terms of sales, production and expenditures. Thus budget acts as a
coordinating device among the various functions of the business.
Definition and Concept of Budgetary Control:
Budgetary control makes use of budgets for planning and controlling all aspects of
producing and/ or selling products or services. Budgetary control attempts to show the
plans in financial terms. Budgetary control is the planning in advance of the various
functions of a business so that the business can be controlled. Budgetary control
relates expenditure to a section or department who incurs the expenditure, so that the
actual expenses can be compared with the budgeted ones, thus providing a
convenient method of control.
Budgetary control includes forecasts of income and expenditures (for the budgetary
period) on equipment, machinery, manpower, materials, etc., necessary for the
efficient production and distribution of estimated volume of sale. The budgetary control
when applied to a business as a whole or to different sections within the businesscompares actual performance and the predicted performance and thus enables all
levels of management and supervision to know how their sections (of business) are
moving towards the achievements of budgeted targets.
Is corrective action needed; should it be applied? Thus, budgetary control attempts to
bring actual performance at par with the predicted perform-ance by keeping a strict
supervisory eye on the actual performance and by exercising a control, if necessary.
Control follows the planning and co-ordination. Deviations from predicted plan or
performance are noticed by comparing actual and budgeted performances and costs.
The differences between the two (i.e., predetermined and actual) figures-the
variances-are analysed and an action is taken quickly, at the right time and in the
correct place to correct the actual performance – as per the predicted or
predetermined plan or performance.
The Objectives (Functions) of Budgets, Budgeting and Budgetary Control:
1. Budget should specify units to be produced, broken down into sizes and styles, as
well as cost of production.
2. Budget should analyze all the factors affecting the sections/departments and the
business as a whole.
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3. Budget should facilitate planning within the company. It should help planning future
income and expenses.
4. Budget should harmonise departmental programmes.
5. Budget should serve as a medium of propagating policies throughout the business
enterprise.
6. Budget should hold back or control unwise expenditure.
7. Budget should help stabilizing production and harmonise production and sale
programmes.
8. Budgeting should decide basis for expenditure of funds.
9. Besides planning, budgetary control should provide a basis for, measuring
performance and exercising control-control means noting when expenditures fall
outside the budget estimates, tracing down the cause of such variation and taking
necessary corrective action.
10. Budgetary control should watch the progress of achievements of the business
enterprise and evaluate policies of the management.
11. Budgetary control should pin-point those areas which are not working efficiently
and according to the predetermined targets.
12. Budgetary control, after planning, should coordinate the activities of a business so
that each is a part of an integral total.
13. Budgetary control should facilitate financial control; and control each function so
that the best possible results may be obtained.
14. A budget should be flexible.
Advantages of Budget, Budgeting and Budgetary Control:
1. Policy plans and actions taken are all reflected in the budgetary control system.
There is a formal recognition of the targets which the business hopes to achieve.
2. Not only departmental programmes are developed, over expenditures in
departments are also curtailed and controlled.
3. Budgeting makes for better understanding, coordination and harmony of action in a
business enterprise, because all departments take part in budget preparation.
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4. The targets, goals and policies of a business enterprise are clearly defined.
5. Deviations from predetermined plans are brought to notice through variance
analysis and cor-rective action is stimulated by reports, statements and personal
contacts.
6. It provides management with a guide of daily activities; thus helps determining
performance and efficiency of each department, thereby leading to improvement.
7. It informs management the progress made towards achieving the predetermined
objectives.
8. It facilitates financial control.
9. Total capital required and price of an item (product) can be estimated in advance.
10. Budgetary control builds morale when operated in a truly managerial spirit, i.e., it
should not acquire merely a clerical outlook (or approach).
Preparation of Budget:
Steps involved:
1. Formulate a budget committee which will take up the job of budget
preparation.
2. The committee consists of chief executive as the chairman of the committee, a
budget officer (who is a senior member of the accounting staff) and representatives of
Sales, Production, Purchases and works engineering (maintenance, etc.)
departments.
Consulting those who are responsible for operating the budget is good psychology; if
employees participate in budget preparation they will automatically work hard to make
budget a success.
3. The budget committee will create standard budget forms on which production plans,
estimated income and costs may be inserted for each section or department of the
business concern.
4. Committee asks accounting department to submit reports for the past years,
showing a compari-son of production costs, income and expenses by subdivisions and
departments.
5. Each functional executive is asked to prepare and submit the forecast for his
department.
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The Production Manager prepares the production forecast, the Sales Manager, the
sales forecast and so on.
Functional executives may take the opinions of Workers, Foreman, Salesman, etc.,
who remain in direct contact with the job.
The budget officer makes rule that all departments forecasts or estimates are
accompanying with sufficient supporting data to provide basis for effective
consideration by the budget committee.
An analysis of general business and market conditions is made with the help of the
statistical department or from data supplied by commercial statistical forecasting
agencies and government and trade reports.
The budget officer presents departmental budgets before the committee and transmits
back to the departments the recommendations of acceptance or revision.
Forecasts submitted by functional (i.e., production, sales, etc.) executives, current
market and trade data and estimates of future sales in the territories enable the budget
committee to formulate general policies and plans for the budget period.
In consultation with functional or departmental executives, the budget committee
reduces general policies of the concern to department plans. Actual departmental
budgets are prepared and revised and they form the standards of performance for the
budget period.
Limitations of Budget:
(i) Since budget is based on estimates, i.e., estimated sales, estimated costs,
estimated business conditions, etc. it may need periodic revisions because estimates
may not come out to be cent per cent true.
(ii) A budget may not work if the idea of budgeting is not sold properly to different
sections of the business. Only the persons working in different sections can make an
established budget, a success. Thus, it should be a cooperative budgeting.
A budget cannot work until the desire to make it work is established in the minds of
persons working in the different sections of a business concern.
Budget as a Means of Planning, Control and Coordination:
(a) Planning:
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Planning implies looking ahead and anticipating probable difficulties. The budget plans
production in accordance with sales estimates and at minimum cost. In addition,
budget plans and forecasts the expenditures as regards production cost, plant
utilisa-tion, selling and distribution, purchases, etc.
(b) Co-Ordination:
Coordination means weaving together the segments of a business into a coherent
whole in such a way that all parts operate at the most efficient level and produce
maximum profit. Budget coordinates the efforts of all the sections, (e.g., sales,
production, etc.) of the business to achieve the common goals.
A properly constructed and operated budget may have a constructive influence in
bringing about a better understanding and team spirit among different persons working
in a business enterprise. A proper budget may make them feel about the common
goals which must be achieved unitedly for bringing profits to the concern and
prosperity to them.
(c) Control:
Controlling means the systematic appraisal of results to ensure that actual and
planned operations coincide or, if there are any deviations, the carrying out of
corrective action.
A budget becomes a means of control when the actual business performance is
compared with the predetermined performance. Every functional executive knows
what was expected of his department and presently where his department stands.
If he feels that his department is falling behind than what was expected of, he prepares
a report and reveals the points of difficulty so that the unfavourable situation may be
analyzed and improved by taking suitable corrective actions.
Operation (Working) of Budgetary Control:
Good budgetary control necessitates establishment of accounting procedures to
record actual operations in terms of sales, income, production, etc. within a
department. The head of each department will receive a copy of the budget
appropriate to his activity. Each month, he will get a copy of the departmental budget
report. From the report, head of the department can visualise at once where he has
over-or under-spent his budgeted allowance.
This enables head of the department to have a constant check on the operation.
Unusual variations come immediately to his attention. The variations between actual
and budgeted performance and the reasons for variation require a thorough analysis.
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It may appear that the department has been operating below strength and this caused
increased over-time costs.
Monthly budget reports should be promptly issued to departments soon after the
monthly period in question, otherwise adverse costs may go unnoticed for a longer
time, and cause problem later on. Various department reports are summarized and
consolidated by the chief budget executive or budget director in his regular report to
the budget committee. On the basis of regular reports the budget committee may
recommend revisions or changes in the budget.
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e-Exercises to check your understanding
https://myglaonline.com/mod/quiz/view.php?id=796
https://myglaonline.com/mod/quiz/view.php?id=787
https://myglaonline.com/mod/quiz/view.php?id=794
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Module 3
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Introduction and Application to
Management Accounting
Introduction
Management Accounts not a specific system of accounting. It could be any form of
accounting which enables a business to conduct more effectively and efficiently. It’s
largely concerned with providing economic information to managers for achieving
organizational goals. It is an extension of the horizon of cost accounting towards newer
areas of management. Much management accounts information is financial but has
been organizing in a manner relating directly to the decision at hand.
Management Accounts comprised of two words ‘Management’ and ‘Accounting’. It
means the study of the managerial aspect of accounting. The emphasis of
management accounting is to redesign accounting in such a way that it is helpful to
the management in the formation of policy, control of execution, and appreciation of
effectiveness. Management Accounts of recent origin. This was first used in 1950 by
a team of accountants visiting U. S. A under the auspices of Anglo-American Council
on Productivity.
DEFINITION OF MANAGEMENT ACCOUNTING:
Definition: It is, also called managerial accounting or cost accounting, is the process
of analyzing business costs and operations to prepare the internal financial report,
records, and account to aid managers’ decision-making process in achieving business
goals. In other words, it is the act of making sense of financial and cost data and
translating that data into useful information for management and officers within an
organization.
“Management accounting is the practical science of value creation within
organizations in both the private and public sectors. It combines accounting,
finance, and management with the leading edge techniques needed to drive
successful businesses.”
More of it:
Anglo-American Council on Productivity defines as:
“The presentation of accounting information in such a way as to assist
management in the creation of policy and the day to day operation of an
undertaking.”
The American Accounting Association defines as:
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“The methods and concepts necessary for effective planning for choosing
among alternative business actions and for control through the evaluation and
interpretation of performances.”
The Institute of Chartered Accountants of India defines as follows:
“Such of its techniques and procedures by which accounting mainly seeks to aid the
management collectively has come to be known as management accounting.”
From these definitions, it is very clear that financial data is recorded, analyzed, and
presented to the management in such a way that it becomes useful and helpful in
planning and running business operations more systematically.
OBJECTIVES OF MANAGEMENT ACCOUNTING:
The fundamental objectives of management accounting are to enable the
management to maximize profits or minimize losses. The evolution of managerial
accounting has given a new approach to the function of accounting.
The main objectives of management accounting are as follows:
Planning and policy formulation:
Planning involves forecasting based on available information, setting goals; framing
policies determining the alternative courses of action, and deciding on the program of
activities. Management Accounts can help greatly in this direction. It facilitates the
preparation of statements in light of past results and gives an estimation for the future.
Interpretation process:
Management Accounts to present financial information to the management. Financial
information is technical. Therefore, it must present in such a way that it is easily
understood. It presents accounting information with the help of statistical devices like
charts, diagrams, graphs, etc.
Assists in the Decision-making process:
With the help of various modern techniques management accounting makes the
decision-making process more scientific. Data relating to cost, price, profit, and
savings for each of the available alternatives are collected and analyzed and provides
a base for making sound decisions.
Controlling:
It is useful for managerial control. Their tools like standard costing and budgetary
control help control performance. Cost control is effected through the use of standard
costing and departmental control is made possible through the use of budgets. The
performance of every individual is controlled with the help of managerial accounting.
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Reporting:
Management Accounts keeps the management fully informed about the latest position
of concern through reporting. It helps management to take proper and quick decisions.
The performance of various departments is regularly reported to the top management.
Facilitates Organizing:
“Return on Capital Employed” is one of the tools of Management Accounts. Since
managerial accounting stresses more on Responsibility Centre’s to control costs and
responsibilities, it also facilitates decentralization to a greater extent. Thus, it helps set
up an effective and efficient organization framework.
Facilitates Coordination of Operations:
Management accounts provide tools for overall control and coordination of business
operations. Budgets are an important means of coordination.
Nature and Scope of Management Accounting:
Managerial Accounting involves the furnishing of accounting data to the management
for basing its decisions. It helps in improving efficiency and achieving organizational
goals. You may know is that Comparative analysis is the scope of management
accounting.
The following paragraphs discuss the nature and scope of management
accounting.
Provides accounting information:
Management accounting is based on accounting information. It is a service function
and it provides the necessary information to different levels of management.
