Accounting:

UNIT 1 ACCOUNTING: AN OVERVIEW An Overview

Structure
1.0 Objectives
1.1 Introduction
1.2 Need for Accounting
1.3 Definition of Accounting
1.4 Objectives of Accounting
1.5 Accounting as Part of the Information System
1.6 Branches of Accounting
1.6.1 Financial Accounting
1.6.2 Cost Accounting
1.6.3 Management Accounting
1.7 Role of Management Accountant
1.8 Financial Accounting Process
1.9 Accounting Equation
1.10 Accounting Concepts
1.10.1 Concepts to be Observed at the Recording Stage
1.10.2 Concepts to be Observed at the Reporting Stage
1.11 Accounting Standards
1.12 Accounting Assumptions and Policies as per Accounting Standards of India
1.13 Let Us Sum Up
1.14 Key Words
1.15 Answers to Check Your Progress
1.16 Terminal Questions
1.17 Some Useful Books

1.0 OBJECTIVES
After studying this unit you should be able to appreciate:
l the need for accounting;
l definition of accounting and its objectives;
l describe the advantages and limitations of branches of accounting;
l identify the parties interested in accounting information;
l activities of a management accountant;
l identify the stages involved in accounting process;
l explain the accounting concepts to be observed at the recording and reporting
stages; and
l understand and appreciate the Generally Accepted Accounting Principles.

1.1 INTRODUCTION
In business numerous transactions take place every day. It is humanly impossible to
remember all of them. With the help of accounting records the businessman is able to
ascertain the profit or loss and the financial position of the business at a given period
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Fundamentals of and communicate such information to all interested parties. In this unit you will learn
Accounting about an overview of accounting and the basic concepts which are to be observed at
the recording and reporting stage. You will also learn different stages involved in
accounting process and importance of accounting standards to maintain uniformity in
the practice of accounting.

1.2 NEED FOR ACCOUNTING

In early days the business organisations and transactions were small and easily
manageable by the owners of the business themselves. The businessmen used to
remember the transactions by memorizing them. In those days accounting developed
as a result of the needs of the business to keep relationship with the outsiders, listing
of their assets and liabilities. The advent of industrial revoluation and technological
changes have widened the market opportunities. Most of the business concerns in
these days are run by company type of organisation. The business concern has
constantly enter into transactions with outsiders. A transaction involves transfer of
money or money’s worth (goods or services) from one person to another. In addition
to the transactions with outsiders, there are also events requiring monetary record.
It is not possible for a human being to keep in memory all the transactions. Therefore,
it is necessary to record all these transactions properly to get required financial
information. With the help of accounting records the businessman would be able to
ascertain the profit or loss and the financial position of his business at the end of a
given period and would be able to communicate the results of business operations to
various interested parties. It is, therefore, necessary to record all the transactions
systematically from time to time irrespective of the form of business organisation.
The accounting information is useful both for the management and the outside
agencies. The management needs it for the purpose of planning , controlling and
decision making. The outsiders like banks, creditors etc. also require it for assessing
the financial solvency of the business and the tax authorities use it for determining the
amount of tax liability. Infact accounting is necessary not only for business
organisations but also for non-business organisations like schools, colleges, hospitals,
clubs etc.

1.3 DEFINITION OF ACCOUNTING

Accounting as said earlier, involves the collection, recording, classification and
presentation of financial data for the benefit of management and outside agencies such
as shareholder, creditors, investors, government and other interested parties.
Accounting has been defined in different ways by different authorities on the subject.
The following are some of the important definitions of accounting:
According to the Committee on Terminology of American Institute of Certified Public
Accountants (AICPA), “Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions and events
which are in part at least, of a financial character, and interpreting the results thereof”.
Eric L. Kohlen (A Dictionary for Accountants) defines accounting as “the procedure
of analysing, classifying and recording transactions in accordance with a pre-
conceived plan for the benefit of : (a) providing a means by which an enterprise can be
conducted in orderly fashion, and (b) establishing a basis for reporting the financial
condition of enterprise and the results of its operations.”
The former definition denotes that accounting is concerned with the recording of
transactions which are measurable in monetary terms in such a way that analysis and
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interpretation of business activities is possible. According to the latter definition
accounting is concerned with the recording of business transactions for better Accounting:
management of the concern and also reporting the true financial position of the An Overview
concern.
The American Accounting Association (AAA) defines accounting as “the process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by users of information.”
Smith and Ashburne define accounting as “the science of recording and classifying
business transactions and events, primarily of a financial character, and the art of
making significant summaries, analysis and interpretations of those transactions and
events and communicating the results to persons who must make decisions or form
judgments.” Thus this definition emphasises financial reporting and decision making
aspects of accounting.
From the above definitions it is clear that accounting is a science of recording
transactions of economic nature in a systematic manner and also an art of analysing
and interpreting the same.
Based on the above definitions, we can summarise the functions of accounting as:
i) Identifying financial transactions,
ii) Recording of transactions which are financial in character,
iii) Classification of transactions,
iv) Summarising the transactions which also includes preparation of trail balance,
income statements and balance sheet,
v) Interpretation of financial results, and
vi) Communicating the interpreted financial results in a proper form and manner to
the proper person.
Look at the following figure and note the functions of accounting which starts from
identifying financial transactions to be recorded in the books and ends with
communicating to the interested parties who use them for decision making.

Functions of Accounting

Identifying financial Recording of Classifying the

s

Transaction Financial Transaction Transaction

s
s
Communication Interpretation of Summarising
s

Make a Decision
s

Owner or Results the Transactions

Management
s

Interested Parties

Make Decision

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Fundamentals of
Accounting 1.4 OBJECTIVES OF ACCOUNTING
The basic objectives of accounting is to provide necessary information to the persons
interested who will make relevant decisions and form judgement. The persons
interested in the business are classified into two types : i) Internal users, and
ii) External users. Internal users are those who manage the business. External users
are those other than the internal users such as investors, creditors, Government, etc.
Information required by the external users are provided through Profit and Loss
account and Balance sheet whereas the internal users get required information from
the records of the business. Thus the main objectives of accounting are as follows:
1) To keep systematic records of the business : Accounting keeps a systematic
record of all financial transactions like purchase and sale of goods, cash receipts
and cash payments etc. It is also used for recording all assets and liabilities of
the business. In the absence of accounting it is impossible to a human being to
keep in memory all business transactions.
2) To ascertain profit or loss of the business : By keeping a proper record of
revenues and expenses of business for a particular period, accounting helps in
ascertaining the profit or loss of the business through the preparation of profit
and loss account. Profit and Loss account helps the interested parties in
assessing the profit or loss made by the business during a particular period. It
also helps the management to take remedial action in case the business has not
proved remunerative or profitable. A proper record of all incomes and expenses
helps in preparing a profit and loss account and in ascertaining net operating
results of a business during a particular period.
3) To ascertain the financial position of business : The business man is also
interested to know the financial position of his business apart from operating
results of the business during a particular period. In other words, he wants to
know how much he owns and how much owes to others. He would also like to
know what happened to his capital, whether it has increased or decreased or
remained constant. A systematic record of assets and liabilities facilitates the
preparation of a position statement called Balance Sheet which provides
necessary information to the above questions. Balance Sheet serves as barometer
for ascertaining the financial solvency of the business.
4) To provide accounting information to interested parties : Apart from owners
there are various parties who are interested in the accounting information. These
are bankers, creditors, tax authorities, prospective investors etc. They need such
information to assess the profitability and the financial soundness of the
business. The accounting information is communicated to them in the form of an
annual report.
Parties Interested in Accounting Information
Many people are interested in examining the financial information provided in the
financial statements besides a owner or management of the concern. These financial
statements help them to know the following :
i) To study the present financial position of business,
ii) To compare its present performance with that of past years, and
iii) To compare its performance with similar enterprises.
The following are the various parties interested in the financial statements:
i) Owners/Shareholders : Shareholders are the real owners of the company
because they contribute the required capital and take the risk of business.
Obviously they are interested to know the result of operations and financial
position of the company. The shareholders are also interested to use the
accounting information to evaluate the performance of the managers because in
company type of organisation management of business is vested in the hands of
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paid managers.
ii) Prospective Investors : The persons who are interested in buying shares of a Accounting:
company or who want to advance money to the company, would like to know An Overview
how safe and rewarding the investments already made or proposed investments
would be.
iii) Lenders : Initially the required funds of the business are provided by the owners.
When business is going on, it requires more funds. These funds are usually
provided by banks and other money lenders. Before lending money they would
like to know about the solvency of the enterprise so as to satisfy themselves that
their money will be safe and repayments will be made on time.
iv) Creditors : The creditors are those who supply goods and services on credit.
These creditors like other money lenders are also interested to know the credit
worthiness of the business. The accounting information greatly helps them in
assessing the ability of the enterprise to what extent credit can be granted.
v) Managers : Accounting information is very much useful to managers. It helps
them to plan, control and evaluate all business activities. They also need such
information for making various decisions relating to the business.
vi) Government : The Government may be interested in accounting information of a
business on account of taxation, labour and corporate laws. The financial
statements are of great importance for assessing the tax liability of the enterprise.
vii) Employees : The employees of the enterprise are also interested in knowing the
state of affairs of the organisation in which they are working, so as to know how
safe their interests are in the organisation. The knowledge of accounting
information helps them in conducting negotiations with the management.
viii) Researchers : The accounting information is of immense value to the
researchers undertaking research in accounting theory and practices.
ix) Citizen : An ordinary citizen as a voter and tax payer may be interested to know
the accounting information to measure the performance of Government Company
or a public utility concern like banks, gas, transport, electricity companies etc.

1.5 ACCOUNTING AS PART OF THE INFORMATION

SYSTEM
Accounting is part of an organisation’s information system, which includes both
financial and non-financial data. Accounting is the process of identifying, measuring
and communicating economic information to permit judgment and decisions by users
of the information. The main objective of accounting is to provide information to the
users. Accounting is also required to serve some broad social obligations since the
accounting information is used by a large body of people such as customers,
employees, investors, creditors and government.
Accounting is commonly divided into (1) Financial Accounting, and (2) Managerial
Accounting. Financial accounting refers to the preparation of general purpose reports
for use by persons outside an organisation. Such users include shareholders,
creditors, financial analysts, labour unions, government regulations etc. External
users are interested primarily in reviewing and evaluating the operations and financial
status of the business as a whole.
Managerial accounting, on the other hand, refers to providing of information to
managers inside the organisation. For example a production manager may want a
report on the number of units of product manufactured by various workers in order to
evaluate their performance. A sales manager might want a report showing the
relative profitability of two products in order to pinpoint selling efforts. The financial
reports are available from the libraries or companies themselves where as managerial
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Fundamentals of accounting reports are not widely distributed outside because they often contain
Accounting confidential information. The following figure shows that accounting is part of an
organisation system which includes both Financial and non financial data :
Accounting as part of the information system

Accounting and Non-accounting Information

Financial Accounting Managerial Accounting

Creditors Shareholders Tax Other Managerial Managerial Planning

Authorities External Decision making Performance Evaluation
Users

Uses of Accounting Information

Accounting provides information for the following three general uses :-
1) Managerial decision making : Management is continuously confronted with the
need to make decisions. Some of these decisions may have immediate effect
while the others have in the long run. Decisions regarding the price of the
product, make or buy the product or to dropt it, to expand its area of operations
etc., are some of the examples of decisions that face management and
accounting provides necessary information to arrive at right conclusions.
2) Managerial planning, control and internal performance evaluation :
Managerial accounting plays an important role in the planning and control. By
assisting management in the decision making process, information is provided for
establishing the standard. Accounting also provides actual results to compare
with projections.
Planning can be defined as the process of deciding how to use available
resources. The key word in this definition is deciding, because planning is
essentially a matter of choosing the set of alternatives which seem most likely to
enable the organisation to meet its objectives. Several different kinds of planning
processes can be identified, but most important is periodic planning for the
activities of the organisation as a whole.
Control is the complement of planning. It consists of management’s efforts to
prevent undesirable departures from planned results and to take corrective action
in response to it.
The planning and control process consist of the following steps :
i) Setting standards as to what actual performance should be.
ii) Measuring the actual performance.
iii) Evaluating actual performance by comparing actual performance with the
standards. This evaluation aids management in assessing actions already
taken and in deciding which course of action should be taken in future.
The main relationship between planning and control is the planning produces a
plan. This becomes a set of instructions to be executed. The results of the action
taken on the basis of the plan are then compared with the planned results. The
difference of the plan are interpreted to determine what kind of response is
appropriate. A corrective response requires a change in the way of plan is
carried out, while adaptive response requires replanning. Each of these leads
back to an earlier phase of the process and the loop is completed.
For example where a marketing manger is given a target of sales revenues of
Rs. 10 crores, the amount of Rs. 10 crores will serve as a standard for evaluating
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 the performance of the marketing manager. If annual sales revenues vary Accounting:
significantly from Rs. 10 crores, steps will be taken to ascertain the causes for An Overview
the difference. When the factors leading to the variance are not under the control
of the marketing manager, then the marketing manager would not be held
responsible for it. On the other hand the cause for variance is under the control
of marketing manager then he will be held responsible in evaluating the
performance of marketing manager.
3) External Financial reporting and performance evaluation : Accounting has
always been used to supply information to those who are interested in the affairs
of the company. Various laws have been passed under which financial
statements should be prepared in such way that required information is supplied
to shareholders, creditors, government etc. For example, the investors may be
interested in the financial strength of the business, creditors may require
information about the liquidity position, government may be interested to collect
details about sales, profit, investment, liquidity, dividend policy, prices etc. in
deciding social and economic policies. Information is required in accordance
with generally accepted accounting principles so that it is useful in taking
important decisions.

1.6 BRANCHES OF ACCOUNTING

To meet the requirements of different people interested in accounting information,
accounting can be broadly classified into three categories :
1) Financial Accounting,
2) Cost Accounting, and
3) Management Accounting

1.6.1 Financial Accounting

The American Institute of Certified Public Accountants has defined Financial
Accounting as “the art of recording, classifying and summarizing in a significant
manner in terms of money transactions and events which are in part at least of a
financial character, and interpreting the results thereof”. Accounting is the language
effectively employed to communicate the financial information of a business unit of
various parities interested in its progress.
The object of financial accounting is to find out the profitability and to provide
information about the financial position of the concern. Two important statements of
financial accounting are Income and Expenditure Statement and Balance Sheet.
All revenue transactions relating to a particular period are recorded in this statement
to decide the profitability of the concern. The balance sheet is prepared at a particular
date to determine the financial position of the concern.

Functions of Financial Accounting

Financial accounting provides information regarding the status of the business and
results of its operations to management as well as to external parties. The following
are some of the important functions of financial accounting :
a) Recording of Information
In business, it is not possible to keep in memory all the transactions. These
transactions need to be systematically recorded and pass through the journals,
ledgers and worksheets before they could take the form of final accounts. Only
those transactions are recorded which are measurable in terms of money. The
transactions which cannot be expressed in monetary terms does not form part of
financial accounting even though such transactions have a significant bearing on
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the working of a business.
Fundamentals of b) Managerial Decision Making
Accounting
Financial accounting is greatly helpful for managers in taking decisions.
Without accounting, the managerial functions and decision making programmes
may mislead. The performance of daily activities are to be compared with the
predetermined standards. The variations of actual operations and their analysis
are possible only with the help of financial accounting.
c) Interpreting Financial Information
Interpretation of financial information is very important for decision making.
The recorded financial data is interpreted in such a manner that the end users
such as creditors, investors, bankers etc., can make a meaningful judgment about
the financial position and profitability of the business operations.
d) Communicating Results
Financial accounting is not only concerned with the recording of facts and
figures but it is also connected with the communication of results. In fact
accounting is the source of business operation. Therefore, the information
accumulated and measured should be periodically communicated to the users.
The information is communicated through statements and reports. The financial
statements and reports should be reliable and accurate. A variety of reports are
needed for internal management depending upon its requirement. In
communicating reports to outsiders, standard criteria of full disclosure,
materiality, consistency and fairness should be adhered to.

Limitations of Financial Accounting

Financial accounting was able to cope up with the needs of business in the initial
stages when business was not so complex. This is because financial accounting is
mainly concerned with the preparation of final accounts, i.e., profit and loss account
and balance sheet. But the growth and complexities of modern business have made
financial accounting highly inadequate. The management needs information for
planning, controlling and coordinating business activities.
The limitations of financial accounting are as follows :
1) Historic nature : Financial accounting is the record of all those transactions
which have taken place in the business during a particular period. As
management’s decisions relates to future course of action, they are made on the
basis of estimates and projections. Financial accounting provides information
about the past data and not about the future. It does not suggest the measures
about what should be done to improve efficiency of the business. Past data are
needed for making future decisions but that does not alone sufficient.
2) It records only actual costs : Financial accounting has always been concerned
with figures treating them as single, simple and silent items because it records
only actual cost figures. The price of goods and assets changes frequently. The
current prices may be different from recorded costs. Financial accounts do not
record these price fluctuations. Therefore, the recorded information may not give
correct information.
3) It provides quantitative information : Financial accounting considers only
those factors which are quantitatively expressed. Anything which cannot be
measured quantitatively will not constitute a part of financial accounting. Today
business decisions are influenced by a number of social considerations.
Governments polices have a direct bearing on the working of business.
Therefore, in addition to social consideration the management has also to take
into account, the impact of government policies on the business. But these
factors cannot be measured quantitatively so their impact will not reflect in
1 2 financial statement.
4) It provides information about the whole concern : Financial accounting Accounting:
provides information about the concern as a whole. It discloses only net results An Overview
of the collective activities of a business. Detailed information regarding product-
wise, process-wise, department wise, etc. is not recorded in financial accounts.
Thus, product wise or job wise cost of production cannot be determined. It is
essential to record the transactions activity wise for cost determination and cost
control purpose.
5) Difficulty in price fixation : The cost of the product can be obtained only when
all expenses have been incurred. It is not possible to determine the prices in
advance. Price fixation requires detailed information about variable and fixed
costs, direct and indirect costs. Financial accounting cannot supply such
information and therefore, it is difficult to quote the prices during the periods of
inflation or depression in trade.
6) Appraisal of policies is not possible : Financial accounting do not provide data
for evaluation of business policies and plans. There is no technique for
comparing actual performance with the budgeted targets. Financial accounting
do not provide any measure to judge the efficiency of a business. The only
criteria for determining efficiency is the profit at the end of financial period.
Therefore, the only yardstick for measuring the managerial performance is profit
and loss account which is not a reliable test for ascertaining efficiency of the
management.
7) It is not helpful in Decision Making : Financial accounting do not help the
management in taking strategic decisions because they do not provide adequate
information to compare the probable effect of alternative courses of action such
as replacement of labour by machinery, introduction of new product line,
expansion of capacity etc. The impact of these decisions and cost involved is to
be ascertained in advance. Due to historic nature of accounting data available
from financial accounts, it is not of much helpful to the management.
8) Lack of uniformity in accounting principles : Accounting policies differ on
the use of accounting principles. There is lack of unanimity on the use of
accounting principles and procedures. The financial statements prepared by two
different persons of the same concern gives different results due to varying
personal judgment in applying a particular convention. The methods of valuing
inventory, methods of depreciation, allocation of expenses between revenue and
capital etc. are the most controversial issues on which unanimity is not possible.
The use of different accounting methods reduces the usefulness and reliability of
financial accounting.
9) It is not possible to control costs : Another limitation of financial accounting is
that the cost figures are known only at the end of financial period. When the cost
has already been incurred then nothing can be done to control the cost. A
constant review of actual costs from time to time is required for cost control and
this is not possible in financial accounting.
10) Possibility of manipulation of accounts : The over and under valuation of
inventory may affect the profit figures. The profit may be shown more or less to
get more remuneration, to pay more dividend or to raise the share prices, or to
save taxes or not to pay bonus to workers, etc. The possibility of manipulating
financial accounts reduces their reliability.
11) Technological revolution : With the advancement in science and technology very
minute and detailed break-up of all types of data relating to various parts of a
business unit have become a must for the management of its day to day
functioning. It is clear that financial accounting with its simple structure is not
in a position to cater the needs of the management because it supplies only
elementary information. 1 3
Fundamentals of The limitations of financial accounting have given scope for the development of
Accounting Costing and Management accounting.

1.6.2 Cost Accounting

Cost accounting is one of the important elements of accounting information about the
problems of internal managerial control. Financial accounts are unable to meet
information needs about the cost structure of a product. The need for cost
determination and controls necessitated new set of principles of accounting and thus
emerged ‘Cost accounting’ as a specialised branch of accounting. Cost accounting is
the process of accounting for costs. It includes the accounting procedures relating to
recording of all income and expenditure and preparation of periodical statements and
report with the object of ascertaining and controlling costs. Such cost accounting is a
good technique for ascertaining profitability and for decision making. The Institute of
Cost and Management, London defines cost accounting as “the application of costing
and costing principles, methods and techniques to the science, art and practice of cost
control and ascertainment of profitability. It includes presentation of information
derived therefrom for the purpose of managerial decision making.”

Functions of Cost Accounting

The main functions of cost accounting can be briefed as follows :
a) Cost accounting enables the management to ascertain the cost of product, job,
contract, service or unit of production.
b) It helps in price fixation or quotation.
c) It provides information for the preparation of estimates and tenders.
d) It helps in minimizing the cost of manufacture.
e) It helps in determining profitability of each product, process, department etc.
f) It is a useful tool for managerial control and helps in cost reduction and cost
control.
g) It increases efficiency and reduces wastages and costs.
h) It provides cost data for comparison in different periods.

Limitations of Cost Accounting

Cost accounting lacks a uniform procedure. It is developed through theories and
accounting practices based on reasoning and common sense. There is no common
system of cost accounting applicable to all industries. A limitation of cost accounting
is its emphasis on cost data and largely based on estimates. Hence, it is considered
very narrow in its perspective as it fails to consider the revenue aspect in detail.
Moreover, cost accounting can be used only in big organisations.

1.6.3 Management Accounting

Cost accounting helps the internal management by directing their attention on
inefficient operations and assisting in a day-to-day control of business activities.
The costing data needs to be arranged, re-analysed and processed further for effective
role in managerial process. In addition to costing and accounting data, managerial
functions need the use of socio-economic and statistical data (e.g., population
break-ups, income structure, etc.). Cost and financial accounting do not provide such
information and this limitation pave the way for the emergence of management
accounting. Management accounting is a systematic approach to planning and control
functions of management. It generates information for establishing plans and
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controls. It provides for a system of setting standards, plans, or targets and reporting Accounting:
variances between planned and actual performances for corrective actions. Thus, An Overview
Management accounting consists of cost accounting, budgetory control, inventory
control, statistical methods, internal auditing and reporting. It also covers financial
accounting.
Management accounting is the process of identification, measurement, accumulation,
analysis, preparation, interpretation and accumulation of financial information used
by management to plan, evaluate, and control within an organisation and to assure
appropriate use of and accountability for its resources. Management accounting also
comprises the preparation of financial reports for management groups such as
shareholders, creditors, regulator agencies and tax authorities.Thus it is the
application of professional information to assist the management in the formation of
policies and in planning and control of the operations of the business enterprise.
Thus Management accounting helps an organisation to accomplish its goals in the
following ways :
1) It provides a way to communicate expectations to managers throughout the
organisation.
2) It provides feedback which enables a manager to monitor the day to day
operations of the company for which he is responsible. If actuals differ
significantly from targeted results, the manager is alerted, can look for causes for
deviation and can take corrective actions.
3) It provides a set of prescribed tools and techniques for use in decision making.

Limitations of Management Accounting

Though Management Accounting is a useful tool for planning, directing and
controlling functions still it suffers from the following limitations :
1) Based on Cost and Financial Information: Management accounting derives
information from financial and cost accounting and other records. The
accounting statements and records suffer from certain limitations as they are
prepared on the basis of certain accounting concepts and conventions. The
correctness and effectiveness of managerial decisions will depend upon the
quality of data on which these decisions are based. If financial data is not
reliable then management accounting will not provide correct analysis. The
limitations of financial statements and records may be transmitted to the
management accounting system. This may limit its effectiveness and make the
information a substandard one.
2) Persistence of Intuitive Decision Making: Management accounting provides
facts and figures of various situations and assists management in taking
decisions scientifically. It includes decision tools such as marginal costing,
differential costing and OR techniques like linear programming, decision theory,
etc. Despite the facilities provided, the management mostly resorts to simple
methods of decision making by intuition. Intuitive decisions limit the usefulness
of management accounting.
3) It has a very Wide Scope: For taking decision, management requires
information from both accounting as well as non-accounting sources and also
quantitative as well as qualitative information. This creates many problems and
brings a degree of inexactness and subjectivity in the conclusions obtained
through it .
4) Lack of Knowledge: The use of Management accounting requires the
knowledge of a number of related subjects. Lack of knowledge in the related
subjects limits the use of management accounting 1 5
Fundamentals of 5) It is very Costly System: The installation of Management accounting system
Accounting needs a very elaborate organisational system. A large number of rules and
regulations are also required to make this system workable and effective. This
results in heavy investment which only big concerns can afford.
6) Scope for Personal Bias: The interpretation of financial information depends
upon the capability of interpreter as one has to make a personal judgment. There
is every possibility of personal bias in analysis and interpretation. Personal bias
will affect the quality of decision making.
7) It invites Resistance within the Organisation: The installation of management
accounting needs a radical change in the accounting organisation. New rules and
regulations are also to be framed. It demands rearrangement of personnel and
their activities. This will affect a number of personnel and therefore, there is a
possibility of resistance by some of the people of the organisation concerned.

Check Your Progress A

1. What is Accounting ?
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2. List out various Accounting activities in an organisation.
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3. What are the limitations of Accounting ?
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4. Name the parties interested in accounting information.
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5. What is the main purpose of Financial Accounting and Management Accounting ?
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6. State whether each of the following statements is True or False :
i) Accounting is concerned only with the recording of transactions.
ii) Accounting is the language of the business.
iii) Accounting records both financial and non financial transactions.
iv) Management accounting provide necessary information to outsiders only.
v) Cost accounting helps in ascertaining and controlling costs.
vi) The main objective of financial accounting is to ascertain the operating
results and financial position of a concern.
vii) Management accounting provides decision to the management.
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 Accounting:
1.7 ROLE OF MANAGEMENT ACCOUNTANT An Overview

The term Management Accountant has been applied to any one who performs
accounting work within a firm and it encompasses persons performing activities which
range from :
i) Posting customers’ receivable accounts,
ii) Doing financial analysis for decision making, and
iii) Making high-level decisions in a large scale organisation.
There is no particular academic or professional accomplishments have been associated
with the term. He plays a significant role in the decision making process of an
organisation. The positional status of management accountant in an organisation
varies from concern to concern depending upon the pattern of management system in
the concern. He plays a significant role in the decision making process of the
organisation heading the accounting department. In large organizations he is known
as Financial Controller, Financial Advisor, Chief Accounts officer etc. He is
responsible for installation, development and efficient functioning of the management
accounting system. He plays an important role in collecting, compiling, reporting and
interpreting internal accounting information. He prepares the financial and cost
control reports to satisfy the requirements of different levels of management. He
computes variances by comparing the actuals with the standards and interprets the
results of operations to different levels of the organisation and to the owners of the
business.
Thus, the management accountant occupies an important position in the organization.
He performs a staff function and also has line authority over the accountants. If he
participates in planning and execution of policies, he is equal to other functional
managers. In most of the organisations, management accountant performs staff
functions. He supplies information and gives his views about the data and leaves the
final decision making to functional heads. If management accountant provides the
facts accurately and are presented in a manner which allows proper analysis and
interpretation then he cannot be held responsible for any wrong judgment by the
management. On the other hand, if the information provided by the management
accountant is biased, inaccurate and is not presented properly then he is responsible to
the management for wrong decision making.

Functions of Management Accountant

The functions of the Management Accountant depends upon the position he occupies
in the organisation and requirements of the organisation. The functions of the
controller, by whatever name he is called, have been laid down by the controllers’
Institute of America which are as follows :
1) Planning and Control : Management accountant establishes, coordinates and
maintains an integrated plan for the control of operations. Such a plan would
provide, to the extent required in the business cost standards, profit planning,
programmes for capital investing and for financing, sales forecast and the
expense budgets, together with necessary procedures to effectuate the plan.
2) Reporting and Interpreting : Management accountant measures the
performance against given plans and standards. The results of the operations are
interpreted to all levels of management and to the owners of the business. This
also includes installation of accounting and costing system and recording of
actual performance to find out deviation, if any.
3) Evaluation of Policies and Programmes : He is responsible to evaluate various
policies and programmes. The effectiveness of policies, programmes and
1 7
Fundamentals of organisation structure to attain the objectives of the organisation to a large extent
Accounting depends upon the caliber of the management accountant.
4) Tax administration : It is also the function of management accountant to report
to the government as required under different laws in force and to establish and
administer tax policies and procedures. He has also to supervise and coordinate
preparation of reports to government agencies.
5) Protection of assets : The management accountant has to assure fiscal
protection for the assets of the business through adequate internal control and
proper insurance coverage.
6) Appraisal of External Effects : He has to assess continuously the effect of
various economic and social forces and government policies and interpret their
effect upon the business towards the attainment of common goals.
The functions as stated above can also prove to be useful under the Indian
context. Some of the above functions, in India are performed by Company
Secretary, top level management, statistical department etc.

1.8 FINANCIAL ACCOUNTING PROCESS

Accounting may be defined as the process of recording, classifying, summarizing,
analysing, and interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.
Thus the accounting process consists of the following five stages :
1) Recording the Transactions,
2) Classifying the Transactions,
3) Summarizing the Transactions, and
4) Interpreting the Tesults.
Let us discuss briefly these stages:
1) Recording the Transactions : The accounting process begins with the basic
function of recording all the transactions in the book of original entry. This book
is called ‘Journal’. The journal is a daily record of business transactions. All
business transactions of financial character are recorded in the journal in a
chronological order (date wise) with the help of various vouchers such as cash
memos, cash receipts, invoices, etc. The process of recording a transaction in
the journal is called journalising. The journal may be further sub-divided into
various subsidiary books such as cash journal for recording cash transactions,
Purchase Journal for recording purchase of goods, Sales Journal for recoding
sale of goods, etc. The number of subsidiary books to be maintained will depend
upon the nature and size of the business.
2) Classifying the Transactions : The journal is just a chronological record of all
business transactions and it does not provide all information regarding a
particular item at one place. To overcome this difficulty we maintain another
book called ‘Ledger’. It consists of systematic analysis of the recorded data with
a view to group the transactions of similar nature and posting them to the
concerned accounts. It contains different pages of individual account heads
under which all financial transactions of similar nature are collected. For
example, all transactions related to cash are posted to cash account and
transactions related to different persons are entered separately in the account of
each person. The objective of classifying the transaction in this manner is to
ascertain the combined effect of all transactions of a given period in respect of
1 8 each account. For this purpose all accounts are balanced periodically.
3) Summarising the Transactions : The third step is presenting the classified data Accounting:
in a manner which is understandable and useful to the internal as well as external An Overview
end users of accounting information. This can be done through the preparation
of a year end summary known as ‘Final Accounts’. Before proceeding to final
accounts one has to prepare a statement called ‘Trial Balance’ in order to check
the arithmetical accuracy of the books of accounts. If the Trial Balance tallies,
more or less it means that the transactions have been accurately recorded and
posted into the ledgers. Then with the help of the Trial Balance and some other
additional information, final accounts are prepared. The objective of preparing
final accounts are :
i) To know the net operating results of the business, and
ii) To ascertain the financial position of the business at a particular date.
The operating results of the business can be ascertained by preparing an income
statement called Trading and Profit and Loss Account and financial position of
the business can be known by preparing a position statement called ‘Balance
Sheet’. The Trading and Profit and Loss account gives information about the
profit or loss made during the year and the Balance Sheet shows the position of
assets and liabilities of the business at a particular time.
4) Interpreting the Results : The final stage of accounting is analysing and
interpreting the results shown by the final accounts. The recorded financial data
is analysed and interpreted in a manner that the end users can make a
meaningful judgement about the financial position and profitability of the
business operations. This involves computation of various accounting ratios to
assess the liquidity, solvency and profitability of the business. The balance on
various accounts appearing in the Balance Sheet will then be transferred to the
new books of account for the next year. Thereafter the process of recording
transactions for the next year starts again.
The accounting information after being meaningfully analysed and interpreted has to
be communicated in the proper form and manner to the proper person. This is done
through preparation and distribution of accounting reports which includes besides the
final accounts, in the form of ratios, graphs, diagrams, funds flow statements, etc.

1.9 ACCOUNTING EQUATION

The recording of transactions in the books of accounts is based on accounting
equation. Each transaction has double effect on the financial profit of a concern.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. Thus, the total claims will equal to the total assets of the firm.
The total claims may be to outsiders and the proprietor. In the beginning the owner of
the firm provides funds to the business in the form of ‘capital’ which is also known as
‘owners equity’. Initially the capital contributed by the owner to the business will be
in the form of cash and this cash is treated as an asset of the firm. At the same time a
liability will be created in the form of owners’ equity according to business entity
concept (i.e., business and the owner are two separate entities). Thus, the asset is
(cash) balanced against liability (capital).
The accounting equation can thus be expressed as follows :
Cash (Asset) = Capital (Liabilities)
Total Assets = Total Liabilities (Capital + Liabilities)
OR
Fixed Assets + Current Assets = Internal Liabilities + External Liabilities
Capital = Assets – Liabilities
OR
Liabilities = Assets – Capital 1 9
Fundamentals of Thus the above relationship is known as accounting equation and it is also called as
Accounting Balance Sheet equation. Each transaction will affect the above equation but the
relationship will remain the same on account of dual aspect of the transaction. An
increase in asset side leads to increase in the liabilities side and vice versa. Thus dual
effect will take place either on the same side or on both the sides of accounting
equation. Let us take a few transactions and see how accounting equation is always
maintained.
1. Mr. X started business with Rs. 1,00,000 cash : The business received a cash of
Rs. 1,00,000 which is an asset to business. The capital contributed by Mr. X is
a liability to the business because from the business point of view owner and
business are separate legal entity.
The equation now stands as follows:
Equation : Assets = Capital + Liabilities
Rs. 1,00,000 (Cash) = Rs. 1,00,000 + Nil
2. The business purchased furniture worth Rs. 15000 and paid cash : The effect of
this transaction is that on one hand it increases one asset (furniture) and on other
hand it decreases another asset (cash). The equation now will appear as follows;
Assets

Cash + Furniture = Capital + Liabilities

Old equation 1,00,000 + – = 1,00,000 + –
New Transaction –15,000 + 15,000 = – + –

New Equation 85,000 + 15,000 = 1,00,000 + –

3. The business purchased goods on credit from Mr. Z for Rs. 10,000: The effect of
this transaction is that it increases an asset (stock of good) and creates a liability
(creditor). The equation now will be as follows :
Assets

Cash + Furniture + Stock = Capital + Liabilities

Old equation 85,000 + 15,000 + – = 1,00,000 + –
New Transaction – + – + 10,000 = – + 10,000
(Creditor)
New Equation 85,000 + 15000 + 10,000 = 1,00,000 + 10,000

4. The business sold goods for Rs. 7,000 on credit : In this transaction, assets will
be decreased by Rs. 7,000 in the form of stock and assets will be increased by
Rs. 7,000 in the form of sundry debtors.
Assets Liabilities

Cash + Furniture + Stock + Sundry Debtors = Capital + Creditors

Old equation 85,000 + 15,000 + 10,000 + – = 1,00,000 + 10,000
New – + – + (–7000) + 7,000 = – + –
Transaction

New 85,000 + 15000 + 3000 + 7000 = 1,00,000 + 10,000

Equation

2 0
5. Mr. X withdrew Rs. 10,000 for his private expenses : Withdrawing of cash from Accounting:
the business for private expenses, reduces business assets in the form of cash as An Overview
well as his capital by Rs. 10,000.
Assets Liabilities

Cash + Furniture + Stock + Sundry = Capital + Creditors

Debtors
Old 85,000 + 15000 + 3000 + 7000 = 1,00,000 + 10,000
equation
New –10,000 + – + – + – = –10,000 + –
Transaction
New 75,000 + 15000 + 3000 + 7000 = 90,000 + 10,000
Equation

Thus, the sum of assets will be equal to the sum of Capital and Liabilities irrespective
of the number of transactions. The equation can also be presented in the form of
statement of assets and liabilities called Balance Sheet which is always prepared at a
particular date. The last equation stated above if presented in the form of Balance
Sheet, it will be as follows :
Balance Sheet of Mr. X as at ………….
Capital and Liabilities Rs. Assets Rs.
Capital 90,000 Cash 75,000
Creditors 10,000 Stock 3,000
Sundry debtors 7,000
Furniture 15,000
1,00,000 1,00,000

It should be noted that the total of both the sides of Balance Sheet should be equal
irrespective of the number of transactions and the items affected thereby. It is due to
the dual effect of business transactions on the assets and liabilities of the business.

1.10 ACCOUNTING CONCEPTS

Accounting is the language of business. Business firms communicate their affairs and
financial position to the outsiders through accounting in the form of financial
statements. To make the language to convey the same meaning to all interested parties
it is necessary that it should be based on certain uniform scientifically laid down
standards. The accountants in general, have agreed on certain principles to be
followed strictly by them to maintain uniformity and also for comparison purpose.
These principles are termed as ‘Generally Accepted Accounting Principles’.
Accounting principles may be defined as “those rules of action or conduct which are
adopted by the accountants universally while recording accounting transactions. They
are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practice and as a guide for selection
of conventions or procedures where alternatives exist.” To explain these principles,
the writers have used a variety of terms such as concepts, postulates, conventions,
underlying principles, basic assumptions, etc. The same rule may be described by one
author as a concept, by another as a postulate and still by another as convention.
Hence, it is better to call all rules and conventions which guide accounting activity and
practice as ‘Basic Accounting Concepts. These are the fundamental ideas or basic
assumptions underlying the theory and practice of financial accounting and are broad 2 1
Fundamentals of working rules for all accounting activities developed and accepted by the accounting
Accounting profession. It brings about uniformity in the practice of accounting.
These concepts can be classified into two broad groups which are as follows :
1) Concepts to be observed at the recording stage i.e., while recording the
transactions, and
2) Concepts to be observed at the reporting stage i.e., at the time of preparing final
accounts.
It must however be remembered that some of them are overlapping and even
contradictory.

1.10.1 Concepts to be Observed at the Recording Stage

The concept which guide us in identifying, measuring and recording the transactions
are :
1) Business Entity Concept
2) Money Measurement Concept
3) Objective Evidence Concept
4) Historical Record Concept
5) Cost Concept
6) Dual Aspect Concept
Let us explain them one by one and learn the accounting implications of each
concept.

1) Business Entity Concept

According to this concept business is treated as a separate entity from its owners. All
transactions of the business are recorded in the books of the firm. Business
transactions and business property are different from personal transactions and
personal property. If business affairs are mixed with private affairs, the true picture
of the business is not available. The owner of the firm is treated as a creditor to the
extent of his capital. From the accounting point of view the owner is different and the
business is different. Therefore, under this concept the capital contributed by the
owner of the firm is the liability to the firm and the owner is regarded as the creditor
of the firm. However, personal expenditure of the owner is met from business funds it
shall be recorded in the business books as drawings by the owner and not as business
expenditure.
The business entity concept is applicable to all form of business organisation. This
distinction can be easily maintained in the case of a limited company because the
company has a separate legal entity of its own. But such distinction becomes difficult
in case of a sole proprietorship or partnership, because in the eyes of law sole
proprietor or partners are not considered separate entities. They are personally liable
for all business transactions. But for accounting purpose they are treated as separate
entities. This enables them to ascertain the profit or loss of the business more
conveniently and accurately.
2) Money Measurement Concept
Usually business deals in a variety of items having different physical units such as
kilograms, quintals, tons, metres, liters, etc. If the sales and purchase of different
items are recorded in the physical terms, it will pose problems. But if these are
recorded in common denomination their total become homogeneous and meaningful.
Therefore, we need a common unit of measurement. Money does this function. It is
2 2 adopted a common measuring unit for the purpose of accounting. All recording,
therefore, is done in terms of the standard currency of the country where business is Accounting:
set up. For example, in India, it is done in terms of Rupees. In USA it is done in An Overview
terms of US dollars and so on.
Another implication of money measurement concept is that only those transactions
and events are recorded in the books of accounts which can be expressed in terms of
money such as purchases, sales, salaries etc. Other happenings (non-monetary) like
labour management relations, sales policy, labour unrest, effectiveness of competition,
a team of dedicated and trusted employees etc., which are vital importance to the
business concern do not find place in accounting. This is because their effect is not
measurable and quantifiable in terms of money.
Another limitation of this concept is that it is based on the assumption that the money
value is constant which is not true. The value of money changes over a period of
time. The value of rupee today is much less than what it was in 1971. This is due to
a fall in money value. Thus this concept ignores the qualitative aspect of things and
the impact of inflationary changes is not adjustable in this principle. That is why
accounting data does not reflect the true and fair view of the affairs of business.
Now-a-days it is considered desirable to provide additional data showing the effect of
changes in the price level on the reported income and the assets and liabilities of the
business.

3) Objective Evidence Concept

The term objectivity refers to being free from bias or free from subjectivity.
Accounting measurements are to be unbiased and verifiable independently. For this
purpose all accounting transactions should be evidenced and supported by documents
such as invoices, receipts, cash memos etc. These supporting documents (Vouchers)
form the basis for making entries in the books of account and for their verification by
auditors. As per the items like depreciation and the provision for doubtful debts
where no documentary evidence is available, the policy statements made by the
management are treated as the necessary evidence.

