MBA-Financial and Management Accounting
May 7, 2017 | Author: MahoKukhianidze | Category: N/A
Short Description
financial and managerial accounting, MBA short course...
Description
Financial and Management Accounting MB 0025 Contents Unit 1 Financial Accounting – An Introduction
1
Unit 2 Accounting Concepts, Principles, Bases and Policies
14
Unit 3 Double Entry Accounting
29
Unit 4 Primary Books
48
Unit 5 Secondary Books
71
Unit 6 Trial Balance
86
Unit 7 Final Accounts
105
Unit 8 Introduction to Management Accounting
140
Unit 9 Financial Statement Analysis Edition: Fall 2008
149
Contents Unit 10 Funds Flow Analysis
184
Unit 11 Cash Flow Analysis
229
Unit 12 Understanding Cost
243
Unit 13 Marginal Costing and Break Even Analysis
264
Unit 14 Budgetary Control
281
Unit 15 Standard Costing
Edition: Fall 2008
BKID – B0668
300
Dr. K. Jayakumar Vice Chancellor Sikkim Manipal University of Health, Medical, and Technological studies Prof. Nandagopal V. B. Director and Dean Sikkim Manipal University of Health, Medical, and Technological studies.
Board of Studies Dr. T. V. Narasimha Rao Professor, Manipal Universal Learning
Prof. K. V. Varambally
Ms. Vimala Parthasarathy Asst. Professor, Sikkim Manipal University of Health, Medical and Technological studies.
Mr. Shankar Jagannathan Former Group Treasurer Wipro Technologies Limited, Bangalore
Ms. Sadhana Dash
Mr. Abraham Mathews
Senor Manager HR Microsoft India corporation ( Pvt) limited
Chief Financial Officer Infosys BPO, Bangalore
Director, Manipal Institute of Management, Manipal
Mr. Pankaj Khanna Director, HR, Fidelity Mutual Fund
Content Preparation Team
Peer Review By
1. Dr. Y. Rajaram Adjunct Faculty, Manipal Universal Learning
Dr. Nagesh Malavalli Principal & Professor of Finance & Accounting M.P. Birla Institute of Management, Bangalore
2. Mr. S. N. Dorai Raj Retd Principal & Professor of commerce, Seshadripuram College, Bangalore. Edition: Fall 2008 This book is a distance education module comprising of collection of learning material for our students. All rights reserved. No part of this work may be reproduced in any form by any means without permission in writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim. Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd., Manipal – 576 104. Printed at Manipal Press Limited, Manipal.
INTRODUCTION
Accounting is a systematic effect of collecting. Classifying and analyzing financial information for effective use in decision making activities. There are two facts of accounting namely Financial Accounting and Management Accounting. While financial accounting is concerned with recording and preparation of financial statements, management accounting focuses on using the information for planning, decision making and controlling the financial activities of business enterprise. In view of the fast changing scenario world over, MBA students should acquaint themselves with rudiments of the subject. This book contains 15 Units.
Unit 1:
Financial Accounting – An Introduction Presents an overview of meaning, purpose and evolution of accounting and introduces basic terminology.
Unit 2:
Accounting Concepts, Principles, Bases and Policies Briefly describes the accounting concepts and assumption in financial accounting.
Unit 3:
Double Entry Accounting Deals with basic accounting principles of Double – entry system.
Unit 4:
Primary Books Contains details of primary books General journal and subsidiary books.
Unit 5:
Secondary Books Covers the process of posting from primary books to ledger, which is called secondary book.
Unit 6:
Trial Balance Deals with the process of preparing trial balance, errors and rectification.
Unit 7: Final Accounts Describes the Preparation of final accounts – Trading A/c, P & L A/c and Balance sheet.
Unit 8:
Introduction to Management Accounting Presents the meaning and scope of Management Accounting.
Unit 9:
Financial Statement Analysis Deals with ratio analysis as a part of analysis of financial statements.
Unit 10: Funds Flow Analysis Focuses on fund flow analysis.
Unit 11: Cash Flow Analysis Gives a brief sketch of cash analysis.
Unit 12: Understanding Cost Throws light on meaning and role of cost accounting.
Unit 13: Marginal Costing and Break Even Analysis Introduces the tool of marginal costing and its usage.
Unit 14: Budgetary Control Provides an insight of budgets – as a means of control.
Unit 15: Standard Costing Introduces the technique of standard costing as an effective controlling system.
Reference Books: 1. 2. 3. 4. 5. 6.
Accounting for managers by Jawahara Lal. Financial Accounting by S.N.Maheswari. Financial Accounting for Managers by R.Narayana Swamy. Introduction to Management by Anthony Reece. Management Accounting by Manmohan and Goel. Cost and Management Accounting to Horugren etal.
Financial and Management Accounting
Unit 1
Unit 1
Financial Accounting – An Introduction
Structure: 1.1
Introductions Objectives
1.2
Evolution Self Assessment Questions 1
1.3
Need Self Assessment Questions 2
1.4
Meaning of Accountancy, book – keeping and Accounting Self Assessment Questions 3
1.5
Characteristics Self Assessment Questions 4
1.6
Functions and objectives of accounting Self Assessment Questions 5
1.7
Difference between book – keeping and accounting, accountancy Self Assessment Questions 6
1.8
Financial accounting and management accounting Self Assessment Questions 7
1.9
Basic terms Self Assessment Question 8
1.10 Summary Terminal Questions Answer to SAQs and TQs
1.1 Introduction Accounting is a branch of knowledge, concerned with recording classifying, analyzing and reporting financial information to owners, bankers, creditors, government and host of stakeholders regarding the financial performance of organizations - business or bon-business entities. Over a period of time, accounting has assumed a status of a science and an art. In order to achieve uniformity globally, international standards have also emerged in accounting. In this Unit, the historical perspective of Accounting, its meaning, functions and basic terms used in the subject are discussed. Sikkim Manipal University
1
Financial and Management Accounting
Unit 1
Learning Objectives: After studying this unit, you should be able to understand the following
1. To expose the students with meaning, need and purpose of accounting. 2. To know the functions Accounting. 3. To understand the difference between Financial Accounting and Management Accounting. 4. To acquaint with the basic terminology used in the subject. 1.2 Evolution of Financial Accounting Any branch of knowledge does not emerge all of a sudden. Knowledge is a product of continuous intellectual exercise and the changes in the environmental and social demands. Accounting is an ancient art. Michael Russel in his article ‘Evolution of Accounting’ points out that as early as 8500 B.C, accounting was existing. Archeologists have found clay tokens as old as 8500 BC in Mesopotamia which were usually cones, disks, spheres and pellets. These tokens correspond to such commodities like sheep, clothing or bread. They were used in the Middle West in keeping records. Similarly in ancient civilizations like China, Babylonia, Greece and Egypt, record keeping was in practice in the same manner as stated above. During 3600 BC in Babylonia payment of salaries was recorded in clay tablets. The rulers of these civilizations kept track of labour and material costs by using accounting methods. In an article published by John R. Alexander on ‘History of Accounting’, he stated that an improved system of book keeping known as double entry book keeping was introduced in 14th century and the following seven key ingredients were responsible for the creation of double entry book keeping. •
Private property: The power to change ownership, because book keeping is concerned with recording the facts about property and property rights
•
Capital: Wealth productively employed, because otherwise commerce would be trivial and credit would not exist
•
Commerce: The interchange of goods on a widespread level, because purely local trading in small volume would not create the sort of press of business needed to spur the creation of an organized system to replace the existing hodgepodge of record keeping
•
Credit: The present use of future goods, because there would have been little impetus to record transactions completed on the spot.
Sikkim Manipal University
2
Financial and Management Accounting
•
Unit 1
Writing: A mechanism for making a permanent record in a common language given the limits of human memory.
•
Money: The common denominator for exchange, since there is no need for book keeping except as it reduces transactions to a set of monetary values.
•
Arithmetic: A means of computing the monetary details of the deal.
Double entry records first came out during 1340 A.D. in Genoa. In 1494, the first systematic record keeping was formulated by Fra Luca Pacioli a Franciscan monk and one of the most celebrated mathematicians to this day. Pacioli is considered as the father of accounting. Michael Russel, in his article states that industrial revolution, which brought paradigm changes in the working and business transactions paved way to the specialized field of accounting called ‘cost accounting’ in order to meet the need for the analysis of various costs. Mean while, corporate form of organisation came into being which made it necessary to report financial information to the owners (shareholders) by the management. Virtually management and ownership got separated and to instill confidence of the shareholders, managers had to submit reports, as prepared on the basis of accounting information. Welsch and Anthony, in their book’ Fundamentals of Financial Accounting’, comment that the growth of business organizations in size, particularly publicly held corporations, has brought pressure from stock holders, potential investors, creditors, government agencies, and the public at large, for increased financial disclosure. The public’s right to know more about organizations that directly or indirectly affect them (whether or not they are shareholders) is being increasingly, recognized as essential. An open society is one that has a high degree of freedom at the individual level and typically evidences an effective commitment to measuring the quality of life attained. These characteristics make it essential that the members of the society be provided adequate, understandable, and dependable financial information from the major institutions that comprise it. So accountants have a greater responsibility of not only being accurate but also transparent to the possible extent. At present, there have been tremendous advancements in accounting to meet the needs brought about by information technology. Work is done faster, more accurate, and more dependable by using computers. Business can be transacted without even facing one another and accounting has become so customer friendly that records and reports are generated instantaneously to all parties concerned. Self Assessment Questions 1: Sikkim Manipal University
3
Financial and Management Accounting
Unit 1
1. __________ is the father of Accounting. 2. A new accounting system called _______ emerged during industrial revolution. 3. Double Entry book keeping was introduced during ___________ century.
1.3 Need Economic activities are carried on by trading and non-trading organizations, the former with profit motive and the latter with a focus on service. Business is prominently carried on under different forms of organizations, namely sole trading, partnership, Hindu undivided family firms (HUF), cooperative societies and companies. Having invested capital in the business, one has to find out at the end of a particular period whether the business has yielded any profit or loss; any assets are created; the liabilities payable; total expenses incurred; total revenues generated and so on and so forth. Innumerable business transactions might have taken place during the period and remembering all transactions is humanly impossible, let alone finding the results of the transactions. Even to put them in a computer, it requires a systematic approach to record, classify, analyse and report the financial data to the stake holders of a business enterprise. Precisely for this purpose, financial accounting is needed. Proprietor/s in case of sole trading and partnership firms, members in case of cooperative institutions, shareholders in case of companies, suppliers, customers, tax authorities, banking institutions, lenders, borrowers, employees, government agencies and general public are the various parties interested in the financial information of a business enterprise and each one them is interested in different aspects of the business. Accounting information has to be supplied in a prescribed manner to these parties and this information is contained in the form of different statements such as trading account, profit and loss account, balance sheet, cash flow statement, fund
flow
statement,
statement
of
investments
and
so
on.
While
a
proprietor/
partner/member/shareholder is interested in profit and loss account and balance sheet, bankers are interested in cash and fund flow statements in addition to P&L account and balance sheet, government is interested in the amount of tax collections, employees are interested in P&L account, customers, in total sales, suppliers in cash statements, security analysts in the ratio analysis of various financial parameters of the business organization. Financial accounting fulfills the aspirations of the above parties regarding the enterprise. Thus Accounting has emerged for two purposes, namely to record all business transactions since one can not remember them and communicate the results of financial data to all interested parties.
Sikkim Manipal University
4
Financial and Management Accounting
Unit 1
Self Assessment Questions 2: 1. What are the two purposes of accounting? 2. Shareholders of a company are interested in ______ and _______ of a business. 3. Bankers are interested in _________ and _______ besides P&L A/C and balance sheet.
1.4 Meaning of Accountancy, Book-keeping and Accounting Book-keeping, accounting and accountancy are the terms used in the science of financial accounting. Book-keeping means recording of business transactions in the books of accounts in accordance with the principles of accounting. Book keeping is an adjunct for accounting. Day to day transactions are entered in a systematic manner to facilitate the preparation of profit and loss account, balance sheet and other statements containing information about debtors, creditors, tax payment etc., For the purpose of recording the financial data, debit and credit principles are adopted so that cross checking is made possible, summary of each account is known at the end of an accounting period. Accounting on the other hand is the discipline of measuring, communicating and interpreting financial activities and it is widely referred to as language of business. Way back in 1941, the definition for the word Accounting was given by the Committee on Terminology of the American Institute of Chartered Public Accountants, (AICPA)thus, ‘accounting is an art of recording, classifying and summarizing in a significant manner and terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.’ The American Accounting Association (AAA) in 1966 provided the following definition: “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information” In 1970, the AICPA emphasized accounting with reference to the concept of information.. Accounting is treated as a service activity. The function of accounting is to provide quantitative information, primarily financial in nature, and about economic activities, that is intended to be useful in making economic decisions. Accountancy is the profession and the practitioners of accountancy are called accountants. Therefore book keeping is the basic activity of recording, accounting is the analysis and reporting function and accountancy is the profession of carrying the above activities. Self Assessment Questions 3: Sikkim Manipal University
5
Financial and Management Accounting
Unit 1
1. What is book keeping? 2. Define Accounting. 3. Accountancy is a __________ and the practitioners of accountancy are __________ .
1.5 Characteristics of Accounting From the above definitions of Accounting, one can list out the characteristics of accounting: 1. Accounting is an art and science: Recording and maintenance of accounts of various transactions needs special skill and knowledge. Reading and interpreting the results, obtained by the accounting system requires experience. From this angle, accounting is an art. Accountants are endowed with this special skill and aptitude and it is difficult to acquire proficiency in this art. It is like a doctor who diagnoses and prescribes medicines just by looking to the medical reports, an accountant on a gaze of the financial reports can find out the financial health of an enterprise and suggests measures to improve the financial position. Accounting is also a science, not like physics or chemistry, but it is an exacting science. Accounting is governed by definite principles, rules, concepts, conventions and policies. A systematic and scientific approach is adopted to classify, record, analyse and interpret the accounting information. 2. Accounting involves a process of identifying, classifying and recording financial information, expressed in terms of money. All financial transactions are expressed in terms of money. Incomes, expenses, acquisition of assets, payment of liabilities, capital of shareholders etc., are stated in money terms and all transactions are broadly classified as related to definite heads of account, namely – personal, real and nominal. After classification, they are recorded in the books of original entry as per the accounting principles. The book of original entry is called Journal. From Journal, the transactions are summarized under each head of relevant account and posting takes place to a book called ledger. At the end of a particular accounting period, the gist or the net balance of all ledger accounts is aggregated to prepare a trail balance. From trial balance, it is possible to prepare trading, profit and loss accounts and balance sheet. 3. Events of non financial nature can not be recorded, even though such events may have an impact on the operational results of the enterprise. For instance financial manager and production manager of a concern
do not have good relationship and owing to this the
production process is affected and subsequently the profitability. This event of non financial nature can not be reflected in accounts.
Sikkim Manipal University
6
Financial and Management Accounting
Unit 1
4. Accounting is an information system. The results of analysis and interpretation are communicated to the management and other interested parties. Internal control is effectively exercised and accountability is ensured through accounting information. 5. It helps in taking managerial decisions. Self Assessment Questions 4: 1. The book of original entry is called __________ . 2. Profitability of an enterprise is affected if the finance manager and production manager do not agree each other. Does this picture in accounts?
1.6 Functions and Objectives of Accounting From the above paragraphs, it can be concluded that accounting involves the following functions and objectives. a) Systematic recording of all business events or transactions and subsequent posting to ledger to finally prepare financial statements – profit and loss account and balance sheet. b) Reporting the results to management, shareholders, creditors, bankers, investors, stock brokers, stock exchanges, employees, governments etc., c) Satisfying the statutory requirements, especially of Registrar of Companies, SEBI (Securities Exchange Board of India) in case the company is listed, tax authorities (sales tax, excise, customs, income tax) and government in order to protect the interest of general public. d)
Protecting the properties of business by recording them on the date of acquisition and showing their accounts in the balance sheet.
e) It helps for internal control by holding the concerned persons responsible for any errors, lapses or under performance. Equally it helps to identify the strong areas of excellent performance and subsequently pin point the individuals or departments to be rewarded or appreciated. f)
Accounting is a tool for effective planning. Current year’s financial performance becomes the basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the functions of accounting.
Self Assessment Questions 5: 1. State any two functions of accounting. 2. Name the different parties to whom accounting information has to be reported?
Sikkim Manipal University
7
Financial and Management Accounting
Unit 1
1.7 Differences between Book Keeping and Accounting As already said, book keeping is a system of recording the day to day transactions in the books of enterprise. Accounting enjoys wider scope and includes not only book keeping but also analysis, interpretation and reporting of financial information. The later part of accounting is the core function of accounting. Now - a-days, owing to information technology, ready made packages like Tally are available, which facilitate entry of transactions and preparation of ledger accounts are made easy. In case of large industrial enterprises and multi national corporations, regular journal entries are not recorded owing to very large number of transactions taking place day in and day out. On the other hand subsidiary books such as cash book, sales book, purchases book, bills receivable book are prepared and ledger accounts are drawn from them. The differences between book keeping and accounting are as under: Book keeping
Accounting
•
It is a process of recording the transactions in books of accounts
•
It includes recording, communicating
analyzing
and
•
Adopt principles of accounting for recording
•
Analysing and interpreting requires skill, knowledge and experience
•
Book keeping is an adjunct to accounting
•
Accounting starts when book keeping ends
•
The objective is to prepare final accounts and balance sheet at the end of accounting period
•
The objective is to inquire and find out the reasons for financial results and communicate the results to all stakeholders in a manner they understand.
Self Assessment Questions 6: 1. When book keeping ends, ________________ commences. 2. State two differences between book keeping and accounting.
1.8 Financial Accounting and Management Accounting Financial accounting is the preparation and communication of financial information to outsiders such as creditors, bankers, government, customers and so on. Another objective of financial accounting is to give complete picture of the enterprise to shareholders. Management accounting on the other hand aims at preparing and reporting the financial data to the management on regular basis. Management is entrusted with the responsibility of taking appropriate decisions, planning, performance evaluation, control, management of costs, cost determination etc., For
Sikkim Manipal University
8
Financial and Management Accounting
Unit 1
both financial accounting and management accounting the financial data is the same and the reports prepared in financial accounting are also used in management accounting But the following are major differences between Financial accounting and Management accounting.
Financial accounting
Management accounting
•
The primary users of financial accounting information are shareholders, creditors, government authorities, employees etc.,
•
Top, middle and lower level managers use the information for planning and decision making
•
Accounting information is always expressed in terms of money
•
Management accounting may adopt any measurement unit like labour hours, machine hours or product units for the purpose of analysis
•
Financial data is presented for a definite period, say one year or a quarter
•
Reports are prepared on continuous basis, monthly or weekly or even daily
•
Financial accounting focuses on historical data
•
Management accounting is oriented towards future
Financial accounting is a discipline by itself and has its own principles, policies and conventions Self Assessment Questions 7:
•
Management accounting makes use of other disciplines like economics, management, information system, operation research etc.,
•
1. Management accounting is concerned with _____________. 2. State any two differences between Financial accounting and Management accounting.
1.9 Basic Terms To understand the subject, proper understanding of the following terms is essential. 1. Transaction: It is transfer of money or goods or service from one person or account to another person or account. For example, purchase of goods, sale of goods, payment of cash towards rent, receipt of cash towards interest on loans given, cash brought in as capital dividend paid to share holders etc are all transactions. There are cash transactions, credit transactions and paper transactions. In all cash transactions, cash is paid or received immediately. Ex: Rama paid cash Rs.10000 for purchase of goods. Krishna sells goods for cash Rs1000.Credit transaction is one where there is a promise to pay/receive cash at a future date. EX: Rama purchases goods from Gopal and promises to pay cash one month after the date. Paper transaction is one where there is no cash inflow or outflow but
Sikkim Manipal University
9
Financial and Management Accounting
Unit 1
adjustment is made in the records only. Bad debts of previous year are written off; depreciation provided on fixed assets etc., 2. Capital: Funds brought in to start business, by the owner/s. In the case of a company, capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed capital and that capital used for day to day affairs of business is known as working capital. From business point of view, Capital is a liability. 3. Assets: Every enterprise has assets. Land and buildings, plant and machinery, furniture and fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, by the use of which business is carried on. Assets may be fixed, current, liquid or fictitious. Fixed assets are those which are held for use in the production or supply of goods and services. Ex: plant and machinery, which is used fairly for long period. Current assets are those which are held or receivable within a year or within the operating cycle of the business. They are intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors, bills receivable, cash at bank etc., Liquid assets are those which can be easily converted into cash and for instance, cash in hand, cash at bank, marketable investments etc., Fictitious assets are in the form of such expenses which could not be written off during the period of their incidence. For example, promotional expenses of a company which could not be treated as expenditure in the year of incidence are shown as fictitious asset. 4. Liability: Obligation to be fulfilled in future with respect to payment towards acquisition of an asset or performance of a service. Current liability is that obligation which has to be satisfied within a year. For example, payment to be made sundry creditors for the goods supplied by them on credit; bills payable accepted by the businessman; overdraft raised by the businessman in a bank etc. 5.
Goods: Commodities or articles purchased for resale are called goods. Furniture items dealt by a furniture dealer constitute goods for that business. If rice dealer purchases furniture, not for resale but for use, it is called purchase of asset and the same furniture becomes asset. Rice for rice dealer is goods, because he purchases only for resale.
6. Trade: Purchase and sale of goods is called trade. 7. Purchases: It refers to goods bought in exchange for cash or credit. In case of credit purchase, goods are received against a promise to pay the price for the same at a future date.
Sikkim Manipal University
10
Financial and Management Accounting
Unit 1
8. Sales: Goods sold to customers either for cash or for credit are regarded as sales. In case of cash sales, cash is received immediately and in case of credit sales, cash will be received at a future date. 9. Sole trader: A single individual carrying on business with or without the help of his kith and kin is called sole trader. 10. Partnership: It is a relationship between partners to contribute capital to start business, agree to distribute profits and losses in an agreed proportion and the business being carried on by all or any one acting for all. Partnership firm refers to business where as the partnership refers to relationship caused by agreement. 11. Joint Stock Company: It is an organization, for which the capital is contributed by shareholders to carry on business and it is registered under Companies Act and it has a legal entity, having perpetual existence and a common seal. 12. Debtor: Debtor is a person who owes some thing to business. A person to whom goods are sold on credit becomes a trade debtor to the business. 13. Creditor: A creditor is a person to whom the business owes some thing. For example, a person from whom goods are purchased on credit and amount is yet to be paid is called a trade creditor. 14. Stock: Total goods kept on hand by a trader or industrial enterprise on a given date. It represents unsold part of goods. Self Assessment Questions 8: 1. A company is registered under ___________ . 2. A partnership is ___________ among partners. 3. Rama & Co., owned by Govind. Is it a firm or sole trader? 4. If A purchases goods from B, A is ___________ to B and B is _________ to A. 5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable after one month. Is it a cash sale or credit sale? 6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000 into his business. Is it capital? Terminal Questions 1. Briefly describe the meaning of accountancy, book-keeping and accounting. 2. Write the differences between accounting and book-keeping.
Sikkim Manipal University
11
Financial and Management Accounting
Unit 1
3. Brief describe the need and evolution of accounting. 4. State the meaning of the folling terms a. Transaction b. Assets c. Joint stock company d. Goods e. Trade. Answer for Self Assessment Questions Self Assessment Questions 1: 1. Fra Luca Pacioli 2. Cost Accounting 3. 14th Century Self Assessment Questions 2: 1. Record all business transactions and communicate the results to interested parties. 2. Profit and loss and balance sheet 3. Cash flow and fund flow statements Self Assessment Questions 3: 1. Recording business transactions as per accounting principles 2. Accounting is the discipline of measuring, communicating and interpreting financial activities. 3. Profession, accountants. Self Assessment Questions 4: 1. Journal 2. No, because this is not financial in nature. Self Assessment Questions 5: 1. Systematic recording, reporting, Satisfying statutory requirements, protecting the properties, internal control, tool for effective planning (Any two). 2. Shareholders, creditors, bankers, brokers, debtors, customers, suppliers, Government etc. Self Assessment Questions 6: 1. Accounting
Sikkim Manipal University
12
Financial and Management Accounting
Unit 1
2. Book keeping is a process of recording but accounting is not only recording but also analyzing and communicating;
book keeping requires the knowledge of accounting principles but
accounting requires not only knowledge but also skill and experience. Self Assessment Questions 7: 1. Taking decisions, planning, evaluating and controlling 2. FA considers historical data and MA focuses on future; FA is a discipline by itself but MA makes use of other disciplines like economics, information system etc. Self Assessment Questions 8: 1. Companies Act, 2. An agreement 3. Sole Trading concern 4. Debtor, Creditor 5. Credit sale 6. Yes, it is capital. Answer for Terminal Questions: 1. Refer to unit 1.2 2. Refer to unit 1.6 3. Refer to unit 1.1 4. Refer to unit 1.8
Sikkim Manipal University
13
Financial and Management Accounting
Unit 10
Unit 10
Funds Flow Analysis
Structure: 10.1
Introduction Objectives
10.2
Meaning Self Assessment Questions 1
10.3
Concept Self Assessment Questions 2
10.4
Technique Self Assessment Questions 3
10.5
Sources Self Assessment Questions 4
10.6
Increase in funds Self Assessment Questions 5
10.7
Decrease in Assets Self Assessment Questions 6
10.8
Increase in Liabilities Self Assessment Questions 7
10.9
Increase in Networth Self Assessment Questions 8
10.10
Sources Self Assessment Questions 9
10.11
Increase in Assets Self Assessment Questions10
10.12
Decrease in Liabilities Self Assessment Questions 11
10.13
Networth Self Assessment Questions 12
10.14
Flow of funds Self Assessment Questions 13
10.15
Transaction not affecting flow Self Assessment Questions 14
10.16
Steps in preparation of funds flow statements
Sikkim Manipal University
184
Financial and Management Accounting
Unit 10
Self Assessment Questions 15 10.17
Computation of changes in working capital Self Assessment Questions 16
10.18
Layout Self Assessment Questions 17
10.19
Treatment of certain items Self Assessment Questions 18 Terminal Questions Answer to SAQs and TQs
10.1 Introduction The usefulness of developing certain financial statements as an aid to evaluate past and / or present performance of a business concern is unquestionable and beyond any dispute. The Income Statement reports the revenues earned and expenses incurred or outstanding. The Balance Sheet conveys about the deployment of funds in various assets and equities The Fund Flow analysis is a modern technique of analyzing the movement of “funds” of a concern. The Fund Flow statement shows the movement of funds between two balance sheet dates. As per Robert N. Anthony “the Funds Flow statement describes the sources from which additional funds were derived and the use to which these funds were put”. Such a statement is becoming more and more popular and is being increasingly published as part of the annual accounts. Para 20 of International Accounting Standards 7 reads as follows : “A statement of changes in financial position should be included as an integral part of financial statements. The statement of changes in financial position should be presented for each period for which the income statement is prepared”. The inclusion of such a statement, therefore, is very helpful to improve the understanding of the operations and activities of an enterprise for the reporting period. Learning Objectives: After studying this unit, you should be able to understand the following 1. Understand the meaning and the concepts of funds flow statement. 2. Familiar with techniques of fund flow statement. 3. Preparation of fund flow statement.
Sikkim Manipal University
185
Financial and Management Accounting
Unit 10
10.2 Meaning of Fund Flow Statement Statement of Sources and Uses of Funds is a statement which depicts the sources from which funds are obtained and the uses to which they are being put. It is essentially derived from the analysis of changes which have occurred in assets and equities between two Balance Sheets periods. It is not the endproduct of accounting records. The statement speaks about the changes in financial items of Balance Sheets prepared at two different dates. Therefore, the funds flow indicates the inflows and outflows of funds during a particular accounting period generally a year. The flow exhibits the movements of funds in both the directions – inside and outside the business. As such, the term ‘flow’ in the context of funds indicates the transfer of cash or cash equivalent from asset to equity or one equity to another equity or from one asset to another asset. Self Assessment Questions 1
1. Fund flow statement is _________ From _________ Changes in _____ and ____. 2. FFS speaks about changes in _______________________ Balance Sheets. 3. Flow exhibits the flows _______________ And ________________ business. 4. Flow refers to transfer of ___________________ And __________________. 10.3 Concept of Fund The term “funds” has been defined in a number of ways in financial circles. The three common usages of the term are cash , working capita and total financial resources.. Cash: Under this concept, the term “funds” is used only in the sense of cash. Here, only the changes in cash are considered. Hence, the statement is called “Cash Flow statement. This statement aims at listing the various items which bring about changes in the cash balance between two balance sheet dates. Cash planning becomes useful for control purposes. Using this method has certain disadvantages. Since cash is considered as short term assets, they are subjected to short term fluctuations. A delay in making payment to suppliers and a provision of one month’s credit for making a payment of land purchases may show sufficient cash flow . They may reflect a satisfactory position. But it is not a reality. Therefore, cash equivalent concept of fund is useful only for short term financial planning and not for long term or general financial position assessment. Working Capital: Working capital is Current asserts minus current liabilities. It is an alternative measure of the changes in the financial position. All those transactions which increase
Sikkim Manipal University
186
Financial and Management Accounting
Unit 10
or decrease working capital are included in this statement. It excludes all such items which do not affect the working capital. The working capital concept of funds is in conformity with normal accounting procedures. Hence, a funds flow statement based on this concept fits well with the other statements. Moreover, working capital is also a measure of short term liquidity of the firm. Therefore, an analysis of factors bringing about a change in the amount of net working capital is useful for decision making by shareholders, creditors and management. Due to these reasons, the working capital approach to funds is more useful than the cash approach. Total Financial Resources : The term “funds” is very often used in the sense of useful financial resources also. Cash approach and working capital approach both are incomplete and inadequate to the extent that they omit a few major financial and investment transactions. Such items do not affect net working capital. But, if they are included, they would certainly provide qualitative information for the decision making., For example issuing equity shares and debentures for purchase of buildings or assets shall not have any effect on the working capital. But it is a significant financial transaction that should be disclosed. Therefore, this concept seems to be the best approach to disclose the changes in the financial position as compared to other concepts. It is in conformity with the statutory regulations and legal requirements. Self Assessment Questions 2 1. The three common funds are __________________________. 2. Cash planning is used for ____________________________. 3. Cash equivalent is used for ___________________________. 4. Working capital is __________________________________. 5. Non working capital items are ________________________. 6. Working capital means ______________________________. 7. Total financial resources considers _____________________. 8. Total financial resources provide _______________________.
Objectives: The main objectives of the funds flow statement is normally based on the purpose its going to be served. These are : a) to help in understanding the changes that are likely to take place in the assets and liabilities portfolio. These may not be readily available from the income statement.
Sikkim Manipal University
187
Financial and Management Accounting
Unit 10
b) To inform the stakeholders as to how a firm can use the funds which are available at its disposal. c) To bring out the financial strengths and weaknesses of the business. Self Assessment Questions 3
1. The objectives of FFS is to identify ______________ in ______. and ____. 2. FFS is to bring out _______________________. 10.4 Techniques Of Preparing A Funds Flow Statement Like other accounting statements, the structure of Fund Flow Statement is based on the equality of financial assets and liabilities including capital. The basic understanding is that the funds are obtained through profit, external borrowings or by issue of shares. If funds are not available readily from these sources, the other alternative available is to sell the fixed assets and investments. . The preparation of Funds Flow Statement is normally based on the following to bring to scientific method of preparation. a) Schedule of working capital changes b) Statement of Sources and Uses of Fund. Schedule of Working Capital Changes : It is also known as “Comparative change in Working Capital Statement” or “Working Capital Variation Statement”. The net change in working capital is projected here in the place of individual changes in all the current assets and current liabilities in the Funds Flow Statement. The statement indicates the amount of working capital at the end of two years. It shows the increase or decrease in the individual items of current assets and current liabilities. The effect of the changes in the individual items of the current assets and current liabilities on working capital is also presented clearly and precisely. The difference in the amount of working capital at the end of two years will depict either the increase or decease in working capital. While ascertaining the increase or decrease in individual items of current assets and current liabilities and its impact on working capital, the following Rules should be taken into account. i) increase in Current Assets will increase the Working Capital ii) Decrease in Current Assets will decrease the Working Capital iii) Increase of Current Liabilities will decrease the Working Capital iv) Decrease in Current Liabilities will increase the Working Capital
Sikkim Manipal University
188
Financial and Management Accounting
Unit 10
It is, therefore, noted that the changes in the items of current assets are positively correlated to the changes in the working capital. On the other hand, changes in current liabilities are inversely related to the changes in the working capital. Self Assessment Questions 4 1. FFS is based on ___________________________. 2. FFS is prepared based on ___________________. 3. Working capital schedule indicates the ______________________. 4. Increase in current assets ___________________ the Working capital. 5. Decrease in CA _____________________________________ the WC. 6. Increase in CL ______________________________________ the WC. 7. Decrease in CL ______________________________________ the WC. 8. Changes in CA ________________________________ changes in WC. 9. Changes in CL ________________________________ changes in WC.
10.5 Sources of Funds The transactions that increase the working capital are sources of funds. Following may the sources of funds in a concern. Funds from operations : Profit earned by the concern during the current year is deemed to be the source of funds. It is very important source of funds inflow. Net profit is arrived at by deducting cost of goods sold and other expenses from total sales revenue. However, the profit so calculated is seldom equal to the funds from operations because there are many items which are debited or credited in the Profit and Loss Account which do not affect working capital. Therefore, in calculating the funds from operations, the following adjustments must be kept in mind:
Items to be added back to net profit : a. Nonfund revenue deductions: These are items which are debited to Profit and Loss account. These do not cause outflow of funds such as depreciation and depletion on non current assets, amortization of fictitious and intangible assets, preliminary expenses, redemption of preference shares or debentures, deferred charges, advertising suspense account written off. If non fund expenditures does not affect the current assets such as unexpired insurance, do not add back. So also, all allowances for income tax payable in future years are excluded.
Sikkim Manipal University
189
Financial and Management Accounting
Unit 10
b. Nontrading charges or losses : These items which were debited to Profit and Loss account reduce the profits but they do not cause any outflow of funds. Hence, profit should be corrected by adding back all such charges and losses. These include appropriation of retained earnings such as general reserve, dividend equalization fund, reserve for contingencies, sinking fund. In addition the dividend on shares must be added back since it is an appropriation and not trading charge. The losses arising out of sale of land, buildings, machinery, long term investments which were written off to the profit and loss account must be added back. Do not add the loss arising out of sale of a current asset such short term investments. It is a trading loss and hence it will not require any adjustment. The amount set aside as provision for current taxation will also be added back. This will be considered only when the provision for taxation is treated as a charge on profits. Items to be deducted from Net Profit. The non fund and non trading revenue receipts or incomes must be deducted Net profit in order to compute funds from operations. The items are: (a) Dividend received or receivable: Although this transaction increases the current assets such as cash and debtors, it is not a trading income. Hence, it should be deducted from the net profits to determine the funds from operations. (b) Retransfer of excess provisions: Where the provisions made for taxation, depreciation, doubtful debts exceed the genuine requirements, the excess amount is transferred back to the Profit and loss account. It does not create any inflow of funds since it is an accounting entry. Hence, deduct it. (c) Profit on sale of non current assets: It is a non trading income. Hence it must be eliminated from the amount of profit. (d) Appreciation in fixed assets: The amount of appreciation on revaluation of fixed assets is normally credited to the profit and loss account. If it is so, deduct it from the profit to compute the funds from operations. Self Assessment Questions 5 1. Increase in working capital ____________________. 2. Decrease in WC _____________________________. 3. Net profit is ________________________________. 4. Items to be added back to net profit are __________. 5. Some of nonfund revenue items _______________.
Sikkim Manipal University
190
Financial and Management Accounting
Unit 10
6. Non trading losses include ___________________.
10.6 Increse in Funds In a nutshell, the sources of funds can be observed as follows : a) increase of fresh shares derived from increase in share capital. b) Issue of debentures derived from increase in debentures. c) Raising of new loan derived from increase in long term loans d) Sale of fixed assets for cash or for other current assets derived from decrease in fixed assets and additional information. e) Non trading income f) Profit from operations before deducting non cash items of expenses and losses and before additional non cash, non trading incomes. g) Decrease in working capital derived from the Schedule of Working capital changes. Self Assessment Questions 6
1. Increase in share capital is ___________________________ of cash. 2. Increase in debentures _______________________________ of cash. 3. Increase in raising loans ______________________________. 4. sale of fixed assets __________________________________. 5. Non trading income is _______________________________. 6. Profit from operations is _____________________________. 7. Decrease in working capital is ________________________. 10.7 Decrease in Assets Decrease in assets is always a source of funds for the business. Decrease may be in many ways: such as cash received from debtors, sale of goods for cash, Bills realized, sale of assets, fixed assets through provision for depreciation or amortization of fictitious assets. Decrease in an item of assets results in either a parallel decrease in some other liabilities or a parallel increase in some other item of assets example repayment of bank loan.. It should be remembered at the very outset that the decrease is ascertained by comparing the cost of fixed assets and not by comparing the written down value i.e cost less depreciation. If fixed assets have been shown not at cost but at written down value, then cost may be ascertained by adding total depreciation written off todate (generally known as accumulated depreciation) to the written down value The decrease in fixed assets results in sale of fixed assets. Specific information is generally given in Sikkim Manipal University
191
Financial and Management Accounting
Unit 10
the problem about this. The decrease in fixed assets not on account of depreciation or writing off is known as sale of fixed assets. It must be noticed that the total sale proceeds and not the cost of fixed assets sold are shown as source of fund. If the information in respect of sale of fixed assets is not clearly given, the following steps should be taken to find out the value of sale proceeds. Cost of Fixed Assets (Previous Year) ……………… Less: Cost of Fixed Assets of Current year ( ………………) Cost of Fixed Assets
x x x x x x x x
ADD : Profit or DEDUCT loss on sale ……………………… Sale Proceeds to be treated as source XXXXXXXXXXXXXX The amount of profit or loss on sale of fixed assets for the above purpose derived from profit and loss account or from capital reserve or from any specific reserve. This is based on the fact that such profit or loss are credited or debited or transferred to these accounts in accordance with the accounting principles. It must be remembered that profit or loss on sale of fixed assets are not included in profit from operation for the purpose of this Fund Flow Statement. If such profit or loss has been included in Profit and Loss Account , adjustment has to be made. If there is profit on sale of assets, the net profit disclosed by Profit and Loss Account is reduced by the amount of profit earned on the sale of fixed assets. On the other hand, the net profit shown by Profit and Loss Account is increased by the amount of loss incurred on the sale of fixed assets. Example: The land and buildings account had a balance of Rs.5,00,000on Jan 2007. A piece of land has been sold . There is no purchase. Rs.30,000 depreciation has been charged in 2007. The profit on sale has been credited to Capital Reserve Account . The balance stood on January 1, 2007 was Rs.20,000 and Rs.50,000 on December 31. The balance of land and building account as on December 31 is Rs.4,50,000. Find the sale proceeds. Solution Balance of land and building on Jan 1, 2007 5,00,000 LESS : Depreciation charged (30,000) 4,70,000
Sikkim Manipal University
192
Financial and Management Accounting
Unit 10
LESS: Balance of Land and Building on Dec 31 ( 4,50,000) Cost of Land sold 20,000 ADD : Profit on sale (derived from capital reserve) 30,000 (closing minus opening balance Rs.50,000 minus Rs.20,000) Sale Proceeds 50,000
Self Assessment Questions 7 1. Decrease in assets is _________________________________. 2. Profit or loss on sale of fixed assets ____________________.
10.8 Increase In Liabilities The increase in liabilities is always a source of funds for the business. It may occur as a result of many transactions such as equity share capital or / and debentures to the public., purchase of goods on credit. Outstanding expenses are also considered as source of funds since payments are postponed and cash saved is parked in the business. A comparison of the amount of the items of long term liabilities i.e debentures and mortgage and other loans for the current year and previous year will disclose the increase or decrease in the long term liabilities. Additional information should also be taken into account for determining the correct amount of increase or decrease for the purpose of this statement. Any increase on account of the issue of debentures for consideration other than cash or current assets for the purchase of fixed assets or redeeming other debentures or preference shares would not at all be shown in the statement because in such a case there is no flow of fund. Self Assessment Questions 8 1. Increase in liability is ______________________ . 2. Outstanding expenses is __________________ .
10.9 Increase In NetWorth There can be only two main channels of increase in networth or equity : a) procurement of more funds by issue of additional shares b) through accumulation of retained earnings or profits in business As the increased in owned funds is concerned, it happens only when the business has plans for expansion, diversification, modernization. The increase in paidup equity Sikkim Manipal University
193
Financial and Management Accounting
Unit 10
Share capital is not a regular feature. Its occurrence is only sporadic. But profit generated from operations is a normal feature and is virtually a continuous process from year to year. Profit earned during an operating period increases the new worth of the business and hence it is always considered as a source of funds. Sometimes, the premium received on sale of equity shares and credited to share premium account is also a source of funds as it adds to the size of net worth . Share capital consists of equity share capital and preference share capital. The change in equity share capital is always in the form of increase; it can never be in the form of decrease. The increase in equity share capital as per Balance Sheet values must be adjusted in terms of additional information. If the increase has taken place on account of the issue of fresh shares, only that portion of increase should be treated as sources which is due to the issue of fresh shares for cash and other current assets. Increase on account of share issues for consideration involving the purchase of fixed assets or redemption of preference shares or debentures shall not partake the character of inflow of funds and hence should not be shown in the statement. If fresh shares have been issued at premium, the amount of premium must be added to the increase in share capital for the purpose of showing it as source of fund. If the fresh shares have been issued at discount, the amount of discount must be deducted from the increase in share capital because it does not involve inflow of fund. Example: The opening and closing balance of Share capital are Rs.6,00,000 and Rs.9,50,000 respectively. The Preference Share capital included in opening balance is Rs.1,00,000. During the year, Rs.75,000 worth of Preference shares were redeemed at 8 % premium. Bonus shares at Re.1 for every five equity shares held . In addition, a business was purchased by issue of Rs.90,000 shares at a premium of 10 %. The opening and closing balance in the Premium Account is Rs.8,00,000 and Rs.14,000 respectively. Calculate the further fresh issue. Solution: Share capital at close DEDUCT : Share capital opening
9,50,000 6,00,000
Less: Redemption of Preference Shares ( 75,000) ( 5,25,000) 4,25,000 Deduct: Shares issued for noncash items Sikkim Manipal University
(90,000) 194
Financial and Management Accounting
Unit 10
3,35,000 DEDUCT : Bonus shares ( 1 / 5 x 5,00,000)
(1,00,000)
(1/5 of 6,00,000) 2,25,000 ADD: Share premium. (14,000 + 6,000 minus 8,000 minus 9,000) Fresh issue of Shares
3,000 2,28,000
Self Assessment Questions 9 1. Decrease in net worth is through __________________________. 2. Increase in net worth is needed for ________________________. 3. Profit earned _________________________________ net worth. 4. Premium on shares is __________________________. 5. Change in equity shares is always ________________. 6. Decrease in preference share capital is ____________.
10.10 Sources Of Funds The use of funds results in cash outflows. The outflows are known as :application” of funds. The uses of funds are mainly concerned with. a) Redemption of Preference shares in cash derived from decrease in share capital. b) Redemption of debentures in cash derived from decrease in debentures c) Repayment of loan derived from decrease in long term loans d) Purchase of fixed assets for consideration other than shares, debentures or long term debt derived from increase in fixed assets and additional information. e) Loss from operations f) Payment of dividend in cash Self Assessment Questions 10 1. Use of funds result in ________________________. 2. Redemption of Preference shares is _____________. 3. Redemption of debentures is __________________. 4. Redemption of long term loan is _______________. 5. Purchase of fixed asset is _____________________. 6. Loss from operations is ______________________. Sikkim Manipal University
195
Financial and Management Accounting
Unit 10
7. Payment of dividend is ______________________.
10. 11 Increase In Assets The increase in fixed assets is known in the accounting language as “Purchase of fixed assets”. In order to find out the increase in fixed assets, cost of fixed assets of previous year as reduced by the cost of fixed assets sold during the current year is deducted from the cost of fixed assets of the current year. In other words, the increase in fixed assets is calculated as under : Cost of Current year fixed assets ……………… DEDUCT ; Cost of previous fixed assets ……….. LESS: Cost of fixed assets sold or Written off during the Current year (……….) (………………..)
INCREASE in fixed assets x x x x x x x
Example: The opening and closing written down balances of an asset are Rs.5,00,000 and Rs.5,50,000. The accumulated depreciation has been Rs.1,50,000 at the beginning and Rs.1,90,000 at the close. A machine costing Rs.30,000 (accumulated depreciation Rs.18,000) was sold during the year for Rs.9,500. Calculate the purchase price of the fixed assets. Solution Closing cost of asset (closing value + closing accumulated Depreciation : 5,50,000 + 1,90,000 7,40,000 DEDUCT : Opening cost of Asset (opening Value + opening accumulated Depreciation 5,00,000 + 1,50,000 6,50,000 Less : Cost of asset sold
(30,000) (6,20,000) 1,20,000
Sometimes, it may happen that the cost figures cannot be ascertained on the basis of information available. Increase in fixed assets, in this case, has to be found out with reference to the written down value along with annual depreciation. If no purchase of fixed assets were made during the current year, then the value of fixed assets shown in the Balance Sheet of the current year
Sikkim Manipal University
196
Financial and Management Accounting
Unit 10
should be equal to the values of the previous year minus annual depreciation for current year. The excess of current year’s value over previous year’s value minus annual depreciation will be treated as increase. This will represent the purchase of fixed assets. Current year written down value of Asset …………….. DEDUCT ; Previous year WDV of Asset …………… Less: Current year Depreciation (…………) ( ……………..) _______________ Increase in Fixed Asset being Purchases x x x x x x Example: The written down value of a Machinery at the beginning and at close were Rs.2,00,000 and 1,75,000. An old machine whose written down value was Rs.12,000 was sold for Rs.6,500. Rs.32,000 depreciation was charged during the current year. Calculate the purchase price. Solution: Current year written down value of Machinery
1,75,000
DEDUCT : Previous year written down Value of Machinery Less : Current year depreciation
2,00,000 ( 32,000) 1,68,000
Less: written down value of machine Sold
( 12,000) (1,56,000)
Purchase price
19,000
Self Assessment Questions 11 1. Increase in fixed asset is known as _____________________. 2. Purchase is _______________________________________. 3. The excess of current year –minus (previous year + Depreciation) is treated as ________________.
10.12 Decrease In Liabilities It implies application which is the flow of funds out of business. Decrease in liability may be done due increase in one or more liability items or due to decrease in one or more asset items. It may also be partly due to increase in liability and partly due to decrease in assets. . Any amount of premium on the redemption of debentures should be adjusted as deduction . Any decrease on
Sikkim Manipal University
197
Financial and Management Accounting
Unit 10
account of redemption of debentures through the issue of another debentures or preference shares should also not be shown in the statement. Example: On January 1, 2007, the balance of 8 % Debentures Account stood at Rs.5,00,000. Rs.60,000 debentures were repaid at 5 percent premium. Rs.75,000 debentures were purchased at Rs.95 from the market and cancelled. The closing balance of debentures was Rs. 2,00,000. Calculate the outflow of funds. Solution: Opening balance of Debenture Account LESS: Closing balance of Debenture Account
5,00,000 ( 2,00,000)
Decrease
3,00,000
LESS : Discount on cancellation (Rs.75,000 / Face Value of Rs.100 each or 750 debentures x Rs.5 each (Rs.100 minus Rs.95)
( 1,250) 2,98,750
ADD: Premium (Rs.60,000 x 5 / 100) Outflow of funds
3,000 3,01,750
Self Assessment Questions 12 1. Decrease in fixed liabilities ________________________ funds. 2. Premium on redemption of debentures is _____________ .
10.13 Net Worth It may be used due to (a) loss from operations (b) payment of cash dividend out of accumulated reserves and (c) return of a part of paid up share capital to shareholders implying reduction of share capital – a rare occurrence. If there is decrease in preference share capital and this decrease is on account of redemption of these shares in cash or other current assets, such decrease should be shown as use of fund. But the decrease on account of redemption by the issue of another preference shares or equity shares or debentures, shall never be shown in the statement because it will not involve outflow of fund. If the preference shares have been redeemed at a premium, necessary adjustments should be made Self Assessment Questions 13 1. New worth is due to _______________________. Sikkim Manipal University
198
Financial and Management Accounting
Unit 10
2. Net worth is also due to ___________________. 3. Net worth can be ________________________.
10.14 Flow of Funds It refers to change in fund. Increase of funds of any transaction is a source and decrease of funds in any transaction is application or uses of funds. But the transactions which do not result in any change in the funds is called “Nonfund”. Flow of fund takes place when a business transaction brings a change in the working capital. Such change may be increase or decrease. The increase is a positive change and the decrease being the negative. These directions in change are known as fund elements or fund factors. They are commonly known as “inflows” and “outflows”. The basic rule is : Flow of fund if a transaction involves : a) Current assets and fixed assets that is machine sold for cash b) Current assets and fixed liabilities that is issue of debentures to the public c) Current assets and owner equity that is issue of shares for cash d) Current liabilities and fixed assets that is transfer of assets to discharge a claim e) Current liabilities and fixed liabilities that is conversion of creditors due by issue of debentures. f) Current liabilities and capital that is conversion of creditors into owner’s equity by issue of equity shares. Self Assessment Questions 14 1. Flow refers to __________________________. 2. Increase in funds _______________________. 3. Decrease in funds ______________________. 4. Non change is known as _________________. 5. Flow takes place due to __________________ working capital. 6. The increase in fund is a __________________ change. 7. The decrease in fund is a __________________ change.
10.15 Transactions that do not affect the flow of Funds a) Current assets and current liabilities creditors paid b) Fixed assets and fixed liabilities purchase of assets for debentures c) Fixed assets and capital purchase of assets by issue of equity shares.
Sikkim Manipal University
199
Financial and Management Accounting
Unit 10
Self Assessment Questions 15 1. Transactions not affecting flow are _______________________.
10.16 Steps In Preparation Of Funds Flow Statement There are three steps involved in the preparation of a Fund Flow Statement (FFS). They are as follows: a) Preparation of Statement of changes in working capital or Schedule of changes in working capital. b) Preparation of Adjusted Profit and Loss Account (APL) c) Statement of changes in Financial position as per AS – 7 Self Assessment Questions 16 1. First step in preparation of FFS is __________________. 2. Second step in the preparation of FFS is _____________. 3. Third step in the preparation of FFS is _______________.
10. 17 Computation of Changes in Working Capital and Funds from Operations It is a customary practice that only the net changes in working capital should be shown in the Fund Flow Statement instead of individual changes. Here, the current assets and current liabilities are considered. For this purpose, a separate statement or schedule is being prepared. Individual items are entered here. The opening and closing balances are entered one after the other. The corresponding increase or decrease are entered based on the following rules : a) Increase in a current asset item increases working capital. b) Decrease in a current asset item decreases working capital. c) Increase in a current liability item decreases working capital. d) Decrease in a current liability item increases working capital . Insert the total of current asset and current liabilities of both opening and closing periods. Say, the total of current assets as A and that of total of current liabilities as B. Deduct A minus B. The answer is known as net Working capital. If the working capital at the end of the current year is more than the working capital at the end of previous year, the excess is called as “increase in working capital”. Otherwise, if previous year’s working capital is more than the current year’s working capital, the difference is called as “Decrease in working capital”. Increase in working capital is shown as application of funds and decrease in working capital as source of funds in the Funds Flow Statement. Sikkim Manipal University
200
Financial and Management Accounting
Unit 10
The funds from operation can be found with the help of preparing an Adjusted Profit and Loss Account. Self Assessment Questions 17 1. Individual items are projected in ___________________. 2. Working capital equation is _______________________. 3. A is total _____________________________________. 4. B is total ____________________________________. 5. Working capital is _____________________________. 6. Net increase or decrease is ______________________.
10.18 Layout The layout for schedule of changes in Working Capital is as follows Balances as on
Effect on
Details Last Current Increase Decrease Year Year CURRENT ASSETS Cash in hand Cash at Bank Sundry Debtors Bills Receivable Stock or Inventory Prepaid expenses Total Current Assets, Say A CURRENT LIABILITIES Sundry Creditors Bills Payable Bank Overdraft Outstanding expenses Total Current Liabilities, Say B NET WORKING CAPITAL A minus B Increase or Decrease in Working Sikkim Manipal University
201
Financial and Management Accounting
Unit 10
Capital (Balancing figure)
Example: DR Ltd provides the following information Jan 1 Dec 31 In Rupees Sundry Debtors 65,000 1,05,000 Cash in hand 13,000 20,000 Cash at Bank 15,000 20,000 Bills Receivable
16,000 30,000
Inventory 90,000 84,000 Bills Payables 12,000
8,000
Outstanding expenses 6,000 5,000 Sundry Creditors 30,000 58,000 Bank Overdraft
30,000 42,000
Short term Loans 32,000 36,000 Prepare a schedule of changes in working capital
Sikkim Manipal University
202
Financial and Management Accounting
Unit 10
Solution Schedule of changes in Working Capital Balances as on Effect of WC Details Jan 1 Dec 31 Increase Decrease Current Assets Cash in hand 13,000 20,000 7,000 Cash at Bank 15,000 20,000 5,000 Sundry Debtors 65,000 1,05,000 40,000 Bills Receivable 16,000 30,000 14,000 Inventory 90,000 84,000 – 6,000 Total Current Assets, A
1,99,000 2,59,000
Current Liabilities Sundry Creditors 30,000 58,000 – Bills Payables 12,000 8,000 4,000 Outstanding expenses 6,000 5,000 1,000 Bank Overdraft 30,000 42,000 – Short term loans 32,000 36,000 –
28,000
12,000 4,000
Total Current Liabilities, B 1,10,000 1,49,000 Working Capital A minus B 89,000 1,10,000 Net Increase in working capital (balancing figure) 21,000 21,000 TOTAL 1,10,000 1,10,000 71,000 71,000
Sikkim Manipal University
203
Financial and Management Accounting
Unit 10
Example : Prepare a statement of changes in working capital from the following information.
Jan 1 Dec 31 In Rupees Share Capital
50,000 50,000
Retained earnings 14,000 40,000 Fixed Assets at cost 80,000 90,000 Provision for Depreciation on Fixed Assets 22,000 27,000 Investments in shares of subsidiaries 15,000 15,000 8% Debentures (redeemable in 5 equal annual instalment of Rs.20,000 each, from the current year)
20,000
–
Prepaid expenses 21,000 14,000 Outstanding expenses 5,000 12,000 Creditors and Bills Payables 30,000 25,000 Debtors and Bills Receivables 18,000 20,000 Cash and Bank balances 5,000
13,000
Provision for Doubtful Debts 4,000 2,000
Solution Statement of changes in working capital during the year Details Current Assets Cash and bank balances
Balances as on Jan 1
Effect on WC
Dec 31
Increase
Decrease
5,000
13,000
8,000
18,000
20,000
2,000
6,000
12,000
6,000
Prepaid expenses
21,000
14,000
–
7,000
Total, say A
50,000
59,000
20,000
20,000
–
20,000
5,000
12,000
–
7,000
30,000
25,000
5,000
4,000
2,000
Debtors and B.R. Government Securities
Current Liabilities 8% Debentures Outstanding expenses Creditors and B.P. Provision for Doubtful Debts
Sikkim Manipal University
204
Financial and Management Accounting
Total, say B Working Capital : A minus B Net increase in working capital
Unit 10
59,000
39,000
( 9,000 )
20,000
3,000
29,000 29,000 20,000
20,000
43,000
43,000
Adjusted Profit and Loss Account The Layout is as follows: Dr.
Cr.
To
By
Depreciation written off Profit and Loss account Depreciation Provision last year from Balance Preliminary expenses written Sheet Off Profit on sale of investments Goodwill written off Profit on sale of Fixed assets Discount on issue of shares and Dividend and interest received Debentures written off from trade investments Fixed assets discarded or Written off Loss on sale of fixed assets FUNDS GENERATED FROM Loss on sale of trade investments TRADING OPERATIONS Transfer to General Reserve, (balancing figure) transferred to Funds Flow Statement as Sinking Funds, Reserve Funds application of funds Transfer to other Reserves Premium on redemption of Preference Shares Provision for Tax Provision for Final or Proposed Dividend Interim Dividends Net Profit as per closing current Year Profit and Loss Account TOTAL
Sikkim Manipal University
205
Financial and Management Accounting
Unit 10
NOTE : If debit total of APL is more than the credit total, the difference is Funds generated from Operation : Record on the credit side of Adjusted Profit and Loss Account. If credit total of APL is more than the debit total, the difference is funds lost in operations. Record on the debit side of Adjusted Profit and Loss Account The balancing figures should be transferred in opposite direction to Funds Flow statement.. Example 3: Calculate funds from operations from the following Profit and Loss Account To By Expenses paid and 3,00,000 Gross Profit 4,50,000 Outstanding Depreciation 70,000 Gain on sale of land 60,000 Loss on sale of machine 4,000 Discount 200 Goodwill 20,000 Net Profit 1,15,800 5,10,000 5,10,000 Solution: ADJUSTED PROFIT AND LOSS ACCOUNT To Rs. By Rs. Depreciation 70,000 Gain on sale of land 60,000 Goodwill written off 20,000 Funds from operations 1,50,000 Discount written off 200 (balancing figure) Loss on sale of machines 4,000 Net Profit 1,15,800 2,10,000 2,10,000 Example 4: Following are the extracts from the Balance sheets of DR Lt. 3132007 3132008 Rs.
Rs.
Profit and Loss account 11,100 14,800 General Reserve 7,400 9,250 Goodwill
3,700 1,850
Provision for depreciation on asset 3,700 4,400 Preliminary expenses 2,200 1,500 Sikkim Manipal University
206
Financial and Management Accounting
Unit 10
During the year, the company sold land whose book value was Rs.50,000 for Rs.54,000 and paid an interim dividend of Rs.2,000 Calculate funds from operations.
Solution ADJUSTED PROFIT AND LOSS ACCOUNT To
Rs By Rs.