Managerial Accounting involves the presentation of information in a way it suits
managerial needs. The accounting data collected by the accounting department is
used for reviewing various policy decisions.
Cause and effect analysis:
The role of financial accounting is limited to find out the ultimate result, i.e., profit and
loss; Managerial Accounting goes a step further. Managerial Accounting discusses the
cause and effect relationship. The reasons for the loss are probed and the factors
directly influencing the profitability are also studied. Profits are compared to sales,
different expenditures, current assets, interest payable’s, share capital, etc.
Use of special techniques and concepts:
It uses special techniques and concepts according to the necessity to make
accounting data more useful. The techniques usually used include financial planning
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and analyses, standard costing, budgetary control, marginal costing, project appraisal,
control accounting, etc.
Taking important decisions:
It supplies the necessary information to the management which may be useful for its
decisions. The historical data is studied to see its possible impact on future decisions.
The implications of various decisions are also taking into account.
Achieving objectives:
It is uses accounting information in such a way that it helps in formatting plans and
setting up objectives. Comparing actual performance with targeted figures will give an
idea to the management about the performance of various departments. When there
are deviations, corrective measures can take at once with the help of budgetary control
and standard costing.
No fixed norms:
No specific rules are followed in Managerial Accounting as that of financial accounting.
Though the tools are the same, their use differs from concern to concern. The deriving
of conclusions also depends upon the intelligence of the management accountant.
The presentation will be in the way which suits the concern most.
Increase in efficiency:
The purpose of using accounting information is to increase the efficiency of the
concern. The performance appraisal will enable the management to pinpoint efficient
and inefficient spots. An effort makes to take corrective measures so that efficiency
improves. The constant review will make the staff cost-conscious.
Supplies information and not the decision:
The management accountant is only to guide and not to supply decisions. The data is
to use by the management for taking various decisions. “How is the data to utilize” will
depend upon the caliber and efficiency of the management.
Concerned with forecasting:
The management accounts concerned with the future. It helps the management in
planning and forecasting. The historical information is used to plan the future course
of action. The information is supplied to the object to guide management in making
future decisions.
Techniques and Procedures Design and Installation:
Management accounting is identifying with the most productive and monetary
arrangement of accounting reasonable for any size and kind of embraced. Additionally,
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it utilizes the best utilization of mechanical and electronic gadgets. Maybe you got your
answer; 10 points of Nature of Management Accounting with their scope.
Break Even Analysis
What is a Break-Even Analysis?
A break-even analysis is a financial tool which helps a company to determine the
stage at which the company, or a new service or a product, will be profitable. In other
words, it is a financial calculation for determining the number of products or services
a company should sell or provide to cover its costs (particularly fixed costs). Breakeven is a situation where an organisation is neither making money nor losing money,
but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed
cost and revenue. Generally, a company with low fixed costs will have a low breakeven point of sale. For example, say Happy Ltd has fixed costs of Rs. 10,000 vs Sad
Ltd has fixed costs of Rs. 1,00,000 selling similar products, Happy Ltd will be able to
break even with the sale of lesser products as compared to Sad Ltd.
Components of Break-Even Analysis
Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the
decision to start an economic activity is taken and these costs are directly related to
the level of production, but not the quantity of production. Fixed costs include (but
are not limited to) interest, taxes, salaries, rent, depreciation costs, labour costs,
energy costs etc. These costs are fixed rrespective of the production. In case of no
production also the costs must be incurred.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the
production volume. These costs include cost of raw material, packaging cost, fuel
and other costs that are directly related to the production.
Calculation of Break-Even Analysis
The basic formula for break-even analysis is derived by dividing the total fixed costs
of production by the contribution per unit (price per unit less the variable costs).
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For an example:
Variable costs per unit: Rs. 400 Sale price per unit: Rs. 600 Desired profits: Rs.
4,00,000 Total fixed costs: Rs. 10,00,000 First we need to calculate the break-even
point per unit, so we will divide the Rs.10,00,000 of fixed costs by the Rs. 200 which
is the contribution per unit (Rs. 600 – Rs. 200). Break Even Point = Rs. 10,00,000/
Rs. 200 = 5000 units Next, this number of units can be shown in rupees by
multiplying the 5,000 units with the selling price of Rs. 600 per unit. We get Break
Even Sales at 5000 units x Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)
Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The excess
between the selling price and total variable costs is known as contribution margin.
For an example, if the price of a product is Rs.100, total variable costs are Rs. 60 per
product and fixed cost is Rs. 25 per product, the contribution margin of the product is
Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40 represents the revenue collected to cover the
fixed costs. In the calculation of the contribution margin, fixed costs are not
considered.
When is Break even analysis used?
Starting a new business: To start a new business, a break-even analysis is a must.
Not only it helps in deciding whether the idea of starting a new business is viable, but
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it will force the startup to be realistic about the costs, as well as provide a basis for
the pricing strategy.
Creating a new product: In the case of an existing business, the company should
still peform a break-even analysis before launching a new product—particularly if
such a product is going to add a significant expenditure.
Changing the business model: If the company is about to the change the business
model, like, switching from wholesale business to retail business, then a break-even
analysis must be performed. The costs could change considerably and breakeven
analysis will help in setting the selling price.
Breakeven analysis is useful for the following reasons:
•
•
•
•
It helps to determine remaining/unused capacity of the company once the
breakeven is reached. This will help to show the maximum profit on a
particular product/service that can be generated.
It helps to determine the impact on profit on changing to automation from
manual (a fixed cost replaces a variable cost).
It helps to determine the change in profits if the price of a product is altered.
It helps to determine the amount of losses that could be sustained if there is a
sales downturn.
Additionally, break-even analysis is very useful for knowing the overall ability of a
business to generate a profit. In the case of a company whose breakeven point is
near to the maximum sales level, this signifies that it is nearly impractical for the
business to earn a profit even under the best of circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point
constantly. This monitoring certainly reduces the breakeven point whenever
possible.
Ways to monitor Break even point
•
•
•
•
Pricing analysis: Minimize or eliminate the use of coupons or other price
reductions offers, since such promotional strategies increase the breakeven
point.
Technology analysis: Implementing any technology that can enhance the
business efficiency, thus increasing capacity with no extra cost.
Cost analysis: Reviewing all fixed costs constantly to verify if any can be
eliminated can surely help. Also, review the total variable costs to see if they
can be eliminated. This analysis will increase the margin and reduce the
breakeven point.
Margin analysis: Push sales of the highest-margin (high contribution earning)
items and pay close attention to product margins, thus reducing the
breakeven point.
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•
Outsourcing: If an activity consists of a fixed cost, try to outsource such
activity (whenever possible), which reduces the breakeven point.
Benefits of Break-even analysis
•
•
•
•
•
•
Catch missing expenses: When you’re thinking about a new business, it’s
very much possible that you may forget about a few expenses. Therefore, a
break-even analysis can help you to review all financial commitments to figure
out your break-even point. This analysis certainly restricts the number of
surprises down the road or atleast prepares a company for them.
Set revenue targets: Once the break-even analysis is complete, you will get
to know how much you need to sell to be profitable. This will help you and
your sales team to set more concrete sales goals.
Make smarter decisions: Entrepreneurs often take decisions in relation to
their business based on emotion. Emotion is important i.e. how you feel,
though it’s not enough. In order to be a successful entrepreneur, decisions
should be based on facts.
Fund your business: This analysis is a key component in any business plan.
It’s generally a requirement if you want outsiders to fund your business. In
order to fund your business, you have to prove that your plan is viable.
Furthermore, if the analysis looks good, you will be comfortable enough to
take the burden of various ways of financing.
Better Pricing: Finding the break-even point will help in pricing the products
better. This tool is highly used for providing the best price of a product that
can fetch maximum profit without increasing the existing price.
Cover fixed costs: Doing a break-even analysis helps in covering all fixed
cost.
Marginal Costing versus Absorption Costing
Understanding marginal and absorption costing should be relatively
straightforward, as it’s covered, in one form or another, at all levels of the AAT
qualification. However, it’s a topic that continues to challenge us.
Let’s start by clarifying that both methods are concerned with production costs and
both require good foundation knowledge of cost categorisation.
•
Marginal costing is based on classifying costs by behaviour, in other
words, whether a cost is variable or fixed.
• Absorption costing focuses on whether a cost is direct or indirect by
nature.
Generally, if a cost is variable, such as a production worker’s wages, then it’s also
direct. Equally, fixed costs are usually indirect, for example factory rent.
This explains why calculations can be ‘built up’ starting with the prime cost, which is
the total of all the direct costs, then adding any variable overheads in order to
calculate the marginal cost.
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When we add the indirect costs to the marginal cost we end up with the full cost.
For example, if the following costs are known:
Then both the marginal and absorption costs of production can be easily calculated
by building up the subtotals, starting with the prime cost:
Then the marginal cost of production:
and finally the absorption cost of production:
Note that the administration, selling and distribution costs haven’t been included.
This is because indirect costs can be split into production and non-production
overheads and we’re just concerned with production costs.
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So, if the figures used in marginal and absorption costing are the same, except for
the inclusion or exclusion of fixed production overheads, why are both costing
systems used?
Why we use marginal and absorption costing
Well, marginal and absorption costing are used for two different purposes.
As marginal costing is only concerned with the variable costs of production, it can be
used to inform short-term decision making because it’s central to contribution
analysis.
For example, if the selling price of a WS47 is £40 but a customer wants to negotiate
a discounted price per unit, then marginal costing would be used to see the impact a
discount would have on profitability. We would do this by calculating the contribution
(selling price less variable costs ie. marginal cost) at a range of discounted selling
prices.
Marginal costing is used to calculate when individual products will break-even and
discounts affect the break-even point.
However, when it comes to analysing how much profit has been made on total sales
over a period of time, for the purposes of the financial statements, then we would
need to use the full cost of production, which is calculated using absorption costing.
Producing statements of profit and loss
Let’s say that we agreed a 5% discount on the sale of 800 units of WS47 and the
remaining 200 units were unsold at the end of the period. Statements of profit and
loss can be produced under both costing methods but will result in different profit
figures.
The start of the statements will be identical:
The first difference is in the treatment of the overheads. Under marginal costing only
the variable production overheads are included at this point, whereas both the
variable and fixed production overheads (£2,000 + £5,000) are including using
absorption costing:
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This is consistent with our previous calculations where we ‘built up’ the costs, just
presented in a different way.
The next difference is in the way that closing inventory is valued.
The quantity is not altered by the method, however the valuation is different. This is
because under marginal costing, closing inventory is valued at the marginal cost per
unit, in this case £24.50, whereas the full absorption cost of £29.50 is used in the
absorption method:
You can see that there is a £1,000 difference between the closing inventory
valuations.
The cost of sales is calculated next and, for marginal costing, requires the fixed
overheads to be added:
You can see that the £1,000 difference in the closing inventory valuations impacts on
the cost of goods sold figures.
Marginal costing values closing inventory at a lower cost per unit than absorption
costing and this means that the cost of goods sold figure is higher using the marginal
method.
The impact for both methods though, is followed through to the profit figures:
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The difference in the profits is directly attributable to the £5 per unit difference in the
valuation of the closing inventory ((£29.50 – £24.50) x 200 units = £1,000). This is
because the absorption method allocates a proportion of the fixed overheads to both
the actual units sold and the closing inventory. However, the marginal method
attributes all of the fixed costs to the period resulting in the lower profit figures.
It is due to this impact on profits that IAS 2 Inventories stipulates that inventory
should be valued on an absorption basis, when included in financial statements, as it
accounts for all of the production overheads.
The standard says that the cost of inventory should include all costs of purchase,
costs of conversion including fixed and variable production overheads, as well as
other costs incurred in bringing the inventories to their present location and
condition. It is also why the non-production overheads were not included, until they
were shown on the profit or loss statements.
In summary
The key differences between marginal and absorption costing are:
•
•
•
•
Purpose – marginal costing enables well informed short-term decision
making, and absorption costing calculates the cost of output as well as
providing the closing inventory valuation for inclusion in the financial
statements.
Calculation – marginal costing is based on variable costs but excludes
fixed costs and absorption costing includes both direct and indirect cost.