4) Historical Record Concept

Recording the transactions in the books of account will be done only after identifying
the transactions and measuring them in terms of money. According to the historic
record concept we record only those transactions which have actually taken place in
the business during a particular period of time and not those transactions which may
take place in future. It is because accounting record presupposes that the transactions
are to be identified and objectively evidenced. This is possible only in the case of past
(actually happened) transactions. The future transactions can hardly be identified and
measured accurately. You also know that all transactions are to be recorded in
chronological (date wise) order. This leads to the preparation of a historical record of
all transactions. It also implies that we simply record the facts and nothing else.
One limitation of this concept is that the impact of future uncertainties has no place in
accounting. Management needs information for future planning not only of the past
but also for future. You know that we will also make a provision for some expected
losses such as doubtful debts at the time of ascertaining profit or loss of the business
which is contrary to the historic record concept. But it is not a routine item. This is
done in accordance with another concept called conservation concept which you will
study later.

5) Cost Concept
The price paid (or agreed to be paid in case of a credit transaction) at the time of
purchase is called cost. Under this concept fixed assets are recorded in the books of 2 3
Fundamentals of account at the price at which they are acquired. This cost is the basis for all
Accounting subsequent accounting for the asset. For example, when an asset is acquired for
Rs. 1,00,000, it is recorded in the books of account at Rs. 1,00,000 even though the
market value may be different later. But the asset is shown in the books at cost price.
You know that with passage of time the value of an asset decreases. Hence, it may
systematically be reduced from year to year by charging depreciation and the assets be
shown in the balance sheet at the depreciated value. The depreciation is usually
charged at a fixed percentage on cost. It bears no relationship with the changes in its
market value. This makes it difficult to assess the true financial position of the
concern and it is, therefore, considered an important limitation of the cost concept.
Another limitation of the cost concept is that if the business pays nothing for an item it
acquired, then this will not appear in the accounting records as an asset. Thus, all
such events are ignored which affect the business but have no cost. Examples are : a
favourable location, a good reputation with its customers, market standing etc. The
value of an asset may change but the cost remains the same in the books of account.
As such the book value of an asset as recorded do not reflect their real value.
It should, however, be noted that the cost concept is applicable to the fixed assets and
not to the current assets.
In spite of the above limitations the cost concept is preferred because firstly, it is
difficult and time consuming to ascertain the market values and secondly, there will be
too much of subjectivity in assessing current values. However, this limitation can be
overcome with the help of inflation accounting.

6) Dual Aspect Concept

This is a basic concept of accounting. According to this concept every business
transaction has a two-fold effect. In commercial context it is a famous dictum that
“every receiver is also a giver and every giver is also a receiver”. For example, if you
purchase a machine for Rs. 8,000, you receive machine on the one hand and give
Rs. 8,000 on the other. Thus, this transaction has a two-fold effect i.e.,(i) increase in
one asset, and (ii) decrease in another asset. Similarly, if you buy goods worth
Rs. 500 on credit, it will increase an asset (stock of goods) on the one hand and
increase a liability(creditors) on the other. Thus, every business transaction involves
two aspects (i) the receiving aspect, and (ii) the giving aspect. In case of the first
example you find that the receiving aspect is machinery and the giving aspect is cash.
In the second example the receiving aspect is goods and the giving aspect is the
creditor. If complete record of transactions is to be made, it would be necessary to
record both the aspects in books of account. This principle is the core of double entry
book-keeping and if this is strictly followed, it is called “Double Entry System of
Book-keeping’.
Let us understand another accounting implication of the dual aspect concept. To start
with, the initial funds (capital) required by the business are contributed by the owner.
If necessary, additional funds are provided by the outsiders (creditors). As per the
dual aspect concept all these receipts create corresponding obligations for their
repayment, In other words, a contribution to the business, either in cash or kind, not
only increases its resources (assets), but also its obligations (liabilities/equities)
correspondingly. Thus, at any given point of time, the total assets and the total
liabilities must be equal.
This equality is called ‘balance sheet equation’ or ‘accounting equation’. It is stated
as under :
Liabilities (Equities) = Assets
Capital +Outside Liabilities = Assets
2 4
The term ‘assets’ denotes the resources (property) owned by the business while the Accounting:
term ‘equities’ denotes the claims of various parties against the business assets. An Overview
Equities are of two types : (i) Owners’ equity, and (ii) outsiders’ equity. Owners’
equity called capital is the claim of owners against the assets of the business
outsiders’ equity called liabilities is the claim of outside parties like creditors, bank,
etc. against the assets of the business. Thus, all assets of the business are claimed
either by the owners or by the outsiders. Hence, the total assets of a business will
always be equal to its liabilities.
When various business transactions take place, they effect the assets and liabilities in
such a way that this equity is maintained. You will study later in detail under ‘1.9
Accounting Equation’ of this unit how the equity is maintained.

1.10.2 Concept to be Observed at the Reporting Stage

The following concepts have to be kept in mind while preparing the final accounts:
1. Going concern concept
2. Accounting period concept
3. Matching concept
4. Conservatism concept
5. Consistency concept
6. Full disclosure concept
7. Materiality concept
Let us discuss the above concepts one by one.

1) Going Concern Concept

According to this concept it is assumed that every business would continue for a long
period. Keeping this in view, the investors lend money and the creditors supply goods
and services to the concern. For all practical purpose the business is normally treated
as a going concern unless there is a strong evidence to the contrary. The current
disposal value is irrelevant for a continuing business. Recording of transactions in
accounting is judged whether the benefits from expenses are immediate (short period,
say less than one year) or a long term. If the benefits from expenses are immediate it
is treated as a revenue or if the benefits are for long term, it is to be treated as capital
depending upon the nature of expenses. Short term benefits expenses like rent, repairs
etc. are limited to one year therefore such expenses are fully debited to profit and loss
account of that year. On the other hand, if the benefit of expenditure is available for a
longer period, it must be spread over a number of years. Therefore, only a portion of
such expenditure will be debited to profit and loss account. The balance of
expenditure is shown as an asset in the Balance Sheet. Similarly fixed assets are
recorded at original cost and are depreciated in a proper manner and while preparing
the balance sheet, market price of fixed asset are not considered. For example, a firm
purchased a delivery van for Rs. 1,00,000 and its expected life is 10 years. The
accountant has to spread the cost of the van for 10 years and charges Rs. 10,000
being 1/10th of its cost to the profit and loss account every year in the form of
depreciation and show the balance in the balance sheet as an asset. While preparing
final accounts, a record will also be made for outstanding expenses and prepaid
expenses on the assumption that the business will continue for an indefinite period and
the assets will be used for its expected life.
This concept will not apply in case of a concern when it has gone into liquidation or it
has become insolvent. In such as case the assets are valued at their current values and
the liabilities at the value at which they are to be met. 2 5
Fundamentals of 2) Accounting Period Concept
Accounting
You know that the going concern concept assumes that life of the business is indefinite
and the preparation of income and positional statements after a long period would not
be helpful in taking appropriate steps at the right time. Therefore, it is necessary to
prepare the financial statements periodically to find out the profit or loss and financial
position of the business. It also helps the interested parties to make periodical
assessment of its performance. Therefore, accountants choose some shorter period to
measure the results and one year has been generally accepted as the accounting period.
However, accounts can also be prepared even for a shorter period for internal
management purposes. But one year accounting period is recognised by law and
taxation is assessed annually. Acconting period may be a calender year i.e., January 1
to December 31 or any other period of twelve months, say April 1 to March 31 or
Diwali to Diwali or Dasara to Dasara. The final accounts are prepared at the end of
each accounting period and the financial reports thus, prepared facilitate to make good
decision, corrective measures, business expansion etc. and also enable the end users to
make an assessment of the progress of the enterprise.

3) Matching Concept
Matching concept is based on the accounting period concept. The matching concept is
also called Matching of costs against revenue concepts. To ascertain the profit made
by the business during a particular period, the expenses incurred in an accounting year
should be matched with the revenue earned during that year. The term ‘matching’
means appropriate association of related revenues and expenses. For this purpose,
first we have to recognize the revenues during an accounting period and the costs
incurred in securing those revenues. Then the sum of costs should be deducted from
the sum of revenues to get the net result of that period. The question when the
payment was received or made is irrelevant. In other words, all revenues earned
during an accounting period, whether received or not and all costs incurred, whether
paid or not have to be taken into account while preparing the final accounts.
Similarly, any amount received or paid during the accounting period which actually
relates to the previous accounting period or the following accounting period must be
eliminated from the current accounting period’s revenues and costs. Therefore,
adjustments are to be made for all outstanding expenses, accrued incomes, prepared
expenses and unearned incomes, etc., while preparing the final accounts at the end of
the accounting period. By application of this concept, the owner of the business easily
know about the operating results of his business and can make effort to increase
earning capacity.

4) Conservation Concept
This concept is also known as Prudent Concept. It ensures that uncertainties and risks
inherent in business transactions should be given a proper consideration.
Conservatism refers to the policy of choosing the procedure that leads to
understatement of assets or revenues, and over statement of liabilities or costs. The
consequence of an error of understatement is likely to be less serious than that of an
error of over statement. On account of this reason, accountants generally follow the
rule ‘anticipate no profit but provide for all possible losses. In other words, profits
are taken into account only when they are actually realized but in case of losses, even
the losses which may arise due to a remote possibility should also be taken into
account. That is the reason why the closing stock is valued at cost price or market
price whichever is less. Similarly, provision for doubtful debts and provision for
discounts on debtors are also made. This reflects a generally pessimistic attitude of
the accountant, but it is regarded as the best way of dealing with uncertainty and
protecting creditors against an unwarranted distribution of the firm’s assets as
2 6 dividends.
This concept is subject to criticism that it is against the convention of full disclosure. Accounting:
It encourages creation of secret reserves and financial statements do not reflect a true An Overview
and fair view of the affairs of the business.

5) Consistency Concept
The principle of consistency means that the same accounting principles should be used
for preparing financial statement for different periods. It means that there should not
be a change in accounting methods from year to year. Comparisons are possible only
when a consistent policy of accounting is followed. If there are frequent changes in
the accounting treatment there is little scope for reliability. For example, if stock is
valued at ‘cost or market price whichever is less, this principle should be followed
year to year. Similarly if deprecation on fixed assets is provided on straight line basis,
it should be followed consistently year after year. Consistency eliminates personal
bias and helps in achieving comparable results. If this principle of consisting is not
followed, the accounting information about an enterprise cannot be usefully compared
with similar information about other enterprises and so also within the same enterprise
for some other period. Consistency principle enhances the utility of the financial
statements.
However, consistency does not prohibit change. When a change is desirable, the
change and its affect should be clearly stated in financial accounts.

6) Full Disclosure Concept

This concept states that the financial statements are to be prepared honestly and all
significant information should be incorporated there in because these statements are
the basic means of communicating financial information to all interested parties.
Therefore, these statements should be prepared in such a way that all material
information is clearly disclosed to the persons interested in its affairs . The purpose of
this concept is that any body who wants to study the financial statements should not
be prejudiced by concealing any facts. It is, therefore, necessary that the disclosure
should be fair and adequate to make impartial judgement.
This concept assumes greater importance in respect of Joint Stock Company type of
organisations where ownership is divorced from management. The Joint Stock
Companies Act, 1956 requires that Profit and Loss Account and Balance Sheet of a
company must give a true and fair view of the state of affairs of the company and also
provided prescribed form in which these statements are to be prepared so that
significant information may not be left out.

7) Materiality Concept
This concept is closely related to the full disclosure concept. Full disclosure does not
mean that everything should be disclosed. It only means that relevant and material
information must be disclosed. American Accounting Association defines the term
materiality as “An item should be regarded as material if there is reason to believe that
knowledge of it would influence the decisions of informed investor”. Materiality
primarily relates to the relevance and reliability of information. All material
information should be disclosed through the financial statements accompanied by
necessary notes. For example commission paid to sole selling agents, and a change in
the method of rate of depreciation, if any, must be duly reported in the financial
statements.
Further strict adherence to accounting principles is not required for items of little
importance or non-material nature. For example, erasers, pencils, stapler, pins, scales
etc., are used for a long period, but they are not treated as assets. They are treated as
expenses. This does not affect the amounts of profit or loss materially. Similarly,
while showing the amounts of various items in financial statements, they can be 2 7
Fundamentals of rounded off to the nearest rupee or hundreds. There may not be any material effect.
Accounting For example if an amount of Rs. 145,923.28 is shown as Rs. 1,45,923 or
Rs. 1,45,900 it does not make much difference for assessment of the performance of
the enterprise.
The materiality and immateriality convention varies according to the company, the
circumstances of the transaction and economic significance. An item considered to be
material for one business, may be immaterial for another. Similarly, an item of
material in one year may not be material in the subsequent years. However, there are
no specific rules for ascertaining material or non-material items. They are rather in
the category of conventions or rules developed from experience to fulfil the essential
and useful needs and purposes in establishing reliable financial and operating
information control for business entities. What is required is just a matter of personal
judgment.

Check Your Progress B

1) What do you understand by money measurement concept ?
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
2) Explain dual aspect concept.
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
3) List the concepts to be observed at the reporting stage.
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
4) What are the stages in accounting process ?
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
............……………………….....………………………………………………..
6) State whether each of the following statements is True or False :
i) In accounting all business transactions are recorded which are having a
dual effect.
ii) It is the basis of a going concern concept that the assets are always valued
at cost price.
iii) Accounting principles are the rules which are adopted by accountants
universally while recording transactions.
iv) A controller is entrusted with the responsibilities of raising funds.
v) Money measurement concept ignores qualitative aspect of things.
2 8
 Accounting:
1.11 ACCOUNTING STANDARDS An Overview

Accounting standards are generally accepted accounting principles which provides the
basis for accounting policies and for preparation of financial statements.
The object of these standards is to provide a uniformity in financial reporting and to
ensure consistency and comparability of the information provided by the business
firms. Therefore, the standards set for must be easily understandable as well as
acceptable by all and significantly reduce manipulation of information in the
books of accounts.
Thus, accounting standards provide useful information to the users to interpret
published reports. It provides information about the basis on which accounts have
been provided and the rules followed while preparing financial statements.

Importance of Accounting Standards

1) It helps the investors in assessing the return and possible risk involved in
evaluating the various investment proposals in different enterprises.
2) It raises the standards of audit while reporting the financial statements to the
management.
3) It helps the government and other interested parties in formulating economic
policies, tax planning, market analysis, investment decisions etc.
4) It helps the Chartered Accountants to deal with their client, in preparing financial
statements on a true and fair basis. They can refuse the reports of their clients
which are found to be incorrect or misleading.
5) It helps the interested parities to understand the information properly and make
meaningful comparisons and interpretations for decision-making purposes.
6) It facilitates inter firm comparison of the financial position and operating results
of similar enterprises.
7) It will reduce the scope of manipulation of accounts to suit the requirement of
management.
8) It would facilitate the development of international trade and commerce as
financial statements are clearly understandable.
Compliance with the accounting standards has been made mandatory. Section 211(3A)
of the Companies Act, 1956 requires that every financial statement i.e., profit and loss
account and balance sheet shall comply with the accounting standards. For the
purpose of this section the accounting standards issued by the Institute of Chartered
Accountants of India (ICAI) shall be deemed to be the accounting standards.
According section 211 (2B), If the financial statements of any company do not
comply with requirements of the accounting standards, it should state the reasons for
such deviations from the accounting standards together its financial effect, if any,
arising due to such deviation. Therefore, it is advisable for the companies as far as
possible to comply with the accounting standards in view of its mandatory nature. In
case the mandatory accounting standards are not complied with, it is in contravention
of provisions of the Companies Act and the financial statements prepared and
presented will not reflect a true and fair view of the state of affairs of the company.
These accounting standards also apply in respect of financial statements audited for
tax purpose under section 44 AB of Income Tax Act 1961.
These accounting standards are applicable to all commercial, industrial or business
activities of any enterprise but not to those enterprises which are not commercial,
industrial or business in nature.

2 9
Fundamentals of
Accounting 1.12 ACCOUNTING ASSUMPTIONS AND POLICIES AS
PER ACCOUNTING STANDARDS OF INDIA
Accounting measurements are not always uniform. Some financial quantities can be
measured in two or more different ways. The management with the help of company’s
accountant decides which measurement alternatives are to be used. These choices are
known as ‘accounting policies’. These accounting polices differ from company to
company. Therefore, it is advisable to each company to state in the notes of its
financial statements which accounting policy it has followed. The company should
not change its policy frequently and when there is a change in the policy, the
company should justify the reason for such a change.
The management is not completely free in choosing any accounting policies because
selection of policy must fit within the limits set by the measurement guidelines known
as ‘generally accepted accounting principles’ as well as to comply statutory
requirements. For example, The Central Board of Direct Taxes requires the following
information to be disclosed in respect of change in accounting polices :
1) A change in accounting policy shall be made only if the adoption of different
accounting policy is required by statute or if it is considered that the change
would result in more appropriate in preparation or presentation of the financial
statements of an assessee.
2) Any change in accounting policy which has material effect shall be disclosed in
the financial statements of the period in which such change is made. Where the
effect of such change is not ascertainable or such change has no material effect
on the financial statements for the previous year but has material effect in years
subsequent to the previous year, the fact shall be stated in the previous year in
which such change is adopted.
Materiality of an item depends on its amount and nature. An item should also be
considered material if the knowledge of it would influence the decisions of the
investors. Materiality varies from one business to another business. Similarly, an item
which is material in one year may not be material in the next year. While preparing
financial statements it is, therefore, necessary to give emphasis only on those matters
which are significant and thereby ignoring insignificant matters.
In order to bring uniformity for the presentation of accounting results, the Institute of
Chartered Accountants of India, established an Accounting Standard Board (ASB) in
April, 1977. The Board consists of representatives from industry and government.
The main function of ASB is to formulate accounting standards to be followed while
preparing and interpreting the financial results. While framing the accounting
standards, the ASB will pay due attention to the International Accounting Standards
and try to integrate them to the possible extent. It also takes into account the
prevailing laws, customs and business environment prevailing in India. To improve
quality and bring parity with the presentation of financial statements in India, the
ASB has formulated the following accounting standards:

No. Title
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events occurring after Balance Sheet Date
AS 5 Net Profit or Loss, Prior Period Items and Changes in Accounting Policies
AS 6 Depreciation Accounting
3 0 AS 7 Accounting for Construction Contracts
AS 8 Accounting for Research and Development Accounting:
An Overview
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 Accounting for the Effect of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Accounting for Retirements Benefits in the Financial Statements of Employers
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Consolidated Financial Statement
AS 21 Earnings per Share
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in Consolidated Financial Statements
AS 24 Discounting Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interest in Joint Ventures

Check Your Progress C

1) Why accounting practices should be standardised ?
..........……….......………………………………………………………………..
..........……….......………………………………………………………………..
..........……….......………………………………………………………………..
.........……….......………………………………………………………………...
2) State whether each of the following statements is True or False:
i) A management accountant is not the custodian of properties and financial
interests of a business enterprise.
ii) ‘Statement of Standard Accounting Practice’ were formulated by an
Accounting Standard Board in India.
iii) The generally accepted accounting principles prescribe a uniform
accounting practice.
iv) The materiality concept refers to the state of ignoring small items and
values from accounts.
vi) The avoidance of insignificant things will not affect accounting results.

1.13 LET US SUM UP

In business a number of transactions take place every day. It is not possible to
remember all of them. Hence there is a need to record them. The recording of
business transactions in a systematic manner is the main function of accounting. It
enables to ascertain the profit and loss and the financial position of the business. It
also provides necessary financial information to all interested parties.
3 1
Fundamentals of Accounting is the process of identifying, measuring, recording, classifying and
Accounting summarizing the transactions and analysing, interpreting and communicating the
results thereof. Accounting provides information for three general uses such as
i) managerial decision-making, ii) managerial planning control, and internal
performance evaluation, and iii) financial reporting and external performance
evaluation. To meet the requirements of different people interested in accounting
information, accounting is classified as financial accounting, cost accounting and
management accounting. Financial accounting refers to the preparation of reports for
general purpose whereas management accounting provides information to inside the
organisation. Cost accounting provides information about the problems of internal
managerial control.
Management accountant plays a significant role in the decision making process and it
depends upon his position and requirements of the organisation. The accounting
process is divided into four stages: (i) recording the transactions, (ii) classifying the
transactions, (iii) summarizing the transactions, and (iv) interpreting the results. The
recording of transactions in the books of accounts is based on accounting equation.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. The relationship will remain the same on account of dual aspect
of the transaction.
The accountants over a period of time, have developed certain guidelines for all
accounting work. These are called basic concepts of accounting. Certain concepts
are to be observed at the time of recording the transactions, while others are relevant
at the summarizing and reporting stages. The concepts to be observed at the recording
stage are : business entity, money measurement, objective evidence, historical record,
cost and the dual aspect concept. Concepts to be observed at the reporting stage are :
going concern concept, accounting period concept, matching concept, conservatism
concept, consistency concept, full disclosure concept and materiality concept. Lack of
uniformity in accounting practice makes it difficult to compare the financial reports of
different companies. The multiplicity of accounting practices makes it possible for
management to conceal material information. To avoid this problem accounting
standards are developed by various professional bodies. The object of accounting
standards is to provide uniformity in financial reporting and to ensure consistency and
comparability of the information provided by the business firms. The management is
not absolutely free in choosing any accounting policy. The accounting policy selected
must fit within the limits set by generally accepted accounting principles and also
comply to the statutory requirements. The Accounting Standard Board (ASB) of
India, has developed so far 27 standards to improve quality and parity with the
preparation of financial statements.

1.14 KEY WORDS

Accounting Period : A period of twelve months for which the accounts are usually
kept.
Balance Sheet : A statement of assets and liabilities as at the end of an accounting
period.
Books of Accounts : Books in the form of bound registers or loose sheets wherein
transactions are recorded.
Business Unit : A unit formed for the purpose of carrying on some kind of business
activity.
Financial Position : Position of assets and liabilities of a business at a given point of
time.
3 2
Financial Statement : Summary of accounting information such as profit and loss Accounting:
account and Balance Sheet prepared at the end of accounting period. An Overview

Profit and Loss Account: An account showing profit or loss of the business during
an accounting period.
Transaction : Transfer of money or money’s worth between the two business units.
Management Accountant : A staff-functionary who uses accounting information for
management planning and control.
Staff Function : It is performed in an advisory capacity without line or decision-
making.
Accounting Conventions : Methods or procedures used in accounting
Accounting Equation : Assets = Owners’ equity + Liabilities
Accounting Principles : The methods or procedures used in accounting for events
reported in the financial statements.
Accounting Standards : Accounting Principles.
Cost Accounting : Classifying, Summarizing, recording, reporting and allocating
current or predicted costs.
Double Entry : The system of recording transactions that maintains the equality of
the accounting equation.
Generally Accepted Accounting Principles (GAAP) : The conventions, rules and
procedures necessary to define accepted accounting practice at a particular time;
includes both broad guidelines and relatively detailed practices and procedures.
Internal Reporting : Reporting for management’s use in planning and control.
Materiality : The concept that accounting should disclose separately only
those events that are relatively important for the business or for understanding its
statement.
External Reporting : Production of financial statements for the use of external
interest groups like shareholders, investors, creditors, government etc.

1.15 ANSWERS TO CHECK YOUR PROGRESS

A) 6 (i) False (ii) True (iii) False (iv) False (v) True (vi) True (vii) True
B) 5 (i) True (ii) True (iii) True (iv) False (v) True
C) 2 (i) False (ii) True (iii) True (iv) False (v) True

1.16 TERMINAL QUESTIONS

1) What are the objectives of Accounting ? Name the different parties interested in
accounting information and state why they want it.
2) Briefly explain the accounting concepts which guide the accountant at the
recording stage.
3) What do you understand by Dual Aspect Concept ? Explain the accounting
implications.
4) Explain the role of Management Accountant in a modern business organisation.
5) What are the accounting concepts to be observed at the reporting stage ?
Explain any two in detail.
3 3
Fundamentals of 6) Discuss in brief the basic accounting concepts and fundamental accounting
Accounting assumptions.
7) Why do accounting practices be standardized ? What progress has been made in
India regarding standardization of accounting ?
8) Is it possible to give a true and fair view of a company’s position using account-
ing information ? Explain.
9) Explain the following :
i) Accounting equation
ii) Convention of materiality
iii) Accounting standards
iv) Accounting process
v) Branches of accounting
vi) Accounting a source of financial information.

1.17 SOME USEFUL BOOKS

Harold Bierman Jr. and Allan R. Drebin, 1978. Financial Accounting : An
Introduction, W. B. Sounders Company, Philadelphion, London (Chapter 1-3).
Maheswari, S. N., 2002, An Introduction to Accounting, Vikas Publishing House :
New Delhi (Chapter 1 and 2)
Patil, V.A.,and J. S. Korlahalli, 1986. Principles and Practice of Accounting,
R. Chand and Co., New Delhi (Chapter 1-3)
Gupta, R. L. and M. Radhaswamy, 1986. Advanced Accountancy, Sultan Chand and
Sons : New Delhi (Chapter I and II)
Anthony, Robert, N. and James Reece, 1987. Accounting Principles, All India
Traveler Book Seller, New Delhi (Chapter 1-3)
Meigs, Walter, B. and Robert F. Meirgs, 1987. Accounting : The Basis for Business
Decisions, MC Graw Hill : New York (Chapter I)
Sidney Davidson, Michael W. Maher, Clyde P. Stickney, Roman L Weil, 1985.
Managerial Accounting, An Introduction to Concepts, Methods, and Uses, Holt-
Saunders International Editors, Japan. (Chapter I)

3 4
 Basic Cost Concepts
UNIT 2 BASIC COST CONCEPTS
Structure
2.0 Objectives
2.1 Introduction
2.2 Need for Cost Data
2.3 Cost Concept
2.4 Classification of Costs
2.4.1 Functional Classification
2.4.2 On the Basis of Identifiability with Products
2.4.3 On the Basis of Variability
2.4.4 On the Basis of Product or Period
2.4.5 On the Basis of Controllable and Non-Controllable Costs
2.4.6 On the Basis of Relevance to Decision-Making
2.5 Concepts of Cost Unit and Cost Centre
2.5.1 Cost Unit
2.5.2 Cost Centre
2.6 Elements of Cost
2.6.1 Materials
2.6.2 Labour
2.6.3 Expenses
2.7 Total Cost Build-Up
2.8 Cost Sheet
2.9 Calculation of Recovery Rates
2.10 Statement of Quotation
2.11 Methods of Costing
2.11.1 Job Costing
2.11.2 Contract Costing
2.11.3 Batch Costing
2.11.4 Unit Costing
2.11.5 Bocess Costing
2.11.6 Operating Costing
2.11.7 Multiple Costing
2.11.8 Uniform Costing
2.12 Types of Costing
2.12.1 Marginal Costing
2.12.2 Absorption Costing
2.12.3 Historical Costing
2.12.4 Standard Costing
2.13 Let Us Sum Up
2.14 Key Words
2.15 Answers to Check Your Progress
2.16 Terminal Questions
2.17 Some Useful Books
3 5
Fundamentals of
Accounting 2.0 OBJECTIVES
After studying this unit, you should be able to :
l describe the need for cost data;
l meaning and classification of costs;
l explain the concept of cost unit and cost centre;
l describe the elements of cost;
l prepare a Proforma of Cost Sheet and identify the components of total cost;
l prepare a statement of quotation and ascertain the price of a tender; and
l describe different methods of costing and identify the industries to which each
method is applicable.

2.1 INTRODUCTION
In this unit you will learn about certain basic cost concepts like cost, cost unit, cost
centre, classification of costs, elements of costs and components of total cost.
Apart from these aspects, the unit also covers preparation of cost sheet showing
details of various components of total cost. You will also study about the
preparation of statement of quotation. The unit also discusses various methods and
types of costing.

2.2 NEED FOR COST DATA

Enterprises may be either profit making or non-profit making organisations. If they
are profit making organisations, one of their primary objectives is to operate at a
profit. Non profit organisations are generally providers of service. Cost data is
required to know how much profit the enterprise is earned. To properly set their
prices at a level to ensure a profit for the entity as a whole, the enterprise must know
what their costs are. Similarly, decisions regarding adding new products or dropping
old products, etc., knowledge of cost data is essential to know how profit changes with
various alternatives. In case of non-profit institution, cost data helps to know what
level of funding is needed to provide the services. It also helps the management to
decide what kind of activities can engage in most efficiently. Thus the management
of an organisation requires cost data for the following purposes :
1) To ascertain profit or loss periodically,
2) To plan the operations and performance evaluation,
3) For cost control,
4) To price the products or services,
5) To value inventory and measure the expenses in external financial reports, and
6) In day to day operations of plans and policies,

2.3 COST CONCEPT

In principle, a cost is a sacrifice of resources. According to the terminology of British
Institute of Cost and Works Accountants, ‘‘Cost is the amount of expenditure (actual
or notional) incurred on or attributable to a given thing’’. In other words, cost
indicates, (i) an actual or estimated expenditure (ii) a direct or indirect expenditure,
and (iii) it relates to a job, process, product or service. Examples of such costs are :
Material, labour, factory overheads, administrative overheads, selling and distribution
3 6 overheads.
Cost is a very broad and flexible term. It does not give an exact meaning unless it is Basic Cost Concepts
used in some particular context. It varies with time, volume, firm, method or purpose.
The meaning of cost may change according to its interpretation and the manner in
which it is ascertained. It does not mean the same thing under all circumstances.
Therefore, cost must indicate its purpose and the conditions under which it is
computed.

Costs and Expenses

Cost information is necessary both for managerial accounting and financial
accounting. When costs are used inside the organisation to evaluate its performance
we say that costs are used for managerial accounting purposes. On the other hand
when costs are used by outsiders (interested parties) to evaluate the performance of
management and make investment decisions in the organisation, then costs are used
for financial accounting purpose.
It is also important to distinguish between cost as used in managerial accounting, from
expense, as used in financial accounting. A cost is a sacrifice of resource to achieve
specific objective which has been deferred or not yet utilized for the realisation of
revenues. The price paid for the acquisition of fixed assets, materials, etc. are the
examples of such deferred costs.
An expense is a cost that is charged against revenue in an accounting period
and hence expenses are deduced from revenue in that accounting period.
Examples are : Salaries, rent rates, etc. Generally Accepted Accounting
Principles and Regulations specify when costs are treated as expenses to be
charged to revenues.
In accounting for managerial decisions the focus is on costs, and not on expenses. For
external reporting, the term expense is used as defined by Generally Accepted
Accounting Principles. But in practice, the terms cost and expenses are sometimes
used synonymously.
Cost and Loss : There is difference between ‘cost’ and ‘loss’. You know that cost
signifies an expenditure incurred for recurring some benefit to the enterprise. If no
benefit is derived from a particular expenditure, it is treated as a loss. Cost of
material destroyed by fire, salary paid to a foreman during the period of strike etc.,
are the examples of loss to the business.

2.4 CLASSIFICATION OF COSTS

Costs may be classified into different categories depending upon the purpose.
The following are the various bases according to which costs have been classified :
1) According to functions to which they relate,
2) According to their identifiability with jobs, products, or services,
3) According to their variability with changes in output,
4) According to the association with product or period,
5) According to their controllability, and
6) According to their relevance to decision-making
Let us discuss all the above in detail.

3 7
Fundamentals of 2.4.1 Functional Classification
Accounting
The most common classification of costs in a manufacturing establishment is on the
basis of functions to which they relate because costs have to be ascertained for each of
these functions. On the basis of functions, costs are classified into four categories.
They are :
i) Manufacturing Costs
ii) Administrative Costs
iii) Selling Costs
iv) Distribution Costs
Manufacturing Costs : Manufacturing costs are those costs related to factory
operations which are essential to the completion of the product. It includes direct
material costs, direct labour costs and manufacturing overheads. Direct materials are
the major components of the finished product and can be easily identified with the
product. Direct labour is the labour which is used in actually producing the product.
Manufacturing overheads consist of all other costs related to the manufacturing
process. These are also termed as ‘production costs’.
Administrative Costs: Administrative costs includes all those costs incurred on the
general administration and control of the firm. Examples of such costs are : salaries
of the office staff, rent of the office building, depreciation and repairs of the office
furniture etc. Infact any expenditure which is not related directly to production,
selling, distribution, research and development forms part of the administrative costs.
Selling Costs: Selling costs are those costs which are incurred in connection with the
sale of goods. Some examples of such costs are : Cost of warehousing, advertising,
salesmen salaries etc.
Distribution Costs: Distribution costs are those costs which are incurred on despatch
of finished products to customer including transportation. Examples of such costs are:
packing, carriage, insurance, freight outwards, etc.

2.4.2 On the Basis of Identifiability with Products

On this basis costs are divided into (i) Direct Costs, and (ii) Indirect Costs:
Direct Costs : Direct costs are those costs which are the major components of the
finished products and can be clearly identified with the product being produced. The
examples of direct costs are : raw materials, labour and other direct expenses which
are exclusively incurred for a particular job, product or process.
Indirect Costs : indirect costs are those costs which cannot be assigned to any
particular product, job or process. These costs are usually incurred for the business as
a whole and therefore, are to be allocated to various products manufactured in the
factory on some reasonable basis. Examples of indirect costs are : factory lighting,
rent of factory building, salaries of foreman, etc, Indirect costs are also called as
‘overheads’ or ‘on costs’. These overheads can be further subdivided into factory
overheads, administrative overheads, selling and distribution overheads.

2.4.3 On the Basis of Variability

Another classification is based on the cost behaviour. On this basis costs are
classified into (i) Fixed Costs, (ii) Variable Costs, and (iii) Semi-variable
(or semi-fixed) Costs, (iv) Step Costs.
Fixed Costs: These costs remain fixed irrespective of a change in the volume of
output. But fixed cost varies when it is expressed on per unit basis. In other words
fixed cost per unit decreases when the volume of production increases and vice versa.
3 8
Rent and lease, salary of production manager, salaries of staff, etc., are the examples Basic Cost Concepts
of fixed cost. It should also be noted that fixed costs do not remain fixed always.
They remain fixed only upto a certain level of production activity. If there is a change
in the production capacity which require additional building and equipment, staff, etc.,
such cost will also change. Therefore, fixed costs are fixed within a relevant range of
production. For example, if we produce 1000 units or 10,000 units of a particular
product during a particular period, the rent of the factory building or the salary of the
production manager will remain the same.
Variable Costs: Variable costs are those costs which vary directly or almost
proportionately with the level of output. When volume of output increases, total
variable cost also increases and when volume of output decreases the variable cost
also decreases. But the variable cost per unit will remain unaffected. The examples
of variable costs are : direct material, direct wages, power, commission of salesmen
etc. Let us see the following example how the variable cost varies with the change in
the level of output.

Variable Cost Level of Output (Units)

3,000 4,000 5,000
Unit Costs: Rs. Rs. Rs.
Direct Material 3,000 4,000 5,000
(Rs. 1 per unit)
Direct Labour 6,000 8,000 10,000
(Rs. 2 per unit)
Direct Expenses 3,000 4,000 5,000
(Rs. 1 per unit)
Total Variable Cost 12,000 16,000 20,000
Cost per unit Rs. 4 Rs. 4 Rs. 4
(Total VC ÷ No. of Units)

In the above example the variable cost varies in direct proportion to the activity level
but the variable cost per unit is fixed.
The following are the characteristics of variable costs :
i) The variable cost varies direct proportion to the volume of output.
ii) The cost per unit will remain the same irrespective of level of activity.
iii) It is easy to accurate allocation and apportionment to different cost centres.
iv) Variable costs can be controlled by functional managers as they incur only when
production takes place.
Semi-variable Costs (or semi-fixed costs): These costs are partly fixed and partly
variable. These are the costs which do vary but not in direct proportion to output.
A part of semi variable costs comprising of fixed cost component , is not expected to
change in response to the changes in the level of activity. Thus, semi-variable
costs vary in the same direction but not direct proportion to the changes in the
volume of output. Telephone bills, power consumption, depreciation, repairs, etc.,
are the examples of semi-variable costs. In case of telephone bills, there is a
minimum rent and after specified number of calls, the charges are according to the
number of calls made. Similarly, power costs include a fixed portion of
minimum charge will be charged even if the power is not consumed and
variable charge is based on the consumption of power. Thus, telephone
and power charges increase with an increase in the usage level but not in the same
direction.
3 9
Fundamentals of Step Costs: Fixed cost in general remain fixed over a range of activity and then jump
Accounting to a new level as activity changes. For example, a foreman can supervise a given
number of workers in a particular shift. The introduction of anther shift will require
additional foreman and certain costs will increase in lumps. Such costs are known as
‘step costs’ or ‘stair step costs’.
The graphical representation of fixed costs, variable costs semi-variable costs and
step costs is shown below:
Fixed Cost-Behaviour Variable Cost-Behaviour

4 4

3 3

2 Fixed Cost Line 2

ƒs
Fixed Cost Line
1 1

0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)

Semi-Variable Cost Behaviour Fixed Costs Rising in Steps

4 4
Semi-variable cost line 3
3
ƒs

ƒs
2 2 Fixed cost rising line

1 1

0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)

Identification of costs according to their behaviour into fixed and variable elements is
essential for profit planning, cost control, fixation of prices, preparation of budgets
and also in various managerial decisions like make or buy or drop out decisions,
selection of a product mix, level of activity decisions, etc.

2.4.4 On the Basis of Product or Period

Product costs are those costs which are easily attributable to products. These costs
are necessary for the production and will not be incurred if there is no production.
Product costs consist of direct material, direct labour and a reasonable share of
factory overhead. These costs are also called inventoriable costs because these are
included the cost of product as work-in-progress, finished goods or cost of sales.
Generally all manufacturing costs are treated as product costs.
Costs which are easily attributable to time interval are known as period costs. These
costs do not attach to products. These costs incurred for a time period and generally
non-manufacturing costs are treated as period costs. These costs are charged to profit
and loss account. The examples of period costs are rent of office building, salary of
company executives, etc.
Period costs affect profit as they are charged to profit and loss account after they are
incurred whereas product costs will affect profit only when they goods are realized.
Thus, classification of costs on the basis of product and period is significant from
4 0 profit determination point of view.
2.4.5 On the Basis of Controllable and Non-Controllable Costs Basic Cost Concepts

Controllable costs are those costs which can be controlled by a specified person or a
level of management. Variable costs are generally controllable by the lower level of
management like departmental heads. For example cost of raw materials can be
controlled by purchasing them in bulk quantities. Uncontrollable costs are those costs
which cannot be controlled or influenced by a specified person of an enterprise. For
example costs like factory rent, managerial salaries etc. It should be noted that the
costs which are not controllable in the short run likely to become controllable in the
long run at some level in the organisation. Similarly, when one moves to the higher
levels of management in the organisation more and more costs become controllable.
Sometimes classification of costs as controllable or non controllable will be a
discretionary matter of the management. The classification of costs on the basis of
controllability is important for the evaluation of performance of the executives and
assigning the responsibility in the organisation.

2.4.6 On the Basis of Relevance to Decision-Making

The following are some important cost concepts which help the management in
decision making process.
Differential Costs: The difference in total costs among the various alternatives is
termed as differential cost. In other words, differential cost is the result of change in
the total cost from an alternative course of action. If the change increases the cost it is
called incremental cost and the change decreases the cost it is called decrimental cost.
The difference in the total cost may be due to change in the methods of production,
change in sales volume, product mix, make or buy or drop out decisions, etc. While
assessing the profitability of a proposed change, the incremental costs should be
matched with the incremental revenues. Look at the following example :
A company is selling 1500 units @ Rs. 15 per unit. The variable cost per unit is
Rs. 7 and the total fixed costs is Rs. 6000. The company receives an export order for
the supply of 300 units @ Rs. 12 per unit. If this order is accepted, fixed cost will be
increased by Rs. 300.
Solution
The cost and sales before and after accepting the export order is worked out as follows:

Particulars Before the Export After the Export Incremental

Order Order
Cost Revenue Cost Revenue Cost Revenue
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 22,500 26,100 3,600
Less Variable Costs 10,500 12,000
Fixed Costs 6,000 16,500 6,300 18,900 2,400

Profit 6,000 7,200 1,200

The proposed export order will result a profit of Rs. 1200. If the proposal is
implemented it results an incremental revenue of Rs. 3600 against the incremental cost
of Rs. 2400. Thus the differential concept is important for managerial decision making.
Sunk Costs: Sunk costs results from past expenditure. Sunk costs cannot be changed
now and management has no control over such costs. The examples of Sunk costs are :
past cost of inventory, past costs of long term assets etc. It should be noted that past
information is totally irrelevant but can be used to predict differential costs in future
course of actions. Further the management uses the past expenditure information in
performance evaluation. 4 1
Fundamentals of Imputed Costs : These costs are also called hypothetical costs or notional costs.
Accounting These costs are included in cost accounts only for the purpose of taking managerial
decisions. For example, interest on capital, rent of own building should be taken into
account while evaluating the relative profitability of the projects.
Opportunity Costs : Opportunity cost refers to the benefit foregone as a result of
accepting one course of action. The manager, while taking a decision should not only
take into account the costs and benefits of the proposed alternative but also the profit
scarified by making the decision. For example, if an owned building is proposed to be
utilized for housing a new project plant, the likely revenue which the building could
fetch, if it is let out, is the opportunity cost which should be taken into account while
evaluating the profitability of the project.