General Reserve Balance brought down 11,100 (9,250 minus 7,400) 1,850 being opening balance Goodwill written off Profit on sale of land 4,000 (3,700 minus 1.850) 1,850 Preliminary expenses Written off
700 Funds generated from
Depreciation written operations (balancing Off 700 figure)
6,800
Interim dividend paid 2,000 Closing balance of Profit And Loss account 14,800
21,900 21,900
NOTES: 1. There is an increase in the balance in General Reserve. It implies that some amount has been transferred to the account from the Profit and Loss account. This is an appropriation of profit which does not result in any outflow of funds. 2. The balance in Goodwill Account and preliminary expenses account has come down which indicates tht the difference has been written. This also does not result in an outflow of funds. 3. The increase in provision for depreciation is on account of current year’s depreciation which does not result in any outflow of funds. 4. Profit on sale of land and interim dividend being nonoperating items are to be separately shown as source and application of funds in the Funds Flow Statement.
Sikkim Manipal University
207
Financial and Management Accounting
Unit 10
Example 5: The following information is provided : Opening balance of Plant Rs.1,32,500. Closing balance of Plant Rs.1,97,500. Provision for Depreciation in Plant at the beginning 45,000; and at close Rs.61,000. During the year Rs.65,000 worth of Plant was purchased in exchange for fully paid debentures and old Plant costing Rs.40,000 was sold for Rs.34,000. Depreciation provided Rs.18,000. Calculate the flow of funds. Solution: Plant Account
To By Opening Balance 1,32,500 Bank : Sale of Plant 34,000 Debenture Account 65,000
Provision for Depreciation
(Plant purchased) Account : Depreciation on sold 18,000 Adjusted P&L Account Profit on sale 12,000* Closing balance 1,97,500 Bank Account : Plant Purchased (balancing Figure) 40,000
2,49,500
2,49,500
Calculation of Profit on sale : 34,000 minus (40,000 – 18,000) = 12,000 Provision for Depreciation on Plant Account
To By Plant Account :Depreciation Opening Balance 45,000 On plant sold
18,000 APL : Current year
Closing Balance 61,000 Depreciation (bal.figure 34,000
79,000
79,000
Note: For all Asset Account, record the opening balance on the debit side and closing balance on the credit side of the concerned Asset Account. For all liabilities , record the opening balance on the credit side and the closing balance on the debit side. Sikkim Manipal University
208
Financial and Management Accounting
Unit 10
10.19 TREATMENT OF CERTAIN ITEMS There are certain items whose treatment is not uniform. Different authors differ differently. But, in this study material, an uniformity is maintained. The likely arguments have been provided for treating items on a particular principle. The items are : Provision for Bad Debts Sometimes, it is shown as reserve for bad / doubtful debts. Actually, this item is shown as deduction from total book debts to the asset side of the Balance Sheet. Therefore, this item should be deducted from the amount of debtors shown in the schedule of working capital changes. Since such treatment may complicate the calculation work, it is suggested that it should be shown along with current liabilities, although, it does not belong to that category. Provision for Tax: DO not treat this item as a current liability. The Provision has to be made to meet the tax liability of current year. If there is a Provision for last year, it has to be paid this year. Hence, the last year Provision actually becomes the current year cash outflow. Hence record it in the Funds flow statement. Proposed Dividend Normally, the proposed dividends are given as Balance Sheet item on the liability side. The Directors propose the final dividend which needs to be approved by the General Meeting. Hence, it is fair to assume that the proposed dividend is not a current liability. Do not show in the schedule of working capital changes. The last year proposed dividend should be paid during the current year, hence a cash outflow Investments It poses problems in its treatment. The Rule is : a) if the investments are in the form of Government or other marketable securities, treat it as current assets. b) If it is mentioned as trade investments, that is investments in shares and debentures of another companies, treat it as fixed assets. c) If nothing is mentioned specifically, the treatment is : : if investments have been sold simultaneously, treat it as current assets : in other cases, treat it as Fixed Assets.
Sikkim Manipal University
209
Financial and Management Accounting
Unit 10
Depreciation Normally, the value of deprecation will be provided in the problem as an adjustment items. Depreciation is a non cash item. It is, therefore, charged to Profit and Loss and recorded in the concerned Fixed Assets Account. If the depreciation is given as a percentage, calculate the value on the opening balance of the concerned account.. If the value of depreciation is not given, it has to be found out as follows : Opening balance of Fixed Assets …….. ADD: Purchases ……. LESS : Fixed assets sold
(…….)
LESS : Closing balance of fixed assets (…….)
Depreciation charges
x x x
If a concern intends to show its fixed assets at its cost price, the periodic annual depreciation is shown under “liabilities” side as Provision for Depreciation commonly known as Accumulated Depreciation Fund Account. If there were to be an Accumulated Depreciation Fund Account in already in operation, the current year depreciation is charged against this Provision for accumulated Depreciation Account and not recorded directly into Adjusted Profit and Loss Account . In other words, the current year depreciation is routed through the Provision Account. Increase / Decrease in Fixed Assets The increase or decrease by means of cash is recorded in the FFS. Increase or decrease due to purchase consideration through shares and debentures are not recorded. Increase / Decrease in longterm liabilities Compare debentures and mortgages as per the Balance Sheet figures. Only consider if cash is the main striker to cause the increase or decrease. If the changes were to be due to consideration other than cash or current assets, do not record it in the FFS.. Hidden Items Prepare the necessary ledger accounts concerned in the fixed assets, fixed liabilities and share capital and carry out all the necessary adjustments. The balancing figure, if any, would be the cash transactions. For all non, cash transactions, concentrate on the Adjusted Profit and Loss Account.
Sikkim Manipal University
210
Financial and Management Accounting
Unit 10
Self Assessment Questions 18 1.
Provision is shown as _______________________
2.
Provision for doubtful debts is _______________ from gross debtors
3.
Provision is shown in _______________________
4.
Provision for tax may be _____________________
5.
If Provision for Tax is maintained , treat it in _________________
6.
Proposed dividend is shown on ________________ of Balance sheet
7.
Proposed dividends are to be approved by _____________________
8.
Proposed divided. Is not considered as ________________________
9.
Last year proposed dividend is cash __________________________
10.
Government investments are _______________________________
11.
Investments in shares and debentures are ______________________
12.
Depreciation is _____________________
13.
Depreciation is a ___________________
14.
If Depreciation is given as a percentage, calculate on _____________
15.
If Provision for depreciation account is maintained, charge the current depreciation to _____________ and not to _______________________
16.
Depreciation is charged only on _______________________________
Problem 6: The Balance Sheets are given below :
Year (Rs.in lakhs) 2006 2007
Fixed Assets 50 60 Investments 10 20 Current Assets
140 150
Share Capital 100 160 Profit and Loss Account
30 30
Debentures 10
Current Liabilities 60 40
Depreciation charges was Rs.6 lakhs. Prepare Fund Flow statement.
Sikkim Manipal University
211
Financial and Management Accounting
Unit 10
Solution: Schedule of changes in working capital
2006 2007
Current Assets 140 150 LESS: Current liabilities ( 60 ) (40)
Working Capital : CA minus CL
80 110
Net Increase in working capital transferred to 30
FFS (application) 110 110
Adjusted Profit and Loss Account To By Depreciation 6 Opening Balance 30 Closing Balance 30 Funds from Operations 6
36
36
Funds Flow Statement Sources Issue of Equity shares
Applications 60 Purchase of Fixed Assets 16
Funds from operation 6 Purchase of investment 10 Redemption of debenture
10
Increase in working capital 30 66
Sikkim Manipal University
66
212
Financial and Management Accounting
Unit 10
Problem 7 : From the following extracts, calculate funds from operations Year 2006 2007
Profit and Loss account 50,000 80,000 Provision for taxation on 10,000 15,000 Proposed dividends 5,000 10,000
Additional information: Tax paid Rs.2,500. Dividends paid Rs.1,000.. Calculate funds from operation taking provision for tax and provision for tax and proposed dividend as (a) non current liabilities and (b) current liabilities. Solution: Provision for tax and proposed dividend are taken as noncurrent liabilities To By Income tax account 2,500 Opening balance 10,000 Tax paid
Profit and loss account 7,500
Closing balance 15,000 provision made (balance Figure) 17,500 17,500
Proposed Dividend Account To By Dividend account being Opening balance
5000
Dividend paid during the Profit and loss account Year 1,000 proposed dividend 6,000 Closing balance
10,000 11,000 11,000
Sikkim Manipal University
213
Financial and Management Accounting
Unit 10
Adjusted Profit and Loss Account To
By
Provision for Tax 7,500 Opening balance 50,000 Proposed Dividend 6,000 Funds from operations Closing balance 80,000
(balancing figure) 43,500
93,500 93,500 c) If Provision of tax and proposed dividend are taken as a current liability, funds from operations will be the difference in Profit and Loss account at the beginning and the end of the year.
NOTES 1. In case a) Income tax paid Rs.2,500 and Dividend paid Rs.1,000 are shown as application of funds in the FFS. 2. In case (b), there is no need to prepare proposed dividend account and provision for tax account,. However, the opening and closing balances of the two accounts are shown as current liabilities in the statement of changes in working capital
Problem 8: The book value of trade investments of DR Ltd as on March 1, 2006 and March 31, 2007 was Rs.50,000 and Rs.70,000 respectively. During the year, Rs.5,000 was received as dividends, of which Rs.2,000 pertained to preacquisition profits which have been credited to Investments Account. Investments costing Rs.10,000 have been sold during the year for Rs.10,000. Find the flow of funds on account of investments. Solution: Investments Account To
By
Opening balance 50,000 Dividend Account : Pre Bank Account : purchase acquisition profit 2,000 Of investments (balance 32,000 Bank : sale of investments 10,000 Closing balance 70,000 82,000
Sikkim Manipal University
82,000
214
Financial and Management Accounting
Unit 10
Notes: 1) The investments purchased were valued cumdividend. Hence, on receipt of dividends, they were rightly credited to Investments. Hence there is no need for any further adjustment. 2) The investments sold has been at the book value. There is no profit or loss on account of the transactions. If the transaction had resulted in profit, it will have to be deducted from net profit to calculate funds from operations. In case of loss, it would be added to net profit to calculate funds from operations.
Problem 9: Prepare a fun d flow statement of DR Ltd. Year 2007 2008 Equity share capital 10,00,000 15,00,000 10 % Preference Share Capital
3,00,000
11 % debentures 8,00,000 6,00,000 Share Premium Account 1,00,000 95,000 Additional information (a) 10 % Preference shares have been redeemed at a premium of 10%, the premium amount was charged to the share premium account (b) There has been a profit of Rs.1,000 on the redemption of debentures.
Solution: Equity Share Capital To By Closing Balance 15,00,000 Opening balance 10,00,000 Bank (Fresh issue) 5,00,000 Balancing figure 15,00,000 15,00,000
Preference Share Capital Account To By Bank (Redemption) 3,30,000 Opening balance 3,00,000 Premium on redemption 30,000 3,30,000 3,30,000
Sikkim Manipal University
215
Financial and Management Accounting
Unit 10
Debentures Account To By Bank (redemption) 1,99,000 Opening balance 8,00,000 Profit on redemption 1,000 Closing balance 6,00,000 8,00,000 8,00,000 Share Premium Account To By Preference share 30,000 Opening balance 1,00,000 capital Closing balance 95,000 Equity share capital * 25,000 1,25,000
1,25,000
STATEMENT SHOWING SOURCES AND APPLICATION OF FUNDS Equity share capital 5,00,000 Redemption of Preference shares 3,30,000 Share Premium 25,000 Redemption of Debentures 1,99,000 Decrease in working capital 4,000 5,29,000 5,29,000
Problem 10: The following are the summarized Balance Sheets of DR Ltd. Liabilities 2006 2007 Share Capital 5,00,000 6,00,000 Reserves 1,50,000 1,80,000 Profit and Loss Account 40,000 65,000 Debentures 3,00,000 2,50,000 Creditors for goods 1,70,000 1,60,000 Provision for Income tax 60,000 80,000 12,20,000 12,20,000 Assets Fixed Assets 10,00,000 11,20,000 Less : Depreciation (3,70,000) (4,60,000) Stock 2,40,000 3,70,000 Book Debts 2,50,000 2,30,000 Cash 1,00,000 75,000 12,20,000 12,20,000
Prepare a Funds Flow statement Sikkim Manipal University
216
Financial and Management Accounting
Unit 10
Solution: Statement of changes in working capital Balances as on Effect on W.C
2006 2007 Increase Decrease Current Assets Stock
2,40,000 3,70,000 1,30,000
Book Debts 2,50,000 2,30,000
20,000
Cash 1,00,000 75,000
25,000 .
Total CA say A 5,90,000 6,75,000 Current Liabilities Creditors for goods 1,70,000
1,60,000 10,000
Provision for income tax 60,000 80,000
20,000
Total CL, say B 2,30,000 2,40,000 Working Capital, A – B 3,60,000 4,35,000 Increase in Working capital 75,000
75,000
Total 4,35,000 4,35,000 1,40,000 1,40,000 Adjusted Profit and Loss Account To
By
Reserve 30,000 Opening balance 40,000 Depreciation 90,000 Funds from Operation 1.45,000 Closing balance
65,000 transferred to source 1,85,000 1,85,000
Sikkim Manipal University
217
Financial and Management Accounting
Unit 10
Statement showing Sources and Application of Funds Sources Application Issue of Share capital 1,00,000 Redemption of debentures 50,000 Funds from operation 1,45,000 Purchase of Fixed Assets 1,20,000 Increase in working capital 75,000 2,45,000
2,45,000
Notes: 1) The increase in General Reserve is due to transfer a part of profit of the current year and hence the difference is transferred to APL since it’s a noncash item 2) The difference in depreciation is charged to APL, since it’s a noncash item. 3) Increase in Equity Share capital is assumed to be the fresh issue which is a cash item. It is recoreded in FFS. 4) The difference is debentures is the redemption. It’s a cash item. Hence taken to FFS 5) Purchase of fixed asset is difference between the opening and closing balance of fixed assets. It’s a cash item. Hence taken to FFS .
Problem 11 Prepare a Fund Flow Statement Balance Sheets 2006 2007
2006 2007
Equity Share capital 50,000 65,000 Cash balances 15,000 9,000 Profit & Loss 14,750 17,000 Debtors 25,000 27,000 Trade Creditors 31,000 29,000 Investment 5,000
Mortgage 10,000 15,000 Fixed Assets 70,000 80,000 Short term loans 16,500 15,000 Less: Depreciation (25,250) (7,000) Accrued expenses 7,500 8,000 Goodwill 5,000 1,29,750 1,49,000
1,29,750 1,49,000
Depreciation provided is Rs.4,750. Write off goodwill. Dividend paid Rs.3,500.
Sikkim Manipal University
218
Financial and Management Accounting
Unit 10
Solution: Schedule of changes in working capital Balances as on 2006 2007 Current Assets Cash 10,000 13,000 Debtors 25,000 27,000 Stock
40,000 35,000 Total current assets, say A
75,000 75,000
Current Liabilities Trade Creditors 29,000 31,000 Short term loans
15,000 16,500
Accrued expenses 8,000 7,500 Total current liabilities, say B 52,000 55,000 Working capital, A – B
20,000 24,000
Net increase in Working capital 4,000
Total 24,000 24,000
Adjusted Profit and Loss Account To By Depreciation
1,750 Opening balance 30,000
Goodwill 5,000 Funds generated from Dividend 3,500 operations
12,500
Closing balance 17,000
27,250 27,250
Sikkim Manipal University
219
Financial and Management Accounting
Unit 10
Funds Flow statement Issue of fresh equity 15,000 Purchase of fixed assets 30,000 Sale of investment 5,000 Payments of dividends 3,500 Loan on mortgage 5,000
Increase in working capital 4,000
Funds from operations 12,500
37,500 37,500
Problem 12 The Balance Sheets of DR Ltd Rupees in 000s 2006 2007
2006 20078
Share capital 50 100 Goodwill 15 25 Debenture
25 Plant
18 96
Profit and Loss 15 25 Stock 40 35 Proposed Dividend 5 6 Debtors 15 32.5 Creditors 20 30 Cash 8 9 Liabilities for expenses 5 3.5 Preliminary exp 4 2.5
100 200 100 200
A business was purchased during the year by the issue of 25,000 shares and 25,000 debentures. Depreciation Rs.6,000 has been provided in the year. A machine has been sold for Rs.1,50,000, the written down value being Rs.1,000. The business purchased had the following assets and liabilities : Machine Rs.20,000, Stock Rs.5,000, Debtors Rs.15,000, Creditors Rs.5,000. Prepare the Funds Flow Statement. Solution In this problem, another business concern was purchased whereby the assets and liabilities come into business. For this purchase, the payment is through the issue of shares and debentures. If the payment were to be in excess of assets and liabilities taken over, the excess payment is known as “Goodwill”.
Sikkim Manipal University
220
Financial and Management Accounting
Unit 10
Assets taken over : Machine 20,000 Stock
5,000
Debtors 15,000
40,000 Less Creditors taken over ( 5,000 )
Net assets taken over 35,000
Total payments made : Share capital + Debentures 50,000 Excess payment being treated as Goodwill (50,00035,000) 15,000
Statement showing changes in working capital: Balances as on 2006 2007 Current Assets Stock
40,000 35,000
Debtors 15,000 32,500 Cash 8,000 Total current assets, say A
9,000
63,000 76,500
Current Liabilities Sundry Creditors 20,000 30,000 Liabilities for expenses
5,000 3,500
Overdraft 5,000 10,500 Total current liabilities, say B Working capital A – B Decrease in working capital (source)
30,000 44,000 33,000 32,500
500
33,000 33,000
Sikkim Manipal University
221
Financial and Management Accounting
Unit 10
Adjusted Profit and Loss Account To
By
Goodwill 5,000 Opening balance 15,000 Preliminary expenses 1,500 Profit on sale of Plant
500
Depreciation 6,000 Funds from operations 28,000 Proposed dividend 6,000 Closing balance 25,000
43,500 43,500
Funds Flow Statement Issue of fresh shares for : cash for current assets Stock 5,000 Debtors 15,000 Less: Creditors (5,000) 15,000 Purchase of Plant 65,000 Sale of Plant 1,500 Payment of dividend 5,000 Funds from operations
28,000
Decrease in working Capital 500
70,000 70,000
Terminal Question Problem 1: The balance in the Provision for taxation : opening Rs.30,000 and closing Rs.40,000. Taxes paid during the year was Rs.25,000. Calculate Funds from operation. (b) What is the provision made during the year?
Sikkim Manipal University
222
Financial and Management Accounting
Unit 10
Problem 2: Extracts of Balance Sheets are given below : 2006 2007
Profit and Loss appropriation account
30,000 40,000
General Reserve 20,000 25,000 Goodwill 10,000
5,000
Preliminary expenses 6,000 4,000 Provision for Depreciation on Machinery 10,000 12,000
Calculate funds from operation
Problem 3: Calculate funds from operations: Profit and Loss Account To By Expenses 3,00,000 Gross profit 4,50,000 Depreciation 70,000 Gain on sale of land 60,000 Loss on sale of plant
4,000
Discount on Debenture 200 Goodwill 20,000 Net profit 1,15,800
5,10,000
5,10,000
Problem 4: Calculate funds from sale of Plant Plant (gross) 1,00,000 1,25,000 Additional information: a) Loss on sale
1,000
b) Depreciation charged
14,000
c) Purchase of Plant
35,000
Sikkim Manipal University
223
Financial and Management Accounting
Unit 10
Problem: 5. The Balance Sheets are as follows
Capital 25,000 20,000 Cash 4,700 3,000 Profit and Loss 2,300 1,000 Debtors 11,500 12,000 Bills Payable 4,500 7,000 Land 6,600 5,000 Stock 9,000 8,000
31,800 28,000 31,800 28,000
Prepare a statement of Sources and uses of funds.
Answer Self Assessment Questions Self Assessment Questions 1 1. Derived, changes, assets, equities 2. Two 3. Inside and outside 4. Cash and cash equivalents Self Assessment Questions 2 1. Cash, working capital, total financial resources 2. Control 3. Short term financial planning 4. Current assets minus current liabilities 5. Excluded 6. Short term liquidity 7. Both financial and investment transaction 8. Qualitative information
Self Assessment Questions 3 1. Changes, assets and liabilities 2. Financial strengths and weaknesses Self Assessment Questions 4 1. Financial assets and liabilities including capital 2. Statement of changes in working capital, statement of sources and uses of funds Sikkim Manipal University
224
Financial and Management Accounting
Unit 10
3. Net increase or decrease in individual items 4. Increases 5. Decreases 6. Decreases 7. Increases 8. Positively corelated 9. Inversely related Self Assessment Questions 5 1. Application 2. Source 3. Gross profit – Cost of goods sold + expenses 4. Non fund revenue, non trading changes or losses 5. intangible assets and revenue items 6. Appropriation of retained earnings. Self Assessment Questions 6 1. Inflow 2. Inflow 3. Inflow 4. Inflow 5. Inflow 6. Inflow 7. Inflow Self Assessment Questions 7 1. Source 2. Excluded from fund flow statement.
Self Assessment Questions 8 1. Source of funds 2. Source of funds
Self Assessment Questions 9 1. Addition of shares, accumulated retained earnings 2. Expansion, diversification and modernization Sikkim Manipal University
225
Financial and Management Accounting
Unit 10
3. Increases 4. Source 5. Increases and never decreases 6. Redemption
Self Assessment Questions 10 1. Outflow of cash 2. Outflow of cash 3. Outflow of cash 4. Outflow of cash 5. Outflow of cash 6. Outflow of cash 7. Outflow of cash.
Self Assessment Questions 11 1. Purchase 2. Current year minus previous year 3. Increase in fixed assets
Self Assessment Questions 12 1. Outflow 2. Deduction.
Self Assessment Questions 13 1. Loss of operation 2. Payment of cash dividend out of accumulated reserves 3. Part of paid up capital + reserves and surplus. Self Assessment Questions 14 1. Change of fund 2. Source 3. Application 4. Non fund 5. Change. 6. Positive
Sikkim Manipal University
226
Financial and Management Accounting
Unit 10
7. Negative.
Self Assessment Questions 15
1. Current assets and Current liabilities. Self Assessment Questions 16
1. Schedule of changes in working capital 2. Adjusted Profit and Loss account 3. Funds flow statement Self Assessment Questions 17
1. Two Balance sheet dates 2. (b) A minus B 3. (c) Current assets 4. Current liabilities 5. A minus B 6. Balancing figure. Self Assessment Questions 18 1. Reserve 2. Deduction 3. Working capital changes 4. Considered as current liabilities 5. In Provision account 6. Liability 7. General Body Meeting 8. Current liability 9. Outflow 10. Current assets 11. Fixed assets 12. Fall in value 13. Non cash item 14. Opening balance
Sikkim Manipal University
227
Financial and Management Accounting
Unit 10
15. Provision account and not to Profit and Loss account 16. Fixed assets
Answer for Terminal Questions 1: 35,000, (b) Taxes paid is an application of funds. 2. Rs.24,000 3. Rs.1,50,000 4. Fund Rs.45,000; Accumulated Depreciation on plant sold Rs.9,000 5. Funds lost from operations. Rs.1,300, Decrease in WC Rs.4,700)
Sikkim Manipal University
228
Financial and Management Accounting
Unit 11
Unit 11
Cash Flow Analysis
Structure: 11.1
Introduction Objectives
11.2
Meaning Self Assessment Questions 1
11.3
Objective Self Assessment Questions 2
11.4
Uses Self Assessment Questions 3
11.5
Steps in preparation Self Assessment Questions 4
11.6
Difference between CFS and FFS Self Assessment Questions 5
11.7
Computation Self Assessment Questions 6 Terminal Questions Answer to SAQs and TQs
11.1 Introduction The funds flow analysis deal with the flow of funds within and outside the organization. The main focus of funds flow statement is to explain the changes which have taken place in net working capital during the period under consideration. Funds flow statement normally fails to explain the changes in cash balance. The movement of cash is of vital importance to the management. The organization may become directionless if the cash inflows are not sufficient to meet the cash outflows. Many a time, a management is posed with the paradox of huge profits and yet impossible to pay dividends or even taxes. This is due to the ground realities that cash is either not received or the cash received is drained out in other items. Hence, it has become a necessity to have a cash flow analysis on a day to day basis. The statement shows the items resulting in cash inflows and cash outflows.
Sikkim Manipal University
229
Financial and Management Accounting
Unit 11
Learning Objectives: After studying this unit, you should be able to understand the following 1. Understand the meaning of cash flow statement. 2. Appreciate the uses of cash flow statement. 3. Acquaint with steps in preparation of CFS. 4. Distinguish between FFS and CFS. 5. Compute the CFS.
11.2 Meaning of Cash Flow Statement Cash flow statement, also known as “Statement Accounting for variations in cash” shows the movement of cash and their causes during the period under consideration. The statement is mainly prepared to show the impact of financial policies and procedures on the cash position. It takes into account all the transactions that have a direct impact upon cash. Self Assessment Questions 1 1. CFS is also known as __________________. 2. CFS is prepared to Know ______________.
11.3 Objectives The main objective of cash flow analysis is to show the causes of changes in cash balances during the period under consideration. The necessary information required to keep the management of the real cash position, this statement is comes handy. It bring in the liquidity position of the firm. It is of particular importance in short range planning. It enables a management to take a strong short term financial decision relating to liquidity and ways and means to achieve it.
Self Assessment Questions 2 1. Main objective of CFS is _______________. 2. CFS brings in ___________________ position. 3. CFS is ________________ of importance in ________ planning.
11.4 Uses of Cash Flow Statement The cash flow statement, being one of the important financial documents a firm has to possess , reveals the effective uses. First of all, it explains in depth the reasons for the low cash balance available at a particular time. Based on this, it is possible to find the reasons for such a situation. Sikkim Manipal University
230
Financial and Management Accounting
Unit 11
It also shows the major sources and uses of cash. By effectively maintaining the cash and controlling the outflow of cash, it is possible to set in motion the smooth functioning of the organization. It helps the financial decisions more effectively with regard to short term liquidity position of an organization. Projections of cash inflows and outflows can be regulated based on the records available in the past. Proper projections can be made once the reasons are analyzed. Based on this, it is possible to liquidate the short term obligations without much fun fare. Short term obligations need to be serviced so that the credit worthiness of an organization can be carried on unabated. Self Assessment Questions 3 1. CFS explain _______________ low cash balance. 2. CFS shows _________ flows. 3. CFS helps ________decision ______________ position.
11.5 Steps In Preparation Of Cash Flow Statement The Cash Flow Statement (CFS) is prepared with the help of Balance Sheet. , income statement. The measurement of cash flow is primarily based on income statement. Under the CFS, the cash basis technique is adopted. The measurement of cash flow is not measurement of net income. The CFS depends primarily on determining cash receipts and disbursements over a given period. The CFS is concerned with cash inflows sources of cash_ and cash outflows (application of cash).The sources and application of cash are computed separately. The various sources for cash inflows are : Cash Sales : When a concern is doing its business on cash basis, the cash flows in out of sales effected. When the cash sales are in vogue, it is quite natural that the business also effects its purchases on cash basis. In addition, the operating expenses should be payable in cash. Therefore the cash inflow should be as follows : Cash inflow from cash sales = Cash sales – cash purchases – operating expenses. In addition, if the business is conducted both on cash and credit basis, then from the total sales effected, deduct the credit sales. Therefore the cash sales is : Total sales – credit sales OR Total sales – increase in debtors and Bills receivable. So also, the cash purchases are also dealt with in the same manner as discussed with cash sales.
Sikkim Manipal University
231
Financial and Management Accounting
Unit 11
Net Profit method : Cash from operations can be determined with the net profits figure also. This method is handy when the amount of sales is not known In this case, non cash and non trading expenses and losses are added back to net profit. From this, the income from investments, increase in Accounts Receivable, increase in prepaid expenses, decrease in outstanding expenses are deducted. In addition to the above, operating profits are also considered as cash from operations, such as increase in share capital, debentures, loans, other receipts such as dividends, interest on investment, and reduction in or sale in assets. Cash outflows : These refers to uses or application of cash. These arises due to operating loss, redemption or repayment of redeemable preference shares or debentures, repayment of loans, purchase of assets, other revenue payments such as dividend, income tax , interest, compensation. Self Assessment Questions 4 1. CFS is prepared with the help of ____________. 2. CFS is based on _________ technique. 3. CFS is ____________________. 4. Cash sales refers_________________. 5. Cash flow _______________________. 6. For credit transaction the equation is cash flow = total sales______________. 7. Cash outflow = total purchase ____________________. 8. Net profit method is used when __________ not known. 9. ______ and ______ added back to net profit. 10. Cash outflow refers to________________.
11.6 Difference Between Cash Flow And Funds Flow Statement The major differences between the two are : 1. FFS is related with accrual basis whereas CFS is on cash basis. For this the, it is necessary to convert the accrual to cash basis. 2. In FFS, a Schedule of changes in working capital delinking the current assets and current liabilities are made. But in FFS, no schedule is prepared. 3. FFS shows the causes of the changes in net working capital. CFS shows the causes for the change in cash 4. In FFS, no opening or closing balances are recorded. But in CFS both are incorporated
Sikkim Manipal University
232
Financial and Management Accounting
Unit 11
5. FFS is not based on the Ledger mode. But CFS is prepared on the basis of Ledger principles. 6. In FFS, “To” and “By” are indicated. In CFS, these are indicated. 7. In FFS, net effect of receipts and disbursements are recorded. In CFS only cash receipts and payments are recorded. 8. FFS is concerned with the total provision of funds. CFS is concerned with only cash. 9. FFS is flexible but CFS is rigid 10. FFS is more relevant for long range financial strategy. CFS concentrates on short term aspects mostly affecting the liquidity of the business.
Self Assessment Questions 5 1. FFS is __________ basis CFS is __________. 2. Statement of working capital is the _____________. And not the ______________. 3. In FFS __________ balance not recorded but CFS _____________. 4. CFS is ____________ mode but FFS_______ 5. FFS ________ receipts are recorded in CFS________ 6. FFS is _________ CFS ___________.
11.7 Computation Of Cash From Operations The Cash Flow Statement should be prepared as per the revised Accounting Standard issued by the ICAI . Accounting Standards 3 specifies : “The cash flow statement should report cash flows during the period classified by operating, investing and financing activities”. As per the revised standard, there are two methods of preparing cash flow statement namely Direct method and Indirect method. In this Study material, indirect method is adopted throughout. Format CASH FLOW STATEMENT AS PER AS 3 For the year ended ………..
A Cash flow from operating activities : Net profit before taxes and extraordinary items ADJUSTMENTS FOR ; 1, Depreciation 2. Miscellaneous expenses written off 3. Loss on sale of fixed assets Sikkim Manipal University
233
Financial and Management Accounting
Unit 11
4. interest expenses 5. Dividend income Operating profit before working capital changes ADD : Decrease in current assets Increase in current liabilities Deduct : Increase in current assets Decrease in current liabilities Cash Generated from operating activities
B. CASH FLOWS FROM INVESTING ACTIVITIES Purchase of fixed assets Sale of fixed assets Purchase of long term investment Sale of long term investment Interest received Dividend received Capital gain tax on income from sale of long term investment Net cash from investing activities
C. CASH FLOWOS FROM FINANCING ACTIVITIES Proceeds from issue of share capital Proceeds from long term borrowing Repayment of long term borrowings Interest paid Dividend paid Tax on distributed profit Net cash from Financing Activities
Total of A + B +C Net Increase or Decrease in cash and cash equivalents Add : Cash and cash equivalents opening balance Cash and cash equivalents : closing balance
Classification of cash flows :
Sikkim Manipal University
234
Financial and Management Accounting
Unit 11
Cash flow statement has been divided into three parts namely: 1. Cash flows from Operating Activities 2. Cash flows from Investing Activities 3. Cash flows from Financing Activities
CASH FLOWS FROM OPEPRATING ACTIVITIES Meaning : Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.,. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss. Object : The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external source of financing. Information about the specific components of future operating cash flows is useful in conjunction with other information in forecasting future operating cash flows.
Self Assessment Questions 6 1. CFS is prepared as a per _________. 2. CFS deals with ____, __________, _____________activities . 3. CFS is based on 2 methods _____________ and _______________. 4. Operating Activity is based on __________.
Sikkim Manipal University
235
Financial and Management Accounting
Unit 11
Problem 1: Compute the cash flow from operating activities Profit and Loss Account To By Cost of goods sold
4,00,000 Sales including cash sales 5,00,000 1,00,000
Office expenses 12,000 Profit on sale of land 30,000 Selling expenses 8,000 Interest on investment 20,000 Depreciation 6,000 Loss on sale of plant 4,000 Goodwill written off 3,000 Income tax 7,000 Net Profit 1,10,000 __________
_________
5,50,000 5,50,000
Position of current assets and current liabilities are as follows : MARCH 31 2006
2007
Stock
30,000
28,000
Debtors
15,000
12,000
6,000
8,000
10,000
12,000
Bills Payable
8,000
5,000
Outstanding expenses
4,000
5,000
Bills Receivable Creditors
Solution Statement showing cash flows from operating activities Net Profit before tax and extraordinary items
1,10,000
ADD : income tax
7,000
Adjustments for Depreciation
6,000
Goodwill written off
3,000
:Loss on sale of plant
4,000
Sikkim Manipal University
236
Financial and Management Accounting
Unit 11
1,30,000 Less: Profit on sale of land
30,000
Interest received
20,000 ( 50,000 )
Operating profit before working capital changes
80,000
ADD : Decrease in current assets Stock
2,000
Debtors
3,000
Increase in current liabilities : Creditors
2,000
Outstanding expenses
1,000 8,000
88,000 Less Increase in current assets : Bills Receivable
2,000
Decrease in current liabilities : Bills payable
3,000 ( 5,000)
Cash generated from operating activities 83,000 Less : Payment of income tax ( 7,000 )
Net Cash from operating Activities 76,000 As per AS – 3, Net profit before taxation must be shown here.
Problem 2 : Calculate cash flow from operating activities MARCH 31 2006
2007
1,00,000
80,000
Bills Receivable
25,000
30,000
Bills payable
30,000
22,000
Creditors
30,000
40,000
Outstanding expenses
10,000
8,000
1,000
800
Debtors
Income received in advance Sikkim Manipal University
237
Financial and Management Accounting
Unit 11
Prepaid expenses
600
500
Accrued income
300
450
Operating profit before working capital changes Rs.3,80,000
Solution Statement showing cash flow from operating activities Operating profit before working capital changes
3,80,000
ADD : Decrease in current assets
Debtors Prepaid expenses
20,000 100
Increase in current liabilities Creditors Outstanding expenses
10,000 2,000 32,100 4,12,100
Less : Increase in current assets Bills receivable Accrued income
5,000 150
Decrease in current liabilities Bills payable Income receivable in advance
8,000 200 (13,350)
Net cash from operating activities 3,98,750
Problem 3: The following is the position of current assets and current liabilities March 31 2006
2007
Short term loan
15,000
18,000
Creditors
30,000
8,000
1,200
Provision for Doubtful debts Bills Payable
18,000
20,000
Stock in trade
15,000
13,000
Sikkim Manipal University
238
Financial and Management Accounting
Bills Receivable
Unit 11
10,000
22,000
Prepaid expenses
800
600
Outstanding expenses
300
500
Current year net loss is Rs.38,000. Calculate the cash flows
Solution Statement showing cash flows from operating activities Net Loss
( 38,000 )
ADD: Decrease in Current Assets Provision for doubtful debts
1,200
Stock
2,000
Prepaid expenses
200
Increase in current liabilities Outstanding expenses Bills payable
200 2,000 + 5,600 __________ 32,400 )
DEDUCT ; Increase in current assets Short term loan
3,000
Bills receivable
10,000
Creditors
22,000 + 35,000
Net cash loan in operating activities ( 67,400 )
Problem 4: Following extracts are in respect of a company. MARCH 2006
2007
Debtors
30,000
10,000
Stock
25,000
28,000
B.R.
40,000
8,000
Short term loan
10,000
11,000
8,000
8,100
Prepaid expenses
Sikkim Manipal University
239
Financial and Management Accounting
Unit 11
Creditors
10,000
20,000
6,000
2,000
600
300
B.P. Outstanding expenses The current year net loss is Rs.50,000. Calculate the cash flows.
Solution : Statement showing cash flows from operating activities Net Loss ( 50,000 ) Add: Decrease in current assets Debtors 20,000 B.R. 32,000 Increase in current liabilities Creditors
10,000 + 62,000 + 12,000
DEDUCT : Increase in current assets Stock
3,000
Short term loan
1,000
Prepaid expenses B.P.
100 4,000
Outstanding expenses
400 (8,500)
Net cash from operating activities
+ 3,500
Terminal Questions 1. What are the objectives of cash flow statements ? 2. Mention the steps involved in the preparation of CFS ? 3. Distinguish between cash flow and fund flow statements. 4. Compute cash flows from operating activities March
Profit and loss account Debtors Sikkim Manipal University
2006
2007
1,00,000
80,000
90,000
72,000 240
Financial and Management Accounting
Unit 11
Bills receivable
50,000
48,000
Stock
60,000
42,000
10,000
20,000
8,000
5,000
4,000
Creditors
26,000
38,000
Bills payable
30,000
26,000
Short term loan Goodwill Prepaid expenses
5. Cash transactions in respect of DR Ltd are as follows :
Balance of cash on hand 70,000 Payment to creditors 25,00,000 Receipts from Debtors 30,00,000
Purchase of fixed assets 2,50,000
Issue of shares 8,00,000 Payment for overheads 1,50,000 Sale of fixed assets 2,00,000 Salaries 70,000 Income tax 1,00,000 Dividend paid
80,000
Repayment of loan 1,50,000 Closing balance of cash 7,70,000 40,70,000 40,70,000
Prepare a cash flow statement
Answer Self Assessment Questions: Self Assessment Questions 1 1. Statement Accounting for variation in cash 2. Financial polices and procedures Self Assessment Questions 2 1. show causes of changes. 2. Liquidity 3. short term. Self Assessment Questions 3 1. reasons. 2. major Sikkim Manipal University
241
Financial and Management Accounting
Unit 11
3. financial, short term liquidity Self Assessment Questions 4 1. B.S. income statement. 2. cash basis 3. measurement of net income 4. sale through case only 5. cash sales – cash purchase – operating expenses. 6. credit sales 7. minus credit purchases 8. sales 9. cash and non trading expenses and losses. 10. application of cash. Self Assessment Questions 5 1. accrual, cash 2. FFS , CFS 3. opening and closing, recorded. 4. ledger, not 5. net effect, cash receipts. 6. flexible, rigid. Self Assessment Questions 6 1. AS 3 2. operating, investing and financing. 3. Direct, Indirect. 4. profit and loss account Answer for Terminal Questions 1. Refer to unit 11.2 and 11.3 2. Refer to unit 11.5 3. Refer to unit 11.6 4. Net cash from operating activities Rs 13,000 5. Net cash from operating activities Rs 1,80,000 Cash flows from investing activities Rs 50,000 Cash flows from financing activities Rs 5,70,000
Sikkim Manipal University
242
Financial and Management Accounting
Unit 12
Unit 12
Understanding Cost
Structure: 12.1
Introduction Objectives
12.2
Meaning Self Assessment Questions 1
12.3
Concepts Self Assessment Question 2
12.4
Components Self Assessment Questions 3
12.5
Total cost Self Assessment Questions 4
12.6
Cost sheet Self Assessment Questions 5
12.7
Format Self Assessment Questions 6
12.8
Valuation of WIP Self Assessment Questions 7 Terminal Questions Answer to SAQs and TQs
12.1 Introduction The need for accounting arose because of limitations of human memory. To preserve the knowledge, various steps are taken both in the past and in future. It is necessary to record all the business purposes. Accounting is a science as well ass an art of recording the business transactions in the books of accounts systematically and scientifically. Until the1980s, the Cost Accounting was in the domain of the Engineer. Its integration with financial accounting started when Accountants started to audit the cost records. The costing technique play a vital role in gathering and analyzing revenue and cost data to assist management in decision making. The point of emphasis has logically shifted from cost accumulation to cost analysis, a change from a limited cost finding function on to a broader
Sikkim Manipal University
243
Financial and Management Accounting
Unit 12
managerial function. All managerial policies and decisions permeate all phases of cost accounting and cost information helps in : Acquiring plant and machinery Adding or reducing a product Buying or making parts Special pricing of products Replacement of equipments.
Learning Objectives: After studying this unit, you should be able to understand the following 1. Explain the meaning of cost. 2. Analyse the cost concepts. 3. Understand the element of cost. 4. Familiarize with components of total cost. 5. Prepare the statement of cost. 6. Understand the valuation procedure of work in progress.
12.2 Meaning Of Cost Cost is the amount of resources given up in exchange of some goods and services. The resources are expressed in money or money’s equivalent. CIMA defines the term Cost as “ the amount of expenditure (actual or notional) incurred on or attributable to a given thing.”. The given thing may be taken as a product, service or any other activity. While the actual expenditure refers to the amount spent , the notional expenditure does not involve in any cash outlay. It does not reflect itself in the accounting records. But, it is important for the purpose of comparison of cost and in decision making. Self Assessment Questions 1 1. CA ___________ resources scarified . 2. Resource are in _________________.
12.3 Cost Concepts Cost represents expenses. It is a sacrifice in advance. It concerns with a release of something of value. The cost is used : The expected cost of a particular action. It is what the cost is expected to be in choosing a course of action. Sikkim Manipal University
244
Financial and Management Accounting
Unit 12
The cost of something purchase i.e. the price actually paid for it. It is the price paid or payable, time of purchase of goods or services. The price paid is the amount of money, the holding of which is foregone. The cost of attaining some end – the sacrifices actually made to attain it experienced costs. Self Assessment Questions 2 1. Cost is ________________. 2. cost __________ advance.
12.4 Component Or Element Of Cost Any product that is manufactured, whether a pin or a computer calls for consumption of some resources. The management, for its planning and control function must know the cost of using their resources. Therefore, the elements of costs are classified as materials, labor and expenses. These three elements of cost would be grouped in to direct and indirect categories Cost
Direct
Raw Material
Labor
Indirect
Chargeable Expenses
Material
Labor
Overheads
Following are the three broad elements of cost Materials Labor Expenses Materials: The term materials may be defined as the substances from which products are manufactured. These materials may be in a raw or a manufactured state. Materials may be direct or indirect. It is an accepted fact, based on statistics, that 75% of the total cost is in the form of raw materials. These are the physical; items used in manufacturing. These are the physical items used in manufacturing. These can be traced precisely and convincingly to the unit of product. It refers to Sikkim Manipal University
245
Financial and Management Accounting
Unit 12
all materials brought for being converted into finished product example log of wood awaiting to be converted into doors and windows. Therefore, the term “raw” indicates that the firm using the materials has not yet processed them. But what is raw material for one manufacturer might be a finished product for another : for example bricks, cement, steel is a raw material for a construction company where for a steel producing firm it is the final product. For admission to I MBA, the raw materials are the graduates. Indirect materials: These are materials which do ot become part of the product. These materials are consumed in the course of production. These materials cannot be conveniently assigned to specific physical units. Some of the indirect materials are consumable stores, oil, lubricants, cotton wastes, printing and stationers. Indirect materials may relate to the factory, the office and administration and the selling and distribution divisions. Direct Labor: It represents wages payable / paid to those employees who directly engaged in the conversion of raw materials into final product. They operate in the manufacturing machinery and equipment. They directly handle the raw materials, work in process and the finished goods on the production line. They account is to see whether the work done on a particular product or a specific group of products. Examples: In a furniture mart, the carpenters engaged in conversion of raw wood with sofa set, computer tables, windows, doors , benches are said to be the direct workers. In an engineering workshop, the wages paid to the operators working with laths, drilling, cutting, shaping machines can be specifically assigned to the products concerned. Therefore, the direct labor costs can be traceable to individual products. Indirect Labor: Indirect labor is the labor which is not directly engaged in the production operations. They are, however, engage themselves to help in the production operations. Such labor does not alter the construction, composition or conditions of the product. Example foreman’s salary, storekeepers salary, Factory manager’s salary etc. The indirect labor may relate to the factory, office and administration and selling and distribution divisions. Chargeable Expenses : The items are of expenses which may be allocated to a specific job, process or operation. The utility of expenses is exhausted on completion of the job concerned. Therefore, logically, they are treated as direct expenses. The chargeable expenses are usually incurred when the business concern undertakes some outside constructional work far away from the principal premises, example widening of road by L & T construction company for the new International Airport. The popular items fall under this category are:
Sikkim Manipal University
246
Financial and Management Accounting
Unit 12
a) cost of pattern, designs, drawings specifically prepared for a particular job b) hire charges of special machinery, plant or equipment c) architects and surveyors fees in connection with particular job or contracts. d) Cost of any experimental work carried out for a particular job Indirect expenses: These are those expenses which cannot be directly and conveniently allocated to specific cost units / cost centers.. They are apportioned. Examples are rent, rates and insurance. They may relate to the factory, the office and administration and selling and distribution divisions. These are now popularly known as “overheads”. These costs arise as a result of overall operations of a business. These costs are shared by all the products. It includes all manufacturing and nonmanufacturing suppliers and services. These costs cannot be associated withy a particular product or unit. Overheads remain relatively constant from period to period. At least they do not fluctuate in amount in relations to changing levels of factor production. Overhead costs are classified by functions of an organization into : Factory, works or manufacturing overheads Administration, office, establishment or general overheads Selling and distribution overheads. Self Assessment Questions 3 1. Cost compose ________________ 2. Direct cost include__________. 3. Indirect cost are know as ___________. 4. Raw refers to ______________. 5. Indirect materials cannot be _____________. 6. Direct labor is ____ for __________. 7. Indirect labor is engaged for ________. 8. Chargeable expenses are ____________ 9. Chargeable expenses are______________________ expand. 10. Indirect expenses are ________________. 11. IDE are known as _________________.
12.5 Components Of Total Cost The components of total costs are based on functional classification. The various stages through which the costs flow are:
Sikkim Manipal University
247
Financial and Management Accounting
Unit 12
Prime cost : It is the total of direct materials cost, direct labor cost and chargeable expenses/ Factory Cost : It consists of prime cost and factory overheads/ Office cost or Cost of Production: It comprises of factory cost and office and administration overheads. Total Cost : By adding selling and distribution expenses to cost of production, one can get the total cost or cost of sales. Self Assessment Questions 4 1. Prime cost is _______________. 2. Factory cost is _____________. 3. Cost of production is _____________. 4. Total cost is ___________________. 5. Sales is _________________. 6. Profit is __________________.
12.5 Statement Of Cost Sheet Cost sheet is a statement prepared to show the different components of the total cost. It generally shows the total cost and sales as well as cost and selling price per unit. It is generally presented in a tabular form. Self Assessment Questions 5 1. Cost sheet shows ___________ cost. 2. It is prepared _________ form.
Sikkim Manipal University
248
Financial and Management Accounting
Unit 12
12.5 Format Specimen Of Cost Sheet Name of Company _______________________________ Cost sheet for the product __________________________ For the year ending _______________________________ Output in units Particulars
Total Per unit Rs. Rs.
Raw Materials consumed: Opening Stock of Raw Material ADD: Purchases of Raw materials Add: Carriage on purchases LESS: Closing stock of Raw material Raw Material Consumed (RMC)
x x x
Director Labor x x x Chargeable Expenses
x x x Prime Cost
XXX
Factory overheads
x x x
Factory Cost Office and Administration Overheads
XXX x x x
Cost of Production
XXX
Inventory valuation Opening stock of finished goods xxx Less: closing stock of finished goods : always To be valued at cost of production ( xxx ) Cost of Goods Sold (COGS)
XXX
Selling and Distribution Overheads x x x Total Cost of Cost of Sales XXX Profit (balancing figure) x x x Sales Revenue or Sales
Sikkim Manipal University
XXX
249
Financial and Management Accounting
Unit 12
Example: Prepare a cost sheet Raw materials consumed Rs.1,60,000. Direct wages Rs.80,000. Factory overheads Rs.16,000. Office overheads 10% of factory cost. Selling overheads Rs.12,000. Units produced 4,000.Selling price per unit Rs.100. Solution:
Cost Sheet
Raw materials
1,60,000
Direct wages 80,000 Prime cost 2,40,000 Factory overheads 16,000 Factory Cost Office overheads (10 % of factory cost) Cost of Production
2,56,000 25,600 2,81,600
Less : Closing stock of finished goods to be valued at Cost of production : 2,81,600 x 400 */ 4000** ( 28,160) Cost of Goods Sold 2,53,440 Selling overheads 12,000 Cost of Sales / Total Cost
2,65,440
PROFIT (balancing figure) 94,560 Sales (3600 x Rs.100) 3,60,000 *Closing stock in units : Units produced minus units sold **Denominator should be the current year production in units. Items not included in Cost Sheet: a) Income tax b) Dividends to shareholders c) Commission to managing directors d) Capital losses i.e. loss out of sales e) Interest on loan or debentures or bank interest f) Donations g) Capital expenditure h) Discounts on shares and debentures i) Premium on redemption of shares and debentures j) Underwriting commission Sikkim Manipal University
250
Financial and Management Accounting
Unit 12
k) Writing of goodwill, preliminary expenses l) Reserve for bad debts m) Transfer to all reserves or appropriation of profits n) Share premium o) Interest on capital p) Drawing of proprietors q) All personal expenses of owner Self Assessment Questions 6 1. RMC is ___________. 2. COGS is _____________. 3. Closing inventory is valued _____________________. 4. Profit ______________ figure.
12.6 Valuation Of WorkinProgress In a manufacturing enterprise, there may be certain amount of goods in a partly manufactured state at the end of a particular period. These are called as “semi manufactured goods” or “work in progress”. The WIP is valued according to the value of raw material, labor and expenses which has so far incurred to the date of closing of financial period. The work in progress has usually three components: Material work in progress cost to date Labor to date Manufacturing expenses incurred to date The treatment of work in progress is to add the opening work in progress to the concerned cost and deduct the closing work in progress against it. Self Assessment Questions 7 1. WIP is nether ____________ nor __________. 2. WIP is treated as ________________. 3. Profit margin as total cost is _____________. 4. Profit margin as selling price is ___________. 5. 25% profit on SP is ______________. 6. 25% on TC is ___________. Example: DR Ltd manufactures Electronic components. The following figures are supplied Rs. Sikkim Manipal University
251
Financial and Management Accounting
Unit 12
Purchase of Raw Material 2,00,000. Direct labor 1,20,000. Carriage inwards 20,000 Manufacturing expenses 10,000. Stock of raw materials : opening 25,000, closing 75,000. Work in progress on 1:4:2006 : Materials 2,000 Labor 5,000 Expenses 1,000. Calculate the Factory cost..
Solution: COST OF PRODUCTION FOR THE YEAR ENDED 31 st March 2008 Direct Raw materials consumed: Opening stock of raw material 25,000 Add: Purchase of raw materials 2,00,000 Add: carriage inwards 20,000 Less: Closing stock of raw materials (75,000) Add: Opening Work in progress of materials 5,000 Less: Closing work in progress of materials (2,000) Raw materials consumed
1,73,000
Director Labor 1,20,000 Add: Opening WIP of labor 8,000 Less: Closing WIP of labor
(5,000) _________ 1,.23,000 ___________
PRIME COST
2,96,000
FACTORY OVERHEADS Manufacturing expenses 10,000 Add:: opening WIP of expenses
2,000
Less : Closing WIP of expenses ( 1,000) ___________ 11,000 ____________ Factory Cost
3,07,000
Problem 1: Calculate the cost of raw materials purchased: Opening stock of raw materials Rs.10,000. Closing stock of raw materials Rs.15,000. Expenses on purchases Rs.5,000. Direct wages Rs.50,000 Prime cost s Rs.1,00,000.
Sikkim Manipal University
252
Financial and Management Accounting
Unit 12
Solution: Computation of cost of raw materials purchased Opening Stock of raw materials 10,000 Add Purchases
X
Expenses on purchases 5,000 ___________ 15,000 + X Less closing stock of raw materials (15,000) ____________ Raw materials consumed Direct wages
X 50,000 _____________
Prime Cost
50,000 + X
Prime cost given in the problem is Rs.1,00,000 Hence substituting , 1,00,000 = 50,000 + X; Therefore X = Rs.50,000 Cost of Raw Materials is Rs.50,000
Sikkim Manipal University
253
Financial and Management Accounting
Unit 12
Problem 2: Prepare a cost sheet: Direct materials Rs.2,00,000. Factory expenses Rs.1,20,000. Office expenses Rs.90,000 Total sales Rs.6,50,000. Prime cost Rs.4,10,000 . 10 % of the output is in stock.
Solution:
Cost Sheet
Direct materials 2,00,000 Direct wages (Prime cost minus Direct materials 2,10,000 _____________ Prime Cost Factory expenses
4,10,000 1,20,000 _____________
Factory Cost
5,30,000
Office expenses 90,000 _____________ Cost of Production
6,20,000
Less: closing stock of finished goods 10 % of 6.20,000 ( 62,000.) _____________ Cost of Sales 5,58,000 Profit (balancing figure) 92,000 _____________ SALES
6,50,000
Problem 3 : The following information is obtained: Stock on Jan 1, 2007 : Raw materials 40,000; Finished goods 30, 000. Purchases of Raw materials 2,40,000. Direct wages 1,36,000. Works expenses 70,400. Dividends paid 40,000. Office expenses 24,000. Depreciation 10,000. Selling and Distribution expenses 32,000. Work in progress : 1.1.2007 64,000. 31:.12.:2007 72,000. Goodwill written off 40,000. Stock on 31.12.2007 Raw materials 42,000 Finished goods 32,000. Sale of finished goods 5,50,000. Payment of sales tax 16,000. Prepare a cost sheet.
Sikkim Manipal University
254
Financial and Management Accounting
Solution
Unit 12
Cost Sheet
Opening stock of Raw materials 40,000 Add: Purchases of raw materials 2,40,000 Less: Closing stock of raw materials ( 42,000) ___________ Raw materials consumed Direct wages
2,38,000 1,36,000 ____________
Prime Cost
3,74,000
Works Overheads Works expenses 70,400 Depreciation
10,000 ____________ 4,54,400
Add : opening stock of WIP 64,000 Less: Closing stock of WIP
( 72,000) ____________
Works Cost
4,46,400
Office and Administration overheads Office expenses 24,000 ____________ Cost of Production
4,70,400
Add : opening stock of finished goods 30,000 Less : Closing stock of finished goods ( 32,000) ____________ Cost of Goods sold
4,68,400
Selling and Distribution expenses 32,000 _____________ Cost of Sales 5,00,400 Sales Tax 16,000 _____________ Total Cost 5,16,400 Profit
33,600 _____________
Sales
Sikkim Manipal University
5,50,000
255
Financial and Management Accounting
Unit 12
Problem 4: Prepare a cost sheet Raw materials Rs.33,000. Unproductive wages Rs.10,500. Factory lighting Rs.2,200. Motive power Rs.4,400. Director’s fees (Works) Rs.1,000. Factory cleaning Rs.500. Factory stationery Rs.750. Loose tools written off Rs.600. Water supply Rs.1,200. Office insurance Rs.500. Chargeable expenses Rs.3,000. Depreciation: Plant and machinery Rs.2,000. Office Building Rs.1,000. Delivery vans Rs.200. Upkeep of Delivery van Rs.700. Commission on sales Rs.1,500. Productive wages Rs.35,000. Factory rent and taxes Rs.7,500. Factory heating Rs.1,500. Haulage Rs.3,000. Director’s fees (office) Rs.2,000. Sundry office expenses Rs.200. Office stationery Rs.900. Rent and taxes (office) Rs.500. Factory insurance Rs.1,100. Legal expenses Rs.400. rent of warehouse Rs.300. Bad debts Rs.100. Advertising Rs.300. Sales Department salaries Rs.1,500. Bank charges Rs.50, Reserve for Doubtful debts Rs.100..Debenture interest Rs.20,000. Income tax Rs.22,500. Total output 20,000 tons. Solution
Statement of Cost (Production 20,000 tons) Direct materials consumed 33,000 Productive wages 35,000 Chargeable expenses 3,000 ____________ Prime Cost
71,000
Works Expenses Unproductive wages 10,500 Factory rent and taxes
7,500
Factory lighting 2,200 Factory heating 1,500 Motive power
4,400
Haulage 3,000 Director’s fees 1,000 Factory cleaning 500 Factory stationery 750 Loose tools written off
600
Water supply 1,200 Factory insurance 1,100 Sikkim Manipal University
256
Financial and Management Accounting
Unit 12
Depreciation of Plant and machinery 2,000 __________ 36,250 ____________ Factory / Works cost
1,07,250
Office and Administration expenses Director’s fees
2,000
Sundry expenses 200 Office stationery 900 Rent and taxes
500
Office insurance 500 Legal expenses 400 Bank charges
50
Depreciation of office building 1,000 _____________ 5,550 __________ Cost of Production
1,12,800
Selling and Distribution Expenses Rent of warehouse 300 Depreciation of Delivery vans 200 Bad debts
100
Advertising 300 Sales Department salaries 1,500 Upkeep of Delivery van
700
Commission on sales 1,500 4,600 Total Cost / Cost of Sales
1,17,400
Cost Per unit : Total Cost / No of Units produced : 117400 / 20,000 Rs.5.87 Note: Ignore reserve for doubtful debts. Ignore Income tax Ignore Debenture interest
Sikkim Manipal University
257
Financial and Management Accounting
Unit 12
Problem 5: The following extract refers to a commodity for the half year ending 31 st March 2008. Prepare a cost statement. Purchase of raw materials Rs.1,20,000. Rent, rate, insurance and works expenses Rs.40,000. Direct wages Rs.1,00,000. Carriage inwards Rs.1,440. Opening stock Raw materials Rs.20,000, Finished goods (1000 units) Rs.16,000. Closi9ng stock : raw material Rs.22,240 Finished Goods (2,000 tons). Work in progress : opening Rs.4,800 and closing Rs.16,000. Sale of finished goods Rs.3,00,000. Cost of factory Rs.8,000. Advertising, discounts allowed and selling costs Re.1 per ton sold. Production during the year is 16,000 tons. Prepare a cost sheet.