Generally if a cost is variable it is also direct, therefore, the addition of
fixed overheads to the marginal cost will give the full absorption cost.
Profitability – when there is closing inventory there will be a difference
in the profits calculated by the two methods. The difference in profit will
be explained by the difference in the value of the closing inventory.
Use – marginal costing is not allowed for financial reporting purposes
whereas absorption costing can be used for both financial and
management accounting.
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Introduction:
A budget is an accounting plan. It is a formal plan of action expressed in monetary
terms. It could be seen as a statement of expected income and expenses under certain
anticipated operating conditions. It is a quantified plan for future activities – quantitative
blue print for action.
Every organization achieves its purposes by coordinating different activities. For the
execution of goals efficient planning of these activities is very important and that is why
the management has a crucial role to play in drawing out the plans for its business.
Various activities within a company should be synchronized by the preparation of plans
of actions for future periods. These comprehensive plans are usually referred to as
budgets. Budgeting is a management device used for short‐term planning and control. It
is not just accounting exercise.
Meaning and Definition:
Budget:
According to CIMA (Chartered Institute of Management Accountants) UK, a budget is “A
plan quantified in monetary terms prepared and approved prior to a defined period of
time, usually showing planned income to be generated and, expenditure to be incurred
during the period and the capital to be employed to attain a given objective.”
In a view of Keller & Ferrara, “a budget is a plan of action to achieve stated objectives
based on predetermined series of related assumptions.”
G.A.Welsh states, “A budget is a written plan covering projected activities of a firm for a
definite time period.”
One can elicit the explicit characteristics of budget after observing the above definitions.
They are…
• It is mainly a forecasting and controlling device.
• It is prepared in advance before the actual operation of the company or project.
• It is in connection with definite future period.
• Before implementation, it is to be approved by the management.
• It also shows capital to be employed during the period.
Budgetary Control:
Budgetary Control is a method of managing costs through preparation of budgets.
Budgeting is thus only a part of the budgetary control. According to CIMA, “Budgetary
control is the establishment of budgets relating to the responsibilities of executives of a
policy and the continuous comparison of the actual with the budgeted results, either to
secure by individual action, the objective of the policy or to provide a basis for its
revision.”
The main features of budgetary control are:
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1. Establishment of budgets for each purpose of the business.
2. Revision of budget in view of changes in conditions.
3. Comparison of actual performances with the budget on a continuous basis.
4. Taking suitable remedial action, wherever necessary.
5. Analysis of variations of actual performance from that of the budgeted performance to
know the reasons thereof.
Objectives of Budgetary Control:
Budgeting is a forward planning. It serves basically as a tool for management control; it
is rather a pivot of any effective scheme of control.
The objectives of budgeting may be summarized as follows:
1. Planning: Planning has been defined as the design of a desired future position for an
entity and it rests on the belief that the future position can be attained by uninterrupted
management action. Detailed plans relating to production, sales, raw‐material
requirements, labour needs, capital additions, etc. are drawn out. By planning many
problems estimated long before they arise and solution can be thought of through
careful study. In short, budgeting forces the management to think ahead, to foresee and
prepare for the anticipated conditions. Planning is a constant process since it requires
constant revision with changing conditions.
2. Co‐ordination: Budgeting plays a significant role in establishing and maintaining
coordination. Budgeting assists managers in coordinating their efforts so that problems
of the business are solved in harmony with the objectives of its divisions. Efficient
planning and business contribute a lot in achieving the targets. Lack of co‐ordination in
an organization is observed when a department head is permitted to enlarge the
department on the specific needs of that department only, although such development
may negatively affect other departments and alter their performances. Thus, co‐
ordination is required at all vertical as well as horizontal levels.
3. Measurement of Success: Budgets present a useful means of informing managers
how well they are performing in meeting targets they have previously helped to set. In
many companies, there is a practice of rewarding employees on the basis of their
accomplished low budget targets or promotion of a manager is linked to his budget
success record. Success is determined by comparing the past performance with
previous period's performance.
4. Motivation: Budget is always considered a useful tool for encouraging managers to
complete things in line with the business objectives. If individuals have intensely
participated in the preparation of budgets, it acts as a strong motivating force to achieve
the goals.
5. Communication: A budget serves as a means of communicating information within a
firm. The standard budget copies are distributed to all management people provide not
only sufficient understanding and knowledge of the programmes and guidelines to be
followed but also give knowledge about the restrictions to be adhered to.
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6. Control: Control is essential to make sure that plans and objectives laid down in the
budget are being achieved. Control, when applied to budgeting, as a systematized effort
is to keep the management informed of whether planned performance is being achieved
or not.
Advantages of Budgetary control:
In the light of above discussion one can see that, coordination and control help the
planning. These are the advantages of budgetary control. But this tool offer many other
advantages as follows:
1. This system provides basic policies for initiatives.
2. It enables the management to perform business in the most professional manner
because budgets are prepared to get the optimum use of resources and the objectives
framed.
3. It ensures team work and thus encourages the spirit of support and mutual
understanding among the staff.
4. It increases production efficiency, eliminates waste and controls the costs.
5. It shows to the management where action is needed to remedy a
position.
6. Budgeting also aids in obtaining bank credit.
7. It reviews the present situation and pinpoints the changes which are necessary.
8. With its help, tasks such as like planning, coordination and control happen effectively
and efficiently.
9. It involves an advance planning which is looked upon with support by many credit
agencies as a marker of sound management.
Limitations of Budgetary control:
1. It tends to bring about rigidity in operation, which is harmful. As budget estimates are
quantitative expression of all relevant data, there is a tendency to attach some sort of
rigidity or finality to them.
2. It being expensive is beyond the capacity of small undertakings. The mechanism of
budgeting system is a detailed process involving too much time and costs.
3. Budgeting cannot take the position of management but it is only an instrument of
management. ‘The budget should be considered not as a master, but as a servant.’ It is
totally misconception to think that the introduction of budgeting alone is enough to
ensure success and to security of future profits.
4. It sometimes leads to produce conflicts among the managers as each of them tries to
take credit to achieve the budget targets.
5. Simple preparation of budget will not ensure its proper implementation. If it is not
implemented properly, it may lower morale.
6. The installation and function of a budgetary control system is a costly affair as it
requires employing the specialized staff and involves other expenditure which small
companies may find difficult to incur. Essentials of Effective Budgeting:
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1) Support of top management: If the budget structure is to be made successful, the
consideration by every member of the management not only is fully supported but also
the impulsion and direction should also come from the top management. No control
system can be effective unless the organization is convinced that the management
considers the system to be important.
2) Team Work: This is an essential requirement, if the budgets are ready from “the
bottom up” in a grass root manner. The top management must understand and give
enthusiastic support to the system. In fact, it requires education and participation at all
levels. The benefits of budgeting need to be sold to all.
3) Realistic Objectives: The budget figures should be realistic and represent logically
attainable goals. The responsible executives should agree that the budget goals are
reasonable and attainable.
4) Excellent Reporting System: Reports comparing budget and actual results should
be promptly prepared and special attention focused on significant exceptions i.e. figures
that are significantly different from expected. An effective budgeting system also requires
the presence of a proper feed‐back system.
5) Structure of Budget team: This team receives the forecasts and targets of each
department as well as periodic reports and confirms the final acceptable targets in form
of Master Budget. The team also approves the departmental budgets.
6) Well defined Business Policies: All budgets reveal that the business policies
formulated by the higher level management. In other words, budgets should always be
after taking into account the policies set for particular department or function. But for this
purpose, policies should be precise and clearly defined as well as free from any
ambiguity.
7) Integration with Standard Costing System: Where standard costing system is also
used, it should be completely integrated with the budget programme, in respect of both
budget preparation and variance analysis.
8) Inspirational Approach: All the employees or staff other than executives should be
strongly and properly inspired towards budgeting system. Human beings by nature do
not like any pressure and they dislike or even rebel against anything forced upon them.
Classification of Budget:
The extent of budgeting activity varies from firm to firm. In a smaller firm there may
be a sales forecast, a production budget, or a cash budget. Larger firms generally
prepare a master budget. Budgets can be classified into different ways from different
points of view. The following are the important basis for classification:
Functional Classification:
SALES BUDGET:
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The sales budget is an estimate of total sales which may be articulated in financial or
quantitative terms. It is normally forms the fundamental basis on which all other budgets
are constructed. In practice, quantitative budget is prepared first then it is translated into
economic terms. While preparing the Sales Budget, the Quantitative Budget is generally
the starting point in the operation of budgetary control because sales become, more
often than not, the principal budget factor. The factor to be consider in forecasting sales
are as follows:
• Study of past sales to determine trends in the market.
• Estimates made by salesman various markets of company products.
• Changes of business policy and method.
• Government policy, controls, rules and Guidelines etc.
• Potential market and availability of material and supply.
PRODUCTION BUDGET:
The production budget is prepared on the basis of estimated production for budget
period. Usually, the production budget is based on the sales budget. At the time of
preparing the budget, the production manager will consider the physical facilities like
plant, power, factory space, materials and labour, available for the period. Production
budget envisages the production program for achieving the sales target. The budget
may be expressed in terms of quantities or money or both. Production may be computed
as follows: Units to be produced = Desired closing stock of finished goods + Budgeted
sales – Beginning stock of finished goods.
PRODUCTION COST BUDGET:
This budget shows the estimated cost of production. The production budget
demonstrates the capacity of production. These capacities of production are expressed
in terms of cost in production cost budget. The cost of production is shown in detail in
respect of material cost, labour cost and factory overhead. Thus production cost budget
is based upon Production Budget, Material Cost Budget, Labour Cost Budget and
Factory overhead.
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RAW‐MATERIAL BUDGET:
Direct Materials budget is prepared with an intention to determine standard material cost
per unit and consequently it involves quantities to be used and the rate per unit. This
budget shows the estimated quantity of all the raw materials and components needed
for production demanded by the production budget. Raw material serves the following
purposes:
It supports the purchasing department in scheduling the purchases.
Requirement of raw‐materials is decided on the basis of production budget.
It provides data for raw material control.
Helps in deciding terms and conditions of purchase like credit purchase, cash
purchase, payment period etc.
It should be noted that raw material budget generally deals with only the direct materials
whereas indirect materials and supplies are included in the overhead cost budget.
PURCHASE BUDGET:
Strategic planning of purchases offers one of the most important areas of reduction cost
in many concerns. This will consist of direct and indirect material and services. The
purchasing budget may be expressed in terms of quantity or money.
The main purposes of this budget are:
It designates cash requirement in respect of purchase to be made during budget
period; and
It is facilitates the purchasing department to plan its operations in time in respect of
purchases so that long term forward contract may be organized.
LABOUR BUDGET:
Human resources are highly expensive item in the operation of an enterprise. Hence,
like other factors of production, the management should find out in advance personnel
requirements for various jobs in the enterprise. This budget may be classified into labour
requirement budget and labour recruitment budget. The labour necessities in the various
job categories such as unskilled, semi‐skilled and supervisory are determined with the
help of all the head of the departments. The labour employment is made keeping in view
the requirement of the job and its qualifications, the degree of skill and experience
required and the rate of pay.
PRODUCTION OVERHEAD BUDGET:
The manufacturing overhead budget includes direct material, direct labour and indirect
expenses. The production overhead budget represents the estimate of all the production
overhead i.e. fixed, variable, semi‐variable to be incurred during the budget period. The
reality that overheads include many different types of expenses creates considerable
problems in:
1) Fixed overheads i.e., that which is to remain stable irrespective of vary in the
volume of output,
2) Apportion of manufacturing overheads to products manufactured, semi variable
cost i.e., those which are partly variable and partly fixed.
3) Control of production overheads.
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4) Variable overheads i.e., that which is likely to vary with the output.
The production overhead budget engages the preparation of overheads budget for each
division of the factory as it is desirable to have estimates of manufacturing overheads
prepared by those overheads to have the responsibility for incurring them. Service
departments cost are projected and allocated to the production departments in the
proportion of the services received by each department.