2.5 CONCEPTS OF COST UNIT AND COST CENTRE

2.5.1 Cost Unit

The main function of costing is to ascertain cost per unit of output. Each economic
activity has to be measured in identifiable units which may serve as the basis of
accounting. Such units for the purpose of costing may be as follows :
1) Unit of product, or a group of products (e.g., pair of shoes or one batch of shoes
say one dozen)
2) Unit of operating service (e.g., cost of running a bus per one kilometer)
3) Unit of time (e.g., cost of generating electricity per hour)
4) Unit of weight (e.g., cost per one tonne of steel)
5) Unit of measurement (e.g., cost per meter of cloth or one litre of petrol)
Thus a cost unit is ‘a unit of product, service or time in relation to which costs may be
ascertained or expressed’. In other words cost unit is unit of measurement of cost. It
will be normally the quantity of product for which price is quoted to the consumers.
The selection of cost unit must be appropriate, natural to the business, easily
understandable and acceptable to all concerned. Firstly, it should offer convenience in
cost ascertainment. Secondly, it should be easier to associate expenses with cost units.
Thirdly, it should be according to the nature and prevailing practice of the business.
Some examples of cost unit for different products and services are given below:
Product/Activity Cost Unit
Cement Per-tonne/per bag
Iron Per-tonne/quintal
Chemicals Per-tonne/kilogram/litre, etc
Power Per-kilowatt hour
Coal Per tonne/kilogram
Bricks Per thousand
Printing press Per thousand copies
Paper Per ream/per kilogram
Transport Per passenger per kilometer/per
kilogram per kilometer
Telephone Per call
Timber Per cubic foot/square foot
Pencils Per dozen or gross
4 2
 Petrol Per litre Basic Cost Concepts
Television Per set
Gold Per gram
Hotel Per room per day
Nursing Homes Per bed per day
Cars Per car

2.5.2 Cost Centre

A cost centre is ‘location, person, or item of equipment (or group of these) for which
costs may be ascertained and used for the purpose of control’. Thus a cost centre
refers to a section of business to which costs can be charged. It may consist of either
or a combination of the following :
Location : Factory, Department, Office, Warehouse, Stores, Sales Depot, etc.
Person : Salesman, a machine operator, customer, etc.
Equipment : Machine, Car, Truck, etc.
Types of Cost Centres : Cost centres may be divided into the following four types :
1) Process Cost Centre (Based on sequence of operations)
2) Production Cost centre (for regular production in a factory)
3) Operation Cost Centre (where various operations are involved in the production
process)
4) Service Cost Centre (for activities supporting the main production)
Thus identification or selection of cost centres depends on the nature and types of
industry. The identification of cost centres helps us in :
i) ascertaining the centre-wise costs,
ii) comparing the centre-wise costs periodically,
iii) finding out the major trends of variance, and
iv) applying the techniques of control to check undue, undesirable or unexpected
movements in cost.
A cost centre segregates operations, democrats activities, and distributes expenses.
This also helps in fixing responsibilities for every cost centre.

Check Your Progress A

1. What is the concept of Cost ?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
2. Distinguish between direct and indirect costs.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
3. Give four examples of indirect expenses.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
4 3
Fundamentals of 4. Distinguish between cost and loss.
Accounting
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
5. Give two examples of semi-variable costs.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
6. State whether each of the following statements is True or False
i) Variable cost remains fixed per unit but varies direct proportion to the
volume of output.
ii) Variable costs are controllable.
iii) Operating costing is used in transport industry.
iv) Semi-variable costs vary in the same direction to the volume of output but
not direct proportion to the changes in the volume of output.
v) Fixed costs are also known as period costs.
vi) Direct Material + Direct wages + Direct expenses = Works cost.
vii) Works cost + Office overheads = Cost of production.

2.6 ELEMENTS OF COST

In order to understand and interpret the term ‘cost’, it will be necessary to
understand about the elements of cost. The following are the three elements
of costs: (1) Materials, (2) Labour, (3) Expenses
These can be further sub-dividend into as direct or indirect as follows :
Direct Indirect
Material Material
Labour Labour
Expenses Expenses

2.6.1 Materials
The term ‘materials’ refers to those commodities which are used as raw materials,
components, or consumables for manufacturing a product. In other words, the
substance from which the product is made is known as ‘materials’. Materials can be
direct or indirect.
Direct Materials: All materials which become an integral part of the finished product
and which can be conveniently assigned to specific physical units is termed as ‘Direct
Materials’. Direct material generally becomes a part of the finished product. The
following are some examples of direct material :
i) All materials or components specifically purchased, produced or requisitioned
from stores (e.g., sugar can for sugar, cloth for ready-made garments, cotton for
cloth, tyres for car, etc.)
ii) Primary packing material (e.g., wrapping, cardboard, boxes etc.)
iii) Partly produced or purchased components
4 4
Indirect Materials: All materials which are used for purposes ancillary to the Basic Cost Concepts
business and which cannot conveniently be assigned to specific physical units is
termed as ‘indirect materials’. These materials cannot be conveniently identified with
individual cost units. Their cost is insignificant in the finished product. Pins, screws,
nuts, bolts etc., are some examples. There are some other items which do not
physically become part of the finished product. Examples are : Consumable stores,
lubricating oil, Greece, printing and stationery etc., These items do not form part of
the finished product.

2.6.2 Labour
The workers employed for converting material into finished product or doing various
odd jobs in the business are known as ‘Labour’. Labour can be direct as well as
indirect.
Direct Labour: The workers who are directly involved, in the production of goods
are known as ‘direct labour’. They may be labourers producing manually or workers
operating machinery. Direct labour costs can be conveniently identified with a
particular product, job or process. For example, the wages paid to a machine
operator engaged in the manufacture of goods. The wages paid to such workers are
known as ‘manufacturing wages’.
Indirect labour : The workers employed for carrying out tasks incidental to
production of goods or those engaged for office work and selling and distribution
activities are known as indirect labourí. The wages paid to such workers are known
as ‘indirect wages’. Indirect labour is of general character in nature and cannot be
conveniently identified with a particular unit of output. The examples of indirect
labour costs are : wages of storekeepers, foremen, directors’ fees, salaries of
salesman, etc.

2.6.3 Expenses
All expenses other than material and labour are termed as ‘expenses’. Expenses may
be direct or indirect.
Direct Expenses : Expenses which can be identified with and allocated to cost
centres or units are called direct expenses. These are the expenses which are
specifically incurred in connection with a particular cost unit. Direct expenses are
also called as ‘chargeable expenses’. The examples of such expenses are : Carriage
inwards, production royalty, hire charges of special equipment, cost of special
drawings, designs and layouts, experimental costs, etc.
Indirect Expenses : These are expenses which cannot be directly or wholly allocated
to cost centres or cost units. In other words, all expenses other than indirect material
and labour which cannot be directly attribute to a particular product, job or service
are called indirect expenses. Examples of such expenses are : Rent and Rates,
lighting and heating, advertising, insurance, repairs, carriage, etc.
The above elements of cost may be shown in the form of a chart as shown below:

Elements of Cost
Cost
s s s
Materials Labour Expenses
s s s s s s
Direct Indirect Direct Indirect Direct Indirect

Overheads
4 5
Fundamentals of All materials, Labour, expenses which cannot be identified as direct costs are termed
Accounting as ‘indirect costs’. The three elements of indirect costs viz., indirect materials, indirect
labour and indirect expenses are collectively known as ‘overheads’ or ‘on costs’.
Overheads are grouped into three categories:
1) Factory (or manufacturing) overheads,
2) Office (or administrative) overheads, and
3) Selling and distribution overheads.

1) Factory Overheads
All indirect manufacturing costs which cannot be identified with specific unit of
output are called factory overheads. It includes:
i) Indirect material such as lubricants, oil, consumable stores etc.,
ii) Indirect labour a such as gate-keepers’ salary, works manager’s salary etc., and
iii) Indirect expenses such as factory rent, depreciation on factory building and
equipment, factory insurance, factory lighting etc.,
iv) Factory overheads are also known as manufacturing overheads, indirect
production costs, factory on cost, overhead expenses etc.

2) Office Overheads
Indirect expenses incurred in connection with the general administration like
formulating policies, planning and controlling of a firm for attainment of its goal, are
included in these overheads. They include (i) indirect material used in office such as
printing and stationary material, brooms and dusters etc. (ii) Indirect labour such as
salaries payable to office manager, clerks, etc. and (iii) indirect expenses such as rent,
insurance, lighting of the office etc.,

3) Selling and Distribution Overheads

Selling and distribution overheads include all those costs which are incurred for
promoting and marketing the products. These include :
(i) Indirect material used such as packing material, printing and stationary
material etc, (ii) Indirect labour such as salaries of salesmen, sales manager, etc. and
(iii) Indirect expenses such as rent, insurance, advertising expenses etc.
The above classification of overheads can be shown with the help of the following
Figure:

Classification of Overheads

Overheads (Indirect Costs)

s s s
Factory Overheads Office Overheads Selling and Distribution Overheads
s s s s s s
s s s
Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect
Materials Labour Expenses Materials Labour Expenses Materials Labour Expenses

4 6
 Basic Cost Concepts
2.7 TOTAL COST BUILD-UP

Components of Total Cost

Total cost of a product is the combination of direct costs and indirect costs. Direct
Costs, as you know, consist of direct materials, direct labour and direct expenses and
it is also known as prime cost. Indirect Costs known as overheads consists of factory
overheads, office overheads and selling and distribution overheads. Thus, the two
main components of total cost are: 1) Prime cost, and (2) Overheads.
If we add various costs one by one, we get the framework of total cost build up as
follows :
1) Prime Cost: It consists of cost of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost. Thus,
Prime cost = Direct material + Direct Labour + Other direct expenses
2) Factory Cost : It includes Prime Cost and factory overheads which consists of
indirect material, indirect labour and indirect factory expenses. The factory cost
is also known as works cost, production or manufacturing costs. Thus,
Factory Cost = Prime Cost + Factory Overheads
3) Cost of Production: It comprises factory cost and office and administrative
overheads. It is also known as office cost. Thus,
Cost of Production = Factory Cost + Office and Administrative Overheads
4) Total Cost: It comprises cost of production and selling and distribution
overheads. It is also called as cost of sales.
Total Cost = Cost of Production + Selling and Distribution overheads
The above framework of total cost building-up is shown in the following Figure :
Total Cost Build Up
Materials
Labour Prime Cost
Direct Expenses +
Factory Factory Cost
Overheads s+ Cost of
Office Production Cost of
Overheads + Sales
Selling and
Distribution
Overheads

Thus, the components of total cost are :

Prime Cost, (2) Works Cost, (3) Cost of Production, and (4) Cost of Sales.

2.8 COST SHEET

The elements of cost can be presented in the form of a statement called ‘Cost Sheet’.
A cost sheet is a statement showing the various components of total cost of output for
a certain period which acts as a guide to pricing decisions and cost control. It has
been defined as ‘‘a document which provides for the assembly of the detailed cost of a
cost centre or cost unit’’. The cost sheet should be prepared properly and at frequent
intervals, i.e., weekly, monthly, quarterly, yearly etc. Cost sheet may be prepared
separately for each cost centre. Additional columns can also be provided for the
purpose of comparison of current data with the previous data. 4 7
Fundamentals of Cost Sheet, generally serves the following purposes :
Accounting
i) It provides total cost and cost per unit of production,
ii) It gives the details regarding various elements of total cost, i.e., material, labour,
overheads, etc.,
iii) It gives scope for a comparative study of cost of production of the current period
with that of the previous period.
iv) It helps the management in taking managerial decisions relating to pricing
decisions, quotation of tenders, cost control etc.
The information to be shown in the cost sheet will depend upon the nature and
requirement of the enterprise. Generally, following information may be incorporated
into a cost sheet :
1) Name of the product, cost centre or cost unit
2) Period to which the statement relates
3) Output of the period
4) Details of various components of total cost
5) Item-wise cost per unit
6) Changes in stock position
7) Cost of goods sold
8) Profit or loss position
The Proforma of Cost sheet is given below :

Proforma of Cost Sheet

COST SHEET OF..................................................
For the month ending..................................................
Output..................nits

Total Per Unit

Rs. Rs.
Raw Materials consumed :
Opening Stock of Raw of materials .....................
Add : Purchases of Raw Materials .....................
Less : Closing stock of raw materials ....................
Direct Labour
Direct Expenses
PRIME COST
Factory Overheads :
Rent
Depreciation on premises
Power and light
Indirect material
Indirect wages
Telephone Charges
Insurance etc.
WORKS COST

4 8
 Basic Cost Concepts
Office and Administrative Overheads:
Office salaries
Office rent
Office expenses, etc
COST OF PRODUCTION
(.................units)
Add Opening Stock of Finished goods
(.................units)
Less Closing Stock of Finished Goods
(.................units)
COST OF GOODS SOLD
(.................units)
Selling and Distribution Overheads :
Salaries and commission
Advertising
Packing expenses
Travelling expenses
Warehouse charges
Carriage outwards, etc.
COST OF SALES
(.................units)
PROFIT (LOSS)
SALES/SELLING PRICE

Look at the following illustration and see how a Cost Sheet is prepared with the
following information:
Illustration 1
From the following particulars of a manufacturing firm prepare a cost sheet showing
different components of total cost for the year ending 31st March, 2003.
Particulars Amount (Rs.)
Stock of material (April 1, 2002) 80,000
Purchase of Raw materials 12,00,000
Stock of finished goods on 1,00,000
1-4-2002 (10,000 units)
Direct wages 8,00,000
Direct chargeable expenses 8,000
Finished goods sold (1,80,000 units) 25,40,000
Factory rent rates and power 20,000
Indirect wages 5,000
Depreciation on Plant and Machinery 2,000
Carriage Outwards 20,000
Carriage Inwards 2,000
Office rent and taxes 1,500
Telephone charges 3,000
Travelling expenses 60,000
Advertising 10,000
Depreciation on office premises 1,500
Stock of materials on 31.3.2003 1,60,000
Stock of finished goods on 31.3.2003 (12,000 units) 1,20,000 4 9
Fundamentals of Solution
Accounting
Firstly, we have to find out the number of units produced during the year, before
preparing the cost sheet.

No. of Units
Closing Stock (31.3.2003) 12,000
Add: Number of Units sold 1,80,000
1,92,000
Less : Opening Stock (1.4.2002) 10,000
Number of units produced during the year 1,82,000

COST SHEET
for the year ending 31.3.2003
Output: 1,82,000 Units

Particulars Total Per Unit

Rs. Rs.
Raw Materials Consumed:
Opening Stock (1.4.2002) 80,000
Add: Purchase of Raw material 14,21,000
Add : Carriage inwards 2,000
__________
15,03,000
Less : Closing stock of raw material 1,60,000
(as on 31.3.2003) __________ 13,43,000
Direct wages 8,00,000
Other direct chargeable expenses 8,000
_________
Prime Cost 21,51,000
Works Overheads:
Indirect wages 5,000
Factory rent, rates and power 20,000
Depreciation on plant and machinery 2,000
______ 27,000
_________
Works Cost 21,78,000
Office and Administrative Overheads:
Office rent and taxes 1,500
Telephone charges 3,000
Depreciation on office premises 1,500
_______ 6,000
_________
Cost of Goods Sold 21,84,000 12.00
(1,82,000 units @ Rs.12 per unit)
Add : Opening stock of Finished goods
(10,000 units @ Rs.12 per unit) 1,20,000 12.00
––––––––
2,30,000
Less : Closing stock of Finished goods 1,44,000 12.00
(12,000 units @ Rs.12 per unit) ––––––––
5 0 21,60,000
 Basic Cost Concepts
Cost of Goods Sold
(180,000 units)
Selling and Distribution Overheads:
Travelling expenses 60,000
Carriage outwards 20,000 90,000 0.50
Advertising Cost of Sales 10,000 _______ _______
Profit 22,50,000 12.50
6,30,000 3.50

SALES 28,80,000 16.00

2.9 CALCULATION OF RECOVERY RATES

Sometimes, you are required to calculate overheads recovery rates based on the cost
sheet prepared by you. Such rates are usually in respect of factory overheads and
administration overheads. Factory overhead rate is usually calculated as a percentage
of direct wages as follows:
Factory Overheads
Factory Overhead Rate = —————————— × 100
Direct wages
Administration overhead rate is usually calculated as a percentage of works cost as follows:

Office Administration Overheads

Administration Overhead Rate = —————————————––––— × 100
Factory or Works Cost
Selling and distribution overheads rate may be computed either as a percentage of Works
cost or as a percentage of sales as follows :
Selling and Distribution Overheads
Selling and Distribution Overhead Rate = ————————————————— × 100
Works Cost or Sales
Let us see the following illustration how the recovery rates are calculated :
Illustration 2
The following is the cost data relating to a manufacturing company for the period ending
December 31, 2002 :
Rs.
Raw material purchased 1,20,000
Stock of raw material on 1-1-2002 25,000
Direct wages 1,00,000
Factory overheads 60,000
Carriage inwards 1,00,000
Selling and distribution overheads 72,800
Administration overheads 67,200
Stock of raw material on 31.12.2002 35,000
Sales during the year 6,12,000
Find out a) Cost of Production
b) Cost of Sales
c) The Net Profit for the year
d) The percentage of factory overheads on direct wages
e) The percentage of administration overheads on works cost
f) The percentage of selling and distribution overheads on works cost and
g) The percentage of profit to cost of sales.
5 1
Fundamentals of Solution
Accounting
Cost Sheet for the period ending December 31, 2002

Cost of Raw material consumed : Rs. Rs.

Stock of Raw Material (as on 1-1-2002) 25,000
Add : Raw material purchased 1,20,000
Add : Carriage inwards 1,00,000
––––––––
2,45,000
Less : Stock of Raw Material (as on 31-12-2002) 35,000
–––––––– 2,10,000
Direct Wages 1,00,000
––––––––
PRIME COST 3,10,000
Factory Overheads 60,000
––––––––
WORKS COST 3,70,000
Administration Overheads 67,200
––––––––
(a) COST OF PRODUCTION 4,37,200
Selling and Distribution Expenses 72,800
—————
(b) COST OF SALES 5,10,000
(c) PROFIT 1,02,000
—————
SALES 6,12,000
—————

(d) Percentage of Factory Overheads to Direct Wages

Factory Overheads
= ————————— × 100
Direct Wages
60,000
= ————— × 100
1,00,000

= 60%

(e) Percentage of Administration Overheads to Works Cost

Administration Overheads
= ————————————— × 100
Works Cost

67,200
= ————— × 100
3,70,000

= 18.16%

(f) Percentage of Selling and Distribution Expenses on Works Cost

Selling and Distribution Expenses

= ———————————————— × 100
Works Cost

5 2
 Basic Cost Concepts
72,800
= ———— × 100
3,70,000

= 19.68%
(g) Percentage of Profit to Cost of Sales

Profit
= ——————— × 100
Cost of Sales

1,02,000
= ————— × 100
5,10,000

= 20%

2.10 STATEMENT OF QUOTATION

A manufacturer, sometimes, may be asked to quote a price for supply a particular
article with certain specifications. The term ‘Quotation’ refers to quoting the
minimum price for obtaining a specific order. Such a price is quoted before the
commencement of actual production in anticipation of obtaining a particular order.
While quoting the price the manufacturer has to keep in view the likely impact of
inflationary trends on the input. Before submitting a tender or fixing price he must
have full information regarding cost of inputs like raw materials, wages, different
overheads and a reasonable amount of profit. On the basis of past records, he can
prepare a cost sheet incorporating inflationary trends in price levels of various
components of production. While quoting the price for such specific order, he has to
be cautious that the price is neither too high nor too low. In case the price is too high,
the tender will be rejected outright. On the other hand, if the price is too low, it will
result in either lower profit or loss. Therefore, it is important to estimate the cost as
accurately as possible.
Statement of quotation is prepared in the same manner as Cost Sheet as shown in
illustration 3

Illustration 3
A manufacturing company receives a quotation for the supply of 10,000 units of its
products. The costs are estimated as follows :
Raw material 80,000 kgs. @ Rs. 4 per kg.
Direct wages 10,000 hours @ Rs. 2 per hour
Variable overheads :
Factory @ Rs. 2.50 per labour hour
Selling and Distribution Rs. 30,000
Fixed Overheads :
Factory Rs. 10,000
Office and Administration Rs. 75,000
Selling and Distribution Rs. 20,000
The company adds 10% to its cost as its margin of profit. Prepare a Statement of
Quotation showing the price to be quoted.

5 3
Fundamentals of Solution
Accounting
Statement of Quotation showing the price to be quoted for 10,000 units

Total Per Unit

Rs. Rs.
Estimated cost of Direct Materials 3,20,000 32.00
(80,000 kgs X Rs. 4 per kg)
Estimated Cost of Direct Labour 20,000 2.00
(10,000 hours X Rs. 2 per hour)
Estimated Prime Cost 3,40,000 34.000
Add : Estimated Factory Overheads :
Variable (10,000 hours X Rs. 2.50) 25,000
Fixed 10,000 35,000 35.00
Estimated Factory Cost 3,75,000 37.50
Add:Estimated Office and Administrative 75,000 45.00
Overheads
Estimated Cost of Production 4,50,000 45.00
Add: Estimated Selling and Distribution Overheads
Variable Rs. 30,000
Fixed Rs. 20,000 50,000 5.00
Estimated Cost of Sales 5,00,000 50.00
Add: Deserved Profit @ 10% on cost price 50,000 5.00
Estimated Selling Price 5,50,000 55.00

Sometimes, cost records for a particular period are given and the estimated cost of
material and labour of a work order are provided for the purpose of ascertaining its
selling price to be quoted. In such a situation, you should prepare the cost sheet first
and ascertain the recovery rates for factory overheads as a percentage to direct wages,
for administrative overheads as a percentage of works costs, and for selling and
distribution overheads as percentage of cost of goods sold or as suggested in the given
question. These rates must be duly adjusted with the anticipated changes, if any,
before preparing the statement of quotation. Look at the following illustration and
how the statement of quotation for a work order is prepared with the help of a give
cost data.
Illustration 4
The following figures have been obtained from the cost records of a manufacturing
company for the year 2002 :
Cost of Materials 1,20,000
Wages for Direct labour 1,00,000
Factory overheads 60,000
Distribution expenses 28,000
Administration expenses 67,200
Selling expenses 44,800
Profit 84,000
A work order was executed in 2003 and the following expenses were incurred :
Cost of Materials 16,000
Wages for labour 10,000
Assuming that in 2003 the rate for factory overheads went up 20%, distribution
charges went down by 10% and selling and administration charges went up by 12 1 2 ,
5 4
at what price should the product be quoted so as to earn the same rate of profit on the Basic Cost Concepts
selling price as in 2002. Show the full workings.
Factory overheads are based on direct wages while administration, selling and
distribution expenses are based on factory cost.

Solution
Statement of Cost for the year 2002
Rs.
Cost of Direct Materials 1,20,000
Direct wages 1,00,000
PRIME COST 2,20,000
Factory Overheads 60,000
WORK COST 2,80,000
Administration Overheads 67,200
COST OF PRODUCTION 3,47,200
Selling Overheads 44,800
Distribution Overheads 28,000
COST OF SALES 4,20,000
Profit 84,000
SALES 5,04,000

Factory Overheads
Factory Overhead Rate = ————————— × 100
Direct Wages

60,000
= ———— × 100
1,00,000

= 60%

Administration Overheads
Administrative Overheads Rate = ——————————— × 100
Works Cost

67,200
= ———— × 100
2,80,000

= 24%

Selling Overheads
Selling Overheads Rate = ———————— × 100
Works Cost

44,800
= ————— × 100
2,80,000

= 16%
Distribution Overheads
Distribution Overhead Rate = —————————— × 100
Works Cost

28,000
= ————— × 100
2,80,000

= 10% 5 5
Fundamentals of
Accounting Profit
Rate of Profit = —————— × 100
Cost of Sales

84,000
= ———— × 100
4,20,000

= 20% cost of sales

Statement of Quotation showing the price to be quoted for a work order

Rs.
Cost of Direct Materials 16,000
Direct wages 10,000
PRIME COST 26,000
Factory Overheads : 60% of wages 6,000
Add 20% increase 1,200 7,200
WORK COST 33,200
Administration Overheads: 24% of works cost 7968
1 996 8,964
Add : 12 increase
2
COST OF PRODUCTION 42,164
Selling Overheads : 16% of works cost 5312
1
Add : 12 increase 664 5,976
2
Distribution Overheads : 15% of works cost 3320
Less : 10% decrease 332 2,988
COST OF SALES 51,128.00
Profit (20% of Cost of Sales) 10,225.50
SALES 61,353.50

Check Your Progress B

1) What is a cost Sheet ?
..........................................................................................................................
..........................................................................................................................
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..........................................................................................................................

2) Name the basic methods of costing

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
3) Name different types of costing.
..........................................................................................................................
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5 6
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4) What do you mean by quotation? Why is it necessary ? Basic Cost Concepts

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
5) State whether each of the following statement is True or False
i) Selling and distribution overheads are recovered on the basis of
percentage to cost of production.
ii) Office and administrative overheads are recovered usually on the basis of
percentage to factory cost.
iii) Factory overheads rate is usually calculated as a percentage of direct
wages.
iv) Cost of sales = Factory cost + Selling and Distribution overheads.
v) Selling price = Cost of sales + Profit.

2.11 METHODS OF COSTING

Business enterprises are not alike. They are different from another in some way or
other. The basic principles and procedures of costing remains the same in all
industries but the method of analysis and presentation of cost of their products and
services vary from industry to industry. Therefore, the choice of a particular method
of costing depends upon the nature and types of the product or service provided by a
business unit. The various methods of costing can be summarized as follows :

2.11.1 Job Costing

Under this method, costs are ascertained for each job or work order separately. The
job may consist of a single unit or it may consist of identical or similar products under
a single work order. This method applies where work is undertaken against
customers’ requirements. Job costing is suitable to industries like printing, repairs,
foundries, interior decorators, building construction etc. Non profit organisations like
rehabilitation or street repair programmes also use job costing to ascertain cost of
individual projects. It can also be used in industries where different product lines are
manufactured. For example, a furniture manufacturer may produce a batch of similar
chairs, a batch of tables and so on. Each batch can be treated as a job for accounting
purposes. Job costing also found in service organisations like engineering,
consultancy and accounting firms. Job costing procedure is the same both in
manufacturing and service organisations, except that service units use no direct
material.
The purpose of job costing is to ascertain the cost of production of each job for fixing
selling prices, bidding, controlling costs and evaluating performance. It also provides
information for negotiating price increase with the customers.

2.11.2 Contract Costing

This method is used in case of big jobs and therefore, the principles of job costing are
applied to contract costing The contract work usually involves heavy expenditure,
spreads over a long period and is usually undertaken at different sites. Hence, each
contract is treated as a separate unit for the purpose of cost ascertainment and control.
Contract costing is also termed as terminal costing as the cost can be terminated at
some point and related to a particular job. Contract costing is employed in business
undertakings engaged in construction of buildings, roads, bridges, ship building and
other civil and mechanical engineering works. 5 7
Fundamentals of 2.11.3 Batch Costing
Accounting
This method of costing is used in industries where the production is carried on in
batches. Each batch consist of identical products which maintains its identity
throughout one or more stages of production. Each batch cost is used to determine the
unit of cost of products. On completion of the batch the cost per unit can be
calculated by dividing the ‘total batch cost’ by the number of units produced. This
method of costing is suitable to industries where production consists of repetitive
production in nature and specified number of products are produced in one batch. It
is generally used in industries like engineering component industry, pharmaceuticals,
footwear, bakery, readymade garments, toy manufacturing, bicycle parts etc.

2.11.4 Unit Costing

Unit Costing is a method of cost accounting where costs are determined per unit of a
single product. This method is also called single or output costing. This method is
suitable to industries where production is continuous and uniform and engaging in the
production of a single product in two or three varieties. The cost per unit is found by
dividing the total cost by the total number of units produced. Where the product is
produced in different grades, costs are ascertained grad wise. It is suitable for
industries like collieries, quarries, brick works, flour mills, paper mills, cement, textile
mills, diaries etc.

2.11.5 Process Costing

Where a product passes through different processes and each process is distinct and
well defined the method employed for ascertaining the cost at each stage of production
is called process costing. Process costing is used in those industries where the
production is continuous and the final product is the result of sequence of operations
or processes. The finished product of one process will become the raw material of the
next process and the output of the last process will be the finished stock. The cost per
unit at each process will be calculated by dividing the total cost by the number of units
produced at each stage and the cost per unit of the final product is the average cost of
all the processes. During the course of processing of raw material, loss of some raw
material is unavoidable or it may give rise to the production of several products called
joint products or by products. Process costing is used in case of chemicals, paints,
textiles, bakeries, oil refining, food products, etc. Standardization of processes helps
the management to submit quotations in time without any delay. As actual and
budgeted costs are available in each process it facilitates managerial control by
evaluating the performance at each process level.

2.11.6 Operating Costing

Operating Costing is also called as ‘service costing’ because this method is used in
those undertakings which provide services and are not engaging in manufacturing
tangible products. It is used for ascertaining the cost of operating a service such as
railways, roadways, airways, hotels, nursing homes, power supply, water supply etc.
In these undertakings the cost unit is a service unit which is as follows:
Undertaking Cost Unit
Canteen per cup of tea
Cinema per seat
Electricity per kilo watt
Hospital per bed
School/College per student
Transport per passenger kilometer/per tonne kilometer
5 8
A large amount of capital is invested in fixed assets and comparatively less Basic Cost Concepts
working capital is required in these industries. Operating costing is different from
operation costing. Operating costing is used to determine the cost of providing a
service whereas operation costing is used to find out cost of each operation
in those of industries which produce goods consisting of a number of
operations.

2.11.7 Multiple Costing

It is an application of more than one method of costing in respect of the same
product. This method is suitable in industries where a number of components are
manufactured separately and then assembled into a finished product. In cases of
motor car, type writer, television, refrigerators, etc., costs are to be ascertained for
each component as well as for finished product. This involves use of different
methods of costing for different components and so it is known as ‘multiple’ or
‘composite costingí.

2.11.8 Uniform Costing

The practice of using a common method of costing by a number of firms in the same
industry is known as ‘uniform costing’. Thus it is not a separate method of costing. It
simply refers to a common system using agreed concepts, principles and standard
accounting practices. This helps in making inter-firm comparisons and fixation of
prices.
It should be noted that there are two basic methods of costing. They are : (i) Job
costing, and (ii) Process costing. The other methods discussed above are simply
variants of these two methods.

2.12 TYPES OF COSTING

2.12.1 Marginal Costing

It is also known as Variable Costing. It may be defined which methods of costing
rebers to the process and practice of ascertaining costs of products and serrices, the
types of costing rebers to the techniqu of analysing and presenting costs for the
purpose of control and managerial decisions. The hypes of costing (also known as
techniques of costing) generally used are as follows:
as ‘‘the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs.’’ It
is a technique of costing which emphasizes the distinction between product costs and
period costs. Only variable costs (direct material, direct labour, other direct expenses
and variable overheads) are allocated to products without taking into account fixed
costs. Fixed costs are treated as period costs and are charged to costing profit and
loss account of the period in which they are incurred. The profitability of the product
is based on the amount of contribution made by each product. Contribution is the
difference between selling price and marginal cost of sales. The price of a product
will be determined on the basis of marginal cost plus contribution. The difference
between the total contribution and total fixed cost represents the profit (Profit =
Contribution – Fixed cost).
The technique of marginal costing is a valuable tool to management in making
managerial decisions like fixation of selling price, selection of suitable product mix,
selection of alternative methods of production, make or buy decisions, and also for
cost control.
5 9
Fundamentals of 2.12.2 Absorption Costing
Accounting
Absorption costing is a principle whereby fixed as well as variable costs are allotted
to cost units. It is a technique of charging all costs, both fixed and variable costs, to
production of a product. Absorption costing does not require a break-down of costs
into fixed and variable costs. As such fixed costs are treated as product costs under
absorption costing. The reports prepared under absorption costing can be used for
external use.

2.12.3 Historical Costing

It refers to a system of cost accounting under which costs are ascertained only after
they have been incurred. In other words, accounting is done in terms of actual costs
and not in terms of predetermined and standard costs. In the initial stages of
development of cost accounting, historical costing is the only system available for
ascertaining costs. This system is not useful for cost control and measuring the
performance efficiency of the concern. Moreover, it is not useful in price quotations
and production planning.

2.12.4 Standard Costing

It refers to the system of cost accounting under which costs are determined in advance
on certain predetermined standards. These are known as standards which indicate the
level of costs that should be attained under a given set of operating conditions. The
standard costs are compared periodically with the actual costs and underlying causes
for variances are analysed so that corrective action may be taken in time wherever
necessary. The Standard Costing is helpful to the management for cost control,
production planning, formulation of policies, measuring efficiencies, eliminating
inefficiencies, etc.

2.13 LET US SUM UP

Cost data is required by an organisation for the purpose of ascertaining profit or loss
periodically, to plan its future operations as well as to evaluate its performance and
cost control. It also requires to price its products or services, to value its inventory and
day to day operations of plans and policies. Costs indicates (i) an actual or estimated
expenditure (ii) a direct or indirect expenditure and (iii) it relates to a job, process,
product or services. Cost is a flexible concept. It varies with time, volume, firm,
method or purpose. There is difference between ‘cost’ and ‘loss’. Cost signifies an
expenditure incurred for recurring some benefit and if no benefit is desired from a
particular expenditure, it is treated as loss.
Cost can be classified in various ways. On the basis of functions to which they relate,
costs are classified into manufacturing costs, administrative costs, selling and
distribution costs. On the basis of Identifiability with products costs can be classified
into direct costs and indirect costs. On the basis variability costs can be classified into
fixed costs, variable costs and semi variable costs. Costs can also be classified on the
basis of product or period. Product costs are those costs which are easily attributable
to products where as costs which are easily attribute to time interval are known as
period costs. Costs can also be classified on the basis of controllable and non-
controllable costs.
A cost unit is a unit of product, service or time in relation to which costs may be
ascertained or expressed. A cost centre is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for the purpose of
control. There are three elements of costs : (i) Materials (ii) Labour and (iii)
6 0
Expenses. These costs can be further sub-dividend into as direct or indirect costs. Basic Cost Concepts
Indirect costs are : indirect material, indirect labour, and indirect expenses. Indirect
costs are known as ‘overheads’. Overheads can be classified into factory overheads,
office overheads, selling and distribution overheads.
The main components of total cost are prime cost, works cost, cost of production and
cost of sales. The elements of cost can be presented in the form of a statement called
‘cost sheet’ A cost sheet is a statement showing the various components of total cost
of output for a certain period which acts as a guide to pricing decisions and cost
control. Overhead recovery rates are based on the cost sheet. Sometimes, a statement
of quotations is required to be prepared in order to find out the price to be quoted to
the prospective buyer for obtaining a specific order. Such a price is quoted before the
commencement of actual production after taking into consideration the inflationary
trends in the price levels of various components of production.
There are various methods of costing. These are: (i) Job costing (ii) Contract costing
(iii) Batch costing (iv) Unit costing (v) Process costing (vi) Operating costing (vii)
Multiple costing (viii) Uniform costing. The types of costing refers to the techniques
of analysing and presenting costs for the purpose of control and managerial decisions.
The types of costing generally used are: (i) Marginal costing (ii) Absorption costing
(iii) Historical costing, and (iv) Standard costing.

2.14 KEY WORDS

Allocation: Distribution of expenditure among various cost centres.
Costing: The technique and process of ascertaining costs.
Cost Sheet: A statement showing different elements of cost relating to a particular
product or a job for a particular period.
Cost Centre: A location, person, equipment or department for which costs may be
ascertained and used for purpose of control.
Direct Expenses: Expenses or decrease in the same proportion on the increase or
decrease in the output.
Cost of Sales: Total cost of a product including selling and distribution expenses.
Prime Cost: Cost of direct expenses including direct materials and wages.
Semi-variable costs: Expenses which change with changes in output, but not in the
same proportion.
Works cost: Prime cost plus factory overheads.
Chargeable expenses: Other direct expenses.
By-product: A product of relatively small value produced incidentally from
processing the raw material for the main product.
Joint Product: Two or more products resulting from processing a particular raw
material.
Process Costing: A method of ascertaining the cost of a product at each stage or
process of manufacturing.
Contract Costing: A special form of job costing applicable to big projects which
involves huge cost to complete and is usually site-based.
Job Costing: Specific order costing involving accumulation of costs relating to a
single cost unit - the job - when each order is of comparatively short duration.
6 1
Fundamentals of
Accounting 2.15 ANSWERS TO CHECK YOUR PROGRESS
A) 6 i) True (ii) False iii) True (iv) True (v) True (vi) False (vii)True
B) 4 i) False (ii) True iii) True iv) False v) True

2.16 TERMINAL QUESTIONS

1) Distinguish among variable, fixed and semi-variable costs. Why is this distinc-
tion important?
2) ‘‘fixed Costs are really variable. The more you produced the less they become’’.
Comment the statement.
3) Describe briefly the different methods of costing and state the particular indus-
tries to which they can be applied.
4) Distinguish between the following :
i) Product cost and period cost
ii) Controllable and uncontrollable cost
iii) Variable and fixed costs
iv) Direct and indirect costs
5) Costs may be classified according to their nature and characteristics’ Explain.
6) Cooling Ltd manufactured and sold 1,000 refrigerators in the year ending 31st
March, 2002. The summarized Trading and Profit & Loss Account is set out
below :
Rs. Rs.
To Cost of Sales 8,00,000 By Sales 40,00,000
To Direct Wages 12,00,000
To Other Manufacturing Cost 5,00,000
To Gross Profit c/d 15,00,000
40,00,000 40,00,000
To Management and Staff Salaries 6,00,000 By Gross Profit b/d 15,00,000
To Rent, Rates and Insurance 1,00,000
To Selling Expenses 3,00,000
To General Expenses 2,00,000
To Net Profit 3,00,000
15,00,000 15,00,000

For the year ending 31st March, 2003, it is estimated that

a) Output and sales will be 1,200 refrigerators.
b) Prices of Material will go up by 20% on the level of previous year.
c) Wages will rise by 5%
d) Manufacturing costs will rise in proportion to the combined cost of Material and
wages.
e) Selling cost per unit will remain unaffected
f) Other expenses will also remain constant
You are required to submit a statement to the Board of Directors showing the price at
which the refrigerators should be marketed so as to show profit of 10% on selling
price.
6 2 (Answer : Estimated selling price Rs. 51,00,000 Profit Rs. 5,10,000)
7) The following particulars have been made available from the Cost Ledger of a Basic Cost Concepts
Company :
Rs.
Stock of Raw materials on 31.12.2000 25,600
Stock of finished Goods on 31.12.2000 56,000
Purchase of Raw materials 5,84,000
Direct wages 3,97,000
Sales 11,84,000
Stock of Raw Materials on 31.12.2001 27,200
Stock of Finished goods on 31.12.2001 60,000
Works Overheads 88,072
Office and general Charges 71,048
The company is required to submit a tender for a large machine. The Cost
Department estimates that the materials will cost Rs. 40,000 and wages to fabricate
the machine Rs. 24,000. The tender is to be made at a net profit of 20% on selling
price.
Prepare a statement showing a) Cost of materials used, b) total cost, c) percentage of
factory overheads to direct wages, and d) percentage of office overheads to works
cost.
Also prepare a statement of quotation showing the price at which the tender of the
machine can be submitted.
(Answer : Cost of materials used Rs. 5,82,400; Total Cost Rs. 11,38,520;
Percentage of Factory overheads to Direct Wages 22%; Percentage of Office
Overheads to Works Cost 6.65%; Price to be quoted in tender : Rs. 92,360)

Note : These questions will help you to understand the unit better.
Try to write answers for them. But do not submit your
answers to the University. These are for your practice only.

2.17 SOME USEFUL BOOKS

Arora, M. N. 2000, A Text Book of Cost Accountancy. Vikas Publishing House Pvt.
Ltd., New Delhi (Chapter 1-2).
Bhar, B. K. 1990. Cost Accounting : Methods and Problems. Academic Publishers,
Calcutta (Chapter 1-2)
Maheswari, S. N. and Mittal, S. N. 1990. Cost Accounting : Theory and Problems.
Shree Mahavir Book Dept, Delhi (Chapter I)
Nigam B. M. L. and Sharma G. L. 1990. Theory and Techniques of Cost Accounting.
Himalaya Publishing House, Bombay (Chapter 1-3)
Owler. L. W. J. and J. L. Brown 1984. Wheldon’s Cost Accounting. ELBS, London
(Chapter 1-2)

6 3
Fundamentals of
Accounting UNIT 3 FINANCIAL STATEMENTS
Structure
3.0 Objectives
3.1 Introduction
3.2 Natural of Financial Statements
3.3 Contents of Financial Statements
3.3.1 Manufacturing Account
3.3.2 Trading Account
3.3.3 Profit and Loss Account
3.3.4 Profit and Loss Appropriation Account
3.3.5 Balance Sheet
3.4 Concept of Capital and Revenue
3.5 Revenue Recognition
3.5.1 Revenue Recognition in Case of Sale of Goods
3.5.2 Revenue Recognition in Case of Rendering of Services
3.6 Format of Financial Statements – Non-corporate Entities
3.6.1 Conventional Format
3.6.2 Vertical Format
3.7 Corporate Financial Statements
3.7.1 Items Peculiar to Corporate Balance Sheet
3.7.2 Items Peculiar to Corporate Income Statement
3.8 Requirements for Corporate Financial Statements as per Schedule VI
3.9 Basic Principles Governing the Preparation of Financial Statements
3.10 Preparation of Corporate Financial Statements
3.11 Let Us Sum Up
3.12 Key Words
3.13 Terminal Questions

3.0 OBJECTIVES
After studying this unit you should be able to:
l state the nature and contents of financial statements;
l know the differences between capital and revenue;
l know the prepration of non-corporate financial statements;
l be acquainted with the items peculiar to corporate financial statements; and
l prepare the profit and loss account and the balance sheet of a company as per the
requirements of the Companies Act.