Solution Statement of Cost Direct materials Opening stock or raw materials 20,000 Add: Purchases of raw materials
1,20,000
Add : carriage inwards 1,440 Less: Closing stock of raw materials (22,240) ____________ Raw materials consumed Direct Wages
1,19,200 1,00,000 __________
Prime Cost
2,19,200
Works Expenses Cost of factory 8,000 Rent, rate and insurance
40,000
Add: opening WIP 4,800 Less: Closing WIP
(16,000) __________ Factory / Works cost
Office and administration expenses
2,56,000 Nil __________
Cost of production
Sikkim Manipal University
2,56,000
258
Financial and Management Accounting
Unit 12
Inventory valuation Opening stock of finished goods
16,000
Less : Closing stock of finished goods to be valued at cost of Production (32,000) __________ Cost of Good Sold
2,40,000
Selling and Distribution Expenses * Advertisement and discount allowed 15,000 __________ Total Cost or cost of sales 2,55,000 Profit 45,000 __________ Sales** 3,00,000
*To be valued only at number of units sold. Opening stock of finished goods + production minus closing stock = Number of units sold. ** Always to be valued at number of units sold. Number of units sold x Selling price per unit. Tender Cost Sheet or Quotations Frequently, a manufacturer of capital goods and consumer durable goods is required to quote the price at which he can supply a particular article. Moreover, demand for certain seasonal articles need to be taken into account. The manufacturer has to fix a competitive price to take care of inflationary trends on the input. These aspects need an estimation at the production level itself. For this purpose, consider the following principle: Works expenses are based on direct wages Office expenses are based on works / factory cost. Finally, since the costs are estimated, the profits can be related either to cost or to the selling price. The formula is : If profit percentage is given on
Profit = Total Cost x given percentage ex.
Cost price ie. On Total cost
for 20 %, TC x 20/100 or 25%, it is TC x 25 /
If profit percentage is given on
Profit = Total cost x given percentage / 100
Selling price, bring the percentage
minus same given percentage eg. For 20 %
to cost price
TC x 20 / 100 minus 20for 25%, it is TC x 25 / 100 minus 25 %
Sikkim Manipal University
259
Financial and Management Accounting
Unit 12
Problem 6: The cost data is as follows: Raw materials consumed Rs.1,82,000. Direct wages Rs.40,000. Chargeable expenses Rs.20,000. Opening stock of finished goods (1,000 units) Rs.32,000. Closing stock 2,000 units. Factory overheads 100 % of direct labor. Office overheads 10% of works cost. Selling of Distribution expenses Rs.4 per unit sold. Units produced 10,000. Profit markup 20% on selling price. Prepare a cost sheet. Solution STATEMENT OF COST Raw materials consumed 1,82,000 Direct wages 40,000 Chargeable expenses
20,000 _____________ Prime Cost
2,42,000
Factory expenses at 100 % on direct wages 40,000 _____________ Works cost
2,82,000
Office and administrative expenses 10 % of works cost 28,200 _____________ Cost of Production
3,10,200
Inventory valuation
Opening stock of finished goods 32,000 Less : Closing stock of finished goods at COP
(62,040) _____________
Cost of Goods sold
2,80,160
Selling and Distribution overheads at Rs.4 per unit sold 36,000 _____________ Cost of Sales or Total sales
3,16,160
Profit 20 % on Selling Price : TC x 20 / 100 – 20 or . 3,16,160 x 20/100 – 80 79,040
Tender Price being sales
Sikkim Manipal University
3,95,200
260
Financial and Management Accounting
Unit 12
Terminal Questions: 1. The costing records show the following Raw materials consumed Rs.3,30,400. Direct wages Rs.3,80,000. Closing stock of finished goods Rs.1`,60,000. Administrative expenses Rs.40,000. Factory expenses Rs.70,000. Sales Rs.7,56,000 Units produced and sold 4,000. The firm received a quotation for supply of 1,000 units. Prepare a quotation based on the above data. 2. Costing Department provides the following information: Total production 5,000 tons. Cost of raw materials consumed Rs.22,00,000. Direct wages Rs.20,00,000. In direct factory wages Rs.1,00,000. Office expenses Rs.10,00,000. Public Relations expenses Rs,.50,000. Expenses on testing laboratory Rs.60,000. Selling overheads Rs.10,00,000. Salary of Managing Director Rs.50,000. Payment of income tax Rs.3,00,000. Dividends paid Rs.5,00,000. A profit margin of 50 % on cost is provided. The Government grants a special export subsidy of Rs.1,000 per ton. Prepare a cost sheet. 3. The Trading, profit and loss account of DR is given below To Cost of materials Consumed 2,00,000 By Sales 8,00,000 To Direct wages 2,00,000 To Works expenses 1,00,000 To Gross Profit 3,00,000
8,00,000
8,00,000
To Selling expenses 1,00,000 By Gross Profit 3,00,000 To Net Profit 2,00,000
3,00,000 3,00,000 The management estimates the following for the year ending 31 st March : a) output and sales will be 2000 units. b) Prices of materials and wages will go up by 25 % of previous year. c) Works expenses will rise in proportion to the combined cost of materials and wages d) Selling expenses per unit are estimated at Rs.50 Prepare a cost statement for quotation purposes so as too yield a profit of 10 % on selling price.
Sikkim Manipal University
261
Financial and Management Accounting
Unit 12
Answer Self Assessment Questions Self Assessment Questions 1 1. Amount of 2. Monetary term Self Assessment Questions 2 1. Expense 2. Sacrifice in Self Assessment Questions 3 1. Direct and Indirect 2. Raw material, labor, direct expenses 3. Overheads 4. Crude form of a substance. 5. Charged to product 6. Conversion of materials to finished products 7. Production operations 8. Allocated 9. Direct 10. Apportioned 11. Overheads Self Assessment Questions 4 1. Aggregation of DM, DL and DE. 2. PC + FOHS 3. FC + AOSH 4. COP + DOSH 5. TC + profit 6. Sales – total cost. Self Assessment Questions 5 1. Components 2. Tabular Self Assessment Questions 6 1. Opening stock + purchase – closing stock. 2. COP + Inventory valuation.
Sikkim Manipal University
262
Financial and Management Accounting
Unit 12
3. At current year COP 4. Balancing figure between SP and TC. Self Assessment Questions 7 1. Raw material, finished product. 2. Add opening WIP and deduct closing WIP 3. TC x given percentage. 4. (TC x given percentage) – 100 – given Percentage. 5. TC x 25 / 100 – 25. 6. TC x 25 / 100. Answer for Terminal Questions 1. Cost of production for 4000 units Rs 8,20, 400; cost of production for 1000 units Rs 2,26,990. Total cost (4000 units ) Rs 6,80,400 ; (1000 units) Rs 2,26,990; profit for quotation of 1000 units Rs 25,221. 2. Cost of production Rs 54, 60,000 per ton Rs 1092; Total cost Rs 64,60,000 ; per unit Rs 1,292. 3. Total cost of the tender Rs 13,50,000 ; Sales Rs 15,00,000
Sikkim Manipal University
263
Financial and Management Accounting
Unit 13
Unit 13
Marginal Costing and Break Even Analysis
Structure 13.1
Introduction Objectives
13.2
Concept Self Assessment Questions 1
13.3
Fixed cost Self Assessment Questions 2
13.4
Variable Cost Self Assessment Questions 3
13.5
Marginal cost
13.6
CVP analysis Self Assessment Questions 4
13.7
Break Even Chart Self Assessment Questions 5
13.8
Break Even Analysis Self Assessment Questions 6
13.9
Break Even Point Self Assessment Questions 7
13.10 Contribution margin Self Assessment Questions 8 13.11 Equation approach Self Assessment Questions 9 13.12 Target profit Self Assessment Questions 10 13.13 Margin of safety Self Assessment Questions 11 13.14 Application Self Assessment Questions 12 13.15 Limitation Self Assessment Questions 13 13.16 Useful equation
Sikkim Manipal University
264
Financial and Management Accounting
Unit 13
Self Assessment Questions 14 Terminal Questions Answer to SAQs and TQs
13.1 Introduction Information is a commodity. It can be purchased, produced and consumed. It can be of high or low quality, timely or late, appropriate for its intended use or utterly irrelevant like all other goods and services. Information entails both costs and benefits. While costs refer to other cost of purchase, cost of compensation, cost of operating computers, cost of time spent by the information users to read, understand and utilize the information, the benefits include improved decisions, more effective planning, and greater efficiency of operations at lower costs and better direction and control of operations.
Learning Objectives: After studying this unit, you should be able to understand the following 1. Understand the concept of marginal cost. 2. Distinguish between fixed cost, Variable cost and Marginal Cost. 3. Familiarize with break even chart, break even analysis and break even point. 4. Understand the contribution marginal approach, equation approach, target profit and margin of safety. 5. Practice the concepts in real life situations.
13.2. Concept Of Marginal Cost According to C.I.M.A. London, “Marginal Cost means the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. Thus, marginal cost is the amount by which total cost changes when there is a change in output by one unit. Marginal cost per unit remains unchanged irrespective of the level of activity or output. It is also known as Variable Cost. Marginal cost is the sum total of direct material cost, direct labor cost, variable direct expenses and all variable overheads. The marginal cost is the same as the variable cost. Self Assessment Questions 1 1. Marginal cost is sum total of ________.
Sikkim Manipal University
265
Financial and Management Accounting
Unit 13
13.3 Fixed Cost It involves the way a cost changes in relation to changes in the activity of an organization. The activity refers to a measure of the organization’s output of products and services example number of contact classes conducted, number of students passed in MBA, number of cars manufactured by an Automobile industry, number of meals served by a hotel. The activities that cause costs to be incurred are called “Cost Drivers”. A fixed cost remains unchanged in total as the level of activity (cost drivers) varies. If activity increases or decreases say by 20 %, the total fixed costs remain the same e.g. depreciation, property tax, rent to landlord. But fixed costs per unit will change. Self Assessment Questions 2 1. Fixed cost remains constant _________. 2. Fixed cost varies with ______________. 3. Variable cost remains constant with ____________.
13.4 Variable Cost A variable cost changes in total in direct proportion to a change in the level of activity or cost driver. If activity increases, say by 20%, total variable cost also increases by 20 %. The total variable cost increases proportionately with activity. Variable cost fixed per unit but varies in total. Self Assessment Questions 3 1. Variable cost varies with _______________. 2. MC is extra cost incurred ________________.
13.5 Marginal Cost It is extra cost incurrent when one more unit is produced. It typically differs across different ranges of production quantities because the efficiency of the production process changes. The marginal cost of producing a unit declines as output increases. It is much more efficient to produce more than to make only one.
13.6 Cost Volume Profit (CVP) Analysis This technique summarizes the effects of changes in an organization’s volume of activity on its costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of changes in selling prices, service fees, costs, incometax rates and the organization’s mix of products or services. It provides management with a comprehensive over view of the effects on revenue and costs of all kinds of short run financial changes Sikkim Manipal University
266
Financial and Management Accounting
Unit 13
Although, the word “profit” appears in the term, CVP analysis is not confined to profit seeking enterprises. Managers in non profit organizations also routinely use CVP analysis to examine the effects of activity and other short run changes on revenue and costs. It is being used as a regular organizational tool. . In CVP analysis, it is necessary that expenses should be categorized according to their cost behavior that is fixed or variable. Self Assessment Questions 4 1. CVP refers to change in ________________. 2. CVP provides _________________. 3. CVP is not ______________ concept. 4. CVP focuses on ________________ cost.
13.7 Break Even Chart It is a graphic or visual presentation of the relationship between costs, volume and profit. It indicates the point of production at which there is neither profit nor loss. It also indicates the estimated profit or loss at different levels of production. While constructing the chart, the following assumption is normally considered. a) Costs are classified into fixed and variable costs b) Fixed costs shall remain fixed during the relevant volume range of graph. c) Variable cost per unit will remain constant during the relevant volume range of graph d) Selling price per unit will remain constant e) Sales mix remains constant. f) Production and sales volume are equal g) There exists a linear relationship between costs and revenue. h) Linear relationship is indicated by way of straight line. Self Assessment Questions 5 1. BEP chart is ______________. 2. Its relation is between ________________. 3. It indicates the estimated ____________.
13.8 Break Even Analysis It is an extension of or even part of marginal costing. It is a technique of studying cost volume profit relationship. Basically, the break even analysis is aimed at measuring the variations of cost
Sikkim Manipal University
267
Financial and Management Accounting
Unit 13
with volume. It is a simple method of presenting the effect of changes in volume on profits. It is also known as CVP analysis. The various assumptions are: a) All costs can be classified into fixed and variable b) Sales mix will remain constant. c) There will be no change in general price level d) The state of technology, Methods of production and efficiency remain unchanged. e) Costs and revenues are influenced only by volume f) Cost and revenues are linear. g) Stocks are valued at marginal cost h) Unit produced and sold are same. Self Assessment Questions 6 1. BEP studies ____________________ relationship.
13.9 Break Even Point BEP is the volume of activity where the organization’s revenues and expenses are equal. At a particular amount of sales, the organizations have no profit or loss: it normally breaks even. Self Assessment Questions 7 1. BEP is a ______________________. Example DR sells 8,000 pens at Rs.16 per pen. The variable expenses amount to Rs.10 per pen. The total fixed expenses are Rs.48, 000. Prepare an Income statement. Solution No. of pens produced 8,000 No. of pens sold
8,000
Unit selling price per pen Rs.16 Unit variable cost per pen Rs.10 Sales Revenue (Quantity sold x unit selling price) 8000 x Rs.16 1, 28,000
Less Variable Cost (8000x Rs.10) (80,000) Less: Fixed expenses
Sikkim Manipal University
(48,000)
268
Financial and Management Accounting
Unit 13
Profit or Loss Zero
Note that the income statement highlights the distinction between variable and fixed expenses.
13.10 Contribution Margin Approach The contribution margin approach refers to the total sales revenue minus the total variable expenses. This is the amount of revenue that is available to contribute to covering fixed expenses after all variable expenses have been covered or recovered. DR’s firm will break even when the organization’s revenue from pen sales is equal to its expenses. How many pens must be sold during one month for DR to breakeven? Each pen sells for Rs.16, but Rs.10 of this is used to cover the variable expense per pen. This leave Rs...6 per pen to contribute to covering the fixed expenses of Rs.48, 000. When enough pens have been sold in one month so that these Rs.6 contributions per pen add up to Rs.48, 000, the organization will break even for the month. The break even can be computed as follows: Breakeven in Fixed Expenses Units = __________________________________________________ Contribution of each pen towards covering fixed expenses Rs.48, 000 / Rs.6 or 8,000 pens The Rs.6 amount that remains of each pen’s price after the variable expenses are covered is called the “Unit contribution margin”. The general formula for computing the break even sales volume in units is: BEP (in units) : Fixed expenses / unit contribution margin Sometimes, the management prefers that the BEP be expressed in sales rupees rather than unit. The formula is: BEP in Rupees: Fixed expenses / Contribution sales ratio The Contribution Sales Ratio is popularly known as “Marginal Contribution Sales Ratio – MCSR “. Its traditional name is: ‘P/V Ratio. ’ Note: Kindly avoid using the term P / V Ratio and only use the modern concept “MCSR” MCSR = Contribution / Sales x 100 Where Contribution = Sales value minus variable expenses Self Assessment Questions 8 1. Contribution margin is _______________.
Sikkim Manipal University
269
Financial and Management Accounting
Unit 13
2. BEP in units is _________________. 3. BEP in rupees is ___________________. 4. Contribution is ___________.
13.11 Equation Approach This approach is based on the profit equation. Income or profit is equal to sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the essence of income or profit statement is captured by the following equation: Sales minus Variable Cost = Fixed Cost + Profit S – V = F + P The contribution margin and equation approaches are two equivalent techniques are two equivalent techniques for finding g the BEP. Both the methods reach the same conclusion, hence personal preference dictates which approach should be used. Self Assessment Questions 9 1. Equation approach is based on ____________. 2. Sales – VC = _______________ 3. SV = _________ 4. SV = C _________________. 5. C = _______________. 6. C _______ = P.
13.12 Target Profit Based on the experiences gained, an organization may intend to increase the production and sales. When an organization was to be on its optimum level, a direction will be provided to achieve the maximum level. In this connection, if one intends to increase the current year production to higher levels, no variable expenses would be incurred. A target net profit or income may be decided in advance. To achieve this profit, efforts will be made to effect sales. The problem of computing the volume of sales required to earn a particular target net profit is very similar to the problem of finding the break even point. After all, the break even point is the number of unit sales required to earn a target net profit of zero. The target net profit is known as “desired profit”. The formula is:
Sikkim Manipal University
270
Financial and Management Accounting
Unit 13
Number of units to be sold: Fixed expenses + Desired or Target profit / Contribution per unit Example: Calculate sales in units and in rupees: Units produced 60,000. Selling price per unit Rs.15. Profits to be earned is Rs.87, 500. Solution: Sales required in units : Fixed expenses + target profit / contribution per unit or 1,50,000 + 87,500 / 15 10 or 47,500 units or Rs.47,500 x Rs.15 or Rs.7,12,500. Self Assessment Questions 10 1. Number of units to be sold is _________. 2. Desired profit is also known as ____________. 3. A target profit is set ____________.
13.13 Margin Of Safety The safety margin of an enterprise is the /difference between the budgeted sales revenue and the break even sales revenue. The safety margin gives management a feel for how close projected operations are to the organization’s break even point. The formula is: MOS = Profit / MCSR Example: Calculate BEP and MOS: Sales at present 50,000 units per annum. Selling price Rs.6 per unit, Prime cost Rs.3 per unit. Variable overheads Re.1 per unit. Fixed cost Rs.75, 000 per annum. Solution: BEP = Fixed cost / (SP VC) per unit or 75,000 / 6 4 or 75,000 / 2 or 37,500 units. BEP in rupees: BEP in units x selling price per unit or 37,500 x Rs.6 or Rs.2, 25,000 MOS: Actual Sales – BEP Sales or (50,000 x 6) – 2, 25,000 or Rs.75, 000 Self Assessment Questions 11 1. MOS is ________________ 2. MOS is calculated as _______________.
13.14 Applications Of Marginal Costs The marginal costing helps the management in taking many policy decisions. The vital areas where these concepts are applied directly are as follows: Level of activity planning:
Normally, the managements will consider different levels of
production or selling activities to decide optimum level of activity. Such periodic exercise shall put
Sikkim Manipal University
271
Financial and Management Accounting
Unit 13
the organization in the right tract to achieve its goal. Since the optimum level of activity results in the maximum contribution per unit, the planning can become a perfect execution tool. Alternative methods of production: With the help of marginal costing techniques, it’s possible to undertake decision about the alternate methods of production. All the decisions should be focused at the greater contribution so that profit can be maintained at a balanced level. Make or buy decision: Depending upon the situational ambience, the management can have a blue print on a vital decision. Management can think of outsourcing the production activities or to undertake it within its purview. Based on the comparative statement of cost of manufacture with the purchase price, decisions can be taken. Fixation of Selling Price: While pricing a product, the marginal costing techniques can come handy. While fixing a price for a product, it is prudent to take into account the recovery of marginal cost in addition to get a reasonable contribution to cover fixed overheads. Pricing will be at ease once the marginal cost and overall profitability of the concern are known. Selection of optimum sales mix: The product mix plays an important role when a firm produces more than one product. The main focus will on profit maximization. With the help of marginal costing techniques, it is possible to decide the best product mix which will result in maximum profits to the firm. New Product introduction: When a firm intends to diversify its activities or to expand its existing markets, with the help of marginal costing techniques. By fixing the time horizon to recover the fixed costs and profit, decisions can be taken for the introduction of new products. Balancing of profits: As the economic trends gets changed on account of government fiscal policies and regulations, competition at the regional, national, and international levels, marginal costing techniques can aid to bring out facts with regard to maintaining a desired level of profits. Final balancing decisions: If the sales of the product were not encouraging to cover the fixed costs, it is quite natural that the firm may decide about its continuance. This may lead to dovetailing or completely closing down the operations. Marginal costing helps the management to take a sound decision. Self Assessment Questions 12 1. The application is as _______________.
13.15 Limitations Of Marginal Costing There are certain limitations which can be described as follows: Sikkim Manipal University
272
Financial and Management Accounting
Unit 13
Suitability: The techniques of marginal costing cannot be applied to all the concerns. When a concern needs to carry large stocks by way of workinprogress, the technique becomes redundant In addition; the marginal costing techniques are not suitable to industries working on contract basis. Inventory valuation difficulties: Since the work in progress and the closing inventories are valued at marginal cost basis, it will not be a sound decision from the Balance Sheet point of view. The main focus on the ‘true and fair value’ concept gets diluted and the very purpose of exhibiting the financial position will get defeated. Segregation of costs: Though the marginal costing principles call for the differentiation of costs into fixed and variable, in actual practice it becomes difficult to classify them precisely. Many overheads which are appear to be fixed and variable may not exactly align at various levels of production. There is no logical method to segregate semivariable expenses into fixed and variable. Time factor: The marginal costing ignores the time factor which is very important for any costing purposes. Ignoring the time would naturally relate to unreliable and incomplete basis for comparing two alternative jobs. Sales emphasis: Marginal costing principles are basically a salesoriented concept. While the selling function gets the prominence, other functions are not given equal weight age. This would be a major set back. Self Assessment Questions 13 1. Limitation include ________________.
13.16 Useful Equations Of Marginal Costing Some of the useful equation of marginal costing are as follows : Basic equation : Sales Revenue – Variable Expenses = Fixed Expenses + Profit Other derivations are as follows Sales Revenue – Variable Expenses – Fixed Expenses = Profit Sales – Variable cost s = Contribution Contribution – Fixed costs = Profit Sales – Contribution = Variable costs Sikkim Manipal University
273
Financial and Management Accounting
Unit 13
Marginal Contribution Sales Ratio (MCSR) = Contribution / Sales x 100 MCSR also can be found out : Change in profit / change in sales x 100 MCSR x Sales = Contribution Sales = Contribution / MCSR Number of units to be sold = Fixed expenses + Desired Profit / Contribution per unit Sales required to earn target net profit in Rupees : Fixed expenses + Profit / Marginal contribution BEP in units = Fixed expenses / MCSR contribution per unit BEP in Rupees : BEP in units x Selling price per unit or Fixed costs x Total sales / Total Sales Variable costs Margin of Safety : Total Sales – Break Even sales OR Profit / MCSR where Profit = Sales – Total Costs
Self Assessment Questions 14 1. Basic equation of M.C is __________. 2. Profit is __________. Problem 1: Find the contribution and profit earned. Selling price per unit Rs.25. Variable cost per unit Rs.20. Fixed Cost Rs.3,,05,000. Output 80,000 units. Solution: Contribution = Sales – variable cost . Rs.25 – Rs.20 or Rs.5 or 80,000 x 5 = Rs.4,00,000 Profit =Contribution – Fixed Cost or 4,00,000 – 3,05,000 = Rs.95,000 Problem 2: Calculate the profit earned. Fixed cost Rs.5,00,000. Variable cost R.10 per unit. Selling price Rs.15 per unit. Output 150,000 units Solution : S – V = F + P or ( 1,50,000 x 15) – (1,50,000 x 20 ) = 5,00,000 + Profit Profit = 22,50,000 – 15,00,000 – 5,00,000 = Rs.2,50,000 Problem 3: Find the fixed costs : Sales Rs.2,00,000. Variable Cost Rs.40,000. Profit Rs.30,000 Solution : S – V = F + P or 2,00,000 – 40,000 = Fixed Cost + 30,000 Fixed Cost = 2,00,000 – 40,000 – 30,000 = Rs.1,30,000 Problem 4: Calculate the variable cost : Sales Rs.1,50,000. Profit Rs.40,000. Fixed cost Rs.30,000. Find the amount of variable cost. Sikkim Manipal University
274
Financial and Management Accounting
Unit 13
Solution : S – V = F + P or 1,50,000 – V = 30,000 + 40,000 or 1,50,000 – 30,000 – 40,000 = Rs.80,000 Problem 5: Calculate MCSR or P / V Ratio : Marginal cost Rs.24,000. Sales Rs.60,000 Solution: Contribution : Sales – Marginal Cost or 60,000 – 24,000 or 36,000 MCSR = Contribution / Sales x 100 or 36,000 / 60,000 x 100 or 60 % Problem 6: The sales turn over and profit during two periods are as under: Period 1 Period 2 Sales Rs.20,000 Rs.30,000 Profit Rs.2,000 Rs.4,000 Calculate the MCSR. Solution : MCSR = Change in Profit / Change in Sales x 100 or 4,000 2,00,000 / 30,000 20,000 x 100 2,000 / 4,000 x 100 or 20 %
Problem 7 : Calculate : MCSR. Total Sales Total Costs Year ending 31 st December 2006 22,23,000 19,83,600 Year ending 31 st December 2007 24,51,000 21,43,200 Solution: Profit = Total Sales – Total Costs or For the year 2006 = 22,23,000 – 19,83,600 = 2,39,400 For the year 2007 = 24,51,000 – 21,43,200 = 3,07,800 MCSR = Change in profit / change in sales x 100 or 68,400 / 2,28,000 x 100 or 30 % Problem: 8 : Calculate the selling price if marginal cost is Rs.2,400 and MCSR is 20 %. Solution: MCSR = 20%, therefore the variable cost is 100 – 20 = 80 % Variable cost given is Rs.2,400 : Therefore, Selling price is 24000 / 80 % Or Rs.3,000. Problem 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40. Selling price per unit Rs.80. Fixed expenses Rs.2,00,000. Output 10,000 units. Solution: Contribution : Sales – variable costs or (10,000 x Rs.80) – (10,000 x Rs.40) 8,00,000 – 4,00,000 or Rs.4,00,000. MCSR = Contribution / MCSR or 4,00,000 / 8,00,000 x 100 or 50 %
Sikkim Manipal University
275
Financial and Management Accounting
Unit 13
Problem 10. Calculate Break even point. Fixed costs Rs.80,000. Variable cost per unit Rs.4. Sales Rs.2,00,000. The number of units involved coincides with expected volume of output. Each unit sells at Rs.20. Solution: BEP in units : Fixed expenses / contribution per unit Contribution = S – V or Rs.20 – Rs.4 or Rs.16 Rs.80,000 / Rs.16 or 5,000 units. Problem 11: Calculate the Break even point : Sales Rs.2,00,000. Fixed expenses Rs.50,000. Variable expenses.Rs.1,00,000. Solution: Since no information about the number of units produced and costs per unit is given, only Break even point in value can be ascertained. BEP in Rs. = Fixed costs x Total sales / Total Sales – Variable costs 50,000 x 2,00,000 / 2,00,000 – 1,00,000 or Rs.1,00,000 Problem 12: Calculate MCSR and Break Even Point : Sales Rs.5,00,000. Fixed Costs Rs.1,00,000. Profit Rs.1,50,000. Solution: MCSR = Contribution / Sales Contribution = Fixed Costs + Profit or Rs.1,00,000 + Rs.1,50,000 = Rs.2,50,000 MCSR = 2,50,000 / 5,00,000 = 50% BEP in Rs. = Fixed Costs / MCSR or 1,00,000 / 50 % or Rs.2,00,000. Problem 13: Find BEP. Variable cost per unit Rs.12. Selling price per unit Rs.20. Fixed expenses Rs.60,000. What will be the selling price per unit if the BEP is brought down to 6000 units? Solution: BEP in units : FC / CPU where CPU S V 20 – 12 or Rs.8, 60,000/8 or 7,500 units 7,500 units x Rs.20 = Rs.1,50,000. Selling price if BEP is 6000 units : FC / CPU or FC / (SP – VP) per unit or 60,000 / (x – 12) Let selling price be Rs .x 6,000 = 60,000 / x – 12 or 6000 (x – 12) = 60,000 or x = Rs.22 on simplification. Problem 14: Calculate MCSR. (2) Profit when sales are Rs.20,000 (3) New BEP if selling price is reduced by 20 %. Given Fixed expenses Rs.4,000 and Break even point Rs.10,000. Solution: Basis BEP sales : BEP in volume : FC / MCSR Cross multiplying, MCSR = FC / BEP Sales or 40,000 / 10,000 x 100 or 40 %. Profit Calculate the contribution first; where MCSR = C/Sales 40 % x 20,000 = Contribution or Rs8,000 Sikkim Manipal University
276
Financial and Management Accounting
Unit 13
C = F + P or 8,000 = 4,000 + P or Profit = Rs.4,000. New BEP is SP is reduced by 20 % : Let the original SP be Rs.x. Therefore, at 20 % reduction, the Revised SP would become 20 % of x or .2x. Hence the revised SP would be x – 0.2x or 0.8x New contribution is S – V or x – (60 % of x ) = C or 0.8x – 0.6x = 0.2x. SR = 0.2x / 0.8x or 0.25 BEP in volume = 4,000 / o.25 or Rs.16,000 Problem 15: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP sales Rs.40,000. Find the actual sales. Solution: MCSR is based on BEP sales : BEP sales = FC / MCSR = FC / BEP sales or 8,000 / 40,000 = 0.2 Actual sales = FC + desired profit / MCSR or 8,000 + 2,000 /0.2 or Rs.50,000
Terminal Questions: 1. A factory is manufacturing sewing machines. The variable cost of each machine is Rs.200 and each machine is sold for Rs.250. Fixed costs are Rs.12,000. Calculate the BEP for output. 2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000. Variable cost per unit Rs.2 and Selling price per unit Rs.18. Also compute the margin of safety if the company is earning a profit of Rs.36,000. 3. Calculate the breakeven point and turnover required to earn a profit of Rs.3,600. Fixed overheads Rs.1,80,000. Variable cost per unit Rs. Selling price Rs.20. If the company is earning a profit of Rs.36,000, express the margin of safety available to it. 4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit Rs.1,00,000. Sales Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit when sales amounted Rs.12,00,000 (d) sales required to earn a profit of Rs.2,00,000. 5. Given : Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit Rs.1,000. Selling price per unit Rs.20. Calculate (a) sales and marginal cost of sales (b) new break even point if selling price is reduced by 10 %. 6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %. 7. Calculate Break even sales and margin of safety. Given Sales Rs.10,00,000.Fixed costs Rs.3,00,000 and Profit Rs.2,00,000. 8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs Rs.12,000. Compute Break even sales, Margin of safety and sales to earn a profit of Rs.4,000.
Sikkim Manipal University
277
Financial and Management Accounting
Unit 13
Answer Self Assessment Questions Self Assessment Questions 1 1. DMC, DLC, variable overheads Self Assessment Questions 2 1. In total. 2. Per unit. 3. Per unit Self Assessment Questions 3 1. Total 2. With one more unit of production. Self Assessment Questions 4 1. Cost, revenue and profits. 2. Comprehensive 3. Profit seeking 4. Categorization of Self Assessment Questions 5 1. A visual presentation 2. Cost, volume and profit. 3. Profit or loss Self Assessment Questions 6 1. Cost, volume, profits. Self Assessment Questions 7 1. No profit, no loss Self Assessment Questions 8 1. Sales – TVC 2. FC / unit contribution margin 3. FC / MCSR 4. Sales – VC Self Assessment Questions 9 1. Profit equation 2. FC + profit 3. F + P
Sikkim Manipal University
278
Financial and Management Accounting
Unit 13
4. Contribution 5. F + P 6. FC Self Assessment Questions 10 1. FC + DP / MCSR 2. Target profit in advance. Self Assessment Questions 11 1. Difference between Budget – BEP sales. 2. Profit / MCSR. Self Assessment Questions 12 1. Activity planning. Self Assessment Questions 13 1. Suitability, segregation of cost. Self Assessment Questions 14 1. S – V = F + P 2. S – V – F
Answer for Terminal Questions 1. Contribution = S –V or 250 – 200 or Rs.50 : Therefore BEP = FC / Contribution or 12,000 / 500 or 240 units. 2. Contribution = S – V = 18 – 2 = 16. BEP in units = Fixed costs / contribution per unit or 1,60,000 / 16 or 10,000 units. Margin of safety = Actual Sales less Breakeven sales : The formula for actual sales is : fixed Cost + Desired profit / contribution per unit or 1,60,000 + 36,000 / 16 or 12,250 units. Therefore, margin of safety is 12,250 10,000 units or 2,250 units. 3. Contribution per unit = S – V or 20 – 2 = 18. BEP in Units : FC / CPU or 1,80,000 / 18 = 10,000 units. Break even sales : BEP in units x Selling price = 10,000 x Rs.20 = Rs.2,00,000 Turnover required to earn a profit of Rs.36,000
Sikkim Manipal University
279
Financial and Management Accounting
Unit 13
Total Fixed overheads + Profit desired / CPU = 1,80,000 + 36,000 / 18 = 12,000 units or in terms of rupees units x selling [rice = 12,000 x Rs.20 = Rs.2,40,000. Margin of safety = Actual sales – Break even sales = Rs. 2,40,000 – Rs.2,00,000 = Rs.40,000 or in terms of units 12,000 – 10,000 units = 2,000 units. 4. MCSR = Contribution / Sales x 100 = Contribution = S – V or Rs.4,00,000. 4,00,000 / 10,00,000 x 100 or 40% Break even point = FC / MCSR = 3,00,000 / 0.4 = Rs.7,50,000 Profit when sales amounted to Rs.12,00,000 . Contribution 40 % Therefore total contribution 12,00,000 x 40 % = Rs.4,80,000 Less fixed costs Rs.3,00,000 = Rs.1,80,000, being profit. Sales to earn a profit of Rs.2,00,000 = FC + Desired profit / MCSR or 3,00,000 + 2,00,000 / 40 % = Rs.12,50,000. 5. BEP = Fixed costs / MCSR = 20,000 = 4,000 / MCSR or MCSR = 4,000 / 20,000 x 100 = 20% Contribution : Fixed cost – Profit = 4,000 + 1,000 = Rs.5,000. MCSR = Contribution / Sales x 100 or 20 = 5,000 / Sales x 100 = Rs.25,000 Marginal cost of sales = Sales – Contribution or 25,000 – 5,000 = Rs.20,000 (b) If selling price is reduced by 10 % : New selling price = 20 – 2 = Rs.18 Variable cost = Rs.16 (20 – 20% of 20) = Rs.2 New MCSR = 2 /18 x 100. Therefore new break even sales = FC /SR or 4,000 / 100 or Rs.36,000. 6. Margin of safety = Profit / 40 % = Rs.50,000 7. MCSR = Contribution / sales = 5,00,000 / 10,00,000 = 50 %. Break even sales : Fixed costs / MCSR = 3,00,000 / 50 % = Rs.6,00,000 Margin of safety = Profit / MCSR = 2,00,000 / 50 % = Rs.4,00,000 8. Sales 20,000, Variable cost Rs.13,000, Total Cost Rs.16,000. Therefore, Fixed cost = Total cost – variable cost = 16,000 – 12,000 = Rs.4,000. Profit = Contribution – Fixed Cost = 8,000 – 4,000 = 4,000. MCSR = Contribution / sales = 8,000 / 20,000 = 40 %.BEP in units : FC / MCSR = 4,000 / 40% = 10,000. Margin of safety = Profit / MCSR = 400 / 40 % = 10,000 Sales to earn a profit of Rs.4,000 = FC + Desired profit / MCSR = 4,000 + 4,000 / 40 % = Rs.20,000.
Sikkim Manipal University
280
Financial and Management Accounting
Unit 14
Unit 14
Budgetary Control
Structure: 14.1
Introduction Objectives
14.2
Meaning Self Assessment Questions 1
14.3
Budgetary control Self Assessment Questions 2
14.4
Objectives Self Assessment Questions 3
14.5
Merits Self Assessment Questions 4
14.6
Essential features Self Assessment Questions 5
14.7
Steps Self Assessment Questions 6
14.8
Types Self Assessment Questions 7
14.9
Cast Budget Self Assessment Questions 8
14.10 Flexible Budget Self Assessment Questions 9 14.11 Limitation Self Assessment Questions 9 Terminal Questions Answer to SAQs and TQs
14.1 Introduction In a competitive environment, the effective operation of a concern resulting into the excess of income over expenditure fully depends upon “as to what extent the management follower proper planning, effective coordination and dynamic control “. For all these aspects, it has become necessary that management should plan for the future financial and physical requirements.
Sikkim Manipal University
281
Financial and Management Accounting
Unit 14
These are the basic criteria that a firm has to adopt to maintain its profitability and productivity. The procedure for preparing plan in respect of future financial and physical requirements is generally called “Budgeting”. It is a forward planning exercise. It involves the preparation inn advance of the quantitative as well as the financial statements to indicate the intention of the management in respect of the various aspects of the business. In a broader sense, it is essentially an economic service. Budgeting requires a deeper understanding of the economic system of the environment in which the business concern operates.
Learning Objectives: After studying this unit, you should be able to understand the following 1. Understand the meaning of budget and budgetary control with its objects. 2. Analyze the merits, demerits, essential features of budgetary control. 3. Note the steps involved in the preparation of budgets. 4. Acquaint with various type of budgets. 5. Prepare cash and flexible budgets.
14.2 Meaning of A Budget It is a numerical statement expressing the plans, policies and goals of an enterprise for a definite period in the future. Budgets are not actual but are estimated. It is therefore a financial and / or quantitative statement prepared and approved prior to a definite period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. (Definition by Cost and Management Accountants, England). Self Assessment Questions 2: 1. Budget is ___________ statement. 2. Budget are _____________.
14.3 Budgetary Control It is applied to a system of management accounting control by which all operations and output are forecasted far ahead as possible and actual results when known are compared with the budget estimates. Self Assessment Questions 3: 1. Budgetary control is ___________.
Sikkim Manipal University
282
Financial and Management Accounting
Unit 14
14.4 Objectives Budgeting is a forward planning. It basically serves as a tool for management control. The objectives of budgeting may be taken as: ·
To forecast and plan for future to avoid losses and to maximize profits.
·
To help the concern in planning the activities both physical and financial.
·
To bring about coordination between different functions of the enterprise.
·
To control; actual actions by ensuring that actual are in tune with targets.
Budgeting and Planning: The planning normally deals with long term and short goals and operations. The goals can be for the entire organization or departmentwise or group wise or segment wise to achieve the maximum results and operational efficiency. After setting up objectives in terms of plans, it becomes imperative to organize the factors of production to convert into a reality and workable preposition. In budgeting, planning refers to the preparation of budgets in respect of sales, advertisement, production, inventory, materials cost and requirements, labor cost and requirements, expenses, research, capital expenditures, financial plans. Planning through budgets brings together all segments of the concern in a cooperative way and they are compelled to think seriously about the planning. The views get enlarged than getting into contraction. Internal refinement, broad indexation of activities, concentrated details is the essential features in planning. All the staff must be involved in the planning function to make it more successful and purposeful. Budgeting and Coordination: It deals with the combined efforts of all the people involved from the shop floor to the top management. Individual and collective wisdom should be considered in the preparation of budgets at all levels to make it a workable document for translation into reality. For this adequate communication at all levels should be established. It is very important that each member of management is having perfect and clear cut knowledge. There must be continuity to coordination. Budget may help us to evaluate and examine whether the members of the management are working in a cooperative way or not Budgeting and control: When one relates control function to budget, we find a system what is generally termed as budgetary control. Control signifies such systematic efforts which help the management to know whether actual performance is in line with predetermined goal, policy and plans. It is basically a measurement tool. Yardsticks should be laid down. Standards must be set up. Therefore, the objectives can be summarized as follows: ·
To conform with good business practice by planning for the future.
Sikkim Manipal University
283
Financial and Management Accounting
·
To coordinate the various divisions of a business.
·
To establish divisional and departmental responsibilities.
·
To forecast operating activities and financial position.
·
To operate most efficiently the divisions, departments and cost center.
·
To avoid waste, to reduce expenses and to obtain the income desired.
·
To obtain more economical use of capital available for the efficient operation.
·
To provide more definite assurance of earning the proper return on capital employed.
·
To centralize management control.
·
To show the management where action is needed to remedy a situation.
·
To help in controlling cash.
·
To help in obtaining better inventory control and turnover.
Unit 14
Self Assessment Questions 4: 1. Budgetary is ____________ planning. 2. Planning deals with _________________.
14.5 Merits In order to help in planning, coordinating and control, budgets need to be prepared for every organization to get the maximum benefit. Broadly, the merits are as follows: 1. It forces basic policies to initiatives 2. The budgetary control aims at the maximization of profits 3. Budgets fix the goals and targets without which operations lack direction 4. Reduction in cost and elimination of inefficiencies 5. Budgetary control facilitates to make ordered effort and brings about overall efficiency in results. 6. Budgetary control ensures that the capital employed at a particular level is kept at a minimum level 7. Budgetary control enables the management to decentralize responsibility without losing control 8. It is a good guide to the management for making future plans. Based on budgetary control realistic budgets can be drawn. 9. Budgetary control facilitates an intelligent and planned forecast of the future 10. Budgetary control acts as a safety signal for the management. It prevents wastages of all types.
Sikkim Manipal University
284
Financial and Management Accounting
Unit 14
11. Budgetary control brings to light the inefficiencies and weakness on comparing actual performance with budget. Management can take timely remedial measures. 12.
Financial crisis can be avoided since budget provides advance information.
13.
It is a guide to the management in the field of research and development in future.
Self Assessment Questions 5: 1. Major merits are __________.
14.6 Essential Features Of Budgetary Control An effective budgeting system should have essential features to get best results. In this direction, the following may be considered as essential features of an effective budgeting. Business Policies defined: The top management of an organization strives to have an action plan for every activity and for each department. Every budget should reflect the business policies formulated from time to time. The policies should be precise and the same must be clearly defined. No ambiguity should enter the document. Clear knowledge should be provided to all the personnel concerned who are going to execute the policies. Periodic suggestions should be called for. Forecasting: Business forecasts are the foundation of budgets. Time and again discussions should be arranged to derive the most profitable combinations of forecasts. Better results can be anticipated based on the sound forecasts. As far as possible, quantitative techniques should be made use of while forecasting Formation of Budget Committee: A budget committee is a group of representatives of various important departments in an organization. The functions of committee should be specified clearly. The committee plays a vital role in the preparation and execution of budget estimated. It brings coordination among other departments. It aids in the finalization of policies and programs. Nonfinancial activities are also considered to make it a wholesome affair. Accounting System: To make the budget a successful document, there should be proper flow of accurate and timely information. The accounting adopted by the organization should be proper and must be finetuned from time to time Organizational efficiency: To make the budget preparation and its subsequent implementation a success, an efficient, adequate and best organization is necessary a budgeting system should always be supported by a sound organizational structure. There must be a clear cut demarcation
Sikkim Manipal University
285
Financial and Management Accounting
Unit 14
of lines of authority and responsibility. There must also be a delegation of authority from top to bottom line. . Management Philosophy: Every management should set a healthy philosophy while opting for the budget. Management must wholehear4tedly support the activities which developing a budget. Encouragement should flow from top management. All the members must be involved to make it a workable preposition and a dreamdriven document. Reporting system: Proper feed back system should be established. Provision should be made for corrective measures whenever comparative measures are proposed. Availability of statistical information: Since budgets are always prepared and expressed in quantitative terms, it is essential that sufficient and accurate relevant data should be made available to each department. Motivation: Since budget acts as a mirror, the entire organization should become smart in its approach. Every employees both executive and nonexecutives should be made part of the overall exercise. Employees should be persuaded than pressurized to appreciate the benefits of the budgets so that the fruits can be shared by all the members of the organization.
Self Assessment Questions 6: 1. Feature are meant for _________. 2. Forecasting is _______________. 3.
Budget committee brings in _________.
14.7 Steps In Budgetary Control The procedure to be followed in the preparation and control of budget may differ from business to business. But, a general pattern of outline of budget preparation and control may go a long way to achieve the end results. The steps are as follows: Formulation of policies: The business policies are the foundation stone of budget construction. Function policies should be formulated in advance. Longrange policies with short term projections should be made for the functional areas such as sales, production, inventory, cash management, capital expenditure. Preparation of forecasts: Based on the formulated policies, forecast should be made in respect of each function. Activity based concepts should be introduced at the micro level for each function Forecasts should not be considered as a mere estimates. Scientific methods should be
Sikkim Manipal University
286
Financial and Management Accounting
Unit 14
adopted for forecasting. Analysis of various factors based on past, and present, future forecast should be made. Preparation of budgets: Forecasts are converted into written codified document. Such written documents can be used for coordination purposes. Function budgets will act as guidelines for implementation. Forecast combinations: While developing the budgets, through a Master Budget various permutations and combination processes are considered and developed. Based on this, establishment of the most preferred one which will yield optimum benefits should be considered. All the factor components should be identified which are likely to cause disturbances while implementing the budgets Self Assessment Questions 7: 1. Important steps in B.C _________________.
14.8 Types of Budgets The budgets are normally classified according to their nature. They are: (a) fixed budget. (b) Flexible Budget. (c) Functional Budget Fixed Budget: It is also known as static budgets. It is prepared for a fixed or standard volume of activity. They do not change with change in the volume of activity. They are prepared well in advance Due to this, there are bound to be variances at the time of comparison. Hence, the budget targets become unsuitable for the purpose of comparison. Wide deviations are noticed due to changes in the volume of activity. Flexible Budget: It is prepared with a view to take into account the periodic changes in the level of activity attained. In this case, the revenues and costs targets are set in respect of different levels of activity even from zero to 100 % of product ion volume. Such mechanism helps to change revenues and cost targets for the actual level of activity and thus makes the comparison more logical and scientific. Functional Budget: These are also known as subsidiary budgets. These are prepared on the basis of approved forecasts for individual department. Since departments are created based on the functions, they are known as functional budgets. The functional budgets may vary in number from business to business. The functional budgets include sales budget. Production budget, selling and distribution overhead budget, plant budget, research and development budget, overheads budget, financial budget such as cash budget and capital expenditure budget.
Sikkim Manipal University
287
Financial and Management Accounting
Unit 14
Self Assessment Questions 8: 1. Classification of budget is based on __________. 2. Types of budgets are _____________.
14.9 Cash Budget A proper control over cash is very essential. Cash is an important component in any activity. The control becomes inescapable. If cash is not properly managed or if it is mismanaged, the ultimate result would be disastrous .In many times and in many business situations, business failures are noticed due to the lacunae found in the cash management. Hence a cash budgeting occupies a pivotal place in the study of Financial Management. Cash budgeting is the process of forecasting the expected receipts known as cash inflows, and expected payments known as cash outflows to meet the future obligations. The written statement of receipts and payments form the cash budget. It is a crystal ball which enables one to observe the future movements in cash position. It is a mere forecast of cash position of an undertaking for a definite period of time. The period may be daily, weekly, monthly, quarterly, semiannually, or annually. The major two components of cash budget would be forecast first the cash receipts and then second forecasting the cash disbursements. The receipts of cash are formatted as follows : 1. Opening balance of cash in hand and cash at bank 2. Cash sales 3. Collection from debtors to whom sales are effected on credit basis 4. College from Bills received 5. Interest and advances and loans granted 6. Dividends received from investments 7. Sale proceeds from capital assets 8. Proceeds from issue of shares and debentures 9.
Other sources.
After determining the various sources, the quantum of receipt should be estimated. Past analysis will help to identify the problem areas for effecting collection of cash. Self Assessment Questions 9: 1. It is prepared on _______________. Problem 1: A large retail stores makes 25% of its sales for cash and the remainder on 30 days net. Due to faulty collection practice, there have been losses from bad debts to the extent of 1 % Sikkim Manipal University
288
Financial and Management Accounting
Unit 14
of credit sales on average in the past. The experience of the store tells that normally 60 % of credit sales are collected in the month following the sale, 25% in the second following month and 14 % in the third following month. Sales in the proceeding three months have been January 2007 Rs.80,000, February Rs.1,00,000 and March Rs.1,40,000. Sales for the next three months are estimated as April Rs.1,50,000, May Rs.1,10,000 and June Rs.1,00,000. Prepare a schedule of projected cash collection . Solution: Statement of expected Cash Receipts Collection form April May June Cash sales 37,500 27,500 25,000 Collection from Debtors : January
8,400
February 18,750 10,500 March
63,000 36,350 14,700
April
May
67,500 28,125
49,500
Total 1,27,650 1,31,750
1,17,325
Assume that the credit policy is enforced strictly ,what would be the cash receipts.
Cash sales : Debtors 37,500 27,500 25,000 March April
1,05,000
May
1,12,500
82,500
Total 1,42,500 1,40,000 1,07,500 Forecasts of cash payments : The items of expenditures differ from business to business. The normal items which come under the lists are : 1. Cash purchases 2. Payment to creditors or suppliers 3. Payments to Bills payable 4. Payment to employees in the nature of wages, salaries 5. Manufacturing, selling and distribution and administration expenses 6. Repayments of bank load and special obligations such as bonus, donations, advances 7. Interest and dividend payments
Sikkim Manipal University
289
Financial and Management Accounting
Unit 14
8. Capital expenditures for acquiring assets of enduring benefit 9. payment of tax liability 10. other expenses of periodic nature The quantum of amount likely to be spend on the above each item is generally determined with reference to functional budgets of the concerns. The policy of the management will also play a crucial role. It is the policy which determines the ratio of cash purchases and credit purchases. In many cases, the time lag affects the amount of expenditures to be incurred in a particular period. The formula adopted for the expenses payable in next month is : month’s amount x time lag Problem 2: The following are the forecasts relating to wages and factory expenses. July Aug Sept Oct Nov Wages 32,000 32,000 32,000
40,000 32,000
Factory expenses 5,000 5,000 5,000 5,000 5,000 The lag in payment of wages is 1 / 8 month and that in case of factory expenses 1/ 2 month. Estimate the amounts of wages and factory expenses payable in each month of September to November. Solution Statement showing the disbursements of cash Particulars Sept Oct Wages: Aug 32,000 4,000
Nov
Sept 32,000 28,000 4,000 Oct 40,000 Nov 32,000
35,000 5,000
28,000
32,000 39,000 33,000
Factory expenses Aug 5,000 2,500
Sept 5,000 2,500 2,500 Oct 5,000
Nov 5,000
Sikkim Manipal University
2,500 2,500
2,500
290
Financial and Management Accounting
Unit 14
5,000 5,000 5,000
Problem 3: The following information is provided in respect o DR Ltd. Prepare a Cash Budget for April, May and June 2007.
Months Details Sales Purchases Wages Expenses (in Rupees) Jan Actual 80,000 45,000 20,000 5,000 Feb Actual 80,000 40,000 18,000 6,000 March Actual 75,000 42,000 22,000 6,000 April Budget 90,000 50,000 24,000 7,000 May Budget
85,000 45,000 20,000 6,000
June Budget 80,000 35,000 18,000 5,000
Additional information: a. 10 % of the purchases and 20 % of sales are for cash b. The average collection period of the company is 1 / 2 month and the credit purchases are paid regularly after one month. c. Wages are paid half monthly and the rent of Rs.500 included in expenses is paid monthly. Other expenses are paid after one mo nth lag. d. Cash balance on April 1, 2007 may be assumed to be Rs.15,000.
Sikkim Manipal University
291
Financial and Management Accounting
Unit 14
Solution DR Limited CASH BUDGET For the month ending June 2007 Particulars April May June RECEIPTS Opening Balance 15,000 27,200 35,700 Cash Sales
18,000 17,000 16,000
Collection from Debtors 66,000 70,000 66,000 Total , say A 99,000 1,14,200 1,17,700
PAYMENTS Cash purchases 5,000 4,500 3,500 Payments to creditors 37,800 45,000 40,500 Wages 23,000 22,000 19,000 Rent 500
500 500
Other expenses 5,500 6,500 5,500
Total, say B 71,800 78,500
69,000
CLOSING CASH BALANCE, A – B 27,200 35,700 48,700
Problem 4: DR is to start production on January 1, 2008. The prime cost of an unit is expected to be Rs.40 (Rs.16 per material and Rs.24 for labor). In addition, variable expenses per unit are expected to be Rs.8 and fixed expenses per month Rs.30,000. Payment for materials is to be made in the month following the purchases. Onethird of sales will be for cash and the rest on credit for settlement in the following month. Expenses are payable in the month in which they are incurred. The selling price is fixed at Rs.880 per unit. The number of units to be produced and sold are expected to be : January 900, February 1,200./ March 1,800. April 2,000. May 2,100. June 2,400. Draw a cash budget indicating cash requirements.
Sikkim Manipal University
292
Financial and Management Accounting
Unit 14
Solution CASH BUDGET For six months ending 30 th June Particulars
Jan Feb March April May June
RECEIPTS Opening balance
34,800 37,600 32,400 5,867
17,600
Cash Sales 24,000 32,000 48,000 53,333 56,000 64,000 Collection from Debtors
48,000 64,000 96,000 1.06.667 1,12,000
Total, say A 24,000 45,200 74,400 1,16,933 1,56,800 1,93,600 PAYMENTS Creditors Wages
14,400 19,200 28,800 32,000 33,600
21,600 28,800 43,200 48,000 50,400 57,600
Variable Expenses 7,200 9,600 14,400 16,000 16,800 19,200 Fixed Expenses 30,000 30,000 30,000 30,000
30,000 30,000
Total, Say B 58,800 82,800 1,06,800 1,22,800 1,39,200 1,40,400 Closing balance : A – B Debit ( + ) Credit ( ) 34,800 37,600 32,400 5,867
17,600 53,200
Cr Cr. Cr Cr
Problem 5: DR wish to approach his Bankers for temporary overdraft facility for the period from June 1 to August 30 th , 2007. During the period of these three months, DR will be manufacturing mostly for stock. Prepare a cash budget for the above period. Sales Purchases Wages April
3.60,000 2,49,600 24,000
May 3,84,000 2,88,000 28,000 June 2,.16,000
4,.86,000 22,000
July 3,.48,000 4,.92,000 20,000 Aug 2,.52,000 5,.36,000 30,000
Sikkim Manipal University
293
Financial and Management Accounting
Unit 14
(a) 50 % of credit sales are realized inn the month following the sales and remaining in the second following month. (b) Creditors are paid in the month following the month of purchase (c) Estimated cash as on June 1 is Rs.50,000 Solution
DR CASH BUDGET For the period ending 20 th August
Particulars
JUNE JULY AUGUST
RECEIPTS Opening balance 50,000 1,12,000 ( 94,000 ) Collection from Debtors 3,72,000 3,00,000 2.82,000 Total, say A 4,22,000 4,12,000 1,88,000 PAYMENTS Payments to creditors
2,88,000 4,86,000 4,92,000
Wages 22,000 20,000 30,000 Total, say B 3,10,000
5,06,000 5,22,000
Closing Balance A – B 1,12,000 94,000 3,34,000 Cr Cr Overdraft needed NIL 94,000 2,40,000
Problem 6: Prepare a cash budget from January to April Expected Purchases Expected Sales Jan 48,000 60,000 Feb 80,000 40,000 Mar
81,000 45,000
April 90,000 40,000 Wages to be paid to workers will be Rs.5,000 per month. Cash balance on January 1 may be assumed to be Rs.8,000. Management decides that : a) in case of deficit within the3 limit of Rs.10,000 arrangement can be made with the bank b) in the case of deficit exceeding Rs.10,000 but within a the limit of Rs.42,000 issue of debentures is to be preferred. c) In the case of deficit exceeding Rs.42,000 the issue of equity shares is to be preferred. Assume that this will be within the Authorized Capital. Sikkim Manipal University
294
Financial and Management Accounting
Unit 14
Solution CASH BUDGET
Particulars Jan Feb March April RECEIPTS Opening balance 8,000 15,000 30,000 (Cr) 71,000 (Cr) Cash sales Total, say A
60,000 40,000 45,000 40,000 68,000 55,000 75,000 31,000
PAYMENTS Purchases 48,000 80,000 81,000 90,000 Wages 5,000 5,000 5,000 5,000
Total, say B 53,000 85,000 86,000 95,000 Closing Balance A – B 15,000 30,000 71,000 1,26,000
The total deficit of Rs,1,26,000 should be raised from the issue of Equity Shares.
14.10 Flexible Budget According to I.C.M.A, London, a flexible budget is “a budget which is designed to change in accordance with the level of activity actually attained”. The basic idea of a flexible budget is that there shall be some standard of cost and expenditures. Thus, a budget prepared in a manner to give budgeted costs for any level of activity is, known as flexible budget. Such budget is prepared after considering the variable and fixed elements of costs and the changes which may be expected for each item at various levels of operations. .The main focus of flexible budget is to re cognize the difference in behavior pattern of fixed and variable costs in relation to fluctuations in production and sales . The flexible budget is, hence, designed to change appropriately with such fluctuations. In flexible budget, data relating to costs and expenses may progressively be changed in any month in accordance with actual output achieved. Costs and estimates are made in advance based on standards. A maximum and a minimum levels of operation is made. Comparison of budgeted with actual are made. Budgeted activities are taken as basis. The principles of flexible budgeting concepts are applied to functional budget, master budgets. Popularly, the flexible budget is adopted for production cost budget. In this area., the costs are classified. A detailed classification is adopted such as variable, fixed and semivariables..
Sikkim Manipal University
295
Financial and Management Accounting
Unit 14
Adopting microlevel classifications, it is intended to pinpoint the various effects on each class of overheads. Self Assessment Questions 10: 1. Flexible budget is _______________. 2. Main focus on flexible budget is ___________. Problem 7: Draw a flexible budget for the level of operation at 70 %, 80 % and 90 %.. Variable overheads : at 80 % capacity. Indirect labor Rs.12,000. Stores and spares Rs.4,000. Semivariable overheads at 80% capacity. Power (30 % fixed) Rs.20,000. Repairs and maintenance at 60 % fixed Rs.2,000. Fixed overheads : at 80 % : Depreciation Rs.11,000. Insurance Rs.3,000. Salaries Rs.10,000. The estimated direct labor hours 1,24,000,.
Solution: FLEXIBLE BUDGET (OVERHEADS) For the period …………………
Particulars
Level of operation
Basis 70 % 80 % 90 %
VARIABLE OVERHEADS Indirect labor
10,500 12,000 13,500
Spares and 3,500 4,000 4,500 Total, say A 13,500
16,000 18,000
SEMI VARIABLE OVERHEADS Power ( 30 % fixed ) consider 80 % Power total 20,000 and segregate between Variable and fixed . For fixed, maintain Uniformity for all levels of production 30% x 20,000 6,000 6,000 6,000 Balance 70 % , proportionately calculate 12,250 14,000 15,750 Sikkim Manipal University
296
Financial and Management Accounting
Unit 14
Repairs and maintenance 60 % fixed on Rs.2,000 (i.e. 80 % capacity) 1,200 1.200 1,200 40 % variable
700 800 900
Total, say B 34,150 38,000 41,850
FIXED OVERHEADS Depreciation 11,000 11,000 11,000 Insurance 3,000 3,000 3,000 Salaries
10,000 10,000 10,000
Total, say C 24,000 24,000 24,000 Grand Total A + B + C 58,150 62,000 65,850 Estimated labor hours 1,08,500 1,24,000 1,39,500
Standard overhead rate / hour 0.54 0.50
0.48
Divide the grand total by estimated Labor hours.