SELLING AND DISTRIBUTION COST BUDGET:
The Selling and Distribution Cost budget is estimating of the cost of selling, advertising,
delivery of goods to customers etc. throughout the budget period. This budget is closely
associated to sales budget in the logic that sales forecasts significantly influence the
forecasts of these expenses. Nevertheless, all other linked information should also be
taken into consideration in the preparation of selling and distribution budget. The sales
manager is responsible for selling and distribution cost budget. Naturally, he prepares
this budget with the help of managers of sub‐divisions of the sales department. The
preparation of this budget would be based on the analysis of the market condition by the
management, advertising policies, research programs and many other factors. Some
companies prepare a separate advertising budget, particularly when spending on
advertisements are quite high.
ADMINISTRATION COST BUDGET:
This budget includes the administrative costs for non‐manufacturing business activities
like director’s fees, managing directors’ salaries, office lightings, heating and air
condition etc. Most of these expenses are fixed so they should not be too difficult to
forecast. There are semi‐variable expenses which get affected by the expected rise or
fall in cost which should be taken into account. Generally, this budget is prepared in the
form of fixed budget.
CAPITAL‐ EXPENDITURE BUDGET:
This budget stands for the expenditure on all fixed assets for the duration of the budget
period. This budget is normally prepared for a longer period than the other functional
budgets. It includes such items as new buildings, land, machinery and intangible items
like patents, etc. This budget is designed under the observation of the accountant which
is supported by the plant engineer and other functional managers. At the time of
preparation of the budget some important information should be observed:
Overfilling on the production facilities of certain departments as revealed by the plant
utilization budget.
Long‐term business policy with regard to technical developments.
Potential demand for certain products.
CASH BUDGET:
The cash budget is a sketch of the business estimated cash inflows and outflows over a
specific period of time. Cash budget is one of the most important and one of the last to
be prepared. It is a detailed projection of cash receipts from all sources and cash
payments for all purposes and the resultants cash balance during the budget. It is a
mechanism for controlling and coordinating the fiscal side of business to ensure
solvency and provides the basis for forecasting and financing required to cover up any
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deficiency in cash. Cash budget thus plays a vital role in the financing management of a
business undertaken.
Cash budget assists the management in determining the future liquidity requirements of
the firm, forecasting for business of those needs, exercising control over cash. So, cash
budget thus plays a vital role in the financial management of a business enterprise.
Function of Cash Budget:
• It makes sure that enough cash is available when it is required.
• It designates cash excesses and shortages so that steps may be taken in time to
invest any excess cash or to borrow funds to meet any shortages.
• It shows whether capital expenditure could be financed internally.
• It provides funds for standard growth.
• It provides a sound basis to manage cash position.
Advantages of Cash Budget:
1. Usage of Cash: Management can plan out the use of cash in accord with the
changes of receipt and payment. Payments can be planned when sufficient cash is
available and continue the business activity with the minimum amount of working capital.
2. Allocation for Capital Investment: It is dual benefits such as capital expenditure
projects can be financed internally and can get an idea for cash availability of capital
investment.
3. Provision of Excess Funds: It reveals the availability of excess cash. In this regard
management can decide to invest excess funds for short term or long term according to
the requirements in the business.
4. Pay‐out Policy: This budgetary system may help the management for future pay‐out
policy in the form of dividend. In case the cash budget liquid position is not favourable,
the management may reduce the rate of dividend or maintain dividend amount or skip
dividend for the year.
5. Provision for acquiring Funds: It gives the top level management ideas for
acquiring funds for particular time duration and sources to be explored.
6. Profitable Use of Cash: Business person can take decision for the best use of
liquidity to make more profitable transaction. It can be used at the time of bulk purchase
payments and one get the benefit of discount.
Limitation of Cash Budget:
1. Complex Assumption: Business is full of uncertainties, so it is very difficult to have
near perfect estimates of cash receipts and payments, especially for a longer duration. It
can be predicted for short duration such as of three to four months.
2. Inflexibility: If the finance manager fails to show flexibility in implementing the cash
budget, it will incur adverse effects. If the manager follows strictly adheres to the
estimates of cash inflow it may negatively result in losing customers. Likewise, loyalty in
payments may lead to deterioration of liquid position.
3. Costly: Application of this technique necessitates collecting of statistical information
from various sources and expert personnel in operation research would be the costliest
deal. It becomes expensive which may not be affordable to small business houses. In
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addition, finding out experts is not always possible. In this situation the long term
predictions do not prove correct.
Methods:
1. Receipt and payment: It is most popular and is universally used for preparing cash
budget. The assumption of statistical data is arrived at calculated on the basis of
requirements like monthly, weekly or fortnightly. On account of elasticity, this method is
used in forecasting cash at different time periods and thus it helps in controlling cash
distributions.
(a) Cash receipts from customers are based on sales forecast. The term of sale, lag in
payment etc., are generally taken into consideration.
(b) Cash receipts from other sources, such as dividends and interest on trade
investment, rent received, issue of capital, sale of investment and fixed assets.
(c) Cash requirements for purchase of materials, labour and salary cost and overhead
expenses based on purchasing, personnel and overhead budgets.
(d) Cash requirements for capital expenditure as per the capital expenditure budget.
(e) Cash requirements for other purposes such as payment of dividends, income‐tax
liability, fines and penalties.
(i) Estimating Cash Receipts: Generally main sources of cash receipts are sales,
interest and dividend, sales of assets and investments, capital borrowings etc. The
Company estimates time‐lag on the basis of past experience of cash receipts on credit
sales while cash sales can be easily determined.
(ii) Estimating Cash Payments: It can be decided on the basis of various operating
budgets prepared for the payment of credit purchase, payment of labour cost, interest
and dividend, overhead charges, capital investment etc.
2. Adjusted Profit and Loss Account: This method is based on cash and non‐cash
transactions. This method estimates closing cash balance by converting profit into cash.
The hypothesis of this method is that the earning of profit brings equal amount of cash
into the business. The net profit shown by profit and loss account does not signify the
actual cash flow into the business. This also leads to another assumption, that is the
business will remain static, i.e. there will be no wearing out or increase of assets and
changes of working capital so that the total cash on hand for the business would be
equal to the profit earned.
3. Budgeted Balance Sheet Method: This method looks like the Adjusted Profit and
Loss Account method only, except that in this method a Balance Sheet is projected and
in that method Profit and Loss Account is adjusted. In this method Balance Sheet is
prepared with the projected amount of all assets and liabilities except cash at the end of
budget period. The cash balance will find out balancing amount. If assets side is higher
than liability side it would be the bank overdraft while liability side is higher than assets
side it gives bank balance. This method is used by the stable business houses.
4. Working Capital Differential Method: It is based on the estimate of working capital.
It begins with the opening working capital and is added to or deducted from any changes
made in the current assets except cash and current liabilities. At the end of the budget
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period balance shows the real cash balance. This method is quite similar to the Balance
Sheet method.
Model of Cash Budget
Particular
Opening Balance
Add: Receipts:
Cash Sales
Receipts from Debtors
Interest and Dividend
Sale of fixed assets
Sale of Investments
Bank Loan
Issue Shares &
Debenture
Others
Total Receipts (A)
Less: Payments
Cash Purchases
Payment to creditors
Salaries & wages
Administrative
expenses
Selling expenses
Dividend payable
Purchase of Fixed
Assets
Repayment of Loan
Payment of taxes
Total Payments (B)
Closing Balance (A ‐
B)
January
‐
February
‐
March
‐
‐
‐
‐
‐
‐
‐
‐
‐
‐
‐
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FIXED AND FLEXIBLE BUDGET:
1. FIXED BUDGET:
A fixed budget is prepared for one level of output and one set of condition. This is a
budget in which targets are tightly fixed. It is known as a static budget. It is firm and
prepared with the assumption that there will be no change in the budgeted level of
motion. Thus, it does not provide room for any modification in expenditure due to the
change in the projected conditions and activity. Fixed budgets are prepared well in
advance.
This budget is not useful because:
135
•
•
•
•
The conditions go on the changing and cannot be expected to be firm.
The management will not be in a position to assess, the performance of different
heads on the basis of budgets prepared by them because to the budgeted level
of activity.
It is hardly of any use as a mechanism of budgetary control because it does not
make any difference between fixed, semi‐variable and variable costs
It does not provide any space for alteration in the budgeted figures as a result of
change in cost due to change in the level of activity.
2. FLEXIBLE BUDGET:
This is a dynamic budget. In comparison with a fixed budget, a flexible budget is one
“which is designed to change in relation to the level of activity attained.” An equally
accurate use of the flexible budgets is for the purposes of control.
Flexible budgeting has been developed with the objective of changing the budget figures
so that they may correspond with the actual output achieved. It is more sensible and
practical, because changes expected at different levels of activity are given due
consideration. Thus a budget might be prepared for various levels of activity in accord
with capacity utilization.
Flexible budget may prove more useful in the following conditions:
Where the level of activity varies from period to period.
Where the business is new and as such it is difficult to forecast the demand.
Where the organization is suffering from the shortage of any factor of production.
For example, material, labour, etc. as the level of activity depends upon the availability of
such a factor.
Where the nature of business is such that sales go on changing.
Where the changes in fashion or trend affects the production and sales.
Where the organization introduces the new products or changes the patterns and
designs of its products frequently.
Where a large part of output is intended for the export.
Uses of Flexible Budget:
In flexible budgets numbers are adjustable to any given set of operating conditions. It is,
therefore, more sensible than a fixed budget which is true only in one set of operating
environment.
Flexible budgets are also useful from the view point of control. Actual performance of an
executive should be compared with what he should have achieved in the actual
circumstances and not with what he should have achieved under quite different
circumstances. At last, flexible budgets are more realistic, practical and useful. Fixed
budgets, on the other hand, have a limited application and are suited only for items like
fixed costs.
Preparation of a Flexible Budget
The preparation of a flexible budget requires the analysis of total costs into fixed and
variable components. This analysis of course is, not unusual to the flexible budgeting, is
more important in flexible budgeting then in fixed budgeting. This is so because in
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flexible budgeting, varying levels of output are considered and each class of overhead
will be different for each level. Thus the flexible budget has the following main
distinguishing features:
It is prepared for a range of activity instead of a single level.
It provides a dynamic basis for comparison because it is automatically related to
changes in volume.
The formulation of a flexible budget begins with analyzing the overhead into fixed and
variable cost and determining the extent to which the variable cost will vary within the
normal range of activity. In a simple equation form it could be put as:
Y=a+bx and it is illustrated as below:
here are two methods of preparing such a budget:
(i) Formula Method / Ratio Method: This is also known as the Budget Cost Allowance
Method. In this method the budget should be prepared as follows:
(a) Before the period begins:
Budget for a normal level of activity,
Segregate into fixed and variable costs,
Compute the variable cost per unit of activity
(b) At the end of the period:
Ascertain the actual activity
Compute the variable cost allowed for this level, add the fixed cost to give the
budget cost allowance.
The whole process is expressed in the formula:
Allowed cost = Fixed cost + (Actual units of activity for the period) (Variable cost per unit
of activity)
(ii) Multi‐Activity Method: This method involves computing a budget for every major
level of activity. When the actual level of activity is known, the allowed cost is found
“interpolating” between the budgets of activity levels on either side.
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Different levels of activity are expressed in terms of either production units or sales
values. The levels of activity are generally expressed in production units or in terms of
sales values.
The fixation of the budget cost gives allowance for the budget centres. According to
CIMA London, the budget cost allowance means, "the cost which a budget centre is
expected to incur during a given period of time in relation to the level of activity attained
by the budget centre."
The determination of the different levels of activity for which the flexible budget is to
be prepared.
(3) Graphic Method: In this method, estimates of budget are presented graphically. In
this costs are divided into three classes, viz., fixed, variable and semi‐variable cost.
Values of costs are obtained for different levels of production. These values are signified
in the form of a graph.
Zero Base Budgeting:
The ‘Zero‐Base’ refers to a ‘nil‐budget’ as the starting point. It starts with a presumption
that the budget for the next period is ‘zero’ until the demand for a function, process, or
project is not justified for single penny. The assumption is that without such justification,
no expenditure will be allowed. In effect, each manager or functional head is required to
138
carry out cost‐benefit analysis of each of the activities, etc. under his control and for
which he is responsible.