3.1 INTRODUCTION
Accounting involves the collection, recording, classification and presentation of
financial data for the benefit of management and external agencies. For this purpose,
the transactions recorded in the books of accounts are periodically summarised and
presented in the form of two financial statements. One is the Balance Sheet or
64 Positional Statement and the other is Profit and Loss Account or Income Statement.
These are periodical reports which reflect the financial position and operating results Financial Statements
of the entire business for an accounting period, generally one year. These financial
statements are the basis for decision making by the management as well as outsiders.
However, the information presented in these statements must be analysed and
interpreted carefully before drawing conlcusions. In this unit we shall study the
preparation of financial statements both corporate and non-corporate entities as well
as the salient points involved in the preparation of these statements in the light of
Sections 210 to 223 and Part I and II of Schedule VI of the Companies Act, 1956.

3.2 NATURE OF FINANCIAL STATEMENTS

Financial Statements are prepared by all forms of business organizations to ascertain
the result of operating, financial and investment activities and to know the financial
position on the date of closing of books of accounts. In case of sole trade or a
partnership firm, maintenance and preparation of financial statements is not
mandatory but desirable. However, in case of Joint Stock Company, Sections 209 and
210 of the Companies’ Act 1956 make it obligatory and compulsory to maintain and
prepare financial statements by the end of each accounting period. Thus, main
objective of financial statements is to serve the information needs of users of
accounting information. These financial statements are the basis for decision making
by the management as well as to the outsiders like investors and share holders,
creditors and Financiers, government authorities, etc.

Objectives of Financial Statements

The primary objective of financial statement is to assist in decision making.
These statements enable the users:
i) To make rational investment, credit and similar other financial decisions.
ii) To estimate future cash flow and bankruptcy risk assessment.
iii) To ascertain NAV (Net Assets Value) or Net worth of the enterprise after
evaluating the value of assets, resources owned and the claims thereon
(liabilities) in order to make share purchase and sale decisions, takeovers and
merger decisions.
iv) Collective bargaining decision relating to wages, working conditions and job security.
v) To make assessment of economic and financial decisions.
(vi) To form appropriate taxation and subsidy policy, regulatory policy and
employment policy.
Besides, the financial statements are tools of judging earning capacity and managerial
efficiency to facilitate comparison and help evaluate its own performance. Thus, these
provide necessary inputs for forecasting and other relevant decision-making purposes.
According to American Institute of Certified Public Accountants “Financial
statements are prepared for the purpose of presenting periodical review or report on
progress by management and deal with the status of the investment in the business and
the results achieved during the period under review. Financial statements reflect a
combination of recorded facts, accounting-conventions and the personal judgment
and the judgments and conventions applied affect them materially. The soundness of
the judgments necessarily depends on the competence and integrity of those who make
them and on their adherence to generally accepted accounting principles and
conventions.
Hence, these financial statements must give sufficient analysis of the figures, without
unnecessary details to enable the users to understand its financial implications. This
calls forth for “convention of materiality” i.e. every material fact has to be disclosed 65
Fundamentals of which affect the decisions of the users of financial statements. It also demands that
Accounting any departure from previous year’s practice should clearly be indicated. In other
words the “convention of consistency” should strictly be adhered to. An enterprise has
to be consistent with reference to depreciation policy, inventory valuation policy and
other policy to facilitate horizonal and vertical comparison. Financial statements are
based on fundamental accounting assumptions of “going concern”, “consistency” and
accrual and are guided by major considerations governing the selection and
application of accounting policies.

3.3 CONTENTS OF FINANCIAL STATEMENTS

3.3.1 Manufacturing Account

Business concerns engaged in the activities of manufacturing or production of goods
which involves purchase of raw materials and in incurring of other manufacturing
expenses, prepare Manufacturing Account which shows the cost of raw materials
consumed, cost of conversion of raw materials into finished product and the cost of
goods produced. The cost of goods produced charged to Trading Account. The cost of
conversion includes–Direct Expenses, Frieght or Carriage Inward, direct labour.
Productive wages/Factory wages and factory expenses, such as factory rent, fuel,
power and gas, etc.
Cost of goods produced = Raw materials consumed + Cost of conversion
If, however, there is opening and closing work in progress due adjustment is made
accordingly. Similarly, value of material residue, which is sold as scrap, is credited to
Manufacturing Account.
Thus, we can say
Cost of goods produced = opening work-in-progress = cost of raw materials
consumed + cost of conversion – closing work in
progress – sale of scrap

Points to note regarding Manufacturing Account

1) Work in progress: It refers to the value of incomplete or semi-finished goods
which includes cost of raw materials, and proportionate wages and direct ex-
pense incurred till this stage of semi completion. Opening and closing balances of
the same are shown to the debit and credit side respectively.
2) Raw materials consumed: This shows the cost of materials used in the produc-
tion process. This is arrived at by Adding the net purchases to the opening
balance of raw materials and deducting the closing balance of raw materials at
hand by the end of accounting period.
3) Direct expenses: These expenses are incurred either on procurement or pur-
chases of raw materials and on conversion thereof into finished product. It
includes productive wages, freight inward, cartage or carriage inward, etc. That
is, it includes direct labour and direct expenses (factory).
4) Factory overheads or indirect expenses: Factory overheads refer to indirect
material, indirect labour and indirect expenses. These include cotton waste,
lubricating of machine oil, works manager, supervisor or foreman’s salary, fuel
and power, repairs and maintenance of factory machine, depreciation of factory
assets, rent, rates and taxes of the factory building, factory insurance, etc.
5) Scrap: It denotes the value of material residue coming out of certain types of
processes. It is sold as scrap and credited to Manufacturing Account to arrive at
66 the correct cost of production.
6) Cost of production: Manufacturing Account ascertains the cost of goods Financial Statements
manufactured during any accounting period as shown in the format of Manufac-
turing Account. The cost of production of goods produced is transferred to
Trading Account.

3.3.2 Trading Account

Trading Account is prepared to know the result of trading operations. It shows the
gross profit or gross loss arising from buying and selling of goods in which the
business enterprise deals in. Gross profit or gross loss is the difference between ‘sales’
and ‘cost of goods sold’.
Cost of goods sold = opening stock + purchases (less returns) + direct
expenses – closing stock
It is to be noted that Trading Account shows the result of trading operations under
normal conditions only. Abnormal losses (items) if any – such as loss of stock due to
fire, theft or accident are credited to Trading Account, at cost.

Analysis of Items Appearing to the Debit Side of Trading Account

1) Opening Stock: It refers to the value of goods at hand at the end of last
accounting year. It becomes the opening stock for the current accounting year. It
represents the value of goods in which business deals in.

2) Purchases: It denotes the value of goods (in which the concern deals in) purchased
either for cost or on credit for the purpose of resale. However, if the goods so
purchased are returned or used by proprietor for self consumption, or distributed as
free samples or taken up by the employer for their use, or given as charity, or to be
sent on consignment, or used for any other purpose, except for resale, such amounts
shall be deducted from the total purchases.

3) Director Expenses: These expenses are incurred in connection with purchase,

procurement or production of goods. It also includes expenses which bring the goods
up to the point of sale. Examples of direct expenses are:
a) Carriage Inwards (carriage paid on purchases)
b) Freight – Railways, Airways and Shipping
c) Transit – Insurance
d) Loading charges
e) Packing
f) Import duty
g) Export duty
h) Custom duty
i) Dock dues
j) Octroi
k) Warehousing wages
However, for a manufacturer in addition to above direct expenses include –
l) Wages and salaries
m) Fuel, coal, power, gas and water
n) Factory heating*
o) Factory insurance*
p) Factory lighting* 67
Fundamentals of q) Foreman’s and Supervisor’s salary*
Accounting
r) Other factory expenses*
s) Royalty on production*
t) Depreciation on Factory Building and machine*

* These are also known as Factory overheads or Factory indirect expenses from cost
accounting point of view but for financial accounting purposes these are treated as
direct expenses.

It is to be noted that a manufacturer prepares a Manufacturing Account

where all the above mentioned direct expenses are debited. However, if in
any case Manufacturing Account is not prepared, then all such expenses
will be charged to Trading Account.

Analysis of Items Appearing to the Credit Side of Trading Account

1) Sale: It refers to the sale of goods in which business deals and includes both cash
and credit sales. It does not include sale of old, obsolete or depreciated assets which
were acquired for use in business. Similarly, goods returned by customers or goods
sent to customers on approval basis or sales tax, if any, included in sales price should
be excluded.

2) Abnormal Loss: It refers to abnormal loss of stock due to fire, theft or accident.
Since Training Account is prepared under normal conditions of the business, abnormal
loss, if any, is credited fully to the Trading Account.

3) Closing Stock: It refers to the value of goods lying unsold at the end of any
accounting year. The stock at the end is valued either at cost or market price,
whichever is less. Since Trial Balance generally does not include closing stock, the
following entry is recorded to incorporate the effect of closing stock in the Trading
Account.
Closing Stock A/c Dr
To Trading A/c

However, if closing stock forms the part of Trial Balance it will not be
transferred to Trading Account but taken to Balance Sheet only.

In case goods have been sent to customer on approval (Sale/Return) basis, such goods
should be included in the value of closing stock if no approval has been received from
them.

Constituents of closing stock are:

i) Stock of Raw materials
ii) Work-in-progress or semi-finished goods
iii) Finished goods – remaining unsold at the end of the year,
– lying unsold at different branches, if any,
– lying unsold with the consignee
iv) Stores supplies = goods, materials required for converting the raw materials
into finished product, such as machine oil, cotton waste,
chemicals and machine spares (as per As-2)
68
Points to Remember Financial Statements

l It is to be noted that Income Statement + (viz. Manufacturing/

Trading/Profit and Loss Account) is parepared on Accrual)
(Mercantile) basis (Accrual concept) covering an accounting period
(accounting period concept) during which expenses are matched with
revenue (Matching Concept) to ascertain the profit or loss of an
enterprise. That is why unpaid expenses are added as outstanding in
the Income Statement and shown as liability in the Balance Sheet.
Similarly income accrued but not received are credited to Income
Statement and shown as asset in the Balance Sheet.

l It is important to remember that “Outstanding” Accrued or “Prepaid”,

if forming part of Trial Balance, then such items will be shown in the
Balance Sheet only and no treatment required in the Income
Statement.

l Conversely, “prepaid expenses” are shown by way of deduction in

the Income Statement and treated as an asset in the Balance Sheet,
whereas income received in advance are subtracted from the income
received and shown as a liability in the Balance Sheet.

3.3.3 Profit and Loss Account

This account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. It starts with gross profit or gross loss
as disclosed by the Trading Account. It takes into account all the remaining direct
(normal and abnormal) expenses and losses related to or incidental to business. These
operating and non-operating expenses are charged to Profit and Loss Account and
shown to the debit side of the Profit and Loss Account.
The operating expenses include:
i) All office or Administrative overheads such as rent, rates and taxes, office staff
salaries, printing and stationary, postage, telephone, office lighting, depreciation
on office equipment, etc.
ii) Selling and Distribution overheads such as Salesmen’s salaries, commission on
sales, travelling expenses, advertisement and publicity, trade expenses, carriage
outward, bad debts, warehouse expenses, delivery van expenses, packing ex-
penses and rebate to customers.
Non-operating expenses include financial expenses such as interest, bank
charges, discount on bill, abnormal losses (loss of goods due to fire, theft or
accident) and loss on sale of fixed assets, etc.
Whereas Non-operating incomes include income from investment and financing
activities, such as Interest Received, Rent Received, Dividend Received, Profit
on Sale of Investment, and Insurance Claims and other Miscellaneous Receipts,
like duty drawback and subsidy and apprenticeship premiums, etc. These
incomes are credited to Profit and Loss Account.
It is to be noted that if an enterprise prepares a Manufacturing Account, the factory
expenses (both direct and indirect) are charged to Manufacturing Account. If a
Manufacturing Account is not prepared, then direct factory expenses are charged to
69
Fundamentals of Trading Account and indirect factory expenses to Profit and Loss Account. Royallties
Accounting paid on production should be treated as direct expenses and royalties based on sales
as indirected expenses.

Some Important Points

1) Salaries: Salaries paid/payable to employees including Directors’ salaries,
Managers’ salaries (except Work Managers salaries) should be debited to
Manufacturing Account. In case a concern does not prepare Manufacturing
Account, the same should be charged to Trading Account. Similarly, salaries and
wages should also be charged to Profit and Loss Account. But wages and
salaries be charged to Trading Account.
2) Brokerge: This refers to brokerage paid on the items in which the business
trades in. Such as brokerage on buying and selling of goods in which the enter-
prise deals in is shown to the debit of Profit and Loss Account. However, any
brokerage paid on sale or purchase of assets is treated as of capital nature and
hence it is deducted from sale proceeds of the asset sold or added to the cost of
the asset required.
3) Trade Expenses: These expenses are of miscellaneous nature and of
small amount and sometimes termed as Sundry expenses or Miscellaneous
expenses or even Petty expenses. These are debited to Profit and
Loss Account.
4) Advertisement: Expenses on advertisement which are of revenue and recurring
nature are charged to Profit and Loss Account. Whereas cost of heavy advertise-
ment the benefit of which is likely to cover more than one accounting year is
treated as deferred revenue expenditure. For example, a company incurs
Rs. 1,00,000 on advertisement and it is estimated that the benefit of this
advertisement expenditure is likely to extend over a period of four years. In this
case Rs. 25,000, i.e. one-fourth of total cost of advertisement will be charged to
current year’s Profit and Loss Account whereas three-fourths, i.e. Rs. 75,000,
will be taken to Balance Sheet to be treated as ‘Deferred Revenue Expenditure’.
However, advertisement expenses incurred for purchase of goods should be
charged to Trading Account. Advertisement expenses paid for acquiring a capital
asset are capitalised. Again, cost of advertisement in respect of sale of any
capital asset is deducted from the sale proceeds of the asset concerned and hence
not charged to profit and loss account.
5) Rebate to Customers: It is an allowance given to a customer when his
purchases from the concern exceeds the certain limits say Rs. 200. In such cases
all those customers who make purchases from the company exceeding Rs. 200
will be entitled to rebate of 1% or 2% depending upon the policy declared
by the company. The amount of rebate so allowed is charged to Profit and Loss
Account.
6) Duty drawback and subsidy: It is a refund of duties levied on purchases made
by exporter. It serves as an incentive to exporter. The duty drawback and cash
subsidy should be deducted from the purchases. But in practice it is treated as
‘income’.
7) Apprenticeship Premium: It is the fee charged by the business enterprise to train
persons in various trades. It is treated as revenue receipts and credited to Profit
and Loss Account.
8) Factory Expenses: Factory expenses are of two types, viz. direct and indirect,
and both are shown in the Manufacturing Account. If a concern does not prepare
Manufacturing Account, then direct expenses are charged to Trading Account
70 and indirect expenses are debited to Profit and Loss Account.
9) Royalties: Royalties are paid by the business concerns to the landlord, author of Financial Statements
a patentee for the right to use their land, copyrights or patents right. Payment of
such royalty sum based on sales is debited to Profit and Loss Account.
However, if royalty is paid on the basis of production, it is charged to Trading
Account.
10) Free Samples and Publicity Expenses: These expenses are incurred to attract
cumtomers for increasing the volume of sale and as such are charged to Profit
and Loss Account. Similarly, money spent on prizes given to customers under the
scheme of ‘sales promotion’ such as ‘Bumper sales’, ‘Dhamaka sales’ are treated
as selling and distribution expenses. If a large sum is incurred on heavy
advertisement under a contract or whose benefits may accrue over a period of
more than one year, say four years, such expenses are spread over the period of
its benefits and a proportionate part is charged to Profit and Loss Account and
remaining is taken to Balance Sheet as deferred revenue expenditure.
11) Abnornal Losses and Insurance Claims: As a rule, the entire amount of
abnormal losses either arising from accident, fire or tgheft are credited to
Trading Account and debited to profit and loss account irrespective of the
insurance claims. The amount so received/settled/receivable from the insurance
company is credited to Profit and Loss Account.
Alternatively, Trading Account may be credited with the net abnormal loss
(abnormal loss insurance claim, if any) and insuracne claims and Profit and Loss
Account may be debited by net abnormal loss only.

3.3.4 Profit and Loss Appropriation Account

This account shows the distribution or appropriation of profit after the same has been
earned and computed. In case of sole proprietor, since entire amount of profit belongs
to him, no Profit and Loss Appropriation is prepared. However, this account is
prepared by partnership firms and Joint Stock Companies where there are several
claimants in the net profit. A partner shares earnings of the firm in the form of salary,
commission, interest and profit and credited to Profit and Loss Appropriation
Account.
However, a company’s Profit and Loss Appropriation account shows the transfer from
Profit and Loss Account an amount equivalent to “currnet year’s profit after tax”.
This account is further credited by the reserves and provisions made last year, now no
longer required, such as Development Rebate Reserve and Provision for Tax, etc. The
following items are debited to Profit and Loss Appropriation Account:
– Transfer to General Reserve
– Transfer to Capital Reserve
– Dividend Paid
– Proposed Dividends
– Bonus to Shareholders
– Excess of actual tax liability over the provisions made last year
– Corporate Dividend Tax, if any.

However, a detailed explanation of Profit and Loss Appropriation Account is to be

made under Corporate Financial Statements under 3.7 of this unit.

3.3.5 Balance Sheet

Balance sheet is a statement of assets and liabilities which helps us to ascertain the
financial position of a concern on a particular date, i.e. on a date when financial
71
Fundamentals of statements or final accounts are prepared or books of accounts are closed. In fact, it
Accounting treats the balances of all those ledger accounts standing to the debit or credit column
of the Trial Balance and which have not been squared up. These accounts relate to
assets owned, expensed incurred but not paid or not due, expenses due but not paid,
incomes accrued but not received or certain receipts which are not due or accrued. In
fact it deals with all those “real” and “personal accounts” which have not been
accounted for in the Manufacturing, Trading and Profit and Loss Accounts. Besides,
the balance sheet also treats all those items in the adjustments, whch affect Real or
Personal Accounts. The Nominal Accounts are treated in the Income Statement
(P&L A/c). A Balance Sheet aims to ascertain nature and amount of different assets
and liabilities so that the financial position could clearly be known to all those
concerned. Thus, the main function of the Balance Sheet is to depict the true picture of
the concern on a particular date.

Preparation and Presentation of Balance Sheet

The process of preparation and presentation of balance sheet involves two steps:
(i) Grouping and (ii) Marshalling. The first step refers to proper grouping of the
various items, which are of similar nature. For example, amount due from persons
who were sold goods on credit basis must be shown under the heading ‘Trade
Debtors’ and must be distringuished from money owing other than due to credit sales
of goods. The second step involves ‘marhsalling’ of assets and liabilities. It means
orderly arrangement in which assets and liabilities are presented or shown in the
Balance Sheet. There are two methods of presentation: (i) In order of “Liquidity, and
(ii) In order of “permanence”.
Under the “Liquidity Order”, assets are shown on the basis of liquidity or realisability.
These are arranged in order of “most liquid”, more liquid”, “liquid”, “least liquid” and
“not liquid” (fixed) assets. Similarly, liabilities are arranged in the order in which
these are to be paid or discharged. The liquility form is suiable for banking and other
financial companies.
Under the ‘‘Order of Permanence”, the assets are arranged on the basis of their useful
life. The assets which are to serve business for the longest period of time are shown
first, i.e. Fixed Assets, Semi Fixed, Current, Liquid and Most Liquid. Similarly, in
case of liabilities, after Capital, the liabilities are arranged as long term, medium term,
short term and current liabilites. The Companies Act has adapted permanency form
preparing balance sheet.
Some Important Items
1) Fixed Assets: Fixed assets are those assets, which are reuired for the purposes of
producing goods or rendering services. These are not held for resale in normal
course of business. Fixed assets are used for the purpose of earning revenue and
these are held for a longer period of time. These are also treated as ‘Gross Block’
(Fixed assets after depreciation) and ‘Net Block’ (Fixed assets after deprecia-
tion). Investment in these assets is known as ‘Sunk Cost’. Examples of fixed
assets are Land and Building, Plant and Machinery, Furniture and Fixtures,
Tools and Equipments, Motor Vehicles, etc. All fixed assets are ‘tangible’ by
nature.
2) Intangible Assets: Intangible assets are those capital assets which do not have
any physical existence. Though cannot be touched or seen yet they have long life
and help to generate income. Such assets have value by virtue of the rights
conferred upon the owner by mere possession. Goodwill, trademarks, copyrights
and patents are the examples of intengible assets.
3) Current Assets: Current assets include cash and other assets which are con-
verted or realized into cash within a normal operating cycle or say within a year.
72
 These are acquired either for the purpose of resale, or assisting and helping Financial Statements
process of production or rendering of service or supplying of goods. These assets
constantly keep on changing their form and contribute to routine transactions and
operations of business. Examples are, Cash in Bank, Bills Receivables, Debtors,
Stock, Prepaid Expenses, etc. Current assets are also known as floating assets or
circulating assets.
4) Liquid or Quick Assets: Those current assets whch can be converted into cash
at a very short notice or immediately without incurring much loss or exposing to
high risk. Quick assets can be worked out by deducting Stock (Raw materials,
work in progress or finished goods) and prepaid expenses out of total current assets.
5) Fictitious Assets: These are the non-existent worthless items which represent
unwritten off losses or cost incurred in the past which cannot be recovered in
future or realized in cash. Examples of such assets are preliminary expenses
(formation expense), Advertisement suspense, Underwriting - commission,
discount on issue of shares and debentures, Loss on issue of debentures and debit
balance of Profit and Loss Account. These fictitious assets are written off or
wiped out by debiting to Profit and Loss Account.
6) Wasting Assets: Assets with limited useful life by nature deplete over a limited
period of time are called wasting assets. These assets become worthless once its
utility is over or exhaust fully. Such assets are natural resources like, timer, coal
oil, mineral deposits, etc.
7) Contingent Assets: Contingent assets are probable assets which may or may not
become assets as it depends upon occurrence or non-occurrence of a specified
event or performance of a specified act. For example, a suit is pending in the
court of law against ownership title of any dispsuted property and if the suit is
decided in favour of the business concern it becomes the asset of the concern. On
the other hand, if the decision goes against the concern, the company cannot
claim to enjoy ownership rights. Thus, it remains a contingent asset as long as
the judgment is not pronounced by court. Such assets are shown by means of
footnote and hence do not form part of assets shown in the Balance Sheet. Beside
this hire purchase contract, uncalled share capital etc. are the other examples of
contingent assets.
8) Classification of Liabilities
Long Term Liabilities: These are the obligations which are to be met by the business
enterprise after a relatively long period of time. Such liabilities do not become due for
payment in the ordinary course of business operation or within normal operating
cycle. Debentgures, long term loans from Bank or financial institutions are the
examples of long-term liabilities.
Current Liabilities: Current liabilities are those liabilities which are payable within
normal operating cycle, i.e. within an accounting year. These may arise either out of
realization from current assets or by creating fresh current liability (obligation). Trade
creditors, Bill payable, Bank overdraft, Outstanding expenses, Short-term loan
(payable within twelve months or within accounting year) are examples of current
liabilities.
Contingent Liability: It is not an actual liability but an anticipated (probable liability
which may or may not become payable). It depends upon happending of certain events
or performance of certain acts. An element of uncertainty is always attached. A
contingent liability, thus, may or may not become a sure liability. Examples are,
liability for bills discounted, liability for acting as surety, liability arising on a suit for
damages pending in the court of law, liability for calls on partly paid shares, etc.
Contingent liabilities are shown as footnote under the Balance Sheet.
73
Fundamentals of
Accounting 3.4 CONCEPTS OF CAPITAL AND REVENUE
You know that a firm prepares Profit and Loss Account for ascertaining the net result
of business operations and the Balance sheet for determining the financial position of
the business. These are prepared with the help of Trial Balance which shows the final
position of all ledger accounts. All items appearing in the Trial Balance are transferrd
either to the Profit and Loss Account or to the Balance Sheet. As per rules, the items
of revenue nature are taken to the Profit and Loss Account and the items of capital
nature are shown in the Balance Sheet. In other words whether an item appearing in
the Trial Balance is to be taken to the Profit and Loss Account or the Balance Sheet
depends upon the capital and revenue nature of the item. If any item is wrongly
classified i.e., if an item of revenue nature is treated as a capital item or vice versa, the
Profit and Loss Account will not reveal the correct amount of profit and the Balance
Sheet will not reflect the true and fair view of the affairs of the business. It is therefore
necessary to determine correctly whether an item is of capital nature or of a revenue
nature and record it in the books accordingly. There are certain rules governing the
allocation of expenditures and receipts between capital and revenue which should be
clearly understood.
Capital and Revenue Expenditures
You incur expenditure on various items every day. You buy food items, stationery,
cosmetics, utensils, furniture, etc. Some of them are consumables and some are
durables. The benefit of expenditure on consumables like stationery, cosmetics, etc. is
derived over a short period. But in case of durables like furniture, utensils, etc., the
benefit spreads over a number of years. Same is true of business also. In business you
incur expenditure on two types of items: (i) routine items like stationery, and (ii) fixed
assets like machinery, builing, furniture, etc., whose benefit is available over a number
of years. In accounting terminology the first category of expenditure is called revenue
expenditure and the second one is called capital expenditure. Let us now study the
exact nature of capital and revenue expenditures.
Capital Expenditure: As stated above, when the benefit of an expenditure is not
exhausted in the year in which it is incurred but is available over a number of years it
is considered as capital expenditure. The following expenditures are usually treated as
capital expenditures:
1) Any expenditure which results in the acquisition of fixed assets such as land,
buildings, plant and machinery, furniture and fixures, office equipment,
copyright etc. you should note that such capital expenditure includes not only the
purchase price of the fixed asset but also the expenses incurred in connection
with their acquisition. Thus, the brokerage or commission paid in connection
with the acquisition of an asset, the freight and cartage paid for transportation of
machinery, the expenses incurred on its installation, the legal fees and
registration charges incurred in connection with purchase of land and buildings
are also treated as capital expenditure.
2) Any expenditure incurred on a fixed asset which results in (a) its expansion,
(b) substantial increase in its life, or (c) improvement in its revenue earning
capacity. Improvement in the revenue earning capacity can be in the form of
(i) increased production capacity, (ii) reduced cost of production, or
(iii) increased sales of the firm. Thus, cost of making additions to buildings and
the amount spent on renovation of the old machinery are also regarded as capital
expenditures. If you buy a second hand machinery and incur heavy expenditure
on reconditioning it, such expenditure is also to be treated as capital expenditure.
Similarly, expenditure on structural improvements or alterations to existing fixed
assets whereby their revenue earning capacity is increased, is also treated as
capital expenditure.
74
3) Expenditure incurred, during the early years, on development of mines and land Financial Statements
for plantations till they become operational.
4) Cost of experiments which ultimately result in the acquisition of a patent. The
cost of experiments which are not successful is not to be treated as capital
expenditure. It is treated as a deferred revenue expenditure which is written off
within two to three years.
5. Legal charges incurred in connection with acquiring or defending suits for
protecting fixed assets, rights, etc.
Revenue Expenditure: When the benefit of an expenditure is not likely to be
available for more than one year, it is treated as revenue expenditure. So all expenses
which are incurred during the regular course of business are regarded as revenue
expenditures. The examples of such expenses are:
1) Expenses incurred in day-to-day conduct of the business such as wages, salaries,
rent, postage, stationery, insurance, electricity, etc.
2) Expenditure incurred for buying goods for resale or raw materials for
manufacturing.
3) Expenditure incurred for maintaining the fixed assets such as repairs and
renewals of building, machinery, etc.
4) Depreciation on fixed assets. This can also be termed as revenue loss.
5) Interest on loans borrowed for running the business. You should note that
any interest of loan paid during the initial period before production
commences, is not treated as revenue expenditure. It is treated as capital
expenditure.
6) Legal charges incurred during the regular course of business such as legal
expenses incurred on collection from debtors, legal charges incurred on
defending a suit for damages, etc.

Deferred Revenue Expenditure

Sometimes, certain expenditure which is normally treated as revenue may be
unusually heavy and its benefit is likely to be available for more than one year. In such
a situation, it is considered appropriate to spread the cost of the expenditure over a
number of accounting years. Hence, it is capitalised and only a portion of the total
amount spent is charged to the Profit and Loss Account of the current year. The
balance is shown as an asset which wil be written off during the subsequent
accounting years. Such expenditure is called a Deferred Revenue Expenditure because
its charge to Profit and Loss Account has been deferred to future years. Some example
of such expenditure are:
1) Expenditure incurred on advertising campaign to introduce a new product in the
market.
2) Expenditure incurred on formation of a new company (preliminary expenses)
3) Brokerage charges, underwriting commission paid and other expenses incurred in
connection with the issue of shares and debentures.
4) Cost of shifting the plant and machinery to a new site which may involve
dismantling, removing and re-erection of the plant and machinery.
Let us take the case of expenditure on advertising campaign. It is not a routine
advertisement and the amount involved is unusually heavy. Its benefit will not
completely exhaust in one accounting year but will contunue over two to three years.
Hence, it is not proper to charge such expenditure to the Profit and Loss Account of
75
Fundamentals of one year. It is better to distribute it carefully over three years. So, in the first year we
Accounting may charge one-third of the amount spent to the Profit and Loss Account and show
the balance in the Balance Sheet as an asset. In the second year again we may charge
a similar amount to the Profit and Loss Account and show the balance as an asset. In
the third year. we may charge this balance to the Profit and Loss Account. Every
expenditure which is regarded as deferred revenue is treated in this way in the final
accounts.
Look at Illustration 1 and note how each expenditure has been treated and why.
Illustration 1
State whether the following items of expenditure would be treated as (a) capital
expenditure, (b) revenue expenditure, or (c) deferred revenue expenditure:
i) Carriage on goods purchased Rs. 25.
ii) Rs. 2,000 spent on repairs of machinery.
iii) Rs. 5,000 spent on white washing.
iv) Rs. 8,000 paid for import duty and cartage on the purchase of machinery from
west Germany.
v) Rs. 25,000 spent on issue of equity shares.
vi) Rs. 14,000 spent on spreading new tiles on factory floors.
vii) Rs. 4,000 spent on dismantling, transportation and reinstalling plant and
machinery to new site.
viii) Rs. 60,000 spent on construction of railway siding.
ix) Rs. 20,000 spent on some major alterations to a theatre which made it more
comfortable and attractive.
x) A second hand maching was bought for Rs. 10,000 and an amount of Rs. 6,000
was spent on its overhauling.

Solution
i) It is a revenue expenditure as it relates to the goods for resale.
ii) It is a revenue expenditure as it relates to the maintenance of a fixed asset.
iii) Same as no. (ii).
iv) It is a capital expenditure as it is spent in connection with the purchase of a fixed
assets.
v) It would be treated as deferred revenue expenditure. It is a heavy amount in-
curred in connection with reising of capital for the company and so capitalised.
Even under the Indian Companies Act and the Indian Income Tax Act this
expenditure is allowed to be written off over a number of years.
vi) It is a revenue expenditure so it is treated as a sort of repairs not leading to any
increase in the earning capacity of a fixed asset.
vii) Normall expenditure on transportation etc. is revenue in nature. But this expendi-
ture has been incurred on shifting to new site which is non-recurring in nature
and involves a heavy amount. Hence it shall be treated as a deferred revenue
expenditure.
viii) It is a capital expenditure as it is incurred on the construction of railway siding, a
fixed asset.

76
ix) It is a capital expenditure as the alterations made the theatre more comfortable Financial Statements
and attractive which is likely to increase its collections.
x) It is a capital expenditure as it is incurred on making the newly bought second
hand machinery operational.

Capital and Revenue Receipts

Receipts refer to amounts received by a business i.e., cash inflows. Receipts may be
classified as Capital Receipts and Revenue Receipts. It is necessary to note this
distinction clearly because only the revenue receipts are taken to the Profit and Loss
Account and not the capital receipts.
Capital Receipts: Capital receipts are the amounts received in the form of (a)
additional capital introduced in the business, (b) loans received, and (c) sale proceeds
of fixed assets. You are aware that a loan taken by the business is repayable sooner or
later. Similarly, additional capital received represents an increase in the proprietor’s
claim over the business assets. Thus these two items represent increase in liabilities of
the business and obviously are not incomes or revenues. These are capital receipts and
should be treated as such. The sale proceeds of a fixed asset are also treated as a
capital receipt because the amount received is not revenue earned in the normal course
of business. The capital receipts increase the liabilities or reduce the assets. They do
not affect the profit or loss.
Revenue Recipts: Revenue receipts are the amounts recived in the normal and regualr
course of business. They take the form of (a) sale proceeds of goods, and (b) incomes
such as interest earned, commission earned, rent received, etc. These receipts are on
account of goods sold or some services rendered by the business and as such they are
not repayable. All revenue receipts are treated as incomes and shown on the credit side
of the Profit and Loss Account.

3.5 REVENUE RECOGNITION

Revenue arises in the ordinary course of business activities of an enterprise from:
– sales of goods,
– rendering of services, and
– use by others of enterprise resources yielding interest, royalties and dividends.
Revenue recognition is mainly concerned with the timing of recognition revenue in the
statement of profit and loss. According to AS-9, “revenue is the gross in flow of cash,
receivables, or other consideration arising in the course of ordinary activities of an
enterprise.”
The basic problem of revenue recognition lies in identifying of the “accounting
period” during which revenues are earned. There are several stages or activities in a
business before the revenues are earned and realized. Hence the problem arises –
should revenue be recognized at the point of production, sale, delivery or receipt of
cash. According to “Realisation Concept” revenues are recognized at the point of
sale or services are rendered. However, there is no single uniform practice to
recognize various types of revenues according to one common principle. There are
guidelines, which help us in recognizing operating revenues and non-operating
revenues. Non-operating revenues include interest, dividend and rent and other
incomes which are not related to normal course of operation of the enterprise.
It is advisable to show operating and non-operating revenues separately in the
Profit and Loss Account.

77
Fundamentals of Following are some of the established practices to recognize revenue as per AS-9.
Accounting
3.5.1 Revenue Recognition in Sale of Goods
Trading and Manufacturing organizations, in general, recognize revenue when sale is
effected. However, the following conditions should be satisfied:
i) The “property in goods” is transferred for a price.
ii) All significant risks and rewards have been transferred and no effective control is
retained by the seller.
iii) No significant uncertainty exists regarding the collection of amount of consider-
ation.

Special Cases of “Sale of Goods” and applicability of AS-9

a) Delivery of goods delayed at buyer’s request and buyer takes title and
accepts billing: Revenue should be recognized and the “goods to be delivered” at
any subsequent date should not be included in the inventory.
b) Goods delivered subject to installation and inspection: Revenue should be
recognized only after the installation and inspection is completed.
c) Sale on Approval: In case of sale on approval or return basis, revenue should be
recognized only when acceptance is received from buyer.
d) Sale subject to warranty: If sales are subject to a warranty, revenue recognition
should not be deferred but a provision should be made to cover the liability
which may arise under the terms and period of warranty.
e) Guaranteed Sales: Sometimes goods are sold and delivery is made giving the
buyer the unlimited right to return. This is under “Money back guarantee”, if not
completely satisfied. Under this situation it is apparent to recognize the ‘revenue’
at the point of sale and to make provisions for returns as well.
f) Consignment Sales: Revenues are recognized when the goods are sold to
customers by the consignee and at the time of dispatch of goods of consignor.
g) Cash on delivery Sales: If a sale has been effected under the terms of
“Cash-on-delivery”, revenue should be recognized only when cash is
received by seller.
h) Installment Sales: Revenues are recognized on delivery to the extent of normal
cash down price. However, interest on deferred payment should be recognized in
the ratio of amount outstanding.
I) Special Order: Where payment is received against the specific order of goods,
which are not in stock. Revenue from such sale should be recognized only when
goods are purchased or manufactured and are ready for delivery.
j) Sale/Repurchase Agreement: Where seller concurrently agrees to repurchase
the same goods at some late date, the flow of cash under such a situation will not
be recognized as revenue.
k) Sales to Distributors to Dealers for Resale: Revenues are recognized only if
significant risks of ownership have passed on distributors/dealers.

3.5.2 Revenue Recognition in Case of Rendering of Services

Revenue recognition in case of rendering services care based on the following
conditions:
i) Revenue recognized either on completed service method or ‘proportionate
completion’ method.
ii) No significant uncertainty exists regarding amount of consideration.
78 iii) It is reasonable to expect ultimate collection of consideration.
Under completed service method revenue are recognized only on completion of Financial Statements
service. In cases there are more than one act involved, revenue are recognized on
execution of all these acts.
Proportionate completion method recognized revenue proportionate with the degree
of completion of services. If there are more than one act involved revenue are
recognized on execution of certain acts. Some examples of recognition of service
revenue are –
1) Installation Fee: In cases where installation fees are other than incidental to
sales, the revenue should be recognized only when the equipment is installed and
accepted by the customer.
2) Advertising and Insurance Agency Commission: Revenue should be recog-
nized when service is completed. For advertising agencies, media commission
will normally be recognized when the related advertisement or commercial
appears before the public, and the necessary intimation is received by the agency.
Insurance agency commission should be recognized on the effective
commencement renewal dates of the related policies.
3) Financial Service Commissions: A financial service may be rendered as a single
act or may be provided over a period of time. Similarly, charge for such services
may be made as a single amount or in stages over the period of the service or the
life of the transaction to which it relates. Such charges may be settled in full
when made or added to a loan or other account and settled in stages.
The recognition of revenue should therefore have regard to:
a) Whether the service has been provided one and for all or in an continuing
basis.
b) The incidence of cost relating to service.
c) Commission charged for arranging and granting of loan or other facilities,
should be recognized when a binding obligation has been entered into.
Commitment, facility or loan management fees which relate to
continuing obligations or service should normally be recognized over the
life of the loan or facility having regard to the amount of the obligation
outstanding, the nature of the service provided and timing of the costs
relating thereto.
Admission Fees: Revenue from artistic performance, banquets and other
special events should be recognized when the event takes place. When fees to a
number of events, it should be allocated to each event on a systematic and
rational basis.

Tution Fees: Revenue should be recognized over the period of instruction.

Entrance and Membership Fees: AS.9 recommends capitalization of entrance fees.
If membership fee permits only membership and all other services of products are paid
for separately or if there is a separate annual subscription, the fee should be
recognized as revenue when received. If the membersyhip fee entitles the member to
services or publications to be provided during the year, it should be recognized on a
systematic and rational basis having regard to the timing and nature of all services
provided.
Subscription for Publications: Revenue received or billed should be deferred and
recognized either on straight-line basis over time or where the items delivered
vary in value from period to period revenue should be based on the sales value
of the items delivered in relation to total sales value of all items covered by
the subscription.
79
Fundamentals of Exceptions to General Rule
Accounting
1) Revenue recognition at the point of production (Completed Production
Method): Under this method revenue are recognozid at the point of production.
It applies to case of agriculture. Extractive industries like gold, silver, uranium,
other metals and oil (crude) etc. revenue are recognized just after completion of
production even before the sales take place.
2) Cash Basis: Under this, revenue are not recognized at the point of sale but when
cash is realized including outstanding, if any. This basis is applicable in case of
hire-purchase system where revenue are recognized on the basis of cash received
and installments due during the year.
3) Revenue Recognition during the production period on percentage of
completion method: Under this method revenue are recognized on the basis of
contract value, associated costs, number of acts or other susitable basis. It is
applicable in case of long-term construction contracts where revenue are
recognized on the basis of degree of completion or what work certified bears to
cash received by the contractor.
4) Time Basis: In many cases revenue are realized on the basis of time or period.
For example, interest on fixed deposits is credited to Profit and Loss Account on
time proportion basis, i.e. interest accrued yet not payable.

It is to be noted that revenue in case of “Royalties” are recognized on an accrual basis

in according with terms of agreement and, Dividends are recognized when the right to
receive payment is established.

3.6 FORMAT OF FINANCIAL STATEMENTS

(NON-CORPORATE ENTITIES)
The financial statements may be prepared and presented either in conventional (also
known as ‘T’ form) or Vertical form. The basic purpose is to serve the information
needs of the users of accounting information. The idea is to present these accounting
figures in such a way that provides maximum input for decision-making purposes.
The income statement gives the clear picture operating efficiency of the enterprises by
disclosing the amount of gross profit or loss through Trading Account. At the same
time Profit and Loss Account reveals the overall ‘net’ result – the “net profit” or “net
loss”. The Balance Sheet, which is also known as “position statement” is required to
depict the true and fair view of state of affairs of business enterprise. Sole traders and
partnership firms are not requqired to comply any legal provisions as far as
presentation and formats of financial statements are concerned. However, these
income statements, meant basically for self consumption, must be prepared in
conformity with the accounting concepts, conventions and applicable accounting
standards.
The financial statements of non-corporate entities may be presented either of the
following ways:
1) Conventional Format, and
2) Vertical Format

3.6.1 Conventional Format

Following are the conventional formats of ‘Income’ and ‘Position statements’:

80
 Format of a Manufacturing Account Financial Statements
For the year ended 31st March....
Dr. Cr
Rs. Rs.
To Opening Work-in progress ----- By Closing Work-in- Progress -----
To Raw materials consumed ----- By Sale of Scrap -----
Operating stock of Raw material By Cost of goods
Add: Purchases produced-transferred
Less: Closing stock of ----- to Trading Account -----
Raw material
To Direct Expense
Productive Wages -----
Freight Inward Raw material -----
Cartage/Carriage Inward -----
To Factory overheads
Salary of Works Manager -----
Gas, Fuel and Power -----
Factory Light -----
Rent, Rates and Taxes -----
Insurance of factory assets -----
Repairs of factory assets -----
Depreciation of factory assets
Other Factory Expenses -----
*** ***

Trading Account (A format)

For the year ended 31st March ....