14.11 Limitations Of Budgeting The main limitations of budgeting are as under : Budget plan : Since budget plans are based on estimates, the success or otherwise depends on the accuracy of basic estimates or forecasts. Due to this while making estimates, judgmental decision may accrue. The results need to be interpreted very cautiously. Rigidity: Since the estimates are quantitative expression of all relevant data, there is likely that finality attachment may become very clear. Such consideration may result in rigidity. Rigidity may become a set back for the changing business conditions. Replacement: Budgeting is not a substitute for management. It is essentially a tool of management. Under no circumstances, it should be concluded that the budgeting is alone sufficient to ensure success and to guarantee future profits. Costly: The installation of budgeting system to an organization involve too much of costs. Its scientific approach will definitely call for huge cost allocation. Small concerns cannot afford to take over huge costs for the establishment of business systems. Since the costs and revenues and operational activities do not match in many occasions, the entire exercise will become costly. The system should be adopted only when benefits exceed the costs. Sikkim Manipal University
297
Financial and Management Accounting
Unit 14
Terminal Questions 1. What are the merits of budgets ? 2. Describe the essential features of budgetary control. 3. What are the steps in budgetary control ? 4. What are the limitations of budgeting ? 5. DR Ltd provides the following Profit and Loss Account for the year 2007. Sales Rs.3,55,000 LESS : Expenses : Raw materials Rs.72,200. Expenses Rs.2,04,000. Stores Rs.48,800. Interest Rs.20,000. Depreciation Rs.20,000. Loss : (Rs.11,200). The company had been working at 60 % capacity during the year 2007. Of the expenses of Rs.2,04,00, 25 % is variable. During the year 2008, production / sales volume at 80 % of capacity is expected to be achieved. Fixed cost is, however, expected to increase by Rs.12,000. Draw a 2008 Budget. 6. The expenses budget for production of 10,000 units in a factory are furnished below. In rupees per unit. Materials 70, Labor 25, Variable overheads 20, Fixed overheads (Rs.1,00,000) 10, variable expenses (direct) 5, Selling expenses (10 % fixed) 13. Administrative expenses (Rs.50,000) 5. Distribution expenses (20 % fixed) 7. Prepare a budget for the production of (a) 8,000 units and (b) 6,000 units. Assume that administrative expenses are rigid for all levels of production. Answer Self Assessment Questions Self Assessment Questions 1 1. Numerical 2. Estimated Self Assessment Questions 2 1. Corrective action. Self Assessment Questions 3 1. Forward 2. Long and short term goals Self Assessment Questions 4 1. Fix financial goals Self Assessment Questions 5 1. Best result 2. Foundation for business activities 3. Group of representatives Sikkim Manipal University
298
Financial and Management Accounting
Unit 14
4. Coordination Self Assessment Questions 6 1. Policy formulation, forecasting Self Assessment Questions 7 1. Fixed, flexible, function Self Assessment Questions 8 1. Process of cash flow forecast. 2. Weekly, monthly, quarterly, annually Self Assessment Questions 9 1. Changes with level of activities 2. Recognize behavior pattern. Answer for Terminal Questions 1. Refer to unit 14.5 2. Refer to unit 14.6 3. Refer to unit 14.7 4. Refer to unit 14.11 5. Refer to unit 14.10 6. Refer to unit 14.10
Sikkim Manipal University
299
Financial and Management Accounting
Unit 15
Unit 15
Standard Costing
Structure: 15.1
Introduction Objectives
15.2
Definition Self Assessment Questions 1
15.3
Meaning Self Assessment Questions 2
15.4
Standard cost and BC Self Assessment Questions 3
15.5
Establish or standard Self Assessment Questions 4
15.6
Variance analysis Self Assessment Questions 5
15.7
Material variance Self Assessment Questions 6
15.8
Material price variance Self Assessment Questions 7
15.9
Material usage Self Assessment Questions 8
15.10 Material Mix Self Assessment Questions 8 15.11 Material Yield Self Assessment Questions 9 15.12 Direct labor variance Self Assessment Questions 10 15.13 Labor Efficiency Variance Self Assessment Questions 11 15.14 Labor rate variance Self Assessment Questions 12 15.15 Labor mix variance Self Assessment Questions 13 15.16 Labor yield variance Self Assessment Questions 14 Sikkim Manipal University
300
Financial and Management Accounting
Unit 15
Terminal Questions Answer to SAQs and TQs
15.1 Introduction Standard costing is a very important system of cost control. It is a system which seeks to control the cost of each unit or batch through determination before hand of what should be the cost and then its comparison with actual cost. Through planned accounting procedures, the difference between the actual and predetermined costs are analyzed and then promptly reported upon to managers. Based on this, it is possible to take corrective and preventive action as well as employ the data for planning, coordination and control.
Learning Objectives: After studying this unit, you should be able to understand the following 1. Define the standard costing. 2. understand the meaning. 3. Differentiate between standard cost and budgetary control. 4. Acquaint with establishment of standards. 5. Practice the variance analysis.
15.2 Definition Of Standard Costing Standard costing may be defined as a technique of cost accounting which compares the standard cost of each product or service with the actual cost to determine the efficiency of the operation so that any remedial action may be taken immediately: Brown and Howard. According to J. Batty “standard costing is a system of cost accounting which is designed to show in detail how much each product should cost to produce and sell when a business is operating at a stated level of efficiency and for a given volume of output”. Self Assessment Questions 1 1. Standard cost is defined as ___________.
15.3 Meaning The meaning of standard costing is focused on the method of financial control. It compares the predetermined and actual costs. It is normally associated closely with budgetary control;. Many organizations use both the systems although one can be used without the other. Standard
Sikkim Manipal University
301
Financial and Management Accounting
Unit 15
costing is mainly applied to products and processes. Therefore, it is a technique that is more commonly used in manufacturing organization, though it may also be useful in service industries. As in budgetary control, it allows the comparison of predetermined costs and income with the actual costs and income achieved. Any difference can then be investigated. Self Assessment Questions 2 1. Standard cost is basically _________.
15.4 Standard Cost And Budgetary Control Both are closely interrelated. They both aim at the improvement of the system of managerial control. They both achieve the same objective of maximum efficiency and cost control; by establishing predetermined standards. They compare actual performance with the predetermined standard. They take necessary steps to improve the situation wherever necessary. Both techniques are forward looking. However, the following are some of the differences identified. 1. The scope of budgetary control is wider. It is integrated plan of action, a coordinated plan in respect of all functions of an enterprise The scope of standard costing, on the other hand, is limited to the operating level. Here too, it is further linked to costs. Budgetary control is extensive whereas standard costing is intensive in its application 2. Budgetary control deals with costs and revenues. But standard costing restricts only with costs . 3. Budgetary control takes into account all activities such as production, sales, purchase3s, finance, capital expenditure, personnel whereas standard costing is restricted to deal with only costs. 4. Budgetary control targets are based on past actual adjusted to future trends. In Standard costing, standards are based on technical assessment. 5. At the approach level, budgeted targets work as the maximum limit of expenses above which the actual expenditure should not normally exceed. Under standard costing, standards are attainable level of performance. 6. Budget are projection of final accounts. Standard costs are projection of only cost accounts. 7. Budgetary control emphasizes the forecasting aspect of the future operations. Standard 8. Costing scope and utility is limited to only operating level of the concern. 9. In budgetary control, the degree of variance analysis tends to be much less and variances are not revealed through the accounts but are revealed in total. But in standard costing, variances
Sikkim Manipal University
302
Financial and Management Accounting
Unit 15
are analyzed in details according to their originating causes and ar3e revealed through different accounts. 10. Budgetary control is possible even in parts of expenses according to the attitude of management. A standard costing system can not be operated in parts. All items of expenditure included in cost units are to be accounted for. Self Assessment Questions 3 1. Standard cost and budget control _________.
15.5 Establishment Of Standards Under standard costing system, there is a need to determine the standard costs for each element of cost. The standards are fixed for three main elements of cost namely direct material, direct labor and overhead. Standards should be fixed for each of them separately. Direct Material : Standard material cost for each product should be predetermined. This will require the determination of material quantity standard and material price standard. The standard quantity of each type of materials is determined by the engineering department on the basis of past records, experience and chemical and engineering tests. While setting such standards, an allowance should be made for the normal wastage of materials. The standard price for each item of material is established after carefully studying the market conditions and forecasting the trend of prices for a future period. This is done by cost accountant with the help of purchase officer.. Direct labor : The standard labor time and standard labor rate should be established. Standard time for each grade of labor is fixed by the production engineering department on the basis of time and motion study. In fixing the standard time due allowance should be made for fatigue, tool setting, receiving instructions and normal idle time. The standard rates of pay for each category of labor are fixed by the cost accountant with the help of personnel department. Overheads : These are aggregate of indirect materials, indirect labor and indirect expenses/ Separate standards must be established for variable and fixed overheads. As variable overheads per unit or per hour remain constant at each level of output / sales but total amount of variable overheads tend to vary directly with volume of output / sales . Therefore, it is sufficient to calculate only a standard variable overhead rate per unit or per hour. This is done by dividing the total variable overheads for the budget period by the budgeted output. In respect of fixed overheads standards are set for total fixed overheads for the budget period and the budgeted
Sikkim Manipal University
303
Financial and Management Accounting
Unit 15
output and standard fixed overhead rate is computed by dividing the budgeted fixed overheads with budgeted output. Self Assessment Questions 4 1. Standards are established for _____.
15.6 Cost Variance Analysis The distinctive feature of standard costing system is variance analysis. By definition, the term “variance” means the variation or deviation of the actual from the standard. In standard costing, it implies the difference between the actual cost and standard cost. Variances indicate the extent to which standards set have been achieved. If properly recorded and analyzed , these variances become very important and useful tool for managerial control. Variances by themselves are not the end. They are computed to know the reasons and fix the responsibility for any deviations of actual performances from pre determined targets. Based on this corrective measures are proposed for adoption in future. Therefore, variance analysis is the process of analyzing variances by subdividing the total variance in such a way that management can assign responsibility for off standard performance It is hence a very useful means for interpreting operating results and spotting situations calling for correction. Variances are interpreted as favorable and unfavorable variances. Each variance is interpreted. Interpretation helps in deciding whether a variance is favorable or unfavorable. When the actual cost is less than the standard cost, the difference is termed as “favorable” or “credit” variance. On the other hand, when actual cost exceeds the standard cost, the difference is termed as “unfavorable”, “adverse” or “debit” variance. Ordinarily, a favorable variance is a sign of efficiency of the organization whereas an unfavorable variance a sign of inefficiency. But in variance analysis, this general logic may prove to be untrue. Therefore, all variances should be interpreted in relation to each other and only the net result be reported to the management for corrective action. Controllable and Uncontrollable variances : The controllable variance can be identified as the primary responsibility of a specified person or a department. F a variance is due to the factors beyond the control of the concerned person or department, it is said to be uncontrollable. No person or department can be held responsible for uncontrollable variances. Actually revision of standards is required to remove such variances in future.
Sikkim Manipal University
304
Financial and Management Accounting
Unit 15
Self Assessment Questions 5 1. Variation refers ________. 2. Variances analysis is _________________. 3. Variances are interpreted as _____ and ____.
15.7 Material Variance It refers to material cost variance. It is the difference between the standard cost of materials allowed for the actual output and the actual cost of materials used. It may be expressed as : Material Cost Variance = Standard Cost – Actual Cost Where standard cost = actual output x standard rate per unit of output Or standard quantity of material for actual output x standard price per unit of material Actual cost = actual quantity consumed x actual price per unit of material. A favorable variance would result if actual cost is less than the standard cost and vice versa. The material cost variance is the sum total of material price variance and material usage variance. Self Assessment Questions 6 1.
Material variance is ______________.
Example: DR Ltd has decided to extend its range to include Denim Jackets. One jacket requires a standard usage of 3 meters of direct material which has been set at a standard price of Rs.2.20 per meter. In the period, 80 jackets were made and 260 meters of material consumed at a cost of Rs.1.95 per meter. Calculate the direct materials total variance. Solution: Calculate the standard quantity of materials for the actual level of production For 1 jacket = standard usage is 3 meters Therefore for 80 jackets, it is 80 x 3 meters / 1 or 240 meters Consider the formula, (SQ x SP ) – (AQ x AP) = (240 x Rs.20 ) = (260 x Rs.1.90 ) or Rs.528 – Rs.507 = Rs.21 (Favorable) variance. The difference indicates that them company has spent less on materials than planned for the level of production.
Sikkim Manipal University
305
Financial and Management Accounting
Unit 15
15.8 Material Price Variance Under Material price variance , the price paid for materials is different from the predetermined price. It is calculated by multiplying the actual quantity of materials used with the difference between standard and actual prices. The formula is : Material Price Variance = (Standard Price – Actual Price ) x Actual quantity used Shorten = ( SP – AP ) AQ A favorable variance would result if the actual price is less than the standard price and vice versa. Self Assessment Questions 7 1. Material price variance is __________. Example : Calculate the direct material price variance from the data of DR Ltd above. Solution : Formula : (SP – AP ) AQ or (Rs.2.20 – Rs.1.90) x 260 meters or Rs.78 FAV It is favorable because the company has paid less for the materials than planned for that level of production
15. 9 Material Usage Variance It is also known as material quantity variance or efficiency variance. It is that portion of material cost variance which measures the difference in material cost arising from higher or lessa consumption of materials than the standard material consumption for the actual output. It is calculated by multiplying the standard price with the difference between the standard and actual quantitities of materials : Material Usage Variance = (Standard Quantity Actual Quantity ) Standard Price Shorten = (SQ – AQ) SP
A favorable variance would result if the actual quantity is less than the standard quantity and vice versa. Self Assessment Questions 8 1. Material usage is _______. Example 1: Citing DR’s example : the direct material usage variance is : (SQ – AQ ) SP or (240 – 260 meters) x Rs.2.20 per unit or Rs.44 (ADV) It is adverse because the company has used more materials than planned for that level of production.
Sikkim Manipal University
306
Financial and Management Accounting
Unit 15
Example 2: It is observed that one unit of product X requires 3 kgs of material M at Rs.2 per kg During January 2008, 200 units of product X were produced consuming 620 kgs of material M, all of which was purchased at Rs.1.80 per kg. Compute material cost variances. Solution: Material Price Variance : ( SP – AP ) AQ or (2.00 – 1.80) x 620 o Rs.124 F Material Usage variance : (SQ – AQ ) SP where SQ for actual consumption is 200 x 3 kg / 1 kg 0r 600 kgs (600 – 620_ Rs.2 or Rs.40 A Material Cost Variance : Material Price Variance + Material Usage variance 124 (F) + 40 )A) or Rs.84 (FAV) Example 3: For producing a commodity, the standard quantity of material was fixed 10 kgs and standard price was fixed at Rs.2 per kg. The actual quantity was consumed 12 kgs and the actual price was Rs.1.90 per kg. Calculate the material variances. Solution: MUV = (SQ – AQ) SP or (10 – 12) 2 or 2 x 2 or 4 ADV MPV = (SP – AP ) SQ or (2 – 1.90 ) 12 or 1.20 FAV MCV = (SQ x SR) – (AQ x AP) = (10 x 2 ) – (12 x 1.90) = 2.80 ADV Example 4: Calculate the material variance. Standard
Actual
Material for 80 kgs Output 1,65,000 kgs Finished products 100 kgs Material used 2,00,000 kgs Price per kg Rs.0.80 paid Actual cost Rs.1,70,000 Solution: Calculation of standard quantity For 80 kgs, finished products needs 100 kgs material Therefore, for 1,65,000 kgs, it is 1,65,000 x 100 / 80 Or 2,06,250 kgs. MUV = (SQ – AQ ) SP or (2,06,250 – 2,00,000) Rs.0.80 = Rs.5,000 FAV MPV = (SP – AP ) AQ or (0.80 – 0.85 ) 2,00,000 or Rs.10,000, ADV Cost of 2,00,000 kgs is Rs.1,70,000 Therefore, cost of one kg is 0.85 MCV = (SQ x SR) (AQ x AP ) (2,06,250 x 0.80) – (2,00,000 x 0.85) Sikkim Manipal University
307
Financial and Management Accounting
Unit 15
= Rs.5,000 ADV. Example 5: It is estimated that in the manufacture of a product, for each ton of materials consumed 100 units should be produced. The standard price per ton of materials is Rs.10. During the first week of January, 100 tons of materials were issued to the Production Department. The purchase price of which was Rs.10.50 per ton. The actual output for the period was 10,250 units. Calculate the cost variances. Solution: Standard rate of material : Standard cost per ton / standard output per ton or 10,250 units / 100 tons or 102.5 per ton Material usage (SQ – AQ) Sp where SQ = Actual output / standard quantity or 10,250 / 100 tons = 102.5 ton (one ton for 100 units Rs.10,250, the standard quantity is 102.5 tons. (102.5 – 100 tons) x Rs.10 or Rs.25 FAV MPV = (SP – AP ) AQ (10 – 10.50 ) x 100 = Rs.50 ADV MCV = (SQ x SP ) – (AQ x AP) or 102.5 x 10 – 100 x 10.50 or Rs.25 ADV
Example 6: A factory works on standard costing system. The standard esti8mates of material for the manufacture of 1000 units of a commodity is 400 kg at Rs.2.50 per kg. When 2000 units of a commodity are manufactured, it is found that 820 kgs of material is consumed at Rs.2.60 per kg. Calculate the material variance Solution : First calculate the standard quantity and standard cost. Standard quantity : For manufacture of 1000 units, the standard estimates = 400 kgs. Therefore, for actual manufactured quantity, the standard is 2000 x 400 / 1000 or 800 kgs. Standard cost = Standard quantity x Standard rate or 800 x Rs.25 or Rs.2,000 Actual Cost = 820 x Rs.2.60 or Rs.2,132 Material cost variance = Standard cost – Actual cost or 2000 – 21312 or 132 ADV. Material price variance = (SR – AR ) AQ or 2.50 – 2.60 x 820 or Rs.82 ADV Material usage variance = 800 – 820 x 2.50 or Rs.50 ADV
15.10 Material Mix Variance This variance arises only when more than one type of materials are used in manufacturing the product and the quantities of materials issued to production are not in proportion of standard mix. It is defined as that portion of the direct materials usage variance which is due to difference between the standard and actual, composition of a mixture. For calculating the mix variance, first Sikkim Manipal University
308
Financial and Management Accounting
Unit 15
calculate the quantities of revised standard mix. This is calculated by dividing the total quantities of actual mix in standard mix proportion. In the terminology of standard costing, quantities of revised standard mix are referred to as “revised standard quantity”. Mix variance is obtained by multiplying the standard price of materials with the difference between revised standard quantity and actual quantity for each material. It may be expressed as follows: Material Mix Variance = Revised standard quantity for each material – actual MMV Quantity for each material) x standard price. Where RSQ = standard quantity for each material / total of standard quantity of all types of materials x actual mix total RSQ = Total weight of actual mix / total weight of standard mix X standard quantity. A favorable variance would result if actual quantity is less than revised standard quantity and vice versa. Self Assessment Questions 9 1. Material mix variance to __________.
Example : The following extracts are extracted from the books of DR Ltd.
Standard Mix
Actual Mix
Material Qty Rate Total Qty Rate Total
X 300 5 1,500 280 5 1,400 Y 200
10 2,000 220 10 2,200
Total 500 500
Calculate the material mix variance Solution : Revised standard quantity = Total weight of actual mix / total weight of standard mix x standard quantity For Material X = 500 / 550 x 300 = 300 For Material Y = 500 /500 x 200 = 200
Sikkim Manipal University
309
Financial and Management Accounting
Unit 15
MMV = For X = (300 – 280)_ 5 = 100 FAV Y = (200 – 220) 10 = 200 ADV Total Mix variance 100 ADV
15.11 Material Yield Variance This variance arises only when the rate of output is known. It is that portion of the direct material usage variance which is due to the difference between standard yield specified and actual yield obtained. It measures the loss or saving due to wastage of materials. This variance is calculated as follows : MYV = (Standard yield – Actual Yield ) x standard rate per unit of output or ( Standard Loss – Actual Loss ) x standard rate per unit of output where standard rate = standard cost of standard mix / standard output from standard mix standard yield = standard output from standard mix / standard mix total x actual mix total MYV is an output variance and hence a favorable variance would result if actual yield is more than standard yield and vice versa.
Self Assessment Questions 10 1. Material yield variance is __________. Example 1: The following extracts refer to DR Ltd.
Standard Mix
Actual Mix
Material Qty Price Total Qty Price Total
X 60 5 300 56
5 280
Y 40 10 400 44 10 440 100 700 100
720
Loss 30 % 30 Loss 25 % 25
a.
75
Calculate the material yield variance.
Sikkim Manipal University
310
Financial and Management Accounting
Unit 15
Solution: Material Yield Variance : (Standard yield – Actual yield) Standard rate Where standard rate = Total cost of standard mix / net standard output or 700 / 70 = Rs.70 MYV = (70 – 75) 10 or Rs.50 ADV. Example 2: DR manufactures a product X. It is estimated that for each ton of material consumed, 100 articles should be produced. The standard price per ton of material is Rs.10. During the first week of January 2008, 100 tons were issued to production, the price of which was Rs.10.50 per ton. Production during the week was 10,200 articles. Compute the variances Solution: Cost variance : Standard cost – Actual Cost or Rs.1,020 – Rs.1,050 = Rs.30 ADV Working : Actual output x standard rate per unit of output or 10200 x 0.10 orRs.1,020 SR = Actual output / standard output per ton or 10,200 / 1`00 or 102 tons Price variance : Actual quantity of input (Standard price – Actual Price) or ( 10 – 10.50) x 100 = Rs.50 ADV Usage Variance : (Standard quantity – Actual quantity) standard price or (102 – 100) x 10 or Rs.20 FAV Yield variance = (Standard yield – Actual yield ) standard rate per unit of output or (10,000 – 10,200 ) 0.10 or Rs.20 FAV Working : Standard yield = Actual quantity of material x standard rate per ton of output or 100 x 100 = 10,000 articles. Example 3 : The standard mix of product MS is as follows Materials
Qty in kg Price per kg
A 50 5 B 20 4 C 30 10 The standard loss in production is 10 % of input . There is no scrap value. Actual production for a month was 7,240 kgs of MS from 80 mixes. Actual purchases and consumption of materials are : A 4,160 5.50 B 1,680 3.75 C 2,560 9.50 Solution Sikkim Manipal University
311
Financial and Management Accounting
Unit 15
Statement showing standard input requirements of 80 mixes of product MS Material Standard
Actual
SQ SR SC AQ AR AC A 4000 5
20,000 4160 5.50 22,880
B 1600 4 6,400 1680 3.75 6,300 C 2400 10 24,000
2560 9.50 24,320
Total 8000 50,400 8400 53,500 Less Std. Loss 800 Final output 7200
50,400
SC per kg of finished product = 50,400 / 7200 kg = Rs.7 per kg Cost variance : SC AC or 7 x 7240 53500 or Rs.2,820 ADV Prince Variance : (SR – AR ) x A Q A = Rs.2,080 ADV B = Rs.420 FAV C = Rs.1,280 FAV Mix Variance = (RSQ – AQ ) SR A = (8400 x 50 / 100) Rs.5 = 200 FAV B = 8400 x 20 / 100 x Rs.4 Nil C = 8400 x 30 / 100 x Rs.10 = 400 ADV Total : 200 ADV Yield variance = (SY – AY ) SR per kg Standard yield = 8400 kg x 9 / 10 or 7560 klg (7,560 – 7,240 ) Rs.7 or Rs.2,240 ADV
15.12 Direct Labour Variances The same principles apply to the calculation of Direct Labor variances as for the direct material variances. Standards are established for the rate of pay to be paid for the production of particular products and labor time taken for their production. The standard time taken is expressed in standard hours or minutes and become the measure of output. By comparing the standard hours allowed and the actual time taken, labor efficiency can be assessed. In practice, standard times are established by work, time and method study techniques.
Sikkim Manipal University
312
Financial and Management Accounting
Unit 15
Direct Labor variance : It is the difference between actual labor cost and the standard labor cost of production achieved. It is calculated as : Total Labor Cost = Hours worked x Rate per hour Labor Cost Variance = Standard Cost – Actual Cost Shorten = SC AC Or (Standard labor hours x standard rate per hour ) – (Actual labor hours x Actual rate per hour) Self Assessment Questions 11 1. Direct labor variance is ___________. Example: The management of DR Ltd decides that it takes 6 standard hours to make one Denim jacket and the standard rate paid to labor is Rs.8 per hour. The actual production is 900 units and this took 5,100 hours at a rate of Rs.8.30 per hour. Calculate the direct labor total variance. Solution : Calculate the standard labor hour for 900 jackets For one Jacket production, the standard hour is 6 Therefore, for producing 900 units, the standard hour is 900 x 6 / 1 = 5,400 hours DLV = (5,400 x 8) )5,100 x 8.30 ) = Rs.870 favorable.
A favorable variance would result when actual cost is less than standard cost and vice versa. Labor cost variance is the sum total of labor rate variance, labor efficiency variance, rate variance, idle time and labor calendar variance
15.13 Labour Efficiency Variance It is that portion of labor cost variance which is due to the difference between the standard lab or hours specified for the activity i.e output achieved and the actual labor hours worked. It is calculated by multiplying standard rate of wages with the difference between standard hours and actual hours worked. LEV = Standard hours – actual hours worked ) x standard rate Shorten = (SH – AH ) SR A favorable variance would result when actual hours worked are less than standard hours and vice versa. Self Assessment Questions 12 1. Labor efficiency variance to _________________.
Sikkim Manipal University
313
Financial and Management Accounting
Unit 15
Example : From the data above, calculate the labor efficiency variance; Solution : (5400 standard hours – 5100 actual hours ) x Rs,8 standard rate Rs.2,400 FAV
15.14 Labor Rate Variance It is that portion of labor cost variance which is due to the difference between the standard rate specified and actual rate paid. It is calculated by multiplying the actual hours paid with the difference between standard rate specified and actual rate paid Labor Rate variance = (Standard Rate – Actual Rate ) x actual hours paid Shorten = ( SR – AR) AH Self Assessment Questions 13 1. Labor rate variance is __________. Example 1: Citing DR example, calculate the direct labor rate variance Solution : (Rs.8 – 8.30 ) x 5,100 hours or Rs.1,530 ADV Example 2: The production of a certain unit is assumed to require 18 hours labor at a rate of Rs.1.25 per hour. On completion of a unit, it was found that the time taken was 16 hours, the wage rate being Rs.1.50 per hour. Calculate labor variances. Solution : Cost variance = Standard cost – actual cost Rs.22.50 – Rs.24 or Rs.1.50 ADV Working : SC = Standard hours x standard rate per hour = 18 x Rs.1.25 = Rs.22.50 OR LCV = LEV + LRV 2.5 FAV + 4 ADV= 1.5 ADV Efficiency variance = (Standard hours – actual hours worked)standard rate ( 18 – 16) x 1.25 or Rs.2..50 FAV Rate variance = (Standard rate – actual rate) actual hours paid (1.25 – 1.50) 16 or Rs.4 ADV Labor Idle Time variance : It is that portion of labor cost variance which is due to abnormal idle time of workers. This variance is calculated to show separately the effect of abnormal causes affecting production such as failure of power supplies, machine break down, waiting for materials, waiting for instructions, strike, lockouts. It is calculated as: Labor idle time variance = Idle hours x standard hourly rate Sikkim Manipal University
314
Financial and Management Accounting
Unit 15
This variance is always an adverse one. Example 3: In the ma manufacture of a product, 200 employees are engaged at a rate of 50 paise per hour. A five day week of 40 hours is worked and the standard performance is set at 250 units per hour. During the first week in January, six employee were paid at 45 paise an hour and four at 56 paise an hour, the remaining employees were paid at standard rates. The factory stopped production for one hour due to power failure. Calculate variances. Solution : Efficiency variance = (Std hours – actual hours worked ) x std rate (8000 – 7800) 0.50 or Rs.100 FAV Rate variance = (SR – AR ) AH (0.50 – 190 employees x 40 hours = Nil (0.50 – 0.40 ) x 6 x 40 12 FAV (0.50 .56 ) 4 x 40 9.60 ADV Total 2.40 FAV Idle time variance = Idle hours x std rate per hour 200 hrs and 0.50 or Rs.100 ADV Labor cost variance = LEV +_ LRV + Idle time variance 100 FAV + 2.40 FAV + 100 ADV = Rs.2.40
15.15 Labour Mix Variance This variance arises only when different types of workers (women and men workers, trained, semitrained and untrained workers, are employed in manufacturing. If actual working force of different grades of workers is not in the predetermined ratio, then the mix variance will occur. The variance shows to the management as to how much of the labor cost variance is due to the changes in the composition of labor force. It is calculated as follows : LMV = (Revised standard hours – actual hours worked) x standard hourly rate Shorten (RSLH – ALH) x SR Where revised standard hour = total time of actual worker / total time of standard workers x standard labor rate. Self Assessment Questions 14 1. Labor mix variance is _________________. Example 1: The labor budget for a week is as follows : 40 skilled men at Rs.1.50 per hour for 80 hours
Sikkim Manipal University
315
Financial and Management Accounting
Unit 15
80 unskilled men at Re.1 per hour for 80 hours Actual labor force was used are given below; 60 skilled men at Rs.1.50 per hour for 80 hours 60 unskilled men at Re.1 per hour for 80 hours Calculate labor mix variance. Solution : Revised standard labor hours = total time of actual workers / total time of standard workers x standard labor hours Skilled worker = 80 / 80 x 80 = 80 hours Unskilled = 80 / 80 x 80 = 80 hours LMV = Skilled = (3,200 – 4,800) 1.50 = Rs.2,400 ADV Unskilled = (6,400 – 4,800) Re.1 = Rs.1,600 FAV Total labor mix variance Rs.800 ADV.
15.16 Labor Yied Variance. This is due to the difference in the standard output specified and the actual output obtained. The formula is as follows : LYV : (Actual output – Standard output ) x standard cost per unit
Self Assessment Questions 15 1. Labor yield variance ________________. Example 1: Actual output 460 units. Standard output 500 units. Standard rate of wages Rs.9 per hour. A Standard time 2 hour per unit. Solution : Standard cost per unit = Rs.9 x 2 hours = Rs.18 LYV = (AO – SO) SC or (460 – 500 units) x Rs.18 or Rs.720 ADV Example 2: Calculate (a) Labor rate variance (b) labor efficiency variance (c) labor cost variance Standard : Labor rate 0.24 paise per hour. Labor hours 3 per unit. Actual : Units produced 250. Labor rate 0.25 perise per hour. Hours worked 800. Solution: LRV : (SR = AR) AH or Rs.8 ADV LEV = (SH – AH ) SR or Rs.12 ADV LCV = (SLC – ALC) or (SH x SR) – (AH x AR) = Rs.20 ADV Example 3 : The standard labor force of DR Ltd is as follows :
Sikkim Manipal University
316
Financial and Management Accounting
Unit 15
20 skilled men at Re.0.50 per hour for 40 hrs 40 semi skilled men at 0.35 per hour for 40 hrs. During a certain week, the actual ,labor force was : 30 skilled men at Rs.0.50 per hour for 40 hours 30 semi skilled men at 0.40 per hour Analyze labor variance for 40 hours. Solution : Calculation of standard hours Actual hours : 30 x 40 = 1,200 hours 30 x 40 = 1.200 hours 20 x 40 = 800 hours 40 x 40 = 1,600 hours Total 2,400 hours Since standard hours and actual hours are the same in total there would be no labor efficiency variance. Labor cost variance : SLC – ALC or Rs.120 ADV Labor rate variance : Skilled : (SR – AR) AH or Nil Semi skilled (0.350.40) 1,200 or 60 ADV Labor mix variance = ( SH – AH ) SR Skilled (800 – 1200) x 0.50 or 200 ADV Semi skilled (1,600 – 1,200)Rs.0.35 or 140 FAV Example 4: A contract job is scheduled to be completed in 20 weeks with a labor force of 10 skilled workers, 4 semi skilled workers and 6 unskilled workers. The standard weekly wages of each type of workers are : Skilled Rs.50, semi skilled Rs.40 and unskilled Rs.30. The work is actually completed in 25 weeks with a labor force of 8 skilled, 5 semiskilled and 7 unskilled workers and the actual weekly wage rates average Rs.55 for skilled, Rs.45 for semi skilled and Rs.25 for unskilled workers. Analyze the variance.
Sikkim Manipal University
317
Financial and Management Accounting
Unit 15
Solution
Grade Standard
Actual
No. Weeks Weekly rate Amount No. Weeks Rate AmountSkilled
10 20 Rs.50 10,000 8 25 Rs.55 11,000 Semiskilled 4 20 Rs.40 3,200 5 25 Rs.45 5,625 Unskilled 6 20 Rs.30 3,600 7 25 Rs.25 4,375 l 20 16,800 20 21,000 Skilled Semiskilled Unskilled
LRV = (SR – AR) AT 1,000 ADV 625 ADV 875 FAV LEV = (ST – AT ) SR Nil
1,800 ADV 1.650 ADV
LMV (RSLH – ALH) SR 2500 FAV 1,000 ADV 750 ADV Total 750 FAV Labor cost variance : LRV + LEV = 750 + 3450 = 4200 ADV Labor yield variance = (Actual weeks – standard weeks ) Standard rate per hour (500 – 400 ) Rs.42 = Rs.4,200 ADV (16800 / (20 nos x 20 weeks) RSLH : Total time of actual workers / total time of standard workers x Standard labor hours 500 / 400 x 200 = 250 = (250 – 200 ) 50 = Rs.2,500 FAV 500 / 400 x 80 = 100 = (100 – 125) 40 = Rs.1,000 ADV 500 / 400 x 120 = 150 = (150 – 175 ) x 30 = Rs.750 ADV
Terminal Questions 1. How is standard costing related to budgetary control ? 2. How do you fix standard for direct material, direct labor and direct overheads ? 3. Write short note on : a. Material Price Variance b. Material Mix Variance c. Material Yield Variance.
4. Briefly describe labor mix variance and yield variance. 5. Compute price, usage, cost and mix variance
Sikkim Manipal University
318
Financial and Management Accounting
Unit 15
Material Standard
Actual
Quantity Price Total Qty Price Total A 6 1.50 9 5 2.40 12 B 2
3.5 7 1 6 6
6. Data given below pertain to DR Ltd DEPARTMENT A B Actual gross wages 2,000 1,800 Standard hours produced 8,000 6,000 Standard rate per hour 0.30 0.35 Actual hours worked 8,000 5,800 Calculate labor variances. Answer Self Assessment Questions Self Assessment Questions 1 1. Cost of each product Self Assessment Questions 2 1. Finical control Self Assessment Questions 3 1. Closely interrelated Self Assessment Questions 4 1. Direct martial, direct labor, overheads Self Assessment Questions 5 1. Deviation 2. Process of analysis 3. Favorable and adverse. Self Assessment Questions 6 1. SC – AC
Sikkim Manipal University
319
Financial and Management Accounting
Unit 15
Self Assessment Questions 7 1. ( SP – AP) x AQ Self Assessment Questions 8 1. SQ – AQ x SP Self Assessment Questions 9 1. RSQ – AQ x SP Self Assessment Questions 10 1. SY – AY x SR Self Assessment Questions 11 1. SC – AC Self Assessment Questions 12 1. SH – AH x SR Self Assessment Questions 13 1. SR – AR x AH Self Assessment Questions 14 1. RSLH – ALH x SR Self Assessment Questions 15 1. AO – SO x SC Answer for Terminal Questions 1. Refer to unit 15.4 2. Refer to unit 15.5 3. Refer to unit 15.8, 15.10 and15.11 4. Refer to unit 15.15 and15.16 5. Price variance = (SR – AR) AQ for A = Rs.4.50 ADV For B = Rs.2.50 ADV total Rs.7 ADV Usage variance : (SQ – AQ ) SP for A = 1.50 FAV For B = 3.50 FAV Total Rs.5 FAV Cost Variance = MUV + MPV = 5 – 7 or 2 ADV Mix variance = (RSQ – AQ ) SP where RSQ = A 6 /8 x 6 or 4.5 kgs
Sikkim Manipal University
320
Financial and Management Accounting
Unit 15
B 6 /8 x 2 or 1.5 kgs For A (4.5 – 5) x 1.5 or 0.75 ADV For B (1.5 – 1) x 3.5 or 1.75 FAV Therefore total 1 FAV 6. Standard labor cost ; Dept A 8000 x 0.30 = 2,400 B 6,000 x 0.35 = 2,100 Actual rate A 2000 ./ 8000 = 0..25 B 1800 / 5800 or 900 /29 paise LRV = (SR – AR ) AH Dept A = (0.30 – 0.25) 8000 = 400 FAV B = (.35 – 900 /25) x 5800 = 230 ADV LEV = (SH – AH) SR For A = (8000 – 8000) x0.30 Nil B = (6000 – 5800)0.35 70 ADV LCV : (SLC – ALC For A (2400 – 2000) 400 FAV B (2100 – 1800) 300 ADV
Sikkim Manipal University
321
Financial and Management Accounting
Unit 2
Unit 2
Accounting Concepts, Principles, Bases and Policies
Structure 2.1
Introductions Objectives
2.2
Accounting concepts, principles, bases and policies – meaning Self Assessment Questions 1
2.3
Types of accounting concepts Self Assessment Questions 2 2.3.1
Business entity concept Self Assessment Questions 3
2.3.2
Going concern concept Self Assessment Questions 4
2.3.3
Money measurement concept Self Assessment Questions 5
2.3.4
Periodicity concept Self Assessment Questions 6
2.3.5
Accrual concept Self Assessment Questions 7
2.4
Basic Principles Self Assessment Questions 8 2.4.1
Principle of Income recognition Self Assessment Questions 9
2.4.2
Principle of expense Self Assessment Questions 10
2.4.3
Principle of matching cost and revenue Self Assessment Questions 11
2.4.4
Principle of Historical cost Self Assessment Questions 12
2.4.5
Principle of full disclosure Self Assessment Questions 13
2.4.6
Double aspect principle Self Assessment Questions 14
Sikkim Manipal University
14
Financial and Management Accounting
2.4.7
Unit 2
Modifying Principle Self Assessment Questions 15
2.4.8
Principle of materiality Self Assessment Questions 16
2.4.9
Principle of consistency Self Assessment Questions 17
2.4.10 Principle of conservatism or prudence Self Assessment Questions 18 Terminal Questions Answer to SAQs and TQs
2.1 Introduction: Any subject for that matter, is based on certain postulates, concepts and policies. Before understanding the subject, one has to go through the basic assumptions on which the subject is built upon. Accounting is a reflection of all business transactions expressed in terms of money relating to a definite period of time and the object of accounting being finding out profit or loss arising out of transactions and finally to judge the financial position of the business organization. In this Unit, the concepts, the basic principles and policies of accounting are briefly described. Learning Objectives: After studying this unit, you should be able to understand the following 1. To know the meaning of concepts, principles and policies basing on which
Accounting
science has emerged. 2. To expose the students to different concepts of accounting. 3. To have an insight into the basic principles of accounting.
2.2 Accounting concepts, principles, bases and policies As we have understood in the Unit 1, accounting is the language of business and it is concerned with measurement of financial performance of a business by recording, analyzing and reporting the business results for the sake of stakeholders. Since all stakeholders should understand the accounting language in the same sense, certain principles, concepts and policies of accounting have been laid down. Principles are basically the rules of action adopted by the accountants universally while recording accounting transactions. The principles are doctrines associated with
Sikkim Manipal University
15
Financial and Management Accounting
Unit 2
theory and procedures and current practices of accounting. These principles may be classified as concepts and conventions. While concepts are in the form of assumptions or conditions, conventions are those customs and traditions which guide the accountants while preparing accounting statements. For instance business is started with an assumption that it shall be continued for a long period of time and no body promotes a business organization to close it down within a short period. Basing on this assumption, business man purchases fixed assets, uses them and values them from time to time. This is a strong assumption that any businessman approaches with. Such assumption is called a concept. To give an example for convention, inventory (stock) in a business is valued at the end of an accounting period, at cost or market price which ever is lower. This is an accepted convention or a practice or a principle in accounting. On the other hand, an accounting policy is one which is adopted by management, relevant to the situations. For example, every asset should be depreciated (this is a concept) at the end of an accounting period. The practice is to adopt fixed installment or diminishing balance method or any other method of depreciation.(this is a convention). The policy of the management may be to adhere to fixed installment method of depreciation and it is their choice. Therefore no management can exercise discretion regarding fundamental presumptions of accounting. But every management has a choice of making an accounting policy. It is not out of place to mention that in order to bring uniformity in terminology, accounting concepts, conventions, and assumptions, the Institute of Chartered Accountants of India (ICAI) established Accounting Standards Board (ASB) in 1977. The principal objective of ASB is to formulate accounting standards so that such standards will be established by the council of ICAI. While formulating the accounting standards, ASB will give due consideration to the International Accounting Standards and try to integrate them to the extent possible. It also considers the customs, practices, laws and usages prevailing in Indian business. There are altogether 30 accounting standards issued by ASB which have to be adopted by management of different enterprises to improve the quality of presentation of financial statements in our country. Self Assessment Questions 1: 1. Accounting principles are _______ , associated with theory and practice of accountings. 2. Principles are classified as ________ and ________. 3. Assets may be depreciated on fixed installment method or reducing balance method. Is this a concept or convention? 4. A business is started with an assumption of making profit. Is this assumption, a concept or convention?
Sikkim Manipal University
16
Financial and Management Accounting
Unit 2
5. The purpose of establishing ICAI and ASB is to ________. 6. How many accounting standards are issued by ASB so far?
2. 3 Types of Accounting concepts As said earlier, concepts are the basic assumptions or conditions upon which the science of accounting is based. There are five basic concepts of accounting, namely – business entity concept, which is also termed as separate entity concept, going concern concept, money measurement concept, periodicity concept and accrual concept. Each concept is discussed below. Self Assessment Questions 2:
1. What are the different types of accounting concepts? 2.3.1 Business Entity Concept The essence of this concept is that business is a separate entity and it is different from the owner or the proprietor. This is true in the case all forms of organization. If X starts business, he should not mix up his personal properties with that of the business. When he invests his funds into the business, it is regarded as capital to the business and capital is a liability from the business point of view. If X withdraws any money from the business, it is deductable from the capital and to that extent the liability of the business towards the owner is reduced. On the other hand, if the proprietor withdraws money from the business for business purposes, then it is treated as expenditure to the business.This legal separation between business and ownership is kept in mind while recording the transactions in the books of business. Self Assessment Questions 3: 1. Business entity concept is also termed as __________. 2. Business and its owner are _______________ entities . 3. Can personal properties of owner be mixed with the properties of business properties? 4. Capital brought in by proprietor to the business is _______ to the business. 5. Profits earned in business form an addition to _____________ of the owner. 2.3.2 Going concern concept The fundamental assumption is that the business entity will continue fairly for a long time to come. There is no reason why an enterprise should be promoted for a short period only to liquidate the business in the foreseeable future. This assumption is called “going concern concept”. For this reason accountants value fixed assets on historical cost method. Had the Sikkim Manipal University
17
Financial and Management Accounting
Unit 2
business been set up to last for a short period, fixed assets should have been valued at a market price. Besides, going concern concept provides for amortization of the cost of fixed assets over the life time of the assets. For example, an entrepreneur purchases a plant for Rs. One crore and it has a life of 10 years. During this period, he sets aside every year certain funds from the income of the business so that it would help him for replacement of the asset at the end of ten years. This process of amortization presupposes that the enterprise will continue to do business fairly for long time. Self Assessment Questions 4: 1. Can a company be promoted to last only for a month? 2. A business concern continues to function for ________. This is the essence of going concern concept. 3. Do you purchase a building for your business to last for a short period or long period? 4. What is the underlying intention in making a provision every year when an asset is purchased? 2.3.3 Money Measurement Concept All transactions of a business are recorded in terms of money. An event or a transaction that can not be expressed in money terms, can not find place in the books of account. The honesty of the employees, dynamism of the selling agents, promptness and integrity of the cashier, even though influence the business results, can not be brought to the books of accounts. Besides it makes no sense if a business has 10 tons of raw material, five vehicles, one premises and a few items of furniture, unless all these assets are expressed in terms of some monetary value. If it is said that the value of these assets is Rs. two crores, it makes a lot of sense. Money is the common denominator in which the business transactions should be expressed. Self Assessment Questions 5: 1. Can honesty of an employee be expressed in terms of money? 2. Transactions should be stated in terms of _______________. 3. We have in a business 5 chairs, one godown, 2 tons of cement. What does it mean? 4. Money is common _______ in which the business transactions should be expressed. 2.3.4 Periodicity Concept The time interval for which accounts are prepared is an important factor, even though we assume long life for a business. The time interval is usually one year and this period is called accounting year. Often the accounting period could be half year or even a quarter. The financial statements
Sikkim Manipal University
18
Financial and Management Accounting
Unit 2
should be prepared at the end of each accounting period so that income statement shows profit or loss for the accounting period. So also a balance sheet is prepared to depict the financial position of the business. Self Assessment Questions 6: 1. The time interval for which accounts are prepared is called ____________. 2. What is the usual accounting period? 3. The expenses of a business are Rs.500000. Why does this statement not make any sense? 2.3.5 Accrual Concept Profit earned or loss suffered for an accounting period is the result of both cash and credit transactions. It is possible that certain incomes are earned but not received and similarly expenses incurred but not yet paid during an accounting period. But it is relevant to consider them while computing the financial results just because they are related to the specific accounting period. For example, interest receivable on Fixed deposit for the year ending 31-12-2006 is Rs. 12000 but it is actually credited to the bank account only in February 2007. For calculating the income from interest, the amount Rs.12000 is considered even though it is not received before 31-12-2006. This amount is called accrued interest. Similarly the expenses which are incurred for the accounting period, might be paid only after the accounting period. Such accrued expenses are deducted while calculating the profit for the accounting period. This is the accrual concept. Self Assessment Questions 7: 1. Interest earned but not received within an accounting period is called _______. 2. Salary payable for
December, 2004 but paid in
January,
2005
is
known as
_________________ for 2004. 3. Accrued items should be _________ to compute profit or los for the said period. 4. Accrual concept considers not only cash transactions but also ______ transactions.
2.4 Basic principles As stated above basic principles are the rules basing on which accounting takes place and these rules are universally accepted. There are ten such basic principles, namely principle of income recognition, principle of expense, principle of matching cost and revenue, historical cost principle, principle of full disclosure, double aspect principle, modifying principle, principle of materiality, principle of consistency and principle of conservatism. A brief description is in the following paragraphs.
Sikkim Manipal University
19
Financial and Management Accounting
Unit 2
Self Assessment Questions 8: 1. Basic principles of Accountancy are _____________ accepted. 2. How many basic principles of accountancy are there? 2.4.1 Principle of Income Recognition According to this concept, revenue is considered as being earned on the date on which it is realized., i.e., the date on which goods and services are transferred to customers for cash or for promise. It should further be noted that it is the amount which the customers are expected to pay which shall be recorded. In effect, only revenue which is actually realized should be taken to profit and loss account. Unreaslised revenue should not be taken into consideration for determining the profit. For example, a sale is considered to be made when the property in goods (ownership) is transferred from the seller to buyer. Similarly, when a businessman receives an order for the sale of such products, yet to be manufactured, then revenue is said to have been generated when the products are ready and physically present in deliverable state and payment is received or promised to be received but not when the order is received. Self Assessment Questions 9: 1. Income is considered as earned only when it is ____________. 2. Income is realized whether it is actually received in cash or promised to be received . Is it True or False? 3. Income realized is different from cash received. Is it true or false? 4. A sale is made on credit. Does it constitute income realization? 5. An order is received for sale of goods. Is it realisation of income? 6. An order is received with an advance of Rs.100000 cash. Can this be called income? 2.4.2 Principle of Expense Expenses are different from payments. A payment becomes expenditure or an expense only when such payment is revenue in nature and made for consideration. Salaries are paid for having received the services of the employees and so it is an expense. If furniture is bought, it is not expenditure because it is a capital payment. Therefore all revenue expenses are transferred to profit and loss account to ascertain profit or loss of the business undertaking. In other words, there are revenue expenses and capital expenses. While revenue expenses are charged against profit, capital expenses are shown in the balance sheet as assets. Self Assessment Questions 10: 1. A cash payment may be a revenue payment or capital payment. Is it true or false?
Sikkim Manipal University
20
Financial and Management Accounting
Unit 2
2. A payment which is revenue in nature is expenditure. Is it true or false? 3. Plant is purchased and payment is made. Is it an expenditure or acquisition of asset? 4. All revenue expenses are charged against ––––––––––––– . 5. Capital payments resulting in acquisition of assets appear in the balance sheet. True or False? 2.4.3 Principle of Matching Cost and Revenue Revenue earned during a period is compared with the expenditure incurred to earn that income, whether the expenditure is paid during that period or not. This is matching cost and revenue principle, which is important to find out the profit earned for that period. Here costs are reported as expenses in the accounting period in which the revenue associated with those costs is reported. For example, sales revenue reported in 2005 is Rs 50 lakh. The expenses to earn this revenue, comprising purchases, wages, salaries, sales commission and so on amount to Rs. 30 Lakh. It is possible that some of these costs might be payable actually in 2006. Even then, they are considered only for the period 2005, when the sales revenue was earned. Adjustments are made for outstanding and prepaid expenses as well as outstanding and pre received incomes while preparing the final accounts for the accounting period. Self Assessment Questions 11: 1. Matching concept of accounting considers only revenue incomes and expenses relating to a particular accounting period. True or False? 2. Incomes and expenses for an accounting period are considered to compute _____ . 3. Expenditure paid or payable and revenue earned whether realised or not in cash are taken into account to find out profit or loss. True or False? 4. For the actual revenue received, outstanding incomes are ________ and pre-received incomes are_________________ to find out the revenue income for the given period. 5. For the actual revenue expenses (costs) paid during the accounting period, outstanding expenses are _____ and prepaid expenses are _____ to find out expenses for the accounting period. 2.4.4 Principle of Historical Costs This is called ‘cost’ principle. All assets are recoded at the cost of acquisition and this cost is the basis for all subsequent accounting for the assets. The expenses and the goods purchased are all shown at the value at which they are incurred. The assets are constantly reduced in their value by charging depreciation against their cost to present their book value in the balance sheet. For
Sikkim Manipal University
21
Financial and Management Accounting
Unit 2
example, land bought for Rs.5,00,000 will be shown at that price only and market value will not be considered. In financial statements, historical cost is considered but not market value for the purpose of consistency. However, on account of inflationary situations, this cost concept does not portray correct picture of the business and so inflation accounting has emerged. Self Assessment Questions 12:
1. All assets are shown at historical cost in balance sheet. True or False? 2. Depreciation is charged against the historical cost of assets. True or False? 3. Historical cost is the cost at which an asset is actually purchased. True or False? 4. A machinery is bought for Rs.200000 and its market value is Rs.80000. Which of these values, do you consider reasonable to mention in the balance sheet?
5. Inflation accounting has emerged as a result of limitation of historical cost concept. True or False? 2.4.5 Principle of Full Disclosure The business enterprise should disclose relevant information to all the parties concerned with the organization. It means that any information of substance or of interest to the average investors will have to be disclosed in the financial statements. For example, the liabilities of the business should be stated along with assets. If only assets are exhibited without disclosing liabilities, it amounts to fraud. The Companies Act, 1956 requires that income statement and balance sheet of a company must give a fair and true view of the state of affairs of the company. Self Assessment Questions 13:
1. The principle of full disclosure implies that information which is of ___________ should be stated in financial statements.
2. The material information that is disclosed should be of great interest to the average investors. True or False?
3. Non-disclosure of material information amounts to ___________. 4. Disclosing about assets without disclosing about liabilities is against to the principle of full disclosure. True or False? 2.4.6 Double Aspect Principle This concept is the most fundamental one for accounting. A business entity is an independent unit and it receives benefits from some and gives benefits to some other. Benefit received and benefit given should always match and balance. For instance capital, say Rs.20000 provided by
Sikkim Manipal University
22
Financial and Management Accounting
Unit 2
the proprietor is a liability to the business and it is used for purchasing goods Rs.10000, kept in bank account of the business Rs.8000 and the balance held in cash.Rs.2000. The goods, cash at bank and cash in hand (10000 + 8000 + 2000) are regarded as assets. The total liabilities balance with total of assets. This is dual aspect of accounting. The established principle of accounting is that for every debit there is an equivalent credit and this is called double entry principle of accounting. Self Assessment Questions 14:
1. Under dual aspect principle, total benefits received by business should match with total benefits given. True or False?
2. Total liabilities should be equal to ___________ as per dual aspect principle. 3. For every debit, there should be an equivalent credit. This is called _________ of accounting. 2.4.7 Modifying Principle The modifying principle states that the cost of applying a principle should not be more than the benefit derived from. If the cost is more than the benefit, then that principle should be modified. This is called cost-benefit principle. There should be flexibility in adopting a principle and the advantage out of the principle should over weigh the cost of implementing the principle. Self Assessment Questions 15: 1. Modifying principle is also known as _____________. 2. The advantage out of the Principle should over weigh the cost of implementing the principle itself. True or False? 3. If the establishment of costing department is too high that the cost of the products produced in the organisation is going to overshoot by50%., far more than the market price. Is it advisable to have cost-department? 2.4.8 Principle of Materiality While important details of financial status must be informed to all relevant parties, insignificant facts, which do not influence any decisions of the investors or any interested group, need not be communicated. Such less significant facts are not regarded as material facts. What is material and what is not material depends upon the nature of information and the party to whom the information is provided. While income has to be shown for income tax purposes, the amount can be rounded off to the nearest ten. And fraction does not matter. When we send statement to a
Sikkim Manipal University
23
Financial and Management Accounting
Unit 2
debtor, all details have to be presented. The same information about the debtors need not be given in great detail, while sending the information to the Registrar of companies. Self Assessment Questions 16: 1. Principle of materiality states that relevant information should be given to relevant parties. True or False? 2. Details of debtors should be given to creditors. True or False? 3. What is material information to one party may not be so for another party. True or False? 4. The method of depreciation adopted should be disclosed to Income Tax Authorities. True or False? 2.4.9 Principle of Consistency Consistency is required to help comparison of financial data from one period to another. Once a method of accounting is adopted, it should not be changed. For instance, stock is valued under FIFO method in an year and it should not be valued under LIFO method in another year. If assets are depreciated under diminishing balance method, it should be continued for ever. It should not be changed. Self Assessment Questions 17 : 1. The purpose of principle of consistency is to help for ______ from one period to another period. 2. Consistency principle helps for proper assessment of profit or loss. True or False? 2.4.10 Principle of Conservatism or Prudence Accountant follow the rule “anticipate no profit but provide for all anticipated losses “Whenever risk is expected, provision should be made. The value of investments is normally taken at cost, even if the market value is higher than the cost. If the market value expected is lower than the cost, then provision should be made by charging profit and creating investment fluctuation fund. This is the principle of conservatism and it does not mean that the income or the value of assets should be intentionally under stated. Self Assessment Questions 18: 1. Provision should be made whenever _____________ is expected. 2. The underlying spirit of principle of conservatism is __________ . 3. The prices of shares in which the business has invested are going up. Do you consider advisable to provide any provision for that?
Sikkim Manipal University
24
Financial and Management Accounting
Unit 2
Terminal Questions: 1. What are the basic principles of Accountancy? 2. The salaries paid in 2004 Rs.500000; Salaries outstanding Rs.20000; Salaries paid in advance for 2005 Rs.30000; What is the actual salary expenditure for 2004? What is the accounting principle involved in this? 3. What is wrong if assets like buildings are shown at market value in the balance sheet? 4. A business receives capital of Rs.100000 and a loan is raised for Rs.50000. This is represented by cash Rs.15000; Machinery Rs.85000; Furniture Rs.20000 and goods Rs30000. Find the total debits and credits from business point of view. What principle of accounting is underlying in this case? Answer for Self Assessment Questions Self Assessment Questions 1: 1. Doctrines 2. Concepts, conventions 3. Convention 4. Concept 5. Bringing uniformity in accounting terminology and principles 6. 30 Self Assessment Questions 2: 1. Business entity concept, Going concept, Money measurement concept, Periodicity concept, and Accrual concept. Self Assessment Questions 3: 1. Separate entity concept 2. separate 3. No 4. Liability 5. capital Self Assessment Questions 4: 1. No 2. Long time 3. Long period 4. To replace it after a certain period.
Sikkim Manipal University
25
Financial and Management Accounting
Unit 2
Self Assessment Questions 5: 1. No 2. Money value 3. It makes no sense unless expressed in terms of money value 4. Denominator Self Assessment Questions 6: 1. Accounting period 2. Year 3. It is because it does not indicate for what period the expenditure is. Self Assessment Questions 7: 1. Accrued interest 2. Accrued salary 3. Added 4. Credit Self Assessment Questions 8: 1. Universally 2. Ten Self Assessment Questions 9: 1. Realised 2. True 3. True 4. Yes 5. No 6. No Self Assessment Questions 10: 1. True 2. True 3. Asset Acquisition 4. Profit 5. True
Sikkim Manipal University
26
Financial and Management Accounting
Unit 2
Self Assessment Questions 11: 1. True 2. Profit or loss 3. True 4. Added, Deducted 5. Added, Deducted Self Assessment Questions 12: 1. True 2. True 3. True 4. Rs.200000 5. True Self Assessment Questions 13: 1. Substance 2. True 3. Fraud 4. True Self Assessment Questions 14: 1. True 2. b) Total Assets 3. c) Double entry principle Self Assessment Questions 15: 1. Cost-benefit principle 2. True 3. No Self Assessment Questions 16: 1. True 2. False 3. True 4. True
Sikkim Manipal University
27
Financial and Management Accounting
Unit 2
Self Assessment Questions 17: 1. Comparison 2. True Self Assessment Questions 18: 1. Risk 2. Anticipate no profit but provide for all anticipated losses 3. No. Answers for Terminal Question: 1. Income recognition, principle of expense, matching of cost and revenue, historical cost principle, full disclosure principle, double aspect principle, modifying principle, materiality principle, consistency principle and conservatism principle. 2. Rs.490000 (500000 + 20000 – 30000); Matching cost and revenue principle. 3. If assets like building are shown at market value instead of historical cost in the balance sheet, the profit or loss arising out of such valuation is against to the principle of income recognition. The profit or loss is said to arise only when the asset is sold or revalued for a specific purpose. The day when the assets are valued, the market value may be high and later the prices may fall. Therefore it is wrong to consider the unrealized or anticipated profit. Hence the assets should be shown at historical cost in the balance sheet. 4. Benefits received Rs.150000 (Capital Rs.100000 + Loan Rs.50000); Benefit given Rs.150000 (Cash Rs.15000 + Machinery Rs.85000 + Furniture Rs.20000 + Goods Rs.30000). It is as per double aspect principle.