The method of ZBB suggests that the business should not only make decision about the
proposed new programmes but it should also, regularly, review the suitability of the
existing programmes. This approach of preparing a budget is called incremental
budgeting since the budget process is concerned mainly with the increases or changes
in operations that are likely to occur during the budget period.
This method for the first time was used by the Department of Agriculture, U.S.A. in the
19th century. Other State Governments of the U.S.A. found this method helpful and so
almost all the states took deep interest in the ZBB method. A number of states of
America use this technique even today. The ICAI has brought out a research in the form
of a monograph showing the application of the ZBB method that worries in tandem with
the concerns for national environment and its requirements. In India, however, the ZBB
approach has not been fully accepted and actualized.
"ZBB is a management tool, which provides a systematic method for evaluating all
operations and programmes, current or new, allows for budget reductions and
expansions in a rational manner and allows re‐allocation of sources from low to high
priority programmes."
‐ David Lieninger
ZBB is a planning, resource allocation and control tool. It, however, presupposes that
(a) There is an efficient budgeting system within the enterprise.
(b) Managers can develop quantitative measures for use in performance evaluation.
(c) Among the new suggestions and programmes, along with old ones are put to a strict
scrutiny.
(d) Funds are diverted from low‐priority suggestions to high priority suggestions.
Procedure of Zero‐base Budgeting:
(1) Determination of the objective: This is an initial step for determining the objective to
introduce ZBB. It may result into the decreased cost in personnel overheads or debunk
the projects which do not fit in the business structure or which are not likely to help
accomplish the business objectives.
(2) Degree at the ZBB is to be introduced: It is not possible every time to evaluate
every activity of the whole business. After studying the business structure, the
management can decide whether ZBB is to be introduced in all areas of business
activities or only in a few selected areas on the trial basis.
(3) Growth of Decision units: Decision units submit their data as to which cost benefit
analysis should be done in order to arrive at a decision that helps them decide to
continue or abandon. It could be a functional department, a programme, a product‐line
or a sub‐line. Here the decision unit sexist independent of all the other units so that
when the cost analysis turns unfavourable that particular unit could be closed down.
(4) Growth of Decision packages: Decision units are to be identified for preparing data
relating to the proposals to be included in the budget, concerned manager analyzes the
activities of his or her own decision units. His job is to consider possible different ways to
fulfill objectives. The size of the business unit and the volume of goods it deals with
139
determine the number of decision units and packages. The decision package has to
contain all the information which helps the management in deciding whether the
information is necessary for the business, what would be the estimated costs and
benefits expected from it.
(5) Assessment and Grading of decision packages: These packages invented and
formulated are submitted to the next level of responsibility within the organization for
ranking purposes. Ranking basically decides as to whether or not to include the
proposals in the budget. The management ranks the different decision packages in the
order from decreasing benefit or importance to the organization. Preliminary ranking is
done by the unit manager himself and for the further review it is sent to the superior
officers who consider overall objectives of the organization.
(6) Allotment of money through Budgets: It is the last step engaged in the ZBB
process. According to the cost benefit analysis and availability of the funds management
has ranks and thereby a cut‐off point is established. Keeping in view reasonable
standards, the approved designed packages are accepted and others are rejected. The
funds are then allotted to different decision units and budgets relating to each unit are
prepared.
Advantages:
ZBB rejects the attitude of accepting the current position in support of an attitude of
inquiring and testing each item of budget.
It helps improve financial planning and management information system through
various techniques.
It is an educational process and can promote a management team of talented and
skillful people who tend to promptly respond to changes in the business environment.
It facilities recognition of inefficient and unnecessary activities and avoid wasteful
expenditure.
Cost behavior patterns are more closely examined.
Management has better elasticity in reallocating funds for optimum utilization of the
funds.
Disadvantages:
• It is an expensive method as ZBB incurs a huge cost every in its preparation.
• It also requires high volume of paper work; hence sometimes it becomes a
tedious job.
• In ZBB there is a danger of emphasizing short‐term benefits at the expenses of
long term ones.
• This is not a new method for evaluating various alternatives, and cost‐benefit
analysis.
• The psychological effects can also not be ignored. It holds out high hopes as a
modern technique, claiming to raise the profitability and efficiency of the
business.
140
Budgets & Budgetary Control
Practical Problems (with solutions)
Flexible Budget
(1) Prepare a Flexible budget for overheads on the basis of the following data.
Ascertain the overhead rates at 50% and 60% capacity.
Variable overheads:
At 60% capacity (Rs)
Indirect Material
6,000
Labour
18,000
Semi‐variable overheads:
Electricity: (40% Fixed & 60%
30,000
variable)
Repairs: (80% fixed & 20%
3,000
Variable)
Fixed overheads:
Depreciation
16,500
Insurance
4,500
Salaries
15,000
Total overheads
93,000
Estimated direct labour hours
1,86,000
Solution:
Flexible Budget
Items
Variable overheads:
Material
Labour
Semi‐variable
Electricity
Repairs
Fixed overheads:
Deprecation
Insurance
Salaries
Total Overheads
Estimated direct labour hours
Overhead Rate
Capacity
50%
Rs.
5,000
15,000
60%
Rs.
6,000
18,000
27,000
2,900
30,000
3,000
16,500
4500
15,000
85,900
1,55,000
0.55
16,500
4500
15,000
93,000
1,86,000
0.50
Working Note:
Electricity
At 50% capacity = 18,000 * 50
60
141
= Rs. 15,000
Rs. 12,000 + Rs. 15,000 = Rs. 27,000
60% capacity = Rs 18,000 + Rs. 12,000 = Rs. 30,000
Repairs
For 60% capacity = Rs.600
=Rs. 2400 + Rs.600 =Rs.3,000
At 50% capacity : = 600/60 * 50
= Rs. 500
=Rs.2400 + 500
=Rs.2,900
(2) Prepare a flexible budget for overheads on the basis of the following data.
Ascertain the overhead rates at 60% and 70% capacity.
Variable overheads:
At 60% capacity(Rs)
Material
6,000
Labour
18,000
Semi‐variable overheads:
Electricity:
30,000
40% Fixed
60% variable
Repairs:
80% fixed
3,000
20% Variable
3,000
Fixed overheads:
Depreciation
16,500
Insurance
4,500
Salaries
15,000
Total overheads
93,000
Estimated direct labour hours
1,86,000
Solution:
Working:
Repairs
For 60% capacity Fixed 80/100 * 3,000 = Rs.2400
Variable = 20/100 * 3,000 = Rs. 600
=Rs. 2400 + Rs.600 =Rs.3,000
Electricity Exp.:
At 60% capacity Fixed= 40/100 *30,000 = 12,000
Variable = 60/100 * 30,000= 18,000 At 70% capacity: Fixed = 40/100 * 30,000 = Rs.
12,000
Variable = 18,000/60 *70 = Rs. 21,000 Total Rs. =33,000
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Flexible Budget
Items
Variable overheads:
Material
Labour
Semi‐variable
Electricity
Repairs
Fixed overheads:
Deprecation
Insurance
Salaries
Total Overheads
Estimated direct labour hours
Overhead Rate
Capacity
60%
Rs.
6,000
18,000
70%
Rs.
7,000
21,000
30,000
3,000
33,000
3,100
16,500
4,500
15,000
93,000
1,86,000
0.50
16,500
4,500
15,000
1,00,100
2,17,000
0.46
(3) The expenses budgeted for production of 1,000 units in a factory are furnished
below:
Particulars
Material Cost
Labour Cost
Variable overheads
Selling expenses (20%
fixed)
Administrative
expenses (Rs.
2,00,000)
Total Cost
Per Unit Rs.
700
250
200
130
200
1,480
Solution: Flexible Budget
Model of Flexible Budget
143
The company decides to have a flexible budget with a production target of 3,200 and
4,800 units (the actual quantity proposed to be produced being left to a later date before
commencement of the budget period)
Prepare a flexible budget for production levels of 50% and 75%. Assuming, selling price
per unit is maintained at Rs. 40 as at present, indicate the effect on net profit.
Administrative , selling and distribution expenses continue at Rs.3,600.
Solution:
The production at 100% capacity is 6400 units, so it will be 3,200 units at 50% and 4,800
units at 75% capacity. The variable expenses will change in that proportion.
Flexible Budget
Particulars
(i)Sales (per unit
Rs.40)
Cost of Sales:
(a)variable costs:
Direct material
Direct Labour
Power
Repairs
Miscellaneous
100%
2,56,000
75%
1,92,000
50%
1,28,000
49,280
1,02,400
1,440
1,700
540
36,960
76,800
1,080
1,275
405
24,640
51,200
720
850
270
144
Total variable
costs
(b)Fixed Costs:
(ii) Total Costs
Gross Profit(i)‐
(ii)
Less: Adm.,
selling and
Dist. Costs
Net Profit
1,55,360
1,16,520
77,680
20,688
1,76,048
79,952
20,688
1,37,208
54,792
20,688
98,368
29,632
3,600
3,600
3,600
76,352
51,192
26,032
(5) A factory engaged in manufacturing plastic buckets is working at 40% capacity
and produces 10,000 buckets per month.
The present cost break up for one bucket is as under:
Materials Rs.10 Labour Rs.3
Overheads Rs.5 (60% fixed)
The selling price is Rs.20 per bucket. If it is desired to work the factory at 50% capacity
the selling price falls by 3%. At 90% capacity the selling price falls by 5% accompanied
by a similar fall in the price of material.
You are required to prepare a statement the profit at 50% and 90% capacities and also
calculate the break‐ even points at this capacity production.
145
CASH BUDGET
(1) Saurashtra Co. Ltd. wishes to arrange overdraft facilities with its bankers from the
period August to October 2019 when it will be manufacturing mostly for stock. Prepare a
cash budget for the above period from the following data given below:
Month
June
July
August
Septembe
r
October
November
December
Sales
(Rs.)
1,80,000
1,92,000
1,08,000
1,74,000
Purchase
s (Rs.)
1,24,800
1,44,000
2,43,000
2,46,000
Wages
(Rs.)
12,000
14,000
11,000
12,000
Mfg. Exp.
(Rs.)
3,000
4,000
3,000
4,500
Office
Exp. (Rs.)
2,000
1,000
1,500
2,000
Selling
Exp. (Rs.)
2,000
4,000
2,000
5,000
1,26,000
1,40,000
1,60,000
2,68,000
2,80,000
3,00,000
15,000
17,000
18,000
5,000
5,500
6,000
2,500
3,000
3,000
4,000
4,500
5,000
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Additional Information:
(a) Cash on hand 1‐08‐2010 Rs.25,000.
(b) 50% of credit sales are realized in the month following the sale and the remaining
50% in the second month following. Creditors are paid in the month following the month
of purchase.
(c) Lag in payment of manufacturing expenses half month.
(d) Lag in payment of other expenses one month.
Solution:
CASH BUDGET
For 3 months from August to October 2019
Particulars
Receipts:
Opening balance
Sales
Total Receipts(A)
Payments:
Purchases
Wages
Mfg. Exp.
Office Exp.
Selling Exp.
Total
payments(B)
Closing
Balance(A‐B)
August (Rs.)
September (Rs.)
October (Rs.)
25,000
1,86,000
2,11,000
44,500
1,50,000
1,94,500
(66,750)
1,41,000
74,250
1,44,000
14,000
3,500
1,000
4,000
1,66,500
2,43,000
11,000
3,750
1,500
2,000
2,61,250
2,46,000
12,000
4,750
2,000
5,000
2,69,750
44,500
(66,750)
(1,95,500)
Working Note:
1. Manufacturing Expense:
Particular
August
July (4000/2)
2000
August (3000/2) 1500
September
‐‐‐
(4500/2)
October
‐‐‐
(5000/2)
Total
3500
September
‐‐‐
1500
2250
October
‐‐‐
‐‐‐
2250
‐‐‐‐
2500
3750
4750
1. Sales
Particular
August
September
October
147
June (180000/2)
July (192000/2)
August
(108000/2)
September
(174000/2)
Total
90000
96000
‐‐‐
‐‐‐
96000
54000
‐‐‐
‐‐‐
54000
‐‐‐
‐‐‐‐
87000
186000
150000
141000
Standard Costing and Variance Analysis
In fast growing business world, major goal of organizations is to reduce the cost of
production and control the cost as there are limited resources in business and
manufacturing concern. Cost accounting has numerous significant tools in order to attain
these goals such as standard costing.