Dr. Cr
Rs. Rs.
To Opening Stock (Finished Goods) ----- By Sales less Returns -----
To Transfer from Manufacturing A/c ----- By Abnormal Loss:
or/and Purchases less returns (Transferred to
To Direct Expense Profit and Loss A/c)
Carriage/cartage Inward Loss by Fire
Freight Loss by Accident
Insurance-in-transit ----- Loss by Theft -----
Wages ----- By Closing Stock -----
* Fuel and Power ----- By Gross Loss A/c
* Coal, Gas and Water ----- (Balancing figure)
Packing (essential) -----
Octroi -----
Import duty
* Consumable Stores -----
Royalty (based on output) -----
81
Fundamentals of * Manufacturing Expenses -----
Accounting * Excise Duty -----
Dock dues
To Gross Profit A/c
(Balance fiture)** -----
*** ***

* Concerns not preparing Manufacturing Account separately

** Balancing figure will be either gross profit or gross loss.

Profit and Loss Account (A format)

For the year ended 31st March ....
Dr. Cr
Rs. Rs.
To Gross Loss* b/d ------- By Gross Profit b/d* ------
To Office & Administration Expenses: By Interest Received ------
Salaries of Office Staff By Dividend Received ------
Office Rent, Rates and Taxes By Rent Received ------
Printing and Stationery ------- By Discount Received ------
Postage and Telephone ------- By Profit on sale of fixed assets ------
Fire Insurance Premium ------- By Profit on sale of Investment ------
Audit Fees ------- By Insurance Claims ------
Repairs and Maintenance ------- By Duty–Draw Backs ------
Legal Expenses ------- By Apprenticeship Premium ------
Office Lighting ------- By Miscellanceous Receipts ------
Depreciation-office assets ------- By Bad debts Recovered ------
Other Office Expenses ------- By Net loss transferred ------
To Selling and Distribution Expenses: to Capital account
Salesmen’s Salaries (Balancing figure)** ------
Commission on Sales
Travelling Expenses
Brokerage
Trade Expenses
Advertisement and Publicity
Sales Promotion Expenses
Carriage Outward
Bad Debts
Provision for Bad Debts
Repairs of Vehicles
Depreciation on Vehicles
Warehouse Expenses
Warehouse Insurance
Warehouse Rent
Delivery Van Expenses
Packing Expenses
Rebate to Customers
Royalty on Sales
To Financing Expenses:
Discount Allowed
Interest on Capital
Discount of Bills
Bank Charges
82
To Abnormal Losses: Financial Statements
Transferred from Trading Account –
(loss by – Fire
– Accident
– Theft)
To Loss on sale of Fixed Assets
To Miscellaneous Expenses
To Net Profit Transferred to
Capital A/c (Bal. Figure)**
*** ***
* Balancing b/d may be either Gross Profit or Gross Loss
** The Balancing figure may be either Net Profit or Net Loss
Profit and Loss Appropriation Account (A format)
For the year ended 31st March ....
Dr. Cr
Rs. Rs.
To Profit and Loss A/c (Net Loss)* —— By Profit and Loss A/c (Net Profit)* ——
To Interest on Partner’s Capitals —— By Interest on Drawings ——
To Salary to Partners —— By Balance (transferred to
To Commission to Partners Partner’s Capital Account) ——
To Balance (Transferred to
Partner’s Capital Accounts)**
*** ***
* There will either be Profit or Loss
** Represent balancing fiture – a residual profit or loss to be shared by partners in
the profit sharing ratio.
Balance Sheet of ......... (A format)
as on 31st March .......
Liabilities Rs. Assets
Capital ----- Fixed Assets: -------
Add Profit or less Loss ----- Goodwill -------
Less Drawings ----- ----- Land and Building -------
Plant and Machinery -------
Long Term Liabilities
Tools and Equipments -------
Mortgaged Loan -----
Motor Vehicles -------
Loan from Bank -----
Furniture and Fixtures -------
Current Liabilities Patents and Trademarks -------
Sundry Creditors -----
Investment (Long Term) -------
Bills Payable -----
Current Assets: -------
Income Received in Advance -----
Stock -------
Outstanding Expenses -----
Accrued Income -------
Bank Overdraft -----
Prepared Expenses -------
Sundry Debtors -------
Bills Receivable -------
Short Term Investment -------
Marketable Securities -------
Cash and Bank Balance -------
Fictitious Assets: -------
Advertisement -------
Profit and Loss Account -------
Miscellaneous Expenditure -------
*** ***
83
*The items in the above format have been shown in order of permanence.
Alternatively, this can be presented in order of liquidity as explained earlier.
Fundamentals of 2. From the following Trial Balance of Trader, you are required to prepare Trading
Accounting and Profit Account for the year ended 31st March 2001 and a Balancing Sheet as
on that date.

Trial Balance as on 31st March 2001

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
Drawing Account 7,500 Capital 1,50,000
Plant and Machinery (1.4.2000) 1,25,000 Returns Outward 1,250
Plant and Machinery 6,250 Sundry Creditors 22,500
(1.4.2000) 19,250 Sales 2,00,000
Stock (1.4.2000) 1,02,500 Porivision for Bad
Purchases 2,500 and Doubtful debts 500
Returns Inward 25,750 Discount Received 1,000
Sundry Debtors 6,200 Rent (up to 30.9.2002) 1,500
Furniture 12,500
Freight 625
Carriage Outward 5,750
Rent, Rates and Taxes 1,000
Printing and Stationary 500
Trade Expenses 875
Insurance Charges 26,625
Salaries and Wages 25,675
Cash in Bank 7,250
Cash in Hand 1,000
Postage and Telegram
3,76,750 3,76,750

Adjustments:
1) Stock on 31st March 2001 was valued at Rs. 15,000
2) Write off Rs. 750 as bad debts.
3) Provision for Bad and doubtful debt is to be maintained at 5% on sundry debtors.
4) Create a provision for discount on debtors and also reserve for discount on
creditors @ 2%.
5) Charge depreciation @ 2% p.a. on Plant and machinery and @ 5% on furniture.
6) Insurance prepaid was Rs. 125.
7) Goods worth Rs. 6,250 were totally demaged in an accident. The insurance
company admitted claim of Rs. 5,000 on 28.3.2001.

84
Solution Financial Statements
Trading Account
For the year ended 31st March 2001
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Opening Stock 19,250 By Sales 2,00,000
To Purchases 1,02,500 Less Returns 2,500 1,97,500
Less Returns 1,250 1,01,250 By Closing Stock 15,000
To Freight 12,500 By Insurance Claims 5,000
To Gross profit transterred By Profit & Loss A/c 1,250
to Profit & Loss A/c 85,750 (Abnornal Loss)

2,18,750 2,18,750

Profit and Loss Account

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Rent, Rates & Taxes 5,750 By Gross Profit b/d 85,750
To Printing and Stationary 1,000 By Discount Received 1,000
To Trade Expenses 500 By Rent Received 1,500
To Insurance 875 Less Prepaid 750 750
Less Prepaid 125 750
To Salaries & Wages 26,625 By Reserve for discount 450
To Postage & Telegram 1,000 on creditors
To Bad debts 750
To Provision for Bad and doubtful debts 750
(New reserve Rs. 1250-Old
reserve Rs. 500)
To Provision for discount on debtors 475
To Carriage outward 625
To Abnormal loss (Accident) 1,250
To Depreciation on:
Furniture 310
Plant & Machinery 25,625 25,935
(Rs. 25000 + Rs. 625)
To Net profit transfered A/c540
to capital 87,950 87,950

Balance Sheet As on 31st March 2001

Dr. Cr.
Liabilities Amount Assets Amount
Rs. Rs.

Add. Capital 1,50,000 Plant & Machinery 1,25,000

Net Profit 22,540 Additions 6,250
1,72,540 1,31,250
Less Drawings 7,500 1,65,040 Less Dereciation 25,625 1,05,62
Sundry Creditors 22,500 Furniture 6,200
Less Provision 450 22,050 Less Depreciation 310 5,89
Advance Rent 750 Closing Stock 15,00
Sundry Debtors 25,750
Less Bad Debts 750
25,000
Less Provision @ 5% 1,250
23,750 85
Fundamentals of Less Provision for discount 475 23,27
Accounting Cash at Bank 25,67
Cash in hand 7,25
Insurance Claims 5,00
Prepaid Insurace 12
1,87,840 1,87,84

Illustration 3
The following is the Trial Balance of Mr. Mahesh as 31st December 2003. Prepare a
Trading and Profit & Loss Account for the year ended 2003 and Balance Sheet as on
31st December 2003.
Dr. Cr

Rs. Rs.

Purchases 1,80,000 Sales 2,05,000

Opening Stock 10,000 Loan (10% interest) 10,000
Salaries Less Provident Fund 5,400 Creditors 15,000
Drawinges 5,000 Capital 55,000
Provident fund remittances including
Proprietor’s contribution 50% 1,200
Rent Rs. 250 per month 2,750
Machinery 29,000
Wages 3,000
Furniture & Fittings 5,000
Electricity 550
Trade Expenses 1,500
Debtors 10,500
Interest on Loan 900
Commission 200
Building 30,000
2,85,000 2,85,000

Wages include Rs. 1,000 Paid for machinery erection charges. Purchases include cost
of moped scooter for Rs. 5,000 Proprietor has taken goods costing Rs. 1,000 for
which no entry has been made, Electricity outstanding Rs. 50. Goods costing Rs.
5,000 were destoyed by fire and insurance claim was receied for Rs. 4,000 Provide
depreciation at 10% on machinery, furniture & moped. Provide depreciation 5% on
Bulding. Closing stock is Rs. 12,000

Solution
Trading And Profit and Loss Account
For the year ended 31st December 2003
Dr. Cr

Particulars Amount Particulars Amount

Rs. Rs.
To Opening Stock 10,000 By Sales 205,000
To Purchases 180,000 By Loss by fire transferred
Less Purchase of Scooter 5,000 to P&L A/c 5,000
Less Drawings (goods used) 1,000 174,000 By Closing Stock 12,000
To Wages 3,000
Less Erection charges 1,000 2,000
To Gross Profit c/d 36,000
222,000 222,000
To Salaries 5,400 By Gross Profit b/d 36,000
Add Subscription 600 By Insurance claims 4,000
86 Contribution 600 6,600
To Rent 2,750 Financial Statements
Add Outstanding 250 3,000
To Electricity 550
Add Outstanding 50 600
To Commission 200
To Trade Expenses 1,500
To Bad debts 500
To Interest 900
Add Outstanding 100 1,000
To Provision for Bad debts 1,000
To Loss by fire (Trading A/c) 5,000
To Depreciation on:
Building 1,500
Machinery 3,000
Furniture 500
Scooter 500
To Net Profit 15,100
40,000 40,000

Balance Sheet
As on 31st December 2003
Dr. Cr
Liabilities Amount Assets Amount
Rs. Rs.
Capital 55,000 Building 30,000
Add Net Profit 15,100 Less Depreciation 1,500 28,500
Less Drawings (5000 + 1000) 6,000 64,100 Machinery 29,000
Add Erection Charge 1,000
30,000
10% Loan 10,000 Less Depreciation (10%) (3,000) 27,000
Creditors 15,000 Furniture 5,000
Rent outstanding 250 Less Depreciation 500 4,500
Interest outstanding 100 Scooter 5,000
Electricity Changes O/s 50 Less Depreciation 500 4,500
Closing Stock 12,000
Debtors 10,500
Less Bad debts 500
Less Provision @ 10% 1,000 9,000
Insurance claims 4,000
89,500 89,500

3.6.2 Vertical Format

Under vertical form various items of incomes and expenses, assets and liabilities are
arranged vertically to get some additional information about the operating efficiency
and financial position of the business enterprise. The vertical form of Income
Statement shows the gross profit, operating profit, net profit. The impact of non-
operating incomes and expenses cannot be ascertained if the Trading & Profit and
Loss Account is not prepared under vertical form. Similarly the Balance Sheet
discloses owner’s capital, borrowed capital, net working capital, etc. It is to be noted
that sole traders and partnership firms hardly adopt vertical form of financial
statements. Following formats will bring about a clarity of understanding of vertical
form of financial statements.

87
Fundamentals of Income Statement (A format)
Accounting For the year ending 31st March .....
Particulars Figures at the end of
Previous Year Current Year
Rs. Rs.
Sales/Turnover -------- --------
Less Cost of Goods Sold* -------- --------
Gross Profit **** ****
Less Administrative Expenses* -------- --------
Less Selling and Distribution Expenses* -------- --------
Operating Profit **** ****
Add Other Incomes* (Non-operating Incomes) -------- --------
Less Financial Expenses (Non-operating Expenses) -------- --------
Net Profit **** ****
Less Transfer to General Reserve and/or capital -------- --------
account/accounts (in the form of profit, -------- --------
salary, commission, etc.)
* Explained earlier under conventional form.

Operating vs Non-operating

Operating Profit/Loss
The excess of operating incomes over operating expenses represents operating
profit, whereas when operating expenses exceed operating income it results in
operating loss.
Operating incomes are those incomes which arise from operating activities in which
the enterprise deals in. For a trading concern, revenue arising from sale of goods in
which the enterprise deals in is treated as operating income. In fact, operating
activities are the principal revenue-producing activities of the entertprise. Operating
income measures the efficiency of a business enterprise, because these activities make-
up the main business of the enterprise and are of recurring in nature. The operating
activities may be:
l Purchasing and selling of goods.
l Services and even securities by a Trading concern.
l Exploration of natural resources by Extracting & Trading entity.
l Granting of loans and advances by a ‘Financial Institution’.
l Construction and development of colonies by construction enterprise.

Operating expenses are those expenses which are incurred in connection with main
revenue producing activities. These operating expenses may be classified under
various heads, such as office and administrative expenses and selling and
distribution expenses. A detailed list of these expenses has already been given under
conventional format of Profit and Loss Account under 3.6.1 of this unit. These
expenses are necessary to run the business enterprise but which are not directly related
to trading or manufacturing activities. These directly related expenses are termed as
direct expenses, which are charged to Manufacturing/Trading/Account. Hence
Operating Profit = Gross Profit – Operating Expenses (Office and Selling
Distribution).

88
Non-operating Incomes Financial Statements

Such incomes arise from other than major or principal revenue earning activities.
These are in the form of, in case of a manufacturing and trading concern, rent
received, interest received, dividend received, which are credited to Profit and Loss
Account. Profit on sale of fixed assets and the revenue arising from activities which
are incidental to main business, are treated as non-operating incomes. Such types of
incomes arise when unused portion of building used for business purposes is let-out or
idle funds of business invested either in shares, debentures, government securities or
deposited in a fixed deposit account. Since such incomes have nothing to do with the
business operation of the enterprise, these incomes are treated as non-operating
incomes.

It is to be noted that “Interest” and “Dividend” received by a “Financial

Institution” is treated as operating income because these incomes arise
from main/principal revenue earning activity.

Non-operating Expenses
These expenses are incurred on activities other than main or principal revenue earning
activities. These may be in the form of non-operating losses. Interest paid on
borrowings (financial overheads), loss on sale of fixed assets, loss on sale of
investment (held as an asset) are some of the examples of non-operating
expenses. Such expenses are also charged to Income Statement to ascertain the
overall net profit.

Balance Sheet of ........................ (A format)

As on 31st March ..........

Assets Figures at the end of

Previous Year Current Year
Fixed Assets -------- --------
Less Depreciation -------- --------
Net Fixed Assets (a) -------- --------
**** ****
Stock-in Trade -------- --------
Sundry Debtors -------- --------
Bills Receivables -------- --------
Cash and Bank balance -------- --------

Total Current Assets* (b) **** ****

TOTAL ASSETS (a+b) -------- --------
Liabilities and Capital
Capital -------- --------
Add Profit (Retained Earnings) -------- --------
Less Drawings -------- --------
Owner’s Equity (c) -------- --------

Sundry Creditors -------- --------

Bills Payable -------- --------
outstanding Expenses -------- --------

Total Current Liabilities (d) -------- --------

TOTAL (c + d) -------- --------

89
* The list is not exhaustive
Fundamentals of Activity
Accounting
1) What are operating and non-operating profits?
2) What do you understand by “Grouping” and “Marshalling” of assets and liabili-
ties?
3) Write short notes on the following:
a) Outstanding of Expenses
b) Accrued Incomes
c) Intangible Assets
d) Fictitious Assets
e) Cost of Conversion
f) Cost of Goods Sold
g) Direct vs Indirect Expenses
4) Draw an imaginary Balance Sheet.

3.7 CORPORATE FINANCIAL STATEMENTS

The process of preparation of financial statements of companies is similar to that of
non-corporate entities except for certain peculiar items and legal requirements. The
corporate reporting has assumed great importance in recent years. The Company Law
Board, the Institute of Chartered Accountants of India and whole corporate world are
trying to bring about a total transparency in the matter of reporting. The fundamental
objective of corporate reporting is to communicate economic information about the
resources and performance of the reporting entity to the users of financial statements.
The professional bodies have also developed several (till date – 28) accounting
standards for the purpose of preparing and disclosing accounting information in order:
1) To serve the varied needs of users for decision-making purposes.
2) To harmonise the diverse accounting practices.
3) To ensure transparency, consistency, comparability, adequacy and
reliability of information-contents.
4) To make accounting information more meaningful and useful.
5) And to improve overall quality of presentation and reporting.
Since every interested party has a right to information which is merely not the
outcome of statue but is based on the principle of public accountability. The financial
statements which are prepared on the basis of various accounting postulates, concepts
and conventions, are supposed to endowed with many qualitative characteristics, viz.
understandability, relevance, materiality, reliability, faithful representation, substance
over form, neutrality, prudence, completeness and comparability.

General and Legal Requirements

Section 209 to 223 of the Companies Act, 1956 deal with provision governing
maintenance and preparation of financial statements.
Section 209 deals with the maintenance of proper books of accounts in respect of
1) Receipts and disbursements of money,
2) Sales and purchases of raw materials/goods,
3) Description peratining to usage of raw material and labout, etc., and
4) All assets and liabilities.
90
Section 209 also requires that books of accounts must show the “True and fair” view Financial Statements
of state of affairs of the company. Section 211 requires that the Balance Sheet must
give true and fair view of the results of operations. It simply implies that financial
statements should disclose every material information without any concealment of
facts and figures and in such a manner that working results and financial position of
the reporting enterprise, may correctly be interpreted in true spirits. It should be free
from personal biases and mis-statements. It will be possible only if financial
statements are prepared in accordance with generally accepted accounting principles
and in conformity with the various accounting standards as applicable to the reporting
enterprise. Companies (Amendment) Act 1999 has made it mandatory for companies
to comply with accounting standards set by ICAI. In case company fails to comply
with any of generally accepted accounting assumptions or standards, the fact should
be disclosed.
Section 210 requires that financial statements should be presented to shareholders at
every Annual General Meeting along with the Auditor’s and Directors’ Reports. Every
Balance Sheet and Profit and Loss Account must be duly authenticated. These
statements must be signed by Manager or Secretary and by two directors, at least one
of whom must be managing director (Section 215).

3.7.1 Items Peculiar to Corporate Balance Sheet

Share Capital: Under this head following details are required to be disclosed:
1) Details of Authorised, Issued and Subscribed Capital along with number and
nominal value of the shares with respect to preference and equity shares.
2) Calls-in-Arrears must be deducted from Called-up Capital. However, Calls-in-
arrears on shares held by directors are to be shown separately. Similarly, Calls-
in-Advance should be treated as a separate items and shown accordingly.
3) Forfeited Shares Account, if any, should be added to paid-up Capital which
forms the part of total of Balance Sheet. It is to be noted that the Authorised,
Issued and Subscribed capitals are not considered for the purpose of total of
Balance Sheet.
4) Shares issued for consideration other than cash must be disclosed. Such as
shares allotted to transferor company under the agreement of takeover/merger,
Issue of bonus shares and the source thereof.
5) If preference shares have been issued, the terms of redemption or conversion
along with the earliest date of redemption/conversion must be specified.
6) Excess application money on account of over-subscription not requiring any
adjustment, should be refunded. If not, the money refundable must be shown as
part of current liabilities.

3.7.2 Reserves and Surplus

This may be in the following forms:
i) Capital Reserves: It refers to those profits which are not earned from normal
business operations. Such profits are not available for the purpose of distribution
as dividend. It is created out of profit on sale of-fixed assets or investments held
as asset, profit on reissue of forfeited shares, pre-incorporation profit, profit on
revaluation of fixed assets, profit on purchase/acquisition of assets or profit on
purchase of business (excess of net assets over purchase price).
ii) Capital Redemption Reserve: It is created when fully paid preference shares
are redeemed out of divisible profits of the company. This reserve may be
utilized for the purpose of issuing fully paid bonus shares to the members of the
91
company.
Fundamentals of iii) Securities Premium: When a company issues shares or debentures at a price
Accounting which is more than its face value, it is said to have issued shares/debentures at a
premium. The premium so received is transferred to “Securities Premium
Account”.
According to Section 78 of Companies Act, the premium may be utilized for –
issuing fully paid bonus shares, writing off preliminary expenses, discount on
issue of shares or debentures, and providing premium on redemption of
preference shares or debentures.
iv) Revenue Reserves: These may be in the form of specific reserves or free
reserves and are created out of revenue profits of the company. Usually such
reserves are formed from annual appropriation. Specific Reserves are created
for specific purpose. For example, Dividend Equalisation Reserve is created to
meet the shortfall in the divisible profits of the company intends to follow a
stable dividend policy. Or to redeem the debentures, a sinking fund or a deben-
ture redemption reserve may be created. Other specific reserves are Development
Rebate Reserve, Investment Allowance Reserve, Export Incentive Reserve, etc.
The term ‘Fund’ is used when the money earmarked for any specific purpose is
invested in ourside securities. For example, if money appropriated for the
purpose of redemption of debentures is invested outside and business is termed as
Debenture Redemption Fund, if not invested outside but retained or ploughed
back in the business, it is called Debenture Redemption Reserve.

Surplus
The Credit balance of Profit and Loss Account or P&L Appropriation Account (i.e.
after making necessary transfer to reserves and appropriating for proposed interim or
final dividend including bonus, if any) is shown under the heading as surplus. If a
company has a debit balance of Profit & Loss Account, the same should be adjusted
under this head.
3) Secured Loans: This refers to mortgaged loan or other loans, which are fully
secured either by a fixed or floating charge on the assets of the Company. It
includes loans from bank, financial institutions or from other companies pro-
vided these are secured against the specific or all assets of the company. Deben-
tures are assumed to have first floating charge on the assets of the company. It is
to be noted that interest accrued and due on secured loans is to be treated as and
shown under Secured Loans. Loan from or guaranteed by directors should be
disclosed and shown separately. In case of debentures, the terms of redemption/
conversion and its earliest date of redemption/conversion be stated.
4) Unsecured Loans: These are the loans against which no security stands a
pledged or mortgaged. It also includes amount not covered by the value of
security provided in respect of partly secured loans. It covers all loans which are
not at all secured such as –
– Fixed Deposits from public
– Loans and Advances from Subsidiaries
– Short-term loans and Advances from Banks and others
– Other Loans and Advances
– It may include creditors for purchase of an asset.
5) Current Liabilities and Provisions: This heading is split in two sub-headings :
current liabilities and prosvisions.
Current Liabilities: It refers to those liabilities which are to be paid or payable within
a period of twelve months. It includes, Sundry Creditors, Bills Payable, Outstanding
92 Expenses, Income Received in Advance, Amount payable to Subsidiaries.
It is to be noted that short-term loans and interest outstanding thereon are to be shown Financial Statements
under “Secured” or “Unsecured Loan” as the case may be and not under Current
Liabilities.
Provisions: Provisions such as Proposed dividend, Provision for Depreciation,
Repairs and Renewals, Provision for Doubtful Debts, Investment Fluctuation Reserve,
Provident Fund, Pension Fund etc. are shown separately under this head.

* Provision for Depreciation and Provision for Doubtful Debts may be

shown on the “Assets side” as a deduction from the asset concerned.

Contingent liabilities: As explained earlier, these liabilities are shown as a footnote

and include the following:
l Liability for bills discounted
l Claims against the company not acknowledged as debt
l Uncalled liability on partly paid shares
l Arrears of fixed cumulative preference dividends
l Guarantee given by the Company on behalf of directors or other officers of the
Company
l Estimated amount of contracts remaining to be executed on capital account not
provided for, and
l Other money for which company is contingently liable.

It is to be noted that if any provision is made against any contingent

liability, the same is to be shown under the head provisions.

Fixed Assets
Under this head there are eleven types of “fixed assets” starting from goodwill to
vehicles. According to AS-10 a fixed asset is an “asset held with the intention of being
used for the purpose of producing or providing goods or services and is not held for
sale in the normal course of business.” Even assets which are not legally owned but
held for the purpose of production are treated and shown under this head. These
include assets acquired under hire-purchase agreement and assets taken on lease, after
considering the addition and disposal, if any. Valuation of fixed assets is made at cost
less depreciation after considering the addition and disposal, if any.
It is worth remembering that “goodwill” should be shown in the books only when it is
acquired for some consideration. According to AS–26 internally generated goodwill
should not be recognized as an asset.
*As per Schedule VI the fixed assets are classified as follows:
1) Goodwill
2) Land
3) Building
4) Leasehold
5) Railway Slidings
6) Plant and Machinery
7) Furniture and Fittings
8) Development of Property
9) Patents, Trade Marks and Designs
10) Live Stock
11) Vehicles 93
Fundamentals of In case of revaluation of fixed assets, every balance sheet subsequent to such
Accounting revaluation must show the revised figures with the date of increase or decrease in
place of original cost. In ascertaining the cost of an asset all expenditures incurred in
bringing the asset to its working condition should be included. This includes cost of
transportation, expenditure on trial runs. In case of land and building, stamp duty,
registration fee and architects fees should be capitalised.
Investments
As per AS-13 (Accounting for Investments), “Investments are assets held by an
enterprise for earning income by way of dividends, interest and rentals, for capital
appreciation or for other benefits to the investing enterprise”. Assets held as stock-in-
trade are not investments. Money invested outside business is termed as investments
which may be long term, current investment or an investment property.

According to AS-13, a “current investment ” by its nature as readily realizable is

intended to be held for not more than one year, whereas an “investment propery” is an
investment in land or building that are not intended to be occupied substantially for
use by the enterprises.
Schedule VI requires investments to be shown as follows:
i) Investments in Government or Trust Securities.
ii) Investments in shares, debentures or bonds, fully paid up and partly paid
up and also different classes of shares.
iii) Immovable properties
iv) Investments in the Capital of partnership firms.
The following details about the investments must be given:
a) Nature of investment.
b) Mode of valuation of Investments.
c) Aggregate amount of company’s quoted investments and its market value.
d) Aggregate amount of company’s unquoted investments.
e) Amount of fully paid and partly paid shares.
f) Investment in subsidiary companies.
Current Assets, Loans and Advances
This is subdivided in two sub-headings:
A) Current Assets: As per the Guidance note issued by ICAI, “current assets means
cash and other assets that are expected to be converted into cash or consumed in the
production of goods or rendering or services in the normal course of business and
include:
i) Stock-in-trade (inventories of raw materials, work-in-progress finished
goods, stores and spare parts to be shown separately) including mode of
valuation.
ii) Debtors should show the age-wise and security-wise classification such as
Debts outstanding for a period of more than six months and other debts.
Debtors considered good in respect of which company holds no security
other than the debtor’s personal security.
Debts considered doubtful or bad.
Debts due by directors on other officers
Debts due from other companies (subsidiaries)
94
 Maximum amount due by directors or other officers of the company Financial Statements
(footnote through)
Provision for doubtful debts is required to be deducted from sundry debtors
Provision should not exceed the amount considered from sundry debtors.
Provision should not exceed the amount considered doubtful or bad. Any
excess provision be shown under “Reserve and Surplus”.
iii) Cash and Bank balances should be shown separately. Bank balances
should be classified into balances with scheduled banks and other banks
along with details of current account, saving bank and fixed deposits. Bank
overdraft, if any, should be shown under Sundry Creditors. This informa-
tion of inclusion be disclosed in a footnote that the Sundry Creditors
include bank overdraft amounting to Rs....

B) Loans and Advances

The disclosure rules which are applicable to sundry debtors, the same should be
applied to “Loans and Advances”, i.e. these should be shown in age-wise, security-
wise and reliability-wise classification. In addition the following should be shown:
i) Advances and loans to subsidiaries
ii) Advances and loans to partnership firms in which the company or subsid-
iary is a partner
iii) Bills of Exchange
iv) Advances recoverable in cash or kind or for value (Rent, Rates and Insur-
ance)
v) Balance with customers, port trust, etc. which are payable on demand
Miscellaneous Expenditure
These are the expenses incurred in earlier years but not written off. These include:
i) Preliminary expenses (Formation expenses incurred on preparation of Memoran-
dum and Articles of Association, legal fees, registration fee, etc.)
ii) Share and Debentures issue expenses, such as brokerage, underwriting commis-
sion, discount on issue of share and debentures.
iii) Interest paid out of Capital during construction.
Such miscellaneous expenditure is written off over a period for which benefit is
available.
Profit and Loss Account (Debit balance)
This represents past unwritten-off losses. These are adjusted and written off against
the free reserves (divisible profits/revenue profits) to the available extent. Unabsorbed
amount is shown under this head.

3.7.2 Items Peculiar to Corporate Income Statement

Salient Features
Though the procedure and the process of preparation of “Income Statement” of a
Company and that of non-corporate entities are similar in principles, there are some
differences in the method of presentation and some additional items which form the
part of a corporate income statement. These differences are as under:
1) Heading: Non-corporate entities name income statement as “Trading and Profit
and Loss Account”, while companies call it “Income Statement” or Profit and
Loss Account only. The items of Trading Account become the part of “Income
Statement”. No separate Trading Account is prepared. 95
Fundamentals of 2) Appropriation: Sole trader does not prepare any appropriation account, while
Accounting partnership firms and companies do. A company’s Profit and Loss Account is
split up in to two parts – “above the line” and “below the line”. All items of
appropriations are shown “below the line” and the remaining balance is trans-
ferred to the liabilities side of the balance sheet. A partnership firm prepares a
separate Profit and Loss Appropriation Account.
3) As per AS–5 extraordinary items (abnormal nature), prior period items are
shown separately whereas in case of non-corporate entities, such items are stated
along with the normal and routine items.
4) Requirement: The Profit and Loss Account of a company should conform to the
requirements of Schedule VI of Companies Act 1956 and adhere to AS–1; AS–4
and AS–5 recommendations, whereas non-corporate enterprises are not required
to do so.
5) Income Tax: It is treated as an expense for the companies while for firms and
sole trade enterprise, it is treated as drawings.
6) Companies’ Profit and Loss Account should disclose the figures for the previous
year along with the current year’s whereas non-company enterprises are not
required to show figures relating to previous year.

Treatment of Special Items of Profit and Loss Account

1) Interest on Debenture and Loans: This item includes interest paid and payable
for the financial period for which accounts are prepared and shown to the debit
side of Profit and Loss Account. Likewise, interest due but remaining outstand-
ing is taken to the liability side of the Balance Sheet. Interest on Debentures and
interest on secured loan outstanding, if any, is shown under the heading “Secured
Loans” whereas interest outstanding on unsecured loan is shown under “unse-
cured loans”.

It is to be noted that interest on loan for the construction period should be

capitalized and added to the cost of the asset concerned.

2) Tax on Interest on Debentures: As per Income Tax Act 1961, every company
must deduct tax at source (TDS) while paying interest to the debenture holders. The
amount so deducted shall be deposited with the Government treasury. The current
rates for TDS are as follows:
Debentures (listed) 10.5% including surcharge
Debentures (unlisted) 21% including surcharge
If A ltd. has to pay interest on its 9% debentures (listed) of the face value of Rs.
5,00,000, then gross interest will be Rs. 45,000 and tax deducted at source Rs. 4,725
balance shall be paid to the Debenture holders Rs. 40,275. The following entry is
recorded –
Interest on Debentures A/c Dr 45,000
To Debenture Holders A/c 40,275
To Income Tax Payable A/c 4,725
Income Tax deducted but not deposited with the Government is to be shown in the
Balance Sheet under the heading “Current Liabilities”.

It should be remembered that Profit and Loss Account will always be

debited with the gross amount of interest.
96
3) Discount on Debentures/Loss on Issue/Debenture Issue Expenses: Discount Financial Statements
on issue of debentures, debenture issue expenses such as commission, brokerage,
etc. are premium payable on redemption (treated as loss on issue which may
include discount also) are to be written off as early as possible, or over the life
span of the debentures, depending upon the policy of the company in the absence
of any specific instructions in the question, such amount should be written off on
the basis of debentures outstanding. The unwritten off balance is to be shown on
the assets side of the Balance Sheet under the heading of ‘Miscellaneous Expen-
diture’.
It should be remember that only written off amount is charged to Profit and Loss
Account.
4) Prelimiary Expenses: As already explained under Balance Sheet items, it
appears on the assets side of the Balance Sheet under the heading ‘Miscellaneous
Expenditure’ as long as it is not written off. The amount written off is charged to
Profit and Loss Account. If there is no specific instructions relating to the
amount to be written off, then the entire amount should be shown in the
Balance Sheet.
5) Corporate Income Tax: This is shown under three stages.
i) Advance Income Tax: As per Income Act 1961, the companies are required
to pay income tax on the profits earned. They have to deposit advance tax
under PAYE (Pay As You Earn) scheme on specific dates during the finan-
cial year. The advance tax so paid is adjusted against income tax liability.
The unadjusted amount of advance income tax is shown as an asset under
the heading Current Assets, Loans and Advances.
ii) Provision for Taxation: While preparing Profit and Loss Account, a
provision for income tax is created on the basis of current year’s profit to
meet the actual tax liability. The amount so provided depends on the prevail-
ing tax rate. The current rate of corporate tax is 35% plus 5% surcharge for
domestic companies and 40% plus 5% surcharge for foreign companies. The
following entry is recorded.
Profit and Loss Account Dr.
To Provision for Taxation A/c
AS–22 “Accounting for Taxes on Income” recommends that the net balance, i.e.
excess of “Advance Tax” may be shown on the assets side or liabilities side of the
Balance Sheet as the case may be, till the final assessment is made and actual tax
liability is determined by the tax authorities.
iii) Determination of Actual Tax Liability: As per Income Tax rules, income
(profits) for the previous year is assessed and taxed in the assessment year.
When the assessment is completed the provision for taxation so created
may either fall short of actual tax liability or may exceed the tax liability.
Such a shortfall or excess is treated as prior period item (AS–5) and
therefore its adjustment is made in the Profit and Loss Account but
“below the line”, either to the debit side (for shortfall) or to the credit
side (for excess).
On the other hand, the actual tax liability is compared with advance income
tax paid. In case actual tax liability is more than the amount of advance
tax paid the same may be paid or shown as a current liability in the
Balance Sheet and if advance tax paid exceeds, the difference being
refund should be stated under Current Assets Loans and Advances in the
Balance Sheet.
97
Fundamentals of Illustration 4
Accounting
Extracts from a Trial Balance of a Company
As on 31st March, 2003.
Dr. Cr.
(Rs.) (Rs.)
Provision for Taxation (2001-02) 2,50,000
Advance Income Tax (for 2001-02) 2,60,000
Advance income Tax (for 2002-03) 3,00,000

Additional Information
i) The actual tax liability for the year 2001-2002 amounted to Rs. 2,75,000
ii) provision for Taxation for the year 2002-03 of Rs. 2,85,000 is required to be
made.
Show the relevant information in the relevant ledgers.

Solution

Profit and Loss Account (Extracts)

for the year ended 31st March 2003
Rs.
To Provision on for Taxation
(2002-03)
285,000

–––––– ––––––
} above the
line

–––––– ––––––
To provision for Taxation (2001-02)
(Rs 2,75000-2,50000)
Tax Liability-Provision
25,000
} below the
line

Balance Sheet (Extracts)

As on 31st March 2003
Liabilities Rs. Assets Rs. Rs.
Loans & Advances
Advance Tax 3,00,000
Current Liabilities (Current Year)
Less Provision for
Income Tax payable (2001-02) 15,000 Taxation 2,85,000 15,000
(Tax liability–Advance Tax)
Rs. 2,75,000 – Rs. 2,60,000)

Provision for Taxation (2001-02)

Rs. Rs.
To Income Tax (Tax liability) 275,000 By Balance b/d 250,000
By Profit & Loss A/c 25,000
(below the line)

275,000 275,000

98
 Financial Statements
Provision for Taxation (2002-03)

Rs. Rs.
To Balance C/d By Profit and Loss A/c
2,85,000 (above the line) 2,85,000

2,85,000 2,85,000

Illustration 5: From the following extract of a Trial Balance and the additional
information, show the treatment of taxation, in the relevant ledger accounts:

Trial Balance (Extracts)

As on 31st March 2002
Dr. (Rs.) Cr (Rs.)
Provision for Taxation 1,20,000
Income Tax 1,10,000
Additional information: Provide Rs. 1,50,000 for provision for taxation.

Solution
Provision for Taxation A/c (old)
To Income Tax 1,10,000 By balance b/d 1,20,000
To Profit and Loss A/c. 10,000
(below the line)
1,20,000 1,20,000

Provision for Taxation A/c (New)

Rs. Rs.
To balance c/d 150,000 By Profit and Loss A/c. 150,000
(To be taken to liabilities) (above the line)
side of B/S
150,000 150,000

Profit and Loss Account (Extracts)

Rs. Rs.
To provision for Taxation 150,000 -Above
(New)

––––––
} the
line
––––––
By Provision
for Taxation

––––––
10,000

––––––
} - below
the
line

99
Fundamentals of Balance Sheet (Extracts)
Accounting As on 31st March 2002

liabilities Assets Rs.

Current liabilities and Provision
B. Provisions:
provision for Taxation 15,000
Illustration 6
From the following particulars prepare necessary accounts for the year ending
31st March 2003:

Trial Balance (Extracts)

As on 31st March 2003
Dr. Cr.
Rs. Rs.
Provision for Taxation (1.4.2002) 4,59,000
Advanced Tax Paid (1.4.2002) 4,20,000
Tax Deducted at Source (1.4.2002) 3,500

On 1.1.2003, the assessment was completed and tax liability of Rs. 5,30,000 was
determined Advance payment of tax for the year 2002-03 amounted to Rs. 5,10,000.
A provision for taxation is to be made for Rs. 5,75,000 for the year ended 31st March
2003.

Solution
Provision for Taxation Account
Rs. Rs.
To Income Tax A/c (Tax liability) 5,30,000 By Balance b/d 4,50,000
By profit & Loss A/c
(below the line) 80,000
5,30,000 5,30,000
To Balance C/d 5,75,000 By Profit & Loss A/c 5,75,000

Advance Income Tax account

Rs. Rs.
To Balance b/d 4,20,000 By income Tax A/c 4,20,000

4,20,000 4,20,000

Income Tax Account (Tax liability)

Rs. Rs.
To Advance Income Tax A/c 4,20,000 By Provision for 5,30,000
To Tax Deducted at source A/c 3,500 Taxation A/c
To Bank A/c. (Balance Paid) 1,06,500
5,30,000 5,30,000
100
 Profit and Loss Account Financial Statements
For the year ended 31st March 2003
Rs. Rs.
To Provision for Taxation
(2002-03) 5,75,000 } Above the line

To Provision for Taxation 80,000 } below the line

(2001-02)

6) Managerial Remuneration
The payment of managerial remuneration is governed by the provisions of
sections 198 and 309 either by the Articles or by a ordinary/special resolution
passed by the company in general meeting. Managerial personnel refers to
managing director, whole-time director, part-time director and manager. The
provisions of Companies Act shall apply to a public company and private
company and a private company which is a subsidiary of a public company but to no
other private company.
The over all managerial remuneration payable by a public company or a private
company which is a subsidiary of a public company to it’s managerial personnel shall
not exceed 11% of the net profits for that financial year. Remuneration limit does not
include fees. Within the maximum limit of 11% a company may pay a monthly
remuneration to its managing or whole-time director in accordance with the provisions
of Section 309 or to its manager in accordance wit the provisions of Section 386 of
the Companies Act. In case there is no profit or inadequate profit for any year, the
company may pay remuneration as per the provisions of Schedule XIII of the
Company Act.

7) Contribution/donation to a Political party

Any contribution or donation to any political party must be disclosed separately
in the Profit and Loss Account. According to section 293, Government
companies and companies with less than three years are not allowed to make any
political contribution or donation. Those allowed can make such contribution up to
5% of it’s average profit. The average net profit for this purpose are to be
determined on the basis of the three immediately preceding financial years’
profit as determined in accordance with the provision of Section 349 of the
Company Act.

8) Prior Period Items

The nature and amount of prior period items should be separately disclosed in the
Profit and Loss Account in a manner that there impact on the current profit or
loss can be perceived. In case, accounts are adopted in the annual general
meeting and if some adjustments relating to previous year are to be made, these
should be stated below the line, i.e. in the Profit net Loss Appropriation account as
per AS-5.

9) Extra-Ordinary items
Extraordinary items are incomes or expenses that arise from events or transactions
which are clearly distinct from the ordinary activities of the enterprise and therefore,
are not expected to recur frequently or regularly, these items should be disclosed in the
statement of profit and loss as a part of profit or loss for the period (AS-5). “Fixed
assets destroyed in an earthquake” is an example of “Extraordinary items”.
101
Fundamentals of 10) Contingencies and Events occurring after balance Sheet Date
Accounting
As per AS-4, the amount of a contingent loss should the be provided for by a charge
in the statement of Profit and loss if:
i) it is possible that future events will confirm that an asset has been impaired or a
liability has been incurred as at the Balance Sheet date and
ii) A reasonable estimate of the amount of the resulting loss can be made.
The existence of a contingent loss should be disclosed in the financial statements if
either of the above condition is not met, unless the possibility of loss is remote.
Contingent gains should not be disclosed in the financial statements. Only virtually
certain gains should be recognized.