Sikkim Manipal University
28
Financial and Management Accounting
Unit 3
Unit 3
Double Entry Accounting
Structure
3.1 Introduction Objectives 3.2 Meaning of double entry accounting Self Assessment Questions 1 3.3 Cash and mercantile system of double entry system Self Assessment Questions 2 3.4 Accounting trail Self Assessment Questions 3 3.5 Transactions and events Self Assessment Questions 4 3.6 Preparation of vouchers Self Assessment Questions 5 3.7 Financial statements and their nature Self Assessment Questions 6 3.8 Accounting equation Self Assessment Questions 7 3.9 Effect of transactions on accounting equation Self Assessment Questions 8 3.10 Meaning and rules of debit and credit Short Answer Questions Self Assessment Questions 9 Terminal Questions Answer to SAQs and TQs
3.1 Introduction: The dual aspect concept of accounting is a fullproof system of recording, having the advantage of internal checking. The very fact that every transaction is recorded of its debit and credit aspects indicates that the final accounts of an organization takes into consideration every small or big transaction and the impact is every account is absorbed in the preparation of final financial statements. Double entry book keeping is definitely an improvement and more systematically
Sikkim Manipal University
29
Financial and Management Accounting
Unit 3
designed than single entry system, where only a few personal and real accounts are considered. In this unit, the process of accounting – recording, journalizing, posting, ledger balancing, preparation of trial balance, preparation of final statements of accounts – is described along with the effect of every transaction on accounting equation. The rules of debit and credit as applicable to various types of accounts are also discussed.
Learning Objectives: After studying this unit, you should be able to understand the following 1. To know what double entry book keeping means. 2. To understand the process of accounting, known as accounting trail. 3. To know the nature of financial statements. 4. To formulate an Accounting equation basing on debits and credits. 5. To know practically the impact of each transaction on the Accounting Equation. 6. To summarize the rules of debit and credit as applicable to different types of accounts. The students should be able to appreciate the double entry system and know the accounting process.
3.2 Meaning of Double Entry Accounting We have learnt that the dual aspect recording is the most important accounting concept. According to the concept, every business transaction involves receiving aspect and giving aspect. If capital is brought in by the owner of the business unit, the owner is the giver of the benefit and the business unit is the receiver of the benefit. It is a liability to the business unit and it is equally balanced by an asset in the business unit, in the form of cash received towards capital. Therefore every liability is represented by an asset. This is also expressed as every debit has an equivalent credit. The logic adopted in double entry accounting can well be understood by an illustration. We shall consider five transactions and show how they are accounted for in the books of the business. a. Mr. Abhi brings Rs.100000 cash as capital into his business. b. He purchases furniture to his shop Rs.10000 c. He buys goods for cash Rs.50000 d. He sells goods worth Rs.30000 for Rs.40000 on credit to Arjun e. He pays wages to servants Rs.1000
Sikkim Manipal University
30
Financial and Management Accounting
Unit 3
In the first transaction, the business receives capital in cash and so capital account and cash account are affected. Capital is a liability and cash is an asset to the business. Capital Rs.100000 (Liability) = Cash Rs.100000 (Asset) In the second transaction, Furniture is purchased for cash and so furniture account and cash account are affected. This transaction can be reflected as under Capital
Rs.100000
Cash Rs. (100000 10000)
90000
Furniture
10000
100000
100000
The third transaction is buying goods for cash, which means that stock of goods are received and cash balance is reduced and this can be reflected in the statement as under. Capital
Rs.100000
Cash Rs (90000 – 50000)
40000
Furniture
10000
Stock of goods
50000
100000
100000
The fourth transaction is a credit transaction of selling goods for Rs40000, the cost of which is only Rs. 30000 to Arjun. So the accounts affected are goods account, Arjun account and profit account. Since the profit belongs to the owner and it is fair to add it to the owner’s capital. The effect of this transaction can appear on the statement as shown below:
Capital Profit
Rs. 100000 10000
110000
Cash
40000
Furniture
10000
Stock of goods(5000030000)
20000
Arjun (Debtor)
40000 110000
The fifth transaction is payment of wages, which means that cash account is affected and profit is reduced as a result of the expenditure(wages account). This changes the statement as shown below:
Sikkim Manipal University
31
Financial and Management Accounting
Capital
Unit 3
Rs. 100000
Profit (100001000) 9000
Cash (40000 – 1000)
39000
Furniture
10000
Stock of goods
20000
Arjun
40000
109000
109000
From the above illustration, it is clear that every transaction has dual effect and recording these two aspects which are known as debit and credit aspects is the fundamental idea behind double entry system of book keeping. So the meaning of double entry system is that every transaction is recorded by identifying the two or more accounts affected therein and suitably reflect them in the financial statements. This is a system where internal cross checking is ensured. Self Assessment Questions 1:
1. The system of recording transactions based on dual aspect concept is called i) Double account system ii) Double entry system iii) Single entry system
2. Show the dual aspect effect of the following transactions on the assets and liabilities of business. a. Purchased goods for cash Rs.80000 b. Purchased delivery van on credit for Rs.400000 c. Paid Rs.5000 to a supplier of goods on credit d. The proprietor withdrew Rs.20000 from the bank account of business for Personal expenses.
3.3 Cash and mercantile system of double entry system There are two systems of double entry book keeping namely cash system and mercantile system. In case of cash system, transactions are recorded only if cash is received or paid. Government accounting is done basing on this system. On the other hand, mercantile system is one where both cash and credit transactions are recorded. Besides, outstanding expenses or incomes also find place in the mercantile system. It is fair enough to adopt mercantile system because when an event takes place, it gets recorded irrespective of its immediate impact on the cash position. In case of credit transactions, cash does not flow immediately but it takes place at a future point of
Sikkim Manipal University
32
Financial and Management Accounting
Unit 3
time. Transactions like sales or purchases on credit, salary payable, rent receivable, interest accrued but not received, depreciation provided etc., influence on the financial position of the business unit and therefore they should be recorded. Mercantile system facilitates this. Hence double entry recognizes the fact that every transaction, whether cash or credit, influences at least two accounts – one representing debit aspect and another credit aspect. Self Assessment Questions 2: 1. The two systems of double entry book keeping are ________ and __________ . 2. Government accounting is based on mercantile system. True or false? 3. All credit transactions come under mercantile system. True or False? 4. Interest receivable, rent receivable, dividend receivable are recorded in cash system of book keeping. True or False? 5. Profit as per cash system and mercantile system of double entry show different figures. True or False
3.4 Accounting Trail Accounting trail is the process of identifying the transactions or events, preparation of vouchers, recording them as journal entries, preparation of ledger accounts, balancing the ledger accounts, incorporating all adjustments, preparation of a trail balance and finally preparing the financial statements and balance sheet. It is a sequential order in which the accounting process flows. All transactions are recorded first in a book called journal. The transactions are posted to the respective accounts, maintained in a separate book called ledger. Later, all adjustments such as opening entries, closing entries, adjusting entries are made in a book called journal proper and there from, the ledger balances are summarized to form a trial balance. From trial balance, trading account, profit and loss account and balance sheet are prepared. The identification of the accounts affected in the transactions is a major task. There are three types of accounts, namely personal accounts, real accounts and nominal accounts. An account is a summary of transactions pertaining to a particular head. Personal accounts include accounts of natural persons, such as Abhi account, Mohan’s account, Sonali account etc; artificial personal accounts such as Syndicate Bank account, X Co. Ltd account, a club account etc; representative personal account like outstanding rent account, salaries payable account etc. Real accounts are those which may be tangible real accounts and intangible real accounts. Tangible real accounts relate to things that can be touched, felt, physically measurable. Building
Sikkim Manipal University
33
Financial and Management Accounting
Unit 3
account, furniture account, stock account, cash account etc are tangible real accounts. Intangible real accounts are such that they can not be seen or touched. They can be measured in terms of money such as goodwill, patent rights etc. Nominal accounts are also known as impersonal accounts. They are in the form of expenses or losses, incomes or gains. They do not really exist in physical form, but behind every nominal account cash is involved. For example, salary account is a nominal account and when salary is paid, the reality is the cash goes out and there is nothing salary in physical form. Therefore salary account is regarded as nominal account. Similarly all expenses and losses and all incomes and gains accounts are regarded as nominal accounts. Self Assessment Questions 3: 1. Accounting trial is a process starting from identifying the transactions or events to preparation of final statement of accounts. True or False 2. There are three types of accounts namely ____________ and ________________. 3. A trial balance is the summarized form of ledger balances. True or False 4. Classify the following accounts into personal, real and nominal i) Bank of Baroda Account ii) Printing and stationery expenses Machinery Outstanding salary iii) Copy Rights iv) Sock of goods v) Loan given to Krishna vi) Loan from Bank vii) Dividend received viii) Discount Account
3.5 Transactions and Events A transaction is a business activity involving transfer of money or money’s worth. It may be cash transaction or credit transaction. In cash transaction cash flows immediately where as in credit transaction cash will be paid or received at future date. Assets acquired or sold, liabilities incurred or paid, expenses paid or payable, incomes received or receivable – are all business transactions. But there are events which are neither cash nor credit transactions but it has an impact on the financial position of a business. These events may include provision for bad debts, provision for repairs, depreciation, taxation, transfer of profit towards reserve fund or sinking fund or investment fluctuation fund, etc., Events happen as a result of internal policies or external needs. In accounting, transactions and events have equal relevance and they must be recorded to arrive at the financial results of the business concern. Self Assessment Questions 4: 1. A transaction is a business activity where there is transfer of money or money’s worth. True or False 2. An event happens as a result of internal policy of an organization. True or False Sikkim Manipal University
34
Financial and Management Accounting
Unit 3
3. Business transactions and events have equal importance in finding the financial results of the business concern. True or False? 4. Identify the following as transactions or events as the case may be. i) Depreciation of assets ii) Tax rates iii) Acquisition of assets iv) Selling an asset v) Transfer of profits to Reserve Fund
3.6 Preparation of Vouchers A voucher is a document in support of a business transaction. It may be a receipt, a counterfoil of a receipt, an invoice or even correspondence with the concerned parties. Usually in large organizations, voucher system is adopted to record payments. Some organizations will have printed voucher book and each voucher contains the number of voucher, date, the name of payee to whom the payment is made, the amount, the purpose for which payment is made, signature of the person authorized to pay and the person who receives the payment. For instance, Ram has supplied to us goods worth Rs5000, for which he has given an invoice. This invoice itself can be regarded as voucher, against which the payment is made. If carriage charges of Rs100 are paid, we prepare a voucher and take the signature of the person who receives it. When we pay cash, the receiver will give us a receipt, that itself becomes a voucher. Vouchers are often prepared basing on the invoices received or goods received returns. The actual payment may be made partially or completely and it may be made in course of time. In such cases, they are entered in Voucher register. The payment of a voucher is recorded in cheque register. The system has the following advantages: 1. It safeguards all cash disbursements 2. Total amount payable to creditors can be found out with the help of unpaid 3. vouchers. 4. Internal check is ensured 5. Information about future cash requirements can be found out. However, the system is not suitable for small organizations because it involves personnel and the cost of maintenance. Self Assessment Questions 5: 1. Voucher system is adopted to record payments. True or False? 2. Voucher system is suitable for small organizations. True or False? 3. Voucher is a document showing the__________for which payment is made. 4. Voucher system ensures internal check . True or False? Sikkim Manipal University
35
Financial and Management Accounting
Unit 3
3.7 Financial statements and their nature Financial statements are prepared to find out the profit or loss at the end of an accounting period. In a trading concern, trading account and profit and loss account are prepared. The purpose of preparing trading account is to find out the gross profit / loss. Similarly, profit and loss account is prepared to find out net profit / loss. Both these accounts are revenue accounts. In other words, all revenue receipts and revenue payments are considered. Revenue expenses are those which are incurred in day to day business activities. Examples may include wages, carriage expenses, insurance premium paid on stocks, salaries, printing, stationary, administrative expenses, selling expenses and so on. Revenue receipts are called incomes and the examples include rent received, sales made, interest received, dividend received, discount received, royalty received, compensation received etc. More details about trading and profit and loss account are given in Unit 7. After preparing final accounts, a balance sheet is prepared containing capital and liabilities on one side and assets on the other side of a statement. Balance sheet is a statement of affairs and not an account. Liabilities of a business include trade creditors, bills payable, bank over draft, loans payable, outstanding expenses, prereceived incomes etc. Capital of the owner, which is called equity, is added with liabilities on the left side of the balance sheet. Assets of a business include fixed assets like buildings, plant, machinery, furniture etc; current assets like sundry debtors, bills receivable, closing stock of materials, outstanding incomes, prepaid expenses, cash in hand, cash at bank etc., Trading account or profit and loss account and balance sheet are prepared at the end of a particular accounting period, say one year. In Unit 7, details about balance sheet preparation are given. Self Assessment Questions 6: 1. Trading account and Profit and loss account are revenue accounts. True or False? 2. What is the purpose of preparing Trading Account? 3. What is the end result of preparing profit and loss account? 4. Is balance sheet an account? What is it otherwise? 5. What items are shown on the left hand side of balance sheet? 6. Assets are shown on which side of balance sheet? 7. What is the purpose of preparing a balance sheet?
Sikkim Manipal University
36
Financial and Management Accounting
Unit 3
3.8 Accounting equation The preparation of balance sheet is the final step in accounting process. The accounting equation indicates that the sources of funds should be equal to uses of funds. In other words, proprietor’s equity and liabilities to outsiders should be equal to assets. Sources of Funds = Application of funds OR Owner’s equity = Asset Owner’s equity + outside liabilities L + P
= Assets
OR OR
= A, where L is liabilities, P is proprietor’ equity and A
means assets. From this equation, the following expressions can be obtained L = A – P P = A – L A – L – P = Zero Self Assessment Questions 7: 1. Liabilities plus Equity is equal to ____________________________. 2. Assets minus liabilities to outsiders is equal to __________________. 3. If assets are Rs.5 lakhs, liabilities are Rs.3 lakhs, find out equity. 4. If Owner’s equity is Rs3 lakhs, Outsider liabilities are Rs.2 lakhs, Owner’s share of profit is Rs.1 lakhs, find out the total value of assets. 5. Every transaction influences balance sheet and it is shown by accounting equation True or False?
3.9 Effect of Transactions on Accounting Equation As said earlier, every transaction has its effect on the balance sheet equation. This has been amply illustrated while discussing the meaning of double entry. The dual aspect of a transaction is reflected on the balance sheet, ultimately making liabilities side equal to asset side of a balance sheet. The following are the possible sets of transactions that can change the values of assets and liabilities but the changes are equal on both sides of balance sheet. 1. Increase in one asset with a decrease in another asset. For example, goods are purchased for cash. It affects cash balance to come down and stock balance increases and both of them are assets. 2. An increase in one asset with an equal amount of increase in liability. For example, a building is purchased for business for Rs500000 by raising a loan from bank. Here an asset is created and a loan is also raised and the balance sheet tallies.
Sikkim Manipal University
37
Financial and Management Accounting
Unit 3
3. An increase in asset with an equivalent rise in the proprietor’s equity. When an additional capital is obtained in cash, Cash account on the asset side increases and capital account on the liabilities side also increases with the same amount. 4. An increase in a liability causing an equal amount of decrease in another liability. Ex: A bank’s overdraft is paid out of debenture amount collected. Here debenture liability increases with an equal amount of decrease in bank’s overdraft. 5. Increase in a liability, followed by decrease in proprietor’s equity. If debentures are issued for the purpose of paying redeemable preference shares, the owner’s equity gets reduced and an additional liability of debentures is added up. 6. Decrease in an asset and equivalent decrease in a liability. For instance, bills payable are paid out by cheque. The bank balance which is an asset is decreased and correspondingly the liability of bills payable is also decreased. 7. Decrease in an asset and corresponding decrease in owner’s equity. If capital is paid out for any reason, cash to that extent is decreased on the asset side and the capital is reduced to that extent on the liabilities side. Self Assessment Questions 8: 1. The principle of accounting equation is that the total of assets should be equal to total of liabilities side. True or False. 2. Show how the accounting equation is affected in the following transactions a. Lal started business with Rs20000 cash b. He purchased goods on credit Rs.80000 c. He sold goods costing Rs.25000 for Rs.30000 on cash. d. He purchased furniture for cash Rs14000 e. He sold goods to Hari costing Rs500 for Rs.800 f. He received dividend on securities Rs.2000
3.10 Meaning and rules of debit and credit Debit and credit are the two words basic for accounting. Debit represents receiving aspect and credit represents giving aspect. However the meaning of debit and credit depends upon the classification of accounts. An account, as we have understood is a summary of transactions pertaining to a particular head. The account may be personal, real and nominal. Before grasping the rules of debit and credit as applicable to various classes of accounts, it is necessary to know how an account appears in the books of accounts. An account is recorded in a ‘ T ‘ form, the left Sikkim Manipal University
38
Financial and Management Accounting
Unit 3
side indicating the debit of the account and the right side representing the credit of the account. On the left side of an account the columns are date, particulars, ledger folio and amount and similarly on the right side (credit side), the columns are date, particulars, ledger folio and amount. The following illustration may be observed: CASH ACCOUNT Debit Side
Credit Side
Date particulars Ledger Amount
Date Particulars Ledger Amount
Folio (Rs)
Folio (Rs)
2005
2005
Jan. 1 To Balance brought down 20000
Jan 05 By salaries 10900
Jan15 To Joseph 35 10900
Jan 25 By Furniture 123 6000
Jan 28 To Sales 18
Jan 30 By purchases 19 58800
108900
Jan 31 By Rent 298 7500 By balance c/d 56600 139800 Feb 1 To balance b / d
139800 56600
Observe from the above form of an account the following: 1. The balance brought down is the closing balance of the last month, December,2004 2. The amount received from Joseph is Rs.10900 and his account is prepared in the in the page number 35 of the ledger. Similarly from sales and its account is found in the ledger folio (page) 18. 3. The credit side contains payment of cash towards salary, furniture, purchase of goods and rent respectively on different dates. 4. The balance carried down is the closing balance on the last day of January, 2005 and it is brought down as opening balance on Feb,1 5. On the debit side, ‘To’ and credit side ‘By’ are the prefix used for every entry as a matter of convention. There is a standard form of drawing a ledger account. It is similar to that of a pass book issued by a bank. The above illustration is shown in the standard form.
Sikkim Manipal University
39
Financial and Management Accounting
Unit 3
CASH ACCOUNT Date
Particulars
Post. Ref.
Debit
Credit
Balance
LF
Rs
Rs
Rs
2005 Jan 1
Opening balance b /d
20000
20000
Jan 5
Salaries
Jan 15
Joseph
Jan 25
Furniture
Jan 28
Sales
18
Jan 30
Purchases
19
58800
64100
Jan 31
Rent
298
7500
56600
10900 35
10900
9100 20000
123
6000 108900
14000 122900
The rules of debit and credit for different classes of accounts are the following 1. In respect of personal accounts
:
Debit the receiver and credit the giver
2. In respect of real accounts
:
Debit what comes in and credit what goes out
3. In respect of nominal accounts
:
Debit all expenses and losses and credit all incomes and gains.
The following steps should be remembered to apply debit and credit principles a) Identify the accounts affected in a transaction from business point of view b) If a personal account is involved, find whether the person is receiver or giver of benefit c) If the real account is affected, find whether it is coming in or going out d) If the account is nominal account, find out if it is expenditure or income or loss or gain. e) Apply the suitable principle to debit or credit the respective affected account. Illustration: Show what accounts are affected in the following transactions. Also show the accounting equation for the transactions 1. Madan commenced business with cash 2. Purchased goods on credit 3. Withdrew for private use 4. Goods purchased for cash 5. Paid wages
Rs. 70000 14000 3000 12000 5000
6. Paid to creditors
10000
7. Sold goods on credit (cost price Rs18000)
22000
8. Sold goods for cash (Cost price Rs.3000)
6000
9. Purchased furniture for cash
5000
Sikkim Manipal University
40
Financial and Management Accounting
Unit 3
10. Received from debtors
11000
Solution: Transaction No
Accounts affected in the Account to be debited and account to be books of the business credited
01
Capital account and cash Cash account being real account is debited account and Capital account being personal account is credited
02
Goods account and creditors Goods account being real account is debited account and creditor’s account being personal account is credited
03
Personal drawings account and Drawings account being personal account is cash account debited and cash account being real account is credited
04
Goods account account
05
Wages account and cash Wages account being nominal account is account debited and cash account being real account
and
cash Goods account being real account is debited and cash account being real account is credited
is credited 06
Cash account and creditors Creditor’s account being personal account account is debited and cash account being real account is credited
07
Goods account, Debtor’s Debtor’s account being personal account is account and profit account debited, profit transferred to capital account being personal account is credited and goods account being real account is also credited
09
Furniture account and Cash Furniture account being real account is account debited and cash account being real account is credited
10
Cash account and debtor’s Cash account being real account is debited account and debtor’s account being personal account is credited.
Sikkim Manipal University
41
Financial and Management Accounting
Unit 3
Accounting equations for the transactions Transaction
Assets = Cash +
01
Goods +
Debtors + Furniture + Creditors = +
Madan’s capital
70000
02
70000 14000
03
3000
04
12000
05
5000
06
10000
07 +6000
09
5000
10
+11000 52000 +
14000 3000
+12000 5000 10000 18000
08
End equation
Liabilities + Owners Equity
22000
+4000
3000
+3000 5000 11000
5000 +
11000 +
5000 +
73000
4000 +
69000
73000
Self Assessment Questions 9: 1. Rules of debit and credit are different for different types of accounts. True or False? 2. Debit the receiver and _______________ the giver. 3. Debit all assets and credit all ________________. 4. Debit _____________________ and credit what goes out. 5. All expenses are ___________________ type of accounts. 6. Incomes and gains are always _________ as per principle of debit and credit for nominal accounts. 7. Capital is ____________________ when it is withdrawn. 8. When cash is received from debtors, debtor’s account is ______ .
Terminal Questions 1. The accounting equation is Assets = _______________ + _______________. 2. State the meaning of double entry book keeping.
Sikkim Manipal University
42
Financial and Management Accounting
Unit 3
3. State the remarkable difference between cash system and mercantile system of double entry. 4. State the important accounting trail. 5. Classify the following accounts as personal, real and nominal a. Land account
b. outstanding expenses account
d. ABC co Ltd., account
e. Discount received account
c. capital account f. salaries account
6. A voucher is a document which _______________ cash disbursement. 7. What is a trading account? 8. The result of a trading account is ____________ or _______________. 9. Net profit or net loss is the result of ____________________account. 10. Give a list of any four items of assets. 11. Name any four items that appear on the liabilities side of balance sheet. 12. Balance sheet is a ________________________ of affairs of a business. 13. Find the value of the following: a. If the total assets are Rs87000 and the liabilities are Rs47000, find out the amount of capital. b. If the capital of proprietor is Rs400000 and the total assets are Rs600000, what is the amount of liabilities to outsiders? c. If creditors are Rs56000, bank overdraft is Rs100000 and outstanding expenses are Rs.8000, what is the total amount of assets? d. Fixed assets are Rs.70000 and current assets are Rs.100000 and the creditors are Rs.30000. What is capital? 14. Show the effect of the following transactions on assets, liabilities and owner’s Equity of the business: i. Ganesh started business with a capital of Rs.40000 9. He purchased stock of goods Rs.30000 10. Sold goods on cash Rs.40000, cost of which is Rs25000 11. Bought goods on credit Rs.10000 12. Sold goods on credit for Rs18000, the cost of which being Rs10000 13. Paid Sales commission Rs.5000 14. Received cash discount Rs3000 15. Purchased furniture Rs.10000.
Sikkim Manipal University
43
Financial and Management Accounting
Unit 3
16. Received cash from debtors Rs.15000 17. Paid cash to creditors Rs.6000.
Answer for Self Assessment Questions Self Assessment Questions 1:
1. Double entry system 2. a. Stock of goods increases and cash balance is reduced b. Delivery Van is an asset and the supplier of the delivery van becomes a creditor and it appears as liability c. Creditor’s balance is reduced on liabilities side and cash paid brings down the cash balance on the asset side d. The bank balance comes down on asset side and capital account is reduced by the amount of drawings on the liabilities side. Self Assessment Questions 2: 1. Cash system, Mercantile system 2. False 3. True 4. False 5. True. Self Assessment Questions 3: 1. True 2. Personal, real and nominal 3. True
i. Personal ii. Nominal iii. Real iv. Personal v. Real vi. Real vii. Personal viii. Personal ix. Nominal x. Nominal Sikkim Manipal University
44
Financial and Management Accounting
Unit 3
Self Assessment Questions 4: 1. True 2. True 3. True 4. i) Event ii) Event iii) Transaction iv) Transaction v) Event Self Assessment Questions 5:
1. True 2. False 3. Purpose 4. True Self Assessment Questions 6: 1. True 2. To find out gross profit or gross loss 3. To find out net profit or loss 4. No. It is a statement of assets and liabilities 5. Capital, liabilities are shown on the left hand side of Balance Sheet 6. On right hand side 7. To know the financial position of the business. Self Assessment Questions 7: 1. Assets 2. Equity 3. Rs.2 lakh 4. Assets are Rs.6 lakh 5. True Self Assessment Questions 8: a) True b) i. Lal’s capital increases on liabilities side and Cash balance increases on the asset side by Rs.20000 ii. Creditors on liabilities side and stock of goods on the asset side increase by Rs.80000 iii. Profit of Rs.5000 is added to capital on the liabilities side, stock of goods is reduced by Rs.25000 and Cash balance increases by Rs.30000
Sikkim Manipal University
45
Financial and Management Accounting
Unit 3
iv. Furniture value increases by Rs.14000 on the asset side, Cash balance is reduced by Rs.14,000, thus making no effect on liabilities side. v. Hari appears as debtor on the asset side for Rs.800, Stock of goods gets reduced by Rs.500 on the asset side but on liability side the profit of Rs.300 is added to capital. vi. Cash balance on asset side increases by Rs2000, dividend being income results in profit of Rs.2000 and so added to capital on liability side. Self Assessment Questions 9: 1. True 2. Credit 3. Liabilities 4. What comes in 5. Nominal 6. Credited 7. Debited 8. Credited. Answers for Terminal Questions: 1. Liabilities + Owner’s capital 2. Every transaction has two aspects, debit and credit and for every debit, there is equivalent credit. 3. 3.All cash transactions are recorded in cash system, while both cash and credit transactions are recorded in mercantile system 4. Identification of accounts affected in transactions, recording them in Journal, post them to ledger, balance the ledger accounts, prepare trial balance, finally prepare final accounts. 5. a) Real b) Personal c) personal d) Personal e) Nominal f) Nominal 6. Records 7. Account showing the result of trading activities (Purchase and sale of goods) 8. Gross profit or gross loss 9. Profit and Loss Account 10. Land and Buildings, Plant and Machinery, Furniture and Fixtures, Debtors, Cash in hand, and Bank, Closing stock etc. 11. Bills Payable, creditors, Bank overdraft, Capital etc., 12. Statement Sikkim Manipal University
46
Financial and Management Accounting
Unit 3
13. a) Rs.40000 b) Rs.200000 c) Rs.164000 d) Rs.140000 14. Refer to Illustration under sub head 9.
Sikkim Manipal University
47
Financial and Management Accounting
Unit 4
Unit 4
Primary Books
Structure: 4.1 Introduction Objectives 4.2
Introduction to Primary books Self Assessment Questions 1
4.3
Journal Self Assessment Questions 2
4.4
Ground rules of journal entry Self Assessment Questions 3
4.5
Types of journal Self Assessment Questions 4
4.6
Purchases Day book Self Assessment Questions 5
4.7
Sales day book Self Assessment Questions 6
4.8
Return Outward book Self Assessment Questions 7
4.9
Return inward book Self Assessment Questions 8
4.10 Bills receivable book Self Assessment Questions 9 4.11 Bills payable book Self Assessment Questions 10 4.12 Cash book Self Assessment Questions 11 Self Assessment Questions 12 Terminal Questions Answer to SAQs and TQs
Sikkim Manipal University
48
Financial and Management Accounting
Unit 4
4.1 Introduction The accounting process actually begins with recording the transactions in an accounting book. This book of original recording is called primary book and of course all transactions are recorded basing on certain documents like invoices, vouchers or receipts etc., All transactions should invariably be entered through the primary accounting books. Other wise, the final results of the business concern project a distorted position or end up in preparing unreliable statements. So making entries in the primary books is the basis for further accounting treatment such as posting to ledger, preparation of trial balance etc., Learning Objectives: After studying this unit, you should be able to understand the following 1. To know the various primary books, containing original entries. 2. To record transactions in General Journal adopting debit and credit principles. 3. To know in brief about subsidiary books 4. To open purchases day book and Purchase Returns Book. 5. To open Sales day book and Sales Returns Book. 6. To know about Bill Transactions. 7. To prepare Bills Receivable Book and Bills Payable Book. 8. To open Cash Book with Cash column only. 9. To understand the preparation of Cash Book with Cash and Bank Columns. 10. To understand the preparation of Cash Book with cash, bank and discount columns. 11. To know the preparation of Petty Cash Book. 12. To know how to prepare ledger accounts from individual subsidiary books.
4.2 Introduction to Primary Books Journal is a book of original entry. In French, ‘jour’ means ‘a day’. Therefore journal is basically a day book in which transactions are first entered in a systematic manner adopting the principles of debit and credit. If a business organization is very small and the number of transactions taking place each day are limited, then all the transactions can easily be recorded in the journal. But it is not so, in case of organizations of large scale, where hundreds of transactions take place. To facilitate convenient way of entering transactions, journal is subdivided into several books of original entry, namely purchases, sales, cash, bills receivable, bills payable, returns inwards, returns outwards books. They are also regarded as primary books or subsidiary books. When
Sikkim Manipal University
49
Financial and Management Accounting
Unit 4
once the transactions are recorded in the journal or other subsidiary books, posting is made to ledger. It is also possible that entries are made directly to ledger accounts without bringing them to journal at all.
However, to help in cross checking, both journal and ledger accounts are
prepared. Self Assessment Questions 1:
1. Book of original entry is called ______________________________. 2. Do you regard subsidiary books as primary books of original entry? 3. Transactions are first recorded in the journal and later posted to ____________________. 4.3 Journal It is a book containing systematic recording of transactions. The entry made is known as journal entry and the process of writing the journal entry is called journalizing. Each page of the journal is numbered and it is called journal folio (JF). Entries are made date wise and they reflect what account is debited and what account is credited. The form of a journal is given below.
JOURNAL Date
Particulars
2-4-2005
Cash A/c Dr To Capital A/c (Being capital brought in cash) Furniture A/c Dr To cash A/c (Being furniture purchased for cash)
3-4-2005
Ledger Folio
Debit Rs. 100000
Credit Rs. 100000
20000 20000
The ledger folio mentioned in the third column indicates the number of page in the ledger book where the respective account summary is stated. For instance, the cash account is separately mentioned in page number 120 of the ledger book, then the ledger folio is 120. Similarly the folio number is given to other accounts. Usually the entry is read as ‘cash account debtor to capital account’ and so on. For every journal entry, narration is given to briefly describe the transaction. Self Assessment Questions 2: 1. What is journal? 2. What does a Ledger folio indicate ?
Sikkim Manipal University
50
Financial and Management Accounting
Unit 4
4.4 Ground rules of journal entry As discussed earlier, a transaction affects at least two accounts and the accounts may be personal or real or nominal. For each class of accounts, the rules of debit and credit are also discussed. ‘Debit the receiver and credit the giver’ is the principle for personal accounts; ‘debit what comes in and credit what goes out’ is the rule for real accounts and ‘debit all expenses and losses and credit all incomes and gains’ is the rule for nominal accounts. To draw journal entries, the following steps be followed: a) Identify the accounts affected in the given transaction b) Classify the accounts as personal, real or nominal c) Apply the relevant rule for debit and credit to determine what account to debit and what account to credit d) Write the journal entry as described above. e) Give the narration for the transaction. Illustration 1 Enter the following transactions in the books of Gopichand 1. 10-5-2004 Started business with capital of Rs.50000 2. 12-5-2004 Bought goods worth Rs.30000 3. 14-5-2004 Sold goods to Ram Charan for Rs.5000 for cash 4. 15-5-2004 Sold goods to Kanthilal Rs.12000 on credit 5. 20-5-2004 Paid wages to daily workers Rs.300
Answer Journal Entries in the books of Gopichand Date
Particulars
10-5-04
Cash A/c Dr To Capital A/c (Being capital brought in cash) Goods A/c Dr To Cash A/c (Being Goods purchased for cash) Cash A/c Dr To Goods A/c (Being goods sold on cash to Ram Charan) Kanthilal A/c Dr To Goods a/c (Being goods sold on credit to Kanthilal) Wages A/c Dr
12-5-04
14-5-04
15-5-04
20-5-04
Sikkim Manipal University
LF
Debit (Rs.)
Credit (Rs.)
50000 50000 30000 30000 5000 5000 12000 12000 300
51
Financial and Management Accounting
Unit 4
To Cash A/c (Being wages paid to daily workers)
300 97300
97300
Note: 1. The fourth transaction is a credit transaction and so the name of the debtor, Kanthilal is debited and the goods account is credited because goods are going out and it is real account 2. The fifth transaction involves an expense and wages account is a nominal account. It is thus debited and since cash account is real account and it is going out and therefore it is credited. 3. At the end of accounting period, the total of debits should be equal to total of credits. Self Assessment Questions 3: 1. All assets should be debited and all liabilities should be ___________________. 2. When interest is received in cash, Cash account is debited and _____ account is credited 3. If bank overdraft is raised, the overdraft account is ________ and cash account is _____. 4. When creditors are paid out, ______is debited and _____________ account is credited. 5. If furniture is bought for cash from X Co Ltd., the company account is not credited. Why? 6. If wages are paid for construction of business premises, ___________ A/c is debited and _____________ A/c is credited. 7. Write the journal entries for the following transactions in the books of Y Co Ltd., i) Advance of Rs. 500000 received from Damodar & Bros for the supply of goods. ii) Sales tax paid Rs. 40000 iii) Amount drawn from Bank of Baroda for miscellaneous expenses Rs. 5000.
4.5 Types of Journal Journal is a book of original entry and only one journal is maintained if the business is very small in size and the transactions are limited. However, if the transactions are multifarious, then subsidiary books which are known as books of original entry are prepared. The types of journal include purchases book, sales book, purchase returns book, sales returns book, bills receivable book, bills payable book, cash book and journal proper. The entries are made in these books straight without recording in usual journal. From the respective books, posting is made to ledger. In fact, from the entries made in the subsidiary books, journalizing can be done. A detailed note is given in the following paragraphs on each of the subsidiary books. Self Assessment Questions 4: State True or False 1. All subsidiary books are also journal because they are books of original entry.
Sikkim Manipal University
52
Financial and Management Accounting
Unit 4
2. All such transaction which cannot be included under different subsidiary books are entered in journal proper. 3. Can we post the transactions to ledger accounts from the entries made in subsidiary books ? 4. The purpose of subsidiary books is to classify enumerable transactions into various functional activities. 4.5 Purchases Book/purchases day book Purchases book is also called purchases journal. Only credit purchases of goods are recorded in this journal. ‘Goods’ mean items or commodities procured for resale. Cash purchases are recorded in cash book and credit purchases are recorded in purchases book. The form of a purchases book is given below. Purchases Book of Johnson and Johnson Co Date
Name of Supplier
Ledger Folio
Inward Invoice No
Amount Rs.
2006 August
5
Rao Bros, Bangalore
567
36,000
8 16
Snow white Co,
87
45,000
Best & Company
146
29,000
Total
1,10,000
Inward invoice is the document sent by the supplier while selling the goods. Every invoice received is numbered and this number is stated in the purchases book for reference. From the above entries made in the purchases book, it is possible to record journal entries. Whenever, purchases are made, goods account is debited because it is real account and the supplier’s account is credited because the supplier is the giver and it is personal account. The journal entries for the above transactions appear as under: Journal entries in the books Johnson and Johnson Co., Date
Particulars
5-8-06
Goods A/c
LF Dr
Debit
Credit
Rs.
Rs.
36,000
Rao Bros A/c
36,000
(Being goods purchased on credit) 8-8-06
Goods A/c
Dr
45,000
Snow White Co A/c
45,000
(Being Goods purchased on Credit) 16-8-06
Goods A/c
Sikkim Manipal University
Dr
29,000 53
Financial and Management Accounting To Best & Co
Unit 4
A/c
29,000
Total
1,10,000
1,10,000
Observe that in every case of credit purchase, the supplier’s account is credited and goods account is debited. At the end of the day or week or month, the total of purchases is transferred to one ledger account known as Purchases account in the ledger. Self Assessment Questions 5: State True or False 1. All purchases cash or credit are entered into purchases day book. 2. Purchases of goods and other assets can also be recorded in purchase book. 3. Inwards Invoice is a document to verify the quantity, price and other details of goods purchased. 4. Purchases made from Mr. Ganesh an credit Rs 6000, entered in the purchases book. What is the journal entry ?
4.7 Sales book or Sales Day book Sales book or sales day book contains the details of credit sales of goods made during a particular period. The total of the sales book is transferred to ledger to an account called sales account. The parties to whom credit sales are made are known as trade debtors. All debtors are classified as personal accounts and for each party, ledger account is prepared in the ledger. Sales account shows credit balance and debtor’s account shows debit balance. A pro forma of sales book is as given under. Sales book of Raghu Medicals Date
Name of customer/debtor
Ledger Folio
Outward Invoice No.
Amount Rs.
4-3-05
French Medicals
476
6,800
18-3-05
Mandara stores
477
19,200
28-3-05
Shaw Medical Stores
478
85,000
and General
Total
1,11,000
Outward Invoice number is the number of the invoice issued by the businessman to the customer. The total of Rs. 1,11,000 will be transferred to sales account in the ledger. Similarly the respective ledger accounts of the customers will be prepared in the ledger.
Sikkim Manipal University
54
Financial and Management Accounting
Unit 4
Self Assessment Questions 6: 1. Sales day book contains only credit sales of goods made. 2. Sale of any other asset other than goods is also recorded in sales day book. 3. Persons to whom sales are made on credit are called ________. 4. Outward invoice is a document issued to customer, when the goods are sold on credit.
4.8 Purchase Returns Book When the businessman purchases the goods and finds that the goods are not as per the specifications or the goods are damaged or for any other valid reason, he may decide to return the goods to the supplier from whom the goods were purchased. All such purchase returns are recorded in a journal called purchase returns book. Normally the supplier’s account is credited when the purchases are made. If the goods are returned, then a debit note will be sent and the number of debit note is recorded in the purchase returns book. Purchase Returns Book of Johnson and Johnson Co., Date
Name of supplier
2006 August, 12 24
Ledger folio
Debit note No.
Amount Rs.
Snow White Co
25
5000
Best & Co
26
7000
Total
12,000
The total of the book is transferred to ledger to an account called purchase returns account, which shows credit balance. The respective personal accounts of the suppliers/creditors are debited in their respective ledger accounts. Self Assessment Questions 7: 1. Purchase returns are also called returns outwards. 2. Purchase returns take place when the goods bought are not as for the specification. 3. When goods, bought, are returned, suppliers account is _________ and purchase return account is _____________. 4. Debit note is a document to slow the supplies account being debited.
4.9 Sales Returns Book Just as goods which do not conform with specifications are sent back to suppliers, our customers may also send the goods sold to them back to us owing to similar reasons. Then a credit note is prepared to show that the customer’s/debtor’s account is credited to the extent of the value of the goods returned by them to us. Goods are received from the customers and a credit note is sent to them. Sikkim Manipal University
55
Financial and Management Accounting
Unit 4
Sales Returns Book of Raghu Medicals Date
Name of customer/debtor
LF
Credit Note No.
Amount Rs.
10-3-05
French Medicals
56
2,000
30-3-05
Shaw Medicals and Gen. Stores
57
4,000
Total
6,000
As usual the total of the book is transferred to an account called sales returns account in the ledger and this account shows debit balance. The respective personal accounts of the customers are credited with the value of the goods returned by them. Self Assessment Questions 8 1. Sales return are also called returns inwards. 2. Credit not is a document to indicate that the goods are recived as returned by customers. 3. Credit noted is sent by _____________ to __________.
4.10 Bills Receivable Book When a businessman sells goods on credit, he does not receive cash immediately. But the businessman requires cash for which he draws a bill of exchange against the customer and the customer accepts it. Such a bill of exchange can be discounted with a banker for commission. The businessman who draws the bill is called drawer and the customer on whom it is drawn is drawee or acceptor. So bill of exchange is a document in writing, promising to pay a certain sum of money or money’s worth to the drawer at a certain date for value received. The businessman maintains a journal/ subsidiary book containing the details of the bills receivable. The bills receivable account shows debit balance and the amount receivable against them is an asset. Bills Receivable Book of Sham Sundar & Co., From Where Whom Acceptor payable received
No. of the bill
Date of Receipt
Date of the bill
1
04-7-04
04-7-04
Mr.X
Mr. X
2
1-8-04
01-8-04
Mr. Y
3
9-9-04
09-9-04
Mr. A
4
10-9-04
10-9-04
Mr. B
Amount
Term of the bill
Due Date
Delhi
3 mths
7-10-04
Mr. Y
Noida
4 mths
4-12-04
9,000
Mr. A
Agra
3 mths
12-12-04
12,000
Mr. B
Delhi
4 mnth
13-1-05
10,000
LF
Rs.
Remarks
7,000
38,000
For every bill the due date is calculated after adding three days of grace. The person from whom the bill is received and the person who accepted the bill could be the same person or different persons. The total of the bill receivable is transferred to bills receivable account in the ledger.
Sikkim Manipal University
56
Financial and Management Accounting
Unit 4
Self Assessment Questions 9: 1. A bill is an instrument in writing similar to that of a promissory note. 2. Who is a drawer of a bill of exchange in a business ? 3. Who is the acceptor of a bill of exchange in a business ? 4. Bills Receivable account shows _____________- balance. 5. Can bills receivable be discounted ?
4.11 Bills Payable Book What is bills receivable for a drawer, is bills payable to the drawee. In a business concern, proprietor draws bills on debtors and accepts bills drawn by trade creditors. All such bills accepted by the proprietor are recorded in a separate book called bills payable book. The sum of the value of bills payable for a period ending will be transferred to the ledger. Usually bills payable account shows credit balance and hence is a liability. The form of bills payable book is given here under. Bills Payable Book of Sun Shine Co., No. of Date of the the bill bill
1
2000
To whom given
Ram & Co
Drawer
Ram & Co
Payee
Ram & Co.
Where payable
Agra
June 07
Term of the bill
Due date
3 months 2000
LF
Amount Rs
Date Repaid marks
56,000
Sept 10
2
June 12
Sundaram
Sundaram
Sundaram
Delhi
4 months Oct 15
3
June 20
KV & Co
KV & Co
KV & Co
Chennai
5 months Nov 23 Total
72,000 50,000 1,78,000
Self Assessment Questions 10: 1. Bills accepted by the proprietor of the business and drawn by supplies are called _________. 2. Every bill has ________ number of grace days . 3. Bill payable account shows _________ balance. 4. Bill payable represent ________. 5. when bills payable account is credited ________ account is debited.
4. 12 Cash Book Cash book is an important subsidiary book and a book of original entry. It is a record of cash receipts and cash payments made during a particular period. On the right hand side, receipts are recorded and on the left hand side, payments are recorded. A simple cash book has two sides, receipts side and payment side. The receipts are on debit side and the payments are on credit
Sikkim Manipal University
57
Financial and Management Accounting
Unit 4
side. Just as a ledger account, the words ‘To’ and ‘By’ are used. Cash book may also contain cash column and bank column. Cash column represents cash in the business and bank column represents cash kept in the bank. Bank column of cash book is a reflection of bank pass book. In this connection, it is important to note that in a few transactions, affecting both cash and bank accounts, contra entries are drawn. For example, cash is deposited in the bank is a transaction in which cash goes out and bank is the receiver. In cash account, it is recorded as payment and in bank account it is treated as a receipt. Similarly when cash is withdrawn from bank for office purpose, contra entry is drawn, debiting cash account and crediting bank account. Cash book containing cash and bank columns is known as two column cash book. In the case of three column cash book, on the receipt side, cash, bank and discount allowed columns are stated. On the credit side, cash, bank and discount received columns are mentioned.
Single column Cash Book of Rekha & Bros Date
Receipts
Cash
Date
Payments
Rs. 2003
Cash Rs.
2003
July 1
To Balance b/d
4,500
July 1
To Sales
8,050
3
10
To Interest on FD
2,000
14
By Purchases
7,000
20
To Commission
4,000
20
By Stationery
800
28
To Sale of goods
10,000
28
By wages
30
To Balagopalan
5,000
31
By Narasimhan
9,000
By balance c/d
13,800
4
By Rent of shop
500
By Postage
33,550
50
2,000
33,550
Two-Column Cash Book of Sampson Co., Date
Receipts
Cash (Rs.)
Bank (Rs.)
2003 Apr 5
Date
Payments
Cash (Rs)
Bank (Rs)
2003 To Balance b/d
1,500
13,000
900
April 2
By Wages
6
To Sales
5
By Electricity
7
To Ashok Co
2,000
8
By repairs
11
To Beta Co
2,350
15
By Yenki Ltd
20
To Sales
30
By Balance c/d
500 2,800
Sikkim Manipal University
17,350
50 400 400 10,800 2,350
6,150
2,800
17,350
58
Financial and Management Accounting
Unit 4
Three-Column Cash Book of Janardhan Works Date
Receipts
Discoun t Rs
Cash
Bank
Rs
Rs
2002
Date
Payments
Discoun t Rs
Cash
Bank
Rs
Rs
2002
Jan 2 5
To balance b/d
10
To Patel
15
To Neelima
30
To Bank
C
31
To Cash
C
100
3,700
4,500 Jan 6 By wages
2,400
3
By Agarwal
15
By Cash C
22
By drawings
30
By Bank
31
By rent
31
By bal c/d
6,000 3,000 1,000
To Dividend from X Co
2,000 100
1,550 50
3,000 2,000
C
9,100 13,500
950
1,000 1,500
50
5,600
7,000
9,100
13,500
Note the following points from the above illustration: a) Discount column on the debit side represents discount allowed and on the credit side, it represents discount received. Balancing is not done for these columns for a simple reason to find out separately the discount allowed and received. b) There are two contra entries each on 15th and 30th. On 15th the transaction is cash withdrawn from bank Rs. 3,000. It is a payment from bank and it is receipt to business cash. Similarly on 30th Cash is deposited to bank Rs.1000. It is a receipt to the bank account and payment from cash account. c) To indicate contra entry, ‘C’ is mentioned against the entry. d) Drawings represent the amount withdrawn from bank for business purposes. e) Dividend from X Co is received by cheque and the company should have remitted the dividend directly to the bank account of the businessman. f) The balance c/d is the closing balance for the month of January 2002 and this becomes opening balance for February, 2002. Self Assessment Questions 11: State True or False 1. Cash book and cash account are one and the same. 2. Cash book may be single column, two column or three column are. 3. Trade discount allowed to customers or received from suppliers are not recorded in cash book.
Sikkim Manipal University
59
Financial and Management Accounting
Unit 4
4. cash discount allowed to customers appears an ____ side of cash book. Cash discount received appears are ____ side of cash book. 5. discount columns are independently totaled and not balanced. 6. Bank columns of cash book indicates Bank transations made by business man. 7. contra entry is an entry where both cash account and bank account are affected.
4.12 (a) Petty Cash Book In large organizations, petty expenses like stationery, postage, stamps, refreshments, carriage, cartage, daily wages etc are incurred day in and day out. All these expenses are more in number and very insignificant in value. To look after payment of such expenses, a separate petty cashier is appointed, who obtains a definite sum of money at the beginning of a month and gives a statement of account at the end of the period to the chief cashier. To record such payments, a separate book, known as petty cash book is maintained. There is a distinct method, namely imprest system which is adopted in maintaining such petty cash book. Under this system, at the beginning of a month, a definite sum of money is given by chief cashier to petty cashier for petty expenses. At the commencement of the next period, the petty cashier receives money equal to what is spent during the earlier period. For instance, in the beginning of January, 2004, a sum of Rs.10000 is given to petty cashier assuming that such miscellaneous expenses may be to the order of Rs.10000. By the end of January, it may be found that the actual expenses are only Rs.9000. Then the chief cashier will reimburse Rs.9000 so that the opening balance for the month of February will be Rs.10000. This is also called analytical petty cash book. Self Assessment Questions 12: State True or False 1. Petty cash book is maintained in case of petty organization. 2. Imprest system of cash book is a system where the expenses paid are reimbursed. 3. The closing balance in case of imprest system of petty cash book always remains the same . 4. Imprest system of cash book is also called analytical cash book. Illustration: Enter the following transactions in an analytical petty cash book. 2005 November
1st . Received a cheque for petty cash Rs.1000 2nd . Paid bus fare to messengers Rs50
Sikkim Manipal University
60
Financial and Management Accounting
Unit 4
4th . Paid auto fare Rs.70 10th . Postal stamps purchased Rs.80 12th . Paid for stationery Rs90 15th . Paid for carriage Rs.60 16th . Purchased envelopes Rs.50 20th . Wages paid Rs 100 . 25th . Tips given to driver Rs.50 30th . Telephone calls paid Rs. 20
Amt Recd CBF Date Rs
1,000
Nov
Particulars
V No
Total Payme nts Rs
To Bank
1
st
By bus fare
50
2
nd
ByAutofare
70
4
th
By postal
80
10th
By Stationery
90
12th
By Carriage
60
15th
By Envelopes
50
16th
By Wages
20th
By tips
25th
By Telegram
30th
By Balance C/d
Analysis of payments
Tra
Post Carr
Rs
Rs
Rs
LF
Ledger A/cs
P&S Wages Sundry Exps Rs Rs Rs
50 70 80
100
90
50 20 570
60
Nov
50
____ 80
30th Dec 1st
100
___120 430
50 20 80
1,000
____ 140
100
_____ 50
Note: 1. CBF stands for cash book folio 2. V.No stands for Voucher No 3. Tra stands for Travelling expenses 4. Carr indicates Carriage expenses
Sikkim Manipal University
61
Financial and Management Accounting
Unit 4
5. P & S stands for printing and stationery Terminal Question 1. Purchases book records___________________ purchases. 2. Cash purchases are recorded on-_____________ side of cash book.. 3. Credit sales are entered in ____________________________ book. 4. Record a journal entry for drawings made for personal purposes of the businessman. 5. If drawings are made from bank for office purpose, what is the entry? 6. During the year, if the total owner’s equity of Beta Co increased from Rs50,000 to Rs60000, it is because of earnings made during the year. Is this statement necessarily true? 7. Complete the following matrix by entering either debit or credit in each cell. Item
Increases
Decreases
Assets Liabilities Owner’s equity Income Expenses
8. Listed below a number of transactions. Identify which account to be debited and which account to be credited, as shown for the first transaction. Transaction
Debit
Paid to Gopal, a creditor
Gopal account
Credit Cash account
Paid rent in advance for the next year Purchased stationery Paid rent for the proprietor’s house Purchases machinery on part payment Charged customers for services provided Collected cash for the services provided Received a cheque from customer on account Paid dividend Paid wages for construction of business premises Paid interest charges on loan Electricity bill paid Salaries paid
Sikkim Manipal University
62
Financial and Management Accounting
Unit 4
9. Journalise the following transactions in the books of Harinam Singh for the month of April, 2005. Rs. st
Harinam Singh started business with cash
60,000
nd
Purchased furniture for cash
10,000
th
Purchased goods for cash
25,000
th
Bought goods from Karmesh
25,000
th
Sold goods for cash
44,000
th
Sold goods to Ramesh
30,000
10
th
Paid cash Kamalnath
15,000
11
th
Received cash from Ramanath
10,000
18
th
Purchased goods from Sohan Kumar
12,000
25
th
Purchased computers on credit from Shivshankar
28,000
1 2 4 5 7 9
29th
Paid salaries
30
th
Withdrew cash for personal use from the office
30
th
Paid wages
10.
7,000 10,000 5,500
Record the following transactions in the subsidiary books of Ramachandra and Sons of Chennai and show the totals of each book for the month of January, 2000. Date
Transaction
Jan 1
Amount (Rs.)
Bought goods from Das Gupta
20,000
2
Sold to Sen Gupta
12,500
3
Sold goods to Ramesh
30,000
5
Bought goods from Suresh
15,000
7
Sold goods to Anand
13,000
8
Received goods returned by Sen Gupta
5,500
9
Purchased goods from Shyam Sundar
16,000
10
Roy bought goods from us
25,000
11
Roy returned goods to us
14
Sold goods to Ram
45,000
16
Bought goods from Naresh
20,000
20
Returned goods to Naresh
4,000
22
Purchased furniture from Vibhu
10,000
30
Sold goods on cash to Khadju
9,000
30
Paid cash to Suresh
Sikkim Manipal University
3,000
10,000
63
Financial and Management Accounting
11.
Unit 4
Enter the following transactions in the single column cash book of Gopichand. March, 2003 1st .Commenced business with cash 2nd
Bought goods for cash
rd
3 . Sold goods for cash 4th . Goods purchased from Ravi Kumar th
10
.Paid to Ravi Kumar
14th . Cash sales
5000 4000 10000 7000 8000
th
4000
nd
500
th
600
th
4000
th
1000
st
900
18 . Purchased furniture for office 22 . Paid wages 25 . Paid rent 30 . Received Commission 30 . Withdrew for personal purpose 31 . Paid salary
12.
20000
Record the following transactions in two column cash book(Cash and Bank)in the books of Soft Silk Co., for the month of July, 2004.Find out the closing balances. July, 2004 st
01 . Opening balance b/d(Cash)
Rs. 14,500
(Bank)
7,000
th
6,700
th
2,500
th
15,200
th
4,350
th
5,000
th
10,000
th
1,000
nd
2,000
04 . Cash purchases 05 . Rent for June month paid by cheque 09 . Cash sales 12 . Dividend received from X Co and paid it into bank 15 . Cash deposited into bank 18 . cash paid to Rahim Bros to settle his account 20 . Repairs paid 22 . Commission paid by cheque rd
23
. Customer, Deepak remitted to our bank account
20,000
th
5,000
th
2,000
th
3,000
th
1,400
25 . Cash withdrawn from bank for office use 27 . Drawings made from business cash for personal purposes 28 . Purchased stationery by cash 30 . Cash withdrawn for personel use from bank
Sikkim Manipal University
64
Financial and Management Accounting
13.
Unit 4
Enter the following transactions in the cash book with discount, cash and bank columns May 1st . Balance of cash in hand Rs. 14000; bank overdraft at bank Rs.5000 4th Invested further capital Rs. 10000 out of which Rs.6000 was deposited in the bank. 6th . Sold goods for cash Rs. 30000 6th Collected from debtors of last year Rs. 80000; Discount allowed to them Rs. 2000. 10th . Purchased goods for cash Rs. 55,000 11th . Paid Ram Vilas, our creditor Rs. 25,000; discount allowed by him Rs.650 13th . Commission paid to our agent Rs. 5,300 14th . Office furniture purchased for cash Rs. 2,000 14th . Rent paid Rs 400; electricity charges paid Rs. 1,000 14th . Drew cheque for personal use Rs. 7,000 17th . Cash sales Rs. 25,000 18th . Collection from Atal Bihari Rs.40,000, deposited in the bank on 19th April. 19th . Drew from the bank for office use Rs.5,000 22nd . Drew cheque for petty expenses Rs.1,500 24th . Dividend received by cheque Rs.500, deposited in the bank on the same day. 25th . Commission received by cheque Rs.2,300, de[posited in the bank on 28th April 29th . Drew from the bank for salary of the office staff Rs15,000 30th . Deposited cash in the bank Rs.10,000.
Answer for Self Assessment Questions Self Assessment Questions 1: 1. Journal 2. Yes 3. Ledger Self Assessment Questions 2: 1. It is a book containing the entry of transactions 2. It indicates the pages number in which the summary of respective account is found in ledger. Self Assessment Questions 3: 1. credited 2. Interest 3. Credited, debited 4. Creditor’s account, cash 5. Because it is cash transaction and X co is insignificant. 6. Business premises, cash 7.
i. Cash A/c Dr 5,00,000 to damodar & Bros 5,00,000 ( Being advance received )
Sikkim Manipal University
65
Financial and Management Accounting
Unit 4
ii. Sales Tax A/c 40,000, To cash A/c 40,000 ( sales Tax paid ) iii. Cash A/c the 5000 To BOB A/c 5000 ( cash drawn for mis.expenses ) Self Assessment Questions 4: 1. True 2. True 3. Yes 4. True Self Assessment Questions 5: 1. False 2. False 3. True 4. Purchases A/c Dr To Ganesh account ( Being purchases made ) Self Assessment Questions 6: 1. True 2. False 3. Debtors 4. True Self Assessment Questions 7: 1. True 2. True 3. Debited, Credited 4. True Self Assessment Questions 8: 1. True 2. True 3. Business, Customer. Self Assessment Questions 9: 1. True 2. Owner of the business who is the seller 3. Customer / debtor 4. Debit 5. Yes
Sikkim Manipal University
66
Financial and Management Accounting
Unit 4
Self Assessment Questions 10: 1. Bills payable 2. Three 3. Credit 4. Liability 5. Supplier’s account / Creditors account Self Assessment Questions 11: 1. True 2. True 3. True 4. Debit, Credit 5. True 6. True 7. True. Self Assessment Questions 12: 1. False 2. True 3. False 4. True Answer for Terminal Questions: Answer 1. Credit 2. Credit 3. Sales Day 4. Drawing are A/c , Dr To Cash a/c 5. Cash account Dr To bank account. 6. The statement is true if additional capital is not brought in during the year. Owner’s equity increases if profits are added or additional capital is brought in. 7. Debit
Credit
Credit
Debit
Credit
Debit
Credit
Debit
Debit
Credit
Sikkim Manipal University
67
Financial and Management Accounting
8.