Standard Costing
Standard costs are extensively recognized in all countries of world. It is an effectual
procedure to control cost and assist to accomplish organizational goal. Standard costs are
realistic estimates of cost based on analyses of both past and projected operating costs
and conditions. In this procedure, standard cost of the product and services is determined
in advance and comparing it with actual cost variance to ascertain and analyse. Huge
accounting literature has stated that standard costing is the preparation and use of
standard costs, their comparison with actual cost and the analysis of variance to their
causes and points of incidence (ICMA, London). According Wheldon, standard costing is
the method of ascertaining the costs whereby statistics are prepared to show standard
cost, actual cost, and the difference between these costs which is termed as variance.
Other theorists like Brown and Howard described that standard costing is a technique of
accounting which compares the standard cost of product and services with actual cost to
determine the efficiency of operations so that remedial actions can be taken immediately
(Gupta, et, al., 2006).
The three components of standard costing:
1 Standard costs, which provide a standard, or predetermined performance level.
2 A measure of actual performance.
3 A measure of the variance between standard and actual performance.
Standard costing uses estimated costs completely to calculate all three elements of
product costs: direct materials, direct labour, and overhead. Managers use standard costs
for planning and control in the management process such as planning for budget
development; product costing, pricing, and distribution.
The main difference between standard costing in a service organization and standard
costing in a manufacturing organization is that a service organization has no direct
materials costs. In a standard costing system, costs are entered into the Materials, Work
148
in Process, and Finished Goods Inventory accounts and the Cost of Goods Sold account
at standard cost; actual costs are recorded separately.
The following elements are used to verify a standard cost per unit:
1. Direct materials price standard
2. Direct materials quantity standard
3. Direct labour rate standard
4. Direct labour time standard
5. Standard variable overhead rate
6. Standard fixed overhead rate
Determination of Standard Costs
The following initial steps must be taken before determination of standard cost:
1. Establishment of Cost Centres: It is the primary step required before setting of
Standards.
2. Classification and Codification of Accounts: Categorization of Accounts and
Codification of different items of expenses and incomes assist quick ascertainment
and analysis of cost information.
3. Types of Standards to be applied: Determination of the type of standard to be used is
vital steps before establishing of standard cost. There are numerous standards:
I.
Ideal Standard
II.
Basic Standard
III.
Current Standard
IV.
Expected Standard
V.
Normal Standard
4. Organization for Standard Costing: The achievement of the standard costing system
depends upon the consistency of standards, therefore the responsibility for setting
standard is vested with the Standard Committee. It consists of following team:
1 Purchase Manager
2 Production Manager
3 Personnel Manager
4 Time and Motion Study Engineers
5 Marketing Manager and Cost Accountant
5. Setting of Standards: The Standard Committee is responsible for developing
standards for each component of costs such as Direct Material, Direct Labour,
Overheads ( Fixed overheads and Variable Overheads).
Features of Standard Costing
1
2
3
4
5
6
Standard costing is a technique of cost accounting.
The cost or service or product is predetermined.
The predetermined cost is known as standard cost.
Actual cost of product and service is ascertained.
The comparison is made between standard cost and actual cost and variances
are noted.
Variances are analysed to find out the reason.
149
7
Variances are reported to management in order to take corrective action.
Ways of Developing Standards
The direct materials price standard is based on a vigilant estimate of all possible price
increases, changes in available quantities, and new sources of supply in the next accounting
period.
The direct materials quantity standard is based on product engineering specifications, the
quality of direct materials, the age and productivity of machines, and the quality and
experience of the work force.
The direct labour rate standard is defined by labour union contracts and company personnel
policies.
The direct labour time standard is based on current time and motion studies of workers and
machines and records of their past performance.
The standard variable overhead rate and standard fixed overhead rate are found by dividing
total budgeted variable and fixed overhead costs by an appropriate application base.
Merits of standard costing: It is a very useful tool to control the cost. It is the analysis of
variances which reduces the cost and increase profitability. It is also beneficial for
management because it assists in fixation of selling price, ascertaining the value of closing
stocks of work in progress, determining idle capacity, and performs various management
functions. The standards provide incentives and motivation to work and help in increasing
efficiency and productivity. This technique is helpful in optimal use of resources. Standard
costing helps in budgetary control and in decision making. This technique is economical for
users (Gupta, et, al., 2006).
Demerits of Standard costing: In this technique, establishing standards is difficult.
Standards are determined by keeping in view the marketing condition, availability, and
efficiency of labour, machine and plant. All these factors are not static. Standard costing
requires specialists and expert staff. This involves heavy expenditure for the concern. This
technique is impractical for small scale industries (Gupta, et, al., 2006).
It can be established that Standard Costing is a notion of accounting to determine of standard
for each constituent of costs. These fixed costs are compared with actual costs to realize the
deviations known as "Variances". Recognition and analysis of causes for such variances and
corrective measures should be taken in order to beat the reasons for Variances.
Variance Analysis
Variance analysis is the procedure of computing the differences between standard costs and
actual costs and recognizing the causes of those differences. Studies indicated that variance
is the difference between standard performance and actual performance. It is the process of
scrutinizing variance by subdividing the total variance in such a way that management can
assign responsibility for off-Standard Performance.
Variance analysis has four steps:
1. Compute the amount of the variance.
2. Determine the cause of any significant variance.
3. Identify performance measures that will track those activities, analyse the
results of the tracking, and determine what is needed to correct the problem.
4. Take corrective action.
variance analysis: A Four-Step Approach to Controlling Costs
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The variance can be favourable variance or unfavourable variance. When the actual
performance is superior to the Standard, it resents "Favourable Variance." Likewise, where
actual performance is under the standard it is called as "Unfavourable Variance."
Variance analysis assists to fix the responsibility so that management can determine-
a. The amount of the variance
b. The reasons for the difference between the actual performance and
budgeted performance.
c. The person responsible for poor performance
d. Corrective actions to be taken.
Types of Variances: Variances is categorized into two categories that include Cost Variance
and Sales Variance.
Cost Variance: Total Cost Variance is the difference between Standards Cost for the Actual
Output and the Actual Total Cost sustained for manufacturing actual output. The Total Cost
Variance consists of:
I. Direct Material Cost Variance
II. Direct Labour Cost Variance
III. Overhead Cost Variance
Direct Material Variances: Direct Material Variances are also known as Material Cost
Variances. The Material Cost Variance is the difference between the Standard cost of
materials for the Actual Output and the Actual Cost of materials used for producing actual
output. The Material Cost Variance is computed as:
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Labour Cost Variance: Labour Cost Variance is the difference between the Standard Cost
of labour allowed for the actual output achieved and the actual wages paid. It is also termed
as Direct Wage Variance or Wage Variance. Labour Cost Variance is calculated as follow:
Overhead variance: Overhead is explained as the cumulative of indirect material cost,
indirect labour cost and indirect expenses. Overhead Variances may occur due to the
difference between standard cost of overhead for actual production and the actual overhead
cost incurred. The Overhead Cost Variance may be computed as follows:
Component of Variance
Analysis.
Sales variance: The Variances so far analysis is linked to the cost of goods sold. Quantum of
profit is derived from the difference between the cost and sales revenue. Cost Variances affect
the amount of profit positively or unfavourably depending upon the cost from materials, labour
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and overheads. Additionally, it is important to analyse the difference between actual sales and
the targeted sales because this difference will have a direct impact on the profit and sales.
Therefore the analysis of sales variances is important to study profit variances.
Sales Variances can be calculated by two methods:
I. Sales Value Method.
II. Sales Margin or Profit Method.
Basis of Calculation: Variance analysis emphasizes the causes of the variation in income and
expenses during a period compared to the financial plan. In order to make variances
significant, the idea of 'flexed budget' is used when calculating variances. Flexed budget acts
as a link between the original budget (fixed budget) and the actual results. Flexed budget is
prepared in retrospect based on the actual output. Sales volume variance accounts for the
difference between budgeted profit and the profit under a flexed budget. All remaining
variances are calculated as the difference between actual results and the flexed budget.
To summarize, Variance Analysis, is administrative accounting which denotes to the analysis
of deviations in financial performance from the standards definite in organizational budgets. In
Variance Analysis, the difference between actual cost and its budgeted or standard cost
segregated into price or quality component. It has been shown that favourable variance occurs
when output exceeds input or when the price paid for the goods and services is less than
anticipated. An unfavourable variance occurs when output is less than input or when the price
for goods and services is greater than expected.
Recent Developments in Accounting and
Responsibility Accounting:
Meaning of Responsibility Accounting:
One of the recent developments in the field of managerial accounting is the
responsibility accounting which is helpful in exercising cost control. It tries to control
costs in terms of the persons responsible for their incurrence.
According to the Certified Institute of Management Accounting, London,
“Responsibility accounting is a system of Management Accounting under which
accountability is established according to the responsibility delegated to various
levels of management and management information and reporting system instituted
to give adequate feed-back in terms of the delegated responsibility. Under this
system divisions or units of an organisation under specified authority in a person are
developed as a responsibility centre and evaluated individually for their performance.
A good system of transfer pricing is essential to establish the performance, and
results of each responsibility centre. Responsibility accounting is thus used as a
control technique”.
According to Charles T. Horngren,
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“Responsibility accounting is a system of accounting that recognises various
decision centres throughout an organisation and traces costs to the individual
managers who are primarily responsible for making decisions about the costs
in question”.
Eric L. Kohler defines responsibility accounting as
“a method of accounting in which costs are identified with persons assigned
to their control rather than with products or functions”.
According to David Fanning,
“Responsibility accounting is a system or mechanism for controlling the wider
freedom of action that executives—decision centre managers in other words—
are given by senior management and for holding those executives
responsible, for the consequences of their decisions”.
Responsibility accounting fixes responsibility for cost control purposes.
Responsibility accounting is a method of accounting in which costs and revenues are
identified with persons who are responsible for their control rather than with products
or functions.
This method of accounting classifies costs and revenues according to the
responsibility centres that are responsible for incurring the costs and generating the
revenues. Responsibility accounting focuses attention on responsibility centres. The
responsibility centres represent the sphere of authority decision points in an
organisation.
A large firm is generally divided into meaningful segments, departments or divisions
in order to have effective control. These segments, departments or divisions of an
organisation are called responsibility centres. Thus, a responsibility centre is a
specific unit of an organisation assigned to a manager who is held responsible for its
operations.
In the words of Anthony and Reece, “Responsibility centre is like an engine in that it
has inputs, which are physical quantities of material, hours of various types of labour
and a variety of services; it works with these resources usually; working capital and
fixed assets are also required. As a result of this work, it produces output, which are
classified either as goods, if they are tangible or as services, if they are intangible.
These goods or services go either to other responsibility centres within the company
or to customers in the outside world”.
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Responsibility accounting is used to measure both inputs and outputs of the
responsibility centre in monetary terms, wherever feasible. The total of various inputs
is called cost whereas the total of outputs is called revenue. Where monetary
measurement of output is not possible (as services rendered by the accounting
department to the organisation), then it may be measured in terms of total cost of
goods or services transferred, or as a number of units of output.
Types of Responsibility Centres:
The following are the main types of responsibility centres for management control
purposes:
(i) Cost (or Expense) Centres:
These are segments in which managers are responsible for costs incurred but have
no revenue responsibilities. The performance of each cost centre is evaluated by
comparing the actual amount with the budgeted/standard amount. Such centres may
be made according to location or person or service or type of product.
It is essential to differentiate between controllable costs and uncontrollable costs
while judging the performance of such centres. A manager responsible for a
particular cost centre will be held responsible for only controllable costs.
(ii) Revenue Centres:
It is a centre mainly devoted to raising revenue with no responsibility for production.
The main responsibility of managers of such centres is to generate sale revenue.
Such managers have nothing to do with the cost of manufacturing a product or in the
area of investment of assets. But he is concerned with control of marketing expenses
of the product.