11) Appropriation and Disposition of Profits

Once the profits have been ascertained as per the statement of profit and loss, the next
step is the appropriation and disposition of the available profit. It includes:
i) Transfer to general reserve and other reserves such as capital redemption reserve.
Development rebate reserve etc.
ii) Transfer to sinking fund.
iii) Transfer to Dividend Equalization fund.
iv) Providing for interim or final dividend, and
v) Paying bonus to share holders.
All these items are treated “below the line” or a separate “Profit and loss
Appropriation Account” is prepared.

12) Dividends
Dividends refers to that amount of divisible profits which is distributed among the
share holders of the company. A member (shareholder) is entitled to receive dividend
when it is declared by the Board of directors as per the provisions of the Article. The
Board has absolute right to recommend the rate of dividend to the declared subject to
the approval of shareholders and provisions of Articles of Association. However, the
shareholders cannot compel the Board recommend & declare dividend. It is to be
noted that dividend is always declared for the working of one financial year at the
annual general meeting. In case the dividend could not be declared at the annual
general meeting the same can be declared at the Extraordinary meeting. The power to
declare dividend is implied and does not require express authority either in the Articles
or Memorandum of Association. It should be remembered that, where a dividend has
been declared at Annual General Meeting, neither he company nor the directors can
declare a further dividend for the same year at the subsequent general meeting. It is
known as Final Dividend.
No devidend should be paid out of capital. Dividends should be paid in proportion to
the amount paid up on each share. No dividend shall be payable on calls in advance
unless authorised by the Articles. Dividend should be payable in cash except when it
is adjusted towards unpaid amount on shares or where bonus shares are issued.
According to Section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits from that year unless certain percentage of profit as
prescribed by Central Government not exceeding 10% has been transferred to reserve.
However, the company may voluntarily transfer higher percentage of the profit to its
revenue subject to the rules laid down under the Companies (Transfer of Profits to
Revenue) Rules 1975 as amended in 1976. A newly incorporated company is
prohibited to transfer more than 10% of its profits to revenue for the initial
102 three years.
i) Preference Dividend: The preference dividend is paid to Preference Financial Statements
shareholders at a pre-determined fixed rate on priority basis. These holders are
entitled dividend in preference to equity shareholders. However the preference
shareholders can claim dividend only out of profits and if it is declared at the
annual general meeting. If preference shares are of cumulative nature, the
arrears of preference dividend if any, shall be payable to preference
shareholders before any equity dividend. It should be noted that preference
shareholders cannot force the company to pay all the dividends including
arrears. If equity shareholders are not paid any dividend, preference
shareholders cannot claim any dividend from the company. It is to be noted
that the arrears of preference dividend are treated as a contingent liability
which appears as a foot note under the Balance Sheet.
Not–cumulative preference shares are not entitled to any arrears resulting from
non-payment of dividend due to losses or inadequate profits. If a company has issued
participating preference shares with a right to participate in the balance of profits, left
after paying fixed preference dividend and a certain percentage of equity dividend,
then the participating preference shareholders are entitled against a certain percentage
out of the balance (residua) profit as per the items of issue. For example 9%
preference shares may be issued with a further right to 40% of the excess dividend
over 20% paid to equity shareholders. If a company declares 25% dividend to equity
to equity shareholders, the preference shareholders will get 11% dividend. (9% plus
40% of (25%-20%) i.e., 2%).
ii) Unclaimed Dividend: According to Section 205 A of the companies Act 1956
dividends remaining unpaid must be deposited in the “unpaid unclaimed Dividend
account within 42 days of declaration of dividend. Any claim thereafter, must be met
out of the unclaimed dividend account. Money so transferred to the aforesaid account
which remains unpaid or unclaimed for a period of seven years from the date of such
transfer, shall be transferred to “Investor Education and Protection Fund” maintained
u/s 205 of Companies (Amendment) Act 1999.
Unclaimed dividend appears on the liabilities side of Balance Sheet under the head
“Current liabilities & Provisions”.
iii) Proposed Dividend: Dividend recommended by the directors to be paid to
shareholders for any accounting period on or after the close of books of accounts but
before the Annual General Meeting, is known as proposed dividend. Once it is
approved by the shareholders in the General meeting, it becomes final dividend. It is to
be noted that rate of dividend declared cannot exceed the proposed dividend. Proposed
dividend is an appropriation of profit, hence it is shown to the debit side of profit and
loss Appropriation Account and on the liabilities side of balance sheet under the
heading “Current liabilities and Provisions”.
iv) Final Dividend: It is a dividend which is declared at the annual general meeting of
the shareholders. Such dividend is declared only after the close of books of accounts;
the share holders may reduce the rate of final dividend but cannot increase it. Once the
final dividend is declared it becomes the liability of the company. It should be noted
that when a final dividend is declared then interim dividend is not adjusted unless there
is any specific resolution for such adjustment. Final dividend is paid on paid up
Capital for the whole year as against the interim dividend, which is usually paid only
for six months. For example N Ltd. has 5,00,000 shares of 10 each Rs. 8 paid,
declares 5% p.a. interim dividend and final dividend @ 10% p.a., then the total
dividend will be Rs. 5,00,000 i.e. (Rs. 1,00,000 interim dividend + Rs. 4,00,000 final
dividend)
I.D. = (4, 00,000 5/100 × 6/12 = 1,00,000) + F.D. = (4,00,000 × 10/100) 103
Fundamentals of v) Interim Dividend: A dividend declared by the Directors between two annual
Accounting general meetings of the company is known as interim dividend, where the directors
believe that the company will have sufficient profits available for dividends at the end
of the year, they may distribute a part of the profit as a part payment on account.
Payment so made in anticipation and on account of total dividend to be paid for the
year is treated as interim dividend. However, such payment must be authorised by the
Articles. Interim dividend should be declared only when the company has even a better
prospects for the second half as well. Regulation 86 of Table–A provides that “Board
may from time to time pay to the members such interim dividend as it appears to be
justified by the profits of the company.” Thus, there is no limit on the number of
interim dividend the company may pay in a year. The payment of interim dividend
does not require approval of general meeting.
Companies (Amendment) Act 2000 has granted statutory recognition to the right of
directors to declare interim dividend. The term dividend now includes interim dividend
also. All provisions the Companies Act which apply to dividends have now become
applicable to interim dividends also. A company cannot declare any interim dividend
unless it has made:
i) necessary provision for depreciation for the whole year.
ii) prior adjustment of accumulated losses, if any
iii) and transfer to general reserve as required u/s 205 (2A)
Once an interim dividend is declared it becomes legally enforceable debt
against the Company. Prior to the Amendment Act 2000 the interim dividend
was not an enforceable debt Board had right to rescind the resolution
already passed.
The period, for which an interim divided is paid, is usually six months. However,
students should note that whether the rate of dividend includes the words “per
annum” or not. For example the directors of a company declare an interim dividend @
12% per annum, the interim dividend shall be calculated only for six months. If the
rate declared by directors is 12% and the words “per annum” are not mentioned, then
the dividend shall be calculated @ 12% without reference to time. i.e. 12% x amount
of paid up Capital. If the Capital of the company is Rs. 10,00,000 then
in the first case interim dividend will amount to Rs. 60,00 and in the second
case Rs. 1,20,000.

vi) Corporate Dividend Tax

Finance Act 1997 had exempted the dividend in the hands of shareholders and
introduced corporate dividend tax to be paid by the dividend paying company.
Thereafter, the corporate dividend tax was withdrawn by the Finance Act 2002
and the burden of tax was shifted on the shareholders and hence company was not
liable to pay any tax on dividend declared, distributed or paid between 1.4.2002. to
31.3.2003.
The Finance Act 2003 has again shifted the liability of such tax on the domestic
companies who shall be liable to pay additional tax on the amount declared,
distributed or paid by way of dividends on or after 1.4.2003. The rate of tax being
12.5% plus surcharge @ 2.5% which is equal to 12.8125%* This rate is applicable
for the financial year 2003-04.
Note: Students should verify the rate applicable because this rate may be changed by
the Finance Act 2004 or by the subsequent Finance Act. It is further to be noted that
dividends from domestic companies in the hands of shareholders are totally exempt
again. As per guidance not it is be treated as appropriation.
104
13) Transfer to General Reserve Financial Statements

According to section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits for that unless a certain percentage of profits as
prescribed by the Central government not exceeding 10%, has been transferred to
reserve. As per the Central Government rules transfer to revenue should be made as
follows:
The Central Government has prescribed the following rules under the companies
(Transfer of profits to reserve) Rules 1975 as amended in 1976.

Rate of Dividend Percentage of profits* to

be transferred to reserve
(i) If the rate of 10% but not 12.5% 2.5%
dividend exceeds
(ii) “ 12.5% to 15% 5%
(iii) “ 15% to 20% 7.5%
(iv) If the rate of 20% 10%
dividend exceeds

Accounting Treatment of Dividend

Illustration 7
X Ltd. has a paid up capital of Rs. 30,00,000 dividend into 2,00,000 equity shares of
Rs. 10 each and 10% 1,00,000 preference shares of Rs. 10 each. Other particulars
were as under.
Rs.
Opening balance of Profits and loss Appropriation Account 57,500
Net profit earned during the year (after Tax) 7,50,000
Dividend Declared for the year 22%
Prepare Profit and Loss Appropriation Account. Comply with necessary statutory
provisions.

Solution
Profit and Loss Appropriation Account
Rs. Rs.
To General Reserve (1) 75,000 By Balance b/d 57,500
To Preference Dividend (2) 1,00,000 By Net Profit 7,50,000
To Equity Dividend 4,40,000
To Corporate Dividend (3) 67,500
Tax 1,25,000
To Balance c/d
8,07,500 8,07,500

Working notes
(1) As per the provisions of the section 205 on a dividend of 22% a statutory
transfer of 10% on the net profit to be made.
(2) Declaration of equity dividend will automatically make the company liable to pay
preference dividend. No equity dividend can be paid without paying preference
dividend.
(3) A corporate dividend Tax (C.D.T.) @ 12.5% has been provided. A surcharge of
2.5% has been ignored for the sake of simplicity. However, the effective rate of
C.D.T. is 12.8123% including surcharge. 105
Fundamentals of Illustration 8
Accounting
Victor Ltd. disclosed the following particulars:
Rs.
9% 80,000 Preference shares of Rs. 10 each fully paid 8,00,000
50,000 Equity shares of Rs. 10 each fully paid 5,00,000
30,000 Equity shares of Rs. 10 each Rs. 8 paid up 2,40,000
20,000 Equity shares of Rs. 10 6 paid up 1,20,000
The directors proposed a dividend of 15% or equity shares and resolved to make the
following appropriations:
– Transfer to general reserve as per the provisions of the section 205
– Transfer to dividend equalisation fund Rs. 1,75,000
– Transfer to debenture Redemption Fund Rs. 1,00,000
– Transfer to Investment Allowance Reserve Rs. 1,25,000
The net–profit (before tax) for the year amounted to Rs. 12,50,000 you are required to
prepare Profit and Loss Appropriation Account. Provide for income tax @ 50% and
Corporate Dividend Tax @ 12.5%

Solution
Profit and Loss Appropriation Account
Rs. Rs.
To General Reserve1 31,250 By Net Profit (After tax) 6,25,000
To Dividend Equalisation fund 75,000
To Debenture Redemption Fund 1,00,000
To Investment Allowance Reserve 1,20,000
To Proposed Dividend
– Preference Dividend 72,000
– Equity Dividend 1,29,000
To Corporate Dividend Tax2
On Rs. (72000 + 1,29,000) 25,125
To Balance c/d 67,625

6,25,000 6,25,000
Working
1. As per the statutory requirement, a transfer of 5% of the net profit after tax” has
been made to General Reserve
2. Corporate dividend tax has beesn provided on the total dividend.

3.8 REQUIREMENTS FOR CORPORATE FINANCIAL

STATEMENTS AS PER SCHEDULE VI
The Balance Sheet of a company like any other business organisation is a statement of
assets and liabilities. However, in the case of a company, the nature of the details to be
shown and the order of the arrangement of the items must conform to the requirements
prescribed in Schedule VI, Part I of the Companies Act. There items are already
discussed under 3.7.1 of this Unit.

The requirements as to Profit and Loss Account are as follows:

i) The Profit and Loss Account shall be so made out as clearly to disclose the result
of the working of the company during the period covered by the P&L account
and shall disclose every material feature, including credits or receipts and debits
or expenses in respect of non-recurring transaction or transactions of an
106 exceptional nature.
ii) The Income Statement is not required to be split in the parts, such as Financial Statements
Trading Account, profit earned and appropriated. Schedule VI only
recommends to disclose gross profit, net profit and it’s appropriation there of.
This may be shown under one head of Income Statement or Profit and Loss
Account. Chargeable items are shown “above the line” whereas appropriations
“below the line”.
iii) Figures relating to previous year should also be shown along with the current
year’s figures in a separate column.
iv) As far as possible information given in the statement must be complete in all
respects. Such as the details of “turnover” made by the company should disclose
sales in respect of each class of goods & their quantities separately. Likewise
commission paid to sole selling agents and to other agents should be shown along
with the brokerage.
v) The Account should disclose quantities and values of various types of raw-
material purchased and quantities and values of various products produced/
purchased including opening and closing balances there of and that of work-in-
progress.
vi) The amount provided for depreciation, renewals or diminution in value of fixed
assets and the method adopted for making such provisions.
If no such provision has been made- the fact should be disclosed by way of note
including arrears of depreciation.
vii) The amount of interest on company’s debentures and on other fixed period loans
be stated separately, including interest paid or payable to directors.
viii) The amount of Income Tax on profits as per Income Tax Act 1961 at the pre-
scribed rate including other taxes if any, should be shown separately.
ix) Expenditure incurred on each of the following items be disclosed separately–
a) Consumption of stores and spare parts
b) Power and fuel
c) Rent
d) Repairs to Building
e) Repairs to Machinery
f) i) Salaries, Wages and bonus
ii) Contribution to provident and other funds
iii) Workmen and staff welfare expenses
g) Insurance
h) Rates and Taxes (excluding income tax)
i) Miscellaneous expenses provided any item exceeds 1% of revenue of
Rs. 5,000
Whichever is higher be shown separately.
j) Payment to Auditor
a) as auditor
b) as advisor in respect of
i) Taxation matter
ii) Company law matters
iii) Management services
k) Remuneration received by managing directors or managers either from the
company or it’s subsidiaries should be indicated separately including it’s
computation. 107
Fundamentals of x) The Profit and Loss Account should disclose the various items of incomes
Accounting arranged under appropriate heads.
a) Turnover giving details in respect of each class of goods indicating
quantities of such sales for each class separately.
b) Amount of income from interest specifying the nature of the income
c) Income from investment stating from trade investments & other investments
d) Profit or losses or investments
e) Dividends including dividends from subsidiary companies
f) Miscellaneous incomes such as royalty, fees etc.
g) Foreign exchange earnings, if any
The Profit and Loss Account must be made out in such a manner that discloses “true
and fair” view of the profit or loss of the company for the current accounting year.
This means that items of extraordinary nature or those unrelated to company’s
business or items relating to previous years (Prior Period items) should be separately
stated, if these are material.
Similarly amount drawn from reserves, profits from revaluation of assets or profits
arising due to change in method of accounting or major policy change in the method of
valuation higher the operating efficiency or position much better that it actually is
would be contraray to the spirit of law.

3.9 BASIC PRINCIPLES GOVERNING THE

PREPARATION OF FINANCIAL STATEMENTS
1) Materiality: It is a relative term. What is material for one company may be
immaterial for other. According to American Accounting Association (AAA) an item
should be regarded as material if there is reason to believe that knowledge of it would
influence the decision of informed investors, banks, creditors & other interested
parties. AS-5 sates that all material information and items should be disclosed which
are necessary and vital to make the financial statements more clear and
understandable – operating efficiency — wise and financial-position-wise. Treatment
of certain expenditure as capital by one company and revenue by the other is a clear
example of it. Hence materiality is purely matter of personal judgment which is guided
by size and nature of enterprise.
2) Prior Period Items: (AS-5)
As a matter of fact the Profit and Loss Account should disclose the profit or loss for
the period for which accounts are prepared, that is for the reported (current) period. If,
however, some items were omitted to be accounted for in the preparation of financial
statements then it is not possible to reopen the accounts for the previous year after it
has been adopted by the shareholders in the annual general meeting. The ICAI defines
“Prior Period Items” as incomes or expenses which arise in the current period as a
result of errors or omissions in the preparation financial statements of one or more
periods”. The errors may occur as a result of mathematical mistakes, oversight
(omissions), misinterpretation of facts and wrong application of accounting policies or
a wrong or inaccurate estimate. Hence these items should be shown “below the line”
i.e. in the Profit and Loss Appropriation Account. However, prior period adjustments
do not cover–
– Minor omissions of accruals and prepayments
– Prior period’s revenue which was not accounted for on the ground of
prudential practice.
– Recovery of bad debts written off earlier
– Adjustments to the useful life of the depreciable assets
108
3) Extra Ordinary Items: (AS–5) Financial Statements
Extraordinary items are income or expenses that arise from events or transactions that
are clearly distinct from the ordinary activities of the enterprise and, therefore, are not
expected to recur frequently and regularly (AS-5). These items are shown in the Profit
and Loss Account for the period but the nature of such items should be disclosed
separately. These include
– Write down of inventories to “net realizable value”
– Profit or loss on sale of fixed assets or long-term investments.
– Reversals of provisions
– Reversals of writing off of the fixed assets
– Losses sustained on account of an earthquake.
4) Change in Accounting Policies: (AS-5)
Accounting policies are the specific accounting principles and the methods of applying
these principles adopted by an enterprise in the preparation and presentation of
financial statements. A change in accounting policy is required by statue or by the
accounting standard setting body or if it is considered that the change will result in a
more appropriate presentation of the financial statements of the enterprise. Any
material effect of such a change in the current or subsequent periods should be
quantified and disclosed together with the reasons for the change. Following are the
change in policy:
– A change in the method of charging depreciation from written down value
(WDV) to straight line method (SLM) and vice versa.
– A change in the method of valuation of inventories.
However, a change in the estimated life of a machine is not a change in policy
but a change in estimate.

3.10 PREPARATION OF CORPORATE FINANCIAL

STATEMENTS
As already stated, the Board of Directors of the company shall present a Balance
Sheet as at the end of the period; and a Profit and Loss Account for that period at the
annual general meeting. In case of company not carrying on business for profit, an
Income and Expenditure Account shall be laid at the annual general meeting instead of
Profit and Loss Account. Every Profit and Loss Account shall also give a “true and
fair” view of profit or loss of the company for the financial year and shall comply with
the requirements of schedule VI. Every Insurance or Banking company or any
company engaged in the generation of electricity or any other class of company for
which the Profit and Loss Account has been specified under the Act governing such
class of company need not follow the Form given in Schedule VI to this Act. Similarly
every Balance Sheet shall give a “true & fair” view of the state of affairs of the
company as per Schedule VI. Any Insurance or Banking company or any company
engaged in generation or supply of electricity or any other class of company for which
a form of Balance Sheet has been prescribed under the Act governing such class of
company need not to follow such form.
Recently the Companies (Amendment) Act 1999 has made the compliance of
accounting standards mandatory. Accordingly every Profit and Loss Account and
Balance Sheet of the Company shall comply with the “Accounting Standards”.
However, in case of non-compliance the company must disclose the ‘deviation’ from
the accounting standards. It should also state “reasons” for such deviation; and
“financial effect” if any, due to such deviation.
On the basis of requirements of Schedule VI and accounting standards following is the
format of Profit and Loss Account of a Company. 109
Fundamentals of Profit and Loss Account of ....
Accounting
For the year ended 31st March ....

Figure Figures Figure Figures

for the for the for the for the
previous current Previous current
year year year year
Rs. Rs. Rs. Rs.

... To Opening Stock ... By Sales Less Returns ...

... Raw Material ... ... By Income from Services ...
... Finished Goods ... ... By Closing Stock ...
... To Purchases (Raw materials) ... ... Raw Materials ...
... Less Returns ... ... Work-in-progress ...
... To Stores & Spares (consumed) ... ... Finished Goods ...
... To Power and Fuel ...
... To Wages (Productive) ...
... To Manufacturing Expenses ...
... To Gross Profit c/d
xxx xxx
... ... ... By Gross Profit b/d ...
... To Rent ... ... By Income from
Investments ...
... To Repairs to Building ... By Profit on Sale of
Investment ...
... To Repairs to Machinery ... By Dividend Income ...
... To Salaries & Bonus ... By Miscellaneous
Incomes ...
... To Contribution to Provident
Fund ...
... To Staff Welfare Expenses ...
... To Contribution to
Pension/Gratuity Fund ...
... To Insurance ...
... To Rates & Taxes ...
... To Printing & Stationery ...
... To Postage, Telegrams, Fax &
Telephone ...
... To Commission, Brokerage
and Discount ...
... To Bank Charges & Interest ...
... To Depreciation ...
... To Loss on sale of Investments ...
... To Remuneration payable to ...
... Directors & other ...
... Managerial Personnel ...
... To Auditor’s Fee ...
... To Provision for Taxation ...
... To Net Profit (transferred to ...
Profit & Loss Account) ...

xxx xxx xxx xxx

110
 Schedule VI Financial Statements
(Part I - Form of Balance Sheet)
(Conventional Format)
Balance Sheet of...............
As on 31st March..............

Figure Figures Figure Figures

for the for the for the for the
previous Liabilities current Previous Assets current
year year year year
Rs. Rs. Rs. Rs.
Share Capital Fixed Assets
Authorised*.... shares of Goodwill
Rs. ...... each. Land
Issued..... shares of Rs. Each Building
(*Various classes of shares and Leasehold
their called up amount including Railway sidings
details of Plant and machinery
- Shares issued for consideration Furniture and Fittings
other than Cash Development of Property
- Bonus Issue made, if any Patents, Trade Marks and
Less Call Unpaid Designs
(i) By Directors Live Stock and Vehicles etc.
(ii) By Other Investments
Add. Forfeited shares Showing nature of Investment
(amount actually paid) and mode of valuation-cost
Reserves & Surplus Or market value, and
(1) Capital Reserve distinguishing between
(2) Capital Redemption Reserves (1) Investments in Government
(3) Securities Premium or Trust Securities
(4) Others Reserves & specifying (2) Investments is Shares,
the nature of each reserve and Debentures or bonds
amount in respect there of (Giving details of classes
Loss Debit balance of P&L A/c of shares along with their
(5) Surplus-Balance in paid up value)
Profit and Loss Account after (5) Immovable Properties
providing for proposed (4) Investments in Capital of
allocation namely Partnership firms.
Dividend-Bonus, or Reserves Current Assets, Loans and
(6) Proposed Additions to Reserves Advances
(7) Sinking Fund (A) Current Assets
Secured Loans (1) Interest Accrued on
(1) Debentures Investments
(2) Loans & Advances from Banks (2) Stores and Spare parts*
(3) Loans & Advances from subsidiaries (3) Loose Tools
(4) Other loans & Advances (4) Stock in Trade*
* Interest accrued and due should be (5) Work-in Progress*
Included in the respective sub-head) * Mode of valuation and
* Nature of security to be specified in Amount in case of raw
each case) materials
* Terms of redemption or conversion of Sundry Debtors
debentures to be stated together with (a) Debts outstanding for a
earliest date of conversion/redemption. period exceeding six
months
Unsecured Loans (b) Other debts
(1) Fixed Deposits (Less Provision)
(2) Loans & Advances from subsidiaries In regard to sundry debtors,
(3) Short-term loans & advances particulars to be given
(a) From Banks separately
(b) From Others (i) Debts considered good
(4) Other loans and advances and In respect of which
(a) From Banks company is fully secured
(b) From Others (ii) Debts considered good
111
Fundamentals of Current Liabilities & Provisions for which company holds
Accounting A. Current Liabilities no security other than the
(i) Acceptances debtor’s personal security.
(ii) Sundry Creditors (iii) Debts considered doubtful
(iii) Subsidiary Companies doubtful or bad.
(iv) Advance payments and (iv) Debts due by directors
Unexpired discounts for the portion or Other officers or any
for which value has still to be give of them either severally
e.g. in the following classes of companies or jointly with any other
Newspaper, Fire-Insurance, Theaters, person or debts due by
Clubs, Banking & Steamship Companies firms or private
(5) Unclaimed Dividends companies respectively
(6) other Liabilities, if any in which any director or
(7) Interest accrued but not due on loans a member–to be
separately stated.
B. Provision (7a) Cash Balance at hand
(8) Provision for taxation (7b) Bank Balances
(9) Proposed dividends (i) With Scheduled banks &
(10) For Contingencies (ii) With Others
(11) For Provident Fund Scheme (B) Loans and Advances
(12) For Insurance, Pension and (8) (a) Advances loans to
Similar Staff Benefit schemes Subsidiaries.
(13) Other provisions (b) Advances and loans to
Partnership firms in which
company or any of it’s
subsidiaries is a partner.
(9) Bills of Exchange
(10) Advance receivable in cash
or in kind or for value to be
received e.g. rate, taxes
Insurance etc.
(11) Balances on Current
Accounts with managing
Agents, secretaries and
Treasures.
(12) Balances with customs
Port trust (where payable
on Demand)
Misc. Expenditure
(1) Preliminary Expenses
(2) Expenses including
commission, or brokerage on
underwriting or subscription
of shares or debentures.
(3) Discount on issue of Shares
or debentures
(4) Interest paid out of capital
during construction period
(5) Development Expenditure
not adjusted
(6) Other items (specifying nature)
Profit and Loss Account
(Debit balance of P&L A/c
Carried forward after
adjusting uncommitted
(free) reserves, is any.)
xxx xxx xxx xxx

112
Footnote: to be shown separately such as: Financial Statements

1) Claims against the Company not acknowledged as debts.

2) Uncalled liability on shares partly paid
3) Arrears of cumulative dividends
4) Estimated amount of contracts remaining to be executed on capital
account and not provided for.
5) Other money for which company is contingently liable.
Preparation of Financial Statements–Conventional Format
Illustration 9
From the following Trial Balance of A Ltd., prepare a Profit and Loss Account of the
company for the year ended 31st March 2003 and a Balance Sheet as on that date.

Rs. Rs.
5,00,000 Equity shares of Rs. 10 each fully called 50,00,000
9% Debentures (Rs. 100 each) 20,00,000
Freehold Building 40,50,000
Plant and Machinery 28,00,000
Profit and Loss Account 2,75,000
Stock (1.4.2002) 7,50,000
S. Debtors and Creditors 9,50,000 4,25,000
Bills Payable 3,75,000
Purchases and Sales 19,75,000 45,25,000
Provision for Bad Debts 45,000
Bad Debts 25,000
General Reserves 3,50,000
Calls in Arrears 75,000
Goodwill 3,00,000
Interim Dividend Paid (1.11.2002) 4,92,500
Cash at Bank 1,60,000
Wages and Salaries 6,95,500
Office Expenses 77,000
Salaries of office and marketing staff 5,15,000
Interest on Debentures 90,000
Discount on Issue of Debentures 40,000

1,29,95,000 1,29,95,000
Adjustments:
i) Stock on 31st March 2003 was Rs. 8,75,000
ii) Depreciate Plant & Machinery by 10% and write off 1/8th of the discount con
issue of debentures
iii) Maintain 5% provision for doubtful debts on debtors.
iv) Interest on debentures has been paid only for the first half
v) Income tax @ 50% is to be provided. Corporate dividend tax is 12.5%
vi) There is a claim for Rs. 50,000 for workmen’s compensation, which has been
disputed by the company. The case is pending in the country of law. 113
Fundamentals of Solution
Accounting
Profit and Loss Account
For the year ended 31st March 2003
Rs. Rs.
To Stock (1.4.2002) 7,50,000 By Sales 45,25,000
To Purchases 19,75,000 By Closing Stock 8,75,000
To Wages and Salaries 6,95,500
To Gross Profit c/d 19,79,500
54,00,000 54,00,000
To Salaries 5,15,000 By Gross Profit b/d 19,79,500
To Office Expenses 77,000
To Bad Debts 25,000
To Provisions for bad debts
(Rs. 47,500 – Rs. 45,000) 2,500
To Depreciation 2,80,000
To Interest on Debentures
Rs. 90,000
Add outstanding interest Rs. 90,000
1,80,000
interest on Debentures
To Discount on issue of Deb. 5,000
To Provision for Tax 4,47,500
To Net Profit c/d 4,47,500
19,79,500 19,79,500
To Interim Dividend 4,92,500 By Balance b/d 2,75,000
To Corporate Dividend Tax 61,563 By Profits and Loss A/c
(Interim dividend (Net Profit) 4,47,500
Rs. 4,92,500 x 12.5%)
To Balance c/d 1,68,437
72,22,500 7,22,500

Balance Sheet of A Ltd.

As on 31st March 2003
Liabilities Rs. Assets Rs.
Called up & paid up Capital Fixed Assets
5,00,00 shares of Rs. 10 each Goodwill 3,00,000
Rs. 50,00,000 Freehold Building 40,50,000
Less Calls-in-Arrears Rs. 75,000 49,25,000 Plant & Machinery
Reserve & Surplus (Rs. 28,00,000–Rs. 2,80,000) 25,20,000
General Reserve 3,50,000 Current Assets, Loans
Profit and Loss Account 1,68,437 Advances
Secured Loan Current Assets
9% Debentures Rs. 20,00,000 Stock 8,75,000
Interest outstanding Rs. 90,000 20,90,000 Debtors (Rs. 9,50,000–Rs. 47,500) 9,02,500
Current Liabilities and Provisions Cash at Bank 1,60,000
Current Liabilities Miscellaneous Expenditure
Sundry Creditors 4,25,000 Discount on Issue 35,000
Bills Payable 3,75,000 of Debentures
Provisions: (Rs 40,000–written off Rs 5000)
Provision for Tax 4,47,500
Corporate Dividend Tax 61,563

114 88,42,500 88,42,500

Note: There is a contingent liability of Rs. 50,000 for workmen’s compensation Financial Statements

l No statutory transfer to general reserve is made, as the dividend paid does not
exceed 10% of paid up capital.
For the sake of simplicity surcharge on corporate dividend tax not taken into
account.

Illustration 10
Following in the Thial Balance of a limited Company as at 31st December, 2004.

Particulars Debit
Credit
Share Capital 4,00,000
Cash in Hand 6,200
Rent 5,300
Prepaid Expenses 4,600
Repairs & Maintenance 8,600
Advances from Customers 50,000
General Reserve 3,00,000
Raw Materials at Cost 2,67,000
Sundry Creditors 3,40,000
Plant and Machinery 4,30,000
Power 8,800
Travelling and Conveyance 4,100
Auditors’ Fees 1,500
Cash at Bank 8,000
Land 30,000
Provision for Taxation 2,10,000
Furniture 12,200
Staff advances 5,300
Sundry Debtors 1,40,000
Misc. Income 54,600
Finished Goods at cost 3,10,000
Income-tax Advances 3,00,000
Misc. Expenses 61,400
Raw Materials consumption 28,60,000
Sales 42,30,000
Development Rebate Reserve 1,00,000
Building 74,100
Salaries, Wages & Bonus 11,60,000
Cash Credit from Bank 12,500

Total 56,97,100 56,97,100

The following additional information is also available:

i) The authorised capital of the company is 80,000 equity shares of Rs. 10 each of
which 50% has been issued and has been recommended by the directors.
ii) A dividend of 15% on the paid up capital has been recommended by the
directors.
iii) The closing stock of finished goods at cost is Rs. 5,60,000.
iv) The development rebate reserve is no langer required.
v) Depreciation on plant and machinery amounting to Rs. 43,000 on furniture
amounting to Rs. 1,300 and on building amounting to Rs. 3,800 has been debited
to miscellanceous expenses.
vi) Surplus in profit and loss account after proposed dividends, is to be transferred
to general reserve. 115
Fundamentals of vii) Income-tax assessment for a prior year has been completed, fixing the income
Accounting tax liability at Rs. 1,55,000 (against which a provision of Rs. 80,000 and
advances of income tax of Rs. 70,000 exists in the books).
You are required to prepare:
i) profit and loss account for the year ended 31st December, 2004; and
ii) Balance sheet in the prescribed form as on that date.

Solution
A Company Limited
Profit and Loss Account
for the year ended 31st December, 2004
Particulars Rs Particulars Rs
To Open. Stock of finished goods 3,10,000 By Sales 42,30,000
To Raw Materials consumed 28,60,000 By Clos. Stock of Finished 5,60,000
To Gross Profit c/d 16,20,000 Goods
47,90,000 47,90,000
To Salaries, Wages and Bonus 11,60,000 By Gross Profit b/d 16,20,000
To Power 8,800 By Miscellaneous Income 54,600
To Rent 5,300
To Repairs and Maintenance 8,600
To Aduditors’ Fees 1,500
To Travelling and Conveyance 4,100
To Depreciation on:
Plant and Machinery 43,000
Furniture 1,3000
Building 3,800
To Miscellanceous Expenses 13,300
To Provision for Taxation 169960
To Net Profit for the year 254940
16,74,600 16,74,600
To Provision for Taxation By Net Profit for the year 2,54,940
(for a prior year) 75,000 By Development Rebate Reserve
To Statutory Reserve 12747 written Back 1,00,000
To Proposed Dividend 60,000
To General Reserve (transfer) 2,07,193
354940 354940
Note: Provision for taxation for the year is assumed to be 40% of the profit.

A Limited Company
Balance Sheet
as on 31st December, 2004
Particulars Rs Particulars Rs
Share Capital: Fixed Assets:
Authorised: Land at cost Rs. 30,000
80,000 Equity shares of Rs. 10 each 8,00,000 Building 77,900
Issued: Subscribed and Paid up: Less: Depreciation 3,800 74,100
40,000 Equity shares of Rs 10 each Plant and Machinery 4,73,000
fully paid up 4,00,000 Less: Depreciation 43,000 4,30,000
Reserves and Surplus: Furniture 13,500
General Reserve: Rs. Less: Depreciation 1300 12,200
Brought forward 3,00,000 Investments –
116 Add: ransfer from Current Assets, Loans and
 Profit and Loss A/c 207193 5,07,193 Advances: Financial Statements
Satutory Reserve 12,747 A. Current Assets:
Development Raw Materials at cost 2,67,000
Rebate Reserve: 1,00,000 Finished Goods at cost 5,60,000
Less: Transferred to Sundry Debtrors 1,40,000
Profit and Loss A/c 1,00,000 – Cosh in Hand 6,200
Secured Loans: Cash at Bank 8,000
Cash Credit from Bank 12,500 B. Loans and Advances:
Unsecured Loans: – Staff Advances 5,300
Current Provisions: Prepaid Expenses 4,600
A. Current Liabilities: Income Tax Advance 2,30,000
Sundry Creditors 3,40,000
Income Tax Payable 85,000
Advances from Customers 50,000
B. Provisions:
Provisions for Taxation 2,99,960
Proposed Dividend 60,000
Total 17,67,400 17,67,400

Working Notes:

(i) Provision for Taxation: Rs

As per Trial Balance 2,10,000
Less: Adjustment for prior year provision 80,000
1,30,000
Add. Provision for current year taxation 169,960
Provision taken to Balance Sheet 2,99,960
(ii) Prior year tax Adjustments:
Income Tax Liability for Prior Year 1,55,000
Less: Prior Provision 80,000
Additional Provision to be made in current year 75,000
Total Tax Liability 1,55,000
Less: Advance Tax 70,000
Tax Payable 85,000
(iii) Advances Income Tax 3,00,000
Less: Adjustment against prior year completed assessment 70,000
Balance in Advance Income tax 2,30,000
(iv) A sum equal to 5% to the net profits is required to be transferred to statutory
reserve as the rate of dividend is 15%.

117
Fundamentals of Illustration 11
Accounting
The Bangalore Manufacturing Co. Ltd., was registened with a nominal capital of
Rs. 15,00,000 divided into equity shares of Rs. 100 each. On 31st March 2004 the
follwing ledger balances were extracted from the company’s books.
Rs. Rs.
Equity Share Capial Called Preliminary Expenses 12,500
up and paid up 11,50,000 Freight and Duty 32,750
Calls-in-arrears 18,750 Goodwill 62,500
Plant and Machinery 9,00,000 Wages 2,12,000
Stock (1-4-2003) 1,87,500 Cash in hand 5,875
Fixtures 18,000 Cash at Bank 95,750
Sundery Debtors 2,17,500 Directors’ Fees 14,350
Buildings 7,50,000 Bad Debts 5,275
Purchases 4,62,500 Commission paid 18,000
Interim Dividend Paid 18,750 Salaries 36,250
Rent 12,000 6% Debentures 7,50,500
General Expenses 12,250 Sales 10,37,500
Debenture Interest 12,250 4% Government Securities 1,50,500
Bills Payable 95,000 Provision for Doubtful Debts 8,750
General Reserve 62,500 Sundry Creditors 1,15,000
Profit and Loss A/c 36,250
(Cr.) 1-4-2003

The stock on 31st March, 2004 was estimated at Rs. 2,52,000

The following adjustments© were to be made:

1) Final Dividend at 5% to be provided.

2) Depreciation on Plant and Machinery at 10% and on Fixtures at 5%.
3) Preliminary expenses to be written off by 20%.
4) Rs. 25,000 were to be transferred to General Reserve.
5) The provision for bad debts to be maintained at 5% on sundry debtors.

You are required to prepare the Trading and Profit and Loss Account and Profit and
Loss Appropriation Account for the year ended 31st March 2004 and the Balance
Sheet as on that date.

118
Solution Financial Statements

Trading and Profit and Loss Account of the Bengal Manufacturing Co. Ltd.
for the year ending 31st March, 2004

Rs. Rs.
To Opening Stock (1-4-2004) 1,87,500 By Sales 10,37,500
” Purchases 4,62,500 ” Closing Stock (31-3-2004) 2,52,000
” Freight and Duty 32,750 2,52,000
” Wages 2,12,000
” Gross Profit c/d 3,94,750
12,89,500 12,89,500
ToSalaries 36,250 By Gross Profit b/d 3,94,750
” Commission 18,000
” Rent 12,000
” General Expenses 12,250
” Directors’ Fees Rs. 14,350
” Debenture Interest 12,500
Add. Outstanding
Interest 32,500
To Bad Debts 5,275
Add: Provision for
Bad Debts
Required @ 5%
on Debtors
Rs. 2,17,500 10,875
16,150
Less: Old Provision
for Doubtful
Dets 8,750
7,400
” Depreciation on:
Plant & Machinery
@ 10% 90,000
Fixtures @ 5% 900
90,9000
“ Preliminary Expenses (20%) 2,500
” Provision for Taxation 62,500
” Net Profit transferred to
Profit and Loss Appro-
priation A/c 93,000
3,94,750 3,94,750

Calculation of Outstanding Interest

Rs.
Interest on Rs. 7,50,000 debentures @ 6% for one year 45,000
Less: Debenture interest paid 12,500
Outstanding interest 32,500

119
Fundamentals of Profit and Loss Appropriation Account
Accounting for the ending 31st March, 2004

Rs. Rs.
To Interim Dividend 18,750 By Balance b/d (1-4-2003) 36,250
” Proposed Final Dividend ” Net Profit for the year 93,600
@ 5% on Rs. 11,31,250
(i.e. Rs. 11,50,000 called) up
capital—Rs. 18,750 calls-in-arrears) 56,562
” General Reserve 25,000
Balance c/d 29,538
1,29,850 1,29,850

Balance Sheet of the Bangalore Manufacturing Co. Ltd.

as at 31st March, 2004

Liabilities Rs. Assets Rs.

Share Capital: Rs. Fixed Assets:
Authorsed Capital: 15,000 Goodwill 62,500
equity shares of Rs. 100 each 15,00,000 Buildings Rs. 7,50,000
Plant & Machinery 9,00,000
Called up and Paid up Capital: Less: Depreciation 90,000
11,500 shares of Rs. 100 each 8,10,000
fully calld up 11,50,000 Fixtures 18,000
Less: Calls-in-arrears 18,750 Less: Depreciation 900
11,31,250 17,100
Reserves and Surplus: Investments:
General Reserve 62,500 4% Government Securities 1,50,000
Add: Transferred during Current Assets, Loans and
the year 25,000 Advances:
87,500 A. Current Assets:
Profit and Loss Account 29,538 Stock 2,52,000
Secured Loans Sundry Debtors 2,17,500
6% Debentures 7,50,000 Less: Provision for
Debenture Interest Outsanding 32,500 Bad Debts @ 5% 10,875
Unsecured Loans Nil 2,06,625
Current Liabilities & Provisions: Cash in hand 5,875
A. Current Liabilities: Cash at Bank 95,750
Bills Payable 95,000 B. Loans and Advances Nil
Sundry Creditors 1,15,000 Miscellanceous Expenditure:
B. Provisions: (to the extent not written
Provision for Taxation 62,500 off or adjusted)
Proposed Dividends 56,562 Preliminary Expenses 10,000
23,59,850 23,59,850

Illustration 12
Spik and Span Ltd. was registered with an authorised capial or Rs. 3 lakh divided into
30,000 equity shares of Rs. 10 each. The company offered 15,000 shares for public
subscription of which Rs. 7.50 pen share was called up.
The following trral balance was drawn from the book of accounts as on March 31,
2004. You are required to prepare a Profit & Loss Appropriation Account for the year
120 ending on March 31, 2004 and Balance Sheet as on that date.
 Debit Credit Financial Statements

Rs. Rs.
Land 23,800
Buildings 52,900
Calls in Arrear 5,000
Brokerage on Shares 8000
Stores and Spare parts 18,000
Preliminary Expenses 7,600
Unexpired Insurance 640
Live Stock 900
Plant & Machinery 1,03,600
Loose Tools 24,000
Stock in trade at cost 50,000
Cash at Office 12,480
Cash Bank 25,000
Sundry Debtors 26,000
Share Capital 1,12,500
Sundry Creditors 1,24,600
Capital Reserve 30,800
Wages Outstanding 1,820
Godown Rent due 700
General Reserve 16,800
Employee’s Benefit Fund 3,000
Salaries Outstanding 1,000
Reserve for Doubtful Debts 1,300
Unpaid Dividends 700
Profit & Loss Accoaunt 57,500
Total 3,50,720 3,50,720

Out of the creditors of, Rs. 1,24,600 Rs. 84,600 were due to bank for a loan secured
by mortage on buildings and machinery, and Rs. 22,000 were due on account of loan
from subsidiary company.
The company earned a profit of Rs. 61,200 during the year. The balance
of profit brought forward from the previous year was Rs. 38,600 out of which it
was decided that Rs. 15,000 be paid as final dividend, Rs. 16,800 the carried to
General Reserve, Rs. 3,000 to Employees Benefit Fund. It was further resolved
that Rs. 7,500 be paid by way of interim dividend for the first half of the
current year.