Unit 4
Prepaid Expenses
Cash
Stationery
Cash
Drawings
Cash
Machinery
Supplier
Customers
Services
Cash
Customers
Cash
Customers
Dividend
Cash
Business Premises
Cash
Interest on loan
Cash
Electricity
Cash
Salaries
Cash
9. 1
st
Cash a/c
Debited
Capital a/c
Credited
2
nd
Furniture a/c
Debited
Cash a/c
Credited
4
th
Goods a/c
Debited
Cash a/c
Credited
4
5
th
Purchases a/c
Debited
Kamalesh a/c
Credited
5
7
th
Cash a/c
Debited
Goods a/c
Credited
9
th
1 2 3
6 7
Ramesh a/c
Debited
Sales a/c
Credited
th
Kamel nath a/c
Debited
Cash a/c
Credited
th
Cash a/c
Debited
Kamanath a/c
Credited
th
Purchases a/c
Debited
Sohan Kuma
Credited
th
Computers a/c
Debited
Shiva Shankar
Credited
th
Salaries a/c
Debited
Cash a/c
Credited
th
Drawings a/c
Debited
Cash a/c
Credited
10
8
11
9
18
10 11 12
25 29 30
10. Total of Purchases Day book: Das Gupta
Rs.
20,000
Suresh
Rs.
15,000
Shyan sunda
Rs.
16,000
Naresh
Rs.
4,000
Rs.
55,000
Purchase Returns Book Sikkim Manipal University
68
Financial and Management Accounting
Naresh
Rs.
Unit 4
4,000
Sales Returns Book Sen Gupta
Rs.
5,500
Roy
Rs.
3000
Rs.
8,500
Total sales Day book
11.
Sen Gupts
Rs.
12,500
Ramesh
Rs.
30,000
Anand
Rs.
13,000
Ray
Rs.
25,000
Ram
Rs.
45,000
Rs.
1,25,500
Cash Book By Goods
5000
To Sales
To Capital
20,000 4,000
By Ravi Kumar
7000
To Sales
8,000
By office furniture
4000
To Commission
4,000
By wages By rent By drawings By salary By bal c/d
36,000
500 600 1000 900 17,000 36,000
Hint: Goods Purchased from Ravi Kumar is a credit purchase. 12. Cash
Bank
To Opening bal b/d
14,500
7000
To Sales
15,200
To Cash To Deepak To Bank ( c )
Cash By Purchases
5000
2500
By dividend By bank By Rahim & Bus By repairs
4350 5000 10,000 1000
By commission paid
2000
By cash ( c )
5000
By drawings
2000
By stationery
3000
By drawings Sikkim Manipal University
6700
By Rent 20,000
Bank
1400 69
Financial and Management Accounting
Unit 4 By bal c/o
24,700
To Bal b/d
13.
7,000
32,000
7000
16750
24,700
32,000
16,750
Cash Book Discount Rs To bal b/d
Cash Rs 14,000
To bal b/d ( OD)
Discount Rs By purchase
5000 By Ram vilas
To Capital
4000
To Sales To Debtors
Bank Rs
2000
By office furniture
80,000
By rent
To Sales
25,000
By electricity
To Atal Bihari
40,000
To Cash ( c) 5,000
To Dividend
2000 400 1000
By drawings
7000 40,000
By cash ( c)
5,000
500 By petty expenses
To Commission
2300
To Cash ( c)
1,500
By bank ( c)
2,300
2300 By salary
To Cash ( c)
15,000
15,000 By bank ( c)
15,000
By c/d Total
Sikkim Manipal University
25,000 5,300
4,000 By banks ( c)
To Bank
2000
2,00,300
68,800 Total
Bank Rs
55,000 650
6000 By commission
30,000
Cash Rs
650
54,300
40,300
2,00,300
68,800
70
Financial and Management Accounting
Unit 5
Unit 5
Secondary Books
Structure
5.1 Introduction Objectives 5.2 Types Self Assessment Questions 1 to 7 5.3 Posting technique in the ledger Self Assessment Questions 8 Terminal Questions Answer to SAQs and TQs
5.1 Introduction Journal is the book of original entry and all transactions are recorded first in that book. We have also learnt that there are subsidiary books, which are different types of journal and in large organizations, these subsidiary books are maintained as books of original entry. However there is a book called Journal Proper, which is also a type of journal in which transactions which can not be entered in any other subsidiary books, shall be recorded. For instance, a loan is declared as bad and it should be written off. This is not a cash transaction non the less a credit transaction. But it should be recorded in some book. Similarly depreciation on assets has to be provided; rent paid in advance ; taxes paid in advance, outstanding expenses payable and so many such transactions have to be recorded for a fair calculation of profit or loss. To facilitate recording of such transactions, a separate book called journal proper is maintained. It is only after all transactions are entered into various books, ledger accounts are prepared entirely in a different book namely ledger. The process of recording the transactions in the ledger is known as posting. Since ledger is prepared basing on journal, it is known as secondary book. Learning Objectives: After studying this unit, you should be able to understand the following 1. To know what secondary books are. 2. To know what Journal proper is and its purpose. 3. To know what a ledger and ledger account mean. 4. To understand the posting of transactions from General Journal 5. To know the technique of posting transactions from subsidiary books Sikkim Manipal University
71
Financial and Management Accounting
Unit 5
5.2 Types There are three types of ledger, namely debtors ledger, creditors ledger and general ledger. Debtors ledger contains accounts of debtors to whom goods are sold on credit. Creditors ledger contains accounts of creditors from whom goods are purchased on credit. General ledger contains real accounts, nominal accounts and all personal accounts, other than debtors and creditors accounts. Before understanding about posting transactions to ledger, it is useful to understand about journal proper. Journal proper contains the following aspects: a) Opening journal entries b) Closing journal entries c) Adjusting entries d) Rectification entries e) Transferring entries f) Credit purchase of assets and sale of assets g) Withdrawal of goods by the proprietor for his personal use h) Loss of goods due to natural causes Self Assessment Questions 1: 1. Ledger is also known as _____________. 2. Journal proper contains ______________. 3. Is Ledger an account or a book ? 4. The three types of secondary books are _____,______ and ______________. 5. Furniture of the office used by the proprietor in his house. where do you find an entry for this transaction in business books? 6. What ever is recorded in journal proper is also posted to ledger.(state whether it is True / False). 5.2 a. Opening Journal entries: In the case of running business, all the assets and liabilities of the previous year should be brought down to the current year and therefore an entry is drawn debiting all assets account and crediting liabilities account and the difference being credited to capital account. In a business on 31 st Dec, 2004, the following assets and liabilities were there: Cash at bank Rs50000; Furniture Rs.48000; Plant and machinery Rs200000; Debtors Rs.100000; Stock in trade Rs.20000; Creditors Rs.50000; Bank loan Rs.45000. On 1 st of January, 2005the assets and liabilities have to be brought in and so in Journal Proper the following entry is recorded. Date
Particulars
1105
Cash at Bank A/c Dr
Sikkim Manipal University
Ledger Folio
Debit Rs
Credit Rs
50000
72
Financial and Management Accounting
Unit 5
Furniture A/c Dr
48000
P and M A/c Dr
200000
Debtor’s A/c Dr
100000
Stock In trade A/c Dr
20000
To Creditors A/c
50000
To Bank Loan A/c
45000
To Capital A/c (Diff)
323000
(Being assets and liabilities of the previous year brought in)
Similarly, a newly set up business may commence its activities with some assets and liabilities. Then the assets are debited and liabilities are credited and the difference is transferred to capital account. Self Assessment Questions 2 1. Opening journal entries are drawn at the commencement of accounting period. (state whether it is True / False). 2. When all assets are debited and all liabilities are credited, the difference is transferred to ___________ account. 3. If opening liabilities including capital are more than assets, to what account the difference is transferred ? 5.2 b. Closing entries Closing entries are drawn at the end of accounting period and the purpose is to close down several account balances for the current period. The accounts of assets and liabilities will not be closed because they continue to exist further. All expenses and income accounts are closed by transferring them to the respective revenue accounts such as Trading account and Profit and Loss account. For example, salaries paid during the year are closed by transferring to P & L account, debiting P & L account and crediting Salaries account, so that the salaries account of the current year does not again appear in the next year. More details about closing entries will be dealt with in Unit 7. Self Assessment Questions 3 1. All revenue accounts are closed at the end accounting period. ( state whether it is True / False). 2. All trade expenses are closed by debiting trading account and crediting _____ accounts. 3. _______ account are closed by transferring them to P & L account.
Sikkim Manipal University
73
Financial and Management Accounting
Unit 5
4. Are assets and liabilities accounts closed at the end of the accounting year ? (state whether it is Yes / No). 5.2 c. Adjusting entries After the closure of accounting year, there might be a few more transactions left over and which are not incorporated into journal or ledger, owing to omission and practical difficulties. For example, closing stock should be valued on the last day of the accounting period. If the stock is so large containing several items, it is possible that the calculation is not made along with physical verification. In such a case, an adjusting entry is made to bring that item into account. Similarly, with regard to rent paid in advance, expenses outstanding, incomes received in advance etc adjusting entries are made in Journal proper. If they are not considered, the profit or loss reflected by the final accounts will not give the correct picture for the accounting period. More details about adjusting entries will be discussed in Unit 7. Self Assessment Questions 4 1. Transaction which are out of trial balance have to be adjusted for proper calculation of profit / loss.( state whether it is True / False ). 2. What is the adjusting entry in the following cases a. Depreciation of Building b. Closing stock c. Prepaid Insurance d. Outstanding salaries e. Stock used for personal purposes 5.2 d. Rectification entries Errors are natural and rectification is a must to arrive at exact position of profit or loss and balance sheet. These errors may or may not be disclosed by trail balance. Casting errors, omissions, commissions, principle errors, compensatory errors etc can occur in the process of accounting. They have to be identified and rectification entries have to be recorded. For example, wages which are paid for construction of a building are wrongly debited to wages account. By doing so, the expenses are increased and the resultant profit is reduced. Really speaking, the wages paid for construction, being a part and parcel of building account, should have been debited to building account. Therefore to rectify this error, building account should be debited and wages account should be credited so that building account gets enhanced and wages account gets reduced. Such rectification entries are drawn in Journal proper. More details are available in Unit 6.
Sikkim Manipal University
74
Financial and Management Accounting
Unit 5
Self Assessment Questions 5 1. Errors occur in the course of accounting and they influence the profit calculation of the business concern ( State whether it is True or False ). 2. What are the broad categories of errors ? 3. Rectification entries are drawn in _____________. 5.2 e. Transferring entries When the balance of one account is transferred to another account, transferring entry is made. For instance, drawings made by proprietor should be reduced from his capital account. To facilitate this, drawings account, which shows debit balance, is credited and capital account is debited (because capital is reduced as a result of drawings). This is a transferring entry and it is recorded in Journal proper. Self Assessment Questions 6 1. When an account showing debit balance, when transferred, should be _______ and vice versa. 2. The cost of stock destroy in fire should be transferred to which account? what is the entry for that ? 3. When drawing are transferred to capital. What is the entry? 5.2 f. Credit purchase of assets and sale of assets Normally, purchase of goods either on cash or credit, get recorded in cash account or purchases account respectively. Cash purchase of assets, like furniture or plant or machinery also get recorded in cash account. But credit purchase of assets, as mentioned above, can not be entered in purchase account or cash account because they are not goods. Hence such entries are recorded in Journal proper, by debiting asset account and crediting the personal account of the supplier of the assets. Similarly, when these assets are sold, an entry is made debiting cash account or personal account of the buyer as the case may be and crediting the concerned asset account. For example, an asset of Rs.5000 is sold for Rs.3000 to Shaym & Bros, who promised to pay the amount later. Then Shyam & Bros account is debited with Rs3000, Loss on sale of asset account is also debited by Rs.2000 and the concerned asset account is credited with the book value Rs5000. The loss sustained in the process is transferred to Profit and Loss account later. 5.2 g. Withdrawal of goods by proprietor for his personal purpose If a proprietor uses the goods of his business for his personal purpose, this should also be recorded. Since this transaction is not a sale, it can not be transferred to sales account. But it
Sikkim Manipal University
75
Financial and Management Accounting
Unit 5
should be regarded as drawings account and it should be debited and the goods which are going out of business should be credited. 5.2 h. Loss of goods and assets due to natural causes Goods may be lost on fire or as a result of any natural calamity. The cost of such goods should be reduced out of the stock of goods. Goods which insured may also be lost. A part of the value of the cost may be recovered. The part not recovered is transferred to P & L A/c. The cost of goods lost is debited and the stock account is credited. Owing to natural causes, wear and tear is caused to assets. Even if the assets are not used, there is obsolescence and as a result, depreciation has to be provided. This is a loss and therefore depreciation is debited and the concerned asset account is credited. Such implied loses are recorded in journal proper. Self Assessment Questions 7 1. Credit purchase of assets is not included in purchases account because assets are not goods. ( state whether it is True or False ). 2. The profit or loss in the sale of assets should be transferred to ________account. 3. Office cash if used by the proprietor is treated as personal drawings ( state whether it is True / False ) 4. A part of the business premises being used by the proprietor for his residence. The rent payable for that portion is drawings. ( state whether it is Yes / No ). 5. Loss of asset as a result of wear and tear is called _______. 6. Loss of goods as a result of fire accident is transferred to ____ account.
5.3 Posting Technique to Ledger – Form of a ledger account Having understood the journal and journal proper, the next important stage of accounting is preparation of ledger accounts in a book called ledger. The book contains the summary of transactions concerning to various heads of accounts for a given period. Posting is made to ledger accounts from journal entries and at the end of the accounting period, each ledger account is balanced. For each ledger account, a few items appear on the debit side and a few on the credit side. While balancing the account, amount on the debit side may be more than that of credit side, and vice versa. The excess of debit over credit is called debit balance carried down to credit side of the account. Similarly, excess of credit over debit is known as credit balance brought down to debit side of the account. For example, observe the following account of Rama, a customer.
Sikkim Manipal University
76
Financial and Management Accounting Debit
Unit 5 Rama’s Account
Credit
Date
Particulars JF
Amount Date
Particulars JF
2202
To balance b/d
By Cash
6,000
4202
To sales
27,000 9202
By Sales returns
4,000
12202
To Sales
30,000 15202
By Bank
25,000
25202
To Sales
6,000 28202
By Cash
20,000
26202
To Sales
28202
To Sales
4,000 28202 13,000 28202
1302
To balance b/d
5,000 8202
By Discount By balance c/d
Amount
2,000 28,000 85,000
85,000 28,000
Note: 1. Every account has four columns on debit side and four columns on the credit side. 2. At the end of period, total of debit side is Rs.85000 and the credit amount is Rs.57000. The balance of Rs.28000 is in excess of debit over credit and is stated on credit side in order to balance the account to an equal amount of Rs85000 3. The closing balance of the account for February month becomes opening balance for the month of March. 4. JF stands for journal folio, where from the transaction is obtained. 5. For closing balance, it is called balance carried down and for opening balance, it is balance brought down. Posting technique Posting is done either from journal or any subsidiary book. For example, there is a transaction that goods are sold to Krishna for cash Rs5,000. The journal entry in the journal is Cash account is debited and goods account is credited with an equal amount. In the ledger, on the debit side of cash account, we write ‘To goods’ Rs.5000 and in the goods account, we write ‘By cash Rs.5000. It is shown here below: Journal entry
Cash account Dr Rs. 5000 To Goods account
Rs. 5000
(Being goods sold to Krishna on cash)
Sikkim Manipal University
77
Financial and Management Accounting
Unit 5
Ledger in the books of business CASH ACCOUNT Particulars To goods
Amount (Rs) Particulars
Amount (Rs)
5,000
GOODS ACCOUNT Particulars
Amount (Rs) Particulars By cash
Amount (Rs) 5,000
From the entries in the subsidiary book also, ledger accounts can be prepared. For example, the total of purchases book for the month of January 2004 is Rs.56000. The purchases are made from supplier ‘A’ Rs.26,000; ‘B’ 20000 and from ‘C’ Rs.10000.We can find the entries in the ledger as shown below. A’s Account Particulars
Amount (Rs) Particulars
January 2004 To balance c/d
Amount (Rs)
January 2004 26,000
By Purchases
26,000
February 2004 By bal b/d
26,000
B’s Account Particulars
Amount (Rs) Particulars
January 2004 To balance c/d
Amount (Rs)
January 2004 20,0000
By Purchases
20,000
Feb, 2004 By balance b/d
20,000
C’s Account
Sikkim Manipal University
78
Financial and Management Accounting
Particulars
Unit 5
Amount (Rs) Particulars
January 2004
Amount (Rs)
January 2004 10,000
To balance c/d
By Purchases
!0,000
Feb, 2004 By bal b/d
10,000
Purchases Account Particulars
Amount (Rs) Particulars
January 2004 To Sundries
Amount (Rs)
January 2004 56,000 By balance c/d
56,000
Feb, 2004 To balance b/d
56,000
Self Assessment Questions 8 1. Ledger is regarded as _______________________ book. 2. Transactions that are not recorded in other journals, are incorporated in _______ 3. What is a closing entry? 4. Rent account is closed by debiting P & L account and crediting ________account. 5. If assets brought in by proprietor are Rs400000 and liabilities are Rs150000, what opening entry, do you draw in journal proper? 6. Out of salaries paid for the year 2005, Rs.6000 is related to the year 2006. How do you adjust this gap? And what entry do you pass? 7. What is balancing of ledger account? 8. Can we draw journal entries from ledger? 9. If Rama has sold goods to Krishna Rs4000 on credit, draw journal entries in the books of Rama and Krishna. 10. State any two differences between journal and ledger. 11. Cash account and cash book look alike. Is it a ledger account or mere subsidiary book? Illustration Journalise the following transactions and open only the personal accounts in the ledger.
Sikkim Manipal University
79
Financial and Management Accounting
2001 July 1
Unit 5
Govind Singh started business with the following
Amount
assets:
Rs.
Cash
20,000
Goods
10,000
Furniture
5,000
July 5 Sold goods to Raghavan
5,000
Sold goods for cash
3,000
July 9 Received from Raghavan on account
3,000
July 12 Purchased goods from Mukundan
9,000
July 15 Paid Mukundan
5,000
July 20 Paid interest to Mukundan
100
July 30 Paid stationery charges
600
Paid Salaries
250
Paid rent
160
Solution Journal entries in the books of Govind Singh Date
Particulars
LF
Debit (Rs)
2001 July 1
Cash account Dr
20,000
Stock account Dr
10,000
Furniture account Dr
5,000
Credit (Rs)
35,000
To Capital account (Being assets brought in as capital) July 5
Raghavan account Dr
5,000
Cash account Dr
3,000 8,000
To Sales account (Being sales made in cash and on credit to Raghavan) July 9
Cash account Dr To Raghavan account
Sikkim Manipal University
3,000 3,000
80
Financial and Management Accounting
Unit 5
(Being cash received from Raghavan) July 12
Purchases account Dr
9,000 9,000
To Mukundan’s account (Being goods purchased on credit from Mukundan) July 15
Mukundan’s account Dr
5,000 5,000
To Cash account (Being cash paid to Mukundan on account) July 20
Interest account Dr
100 100
To Cash account (Being interest paid to Mukundan) July 30
Stationery account Dr
600
Salaries account Dr
250
Rent account Dr
160 1,010
To cash account (Being the above expenses paid out)
In this problem, there are 12 ledger accounts affected, namely Cash, furniture, stock, Raghavan, sales, purchases, Mukundan, interest, stationery, salaries, rent accounts. However, the personal accounts are Raghvan’s account and Mukundan’s account. These ledger accounts appear in the following manner in the ledger. Dr
Raghavan’s Account in the books of Govind Singh Cr
Particulars
Amount Particulars (Rs)
July, 5 To Sales
( Rs)
5,000 July 9 By Cash July 31 By Balance c/d 5,000
August, 1 To balance b/d
Amount
3,000 2,000 5,000
2,000
The above account shows that Raghavan is owing to Govind Singh Rs.2000 as on 31 st July and this is the opening balance for August.
Sikkim Manipal University
81
Financial and Management Accounting
Dr
Unit 5
Mukundan’s Account in the books of Govind Singh Cr
Particulars
Amount Particulars
Amount
(Rs)
(Rs)
July 15 To cash
5,000 July 12 By purchases
July 31 To balance c/d
4,000
9,000
9,000
9,000 August 1 st By balance b/d 4,000
This means that Mukundan is owing to Govind Singh Rs.4000 as on 31 st July and this is the opening balance for August 1 st . Summary Ledger accounts are prepared from General journal and other subsidiary books including Journal proper. All transactions are posted to ledger accounts and some of them show debit balance and some other credit balance. For convenience of the students, the following table gives a fair idea of what account usually shows what balance.
Name of the account
Debit / credit balance
Capital
Credit
Personal Drawings
Debit
Creditors
Credit
Bills Payable
Credit
Bank overdraft
Credit
Loans from others
Credit
Outstanding expenses
Credit
Pre received incomes
Credit
Reserves for future expenses or losses
Credit
All items of incomes
Credit
Cash in hand or at bank
Debit
Assets such as furniture, buildings, plant, machinery, tools, stock
Sikkim Manipal University
82
Financial and Management Accounting
Unit 5
of goods, etc
Debit
Debtors, Bills receivable
Debit
Loans given to others
Debit
Investments made
Debit
All expenses such as wages, carriage, insurance, salaries, printing and stationery, advertising, commission paid, interest
Debit
paid, etc Prepaid insurance, rent or any prepaid expenses
Debit
Outstanding incomes
Debit
Losses like depreciation, loss in the revaluation of assets or sale
Debit
of assets, Any other asset
Debit
Terminal Questions 1. A company is engaged in the following transactions in June. You are required to record transactions in general journal. 1. Received cash from customers Rs.14000 2. Returned goods to suppliers Rs.4000 6. Paid for type writer purchased on credit on May 4, Rs.6000 10. Received cash for services provided Rs.Rs.2300 13. Paid for supplies purchased Rs5600 18. Paid telephone bill for the month Rs.8400 20. Provided professional services for Rs.9000 to the customer who paid advance Of Rs2000 30. Paid salaries for the month of June Rs3400 2. Mr. Lakshminarayana set up a finance company. The following transactions took place in the month of January. Draw the journal entries a) Began business by depositing Rs60000 in bank in the name of the company. b) Paid office rent for two months in advance Rs.6000 c) Purchased office supplies on credit from ‘C’ Rs.3000 d) Purchased office equipment for cash Rs.5000
Sikkim Manipal University
83
Financial and Management Accounting
Unit 5
e) Received cash for the services rendered Rs.10000 f) Paid security guard salary Rs.3000 g) Paid to a creditor ‘C’ on his account Rs.1200 h) Billed customers for services provided Rs.9500 i) Paid insurance premium for the month Rs.500 j) Paid advertisement charges Rs. 2000 k) Collected amounts due from customers Rs.5000 l) Purchased office supplies for cash Rs.800 m) Paid telephone expenses Rs.700 n) Paid electricity expenses Rs.200 3. Prepare ledger accounts for the journal entries recorded for the transactions as given in the exercise 2. 4. Record the following transactions in the personal account of Mr. Ravindranath and balance the account at the end of each month. Find out the closing balance for each month. Date
Particulars
Amount Rs.
1998 September 1
Sold goods to Ravindranath
54250
4
Received from Ravindranath
51538
4
Allowed him a discount
2712
15
Ravindranath bought goods
60000
18
Received from Ravindranath cash on account
20000
October 1
Balance from last month
3
Sold goods to Ravindranath
21
Received from Ravindranath cash Allowed him discount
31
Received cash in full settlement of account
? 10000 3960 40 ?
Answer for Self Assessment Questions Self Assessment Questions 1 1. Secondary book 2. All such transactions which are not entered in any other journal
Sikkim Manipal University
84
Financial and Management Accounting
Unit 5
3. Book. 4. Journal proper and Ledger. 2. Journal proper 3. True. Self Assessment Questions 2 1. True 2. Capital 3. Goodwill Self Assessment Questions 3 1. True 2. Trade expenses 3. All expenses other than trade expenses 4. No. Self Assessment Questions 4 1. True 2. a. Depreciation is debited & building account is credited b. Closing stock A/c is debited and trading A/c is credited c. Prepaid expenses account is debited and insurance A/c is credited d. Salaries A/c is debited and outstanding expenses account is credited. e. Drawings A/c is debited and stock account is credited. Self Assessment Questions 5 1. True 2. Errors that can be disclosed by trial balance and errors that cannot be disclosed by trial balance 3. Journal proper. Self Assessment Questions 6 1. Credited 2. Trading account, stock destroy of account is debited and stock account is credited. 3. Account is debited and drawings account is credited. Self Assessment Questions 7 1. True 2. P & L
Sikkim Manipal University
85
Financial and Management Accounting
Unit 5
3. True 4. Yes 5. Depreciation 6. P & L Self Assessment Questions 8 1. Secondary 2. Journal proper 3. Closing entry is an entry to close expenses, incomes (revenue items ) to the respective revenue accounts( Trading and P & L A/c ). 4. Rent 5. Assets account Dr 4,00,000 To Liabilities account 1,50,000 To Capital account 2,50,000( Difference)
6. The salary paid in advance is Rs 6,000. It should be deducted out of salaries paid in 2005. The entry is : Prepaid salaries A/c 6000 To Salaries A/c 6000 ( Being salary paid in advance adjusted ). 7. Balancing of a ledger account means finding out excess of debit over credit or vice versa and equating both debit and credit sides of account. 8. Yes 9. Books of Rama: Krishna’s A/c Dr To sales account. Books of Krishna : Purchases A/c Dr To Rama’s account. 10. a. Journal is a book of original entry where as ledger is a secondary book. b. Journal includes General journal and subsidiary books. But ledger does not. 11. cash account is both a subsidiary book and a ledger account. Answer for Terminal Questions: 1. Refer to unit 5.3 illustration. 2. Refer to unit 5.3 illustration. 3. Refer to unit 5.3 illustration 4. Closing balance Sept 30 Debit balance b/d 40,000.
Sikkim Manipal University
86
Financial and Management Accounting
Unit 5
Closing balance Oct 31 Balance Nil. Amount paid in full settlement is Rs 46,000.
Sikkim Manipal University
87
Financial and Management Accounting
Unit 6
Unit 6
Trial Balance
Structure 6.1 Introduction Objectives 6.2 Meaning Self Assessment Questions 1 6.3 Objectives Self Assessment Questions 2 6.4 Methods of preparing trial balance: Total Method and Balance Method Self Assessment Questions 3 6.5 Preparation op Trial balance Self Assessment Questions 4 6.6 Errors and their rectification Self Assessment Questions 5 6.7 Errors disclosed by a Trial Balance Self Assessment Questions 6 6.8 Errors not disclosed by Trial Balance Self Assessment Questions 7 6.9 Steps to locate the errors 6.10 Trial Balance and adjustments Self Assessment Questions 8 Terminal Questions Answer to SAQs and TQs
6.1 Introduction Journal and ledger are the books containing the details of business transactions which have taken place during a particular period. The purpose of these records is preparation of final accounts – trading account, profit and loss account and balance sheet. Before attempting to prepare final accounts, a summary of the transactions, as depicted by ledger should be available in a form that is easy to classify the assets, liabilities, expenses and incomes. While expenses and incomes are used to prepare trading and profit and loss accounts, assets and liabilities are presented in the balance sheet. Trial Balance stands as a bridge between primary and secondary books on one hand and final statements of accounts on the other hand.
Sikkim Manipal University
86
Financial and Management Accounting
Unit 6
Learning Objectives: After studying this unit, you should be able to understand the following 1. To know the meaning and format of trial balance. 2. To understand the objectives of preparing a trial balance 3. To know the guidelines to prepare a trial balance. 4. To identify and rectify the errors that can be disclosed by trial balance 5. To identify and rectify the errors that can not be disclosed by trial balance 6. To know the steps to locate the errors. 7. To prepare trial balance after incorporating adjustments.
6.2 Meaning Trial Balance is a statement containing the various ledger balances on a particular date. It is used to verify the equality of debits and credits in the ledger. When the total of debit balances equals the total of credit balances, the ledger is said to be in balance. A trial balance is prepared as follows: TRIAL BALANCE AS ON 31 ST MARCH, Particulars Cash account
Debit Rs. 1,20,000
1,00,000
Capital account Purchases account
Credit Rs.
40,000
Mohan account (creditor)
20,000
Sales account
40,000
Total
1,60,000
1,60,000
Self Assessment Questions 1 1. The purpose of preparing journal and ledger accounts is to prepare __________. 2. The final accounts include _________, ____________ and ________. 3. Trial balance is regarded as a bridge between primary and secondary books and preparation of final accounts (True / False ). 4. Trial balance contains debit balances and credit balances. (True / False ) 5. If trial balance tallies, balance sheet also tallies. (True / false )
Sikkim Manipal University
87
Financial and Management Accounting
Unit 6
6.3 Objectives There are three objectives of preparing a trial balance. a) To check the arithmetic accuracy of entries made. In double entry, every debit has an equivalent credit. Even in General Journal, we have seen that the total of debits equals the total of credits. Similarly, if the debits and credits tally in a trial balance, it indicates that the books of account are arithmetically accurate. If the two sides do not tally, it is sure that errors have crept in. b) Basis for financial statements. As stated earlier, trial balance is a bridge between ledger and final statements. It is only through trial balance, trading account, profit and loss account and balance sheet are prepared. If trial balance tallies, it means that the final statements should invariably tally. c) It is a summarised ledger. The position of a ledger account be judged simply by looking at the trial balance. It is because, all ledger accounts, after being balanced, are grouped as those showing debit and those showing credit balances. They must be equal in value.
Self Assessment Questions 2 1. Trial balance checks the arithmetic accuracy of debits and credits ( True / False) 2. Trial balance is a summary of ledger accounts. So, if ledger accounts are properly prepared and balanced, trial balance tallies ( True / False).
6.4 Methods of preparing Trial Balance Totals method and Balance method are the two techniques of preparing trial balance. In the first method, the totals of debits and credits of every account are shown in the trial balance. For instance, a cash account shows Rs.45000 as debit total (Receipts) and Rs35000 as credit total (Payments). Both these totals are carried to trial balance. The same logic is applied for all other accounts. Then also the trial balance tallies In the second method, instead of transferring the totals of both debit and credit, the net balance Rs.10000 (45000 – 35000) is shown on the debit side of trial balance. Same principle is adopted for all other accounts. The trial balance tallies. In the former method, more details can be understood but it is cumbersome. The second method gives the gist of the account and second method is popular. Self Assessment Questions 3 1. Trial Balance is prepared either under total method or balance method ( True / False). 2. Which method is popular ? Sikkim Manipal University
88
Financial and Management Accounting
Unit 6
3. What ever be the method of preparing trial balance, debit total should be equal to total of credit (True / False ).
6.5 Preparation of Trial Balance A trial balance can be prepared just as an account having debit side and credit side. It can also be prepared by enlisting all ledger accounts one below the other and showing their respective debit or credit balances on separate columns. Both methods are equally prevalent. However, the following steps should be followed to prepare a Trial Balance. a) Prepare the ledger accounts b) Balance them at the end of accounting period c) Group all accounts showing debit balance and show them of left hand side of trial balance d) Group all those accounts showing credit balance and show them on the right hand side of trial balance. e) Total the debits and credits and they must be equal, what ever be the method of preparing the trial balance. Self Assessment Questions 4 1. How do you prepare trial balance ? 2. If total of debits and credits do not tally, do you suspect any errors ? Illustration: The following are the ledger accounts of Mr. X as on 31 st December, 1998. Prepare a trial balance. Dr.
Cash Account Amount
Cr.
Particulars
1404
To balance b/d
50,000 6404
By Cash
24—04
To Sales
45,000 10404
By Kumar
29,000
16404
To Mohan
35,000 14404
By Purchases
50,000
26404
To Sales
10,000 18404
By creditors
20,000
20404
By Furniture
5,000
22404
By Wages
500
By Printing
1,000
By Comm
2,000
Rs.
Date
30404
Particulars
Amount
Date
By Electricity By Telephone
Sikkim Manipal University
Rs. 5,000
500 1,000
89
Financial and Management Accounting
Unit 6
By salaries By balance c/d 1,40,000
4,000 22,000 1,40,000
1504 To balance b/d 22,000 Building Account Date
Particulars
Amount Date Rs.
Particulars
Amount Rs.
1404
To balance b/d
2,00,000 30404
By balance c/d
2,00,000
Particulars
Amount
1504
To balance b/d 2,00,000 Furniture Account
Date
Particulars
1404
To balance b/d
20404
To Cash
Amount Date Rs.
Rs.
10,000 5,000 30404
By balance c/d
15,000 1504
15,000
To balance b/d 15,000 Bank Fixed Deposit Account
Date
Particulars
1404
To balance b/d
12404
To Interest
Amount Rs.
Date
Particulars
Amount Rs.
1,00,000 7,000 30404
By balance c/d
1,07,000 1504
15,000
1,07,000 1,07,000
To balance b/d 1,07,000 Stock Account Amount
Date
Particulars
1404
To balance b/d
1504
To balance b/d 25,000
Rs. 25,000
Date
Particulars
30404
By balance c/d
Amount Rs. 25,000
Creditor’s Account Amount
Date
Particulars
18404
To Cash
20,000
30404
To balance c/d
15,000
Sikkim Manipal University
Rs.
Date
Particulars
1404
By balance b/d
Amount Rs. 35,000
90
Financial and Management Accounting
Unit 6
35,000
35,000
1504 By balance b/d 15,000 Capital Account Date
Particulars
30404
To balance c/d
Amount Rs. 3,50,000
Date
Particulars
1404
By balance b/d
35,000 1504 By balance b/d
Amount Rs. 3,50,000 3,50,000
3,50,000 Purchases Account
Date 4404 14404
Particulars
Amount Rs,
To Kumar
30,000
To Cash
50,000
To Sarin
15,000
Date
Particulars
30404
By balance c/d
95,000 1504
To balance b/d
Amount Rs. 95,000
95,000
95,000 Sales Account
Date
Particulars
30404
To balance c/d
Amount Rs. 95,000
Particulars
2404
By Cash
45,000
8404
By Mohan
40,000
26404
By Cash
10,000
95,000 1504 By balance b/d
Amount
Date
Rs.
95,000
95,000 Kumar Account
Date 10404
Particulars To Cash To discount
Amount Rs. 29,000
Particulars
4404
By Purchases
Amount Rs. 30,000
1,000 30,000
Sikkim Manipal University
Date
30,000
91
Financial and Management Accounting
Unit 6
Repairs Account Date
Particulars
6404
To Cash
Amount Rs. 5,000
Date
Particulars
30404 By balance c/d
5,000 1504
Amount Rs. 5,000 5,000
To balance b/d 5,000 Mohan Account
Date
Particulars
8404
To sales
Amount Rs. 40,000
Date
Particulars
16404 By Cash 30404 By balance c/d
40,000 1504
Amount Rs. 35,000 5,000 40,000
To balance b/d 5,000 Discount Received Account
Date
Particulars
30404
To balance c/d
Amount Rs. 1,000
Date
Particulars
10404
By Kumar
1,000
Amount Rs. 1,000 1,000
1504 By balance b/d 1,000 Interest on Fixed Deposit Account Date
Particulars
30404
To balance c/d
Amount Rs. 7,000
Date
Particulars
12404
By Bank FD
7,000
Amount Rs. 7,000 7,000
1504 By balance b/d 7,000 Wages Account Date
Particulars
22404
To Cash
Amount Rs. 500 500
1504
Date
Particulars
30404
By balance c/d
Amount Rs. 500 500
To balance b/d 500
Sikkim Manipal University
92
Financial and Management Accounting
Unit 6
Printing Account Date
Particulars
Amount
Date
Particulars
Rs. 22404
To Cash
1,000
Rs. 30404
By balance c/d
1,000 1504
Amount 1,000 1,000
To balance b/d 1,000 Commission Account
Date
Particulars
22404
To Cash
Amount Rs. 2,000
Date
Particulars
30404
By balance c/d
2,000
Amount Rs. 2,000 2,000
1504 To balance b/d 2,000 Electricity Account Date
Particulars
Amount
Date
Particulars
Rs. 30404
To Cash
500
Rs. 30404
By balance c/d
500 1504
Amount 500 500
To balance b/d 500 Telephone Account
Date
Particulars
30404
To Cash
Amount Rs. 1,000
Date
Particulars
30404
By balance c/d
1,000 1504
Amount Rs. 1,000 1,000
To balance b/d 1,000 Salaries Account
Date
Particulars
30404
To Cash
Amount Rs. 4,000
Date
Particulars
30404 By balance c/d
4,000
Amount Rs. 4,000 4,000
1504 To balance b/d 4000 Sarin’s Account Date
Particulars
30404
To balance c/d
Sikkim Manipal University
Amount Rs. 15,000
Date
Particulars
28404
By Purchases
Amount Rs. 15,000 93
Financial and Management Accounting
Unit 6
15,000 1504
15,000
To balance b/d 15,000
Solution TRIAL BALANCE AS ON 30 TH APRIL, 2004 Debit balances
Amount Rs.
Cash Building
22,000 2,00,000
Furniture
15,000
Bank FD
1,07,000
Credit balances Creditors Capital Sales
Amount Rs. 15,000 3,50,000 95,000
Discount received
1,000 7,000
Stock
25,000
Interest on FD
Purchases
95,000
Sarin
15,000
Total
4,83,000
Repairs
5,000
Mohan
5,000
Wages
500
Printing
1,000
Commission
2,000
Salaries
4,000
Telephone
1,000
Electricity Total
500 4,83,000
6.6 Errors and their rectification An error is unintentionally committed mistake. Trial Balance, if does not tally, is a clear indication that there are some errors committed. The errors may be committed at various stages – journalizing, posting, casting (totaling), balancing, transferring to trial balance and so on. Mere tallying the trial balance does not ensure error free statement. For example, if a transaction is completely omitted, the trial balance still tallies. But there is inherent error. Errors whether disclosed or not disclosed by trial balance, have to be corrected or rectified in order to obtain the correct picture of profit or loss. It should be remembered that errors will have their impact not only on profit but also on the asset and liability position of the business organization. Self Assessment Questions 5 1. Errors can be committed at all stages, commencing from journalizing, posting, costing, balancing, transferring the closing balances, etc. (True / False). 2. Errors of omission, error of principle and compensating errors are not disclosed by trial balance (True / False). Sikkim Manipal University
94
Financial and Management Accounting
Unit 6
3. Errors of costing, posting to wrong side of an account, wrong amount etc can be detected by trial balance (True / False).
6.7 Errors disclosed by Trial Balance Those errors that can be disclosed by trial balance can easily be located. As soon as the trial balance does not tally, the accountant can proceed to find out the spots where the errors might have been committed. The total amount of difference in the trial balance is temporarily transferred to a ‘Suspense Account’ so that it can be mitigated as and when the errors get rectified. Therefore the suspense account gets debited or credited as the case may be for rectification of this type of errors. The following are the errors which are disclosed by trial balance: a) Posting a wrong amount: While posting an entry from subsidiary book to ledger, b) this mistake may happen. For example, Cash received from Rama Rs1150 is posted to Rama’s ledger account as Rs.1500, while it is correctly recorded in cash account. As a result of this error, trial balance does not tally. To rectify this Rama’s account should be debited by Rs350 (1500 – 1150) and credit should be given to suspense account. c) Posting to the wrong side of an account: This error is committed while posting entries from subsidiary books to ledger. For instance, Sales made to Krishna Rs5000 is transferred to credit side of Krishna’s account in the ledger. This error can be rectified by debiting Krishna’s account by Rs1000 and crediting suspense account. Note that the amount debited is double the actual amount. d) Wrong totaling: Both under casting and over casting are detected by trial balance. If any account is wrongly totaled, it gets reflected in the trial balance. To illustrate, purchases book total is Rs.5800. If it totaled as Rs.5700 or 5900, the difference will be shown in the trial balance. To rectify this, first find out what is the normal balance shown by the account wrongly totaled. If it is debit balance and it is under cast, the same account can be debited and credit is given to suspense account. If it is over cast, the respective account should be credited by the amount of difference and debit is given to suspense account. It is quite opposite in case the respective account is one which normally shows credit balance. e) Omitting to post an entry from subsidiary book to ledger: If an entry made in the subsidiary book does not get posted to ledger, the trial balance does not tally. For instance, rent paid Rs2000 recorded in cash account but is not posted to rent account at all. To rectify such error, the respective account should be debited or credited as the case may be and suspense account is credited or debited as the case may be.
Sikkim Manipal University
95
Financial and Management Accounting
Unit 6
f) Omission of an account altogether from being shown in trial balance: For instance, advertisement account which shows a debit balance is completely omitted from trial balance. This can be rectified by bringing it to trial balance and suspense account can be credited and advertisement account is debited. g) Posting an amount to a correct account more than once: This results in imbalance in the trial balance. The concerned account which is posted twice should be cancelled and suspense account to be suitably debited or credited as the case may be. h) Posting an item to the same side of two different ledger accounts: If two accounts are debited /credited for the same transaction, this type of error occurs. For example, Furniture purchased should be debited to furniture account only. If it is posted to furniture account and purchases account, then the difference arises in the trial balance. To rectify this, the ledger account to which it is debited wrongly should be credited and suitably suspense account is debited. Self Assessment Questions 6 1. Suspense account is the difference between debit total and credit total of a trial balance. ( True / false ). 2. Suspense account is created temporarily and later, it is removed as and when errors are detected and suitable rectified ( True / False ). 3. if amount paid to Rama Rs 500 is credited to Ramanan accounts, what rectification entry should be made ? 4. Instead of putting Rs. 1500 to debit of wages account, Rs 15000 is recorded. What impact, it has an profit ? 5. How do you rectify the above error ? 6. Telephone expenses of Rs 2500 is entered in cost account but not posted to ledger. How do your rectify ? 7. Rs. 2116 interest paid an loan is posted to interest accounts once as Rs 2611 and second time as Rs. 2161. How do you rectify?
6.8 Errors not disclosed by Trial Balance There are four errors regarded as those which do not affect trial balance and it is difficult to locate them. A brief description of the four errors is offered in the following paragraphs: a) Error of omission: Error of omission occurs when a transaction is completely omitted from the books of accounts. If purchase of goods from Jairam on credit is not recorded at all either
Sikkim Manipal University
96
Financial and Management Accounting
Unit 6
in the general journal or in the purchases book, it is termed as error of omission. Since both aspects – debit and credit – of the transaction are missing, the trial balance is not affected at all. To rectify such errors, the transaction should be recorded when it is traced. b) Error of commission: If the error of wrong posting, wrong casting, wrong calculation etc., committed in the books of original entry or ledger, it is said to be error commission. For instance, purchase invoice of Rs.1730 may have been entered as Rs.1370 in the purchases book itself, then in the subsequent ledger accounts, the same mistake continues and thereby can not be disclosed by trial balance. The difference of Rs.360 (17301370) should be added to purchases account and to the respective supplier’s account. The error can be detected only when the original invoice is referred to after getting the complaint from the supplier. In the above example, purchases account is debited and the concerned supplier’s account is credited to rectify the error. Such errors have repercussion on the profit or loss of the organization. From the above example, additional purchases will have to be incorporated and to that extent the expenses will be increased or profit will be affected. c) Error of principle: While drawing journal entries, often error of principle is committed and this goes un noticed because it does not affect the total of trial balance. For instance, ‘wages’ paid to workers engaged in the construction of building of the organization, constitutes part of the cost of the building. So the wages paid should be debited to building account but not wages account. If the building account is debited, the value of the asset appears in the balance sheet and the expenditure is actually capitalized. In case the wages are treated as usual revenue expenditure, they are deducted from profit. The error here is wages account is debited and not building account. Therefore to rectify this, building account should be debited and wages account should be credited to erase. Similarly, treating incomes as liabilities, providing insufficient provision for bad and doubtful debts, inadequate depreciation against assets etc., come under errors of principle. They must be rectified by applying the correct principles of accountancy. d) Compensating errors: It is also called offsetting error. Compensating error is one which is counter balanced by another error. If the account of Mr. X is to be debited for Rs1000, but it is debited for Rs100 while the account of Mrs X account is to be debited Rs.100 but it is debited by Rs.1000, the first error is compensated by the second error and therefore the trial balance is not affected. This comes to light only at a later stage. To rectify the error, Mr. X account should be debited by Rs.900 where as Mrs. X account should be credited by Rs.900.
Sikkim Manipal University
97
Financial and Management Accounting
Unit 6
Self Assessment Questions 7 1. If error of wrong posting, wrong costing, wrong calculation are committed in the books of original entry or secondary books, such errors are called ________. 2. Error of commission affects trial balance (True / False). 3. Furniture purchased for cash Rs 5000/ is to recorded in journal. What type of error is this ? 4. Error of omission can be detected only after a careful review of ledger balances of previous years (True / False). 5. Error of principle affects the value of revenue and capital items (True / False). 6. It is very difficult to find out the compensating errors. (True / False).
6.9 Steps to locate the Errors The following steps help to locate the errors. In spite of the efforts, if the difference in the trial balance persists, a suspense account may be created and subsequently the suspense account can be eliminated as and when the errors are located and rectification is made. i) Check both sides of the trial balance to ensure that mistake of totaling is not there. ii) Check the totals of debtors and creditors accounts iii) Find out whether all ledger balances are carried to trial balance iv) Verify the totals of all ledger accounts v) Divide the amount of difference in the trial balance by 2 and see if any item of the debit or credit side, equal to that amount has been posted to the opposite side. vi) Check whether the opening balances are brought down correctly from the previous accounting period vii) Make a comparison with trial balance of the previous year to find out if there are any items missing. viii) Where the difference in the trial balance is divisible by 9 then the difference is likely to be due to misplacement of figures like 12 for 21; 24 for 42;36 for 63 and so on.
6.10 Trial Balance and adjustments When errors are located, they should be rectified. It is not a good practice nor does it have any legal sanction to erase the mistakes and re write the correct ones. Rectification entries are recorded in General journal or journal proper. The following illustrations are given to show how to rectify the different types of errors. Self Assessment Questions 8: 1. Summary of all ledger balances is called ______________________ . Sikkim Manipal University
98
Financial and Management Accounting
Unit 6
2. Trial balance is necessary to prepare _________________________ . 3. The broad two categories of errors are a)________________ b) ____________. 4. Is casting error of principle or error of commission? 5. Purchase of machinery is included in the purchases book. What type of error is it? 6. What is error of omission? Illustrate. 7. What are the errors that can not be disclosed by trial balance? 8. The sum of errors in accounting is transferred temporarily to _________ account. 9. In which journal do you make rectification entries? 10. State any four steps to locate errors. 11. If sales account is under cast by Rs.45, what is the rectification entry? 12. Returns inwards book is over cast by Rs9, write rectification entry. 13. salary paid to Gopal is debited to his personal account. What is the rectification entry to correct the error? 14. Discount received Rs50 is transferred to the debit side of discount account. Write the rectification entry. 15. An invoice of purchase for Rs.760 is entered as Rs.670. What type of error is this? How to rectify this error?
Illustration 1 An accountant finds that the trial balance of his client did not tally and it showed an excess credit of Rs.69.74. He transferred it to a suspense account and later discovered the following errors. a) Rs.44.37 paid to Anand has been credited to his account as Rs34.37. b) A purchase of Rs.145.50 has been posted as Rs154.50 to the purchases account c) An expenditure of Rs.158 on repairs has been debited to the Buildings account d) Rs.80 was allowed by B as discount which has not been entered in the books. e) A sum of Rs.125.05 realized on the sale of old furniture has been posted to the sales account. Give journal entries to rectify the errors and show the suspense account as it would appear after adjustments. Solution Date
Particulars 1
Anand’s account Dr To suspense account
LF
Debit (Rs.)
Credit (Rs.)
78.74 78.74
(Being wrong amount, wrong ly credited to Anand’s a/c Sikkim Manipal University
99
Financial and Management Accounting
Unit 6
rectified) 2
Suspense account Dr
9.00
To Purchases account
9.00
(Being over debit of purchase account rectified) 3
Repairs account Dr
158.00
To Buildings account
158.00
(Being wrong debit given to building account rectified) 4
80.00
B’s account Dr
80.00
To Discount received a/c (Being discount received from B, omitted earlier, brought to account) Sales account Dr
5.
125.05
To old furniture account
125.05
(Being sale of old furniture wrongly transferred to sales account rectified)
Suspense Account Date
Particulars To Difference in trial balance
Amount Rs. 69.74
To Purchases a/c
Date
Particulars
Amount Rs.
By Anand’s a/c
78.74
9.00 78.74
78.74
Note: 1. The excess of credit balance of trial balance means that the total of credit is more than debit by Rs69.74 and so the difference is shown on the debit side of suspense account. 2. When amount is paid to Anand, his account should have been debited. On the other hand, his account was credited and that too with a wrong figures. To rectify this double error, Anand’s account has to be debited with Rs.78.74 (Rs.44.37 + 34.37) and the suspense account is credited. 3. Purchases account was over debited by Rs9 and so Purchases account is credited to nullify the effect and suspense account is debited. Sikkim Manipal University
100
Financial and Management Accounting
Unit 6
4. Repairs spent on building are, by mistake, debited to buildings account. This is error of principle. So repairs account is debited and buildings account is credited to rectify the mistake. 5. Discount received from B has not been taken to records. This is an error of omission. Therefore, it is now brought to accounts. This has not affected the trial balance. 6. When old furniture is sold, the furniture account should have been credited. On the other hand, sales account was credited against to the principle of accounting. To rectify the error, sales account is debited and old furniture account is credited. Illustration 2 The trial balance of Evergreen Co Ltd., taken out as on 31 st December, 2002 did not tally and the difference was carried to suspense account. The following errors were detected subsequently. a) Sales book total for November was under cast by Rs1200. b) Purchase of new equipment costing Rs.9475 has been posted to Purchases A/c. c) Discount received Rs1250 and discount allowed Rs850 in September 2002 have been posted to wrong sides of discount account d) A cheque received from Mr Longford for Rs.1500 for goods sold to him on credit earlier, though entered correctly in the cash book has been posted in his account as Rs.1050 e) Stocks worth Rs.255 taken for use of Mr Dayananda, the Managing Director, has been entered in sales day book. f) While carrying forward, the total in Returns Inwards Book has been taken as Rs.674 instead of Rs.647. g) An amount paid to cashier, Mr. Ramachandra, Rs.775 as salary for November month has been debited to his personal account as Rs757. Pass journal entries and draw up the suspense account. Solution Journal Proper of Evergreen Co Ltd., Date
Particulars
31122002 Suspense account Dr
L F
Debit
Credit
Rs.
Rs.
1,200
To Sales account
1,200
(Being under casting of sales book rectified) 31122002 New Equipment account Dr To Purchases account
Sikkim Manipal University
9,475 9,475
101
Financial and Management Accounting
Unit 6
(Being wrong debit given to purchases account rectified) 31122002 Discount allowed account Dr
1,700
Suspense account Dr
800
To Discount received a/c
2,500
(Being discount received and discount allowed posted to wrong sides of discount account rectified) 31122002 Suspense account Dr
450
To Longford account
450
(Being short credit given to Longford rectified) 31122002 Sales account Dr
255
To suspense account
255
(Being stock used for personal purpose wrongly credited to sales account rectified) 31122002 Suspense account Dr
27
To Returns Inwards account
27
(Being excess debit given to returns inwards account to the extent of Rs27, now rectified) 31122002 Salary account Dr
775
To Ramachandra ‘s a/c
757
To Suspense a/c
18
(Being the wrong debit of salary to the personal account of Ramachandra now rectified)
Dr Particulars To sales account
SUSPENSE ACCOUNT Cr Amount Rs. 1,200
To Discount received a/c To Longford
By Sales
800 450
To Returns Inwards a/c Total
Particulars
By Salary By balance c/d
Amount Rs. 255 18 2,204
27 2,477 Total
2,477
Terminal Questions 1. Prepare a trial balance from the following Particulars
Amount Rs.
Particulars
Amount Rs.
Purchases
8,225
Premium on lease
1,200
Wages
1,025
Loan on mortgage
2,500
Sales
12,450
Plant and machinery
2,000
Arun’s capital
13,500
Provision for doubtful debts
Sikkim Manipal University
300 102
Financial and Management Accounting
Stock on 1198
1,500
Unit 6
Sundry debtors
16,550
Salary
410
Trade charges
200
Rent and taxes
162
Bad debts
200
Sundry creditors
2,572
(Ans: Rs .31322). 2. The following Trial balance was extracted from the books Chetan, a small businessman. Do you think that it is correct? If not, rewrite it in the correct form. Debits Stock Purchases
Rs. 8250 12750
Credits
Rs.
Capital
10000
Sales
15900
Returns outwards
700
Returns inwards
1590
Discount received
800
Discount allowed
800
Wages and salaries
2500
Scooty
1750
Rent and rates
1850
Carriage charges
700
Sundry debtors
7600
Sundry Creditors
7250
Bank Overdraft
2450
Bills payable
690
(Ans: Rs. 37,790).
3. Mr. Abhijit was unable to tally Trial balance last year and wrote off the difference to the Suspense account. He appointed a chartered accountant who examined the old books and found the following mistakes. a) Purchase of a cycle was debited to conveyance account Rs.3000 b) Purchase account was over cast by Rs.10000 c) A credit purchase of goods from Padam for Rs4000 was entered as sale. d) Receipt of cash from Allum was posted to the account of Arun Rs.3000 e) Receipt of cash from Cherag was posted to the debit side of his account Rs.6000 f) Rs.1000 due by Mr. Zavahir was omitted to be taken to trial balance. g) Sales of goods to Mr. Rajaram for Rs6000 was omitted to be recorded. h) Payment of Rs.5050 for purchase was wrongly posted as Rs.5500 in purchases account.. Suggest the necessary rectification entries. Prepare suspense account. Answer for Self Assessment Questions Self Assessment Questions 1 1. Final Accounts
Sikkim Manipal University
103
Financial and Management Accounting
Unit 6
2. Trading A/c, P & L A/c, Balance sheet. 3. True 4. True 5. False Self Assessment Questions 2 1. True 2. True Self Assessment Questions 3 1. True 2. Balance method 3. True Self Assessment Questions 4 1. Group all ledger accounts showing debit balance and group all accounts showing credit balance. summaries them total of debit is equal to total of credit. 2. Yes
Self Assessment Questions 5 1. True 2. True 3. True Self Assessment Questions 6 1. True 2. True 3. Rama account should be Debited by Rs 500, Ramanan’s account should be debited by Rs 500 and credit should be given suspense account Rs 1000. 4. Profit – (gross ) is Reduced by Rs 13500. 5. Wages account is credited by Rs 13500 and debit is given to suspense A/c. 6. Telephone expenses account is debited and suspense account is credited 7. Total amount debited to interest account is Rs 2611 + 2161 = 4772. The correct amount by crediting interest account and debiting suspense account with similar amount.
Sikkim Manipal University
104
Financial and Management Accounting
Unit 6
Self Assessment Questions 7 1. Error of commission 2. False 3. Error of omission 4. True 5. True 6. True Self Assessment Questions 8 1. Trial balance. 2. final accounts 3. Error that are disclosed by trial balance and those which cannot be disclosed by trial balance. 4. Error of commission. 5. Error of principle. 6. Omitting completely a transaction from books of original entry. Sales made to Raghu Rs 120 completely ignored. 7. Error of omission, commission, principle, compendating error. 8. suspense account. 9. Journal proper 10. check the total of both sides of trial balance, total debtors & creditors, verify whether balancing is done correctly, check the totals of ledger balances etc. 11. suspense account is debited and sales account is credited. 12. suspense a/c is debited and sales returns a/c is credited. 13. Salary a/c is debited and Gopal a/c is credited. 14. Discount a/c is credited by Rs 100 and suspense a/c is debited 15. This is an error of omission. By checking the original invoice document, it can be rectified. Debit purchases account and credit the creditor’s account. Terminal Question Answers : 1. Refer to unit 6.5 Ans – Rs 31322 2. Refer to Unit 6.5 Ans – Rs 37790 3. Refer to unit 6.10 Ans Suspense A/c Excess debit over Credit is Rs 5450.
Sikkim Manipal University
105
Financial and Management Accounting
Unit 7
Unit 7
Final Accounts
Structure: 7.1
Final Accounts – Introduction Objectives
7.2
Adjustments before preparing final accounts Self Assessment Questions 1 7.2.1 Outstanding expenses Self Assessment Questions 2 7.2.2 Prepaid Expenses Self Assessment Questions 3 7.2.3 Accrued Income Self Assessment Questions 4 7.2.4 Income received in advance Self Assessment Questions 5 7.2.5 Depreciation Self Assessment Questions 6 7.2.6 Bad Debts Self Assessment Questions 7 7.2.7 Provision for Doubtful Debts Self Assessment Questions 8 7.2.8 Reserve for Discount on debtors: Self Assessment Questions 9 7.2.9 Reserve for discount on creditors Self Assessment Questions 10
7.2.10 Closing stock Self Assessment Questions 11
Sikkim Manipal University
105
Financial and Management Accounting
7.3
Unit 7
Trading Account Self Assessment Questions 12
7.4
Preparation of Trading Account Self Assessment Questions 13
7.5
Profit and Loss Account
7.6
Preparation of Profit and Loss Account Self Assessment Questions 14
7.7
Balance Sheet – Meaning Self Assessment Questions 15
7.8
Preparation of Balance Sheet Self Assessment Questions 16 Terminal Questions Answer to SAQs and TQs
7.1 Final Accounts – Introduction The last step of accounting process is preparation of final accounts. Final accounts are Trading account and Profit and Loss Account with respect to any trading organization. If it is non trading organization like a club or an Educational Institution, Receipt and Payment Account and Income and Expenditure Account are the final accounts. In case of a manufacturing unit, a Manufacturing account is prepared in addition to Trading Account. Profit and Loss Account is prepared by all trading and manufacturing units. Balance Sheet is closely associated with these final accounts. But Balance Sheet is not an account. It is a statement of assets and liabilities of business organization prepared at the final stage of the accounting process. Therefore balance sheet is regarded as a part of final accounts. The purpose of preparing final accounts is to find out the end result of business at the end of an accounting period, may it be profit or loss. The basis for preparing final accounts is the Trial Balance. For Trial Balance, the ledger balances are the root. For ledger accounts, the journal entries or entries in the subsidiary books (Books of original entry) are the roots. Hence the final accounts reflect the original business transactions, which are systematically and scientifically recorded, classified, and analyzed. Final accounts provide bundle of information for decision making activities. Learning Objectives: After studying this unit, you should be able to understand the following 1. To know the meaning and purpose of final accounts 2. To identify the items of Trading Account Sikkim Manipal University
106
Financial and Management Accounting
Unit 7
3. To identify the items of Profit and Loss Account 4. To identify the items of assets and liabilities of a Balance Sheet and modes of preparing it. 5. To know the adjustments such as Reserve for bad debts, Reserve for discounts on Debtors, Reserve for discount on Creditors, bad debts out side the trial balance. 6. To understand the adjustments like depreciation on assets, closing stock, stock lost in fire, goods given as samples, goods used for personal purpose etc., 7. To know the adjustments of prepaid expenses, outstanding expenses, pre-received incomes, outstand incomes etc. 8. To prepare Balance Sheet without any adjustments from trial balance. 9. To prepare Balance Sheet with adjustments.