(iii) Profit Centre:
This is a centre whose performance is measured in terms of both expenses it incurs
and revenue it earns. Thus, a factory may constitute a separate profit centre and sell
its production to other departments or the sales department. Even within the factory,
the service departments (as maintenance department) may sell their services to the
production department.
This is the practice in large undertakings where each divisional manager is given a
profit objective and his performance is measured accordingly. The main problem in
designing control system on the basis of profit centre arises in fixing transfer pricing.
(iv) Contribution Centre:
It is a centre whose performance is mainly measured by the contribution it earns.
Contribution is the difference between sales and variable costs. It is a centre devoted
to increasing contribution. The main responsibility of the manager of such a
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responsibility centre is to increase contribution. Higher the contribution, better will be
the performance of the manager of a contribution centre.
A manager has no control on fixed expenses because these expenses are constant
and depend on policy decisions of the higher level of ‘management. He can control
contribution by increasing sales and by reducing variable costs. The manger of such
a centre is to see that his unit operates at full capacity and contribution is maximum.
(v) Investment Centre:
It is a centre in which a manager can control not only revenues and costs but also
investments. The manager of such a centre is made responsible for properly utilising
the assets used in his centre. He is expected to earn a requisite return on the
amount employed in assets in his centre. Return on investments is used as a basis
of judging and evaluating performance of various people. Many large undertakings in
the U.S.A. like General Motors etc. follow this system of management control.
In calculating return on investments, beginning-of-period investment, end of period
investment or average investment may be taken. However, the choice seems to be
between beginning-of-period investment arid average investment. Divisional
investment is equal to net fixed assets of the division + current assets of the division
– current liabilities of the division.
Return on Investment (ROI) = Net Profit of the Division/Investment of the Division x
100
As an alternative to return on investment, the performance of the responsibility
centre can be measured by another method known as residual income method.
Under this method a charge for the use of assets (i.e., cost of capital) is deducted
from the divisional or responsibility’s centre profit and the surplus remaining after the
deduction of cost of capital or imputed interest is the residual income. Residual
income method is favoured in those cases where managers of responsibility centres
are autonomous and accountable for their performances and make their own
investment decisions.
Principles of Responsibility Accounting:
The individual managers of centres are held responsible for the incurrence and
control of costs relating to their responsibility centres. Responsibility and authority
should be clearly defined to get the desired results of responsibility accounting; thus
responsibility accounting refers to the principles, practices and procedures under
which costs and revenues are classified according to persons responsible for
incurring the costs and generating the revenues.
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It is a system in which the persons holding the supervisory posts as president,
departmental head, foreman etc. are given a report showing the performance of the
company, department or section as the case may be. The report will show the data
relating to operational results of the area and the items of which he is responsible for
control.
If certain items are not within the control of a particular centre, these should not be
included in the report of that centre. If at all included as share of maintenance costs
included in the report of production shop, this will be for information only and not for
control as the maintenance cost is not directly controlled by the production shop
foreman.
Thus, responsibility accounting is based on the basic principle that an executive will
be held responsible only for those acts over which he has control.
Responsibility accounting follows the basic principles of any system of cost control
like budgetary control and standard costing. It differs only in the sense that it lays
emphasis on human beings and fixes responsibilities for individuals. It is based on
the belief that control can be exercised by human beings; so responsibilities should
also be fixed for individuals.
Principles of responsibility accounting are as follows:
1. Determination of responsibility centres.
2. A target is fixed for each responsibility centre.
3. Actual performance is compared with the target.
4. The variances from the budgeted plan are analysed so as to fix the responsibility
of centres.
5. Corrective action is taken by the higher management and is communicated to the
responsibility centre i.e., the individual responsible.
6. Offer incentive as inducement.
7. All apportioned costs and policy costs are excluded in determining the
responsibility for costs because an individual manager has no control over these
costs. Only those costs and revenues over which an individual has a definite control
can be attributed to him for evaluating his performance.
For getting a correct appraisal of the performance of a particular responsibility
centre, distinction should be made between controllable costs and uncontrollable
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costs. Controllable costs are those costs which can be influenced or controlled by a
specified person whereas uncontrollable costs are those which cannot be controlled
or influenced by the action of a specified individual.
Uncontrollable costs should not be taken into consideration while evaluating the
performance of a particular responsibility centre over which the centre has no
control.
8. Report to responsible individual for action.
9. Transfer Pricing Policy. To get the desirable result of responsibility accounting, a
suitable transfer pricing policy should be followed.
Advantages of Responsibility Accounting:
1. It establishes a sound system of control.
2. It is tailored according to the needs of an organisation.
It forces the management to consider the organisational structure to result in
effective delegation of authority and placement of responsibility. It will be difficult for
individual manager to pass back unfavourable results as it clearly defines the
responsibility of each executive.
3. It encourages budgeting for comparison of actual achievements with the budgeted
figures.
4. It increases interests and awareness among the supervisory staff as they are
called upon to explain about the deviations for which they are responsible.
5. It simplifies the Structure of reports and facilitates the prompt reporting because of
exclusion of those items which are beyond the scope of individual responsibility.
6. It is helpful in following management by exception because emphasis is laid on
reporting exceptional matters to the top management.
Major Difficulties Encountered in Introducing Responsibility Accounting:
The following are the major difficulties encountered in introducing a system of
responsibility accounting:
(i) Generally, the prerequisites for a successful responsibility accounting scheme
(i.e., a well defined organisation structure, proper delegation of work and
responsibility, proper allocation of costs, a proper system of reporting etc.) are
absent and makes it difficult to have a responsibility accounting.
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(ii) It becomes difficult to have a further analysis of expenses than provided by
traditional classification of expenses. For example, wages of workman is controllable
but fringe benefits included in it have to be paid under law or as per agreement with
the workers’ union.
(iii) While introducing the system supervisory staff may require additional
classification especially in the responsibility reports. They must be explained properly
the purpose and benefits of the new system.
Accounting for Price Level Changes:
The following points highlight the four methods of price level accounting, i.e.,
1. Current Purchasing Power Technique (CPP) 2. Replacement Cost
Accounting Technique (RCA) 3. Current Value Accounting Technique (CVA) 4.
Current Cost Accounting (CCA).
Method of Price Level Accounting # 1. Current Purchasing Power Technique:
Current Purchasing Power Technique of accounting requires the companies to keep
their records and present the financial statements on conventional historical cost
basis but it further requires presentation of supplementary statements in items of
current purchasing power of currency at the end of the accounting period.
In this method the various items of financial statements, i.e. balance sheet and profit
and loss account are adjusted with the help of recognized general price index. The
consumer price index or the wholesale price index prepared by the Reserve Bank of
India can be taken for conversion of historical costs.
The main objective of this method is to take into consideration the changes in the
value of money as a result of changes in the general price levels. It helps in
presenting the financial statements in terms of a unit of measurement of constant
value when both cost and revenue have been changing due to changes in the price
levels.
This technique of price level accounting has been followed by a number of
companies in Germany, Australia and U.S.A. But although this method is simple, it
may be considered as only a first step towards inflationary accounting.
The major weaknesses of these techniques are as follows:
(i) As it takes into account the general price index, it does not account for changes in
the individual assets of the company. Sometimes it is possible that there may be an
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increase in the general price index, but there may not be any increase (rather there
might be a decrease) in the value of a particular asset of a certain company.
(ii) The technique seems to be more of theoretical nature than of any practical utility.
(iii) In a country like India, even the price indices may not be correct and it may
further cause inaccurate presentation of the financial statements.
Mechanism of Preparing Financial Statement under CPP Method:
(a) Conversion Technique:
Current Purchasing Power Method (CPP) requires conversion of historical figures at
current purchasing power. In this method, various items of balance sheet and profit
loss account are adjusted with the help of recognized general price index. The
consumer price index or the wholesale price index prepared by the Reserve Bank of
India can be taken for conversion of historical costs. For this purpose, historical
figures must be multiplied with the conversion factor. The conversion factor can be
calculated with the help of the following formula:
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(i) (b) Mid-Period Conversion:
There are several transactions which take place throughout the year such as purchases,
sales, expenses, etc. For conversion of such items, average index of the year can be taken
as the one index for all such items. If such an average is not available, the index of the midyear is taken for this purpose. And, if the index of the mid year is also not available, then the
average of index at the beginning and at the end of the period may be taken.
(ii) (c) Monetary and Non-Monetary Accounts (Gain or Loss on Monetary items):
For the conversion of historical costs in terms of current purchasing power of
currency, it is useful to make a distinction between:
(a) Monetary accounts, i.e., money value items;
(b) Non-monetary accounts, i.e., real value items.
Monetary accounts are those assets and liabilities which are not subject to reassessment of
their recorded values owing to change of purchasing power of money. The amounts of such
items are fixed, by contract or otherwise in term of rupees, regardless of change in the
general price level.
The examples of such items are cash, debtors, bills receivables, outstanding incomes, etc.,
as assets and creditors, bills payable, loans etc., as liabilities. Such items whose amounts
are fixed and do not require reassessment are also known as money value items.
Other assets and liabilities, the values of which do change or are subject to reassessment
along-with the change in the purchasing power of money are called non-monetary items or
real value assets and liabilities. Non-monetary: items include items such as stocks, land,
building, plant and machinery, etc.
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It must be noted that, in the process of conversion, it is only the non monetary items which
are adjusted to the current purchasing power of money. Further, if assets and liabilities are
converted as stated above, it may be found that a loss or gain arises from the difference of
the converted total value of assets and that of liabilities. This loss or gain arises through
monetary items or money value assets and liabilities i.e., cash, debtors, receivables,
creditors, bills payable, etc., and not through real value assets and liabilities or non-monetary
items.
The computation of monetary gain or loss can be followed with the help of the following
illustrations.
Illustration 4:
A company has the following transactions at the given dates and price indices for the
first quarter of 2008:
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(iii) (d) Adjustment of Cost of Sales and Inventory:
As inventory is purchased in period n and sold in (n + x) period, there is a time gap between
purchases and sales. During this time, there might be changes in the price levels. Because
of inflation, the selling prices would indicate the value realized in terms of the increased price
levels and costs which relate to the earlier periods would imply lower values.
This results in over-statement of profits which are often misleading. The same is true is in
deflation also, as current revenues are not matched with current costs. Hence, adjustment of
inventory and cost of sales is very important. This adjustment depends upon the method
adopted for the outflow of inventories, viz., first-in-first-out or last-in-first-out.
Under first-in-first out method (FIFO) cost of sales comprise the entire opening stock and
current purchases less closing stock. The closing inventory is entirely from current
purchases. But under the last-in-fist-out method (LIFO) cost of sales comprise mainly of the
current purchases and it is only when the cost of sales exceeds current purchases, opening
stock enters into cost of sales. The closing stock enters current purchases opening stock
enters into cost of sales. The closing inventory in LIFO is out of the purchases made in the
previous year.
For adjusting the figures for price level changes the following indices are applied:
(a) For current purchases—the average index of the year.
(b) For opening stock—the index at the beginning of the year.
(c) For purchases of previous year—the average index of the relevant year.
This process of adjustment of cost of sales and inventory has been explained in the following
illustration.
Illustration 6:
From the information given below, ascertain the cost of sales and closing inventory
under CPP method, if (i) LIFO and (ii) FIFO is followed:
Solution:
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(iv)
(e) Ascertainment of Profit:
Profit under Current purchasing Power (CPP) accounting can be ascertained in two
ways:
(i) Net Change Method:
This method is based on the normal accounting concept that profit is the change in equity
during an accounting period. Under this method, the openings as well as closing balance
sheets are converted into CPP terms by using appropriate index numbers. The difference in
the balance sheet is taken as reserves after converting the equity capital also.
If equity capital is not converted, it may be taken as the balancing figure. It must be
remembered that in the closing balance sheet, the monetary items will remain unchanged.
Profit is calculated as the net change in reserves, where equity capital is also converted; and
will be equal to net change in equity, where equity is not converted.
(ii) Conversion of Income Method:
Under this method, the historical income statement is converted in CPP terms. Purchases,
sales and other expenses which are incurred throughout the year are converted at average
index. Cost of sales is adjusted as discussed in point (d) above. Depreciation can be
calculated on converted values. Monetary gain or loss is also ascertained as explained in
point, (c) The process of ascertainment of profit under the CPP accounting can be followed
with the help of the following s
Illustration 7:
Arjun Ltd. furnishes the following income statement for the year ending 31st
December 2007, prepared on the basis of conventional accounting. You are required
to adjust the same for price level changes under CPP method.