Solution
Spik and Span Ltd.
Profit and Loss Appropriation A/c for the year ended March 31, 2004

Rs. Rs.
To Interim Dividend 7,500 Balance as per P & L A/c for the
To Balance of Profit 57,500 year ending March 31, 2003 38,600
To Dividend 15,000
To General Reserve 16,800
To Employee’s Benefit Fund 3,00 Profit as per P & L A/c 61,200

99,800 99,800
121
Fundamentals of Spik & Span Ltd.
Accounting Balance Sheet as on March 31, 2004

Liabilities Rs. Assets Rs.

Share Capital: Fixed Assets:
Authorised (Net Block) Rs.
30,000 Equity Shares of Land 23,800
Rs. 10 each 3,00,000 Buildings 52,900
Issued & Subscribed Capital:
15,000 Equity Shares of Plant &
Rs. 10 each Rs. 750 per Machinery 103,600
Share called up Rs. 1,12,500 Live Stock 900 1,81,200
Less Calls in Arrear Rs. 5,000 Current Assets:
1,07,500 Stock in trade at cost 50,000
Stores & Spares 18,000
Reserves and Surplus:
Capital Reserve 30,800 Loose Tools 24,000
General Reserve 16,800 Sundry Debtors 26,000
Less Reserve
Profit & Loss Account 57,500 for D’ful Debts 1,300 24,700
Empioyees Benefit Fund 3,000 Cash & Bank Balances 37,480
Secured Loans: Loans and Advances:
From Bank (Secured by Unexpired Insurance 640
mortgage on buildings machinery) 84,600
Unsecured Loans: Miscellanceous Expenditure
From Subsidiary 22,000 & Losses:
Current Liabilities and Preliminary Expenses 7,600
Provisions: Brokerage on Shares 800
Sundry Creditors 18,000
Unpaid Dividends 700
Outstanding Wages 1,820
Outstanding Salary 1,000
Godown Rent due 700
3,44,420 3,44,420

Adjustment: (1) Stock on 31st March 2003 was valued at Rs. 3,42,000
(2) Depreciate:
Plant and Machinery 15%
Computers 10%
patents & Trade Marks 5%
(3) Provision for Bad & doubtful debts is required at Rs. 2,040
(4) Provide for–
Rent o/s Rs. 3,200
Salaries o/s Rs. 3,600
Proposed Dividend 15%
Provision for Income Tax 50% & Corporate Dividend tax 12.5%
Ans: Net Profit after Tax Rs. 1,03,900
Corporate dividend Rs. 12,000
Balance Sheet Total Rs. 8,32,800
Corporate Tax = Rs. 6000 + Rs. 3600 = Rs. 9600
122 Rs. 96000 × 12.5% = Rs. 12000
2. The following balances appeared in the books of ABC Co. Ltd. as on Financial Statements
December 31, 2004.
Particulars Rs. Rs.
Paid up Capital 6,00,000
60,000 Equity Shares of Rs. 10 each 2,50,000
General Reserve 6,526
Unclaimed Dividend 36,858
Trade Creditors
Buildings at Cost 1,50,000
Purchases 5,00,903
Sales 10,83,947
Manufacturing Expenses 3,59,000
Establishment Charges 26,814
General Charges 31,078
Machinery at Cost 2,00,000
Motor Vehicle at Cost 30,000
Furniture at Cost 5,000
Opening stock 1,72,058
Book Debts 2,23,380
Investments 2,88,950
Depreciation Reserve 71,000
Advance Payment of Income Tax 50,000
Cash Balnce 72,240
Directors Fees 1,800
Investment’s Interest 8,544
Profit and Loos Account
(January 1,2004) 16,848
Staff Providend Fund 37,500
21,11,223 21,11,223

From these balances and the following information prepare the Company’s Balance
Sheet as on December 31, December 31, 2004 and its Profit and Loss Accout for the
year ended on that date.

a) The stock on December 31, 2004 was Rs. 1,48,680.

b) Provide Rs. 10,000 for depreciation on fixed assets, Rs. 6,500 for Managing
Director’s Commission and Rs. 1,500 for the Company’s contribution to the
Staff Providend Fund.
c) Interest accrued on Investment amounted to Rs. 2,750.
d) A Provision of Rs. 60,000 for taxes in respect of the profit for 2004 is
considered necessary.
e) The directors propose a final dividend at 4% after transfering Rs. 50,000 to
general Reserve.
f) A claim of Rs. 2,500 for workmen’s compensation is being disputed by the company.
g) The Market value of investment as on 31.12 2004 amounts to Rs. 3,02,500.

(Ans: Net Profit after tax Rs. 74,268, P and L Appn. A/c Rs. 17,116, Balancer Sheet
Rs. 10,90,000).
123
Fundamentals of 3) An inexperienced accountant has prepared the balance sheet of ABC Ltd. as follows:
Accounting
Balance Sheet of A B C Limited
Liabilities Rs Assets Rs
Trade Creditors 80,900 Stock:
Advances from Customers 42,260 In hand 3,60,480
Share Capital 8,00,000 With Agents 24,300
Profit & Loss A/c 45,630 Cash in hand 23,540
Provision for Taxes 95,000 Investments 20,000
Proposed Dividend 59,000 Fixed Assets:
Loan to Managing Director 5,000 Land 1,80,000
General Reserve 75,000 Plant & Machinery
Dev. Rebate Reserve 30,000 (W.D.V.) 4,10,000
Provision for Contingencies 23,000 Debtors 2,15,450
Share Premium A/c 22,000 Less: Provision
Forfeited Shares 3,000 For B/D 9,300
2,06,150
Bills Receiveable 5,000
Amount due from Agents 51,320

12,80,790 12,80,790

Redraft the above Balance Sheet in the form prescribed by Indian Companies Act,
1956 giving necessary details yourself.
4) The following balances have been extracted from AB Ltd. as on
September 30, 2004:

Rs. Rs.
Share Capital (Authorised and issued):
Equity (1,50,000 shares) 15,00,000
8% Redeemable Preference (400 shares) 40,000
Share Premiium 25,000
Preference share Redemption 48,000
General Reserve 1,00,000
Land (Cost) 3,00,000
Buildings (Cost less Depreciation) 7,00,000
Furniture (Cost Less Depreciation) 20,000
Motor Vehicle (Cost less Dep.) 35,000
Trading Account–gross Profit 9,00,000
Establishment Charges 2,50,000
Rates, Taxes and Insurance 12,000
Commission 4,000

Commission 5,000
Discount received 8,000
Directors’ Fees 2,000
Depreciation 60,000
Sundry Office Expenses 60,000
Payment to Auditors 4,000
Sundry Debtors and Creditors 1,06,600 25,600
124
Profit and Loss Account Financial Statements
(as on 30.9.2003) 10,000
Unpaid Dividend 2,000
Cash in hand 12,000
Cash at Bank in Current Account 1,95,000
Security Deposit 10,000
Outstanding Expenses 6,000
Investment in G.P. Notes 2,00,000
Stock-in-trade (at or below cost) 3,53,000
Provision for taxation (y/e 30.9.03) 70,000
Income tax paid under dispute (y/e 30.9.03) 1,00,000
Advanced payment of income-tax 2,20,000
Total 26,91,600 26,91,600

The following further details are available:

1) The Preference shares were redeemed on 1st October, 2003 at a premium of 20%
but no entries were passed for giving effect thereto, except payment standing to
the debit of Preference Share Redemption A/c.
2) Depreciation provided up to 30th September, 2004 is as follows:
a) Buildings 2,10,000
b) Furniture 20,000
c) Moter Vehicles 60,000
3) Establishment charges include Rs. 18,000 paid to Managing Director as mini-
mum remuneration in terms of agreement which provides for a remuneration of
5% of annual net profits subject to the above minimum in the case of absence or
inadequacy of profitsw in the year.
4) Payment to Auditors includes Rs. 1,000 for taxation work in addition to audit
fees.
5) Market value of investments on 30th September 2004 Rs. 1,80,000
6) Sundry Debtors include Rs. 40,000 due for a period exceeding six months.
7) All receivables and deposits are considered good for realisation.
8) Income-tax demand for the year ended 30.9.2003 Rs. 1,00,000 has not been
provided for against which an appeal is pending.
9) Income-tax to be provided@ 55%.
10) Directors decide to transfer Rs. 25,000 to the General Reserve and to recommend
payment of dividend on equity shares at the rate of 5%.
11) Ignore previous year’s figures.
You are required to prepare the Profit and Loss Account for the year ended
30th September, 2004 and the Balance Sheet as at that date.
(Ans: Net profit after tax and commission Rs. 2,30,422,
Balance of P/L Appn. A/c Rs. 1,40,422
Balance Sheet Total Rs. 22,51,600).
Hint: 5% Remeneration Rs. 26950

125
Fundamentals of 5) The following balances have ben extracted for the books of XYZ Company Ltd.
Accounting as on March 31, 2004.

Rs. Rs.
Freehold Land 23,000 Income from Investments 1,200
Building 7,500 Provisions for doubtful debt
Furniture 2,000 (1st April 2003) 200
Debtors 5,000 Creditors 2,000
Stock (31 March 2004) 4,000 Provision for Depreciation
Cash at Bank 500 (1st April, 2003) 500
Cash in hand 100 Buildings
Cost of Goods sold 30,000 Furniture
Salaries and Wages 1,500 Suspense A/c
Misc. Expenses 800 Equity Share Capital 36,750
Investment in Shares 18,000 6% Cumulative Pref.
Interest 300 Share Capital 8,000
Bad Debts 100 Share Premium 1,000
Repairs and Maintenance 150 Bank Overdraft 5,000
Advance payment of Sales 38,000
Income-tax 600 Profit and Loss A/c
(1st April, 2003) 250
93,550 93,550

The following further particulars are available:

1) The land was revalued on 1st january, 2004 at Rs. 30,000 by an expert valuer
but no effect has been given in the books although the Directors have decided to
adjust the relavant amount.
2) Provision for doubtful debt is to be adjusted to 5% on the amount of debtors.
3) Equity Share Capital is composed of Rs. 10 Shares, 3640 shares were fully paid
and 50 on which a call of Rs. 3 remains unpaid.
4) Suspense A/c represents money received from the new allottee for re-issue of
50 shares shares forfeited during the year for non-payment of the final call, but
no entry for adjustment thereof has been passed.
5) Provision for taxation is to be made at 45%
6) Market value of investments was Rs. 18,500 on 31st March 2004
7) The company is managed by the Directors who are entitled to a remuneration of
3% on the annual net profits.
8) Depreciation is to be charged on written down value of:
Building at 2%
Furniture at 10%
9) The land and buildings of the company are mortgaged in favour of the bank as
security for overdraft sanctioned up to a limit of Rs. 25,000.
10) Dividend on Cumulative preference shares were in arrears for 5 years upto
March 31, 2004. The Directors have recommended payment of dividend for two
years.
Prepare Profit and Loss Account for the year ended March 31, 2004 and Balance
Sheet on that date.
126
(Answer: Profit Rs. 5,999, Balance Sheet total Rs. 60,491) Financial Statements

6) Ajax Co. Ltd. had an authorised capital of 5,000 equity shares of Rs. 100 each.
As on December 31, 2003, 3000 shares were fully called up, and the following
balances were extracted from the company’s ledger accounts.
Rs. Rs.
Salary 4,85,000 Printing and Stationery 2,300
Purchases 3,20,000 Advertishing Expenses 7,300
Stock 75,000 Sundry Debtors 52,700
Manufacturing wages 70,000 Sundry Creditors 34,200
Insurance upto 31-3-2004 6,720 Plant & Machinery 83,500

Rent 6,000 General Reserve 60,700

Salaries 18,500 Furniture 27,100
Discount Allowed 1,050 Building 84,580
General Expenses 9,050 Cash at Bank 1,24,000
Calls in Arrear 4,800 Loans from Managing Director 3,700
Profit and Loss A/c (Cr.) 21600 Bad Debts 12,600

The following further information is given: (i) Depreciation to be charged on

Machinery and Furniture at 15% and 10% respectively; (ii) Provision for Taxation to
be made Rs. 19,000; (iii) Closing Stock Rs. 1,21,000; (iv) Outstanding liabilities:
Wages, Rs. 7,000; Salaries Rs. 8,200; Rent, Rs. 1,600; (v) Dividend at 5%
on paid-up capital to be provided; (vi) Rs. 10,000 to be transferred to
General Reserve.
Prepare Profit and loss Account for the year ended December 31, 2003 and Balance
Sheet (in proper form) as on that date.
(Answer: Profit for the year Rs. 28125, total of Balance Sheet Rs. 4,79,325).
7) The following balances are extracted from the books of ABC Ltd., as on
31 March, 2003.
Share Capital 40,00,000
Cash in hand 62,000
Repairs and Maintenance 86,000
Raw Materials at cost 26,70,000
Furniture 1,22,000
Sundry Creditors 34,00,000
Directors’ Fees 4,000
Plant and Machinery 43,00,000
Miscellaneous Expenses 6.10,000
General Reserve 30,00,000
Land 3,00,000
Finished Goods at cost 31,00,000
Sales 4,33,00,000
Buildings 7,41,000
Cash at Bank 80,000
Provision for Taxation 21,00,000
Sundry Debtors 14,00,000
Raw Materials Consumption 2,86,00,000 127
Fundamentals of Staff Advance 53,000
Accounting
Advance from customers 5,00,000
Salaries, Wages and Bonus 1,16,00,000
Cash credit from Bank 1,25,000
Power 88,000
Prepaid expenses 46,000
Rent 53,000
Travelling and Conveyance 41,000
Auditors’ Fees 15,000
Miscellaneous Income 5,46,000
Income Tax Advance 30,00,000

The following further information is also given:

1) The authorised share capital of the company is 80,000. Equity Shares of Rs. 100
each which has been issued and subscribed to the extent of 50%.
2) Tax provision @ 6% is to be made on current year’s profits.
3) 15% dividend on the paid-up share capial is recommended by the Directors.
4) The closing stock of finished goods at cost is Rs. 56,00,000.
5) Depreciation on assets amounting to Rs. 4,30,000 on Furiture and Rs. 33,000 on
Building has been debited to miscellanceous expenditure.
6) The surplus in profit and loss account is to be transferred to General Reserve
Account.
Prepare Profit and Loss Account and Balance Sheet as on 31.3.2003.
(Answer: Net Profit before tax Rs. 25,79,000
Total of Balance Sheet Rs. 1,57,04,000)
8) An inexperienced accountant has prepared the balance sheet ABC Ltd. as follows:

Balance Sheet of A B C Limited

Liabilities Rs Assets Rs
Trade Creditors 80,900 Stock:
Adances from Customers 42,260 In hand 3,60,480
Share Capital 8,00,000 With Agents 24,300
Profit and Loss A/c 45,630 Cash in hand 23,540
Provision for Taxes 95,000 Investments 20,000
Proposed Dividend 59,000 Fixed Assets:
Loan to Managing Director 5,000 Land 1,80,000
General Reserve 75,000 Plant and Machinery
Dev. Rebate Reserve 30,000 (W.D.V.) 4,10,000
Provision for Contingencies 23,000 Debtors 2,15,450
Share Premium A/c 22,000 Less: Provision
Forfeited Shares 3,000 For B/D 9,300
2,06,150
Bills Receiveable 5,000
Amount Due from Agents 51,320
12,80,790 12,80,790
128
 Financial Statements
3.11 LET US SUM UP
Financial statements are prepared by all forms of business organisations to ascertain
the operating results of the business and to know the financial position on a particular
date. Before preparing financial statements one must gain clarity about the nature of
certain items and their treatment in the final accounts. It is obligatory on the part of
companies to maintain and prepare financial statements by the end of each accounting
period. Manufacturing account is prepared to know the cost of goods produced while
Trading account is prepared to know the results of trading operations. Profit and loss
account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. The operating and non-operating
expenses are charged to profit and loss account. The distribution or appropriation of
profit is shown under Profit and Loss Appropriation Account, which is also called
‘Below the Line’.
Balance Sheet is a statement of assets and liabilities to ascertain the financial position
of a concern at a particular date. The assets and liabilities are presented either on the
basis of liquidity or performance. Under ‘liquidity order’ assets are shown on the
basis of ‘most liquid’, ‘liquid’ and ‘least liquid’ assets. Liabilities are shown in the
order of payment. Under ‘order of performance’ the assets are arranged on the basis
of their useful life whereas liabilities are shown on the besis of long term, medium
term, short term and current liabilities.
It is important to distinguish between capital and revenue to ascertain correct profit or
loss amount and fair view of the affairs of the business. There are certain rules which
guide us to determine whether a particular expenditure or receipt is of a capital nature
or of a revenue nature.
Revenue recognition is concerned with the timing of recognition revenue in the
statement of profit and loss. ‘Realisation Concept’ recognises the revenue at the point
of sale or service rendered. Operating and non-operating revenues should be shown
separately while preparing Profit and Loss Account. There are some established
practices as per the Accounting Standards to recognise certain items as revenues. The
Accounting Standards have some established practices to recognise revenue in cases
of sale of goods, rendering services and financial services. But there are also certain
exception to this general rule.
The financial statements of non-corporate entities may be presented either in
conventional format or vertical format. Under vertical form various items of incomes
and expenses, assets and liabilities arranged vertically to get some additional
information about the operating efficiency and financial position of the business
enterprise. The sole traders and partnership forms hardly adopt vertical form of
financial statements. As regards preparation of Balance Sheet of a company, the
nature of details shown with respect to the liabilities and assets and the order of
arrangement of the items are prescribed in Schedule VI, Part I of the Companies Act.
There are two alternate proformas given in Schedule VI for the preparation of
Company Balance Sheets: (i) horizonal and (ii) vertical. Any of these forms may be
adopted for the Balance Sheet of a Company. Both the prescribed forms may require
that the figures of the previous year should be shown in a separate column along side
the figures of the current year.

3.12 KEY WORDS

Capital Expenditure: An expenditure which results in the acquisition of fixed asset
or addition to fixed asset, or an improvement in the earning capacity of the business.
Capital Receipt: Receipt in the form of additions to capital, liabilities or sale
proceeds of a fixed asset. 129
Fundamentals of Revenue Expenditure: An expenditure the benefit of which is limited to one year.
Accounting
Revenue Receipt: Receipts on account of goods sold or services provided.
Deferred Revenue Expenditure: A revenue expenditure which involves a heavy
amount and the benefit of which is likely to spread over the years.
Appropriation: Distribution of profits.
Balance Sheet: Statement of assets and liabilities depicting the financial position at
the end of the financial year.
Below the line: Part of the Profit and Loss Account which shows the appropriation of
profits.
Above the line: Profit and loss account which shows the profit or loss before
appropriation of profits.
Contingent Liability: Liability which depends upon the happening of a certain event
Preliminary Exenses: Expenses incurred in connection with the formation and
registration of a company.
Profit and Loss Account: Income statement disclosing the results of operation (profit
or loss) for the financial year.
Dividend: Part of profits distributed to the equity shareholders.
Final Dividend: Dividend declared in the annual general meeting.
Provision for Taxation: The amount appropriated from profit for the liability arising
on account of payment of taxes.
Financial Statements: Annual statements of assets and liabilities (Balance Sheet) and
of income and expenditure (Profit and Loss Account).

3.13 TERMINAL QUESTIONS

1) Following is the Trial Balance of V.N. Ltd. as on 31st March 2003. Prepare
Trading and Profit and Loss Account and Balance Sheet after taking into account
the adjustments.
Rs. Rs.
Opening Stock 3,00,000
Purchases/Sales 9,80,000 13,60,000
Bills Receivable/Bills Payable 20,000 28,000
Patents and Trade Marks 19,200
General Reserve 62,000
Cash at Bank 1,84,800
Plant and Machinery 1,16,000
Debtors and Creditors 1,10,000 70,000
Share Capital 4,00,000
Dividend paid for 2001-2002 36,000
Profit and Loss A/c (1.4.2002) 94200
Sundry Expenses 28,200
Rent 16,000
Salaries 30,000
Computers 68,000
Carriage–Inward 38,000
Discount Received 12,000
Wages 1,20,000
Return outwards 40,000

130 20,66,200 20,66,200

 Understanding
UNIT 4 UNDERSTANDING FINANCIAL Financial Statements

STATEMENTS
Structure
4.0 Objectives
4.1 Introduction
4.2 Vertical Format of Corporate Financial Statements
4.2.1 Vertical Format of Balance Sheet
4.2.2 Vertical Format of Profit and Loss Account
4.3 Revenues and Provisions
4.3.1 Reserves
4.3.2 Provisions
4.3.3 Distinction between Provision and Reserve
4.4 Concepts of Profits
4.4.1 Gross Profit
4.4.2 Operating Profit
4.4.3 PBIT, PBT, PAT
4.4.4 Cash Profit
4.4.5 Profit Available to Equity Shareholders (Residual Profit)
4.5 Concept of Capital
4.5.1 Capital Employed
4.5.2 Shareholders Funds
4.5.3 Shareholders Equity
4.5.4 Debt Fund
4.5.5 Net Working Capital Employed
4.6 Uses of Financial Statements
4.7 Limitations of Financial Statements
4.8 Let Us Sum Up
4.9 Key Words
4.10 Answers to Check Your Progress
4.11 Terminal Questions
4.12 Suggested Readings

4.0 OBJECTIVES
After studying this unit you should be able to:
l prepare company financial statements in vertical form;
l acquaint with the concepts of revenues and provisions, profit and capital; and
l appreciate the uses and limitations of financial statements.

4.1 INTRODUCTION
According to Section 210 of the Companies Act, a company is required to prepare a
balance sheet at the end of each trading period. Section 211 requires the balance sheet
is to be prepared in the prescribed form. Schedule VI Part I permits presentation of
Balance Sheet either in horizontal or vertical forms. The present trend of the whole
corporate world is to present their annual accounts in vertical form which has now 131
Fundamentals of become a modern practice. The purpose of this unit is to provide knowledge of
Accounting working model of annual financial statements prepared in accordance with Schedule
VI of Companies Act 1956, Accounting Standards applicable to reporting enterprise
and the basic concepts of reserves and provisions, profit and capital. It also deals with
the uses and limitations of financial statements.

4.2 VERTICAL FORMAT OF CORPORATE FINANCIAL

STATEMENTS
The Profit and Loss Account and Balance Sheet may also be presented in vertical
form. In the vertical form, a summarised profit and loss account is prepared and
details of the items are shown separately in the form of annexures. In the case of
balance sheet, the liabilities are shown under the heading ‘Sources of Funds’ and the
assets are shown under the heading ‘Application of Funds’. Both the prescribed forms
of profit and loss account and balance sheet require that figures of the previous year
should be shown in separate column along with the figures of the current year with
respect to each of the items. The current trend of the whole corporate world is to
present their annual accounts in vertical form. Part I of Schedule VI permits
preparation of financial statements in vertical form which has now become a modern
practice.

4.2.1 Vertical format of Balance Sheet

Under vertical form, a Balance Sheet is prepared under single column divided in two
sections. First section shows the “Sources of Funds” which includes Share Capital,
Reserves and Surplus, Secured and Unsecured Loans. The second section is
represented by “Application of Funds” in the form of Fixed Assets, Investments, Net
Current Assets (Current Assets-Current Liabilities) and Miscellaneous Expenditure.
A format is given below.
Balance sheet of ............
As on ......
I Sources of Funds Schedule Figures for the Figures for the
No. current year previous year
1. Shareholders’ Funds
(a) Share Capital 1 ............... ...............
(b) Reserves and Surplus 2 ............... ...............
2. Loan Funds 3
(a) Secured Loans ............... ...............
(b) Unsecured Loans ............... ...............
Total ............... ...............
II Application of Funds:
1. Fixed Assets 4
(a) Gross Block ............... ...............
(b) Less Depreciation ............... ...............
(c) Net Block ............... ...............
(d) Capital Work-in-progress ............... ...............
2. Investments 5 ............... ...............
3. Current Assets, Loans and 6 ............... ...............
132 Advances
 (a) Inventories Understanding
Financial Statements
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less: Current Liabilities and 7
Provisions
(a) Liabilities
(b) Loans and Advances
Net Current Assets
4. (a) Miscellaneous Expenditure
(Amount not written off)
(b) Profit and Loss Account
(Less) Balance in General Reserve
As per contra
Total
Significant Accounting Policies & 15
notes on accounts
Various schedules as mentioned above, will provide necessary details of items and
information as required to be given as per schedule VI of Companies Act 1956. The
figures in the amount column may be rounded off to the nearest thousand (000) as
may be decided by the management. These schedules, significant accounting
policies and explanatory notes form an integral part of the Balance schedules,
significant accounting policies and explanatory notes form an integral part of the
Balance Sheet as required by applicable Accounting regarding disclosure of
accounting policies. Contingent liabilities are shown by means of footnote to the
Balance Sheet.

4.2.2 Vertical Format of Profit and Loss Account

Almost all the companies prepare and present their Income Statement (Profit and Loss
Account) in vertical form. In fact the information relating to activities (operating ,
investing, financing) of the companies are arranged in vertical order rather than
conventional (horizontal ‘T’ form). A format of Profit and Loss in vertical form is
given below:
Particulars Schedule Figures at the Figures at the
No. end of current end of previous
year year
I Income
Sales
Services
Dividend
Interest
Other Income 8
TOTAL
II Expenditure
Cost of goods sold/raw 9
material consumed
Selling and other expenses 10
Depreciation 11
Financial Expenses 12
TOTAL 133
Fundamentals of Profit before Taxation, Extraordinary
Accounting and Prior Period Items
Provision of Taxation
Net Profit before Extraordinary and 12
Prior Period Items
Extra Ordinary Items (Net of Tax) 13
Prior Period Items (Net of Tax) 14
Net Profit
Balance brought forward from
Previous year profits available for appropriation
Appropriation
Interim Dividend
Dividend on Preference Shares
Proposed Final dividend
Corporate Dividend Tax
Transfer to Debenture
Redemption Reserve
Transfer to Capital Redemption
Reserve
Transfer to General Reserve
Balance taken to Balance Sheet
Significant Accounting Policies and notes on accounts 15
(For details of schedules learners are advised to refer to Horizontal (conventional)
form of Balance Sheet)
A list of significant accounting policies and notes is as follows:
1. Basis of Accounting
2. Revenue Recognition
3. Fixed Assets
4. Depreciation and Amortisation
5. Investments
6. Inventories
7. Foreign Currency Transactions
8. Retirement Benefits
9. Deferred Revenue Expenditure
10. Hire Purchase-Lease rental income
11. Product warranty expenses
12. Provision for contingencies
13. Research and Development
14. Taxation
15. Investment in debt and equity shares
16. Long term contracts and property development activity
17. Government grants
18. Amortisation of License fees
19. Changes in accounting policies
20. Amortisation of License fees
21. Provision for re-inventing the company
22. Employees stock option scheme.
134 23. Amalgamation
24. Changes in provisions of retirement benefits of employees. Understanding
Financial Statements
25. Investment in sick units
26. Contingencies
27. Approval of managerial remuneration
28. Extraordinary items.

Illustration 1
The following is the trail balance of ABC Ltd. as on 31st March 2003 (Rs. In ‘000’)
Debit Balances Rs. Credit Balances Rs.
Freehold Building 2750 Equity Share Capital 3750
(Shares of Rs. 10 each)
Plant and Machinery at Cost 9500 10% Debenture 2500
Debtors 1200 General Reserve 1625
Stock (31.03.2003) 1075 Profit and Loss Account 900
Bank 250 Securities premium 500
Adjusted Purchases 4000 Sales 8750
Factory Expenses 750 Creditors 650
Administration Expenses 375 Provision for Depreciation 2050
Selling Expenses 375 Other Income 25
Debenture Interest 250
Interim Dividend 225
20750 20750

Additional Information:
i) The authorised share capital of the company is Rs. 75,00,000.
ii) Freehold premises have been valued at Rs. 45,00,000.
iii) Proposed final dividend is 10% & corporate dividend tax 12.5%.
iv) Depreciation on Plant & Machinery is to be provided at 10% on cost.
v) Provided for income tax @ 40%.
You are required to prepare Profit and loss account for the year ended 31st March
2003 and a Balance Sheet as on that date in vertical form as per the provisions of
Schedule VI of the Companies Act 1956.

Solution ABC Ltd.

Profit and Loss Account for the year ended 31st March 2003
Particulars Schedule No. Rs. (in ‘000’)
Income:
Sales 8750
Other Income 25
8775
Expenditure:
Purchases (Adjusted) 4000
Factory Expenses 750
Administration Expenses 375
Selling Expenses 375
Depreciation 950
Interest on debentures 250
6700 135
Fundamentals of Profit before tax 2075
Accounting Less: Provision for taxation @ 40% on Rs. 2075 830
Net Profit after tax 1245
Less: Dividend: Interim 225
Final (Rs.3750 × 10%) 375
Dividend tax 75 675
1
(225+375 = 700 × 12 /2%) 570
Balance Sheet as on 31st March 2003
Schedule No. Rs. (in ‘000’)
I Sources of Funds
Shareholders Funds
(a) Share Capital 1 3750
(b) Reserves and Surplus 2 5345
9095
Loan Funds: a) Secured
10% Debentures 2500
Total 11595
II Application of Funds
Fixed Assets 3
(a) Gross Block 1400
(b) Depreciation 3000
(c) Net Block 11000
Current Assets, Loans and Advances
Current Assets:
(a) Stock 1075
(b) Debtors 1200
(c) Bank 250 2525

Less: Current Liabilities

Creditors 650
Provision for Taxation 830
Proposed Dividend 375
Corporate Dividend Tax 75 1930
595
Net Current Assets 11595
Schedule 1: Share Capital:
Authorised
75,000 shares of Rs. 10 each Rs. 75,00,000
Issued, Subscribed & paid up
37500 shares of Rs. 10 each
fully paid Rs. 37,50,000
Schedule 2: Reserves and Surplus Rs.
Securities Premium 5,00,000
Revaluation Reserve 17,50,000
General Reserve 16,25,000
Profit & Loss Account*
(9,00,000 + 5,70,000) 14,70,000
* (Opening Bal. +Bal. of Current year’s P&L A/c) 53,45,000
136
Schedule 3: Fixed Assets Understanding
Financial Statements
Opening Additions Revaluation Disposal Provision Closing
Balance Reserve for Dep. Balance
1 Freehold 27,50,000 – 17,50,000 – – 45,00,000
Premises (4500000–2750000)
2 Plants & 95,00,000 – – – 30,00,000 65,00,000
Machinery
1,22,50,000 17,50,000 30,00,000 1,10,00,000

Illustration 2
From the following information, prepare a Balance Sheet in a vertical form as on 31st
March 2003 as per the provisions of Schedule VI of Companies
Act 1956.
Debit Balances Rs. (000) Credit Balances Rs. (000)
Fixed Assets 14,300 Equity Share Capital 4,000
Finished Goods 1,500 10% Pref. Share Capital 1,600
Stores 800 Profits for the year 1,810
(Before interest & tax)
Preliminary Expenses 206 12% Debenture 3,000
Advance Tax 400 P & L Account (1.04.2002) 100
Capital Work-in-progress 640 Security deposits from dealers 240
Interest on debentures (net) 324 Securities Premium 1,000
Interest on Loans (other) 160 Investment Allowances Reserves 300
Cas at Bank 550 Creditors 2,300
Loose Tools 100 Provision for doubtful debts 50
Short term investment at cost 450 Provision for Depreciation 3,000
(Market value Rs. 440)
Advance to staff 120 Loan from Customers 400
Debtors 2,450 General Reserve 4,200
22,000 22,000
Additional Information:
(i) Dividend is proposed on equity shares @ 0%.
(ii) Provide TDS:
Interest on debentures @ 10%
Corporate dividend tax @ 12.5%
Corporate Income tax @ 40%
Solution
Balance sheet of...
As on 31st March 2003
Schedule No. Rs. (in ‘000’)
I Sources of Funds
1 Shareholders funds
a. Share Capital 1 5,600
b. Reserves & Surplus 2 5,738
11,338
2 Loan Funds
a. Secured Loans 3,000
b. Unsecured Loans 3 640
TOTAL 14,978 137
Fundamentals of II Application of Funds:
Accounting 1. Fixed Assets 4
a. Gross Block 14,300
b. Less Depreciation (3000)
c. Net Block 11,300
d. Capital work-in-progress 640
11,940
2. Short term Investments (at realisable value) 440
3. Current Assets, Loans and Advances
a. Inventories 2400 5
b. Debtors less provision 2400
c. Cash at Bank 550
d. Loan & Advances 120
(Advance to staff)
5470
Less: Liabilities and Provision
a. Liabilities (2336) 6
b. Provisions (742) 7
Net Current Assets (Working Capital) 2,392
4. Miscellaneous Expenditure 206
(Prelim. Exp.)
TOTAL 14, 978
Schedule 1
Share Capital
Equity Share Capital 4000
10% Pref. Share Capital 1600
5600
Schedule 2
Reserves and Surplus:
Securities Premium 1000
Investment allowance Reserve 300
General Reserve 4200
Profit & Loss Account 238
5738
Schedule 3
Unsecured Loans:
Security deposits from Dealers 240
Loans from Customers 400
640
Schedule 4
Fixed Assets 14300
Less Depreciation 3000
11300
Capital work-in-progress 640
11940

138
Schedule 5 Understanding
Financial Statements
Current Assets, Loans and Advances
a. Inventories
Loose tools 100
Stores 800
Finished Goods 1500
2400
Schedule 6
Current Liabilities Rs.
Creditors 2300
TDS on interest on debentures 36
2336
Schedule 7
Provisions: Rs.
Provision for Income Tax 512
Less Advance Tax 400 112
proposed Dividend:
Equity 400
Preference 160
Corporate Dividend Tax 70
742
Working:
Profit and Loss Appropriation Account
Rs. Rs.
To Interest on debentures 360 By Profit 1810
To Interest on Loan 160
To Loss on Investment 10
To Provision for Income Tax 512
{1810 – (360+160+10) x 40/100}
To Balance c/d 768
1810 1810
To Proposed Dividend: By Balance b/d 768
Equiity 400
Preference 160 By profit 100
To Corporate Tax 70 (1.4.02)
To Balance (Carried to Balance Sheet) 238
868 868
Check Your Progress A
1) Under what headings will you classify the following items:
a) Securities Premium
b) Preliminary Expenses
c) Live-Stock
d) Unclaimed Dividend 139
Fundamentals of e) Interim dividend declared but not paid
Accounting
f) Arrears of fixed cumulative preference dividend
g) Share forfeited account
h) Loose tools
i) Advance income tax paid
j) Sinking fund
2. State briefly the items that are included under the following heads:
a) Contingent Liabilities (b) Unsecured Loans (c) Secured Loans
d) Reserve & Surplus (e) Current Liabilities & Provisions
f) Current Assets, Loans & Advances
l Students are advised to see the annual reports of various companies to develop
a better understanding of financial statements through notes attached thereto.

4.3 RESERVES AND PROVISIONS

The reliability, and accuracy of income statement (profit & loss account) and financial
position statement (balance sheet) depends to a greater extent, upon the estimates,
which govern the amount of various provisions to be made. And similarly transfers to
various reserves including statutory transfer, determine the financial soundness,
creditworthiness and depict strong fundamentals which send clear signal to stock
market and other interested parties. Hence, the concepts of ‘reserves’ and ‘provisions’
are of utmost importance while preparing, analysing and understanding the financial
statements.

4.3.1 Reserves
The portion of earning, receipts or other surplus of an enterprise (whether capital or
revenue) appropriated by management for a general or specific purpose is known as
reserve. These reserves are primarily of two types: Revenue and Capital reserves
which may be classified and treated as follows:
1) Revenue Reserves: are also know as free reserves. These are created to meet a
contingent liability not specifically mentioned. These contingencies reserves
indicate management’s belief that funds may be required for an usual purpose or
to meet a possible obligation that does not yet have the status of a liability such
as settlement of a pending law suit or to meet any trading loss. These reserves
are also created for any other general purposes such as for expansion or
modernisation. For accounting purposes the transfer of amount to such ‘general
reserve’ or ‘contingency reserve’ is treated as appropriation and not a charge.
2) Specific Reserve: When a reserve is created for a specific purpose it is known as
‘specific reserve’. It may be created to maintain a stable rate of dividend or to
meet redemption of debentures after a stipulated period of time. Such reserves
may take form of “Dividend Equalisation Reserve”, “Debenture Redemption
Reserve” etc. None of these reserves represent maney or anything tangible. From
accounting point of view it is simply a transfer of divisible profit to other head.
However, when these Revenue Reserves (General/Specific) are not retained
within the business but invested outside business are termed as “reserve Funds”.
3) Capital Reserve: A reserve which is created not out of divisible profits is called
capital reserves. Such reserve is not available for distribution among sharehold-
ers as dividend. It is generally created out of capital profits such as profits prior
to incorporation, securities premium, profit on re-issue of forfeited shares, profit
140
 on redemption of debentures, profit on sale of fixed assets, profit on revaluation Understanding
of fixed assets and capital redemption reserve crated as per the provisions of Financial Statements
Companies Act on redemption of preference shares.
As stated above, such profits are not available for distribution as dividend.
However, some of the capital profits (profit on sale of fixed assets) can be
distributed as dividend if the same are realised in cash. But the companies act
expressly prohibits the following to be used for payment of dividend:
Premium on issue of shares.
Profit on re-issue of forfeited shares and
Capital redemption reserve
Revaluation reserve
According to section 7 of Companies Act 1956, Securities Premium can be utilized
only for the following purposes:
1) Issue of fully paid bonus shares.
2) Writing off the preliminary expenses, discount on issue of shares or debentures
or other fictitious assets.
3) Providing for the premium payable on redemption of debentures or preference
shares.
U/s80, Capital Redemption Reserve can be utilised only for the purpose of issuing
fully paid bonus shares.
4) Secret Reserve: A reserve which is not disclosed in the Balance Sheet is known
as secret reserve. The companies Act 1956 prohibits creation of secret reserve
because it conceals the actual financial position. However, the financial position
of the company is definitely better what it appears from the balance sheet. Such
reserve is created in any of the following manner by:
1) Writing of excessive depreciation
2) Understating the value of assets.
3) Overstating liabilities.
4) Treating capital expenditure as revenue.
5) Creating excessive provision for bad debts.
6) Creating provisions which are not required.
7) Treating contingent liability as an actual liability
8) Treating revenue receipt as capital
Secret reserve may arise on account of a permanent appreciation in the value of assets
or a permanent diminution in the value of a liability. Such changes usually are not
accounted for in the books of accounts.
The policy of secret reserve is adopted by the management to achieve the following
objectives:
l To meet the exceptional losses
l To bring down the market value of shares within the trading range.
l To enhance the availability of working capital
l To maintain dividend rate
l To elude competition by concealing large profits
l To minimize tax liability
l To keep strong financial position
l To lessen the dependence on external finances
All these reserves are shown on the liabilities side of the balance sheet. 141
Fundamentals of 4.3.2 Provisions
Accounting
The companies Act 1956 states that, “Provision means amount written off or retained
by way of providing depreciation, renewals of diminution in the value of assets or
retained by way of providing for any known liability the amount of which can not be
determined with substantial accuracy”.
Thus the above definition clearly mentions that a provision may be created either for
depreciation or for a known liability, the amount which cannot be ascertained with
substantial accuracy such as:
– Provision for bad & doubtful debts
– Provision for Repairs and renewals.
– Provision for discount on debtors
– Provision for fluctuation in investments
Therefore, it can be summed up that a provision is created either against the loss (fall)
in the value of assets in the normal course of business operation or against a known
liability the amount of which cannot be determined accurately but in estimated only.

4.3.3 Distinction between Provision and Reserve

1) A provision is a charge against the profits which reserve is simply an appropria-
tion of profits.
2) A provision is created to meet a known liability whose amount is uncertain while
reserve is created to strengthen the financial position and the meet contingency, if
any.
3) A provision is shown as a deduction out of the assets concerned whereas reserve
is shown separately on the liabilities side.
4) The sum so set aside as provision is never invested outside business whereas
reserves may be invested outside business.
5) Provision is part of divisible profits but the same cannot be made available for
the purpose of distributing dividend while reserves (revenue) are always avail-
able to be distributed as dividends.
6) Provisions have to be created whether there is profit or loss while reserve is
created only when there is profit.