7.2 Adjustments before preparing final accounts The Generally Accepted Accounting Principles (GAAP) supports the accrual basis of accounting, according to which revenue is recognized when it is earned and expenses are recognized when they are incurred, irrespective of their actual receipt or actual payment. If the accrual basis of accounting is used, adjusting entries are required at the end of the period to record any changes in assets, liabilities, revenue incomes, revenue expenses, previously unrecognized. Adjusting entries are regarded as internal transactions. For instance, salaries are paid in advance to a few employees and the excess paid in the current period, should be adjusted to the coming period and what is paid in advance now should not be charged against the revenues relating to the current period. Similarly, insurance paid in advance, rent paid in advance etc., Like wise incomes received in advance should not be considered for the current period. On the other hand, expenses yet to be paid for the current period should be charged against the current period’s income. On the same lines, incomes yet to be received for the current period should be considered as incomes for the current period whether actually received in cash or not. Every asset is subject to wear and tear and the value of the asset gets reduced even if the loss on account of this is not recorded by means of a journal entry. Some stock of goods at the end of the period is left over and it has to be valued and be taken to accounts for fair computation of profit. Such internal adjustments have to be made and recorded before preparing Trading Account, Profit and Loss Account and Balance Sheet. The adjustments to be incorporated are briefly described in the following paragraphs.
Sikkim Manipal University
107
Financial and Management Accounting
Unit 7
Self Assessment Questions 1 1. Final account are prepared from trial balance, trial balance from ledger accounts and ledger account from books of original entry. So final accounts are reflection of original transaction (state True / False ). 2. Final accounts speak about profit or loss as on a particular day ( state True and False ) 3. Balance sheet tells the value of assets and liability as standing an a the last day of accounting period ? ( True / False ) 4. Adjustment in final accounts is necessitated because of accrual basis of accounting (state True / False ). 5. Adjusting entries are also regarded as ______ . 6. Adjustments such as outstanding and prepaid / received items are needed to find out _____________. 7. Adjustment entries are made before preparing tracking and P & L and balance sheet (True/False ). 7.2.1 Outstanding expenses Expenses due but not yet paid are known as outstanding expenses. Wages, salaries, rent, commission etc payable in the current month are paid in the following month. If final accounts are prepared for year ending 31st December, then the expenses payable for December will be paid in January of next year. The extent to which the amount belongs to the current year but payable in the next year is called outstanding expenses. To record that aspect, the journal entry drawn in the Journal proper is: Concerned Expenses account Dr To outstanding Expenses account. Outstanding expenses account indicates liability for the current year and it will appear in the balance sheet. Example: Advertisement expenses for year 31-12-2003 outstanding is Rs.5000. The journal entry is Advertisement expenses account
Dr
To Outstanding expenses account
5000 5000
Self Assessment Questions 2 1. Expenses due but not yet paid are known as ___________. 2. What is the entry if salaries are outstanding ? Sikkim Manipal University
108
Financial and Management Accounting
Unit 7
3. If ‘outstanding expenses’ appear in trial balance, what does it mean ? 4. Outstanding expenses appear an assets side of balance sheet ( state True / False ). 7.2.2 Prepaid Expenses Expenses paid in advance are regarded as prepaid expenses. Prepaid expenses form an asset and therefore prepaid expenses account is debited. For example, insurance premium is paid from April, 2004 to March, 2005 and the amount is Rs.3600. The financial year ends by 31st December, 2004. Therefore the premium relating to Jan, Feb and Mar of 2005 Rs.900 is said to have been paid in advance. To record this internal adjustment, the entry is Prepaid Expenses account
Dr 900
To Insurance account
900
Note that outstanding or prepaid expenses accounts are regarded as personal accounts. Self Assessment Questions 3 1. Expenses paid even before incurred. They are know as _____. 2. Prepaid expenses appear on the asset side of balance sheet. ( state True / False). 3. Opening balance of prepaid insurance is Rs 1000; insurance paid during the year Rs. 5600; Insurance paid in advance include in the above is Rs 800: Find out actual expenditure for insurance for the current year. 4. Prepaid expenses account is a personal account ( True / False). 7.2.3 Accrued Income Accrued income is also called outstanding income. Outstanding income account is a personal account and it represents an asset. This account is credited and the concerned income account is debited in the journal proper as an adjusting entry. The entry is Outstanding incomes account Dr To Concerned income account Example Interest accrued on Fixed Deposit of Rs 200000 at 12% simple interest on 31-12-2006, not yet received. The entry is Outstanding incomes account
Dr
To interest on FD account
24,000 24,000
Outstanding Income account appears as an asset in the balance sheet. Self Assessment Questions 4 1. Income earned but not received is called ____________.
Sikkim Manipal University
109
Financial and Management Accounting
Unit 7
2. Outstanding income is an asset ( state True / False ). 3. Outstanding income is a personal account. (True / False ). 7.2.4 Income received in advance Just as income is accrued, there are instances where income is received in advance. The amount is shown as liability in the balance sheet and it shows a credit balance. The adjusting entry to record the income received in advance is Concerned item of income account Dr To Income received in advance account Example Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts are finalized on 3112-2005. Therefore rent received for January, February and March of 2006 is said to have been received in advance Rs.12000. The entry is Rent received account Dr
12000
To Income received in advance a/c
12000
Self Assessment Questions 5 1. Any income received in advance is a liability (state True / False ). 2. What is the adjusting entry for rent received in advance ? 3. Income received in advance in the current year is ________ from the unearned item of income received. 7.2.5 Depreciation Depreciation is reduction in the value of an asset due to constant use of the same, which is called wear and tear. Fixed assets like, buildings, plant, machinery, furniture etc., are subject to depreciation. Whenever, an asset is depreciated, its value goes down and therefore it is a loss to the organization. Depreciation account is debited and the concerned asset account is credited. The item of depreciation may appear in the trial balance, which means that already the concerned asset is reduced by the amount of depreciation. If depreciation is given as an additional adjustment, then the depreciation amount should be charged against profit and loss account on one hand and the concerned asset account is reduced on the other hand in the balance sheet. There are two popular methods of depreciation, namely fixed installment method and reducing balance method. In fixed installment method, depreciation is calculated on cost of the asset. In case of reducing balance method (Diminishing balance method), the depreciation is charged on Sikkim Manipal University
110
Financial and Management Accounting
Unit 7
the reducing balance of the book value of the asset. Reducing balance method is more popular and well recognized. Example Building is of the book value of Rs.400000. It is depreciated at 10% on fixed installment method. Show the journal entry and how does it appear in the balance sheet? Solution The entry for depreciation is Depreciation account
Dr 40,000
To Building account
40,000
Depreciation being a loss is transferred to profit and loss account and in the balance sheet, the value of Building is shown as Rs.400000 – 40000 = 360000. Note: For the second year the depreciation will be Rs.40000 if the asset is depreciated under fixed installment method. If it is depreciated under reducing balance method, the depreciation for the second year is Rs.36000 (10% of 360000). Self Assessment Questions 6 1. Depreciation is for __________ of an asset. 2. What entry is drawn if depreciation is provided ? 3. When depreciation account is transferred to P & L A/c , what entry do you draw ? 4. If depreciation to be provided in the adjustments, what do you understand by this ? 5. What is the method of depreciation recognized by Indian Income Tax Act? 6. If depreciation appears in the trial balance, what does it indicate ? 7.2.6 Bad Debts Bad debts are those debts which are not recovered. Bad debts form loss to the business and reduce the amount of debtors. Since bad debts are losses, they are debited and the debtor’s account is credited because the outstanding amount of debtors comes down. If bad debts are identified well before preparing trial balance, then bad debts appear in the trial balance and they should be taken to the debit side of profit and loss account. Since debtors account is already reduced by the amount of bad debts, it does not require any further adjustment in the balance sheet. If bad debts are shown outside the trial balance, which means that they are identified after the preparation of Trial Balance, then two adjustments should be incorporated. One – bad debts
Sikkim Manipal University
111
Financial and Management Accounting
Unit 7
should be charged against profits in P & L A/C and the second – the debtor’s account should be reduced by the amount of bad debts in the balance sheet on the asset side. Example The sundry debtors for the year 2005 are Rs.50000. The bad debts amounted to Rs.4000 as on 31-12-2005 already shown in the trail balance. Write off further bad debts Rs5000. Show how the above internal adjustments appear in the final accounts. Solution •
There are bad debts shown in the trial balance Rs4000 and not shown in the trial balance Rs.5000. To incorporate those bad debts not yet shown in the trial balance, the adjusting entry is Bad debts account
Dr
5000
To Debtor’s account •
5000
In the profit and loss account of 2005, the total bad debts appearing on the debit side are Rs. 9000(4000 + 5000)
•
In the balance sheet, on the asset side, the amount of debtors is Rs45000(50000 -5000).
Self Assessment Questions 7 1. Unrecovered debts are called ______. 2. Bad debts are not expenses but they form losses. (state True / false ) 3. What is the entry made in journal proper, if bad debts are recorded. 4. What entry do you make to close the bad debts ? 5. What impact bad debts have on profits ? 6. If bad debts are recovered, what entry can be drawn ? 7.2.7 Provision for Doubtful Debts Debts that can not be recovered are called bad debts but debts, the recovery of which is doubtful, are called doubtful debts. From the past experience of the business proprietor, what percentage of good debts may become bad in future, can be estimated and in the current year itself an equal amount of profit be set aside. This provision is known as Reserve for Bad Debts or Provision for Doubtful Debts or Reserve for Doubtful Debts. Since the provision for bad debts is a charge against current year profit, the adjusting entry is to debit P & L A/C and credit Provision for Bad Debts Account. Profit and Loss Account
Dr
To Provision for bad debts account
Sikkim Manipal University
112
Financial and Management Accounting
Unit 7
Provision for bad debts is a liability to be incurred in future and so it should appear on the liability side of balance sheet. However, the convention is - RBD (Reserve for Bad and Doubtful Debts) is deducted from the amount of good debtors. The important note here is that RBD is computed as a percentage of good debts, which means total debtors minus bad debts unadjusted. Provision for bad and doubtful debts is a running account and every year the amount keeps on changing because from the provision made in the current year, bad debts occurring in the following year have to be adjusted and additional amount of provision to be made is calculated. Every year, the amount transferred to P & L A/C is B + N – O, where B stands for bad debts; N stands for new provision and O stands for old reserve. For example, the old reserve stands at Rs.15000 and bad debts to be adjusted is Rs4000 and new reserve to be maintained is Rs18000. The amount to be charged against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The formula can also be shown as N - O + B = 18000 – 15000 + 4000 = 7000 Self Assessment Questions 8 1. What is the difference between Bad debts and doubtful debts? 2. Provision is made for Debts which have become bad (state True / False ). 3. Provision for Doubtful debts is a change against the profits of the firm (state True / False ) 4. Bad debts incurred in the subsequent period are written off against reserve for bad debts (state True / False ). 5. What is the entry for writing off of bad debts against RBD? 6. If RBD is fresly to be provided, what entry can be draw? 7. RBD is calculated on debtors which are good and so any bad debts out side trial balance should be deducted out of total debtors (state True / False ). Illustration: On 1st January 2006, the RBD account stood at Rs.9000 in the books of a merchant. The bad debts written off during the year ended 31st December, 2006 amounted to Rs.4800 and Sundry Debtors stood at Rs.480000. It was desired to maintain the reserve for bad debts at 5% on Debtors. During the year 2007 bad debts written off amounted to Rs.12000 and sundry debtors on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was required. Show the journal entries for recording the above transactions and write up the bad debts reserve account.
Sikkim Manipal University
113
Financial and Management Accounting
Unit 7
Solution Journal Entries Date
Particulars
2006
LF
Bad debts account st
Dec, 31
Dr
Debit
Credit
Rs.
Rs.
4800 4800
To Sundry Debtors Account (Being the bad debts written off)
Dec, 31st
Bad Debts Reserve account Dr To Bad Debts account
4800
4800
(Being bad debts set off against RBD) Dec 31
st
Profit and Loss Account
Dr
19800
To Bad Debts Reserve account (Being additional RBD made to bring the
19800
reserve to 5% of 480000) 2007 Dec, 31st Dec 31
st
Bad debts account Dr To Sundry Debtors account
12000 12000
(Being bad debts written off ) Bad debts Reserve account Dr To bad debts account
12000
12000
(Being bad debts written off against RBD) Profit and loss Account Dec 31st
Dr
To Bad debts reserve account (Being additional RBD made to bring the reserve to 5% of 380000)
7000
7000
NOTE: On January 1st 2006, the RBD account stands at Rs9000 and during the year the actual bad debts are Rs4800 and so there is unused balance of Rs.4200 (9000 -4800). It is desirable to have reserve of 5% of 480000 – Rs24000. Therefore additional reserve required to be provided in P & L A/C is Rs19800 (24000 – 4200). Similarly during 2007 the actual bad debts are Rs.12000 and the available reserve is used for writing it off. Still there is a balance left over is Rs.12000 (24000 – 12000). The additional reserve to be maintained is 5% of 380000, that comes to Rs19000. So the additional amount to be provided in P & L A/C in 2007 is Rs.7000 (19000 – 12000).
Sikkim Manipal University
114
Financial and Management Accounting
Unit 7
Reserve for Bad Debts Account Dr
Cr
Date
Particulars
JF
Amount Rs.
Date
Particulars
JF
Amount Rs.
2006
2006 st
Dec, 31
To bad debts
4800
To balance c/d
24000
Total
28800
2007 Dec,31st
Jan, 1st
By Balance b/d
Dec 31st
By P&L A/C
19800
Total
28800
By balance b/d
24000
2007
9000
st
To bad debts
12000
Jan 1
To balance c/d
19000
Dec 31st
Total
31000
By P&L A/C Total
7000 31000
7.2.8 Reserve for Discount on debtors: There are two types of discounts allowed to customers in a business. One is trade discount and another is cash discount. Trade discount is given to customers to retain the customers and it is shown in the invoice itself. It means that trade discount does not come to accounting records at all. But cash discount is allowed to customers to encourage them to pay cash promptly at the earliest. Normally cash discount gets recorded in cash account. Out of experience, a businessman can guess how much of cash discount he may have to give on customer’s accounts. Cash discount given to debtors is always a loss and is shown as expenditure in the Profit and Loss Account. After anticipating the amount of cash discount allowable, a provision is made in the current year itself. In the subsequent years, the actual discount allowed is set off against the provision for discount on debtors. Every year, the amount of provision for discount on debtors is deducted from the profits. The entry for making the provision is Profit and Loss Account
Dr
To Provision for discount on debtors account Just as in the case of provision for bad and doubtful debts, the bad debts are first written off against provision for bad debts and later the required amount of provision is provided in the P&L A/c, similar procedure takes place in the case of provision for discount on debtors. The following guide lines may be kept in mind while dealing with the reserve for discount on debtors 1. If a reserve for discount on debtors is not existing and cash discount is allowed, then transfer the discount to P&L account. 2. Any fresh reserve for discount on debtors is to be made, debit the P&L A ccount with the amount of reserve.
Sikkim Manipal University
115
Financial and Management Accounting
Unit 7
3. If provision for discount on debtors exists at the time of providing discount, then write off the discount from the provision already made for the purpose. 4. New provision should then be calculated and only as much as required to bring the existing provision to the new figure should be debited to P&L Account. 5. If the new provision required is lower than the provision already existing (old), then the difference shows profit and transfer the same to P&L Account. Self Assessment Questions 9 1. what is the aim of giving cash discount ? 2. If discount is allowed against receivables, what entry do you draw in journal proper? 3. Provision for Discount on debtors is a charge against P & L a/c. (state True / False). 4. Provision for discount on debtors appears as a liablility in the balance sheet ( state True / False ) 5. What is the basis for calculating provision for discount an debtors? Illustration The following items are found in the trial balance of Praksh on 31st December 2000. Sundry Debtors
Rs. 160000
Bad Debts written off
9000
Discount allowed to Debtors
1800
Reserve for Bad and doubtful Debts 31-12-1999 Reserve for discount on Debtors 31-12-1999
16500 3200
You are required to provide for the bad and doubtful debts at 5% and for discount on debtors at 2%. Give necessary journal entries and show bad debts account, bad debts reserve account, discount account and provision for discount on debtors account. Solution Date 2000 31st
Particulars Dec, RBD account
LF
Debit
Credit
Rs.
Rs.
Dr
To Bad Debts account
9000 9000
(Being bad debts written off against existing RBD) P & L Account Dr To RBD account Dec 31st
(Being addition to RBD to make the new RBD equal to 5% of 160000)
Sikkim Manipal University
500
116
Financial and Management Accounting
Unit 7
500 Reserve for discount on debtors account
Dr
To Discount on Drs A/c Dec 31
st
(Being discount on debtors written off against Reserve for discount on Debtors) P & L Account
1800
1800
Dr
To Reserve for discount Dec 31st
On debtors account ( Being additional reserve made to make the new reserve for discount on debtors to 2% of 152000)
1640 1640
NOTE: 1. The amount debited to P&L Account towards RBD is computed as follows Old RBD Less Bad debts
= =
Rs.
Balance = New RBD @5% on160000 = RBD to be provided
=
16500 9000 7500 8000
500 (8000-7500)
2. The amount debited to P&L Account towards Reserve for Discount on Debtors is computed as follows: Good Debtors
=
160000 – 8000 (New RBD)=152000
Old Res for Dis On Drs Less Discount on Drs
= =
Rs. 3200 1800
Balance Reserve New Res for Disc at 2% On good drs 152000 Res for Discount to be
=
1400
=
3040
Provided now
=
1640 (3040 -1400)
Bad Debts Account Dr
Cr
Date
Particulars
JF
Amount Rs.
Date
Particulars
JF
Amount Rs.
2000
2000 st
Dec, 31
To Sundry debtors account
9000
Total
9000
Sikkim Manipal University
Dec 31st By RBD account 9000 Total
9000
117
Financial and Management Accounting
Unit 7
Reserve for Bad Debts Account Dr
Cr
Date
Particulars
JF
Amount Date
Particulars
JF
Rs.
Amount Rs.
2000
2000 st
Dec, 31
To bad debts
9000
To balance c/d
8000
Total
Jan, 1st
By Balance b/d
Dec 31st
16500
By P&L A/C
17000
500
Total
17000
Discount on Debtors Account Dr
Cr Date
Particulars
JF
Amount Rs.
2000
Date
Particulars
JF
Amount Rs.
2000 st
Dec, 31
To Sundry debtors account Total
Dec 31st 1800
By Reserve for Discount on Debtors A/C
1800
1800
Total
1800
Reserve for Discount on Debtors Account Dr
Cr Date
Particulars
JF
2000 Dec, 31st To Discount on Debtors To balance c/d Total
Amount Rs. 1800 3040 4840
Date
Particulars
2000 Jan, 1st By Balance b/d Dec 31st By P&L A/C Total
JF
Amount Rs. 3200 1640 4840
In the balance sheet, the Sundry debtors are reduced by bad debts shown out side the trial balance, the new RBD, discount on debtors shown out side the trial balance and the new Reserve for discount on debtors. 7.2.9 Reserve for discount on creditors Just as reserve is for discount on debtors is created, reserve for discount on creditors is also created. Businessman expects that he would receive discounts from suppliers (creditors), when the businessman remits cash to them. Anticipating some percentage of creditors being received as discount in the coming year, the business proprietor makes a provision for the expected income in the current year itself. Discount on creditors is an income and therefore reserve for Sikkim Manipal University
118
Financial and Management Accounting
Unit 7
discount on creditors is debited and profit and loss account is credited to show it as anticipated profit. In the subsequent year, when discount on creditors is actually received, it is first set of against provision for discount on creditors and the difference between the new provision for discount on creditors and the balance of old provision left over is carried to P&L Account. Discount on creditors is income and to that extent the creditors due is reduced. So the journal entry to record them is Creditor’s account
Dr
To discount on creditors account Later if the discount received is adjusted against reserve for discount on creditors, the entry will be Discount on creditor’s account
Dr
To Reserve for discount on creditors When provision for discount on creditors is made in P&L Account, the entry will be Reserve for discount on creditors account Dr To Profit and loss account The amount of provision for discount on creditors is calculated at a percentage on creditors. In the balance sheet, creditors are shown after deducting reserve for discount on creditors. Self Assessment Questions 10 1. Discount on creditors is an item of income (state True / false ). 2. Provision for discount on creditors is shown as an anticipated income (State True/False ). 3. How do you treat provision for discount an creditors in balance sheet ? 4. Discount received from creditors subsequently is changed against provision for discount on creditors. (state True / False ). 7.2.10 Closing stock Stock of goods – raw materials, semi finished goods, finished goods – at the end of the accounting year should be considered for preparing trading account and balance sheet. It is an internal adjustment. Closing stock is normally valued at cost or market price which ever is lower, even though there are several other methods to value stock. Closing stock does not appear in the trial balance because the value of it is ascertained only after the preparation of trial balance. To bring to the records, a journal entry is passed in journal proper by debiting closing stock account and crediting trading account. In the balance sheet, closing stock appears as an asset.
Sikkim Manipal University
119
Financial and Management Accounting
Unit 7
Self Assessment Questions 11 6. what is the popular valuation method of closing stock ? 7. what is the entry for adjusting the closing stock ? 8. what does happen in case closing stock is not considered for computing gross profit ? 9. Closing stock always appears as an asset in balance sheet. (state True / false).
7.3 Trading Account Trading account shows gross profit or gross loss arising out of trading activities. Trade means buying and selling. The account mainly focuses on finding the result of goods bought and goods sold. Interestingly, goods are bought for a cost and the proprietor incurs a few items of purchase expenses and the goods are sold at a price higher or lower than the cost incurred. At the end of accounting period, some stock is left over and it should be valued so as to calculate the profit or loss from the cost of goods sold. Therefore, opening stock of goods, cost of purchases made, expenses on purchases are taken on debit side of the trading account. On the credit side of the account, the sales of goods and the value of closing stock are shown. The excess of credit over debit is gross profit and vice versa. The gross profit or gross loss is transferred to Profit and Loss Account. The format of a Trading Account is given below: Dr
Trading Account for the year ending- - - -
Particulars To opening stock To Purchases Less Purchase returns/returns outwards
Rs.
Particulars By sales Less returns inwards/sales returns By Closing stock
Cr Rs.
To Carriage inwards To freight and octroi To wages Add outstanding wages Less prepaid wages To fuel and power To Gas, coal, electricity for production To Import duty and clearing charges To stores consumed To factory rent, insurance, factory expenses To other direct expenses To Royalty paid To Profit and Loss A/c (Gross Profit)
Note: For every expenditure, outstanding and prepaid aspects must be considered.
Sikkim Manipal University
120
Financial and Management Accounting
Unit 7
From the above account, it is easy to learn the transferring entries made to close the accounts of expenses and incomes. The transferring entries are 1. Trading account
Dr
To opening stock a/c To purchases a/c/ To Wages a/c To Royalty paid a/c etc (Being all expenses of trading transferred to trading account) 2. Sales account
Dr
Closing stock account
Dr
To Trading account (Being sales and closing stock transferred to trading account) 3. Trading account
Dr
To Profit and Loss Account (Being gross profit carried forward to P&L A/C) 4. Profit and Loss Account
Dr
To Trading account (Being gross loss transferred to P&L Account) Self Assessment Questions 12 1. Trading account is an account showing profit on cost of goods sold.( state True / False). 2. Cost of goods sold include opening stock + Purchase expenses – closing stock. (state True/ False ). 3. Gross profit is ______minus cost of goods sold. 4. Gross profit or loss is transferred to ___________ account.
7.4 Preparation of Trading Account To prepare Trading Account, the following steps may be followed: a) Identify the items of expenses relating to trading and show them on the debit side of Trading Account. b) Effect the adjustments such as outstanding or prepaid to the relevant items of expenses c) Show the sales less returns and closing stock on the credit side of trading account
Sikkim Manipal University
121
Financial and Management Accounting
Unit 7
d) The difference is gross profit if credit total is more than debit and gross loss if debit total is more than credit. e) Transfer the gross profit or gross los to Profit and Loss Account as the case may be. Self Assessment Questions 13 1. Do you consider gross purchases or net purchases while preparing trading account ? 2. Do trading concerns prepare manufacturing account ? Illustration From the following balances extracted from Trial balance, prepare Trading Account. The closing stock at the end of the period is Rs56000
Particulars Stock on 1-1-2004 Returns inwards Returns outwards Purchases
Amount in Rs. 70700 2000 3000 102000
Debtors
56000
Creditors
45000
Carriage inwards
5000
Carriage outwards
4000
Import duty on materials received from abroad
6000
Clearing charges
7000
Rent of business shop
12000
Royalty paid to extract materials
10000
Fire insurance on stock
2000
Wages paid to workers
8000
Office salaries
10000
Cash discount
1000
Gas, electricity and water
4000
Sales
Sikkim Manipal University
250000
122
Financial and Management Accounting
Dr
TRADING ACCOUNT FOR THE YEAR ENDING - - - -
Particulars
Rs
To stock on 1-1-2004 To Purchases
Unit 7
Particulars 70700
102000
Inwards 3000
To Carriage inwards To import duty To Clearing charges To Royalty To Fire Insurance To Wages To Gas, electricity, water To P & L Account (GP)
Rs 250000
Less Returns
Less Returns Outwards
By sales
Cr
99000
3000
By Closing stock
247000 56000
5000 6000 7000 10000 2000 8000 4000 91300
303000
303000
7.5 Profit and Loss Account Profit and los account is an important final account in the sense that the net result of the business in the form of net profit or net loss is disclosed by preparing the same. All business expenses like administrative expenses, office expenses, selling and distribution expenses are shown on the debit side of the account. Besides, all provisions made for different purposes such as reserve for bad debts, reserve for discount on debtors, reserve for repairs, depreciation etc., also picture on the debit side of the account. On the credit side of the account, all incomes of revenue in nature, reserve for discount on creditors and gross profit carried from trading account are mentioned. In this connection, it is important to note that Trading and Profit and Loss Account are regarded as revenue accounts. Any capital receipts or capital payments are not considered while preparing them. In brief, revenue receipts are those which are received regularly arising out of day to day activities of the business and similarly revenue payments, which are known as expenses are incurred regularly and for every day functions of the business. Capital receipts are in the form of Sikkim Manipal University
123
Financial and Management Accounting
Unit 7
sources of funds such as capital received, sale of capital asset like building etc., Capital payments are those spent for acquisition of capital assets, incurring capital expenditure etc., The transferring entries are drawn to prepare Profit and loss account. They are 1. Profit and Loss Account Dr To all expenses account 2. All Incomes account
To Transfer all expenses
Dr
To Profit and Loss Account 3. Profit and Loss Account
To Transfer all incomes
Dr
To Capital account
To Transfer Net Profit to Capital
4. Capital account
Dr
To Profit and Loss Account
To Transfer Net loss to Capital
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING --Dr
Cr
Particulars
Rs
Particulars
Rs
To Trading Account (GL)
By Trading account (GP)
To Salaries + Out standing
By
–Prepaid salaries as per
Accrued
adjustments
adjustments
To Rent of the premises
By Commission earned
To Travelling expenses
By discount earned
To Rates and Taxes
By Rent received
To Printing and stationery
By Bad debts recovered
To Postage and Telegram
By Interest on drawings
To Telephone charges
By Reserve for discount on
To
Creditors
Insurance
–Prepaid
Interest
earned
interest
as
+ per
amount as per adjustment
By Dividends received
To Interest paid
By Royalty Received
To Discount allowed
By Capital Account( Net
To Sundry expenses
Loss)
To Advertisement
Sikkim Manipal University
124
Financial and Management Accounting
Unit 7
To Commission To Carriage outwards To Bad Debts To Reserve for Bad debts To Reserve for discount on Debtors To Depreciation To Legal charges To Audit fee To Interest on Capital To Capital Account (Net Profit)
7.6 Preparation of Profit and Loss Account The following steps may help to prepare Profit and Loss Account 1. Identify the expenses and bring them to debit side of P&L Account 2. Identify the revenue incomes and put them on the credit side of P&L Account 3. Check whether all adjustments like outstanding, prepaid, pre received expenses and incomes as the case may be are brought to the account 4. Check the transfer of reserves to the relevant sides of the account 5. Transfer the net profit / net loss to the capital account Self Assessment Questions 14 1. What types of expenses are shown on the debit side of P & L account ? 2. P & L account is revenue account showing the revenue net profit or loss for the accounting period(state True / False ). 3. Painting for a new building, Installation expenses paid to install a plant, amount spent for advertising for promotion of sale of a product are revenue expenses (state True / False ). 4. Net profit / loss is carried to owners equity / capital (state True / False )
Sikkim Manipal University
125
Financial and Management Accounting
Unit 7
Illustration The following Trial Balance is extracted from the books of a merchant on 31-12-2004. Rs
Particulars Furniture and fittings
640
Motor Vehicles
6250
Buildings
7500
Capital Account
12500
Bad Debts
125
Provision for Bad debts
200
Sundry Debtors
3800
Sundry Creditors
2500
Stock on 1-1-2004
3460
Purchases
5475
Sales
15450
Bank Over Draft
2850
Sales Returns
200
Purchase Returns
125
Advertising
450
Interest on Bank Over Draft
118
Commission
375
Cash
650
Taxes and Insurance
1250
General Expenses
782
Salaries
3300
The following adjustments are to be made. 1. Stock in hand on 31-12-2004 was Rs3250 2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and Motor Vehicles @ 20%. 3. Rs.85 is due for interest on bank overdraft. 4. Salaries of Rs300 and taxes Rs.120 are outstanding. 5. Insurance amounting to Rs.100 is prepaid 6. One-third of the commission received is in respect of work to be done next year Sikkim Manipal University
126
Financial and Management Accounting
Unit 7
7. Write off a further sum of Rs.100 as bad debts and provision for bad and doubtful debts to be made equal to 10% on sundry debtors. 8. Prepare Trading Account and Profit and Loss Account. 9.
Dr
Trading Account for the year ending 31-12-2004
Particulars
Rs
To Stock on1-1-2004
3460 By Sales 15450
To Purchases
Particulars
5475
Les Returns 200
125
5350 By Closing Stock
Less returns To P & L A/C (GP)
Cr Rs
15250 3250
9690
Total
18500 Total
18500
Profit and Loss Account for the year ending 31-12-2004 Dr
Cr
Particulars To Salaries Add Outstanding
Rs Particulars 3300 300
To Advertising To Interest on OD Add Outstanding Int
Rs
By Trading Account (GP) 3600 By Commission
375
9690
450 Less Pre-received 125 118 85
To Taxes and Insurance
1250
Add Out standing tax
120
250 203
1370 Less Prepaid Insurance
100
1270
To General expenses
782
To bad debts
125
To RBD(New) Less old RBD balance
370 100
270
To Depreciation: On Bldgs @ 5% On FF
@ 10%
375 64
On M Vehicles @20% 1250
1689
To Capital Account (NP)
1551
Total
9940 Total
Sikkim Manipal University
9940
127
Financial and Management Accounting
Unit 7
Note: Sundry Debtors are Rs.3800 and there have been bad debts outside TB Rs100. The good debtors are Rs.3700. The new RBD is 10% of 3700, i.e.Rs370. The old RBD unspent is Rs100 (200 -100). Therefore RBD to be charged against profit is Rs270
7.7 Balance Sheet Balance Sheet is the sum and substance of financial performance a business undertaking. It shows the assets and liabilities of business on a particular day. It is not an account but is a statement of affairs. The statement of assets and liabilities is prepared, having two sides, left side containing capital and liabilities and on the right side, containing assets and properties. Often the statement is prepared vertically, mentioning sources of funds first and later application of funds. Sources of funds indicate capital and liabilities and application of funds indicate assets. Balance Sheet is prepared from Trial Balance. In case of sole trader organization and Partnership organization, the format of preparing Balance Sheet is arranged basing on liquidity of the assets. In case of Companies, the Companies Act, 1956 has specified a definite pattern of preparing Balance Sheet. Both the models of preparing Balance Sheet are stated here under. BALANCE SHEET FOR THE YEAR ENDING 31-12-2003 OF Mr. X Capital and Liabilities Sundry Creditors Less Reserve for Discount on Creditors Bills Payable Bank Over Draft Loans Borrowed Outstanding Expenses Pre-received Incomes Capital (Opening) Add Additions to capital Add interest on capital if any Add Net profit as per P&L a/c Less personal drawings Less Net loss as per P&L A/C
Total Sikkim Manipal University
Rs
Assets
Rs
Cash in hand Cash at Bank Land and Building Add Additions if any Less depreciation Plant and Machinery less depreciation Furniture and Fixtures less depreciation Sundry debtors Less Bad debts out side Trial Balance Less Reserve for Bad Debts Less Reserve for discount on Debtors Bills Receivable Loans and advances given to others + Interest outstanding Investments + outstanding income on investments Other outstanding incomes Pre-paid expenses Closing stock Total 128
Financial and Management Accounting
Unit 7
The Format of Balance Sheet of a Company Capital and Liabilities
Rs
Assets
Capital:
Fixed Assets:
Authorised, Issued,
Goodwill, Land
Subscribed,Called up,
Buildings,Furniture, Fixtures,
Paid-Up capital with
Equipment, Plant, Machinery,
adjustments
Copy Rights, Patents
Reserves and Surplus
Investments
Loans and Borrowings
Loans and Advances
Long Term Loans
Current Assets:
Short Term Loans
Debtors, B/R, Inventory,
Current Liabilities:
Cash, Bank, Outstanding
Sundry Creditors, B/P,
incomes, Prepaid expenses
Outstanding expenses, pre-
etc
Rs
received incomes, dividends payable, etc., Total
Total
Self Assessment Questions 15 1. The two sides of a balance sheets are ____ and ___________. 2. balance sheet is prepared on the bases of trial balance. (state True / False ). 3. balance sheet portrays the financial soundness of a concern (state True / False).
7.8 Preparation of Balance Sheet: A few guide lines are given here under to prepare balance Sheet of a business concern. Balance Sheet is not an account and there is nothing like debit side and credit side. If Trial Balance tallies, naturally Balance Sheet also tallies: 1. Identify all assets from the trial balance. Assets are shown on the debit side of T.B 2. Identify all liabilities from the Trial Balance and they are on the credit side of TB. 3. Make a mark of items with respect to which adjustments are given out side the TB 4. All adjustments should find place in two places, one either in Trading account or in Profit and Loss Account and another invariably Balance Sheet. For example, closing Stock given outside TB is first shown on the credit side of Trading Account and it is shown as an asset in
Sikkim Manipal University
129
Financial and Management Accounting
Unit 7
the Balance Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and later shown as a deduction from Sundry Debtors in the Balance Sheet. Similarly depreciation is charged against profits first and later deducted from the book value of concerned asset in the balance sheet. Illustration 1 From the Trial Balance given in para 6, prepare Balance Sheet of the merchant as on 31-122004. Solution Balance Sheet as on 31-12-2004 Capital and Liabilities Sundry Creditors Bank Over Draft
Assets
Rs 2500
Add interest due
85
Cash Building
2850 2935
Commission received in
Rs 650 7500
Less Depreciation
375
Furniture and Fixtures 640
advance
125
Less Depreciation
Outstanding Taxes
120
Motor Vehicle
Outstanding Salaries
300
Less Depreciation
1250
Sundry Debtors
3800
Capital Add Net Profit
7125
12500 1551
14051
64
576
6250 5000
Less bad debts as per Adjustments
100
Balance
3700
Less Reserve for Bad Debts(New) Closing Stock Pre-Paid Insurance
Total
20031 Total
370
3330 3250 100
20031
NOTE: Every adjustment given outside Trial Balance finds place in two accounts –Trading account / Profit and Loss Account and invariably in Balance Sheet.
Sikkim Manipal University
130
Financial and Management Accounting
Unit 7
Self Assessment Questions 16 1. What is the purpose of creating Reserve for Bad debts? 2. State the purpose of creating reserve for discount on creditors. 3. Insurance paid on 1-1-2000 up to 31-12-2000 Rs.4800. If the books are closed on 31-7-2000, what is the amount of prepaid insurance? 4. Select the most appropriate answer. i) Sales are equal to a) Cost of goods sold + Profit b) Cost of goods Sold – Gross Profit c) Gross Profit – Cost of Goods sold ii) Interest on Drawings is
a) Expenditure for the business
b) Expense for the business
c) Gain for the business iii) Goods given as samples should be credited to a) Advertisement account b) Sales account
c) Purchases account
iv) Out standing salaries are shown as a) an expense
b) a liability c) an asset
v) Income tax paid by a sole trader on his business income should be a) debited to the Trading Account b) debited to P&L Account c) deducted from capital account in the Balance Sheet 5. Stock at the end, if appears in the Trial Balance is taken only to the Balance Sheet – Yes or No? 6. Goods taken by the proprietor for personal use are credited to sales account – Yes or No? 7. Salary paid in advance is not an expense because it neither reduces assets nor increases liabilities. – Yes or No? 8. Balance Sheet is an account because it is included in the scope of final accounts – Yes or No Terminal Questions. 1. In taking out a Trial Balance, a Book keeper finds that debit total exceeds the credit total by Rs.611. The amount is placed to the credit of a newly opened Suspense Account. Subsequently the following mistakes were discovered. You are required to pass the necessary entries for rectifying the mistakes, and show how Suspense account. (a) Sales day book was over cast by Rs.1000 (b) A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna (c) General expenses Rs.180 were posted as 801 (d) Cash received from Bhatt was debited to his account RS.450 (e) While carrying forward the total from one page of the Purchases book to the next, the amount of Rs.1235 was entered as Rs.1325.
Sikkim Manipal University
131
Financial and Management Accounting
Unit 7
2. Rectify the following errors: (i) Furniture purchases for Rs.2500 was debited to Purchases account (ii) A sum of Rs.500 paid to Lalitha was debited to Shantha (iii) A bill receivable for Rs.1000 received from Kumar has been omitted to be entered. (iv) Goods worth Rs2040 taken away by the proprietor were debited to Bharath (v) An engine purchased for Rs.12500 had been posted to Purchases account 3. An accountant could not tally the Trial Balance. The difference was temporarily transferred to Suspense account for preparing the final accounts. The following errors were later discovered. (a) The sales book was under cast by Rs.500 (b) Entertainment expenses Rs.950 though entered in the cash book were omitted to be posted in the ledger. (c) Discount column of the receipt side of cash book was wrongly added as Rs114 instead of Rs.144. (d) Commission of Rs.250 paid, was posted twice, once to discount account and once to Commission account. (e) A sale of Rs.169 to Rama Murthy though correctly entered in sales book, was posted wrongly to his account as Rs.196. (f) A purchase from Neeraj of Rs.290 though correctly entered in purchases book was wrongly debited to his personal account. You are required to 1. Pass the necessary rectifying entries 2. Prepare Suspense account 3. State the effect of each of the rectification on the profit. What would be the correct profit originally arrived at was Rs.10000? 4. The trial balance of Raj Bahadur of Vijayanagaram as on 31-12-2005 is given below.Prepare Trading Account, Profit and Loss Account and Balance Sheet for year ending 31-12-2005 after taking into consideration the following adjustments. (a) Stock on 31-12-2005 was 15000 (b) Debts worth Rs.2000 should be written off as bad (c) Depreciate Machinery by 5% and Motor Van by 15% (d) Reserve for bad and doubtful debts should be increased by Rs.600 (e) Commission accrued and not received Rs.500
Sikkim Manipal University
132
Financial and Management Accounting
Unit 7
(f) Goods worthRs.500 were used by the proprietor for his personal use (g) On September,2005, a fire broke out in the shop and goods worth Rs.2000 were completely destroyed. The insurance company accepted a claim of Rs.1500 only and paid the amount on January 1st 2006. TRIAL BALANCE AS ON 31-12-2005 Particulars
Debit in Rs
Capital Drawings
Credit in Rs 85000
7500
Opening Stock
12000
Purchases and Sales
86000
170000
2000
1000
500
700
Returns Discounts Commission Income Tax paid Office Salaries
1000 700 17300
Advertising
2000
Sundry Debtors and creditors
1700
Reserve for Doubtful Debts
85000
30000
Manufacturing Wages
8600
3000
Bills Receivable and Payable
5000
Carriage
600
Machinery
40000
Motor Vans
7000
Land and Buildings
5000
10000
Office Expenses
1500
Cash at Bank
6000
Cash in Hand
2300 295700
295700
Ans: Gross Profit Rs.79300; Net Profit: 52350; BS163650
Sikkim Manipal University
133
Financial and Management Accounting
Unit 7
5. On 31st December,2003 the following trial balance has been extracted.
Rs Drawings Sundry Debtors Interest on loan
4000 Establishment 20500 Rent, rates and insurance 300 Advertisement
Rs 9100 5000 4160
Cash in hand
4000 Credit Balances
Stock (1-1-2003)
6050 Capital account
50000
10000 Sundry creditors
12000
Motor Vehicles Cash at Bank
5600 Loan on mortgage
15700
Land and buildings
62000 Bad debts Provision
2000
Purchases
97500 Sales
170000
Salaries
8600 Purchase returns
1460
Carriage in
4100 Discounts
Carriage out
2200 Bills payable
3000
General Expenses
5100 Rent received
600
Bills receivable
7050
500
Adjustments 1. Depreciate land and buildings at 5% and Motor Vehicles at 15% 2. Interest on loan is at 5% taken on 1st January,2003 3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due. 4. There has been a fire on 1st January, 2003 destroying goods worth Rs.200 5. The bad debts provision is to be brought up to 5% on Sundry debtors 6. The stock in hand on 31-12-2003 was valued at Rs16000 7. Goods costing Rs.1000 were taken away by the proprietor for his personal use, but no entry has been made in the books of accounts 8. Prepaid insurance amounted to Rs.500 9. Provide for Manager’s commission at 5% on net profit after charging such commission. Prepare Trading & P&L a/c and balance sheet.
Sikkim Manipal University
134
Financial and Management Accounting
Unit 7
6. A firm had the following Balances on 1st January 2000 (a) Provision for bad debts (b) Provision for discount on debtors
Rs7500 3600
(c) Provision for discount on creditors 3000 During the year Bad debts amounted to Rs.6000, Discounts allowed were Rs300 and discounts received were Rs.600. During 2001, bad debts amounted to Rs.5000 and discounts allowed and received were respectively Rs.6000 and Rs1500. Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off of bad debts, but after allowing discounts. On December 31st, 2000, the amount of debtors was Rs.57000 after writing off the bad debts but before allowing discounts. Total creditors on these two dates were Rs.60000 and Rs.75000 respectively. It is the firm’s policy to maintain a provision of 5% against bad and doubtful debts and 3 % for discount on debtors and a provision of 3% for discount on creditors. Show the accounts relating to provision on Debtors and provision on creditors for the year 2000 and 2001 (Ans: Provision for bad debts-2000 Rs.6900 and 2001 Rs.2850; Provision for discount on debtors – 2000 Rs.3933, 2001 Rs.1530; Provision for discount on creditors – 2000 Rs.1800, 2001 Rs2250) 7. In a business, Sundry debtors were Rs.40000 at the beginning of the year and there was 5% Reserve for Doubtful Debts and also 5%Rreserve for Discount on Debtors. During the year the actual bad debts amounted to Rs.1600 and the discount allowed were Rs.1700. At the close of the year, the debtors were Rs.50000; and the percentage of the two reserves have to be maintained as at beginning. Show ledger accounts. Answer for Self Assessment Questions. Self Assessment Questions 1 1. True 2. False 3. True. 4. True 5. Internal transactions 6. profit / loss for the accounting period 7. Time.
Sikkim Manipal University
135
Financial and Management Accounting
Unit 7
Self Assessment Questions 2 1. Outstanding expenses 2. Salaries account Dr To outstanding expenses account 3. It means t hat they are already considered. 4. False. Self Assessment Questions 3 1. Prepaid expenses 2. True 3. 1000 + 5600 – 800 = 5800 4. True. Self Assessment Questions 4 1. Accrued or outstanding income 2. True 3. True Self Assessment Questions 5 1. True 2. Rent account Dr To Income received in advance account 3. Deducted. Self Assessment Questions 6 1. Wear & tear / usage 2. Depreciation a/c Dr To asset account 3. P & L a/c Dr To Depreciation a/c 4. It means that the concerned asset is get to be depreciated 5. Diminishing(Reducing) balance method. 6. It indicates that the asset is already depreciated and depreciation should be transferred only to P & L a/c.
Sikkim Manipal University
136
Financial and Management Accounting
Unit 7
Self Assessment Questions 7 1. Bad debts 2. True 3. Bad debts a/c Dr To Debtor a/c 4. P & L a/c Dr To Bad debts a/c 5. Profits are reduced. 6. Cash a/c Dr. To Bad-debts recovered a/c. Self Assessment Questions 8 1. Bad debts are totally not recoverable, doubtful debts may be recovered. 2. False 3. True 4. True 5. R.B.D a/c Dr To bad debts account. 6. P & L a/c Dr To R BD a/c 7. True Self Assessment Questions 9 1. To encourage customers to make quisk & prompt payment. 2. Cash discount a/c Dr To Debtors a/c 3. True 4.
True
5. Good debtors (Meaning total debtors- Bad debts outside trial balance-RBD ) Self Assessment Questions 10 1. True 2. True 3. Deduct the provision from the amount of creditors 4. True. Sikkim Manipal University
137
Financial and Management Accounting
Unit 7
Self Assessment Questions 11 1. Cost on market price which ever is lower 2. Closing stock is debited and trading account is credited 3. Gross profit is reduced by not considering unsold stock 4. True. Self Assessment Questions 12 1. True 2. True 3. Sales 4. P & L Self Assessment Questions 13 1. Net purchases meaning (Total purchases – purchase returns – stock destroyed – stock used for personal use ). 2. No, because they do not manufacture any product. Self Assessment Questions 14 1. Indirect expenses office & administrative expenses, selling & distribution expenses etc. 2. True 3. False 4. True Self Assessment Questions 15 1. Assets, liablities 2. True 3. True Self Assessment Questions 16 1. To write off bad debts against the reserve and reduce the pressure on cuurent profits. 2. to provide for anticipated profits. 3. Rs 2000 relating to 5 months ( 1.8.2000 to 31.12.2000) 4. i) a ii) c iii) c iv) b v) c 5. Yes
Sikkim Manipal University
138
Financial and Management Accounting
Unit 7
6. No 7. Yes 8. No Answer for Terminal Question: 1. Refer to unit 6.10. 2. Refer to unit 6.10. 3. Refer to unit 6.10. 4. Refer to unit 7.4, 7.6, 7.8. Ans: Gross profit Rs 79300, Net profit Rs 52350 Balance sheet Rs 163650. 5. Refer to unit 7.4, 7.6 & 7.8 Gross Profit Rs 81010; Net Profit Rs 40706; Commission Rs 2034; Balance Sheet Total Rs 1,20,025 6. Refer to unit 7.2.7, 7.2.8, 7.2.9 Answer : Provision for Bad debts 2000 – Rs 6900 ; 2001 – Rs 2850. Provision for discount on debtors 2000 – Rs 3933; 2001- Rs 1530 Provision for discount on creditors 2000 – Rs 1800; 2001 – Rs 2,250. 7. Refer to unit 7.2.7, 7.2.8 Closing Balance of RBD Rs 2,500 Closing Balance of Reserve for Discount on Debtors Rs 2,375. RBD Transferred to P & L account Rs 2,100 Reserve for Discount Transferred to P & L account Rs 2,175
Sikkim Manipal University
139
Financial and Management Accounting
Unit 8
Unit 8
Introduction to Management Accounting
Structure: 8.1 Introduction Objectives 8.2 Decision Making Self Assessment Questions 1 8.3 Meaning and scope Self Assessment Questions 2 8.4 Cost analysis 8.5 Budgetary control Self Assessment Questions 3 8.6 Standard costing 8.7 Financial analysis Self Assessment Questions 4 8.8 Relevant cost Self Assessment Questions 5 8.9 Management accounting framework 8.10 Function of management accounting Self Assessment Questions 6 8.11 Special features 8.12 Merits and Demerits 8.13 Distinction between M.A and F.A Terminal Questions Answer to SAQs and TQs
8.1 Introduction Management accounting is an accounting service to the management. It assists the managers in the formulation of policy, taking a decision, control of execution. It focuses in increasing the managerial efficiency. Hence management accounting is also called as “Accounting for Management”. Learning Objectives: After studying this unit, you should be able to understand the following 1. Spell out the meaning, scope, functions, special features, role of Management accounting, 2. Expose the cost analysis, Sikkim Manipal University
140
Financial and Management Accounting
Unit 8
3. Appreciate the budgetary control, 4. Deal with standard costing, 5. Recognize the merits and demerits of management accounting, 6. Identify the differences between management accounting and financial accounting, 7. Perform some basic financial analysis.
8.2 Decision Making as a Nucleus of Management Decisionmaking in any business organization( individuals or groups of individuals) is primarily a function of management. Decisions are normally taken under uncertainty. Decision under trial and error or intuition will not end in good results. Scientific decision need to be made from time to time. For this, the management has to rely on the information supplied by professionals and specialized agencies. One of the important components in information collection is in the field of internal financial information. Accounting acts as a basis upon which crucial decisions can be made. The financial statements prepared in its traditional form may not convey the required information for taking decisions. The financial information need to be finetuned for use by the busy management. This function is being performed by the management accounting. Self Assessment Questions 1 1. Decision making is a painful game (True or false). 2. Decision based on trial and error method bring in good results (true/false). 3. Decisions are normally based on financial statements (true or false) . 4. Financial information need to be ________ For use by management.
8.3 Meaning And Scope Management accounting is an accounting service to the management. It covers all those services by which the accounting department can assist the managers in the formulation of policy, taking a decision, the control of its execution and the appreciation of effectiveness. As regards the scope of management accounting, it is very wide. It is based on historical financial data. It is concerned with future. It uses the information available from different walks of life like Political Science, Statistics, Mathematics, Economics, Cost Accounting and Financial Accounting. The main purpose of management accounting is to utilize information in solving the business problems and taking scientific decisions. Hence, it is difficult to pinpoint the exact scope. The Management Accountant seek to support management decision making by the provision of information and the analysis of financial performance. As the data is required for internal
Sikkim Manipal University
141
Financial and Management Accounting
Unit 8
purposes, the management accountant is not constrained by the need to comply with regulations of the format for presentations. The main scope is : 1. To identify and calculate costs of production. This is known as Cost Accounting 2. To provide estimates for future expenses and revenues. This is known as Budgeting 3. To identify inefficiencies within the organization 4. To control costs and manage the flow of cash 5. To seek opportunities e.g. to identify “tax breaks”, possible cost savings and movements in foreign exchange rates which could be exploited by the organization. The main management accounting techniques are: 1. Breakeven analysis 2. Costing 3. Budgeting 4. Ratio Analysis 5. Variance analysis Self Assessment Questions 2 1. Function of accounting department is _______, ________, _______, ______ . 2. Main purpose of Management accounting is _______ and ______________ .
8.4 Cost Analysis M.A take into account some of the concept of cost accounting technique. The cost analysis is an important aspect. A management accountant has to face questions such as “what will our cost be next year”. This deceptively simple boundary question. Such question can occur in virtually every aspect of work and knowledge of the patterns of cost behavior and ways that future cost can be predicted is fundamental requirement when concerns with decision makers.
8.5 Budgetary Control Modern business world is full of competition, uncertainty and exposed to different types of risks. The complexity of managerial problems has led to development of various managerial tools, techniques and procedures useful for the management in managing the business successfully. In this direction, planning and control plays an important role. Budgeting is the most common and powerful standard device of palling and control.
Sikkim Manipal University
142
Financial and Management Accounting
Unit 8
Budgetary control is a technique of managerial control through budgets.. A budget is a quantitative expression of plan of action. . It is a predetermined detailed plan of action developed as a guide for future operation. According to Wheldon “Budgetary control is the planning in advance of the various functions of business so that the business as a whole can be controlled”. Budgetary controls deals with planning, coordination, recording appraisal and follow up of actions. Self Assessment Questions 3 1. Budget is ____________ _________________ Plan of action 2. Budgetary controls deals with _______, ________, _______, _____, _____ .
8.6 Standard Costing and Variance Analysis Businesses need to plan and budget for their future activities if their objecti are to be achieved. Planning and budgeting are not enough. It is necessary to monitor progress against the planned outcomes to establish significant differences and to permit corrective action to take place. This means that performance must be regularly assessed, differences identified and plans revised.. Although the ultimate objectives may not change, the way in which they are to be achieved may be very different and might make additional demands on resources than originally anticipated. A standard is a specified quantity or money amount that has been estimated with reference to past experience and the future expectations of efficiency levels, productivity and prices. Product or service costs can be estimated by ascertaining amount of material if applicable, and direct labour spent on each unit. This might be determined by observing what quantity of material is used in a product and at which price it may be purchased. It will also involve estimating how long a particular type of direct employees spend on various aspects of making the product or providing the service and what the various wage rates are for each type of labour involved. Therefore, the setting of these standards is a subjective process. The acceptable or desired standards may vary from manager to subordinate, from individual to individual. Standard costing makes the planning and budgeting easier and avoids the problem of completely reformulating budgets every period. Standards also provide a controlling mechanism where behavior is modified through motivation and appraisal. Standard costing allows management to locate operational problems. Standard costing is best applied to manufacturing concerns where many products are produced and their components numerous. Deviation from standards is called variance. In budgeting language, a difference is known as variance. Differences between budgeted and actual performance will be referred to as variances.
Sikkim Manipal University
143
Financial and Management Accounting
Unit 8
8.7 Financial Analysis It is the process of determining the significant operating and financial characteristics of a firm from accounting data. An organization has to deal with three areas viz. financial records and external reports, accounting for management decisions and internal reports and finally financial assessment and analysis. Financial statement analysis is therefore largely a study of relationship among the various financial factors in a business . It is the process of selection, relation and evaluation. The focus of financial analysis is on key figures in financial statements and the significant relationship that exists between them. The technique of financial analysis is typically devoted to evaluate the past, present and projected performance of a business firm. Financial analysis is commonly called “the analysis and interpretation of financial statements”. Self Assessment Questions 4 1. An organization has to deal with three areas _______, _______ and ______ . 2. Financial analysis is also known as _______________________________ .
8.8 Relevant Cost Management decision is based on relevant costs. Costs incurred in the past is sunk cost. Whether to replace a machine or a not is a decision not based on how much was invested to buy that machine. This is based on comparative cash inflows from replacements and additional investments necessary net of realization of the old asset. Thus, sunk costs are not relevant costs. Thus management accounting accumulates cost data but classifies them into relevant costs to aid management decisionmaking. Discretionary costs are incurred at the discretion of the management. A percentage of profit may be used for research and development. Unless discretions are compulsions, these should not be treated as relevant costs. Self Assessment Questions 5 1. Sunk cost is ________________________. 2. Sunk costs are not __________________ Costs. 3. A _______________________ is used for research and development.
8.9 Management Accounting Framework For offering accounting and financial advice as well as for capitalizing the available opportunities for future development, it is necessary that an effective development, it is necessary that an effective frame must should be designed. The management accountant must organize the whose accounting division in such a way that there is prompt and immediate recording of the entire Sikkim Manipal University
144
Financial and Management Accounting
Unit 8
information flow into the department from functional and service department. The frame must concentrate on. ·
Getting rid of routine work
·
Reporting actual and planned performance
·
Fixing organizational responsibilities
·
Application of new modern and modified practices of analyzing and interpreting results.
·
Designing of sound and efficient organization taking into account the native and size of the business unit.
8.10 Functions of Management Accounting Management Accounting functions nay be said to include all activities with collecting, processing , interpreting and presenting information to management. More specifically, the functions are as follows: Forecasting and Planning: Short and long term forecasts are very essential. Planning the future operations of a business is crucial. Necessary information and data for forecasting should be provided from time to time. Various tools and techniques should be made use of. Organizing: Organizing of finance and accounting functions is an important function of management accounting. Coordinating: Coordination increases the efficiency of an organization and maximizes its profits. Controlling performance: The management accounting is very helpful in controlling the financial performance of the organization through financial reporting, budgeting, financial analysis . Communication: It is an important medium of communication. The management reporting mechanism is a typical example of communicating the results to the superiors. Other functions: Management accounting serves in a number of other ways. It supplies useful information to different functional authorities. It provides accounting information and advice for price determination and pricing decisions. It also helps in making certain strategic decisions, decisions regarding seasonal or temporary suspension of production, make or buy decisions, replacement decisions. Self Assessment Questions 6 1. Management functions include ________, ________, ________, _________ . 2. Controlling performance is done through _______,__________,________ .
Sikkim Manipal University
145
Financial and Management Accounting
Unit 8
8.11 Special Features Of Management Accounting Accounting principles are manmade. Unlike the principle of natural science, accounting principles were not deducted from axioms, nor is their validity verifiable by observation and experiment. They have been evolved as “ necessity is the mother of invention” Based on this the special features are: 1. Selective in Nature : It is technique of selective nature. It picks up only those data which are relevant for decision making. 2. Provides Data : The function is to provide data and not the decision. It can inform but it cannot prescribe. 3. Future oriented: It helps in planning for the future decision and hence future oriented. 4. Cause and effect relationship : M.A studies the causes of profits or losses since the profit and loss account does not tell the reasons for profit or losses. M.A analyses the results of different variables on the profits and the profitability. 5. NonAdherence of rules : M.A does not follows set rules and formats like financial accounting. The basic task is to motivate management action. Hence M.A is on the utility of information and not on formats and legal presentation. 6. Economic Reality : Accounting data and information represents the economic activities but M.A is used to guide future planning and decision making thereby representing the underling economic realities in a clear and unambiguous manner. 7. Goal congruence : M.A normally encourages all employees to act in a fashion which contributes to the overall objectives. 8. Information system : An organization comprises a number of information system or networks. In other accounting system the information system are rarely integrated. But in M.A these are designed in accordance with the principle of system theory to make it more efficient. 9. Quantitative Techniques : Certain aspects of management accounting particularly in the area of planning and decision making, statistical and operational research techniques are used extensively, By use of it, a particular solution is being refined for cost effectiveness. 10. Uncertainty : Conditions of certainty are said to exist when a single point estimate can be made which will be exactly archived. Conversely, Uncertainty exists where there are various possible outcomes or results or values.