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Illustration 8:
The Glamour Corporation has prepared the following comparative position statement
(unadjusted):
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Assuming that all sales and purchases were made at an average of the period, beginning
and ending price indices.
(a) Prepare comparative position statements for January 1,2011 and December 31, 2011,
where all items are expressed in terms of rupees of the value of December 31, 2011;
(b) Compute monetary gain or losses;
(c) Prepare an income statement that shows all items in rupees of year-end purchasing
power. This statement should include the monetary gain or loss and a reconciliation of
changes in the stock equity.
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(b) Method of Price Level Accounting # 2. Replacement Cost Accounting
Technique:
Replacement Cost Accounting (RCA) Technique is an improvement over Current Purchasing
Power Technique (CPP). One of the major weaknesses of Current Purchasing Power
technique is that it does not take into account the individual price index related to the
particular assets of a company.
In the Replacement Cost Accounting technique the index used are those directly relevant to
the company’s particular assets and not the general price index. In this sense the
replacement cost accounting technique is considered to be a improvement over current
purchasing power technique.
But adopting the replacement cost accounting technique will mean using a number of price
indices for conversion of financial statements and it may be very difficult to find out the
relevant price index to be used in a particular case. Further, the replacement cost accounting
technique provides for an element of subjectivity and on this ground it has been criticized by
various thinkers.
(i) Depreciation and Replacement of Fixed Assets:
Another problem posed by the price level changes (and more so by inflation) is that how
much depreciation should be charged on fixed assets.
The purpose of charging depreciation is twofold:
(i) To show the true and fair view of the financial statements and the profitability of the
concern, and
(ii) To provide sufficient funds to replace the assets after the expiry of the life of the asset.
Depreciation charged on historical or original cost does not serve any of the two purposes.
Suppose a machine was purchased in 2000 for Rs 1, 00,000 having a life of 10 years. In
case depreciation is charged on original cost, after 10 years we shall have Rs 1, 00,000 from
the total depreciation provided. But due to inflation the cost of the machine might well have
gone up to Rs 2, 00,000 or even more in 2011 when the machine is to be replaced and we
may find it difficult to replace the asset.
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It proves that we have been charging less depreciation which resulted in overstatement of
profits and higher payment of dividends and taxes in the past and insufficient funds now to
enable the replacement of the asset. Hence, to rectify this, it is necessary that fixed assets
are valued at replacement cost values and depreciated on such replacement cost values.
But adopting replacement cost method is also not free from difficulties.
The main difficulties are as follows:
(1) It is not possible to find accurately the replacement cost till the replacement is actually
made.
(2) The replaced new assets are not of the same type and quality as old assets because of
new developments and improved qualities.
(3) Income Tax Act. 1961 does not provide for any other method than the actual cost
method.
(4) The fixed assets should not be written-up in the balance sheet when the prices are not
stable.
Hence, it may not be possible to charge depreciation on replacement cost basis. However, it
is still advisable to retain profits ad restrict dividends so as to enable funds for replacement
of fixed assets. For this purpose. ‘Specific Capital Reserves’ or ‘Replacement Reserves’
should be provided in addition to the normal depreciation provided on actual cost of the
asset.
Illustration 9:
The following information has been extracted from the books of a company.
The general price index in 2000 (base year) was 100: in 2006,200 and in 2011 it was 300.
The replacement cost of the assets on 31st December is Rs 80,000. Rs 1, 00,000 and Rs 1,
50,000 respectively.
You are required:
(i) To calculate the amount of depreciation up to 2000 on Historical Cost and Current
Purchasing Power basis and
(ii) To make necessary entries for recording the changes in the ledger using the index
numbers and the replacement cost.
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(c) Method of Price Level Accounting # 3. Current Value Accounting Technique:
In the Current Value Accounting Technique of price level accounting all assets and liabilities
are shown in the balance sheet at their current values.
The value of the net assets at the beginning and at the end of the accounting period is
ascertained and the difference in the value in the beginning and the end is termed as profit
or loss, as the case may be. In this method also, like replacement cost accounting
technique, it is very difficult to determine relevant current values and there is an element of
subjectivity in this technique.
Illustration 10:
The following are the Balance Sheets of XYZ Company Limited.
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(d) Method of Price Level Accounting # 4. Current Cost Accounting Technique:
The British Government had appointed a committee known as Sandilands Committee under
the chairmanship of Mr. Francis C.P. Sandilands to consider and recommend the accounting
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for price level changes. The committee presented its report in the year 1975 and
recommended the adoption of Current Cost Accounting Technique in place of Current
Purchasing Power of Replacement Cost Accounting Technique for price level changes.
The crux of the current cost accounting technique is the preparation of financial statements
(Balance Sheet and Profit and Loss Account) on the current values of individual items and
not on the historical or original cost.
The essential characteristics of current cost accounting technique are as follows:
1. The fixed assets are shown in the balance sheet at their current values and not on
historical costs.
2. The depreciation is charged on the current values of the fixed assets and not on original
costs.
3. Inventories or stocks are valued in the balance sheet at their current replacement costs on
the date of the balance sheet and not cost or market price whichever is lower.
4. The cost of goods sold is calculated on the basis of their replacement cost to the business
and not on their original cost.
5. The surpluses arising out of revaluation are transferred to Revaluation Reserve Account
and are not available for distribution as dividend to the shareholders.
6. In addition to the balance sheet and profit and loss account, an appropriation account and
a statement of changes is prepared.
The current cost accounting (CCA) technique has been preferred to the current purchasing
power (CPP) technique of price level accounting as it is a complete system of inflation
accounting. The financial statements prepared under this technique provide more realistic
information and make a distinction between profits earned from business operations and the
gains arising from changes in price levels.
As depreciation under CCA is provided on current cost, the method prevents overstatement
of profits and keeps the capital intact. The effect of holding monetary items in terms of gains
and losses having an impact on the finance of the business is also highlighted.
However, there are many difficulties in the operation of CCA technique:
(a) It is very difficult to determine the ‘value to the business’ of a real asset.
(b) There is an element of subjectivity in this technique.
(c) It does not hold good during the periods of depression.
(i) Some Important Adjustments Required under the CCA Technique:
(i) Current Cost of Sales Adjustment (COSA):
Under the CCA technique, cost of sales are to be calculated on the basis of cost of replacing
the goods at the time they are sold. The important principle is that current costs must be
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matched with current revenues. As for sales are concerned, it is current revenue and out of
the costs, all operating expenses are current costs. But in case of inventories, certain
adjustments will have to be made, known as cost of sales adjustment.
Cost of sales adjustment can be calculated with the help of the following formula:
Illustration 11:
Calculate the ‘Cost of sales adjustment’ (COSA) from the following:
Illustration 12:
A machine was purchased on 1.1.2004 at a cost of Rs 10, 00,000 and its useful life was
estimated to be 10 years. Its replacement cost was Rs 18, 00,000 on 1.1.2009 and Rs 20,
00,000 on 31.12.2009.
Calculate the amount of depreciation adjustment.
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(iii) Backlog Depreciation:
Whenever an asset is revalued, the profit on revaluation is transferred to Revaluation
Reserve Account. But, the revaluation also gives rise to backlog depreciation. This backlog
depreciation should be charged to Revaluation Reserve Account.
The concept of backlog depreciation can be followed with the help the following
illustration:
Illustration 13:
Compute the backlog depreciation from the information given in illustration 14.
(iv) Monetary Working Capital Adjustment (MWCA):
Working capital is that part of capital which is required to meet the day to day expenses and
for holding current assets for the normal operations of the business. It is referred to as the
excess of current assets over current liabilities. The changes in the price levels disturb the
working capital position of a concern.
CCA method requires a financing adjustment reflecting the effects of changing prices on net
monetary items, leading to a loss from holding net monetary assets or to a gain from holding
net monetary liabilities when prices are rising, and vice-versa, in order to maintain the
monetary working capital of the enterprise. This adjustment reflects the amount of additional
finance needed to maintain the same working capital due to the changes in price levels. The
method of calculating MWCA is the same as that of COSA. Symbolically.
176
Illustration 14:
Calculate the Monetary Working Capital Adjustment (MWCA) from the following data:
(v) Current Cost Operating Profit:
Current cost operating profit is the profit as per historical cost accounting before charging
interest and taxation but after charging adjustments of cost of sales, depreciation and
monetary working capital.
(vi) Gearing Adjustment:
During the period of rising prices, shareholders are benefitted to the extent fixed assets and
net working capital are financed while the amount of borrowings to be repaid remains fixed
except interest charges. In the same manner, there is a loss to the shareholders in the
period of falling prices. To adjust such profit or loss on account of borrowings, ‘gearing
adjustment’ is required to be made. ‘Gearing adjustment’ is also a financing adjustment like
COSA and MWCA. This adjustment reduces the total adjustment for cost of sales,
depreciation and monetary working capital in the proportion of finance by borrowings to the
total financing.
Gearing adjustment can be calculated with the help of the following formula:
177
Illustration 15:
178
179
180
e-Exercises to check your understanding
https://myglaonline.com/mod/quiz/view.php?id=804
https://myglaonline.com/mod/quiz/view.php?id=792
https://myglaonline.com/mod/quiz/view.php?id=803
https://myglaonline.com/mod/quiz/view.php?id=800
https://myglaonline.com/mod/quiz/view.php?id=15657
181
Acknowledgements
GLA University, Mathura faculties have taken references and used the learning
material from the below referred Open Educational Purposes for the development of
Quadrant 2 material for their online Learners.
Area
Subject
Principles of Management
General
https://open.umn.edu/opentextbooks/tex
tbooks/693
Mastering Strategic
https://open.umn.edu/opentextbooks/tex
Management
tbooks/73
Organizational Behavior
Introduction to Financial
Accounting
Principles of Accounting
Principles of Accounting,
Volume 2: Managerial
Accounting
Accounting
OER link
https://open.umn.edu/opentextbooks/tex
tbooks/organizational-behavior-2019
https://lifa1.lyryx.com/textbooks/ANNAN
D_1/marketing/DauderisAnnandIntroFinAcct-2019B.pdf
https://openstax.org/details/books/princip
les-financial-accounting
https://openstax.org/details/books/princip
les-managerial-accounting
Accounting Principles: A
https://lib.lavc.edu/c.php?g=571229&p=5
Business Perspective
250121
Intermediate Financial
https://lyryx.com/intermediate-financial-
Accounting, Vol 1
accounting-volume-1/
https://ocw.mit.edu/courses/science-
Finance and Society
technology-and-society/sts-002-financeand-society-spring-2016/
Managerial Accounting
Introduction to Business
Business
Fundamentals of Business
http://saylordotorg.github.io/text_manage
rial-accounting/index.html
https://openstax.org/details/books/introd
uction-business
http://vtechworks.lib.vt.edu/handle/1091
9/84848
182
Business Ethics
https://open.lib.umn.edu/businesscommu
Success
nication/
ss-law-i-essentials
https://lib.lavc.edu/c.php?g=571229&p=5
Educational Resource
250651
Business Math: A Step-By-Step
https://lyryx.com/subjects/business/busin
Handbook
ess-mathematics/
Introductory Business
https://openstax.org/details/books/introd
Statistics
uctory-business-statistics
Principles of Macroeconomic
Principles of Microeconomics
The Process of Research
Writing
Principles of Marketing
Marketing
https://openstax.org/details/books/busine
Business Law: An Open
Principles of Economics
Research
ss-ethics
Business Communication for
Business Law
Economics
https://openstax.org/details/books/busine
eMarketing: The Essential
Guide to Marketing in a Digital
World
https://openstax.org/details/books/princip
les-economics-2e
https://lyryx.com/subjects/economics/prin
ciples-of-macroeconomics/
https://openstax.org/details/books/princip
les-microeconomics-2e
http://www.stevendkrause.com/tprw/
https://scholar.flatworldknowledge.com/b
ooks/31288/preview
https://open.umn.edu/opentextbooks/tex
tbooks/14
183