Check Your Progress B

I.
1. ................... is created to meet a known liability. (Provision)
2. ................... is built to meet a contingency. (Revenue reserves)
3. ................... is treated as a charge against profits. (Provision)
4. Transfer to ................... is an appropriation. (General reserve)
5. ................... is not affected by profit or loss of the enterprise. (Secret reserve)
6. ................... is made only when there are profits. (Reserve)
II. Write a short note on usage of “Securities Premium”, U/s 78
III. Prepare a list of possible capital profits.
IV.. What are managerial objectives for creating secret reserves, and how is it
created?
V. Distinguish between: Reserve and Reserve Fund
General Reserve Vs Specific Reserve.
142
 Understanding
4.4 CONCEPTS OF PROFITS Financial Statements

The main objective of this topic is to make students familiar with the various concepts
of profits which are used by the management as the basis for taking appropriate
decisions. A clear line of demakation between these terms will help to understand their
application for decision-making purposes.

4.4.1 Gross Profit

It is also known as gross margin. As per the provisions of Companies Act 1956,
Gross profit is ‘the excess of the proceeds of goods sold and services rendered during
a period over their cost, before taking into account administration, selling and
distribution and financing expenses”.
So the difference between the revenue (Sales) and cost of goods sold is the gross
profit. Normally, the profit and loss account is prepared in two parts– (1) Trading
Account and (2) Profit and Loss Account. Trading Account shows the “result” of
trading operation under normal conditions which represents “Gross Profit” or “Gross
Loss”. Revenue means the inflow from main business activity in which the enterprise
deals in whereas the cost of goods sold, in case of trading concerns, comprises
purchases (of goods in which concern deals in) and direct expenses incurred (such as
freight, octroi, duty etc) on or before purchases. However, in case of a manufacturing
concern, the cost of goods sold will include cost of materials consumed, wages and
other manufacturing expenses.
Modern practice of the whole corporate world is to present the information in a
summarized statement (called abridged profit and loss account) giving the details in
various schedules forming part of income statement.
Illustration 3
From the following details of ABC manufacturing company find the gross profit:
Rs.
Raw Material Purchased 12,00,000
Stock of raw material in the beginning 2,50,000
Productive wages 3,50,000
Carriage Inward 20,000
Freight and Octroi 60,000
Other manufacturing expenses 1,20,000
Stock of raw material at the end 2,40,000
Sales 18,75,000
Solution
ABC Company
Profit and Loss Account
For the year ended ....................
Particulars Schedule No. Rs. (in ‘000’)
Income:
Sales 1 1875
Other Income* (not related business) –
1875
Expenditure
Cost of goods sold 2 1760
Gross Profit 115
* Not to be considered for gross profit purposes. 143
Fundamentals of Schedule 1: Provides the details of sales: product-wise, segment-wise (Business
Accounting segment/Geographical segments) etc in India and outside India less returns inwards &
sales or trade discount.
Schedule 2:
Cost of goods sold: Rs.
Opening stock of raw material 2,50,000
Add: Purchases 12,00,000
14,50,000
Less: Closing Stock 2,40,000
Raw Material Consumed 12,10,000
Add: Direct expenses
Carriage Inward 20,000
Freight & Octroi 60,000
Productive wages 3,50,000
Other manufacturing expenses 1,20,000
Cost of goods produced (sold) 17,60,000
l Because there is no closing balance
l When there is opening and closing work in progress (semi-finished goods), then
along with the opening and closing stock of raw material, the work-in-progress
(semi-finished goods) will also be added and subtracted accordingly.
l However, if there is opening and closing stock of finished goods, this will also
form the part of inventory.
Illustration 4
In the above illustration, if the following balances also appear, findout the cost of
goods sold:
Rs.
Opening balance of work-in-progress 35,000
Opening balance of finished goods 1,25,000
Closing balance of work-in-progress 55,000
Closing balance of Finished goods 1,75,000
Solution
The following changes will be made in the Schedule 2:
Schedule 2: Cost of goods sold will be as follows
Inventory on 1st April...........
Raw Material 2,50,000
Semi-finished goods 35,000
Finished goods 1,25,000 4,10,000
Add: Purchases 12,00,000
Direct Expenses 5,50,000
21,60,000
Less: Inventory on 31st March
Raw Material 2,40,000
Semi-finished goods 55,000
Finished goods 1,75,000 4,70,000
Cost of Goods Sold 16,90,000
144
4.4.2 Operating Profit Understanding
Financial Statements
It refers to net profit arising from the main revenue producing activities of an
enterprise after accounting for operating expenses but before taking into account
expenses of financial nature and non-operating income. Operating expenses include
over and above the cost goods sold, such as:
l Factory overheads
l Administration Overheads (Office Over-Heads) and
l Selling and Distribution over-heads
In other words, when above mentioned operating expenses are subtracted from the
gross profit, the resultant figure is “operating profit” and if total operating expenses
exceed gross profit, the difference is treated as operating loss. Operating profit is the
measure of operating efficiency of the enterprise and it is referred as OPBIT
(Operating Profit before and Tax). When non-operating items are also considered, the
resultant figure is Profit Before Tax (PBT). Let us consider the following illustration:
Illustration 5
From the following information, calculate gross profit and OPBIT
Rs. (in ‘000’)
Sales (Gross) 2,075
Return Inwards 15
Return Inwards 60
Rent Received 25
Interest & Dividend on investments 35
Direct Expenses (Manufacturing) 375
Selling and Distribution expenses 75
Office and Administration Expenses 150
Purchases Less returns 850
Inventories (1.4.2002) 145
Inventories (31.03.2003) 165

Solution
Profit and Loss Account
For the year ended 31st March 2003
Particulars Schedule No. Rs. (in ‘000’)
Sales 1 2,060
Less Cost of goods sold 2 1,205
Gross Profit 855
Operating Expenses:
Office and Administration expenses 150
Selling and Distribution expenses 75
225
Operating Profit (OPBIT) 630

Schedule 1: Rs. (000)

Gross Sales 2,075
Less Returns 15
2,060

145
Fundamentals of Schedule 2:
Accounting
Inventories (1.4.2002) 145
Add: Purchases Less Returns 850
995
Add: Direct Expenses 375
1,370
Less: Inventories (31.03.2203) 165
Cost of goods sold 1,205

4.4.3 PBIT (Profit Before Interest and Tax)

It refers to net profit before deducting any amount of financing expenses and income
tax. other words when interest expense and tax liability are not accounted for while
calculating profit or loss of an enterprise, it is treated as PBIT. Interest expense includes:
Interest on debentures
Interest paid or public deposits accepted by a trading or manufacturing organisation
Interest on Loan from public
Interest on Loan from Banks, financial institution or from Government.
Cas packaging or credit from Banks.

PBIT = Operating Profit + Other Income

* PBT (Profit Before Tax)

PBT = PBIT – Interest
When interest expense is subtracted from ‘Profit Before Interest & Tax’ (PBIT) (or
total net earnings) before providing for any income tax thereon, it is called ‘Profit
before Tax’. This shows overall performance of an enterprise resulting from
operating, investing and financing activities. This is also termed as EBT (Earnings
before tax). Thus,
PBT = PBIT – Interest.

* Pat (Profit After Tax)

This refers to net profit after taxes, but before making nay appropriation during the
year. The net profit before tax (PBT) is adjusted for tax liability calculated at the
current rate of taxation. For various sources of incomes there are different rates. Such
as income from business is taxed at a flat rate of 35%, income from long-term capital
gains @ 20%. The tax so calculated will be enhanced by a surcharge of 5% for
assessment year 2003-2004 and 2.5% for 2004-2005 However, for foreign companies
the tax rate is 40%.

PAT = PBT – Provision for Taxation

It should be noted that income tax purposes the profits are recomputed for determining
tax liability by income tax authorities. The actual tax liability is determined only after
the assessment is completed. That’s why in the profit and loss account the amount of
tax so determined on the basis of net profit as disclosed by Profit and Loss Account is
transferred to ‘Provision for Taxation’. This provision is adjusted against the actual
tax liability. You might have already learnt more about provision for taxation under
Unit 3.

Illustration 6
From the above Illustration 5, calculate Gross Profit, Operation Profit, PBIT, PBT
146 and PAT
Solution Understanding
Financial Statements
Particulars Schedule No. Rs. (in ‘000)
Sales 1 2,060
Less cost of goods sold 2 1,205
Gross Profit 855
Operating Expenses:
Office and Administation expenses 150
Selling Distribution expenses 75
225
Operating Profit (OPBIT) 630
Add: Non Operating Incomes 60
Net profit before interest and tax (PBIT) 690
Less: Financial expenses (Non-operating) 60
Net profit before tax (PBT) 630
Less: Provision for Taxation 220.5
(630000 × 35%) 220.5
Profit After Tax (PAT)
409.5
Schedule 1:
Rs. (000)
Gross Sales 2,075
Less: Returns 15
2,060
Schedule 2:
Inventories (1.4.2002) 145
Add: Purchases Less Returns 850
995
Add: Direct Expenses 375
1,370
Less: Inventories (31.3.2003) 165
Cost of goods sold 1,205
Schedule 3:
Other Income (Non-operating):
Rent Received
Interest and Dividend 25
35
60

147
Fundamentals of 4.4.4 Cash Profit
Accounting
When all the non-cash charges which have been debited to Profit and Loss Account
are added back to net profit, the amount so arrived at is termed as cash profit. Non-
cash charges are those expenses in respect of which no payment is to be made to
outside parties. It includes
– Depreciation
– Discount on issue of shares & debentures written off
– Preliminary Expenses written off, etc.
It should be noted that ‘outstanding expenses’ are not treated as non-cash charges
because in respect of such expenses, the payment has to be made in the next
accounting year. Whereas cash does not flow-out in respect of depreciation and
discount on issue of shares or debentures. Preliminary expenses are the formation
expenses which have already been incurred in yester years, hence question of making
payment of such expenses does not arise. That’s why while calculating cash profit
such non-cas charges are added back to net profit. Suppose net profit of an enterprise
amounts to Rs. 15,30,000 after changing depreciation of Rs. 3,70,000 and writing off
of Rs. 15,000 preliminary expenses. The cash profit will be taken at Rs. 19,15,000.
(Rs. 15,30,000 + 3,70,000 + 15,000).
The concepts of Gross Profit, Operating Profit before interest and Tax, Operating
Profit before Tax and Operating Profit after Tax can be found out with the help of the
following format:
Operating Income Statement for the period ........
Gross Sales xxx
Less: Returns xxx
Net Sales xxx
Less: Cost of sales:
Material consumed xxx
Direct wages xxx
Manufacturing expenses xxx
Finished goods, etc. xxx xxx
Less: Closing stock xxx
Gross Profit xxx
Less: Operating expenses:
Office & Administrative expenses xxx
Selling ad Distribution expenses xxx xxx
Net Operating Profit (Opit) xxx
Add: Non-operating Incomes
Interest Received xxx
Dividend Received xxx
Rent Received, etc. xxx
Less: Non-operating expenses: xxx
Discousnt Allowed xxx
Interest on Debentures xxx
Interest on Borrowings, etc. xxx xxx
Net Profit Before Tax (PBT) xxx
Less: Provision for Income Tax xxx
148 Net Propfit After Tax (PAT) xxx
4.4.5 Profits Available to Equity Shareholders (Residual Profit) Understanding
Financial Statements
Residual profit is that portion of profit which is available for equity share holders. It
means the profit which the directors consider, should be distributed among equity
shareholders after making necessary adjustments as per the provisions of companies
Act. In normal course, profits are distributed as dividend only after meeting all
expenses, losses, depreciation (current & unabsorbed), fall in the amount of current
assets, taxation, past losses, preference dividend and transfer to sinking fund,
debenture redemption fund and to general reserve U/s 205 (2A). However, profit
arising out of revaluation of fixed assets and other profits of extra ordinary nature
(capital profits) are not included in the profits available for equity shareholders ads
dividend. It should be noted that the depreciation must be calculated as per the
provisions of the section 205 of the Companies Act 1956.
Illustration 7
You are given the following information:
Rs. (000)
PBIT 5,782
Depreciation charged as per Books 182
Depreciation as per Section 205 360
10% Preference Share Capital 1,500
Past Accumulated Losses 1,500
Transfer to Debenture Redemption Fund 1,200
Unabsorbed Depreciation as per section 205 560
Interest on Loans & Advances 252
Transfer to General Reserves 600
Calculate profit available for equity shareholders, presuming tax rate of 40%.
Solution
Rs. (000)
PBIT (as given) 5782
Less Interest 252
5530
Less provision for transfer @ 40% 2212
3318
Add Depreciation as per books 182
3500
Less Depreciation as per section 205 360
3140
Less Unabsorbed Depreciation 560
2580
Less Accumulated Past Losses 1200
1380
Less Transfers-Debenture Redemption Fund150 150
General Reserve 600 750
630
Less Preference Dividend 150
Profits available to equity shareholders 480

Check Your Progress C

1. Gross Profit is the result of two variables
(i) Turnover & (ii) ..................................
2. Turnover is the total of:
(i) Gross Profit & (ii) .................................. 149
Fundamentals of 3. Operating profit is equal to
Accounting (i) ..................... (ii) Operating expenses
5. Operating expenses include:
(i) .....................
(ii) .....................
(iii) .....................
6. Financial expenses are treated as .....................
7. When non-cash charges are added back to net profit the resultant is ....................
8. Non-cash charges include:
(i) ................................
(ii) ................................
(iii) ................................

4.5 CONCEPTS OF CAPITAL

There are certain key terms which are used in the process of analysis of financial
statements, to draw certain conclusions after judging the company’s networth,
liquidity, solvency and credit worthiness etc.

4.5.1 Capital Employed

The term capital employed has been defined as the finances deployed by an enterprise
in it’s fixed assets, investments and working capital. However, if the investments are
non-business or non-trading, the same may be excluded from the capital employed.
The capital employed can be worked out by two methods:
First Method: Capital Employed = Fixed assets (Less Depreciation)
+ Net working capital (Current Assets – Current Liabilities)
Since spare funds are used to buy government, semi-govt, or commercial securities the
same are treated as non-trading assets. Hence, such funds are not used for business
purposes. However, if such assets have to be acquired, these should be treated as trade
investments and should form part of capital employed.
Second Method: Capital employed can also be worked out and expressed as the total
sum of share capital (Preference & Equity both), reserves (accumulated till date) and
long-term liabilities (loans & debentures) as reduced by fictitious assets such as Debit
balance of profit and loss account, preliminary expenses, discount on issue of shares
and debentures and non-business assets.
It should be noted that certain intangible assets which have been generated over the
years and no payment has been made to acquire them, are not considered for the
purpose of determining capital employed. These intangible assets include goodwill,
patents, copyrights, trade marks etc.
Thus capital employed = Paid-up share capital (Preference & Equity) + Reserves +
Accumulated profits + Revaluation – Revaluation Loss-
Fictitious assets–intangibles (generated.)

Average Capital Employed

It is calculated by adding the capital employed in the beginning and at the end divided
by two. Alternatively, half of the current year’s profits may be added to the capital
employed in the beginning or subtracted from the capital employed at the end to arrive
at the figure of average capital employed which fairly represents capital employed
throughout the year.
Capital Employed at the beginning + Capital Employed at the end
150 Average capital employed =
2
 It should be remembered that when capital employed is calculated for the Understanding
purpose of determining the rate of net profit on capital employed then, Financial Statements
debentures and loans are excluded for the purpose of computing the capital
employed because net profit does not include interest on loans and debentures.

Illustration 8

From the following Balance Sheet, calculate capital employed under both the methods:
Liabilities Rs. Assets Rs.
9% 2500 preference shares of 2,50,000 Goodwill 50,000
Rs. 100 each
50,000 equity shares of Rs. 10 5,00,000 Fixed Assets 9,00,000
each
Reserve Fund 4,50,000 Investment in Govt. 1,00,000
Securities
10% Debentures 2,50,000 Current Assets 5,00,000
Provision for Taxation 50,000 Preliminary Expenses 50,000
Creditors 1,25,000 Discount on issue of 25,000
debentures
16,25,000 16,25,000
Fixed assets are valued at Rs. 9,25,000.

Solution
Computation of capital employed: (First Method)
Rs.
Fixed Assets (after revaluation) 9,25000
Current Assets 5,00,000
14,25,000
Less: Creditors 50,000
Provision for taxation 1,25,000 1,75,000
12,50,000
Alternatively: (Second Method)
Rs.
9% Preference Share Capital 2,50,000
Equity Share Capital 5,00,000
Reserve Fund 4,50,000
10% Debentures 2,50,000
14,50,000
Add: Revaluation Profit 25,000
14,75,000
Less: Goodwill 50,000
Investment 1,00,000
Preliminary Expense 50,000
Discount on issue of 25,000 2,25,000
shares & debentures
Capital Employed 12,50,000

4.5.2 Shareholders Funds

Shareholders funds are also referred as networth which is equal to the excess of total
assets (excluding fictitious) over the liabilities. This represents the amount belonging
to shareholders i.e. what amount the shareholders will be paid, had there been 151
liquidation of the company.
Fundamentals of Hence, shareholders funds = All assets (excluding fictitious) less liabilities (short-term
Accounting and long-term both)
or
Shareholders funds = Preference share capital + Equity share capital + Reserves +
Accumulated Profits (Capital/Revenue)–Fictitious assets– Assets which are worth less
+ revaluation profit - Revaluation loss.
Illustration 9
From the following information compute shareholders’ funds
11% Preference Share Capital 3,00,000 Goodwill 2,50,000
Equity Share Capital 7,00,000 Fixed Assets 10,00,000
Reserves (Revenue) 1,50,000 Investments 2,50,000
Capital Reserves 75,000 Current Assets 3,75,000
Securities Premium 1,25,000 Preliminary Expenses 80,000
9% Debentures 5,00,000 Discount on debentures 45,000
Current Liabilities 1,50,000
20,00,000 20,00,000
Fixed assets include Rs. 40000 for patents which are considered useless and freehold
premises which is valued Rs. 75000 more than its bookvalue. Goodwill is to be valued
at Rs. 2,20,000.
Solution
Computation of Shareholders’ Funds
First Method
Rs.
Goodwill 2,50,000
Fixed Assets 10,00,000
Investments 2,50,000
Current Assets 3,75,000
18,75,000
Less: 9% Debentures 5,00,000
Current Liabilities 1,50,000
Revaluation Loss:
Patents 40,000
Goodwill 30,000 7,20,000
11,55,000
Add: Revaluation Profit (Freehold premises) 75,000
Shareholders’ Funds 12,30,000

Second Method: Shareholders’ Funds may also be computed as follows:

Rs.
Pref. Share Capital 3,00,000
Equity Share Capital 7,00,000
Revenue Reserve 1,50,000
Capital Reserve 75,000
Securities Premium 1,25,000
13,50,000
Less: Preliminary Expenses 80,000
Disc. On debentures 45,000
Revaluation Loss (Patent Rs. 40,000 + 70,000 1,95,000
Goodwill Rs. 30,000) 11,55,000
Add: Revaluation Profit (Freehold premises) 75,000
152 Shareholders’ Funds 12,30,000
4.5.3 Shareholders Understanding
Financial Statements
It is the interest of equity shareholders in the net assets of the company. However, in
case of liquidation it is represented by the residual assets meeting prior claims. If the
claims of the preference shareholders are subtracted from the shareholders’ funds the
remaining balance is termed as equity shareholders’ equity.
Shareholders’ Equity = Shareholders’ Funds – Preference Shareholders claim
In the above example, equity shareholders’ equity will be Rs. 9,30,000
(Rs. 12,30,000-3,00,000). That is shareholders funds less preferences share capital,
if the preference shares are participating i.e. they are entitled to share surplus assets
after meting the claims, then such share of preference shareholders will also be
subtracted from the shareholders’ funds.
It is to be noted that “Shareholders’ Equity” includes preference share capital
also as against the “Equity Shareholders’ equity” which expressly excludes
preference share capital and other claim thereof.

4.5.4 Debt Funds

Debt Funds are represented by outside liabilities. It is also known as “external
equities”. It consists of short-term as well as long-term liabilities. Debt funds are in
the form of debentures, loans and borrowings, and current liabilities such as creditors,
bills payable, bank overdraft and short term bank credit. By and large these current
liabilities are always available year after year on a permanent basis, thus become a
part of debt funds.
However, there is no unanimity or consensus on this point. Some authors do not treat
current liabilities as a part of debt funds, especially for the purpose of calculating
debt-equity ratio because of the following reasons:
i) Currnet liabilities are of a short-term nature and the liquidity ratios are
calculated to judge the ability of the firm to honour current obligations.
ii) Current liabilities vary from time to time within a year and interest thereon has
no relationship with the book value of current liabilities.
The reasons for taking both short-term and long-term debts are as follows:
i) When a firm has an obligation, no matter whether it is of short-term or long-term
nature, it should be taken into account to evaluate the risk of the firm.
ii) Just as long-term loans have a cost, short-term loans do also have a cost.
iii) As a matter of fact, the pressure from the short-term creditors is often greater
than that of long-term loans.

4.5.5 Net-working Capital Employed

Net working capital implies to the “funds available for conducting day-to-day
operations of an enterprise”. It can also be referred as excess of current assets over
current liabilities. Hence working capital is the results of two variables viz current
assets and current liabilities. A change in the amount of either of two variables brings
about a change in the amount of working capital employed.
Net working capital employed = current assets–current liabilities.
Current assets refer to “cash and other assets which are expected to be converted into
cash or consumed in the production of goods or rendering of services in the normal
course of business. This includes stock, debtors, bill receivable, short-term trade
investment or marketable securities & pre-paid expenses etc.
153
Fundamentals of Current Liabilities are those liabilities which have to be paid within a normal course
Accounting of business (within a year). It includes creditors, bills payable, Bank-overdraft, short-
term loans, outstanding expenses of other liabilities which fall due for payment in a
relatively short period, not more than twelve months.
An enterprise should employ enough working capital so that it can meet its current
obligations to keep the enterprise on the margin of safety. However, tis margin of
safety should not be big enough that the most of the funds remain idle. Otherwise the
company cannot make optimum use of the funds employed. The ideal amount of net
working capital to be employed, according to traditional belief, should be equal to
current liabilities i.e. current assets should be double of the amount of current
liabilities so that company enjoys better liquidity position and does not become
technical insolvent.

4.6 USES OF FINANCIAL STATEMENTS

The financial statements are useful in many ways in the process of decision making.
They are the basis of decision making for its users, namely management, investors,
creditors, government authorities, etc. Let us now discuss the usefulness of financial
statements.

1) Economic Decision-making
Sound economic decisions (of external users) require assessment of impact of current
business activities and development on the earning power of the company. Information
about economic resources and obligations of a business enterprise is needed to form
judgement about the ability of the enterprise to survive, to adopt, to grow, to prosper
amid changing economic conditions. In this process, the financial statements provide
information that is important in evaluating the strength and weaknesses of the
enterprise and its ability to meet it’s commitments.

2) Investors Decisions
Adequate disclosure in the financial statements in expected to have favourable effect
on security process of the company. An informed investor is always in a position to
take appropriate and timely decision on investment or disinvestment. Financial
statements and annual reports provide necessary information regarding profitability,
dividend policy, net worth, intrinsic value of shares. Earnings per share (EPS) to
assess future prospects to substantiate their investment decisions. The group is not
only interested in present health of the enterprise but the future fitness as well.
Bankers & financial institutions and foreign institutional investors are always worried
about the future solvency of the invested firms.

3). Employees’ Decisions

Employees’ decisions are usually based on perceptions of a company’s economic
status acquired through financial statements. Employees and their trade unions use the
financial statements to assess risk and growth potential of a company, which helps
settle industrial disputes, avert lockout & strike or likewise situation arise form
demand for wage hike, bonus, higher compensation, more fringe benefits, better
working conditions and so on. Labour unions and individual employees use financial
statements as the basis for collective bargaining and settlement. Tis develops sense of
belongingness among the workers for they know that their interest is not being
jeopardised.

154
4) Creditors and Financiers Understanding
Financial Statements
Short-term creditors make use of the financial statements mainly to ascertain the
ability of the firm to pay its current liabilities one time and the value of stock
and other asset which can be accepted as security against credits granted.
Long-term creditors and financiers are more concerned about the firm’s
ability to repay the principal amount as and when due. From the financial data
provided by the periodic statements, it is possible to make projections about the
generation of funds and cash flows, which may assure the safety of investment in
debentures and loans.

5) Customers’ Public and Competitiors’ Decisions

Customers and the public in general may use financial statements to predict and
forecast future prospect of the company. This information may be important in
estimating the value of warranty or in predicting the availability of supporting services
or continuing supplies of goods over an extended period of time. Likewise,
competitors may analyse financial statements (from competition point of view) to
judge the ability of competitor to withstand competition and it’s absorbing capacity.

6) Managerial Decisions
Published account and reports forming part of financial statements may have
economic effects through it’s impact on the behaviour of the managers of corporate
enterprises. Financial statements provide necessary information base for taking all
managerial decisions. In the absence of accounting information neither the objectives
of the enterprise can be laid down nor measurement and evaluation of performance is
possible nor corrective measures can be taken. Managerial tools such as production
budget, sales budget, cash budget, capital budget, and master budget etc. are all the
offspring of financial statements. Similarly, wage policy, price policy, credit policy,
recruitment policy and other policy matters are decided after careful analysis of
financial statements.

7) Government and it’s Agencies

Government Agencies include taxation authorities and regulatory bodies such as
Ministry of Trade & Commerce, Company Law Board, Registrar of Joint Stock
Companies, Securities Exchange Board of India (SEBI). These agencies require
information for policy decisions purposes. It may be a fiscal policy of Central Board
of Direct Taxes (CBDT) or a regulatory policy of company law board and so on, they
all require financial statements for policy formulation purposes.

8) Others
The financial statements are also useful to stock exchange, brokers, underwriters,
press and the public in general. Though Their interest and goals being altogether
different in nature, yet they require accounting information in the form of financial
statements to serve their own ends. For example researchers may provide some
startling facts and findings which may be used by Government to set its economic
policy, by regulatory agencies to take regulatory measures and by management to
review its own policies and by the public (NGO’s) for social reporting purposes.
Social reporting aims at measuring adverse and beneficial effects of an enterprise
activities both on the company and those affected by the firm; it measures social costs
and the related benefits thereof.

155
Fundamentals of
Accounting 4.7 LIMITATION OF FINANCIAL STATEMENTS
Despite the fact that financial statements are the back-bones of the decision-making
process for different levels of executives in an organisation, financial analysts and
advisors and other interested persons, these suffer from certain limitations because the
facts and figures which are reported may not be precise, exact and final. Again some
aspects which may be crucial for decision-making purposes may go unreported.

1) Periodic nature of statements: The profit or loss arrived at in the Profit and Loss
Account is for a specified period. It does not give any idea about the earning capacity
over time. Similarly, the financial position as at the date of Balance Seet is true of that
point of time. The likely change in position on a future date is not depicted. Liabilities
which were dependent on future events (contingent liabilities) are estimated and shown
in the Balance Sheet. They are not accurate figures. Similarly, revenue expenditure is
sometimes partly charged to Profit and Loss Account and partly deferred or carried
forward. The proportion which is deferred and shown on the asset side of Balance
Sheet is based on convenience and depends on the level of earnings relatively to the
expenditure. In all these respects the annual statements do not reveal the exact earning
capacity or financial state of affairs.
2) The statements are not realistic: Financial statements are prepared on the basis
of certain accounting concepts and conventions. As a result, the financial position
depicted in the statements cannot be considered realistic. For example, fixed assets are
required to be shown on the basis of their value to the business as represented by their
acquisition price less depreciation, not as per the estimated resale price. Also, the
Profit and Loss Account invariably includes probable losses but does not include
probable income. This is according to the accounting convention of conservation.
3) Lack of objectivity due to personal judgement: Values assigned to many items
are determined on the basis of the personal judgement of accountants. Hence, relevant
amounts shown in the financial statements have no objectivity and they are not
varifiable. For instance, estimates of the life of fixed assets and the method of
depreciation to be used are based on the personal judgement of accountants. So is the
case with valuation of inventories (stock) of materials, work in progress, stores and
spare parts, etc. The method of valuation to be adopted depends on the poilicy at the
discretion of management based on their judgement.
4) Only financial matters are reported: The financial statements present
information in terms of monetary units. There is no information relating to the non-
monetary aspects of business operations. Facts which cannot be depicted in money
terms are excluded from the statements. Thus, information relating to the development
of skill and efficiency of employees, the reputation of management, public image of
the firm, and such matters do not find a place in the financial statements. Yet these are
very relevant for investors to consider while forming any opinion about the future
prospects of the firm.

5) No Suggestive Approach: Financial Statements disclose information about the

past (historical) i.e. what has happened? But it does not disclose why and how it
happened. If a company makes profits or incurs losses, the financial statements will
show only the amount of profits or losses made but fails to divulge any details as to
why there is an increase or decrease in profits or losses.

6) Subjective Approach of the Management: Financial performance (profitability)

cannot be taken as the only indicator of managerial performance. The profit figures, to
a greater extent, are affected by managerial policy of charging depreciation, writing
off fictitious assets, amortisation of intangible assets, allocation of advertisement cost,
156
valuation of stock etc. Likewise, objectivity factor is lost while preparing financial Understanding
statements to depict the financial position of the concern. Further application of Financial Statements
certain concepts and conventions does not allow to show the assets at the true current
values (cost concept). The assets shown in the Balance Sheet reflect unexpired cost
(W.D.V.) However, liabilities are shown at the same figures thereby distrorting the
solvency position of the enterprise. Likewise, the accounting year may be chosen after
due thought so that financial statements can send the desired signals to outside
interested parties.

7) Conflicting Principles: According to Principle of conservatism stock may be

valued at cost or market price whichever is less. This implies that current assets are
shown at cost in one year and at marker price the other year. It shows clear violation
of principle of consistency. Similarly the change of method of charging depreciation
from straight line method to written down value method and vice versa highlights
contradiction in application of accounting principles. Again, because of flexibility of
accounting principles, certain liabilities are not provided for, such as no provision for
gratuity payment is made. This is bound to give distorted picture of the financial
statements.

8) Figures are not-self explanatory: How far the financial statements are useful
depends upon the ability of the users to analyse and interpret accounting data for their
decision making purposes. Truly accounting is the language of the business but
financial statements do not speak themselves, you need certain expertise and tools to
make them speak. Every user is not competent to draw conclusions from these
statements. Even audited financial statements do not provide a complete and total
guarantee of accuracy.

Check Your Progress D

1. Fill in the blanks:
(a) Final accounts of a company are prepared according to ............. Companies
Act ...........
(b) Excess of current assets over current liabilities is called .................
(c) Shareholders’ funds comprise of ................ and .................
(d) Liquidity is the ability of the company to meet ................
(e) Net worth of the company is equal to ................
(f) ................ are show by means of footnote under the Balance Sheet.

4.8 LET US SUM UP

The financial statements are presented either in horizontal or vertical form. The
present practice of the corporate enterprises is to present their annual accounts in
vertical form which has now become a modern practice. Under vertical form, in case
of Balance Sheet, the liabilities are shown under the heading “Sources of Funds” and
the assets are shown under the heading “Application of Funds”. A summarised profit
and loss account is prepared to know the profit or loss and the details of the items are
shown separately in the form of annexures.
The concepts of “Reserves” and “Provisions” have its own significance in the
preparation of financial statements. The portion of earning whether capital or revenue
appropriated by management for a general or specific purpose is known as reserve. A
reserve may be a revenue reserve or capital reserve. A revenue reserve may be either a
general reserve or specific reserve. General reserve is created to meet a contingent
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Fundamentals of liability. A specific reserve is created for a specific purpose. It may be created to
Accounting maintain a stable rate of dividend or to meet redumption of debentures, etc. A reserve
which is not created out of ‘divisible profits’ is called ‘capital reserve’ and is generally
created out of capital profits. Capital profits are not available for distribution as
dividends. A reserve which is not disclosed in the Balance Sheet is called as ‘secret
reserve’. Secret reserves may arise on account of permanent appreciation in the value
of assets or permanent diminution in the value of a liability which is not
accounted for in the books of accounts. A provision may be created either
against the loss (fall) in the value of assets in the normal course of business
operation or against a known liability the amount of which cannot be determined
accurately but is estimated only.
Gross profit is the difference between the revenue (sales) and cost of goods sold. If we
deduct operating expenses from the gross profit, the resultant figure is ‘operating
profit’. When interest expense and tax liability are not accounted for while calculating
profit or loss, of an enterprise, it is treated as ‘Profit before Interest and Tax’ (PBIT).
When interest expense is subtracted from PBIT before providing any income tax, the
resultant figure refers to PBT. PAT refers to net profit after taxes. When all non-cash
charges which have been debited to Profit and Loss account are added back to net
profit, the amount so arrived at is termed as ‘cash profit. There are certain key
concepts which are used in the process of analysing financial statements. These
concepts are: capital employed, shareholders’ funds, equity shareholders’ equity, debt
fund and net working capital.
The financial decisions are useful in many ways in the process of decision-making.
These statements are the basis for decision making for its users, e.g. management,
investors, creditors, government authorities, etc. They help us in evaluating the
strength and weaknesses of the enterprise and investment decisions. Inpsite of its uses,
these statements are subject to certain limitations because the facts and figures which
are reported may not be precise, exact and final. Further, some aspects which are
crucial for decision making may go unreported.

4.9 KEY WORDS

Vertical form of Balance Sheet: A statement prepared under single column divided in
two sections, viz. ‘Sources of Funds’ and ‘Application of Funds’.
Vertical form of Profit and Loss Account: A summarised profit and loss account
prepared in vertical form and details of the items are shown separately in the form of
annexures.
Residual Profit: Net profit available for equity shareholders.
Secret Reserve: A reserve which is not disclosed in the Balance Sheet which may
arise on account of a permanent appreciation in the value of assets or a permanent
diminuation in the value of a liability.
Gross Profit: The difference between net sales and cost of goods sold.
Operating Profit: Gross profit minus operating expenses.
Cash Profit: The amount which is arrived at by adding back to net profits those non-
cash charges which have been debited to the profit and loss account.
Capital Employed: Long-term funds including owners’ capital and borrowed capital.
Net Working Capital: Excess of current assets over current liabilities.

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 Understanding
4.10 ANSWERS TO CHECK YOUR PROGRESS Financial Statements

A. 1 (a) Reserves and surplus, (b) Miscellaneous expenditure, (c) Fixed assets,
(d) Current liabilities and provisions, (e) Current liabilities and provisions,
(f) Contingent liability, (g) Reserves and surplus, (h) Current assets,
(i) Loans and advances or a deduction from liability for tax, (j) Reserves and
surplus.
B. 1. Provision, 2. Revenue reserves, 3. Provision, 4. General reserve, 5. Secret
reserve, 6. Reserve.
C. 1. Cost of goods sold, 2. Cost of goods sold.
4. Gross profit, 5(i) Factory overheads, (ii) Office and administrative
overheads, (iii) Selling and distribution overheads, 6. Non-operating
expenses, 7. Cash profit, 8(i) Depreciation, (ii) Discount on issue of shares
and debentures written off, (iii) Preliminary expenses written off.
D. 1 (a) Schedule VI, 1956, (b) Net working capital, (c) Share capital, reserves
and surplus, (d) Debts, (e) Excess of total assets over the liabilities,
(f) Contingent liabilities.

4.11 TERMINAL QUESTIONS

1) Write notes on:
a) Horizontal presentation of Balance Sheet, and
b) Vertical presentation of Balance Sheet.
2) “Balance Sheet is a statement of assets and liabilities or sources and uses of
capital or both”. Comment.
3) What are the financial statements? How far are they useful for decision-making
purposes?
4) Write a note on nature and limitations of financial statements.
5) Z Ltd. made a loss of Rs. 50,000 after providing depreciation of Rs. 1,00,000 in
2002. In 2003 the company earned a profit of Rs. 3,00,000 before charging
depreciation of Rs. 75,000.
b) Also find out cash profit for the year 2002 and 2003.
(Ans: (a) Rs. 1,25,000 (b) Rs. 50,000 and Rs. 3,00,000)
6) From the following calculate Gross Profit, operating profit, Profit before tax
(PBT) and Profit after Tax (PAT). The balance of profit standing to the credit of
Profit and Loss Account after making following adjustments Rs. 61,000.
Rs.
Depreciation 85000
Proposed Dividend 1,50,000
General Reserves 45,000
Dividend Received 10,000
Loss on sale of fixed assets 23,000
Indirect Business Expenses 3,05,000
However, Income tax @ 50% has not been provided for.
(Ans: Gross Profit : Rs. 6,53,000
Net Profit : Rs. 2,50,000 (PBT) & Rs. 1,25,000 (PAT)
Operating Profit : Rs. 2,40,000)

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Fundamentals of 7) Explain the purpose and procedure of calculating the following:
Accounting
1) Gross Profit
ii) Operating Profit
iii) PBIT
iv) PAT
8) An inexperienced accountant has prepared the balance sheet of ABC Ltd. as
follows:
Balance Sheet of ABC Limited
Liabilities Rs. Assets Rs.
Trade Creditors 80900 Stock:
Advances from Customers 42,260 In hand 3,60,480
Share Capital 8,00,000 With Agents 24,300
Profit & Loss A/c 45,630 Cash in hand 23,540
Provision for Taxes 95,000 Investments 20,000
Proposed Dividend 59,000 Fixed Assets:
Loan to Managing Director 5,000 Land 1,80,000
General Reserve 75,000 Plant and Machinery
Development Rebate Reserve 30,000 (W.D.V.) 4,10,000
Provision for Contingencies 23,000 Debtors 2,15,450
Share Premium A/c 22,000 Less: Provision
Forfeited Shares 3,000 for B/D 9,300
2,06,150
Bills Receivable 5,000
Amount due from Agents 51,320
12,80,790 12,80,790

Redraft the above Balance Sheet in the vertical form prescribed by Indian Companies
Act, 1956 giving necessary details yourself.
9) From the following prepare a Balance Sheet in vertical form as on 31st
March 2003
Sundry Debtors 612500
Profit & Loss A/c (Dr.) Current year 150000
Miscellaneous Expenses 29000
Investments 112600
Loose Tools 25000
Securities Premium 237500
Securities Premium 85000
Advances to staff 27500
Cash & Bank Balances 137500
Advances 186000
S. Creditors 572500
Term Loan 500000
Capital work-in-progress 100000
General Reserve 1025000
Finished Goods 375000
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 Gross Block (NDR) 2575000 Understanding
Financial Statements
Stores 200000
Provision for doubtful debts 10100
Loans from Customers 100000
Share Capital: Equity Shares 150000
10% Preference Shares 500000

Additional Information:
(1) Terms Loans are secured (2) Depreciation on fixed assets Rs. 2,50,000
10) From the following particulars prepare profit and loss account for the year ended
31st March 2003 and a Balance Sheet as on that data in vertical form. The
company has a authorised capital of Rs. 50,00,000 divided in to 2,50,000 equity
of Rs. 10 each and 2,50,000 10% preference shares of Rs. 10 each.

Debit Balances Rs. (000) Credit Balances Rs. (000)

Materials Purchased 1233 4% debentures 500
Furniture & Fittings 150 Equity Share Capital 1500
Stock (1.4.2002) 665 10% Preference Share Capital 500
Discounts & Rebates 30 Bank overdraft 757
Patents 375 S. Creditors 240
Carriage Inwards 57 Sales 3617
Rent, Rates & Insurance 55 Transfer Fees 7
Wages 1305 Rent Received 30
Coal & Coke 63 Profit & Loss A/c (1.4.02) 67
Bank Balance 20
Cash in Hand 8
Debenture Interest (for 6 month) 10
Bank Interest 91
Preliminary Expenses 10
Calls-in-Arrears 10
Freehold Premises 1250
Plant & Machinery 750
Tools & Equipment 150
Goodwill 375
S. Debtors 266
Bills Receivable 134
Advertisement 15
Commission & Brokerage 68
Business Expenses 56
Repairs 47
Bad Debts 25
7218 7218

Additional Information:
The closing stock was valued at Rs. 712000. Outstanding liabilities for wages Rs.
25,000 and for business expenses Rs. 25,000 Charge depreciation on:
Plant and Machinery @ 5%
Tools and Equipments @ 20%
Patents @ 10%
Furniture & Fixtures @ 10%
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Fundamentals of Provide 2% on debtors for doubtful debts after writing off Rs. 16,000 as bed debts.
Accounting Write off preliminary expenses Rs. 5000. Transfer Rs. 50,000 to debenture
Redemption Fund. A dividend of 10% was declared. Corporate Income tax @ 5-% is
to be provided. Ignore dividend tax.

Hints
1. Provision for Bad debts (Debtors-Additional Bad debts) 2% on (Rs. 2,66,000-
16000) = 5000
2. Dividend @ 10 % on paid up capital:
Preference : 50000
& on Equity Capital @ 10% :
(Rs. 150000-1000) 149000
199000
3. Add amount of Outstanding expenses to their respective heads
4. Balance of profit and loss account after appropriation: Rs. 38,000
5. Outstanding debenture interest for six months: Rs. 10,000

(Ans: Net Profit Rs. 2,20,000 (after tax))

4.12 SUGGESTED READINGS

1. Report of the study group on the “Objectives of Financial Statements” AICPA,
1973
2. ‘Accounting for Financial Statements Presentation’ by Smith & Keith.
3. Financial Accounting “A Simplified Approach” by Dr. Naseem Ahmed–Atlantic
Publishers & Distributors 2002, Darya Ganj, New Delhi.

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