Sikkim Manipal University
146
Financial and Management Accounting
Unit 8
8.12 Merits and Demerits of Management Accounting Merits 1. Efficient palling and effective organization which are the end product of the system of management accounting bring systematic regularity in the business activities. 2. Maximum return on capital employed is ensured by the use of management accounting because it helps in the functions of planning, coordination and control 3. Better and improved services by management to customers are assured by this system. 4. Management accounting removes unacceptable standards or substandards. 5. Industrial relations may be improved by adoption of management accounting principles. 6. Eliminations of various types of wastages, production defectives and other related work deficiencies are removed with the help of management accounting. 7. Economic uplift of community and development of nation’s economy can be achieved by the use of management accounting. Demerits 1. Most of the information used in Management accounting are derived from financial accounting records or cost accounting records other records. As such fairness and accuracy of decisions deduced depends to a greater extent upon fairness and accuracy of these original records. 2. Decisions or conclusions derived are insignificant unless properly executed at all levels of business operations. 3. Management accounting is a mere tool for management. It cannot substitute for management. 4. The evolution has been on account of interalia development of new theories in other sciences. Hence there is a need to have a comprehensive knowledge and understanding of all these related disciplines to derive the full advantage. 5. Management accounting is still in its evolutionary stage. Hence, there is an uncertainty in its use. 6. The installation of management accounting is a costly affair and as such it has very limited scope for its use.
8.13 Distinction Between Management Accounting And Financial Accounting Management accounting initially is said to emanate from financial accounting in the sense that financial accounting in the beginning designed to supply information in the form of statements for management use. In fact, both management accounting and financial accounting are
Sikkim Manipal University
147
Financial and Management Accounting
Unit 8
complementary in nature to each other. But they are distinguished in terms of kind and relative importance of the problems involved
Area
Financial Accounting
Management Accounting
Objective
Limited to the preparation for external use
Information is collected for internal communication and use.
Process
Recoding of financial transactions
Data is collected for internal use
Nature
It is objective
It is Subjective
Flexibility
It is rigid
It is flexible
Data
Emphasis on Past data
It lays stress on future
Precision
It is precise
It is approximation
Legality
It is a legal Document
It is voluntary
Unitization
It covers entire organization
It is based on activity, Department, Division
Audit
Compulsory
Voluntary
Publication
Mandatory
Voluntary
Terminal Questions 1. Briefly explain the merits and demerits of Management Accounting. 2. Distinguish between Management Accounting and Financial Accounting 3. Describe briefly the scope of Management Accounting. 4. Describe the functions of Management Accounting. 5. Define Standard Costing and Variance Analysis.
Answer for Self Assessment Questions Self Assessment Questions 1 1. False 2. True 3. False 4. Finetuned Self Assessment Questions 2 1. To prepare financial statements 2. Formulation of policy and taking decision.
Sikkim Manipal University
148
Financial and Management Accounting
Unit 8
3. Breakeven analysis, Costing, Budgeting, Ratio analysis, Variance analysis. Self Assessment Questions 3 1. Most powerful. 2. Planning and appraisal Self Assessment Questions 4 1. Financial ,external reports, Accounting. 2. Analysis and interpretation of financial statements Self Assessment Questions 5 1. Past cost 2. Relevant. 3. Percentage of profit. Self Assessment Questions 6 1. All functional Activities 2. Financial documents. Answer for Terminal Questions: 1. Refer to unit 8.12 2. Refer to unit 8.13 3. Refer to unit 8.3 4. Refer to unit 8.10 5. Refer to unit 8.6.
Sikkim Manipal University
149
Financial and Management Accounting
Unit 9
Unit 9
Financial Statement Analysis
Structure 9.1
Introduction Objectives Self Assessment Questions 1
9.2
Meaning of Ratio Self Assessment Questions 2
9.3
Meaning of ratio analysis
9.4
Scope Self Assessment Questions 3
9.5
Advantages Self Assessment Questions 4
9.6
Classification Self Assessment Questions 5
9.7
Liquidity Self Assessment Questions 6 to 8
9.8
Solvency Self Assessment Questions 9 to 11
9.9
Profitability Self Assessment Questions 12 to 15
9.10
Activity Self Assessment Questions 16 to 19
9.11
Leverage Self Assessment Questions 20 to 22
9.12
Limitation Self Assessment Questions 23
9.13
Computation Terminal Questions Answer to SAQs and TQs
9.1 Introduction “Every fact that is learned becomes a key to other facts” – E.Y. Youmans. Based on this, this Unit deals with analysis of financial statements, the functions of which is to identify and highlight Sikkim Manipal University
149
Financial and Management Accounting
Unit 9
the firm’s strengths and weaknesses. The objective of ratio analysis is to provide with the financial information necessary to make financial decisions. Learning Objectives: After studying this unit, you should be able to understand the following
1. Understand the concept of ratio analysis and its role in comparative analysis 2. Explain the fundamental relationship between the gross profit ratio, the expenses to sales ratio and the net profit margin ratio.
3. Define and calculate the three primary ratios which explain how well a business is utilizing the resources to generate revenue and profit. Ratio analysis can provide you with this information in three steps: 1. Calculate the firm’s ratios for the current or recent period . Ratios are calculated from the firm’s income statement or balance sheet It is helpful and sometimes necessary to have the financial statement independently audited. 2. Compare these ratios to those calculated in past records. The purpose of this comparison is to identify tendencies in the firm’s ratios. This is known as trend analysis. 3. Compare the ratios to industry averages to show how the company compares to firms of the same size in its industry. This process is known as Cross sectional analysis. After completing the analysis, one can have a great deal of information on how the company is doing both over a period of time and compared to other firms in its industry. Self Assessment Questions 1: 1. Ratios are calculated from _____________ Statement and _____________. 2. Identifying tendencies in the firm’s ratio is known as ___________ analysis. 3. Comparing firm’s ratio with industry ratios is known as __________ analysis. 4. Ratios enable a company to have _______________ data.
9.2 Meaning of Ratio Absolute numbers tell very little. Assume that two companies A and B, operating within the same industry supply the information: Company A B NET PROFIT in Rs. 10,000 1,00,000
Sikkim Manipal University
150
Financial and Management Accounting
Unit 9
One can easily say that Company B makes the most profit. But which company is most profitable? The answer for this will naturally call for further additional information relating to profit such as size of the company, the total sales it generates or to how much capital is invested in it. Hence, an assessment or a judgment is made based on making some sort of comparison. Extending the example,
A B Net Profit 10,000 1,00,000 Sales 2,00,000 5,00,000 Net worth (Capital and Reserves) 1,00,000 2,00,000 If net profit is compared with Sales, an assessment can be made on which company generates the most net profit per Re.1 received from customers. Company A : Net Profit/ sales * 100 i.e. 5 percent and Company B it is 20 percent. If the net profit is expressed in terms of investments made by the owners in each company, it is Net Profit / Net worth *100. For Company A, it is 10% and for it is 25%. It is also known as Return on Capital Employed. ROCE. Ratios are useful in two ways: 1. To make interbusiness comparisons 2. To make comparisons across financial periods A ratio is simply one number expressed in terms of another. It is a means of highlighting in arithmetical terms the relationship between figures drawn from various financial statements. Therefore, it refers to the numerical or quantitative relationship between two variables or items. A ratio expresses simply in one number the result of comparison between two figures. It is calculated by dividing one figure by the other. The quotient so obtained is the ratio of the figures. Ratio can be expressed in the following three forms: 1. As proportion 2. As percentage 3. As turnover or rate The Dictionary meaning of Analysis is “separation or breaking up of anything into its elements or component parts”. Ratio Analysis is, therefore, a technique of analysis and interpretation of financial statements. Ratio analysis is the process of establishing and interpreting various ratios for helping in making certain decisions. It involves the methods of calculating and interpreting financial ratios to assess the firm’s performance and status.
Sikkim Manipal University
151
Financial and Management Accounting
Unit 9
Self Assessment Questions 2: 1. a) Ratios are useful to make ____________ and _________________. 2. Ratio is __________________________________________. 3. Ratio refers to ________________________________ relationship. 4. The answer for a division is known as _______________________. 5. Ratio can be expressed in three ways _________,_______,___________. 6. Ratio analysis is ____________________________________.
9.3 Meaning Of Ratio Analysis The Dictionary meaning of Analysis is “ separation or breaking up of anything into its elements or component parts”. Ratio analysis is therefore a technique of analysis and interpreting various ratios for helping in making certain decisions. It involves the methods of calculating and interpreting financial ratios to assess the firm’s performance and status
9.4 Scope The ratio analysis is one of the most powerful tools of financial analysis. The firm is answerable to the owners, the creditors and employees. The firm can reach a number of parties. On the other hand, parties interested in the business can compute ratios based on the financial statements of the firm. The analysis is not restricted to any one aspect but takes into account all aspects such as earning capacity of the firm, financial obligation, liquidity and solvency aspects, liquidity and profitability concepts. Self Assessment Questions 3: 1. Ratio analysis is power tool _______________________. 2. ratios are based on _______________________. 3. Ratio indicates ___________________________.
9.5 Advantages The various advantages of ratio analysis are as follows: a) Financial Forecasting and Planning Ratio analysis helps in the financial forecasting and planning activities. Ratios based on the past sales are useful in planning the financial position . Based on this, future trends are set. b) Decision Making Ratio analysis throws light on the degree of efficiency. It is also concerned with the management and utilization of the assets. Thus, it enables for making strategic decisions.
Sikkim Manipal University
152
Financial and Management Accounting
Unit 9
c) Comparison With the help of ratio analysis, ideal ratios can be composed. These can be used for comparison in respect of the firm’s progress and performance, interfirm comparison with industry average. d) Financial Solvency Ratios are useful tools. It indicates the trends in the financial solvency of the firm. Long term solvency refers to the financial liability of a firm. It can also evaluate the short term liquidity position of the firm. . e) Communication The financial strength and weaknesses of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner. It, thus, helps in the communication and enhance the value of the financial statements. f) Efficiency Evaluation It evaluates the overall efficiency of the business entity. Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business liquidity, solvency, profitability. A critical study of these aspects may enable conclusions relating to capabilities of business. g) Control It helps in making effective control of the business. Actual results can be compared with the established standard and to take corrective action at the right time. h) Other uses Financial ratios are very helpful in the early and proper diagnosis and financial health of the firm. Self Assessment Questions 4:
1. There are major ______________________ advantages. 2. Financial forecasting is useful for ___________________. 3. Decision making concerned with ______________________. 4. Comparison is for ________________________________. 5. Financial solvency includes ________________________. 6. Communication enhances _________________ statements. 7. Evaluation done for ______________________________. 8. Through control,________________________________.
Sikkim Manipal University
153
Financial and Management Accounting
Unit 9
9.6 Classifications Of Ratios The diagrammatic representation of ratios are as follows :
TYPE OF RATIO
LIQUIDITY
SOLVENCY
PROFITABLITY
Current liquid
Debt Equity
Gross Profit Net Profit Operating
ACTIVITY
STO DTO CTO
LEVERAGE
Gearing TI to LT
Self Assessment Questions 5: 1. Types of ratios are _____________________________________. 2. Liquidity ratios consist of ______________________________. 3. Solvency ratio consists of ______________________________. 4. Profitability ratio consists of ____________________________ . 5. Activity ratio consists of _______________________________.
9.7 Liquidity Ratio It means the liquidity of the firm. Liquidity is the ability of the firm to meet its current liabilities as they fall due. Since the liquidity is basic to continuous operations of the firm, it is necessary to determine the degree of liquidity of the firm. These are important because liquidity is close to the heart of the firm. A firm may have a high level of long term assets and substantial net income, but if they do not have enough cash on hand or assets that can be turned into cash fairly quickly, they will not be able to operate day to day. The liquidity ratios examine the current portion of the balance sheet : current assets and current liabilities. The implicit assumption is that current assets will be used to pay off current liabilities. This makes sense due to the matching principle (match the maturity of the debt with the duration of the need) e.g. one would not take a five year bank loan to pay off an account payable due in thirty days. There are two ratios that determine how liquid a firm is : the current ratio and quick ratio. Self Assessment Questions 6:
1. Liquidity is the ability ________________________.
Sikkim Manipal University
154
Financial and Management Accounting
Unit 9
2. Liquidity ratios deal with ______________________. 3. Liquidity ratios place importance on _____________. 4. Two ratios that determine liquidity _______________. Current Ratio It is one of the popular financial ratios. It measures the firm’s ability to meet its short term obligations. This is achieved by comparing the current assets of a business with its current liabilities.. The formula for current ratio is : Current Ratio = Current Assets / Current Liabilities Example:
Current Assets Stock Debtors Cash
A
B
Rs.
Rs.
3,000
60,000
16,000
Nil
5,000
Nil
24,000
Nil
Nil
10,000
Current Liabilities Creditors Bank Overdraft
The liquidity of the firms are determined by the amount of working capital available to the business. This is defined as current assets minus current liabilities. The current ratio is not expressed as a percentage but as a proportion. The current ratio of the above two firms are: 1 for A and 5 for B. The ratio reveals a considerable difference between the two companies. Company B is five times more liquid than company A. Company A can only just cover its obligations to creditors in the short term, yet Company B can cover its obligation to the bank five times over. Although company A would be less vulnerable if its ratio was higher, it can be argued that to have a ratio that is too high indicates inefficiency, in that too much working capital is available, which might be better invested in fixed assets. However, it is important to identify the specific types of current assets that are excessive such as 1. Excessive stock levels, indicating poor stock control or a decline in sales volume 2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts 3. Excessive cash or near cash equivalents, indicating a lack of suitable investment opportunities in capital projects. Sikkim Manipal University
155
Financial and Management Accounting
Unit 9
A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is acceptable. However, the current ratio may vary from less than one in such industries as fast foods to more than two in the telephone apparatus manufacturing industry. Consequently, it is important too utilize the industry averages. A ratio that is much higher than the industry average indicates that the firm may have excessive current assets. Further investigation may demonstrate the cause of the excess. One reason may be that the firm is having trouble in the collection of its debtors or has high inventory, both of which will be identified through the use of other ratios. Another reason may be that the firm is holding too much cash or short term investments which could be earning more money if they were invested in long term instruments. Still another reason for a high ratio is that the firm may be at a specific point in its business cycle. The company that sells woolen goods in winter is expected to have high inventory in November, December, January and high debtors in February. A ratio which is much lower than the industry average indicates that the firm is having liquidity problems, meaning that it may not be able to meet its short term obligations. Accordingly, an extremely low current ratio should be a red flag to the company being analyzed.
The components of current assets and current liabilities are: Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock, prepaid expenses, trade investments, marketable securities Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or accrued expenses, tax payable, provision for tax, dividends payable. Example: Given: Current Ratio is 2.5 and working capital is Rs.1,80,000. Calculate the Current Assets and current liabilities. Solution: Given data is working capital, hence : Working capital = Current assets minus current liabilities Current Ratio = CA / CL In the absence of any value, the current liability is always taken as 1 unit 2.5 = CA / 1 and cross multiplying , CA is 2.5 Working capital ratio is 2.5, then substituting the values, 2.5 = 2.5 minus 1 or WC = 1.5 For 1.5 WCR = Working capital value is Rs1,80,000
Sikkim Manipal University
156
Financial and Management Accounting
Unit 9
For 2.5 CAR, the current asset is Rs.1,80,000 x 2.5 / 1.5 = Rs.3,00,000 For 1 CLR, the current liability is 1,80,000 x 2.5 / 1 = Rs.1,20,000 Self Assessment Questions 7: 1. Current Ratio is___________________________________ ratio. 2. Current ratio measures ____________________________. 3. Current ratio compares ___________________________. 4. The formula for current ratio is _____________________. 5. Current ratio is expressed in _______________________. 6. The rule of thumb in Current ratio is ___________________. 7. Working capital is the result of _______________________. 8. The working capital is Rs.80,000 and its current ratio is 5. What are the 9. current assets and current liabilities. Liquid Ratio It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except that it excludes inventory which is generally the least liquid current asset. The reason for eliminating inventory may be due to two primary factors a. Many types of inventory cannot be easily sold because they are partially completed items, obsolete items, special purpose items. b. The items are typically sold on credit. This results in the creation of trade debtors or bills receivables before being converted into cash. Citing the example, in the case of company B, the only current asset that it carries is stock. The question must be asked : is this level of stock too high or might it be essential to this type of business ? As stock is the least liquid of the current assets, prudence requires that liquidity be looked at in another way. If current assets excluding stock are compared with current liabilities, a more cautious assessment of the liquidity of the two companies is given.. This ratio is calculated as follows: Acid Test Ratio = Current assets less Stock / current liabilities The quick ratios for companies A and B are as follows : A = 24,000 3,000 / 24,000 = 0.875 B = 50,000 50,000 / 10,000 = 0
Sikkim Manipal University
157
Financial and Management Accounting
Unit 9
This time the quick ratio indicates that company A has a considerably better liquidity from this point of view and company B is dangerously insolvent. Illustration: Given that Current ratio is 3.5, acid test ratio is 1.5 and working capital is Rs.6,50,000. Compute current assets, current liabilities, liquid assets Solution: Given data, Working capital
= Current Assets minus current liabilities Where current liability is taken as 1
CR = CA /.CL = 3.5 = CA / CL Crossmultiply = 3.5 x 1 = Current Assets Working Capital Ratio is therefore : CAR – CLR or 3.5 minus 1 or 2.5 For 2.5 WCR, the amount is Rs.6,50,000 For 3.5, CAR, the current asset is 6,50,000 x 3.5 / 2.5 or Rs.9,10,000 For 1, CLR, the current liability is 6,50,000 x 1 /2.5 or Rs.2,60,000 Liquid asset is based on Acid Test Ratio where, 1.5 = LA / CL Liquid asset, therefore, are = 2,60,000 x 1.5 or Rs.3,90,000 Problem: Given Current ratio 1.5 :1; Quick ratio 1 : 1 and Current liabilities Rs.50,000. Calculate current assets, quick assets and inventory. Solution: Given Current ratio : 1. 5 : 1 and value of current liabilities Rs.50,000 Current assets : CR = CA /e 1.5 = CA / 50,000 or CA = Rs.75,000 Quick Asset : QR = QA / 1 or 1 = QA / 50,000 or Rs.50,000 Inventory = CA – QA or 75,000 – 50,000 or Rs.25,000 Problem: Assuming the Current ratio of DR Ltd is 2, state in each of the following cases whether the ratio will improve or decline or will have no change. (a) payment of current liability (b) purchase of fixed assets (c) cash collected from customers (d) Bills receivable dishonored and (e) issue of new shares. Solution: CR = CA / CL where 2 = CA / 1 or CA = 2 and CL = 1 a) Payment of current liability : Current ratio will improve. The reason is that when current ratio is 2:1, payment of current liability will reduce the same amount in the numerator and denominator. Hence, the ratio will improve. b) Purchase of fixed assets : here, the current ratio will decline.
Sikkim Manipal University
158
Financial and Management Accounting
Unit 9
c) Cash collection : Current ratio will not be changed because cash will increase and debtors will decrease d) BR dishonored : Current ratio will not change. Reason is that BR will decrease and debtors will increase e) Issue of new shares : Current ratio will improve because cash balance will increase. Self Assessment Questions 8: 1. Liquid Ratio is also known as ________________________. 2. Liquid ratio excludes _______________________________. 3. The reason for exclusion is __________________________. 4. The formula to calculate the liquid ratio is ______________. 5. Payment to current liability will improve _______________. 6. For Bills dishonored, Current ratio _____________________. 7. For issue of new share, current ratio ____________________. 8. For purchase of fixed assets ___________________________. 9. For cash collection, __________________________________. 10. Given CR is 1.75. Liquid ratio is 1.25.. Net working capital is Rs.1,50,000. Calculate (a) current assets (b) current liabilities and (c) liquid assets and stock. 11. DR’s current ratio is 5.5 : 1 . Quick ratio is 4 to 1. Inventory is Rs.30,000.find out the current liabilities. 12. Given CR is 2.5. Liquid ratio 1.5 working capital Rs.6,00,000, Bank overdraft Rs.10,000. Calculate Current assets, current liabilities. Stock and liquid assets.
9.8 Solvency Ratios The ratios are analyzed on the basis of long term financial position of a firm. It is also known as test of solvency or analyzing the debt. Many financial analysts are interested in the relative use of debt and equity in the firm. Debt refers to outside borrowings by the firm. The debt position of a firm indicates the amount of other people’s money being used in attempting to generate profits. The long term debts are of much importance to the firm since a firm is expected to commit the payment of periodic interest over the long run. In addition, repayment of loan after the expiry of maturity date has to be planned. Since the creditor’s claims must be satisfied before the distribution of earnings to shareholders, present and prospective shareholders pay close attention to the degree of indebtedness and
Sikkim Manipal University
159
Financial and Management Accounting
Unit 9
ability to repay the debts. Lenders are also equally concerned about the indebtedness and the repayment modes. Hence, the solvency of the firm in particular needs consideration. Self Assessment Questions 9: 1. Solvency ratio are analyzed on __________________________basis. 2. Solvency ratio is also known as ______________________. 3. Solvency ratio is combination of ____________________. 4. Debt refers to ____________________________________. 5. Lenders are concerned about ________ and ____________. Debt Ratio Debt ratios are important because debt is widely considered to be a measure of the health of the firm and the risk associated with it. If a firm has high debt, they have fixed payments which must be made. This means that limited funds may be directed to debt payment (either principal or interest or both) instead of investments. . The debt ratio is : Total Liabilities / total assets This ratio tells you how much of the firm’s assets are financed with debt. A high debt ratio indicates that the firm may be carrying too much debt. This is of concern to the firm because it may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a firm in this situation is considered risky because short term financing is limited and may not be available in an emergency. A low debt means that the firm has a low level of liabilities compared to its total assets. Such a ratio indicates that the firm is not risky because it has plenty of financing available when compared to its need. However, a low ratio may also indicate that the firm should take on more debt. The reason for this is that the ability to borrow is considered a resource and a firm with low debt may not be taking advantage of this resource. Self Assessment Questions 10: 1. Debt is considered as _________ Of the firm and ________ Associated ________. 2. The formula is __________________________. 3. High debt ratio indicates __________________. 4. The result of high debt ___________________. 5. Short term financing is ____________________. 6. A low debt ratio indicates __________________.
Sikkim Manipal University
160
Financial and Management Accounting
Unit 9
Debt : Equity Ratio The debt : equity ratio is : Long term Debt / Shareholder’s equity The debtequity ratio deals with the long term liabilities and equity portion of the balance sheet. Note that shareholders’ equity includes retained earning (Equity may also be known as net worth). The debtequity ratio provides information on the capital structure (relationship between debt and equity) of the firm. Such information is important because it affects the value of the firm. The value of the firm is important because it has an impact on the ability to raise funds., either through increased borrowing or the sale of shares or both. A high debtequity ratio indicates a poor capital structure because it signifies that the firm has high debt in comparison to its level of shareholders’ equity. This means that the firm’s creditors may be concerned about the repayment of debt, which in turn leads to high interest rates, which in turn leads to higher required returns on the firm’s potential investments.. A low debt equity ratio is an indication that the firm is in sound financial position and therefore is not considered risky. Normally, the debt equity ratio vary tremendously from industry to industry.
Problem: The Balance Sheet of DR Ltd is as follows :
Assets: Fixed Assets 10,00,000 Current Assets 5,00,000
Represented by: Current Liabilities 1,00,000 Reserves and surplus 1,00,000 10 % Debentures 2,00,000 6 % Preference Share capital 3,00,000 Equity Share capital
8,00,000
Calculate the Debt Ratio and Debtequity ratio. Solution: Debt Ratio : Total Liabilities to outsiders / total assets : Debentures + Trade creditors / Fixed + current assets 3,00,000 / 15,00,000 or 1 : 5
Sikkim Manipal University
161
Financial and Management Accounting
Unit 9
Debt – equity ratio : Outsiders’ funds / shareholders’ equity Outsiders’ funds 10 % Debentures only + Sundry Creditors Shareholders’ funds Equity Share capital + Preference share capital + Reserves 3,00,000 / 12,00,000 or 1 : 4 Self Assessment Questions 11: 1. Debt equity deals with ____________________________. 2. Shareholders equity is ____________________________. 3. The formula is __________________________________. 4. Debt equity provides information on_________________. 5. Capital structure refers to _________________________. 6. Capital structure affects ___________________________. 7. value is important to raise _________________________. 8. Raising of funds is done through ____________________. 9. High debt indicates _______________________________. 10. Creditors may get upset over _______________________. 11. Low debt indicates ______________________________ 12. Low debt is not __________________________________ . 13. Debt equity ratio _____________ from industry to industry.
9.9 Profitability Ratios A firm’s profitability can be assessed relative to sales, assets, equity or share value. The profitability ratios are important because they indicate whether the firm is doing what it set out to do : make a profit and provide a return to its investors. There are many measures of profitability. Each relates the returns of the firm with regard to the sales, assets, equity or share value. As a group, these measures enable to evaluate the firm’s earnings. The criteria for earnings can be related to a given level of sales,. A certain level of assets, the owner’s investment or share value. Earnings result in profits. Without profits, a firm may be handicapped to attract outside capital. The income statement of the firm shows the total profits earned by the firm during the preceding fiscal period. The important ratios which highlight the profitability of a firm would be as follows: Self Assessment Questions 12: 1.
Profitability ratio is important as ______________________.
2.
Profitability can be assed to ___________________________.
3.
Profitability ratio evaluates firm’s _____________________.
Sikkim Manipal University
162
Financial and Management Accounting
Unit 9
4.
Earnings result in ___________________________________.
5.
Without profit, ______________________Cannot be attracted.
Gross Profit Ratio It measures the percentage of each sales value remaining after the firm has paid for its goods. The higher the gross profit margin, the better and lower the relative cost of merchandise sold. Thus, it serves an important tool in shaping the pricing policy of the firm. The formula is : Gross Profit = ( Gross Profit / Sales ) x 100 Where Gross profit = Sales minus Cost of goods sold (COGS) Net Sales = Cash Sales + Credit Sales minus Sales Returns It is normally expressed as a percentage. If we deduct gross profit ratio from 100, the ratio of COGS is obtained.. Problem DR Ltd provides the following information. Cash Sales Rs.8,00,000; Credit Sales Rs.10,000; COGS Rs.15,80,000 and Return Inwards Rs.20,000. Calculate Gross Profit Ratio and ratio of COGS. Solution GPR: GP / Net Sales x 100 : Gross Profit : Net Sales minus COGS Net Sales : Gross Sales minus Return Inwards Gross Sales : Cash + Credit Sales 8,00,000+10,00,000 minus 20,000 or Rs.17,80,000 Gross Profit : 17,80,000 minus 15,80,000 or Rs.2,00,000 GPR 2,00,000 /17,80,000 x 100 or
11.2 %
Ratio of COGS : 100 – GP Ratio or 100 – 11.2 or 88.76 % Self Assessment Questions 13: 1. Gross profit measures __________________ of each sales value. 2. Gross profit measures __________________. 3. The formula is _________________________. 4. Gross profit is _________________________. 5. Net sales is ____________________________. 6. Gross Profit ratio is expressed as ___________.
Sikkim Manipal University
163
Financial and Management Accounting
Unit 9
Expenses Ratio These ratios indicate the relationship of various expenses to net sales. Individual expenses are calculated based on the net sales and indicated as a percentage to net sales. Self Assessment Questions 14: 1. Expense ratio indicate ____________________of expenses to net sales. 2. Individual expenses are calculated on ___________________. Net Profit Ratio It is also known as Net Profit Margin. It measures the percentage of each sales in rupee after all expenses including taxes have been deducted This ratio provides considerable insight into the overall efficiency of the business. A higher ratio speaks about the overall efficiency of the business. It also focuses the attention of the better utilization of total resources. A lower ratio would mean a poor financial planning and low efficiency. A net profit margin of 1 percent or less would be unusual for a grocery store which a net profit margin of 10 percent would be low for a retail stores. It is divided by net income by net sales. The formula is : Net Profit Ratio = (Net Profit after taxes / Net Sales ) x 100 The net profits are calculated after excluding the income tax, the nonoperating incomes and nonoperating expenses. It is expressed as a percentage on net sales..
Example: The income statement of DR Ltd is as follows: To Opening Stock 2,00,000 By Sales 12,00,000 Purchases 8,00,000 Closing Stock 1,00,000 Direct Expenses 1,00,000 Gross Profit 2,00,000 13,00,000 13,00,000 To Admn Expenses 1,00,000 By Gross Profit 2,00,000 Selling Expenses 80,000 Profit on sale of Investments 60,000 NonOperating exp 40,000 Dividends received 40,000 Net Profit 80,000 3,00,000
3,00,000
Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and Expense Ratio.
Sikkim Manipal University
164
Financial and Management Accounting
Unit 9
Solution Gross Profit Ratio = GP / New Sales x 100 or 2,00,000 / 12,00,000 x 100 or 16.61 % Net Profit ratio = NP after tax / Net Sales x 100 or 80,000 / 12,00,000 x 100 or 6.67 % Operating Ratio = COGS + operating expenses / Net Sales x 100 Sales minus Gross profit = COGS 10,00,000+1,00,000+80,000 / 12,00,000 x 100 or 98.33 % Operating Profit = 100 – 98.33 or 16.67 % Ratio Admn Expenses Ratio = Admn Expenses/Net sales x 100 or 1,00,000/12,00,000 x 100 8.33 % Selling Expense Ratio = Selling Expenses/Net Sales x 100 or 80,000/12,00,000 x 100 or 6.67 % Self Assessment Questions 15: 1. Net profit is known as __________________________. 2. Net profit measures percentage of each _________________ after ___________. 3. Net profit provides _________________________ of business. 4. Net profit focuses on ________________________. 5. Low ratio refers to __________________________. 6. The formula is _____________________________. 7. Calculation is based on ______________________.
9.10 Activity Ratios These are used to measure the speed with which various accounts are converted into sales or cash. Measures of liquidity are generally inadequate due to the composition of the firm’s current assets and current liabilities. The activity ratios are also known as turnover ratios. Some of the turnover ratios are as follows : Stock Turnover Ratio
: STO
Debtors Turnover Ratio
: DTO
Creditors Turnover Ratio
: CTO
Self Assessment Questions 16: 1. Activity ratios measure __________________________________. 2. Measures of liquidity is inadequate due to __________________. 3. STO, DTO, CTO are also known as ________________________________.
Sikkim Manipal University
165
Financial and Management Accounting
Unit 9
Stock Turnover Ratio I t commonly measures the activity or liquidity of the firm’s stock.. The STO is also known as stock velocity. Velocity refers to “speed” with which an object travel. Here, it is the speed on converting the stock into sales then to cash. It indicates the number of times the stock has been turned over as cash during a given period of time. It evaluates the efficiency with which a firm is able to manage its stock. If the cost of goods sold )COGS) is known, the STO can be calculated as follows: STO = COGS / Average stock at cost Where COGS = Net Sales – Gross Profit Average Stock = Opening + Closing Stock / 2 If COGS is not known, it can be computed as follows: STO = Net Sales / Stock Example: DR Ltd provides the following Stock: Opening Rs.75,000; Closing Rs.1,00,000. Credit Sales Rs.2,00,000. Cash sales Rs. 50,000. Gross Profit 25 %. Calculate the Stock Turnover Ratio Solution: STO = COGS / Average stock COGS = Net Sales – Gross Profit Net Sales = Cash Sales + Credit Sales or 2,00,000 + 50,000 or 2,50,000 Average stock = Opening + closing stock / 2 or 75,000 + 1,00,000 / 2 or 87,500 Gross Profit = 25 % on Rs.2,50,000 or 62,500 COGS = 2,50,000 – 62,500 or 1,87,500 STO = 187,500 / 87,500 or 2.14 times. Self Assessment Questions 17: 1. STR measures ______________________________. 2. STR is also known as _______________________. 3. Velocity refers to ___________________________. 4. STR commonly refers to _____________________. 5. STR evaluates the ___________________________. 6. The formula for STR is ______________________. 7. COGS is __________________________________. 8. Average Stock is ____________________________.
Sikkim Manipal University
166
Financial and Management Accounting
Unit 9
9. If COGS not given, the formula is _______________. Debtors Turnover Ratio : DTO It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors include the Bills Receivable also. The Bills receivables are written promise of trade debtors. Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay cash. Thus, debtors are expected to be converted into cash within a short period. Therefore, it is included in the current assets. It is calculated as follows : DTO = ( Debtors + BR / Net credit sales) x Number of working days DTO indicates the velocity of debt collection of firm. It indicates the number of times average debtors convert themselves over into cash during a year. Debtors care should always be taken on gross value/ Do not deduct the bad debts or provision for doubtful debts. It is expressed as the number of times. If DTO is given in months, convert it into a common base period. If it is given as a number of times, do not reduce it to a base period. Example: Total sales of a firm Rs.5,00,000, of which the credit sales are Rs.3,65,000.Sundry Debtors and Bills receivable are Rs.50,000 and Rs.2,000 respectively Calculate the DTO. Solution:
DTO = Debtors + BR / Net credit sales x 365 50,000 + 2,000 / 3,65,000 x 365 or 52 days
Self Assessment Questions 18: 1. DTO is also known as ___________________________. 2. Birth of debtors is from _________________________. 3. Debtors are based on ____________________________. 4. Debtors include ________________________________. 5. Total debts include _____________________________. 6. Bills receivable is _______________________________. 7. Trade debtors are provided with ___________________ credit time . 8. Debtors are included in ___________________________. 9. Formula for DTO ________________________________. 10. Net credit sales include ___________________________. 11. DTO involves in _________________________________. 12. Total sales R.1,00,000. Cash sales Rs.20,000. Opening Debtors Rs.10,000,
Sikkim Manipal University
167
Financial and Management Accounting
Unit 9
13. Debtors at close Rs.15,000. BR opening Rs.7,500 and at close Rs.12,500. 14. Calculate DTO. 15. Total annual sales Rs.10,00,000 and BR or Rs.1,60,000. How rapidly must BR 16. be collected if the management wants to reduce the BR to Rs.1,20,000? Creditors Turnover Ratio : CTO Creditors come into being out of credit purchases. Creditors include both trade creditors and bills payables. It is included in the current liability since the payment has to be made within three months normally. The formula is as follows : CTO = ( Creditors + Bills Payable / Credit purchases ) x 100 Where credit purchases = Total purchases minus cash purchases Example: Total purchases Rs.1,00,000. Cash purchases Rs.20,000. Discount Provision on creditors Rs.1,000. Purchase returns Rs.2,000. Creditors at close Rs.30,000. Bills payable at close Rs.25,000. Calculate CTO. Solution: Credit purchases = Total purchase – cash purchase – purchase return 1,00,000 – 20,000 – 2,000 or Rs.78,000 CTO = 30,000 + 25,000 / 78,000 x 365 or 257 days The Reserve for discount on creditors should not be considered for calculating the net credit sales.
Self Assessment Questions 19: 1. The birth of creditors __________________________ . 2. Creditors include ___________________________ . 3. Creditors are ______________________________ . 4. The formula is ____________________________ . 5. Credit purchases ____________________________ .
9.11 Leverage Ratio A firm’s capital structure is the relation of debt to equity as sources of the firm’s assets.. Normally both the owners and the creditors of the business will be interested in analyzing its capital structure. The ratios that deal with the leverage are as follows : Self Assessment Questions 20: Sikkim Manipal University
168
Financial and Management Accounting
Unit 9
1. Leverage ratio refers to _____________________________ . 2. It is based on ____________________________________ . Capital Gearing Ratio: : It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the preference share capital and the debentures as against the equity funds provided by the equity shareholders. The ratio is calculated as: Capital Gearing Ratio : Fixed cost bearing capital / variable cost bearing capital Where fixed cost bearing capital = preference share capital, debentures , long term bank borrowings. Variable cost bearing capital = equity share capital, reserves and surplus. If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm is said to be highly geared. On the reverse, it is low geared. Example: The capital structure of two companies, Neverdowell and Goodfornothing Ltd are as follows: NDW GDF
Equity Share Capital (Rs.) 10,00,000 6,00,000 6 % Preference Share Capital 3,00,000 4,00,000 7 % Debentures Reserves and Surplus
2,00,000
2,00,000 2,00,000
Solution: Capital Gearing Ratio : NDW : 3,00,000 / 12,00,000 or 0.25:1 GDF : 6,00000 / 8,00,000 or 0.75 : 1 The capital of NDW is low geared when compared to GDF. Self Assessment Questions 21: 1. CGR relies on ______________________________ . 2. Fixed cost securities include _________________ . 3. The ratio is _______________________________ . 4. Variable cost bearing capital include ___________ .
Sikkim Manipal University
169
Financial and Management Accounting
Unit 9
Debtequity Ratio: The ratio compares the debt with equity. Debt refers to long term loans and liabilities. Redeemable Preference shares are also considered as debt. This measure is helpful to assess the soundness of the longterm financial policies. It determines the relative stake of outsiders and shareholders in the company . Lower the ratio, it is considered more comfortable for the creditors financial position. 2 : 1 is taken as a satisfactory debt – equity ratio. However, it is not a very satisfactory measure. since the nominal values may bear very little relationship to their current market values. The calculation is as follows: Debt – equity Ratio = Long term debts / Shareholders’ funds + Long term debts Self Assessment Questions 22: 1. DER compares ______________ with _____________________ . 2. Debt refers to _______________________________________ . 3. Redeemable Preference shares are taken as _______________ . 4. DER determines ________________________________ stake. 5. Lower ratio indicates __________________________________ . 6. ________________________________________ Rule of thumb. 7. Formula _____________________________________________ . Example: The capital structure of DR Ltd is as follows : Equity Share Capital : 10,00,000 Redeemable Preference Capital 5,00,000 6 % Debentures 3,00,000 Long term liabilities 2,00,000 Reserves and surplus 2,00,000 Calculate the Capital Gearing Ratio and Ratio of Total Investment to Longterm liabilities Solution: CGR : Fixed Cost bearing capital / variable cost bearing capital 10,00,000 / 12,00,000 or 0.83 : 1 TI to LTL : Equity Share capital + Reserves and surplus + Long term Liabilities / Long term liabilities 22,00,000 / 10,00,000 or 2.2 : 1
9.12 Limitations Of Ratio Analysis
Sikkim Manipal University
170
Financial and Management Accounting
Unit 9
Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance comes from proper use of these ratios. Misuse or mishandling of these ratios and using them without proper context may lead the analyst or management to a wrong direction. The person who uses these ratios should be well versed and should possess expertise knowledge about making proper use of these ratios. Like all tools, ratios also suffer from several ‘ifs’ and ‘buts’ and for a thorough understanding of proper use of these ratios. There are certain limiting factors in the case of ratio analysis. These limiting factors are : 1. The user should possess the practical knowledge about the concerns and the industry in general. 2. Ratios are not an end. They are only means to an end. 3. A single ratio in itself is not important. The trend is more significant in the analysis. Comparison of ratios should be made. 4. For comparative purposes, there should be a standard ratio. There is no such standards prescribed for the ratios. 5. The accuracy and correctness of ratios are totally dependent upon the reliability of the data contained in the financial statement on the basis of which ratios are calculated. 6. To use ratios, first of all there should be uniformity in the accounting plan used by both the firms. In addition. There must be consistency in the preparation of financial statement and recording the transactions from year to year within that concern. 7. Ratios become meaningless if detached from the details from which they are derived. The should be used as supplementary and not substitution of the original absolute figures. 8. Time lag in calculation and communicating the same should not be unnecessarily too much. 9. The method of presentation should be precise and without any ambiguity. 10. Price level changes make the ratio analysis meaningless. 11. Interfirm comparison should never be undertaken iin the case of concerns which are not associated or comparable. 12. All techniques concerning the ratio analysis should be taken into account. Self Assessment Questions 23: 1. One should possess ___________________ about the concern. 2. Ratios are not _______________ But ______________________. 3. Ratio should be studied ________________________________ . 4. Comparison of ratios is done with the help of _______________ . 5. _________________________ Make ratio analysis meaningless. Sikkim Manipal University
171
Financial and Management Accounting
Unit 9
9.13 Computation of Ratios Problem 1: Extracts from financial account of DR ltd are given below Year 2006 Year 2007 Assets Stock
10,000 20,000
Debtors 30,000 30,000 Payment in advance
2,000
Cash in hand 20,000 15,000
Liabilities Sundry creditors 25,000
30,000
Bills payable 15,000 12,000 Bank Overdraft 5,000 Sales amounted to Rs.3,50,000 2006 an Rs.3,00,000 in 2008. Compute the solvency position of DR. Solution: Shortterm solvency analysis Current Ratio : CA / CL or Year 2006 : 62,000 / 40,000 or 1.55 : 1 2007
: 65,000 / 47,000 or 1.38 : 1
Liquid Ratio : LA / Liquid liabilities For 2006 : 52,000 / 40,000 or 1.30 : 1 2007 : 45,000 / 42,000 or 1.07 : 1 Bank overdraft is not included in liquid liabilities as it tends to become some sort of a permanent mode of financing. Inventory turnover ratio : Net sales / average inventory For 2006 : 3,50,000 / 10,000 or 35 : 1 2007
: 3,00,000 / 15,000 or 20 : 1
The liquid position is not sound. The current ratio I the year 2006 does not appear to be good enough as it is below the rule of thumb i.e. 2 : 1 . In the year 2007, the position has further deteriorated to 1.38: 1. The later ratio shows a definite weakening in the solvency position of the company. As regards the acid test ratio, it is satisfactory in the year 2006 and not alarming in the year 2007. However, the fall in the cash balance and appearance of bank overdraft in the year
Sikkim Manipal University
172
Financial and Management Accounting
Unit 9
shows a definite deterioration in the financial position. Moreover, because of factors concerning sales, stock and debtors, the quick ratio is likely to soon deteriorate. As regards inventory turnover ratio, it indicates an alarming deterioration in the year 2007. The disproportionate rise in the percentage of stock to total current assets from 16% in the year 2006 to 31 % in the year 2007 is also a matter of concern. This shows over purchase of materials which needs through investigation. A comparison of debtors turnover ratios of the two years indicates worsening of the company’s liquid position. There will be much cause of worry if the sales is only to a few customers. LONG TERM RATIOS Debt to equity ratio : External equities / Internal equities For 2006 : 40,000 / 22,000 or 1.82 : 1 2007 : 47,000 / 18,000 or 2.61 : 1 Proprietary Ratio : Shareholders’ Equities / Total Equities For 2006 : 22,000 / 62,000 or 0.35 : 1 2007 : 18,000 / 65,000 or 0.28 : 1 From the long term point of view, the financial position of DR is very unsatisfactory as the debt to equity ratio and proprietary ratio are far off the norm in both years. The situation has worsened in the year 2007 resulting in a serious decline in the shareholders’ equity. The company seems to be heavily banking upon the creditors’ funds. The overall conclusion of the above analysis is that the solvency position of DR is not satisfactory and needs careful planning. Problem 1 A manufacturer of stoves sells to retailers on terms 2 .5 % discount in 30 days, 60 days net. The debtors and receivables at the end of December of past three years and net sales for all these three years are as under. Year 2005 2006 2007 Debtors
54,842 33,932 85,582
Bills Receivable 4,212 3,686 9,242 Net Sales
2 ,68,466 3,47,392 4,43,126
Determine the average collection period for each of these three years and comment. Solution: Collection period : Trade receivables / Net credit sales x Number of working days Sikkim Manipal University
173
Financial and Management Accounting
Unit 9
Year 2005 : 59,054 / 2,68,466 x 365 = 80 days 2006 37,618 / 3,37,392 x 365 = 41 days 2007 94,824 / 4,43,126 x 365 =
78 days
The average collection period in all the three years has been within standard period 80 days, i.e. 60 + 1/3 of 60 days . Hence, it is good. Problem 2: DR purchases goods both on cash and credit terms. The following particulars are obtained from the books: Total purchases Rs.2,00,000. Cash purchases Rs.20,000. Purchase returns Rs.34,000. Creditors at the end Rs.70,000. Bills payable at the end Rs.40,000. Reserve for discount on creditors Rs.5,000. Calculate average payment period. Solution: Calculation of net credit purchases : Total purchases minus cash purchases minus purchase returns or Rs.3,00,000 – 20,000 – 34,000 or Rs.1,46,000. Average payment period : Creditors + Bills payable / Net credit purchases x 365 days 70,000 + 40,000 / 1,46,000 x 365 days or 275 days. Problem 3 : From the following Balance sheet , compute the Balance Sheet ratios Assets: Plant and Machinery Rs.2,00,000. Land and Building Rs.2,00,000. Stock Rs.1,50,000. Debtors Rs.50,000 and Cash balances Rs.1,00,000 = Rs.7,00,000 Liabilities: Equity Share capital Rs.2,00,000. 6 % Preference Share capital Rs.1,00,000. 8 % Debentures Rs.1,00,000. Reserves and surplus Rs.1,00,000. Long term loan Rs.50,000. Creditors Rs.1,00,000. Bank overdraft Rs.50,000 = Rs.7,00,000. Solution: Current Ratio: CA / CL or 3,00,000 / 1,50,000 or 2: 1 Liquid Ratio: LA / CL or 1,50,000 / 150,000 or 1 : 1 Absolute Liquid Ratio: Absolute liquid assets / current liabilities or 1,00,000 / 1,50,000 Or 1 ; 0.67 Proprietary Ratio: Proprietors’ equity /current liabilities or 4,00,000 / 7,00,000 or 0.57 : 1 Assets Proprietary Ratio: Fixed assets / Proprietors’ equity or 4,00,000 / 4,00,000 or 1:1 Current assets to proprietors’ equity: Current assets/ Proprietors’ equity or 4,00,000 / 4,00,000 or 1 : 1 Debt Equity Ratio: Total debts / Proprietors’ equity or 3,00,000 / 4,00,000 or 0.75 : 1 Stock to Current asset Ratio: Stock / Current assets or 1,50,000 / 3,00,000 or 0.50:1 Sikkim Manipal University
174
Financial and Management Accounting
Unit 9
Stock to working capital ratio: Stock/working capital or 1,50,000 / 1,50,000 or 1:1 Current assets to working capital ratio: CA / WC or 3,00,000 / 1,50,000 or 2:1 Current assets to Liquid assets ratio: CA / LA or 3,00,000 / 1,50,000 or 2:1 Long term funds to working capital ratio: All long term funds / working capital or 2,50,000 / 1,50,000 or 1.67 : 1 Tangible assets to working capital ratio: Tangible assets / current liabilities or 4,00,000 / 1,50,000 or 2.67 : 1 Tangible assets to current liabilities ratio: Tangible assets / current liabilitieisi or 4,00,000 / 1,50,000 or 2.67 : 1 Capital Gearing Ratio: Equity share capital / Preference shares + Debentures or 2,00,000 / 2,00,000 or 1:1 Problem 4: A factory engaged in an industry which is capital intensive has been in operation for ten years. The capital employed is Rs.17,00,000, out of which Rs.10,00,000 represent equity capital and reserves, Rs.5,00,,, long term borrowings on Debentures and Rs.2,00,000 cash credit from banks. The working capital of the company is Rs.8,50,000 made up of stocks Rs.3,00,000, Stores Rs.1,40,000, Debtors Rs.3,50,000, Advances and deposits Rs.60,000. Annual Sales Rs.8,00,000. Calculate current ratio, liquidity ratio, debt equity ratio, proprietary ratio, Fixed assets to proprietors’ funds, Fixed asset ratio. Solution: Current Ratio : 8,50,000 / 2,00,000 or 4.25 : 1 Liquidity Ratio = 4,10,000 / 2,00,000 or 2.05 : 1 Debt equity ratio : 7,00,000 / 10,00,000 or 0.7 : 1 Proprietary ratio : 10,00,000 / 17,00,000 or 0.59 : 1 FA to Proprietors’ fund or 8,50,000 / 10,000 or 0.85 : 1 Fixed assets ratio or 8,50,000 / 15,00,000 or 0.57 : 1 Problem 5: The ratios relating to DR Ltd are given below Gross profit ratio 15 %. Stock velocity : 6 months. Debtors velocity 3 months. Creditors velocity 3 months. The gross profit for the year amounts Rs.60,000. Closing stock is equal to opening stock. Find sales, closing stock, sundry debtors and sundry creditors. Solution: Gross Profit Ratio = Gross Profit / sales and 100 or 15 % = 60,000 / sales x 100 or Sales is Rs. 4,00,000. Sikkim Manipal University
175
Financial and Management Accounting
Unit 9
Closing stock = Basis stock velocity or Cost of goods sold / average stock where COGS = Sales – Gross profit or Rs.4,00,000 – Rs.60,000 or Rs.3,40,000 6 months = 3,40,000 / Average stock of Average stock is Rs.6,80,000. Since opening and closing stocks are the same, the closing stock is Rs.6,80,000 Sundry Debtors : Basis Debtors velocity = Total debtors / sales x Number of months Total Debtors is 4,00,000 x 3 /12 or Rs.1,00,000 Sundry Creditors : Total creditors / purchases x Number of months Where Purchases = Opening stock + purchases closing stock or Rs.3,40,000 Creditors = 3,40,000 x 3/12 or Rs.85,000 Problem 6: Prepare a Balance sheet from the following Current Ratio 1.4. Liquid Ratio 1. Stock turnover Ratio 8. GP Ratio 20 %. Debt collection period 1.5 months. Reserves and surplus to capital 0.6. Turnover to fixed assets 1.6. Capital Gearing Ratio 0.5. Fixed assets to net worth 1.25. Sales Rs.10,00,000. Solution: Calculation of cost of Sales : Sales – Gross profit 10,00,000 minus 2,00,000 (20 % of 10,00,000) Rs. 8,00,000. Closing Stock: Cost of sales / Stock Turn over Ratio or 8,00,000 / 8 or Rs.1,00,000 Fixed Assets: Cost Sales / FA turnover or 8,00,000 / 1.6 or Rs.5,00,000 Debtors: Total sales x Debt collection period of 10,00,000 x 1.5 / 12 or Rs.1,25,000 Current assets based on liquid ratio: Current Ratio is 1.4. Therefore Stock is Current Ratio minus Liquid Ratio of 1.4 minus 1.0 or o.4 or Value of stock x current ratio / stock ratio o 1,00,000 x 1.4 /4 or Rs.3,50,000 Liquid assets = Current assets minus stock or 2,50,000 minus 1.25,000 or Rs.1,25,000 Cash balances : Liquid assets minus Debtors or 2,50,000 minus 1,25,000 or Rs.1,25,000 Current Liabilities : Current Ratio is 1.4 Therefore, current liabilities is Current assets / current ratio or 3,50,000 / 1.4 or Rs.2,50,000 Net Worth : Fixed Assets / FA to net worth or 5,00,000 / 1.25 or Rs.4,00,000 Reserves and Surplus : Ratio 0.6 Let the Capital be 1 Add: Reserves and surplus which is 0.6, hence it is 1.6
Sikkim Manipal University
176
Financial and Management Accounting
Unit 9
Reserves and surplus will be : Shareholders funds x Reserves / Total ratio or 4,000 x 0.6 / 1.6 or Rs. 1,50,000 Share Capital : Shareholders funds minus Reserves or 4,00,000 minus 1,50,000 or Rs.2,50,000 Long term Liabilities : Capital Gearing ratio is 0.5 Share capital x Gearing ratio or 4,00,000 x 0.5 or Rs.2,00,000 BALANCE SHEET Liabilities
Assets
Share capital 2,50,000 Fixed Assets 5,00,000 Reserves and Surplus 1,50,000 Stock 1,00,000 Long term Liabilities 2,00,000 Debtors 1,20,000 Current Liabilities 2,50,000 Cash balances 1,25,000
8,50,000
8,50,000
Terminal Questions: Problem 1: Calculate Current ratio, acid test ratio.: Cash in hand Rs.3,000. Cash at Bank Rs.65,000. Bills receivable Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses Rs.2,000. Creditors Rs.1,20,000. Bills payable Rs.20,000. Problem 2: Calculate : Debts to equity Ratio and Proprietary ratio : Equity share capital Rs.5,00,000. Preference share capital Rs.3,00,000. Reserves Rs.2,00,000. Current liabilities Rs.1,00,000. 8 % Debentures Rs.3,00,000. Fixed assets Rs.10,00,000. Current assets Rs.4,00,000 Problem 3: The current assets and current liabilities were Rs.16,00,000 and Rs.8,00,000 respectively. What is the effect of each of the following transactions individually and totally on the current ratio : 1. Purchase of new machinery for Rs.5,00,000 2. Purchase of new machinery for Rs.10,00,000 on a medium term loan from a bank with 20 % margin. 3. Payment of a dividend of Rs.2,00,000 of which Rs.0.47 lakh was tax deducted at source. 4. Materials purchased costing Rs.5,00,000 in respect of which bank financed Rs.3,00,000. Sikkim Manipal University
177
Financial and Management Accounting
Unit 9
Problem 4: The current ratio is 2 : 1. Which of the following suggestions would improve the ratio, which would reduce it and which would not change it. a) to pay a current liability b) to sell a motor car for cash at a slight loss c) to borrow money for short time on an interest bearing ;promissory note d) to purchase stock for cash e) to give an interest bearing promissory note to a creditor to whom money was to be paid. Answer for Self Assessment Questions Self Assessment Questions 1: 1. Income and balance sheet 2. Trend 3. Cross sectional 4. Comparative Self Assessment Questions 2: 1. Interbusiness comparison and across financial period 2. One number expressed in terms of another 3. Numerical or quantitative 4. Quotient 5. Proportion, percentage and turnover 6. Process of establishing and interpreting ratios for decision making Self Assessment Questions 3: 1. Financial analysis 2. Financial statements 3. Liquidity, solvency and profitability aspects Self Assessment Questions 4: 1. Eight 2. For forecasting and planning activities 3. Management and utilization of asset 4. Firm’s progress and performance 5. Short term and long term liquidity position 6. Value of the financial statements 7. Overall efficiency of the business entity Sikkim Manipal University
178
Financial and Management Accounting
Unit 9
8. Actual results can be compared with established standards Self Assessment Questions 5: 1. Current and liquid 2. Debt and equity 3. GP, NP, and operating 4. STO,DTO and CTO 5. Gearing. Self Assessment Questions 6: 1. To meet current liability 2. Current assets and current liabilities 3. Matching principle 4. Current ratio and quick ratio. Self Assessment Questions 7: 1. Financial 2. Short term obligations 3. Current and current liabilities 4. Current assets : current liabilities or current assets / current liabilities 5. Proportion 6. 2 : 1 7. Current assets minus current liabilities. 8. CA 1,00,000 and CL 20,000 Self Assessment Questions 8: 1. Quick, acid test 2. Stock 3. Stock cannot b e sold easily and stock typically sold on credit 4. Current stock minus stock / current liabilities 5. Will not change 6. Will improve 7. CR will decline 8. CR will not change. 9. 3,50,000; 2,00,000, 2,50,000 and Rs.1,00,000. 10. Rs.20,000 11. CA Rs.1,00,000, CL Rs.40,000, Stock Rs.40,000 and LA Rs.60,000. Sikkim Manipal University
179
Financial and Management Accounting
Unit 9
Self Assessment Questions 9: 1. Long term financial position 2. Test of solvency 3. Debt and equity 4. Outside borrowings 5. Indebtedness and repayment Self Assessment Questions 10: 1. Health and risk 2. Total liabilities / total assets. 3. Too much of debt 4. Inability to repay debt 5. Limited 6. Non risky situations. Self Assessment Questions 11: 1. Long term liabilities and equity portion in Balance sheet 2. Equity share capital + Reserves and surplus 3. Long term debt / shareholders’ equity 4. Capital structure 5. Relationship between debt and equity 6. Value of the firm 7. Funds 8. Increased borrowings or sale of shares or both 9. Poor capital structure. 10. Repayment of debt 11. Sound financial position 12. Risky 13. Vary Self Assessment Questions 12: 1. Tells the status 2. Sales, assets, equity or share value 3. Earnings 4. Profits 5. Capital.
Sikkim Manipal University
180
Financial and Management Accounting
Unit 9
Self Assessment Questions 13: 1. Percentage 2. Pricing policy 3. Gross profit / sales x 100 4. Sales minus Cost of goods sold 5. Cash + credit sales minus returns 6. Percentage. Self Assessment Questions 14: 1. Relationship 2. Net sales Self Assessment Questions 15: 1. NP margin 2. Sales in rupee, expenses and taxes 3. Overall efficiency 4. Overall efficiency 5. Poor financing planning and low efficiencies 6. f ) Net profit after taxes / net sales x 100 7. Income statement Self Assessment Questions 16: 1. Speed 2. Composition of Current assets and current liabilities 3. Turnover. Self Assessment Questions 17: 1. Firm’s stock 2. Inventory turnover, stock velocity 3. Speed of converting stock into sales to cash 4. Number of times turnover 5. Efficiency to manage stock 6. Cost of Goods Sold (COGS) / Average stock 7. Net sales minus gross profit. 8. Opening + Closing stock / 2 9. Net sales / Stock
Sikkim Manipal University
181
Financial and Management Accounting
Unit 9
Self Assessment Questions 18: 1. Debtors velocity 2. credit sales 3. Gross value 4. Bad debts and reserve e for doubtful debts 5. Trade debtors and Bill receivable 6. Written 7. Three months 8. Current assets 9. Debtors + Bills receivable / net credit sales x number of working days. 10. Sales minus return inwards 11. Velocity of debt collection 12. DTO 3.56 13. Collection period 43 days. Self Assessment Questions 19: 1. Credit purchases 2. Trade creditors + bills payable 3. Current liabilities 4. Creditors + BP / credit purchases x Number of days. 5. Credit purchases minus return outwards. Self Assessment Questions 20: 1. Relation of debt and equity 2. Capital structure. Self Assessment Questions 21: 1. Fixed cost bearing securities. 2. Preference share capital + debentures. 3. Fixed cost bearing securities / variable cost bearing capital . 4. Equity share capital + reserves and surplus. Self Assessment Questions 22: 1. debt, equity 2. Long term loans and liabilities 3. Long term debt 4. relative
Sikkim Manipal University
182
Financial and Management Accounting
Unit 9
5. comfort zone 6. 2 : 1 7. Long term debts / Shareholders’ funds + long term debt Self Assessment Questions 23: 1. Comprehensive and practical knowledge 2. Ends but means 3. In totality 4. Standards 5. Price level changes Answer for Terminal Questions: 1. Refer to units 9.7 2. Refer to units 9.8 & 9.13 3. (1) Decrease (2) decrease (3) decrease (4) increase 4. (a) increase (b) increase (c) decrease (d) no change (e) no change
Sikkim Manipal University
183
View more...
Comments
